The Debt of Unemployment

In the United States

Calls for fiscal policy change have arisen in the US - for both spending cuts and tax increases.  A so called fiscal cliff will be enacted at the beginning of 2013 whereby some spending is reduced and some tax revenue increased.  The recent recession has created a large budget deficit, bringing gross federal debt to $16 trillion with a net federal debt of $11 trillion (non-intragovernmental).

 

Quarterly yearly change in US federal debt held by the public (blue) and the monthly unemployment rate (red).

During recessions, when GDP growth decreases and unemployment increases, tax revenue decreases and unemployment insurance increase (as well as other welfare spending).  The combination of declining revenue and rising spending on such a short time scale can only be funded by issuing debt to the public (investors, foreign governments, etc).



Annual federal budget surplus or deficit (blue) and the monthly unemployment rate (red).



Since the early-1970s, the US has run some very large non-wartime budget deficits.  The budget surpluses of the late-1990s almost seem like a fluke - perhaps the culmination of a secular bull market in stocks from 1982 to 2000.  Since the end of the secular bull market, we have now gone into a secular bear market.  In the late-1990s,  an unprecedented increase in housing market prices began; the housing bubble deflated in the mid-2000s, and the government has been running a large deficit since.



Various orders of economic cycles at work. Unemployment data at FRED goes back to 1948; the unemployment rate in 1934 was about 22%.

Spain

The situation in Spain, where a real estate bubble has formed a very large economic imbalance, is experiencing a similar yet harsher situation compared to the US.  Spain and other fiscally troubled countries have been told they must cut spending from their budgets.  The austerity measures have thus far lead toward sky-rocketing unemployment while the European Debt Racket seeks to impose its will.  Spain is stuck in a Catch-22 in which its fiscal policy becomes a type of end-all-be-all solution while in either case (remaining in the Euro or exiting) real estate must go down, employment must increase and real income must grow.


Spain's neighbors think that by adjusting Spain's budget deficit to 5% of GDP somehow everything will be fine again.

No stranger to high-unemployment, Spain's unemployment rate is now rising above 25%, and welfare is now a major transgenerational benefit.  The unemployed youth, victims of the post real estate bubble, are relying upon family household wealth and family income to support themselves, often in the form of government welfare.  The high unemployment rates Spain felt in the 1990s are now being cast into a greater long-term structural problem - as real estate prices decline so too will household net worth.

The combination of falling real estate prices and high unemployment will have the effect of driving down labor costs in Spain - recently passed by Australia as the 12th largest world economy.  This phenomena is happening in other Euro countries.  For Germany, the looming prospect of slower-than-expected growth in China and contracted purchasing power in their Euro neighbors has already driven down factory production outlook - a likely indicator of increasing unemployment.

Compare and Contrast
Fiscal restraint is needed in Spain but that can only happen when unemployment rates decline.  What needs to unwind in both Spain and the US (and throughout much of the world) is inflation disparity.  As real estate prices rise, people are priced out of the market, and they transfer a greater share of their income to pay rent or mortgage.  In the long-term, only an increase in income or decline in real estate value can resolve such a disparity. 

When inflation lead GDP growth and real estate prices greatly outpace the growth in real income the consumer becomes overleveraged.  In order to pay for the deficit, as a result of this imbalance, the US has run a carry trade amongst interest rates.  To run the carry trade, short-term rates are lowered relative to long-term rates.  Therefore, the short-term debt is rolled over at the expense of passing interest along to the long-term debt (which pays the yield).


The carry trade has been most pronounced since the early-1990s recession.

In Spain, this past summer, interest rates on 2-year and 10-year bonds rose.  How much longer can Spain pass along interest payments while unemployment continues to increase?

The great convergence, at the heart of the matter many countries benefited from the "artificially" low interest rates under the one exchange rate mechanism (essentially a currency peg). Since problems in the economy cannot be corrected with exchange rates they must be corrected with taking on unsustainable debt.  Germany (blue), France (purple), Euro are (orange), Italy (green) and Spain (red).

LIBOR Part II: Interest Rate Indexing

Worldwide Benchmark

LIBOR is used around the world as an index to determine other interest rates.  One interest rate often pegged to LIBOR that is most familiar to people is the adjustable-rate mortgage (ARM) rate.  After a fixed-rate period, ARMs reset to a floating rate and each year are subsequently changed based upon changes in the index rate.

