Bubbling Up...11/27/12

1) What Drives Trade Flows? Mostly Demand, Not Prices by JW Mason @ The Slack Wire

The heart of the paper is an exercise in historical accounting, decomposing changes in trade ratios into m*/mand D*/D. We can think of these as counterfactual exercises: How would trade look if growth rates were all equal, and each county's distribution of spending across countries evolved as it did historically; and how would trade look if each country had had a constant distribution of spending across countries, and growth rates were what they were historically? The second question is roughly equivalent to: How much of the change in trade flows could we predict if we knew expenditure growth rates for each country and nothing else?

The key results are in the figure below. Look particularly at Germany,  in the middle right of the first panel:

The dotted line is the actual ratio of exports to imports. Since Germany has recently had a trade surplus, the line lies above one -- over the past decade, German exports have exceed German imports by about 10 percent. The dark black line is the counterfactual ratio if the division of each county's expenditures among various countries' goods had remained fixed at their average level over the whole period. When the dark black line is falling, that indicates a country growing more rapidly than the countries it exports to; with the share of expenditure on imports fixed, higher income means more imports and a trade balance moving toward deficit. Similarly, when the black line is rising, that indicates a country's total expenditure growing more slowly than expenditure its export markets, as was the case for Germany from the early 1990s until 2008. The light gray line is the other counterfactual -- the path trade would have followed if all countries had grown at an equal rate, so that trade depended only on changes in competitiveness. When the dotted line and the heavy black line move more or less together, we can say that shifts in trade are mostly a matter of aggregate demand; when the dotted line and the gray line move together, mostly a matter of competitiveness (which, again, includes all factors that cause people to shift expenditure between different countries' goods, including but not limited to exchange rates.)

Woj’s Thoughts - If correct, this explanation for global trade imbalances would certainly throw a wrench in standard, mainstream theories that assume prices and exchange rates respond to alleviate any imbalances. Clearly greater relative income growth should lead to larger imports relative to exports. Using a sectoral balances approach, the question is why doesn’t the boost to aggregate demand from rising trade surpluses alter prices and income in a manner that creates convergence? I certainly don’t expect the changes to happen quickly, but remain of the view that some institutional factors (e.g. tax policy, financial regulations) likely encourage diverging prices and incomes.

2) Hoenig: A Better Alternative to Basel Capital Rules by Thomas Hoenig via The Big Picture

Basel III is intended to be a significant improvement over earlier rules.  It does attempt to increase capital, but it does so using highly complex modeling tools that rely on a set of subjective, simplifying assumptions to align a firm’s capital and risk profiles.  This promises precision far beyond what can be achieved for a system as complex and varied as that of U.S. banking.  It relies on central planners’ determination of risks, which creates its own adverse incentives for banks making asset choices.

3) S&P: Australia is Spain in waiting by Houses and Holes @ MacroBusiness

Australia must find a Budget surplus before 2014 or it will lose its AAA rating, according Kyran Curry, S&P sovereign analyst via the AFR:

“If there’s a sustained delay in returning the balance to surplus, as the economy gathers momentum and as people start spending again, as the import demand picks up and current account blows out, we might not see the government’s fiscal position as being strong enough to offset weaknesses on the external side and that’s what worries us…Australia’s already, as we see it, got some credit metrics that are right off the scale when it comes to assessing Australia’s external position…It’s got high levels of external liabilities, it’s got very weak external liquidity and that basically means the banks are very highly indebted compared to their peers…For us, we look to Spain, which was Australia’s closest peer four or five years ago in terms of having a very strong fiscal position, very similar to what Australia has at the moment, its external position was weaker, like Australia’s, and it got routed very quickly…The government needed to provide support to the banks, it had to shore up growth in the economy and its debt levels more than doubled…We can see that happening in Australia’s case.”

Woj’s Thoughts - Contrary to popular perception and especially the Market Monetarist crowd, I’ve been arguing that Australia is facing serious headwinds that will end its impressive growth streak. In this context, Spain offers a reasonable comparison considering its high levels of private debt, housing bubble and high level of external liabilities prior to the current crisis. Having a sovereign currency permits Australia more scope in terms of policy responses, however the current government seems keen on following Europe’s approach. If the Australian government attempts to “find a Budget surplus before 2014,” it may keep its AAA rating while almost certainly exacerbating the downward spiral.  

