One of the concerns with the Fed’s policy of low interest rates is the prospect of financing a bubble. Usually that story involves individual investors buying stocks on margin and because those margin purchases enable larger purchases the stock price rises above fundamentals.
This story suggests another route for stock prices to exceed fundamentals. The idea is that low interest rates enable firms to finance purchases of their own stock. Should investors not recognize that the resulting stock prices stem from elevated leveraging rather than improved fundamentals, they–in turn–buy those stocks driving their prices still higher.
Here (Cyprus Bailout Revisited) Holman Jenkins argues that Cypriots would have fared better with a flat tax on all deposit accounts. This is uncharacteristic of Mr. Jenkins as a flat tax would have reneged on the country’s deposit insurance contract. Reneging has consequences. In Finance, it is often said: “fool me once, shame on you, fool me twice shame on me.” In other words, if I fall for your lies/stories/miss-characterizations twice then I’m to blame. In this application, should I default on a contract with you, then you should not enter into a second contract with me. (I’ll come back to this point below.)
Deposit insurance is a contract. It promises to protect account holders from loss should the bank holding those deposits fail. In Cyprus, that protection extended to the first €100,000 of the account. Amounts beyond that threshold were uninsured. Mr. Jenkins’ article argues that reneging on all deposit insurance contracts would have been preferable.
Jenkins does this without describing, or even mentioning, the long term consequences of a Cypriot default. Above I said, once fooled one by someone–that is, once defaulted on; I am the fool on entering into yet another contract with that defaulter. The statement should be qualified. For example, were the proposed contract fully guaranteed by a third party then entering into the contract may be acceptable. The point is that guarantees and other conditions raise subsequent contracting costs for the defaulting party. It is these costs that Jenkins ignores.
It is far from clear that the default Jenkins favors should be preferred over the higher cost that the Cypriot banking system would incur as it tries to attract deposits. A more reasoned approach would allocate losses strictly to uninsured deposits. There being no contractual duties to protect those depositors, this loss allocation maintains Cyprus’s credibility as a contract participant.
Jenkins is right to criticize certain exemptions to the allocation of losses. These are egregious, but reneging on all deposit insurance contracts is at least as bad.
Chilton argues that the CFTC budget was cut by one third because the Commission has pushed Dodd-Frank implementation. You’ll find that opinion expressed here
Chilton’s budget argument is off a bit. Current budget levels are consistent with levels needed for oversight of the futures markets but do not reflect the increased responsibilities assigned by Dodd-Frank for OTC markets. For its added oversight responsibilities, the CFTC in 2010 requested a budget increase. They didn’t get it. So what Commissioner Chilton calls a “cut” is better described as not funding the new responsibilities.
His response is to ask for a transaction tax. The idea is to make the CFTC self-funding. The tax assessment would give the CFTC a revenue stream from which it could cover its expenses. The excess over its expenses would then go to Treasury. This is similar to how the SEC is funded.
His point is that the current budget arrangement allows lobbyists to interfere with staffing for regulatory oversight. Were the CFTC self funded, the Commission would be less dependent on Congress and, therefore, more independent of lobbying pressure.
One criticism of his approach is that OTC regulation would be funded by taxing exchange markets. Since exchange-traded contracts markets compete with OTC contract markets, funding one with a tax on the other might be called robbing Peter to pay Paul. This is especially the case because futures transactions far outnumber OTC transactions.
This past December CME Group complained to the CFTC that the Commission had permitted certain academics to use CME trade data for non-Commission matters. In response, the CFTC cut off all access to those data with the exception of full time staff while the Commission investigated the matter. Details are covered in this link.
This action has consequences beyond the careers of the academics involved. Much of the CFTC’s expertise in handling the data needed to investigate high frequency trading as well as other issues resides among those academics. The Commission should complete its investigation so that access, with proper oversight, can be restored.
Errors in academic papers are seldom news but the Reinhart-Rogoff paper has played a significant role in the austerity initiative. To access the paper that reports those errors click here.
When it comes to gold and its reputation among some investors as a predictor of calamity I’m a skeptic. But its universality as a source for liquidity as argued in this piece does impress me as reasonable. On the other hand, JP Morgan argues here the decline stems from a drop in world wide inflation is down to 2% (from 4%). Then there’s also news that Cyprus plans a sell off of its holdings.
That said, none of these explanations by themselves strike me as sufficient to explain the record drop. I don’t see an incipient crisis suggesting huge run up in demand for liquidity demand, the decline in inflation did not occur overnight and I don’t believe sales by Cyprus sufficient to drive down gold prices. On the other hand, the confluence of all three of these explanations (plus other stories yet to come?) does seem plausible.
The Law school is running a program on white collar crime. This is how to avoid being charged with a criminal offense. You may think that easy. Well, think again. Link is here.
Here Bob Eisenbeis has a good analysis of the situation in Cyprus. To his analysis I would add that this is a wealth tax. I understand the reason for requiring this approach to be the EMU’s debt-to-GDP limit. Were Cyprus to borrow the funds its debt-to-GDP would violate that limit. The last paragraph of Bob’s piece points out that should US debt levels continue to climb faster than GDP, then the US may find itself in a similar bind.
The CFTC deserves and is getting some push back on its regulatory approach. Here Bloomberg is reported to be considering a suit against the CFTC over its blanket margin provision for all swaps regardless of the level of actual risk. My comments are below. A liquidity add-on for swaps certainly makes sense but CFTC presumes that all swaps are equally illiquid. Rather than doing the harder work of assessing correct add-on amounts for actual risk levels, the Commission sets a 5-day rule which will be inadequate for some swaps and excessive for other swaps. Consider for example two facts.
First, that the majority of interest-rate swaps are classified as vanilla, that is, they do not include special terms that would cause them to be difficult to transfer during a bankruptcy event. A margin rule that presumes vanilla swaps to be illiquid raises their cost by assessing margin requirements as if those contracts were as difficult to liquidate as specialized contracts. Those higher costs will result in more costly risk management and, therefore, less risk management being undertaken.
Second, that even during the third quarter of 2008, interest-rate swaps did not prompt either failures or bail outs. The problems that did arise stemmed from much more exotic contracts. Mr. Gensler and the Commissioners appear less interested in developing appropriate regulations and more interested in punishing all market participants regardless of their guilt or innocence.
In short a VaR method that includes provisions for illiquidity makes more sense than a one-size-fits-all, 5-day provision.
I and other Kogod faculty comment on sequestration and its effects here.