This sounds scary

I haven’t had time to digest the implications of this story which has been around for at least a month, but only now seems to be attracting attention (I’ve seen it in a few different places today). Apparently, short sellers in the US Treasury bond market are failing to deliver the securities they’ve sold. As long ago as 1 October, the shortfall was more than $2 trillion by one report. Via Felix Salmon, here’s Helen Avery in Euromoney.

I’m not an expert on this stuff, but it seems to raise the question of whether bond markets can and should continue to exist in their current form. Maybe the US and other Treasuries should be selling bonds directly, and offering repurchase options to provide liquidity, perhaps using the banks they’ve already part-nationalised to handle the mechanics.

48 thoughts on “This sounds scary

  1. look i’ve got no evidence to prove this, but isnt it obvious?

    these guys are smart, and they are trying to break the financial system not fix it,

    now some of you will attack me and say its preposterous, but i’m sure i’m right

    the signs all point in the same direction /

  2. One can only guess that the short sellers have taken a bath or are rapidly being deleveraged and the dealers who did the deals for them are stuck in the middle unable to deliver. Another legal quagmire as Treasury always will honour the bonds but who owns them is going to be an interesting tussle. Yet again another critical debt market the US government has relied on to keep the financial system working would appear to be broken. If the very bonds the US Treasury is selling to raise cash to keep the banks liquid are failing to transact, looks like the US Government will have to take-over this market as well. IF you really wanted to stampede foreign and domestic investors well this appears to be the way to do it. Also sounds like the hedgefunds and bond traders are rapidly becoming illiquid like the rest of the system, I would estimate the $T1.3 for outstanding deliveries pretty well adds into the @$2.0 in unfunded bank security liabilities. The signals are also out for imminent massive failures in the CDO and other financial instrument insurers. I have come to the conclusion that the intervention by Paulson and the Bush Administration has sought to buy back the financial bubble created over many decades, it is a no win strategy. The world as we knew it is becoming more erratic and frightening by the day. By the end of 2009 early 2010 we will be actually using the Big D word, the US and other sovereign treasuries do not have the ability to own the bubbles in housing, finance, resource development and consumer finance.

  3. Is the current world financial system, in general, and the US financial system, in particular, a pyramid scheme? This is the question which begins to exercise my mind. I have neither the knowledge nor the economic training to determine the answer to this question.

    Did the continuous on-selling of dubious derivates come to resemble a classic pyramid scheme? Pyramid schemes, if they “succeed”, grow exponentially and then collapse when “saturation” point is reached. There are no more suckers to bring into the game and all the suckers, except the very early instiagtors, must suffer losses. Is that where we are at? Opinions anyone?

  4. Perhaps, on reflection, I can answer my own question. A “bubble” is a “pyramid” scheme is it not? The US housing bubble serves as an example.

  5. Scary? How about $US7.7 Trillion !

    Following Citibank, this is the subsidy American capitalists now need to stave-off systematic bankruptcy.

    But this bailout, equivalent to 11 trillion Australian, only counters symptoms – the underlying structure and mechanism of debt-ridden, over-populating, bloated capitalism remains.

    Whose to say American companies will not ask for more?

    bye bye Citibank, bye bye halifax, bye bye Woolworths and on and on its goes.

  6. Of course, Andrew’s answer is question begging if tradeable banking assets are a bubble market.

    I tend to agree with Ikonoclast on the basis that compulsory retirement savings schemes and the age profile of our community means that a growing amount of funds was pouring into these markets, but assets of corresponding value were not being created. So they became a bubble.

    The bit I resent is that I am one of the suckers, even though I have been skeptical of this market for some years. Via super I am one of the compulsory investors.

  7. Chris, that $7.7 trillion figure is grossly inflated because it includes loan guarantees.

    It also includes $2.4 trillion which is the total value of short-term paper the Fed has been authorised to purchase – much of which has already been repaid.

  8. Ikonoclast, your analogy to pyramid selling is not wrong – subject to the qualifications about the usefulness of analogies about which, I understand, we agree (previous comments).

  9. Well put, Terje, though I don’t think “evil” is quite the right word. I’d say “dysfunctional and destabilising” would be a better description of the markets concerned.

    Unfortunately, it looks as though there is no alternative to propping them up for the moment, so as to allow an orderly winding down rather than a crash.

  10. “I have come to the conclusion that the intervention by Paulson and the Bush Administration has sought to buy back the financial bubble created over many decades, it is a no win strategy.”

