The Chinese are right on the money about the irresponsible US Dollar depreciation that has directly resulted from reckless Federal Reserve monetary policies.

Broad M-3 Money Supply Statistics
http://www.shadowstats.com/cgi-bin/sgs/data

Wholesale prices largest jump in 34 years
http://money.cnn.com/2007/12/13/news/economy/ppi/index.htm?postversion=2007121312

Wonder why the Federal Reserve has discontinued reporting official broad M-3 money supply statistics? With broad M-3 money supply exploding at an 18 percent annualized rate, Bernanke can hide his irresponsible money printing charade to bailout reckless Wall Street investment banks with “cheap” dollars. What ever happened to the economic monetary principles of “sound money” ?

what if ‘china’ implodes: (China’s top-down leadership dithers as economic storm clouds gather http://www.globeinvestor.com/servlet/story/GAM.20071212.IBASIA12/GIStory/ and “… China is just not that big and it will not get that big any time soon.”…” http://www.globeinvestor.com/servlet/story/GAM.20071212.REYNOLDS12/GIStory/)

and what is your/ wolf et al’s end game?

Your characterization of US China relationship as acrimonious is shrill and misleading. Certainly, US China economic relationship is deepening and going as well as ever. More US companies are getting bigger footholds in China and vice versa. Trade oversight is improving and even central bank coordination is starting in face of the subprime issue. The only area that’s acrimonious is the silly political rhetoric targeted at specific domestic audiences and that does not characterize the whole relationship.

Helicopter Ben Bernanke has his finger glued to the print button as M-3 money supply is exploding and accelerating.

Reconstructed broad M-3 money supply statistics
http://www.nowandfutures.com/key_stats.html

then if you could reconcile:

“It has been reasonably clear for some time that the dollar would need to depreciate over time to help reduce the US trade deficit”

and:

“The [United] States dollar policy has long been to ignore the dollar’s external value and direct policy toward stabilizing economic conditions in the US. If that means a strong dollar, so be it. If that means a weak dollar, so be it.”

and tell us why wolf’s column is important, other than the fact that rge seems to have contributed in some way.

If the US policy is to stablize economic conditions in the US, then the US dollar, as a reflection on US economic strength, will hold its value. Short term falls or rises are temporary deviations from that fundamental dollar value. (Delong and others make similar observations on US dollar as well.)
Also, it’s now fashionable to state the world has lost faith in US financial/political model, but that all could change in a relative short time, with a new administration or an uptick in finanical conditions next year or two. Over the long run, the US model of economic openess, personal freedom and greater transparency in governing affairs is still very attractive and will make US very competitive. None of this means that Euro-dollar-yuan ringlings going on now will be end of the US financial system. As diplomacy and negotiations go, this sort of fricition is normal interaction and doesn’t change the long term fundamentals.

“anglo-american model of transaction based financial capitalism”

I think the London markets still have a great deal more of integrity, proper regulation, and trust than the rotten US financial system. It is worth recalling that the British Northern Rock banking bust was a direct result of the US Subprime CDO fiasco. An elderly British man lining up to withdrawal his money from Northern Rock bank was quoted on the BBC, “Don’t the Americans have any rules and regulations anymore”. Wall Street financial institutions have no compunction in even screwing the British public across the pond. The US capital markets use to be the pinnacle of world capitalism, but not anymore with the US government regulatory agencies themselves hijacked by the Wall Street banksters.

Northern rock got into trouble b/c it relied on the securities market (and the interbank market) to finance its mortgage lending …. British banks weren’t willing to lend to it to make mortgages denominated in British pounds.

re: “the key clue”

so what?

I don’t think anyone who reads this blog thinks I am a fan of the Chinese model! I am in favor of a reformed anglo-saxon model. But I believe there is a need for serious reforms — tho I don’t as of yet have a precise agenda in mind.

I think I have also encouraged frequent commentators to pick an identifiable moniker — GuestA for example.

gillies — interesting comment. tho someone has to live beyond their means (in the sense of borrowing a ton) if china and the gulf are going to save a ton. i would have more sympathy for their critique of the US is they were not so keen on financing it — and might have more sympathy for their complains about $ weakness if they stopped selling $ for euros and other currencies and thus took some pressure off the market –

And unfortunately (for the us, not for other countries taxpayers) is seems like us and european banks that borrowed in the us money market ended up with more AAA subprime than the rest of the world …

A large part of the problem is that the LIBOR market is very different than the Fed Funds market. The LIBOR based European market shares much of the credit risk origination problem. Hence the very wide spreads between LIBOR and funds. Similarly for the US commercial paper market. The key question for the Fed is whether further easing of Fed Funds will be required to lower absolute levels of LIBOR and commercial paper – as opposed to yesterday’s year end turn band-aid ‘solution’. Only one of the Fed’s communication problems yesterday was that they confused a tactical year end goal with the market’s demand for strategic action.

