Please, Listen to the Lady!

The short essay below was first published online by The New York Times earlier today, as part of its Dealbook blog, edited by Andrew Ross Sorkin. Sheila C. Bair, the Federal Deposit Insurance Corporation’s chairwoman, has had a tough time keeping her opinions to herself during this financial crisis, often in private and, not infrequently, […]

The Next Step in the Bank Explosion Cycle???

Of the many issues that I have been warning about concerning banks, their balance sheets and the risks that they take, one of the (and there are a few) most underappreciated is the currency risk of the “mother of all carry trades”. See Roubini Not Alone in Fearing Dollar Carry Trade and Roubini Sees `Huge’ Asset Bubbles Growing in `Mother of All Carry Trades’.

Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini.

“We have the mother of all carry trades,” Roubini, who predicted the banking crisis that spurred more than $1.6 trillion of asset writedowns and credit losses at financial companies worldwide since 2007, said via satellite to a conference in Cape Town, South Africa. “Everybody’s playing the same game and this game is becoming dangerous.”

The dollar has dropped 12 percent in the past year against a basket of six major currencies as the Federal Reserve, led by Chairman Ben S. Bernanke, cut interest rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. Roubini said the dollar will eventually “bottom out” as the Fed raises borrowing costs and withdraws stimulus measures including purchases of government debt. That may force investors to reverse carry trades and “rush to the exit,” he said.

“The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.”

As has been the case at least twice in the past, I am in agreement with the man. The amount of bubbliciousness, overvaluation and risk in the market is outrageous, particularly considering the fact that we haven’t even come close to deflating the bubble from earlier this year and last year! Even more alarming is some of the largest banks in the world, and some of the most respected (and disrespected) banks are heavily leveraged into this trade one way or the other. The alleged swap hedges that these guys allegedly have will be put to the test, and put to the test relatively soon. As I have alleged in previous posts (As the markets climb on top of one big, incestuous pool of concentrated risk… ), you cannot truly hedge multi-billion risks in a closed circle of only 4 counterparties, all of whom are in the same businesses taking the same risks.

Click to expand!

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Has the US Financial System been Nationalized?

No, but we’ve taken big steps in that direction.  For example, the government owns a large insurance company (AIG).  More importantly, it has nationalized 95% of the single largest component of the financial sector:  home mortgages. Investor Type Shares of Mortgage Origination (black = other) From “Recent Developments in Mortgage Finance“, John Krainer, Federal Reserve Bank of San […]

Beyond the Consensus on European Bank Credit

Well, I never thought I would have to wait very long to get some confirmation of my last post on things that could go bump in the night in France, but even I wasn’t expecting confirmation of what I was trying to get at so quickly. Now, according to Frank Atkins in The Financial Times […]

The French Rebound Continues In October While Germany Moves Sideways

Whoever would have thought that some people once called economics the most dismal of sciences? Certainly, as the current crisis goes on and on, those of us who consider ourselves to be economists scarcely are able to find the time to squeeze in a dull moment, even here and there. But even at a broader level, interest in that most dismal of dismal topics – the theory and practice of central banking – seems now to fire up levels of enthusiasm here in Spain that make even the appetising prospect of a forthcoming Real Madrid-Barça football match pale in intensity. Even if it is the case, I have to admit, that the everyday Johnny (or Jill) come lately sitting in the bar still – truth be told – prefers the sports columns of the daily newspapers, or the lacivious details of the latest romantic adventure of one of the rich and famous to a careful perusal of the detailed minutes of the last policy rate setting meeting over at the central bank.

The reason for the sudden and unexpected upsurge in interest should, I would have thought, be obvious – since with 85% of Spanish mortgages being variable (and thus determined by the ECB policy rate), and Spain’s economy sinking into an ever deeper pit, the impact of the coming decisions (or even the hints at possible future decisions) have entered peoples lives like never before. And this is doubly the case in an environment where – as Bloomberg inform us this morning – central bankers from across the global, from Washington, to Sydney, to Oslo are likely to take increasing account of future accelerations in asset prices in an attempt to avoid repeating policy mistakes that are presumed to have inflated two speculative bubbles in a decade, culminating in the worst financial crisis since the Great Depression.

By way of illustration for their feature story the Blomberg reporters single out the prime example cases of Norway and Australia, countries whose recent stronger than average inflation and growth performance is now so well known to regular investors for the mention of their name in such reports to have become a mere commonplace, with the respective currencies being eagery purchased to the sound of hearty lipsmaking at the thought of all the juicy carry which lies ahead. Personally though, had I been doing the writing, I would have chosen a rather different example, one much nearer to the heart of Europe (and thus a little closer to my own) – France.

And why France you may ask? Well quite simply because the French economy is now plainly and evidently on the mend. That is the big, big news which can be gleaned from last Friday’s Flash Markit PMI readings (see detailed breakdown below). Now those who regularly follow this blog will know that this seemingly unexpected leap into poll position hardly comes as a surprise to me, since I have long been arguing that the French economy would emerge as the strongest among the EU economies from the present deep recession, and some of the theoretical justification for this view can be found in this post here, while an earlier piece from Claus Vistesen in 2006 also gives an illustration of how we might conceptualise the problem.

So one epoch ends, and another begins, inauspicious as the beginnings may be. To summarise briefly the argument which will be presented below, there is both good and bad news here, since this early and isolated recovery in France is bound to create difficulties of the “exit thinking” kind for policymakers over at the ECB. The most pressing of the problems will concern what to do about containing French inflation if exit dependency in Germany means that a full recovery there remains out of reach, while Italy languishes where it has always languished and Spain’s seemingly intractable difficulties only increase. In other words, what will happen if – as seems obvious – the eurozone economies are in fact diverging, and not converging, and the divergence far from reducing is in fact increasing.

As we will see in the charts which follow the long term decline in the GDP share of French manufacturing, which is closely associated with the steady opening of a trade deficit there, poses special threats and problems for ECB monetary policy. This long term manufacturing decline and growing external deficit are, in my opinion, the tell tale first signs of larger structural problems to come should inappropriate monetary policy be applied too hard for too long. That is to say France is well positioned to get a distortionary bubble next time round (of the exactly the kind the newly vigilant central banks should be at pains to avoid, and indeed precisely the bubble they successfully avoided last time round) unless the ECB and the French government are very clever and very agile indeed.

Above-par Inflation Looming Just Over The Horizon

Oil Prices and Bank Profitability: Evidence from Major Oil-Exporting Countries in the Middle East and North Africa

Bank balance sheets in oil-exporting economies have been hard hit recently. This column provides the first empirical evidence linking oil prices to bank performance in such economies. It suggests that easily observed oil prices could inform macro-prudential regulation in these countries and mitigate pro-cyclical bank lending. The recent economic and financial crisis and the sharp […]

What if Regulating Executive Pay Doesn’t Work? A Brief Primer on the Limits to Knowledge in Corporate Governance Research

Below is a brief missive on the topic of this Thursday’s World Growth Panel Discussion, entitled “Corporate Governance Rating Agencies and Conflicts of Interest: Harming Pension Funds, Individual Investors, and Company Employees, Investor Harm and Future Policy Implications.” The flyer for the event is included at the end of this email. After WorldCom, Enron, and […]

Case Shiller: Home Prices Fall More Slowly

Home prices fell less than they had been in August, according to Case Shiller. The Index shows a 7th consecutive months of improved readings in these statistics, beginning in early 2009.  By improved, prices continue to slide year over year, but at a slower rate. Monthly prices show modest gains. Year over year, the 10-City […]

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