Bank of China Credit Card Point Redemptions by ocn11451


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									         “Liquidity, Liquidity Everywhere
               But Not a Drop to Drink
           Liquidity, Liquidity Everywhere
            and all the Banks did Shrink”
With sincere apologies Samuel Coleridge and the Rime of the Ancient Mariner

              Professor Michael Palmer
          Presentation to Schnitzer West, LLC
                 Seattle, Washington
                 September 24, 2008
                Quick Bio
• Michael Palmer, Professor of Finance, Leeds
  School of Business, University of Colorado.
• Education: Ph.D. University of Washington,
  1967 (Finance and Macro-economics)
• Visiting Professor Status: Kansai Gaidai
  University, Osaka, Japan; Jiao Tong
  University, Shanghai, China; Semester at Sea
• Academic Director: London Seminar in
  International Finance
                Punch Line
• We have experienced an unprecedented
  freezing of global financial markets which
  is now affecting real economic activity.
  – Financial markets are showing some sign of
    thawing, but is it too little and too late to
    avoid a major global slowdown?
                Theme #1
• Current financial crisis is not a liquidity
              Liquidity is Not the Issue
There’s plenty of liquidity                       Borrowing from the Fed, $bn
•   Fed’s Discount Window Facility and 28 and
    84-day TAF program; 2008 data:
           • Discount Window (Primary)
              borrowing : $180bn
           • Primary Dealer Credit Borrowing:
           • Term Auction Facility: $1.7tr
     – Fed buying 3 month commercial paper
         from issuers.
     – Specific companies:
           • AIG: $85 billion (US Treasury) +
              $38bn (Federal Reserve)
•   Fed assets have ballooned to $1.8tr, or 12%
    of GDP – double from last year.
    Foreign Central Banks and Governments
          have also Expanded Liquidity
United Kingdom                           Euro-Zone
•   September 19, 2007: The Bank of      •   ECB permits approximately 1,900
    England announced that it would          member country (15) banks to
    conduct auctions to provide funds        raise 3- and 6-month funds through
    to banks at 3 month maturity.            weekly auctions.
     – Expected injection with this           – Funds injected through October
        program: $350bn                          8: $590bn.
•   October 8, 2008: Government          •   October 6, 2008: German
    announced it would buy shares in         Government announced a state-
    UK banks                                 lead rescue package for commercial
     – - Estimated injection: $90bn to       property lender Hypo Real Estate.
        135bn                                 – Estimated injection: $68bn.
U.S. Financial System has Plenty of
Reserves (Depository Institutions)
Excess Reserves                         Non-Borrowed Reserves
• = Total Reserves* - Required** • Total – Borrowing from
• Average Monthly Data ($Bn)       Fed
     – 2005 through 2007: $1.7          • Average Monthly Data
     – 2008 (Jan – Sep): $8.5***          ($Bn)
•   *Deposits at Fed + Vault Cash          – 2005 through 2007: $43.5
•   **Legal Reserves against Deposits
                                           – 2008 (Jan – Aug): -$92.0
•   ***$6.0Bn in September
But Reserves Are Not (Yet) Showing up
      in Money Supply Growth
M2 Growth*                      Commercial Loans*
• 3 Months, May 2008 to Aug     •   Aug 4-8, 2008:        $42.4Bn
   2008:        1.5%            •   Aug 6-10, 2007:       $39.7Bn
• 6 Months, Feb 2008 to Aug     •   Aug 7-11, 2006:       $44.0Bn
   2008:        3.3%            •   Aug 1-5, 2005:        $48.0Bn
• 12 Months, Aug 2007 to Aug    •   *Commercial and industrial
• 2008:         5.3%                loans made by large domestic
*Percent change an seasonally       commercial banks. Data are
   adjusted annual rates.           collected during the middle
                                    month of each quarter.
    What have Financial Institutions Done
         With Their New Liquidity?