Brad,

I’ve never been to the far east, maybe you can tell more than me, but I think that in a place where financial markets are (a bit) less developed and where you can even be arrested if you dare arbitraging with currencies (see the Economist of couple of weeks ago) financial derivatives might be less attractive than they are in more developed countries.

One of the most interesting features of today’s world is that it feels like it is so unsafe. I also feel that our reaction to this is being that of shouting to each other pretending that ours is the worse situation. This is not a good strategy and it may only yield a big misunderstanding. We can’t all be on the right side. Each of us should take responsability for his own faults. Here is an example: only last summer China’s government decided to invest some money on Blackstone Group. Did you take it as a sign that China’s bargaining power is strong? I did not.

I think August 2007 crisis will end up as one of Poe’s narratives for the USA and probably for Europe as well. Will it be Countrywide, or Bernanke or supbrime borrowers’ fault nobody knows. But it was not sustainable, no matter what the rest of the world wanted to save (sorry Brad, but “CA=0 for the world” argument is not enough for me to clear the shrewd lenders’/borrowers’ faults).

I hate saying this, but risk is not just a theoretical aspect of economics. And risk implies that losses occur, sooner or later. These might be stressing moments. They will not last long, hopefully.

a fair amount of us external debt is also indexed to LIBOR.

Doesn’t the USA have a LIBOR-like index of its own?

It’s funny that Wolf doesn’t seem to think of the obvious answer – figuring out a way to end term transformation (maturity mismatching).

Why on earth does everyone seem to assume that term transformation is a socially productive function? Its association with these kinds of crises is about as regular, about as obvious, and (IMHO) about as debatable, as the association between smallpox and the smallpox virus. No term transformation, no financial panics, no “business cycle.” (Actually, if this is indeed a case of blaming the victim, “banking cycle” might be a better term.)

Sure. It makes more present money available to people who want to borrow. So does a policy of having the Fed just print money and lend it. (Excuse me, “back currency with debt.”) In the end term transformation turns out to be just an especially opaque and tortuous (if not indeed tortious) way to accomplish this same strategy. Because term transformation does not work without a liquidity guarantee, and there is no way to construct a liquidity guarantee which is not also an insolvency guarantee.

The TAF is an obvious baby step toward this future. I’m sure that if you disguise it sufficiently, it won’t smell at all. My inclination would be to go in the other direction, and formally nationalize.

(For example, why aren’t the GSEs part of the Fed? Isn’t the Fed itself basically the original government-sponsored enterprise? If the Fed simply purchased all outstanding equity of the GSEs, at the present market price, with its “device called a printing press,” who, exactly, would be the loser? At least we could start thinking about how to actually privatize the damned things.)

Furthermore, term transformation is an attempt to win at a zero-sum game, because it is creating present money but not, of course, present goods. The more future money is transformed into present money, the more present money chases present goods. From a social welfare standpoint, the only way this can possibly be beneficial is if you consider income redistribution socially beneficial.

Which, when the primary beneficiaries of your redistribution appear to be hedgies in London who promptly exchange their profits for M3s – and I’m not talking about the monetary indicator – is a rather difficult case to make, n’est ce pas? I’d really hate to see what would happen if the marks started to figure this one out.

RE, I think what you (like Hussman) are missing is the large quantity of assets whose present price is guaranteed by the implicit power of the Fed to do exactly what I propose above. Eg, of course, agency notes. And if it isn’t the Fed, it’s the BWII codependents.

Written by bsetser on 2007-12-13 16:51:56

LIBOR is the interbank deposit interest rate index for lending between non-US banks in US dollars (or in what used to be called much more regularly Eurodollars – the introduction of the Euro sort of mucked up this terminology.)

Fed funds is the interbank deposit interest rate index for lending between US domestic banks in US dollars. Domestic banks can also lend using LIBOR but I believe in general this is done using their offshore domiciles.

The difference between the two is very important for this crisis. I don’t have a ready source of data, but I believe the spread is normally fairly small, but positive – in basis points. The spread these days is huge – I think in the order of 1 per cent give or take.

The reason for the current spread is twofold. One is that European banks have been a big source of US dollar revealed credit risk during this crisis. So these banks have tiered in their willingness to lend each other money and pushed LIBOR up, other things equal. Two is that on the other side, fed funds is the rate that the Fed targets and essentially controls through its own intervention from a supply and demand perspective. It is little understood that the Fed in fact has been RELATIVELY successful in maintaining a minimal trend deviation of the actual funds rate to the target rate during this crisis. To prove this, simply find a source of data known as the ‘fed effective’ rate, which is essentially the actual average fed funds rate on a daily basis. It deviates from the current target, but it tends to deviate either side of the target. True it has been more volatile in recent months, but the fed is inevitably effective in getting the actual to trade roughly around target on average.

