Dr. Sherry Jarrell

Bernanke on selling toxic assets

Ben Bernanke, the Chairman of the U.S. Federal Reserve, announced that the Fed was likely to begin to sell some of the $1 trillion in mortgages, the so-called “toxic assets,” that it purchased over the last fifteen months to help stave off a total credit market meltdown. Those purchases essentially doubled the U.S. money supply, igniting fears of potential inflation should the underlying real economy recover before the money supply could be drawn back down. See earlier post.

Well, the process of tightening the money supply may be just around the corner. And increases in interest rates and the cost of everything purchased on credit – homes, cars, durable goods, and business capital expenditures – are not far behind. Increases in interest rates dampen economic activity, an unfortunate development given the current lethargic state of the U.S. economy. But it has to be done sometime – we cannot sustain such a huge increase in the money supply without paying an even higher price in terms of inflation and a weak dollar.

It will be interesting to see who buys the toxic assets and how much they will pay. Regardless, the sale will reduce the money supply which, if done in a slow, orderly manner, is a good thing for the economy. Getting the Fed out of the business of buying and selling private market securities will be an even better thing for the U.S. economy. Now more than ever we need a monetary authority that is focused on the best policies for our economy, not those that help Fannie Mae, the White House, or the Treasury Secretary save face. 

Should You Invest in U.S. Bonds? Part 2

Sources and types of risk in U.S. and other bonds.

This is part 2 of a multipart series on the factors that drive U.S. and foreign bond prices and yields.

Recall that a bond’s price is the present value of its coupons (if any) and face value (or principal or par value).  Let’s keep things simple for now and consider a zero-coupon or “discount” bond.

One thing of interest to note first: As we move forward in time from the issue date toward the maturity date, and the number of periods between now and the maturity date falls, the price of a discount bond rises toward the face value of the bond, even with no changes in the interest rate.  At maturity, the price of the bond equals the face value. Only unexpected changes in the effective return on a bond can change the natural upward progression of its price toward face value between the issue and maturity dates.

This example makes clear that the (annual) yield on a bond, simply put, is driven by the difference between the price paid for the bond and the cash flows it generates, that is, the difference between “dollars out” today and “dollars in” later.

The “dollars out” are known because we pay a given price for the bond today.  The “dollars in,” consisting of coupons (if any) and the face value of the bond, are also “known” in that they are specified in a contract at the time the bond is issued.  The realized value of these dollar returns is, however, subject to many different sources of uncertainty or risk. A short list includes:

Interest rate risk: how sensitive the price of the bond is to changes in interest rates over the life of the bond.  Interest rate risk is higher for bonds with a longer maturity (more time for the unexpected to happen), a lower coupon (more of the value of the bond is tied up in the principal), and a lower initial yield (a 1 percentage point change in interest rates represents a higher relative change in low yields).  Floating-rate bonds have much lower, though not zero, interest rate risk.

Reinvestment rate risk:  Bondholders may reinvest their coupons at the then-prevailing rate of interest. As those market rates of interest change, the return on reinvested coupons becomes less certain. Reinvestment risk is higher the higher the coupons, the more frequently the coupons are paid, and the longer the maturity of the bond.

Bankruptcy Court: Destination for issuers in default

Credit or default risk:  the risk that the issuer will default on the payments of the bond, which reduces the number of “dollars in” relative to price paid, lowering the earned yield on the bond.   Credit risk is frequently measured as the credit spread over like Treasuries, which are assumed to have zero credit risk.  Credit risk includes downgrade risk, where a credit rating agency lowers the rating on an issuer as their ability to repay the debt is brought into question.

Call risk:  the risk that a callable bond will be called by the issuer. Since a bond is typically called only when it’s in the best interest of the issuer, the call feature is systematically harmful to the bondholder.  Prepayment risk reverses these risks:  prepayment is good for the bondholder, and bad for the issuer.