 

There are a variety of interest rates to chose from when indexing an ARM.  The most common of which are LIBOR and short-term US treasury rates (constant maturity).  To create the floating rate, lenders will add a margin to the index rate; ceilings, floors and annual caps are written into the contract to further determine the floating rate.

 

Lockstep Movement

LIBOR and short-term US treasury rates behave in similar fashion.  The way one rate moves, the other has the same relative movement.  They track each other's motion well, from the 30-year downward trend to the 2008 dead cat bounce.  Since the 2007-2008 financial crisis the spread between the two has widened.



LIBOR and short-term US treasury rates show tight movement, but have widened since the dead cat bounce in 2008.

LIBOR and the 2007-2008 Financial Crisis

Subprime ARM defaults gained notoriety for their crucial role in the financial crisis.  Their losses alone were not large enough to bring down the financial sector.  However, when packaged into complex securities with default swaps the subprime crisis created a sort of perfect storm.

 

During the 2007-2008 financial crisis, the prices of these securities fell dramatically and the insurance payments on default swaps grew very large.  This happened for a number of reasons: poor understanding of risk, poor understanding of complex securities, credit downgrades of bond insurers, etc.  However, defaults in the subprime market acted like a flash flood.  Many of these subprime defaults were ARM defaults - many of them indexed to LIBOR.  The mark down of  subprime-backed securities caused a crisis of confidence in the repo market.


Mortgage delinquency rate increases lagged LIBOR and treasury interest rate increases by about 1-2 years.  The delinquency rate flattened 2 years after rates hit their bottom.

Other Uses
The 3-month LIBOR is indexed to the Chicago Mercantile Exchange's (CME) Eurodollar future contract.  LIBOR is also used by state and municipal governments to borrow money, and was used as an index in the Term Asset-Backed Securities Loan Facility (TALF) during the American bailouts.  LIBOR is also used heavily in swap agreements - some of which help bring down interest rates for fixed-rate and floating-rate borrowers.

The European Debt Racket

Definition

Dictionaries define racket as a loud noise, or a deceitful business scheme often used to extort influence through the use of intimidation.  There is both a very loud noise and a deceitful business practice underway in Europe.  The racket goes by the name of the European Union and it is intimidating the various nation states with their own debt.

 

The Fear of the Unknown

Bailouts, infamously, have been given to Ireland and Greece, and many in Europe proclaimed victory as a result.  The bailouts are seen as sign that the European Union works.  Many in Europe, see it as a positive sign that the union is able to come together and sacrifice for the greater good: digging their neighbor out of unmanageable debt while they further indebt themselves to do it.

 

 

The bailouts, while proclaimed successful for Ireland and Greece for helping them to regain some fiscal control, have done very little to put people back to work and to decrease the unemployment rate.  In fact, Greece's unemployment rate is rising faster than Spain's, and may very well overtake Spain as the most unemployed EU nation - both nations are at about 25% unemployment.

 



Don't worry, the European Union is working. Data taken from Eurostat database.



Consider for a moment, what a retreat back to the drachma would do for Greece's already defunct economy.  There are EU parliament members who say that Greece would be at the mercy of the market - a ravenous pack of hungry wolves - as they see it.  The drachma, the currency once the envy of the world even centuries after ancient Greece's demise, is now a fading alternative to the Euro.  Greek, and Spanish, spirits are being ground into dust by both frightening unemployment numbers and a heavy debt burden, but they are increasingly being told that leaving the Euro will bring about far worse consequences.

Adding to the misery, Euro currency countries have been paying higher prices for oil than most of the rest of developed and developing world.  Over the past year at times, the price of oil in Euros has exceeded the price peak in 2008.  The credit rating of Greek companies is so poor that they are relying on the charitable marked-up premiums from Glencore and Vitol; they have also stopped purchases of cheaper Iranian oil due to the US lead banking embargo.  What then does the fear of the unknown hold for oil prices under the drachma or piece of eight?



Brent oil price denominated in the Euro. India has experienced a similar peak-2008 price level. China, US, Brazil and Japan however have not reached the same peak-2008 price level

 

Nigel Farage: "You saw the bailouts as your opportunity to take control"

Fear is being used to intimidate nations into staying within the currency union debt racket.  A massive power grab is underway in which a growing faction of EU parliament members are pushing toward the abolition of the sovereign state.  The people of the various indebted Euro nations are effectively stuck between a rock and an even larger rock - their resilience is being tested in a very dangerous manner.  A new banking union now makes the appeal of staying with the Euro more enticing, while eroding nation state influence.

