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JasonC

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  • How To Use Money Supply Statistics For Market Predictions [View article]
    John -

    "If excess reserves are removed by member banks would they in turn have to be lent out in order to become part of M1 or M2?"

    First the mechanics. A commercial bank does not need any reserves to make a new loan, though it may wind up needing them once the loan account is actually drawn on.

    Making a new loan is a mutual balance sheet expansion by both the bank and the borrower. The bank increases its assets by the borrower's note, the loan. The bank increases its liabilities by the deposit account balance it creates or increases, in the borrower's favor. So both sides of the bank's sheet expand and by the same amount. No net worth effect, an increase in leverage but that is all (initially). The borrower likewise expands both sides of his own balance sheet. His liabilities have increased by the loan he must eventually repay to the bank. But in return he got a deposit balance that fully matches that amount. So his sheet expanded on both sides, with no net worth impact. That is the full state of affairs when the loan is *created* - written into existence by the borrower, and sold to the lender in return for a deposit balance that is written into existence by the bank, and sold to the borrower. It is a credit increasing trade, nothing more.

    But borrowers don't enter into loan transactions with the intention of leaving their new deposit balance lying idle at their bank. They intend to use it for something, and they quickly do so. Which means they write checks against that deposit account, or they withdraw physical cash against it, or they wire transfer out of it to fund a purchase, etc. This is *not* the loan creation act. It is a *withdrawal of a deposit*.

    And like any withdrawal of a deposit, whether a new one or one that has been sitting there idle for 20 years, the bank must cover that withdrawal.

    If the transfer is by check or wire to another customer of the same bank, then all the bank needs to do to cover the transfer is increase the balance of the paid party to match the deduction to the paying party. It is funding the run down of one deposit by running up another deposit. The paid side is effectively lending right back to the same bank, replacing the lending role of the previous depositor. There is nothing to fund.

    But if the transfer is to a customer of a different bank, then the withdrawal will show up in clearing at the end of the day of the withdrawal, as an increase in a net imbalance with that other bank. If a Chase depositor is paying a Citi customer, Chase must pay Citi. Chase pays Citi *with bank reserves* - that is, with a portion of its funds on deposit at the Fed. The Fed reduces the bank reserves that Chase owns, and increases the bank reserves that Citi owns. Notice, the bank reserves that *both* own, *combined*, is *completely unchanged* by this transaction.

    Citi in turn receives the bank reserves that Chase lost, and that is an increase in its assets. But it must also record an increased deposit liability to its customer, to whoim the funds were directly paid.

    Chase's whole sheet shrinks - it has few bank reserves, but it also owes less on its deposits, because it paid some of them out, fulfilling that contract completely, "paid in full". Its net worth is unchanged. Citi's whole sheet grows - it has more bank reserves, but it also owes more on its deposits. Its net worth it also unchanged.

    The net worth of the payer may appear to have gone down, and within the banking system it has - he doesn't have the deposit balance at Chase running in his favor any more, and he still owes Chase on his loan. But the payer wasn't paying out as an act of charity - he bought something, or received something else of value, that he considered worth as much as the deposit he just paid. Similarly, the paid party has a new bank deposit balance and no bank liability offsets it, so he has gained in claims on the banking system, what the payer has lost in such claims. But he presumably handed over something of value in return for the payment he received.

    I trace all of that to make clear that there are always two sides to every single transaction, and even each side is effected in their asset accounts and their liability accounts by every one of them. There are no one way transactions, just as there is no single entry bookkeeping.

    That was mechanics. Now ask, does Chase making a new loan cost it bank reserves? Answer, it can, because most of them (its market share for paid parties not being 100%) will result in withdrawals that pay out to some other bank, and it will pay reserves to clear those transactions. But what Chase pays, others get. Bank reserves are not created or destroyed or used up or moved out of the banking system, either by loan transactions or withdrawals of deposits to pay customers of other banks.

    Suppose, though, that pay out takes the form of physical cash paid over the counter or out of its ATM machines. Suppose the party receiving that cash doesn't redeposit it *in any bank*, but continues to hold that physical currency.