One corollary is that the Fed can target the funds rate pretty well. But it can’t target the LIBOR spread in this environment. Yet that is precisely what it is now attempting to do with this recent action. I don’t think its going to work. On the other hand, given the current LIBOR spread against funds, it can take this into account and indirectly target the full LIBOR rate by targeting fed funds – i.e. by lowering the funds rate more. LIBOR spreads will only return to normal, and gradually, if the full LIBOR rate is lowered by lowering the funds rate. This is in my view what they need to do urgently.

You are right to be interested in this topic. It could be useful in understanding the flows.

Also, the London financial services industry is dominated by basically the same largely American-headquartered banks that run Wall Street. They really aren’t two separate markets but rather part of one 24-hour global market. It’s very common for someone in NYC to be assigned to a team whose manager is in London and vice versa, and with e-mail, telephone, IM, and the occasional trans-Atlantic flight, it’s really one single team.

Bernando Alto: if you dare arbitraging with currencies (see the Economist of couple of weeks ago) financial derivatives might be less attractive than they are in more developed countries.

That actually makes them more attractive since in these situations derivatives are used for someone to do something that they can’t do directly. Want to arb currencies but can’t because of capital controls, have we got a product for you!!!!!

bsetser: could you spell out the difference between LIBOR and Fed funds a bit more? It isn’t something I understand well but it is something that I sort feel like I have to understand.

LIBOR is what banks in London charge to lend money to each other. Fed funds is what banks in the US charge to lend money to each other. Most dollar securities are based on LIBOR rather than Fed Funds since the Federal Reserve does have the authority to force banks to lend to each other at a certain rate (although it hasn’t used that authority in years) whereas the Federal Reserve doesn’t have that jurisdiction over banks in London.

bsetser: I am in favor of a reformed anglo-saxon model.

The problem I have with talking about models is that things change and change quickly. The current way the US economy works is somewhat different from the way it works in 1997, very, very different from the way it worked in 1987, and if you go back to 1977 and 1967, it becomes unrecognizable.

This becomes a huge problem when you talk about having China copy the “Anglo-Saxon model.” Which Anglo-Saxon model? In 1994, the Chinese government decided to copy the structure of the US banking industry by imposing a wall between commercial and investment banking, and by creating a set of what in the US would be called regional banks. That legal barrier still exists in China even though the US got rid of it in 1998 prompting a set of financial mega-mergers that give you banks that look rather German and are gobbling up regional banks.

Functional complex systems evolve and are not planned. The current US finance structure came about through trial and error and lots of messy politics, and there is no reason to think that China would be better off if it didn’t go through a process of trial and error and lots of messy politics.

Written by bsetser on 2007-12-13 16:51:56

Finally, to be clear, Bernanke is in the process of making a huge error in monetary policy – and this LIBOR symptom is a big part of it.

Written by Twofish on 2007-12-13 20:54:58

LIBOR is used in London but not just in London – it’s used anywhere outside of the US for US dollar interbank lending. E.g. it would be used by Citi Tokyo lending to UBS Nassau.

Moldbug is fascinating.

anonymous — it might be a bit clearer if you started with “in response to bsetser at 16:51; that way it is clear that you are writing, not me. no matter tho. huge thanks for your response.

a couple of questions tho — my sense is that fed funds is banks lending mandatory reserves (i.e. something they have to hold) among themselves, while libor is broader, i.e. it captures all bank lending among themselves, not just to meet mandatory reserve requirements. is that remotely correct?

and if say citi london is short on $ cash (as it needs to in effect buy the assets of a city SIV or meet a commitment to supply credit to firm), would it borrow the funds in London at LIBOR or in NY at fed funds. My sense is in London, not in NY — but given the price differential i don’t understand why. The same applies to most European banks — they have NY operations. why not borrow more cheaply in NY?

I am sure there is a really simple explanation for all this, but it isn’t something I know well. I do appreciate the tutorial.

2fish — your point about the evolution of the anglo-saxon model is a good one. and I am waiting for you to find a way to offer a one-year RMB forward at a price close to the current interest rate differential between USD and CNY!

bsetser- why not borrow more cheaply in NY?

Could it be that there are regulations preventing the $ from leaving ny for london or the possibility for transaction costs to be jacked up beyond the price differentials. Would be nice to have an answer, remember reading it in one of those textbooks on finance but never could remember the text.

twofish- term transformation

bet those economic profs are all falling off their chairs, “term transformation” is a blatant ignoring of basic treasury management rules but the again, most people view rules as something to be vbroken

In Response to bsetser on 2007-12-13 22:15:15

By the way, this is already implied in some of my comments, but the early morning demand for US LIBOR borrowing in Europe has been a tremendous headache for the Fed during this crisis. They can’t response directly to the LIBOR pricing pressures. These pricing pressures may also reflect in unusual funding requirements through the internal clearing accounts of US banks operating in Europe with their parent operations in New York, as well as in the New York clearing accounts of European and other foreign banks (through their domestic US clearing agent banks). The Fed initiative yesterday is an attempt to respond to all of this. Again, I doubt its going to work very well. The market doesn’t seem to think so either at this point.