    That’s what the Austrians have been trying to tell Keynesians. The answer to their long moral hazard is not shock and awe moral hazard. If 38% of the value of the world’s companies have been wiped out along with their owners’ home values and now commercial and industrial RE following in lockstep, then so be it. That’s why the money supply is deleveraging and trying to prevent that by passing the buck to our dwindling taxpaying children and grandchildren is obscene, yet that’s all we hear from Govts and their media parrots brought up in our Keynesian bottle fed universities. The thought that they are being forced to give up their bottle fed world now and be grown ups is terrifying them. Basically if we’re privately broke let’s print more money or borrow for more comforting bottles for everyone.

    If we’ve been living beyond our means and it’s quite clear we have been, then to go into deficit and borrow in the belief we’ll put off the day of reckoning is delusional. We must take the same medicine we recommended to our neighbours in the Asian meltdown. If we lose our investments and savings in dodgy institutions there’s always Centrelink for us, ABC Learning, Babcock and Brown, Elders and car Co workers alike. No special favourites for Govt handouts. As well Govts have to cut their suit to their cloth. Start with their $13mill Grocerywatchs and keep on slashing until they’ve balanced our books. It’s pretty simple really and then we can get on with balancing our books closer to home.

  11. John – so your aim would be to delay recovery? A lot of US banks have a solvency problem (a few outside the USA also) so we unwind it all slowly and the rest of the world has to endure a slow unwinding of the financial uncertainty. Better to let the big fish (and some little ones) go into receivership ASAP and then get on with growing the economy. Confidence will begin to restore once the collapses stop coming. Better to get all the collapses out of the way then. Isn’t public money merely slowing down the clean up? And imagine the tax cuts that could have been dolled out to successful producers with all that dosh (Gordon Brown seems to have got it half right in my book).

    p.s. Why is nationalisation of banks better than receivership? Or is the former merely a vehicle for the later?

  12. Yes

    The 7.7 trillion is the highest number I have seen and there appears to be no detailed breakdown.

    No source has yet added-up the value of each national bailout – UK, German, Japan, IMF etc. to get the real picture.

    Of course this money does not exists – it is a charge on future generations.

  13. “Buy time” is never a sound strategy, “buy time and use it” is, the way Pericles told someone who said Pericles had bought peace by bribing the Spartans to go away that he had bought not peace but time.

    So what’s happening now isn’t directly constructive, but could be indirectly such if those doing it are – right now – busily looking for a real medium term way out in the short term they have bought and if they find one. Those are two long shots, since I suspect this lot believe buying time is all they need, but that is all there is short of collapse and (hopefully) rebuild from a low base afterwards.

  14. Terje – if Citigroup, for example, went into receivership, would would buy it in the current economic circumstances?

    Citigroup has an outstanding asset – one of the largest retail banking businesses in the world. However it also has massive obligations and numerous other operations which are unprofitable.

    There’s a real possibility that in the absence of a bail-out , a Citibank receivership would rapidly turn into a liquidation in which the good assets would be lost along with the bad.

    It’s all well and good to say that the assets with real value would be purchased by new owners but that’s by no means certain in the current market.

  15. John, according to the DTCC stats last year a mind-boggling $1.8 quadrillion plus in securities transactions were settled. Currently fails to deliver are running at about 24,000 transactions daily, and that includes both new and aged fails, out of an average of 23 million new transactions processed daily by the NSCC.

  16. The plain facts of the matter are that the administering classes, private and public have conspired in their own self-interest, or simply path of least resistance, to defraud working families and battlers everywhere. The latter can easily see the giant fraud exposed now as their administering classes collude and print fiat money at obscene rates to continue their divine right to plunder, or simply carry on with business as usual. Real workers and wealth creators everywhere should rightly be mad as hell and refuse to be fooled by the Tweedledum and Tweedledee representatives of these administering classes trying to point fingers at each other, to distract from their own culpabiliity. Their Freddies, Fannies, GMACs and GE Genie moneys, not to mention their glaring deficits in public and private bottom lines are all one and the same now, just as they are. All caught like rabbits in the spotlight and the quicker we pull the trigger on them all the less hungry we’ll be in future.