4) Borrowers with modified mortgages re-default as homes re-enter shadow inventory by Walter Kurtz @ Sober Look

We are therefore seeing a sharp rise in re-defaults from modified mortgages.

This is telling us that mortgage modification programs have not been very successful, as the probability of re-default rises. By modifying mortgages, banks in many cases are simply kicking the can down the road - and now some are writing down these mortgages (which may be what is driving the higher charge-off numbers). We are therefore seeing an increase in delinquencies, but mostly among modified mortgages and concentrated in sub-prime portfolios.

Woj’s Thoughts - Bad news for banks and the government. Mortgage modifications were simply not enough for many homeowners who remain underwater and without the requisite income and/or savings to seemingly ever repay the entire loan. If this new wave of re-defaults persists, as JP Morgan expects, housing prices and bank earnings may return to a downward trend.

5) China's Economic Growth: A Different Storyline by Timothy Taylor @ Conversable Economist

When I chat with people about China's economic growth, I often hear a story that goes like this: The main driver's behind China's growth is that it uses a combination of cheap labor and an undervalued exchange rate to create huge trade surpluses. The most recent issue of my own Journal of Economic Perspectives includes a five-paper symposium on China's growth, and they make a compelling case that this received wisdom about China's growth is more wrong than right.

For example, start with the claim that China's economic growth has been driven by huge trade surpluses. China's major economic reforms started around 1978, and rapid growth took off not long after that. But China's balance of trade was essentially in balance until the early 2000s, and only then did it take off. Here's a figure generated using the ever-useful FRED website from the St. Louis Fed.

Woj’s Thoughts - I always have a soft spot for arguments, backed by data, that undermine the mainstream opinion. Although I continue to side with Michael Pettis on the forthcoming rapid slowdown in China’s GDP growth, I agree that growth will persist and lead to a much higher standard of living in the future.

Euro-area in Double-Dip Recession...Since Q3 2011

At the beginning of the year I outlined Predictions for 2012, which included the following:

3) The Eurozone enters recession - Practically the entire Eurozone falls into recession, including the likes of France and Germany. A deteriorating economic outlook causes deficit estimates to be raised across the board, facilitating credit rating downgrades. Agreements for greater austerity fail to stem the tide and other attempts to kick the can down the road are pursued.

While many sources expected and continue to expect a rebound in growth, I have consistently highlighted weakening data and economic policies that would only depress growth further. Well, according to The Euro Area Business Cycle Dating Committee of the Centre for Economic Policy Research (CEPR), the euro-area is now officially in a new recession. What may surprise many readers is that the recession officially began in the third quarter of 2011. The failure of many economists and other forecasters to acknowledge the probability of a recession that had already begun several months earlier is all too reminiscent of commentary during the first half of 2008. Considering current and proposed policies within the euro-area, I fully expect the recession to continue and likely worsen in 2013.

(Note: Credit ratings downgrades have also come in mass this year with France the most recent recipient, losing its AAA rating from Moody’s yesterday.)

(h/t James Hamilton @ Econbrowser)

Related posts:
ECB's Changing Philosophy is Good for Bond Holders but Bad for the Economy
ECB's Means (Lost Decade With High Unemployment) To An End (Structural Reform)
Europe's Leaders Should Learn From Game of Thrones
Unending Subordination of Private Creditors Continues

Rating Agencies Now Detract Value

Now that the well telegraphed downgrades are over, bank CDS are tightening this morning (MS and JPM CDS shown below).

At this point Moody's might as well downgrade major banks to below investment grade level and be done with it. Over time rating agencies will become less relevant for large bank credits as all major banks involved in capital markets will converge to roughly the same rating.

Read it at Sober Look
Rating agencies will become less relevant for bank risk
By Walter Kurtz

Where I wonder about the ongoing impact of rating agencies is with investment funds (primarily mutual and pension). I think many of these funds are only allowed to hold debt with certain ratings, so at some level they may be forced to sell or no longer hold bank debt. This would remove a significant bid from debt of those banks (or other companies for that matter). Anyone have a sense of how large that issue might or might not be?

Separately, the reaction in markets today (improving CDS and debt) may disappoint banks who were expecting a boost to profits from DVA.