Disgruntled — I am with you on Bali. The US clearly could (and in my view should) commit to do more. And there are known policy steps that US could take that would reduce US emissions.

I am not with you on “forced savings” outside the US — savings rates are a choice, and often a public policy choice. two examples.

the Saudis have chosen to budget for $50 a barrel oil next year. They could have budgeted for $70 or $90 (and saved less), or budgeted for $30 and saved more. They also could choose to pay dividends to all saudi citizens out of the oil revenue and let the saudi population decide how much to save.

And china could have required that profitable state owned enterprises pay dividends to the state and then used to the dividend income to finance higher levels of social spending, reducing individual incentives to save. The SOEs have the cash and could pay — cutting into enterprise savings. But the Chinese government opted not to make this policy change.

I could outline the ways the US could reduce its carbon footprint as well — import Brazilian sugar cane ethanol rather than use energy inefficient corn based enthanol for bio-fuels, tax gasoline at a eurpoean level, impose higher CAFE standards on cars and critically light trucks, start building a lot nuclear reactors (a la France) and so on … there we opted not.

I do not know quite how to prevent — in a private system — US households from borrowing more (And saving less) when the financing is there. I guess the US could have imposed stricter regulations on certain kinds of mortgages, but that risks pushing rates down until someone borrows or someone decides to save less to bring the system back into equilibrium. in retrospect (for that matter even at the time) it seems like a good idea.

but nonetheless some in a closed system (like the world economy) has to offset a surplus with a deficit — and my read is that policies in the surplus countries played a large role in inducing the deficits in the deficit countries (With the evidence being low interest rates which imply a surplus of savings … )

This may be a little off-topic, and may get me hammered in this forum, but while the Anglo-Saxon financial model may well need some reform, perhaps I am a little more optimistic than you are about its functioning. In my view a well-functioning financial system needs lots of moving parts to maintain flexibility and needs systematically to assume, transform and pass risk around. As Minsky has argued, it is impossible even in theory to eliminate this risk, and an inevitable consequence is that there will be crises – and so they are not necessarily evidence of a failure of the system. The real question for me is whether the financial system can work its way out of the crisis quickly and can resume functioning as an efficient allocator of capital. In other words will the current crisis lead to Japan after 1989 or the US after 1987. I discussed this in Volatility Machine, especially in reference to a fascinating (to me) bit of speculation by the Belgian historian Raymond de Roover. Sorry for self-quoting, but here it is:

…the relationship between hard and stable money and rapid economic development is perhaps not as clear as it ought to be, even though among most economists the importance of sound money is often an article of faith. Economic historians, however, have been much less certain. The problem arises in part because periods of rapid economic growth were not always periods of sound banking and stable money. Bank historian Raymond de Roover makes the point explicitly when he surmises, in discussing the early economic experiences of the United States, that “perhaps one could say that reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada”.

Incidentally, a similar increase in spread has occurred between the BoE repo rate and sterling LIBOR.

RebelEconomist on 2007-12-14 05:58:36

Your concerns seem more mechanical than conceptual.

Fed funds settle the day of – i.e. real time t in terms of a daily calendar. If you’re short fed funds at 6 p.m., you go to the discount window if you have an account with the Fed. That’s the drill. Eurodollar LIBOR settles t + 2 and no LIBOR funds settle directly through the Fed. They settle t + 2 through a clearing bank which then settles its entire position including that day’s fed funds borrowing and lending through the Fed. There’s no FDIC premium on Fed funds because they’re not technically deposits (they’re considered ‘borrowed funds’). There’s no FDIC premiums on LIBOR priced Eurodollar deposits because they’re not domestic US deposits.

anonymous — what is the condition that prevents arbitraging the difference between onshore fed funds (i.e. borrowing funds in that market) and offshore LIBOR (i.e. lending in that market)?

My guess is that settlement through the fed is key, so there is no counter-party risk with fed funds and there is with offshore LIBOR.

Anonymous: Since Markowitz’s article on portfolio theory in 1952, finance has embraced the notion that risk is equivalent to standard deviation.

This is simply not true. Standard deviations are a useful tool in thinking about risk because they can give you very quick, very rough numbers, but they are only one tool in the toolbox.

Anonymous: It is a simple fact that the standard deviations that were used in both the LTCM models and in the ABS and CDO models were ultimately inapplicable.

This is also not true. LTCM got in trouble with convergence trades which have nothing to do with standard deviations. The heart of CDO modelling involves coorelations. If company A goes under, how does that affect the chances of company B going under? This again has nothing to do with standard deviations.

