Policy Tensor

Will Anyone Call ISIS’ Bluff?

In Middle East on November 16, 2015 at 9:37 pm

Any doubt on whether the Islamic State poses a grave threat to global security vanished in recent weeks as ISIS demonstrated an impressive capability to organize large-scale terror attacks very far from home. It was behind the downing of the Russian plane over the Sinai that killed all 224 passengers onboard; the double suicide bombing in a Shia neighborhood of Beirut that claimed at least 43 lives and injured more than 200; and, of course, the gruesome attack in Paris on Friday that killed 129 people and wounded hundreds more. ISIS is bluffing that global powers would not respond in force. 

There is now growing recognition that the nascent outlaw state must be destroyed. Half the world’s air forces already crowd the skies over its territory. The United States, Russia, France, Britain, Turkey, Australia, Canada, the Netherlands, Jordan, Qatar, UAE, and Saudi Arabia have all bombed ISIS; although the Arabs seem to have given up on the project in the past few months. The air campaign has been a predictable disappointment. The Islamic State had largely reached the ethnic limits of its expansion before the air war began; so that even the halt in ISIS’ territorial expansion cannot be honestly credited to the airstrikes.

That the Islamic State cannot be dispatched without landing ground forces is now manifest; as the Policy Tensor predicted more than a year ago. This page argued that Obama’s strategy was based on the Afghan-model of warfare. It was assumed that precision airstrikes directed by US scouts on the ground would allow even untrained allies to rapidly retake territory from ISIS. But on the modern battlefield, air power and ground-force skill are not fungible but rather complementary; so that, as Biddle argued, the viability of the Afghan-model depends on the balance-of-skill on the ground. Once it was clear that there were no competent ground forces available to do the job, the failure of the administration’s war strategy was the baseline scenario. 

Now that any lingering hope that the Islamic State could be destroyed from the air has been dashed, the question is this: How long will it take for global powers to come around to landing an army? And just who will do this dirty work? The existing ground forces of Britain, France, and Germany are simply insufficient to the task at hand. The Russians are more interested in defending Assad than taking on the Islamic State. The Turks care more about preventing the Kurds from establishing a statelet in northern Syria than defeating ISIS. The Kurds neither have the mass nor the motivation to protect anyone other than themselves. The Saudis and other gulf monarchies are too busy containing Iranian influence in the region and imposing themselves on Yemen. The Iranians on their part would love to dispatch ISIS but are deterred by the idea of trying to pacify Sunnistan. Which brings us to the only actor capable and potentially willing to do the job. 

President Obama has again ruled out sending ground forces. But US opinion is shifting rapidly. Senators John McCain and Lindsey Graham have been gunning for it. Jeb Bush has come out in support. Even Roger Cohen has come around. Expect more and more people to join the chorus as reality sinks in. Sooner or later, the United States will be leading the conquest of the Islamic State.

The caution of global powers reflects the complexity of the challenge posed by the Islamic State. For the Islamic State is the superposition of three distinct developments. First, ISIS contains the ghost of Saddam Hussein: The Islamic State’s military prowess comes from the reconstitution of the core of Saddam’s army. Second, it is the most virulent manifestation so far (and the clear flag-bearer) of the Salafist-Jihadist movement powered by gulf money; feeding on the disaffection of Arab youth, both in the Middle East (as a consequence of the societal crises of the Arab states) and in the West (a result of their exclusion from national culture). Third, ISIS is riding arguably a much more enduring ethno-political development, the rise of Sunni-Arab nationalism in Iraq and Syria. To put it bluntly, Iraq and Syria are history. Humpty-Dumpty cannot be put back together because the Sunni-Arabs will never again submit to Damascus or Baghdad; not unless they dominate them.

