What went wrong at MF Global

Here is a nice quick summary of what went wrong: CNBC video (short, sweet, and to the point.)

It's the same old song. Big financial firm makes a big bet. Information flows relating to probable payoffs suddenly signal higher risk. Rating agencies move in to downgrade firm's liabilities. A "run" ensues (widespread redemptions) leading to...a liquidity event? or a solvency event? (only time will tell, I suppose.)

Why does MF Global matter? One reason is that the institution was added to the Fed's list of 22 primary dealer banks just 8 months ago. See WSJ article below.

Fed Takes Collateral Damage in MF Global Meltdown

WSJ Tue, 1 Nov 2011 698 words

By Min Zeng November 1, 2011, 10:16 AM ET The Federal Reserve is among those feeling the pinch from the collapse of MF Global Holdings Ltd., which only eight months ago was added to the Fed’s list of 22 primary dealer banks. MF Global’s spectacular downfall seems unlikely to pose a systemic financial risk to either the U.S. economy or the Fed, in sharp contrast to the fallout from Lehman Brothers in 2008. But it’s possible it will make the selection procedure tougher for primary dealers, an elite group of institutions with which the New York Fed conducts monetary policy and which are obligated to participate in U.S. Treasury debt auctions. MF Global’s fortunes quickly went downhill over the past week amid concerns over its exposure to the euro zone’s sovereign debt. In this way, its travails underscore the potential contagion risks to the U.S. financial system via the primary dealer network. Besides MF Global, several primary dealers are owned by big European banks, including France’s BNP Paribas SA and Societe Generale SA, whose shares sold off in September due to concerns about their exposure to debts in Greece and other heavily indebted euro-zone sovereigns. “At the very least these applications will undergo a much more stringent vetting procedure,” said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “The lesson of history after these sudden financial bankruptcies is that regulators come down harder than ever. They don’t want to see another MF Global again on their watch.” The Fed may need to increase the standards of its scenario analysis when determining the balance-sheet strength of the primary dealers, said Adrian K. Miller, senior fixed income strategist at Miller Tabak Roberts Securities LLC in New York. A spokesman from the New York Fed declined to comment Monday afternoon. The Fed had already tightened conditions for selecting dealers. The latest revision came in January 2010, which included an increase in capital requirements from $50 million to $150 million. On that basis, some believe the Fed can’t be faulted for having one of its dealers go bankrupt. “No one can hold the Fed responsible for the risk of the firm,” said Michael Franzese, head of Treasury trading at Wunderlich Securities in New York. “You try and put adequate procedures in place so it doesn’t happen but you have to trust people to do the right thing.” Firms that have been seeking to join the primary dealer list include Toronto-Dominion Bank, the second-largest bank in Canada, and CRT Capital, a Connecticut-based broker dealer. Membership has proven profitable at time when Treasury volumes have increased and demand for Treasury bonds has been fueled by the more conservative strategies of investors spooked by the euro-zone crisis and by the Fed’s support for the market. After naming MF Global and Societe Generale to the list in February, earlier this month the Fed added BMO Capital Markets Corp. and Bank of Nova Scotia, both of Canada, boosting the dealer number to 22. Now, with MF Global’s exit leaving a space open, other prospective dealers could campaign for entry, knowing that the central bank needs an enlarged pool to facilitate the giant bond transactions it undertakes to channel monetary stimulus into the economy, according to market analysts. The Fed at the start of this month launched “Operation Twist” — a $400 billion operation to run until mid-2012 through which it will sell short-dated Treasurys and buy those with maturities of between six years and 30 years. Those transactions will be carried out via primary dealers. Primary dealers will also be needed once the Fed starts to withdraw the cash it pumped into the banking system over the past few years, a strategy that has swollen the central bank’s balance sheet to beyond $2 trillion from less than $900 billion shortly before the 2008 financial crisis. The Treasury Department has an interest in sustaining a large membership list for primary dealers, too. It needs these institutions to underwrite government bond sales as it continues to announce giant auctions to fund the fiscal deficit. If the auctions don’t go smoothly, the Treasury’s borrowing costs will rise.