Anonymous: But you have to know something about what a standard deviation is in order to call the bluff of the 26 year old quant and still retain leadership credibility before the ship goes down.

This is completely backwards. The risk models that quants came up with seemed to be pretty accurate about what was going to happen, and you don’t need a Ph.D. in mathematics to know that lending to people with bad credit on inflated real estate prices was a stupid idea, and if you put in likely default rates into the models, then the output is surprise, surprise, surprise, you lose lots of money. If management forces you to put stupid numbers in, you’ll get stupid numbers out.

The banks where the quants and people with some basic common sense were able to run things did well. Those that didn’t, didn’t.

“…Unlike BBA Euro LIBOR, EURIBOR, the complementary fixing which has been established by the European Banking Federation and ACI to benchmark in-zone rates, applies a concept of country quota. Each in-country has at least one bank represented on the Panel and smaller countries will rotate membership of the Panel amongst their leading commercial banks every 6 months. EURIBOR has a panel of 49 reference banks from in zone countries as well as international banks. Bank of Tokyo-Mitsubishi, Chase, Citibank, JP Morgan Bank of America and UBS have been selected to represent international banks. The averaging method of BBA LIBOR (wherein the top and bottom quartiles are discarded and the middle 50% averaged to produce the LIBOR fixing) is similar to EURIBOR’s although only the top and bottom 15% are rejected in the FBE/ACI process. This differential topping and tailing will result in there being a greater ratio of smaller banks to larger banks in EURIBOR. The degree to which EURIBOR and BBA Euro LIBOR are used in the wholesale markets could be determined by differences in perception about the credit quality of the 16 large banks comprising the BBA Panel and the banks on the EURIBOR Panel, some of which are comparatively small. The BBA Euro benchmark is vested with the same degree of authority and worldwide acceptance as the existing BBA LIBOR fixing series. Banks in London can be sure that the BBA Euro LIBOR rate is as representative of activity in Europe’s major financial centre and many are likely to prefer it to EURIBOR in their wholesale cash and derivative contracts…” http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=225&a=1415

Written by Twofish on 2007-12-14 09:02:06

I generally ignore your know-it-all, negative, ‘twofishipedia’ comments.

But if you knew anything at all about the mathematics of the subject, you would understand that standard deviations are the building blocks of covariance and correlation statistics. The rest of your observations warrant a similar caveat but I can’t be bothered.

response to bsetser on 2007-12-14 08:19:50

I’d be guessing somewhat at your fed funds/LIBOR arbitrage question. But fed funds are essentially onshore and LIBOR offshore. I think there are regulatory or tax constraints that would prevent too much in the way of on-shore fed funds funding of offshore LIBOR lending. Fed funds are funds borrowed between banks and they are unsecured. I’m not sure the interposition of the Fed as the clearing bank changes the credit risk. LIBOR lending is also unsecured. I think there is a real differentiation in this market between onshore credit risk and offshore credit risk, although I’m not sure why the spread should be as large as it is – doesn’t make entire intuitive sense given the shape some of the US institutions seem to be in. I think its more the fact that the Fed can directly force down the funds rate by injecting reserves – funds borrowing and lending can’t come to a complete halt so I assume domestic insitutions would favor other domestic institutions.

moldbug,

Point taken. But I believe a targeted ‘unsophisticated’ (i.e. simple) way of referencing the mathematical kernel of the thing (e.g. standard deviation and correlation obviously as the engine of Markowitz and co) is in keeping with the theme that mathematical sophistication has become a catalyst for a very unsophisticated and slavish devotion to quantification.

moldbug: stochastic risk models which expect the future to mirror the past

They don’t. The risk models that people use are usually “what-if” simulations. Suppose the Dow dropped 50%, what happens? Suppose the Dow *rose* 50%, what happens? The goal in the non-proprietary part of an investment bank is to be market neutral so that your assets and liabilities match regardless of what the market does. Because the basic assumption is that the market cannot be predicted and anything can happen.

A really, really good trader with years of experience will guess market moves incorrectly about 40% of the time.

2fish,

Every model needs inputs, and these inputs are stochastic. If your risk model does not assume that it is more likely for the Dow to drop 50% than for it to drop 75%, it’s a very strange model indeed.

And how likely is this? Well, you could look at what the Dow has done in the past… and this is how you get to Taleb’s 10,000-year-old economist.

Anonymous: You’ve immediately contradicted yourself following your emphatic protestations that the LTCM problem was one of correlation and not standard deviation (which in itself was a contradiction).

I said: This is also not true. LTCM got in trouble with convergence trades which have nothing to do with standard deviations.

Market makers do not use models to predict future prices. (Prop traders do.)

This is what they do. Suppose I find that the price of apple is $1 and the price of a orange is $2. What is the fair price of one apple and one orange? The answer is $3. What about half an apple and 2/3′s an orange? etc. etc. What if someone gives me the price of half an apple and half an orange? What should I sell one apple at?