 

Hope is deteriorated, confidence is lost and democracy is at risk.  Imagine if there were 25% unemployment in the United States - there would be rioting in the streets.  In fact, that is what we are seeing - rioting in Greece, threats of secession and military action in Spain and flight of capital.  A spectre is haunting Europe.

 

2015: Commodity Price Collapse, US Treasury Rates and Bursting the Gold Bubble



Overshoot, Overestimate, Overdistribute, Overhang

Michael Pettis' in his recent article By 2015 hard commodity prices will have collapsed argues that hard commodities - mainly iron and copper - will have hit a price bottom by 2015.  Large mining projects in Australia have lead to and overshoot in demand estimates and speculative purchases have lead to swelling surplus stocks of hard commodities in China; slowing demand for commodities in China and a Chinese economic rebalancing (slow down in the number and scale of construction projects) threaten to cause a price bottom by 2015 according to Pettis.  From the article:



There are four reasons why I expect prices to drop a lot more.　First, during the last decade commodity producers were caught by surprise by the surge in demand. Their belated response was to ramp up production dramatically, but since there is a long lead-time between intention and supply, for the next several years we will continue to experience rapid growth in supply. As an aside, in my many talks to different groups of investors and boards of directors it has been my impression that commodity producers have been the slowest at understanding the full implications of a Chinese rebalancing, and I would suggest that in many cases they still have not caught on.

Second, almost all the increase in demand in the past twenty years, which in practice occurred mostly in the past decade, can be explained as the consequence of the incredibly unbalanced growth process in China. But as even the most exuberant of China bulls now recognize, China’s economic growth is slowing and I expect it to decline a lot more in the next few years.

Third, and more importantly, as China’s economy rebalances towards a much more sustainable form of growth, this will automatically make Chinese growth much less commodity intensive. It doesn’t matter whether you agree or disagree with my expectations of further economic slowing. Even if China is miraculously able to regain growth rates of 10-11% annually, a rebalancing economy will demand much less in the way of hard commodities.

And fourth, surging Chinese hard commodity purchases in the past few years supplied not just growing domestic needs but also rapidly growing inventory. The result is that inventory levels in China are much too high to support what growth in demand there will be over the next few years, and I expect Chinese in some cases to be net sellers, not net buyers, of a number of commodities.

Aside from the articles cited by Pettis, there is one other peculiar news story corroborating his prediction: Caterpillar's 2015 outlook downgrade.

Caterpillar said profit will be $12 to $18 a share, compared with previous projections of $15 to $20. While a global recession remains possible, Caterpillar is forecasting moderate and “anemic” growth through 2015, Chairman and Chief Executive Officer Doug Oberhelman said yesterday in a presentation to analysts at the MINExpo industry conference in Las Vegas. Construction activity in emerging markets will probably show modest improvements, he said.

“We’ve seen a slowing in economic growth that was more than we expected,” he said. “We think ’13 could look like 2012 in terms of worldwide economic growth.”

Oberhelman has bet on a continuation of growth in commodity demand by buying mining-equipment maker Bucyrus International Inc. for $8.6 billion last year and agreeing in November to acquire ERA Mining Machinery Ltd. in China. His plans are coming under pressure as mining companies cut capital expendituresafter economic expansion slowed in China, the world’s largest user of coal and metals.

In other words, Caterpillar is betting on possible "anemic" growth and hoping for moderate growth.

 

Musings on the Overhang

Pettis elaborates that Chinese firms with large commodity stockpiles have fared better than their counterparts who do not maintain such large stockpiles.  The reason being, that as commodity prices increase so to does the value of the stockpile.  These firms are able to borrow against the increasing value of their commodity stockpiles.

 

A similar practice is used by home owners to refinance their mortgage.  For instance, a $100,000 mortgage on a home worth $100,000 can be refinanced when the home value rises.  This can be done so long as the home's value continues to rise.  What happens when it doesn't?  Short-sale?  Default?  Pain?

 

There are a few financial outcomes for Chinese firms as their commodity stockpiles' value begins to decline.  How these firms (and the broader Chinese economy) manage to deal with these declining commodity prices will be worth keeping an eye on.  Initial actions may include a kind of stockpile liquidation sale which could cause further downward pressure on commodity prices.