    In that case and only in that case, bank reserves leave the commercial banks. Chase runs down its account at the Fed to get replacement cash for the cash paid out to withdrawing customers. If that cash is not redeposited elsewhere, there is no other commercial bank that is the gainer side as in the previous example with Citi.

    Instead, the public increases its direct holdings of Fed liabilities - which is what physical Federal Reserve Notes are. That is the *only* way that bank reserves can become part of M1 - because currency in the hands of the public (not the banks) counts as "in circulation" money and is part of all the monetary aggregates.

    The quantity, all bank reserves plus physical currency in circulation, is unchanged by that transaction. When the public shows a preference for currency over deposits, the currency component of that total rises, and the bank reserve portion of that total falls, but the sum of the two is unchanged. But notice further that the deposit accounts that are drawn down when the public takes physical currency out of the banking system are also part of the money supply. If taken from savings rather than checking, part of M2 rather than part of M1, but either way part of the broad money supply. So even that preference does not increase the quantity of money in the hands of the public - it just shifts its composition to more currency, less deposits.

    The Fed sets the size of the total, bank reserves plus physical currency. The public controls how much of that will take the physical currency form, by its preference for currency over deposits or vice versa. *Neither* is controlled by the commercial banks. There is no action that the commercial banks can take that "uses up" bank reserves, for all of them in the aggregate. At most, if they induce the public to want to hold physical currency more than it wants to hold deposits, they can induce part of the public to use the public's control over the mix of currency vs bank reserves, to favor the former. Note - they don't actually want to do that and in practice they don't; they want the public to prefer deposits and they would rather the total, currency plus bank reserves stay mostly in the form of bank reserves. Because the public prefer deposits means the banks can use their lent funds to earn more by carrying more assets themselves.

    "if The Fed stopped paying a small amount of interest on excess reserves it would provide some impetus for banks to utilize the funds"

    They can't "utilize the funds". It is (meta)physically impossible for the commercial banks to reduce the quantity of bank reserves outstanding by any action of their own. They can only pass them from hand to hand. It is like asking what Apple could do to get Apple shareholders to use up their Apple shares. Only Apple can change the number of shares of Apple issued and outstanding. Apple shareholders can only pass them from hand to hand; no trade in existing Apple stock uses up one share of Apple stock. Similarly, no use of bank reserves by the commercial banks uses them up. They can only pay them out to each other and receive them too.

    So what are the actual effects on the commercial banks of having a largely volume of bank reserves on the asset side of their balance sheets?

    First, they are more liquid. They can more readily meet their claims in clearing with each other without selling other assets or borrowing. Just as you could pay your transactions more readily if you sold all your bonds and put the proceeds in your checking account, the banks can more readily meet any of their current payments falling due, if their assets are already liquid cash, rather than illiquid loans or negotiable securities (the latter being liquid at a price, but a price that can move against the bank).

    Second, they are less profitable. Because holding bank reserves as assets on the asset side of the sheet, earning 0.25%, meanings not holding bonds or loans there, that pay more than that. The Fed has made large profits carrying its bond position by issuing currency and bank reserves to buy them, because the bonds pay it more than those liabilities cost the Fed. Well, the people it bought those bonds from and the people who accepted those liabilities, are in the exact reversed position, due to those trades having happened. If the Fed is earning $50 billion a year more carrying bonds that other men use to own, those other men are earning $50 billion a year less by not owning those bonds.

    Third, the banks and others who sold the bonds to the Fed are running much less risk. Those higher earnings come at a potential cost, especially a vulnerability to quotational losses if interest rates rise. The rest of the world sold trillions of bonds with a duration of perhaps 5 years to the Fed, and got cash with a duration of 0 in return. That is equivalent to the rest of the world making a big bet that interest rates will rise soon, and it protects them against losing anything on that portion of their capital, if that should actually happen. But notice, for the last 5 years, it hasn't.

    Fourth, the banks have no practical reserve requirements on their issuance of new demand deposit liabilities. With trillions in free reserves, they could in theory issue tens of trillions in new checking accounts without hitting their reserve requirement (liquidity motivated) limits. But this does not mean that banks can expand their balance sheets at will. Because reserve requirements are not the only regulatory constraint on their sheet size that banks face, nor the most important one these days.