Preparing for Manic Monday

U.S. equity market futures are currently down nearly 2%. Markets across the Middle east sold off earlier, while Asian and European markets looked poised for similar declines. An exaggerated sense of uncertainty is affecting markets even before the true effects of a U.S. sovereign downgrade are known. For many individuals in the investment world, this weekend was likely very busy as investors and asset managers tried to assess the potential consequences and create a game plan moving forward. Much of my weekend was spent in this fashion so I’ll try to lay out the possible repercussions of the U.S. credit rating downgrade and thoughts on how to invest around it.

As surely everyone is aware by this time, Standard and Poor’s (S&P) downgraded the U.S. credit rating from AAA to AA+ on Friday evening. Potential ramifications are beyond complete comprehension, making it relatively easier to think of possibilities within simplified categories. In this sense the following discussion will focus on treasury debt, U.S. dollar exchange rates, states/municipalities, banks/GSEs, money market funds, investment funds and international markets.

Treasury Debt
To many individuals, the most obvious response to the credit downgrade should be a decrease in price of U.S. debt and corresponding increase in yields. While I expect a quick sell off when markets open tomorrow, buyers may soon after swarm the market searching for yield. Despite the downgrade, treasuries still represent the largest and most liquid asset in the world. With most of the developed world experiencing an economic slowdown and increasing risk of disinflation (possibly, deflation), long-term treasuries still represent a safe, solid investment. Maintaining the expectation that 30-year treasury yields will fall to 3% within the next 5 years, entry points above 4% remain ideal.

U.S. Dollar
Similar to treasuries, most individuals are probably expecting weakness in the dollar. When currency markets opened this afternoon, the dollar was substantially weaker against most currencies, including the euro and yen. However, when U.S. equity futures opened down sharply, the U.S. dollar rallied back. Regardless of the U.S. credit rating, no other currency options currently exist to replace the dollar as the world’s reserve currency. Tonight, the G-7 vowed to provide liquidity and ensure against disorderly variations in currency exchange rates. Since exchange rates naturally reflect movements of one currency against another, it’s unclear which currencies they will aim to support and at what levels. Either way, central planning is unlikely to be successful for very long. Equity market weakness and increasing fears of deteriorating economic growth will likely push the dollar higher in the coming week.

States and Municipalities
Moving into secondary effects of the rating downgrade is where making judgments becomes far more troublesome. Acknowledging the financial support and backing provided by the federal government to states and localities, many of these entities will likely face downgrades starting tomorrow. While treasuries may be exempt from AAA requirements at various investment funds, it’s unclear whether state and local government debt is treated similarly. Either way, the recent debt limit agreement has made it clear that state government funding will not be increased going forward. Already under budgetary pressure, a number of states and municipalities may face higher interest rates and worsening financial conditions.

Banks and GSEs
Possible outcomes become really interesting in this sector as ratings of several firms are almost certain to be negatively impacted. Many American banks, as well as the GSEs (Fannie Mae, Freddie Mac), currently enjoy somewhat higher credit ratings because of the belief that the federal government would once again bail out debt investors, if necessary. However, S&P notes the following negative consideration in their Sovereign Government Rating Methodology And Assumptions:

“Contingent liabilities refer to obligations that have the potential to become government debt or more broadly affect a government's credit standing, if they were to materialize. Some of these liabilities may be difficult to identify and measure, but they can generally be grouped in three broad categories:

· Contingent liabilities related to the financial sector (public and private bank and non-bank financial institutions);

· Contingent liabilities related to nonfinancial public sector enterprises (NFPEs); and

· Guarantees and other off-budget and contingent liabilities.”

Given recent plans to cut federal spending and potential fear of further downgrades, the willingness to bail out these institutions going forward may be reduced. Ratings downgrades for these firms could result in higher capital requirements and some potential forced selling of assets. Already witnessing heavy selling in equity markets the past couple weeks, the pressure may become even more pronounced in the days ahead.

Money Market Funds
Although the long term credit rating of the U.S. was downgraded, the short term rating retained the highest ranking. Treasuries therefore seem unlikely to create any holding issues for these funds. Potential problems could arise if the short term ratings of other investments in bank or GSE paper is downgraded. However, this currently appears to be an area of minimal concern.