The first development (the reconstitution of Saddam’s army) means that dispatching ISIS requires landing a superior concentration of ground forces. The second means that ISIS will continue to espouse unlimited aims; that it cannot be contained like a regular outlaw state; and indeed must be crushed out of existence. But the third development means that whosoever conquers the Islamic State would be taking up the unenviable task of pacifying Sunnistan. There are only two options here for a global power committed to conquering the Islamic State. Either it can try to reconstitute the Sykes-Picot states or it can forge a brand-new Sunni-Arab state; recognized by the United Nations and ratified by a UN-mandated referendum to boot. One of these leads back to square one; the other to a permanent resolution of the challenge posed by the Islamic State.

An effective US response to the challenge posed by the Islamic State must begin with a reversal of policy in Syria. The United States must drop its counter-productive insistence of Assad’s premature ouster. That will open the way to a great power settlement in Syria. The second step would be to lead a broad international coalition of ground forces to conquer the Islamic State and impose the peace in Sunnistan. A UN supervised referendum would then follow. If a nascent Sunni-Arab state does emerge from this process in Sunnistan, it would remain a ward of international society until it is ready to shoulder the burden of imposing the peace.

The strategy outlined above will be costly in terms of both blood and treasure. But with the Europeans eager for a solution to the coupled refugee and security crises, and the Russians eager to have a seat at the table, the United States can share these costs with other global powers.

It is surely time to call ISIS’ bluff. Or does anyone seriously think that it is a good idea to dilly-dally until the message is brought home in an even more brutal manner?  

Hawks Take Centerstage

In Markets on November 11, 2015 at 8:47 am

ACM term risk premia since 2000

Abstract: The market seems convinced that the Federal Reserve will lift-off in December, 2015. We argue that this expectation needs to be tempered because the economy begs to differ with the hawks. Fatally for the hawks’ case, the Phillips Curve is broken. And since the neutral rate is now exceptionally low and on a downward trend, the Fed’s model risk has increased considerably. The labor market continues to show slack on many indicators including decidedly tepid wage inflation. Moreover, the US economy is not nearly as resistant to an imported deflation as it is to recessionary headwinds from abroad. The baseline scenario continues to be lowflation and stagnation for some time to come. The FOMC is therefore likely to hold fire. And if it does hike in December, it would be running the risk of deflation. A premature exit would harm the recovery that is still underway in the real economy. At the very least, the Fed would be sure to miss its inflation target over the medium term.

Read the research note here (pdf). 

How the US Market-Based Credit System Works

In Markets on October 30, 2015 at 5:09 am

In a recent primary debate, Hillary Clinton suggested that risks in the financial system are now concentrated in ‘shadow banks’. I do not like this terminology. The so-called ‘shadow banking system’ is the very core of the US financial system. It is where money is manufactured and the price and quantity of credit determined. We shall use more neutral terms such as ‘the market-based credit system’ or when the intent is clear, simply as ‘the modern system’ instead. In this essay, my goal is to demystify the system for the reader. In what follows, we shall describe the core institutions and key working parts of the modern system. In particular, we shall describe how money is manufactured today; the role played by various actors; and the evolution of the system. Readers interested in understanding the system in greater detail should begin with the works of Pozsar, Mehrling and Adrian (see references at the bottom); as well as the excellent treatment by the Federal Reserve Bank of New York.

How money is manufactured in the modern system

In a prison, money is cigarettes; for drug dealers and suchlike, money is cash; for most of us, money is bank deposits. But for those with really big balance sheets—corporate treasurers, money-market mutual funds, institutional investors, central banks and big investment firms—it is paper. What is paper? Paper, or more formally a deposit-equivalent, is whatever can be exchanged at par on demand with near certainty. That is, it is an ultra-safe, short-term asset that can be exchanged without loss for cash or bank deposits on demand. A market-based credit system revolves around the manufacture of paper.

How is paper manufactured? Take a risky asset—a claim on any stream of cash payments such as a mortgage or a standard semiannual coupon bond (which pays a fixed coupon rate every six months)—and break down its price into the price of risk and the price of paper according to the first fundamental equation,

asset = paper + risk.