So given a set of market prices, it is possible to come up with a consistent price of a combination instrument. Derivatives pricing is just a complex form of this.

Also people who write these models do have something called common sense. If a model comes out with the answer that you should sell gold and buy chicken feathers, then people will question the model, and sometimes you don’t need math to tell you that you are doing something really stupid.

bsetser: ah — but don’t most correlation trades assume that nothing strange will happen

Most statistical arbitrage trades assume that a relationship is statistical. Some of the time things will go the way that you think they will, some of the times they want, but you hope that you win more than you lose, and when you lose, you don’t lose big enough to be pushed out of the game.

Part of effective risk management and trading is to know when to close your positions and take your losses so that you don’t throw good money after bad.

The dangerous thing about computer trading is that you can’t just shut down your machines when things go bad. In October 1987, and 8/7, 8/8 and 8/9, this year, it was perfectly obvious to people what was happening. People were selling, this was pushing down prices, and causing more people to sell. Why didn’t people stop trading? Well, if *you* stopped trading and everyone else didn’t, you lose. So the rational thing to do is to join the stampede. This is why one of the changes is now to have everyone shut off the computers when the price goes up and down a certain amount on the NYSE.

But that’s very different from CDO’s, ABS’s and complex derivative pricing. There are about a two dozen different things that people do with mathematical models in finance, and part of the confusion is that people get things mixed up. Hedge funds are different from investment banks. Different parts of investment banks do different things and different hedge funds do different things. You have execution, algorithmic trading, portfolio management, and derivatives valuation, all of which involve different things.

It also didn’t help LTCM that once is was clear that they were in trouble everyone was out to kill them.

Anonymous on 2007-12-13 22:51:05 and Anonymous on 2007-12-13 23:02:08

Excuse this dumb question but surely there must be recognition that in times like these when Fed funds seem much “cheaper” than Libor funds that there must be regulations restricting the borrowing of funds by foreign banks and other entitites channelled through US banks/entities, if not there would be a “carry trade” of sorts in these loans, considering the spread?

Accounting wise, wouldn’t it be difficult to square associate/subsidiary A seeking financing by asking associate/subsidiary B or C based in the states to borrow Fed funds and transfer it to A ? Transfer fees and the red tape in transfer procedures might weigh the entire process down, or is this too simplistic a view?

Guest on 2007-12-14 18:42:37:

According to the Fed, the value of the stock of US currency in circulation was $759.5bn as of December 3rd. For the latest figure, see:
http://www.federalreserve.gov/releases/h6/Current/

In 2002, it was estimated that at least half of dollar banknotes circulated outside the United States, although if Jay-Z and reports from Russia are to be believed, this proportion may have fallen as the dollar is being supplanted by the euro for gangster business. For an interesting account of external dollar circulation see:
http://www.bis.org/publ/bppdf/bispap15r.pdf

I leave it to you and others to consider whether this amount of currency is insufficient to support dollar banking without recourse to payment systems under US control.

Guest — I suspect you are right. The US would step in in one way or another to block truly massive sales intended to disrupt markets. Of course, that is only act one in a bigger game; China would respond in one form or another.

Judy Yeo — not a silly question at all (I asked it myself earlier). not 100% sure we have a precise answer yet tho …

moldbug: The problem is that somewhere, somehow, you have to come up with a probability number.

No you don’t. In risk management, you care about whether or not the bank can survive a 50% drop in the Dow. The probability that this happens is unknown, probably unknownable, and in the case of risk management, irrelevant.

moldbug: The sigmas are not handed down by God.

In the case of derivatives pricing the sigmas are handed down by the market. Based on the price of the bond, you can calculate that the market believes that there is a 10% chance of event happening, therefore to price some other bond consistently, you set that chance at 10%.

Note here that that *doesn’t* mean that the chance of the thing happening is 10%. It means that the market thinks it is 10%, and if you price something at 15%, someone is going to make money off of you..

moldbug: Do you stress-test your system to the Dow falling 50%, 75%, 90%, 99%? What about the Rapture? What’s the chance of a Rapture, and how would it affect the dollar?

Risk management people think about this, yes. The goal is to have a balanced book. If the Dow falls 90%, then some things in your book will drop in value, but some other things will increase in value. Of course, when extreme moves in the market, then you have to worry a lot about counterparty risk. If the Dow dropped 90%, you are likely to see a massive number of people go under. However, if people go under and you wrote your contracts correctly to allow “netting”, then you don’t owe them money.

moldbug: Raptures aside, the numbers come from somewhere. Obviously, they come from past performance. Or are you saying that risk managers just make them up?

No they don’t come from past performance. Past performance tells you nothing about future performance.