 

Chinese GDP Growth Rate Falls Below 5-Year Plan

Chinese GDP growth figures for the latest quarter were below 5-year plan estimates.  Not to be discouraged, Premier Wen Jiabao has called the news "relatively good".  It should be taken as relatively good news that the Chinese politburo has come around to acknowledging their nation's economic slowdown, to some degree.  China has a large export based economy and their largest trading partners, the European Union and the US, have experienced declines in aggregate demand.  Inevitably China was due to experience a post-recession slowdown in its own economy.

 

2015: The Finish Line or Start Line?

Pettis' 2015 date is rather interesting.  By 2015, US treasury rates should begin to rise (or at least stop declining in some cases).  That at least was the implicit promise by the Federal Reserve after announcing QE 3.0, which by then hopefully will have concluded (with a possible $2 trillion worth of MBS (mortgage-back securities) on their books).





MBS Held by Federal Reserve. Rough projection to the end of QE 3.0 at the end of 1Q 2015 - totaling $2 trillion.







If interest rates do rise, look for the gold bubble to deflate.  According to Henry C. K. Liu:

If gold is the measuring monetary metal, when gold prices rise against the dollar, or other dollar-linked currencies, the holder of gold has not become richer, he/she has only protected him/herself against inflation. However, money generates interest payments, and gold does not, unless it is leased, then it ceases to be a monetary metal. Most of the comfort of holding gold is psychological. With US treasuries paying next to nothing and some 3% behind inflation, gold is an instrument of no penalty. But interest rate will rise which puts pressure on gold.

Adjustable-rate mortgages are usually indexed to the 1-year Constant Maturity Rate or its lock-step cousin LIBOR.  By the time the Federal Reserve increases interest rates, it will probably have $2 trillion of the worst MBS on their books.  Which I think is when they expect the next housing boom (bubble) to begin - which defies the inverse relation between asset (security) price and interest rates the Fed will start imposing.  However, the housing boom and the increase in treasury rates (especially short-term rates which could end the Treasury's current carry trade) should begin to deflate the gold bubble.

 





Expansion and contraction of long-term and short-term US treasury rates. Many short-term interest rates have been held at their lowest levels for the past 3 years and may stay low for another 2-3 years.

LIBOR Part I: LIBOR-OIS Spread




Hindsight
Let's jump back in time to 2007.  What indicator could we use to forecast an impending financial crisis?  One indicator to use is the 3-month LIBOR-OIS spread - the spread between a 3-month LIBOR (London Interbank Offered Rate) loan rate and an overnight OIS (overnight indexed swap) loan rate.

The OIS is taken on an equivalent period basis to the short-term loan (3-months in this case) as a series of overnight rates for that period added together.  The loan is an indexed swap, which tries to capture a consensus of what other parties are willing to trade (swap) for.

The spread helps to measure the money-market risk of lending long-term versus lending short-term on an unsecured basis.  The spread gives banks an idea of counter-party risk.

Because the LIBOR-OIS spread involves unsecured loans it represents risk associated with the debtor; where as secured loans involve the risk of the underlying loans in the security - not the counter-party issuing such securities.



Hindsight - it all seems so obvious now. It became much m
ore risky to lend 3-months than to lend overnight. Image taken from http://research.stlouisfed.org/publications/es/08/ES0825.pdf

Since the OIS is a type of overnight loan rate (referenced in the US to Fed Funds rate), let's look at what similar spreads looked like during the same time period as above:

3-Month LIBOR-Fed Funds spread.



3-Month LIBOR-Primary Credit spread. Primary credit is the discount window rate for "prime" borrowers.



Primary Credit-Fed Funds spread.





It all looks rather obvious now; things really hit the fan in 2008, and there were some visible signs of things to come back in 2007.  These spreads aren't useful for predicting future economic turmoil; in fact if you look at many of the above spreads over the past decades you will find similar changes (though not like what happened in 2008). 

The interest spreads instead offer a useful guide to understanding the relation between borrowing short and borrowing very-short.  The difference in interest rates can present opportunities for arbitrage - playing the difference in interest rates against one another.

Here is one last spread: 



Eurodollar-LIBOR spread (3-Month)

LIBOR-OIS remains a barometer of fears of bank insolvency. - Alan Greenspan

Technical Analysis: Lost Decades Deja Vu

I think we are seeing a pattern emerging in the equity markets between QE bailouts and stock market growth (if you so wish to call it).  Whether we all think technical analysis is a useful tool or not, in this case it certainly yields intriguing results.  Below is the Market Value of Equities Outstanding for Nonfinancial Business graph (kind of like the dollar value of nonfinancial corporate America).