If you can find someone to bear the risk (and earn the reward) of this asset, you can decompose the cash-flow of the asset into junior tranches of asset-backed securities (ABS) that bear most of the risk and senior tranches that bear little. The senior-most tranche after all the slicing and dicing is paper; stamped AAA for good measure. Let’s work with a concrete example to illustrate the manufacturing process of paper.

Let’s take a pool of 10,000 mortgages. Suppose we create just two tranches of mortgage-backed securities (MBS). The senior tranche gets paid in full unless at least 9,000 mortgages default; the junior tranche gets the rest. Now, the probability that 9,000 of 10,000 mortgages default in any given year mathematically depends on the correlation of the rates of default on the 10,000 mortgages. For uncorrelated mortgages, the probability is vanishingly small. And the higher the correlation, the higher the probability that the holders of the senior tranche will lose money. In the extreme, if defaults are perfectly correlated, then the probability that the holders of the senior tranche get burned is the same as the probability of a single default! In practice, the correlation is essentially zero for prime loans. And as we found out in the course of 2007 and 2008, not quite zero for subprime. Anyway, let’s stay with a pool of prime loans—those that are expected to be repaid with very high probability and have low correlation. Since the probability that the holder of the senior tranche will bear any loss whatsoever is basically zero, the senior tranche is paper.

Overnight paper

There are four kinds of paper in a market-based credit system.

(1) Purely public money, where the asset is public and the state provides a backstop. In the United States, these are Treasury bills (Tbills) issued by the government as well as overnight reserves at the Fed. Other government bonds do not qualify as paper because they are subject to considerable interest rate risk.

(2) ‘Public-private’ money, where the asset is public but there is no public backstop. Secured borrowing (called repo) when the collateral on the loan is Tbills and constant net asset values accounts of government-only money-market mutual funds both qualify as this type of paper.

(3) ‘Private-public’ money, where the asset is private but enjoys a public backstop. Bank deposits insured by the FDIC qualify for this type, as do term deposits in wholesale banks.

(4) Purely private money, where the asset is private and enjoys no state backstops. Repo with private asset-backed securities and CNAVs of MMMFs as collateral qualify for purely private paper.

The following table reports the total amount of paper outstanding in the financial system estimated by Pozsar (2014). Note that the largest pile is purely private paper accounting for a full third of the total; whereas purely public paper accounts for about a quarter; about the same as shadow money created on the backs of public assets. Bank deposits, the flag bearers of traditional banking money, account for less than a sixth.

           Type                Quantity          Share

(1) Purely public          $2.6 trillion     27%

(2) Public private         $2.3 trillion     24%

(3) Private public         $1.4 trillion     15%

(4) Purely private         $3.2 trillion     34%

       Total                      $9.5 trillion  100%

Instead of the traditional ‘originate-to-hold’ banking model wherein the loan sits permanently on the balance sheet of the lending bank, the modern banking system is characterized by the ‘originate-to-distribute’ model that parcels out the risks to those who are most willing to bear it; in the process, manufacturing copious amounts of private money. The manufacture of paper involves warehousing the assets off balance-sheet in artificial firms called conduits in offshore locations; and selling some of their risk to monoline insurers. But the paper itself and much of the risk exposure makes its way to the wholesale market; as is clear from a map of the entire system

The Wholesale Funding Market

At the core of the market-based credit system sits the wholesale funding market. It is here that almost all the paper manufactured in the system circulates. At the center of the whole system sits Wall Street. More precisely, the central players in the modern system are market-makers—those who stand ready to buy and sell, as well as borrow and lend, both paper and assets in bulk at posted (bid-ask) prices. Dealers supply market liquidity by quoting a two-sided market and absorbing the resulting order flow on their own balance sheets (Harris, 2003). Indeed, a dealer that insisted on a matched book at every instance would not be supplying liquidity at all. Both the volume of order flow and the dealers’ willingness to hold inventories is thus necessary for market liquidity. As Mehrling et al. (2014) note, “If customers are able to buy or sell quickly, in volume, and without moving the price, it is because some dealer is willing to take the other side of that trade without taking the time to look for an ultimate offsetting customer trade.”