If you want to know what happens to your book if the Dow drops 90%, then you look at the contracts you’ve written and go from there. Either the contracts get executed or they don’t, and if they don’t get executed (counterparty risk), and if they don’t get executed, then there are processes for dealing with that.

As far what the odds are that the Dow drops 90%, who cares? Risk managers don’t. If it happens, it happens.

RebelEconomist: I leave it to you and others to consider whether this amount of currency is insufficient to support dollar banking without recourse to payment systems under US control.

Yes for North Korea and Iran and for any corrupt and petty dictators. No for China. If you want to move $100 million without going through the US you can. If you want to move $100 billion without going through the US you can’t. My original objection was to the statement that dollars *never* leave the US. They do. If the statement was revised slightly to generally don’t leave the US then I don’t object.

This actually came up in a discussion about “negative interest” rates. Interest rates can’t be negative, can they? Normally the argument against negative interest rates is that if interest rates go negative, people do “matress arbitrage”. You go the bank, withdraw the money in paper, and stuff it into a matress. This works if you are dealing with $25 billion, but not $100 billion.

Also, in the conversation, the consensus was one shouldn’t worry too much about China dumping dollars. If China wanted to dump dollars, there would be a series of phone calls between Washington and Beijing to figure out how to go about doing this in an orderly manner. Same with Russia. The problem is the Middle East, since there is not one person on the other side of the phone.

This has relevance to my views on the relationship between governments and markets and the myth of the “Anglo-American neo-liberal model.” There’s this nonsense idea that American markets just go out and operate without government interaction, when in fact there are constantly phone calls and meetings going back and forth between the banks, the regulators, and the Fed all to keep the markets running smoothly.

Also, the distinction between *never* and *almost never* might seem like nitpicking but it isn’t. When you tell someone with a mathematical background, *never* that means *never*, and if you mean *almost never* then say *almost never*. In quantitative modelling, it’s the exceptions that kill you. If you look at the performance of quant stock funds for the last ten years, every single day works according to the model,,,, except for three. August 7, 8, and 9 2007, and if what happened on those three days had continued for another two then we would have been in a major, major crisis. What kept things from falling apart were a likely a whole bunch of frantic phone calls and polite requests to do certain things that were done.

Twofish: Most transactions are settled through CHIPS, but there is no legal requirement that they be settled that way. If you doing things legally and aren’t afraid of the US government, there’s no reason not to, but if you are, then you can settle things by cash filled suitcases……………The Fed gets on the phone to the banks to politely ask that they do (or not do) certain things all of the time. It’s quite legal since the Fed has the authority to look after the overall stability of the monetary system.

Reminds me of one day quite a fews years back when I was a trainee. During one of the many long periods of boredom common to financial market trading, our chief dealer, Johann, picked up the phone to one of our brokers and asked for a price on a Burger King Whopper, small fries and coke. The broker said $4.75 and Johann said, “I’ll take 100.” He then picked up the line to another broker and asked him for a price on a Whopper, fries and coke. This other broker quoted $5.25. “I’ll sell you 100″ said Johann. Then Johann put the phone down, looked at me and me said, “You’re in charge of settling the trade.” Needless to say, it was a very interesting afternoon for yours truly, as I created quite a scene at various places throughout Lower Manhattan, purchasing, transporting and delivering my delicious foodstuffs(which incidentally created a unique odor that I have never quite been able to extinguish from my aroma memory). In addition to making a quick buck, Johann was teaching me an important lesson about the amount of work performed by our unsung colleagues in the back office every day.

I am neither a banker, nor an economist, but I doubt if an extensive sophisticated shadow US dollar banking system has evolved based our expatriated suitcases of $100 bills. The amount of infrastructure required to administer and control such a system is mind boggling. Such a fantasy reminds of the evil character Dr. No from the James Bond films, who somehow managed to secretly construct a vast underground city beneath a small Caribbean island right off the coast of Jamaica. I may not be calculating this correctly, but if – as Brad suggested – the amount of physical cash outside of the US is $350 billion and M2 is $7 trillion, then offshore cash would only represent about .5 per cent of existing dollars, even less if you count all the Eurodollars and Repos that used to be included in the broader M3 releases. If I’m wrong on this, I’m sure Twofish will be quick to point out the factual error, while ignoring my broader point, since that seems to be his MO (no pun intended).

By my recollection, I brought of the notion of USD never leaving NY, GBP never leaving London, JPY never leaving Tokyo simply because people have started discussing LIBOR and the Eurodollar market due to recent funding issues resulting from the subprime crisis. I think people get a little confused when talking about USD being borrowed and lent in London and I thought it would be helpful for them to gain a little better understanding of what was really going on in terms of where and how USD and other currencies actually move about. The Eurodollar market may have been created by the Soviets, but it grew and developed into the market it is today simply because of a desire by financial institution to bypass the Fed’s reserve requirements, not due to the patronage of Columbian drug lords and North Korean arms dealers. I’m not sure how this turned into a discussion of suitcases full of $100 dollar bills. I will leave it to you experts to sort out, but it doesn’t seem to me that this is a significant activity in terms of macro economic flows, the USD and US monetary policy.