Financialization's new drug: quantitative easing.

There looks to be a $17 trillion to $17.2 trillion upper resistance level for 2013-2014.  It almost looks as though the current QE-propped bubble will reach its peak sometime in 2015.  I don't actually have such a negative outlook that far in the future (other than some commodity prices decreasing), but I do believe ESRI's recession call is looking good for 2013.

The Divot

In a previous post I showed the following graph and explained it showed 4 events: QE 1.0, QE 2.0, Operation Twist (QE 2.1) and one other event.

Recent Federal Reserve Holdings.  Data goes as far back as available from the source.

From about the beginning of 2008 to the start of QE 1.0 in the first quarter of 2009 the Federal Reserve shed about $250 billion of US treasuries off of its balance sheet.  From the above graph, the event looks like a listric curve or a divot.  In order to see why this occurred I will need to present a little bit of information about the crisis's timeline.

Gross repo deals by the Federal Reserve - repo and reverse repo.  Repos played a role in the decrease of the Federal Reserve's balance sheet.  For more on what is a repo, see my previous blog entry.

The Crisis History
A timeline history of post housing-bubble troubles:

• February 2007: Freddie Mac announces it will no longer purchase subprime mortgages and risky mortgage-backed securities (MBS).

• June 2007: S&P and Moody's begin downgrading the credit of hundreds of MBS backed by subprime mortgages - remember the various credit downgrades listed here directly affect securities and their default swaps in the repo and secondary-market.

• July, August, September and October 2007: Bear Stearns liquidates two hedge-funds; Fed Funds target maintained at 5.25%, Fitch downgrades Countrywide Financial to BBB+; The Bank of England, Citigroup, JPMorgan, and Bank of America announce various liquidity plans.
 
• January, February and March 2008: S&P and Fitch downgrade bond insurer Ambac; US Stimulus Act, Federal Reserve $50 billion TAF auction; JPMorgan acquires Bear Sterns.
 
• September 2008: Bank of America announces acquisition of Merill Lynch ON THE SAME DAY Lehman files largest US bankruptcy - beginning a run on securitized banking that tightens the repo market.

From there on out, history...

AIG receives $182 billion bailout to cover huge default swap exposure in the US and Europe (over $100 billion loss with over $400 billion exposure at the time of its bailout), government enterprise bailout (Fannie Mae and Freddie Mac), Federal Reserve insures various risky securities, Fed Funds and Discount Window at the Fed reduced to zero, US short-term treasury interest rates reduced to near zero levels, huge off-balance sheet accounts at Citigroup...one big headache.

Life Support

Based on the above graph and the above events, it looks as though the Fed stepped in as repoer-of-last-resort at various times starting in 2007.  In August 2007 the Fed increased its repoing activity after Bear Stearns liquidated two hedge-funds, and in March 2008 it aggressively increased its repoing when Fitch and S&P downgraded the various bond insurers.  By the time Lehman and Merill were finished, repoing fell off and the Fed began aggressively reverse repoing.

By the beginning of 2009, the Fed must have concluded that reverse repoing the financial sector back to health was not going to work.  The Fed then settled on a policy of selling the securities that everyone needed and purchasing the worst-of-the-worst (MBS from Fannie and Freddie).

Here is what it looks like:

 



Relationship between Federal Reserve assets and lending operations.

The Federal Reserve tried to save the financial sector by repoing it back to health.  Investment banks and banks that took on distressed banks needed stronger medicine and so the Fed began its QE program - the bailout program which continues to this day.  I am very certain the Fed knew well in advance what was going on in the securitized banking sector - as far back as 2005 and obviously knew tings were bad throughout 2007.  However, they remained a patient observer until it appeared that damages threatened the financial sector with beyond-repair damages.

Maturity Expiration or Sell-Off?

The first graph shows the relation between US treasuries held by the Federal Reserve with maturities of 1+ to 5 years and 5+ years.  What about those treasuries with 1 year or less maturity?

Treasuries with 1 year or less maturity had a big influence on the divot.  The divot was not caused by the Federal Reserve allowing securities to expire.  If that were the case there should have been a build up in the 1 year or less maturity class prior to the divot.  Taking a look at couple further graphs should shows in more detail why this is. 

 

 

These graphs show that the divot is due to an outright sell-off of treasuries - but to who and why?  Well, if you were motivated enough, you could have used the link to the Federal Reserve's crisis timeline and figured this out several paragraphs ago.

 

On March 11 2008, from the crisis timeline website:

 

The Federal Reserve Board announces the creation of the Term Securities Lending Facility (TSLF), which will lend up to $200 billion of Treasury securities for 28-day terms against federal agency debt, federal agency residential mortgage-backed securities (MBS), non-agency AAA/Aaa private label residential MBS, and other securities. The FOMC increases its swap lines with the ECB by $10 billion and the Swiss National Bank by $2 billion and also extends these lines through September 30, 2008.

 

The TSLF was not created to repo but to swap out bad assets for good assets; the TAF was created to repo:

On March 7 2008, from the crisis timeline website:

The Federal Reserve Board announces $50 billion TAF auctions on March 10 and March 24 and extends the TAF for at least 6 months. The Board also initiates a series of term repurchase transactions, expected to cumulate to $100 billion, conducted as 28-day term repurchase agreements with primary dealers.

The Fed took a whack at reviving the financial sector with the first bailout program, but all it did was make a divot on its balance sheet.

Securitized Banking: A Brief Explanation

Here is an excerpt I dug up from the first part of Henry C.K. Liu's series Greenspan - The Wizard of Bubbleland concerning a possible housing bubble:

Through mortgage-backed securitization, banks now are mere loan intermediaries who assume no long-term risk on the risky loans they make, which are sold as securitized debt of unbundled levels of risk to institutional investors with varying risk appetite commensurate with their varying need for higher returns. But who are institutional investors? They are mostly pension funds who manage the money the working public depends on for retirement. In other words, the aggregate retirement assets of the working public are exposed to the risk of the same working public defaulting on their own house mortgages. When a home owner loses his/her home through default of its mortgage, the home owner will also lose his/her retirement nest egg invested in the securitized mortgage pool while the banks stay technically solvent. That is the hidden network of linked financial land mines in a housing bubble financed by mortgage-backed securitization to which no one is paying attention. The bursting of the housing bubble will act as a detonator for a massive pension crisis.

Liu is referring to securitized banking (coined by Gary Gorton).  Loans backed by someone else's debt have security not available in purely credit-based loans.  Mortgages represent the largest component of consumer debt and represent the so called "American Dream".  Mortgages are prevalent in securitizing loans because of the enormous volume and demand for mortgage debt - due in large part to reduced lending standards in the early to mid-2000's and low interest rates (also due to reduced lending standards!).

Securitization, Sale and Supply
Mortgages issued by banks or lenders are not always kept on their books.  Mortgages are oftentimes sold and pooled together into a single investment by an underwritter (usually an investment bank).  The investment, which is usually a mortgage-backed security (MBS), is then sold to investors in the secondary-market.  These investors can be pension funds, institutional investors or other banks.

 

Investors in the secondary-market purchase a variety of mortgage-linked securities such as mortgage-backed securities, collateralized-debt obligations, collateralized-mortgage obligations and asset-backed securities.  Investors in the secondary-market also purchase other securities, and the most important securities are the high-rated (low risk) US treasuries.  US federal government debt is the near equivalent of gold. 

Once securities have been purchased in the secondary-market they may again pass from one investor to another.  These securities can be lent, usually overnight, in what is called the repo market (extra link). 

In the second part of his series, Liu explains that repos are the most important and fastest growing sector of the money market:

The repo market is the biggest financial market today. Domestic and international repo markets have grown dramatically over the last few years due to increasing need by market participants to take and hedge short positions in the capital and derivatives markets; a growing concern over counterparty credit risk; and the favorable capital adequacy treatment given to repos by the market. Most important of all is a growing awareness among market participants of the flexibility of repos and the wide range of markets and circumstances in which they can benefit from using repos. The use of repos in financing and leveraging market positions and short-selling, as well as in enhancing returns and mitigating risk, is indispensable for full participation in today’s financial markets. 

A repurchase agreement (repo) is a loan, often for as short as overnight, typically backed by top-rated US Treasury, agency, or mortgage-backed securities. Repos are contracts for the sale and future repurchase of a top-rated financial asset. On termination date, the seller must repurchase the asset at the same price at which he sold it, pay interest for the use of the funds, and if the asset was borrowed, the borrowed assets will be returned to the lending owner who also receives a fee for lending. If the repoed security pays a dividend, coupon or partial redemptions during the repo, this is returned to the original owner. Institutions with excess assets routinely avoid holding unproductive idle assets by lending them for a fee to institutions in need of more assets. A well defined legal framework has developed to facilitate repo transactions.

The cash acquired in a repo deal can be used to purchase additional securities, conduct other business operations, or fund reserve requirements.  On the other side of the transaction (known as a reverse repo) the securities can be used for short selling or to close out a position - perhaps another repo deal.  Tri-party repo deals are brokered through a clearing house - usually another bank - and allow an extra degree of leverage not available in a two-party repo deal.

Credit-Financed Debt
Additionally from the second part of the series:

Because repos are essentially secured loans, their interest rates do not depend upon the respective counterparties’ credit ratings.

Repo deals depend upon the security's credit rating and do not depend upon the lender's or borrower's credit rating.  Another, very imortant, detail is that a security's rating also effects the capital requirements of the bank when it holds that particular security.  Known as the recourse rule (discussed in more detail), banks are required to hold a certain amount of capital against the securities they hold.  As you can imagine, they must hold less capital for high-rated securities and more capital for low-rated securities.  That means high-rated securities are most desirable and low-rated securities are least desirable (obviously!), and a credit-downgrade on securities can have an enormous impact on capital requirements. 

Aptly named the recourse rule, there is a recourse around the higher capital requirements for low-rated securities.  A low-rated security with a default-swap becomes a high-rated security.  This happens because a third party pledges to cover the low-credit of the security, and they insure against non-payment cash flow of the security.  High-rated MBS usually have their mortgage loans insured by government enterprises such as Fannie Mae and Freddie Mac.

panic. Panic. PANIC. PANIC!!!
What would happen if the securitized banking sector experienced a mortgage-default based credit-downgrade on its securities?  The securities, without a default swap, would lose their value - the price of the security would go down - and there would be a drop in cash flow from the securities.  More importantly for the banks, the credit-downgrade would increase their capital requirements and it would eliminate the securities' use in a repo deal.  Finally, if mortgage defaults were large enough to place deafault swap underwritters in insolvent position, it would put all other participants on the hook for solvency-challenging  losses.

To deal with such an event, Liu suggests that government intervention is built into the system:

Selective government intervention into markets to relieve business of external costs will be the cornerstone of the new normalcy. “Too big to fail” becomes a dogma for believers of the free market. Corporate strategy quickly adjusts to this game by getting bigger through mergers and acquisition to secure the added protection from government based on its size. Would the government allow Citigroup to fail? No one expects Fannie Mai to fail.

Liu suggests that too big to fail and (later in the article) too important to fail will become the rally-cry of an overleveraged volatile market.  According to Liu, the US manufactures a fiat currency which it exports abroad to purchase goods produced by the rest of the world for the purpose of collecting US fiat currency.  This is known as dollar hegemony.  The rest of the world cannot manufacture and export goods to the US in the event of a credit crunch, unless they wish to produce goods for a more solvent, abundant currency.

Technical Difficulties
Liu concludes the second part of the series with a critique of US central bank policy:

The individual management of risk, however sophisticated, does not eliminate risk in the system. It merely passes on the risk to other parties for a fee. In any risk play, the winners must match the losers by definition. The fact that a systemic payment-default catastrophe has not yet surfaced only means that the probability of its occurrence will increase with every passing day. It is an iron law of an accident waiting to happen understood by every risk manager. By socializing their risks and privatizing their speculative profits, risk speculators hold hostage the general public, whose welfare the Fed now uses as a pretext to justify printing money to perpetuate these speculators’ reckless joyride. What kind of logic supports the Fed’s acceptance of a 6% natural rate of unemployment to combat phantom inflation while it prints money without reserve, thus creating systemic inflation to bail out reckless private speculators to fight deflation created by a speculative crash?

 

The Federal Reserve's mandate of structurally low unemployment comes at the cost of increased inflation, reduced saving rate and lower confidence in the system.  A quasi-government's inflation driven mandate for low unemployment bails out the very speculative entities which create such a need for a central bank.  Imagine a world in which fires do not exist, what then is the purpose of funding a fire department?

Without having done anything more than played by the rules of money market speculation, participants are guranteed reputational decay in place of criminal charges.  The Federal Reserve and the US federal government become more than regulators in such a system, they become willing particpants in a perverted scheme.  What will happen when gold turns to silver?