    Much tighter are their capital requirements. Understand, banks are required to have bank reserves left at the Fed to cover themselves in daily clearing, up to 10% of their checking account deposit liabilities. But they are also required to have a net worth of 8.5% of their risk adjusted assets - and higher for mandated safety cushions etc. The capital requirement is not aimed at liquidity and what might happen in clearing one afternoon. It is aimed at solvency, and the worry about what might happen if all the assets on the other side of the bank's sheet prove to be worth less than expected, less than their carrying value. Because their deposit and other liabilities on the owed side of their sheet are not going to drop. The bank needs capital - its own net worth - standing between any fall in the value of all of its assets, and what it owes, all of it.

    Right now that constraint binds oh about 10 to 15 times tighter than reserve requirements. Practically speaking, to make a new $10 million in loans, the bank first wants to have $1 million more in net worth to be on the safe side.

    Which means the factor governing how fast the bank's expand their sheets it not the mechanics of making loans, nor the amount of bank reserves they have. It is how fast they can grow their net worth. Their *profitability*, not their *liquidity*, is the rate determiner.

    If you want banks to growth their sheets faster, then you want banks to make more money themselves, first. Anyone who does not understand that has fundamentally misunderstood our current banking system, and where it is now that the Fed has provided trillions in excess reserves.

    They would also need demand for loans to match those higher earnings, to be sure.

    But people expecting to punish the banks into lending more are trying to grow taller by chopping their legs off - they just haven't the faintest idea what they are doing. Regulators have dramatically increased the capital requirements at the banks, and that makes them safer, certainly. But higher capital requirements and fast loan growth require vastly more total capital in the banks, not lower capital in the banks, and the only way we get there is by the banks making obscene piles of profits, first.

    Those who desire prosperous capitalism desire prosperous capitalists. Those who think they can have one without the other are merely confused.
    Sep 15 01:45 AM | 10 Likes Like |Link to Comment
  • Brazil seeks to freeze Eike Batista's assets [View news story]
    Um, a put option is an *option*, not an obligation. This story makes no sense ("tabled" the put option? What does that even mean? Does it mean he decided not to exercise it? They don't even tell us what entity had which side of the option, write vs owned, and for what consideration...), and smells of a political witch hunt.
    Sep 14 07:26 PM | Likes Like |Link to Comment
  • How To Use Money Supply Statistics For Market Predictions [View article]
    "Federal Reserve member banks (all banks) can take those excess reserves out of the Fed at any time and they then become part of M1 or M2."

    No, they really can't. Only the public can, if it chooses to hold additional physical currency in place of bank deposits.

    A dollar of issued high powered money can take only two forms - a physical federal reserve note or a dollar of bank reserves on deposit at the Fed branch. Banks that pay out bank reserves do so to other banks or customers of other banks, who have the same choices. No action by a commercial bank uses up a single dollar of bank reserves. If the public keeps its holdings of physical currency unchanged, no action of the commercial banks can reduce the volume of bank reserves outstanding by a single dollar. One can reduce its holdings of them only if another willingly raises its holdings of them by the same amount.

    Note that if a commercial bank swaps its bank reserves for physical currency but nobody withdraws that currency from the banking system, it becomes "vault cash" - which is *not* part of the money supply. All the money aggregates measure money *in the hands of the public*, not in the hand of commercial banks.
    Sep 14 06:53 PM | 2 Likes Like |Link to Comment
  • How To Use Money Supply Statistics For Market Predictions [View article]
    Counterfeiting is the act of signing someone else's name to an IOU. You can issue all the promissory notes you like, on any terms any counterparty will accept, as long as you sign your own name to them. If you sign my name instead, trying to issue my liability for your own benefit, without my authorization, then you are engaged in counterfeiting. The Fed counterfeits nothing - every liability it issues is signed with its own name.