Setzer – I really need to research the real mechanics of fed funds and libor (any recommendations), but i think fed funds is borrowing to meet required reserves, and that in some ways constrains folks ability to borrow at fed funds and lend at libor, capturing the spreak. you only borrow fed funds to meet the reserve requirement.

I am not a banker so I don’t know all this intuitively, but my strong sense is that libor is so widely used in US contracts that it isn’t really the offshore dollar rate these days. tis more like the rate to borrow dollars unsecureed for short-terms.

Sorry, can’t help. The funding desk was always on the other side of the room from us FX “gamblers”. We never learned much about their business. Our adrenaline was running too high and interrupted the higher thought processes necessary for funding the bank’s assets. The only day we paid attention to those guys was on Dec 31. We were always bored and the Fed Funds rate would gyrate wildly due to the over the year funding. It was the one day of the year they had to trade like us. I assure you, there are already a few scrotums tightening up anticipating funding the year end turn this year.

brad – if you could point out the ‘guest’ “(mafia, etc)” comments…

re: “frozen markets would mean that we are in a new and scary world.”

just to review: “…On 9 August 2007 BNP Paribas announced that it could not fairly value the underlying assets in three funds [as of Aug. 7] as a result of exposure to U.S. subprime mortgage lending markets. Faced with potentially massive (though unquantifiable) exposure, the European Central Bank (ECB) immediately stepped in to ease market worries by opening lines of €96.8 billion (US$130 billion) in low-interest credit…” http://en.wikipedia.org/wiki/BNP_Paribas#_note-0

“…the funds are held by BNP clients and represented just a fraction, about 1.6 billion euros of the 600 billion euros the bank has under management…” http://www.nytimes.com/2007/08/10/business/worldbusiness/09cnd-eurobank.html?_r=1&hp&oref=slogin

“…”There’s so much CP out there, and if one part of the market locks up, it tends to be contagious”…” http://immobilienblasen.blogspot.com/2007/08/conduit-siv-trouble-in-canada-coventree.html

from the same BNP wikipedia post shown above, the significance of drawing attention to this? “…On September 23, 2005, BNP Paribas is set to take a 20% stake in China’s Nanjing City Commercial Bank, a Chinese official and state press reports said on Friday… BNP Paribas refused to comment. The International Financial Corporation, the investment arm of the World Bank, already owns 15% of Nanjing City Commercial Bank, which has regulatory approval to list on the country’s domestic stock markets.”

2fish,

You keep managing to elude my point.

Past performance may be – or may not be – a factor in your analysis of what happens if the Dow drops 90%. But it is necessarily a factor in your decision of whether to structure your balance sheet so that it blows up if the Dow drops 90%, or 99%, or 20%, or whatever.

The question is: what is the probability that the Dow will drop 99%? Or X%? And the goal is a balance sheet that will only blow up “once in 10,000 years” or whatever.

The former probability can only be obtained by analysis of past performance. The latter probability is a prediction of future performance. Ergo, past performance is being used to predict future performance.

bsetser-fed rates and libor
Agree in part with guest on the fed borrowing to meet reserve requirements but ‘cos the fed is last lender of resort, it’s also for emergencies, kinda like the emergency services, it’s a central bank -to- non-central bank type of transaction, LIBOR is bank to bank and whoever else needs the funding. Fed and BOE (plus other central banks, yes, they do exist rates impact on those ‘cos banks usually charge a “mark-up” rate on the base rates charged by the central banks, by the time it gets to those who don’t have a commercial banking arm , the rates are usually quite “different” from base rates. My best bet is the mark-up and fed regulations, not to mention red tape , blocks the type of borrowing you mentioned.

Our adrenaline was running too high and interrupted the higher thought processes necessary for funding the bank’s assets. The only day we paid attention to those guys was on Dec 31. We were always bored and the Fed Funds rate would gyrate wildly due to the over the year funding. It was the one day of the year they had to trade like us. I assure you, there are already a few scrotums tightening up anticipating funding the year end turn this year.

Written by Guest on 2007-12-15 20:11:06

waay too much testosterone here, maybe the cycling world could reference you guys?!
but seriously, that’s why accountants have a much less fun time , dealing with the fx and the funding, try explaining the dodginess of it all in simple terms!

as for the mafia issue- huh? whats with those $100 bills? would have thought money laundering was a lot more sophisticated these days…

Guest on 2007-12-18 06:46:38

sorry to disappoint, I’m not an accountant but you could see my response on my blog foesskewered.livejournal.com. Just to confirm that you’re not an acquaintance, you didn’t like jokes about dead horses, did you?