Exchange rate risk (that the value of the repaid currency will be lower), inflation risk (that the value of the repaid dollar will be lower), and event risk (natural disasters, corporate restructurings, regulatory changes, sovereign or political changes) round out the list of broad types of risks that drive bond yields.

Next time: why the types and level of risks are so difficult to measure and predict.

by Sherry Jarrell

The Fed's Exit Strategy

Finally, we hear from the Federal Reserve about how they plan to unwind the billions of dollars of toxic assets they purchased over the last 18 months or so without creating further distortions in the U.S. and world financial markets (Fed lays out exit detail). This after the Fed barely acknowledged one of the most dramatic runups in the money supply in U.S. history. 

The announcement came in a speech by Brian P. Sack (pictured at left), the executive Vice President of the Markets Group at the Fed.  I am impressed by this guy. He seems to know what he's talking about and seems to understand how markets and fed policy interact.  

In earlier posts (http://www.sherryjarrell.com/2009/06/t.html) I wondered aloud how the Fed might accomplish this tricky task. It is a very delicate balance between reducing the money supply too quickly, which would spike short term rates, and too slowly, which would increase long-term rates due to worries about inflation (which occurs when money growth is higher than the economy's real growth, even if money growth is falling). 

The Fed, the article explains, apparently intends to let $200 billion of the estimated $1.25 trillion in new money supply simply "mature" by the end of 2011 without replacing it. This represents largely toxic assets. The Fed might let another $140 billion of Treasuries it purchased during normal open market operations mature at the end of 2011, but they aren't committing to that.  So that's about $340/$1,250 or about 35% of the historic increase in money supply that may be vaporized over the next 21 months. What about the rest?  It would be nice to know but....

The Fed is doing the right thing by explaining its policy intentions -- ANY of its policy intentions -- to the markets.  Markets want, need, and deserve information from our officials, something that has been sorely lacking of late. With information, lenders and borrowers can plan, they can optimize. Without information, guessing, withdrawing from the market, and fear rule the day. Not a good environment for economic recovery.

Lessons learned as a Government Intern

When lending is motivated by politics, losses are not far behind.

Years ago, in the summer of 1980, I worked as an intern in the Federal Home Loan Bank Board at the Department of Agriculture.  I was a senior in college majoring in business and had been accepted to the University of Chicago doctoral program.  I didn’t want to take the internship because I wanted to take more courses over the summer to help prepare me for the rigors of grad school, but my college advisor had openly worried that I was far too serious for a young person.  He strongly encouraged me to accept the internship and take a break from academics before I immersed myself in graduate school, and buried myself once again in all things economics!

The U.S. Department of Agriculture was a major lender

I agreed, but only after I had arranged to take 6 credits of independent study in D.C.  I chose to examine the Negative Income Tax program, one of the largest social experiments in U.S. history. More on that at another time. Today, I want to talk about what I learned from being an employee of the U.S. federal government.

The first thing I learned was that the “problem” with government work is not the people; well, not all the people.  There was one man who spent his entire day going back and forth to feed quarters to the parking meter rather than pay for public transportation or do his work.  He represented the worst in government employees.  Most all of the others I met were hard-working and honest people, trying to do a good job and make a difference.

President George H. W. Bush

No, I learned that the real problem was with the way the "work" is done in government. I worked for the Federal Home Loan Bank Board (FHLBB) that summer, which was one of the largest lenders in the world.  The FHLBB was responsible for small business, rural, agricultural, and economic development lending. My job was to review loan applications from community groups, fairs, farmers’ markets, and various municipal organizations to make sure that they were complete.  We did not analyze the applicants for creditworthiness.  Instead, if the application was correct and complete, and satisfied the application process, it was approved.  The FHLBB, which was publicly trashed by the first President Bush as being largely responsible for the savings and loan crisis, was abolished and replaced by the Office of Thrift Supervision (OTS) under the Department of the Treasury in 1989.  The OTS eventually expanded its oversight to companies that were not banks, including Washington Mutual, American International Group (AIG),  and IndyMac,  all implicated in the current U.S. financial crisis.

