Opinion

Felix Salmon

The default has already begun

Felix Salmon
Oct 14, 2013 22:23 UTC

The big question in Washington this week is whether, in the words of the NYT, we’re going to see “a legislative failure and an economic catastrophe that could ripple through financial markets, foreign capitals, corporate boardrooms, state budget offices and the bank accounts of everyday investors”. In this conception — and I have subscribed to it just as much as anybody else — the sequester is bad, the shutdown is worse, and the default associated with hitting the debt ceiling is so catastrophic as to be unthinkable.

This frame is a useful one, not least for the politicians in Washington, who seem to have become inured to the suffering caused by the shutdown, and downright blasé about the negative consequences of the sequester. Both of them could last more or less indefinitely were it not for the debt ceiling, which is helpfully providing a hard-and-fast deadline: Congress is going to have to come up with a deal before the ceiling is reached, because the alternative is, well, the zombie apocalypse.

There’s more than a little truth here: I’m a firm believer, for instance, that the president both can and should prioritize debt repayments in the event that the debt ceiling is reached. If we’re going to be so stupid as to hit the ceiling, then prioritizing debt service is the least-worst outcome. But at the same time, the situation is less binary than it looks, not least because the US government is already in default on its obligations.

The best way to look at this, I think, is that there’s a spectrum of default severities. At one end, you have the outright repudiation of sovereign debt, a la Ecuador in 2008; at the other end, you have the sequester, which involves telling a large number of government employees that the resources which were promised them will not, in fact, arrive. Both of them involve the government going back on its promises, but some promises are far more binding, and far more important, than others.

Right now, with the shutdown, we’ve already reached the point at which the government is breaking very important promises indeed: we promised to pay hundreds of thousands of government employees a certain amount on certain dates, in return for their honest work. We have broken that promise. Indeed, by Treasury’s own definition, it’s reasonable to say that we have already defaulted: surely, by any sensible conception, the salaries of government employees constitute “legal obligations of the US“.

Conversely, if you really do expect zombies to start roaming the streets the minute that the US misses a payment on its Treasury obligations, you’re likely to be disappointed. Yes, the stock market would fall. But the price of Treasury bonds would remain in the general vicinity of par, and it might even go up if Treasury announced that past-due interest would be paid on all debt at a statutory rate of 8% per annum. Even when it’s Treasury bonds themselves which are the instruments in default, Treasury bonds remain the world’s flight-to-quality trade, and the expected recovery on all defaulted Treasury obligations would be 100 cents on the dollar — or more.

The harm done to the global financial system by a Treasury debt default would not be caused by cash losses to bond investors. If you needed that interest payment, you could always just sell your Treasury bill instead, for an amount extremely close to the total principal and interest due. Rather, the harm done would be a function of the way in which the Treasury market is the risk-free vaseline which greases the entire financial system. If Treasury payments can’t be trusted entirely, then not only do all risk instruments need to be repriced, but so does the most basic counterparty risk of all. The US government, in one form or another, is a counterparty to every single financial player in the world. Its payments have to be certain, or else the whole house of cards risks collapsing — starting with the multi-trillion-dollar interest-rate derivatives market, and moving rapidly from there.

And here’s the problem: we’re already well past the point at which that certainty has been called into question. Fidelity, for instance, has no US debt coming due in October or early November, and neither does Reich & Tang:

While he doesn’t believe the U.S. will default, Tom Nelson, chief investment officer at Reich & Tang, which oversees $35 billion including $17 billion in money-market funds, said that the firm isn’t holding any U.S. securities that pay interest at the end of October through mid-November because if a default does take place, “we’d be criticized for stepping in front of that train.”

The vaseline, in other words, already has sand in it. The global faith in US institutions has already been undermined. The mechanism by which catastrophe would arise has already been set into motion. And as a result, economic growth in both the US and the rest of the world will be lower than it should be. Unemployment will be higher. Social unrest will be more destructive. These things aren’t as bad now as they would be if we actually got to a point of payment default. But even a payment default wouldn’t cause mass overnight failures: the catastrophe would be slower and nastier than that, less visible, less spectacular. We’re not talking the final scene of Fight Club, we’re talking more about another global credit crisis — where “credit” means “trust”, and “trust” means “trust in the US government as the one institution which cannot fail”.

While debt default is undoubtedly the worst of all possible worlds, then, the bonkers level of Washington dysfunction on display right now is nearly as bad. Every day that goes past is a day where trust and faith in the US government is evaporating — and once it has evaporated, it will never return. The Republicans in the House have already managed to inflict significant, lasting damage to the US and the global economy — even if they were to pass a completely clean bill tomorrow morning, which they won’t. The default has already started, and is already causing real harm. The only question is how much worse it’s going to get.

COMMENT

The posturing of the egocentric leadership “on the Hill” is despicable. They make too much money to do too little work and are only interested in promoting their private agendas (Reelection, Power, Money, Reelection,….) As an active constituency (NOT Tea Party), we MUST take back our government by voting out all incumbents and create “Term limits by the People, for the People and of the People” to remove the decaying odor of those gluttonous relics who have been feeding at the trough for far too long. We need people to lead our great nation out of this quagmire through compromise and respectful dialog with a genuine desire to serve the interests of the American People First & Foremost through reinstatement of the core values of The Declaration of Independence and The Constitution of the United States of America (51% Rules)!

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Is JP Morgan being unfairly singled out?

Felix Salmon
Oct 11, 2013 20:41 UTC

JP Morgan is the first big bank to suffer a quarterly loss on account of multi-billion-dollar legal bills. It is also the most profitable bank in America (or was, up until this morning). Which means there are three possibilities here:

  1. The profits and the fines share a common cause: the internal behavior which produces massive profits also — eventually — has a tendency to produce massive fines.
  2. The profits and the fines are unrelated: it’s just unfortunate bad luck that such a well-run, profitable bank should come unstuck in this manner.
  3. The profits in some way caused the fines: regulators feel comfortable going after JP Morgan precisely because it has a fortress balance sheet and can easily pay the fines.

All three of these have a kernel of truth to them, I think. If you look at misbehavior like the Libor scandal or the London Whale debacle, the misconduct in question was clearly driven by traders looking to make as much money as possible. But all banks have traders looking to make as much money as possible, and most of the world’s biggest banks have been sucked in to the Libor scandal, in one way or another. And if you look at classic trading blowups, they’re pretty uncorrelated with profitability.

JP Morgan is also a little bit unlucky here, in that it’s literally paying the price for misconduct at companies (WaMu and Bear Stearns) it wasn’t managing when the misconduct took place. Few of us are going to shed any tears as a result: those two acquisitions were still wildly profitable for JP Morgan even after accounting for all their associated legal liabilities. But it is a bit of a stretch to blame Jamie Dimon personally for actions which took place at rival banks, before he bought those banks.

But it’s the third possibility which is the most intriguing. JP Morgan is hardly alone in having engaged in the kind of behavior which has produced all these fines — but it is alone in building up a $23 billion reserve against future legal costs, and spending $9.2 billion on such things in a single quarter. Were Washington Mutual and Bear Stearns really worse than Countrywide and Merrill Lynch? If not, how come it’s JP Morgan with the legal losses, and not Bank of America as well?

One theme running through the aftermath of the financial crisis is that banks have to some extent been insulated from being held accountable for their actions by fears that aggressive prosecutions could endanger America’s fragile economic recovery. We’re trying to recapitalize the banks, trying to get them to lend more; if we simply suck out all their capital in the form of fines, then that will only serve to weaken them. If that’s a real fear, and I think it probably is, in corners of Washington, then it makes sense that JP Morgan would be the biggest target of prosecutorial zeal — just because it’s the bank with the strongest balance sheet, and therefore the bank which is most capable of paying big fines.

None of which in any way excuses JP Morgan’s actions, or implies that the fines it’s suffering are any less than fully deserved. It just implies that weaker banks might also deserve such massive fines as well — and are managing to avoid them only because they have less ability to pay them.

I’m fine with this possibility. When the Obama administration was forced to decide whether or not to nationalize America’s biggest banks, it knew that one of the consequences of its ultimate choice — not to nationalize — was that it would see less upside if and when its bailout worked. So in a weird way, JP Morgan’s current legal woes are a way of it paying the US government back for all the help we gave the bank during and after the financial crisis.

Think about it this way: let’s say you went up to Jamie Dimon during the height of the crisis, and told him that the Fed would implement an all-out flood of liquidity, and the Bush and Obama administrations would stop at nothing in their attempts to rescue the financial system, on one condition. The bargain would be this: if all those efforts worked, and JP Morgan ended up as a bank making $6 billion per quarter in profits, then at that point it would have to fully atone, with a few quarters’ profits, for its own sins and those of the banks it wanted to acquire. JP Morgan’s solvency and capital adequacy would be guaranteed: it would only face the fines if it was more than capable of paying them.

Dimon would have jumped at such a bargain, and so would any other bank CEO. (Well, maybe not Dick Fuld.) As a result, JP Morgan’s fines are entirely fair. They are deserved on a narrow basis, and they are easily within the bank’s ability to repay. The only reason for Dimon to feel hard done by, here, is if he thinks that rival banks are getting off easier than he is, just because they’ve got less money. That might be the case. But that doesn’t mean he’d be willing to trade places with them.

COMMENT

I guess this falls under #1, but JPM has done more damage than is widely recognized. One example comes from the Chase credit card, where fixed rate “for the life of the loan” balance transfers were agressively marketed while the prime rate was MUCH higher than the offered rate. Apparently, the expectation that most would mess up and end up paying the higher rates that come after a mistake. When that did not occur across the board and the prime rate got below the promotional rate, Chase hit the responsible borrowers with a 5% minimum payment.

Perhaps this was Gordon Smith and not Jamie Dimon, but it drove some to bankruptcy. There was a class action settlement but that reaped more reward for attorneys than for those harmed. As one harmed, I have a difficult time fining any fine too large for this company.

Posted by nprfreak | Report as abusive

Kill the sticky nav

Felix Salmon
Oct 11, 2013 14:35 UTC

It might have been the Slate redesign which pushed me over the edge, I’m not sure. Maybe it’s just PTSD from Reuters Next. But at this point I will seriously donate a substantial amount of money to anybody who can build a browser plugin which automatically kills all persistent navbars, or “sticky navs”, as they’re also known.

It’s impossible to identify who started this trend, but it has become the single most annoying thing on the news web, recently overtaking even the much-loathed pagination for that title. If you’re reading a story on Pando Daily, then no matter what page you’re on, no matter where you are in the story, the top of your browser window always looks like this:

Screen Shot 2013-10-11 at 9.16.09 AM.png

The Businessweek.com version is even fatter, and adds lots of color:

Screen Shot 2013-10-11 at 9.25.11 AM.png

Meanwhile, if you’re reading a story on Slate, then it all looks perfectly normal until you start scrolling down, at which point the persistent nav magically appears, looking something like this:

Screen Shot 2013-10-11 at 9.22.40 AM.png

These navbars have their differences, but they invariably include a suite of sharing tools, the name of the website you’re reading, and usually some kind of drop-down menu (or, in the case of Businessweek, ten of the things). They take over the most important part of your precious browser real estate, and the only way to make them disappear is to leave the website entirely.

Readers hate these things, for good reasons. Many of them are so badly designed that when you hit the spacebar to scroll down one page, the next couple of lines that you want to read get hidden behind the navbar, and you need to scroll back up to see them. All of them confound intuition: the page/scroll metaphor has become so ubiquitous online that we don’t even think of it as a metaphor any more. The text sits on the page, and when you scroll, the page that you’re looking at moves up towards the top of the window. If something at the top of the page doesn’t move, then that’s just as distracting as looking at an otherwise static page and seeing a single element which does move. It drags your attention away from the thing which you want to be concentrating on — the story — and towards something with no real informational content at all.

A quick thought experiment should suffice to prove just how evil sticky navs are. Suppose that instead of featuring navigational aids, these things instead featured some kind of banner ad. In order to read any story on a site, you’d need to be constantly staring at a page with a sticky unit saying “Drink Coca-Cola” at the top. No editor would countenance such a thing: annoying ads are one thing, but they all at least feature a little “x” which you can click on to make them go away. And yet there’s one kind of branding which seems to be the exception to this rule — and that’s when the brand in question happens to be the very publication you’re reading.

None of this should come as any surprise: we went through all of this back in the 1990s, when some bright spark invented frames. Remember frames? Maybe Google can help you out:

Screen Shot 2013-10-11 at 9.40.43 AM.png

Sticky navs are just a whiz-bang version of frames, only without the one tiny justification that frames had, which was that they stopped people having to reload navigational elements many times over when they were trying to make their way around a website on their dial-up modems.

So what is the justification for these horrible, intrusive things? The first, and most important, is that they serve a branding function. You know what a brand is, right? It’s a piece of hot metal which is seared into your flesh so that it leaves an indelible mark. Historically, sites used their home page to define themselves in the minds of readers, and would even complain quite vociferously if people dared link directly to articles. Today, however, in a world where site designers like to say that “every page is the home page”, publishers have decided not only that every page must serve the same branding function that the home page used to have, but even that the branding must persist even once you’ve started scrolling down. This does nothing for advertisers, and does nothing for readers, but it tends to make proprietors happy, and that, it seems, is all that matters.

The other reason, which is more insidious, is the way that everybody wants to be an app these days. Some services, like webmail and Twitter and Facebook, really are apps, at heart, and their websites are full of persistent elements which nobody minds. They’re a frame within which outside information is presented, and in that case persistent elements are fine, even desirable. And as traffic becomes increasingly mobile, publishers try very hard to create an immersive environment for their tablet-based content. Which is fine. People use tablets in a very different way to how they use the web on a desktop or laptop, and page design for tablets should be different than page design for the web. The problem is that designers are creating things which work very well on tablets, and then just porting that app-like experience over to the desktop web, even though no one actually wants an app-like experience when reading a story on their computer. The worst offender here is Quartz, which desperately wants desktop web browsers to behave as though they’re tablets, and which as a result has not one but two sticky navs taking up a huge amount of screen real estate.

So please, publishers, lose your vanity, and kill the sticky navs. If I’m reading a story on Slate, have no need whatsoever to be reminded of the headline at all times — in extra-bold all-caps, to boot. (Stop shouting at me!) If I’m being trolled by Sarah Lacy on Pando Daily, she should want my attention, rather than trying to inform me that there’s a section of her site with video on it. And when I start reading a long story in Businessweek’s beautifully-designed print magazine, and then want to finish it when I’m at my computer, there is no reason at all to hit me over the head while I’m doing so with an incoherent series of colored blocks. If you give me my browser window back, I’ll be much more avid, and much less resentful, when it comes to consuming your content. Which is what both of us really want, right?

COMMENT

I absolutely disagree! sticky navs are a blessing. There’s not that irritates me more than reading a long article and HAVE TO SCROLL BACK to the very beginning to jump to another part of the site. ads are bad everywhere. Sticky navs are not. Also in regards to frames, the metaphor that a web page needs to be like a print page is outdate and extremely restraining. The whole point of a webpage is that can display dynamic content, therefore frames and static areas on a page are more than welcome when used properly. Don’t you remember how annoying is going back and forth in a book to the index to find other sections of the book? why you want that in a webpage?

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How Janet Yellen should embrace the Fed’s dissenters

Felix Salmon
Oct 9, 2013 21:42 UTC

The Fed Whisperer, John Hilsenrath, had a great insidery article yesterday about forward guidance, and about the Fed’s ability — or lack thereof — to effectively signal its future actions. And it was timely, too, coming as it did a day before the official nomination of Janet Yellen as the new Fed chair.

The job that Yellen inherits is very different from the job which faced all of her predecessors. They focused almost exclusively on the question of where to set the Fed funds rate; that’s a non-issue for Yellen, who is certainly going to keep that rate at zero for the foreseeable future. Instead, Yellen has two other tools at her disposal. One is QE: the Fed can continue to pump money into the economy for as long as it likes, although no one on the committee loves the idea of doing so indefinitely. And the second is forward guidance, or what is sometimes called “federal open mouth operations”: the ability of the Fed to set expectations by being very clear about what it intends to do in the future.

As Hilsenrath details, the Fed’s new commitment to transparency — something Yellen strongly believes in — has not gone entirely smoothly. As Fed governor Jeremy Stein said in a speech last month, there’s clear “room for improvement” when it comes to the Fed acting transparently and predictably.

The problem is that transparency and predictability are incompatible goals. Look at the minutes of the September FOMC meeting, which were released today: they reveal a tortured meeting, spread over two days, with more than its fair share of meta-worries about desirable and undesirable feedback loops between the markets, the Fed’s statement, and the minutes themselves. Frankly, the more transparent the Fed is, at times like this, the less predictable it becomes.

This is one area where I think that Yellen could be a real improvement over Bernanke. Think of Fed communication as starting with the studied opacity of Volcker and Greenspan, who once famously told reporters that “if I seem unduly clear to you, you must have misunderstood what I said”. As Binyamin Appelbaum says, central bankers historically have “regarded secrecy as a virtue and obfuscation as a prized technique”.

The Fed then evolved, as serious academic work managed to find strong evidence for the idea that transparent communication can and should be an important part of monetary policy. This was one of the great innovations of the Bernanke era: an unprecedented degree of specificity about how the Fed intended to behave in the future.

The problem is that the Fed and the markets both conceived of the forward guidance in terms of what economists might call the “stylized fact” that the Fed is a single actor making a single decision. There is a series of monetary-policy actions that the Fed is going to take in the future, and everybody started behaving as though (a) the FOMC had a pretty good idea what it was going to do; and that (b) the only question was how much leg the FOMC would show, in terms of revealing what it knew.

In reality, however, the tail soon started wagging the dog: when the Fed announced that it would keep interest rates at zero until at least mid-2015, for instance, that was not a simple expression of a decision which they had already made internally. Instead, the FOMC came to the conclusion that the announcement, in and of itself, would have a desired effect on economic conditions, and therefore said something which was carefully calibrated to have that specific effect (while also being consistent with what they thought they would probably want to do in terms of interest rates).

This was where tensions started setting in: it’s one thing for a Fed chairman to rally his FOMC troops and get them all to agree on a certain course of action at a certain meeting. It’s another thing entirely to try to get those troops to agree to a future course of action, stretching out as far as mid-2015, despite the fact that no one really knows what the economy is going to look like then. Promises can be broken, of course. But if you’re trying to build consensus, then the best way to do so is always to keep things narrow, rather than asking people to make broad, long-lasting commitments.

On top of that you have the fact that QE is an unproven experiment — and one which is pretty explicitly opposed by various FOMC members, especially some of the regional bank presidents. Making promises about the future of QE is dangerous, because those promises will be very hard to keep — but then again, not making any promises is also dangerous, since it results in markets throwing around terms like “QE infinity” or “QEternity”. And that’s a message the Fed very clearly does not want to send.

Enter Janet Yellen — someone who’s incredibly good at economic forecasting and academic analysis, and who is (I think) more comfortable with tension and conflict than Bernanke. Yellen has often been in the minority on the FOMC, and nearly always, when she has been in the minority, she was ultimately proved correct. She has far more FOMC experience than Bernanke did, when he became Fed chair — which means that she’s deeply familiar with the kind of personalities who populate the board, the range of opinions they hold, and the degree to which the chairman can nudge those opinions in a certain direction.

I suspect that when Yellen gives her post-meeting press conferences, we’re going to see something very different from what we’ve been used to with Bernanke. The current chair is patient, avuncular, friendly, eager to help people understand what he’s saying. He has a specific message, and he wants to get that message across as clearly as he can. Yellen, by contrast, is going to be more scripted, more empirical — and, I hope, more honest about the fact that the FOMC is a diverse group of people, with a range of opinions. Markets are naturally comfortable with probability distributions: they don’t need to be told with great specificity exactly what is going to happen.

What I’d like to see from Yellen is less of an attempt to artificially move markets by saying the right words at the right time, and more of an attempt to be honest and clear about the full range of opinions on the FOMC. Where Bernanke always just attempted to get across a single consensus view, Yellen should instead be more open about the full spectrum of opinions on the FOMC, and how that spectrum ultimately ended up being reduced to a consensus about what to do and say.

We live in a world where both the legislative and the judicial branches of government are racked with very open dissent — and yet where the Fed likes to pretend that it somehow manages to always rise above such things. It doesn’t; it can’t; it shouldn’t even really aspire to doing so. The most effective communication is honest communication: if Yellen can be open about disagreements within the FOMC, then that will have three positive long-term effects. Firstly, it will make market misunderstandings less likely, since there will be less of a feeling of “you said you would do this, but then you did that”. Secondly, it will give the FOMC more credibility in terms of the committee binding itself to future actions: if Yellen can show that the full spectrum of opinion falls in a certain range, then the market will be more comfortable expecting that outcome. And thirdly, it will allow Yellen to be an effective chairman even in the face of certain future dissents. She could even be an effective chairman if she found herself in the minority, once or twice — something which could never be said about Greenspan or Bernanke.

Yellen gets on very well with ultra-hawkish FOMC members: she should make that her not-so-secret superpower. If she can effectively represent the views of someone like Richard Fisher when she gives her press conferences, she will effectively move the markets from a naive expectation that Bernanke will simply tell them what he’s going to do, to a much more effective and sophisticated expectations that Yellen will be genuinely open about the full range of views on the committee. Which would be a genuine and important improvement.

COMMENT

I don’t quite agree that the Fed shouldn’t make forward pronouncements. Expectations are commonly modelled explicitly, with their own variable. A classic example is getting inflation expectations down. It’s going to cause pain; the Fed just needs to announce it and then do it. If it announces it and then doesn’t follow through, it loses credibility, and even members who were against the original announcement should understand that. Sometimes, bold talk is required, and it’s not a matter of “here’s what we think we will do in a year’s time;” the announcement IS the plan itself.

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The un-terrifying Treasury bill market

Felix Salmon
Oct 8, 2013 19:43 UTC

Neil Irwin isn’t mincing words. “What’s happening in the Treasury bill market today should terrify you” is the headline, and this is the accompanying chart:

Oct17BillRate.png

That is indeed a nasty spike! But it isn’t remotely as terrifying as Irwin says.

For one thing, let’s put the instrument in question into context. Here’s the chart that I get, when I bring up the same instrument on my Thomson Reuters Eikon terminal. It shows more clearly just how few data points we’re really talking about here: these things are spiky. Here’s another reason not to take these charts too seriously: if you take a second look at Irwin’s chart, it shows that the bill was trading at a negative yield in mid July; I would deduce nothing from that datapoint except for that the data is noisy, and it’s hard to draw too many conclusions from it.

Chart 912828RN2=TWEB.png

Here’s another version of the same chart, showing the price action just for the past five days. Again, this isn’t terrifying, so much as it’s just plain noisy:

Chart 912828RN2=TWEB.png

Wait, did I say price action? Scratch that, I meant yield action. The price action shows you the simple truth of the matter — and it’s so boring I can’t even work out how to make a chart of it. Still, I can give you the numbers: the Treasury bill maturing on 10/31/2013, with a coupon of 0.25%, is bid at 99 253/256, to yield 0.446%, and is offered at 100 1/256, to yield 0.184%.

So, here’s Irwin’s dystopian fantasy:

If, for example, investors were only willing to pay $950 for a 90-day, $1,000 bill (about a 20 percent annualized interest rate), then the government would run into its legal debt limit even faster than it is now scheduled to.

And here’s the reality: let’s say the yield on your $1,000 bill soars to a terrifying 0.446% from a relatively benign 0.184%. That means the price of your bill has plunged from $1,000.04 all the way to $999.88. You’ve lost a whole 16 cents — or 0.016%. If the price of your bond continues to dive at that rate every day, then after a couple of months you might start approaching a full 1% drop in paper wealth!

If you look at the actual price action in Treasury bills, then, it isn’t terrifying in the slightest; what’s more, it’s very difficult to separate signal from noise. There’s no indication whatsoever that it’s significantly raising the US government’s cost of borrowing, and there’s not even any real evidence that what we’re looking at here reflects credit risk being abruptly inserted into the interest-rate market.

For the fact is that Treasury bills trade far too close to par, far too predictably, for them to really trade at all. If you want to buy Treasury bills, you buy them at a Treasury auction, you hold them to maturity, and then — most likely — you roll them over into a new series of Treasury bills. On the other hand, if you want to trade day-to-day movements in short-term interest rates, you don’t go to the Treasury bill market at all: instead, you go to Chicago, and use the eurodollar futures market, or something like that.

The Treasury-bill market, then, is a bit like the market in US CDS: it’s a thin market which is being asked to support much more rhetorical weight than it can reasonably bear. In the real world, Treasury bills remain an absolutely safe market — and I fully expect them to continue to trade at (or extremely close to) par even if we hit the debt ceiling. The world will get much riskier, if that happens — and in a risky world, US government debt is still going to be the safest possible asset.

COMMENT

I know what the traders will do with the increased debt, they will collect insurance bets.

Posted by 2Borknot2B | Report as abusive

Felix Salmon smackdown watch, debt prioritization edition

Felix Salmon
Oct 7, 2013 21:45 UTC

On Thursday I said that the US is not going to default on its bonded debt, even if the debt ceiling is reached: “with Jack Lew (or anybody else, really) as Treasury secretary, you can be sure that debt service payments would be priority number one”.

This is not a popular view within the blogosphere, maybe because it’s generally associated with Republicans trying to say that hitting the debt ceiling wouldn’t be that bad. Both Cardiff Garcia and Dylan Matthews have come out with sterling attempts to answer the question of whether debt prioritization is even possible; Danny Vinik, for one, says that there’s “pretty good evidence to demonstrate that prioritizing debt payments is not possible”. The problem, however, as Garcia says, is that most of the primary sources you’d want to go to on a question like this “are vague and unhelpful”.

It’s worth stipulating up front that hitting the debt ceiling would be disastrous even with prioritization: Garcia calls it “breaking the economy’s knees with a fiscal crowbar”, while Paul Krugman says that it would be “a catastrophe”. But it would be much better than the truly apocalyptic state of affairs that we would see in the event of a Treasury bond default. Deutsche Bank says that in that event, the S&P 500 would fall some 45% — and, boldly, puts a 0% probability on that actually happening.

It’s also worth stipulating that before the debt ceiling is hit, a lot of very sensible politicians want to make prioritization seem as unlikely as possible, because that maximizes the incentive to avoid hitting the ceiling at all. On the other hand, after the debt ceiling is hit, the very same politicians should be willing to move heaven and earth to ensure those bond coupons get paid.

So, why is Matt Yglesias so convinced that prioritization is impossible? He gives four reasons.

The first is that prioritization is illegal: “Treasury is not authorized to unilaterally decide to pay certain bills and not others”. This is true — but also a bit irrelevant. Treasury is under unambiguous Congressional orders to pay lots of bills — all of them, in fact. If it fails to pay those bills, it will be violating the law as laid down by Congress. Hence the 14th Amendment argument that the president should simply ignore the debt ceiling entirely, if it comes to that. But underneath it all, it’s hard to credit any argument which says “Treasury isn’t allowed to pay its own bonds”. If that’s what Treasury wants to do, then surely it can do so. Besides, who would even have standing to sue?

Yglesias’s second reason is that prioritization is just not feasible: it can’t be done in the real world. Both he and Matthews cite the Treasury inspector general, who does indeed say what they say he says:

Because Congress has never provided guidance to the contrary, Treasury’s systems are designed to make each payment in the order it comes due.

It’s worth reading the whole letter, however, because the inspector general says a lot more than that. And while the systems are designed to make payments in the order they come due, they have also been designed so as to effectively insulate bond repayments from all other payments. Bond repayments are made through a system called Fedwire, while all other payments are made through the standard banking ACH system. Logistically, it’s entirely possible to keep up to date on all Fedwire payments without making any ACH payments at all.

And the inspector general was very careful to keep all options open:

Ultimately, the decision of how Treasury would have operated if the U.S. had exhausted its borrowing authority would have been made by the President in consultation with the Secretary of the Treasury.

What’s more, the inspector general does rather fudge the central issue of prioritization, which is whether debt repayments can carry a higher priority than everything else. “Treasury officials determined that there is no fair or sensible way to pick and choose among the many bills that come due every day,” he said — but that’s false on its face: prioritizing debt repayments is very sensible, since defaulting on Treasury bonds would be much more harmful than simply paying all bills as they come due, whether they’re a bond coupon or a fighter jet.

There is an argument from the left that prioritization constitutes “paying China first”, and would “require the government to cut large checks to foreign countries, and major financial institutions, before paying off its obligations to Social Security beneficiaries and other citizens owed money by the Treasury”. Well, yes. But I don’t think anybody in Treasury is swayed by such arguments: they know that in the grand scheme of things, all Social Security beneficiaries would be much better off receiving their money in arrears than they would be if Treasury defaulted on US sovereign bonds.

Yglesias then rolls out the timing argument, which is further developed by Zero Hedge: debt repayments are lumpy things, and it would be hard to “save up” enough money before the big repayments were due, if you were paying any other bills at all. Zero Hedge improbably says that “Treasury will simply halt new Bill issuance” if the debt ceiling is reached, but I don’t buy it: no one’s requiring that the national debt go down. And investors generally want to be able to roll over their short term debt: failure to be able to do so would be better than default, but not much.

Could Treasury decide to prioritize Fedwire payments, and then turn on the ACH payments sporadically, only insofar as they didn’t eat up enough cash to endanger bond repayments? I don’t see why not. Treasury wouldn’t like it, of course. And as Yglesias says in his final point, such a scheme might well be so messy that the markets would have to end up assigning some kind of credit risk to Treasury bonds anyway. Still, doing so would send a very clear message to markets, that Treasury cares about them more than it cares about the sick, the elderly, or any other recipients of government funds. And the markets, in return, would probably reward Treasury with lower interest rates on Treasury bonds. After all, in a crisis, money always flows into Treasuries — even when it’s a Treasury-bond crisis.

COMMENT

“Because Congress has never provided guidance to the contrary, Treasury’s systems are designed to make each payment in the order it comes due.”

Yup, we’re on total auto-pilot. The system cannot be stopped, re-booted, intervened – its all hard-coded. Its a doomsday machine. Its a like a shark – if it stops swimming we all die.

“…speaking as someone who covered federal civilian ADP — and who has a spouse who worked in federal civilian ADP for many years — the idea that Treasury would be able to improvise those procedures on the fly doesn’t even come close to passing the laugh out loud test.”

Really? Just how close to the mainframes did they let you get, anyway? Here’s the bottom line: We’re being told not to touch the “concentrated evil” because if we do the entire world will explode. If THAT is the case then the systems group at Treasury has been run by legions of incompetents for literally decades.

Nobody, but NOBODY, engineers systems that poorly. This is classic progressive hyperbole and I discount it in it’s entirety.

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Dan Loeb’s doomed Sotheby’s campaign

Felix Salmon
Oct 4, 2013 16:58 UTC

Dan Loeb is going to lose his latest fight, at Sotheby’s. That’s because it’s a Sony, not a Yahoo.

To recap: on Monday, Loeb filed his broadside against the auction house, where he said that he holds a 9.3% stake in the company, and called for the resignation of Bill Ruprecht, its chairman and CEO. It’s worth comparing Loeb’s letter to Sotheby’s with his May letter to Sony, or his September 2011 letter to Yahoo.

The tone of Loeb’s Sotheby’s letter is significantly harsher than the tone he took with either Sony or Yahoo: in those cases, while he was critical, he avoided getting personal in the way he’s doing with Ruprecht. Loeb’s latest attack, by contrast, concentrates on things like Ruprecht’s salary, and the amount of money managers spend at swanky restaurants — juicy details, to be sure, but hardly of strategic importance.

That kind of ad hominem attack was never going to be well received — and today Sotheby’s announced, to no one’s surprise, that it was retaliating with a classic poison-pill defense. Translating from the corporatespeak, Ruprecht is telling Loeb, quite simply: “you want a fight? OK, you’ll get a fight”.

Loeb concentrates on Sotheby’s competitive position with respect to Christie’s, which is owned by French billionaire François Pinault. Pinault is an avid collector of modern and contemporary art, and he has turned Christie’s into a powerhouse in that sector — which also happens to be the hottest sector of the art world right now. Loeb knows the art-auction business about as well as he knows the music business, which is to say that he knows what’s hot, and he wants to ride the trends. “Sotheby’s success,” he writes, “will be defined in large part by its ability to generate sales and profits in Contemporary and Modern art, as this is where the greatest growth potential lies.”

Sotheby’s is no slouch in that business. Just today, it announced that it is going to sell a major Warhol disaster painting, which is very likely to set a new auction record — Warhol’s record could easily be broken, and even possibly the all-time auction record as well. The announcement features some classic auction-house hyperbole, saying that Silver Car Crash (Double Disaster) “takes its place alongside paintings such as Pablo Picasso’s Guernica and Théodore Géricault’s The Raft of the Medusa as one of the definitive masterpieces of history painting”. But it actually stops short of the kind of language that Christie’s employs in its own press releases. Here’s the announcement of Christie’s own Warhol, which will appear alongside a big Koons sculpture and be sold a day before the Sotheby’s Warhol:

Christie’s evening sale in November will offer a unique dialogue between two masters of Pop, Andy Warhol with Coca-Cola (3) and Jeff Koons, with his Balloon Dog (Orange). Two different generations of Pop artists standing side by side; Andy Warhol is the father of everything we know about Pop Art and Jeff Koons is his anointed successor. Both create objects which are totally universal and loved by the public, truly POPular in that sense.

(Bizarre capitalization in the original, along with the subtle — and untrue — suggestion that somehow Warhol anointed Koons as his successor-in-pop.)

Warhols aside, it makes sense that Sotheby’s, as a storied company being run to last in perpetuity, should naturally behave differently than Christie’s, which is a billionaire’s plaything. Indeed, when Loeb first revealed his interest in Sotheby’s back in September, I thought that was his end-game: that he was looking to shop the auction house to some other billionaire. (Bernard Arnault, perhaps, or maybe even Larry Gagosian.)

Monday’s letter, however, shows that Loeb is thinking about keeping Sotheby’s public, while attempting to oust the current senior management. That’s a move akin to central-bank currency interventions: you need a lot of firepower, and you also need the trend on your side. In this case, Loeb’s arsenal has already been seriously depleted by the poison-pill defense — and shareholders aren’t particularly likely to want to side with him, not when Ruprecht’s performance has delivered a share-price rise from less than $30 at the end of last year to move than $50 today.

If you look at the success of Loeb’s strategy at Yahoo, it was based on applying astonishing leverage: with control of just 5% of the company’s shares, Loeb first managed to get himself multiple seats on the board, and then used those seats to astonishing effect, overriding the chairman’s preferences and effectively installing his own nominee as CEO — the person who could achieve the fastest run-up in the share price, after which he could exit with a large profit. In order to execute that kind of strategy, your relationships with the company and its governors can’t be personal and adversarial: you have to persuade them that your interests are aligned.

And it seems obvious to me that Loeb isn’t going to persuade the Sotheby’s board that he knows best how to run Sotheby’s, any more than he persuaded the Sony board that he knows best how to run Sony. Instead, the Sotheby’s board is going to close ranks behind Ruprecht, defending itself from a hedge-fund manager who never has the genuinely long-term health of a company at heart.

What Loeb wants is a quick boost in the Sotheby’s share price: that’s why he’s concentrating so hard on the white-hot areas of contemporary art and China. Given that, it’s going to be very easy for Ruprecht to persuade the board that he stands for something more permanent, more noble, and, ultimately, more likely to survive the when-not-if moment at which the Chinese/Contemporary art bubble bursts.

Of course, it’s entirely possible that Loeb will make money on his investment, if his shares rise in value. But I very much doubt that he’s going to succeed in ousting Ruprecht, and the chances are that he will quietly exit his position once the failure of his strategy becomes obvious. After all, he’s an activist investor. And if he can’t shake things up at Sotheby’s, he’s going to move on to another company where he can.

COMMENT

what about ruprecht’s history of selling his stock in sotheby’s?
at least, mr loeb puts his money where his mouth is. ruprecht’s record is damning.

and let’s talk about loeb, he’s actually been a major supporter of the arts and collector for over 20 years. he actually does know quite a bit about this world. he’s certainly done more personal business with an auction house than 99% of the world.

ruprecht also ran the company into the ground before the stock price rose to $30 and $50 a share, thanks solely to the rising tide of contemporary art values.

don’t forget that sotheby’s is a company which makes no money on any category but contemporary art, and their marketing expenses and cost of sales are astronomical.

the only thing more damaging than ruprecht’s bloated way of doing business is the anachronistic business model of both auction houses.

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Making sense of the market in US CDS

Felix Salmon
Oct 3, 2013 14:53 UTC

Matt Levine had an excellent post last week on the bizarre market in credit default swaps on the USA — a market which people only ever look at during times of crisis or potential crisis. The nihilists are out in force today, using this market to confirm their priors, but the problem is that it’s very, very hard to look at US CDS, or to look at the yield on short-dated Treasury bills, and draw anything much in the way of meaningful conclusions.

One reason why is that Treasury bills are unique in many ways, including the weirdest way of all: as worries about the creditworthiness of the US government increase, the price of Treasury securities tends to go up, rather than down. Even if the US hits the debt ceiling, that won’t hurt the price of US debt; instead, general nervousness will only cause investors to flow into Treasuries and out of riskier assets. Which is to say, out of everything else.

And although Levine has managed to piece together a scenario under which a temporary technical default on US debt could cause a real payout for holders of US CDS, I don’t think that scenario really explains the price action either. The problem with it is that the government would still need to miss an interest payment on its Treasury securities, and there’s no way that it’s ever going to do that, whatever happens to the debt ceiling.

Think about it this way: if I roll over my debts, then my total debt does not actually increase. So if a T-bill is coming due today, then the government can pay it off in full, and issue a new T-bill, without increasing its total indebtedness. It’s true that a failure to raise the debt ceiling would prevent the government from funding its expenditures with new borrowing — although John Carney makes a good case that the government could just issue Obama Bonds instead.

The government still receives substantial tax revenues every week. So although the government would have to live within its means, spending no more than it got in revenues, its revenues would still be far greater than the total amount of debt service. And with Jack Lew (or anybody else, really) as Treasury secretary, you can be sure that debt service payments would be priority number one. US government payroll — especially for the president and Congress — would probably be the first thing to get cut; the armed forces might be next, just to place maximum pressure on House Republicans. Then Medicare and Medicaid, maybe — the doctors and hospitals providing those services would just have to wait until the debt ceiling got raised before they received their checks. Failing to meet any of those obligations would not be considered a debt default, and would not trigger CDS.

So what’s going on in the odd corners of the financial markets which are suddenly receiving so much attention? The simple answer is that they’re trading markets. They don’t only go weird when the debt ceiling approaches: something similar happened back in January 2009. And here’s what I wrote back then:

Anybody who bought protection at, say, 25bp is now sitting on a very nice profit if they close out their position. Maybe this is just a form of black swan insurance: buying US government CDS is a way of making money when everything else plunges in value. You’re not really insuring against an actual default, you’re just betting that if the world starts to implode, the price of your CDS is going to rise even higher.

No one knows exactly how high CDS rates would go if we pierced the debt ceiling, but it’s a reasonable assumption that they would go higher than they are now, even if (as is almost certain) they never pay out a penny. The US CDS market is a speculative, greater-fool market: the trick is to buy at a low level, and then sell at a higher level. A bit like bitcoins, really. If you think that the debt ceiling is going to be hit, then it makes sense to buy CDS today, just because spreads are going up rather than down. The only trick then will be trying to time the perfect moment to sell.

COMMENT

At this time the areas getting the most activity are shady areas. Trying to protect the casino bets. Buying delusional insurance to pay for a bet on which way a particular market will fall. Then create the situation you want to happen (or rigging) the market to collect on the insurance that is bought and paid for buy USA workers. It is like a cheater at a casino who knows how to count cards allowing him to rob the house. At this point, money is just binary symbols bouncing around a cow casino.

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The FBI and the legitimation of the bitcoinverse

Felix Salmon
Oct 2, 2013 21:57 UTC

Did the FBI just deal a fatal blow to bitcoin? Zero Hedge is at his most apocalyptic this afternoon, saying that “the end may be nigh” for bitcoin now that Silk Road, the bitcoin-fueled drugs bazaar, has been closed down by the Feds. Even Adrian Chen, who has done most of the best reporting on Silk Road, was shocked by what the FBI found:

According to the indictment, Silk Road was bigger than anyone had suspected: It boasted over $1.6 billion in sales from 2011-2013, which resulted in $80 million in commissions. (Researchers had previously estimated that Silk Road was doing about $22 million in total sales per year.)

Chen, too, sees today’s news as bearish for bitcoin: “the extent to which Silk Road underpinned the Bitcoin market is pretty amazing,” he tweeted. After all, the complaint reveals that from February 2011 through July 2013, Silk Road’s revenues totaled 9,519,664 bitcoins — that’s almost as many as the total number of bitcoins in circulation (11,744,575).

But although I’m skeptical about bitcoin’s future, I don’t see today’s news as bad for the cryptocurrency. In fact, quite the opposite. If Silk Road is now shut down and if no one else manages to enter the vacuum caused by its disappearance, then the FBI will at a stroke have managed to remove the single skeeviest aspect of bitcoin, and the main reason why people like Chuck Schumer are so suspicious of it.

On top of that, the numbers in the FBI complaint are highly misleading. The complaint says that Silk Road’s total revenue, of 9.5 million BTC, and commission, of 614,305 BTC, “are equivalent to roughly $1.2 billion in revenue and $79.8 million in commissions, at current Bitcoin exchange rates, although the value of Bitcoins has fluctuated greatly during the time period at issue”. That’s putting it mildly. Here’s how Chen described Silk Road back in June 2011:

Mark, a software developer, had ordered the 100 micrograms of acid through a listing on the online marketplace Silk Road. He found a seller with lots of good feedback who seemed to know what they were talking about, added the acid to his digital shopping cart and hit “check out.” He entered his address and paid the seller 50 Bitcoins—untraceable digital currency—worth around $150. Four days later the drugs, sent from Canada, arrived at his house.

Those 50 bitcoins are part of the FBI’s 9.5 million BTC total, but rather than being worth $50, the FBI is now valuing them at about $6,300. As a result, the $1.2 billion number should be taken with a monster pinch of salt. Besides, if you consider that the FBI is looking at 898 days of Silk Road activity, that averages out at a pretty modest 10,600 BTC per day. That’s hardly the “underpinning” of the bitcoin market, which normally sees somewhere between 200,000 BTC and 400,000 BTC per day in total trading volume.

The US government doesn’t seem to have a reflexively negative attitude towards bitcoin: in a letter sent on August 12 to Janet Napolitano, Senators Thomas Carper and Tom Coburn write that while virtual currencies come with “threats and risks”, there should also be “a sensible regulatory framework” which will “ensure that rash or uninformed actions don’t stifle a potentially valuable technology”. Meanwhile, while Treasury certainly wants to regulate such currencies, they don’t seem to want to outlaw them.

In other words, for anybody wanting to see the broader adoption of bitcoin, the shuttering of Silk Road should be considered a necessary and very welcome step — and one which will help support its value over the medium term. Sure, the price fell today — but not egregiously so: it was about $140 in the morning, briefly fell as far as $110, and is now back to $125. By bitcoin standards, that’s a surprisingly low amount of volatility on a big-news day. And with Silk Road gone, a significant source of downside tail risk has now been effectively removed from the bitcoinverse.

So if the shuttering of a significant source of bitcoin demand isn’t bad for the currency, what would cause its demise? The answer is basically just neglect. Bitcoins are a fad, and they’re a fad which will pass, a bit like Beanie Babies. There was no one thing which caused the market in Beanie Babies to implode, it was more that people just moved on to other things. Bitcoin’s the same: newer, shinier virtual currencies will arrive, the techno-utopians will latch onto something else, and eventually the people holding bitcoins will understand that if an asset doesn’t throw off any cashflow, the only way to make money from it is to sell it at a higher price than you bought it. In other words, bitcoin is the ultimate speculative vehicle, one which you might be able to trade in and out of, but one which has no value at all as a buy-and-hold investment. Which is something to bear in mind when you read the next big Bloomberg article on bitcoins as an asset class.

COMMENT

So Bitcoin = Beanie Babies…

I’ve read all your Bitcoin articles and more and more they seem to be written as hopeful “I told you so” with little downside risk if the author is wrong.

I’m sure if and when Bitcoin is mainstream as an asset and perhaps as a currency as well, you’ll just write “While I didn’t think that blah blah blah, blah blah blah happened and changed the blah blah blah that I based my original opinions on. However, if it hadn’t been for that one blah blah blah I would have been proved correct.

My money is on you looking like the internet skeptics of 1996.

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