Strategy #1                                3-month TED Spread
•    Investing in Safe-Haven Financial
      – Increase in Risk Aversion
•    Represented by TED Spread
      – Three month U.S. dollar Libor –
         Three month U.S. T-Bill rate.
      – Early 2007 spread 20 basis
      – Oct 14, 2008 spread reached 445
         basis points (the largest since
         data collection began in 1984)
   Impact of Safe Haven on Yields
                                         Yield Curve: Oct 2007 to
Strategy                                 Oct 2008
• Investing in Safe-Haven
  Financial Assets
   – Increase in Risk Aversion
   – Moving into Treasury Bills
       • Biggest impact on short
         segment of U.S. yield curve
       • Pushing down the short
         end of the curve.
           – Fed policy also affecting
             this segment.
    Financial Institutions Hesitate to Lend to
      One Another or to End-User Market
Strategy #2                                   U.S., U.K. and Euro-Zone
•   Hoarding Reserves
     – Represented by spread of LIBOR
        over Central Bank policy interest
     – Early 2008 U.S. spread was around
     – Currently spread is around 200
        basis points.
•   Increasing deposits with central banks.
     – Banks deposited a record amount
        of cash with the ECB (182.6bn
        euros) on Oct 13th
Financial Institutions Are Increasing
 their Deposits with Central Banks
• In addition to investing in safe haven
  assets, commercial banks are also
  increasing their deposit holdings at their
  respective central banks.
• ECB data:
  – Friday, Oct 10, 2008: Bank deposits with ECB
    totaled 154.7Bn euros.
  – Monday, Oct 14, 2008: Bank deposits with
    ECB totaled a record 182.8Bn euros.
                Theme #2
• Current financial crisis has little to do
  with interest rates!
    Central Bank Interest Rates on the
               Way Down
Central Bank Target Rates                       Through Oct 8, 2008
•   Key short term central bank rates are
    coming down.
     – U.S. response earlier and deeper.
     – From cycle peak:
          • U.S. 5.25% (6/06) – 1.5%
                – Easing began: Sept 2007
          • U.K. 5.75% (7/07) – 4.5%
               – Easing began: Dec 2007
          • Euro-zone 4.25% (7/08) – 3.75%
               – Easing began: Oct 2008
     – Other central banks are lowering rates
       as well (Australia, India)
     Are European Central Banks
  Abandoning their Inflation Targets?
Bank of England                        European Central Bank
   – Inflation targeting adopted in      – Inflation targeting adopted in
     May 1997 and set by                   1997 through an amendment to
     Government.                           original treaty of Rome.
   – Current CPI Inflation target:       – Inflation target: “Below, but
     2.0%                                  close to, 2% over the medium
   – Current inflation (Oct): 4.7%         term.”
   – Bank of England “seeks to meet      – Current CPI inflation (June –
     the inflation target by setting       Aug): 3.9%
     an interest rate.”                  – ECB meets their inflation target
                                           through setting an “appropriate
                                           level of the key interest rates.”
Why Might Lowering Interest Rates
           Not Work?
Keynesian Liquidity Trap                          Elastic Demand for Reserves
•   Are we approaching, or perhaps already in,
    some form of the Keynesian liquidity trap?
     – “Liquidity-preference may become
        virtually absolute in the sense that
        almost everyone prefers cash to holding
        a debt which yields so low a rate of
        interest. In this event the monetary
        authority would have lost effective
          • General Theory (1936)
     – Monetary policy will not work at this
       point because lenders are not willing to
       make loans.
Bank Lending Rates Have Come Down,
    but Loans have Not Gone Up
Commercial Loans*                   Interest Rate on Loans*
•   Aug 4-8, 2008:        $42.4Bn   • Aug 4-8, 2008       4.36%
•   Aug 6-10, 2007:       $39.7Bn   • Aug 6-10, 2007 7.00%
•   Aug 7-11, 2006:       $44.0Bn
                                    • Aug 7-11, 2006 7.14%
•   Aug 1-5, 2005:        $48.0Bn
•   *Commercial and industrial      • Aug 1-5, 2005       5.32%
    loans made by large domestic    *Weighted average effective
    commercial banks. Data are        loan rate, calculated from
    collected during the middle
    month of each quarter.
                                      the stated rate and other
                                      terms of the loans.
Lessons from
•Paul Krugman (1998) has
argued that Japan fell into a
liquidity trap in the 1990s.
     •Japan was very slow to
•Monetary policy became
useless because banks
stopped lending.
     •Credit freeze!
•Fiscal policy in the form of
large public projects finally
moved Japan out of
     •But Government debt
     now 180% of GDP (US:
                 Theme #3
• Authorities seem to be treating the current
  crisis (in varying degrees) as an liquidity
  – Fed of New York (Oct 8), announcing an
    additional $37.8bn for AIG stated: This new
    action will help AIG “replenish liquidity…”
• But, the current crisis is about(1) insolvency
  concerns and a resulting (2) credit freeze!
• It’s really about a loss of confidence.
Interbank Lending is the Problem
• Domestic and interbank lending markets
  are frozen.
  – Liquidity is there, but banks have been
    reluctant to lend to one another.
     • Federal funds market.
     • LIBOR market.
     What is LIBOR and why is it
• LIBOR: The London Interbank Offer Rate is the
  interest rate that large banks charge one another for
  10 foreign currency denominated loans (deposits)
  ranging from overnight out to 12 months.
   – Set each day in London around noon through the BBA by
     a representative panel of commercial banks.
   – US dollar LIBOR the most important.
• It is estimated that $360tr of financial products
  worldwide, from mortgages to company loans and
  derivates, is tied to a LIBOR rate.
   – Other regional markets have similar interbank rates
     (HIBOR, in Hong Kong).
        Retail Lending is the Problem
Commercial Paper Markets                     Shift to Short Term
•   Key source of short term funding is
    drying up.
     – Especially for longer term (3-
         month) paper.
•   Last year outstanding commercial
    paper: $2.2tr
•   Recently: $1.6tr (3 year low)
     – Most of it 1 to 4 days maturity.
•   Markets do NOT want to lend
     – Prime money market funds pulled
         $200bn from this market from Sept
         16 to October 8th
        Bond Spreads are Increasing
Pre-Financial Crisis                       Now
•   September 20, 2007                     •   October 14, 2008
•   Corporate:                             •   Corporate:
     – Aaa:          5.88%                      – Aaa:         6.55%
     – Baa:          6.73%                      – Baa:         8.86%
•   Spread: Baa- Aaa                       •   Spread: Baa – Aaa
     –              + 85 basis points*          –              +231 basis points
• Government                               •   Government
     – 10 year      4.69%                       – 10 year      4.08%
• Spreads (over 10 year Government rate)   •   Spreads (over 10 year Government rate)
     – Aaa:         +119 basis points           – Aaa:         +247 basis points
     – Baa:         +204 basis points           – Baa:         +478 basis points
* 1934 – 2003 spread = 103 basis points
              U.S. Bond Markets
• U.S. corporate bond sales were at their lowest September
  level since 2000.
   – September 2008: $11.7bn
   – September 2007: $32.7bn
• “Corporate borrowing options have dwindles as the
  investment grade bond market (Baa and above) remained
  all but closed for a fifth week.” (Bloomberg, Oct 8)
   – Companies like Gannett (the largest newspaper company in the
     U.S.) and Southern have had to forego issuing debt.
   – The new issue market is especially troubling for financial firms,
     which have about $145 billion in fixed- and floating rate debt
     maturing in the rest of 2008, according to JPMorgan data.
   – Overall corporate bond spreads have hit record highs , closing
     on October 2 at 339 basis points, up from 317 at the start of the
               Theme #4
• Until we understand the current
  situation, we cannot offer appropriate
  and lasting solutions.
              Financial Markets
• Financial markets work best when participants have
  confidence in dealing with one another and with the
  “value” of the assets they are involved in.
• Today, confidence has broken down.
   – Confidence regarding the solvency of borrowers.
   – Confidence regarding the solvency of lenders.
   – Confidence regarding the “market-values” of financial
   – Confidence regarding the “tradability” of financial assets.
   – Confidence regarding the regulation of markets.
   – Confidence regarding policy makers.
   – Etc.
         Lack of Confidence
• When confidence breaks down, financial
  markets cease to function (efficiently).
• Examples:
  – Interbank market – which has been regarded
    as close to risk free- suddenly freezes up.
  – High investment grade companies are forced
    out of the long term bond markets.
  – High investment grade companies struggle
    to raise short term funds.
    Will $700Bn Bailout Restore
• On Oct 3, Congress passed a $700Bn bailout
• In and of itself will this restore confidence? I
  don’t think so.
   – Issue: What if “toxic” loans are removed from
     the balance sheets of financial institutions?
      • Will the credit markets “unfreeze?”
      • Will the interbank market “unlock?”
      • Will financial institutions continue to seek “safe
        haven investments?”
Will The Injection of Government Money
into the Equity Position of Banks Restore
• U.S. announced that they will inject $250Bn into
  banks through the purchase of preferred stock.
   – What will banks do with these funds?
   – With this action, combined with the $700bn bailout,
     there is the issue of “moral hazard.”
      • Essentially rewarding bad behavior and setting a precedent
        for future bailouts.
• French model: (Oct 20) Announced that they
  would invest $13.99 billion (in subordinated
  debt) in the country's six biggest banks by year-
  end on condition that they increase lending to
  companies, households and local governments.
Will a More Globally Coordinated Policy
     Response Restore Confidence?
• Over the last two weeks, central banks have
  engaged in coordinated policy actions:
   – Central banks are taking equity positions in their big
   – FED, BOE, and ECB all lowered their key short term
     target interest rate by 50 basis points.
   – Central banks have agreed to provide unlimited
     dollar funds to financial institutions in Europe and
      • Trying to bring down the overseas dollar rate.
   – Central banks are lending to corporate borrowers in
     their money markets.
    Key: Restoring Confidence
• How might financial market confidence be
  – Greater transparency by all participants, but
     • Originators of new financial products.
     • Risk evaluation services.
     • Major financial institutions, include government
     • Policy makers.
  – Acting as lenders of last resort to end users.
  – Through globally coordinated action
 Theme # 5: Looking at the Big
• What About the Economy?
  – How Did we Get Where we Are Today?
  – Where Are we Today?
  – Where Are we Going?
             How Did We Get Here?
Recent History                        Lead to
• Easy monetary policy                • Increasing domestic debt
  fueled economic growth                 – Explosion of household
• Generally a period of low                debt.
  and falling inflation                  – Deteriorating current
   – China Effect                          account balance
   – Resulted in low interest rates      – Increasing foreign
     (falling cost of debt)                ownership of U.S. debt
• Long Equity Bull Market             • Easing spreading to the
  Bull                                  housing market
   – Increasing wealth effect
 Fed Policy and Economic Growth
Monetary Policy   Economic Growth
      Inflation and Interest Rates
Inflation           Long term Interest Rates
Relationship of Inflation to Long
      Term Interest Rates
  Consumer Credit and Household
                  Household Debt Service
Consumer Credit   Ratio
   Equity Markets: Wealth Effect
1990’s            2000 – Oct 2007
Impact on Housing Sector
  Mortgage and Housing Markets
Mortgage Markets   Housing Prices
               Where are we Today?
•   Financial crisis spilling over to real economy
     –   Recent announced job cuts (downsizing)
     –   Surveys of consumer holiday buying intentions
•   Housing lead slowdown (recession?)
     –   Bloomberg GDP survey: 3Q: -0.2%; 4Q: -0.8%
•   Falling asset prices
     –   Equities and real estate
     –   Stock market generally a leading indicator of a recession
•   Frozen credit markets
•   Weakened financial institutions
•   Weak household balance sheets
•   Global contagion (economic slowdowns coupled with rising cost of
    developing nation debt)
•   Loss of confidence (in markets, in financial institutions, in regulators and
    policy makers)
   Leading Indicators of Economic
Useful Leading Indicators       Stock Prices
• Conference Board’s            •   Shaded area is a NBER dated
  Leading Indicator Series
   – Indicates direction of
     economy over next 3 to 6
      • Oct:
      • Sept +0.3%
      • Aug – 0.9%
• Stock prices
        So Where is the Economy
• Consumer spending is the key.
    – Represents about 68% of GDP (2006)*
        • Services: 38%; Durables: 10%; Non-durables: 20%
    – Private Investment about 17%**
        • Housing: 3.5%; Producers durables: 11%
    – Government Expenditures about 17%
        • Federal Government: 5%; State/Local: 12%
*Consumer sector represented 66.5% of GDP from 1996-2006
**Private Investment represented 25.2% and housing 1.6% of GDP from
   1996 to 2006
 So What About the Consumer?
• Consume spending will be affected by:
  – Confidence (contagion effect of financial
  – Income levels (income and unemployment
  – Wealth effects (stock market and housing
    prices effect)
 Signals from Today: How is the Consumer
       Likely to React in the Future?
                      Unemployment Rate (Sept
Consumer Confidence   6.1%)
 Signals from Today: How is the Consumer
       Likely to React in the Future?
                     Wealth Effect: DJA Down
Earnings Growth      38% from high
       Wealth Effect: Housing Prices
Housing Price Data                              1975 – 2Q2008
•   During the 25-year period from 1975
    through 1999, real house prices stayed
    within the range of $132,000 to $171,000.
•   Only since the year 2000 have real house
    prices risen above this range.
•   The United States median price was at
    approximately $206,500 as of the second
    quarter of 2008.
     – This is 21% higher than the previous
         housing boom peak of an inflation-
         adjusted $170,900 in 1989.
•   Nominal prices peaked in 2Q2006 at
    $252,514. Currently at $206,500 (-18%)
     Regional Impacts of Housing
Los Angeles: Sept 06: -26%   Seattle: July 07: -7%
     Where are Financial Markets
    Headed? Are we at the Bottom?
•   Indications of some financial market thawing out
     – LIBOR (dollar) rates easing (Oct 22, overnight USD at 1.12% has fallen to lowest
         level since 2004).
     – TED spread easing (from 434 a week ago to 250 now).
     – Interbank rates easing (globally, in Asia and Europe).
     – Commercial paper rates easing (Oct 22, 30-day paper at 1.93% at lowest level in 4
     – Money market fund rates easing.
     – Recent money supply growth.
     – Perhaps some confidence is coming back, BUT spreads are still historically high
         suggesting the thaw still has a way to go.
•   Future short term and longer term problems?
     – Mounting credit card delinquencies
           • BofA lost $373 million in the 3rd quarter on card services unit.
     – Falling U.S. savings rate might discourage household consumption (if rebuilding
         savings takes place).
     – Rising Federal government deficit.
Is the Federal Reserve Running out
       of Traditional Options?
Traditional Policy Tools          Contemporary Approach
                                  •   Lender of last resort to important
• Fed funds rate now at 1.5%          financial markets.
   – Running out of downside            – Oct 21: Providing $540bn to
      room?                                money market mutual funds so
                                           they can meet redemptions.
• Discount window borrowing
                                        – Unfreeze frozen markets
  facility has been expanded to
                                        – Expand direct lending beyond
  non-commercial bank                      the commercial paper market
  borrowers.                               where needed.