AIG

Little did I know back in 1980 that I was witnessing, from the inside, a government lending process that would lead to the most significant financial crisis since the Great Depression. Looking back, the outcome was perfectly predictable: when politics replaces profits as the motivation of the lender, it should be no surprise that losses result.

The Hypocrisy of Finding Medicare Waste

I honestly cannot understand how President Obama can look the American people in the eye and tell them that Health Care reform will be paid for, in part, by finding savings and reducing fraud in Medicare over the next several years.

President Obama on Health Care Reform

If it is possible to operate Medicare more efficiently, why have we not done it already?  Why must doing it right wait for new programs and new legislation?  Why doesn't Congress first prove to the American people that it can operate a program efficiently and then come back and ask for more?

Because it can't, that's why not.   The plain and simple truth is that it cannot do so now, and will not do so in the future.  So why are we letting our elected officials get away with such a charade?

I just don't understand it.

Kucinich's Early Retirement Proposal

Senator Dennis Kucinich (Democrat – Ohio) is on the media circuit promoting his rather novel idea on how to “create” jobs for younger people who are trying to enter the work force but can’t because of the recession.

The Senator has proposed legislation that would allow people to take voluntary early retirement at age 60 instead of age 62, as the law now stands.http://tinyurl.com/kucinich-job-creation.

Kucinich, who ran for the Democratic nomination for President in both 2004 and 2008, estimates that about 25% of those eligible to retire at age 62, or about 1 million people, would choose to take early retirement under his plan. He claims that this is a conservative estimate, since about 70% of those who can retire at 62 do so now.

These early retirees would, of course, collect social security earlier, after having worked fewer years and contributed less to Social Security. And then we’d have to assume that these workers would be replaced by the younger people now looking.  And that they would generate the same tax revenues for the government that the early retirees did.

What a plan!  Lock in higher costs, with no guarantee of any benefits.  This is the kind of logic that put the U.S. into this pickle in the first place.

How does Senator Kucinich propose to pay for this plan?  Why, with government funds, of course!  Specifically, with the “extra” unspent stimulus and TARP funds.  This, despite the fact that he has spoken repeatedly about voting against the TARP funds because he opposes government interference in the private economy. But, hey, he goes on to say, “Since the money is lying around anyway, let’s use it!”  You’d think tax revenues fall out of the sky!

I do not know which is worse, the hypocrisy or the ignorance.  What folly! This man has absolutely no business talking about how to create jobs when he has no idea how the economy actually works.

Here’s an idea that is guaranteed to help the economy recover.  Why doesn’t Senator Kucinich take voluntary early retirement!?

Latest US Growth Rate

The U.S. GDP grew at an annual rate of 5.9% in the last quarter of 2009 which may look good at first glance, but when we dig a little deeper, we find some concerns about the implications for sustainable growth.  A large fraction of this reported growth came from businesses selling off accumulated inventories, which has more to say about past production than current. Exports were also a significant source of fourth quarter growth, driven in large part by a weak dollar.  Of course, a weak dollar is a very mixed blessing for the economy, and is hardly a sign of a strong or recovering economy.
 

Real residential fixed investment increased 5.0 percent, helped along by the extension of the home purchase tax credits from the federal government. 

Real nonresidential fixed investment increased 6.5 percent. This figure nets out nonresidential structures, which decreased at a troubling rate of 13.9 percent, and equipment and software, which increased 18.2 percent. Investment in equipment and software consists of capital account purchases of new machinery, equipment, furniture, vehicles, and computer software; dealers’ margins on sales of used equipment; and net purchases of used equipment from government agencies, persons, and the rest of the world. Own-account production of computer software is also included, which is production performed by a businesses or government for its own use.  

Again, the underlying figures show that those variables most associated with building a sustainable productive capital base for the economy – nonresidential fixed investment –are declining at an alarming rate. This, combined with a 9.7% unemployment rate and the specter of rising debt levels, energy prices, and taxes, paints a picture of a slow to non-existent recovery to a robust economy any time in the next year. 

http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm