Last week Chinese central bank governor Zhou Xiaochuan made a proposal that caused quite a stir among the international finance circles. Zhou proposed to elevate the status of SDR (Special Drawing Rights) in IMF (Internationa Monetary Fund) to replace US dollar as international reserve currency. Both Obama and Geither rejected it as "not necessary". But is it really?
What are the problems of current system where US dollar is the de facto currency for international trades and the world currency reserve? There are many. And I believe the main cause of the current global financial crisis can be traced to the problems with US dollar:
1) US has enjoyed an extremely low interest rate for a long time due to dollar's special status
Because dollar is the standard currency in which international trades are settled, excess capital has to flow to dollar denominated assets (US treasuries, agency MBS, and other US assets), creating an artificially low interest rate environment for the US and relatively high interest rate environment for the rest of the world. Due to the low borrowing costs, US government and consumers have over time accumulated huge amount of debt to support large government spending and lavish personal consumption. The gradual increase in US national debt (leverage) initially created bubbles in asset pricing (late 90s Nasdaq equity bubble and 2008 real estate assets bubble), and eventually led to global crisis of confidence in the value of dollar (2002-2008) and bursting of the asset bubbles (2008 financial meltdown).
2) When US dollar serves as world reserve currency, US monetary policy has impact beyond US borders, affecting global economic growth. When US loosens monetary control to try to finance domestic spending, it also creates liquidity glut around the world, and causes inflation to spike. That was what happened during 2002-2008: crude oil price rose from 20s to 150. Prices of grains, and other commodities rocketed during the same period. On the other hand, when the US ran into a liquidity crisis, as it is now, countries around the world are facing liquity freeze as well.
3) Individual countries can use currency manipulation to gain competitive advantage in international trades.
When US devalues its currency, it is essentially reducing its debt obligation to countries who hold US dollar reserve (lend money to the US). Often time, countries resort to currency devaluation to get out of national debt (Obama may be doing it now for the US). And in the menawhile, a cheaper currency increases export and reduces import, helping domestic industries to gain global competitive advantage. Such practices will lead to protectionism in global trades. Protectionsim will result in slower global economic growth.
All these problems can be corrected with a truly global currency, not in place of but on top of local currencies. A global currency, independent of the influence of any single country's domestic economic and monetary policies, should attain a much more stable value. Individual countries can still pursue its owm monetary policy flexibility without too much an impact on global economy. Countries don't feel cheated if their exports are paid for in the international currency that has stable value and cannot be devalued by single country for the purpose of gaining competitive advantage. So all in all, an international currency, maybe in the form of SDR of the IMF, may be a great idea, and may cure the US addiction to low borrowing cost and high consumption.
Isn't US trying to reverse trade deficit with other countries? SDR may help a long way towards that objective.
Tuesday, March 31, 2009
Thursday, March 19, 2009
What is money?
What is money?
In ancient times, money used to be something tangible, such as gold, silver or copper. Business transactions, be it trade of physical goods or capital transaction, were done with physical money changing hands.
But the world has evolved into a credit world. Business transactions have long gotten rid of changing-hands of physical money. Transactions have been done through credit: a promise to pay in physical money in the future.
With the adoption of computer technology, money is just a number on the ledger. It is an accounting entry, a mere measurement of wealth. It no longer takes a physical shape.
So in essence, money is just a promise, a credit, or a trust. When the trust in money is broken, such is the case right now, money becomes elusive. When the central banks around the world are freely printing money to bail out financial institutions and businesses that are deemed too-big-to-fail, what is the worth of money we are holding? At what point, the trust in paper money will be completely broken?
We have already seen people fleeing paper money to find refuge in the physical store of value, such as gold and silver. Gold price is approaching $1000.
But the question is: should we go back to gold? Will commodity-based money cure the ill of paper-based (or promise-based) money?
The answer in my view is no. We are not going back to the days when physical money was the primary medium of business transactions. Credit money is here to stay, which means, even in a commodity-based monetary system, money will still be just a promise, a promise to pay in gold, silver, or what ever commodity the money is backed with, in the future. When business transactions (trades of goods and flows of capital) continue to expand, credit money will also expand. Credit money will always be greater than the ACTUAL physical reserve the central banks hold. In times of financial crisis, when people come to redeem the credit for physical money, central banks won’t have adequate physical money to meet the redemptions. At that point, the decoupling of money from its commodity backing will have to occur (such was the case in 1971 when President Nixon formally decoupled US dollar from gold).
My view is that we should not go back to gold or silver standard. And I do not believe commodity-based monetary system is the answer. The answer is proper regulatory oversight of the financial institutions.
Money is a trust. We need stringent regulation to safeguard the trust.
In ancient times, money used to be something tangible, such as gold, silver or copper. Business transactions, be it trade of physical goods or capital transaction, were done with physical money changing hands.
But the world has evolved into a credit world. Business transactions have long gotten rid of changing-hands of physical money. Transactions have been done through credit: a promise to pay in physical money in the future.
With the adoption of computer technology, money is just a number on the ledger. It is an accounting entry, a mere measurement of wealth. It no longer takes a physical shape.
So in essence, money is just a promise, a credit, or a trust. When the trust in money is broken, such is the case right now, money becomes elusive. When the central banks around the world are freely printing money to bail out financial institutions and businesses that are deemed too-big-to-fail, what is the worth of money we are holding? At what point, the trust in paper money will be completely broken?
We have already seen people fleeing paper money to find refuge in the physical store of value, such as gold and silver. Gold price is approaching $1000.
But the question is: should we go back to gold? Will commodity-based money cure the ill of paper-based (or promise-based) money?
The answer in my view is no. We are not going back to the days when physical money was the primary medium of business transactions. Credit money is here to stay, which means, even in a commodity-based monetary system, money will still be just a promise, a promise to pay in gold, silver, or what ever commodity the money is backed with, in the future. When business transactions (trades of goods and flows of capital) continue to expand, credit money will also expand. Credit money will always be greater than the ACTUAL physical reserve the central banks hold. In times of financial crisis, when people come to redeem the credit for physical money, central banks won’t have adequate physical money to meet the redemptions. At that point, the decoupling of money from its commodity backing will have to occur (such was the case in 1971 when President Nixon formally decoupled US dollar from gold).
My view is that we should not go back to gold or silver standard. And I do not believe commodity-based monetary system is the answer. The answer is proper regulatory oversight of the financial institutions.
Money is a trust. We need stringent regulation to safeguard the trust.
Monday, March 16, 2009
AIG disclosed payments of > $100B to banks related to its derivative bets
Finally AIG disclosed the names of the counter parties of the CDS contracts it has written. The headline reads that AIG paid out >100B. But in fact, that wasn't exactly final payment. AIG just posted collateral on the CDS contracts that it has sold to those counter parties, Goldman being the No. 1 on the list.
Regardless it is payment or collateral, AIG should not be allowed to write so much CDS contracts without having sufficient capital to back them up. Gambling on CDS should never be allowed for the regulated financial institutions. If investors wanted to gamble, let them do that. But regulated financial institutions have fiduciary obligations to its constituents (depositors in the case of banks, and policy holders in the case of insurance companies).
_______________________________________
Here are quotes from CNNMoney.com:
AIG Reveals Over $100 Billion Of Payments To Banks, U.S. States
March 16, 2009: 07:55 AM ET
LONDON (Dow Jones) -- American International Group said over the weekend it had paid over $100 billion of its bailout funds to U.S. states and international banks including Goldman Sachs, Deutsche Bank and Societe Generale.
The cash was used to cover collateral payments, cancel derivative contracts and meet obligations at its securities lending business after the firm had to be bailed out last year.
Most of the major U.S. and European banks were represented on the list, but AIG (AIG) revealed that Goldman Sachs was the biggest single beneficiary from the payments, receiving $12.9 billion.
Bank of America Corp. and Merrill Lynch together received $12 billion in payments, followed by Societe Generale , which got $11.9 billion and Deutsche Bank , which was handed $11.8 billion.
Payments to municipalities totaled $12.1 billion.
"AIG recognizes the importance of upholding a high degree of transparency with respect to the use of public funds," the group said in a statement.
The group had previously argued that disclosing the identity of counterparties could damage its business relationships or cause competitive harm, but it had come under increasing pressure from lawmakers to provide details.
The remainder of the $173 billion that AIG received from taxpayers has been used to repay debt, boost capital levels at some of its units and fund vehicles created to wind down its derivatives contracts.
Shares in the group, which is now 80% owned by the government, have fallen more than 99% from their peak in early 2007.
The announcement over bailout payments came after AIG became embroiled in a row over bonus payments to employees at the unit that was largely responsible for its near collapse last fall.
The decision to pay around $450 million in bonuses elicited howls of protest in Washington, with key House lawmaker Barney Frank, D.-Mass, calling on the government to examine whether the bonuses can be legally recovered.
Regardless it is payment or collateral, AIG should not be allowed to write so much CDS contracts without having sufficient capital to back them up. Gambling on CDS should never be allowed for the regulated financial institutions. If investors wanted to gamble, let them do that. But regulated financial institutions have fiduciary obligations to its constituents (depositors in the case of banks, and policy holders in the case of insurance companies).
_______________________________________
Here are quotes from CNNMoney.com:
AIG Reveals Over $100 Billion Of Payments To Banks, U.S. States
March 16, 2009: 07:55 AM ET
LONDON (Dow Jones) -- American International Group said over the weekend it had paid over $100 billion of its bailout funds to U.S. states and international banks including Goldman Sachs, Deutsche Bank and Societe Generale.
The cash was used to cover collateral payments, cancel derivative contracts and meet obligations at its securities lending business after the firm had to be bailed out last year.
Most of the major U.S. and European banks were represented on the list, but AIG (AIG) revealed that Goldman Sachs was the biggest single beneficiary from the payments, receiving $12.9 billion.
Bank of America Corp. and Merrill Lynch together received $12 billion in payments, followed by Societe Generale , which got $11.9 billion and Deutsche Bank , which was handed $11.8 billion.
Payments to municipalities totaled $12.1 billion.
"AIG recognizes the importance of upholding a high degree of transparency with respect to the use of public funds," the group said in a statement.
The group had previously argued that disclosing the identity of counterparties could damage its business relationships or cause competitive harm, but it had come under increasing pressure from lawmakers to provide details.
The remainder of the $173 billion that AIG received from taxpayers has been used to repay debt, boost capital levels at some of its units and fund vehicles created to wind down its derivatives contracts.
Shares in the group, which is now 80% owned by the government, have fallen more than 99% from their peak in early 2007.
The announcement over bailout payments came after AIG became embroiled in a row over bonus payments to employees at the unit that was largely responsible for its near collapse last fall.
The decision to pay around $450 million in bonuses elicited howls of protest in Washington, with key House lawmaker Barney Frank, D.-Mass, calling on the government to examine whether the bonuses can be legally recovered.
Wednesday, March 11, 2009
Citi shares will soar if mark-tomarket accounting is modified
It appears that the regulators are finally examining issues with the current mark-to-market (MTM) policy governing regulated financial institutions (mainly banks), and close to provide new guidance for MTM accounting.
In concept, MTM accounting is a good thing, because it requires companies to report their assets at the true market value. However, in practice, such requirement has serious flaws, and is threatening (or has already threatened the viability of the entire US banking system). Many of the assets carried on the banks' balance sheet do not trade on a liquid market. To account for their market value is very difficult, and in many cases, seriously flawed standards have been applied to mark the value of the these assets. For example, it is seriously flawed to use thinly traded CDS contracts or CDOs to mark the implied value of these assets. CDS and CDO are not traded on a public exchange, and are subject to price manipulations.
What happened in this financial crisis was that banks were forced to mark down the value of their perfectly fine assets, due to the use of flawed market value indexes such as CDS and CDO. Hedge fund managers who have shorted bank stocks manipulated the prices of CDS and CDO, forcing banks to mark down their assets value, triggering capital shortfall and credit downgrades. In many cases, the assets that banks are forced to mark down are performing assets, generating steady incomes. After the mark down, banks have either to sell these assets at depressed valuation, or have to raise capital at prohibitively expensive rates.
What we need is a MTM accounting system that does not rely on flawed valuation methodology, but rather truly reflects the economic value of the assets.
I am hopeful that we soon will have a new set of MTM accounting guide lines that will reflect the true economic fundamentals of the financial institutions. If that happens, many bank stocks will soar. Citi shares can increase more than ten-fold easily.
With the current incredibly wide credit spreads, US banks must be making huge amount of profit. Yesterday's news about Citi is not an isolated event. I believe other banks are also generating handsome profits. In terms of really depressed valuation, I like Capital One (COF), which is trading at only 0.2 times of its book value! Obviously Citi is even cheaper. But Citi faces large dilution from government stakes in the company. So I prefer COF. WFC and JPM are also good investments at current prices.
Disclaimer: You should consult your financial advisers before making any investment decision. The above opinion is not a recommendation for anyone to buy or sell any stock or other financial assets. Invest at your own risk!
In concept, MTM accounting is a good thing, because it requires companies to report their assets at the true market value. However, in practice, such requirement has serious flaws, and is threatening (or has already threatened the viability of the entire US banking system). Many of the assets carried on the banks' balance sheet do not trade on a liquid market. To account for their market value is very difficult, and in many cases, seriously flawed standards have been applied to mark the value of the these assets. For example, it is seriously flawed to use thinly traded CDS contracts or CDOs to mark the implied value of these assets. CDS and CDO are not traded on a public exchange, and are subject to price manipulations.
What happened in this financial crisis was that banks were forced to mark down the value of their perfectly fine assets, due to the use of flawed market value indexes such as CDS and CDO. Hedge fund managers who have shorted bank stocks manipulated the prices of CDS and CDO, forcing banks to mark down their assets value, triggering capital shortfall and credit downgrades. In many cases, the assets that banks are forced to mark down are performing assets, generating steady incomes. After the mark down, banks have either to sell these assets at depressed valuation, or have to raise capital at prohibitively expensive rates.
What we need is a MTM accounting system that does not rely on flawed valuation methodology, but rather truly reflects the economic value of the assets.
I am hopeful that we soon will have a new set of MTM accounting guide lines that will reflect the true economic fundamentals of the financial institutions. If that happens, many bank stocks will soar. Citi shares can increase more than ten-fold easily.
With the current incredibly wide credit spreads, US banks must be making huge amount of profit. Yesterday's news about Citi is not an isolated event. I believe other banks are also generating handsome profits. In terms of really depressed valuation, I like Capital One (COF), which is trading at only 0.2 times of its book value! Obviously Citi is even cheaper. But Citi faces large dilution from government stakes in the company. So I prefer COF. WFC and JPM are also good investments at current prices.
Disclaimer: You should consult your financial advisers before making any investment decision. The above opinion is not a recommendation for anyone to buy or sell any stock or other financial assets. Invest at your own risk!
Tuesday, March 10, 2009
Market shot up more than 6% on Citi news
Today, the market rose more than 6% (Nasdaq was up actually 7%), on the report that Citi was profitable for the first two months of the year.
Investors seemed to be surprised by this news. That just shows that majority of the investors do not understand the nature of the current financial crisis.
I am not surprised at all. Citi, and other banks, should be making tons of money right now. The yield curve is so deep, and the FED is giving them almost free money to borrow. If they can't make money now, when can they?
In fact, according to an internal memo sent to Citi employees by Citi CEO Vikram Pandit, the company may generate more than 8B operating profit in the first quarter of the year.
From the very beginning, the root problem of many US financial institutions was not operating problem, but asset problem. Because the value of mortgage back securities many of these company hold on their balance sheet has declined dramatically, these companies are facing a capital shortfall.
I would argue that some of the decline in value of the mortgage-backed securities was artificial, a result of mark-to-market accounting based on questionable market valuation (for example, CDS-implied value), and does not reflect true economic value of these securities.
Let me explain: the total US MBS outstanding is valued at 10 trillion. Most of these MBS should have loan-to-value ratio of 80%. Let's assume that house prices have all declined 40%, which is a much worse assumption than what actually occurred, then the maximal write-off of the MBS value should be 20% of the 10 trillion, or 2 trillion. Between the FED and Treasury, more than $5 trillion has been pumped into the US financial institutions. Are we still saying these companies are insolvent? Give me a break!
I believe that most of the US banks are now making a killing. Their borrowing cost is almost none (interest rate is close to zero), but the interest rates they charge to borrowers are very high. And the Fed is willing to lend to the banks as much as the banks demand, through the Fed funds discount window. There is absolutely no reason why banks won't make huge profits right now.
But banks will have to continue to face asset write-off problems, as long as the current flawed mark-to-market accounting is in place. There is an analogy here: the banks are like a person who have a very well paid job. The person is earning a very high income, but because of the bear market, the person's 401K and other equity investment accounts have lost a lot of money, and his house is probably worth a lot less. But the person does not intend to cash out his investments, or sell his house. His job pays him well. Is he worried? No. He shouldn't. Because the stock market will eventually recover, and the house price won't remain depressed.
I think same is true with the banks now. The value of their assets is now depressed, because risk premium is high (the discount rate is high). But the banks continue to earn good profit from loans they give out. Overtime, when risk premium starts to subside, the value of the banks' assets will recover.
All of those doomsday-sayers don't know what they are talking about.
Investors seemed to be surprised by this news. That just shows that majority of the investors do not understand the nature of the current financial crisis.
I am not surprised at all. Citi, and other banks, should be making tons of money right now. The yield curve is so deep, and the FED is giving them almost free money to borrow. If they can't make money now, when can they?
In fact, according to an internal memo sent to Citi employees by Citi CEO Vikram Pandit, the company may generate more than 8B operating profit in the first quarter of the year.
From the very beginning, the root problem of many US financial institutions was not operating problem, but asset problem. Because the value of mortgage back securities many of these company hold on their balance sheet has declined dramatically, these companies are facing a capital shortfall.
I would argue that some of the decline in value of the mortgage-backed securities was artificial, a result of mark-to-market accounting based on questionable market valuation (for example, CDS-implied value), and does not reflect true economic value of these securities.
Let me explain: the total US MBS outstanding is valued at 10 trillion. Most of these MBS should have loan-to-value ratio of 80%. Let's assume that house prices have all declined 40%, which is a much worse assumption than what actually occurred, then the maximal write-off of the MBS value should be 20% of the 10 trillion, or 2 trillion. Between the FED and Treasury, more than $5 trillion has been pumped into the US financial institutions. Are we still saying these companies are insolvent? Give me a break!
I believe that most of the US banks are now making a killing. Their borrowing cost is almost none (interest rate is close to zero), but the interest rates they charge to borrowers are very high. And the Fed is willing to lend to the banks as much as the banks demand, through the Fed funds discount window. There is absolutely no reason why banks won't make huge profits right now.
But banks will have to continue to face asset write-off problems, as long as the current flawed mark-to-market accounting is in place. There is an analogy here: the banks are like a person who have a very well paid job. The person is earning a very high income, but because of the bear market, the person's 401K and other equity investment accounts have lost a lot of money, and his house is probably worth a lot less. But the person does not intend to cash out his investments, or sell his house. His job pays him well. Is he worried? No. He shouldn't. Because the stock market will eventually recover, and the house price won't remain depressed.
I think same is true with the banks now. The value of their assets is now depressed, because risk premium is high (the discount rate is high). But the banks continue to earn good profit from loans they give out. Overtime, when risk premium starts to subside, the value of the banks' assets will recover.
All of those doomsday-sayers don't know what they are talking about.
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