Dealers interface with two types of actors in the wholesale funding market—yield seekers who want the returns that come with risk and cash pools who want paper.

Yield seekers are asset managers whose motto is “beat the benchmark”. In order to earn returns, asset managers seek to bear risk. There are two kinds of asset managers. Real money investors who have their own risk bearing capacity such as pension plans, endowments and other institutional investors. And leveraged investors such as hedge funds and other alternative asset managers. These categories are somewhat muddled in that real money investors often invest in hedge funds themselves. But it is important to distinguish between them in order to highlight a major financial innovation called leveraged beta strategies.

Instead of holding equities that would yield 12 per cent with a good deal of uncertainty, a leveraged beta investor holds a combination of paper and derivatives to make a leveraged bet whose expected return is 12 per cent (the leverage comes from the derivative, not from outright borrowing). Such strategies allow for ‘equity like returns for bond like volatility’. This can be seen from expanding the first fundamental equation (asset = paper + risk) into the second fundamental equation,

asset = paper + CDS + IRS + FXS,

where the derivatives—credit default swap (CDS), interest rate swap (IRS), and exchange rate swap (FXS)—are the prices of credit, interest rate, and exchange rate risks, respectively. Leveraged beta strategies seek to obtain excess returns by bearing carefully chosen risks. They do so by holding specific combinations of paper and derivatives. The proliferation of leveraged beta strategies has therefore generated brisk business for dealers who are market-makers in the asset, paper and derivative markets.

Cash pools’ motto is “do not lose”. These are usually money-market mutual funds, corporate treasuries, foreign central banks, and institutional investors—those holding such a large pile of cash that it is risky to park it at a bank! Since the FDIC only insures the first few hundred thousand dollars in any individual account, cash pools prefer to hold Tbills or ‘quasi-Tbills’ instead. That is, cash pools prefer even purely private paper to bulk bank deposits because the former is more secure. They also want paper for yield since the fractions of a cent on the dollar that paper yields adds up quickly when you have billions of dollars to park. As corporate coffers have filled up with cash and the assets of money market funds has skyrocketed, the demand for paper has exploded. Pozsar (2014) estimates that between 1997 and 2013, while US GDP doubled, cash pools trebled (from $2 trillion to $6 trillion).

The wholesale funding market consists of the wholesale money market and the wholesale capital market. The wholesale money market is the market for paper where money dealers borrow and lend paper in bulk. In the wholesale capital markets, the market-makers can be thought of as risk dealers or derivative dealers.

The repo market for collateralized borrowing, the interdealer overnight lending market, and the off-shore eurodollar market are all part of the wholesale money market. The main one is the repo market. A repo transaction is best thought of as one party borrowing money from another by posting paper as collateral. A reverse-repo is just a repo with the positions of the parties interchanged. Interestingly, while there were runs on the bilateral repo market as a whole in 2007-2008, there were no generalized runs on the tri-party repo market (where the runs were restricted to specific asset classes). This suggests that the panic was about specific counterparties and specific assets. In other words, the plumbing of the system is more resilient that it looks from this side of the financial crisis.

Dealers respond to inventory buildups by adjusting their bid-ask prices. But even matched-book dealers bear liquidity risk because they must repay their creditors even if their own debtors do not repay them. The size of dealer books determines the liquidity in the entire wholesale funding market. In turn, the size of dealer books depend on macro (co)volatilities. Dealer balance sheet optimization is inherently procyclical: Dealers respond to low macro volatilities by expanding their books, which in turn further suppresses macro volatilities.