• Reserve ratio remains           •   But, Fed assets are ballooning,
  unchanged.                          $1.8tr, or 12% of GDP – double from
                                      last year.
       What else Needs to be Done?
Restore Confidence                           Ongoing Issues
•   “Temporary” increase in FDIC             •   Cleaning up the securitizations and
    insurance and guarantee of money             derivatives markets.
    market mutual funds.                          – Including educating end users to the
•   Global coordination must continue.              risks involved.
     – Europe has increased deposit          •   Revising regulation decisions.
        insurance as well.                        – Glass-Steagall
•   But, continuation of strong dollar            – Mark- to-market accounting rules
    suggests ongoing global flight to                 • Europe easing rules allowing
    safety is still an issue (next slide).              banks to reclassify some assets
                                                        as long term.
•   Balance all actions against moral
                                             •   Examining the response of credit
    hazard issue.
                                                 rating agencies.
      U.S. Dollar Remains Strong
Turnaround in July   Consequences of strong $
                     • Keep U.S. inflation in check.
                        – Provide greater flexibility to
                          Federal Reserve.
                     • Discourage foreign central
                       bank withdrawals from U.S.
                       financial markets.
                        – Foreign ownership of U.S.
                          marketable debt now around
Do We Need Another Stimulus Package?
•   Bernanke (Oct 20): indicated that
    he would endorse additional
    fiscal stimulus to help
     –   “The pace of economic activity is
         likely to be below that of its longer-
         run potential for several quarters.
         The slowing in spending and
         activity spans most major sectors.''
•   Bush Administration indicated
    they were open to the idea.
•   House democrats suggested
    “infrastructure spending and
    extended unemployment
     –   New infrastructure projects
         generally slow to come on line.
     –   Perhaps we need to consider tax
         cuts for businesses.
   Two Macro-Economic Scenarios
Scenario 1: V shape                  Scenario 2: U, W or L shape
• Quick recovery                     • Now some are thinking:
   – Within 2 to 3 quarters             – U: More gradual recovery
• Historically this has been the          (e.g., 1990/91), or
  case                                  – W: Recovery followed
• Early 2008 optimism for                 closely by another recession
  second half turnaround                  (aka “double dip”) as 2008
  resulting from:                         stimulus dries up (e.g., 1981,
   – Assumed positive lagged              2001), or
     response of Fed interest rate
     cuts.                              – L: Prolonged recession (e.g.,
                                          1929 or Japan in the 1990s).
   – Spring tax rebates.
                                        – .
      U-Shaped Recovery Likely
• Caveat: The factors underlying a U-shaped scenario
  are notoriously difficult to predict.
   – Specifically, exactly when and to what degree factors
     impacting household and business behavior will kick in
     and when they will translate into GDP.
• U-Shaped recovery scenario likely based on:
   – Severity of financial asset bubble collapse
   – Large debt burdens (household)
   – Financial market freeze (and its contagion effect on real
   – Global reach of current situation (through
     trade/business coupling of economies)
Post Scrip: The U.S. Economy and
the Rime of the Ancient Mariner
• The mariner’s tale is about a ship (U.S. Economy) which
  leaves its native harbor. Initially, all goes well and the ship
  smoothly sails across the seas. However, misfortune strikes
  as the voyage darkens and the ship is caught in a labyrinth of
  ice (Credit Crisis; Frozen Capital Markets).
• The ship is lead from ice to uncharted waters (Sub-Prime
  Mortgage Meltdown and Non-traditional policy responses).
• The mariner eventually hears the voices of two angelic
  spirits (Ben Bernanke and Henry Paulson) whose
  conversation reveals that his ship was maneuvered by
  heavenly forces. When the mariner awakes he finds himself
  home among familiar landmarks (Hoped for Outcome?)
Questions and Answers and

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