Investment Funds
Leading up to the recent market sell off, margin debt on the NYSE was near record highs and cash holdings by mutual funds were near record lows. Investment funds, in general, appear to have been heavily leveraged on the long side after witnessing nearly two years of upwards markets with small pullbacks. Over the past eleven trading days global equity markets fell significantly, with several down over 10%. Further declines could spark margin calls, resulting in forced selling. These circumstances have potential to spiral quickly out of control and feed on themselves in a vicious cycle.

The other primary fear for investment funds stems from potential bylaws requiring a funds’ holdings maintain certain average credit ratings or a specified percentage in AAA-rated securities. Strict bylaws with these constraints have potential to cause forced selling of securities. Many investors have argued that since only S&P downgraded the U.S., bylaws would not be broken (two of three still rate U.S. AAA). Although this may be true, the potential for Fitch or Moody’s to follow suit in downgrading the U.S. (regardless of recent actions) seems fairly high. Asset managers may therefore find it prudent to sell certain holdings in advance of any potential forced selling later on.

International Markets
Recognizing added uncertainty over the coming week, odds seem high that international equity markets will continue selling off. Last week Japan and Switzerland intervened in markets attempting to weaken their respective currencies. The U.S. rating downgrade may increase pressure on those safe-haven currencies again and force further government intervention. Japan, especially, can ill afford an ever stronger yen and maintain hopes of an economic recovery.

Although most discussion within the U.S. has focused on the rating downgrade, some very important news has come out of Europe this weekend. Earlier today Germany says eurozone can't save Italy. In EU Steps Forward, Still Much More Needed, I explained that using the EFSF to support Spain and Italy would require Germany to accept an absurd amount of liability, especially if France were no longer rated AAA. Well, comparing the U.S. and France across many of S&P’s metrics, it appears that downgrade may not be far off. Without France’s AAA rating, the EFSF would be unable to maintain its AAA rating, throwing the whole bailout mechanism into question. Tonight the ECB announced it will purchase Spanish and Italian sovereign debt to stem the crisis. Although they should be commended for following the poem, “if at first you don’t succeed, try, try, try again,” this attempt seems equally doomed to failure. As markets move further into risk-off territory, Europe’s crisis may become increasingly untenable.

Actionable Advice
When I was an options market maker, during times of extreme uncertainty and volatility we always widened out prices. For investors I’d recommend setting limit orders with an extra margin of safety to protect against further downside but take advantage of large moves that present incredible opportunities. While I was certainly bearish on equities with the S&P above 1300, I’m increasingly more constructive in the 1100’s. Over the past two years the market has been led by several high flying stocks that now support price-to-earnings ratios in the stratosphere. Beneath the surface remains numerous securities offering significant yields at reasonable prices. Investors who are currently underweight equities should therefore look to add exposure on further pullbacks.

In spite of its weaknesses, the U.S. remains the most dynamic economy and global safe-haven. Recognition of a global economic slowdown, now recognized, will likely further pressure equity markets to the downside. Europe’s problems continue to worsen with no valid remedy in sight. Japan’s pattern of recurring recessions and deflation continues unabated. China faces prospects of a hard landing as it tries to reign in inflation. As astonishing as it seems, the uncertainty caused by the U.S. downgrade may actually create strength for treasuries and the dollar. For those prepared investors, heightened uncertainty generates the greatest investing opportunities. Get ready for an exciting week!

Reflecting on Rating Downgrade

On Friday night, for the first time in 70 years, Standard and Poor’s (S&P) downgraded the sovereign credit rating of the United States from AAA to AA+. News of the potential downgrade was leaked Friday morning spurring much discussion on Twitter. Friday afternoon it became clear the Treasury, Administration and Congress had been notified of the impending downgrade and seemingly allowed a rebuttal. Since the official announcement, nearly all financial discussion has focused on the uncertain consequences and baffling decision by S&P. Later today I hope to provide some commentary on the possible repercussions of the downgrade, but for now I actually want to take a moment to defend S&P when seemingly nobody else will.