Dealer behavior is also procyclical with respect to order flow. Specifically, dealers move prices to bring buy and sell order flows more into line with each other, but in doing so they move prices away from their matched-book values. This generates a credit cycle. In expansion mode, the boom is exacerbated. And in contraction mode, liquidity dries up.

Pozsar’s central thesis is that the emergence of the market-based credit system can be explained by the growing demand for paper from cash pools on the one hand, and the increasingly frantic search for yield by asset managers on the other. The former is the consequence of a shortage of Tbills—there are only about $800 billion worth of Tbills in circulation. The latter is the consequence of increasingly difficult-to-satisfy obligations of institutional investors. Basically, pension funds and other institutional investors made promises based on overly optimistic assumptions about returns. They were implicitly assuming that productivity would grow at a faster pace than it has. They are thus desperate for excess returns.

Wholesale funding market

These sources of powerful flows on both ends of the wholesale funding market had two consequences. First, they made market-making in the wholesale market extremely profitable. Second, they lowered the price of credit system-wide. Pozsar posits that this mechanism provides a competing explanation (to Bernanke’s ‘global savings glut’ and Shin’s ‘global banking glut’) of Greenspan’s conundrum (the failure of long rates to rise despite rate hikes). [These competing explanations can be tested in a vector autoregression. Yet another project for the Policy Tensor!]

The Fed’s Reverse-Repo Facility

During and after the financial crisis, the Fed moved in to stabilize the wholesale funding market by buying vast quantities of troubled assets; mostly MBS. In addition it expanded the supply of Tbills. The Fed also created an entirely new form of purely public money. This is the Fed’s reverse-repo facility that provides publicly guaranteed paper to the Fed’s counterparties. Moreover, the Fed has given access to the facility not just to primary dealers (who otherwise enjoy exclusive access to the Fed), but also money-market mutual funds. This serves to ameliorate the problem of the shortage of Tbills. Pozsar expects the facility to expand in a big way and drive out much of the private paper in circulation today. So far, the Fed has said that it is a temporary facility that only exists to give the Fed another lever to control the short rate. The facility is expiring in January 2016. It will be interesting to see which way the Fed decides to go in the December meeting. I wouldn’t bet against Pozsar.

A Dealer of Last Resort

The Achilles heel of the modern system is liquidity risk. This is because while credit, exchange rate and interest rate risks end up on the books of those willing and able to bear them (insurers, real money investors and leveraged investors), liquidity risk cannot be so efficiently disposed. This is the familiar problem of systemic risk arising from multiple equilibria—when there is a run on the system, liquidity evaporates. What matters is your ability to make that margin call, not whether you are ‘fundamentally solvent’. What is required, as Bagehot argued in the nineteenth century, is a dealer of last resort. Someone who is willing and able to step in when others aren’t—a role that J.P. Morgan famously played in the panic of 1907. Bagehot’s advice for the Bank of London was to lend freely on (normally accepted) collateral and charge a high rate of interest.

Pozsar, Mehrling, and Adrian counsel the Fed to play this role. On the other side of the pond, the Bank of England has already made moves in this direction. So far, the Fed has declined to accept private paper. My position is that the Fed does not have much wiggle room. It must either produce enough public paper (say through the reverse-repo facility) to drive private paper largely out of circulation, or it must become a dealer of last resort. Otherwise, the market-based credit system will remain prone to runs.

Selected References

Mehrling, The New Lombard Street: How the Fed Became the Dealer of Last Resort, 2010.
Pozsar, “Institutional Cash Pools and the Triffin Dilemma of the US Banking System,” 2011.
Mehrling et al. “Bagehot was a Shadow Banker,” 2013.
Adrian et al. “Repo and Securities Lending,” 2013.
Pozsar, “Shadow Banking: The Money View,” 2014.
Pozsar, “A Macro View of Shadow Banking,” 2015.


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