    Balance sheet expansion is not counterfeiting, it is simple credit freedom, and anyone can do it. I paid for my last airline ticket by issuing an IOU through my credit card; I paid for my last car in large part by signing a note; I refinanced my house by signing another note. All are balance sheet expansion of the same exact economic nature as what the Fed does when it expands its sheet. There are just more people willing to accept its liabilities than mine, and on easier terms. That is quite completely all.
    Sep 14 12:48 PM | 2 Likes Like |Link to Comment
  • What Is Your Emerging-Markets Allocation? [View article]
    Answer - 0. The core periphery model is sound, it reflects reality. Political risk in the developing world is very high and it is growing, not falling. Sometimes statistics are just mindless.
    Sep 12 12:27 PM | 1 Like Like |Link to Comment
  • The Risk Of Permanent Loss [View article]
    I have nothing against the MLP form, and I've used REITs in a similar way in the past, but I find it not practical to get adequate diversification with MLPs today. With REITs you can get diversification, but the valuation just isn't there (anymore). Too long a past good run to too high valuations etc. Undiversified positions, to me, just accept too much uncompensated risk.

    If you can hold 20 of the things and still have them be only a portion of your portfolio, good for you; most people can't do that research themselves, monitor all of it closely enough; cover their transactions costs in many small positions, etc. That asset class really needs a good ETF that gives full diversification and minimal trading and monitoring costs, without too much added expense (through scale economies etc).

    On the growth I expect, yes that is roughly my expectation for the large value asset class over 10 to 20 years. If you use a lower expectation, you might drive the expected growth to 2.5% instead of a bit over 3%, but I would still consider that an expected rate of inflation - which the the target. These people do not need their real income to grow, they just need to keep up with prices and then live on what they can safely spend once that is accomplished - here, about 4% of portfolio value. My large value expectation is based on historical performance and their current valuation (PEs etc).

    I don't like smalls and midcaps at PEs as high as 30, and I think the growth stock style is overvalued generically right now, for cycle phase reasons. A younger profile investor, in their accumulation phase, could use full index stock for half, and large value for half, of a higher stock weighting; they have the time to tolerate a higher total standard deviation. Already in retirement with only a keep pace with inflation goal, to me large value fits the bill.

    I should also point out, thought, that the stocks held by those two chosen fund are different from some others of the dividend income style. They do not focus on utilities, phone companies, REITs and the like, chasing dividend yield. They focus on large value in operating industries that are also paying an adequate and growing dividend. That includes large tech companies (Apple is the largest holding of the dividend index fund e.g.), oil majors, banks, etc. Their Sharpe ratios are very good, incidentally. Their current yield is only around 3%, which is certainly above the market, but isn't going to be a majority of their total return. In other words, the stock allocation (where the target weight is 35%) is deliberately targeted at large value with moderate PEs, good Sharpe, and diversified operating industries, not pure income vehicles.

    I hope that helps explain the rationale etc.
    Sep 12 12:10 PM | Likes Like |Link to Comment
  • Bank Lending Through August: Commercial Real Estate Lending At Smaller Banks Continues To Thrive [View article]
    Useful run down, thanks for posting it.

    To me the really big news in the banking sector these days is the huge improvement in write off rates. I understand you are looking at the H.8 release, and that always bears watching. But I am also looking at the "Charge off rates" release -

    http://1.usa.gov/KHLFCL

    Notice that commercial real estate loan charge off rate, 9 basis point annual rate in the latest quarter, down from recession peaks of 3.26% annual rate. The C&I loans category, 20 basis points, down from 2.66% at its recession peak. Credit cards, 3.45% annual rate down from 11%. And the overall total is now running 0.49% per year, down from 3.14% in the 4th quarter of 2009.

    Basically, loan losses have disappeared. Working through recession defaults, tighter standards for new business, and especially just the recovery, have all done their jobs in healing credit behavior.

    We are now in fact in a new transition period, it seems to me, in which credit losses have fallen back to near zero levels, but rates have not normalized higher yet. The next phase I would expect would be rising rates on the loan side, and then rising rates on savings, following those with a lag. Banks could not afford to pay savers to gather loanable funds when their loan books were defaulting at 2 and 3% annual rates. But now they should be able to expand by gathering e.g. CD deposits - if their regulatory capital allows, at least.
    Sep 12 02:16 AM | 1 Like Like |Link to Comment
  • The Risk Of Permanent Loss [View article]
    Sample retirement income positioning, to show what I mean about income risk...