Before placing judgment on the ensuing discussion, please recognize that I do not believe S&P or the other Nationally Recognized Statistical Rating Organizations (NRSRO) are deserving of the legitimacy and power assigned to their credit ratings. Relying on payments from issuers of bonds creates a severe conflict of interest that most notably hurt investors during the widespread misrepresentation of credit risk on mortgage backed securities and other structured finance products. However, many of the current criticisms appear to reflect either a misunderstanding of credit ratings or failure to read S&P’s Sovereign Government Rating Methodology And Assumptions.

“Standard & Poor's credit ratings express a relative ranking of creditworthiness” that is primarily free information available to individuals. It’s important to remember that any credit rating is merely the opinion of an independent company. A credit rating may aid an investor in valuing a bond, but should never replace actual due diligence in determining his/her own opinion on an issuer’s creditworthiness. Since credit ratings represent an opinion, I have no qualms against anyone stating their disagreement with S&P’s view. My urge to write this piece is against those commentators claiming, in various forms, that S&P holds no right to have an opinion. These complaints seem childish and perpetuate many of the political weaknesses noted in the downgrade. Ultimately the decision at S&P was made by a group of individuals with similar rights to an opinion on the creditworthiness of the U.S. as anyone else. Going forward I hope discussions will focus on disagreements in rating methodology or the use of credit ratings and not on who deserves an opinion.

Apart from frustration at S&P stating their opinion, a greater proportion of recent discussion seems focused on displaying disgust towards S&P’s rating methodology. While I certainly don’t believe S&P’s sovereign rating system is flawless (if that were even possible), potential errors do not appear as glaring as many have opined. Although the $2 trillion mathematical error sounds bad, the reality is that amount makes little difference in the long-term outlook or reasons cited by S&P for the downgrade.

One frequent objection that stands out is the claim that S&P should not make qualitative judgments regarding the creditworthiness of the U.S. A number of highly educated people have even appeared surprised by this notion. From S&P’s website (emphasis mine): 

THE BASICS OF SOVEREIGN RATINGS

Standard & Poor's appraisal of each sovereign's overall creditworthiness focuses on political and economic risks and is both quantitative and qualitative. The quantitative aspects of the analysis incorporate a number of measures of economic performance, although judging the integrity of the data is a more qualitative matter. The analysis is also qualitative due to the importance of political and policy developments and because Standard & Poor's ratings indicate future debt-service capacity.

Clearly S&P has not hidden the fact it makes qualitative judgments and I can only assume this basic statement has been available to the public for years, if not decades. Sudden outrage certainly seems misplaced.

Beyond the fact that S&P uses qualitative measures, the question remains whether or not this practice is valid. To address this issue it’s imperative that the meaning of a sovereign credit rating is clear. From S&P’s Sovereign Government Rating Methodology And Assumptions (emphasis mine):

“All references to sovereign ratings in this article pertain to a sovereign's ability and willingness to service financial obligations to nonofficial, in other words commercial, creditors.”

Ability and willingness are highlighted since they represent the similar dichotomy between quantitative and qualitative. As I’ve stated in previous posts, the U.S. is a currency issuer with debt denominated in its own currency and therefore never faces an inability to pay. Laws, such as the debt limit, reflect self-imposed constraints on the country’s willingness to pay. Fathoming ways to quantify future Congress’ willingness to pay is quite difficult. The reality is that U.S. debt currently only faces default risk related to willingness to pay and that risk is by nature qualitative. Therefore, ignoring qualitative measures would be equivalent to disregarding the possibility that Congress could ever choose to default (and has happened before).

The first downgrade in history has now occurred, which makes it time to address and deal with the consequences. From my perspective, too much time has already been spent degrading S&P and complaining about the decision. If investor’s opinions differ from S&P, than any related sell off in treasuries should provide a nice buying opportunity. If people believe credit ratings are used by investors inappropriately, then they should work to increase education and improve dialogue on the matter. If Congress believes S&P’s critiques were out of line, then they should prove an unbound willingness to pay by removing self-imposed restraints such as the debt limit.

Ten days ago President Obama said the following in a speech on the debt ceiling:

Now we have a AA+ credit rating, to match our (at best) AA+ political system. S&P’s credit rating downgrade only confirmed this belief that most already held. Less time should be spent demonizing S&P and more time focused on rebuilding a AAA political system. When that day comes, I have a feeling the credit rating will also display AAA.