The slogans stop here

Tom Sargent finally speaks out; see here: The Slogans Stop Here.

In a telephone interview last week, Professor Sargent said he felt insulted by people who called him "non-Keynesian" or "right wing," terms that, he said, are based on a misunderstanding of his thinking. And he rejected attempts to categorize his views in simple slogans.  
...
Fundamentally, he said, "What I really don't like is oversimplification." He tries to think things through, he said, and avoid having "one slogan fighting another."

I like this guy. He should start a blog. I've got the perfect name: Conscience of a Scientist. 

What Happens If Europe Crushes the Swap Market?

An interesting piece here by John Carney: What Happens if Europe Crushes the Swap Market?

An excerpt:

Many European politicians probably wouldn't mind killing the CDS market. From their point of view, the CDS market has been an unmitigated evil, allowing speculators to profit from the debt burdens of Europe's peoples. Even worse, because the bond market appears to react to widening credit spreads by pushing down the value of sovereign bonds, it appears to make government borrowing more expensive.

Some of Europe's leaders believe the CDS market is manipulated by hedge funds.

But the European leaders misunderstand the CDS market and its relationship to the bond market. The CDS market serves two important purposes: It's both a hedge for investors and an indicator of how risky the market thinks certain bonds are. Many investors are able to buy more of a country's bonds because they can reduce their risk by purchasing swaps that pay off in a default. And the price of the swaps is an indicator—albeit not always a reliable one—of the riskiness of the underlying bonds. In short, the CDS market provides liquidity and transparency to the bond market.

Take away that liquidity and transparency and governments will likely find that lenders are less likely to extend credit. With fewer opportunities to hedge, and prices based on less information, fewer investors will be willing to buy. That would mean selling bonds that have already been issued and staying out of new issues, which would ultimately push up the cost of government borrowing.

The rise and fall of Bitcoin

Apparently, it's not so easy setting up a competing currency with a stable value. Bitcoin seems to be having a hard time as of late, losing more than 90% of its value since it's June peak; see here (h/t Fernando Martin). It will be interesting to see how the Bitcoin issuers respond to these challenges.

P.S. Steve Williamson provides a nice economic summary of bitcoin here. 

The great sectoral shock of 2006

There's a lot to disagree about when it comes to understanding the great recession and subsequent slow recovery. But at least one thing seems clear: the U.S. real estate sector has played, and continues to play, a significant role in the ongoing saga.

In this post I want to talk about an old theme: the idea that a shock in one sector of the economy can reverberate throughout the entire economy. This theme was highlighted by John Long and Charles Plosser in their classic paper Real Business Cycles (JPE 1983). But it was a view that really never gained much traction. The one-sector neoclassical growth model was, and continues to be, the preferred basic framework of modern macroeconomic analysis.

The fact that most economic sectors tend to expand and contract together has something to do with the willingness to approximate the economy as consisting of one sector. But in doing so, one is then led to search for explanations in terms of hypothetical "aggregate demand" and "aggregate supply" shocks. And so we hear today that the slow recovery is attributable to "deficient demand," and that this explanation is borne out by the survey responses of businessmen who report that their main problem is a lack of product demand. (I have spoken about the pitfalls of this interpretation here.)

In any case, what I want to talk about here is the work of my colleague Juan Sanchez (with Constanza Liborio) about the role of the construction sector in the great recession. Let's start off with a look at U.S. construction sector data over the period 2005-2010.

Construction sector GDP (value-added), gross output, and employment are all normalized to 100 in the year 2006. All variables decline by about 30% over the next four years. Note that the U.S. economy officially went into recession in December 2007. The decline in the construction sector occurred over a year before that.