    20% in Vanguard High Dividend ETF (VYM)
    40% in Vanguard Wellesley Income (VWINX)
    20% in Loomis Sayles Bond Retail (LSBRX)
    20% in iShare Preferred Stock (PFF)

    Current yield 3.86%, can expect a bit over 3% growth from stock component, expected return around 7%, standard deviation of returns also about 7%, risk about 55% of the market, duration risk about 5.9 (from 64% income weighting with 9.2 duration average, but split between 4.5, 6.2, and 15 year portions).

    Meant for someone with at least a 10 year time horizon living off the income the portfolio throws off (plus other sources e.g. social security; it isn't their only income etc).

    If interest rates stay low for an extended period, the above position will do fine. If they rise materially, the duration may cause some short term and merely quotational dips, without the income being affected. In a 5-6 year time frame the bond portions (44%) will reset to a higher level of rates, in that scenario; the preferred will not, but is starting out at 6.7% to begin with.

    Compare that to someone with a third each in CD cash at 1% (and a few years maturity to get even that), 10 year Treasuries at 2.5%, and in index common stock yielding 1.8% (with no value / income emphasis), for under 1.8% income instead of 3.9% (less than half), thus effectively betting the house that rates will soar in less than that 5-6 year time frame. By standard volatility of principal measures (or even credit risk of permanent loss ones), the latter may seem "less risky", but by any realistic standard it is running a much higher risk of a bad outcome, and precisely in a market timing fashion, pretending it can "call" the next move in interest rates.
    Sep 12 01:58 AM | 1 Like Like |Link to Comment
  • The Risk Of Permanent Loss [View article]
    Wall-Invest - sensible. I have seen another which may fall under your number 3 but sometimes it isn't obvious that it will - income risk. This happens when investors too fixated on possible loss of capital put all their fixed income investments too short on the maturity spectrum, and then face low short term rates. They back in to your number 3 without realize they were headed there, basically. Because they didn't know this kind of risk exists and thought only of volatility or permanent loss of capital as being risks.

    Longer maturity fixed income assets do have a higher variability of the market value of the principal, but they have greater stability of the income from that principal than do short maturity fixed income assets, because interest rates move.
    If someone is actually going to be living from the income from a fixed income investment for 20 years or more, the fluctuations in the value of the principal may be a matter of complete indifference. But a drop in the income from that principal that could amount to 80% of it or more, is a very serious risk.

    Fixed income investors need to understand the concept of duration, and the "pay me now or pay me later" nature of principal value fluctuations, for income investments with fixed coupons and certainty of actual payments being made. To the duration point, you are going to get the bought yield, regardless of what interest rates do in the meantime.

    A portfolio of sound preferred stocks paying 6% with a duration of 15 years may in fact be a much less risky income investment for a retiree than short term corporates or intermediate Treasuries. Or a mix of those with 10 year corporates paying 3-4%, to have some reinvestment "course correction" possible if rates do move upward appreciably, at some point in a long future retirement.

    It isn't just a higher expected return from running a higher risk that is involved here. It is that there is a very meaningful sense in which the future risk from fixed income investments that reset more often and more rapidly, is actually higher than the future risk in such investments which will either never reset, or reset only once, over the course of your expected use of their income.

    To see this, consider not the volatility of the market quote for your principal at one moment in time, but the "volatility" (really, dispersion) of the total present value you could be paid over the entire lifetime, over the set of all likely future interest rate paths. The discounting factor will affect the alternatives equally on any path. But an all-short maturity position faces a much wider dispersion in the actual nominal payments received, over all likely future interest rate paths.

    Going all short maturity is in fact a heavily weighted, market-timing style "bet" that interest rates are about to rise by a whole bunch, and not a risk-avoiding, neutral, or default positioning. Such "all in", market timing bets are usually a very bad idea, adding lots of risk without any appreciable gain in expected return.

    Another way of putting this is that those offering longer maturity fixed income assets are effectively offering a kind of insurance effect, in which they promise to pay you an expected average of future short rate paths, which the contract price negotiates in advance. And if the future winds up being materially different from that estimate, that they will be the side exposed to the "miss". Longer maturity rates are higher than short ones because that long run average is already expected to be higher than current short rates. But the range of possible "integrals" of the short rate, is much wider (less certain) than the market's best guess today about what that average might be. Unless one knows that market estimate is very likely to be seriously wrong, the risk reducing course of action is to take up the market's offer, and bank the average.

    FWIW...
    Sep 12 12:58 AM | 1 Like Like |Link to Comment
  • The Risk Of Permanent Loss [View article]
    Praveen - the board doesn't decide. They can oppose the sale, and it will still happen as a hostile takeover, if the buyer just convinces 51% of the shares to sell to them. Happens all the time. And no, the initial valuation need not have been incorrect for the sequence to happen.

    Market valuation matters. Normally it matters as an opportunity, but it can matter as a threat as well - either because you can in fact be forced to sell, or because the company can be forced to sell shares that dilute you, at too low a price.

    We have all read our Graham and know its "just so" storyline. But 30 years of actual investing have taught me that there are more things in heaven and earth than are dreamt of in that particular story.
    Sep 10 07:26 PM | 3 Likes Like |Link to Comment
  • The Risk Of Permanent Loss [View article]
    So I value a company and get $20 a share as the full private owner's value, and see the stock is trading at $14, and buy in at that price. The price subsequently falls to $7 a share. Now clearly my chance of losing that remaining $7 is lower than the chance of losing the first $7 per share, but that doesn't mean my chance of suffering a permanent loss of some kind from my original $14 paid in, has gone down. On the contrary.

    There is now the prospect that another company or private equity firm might come along and offer $10 a share for the entire company, and a majority of my fellow shareholders might agree to that, since it is above the $7 the market is offering them. And I might thus be forced to sell at $10 a share, when I bought originally at $14 and think the company is fairly worth $20.

    One is not always allowed to hold forever, in other words. Not if all your fellow shareholders think the company is worth much less than you do.
    Sep 10 03:06 PM | 2 Likes Like |Link to Comment
  • The Risk Of Permanent Loss [View article]
    "First, can I lose all the money I have in a company or portfolio by it going bankrupt? Second, can I severely damage my liquid assets by not handling the emotional pressure of a big decline (20% or more) and selling at the depths of the market low?"

    These are not the only varieties of permanent loss.

    Citigroup common currently shows a 90% loss since its 2007 high price. It declined 97% to its 2009 low and then rose 3.5 fold. The market cap today is $157 billion; it certainly wasn't $1.57 trillion in 2007. What happened is that the company avoided bankruptcy *by issuing more stock, near the lows*. This diluted the previous holders materially. The people who own most of the company today are not the common shareholders of 2007, but those who bought the new shares in 2009. It doesn't matter that the price per share "recovered", when in between the stock split 1 for 10. The recovery is all the way up to $5.18 per 2007 share; 2007 shareholders own less than a quarter of the company.
    Sep 10 12:50 PM | 5 Likes Like |Link to Comment
  • U.S. banks to be hit with tougher capital rule [View news story]
    So the regulators require that banks have 11 to 12% capital, the government and lawyers loot them for $200 billion in shakedowns, on top of the $1.5 trillion in defaults that main street stuck them with - and then everyone turns around and wonders why the economy isn't growing faster.

    No credit, no fuel, no growth. No leverage, no expansion of credit without much higher profits. Defaults and shakedowns, no profits. Nobody here can play this game - or even think straight. The desire for prosperous capitalism while all actual capitalists are boiled in oil, is a round square and a misunderstanding.
    Sep 9 04:17 PM | 10 Likes Like |Link to Comment
  • Central Bank Balance Sheets [View article]
    "Those with capital are ripped off by artificially low to no interest."

    US Household sector assets, top line, June 2014 Z.1 table B.100 - $95.549 trillion.
    US Household sector assets, top line, end of 2008, same table - $71.476 trillion.

    Net change in the value of assets of "those with capital" since the Fed initiated its emergency operations - plus $24.073 trillion.

    Um, if that is being ripped off, what is being pampered?
    Sep 8 10:49 AM | 4 Likes Like |Link to Comment
  • Big banks get hit with CDS lawsuit [View news story]
    TBTF is short for "too big to fail". Meaning a bank so large the government cannot tolerate it going bankrupt, because it would crash the whole economy.

    But hey, they and the lawyers can bleed them forever and pretend the actual stockholders are their own personal ATM machines.
    Sep 5 02:59 PM | 5 Likes Like |Link to Comment
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