The Direct Effect

Construction sector employment at it's peak in 2006:Q1 was 7,651,000 workers. By 2010:Q4, employment in this sector shrank to 5,505,000 workers; a decline of 28.1% (2,146,000 workers).

Total employment in 2006:Q1 was 135,401,000 workers. By 2010:Q4, total employment fell to 130,128,000 workers; a decline of 3.9% (5,273,000 workers). 

Consequently, 40.7% of the decline in total employment over this period of time is directly attributable to the employment losses experienced in the construction sector. 

This sounds like a big number--and it is. But there is reason to believe that it is, in fact, just a lower bound. That's because this direct effect is likely to have implications for product demand in other sectors that supply the construction industry. 

Indirect Effects

The following data shows the share of a sector's output used in the construction sector (for the year 2006). 

The way to read this graph is as follows. In 2006, roughly 3% of what was produced by the U.S. mining sector was used as an intermediate input in the U.S. construction sector; and so on. According to this data, Both manufacturing and retail depend heavily on product demand generated by construction.

Quiz: A business manager at the local Home Depot (retail sector) reports that her regular customers in the construction sector have scaled back their purchases. She would like to hire more workers but the problem, she explains, is a "lack of demand" for her store's product. It follows immediately and conclusively that the problem with the U.S. economy is "deficient demand" and that government stimulus is needed. Answer true/false/uncertain; and explain.

Input-Output Analysis

To get a rough sense of how the collapse of the construction sector may have spilled over into the rest of the economy via the intersectoral linkages described above, Juan uses the BEA input-output tables to construct a simple model.

To be conservative, he applies the actual decline of output in the construction sector from 2006-2007 (average of these two years) to 2009. Evidently, the effect will be larger if one considers the change from 2006 to 2010.

The result of this simple simulation exercise suggests that the collapse of the construction sector accounts for 46.4% of the decline in U.S. GDP and 51.9% of the decline in total employment (roughly 3.4 million jobs).

The following bar graph summarizes his results.

Juan uses the same model to ask how much of the expansion during 2002-2006 was attributable to construction. His analysis suggests that construction played a much smaller role in the expansion, accounting for only 7.4% of the increase in GDP over this period.

Conclusion

The rosy expectations that drove residential investment prior to the recession turned out to be overly optimistic. The "overbuild" in residential capital needs time to work off, through depreciation and population growth. The adjustments taking place in this sector will take time. To the extent that other sectors are tied to the fortunes of the construction sector, economic activity throughout the economy is likely to remain relatively depressed. What can or should be done about this remains an open question.

PS. If you would like to contact Juan to learn what he did in greater detail, send him a message here: sanchez@stls.frb.org

Wall street protesters (a bit of irony)

This one is just too good not to share...

Oh, and heck, speaking of irony, here's another one...

Have a nice weekend!

P.S. I am also reminded of this classic scene from the Life of Brian: What Have the Romans Ever Done for Us?

The St. Louis Fed Financial Stress Index

My colleague Kevin Kliesen (and his coauthor, Doug Smith) have recently introduced a new financial market stress index; see Measuring Financial Market Stress. Here's a link to the Appendix, which describes its construction and the data series used: appendix. A brief description:

The St. Louis Fed’s Financial Stress Index is constructed using principal components analysis. Briefly, principal components analysis is a statistical method of extracting factors responsible for the comovement of a group of variables. We assume that financial stress is the primary factor influencing this comovement, and by extracting this factor (the first principal component) we are able to create an index with a useful economic interpretation. We construct the STLFSI using 18 weekly data series beginning December 31, 1993.  Prior to the principal components analysis, each of the data series are de-meaned and then divided by their respective sample standard deviations.

The index is available on FRED here. Let me reproduce some of this data here. Here is what the FSI looks like since December 2009.

Stress is on the rise, but looks like we're still a long way from 2008...

The big question, however, is whether the temperature will keep rising.