    If our administering classes have colluded and failed us abominably, it’s time to put ourselves in the hands of decent administrators, be they Asian savers or whatever. We shouldn’t be conned by any xenophopic bleatings of the current bad lot as they get shunted out the door. The NAB bank raising $2bill, oversubscribed in an hour, shows us there’s no shortage of capital looking for a home. We just need to make sure it’s real capital rather than more funny money from the usual suspects protecting their domestic backsides and their own particular caravan of sycophants and media lapdogs. Ignore their common siege mantra and spin. It’s time for some swift, destructive creationism, to send the current lot of carpetbaggers packing.

  17. Michael, I’m aware of the orders of magnitude involved. It’s hard to know which is more striking: the fact that such a system can operate with 99.9 per cent of trades going through successfully, or the fact that the remaining 0.1 per cent that fail involve an amount large enough to bankrupt what’s left of the financial system.

  18. I just don’t understand how the US Treasury can afford this at all. They were stretched when they began, they can’t just keep borrowing more from overseas can they?

    Or are their options
    1) raise taxes, cut expenditure?
    2) print more money?

    Help me out – how is the US Gov’t going to keep on bailing?

  19. “…the remaining 0.1 per cent that fail involve an amount large enough to bankrupt what’s left of the financial system.”

    Failure to settle a short-selling contract doesn’t involve a loss on the part of either party to the contract of the face value of the stock involved.

  20. Time for a closer look at how Libor is set?

    Everyone agrees that monetary policy is very important and that the setting of the base rate is the main way to exercise that policy. Lots also agree that we need to loosen up monetary policy right now by cutting the base rate to prevent us slipping into an even deeper recession. And everyone seems to agree that cutting the base rate isn’t working because the banks can’t lend at anything close to the base rate and still generate a profit for themselves because Libor is so much higher than the base rate. In short, monetary policy no longer works at precisely the time we need it because Libor is too high.

    So we have this very carefully crafted, politically independent architecture involving some of the best economic minds and the best economic data to set the base rate which is rendered ineffective by a separate interest rate that is set by … well, who is Libor set by? To hear some commentators and bankers speak, you’d think Libor was a force of nature that simply found its level. In fact, it is set every working day by the British Bankers Association (BBA) based on a survey of a panel of banks. Full details of the process are published on the BBA site and it raises some interesting questions.

  21. Wilful, US national debt is currently around 80% of GDP. Back in the 70’s and 80’s many countries ran national debts well in excess of 100% of GDP – but they did so at the expense of higher taxes, higher interest rates and higher inflation.

    The answer to your question is probably 3. all of the above.

    The US will borrow in the short term and be forced both to raise taxes and cut expenditure. There will also be enormous pressure on the US government to encourage high inflation as a way of reducing the real value of the debt.

    The actual final cost of the bail-out 2-3 years out is likely to be far less than the current headline figures being quoted – some guarantees won’t be called on; assets used as security for loans and guarantees will be sold off even if at a loss and so on.

    The nearest historical parallel we have to the current situation in recent US history is the S&L crisis. The US government ended up making a profit on the bail-out by selling assets bought at distressed prices after markets recovered.

    The other parallel is with Japan which is currently running national debt of 186% of GDP (more than double than in the US if my memory is correct)after a decade-long attempt to reflate it’s economy after their own asset bubble burst.

    Whether the world has sufficient capital to refinance the US is an interesting question. Currently, one reason the US dollar is so strong and that non-US stock markets are falling is that US financial institutions are selling non-US assets and repatriating the proceeds.

  22. “Failure to settle a short-selling contract doesn’t involve a loss on the part of either party to the contract of the face value of the stock involved.”

    Yes it can. It’s called market risk.

    The buyer may be buying to close out their own short position. If the buy falls through, they would have to go to the market to fulfill their obligation. When yields are falling, it will cost them.

  23. “Failure to settle a short-selling contract doesn’t involve a loss on the part of either party to the contract of the face value of the stock involved.”

    Unfortunately, the shops I go to don’t accept face values of stock as payment.

    Failure to settle a short-selling contract is a breach of contract and the term breach of contract seems to me to be much clearer than the expression ‘lack of confidence’.

  24. “When yields are falling, it will cost them.”

    Yes but not anything close to the total value of the bonds.

    The Big Scary Numbers being tossed around need ot be discounted by about 90 or 95%.

  25. Ian, even a 95 per cent discount gets us down to $100 billion. Small beer in the context of the current crisis, but enough to sink a fair bit of the banking system depending on where it falls. In any case, what matters isn’t the exact number but the fact that yet another financial market, and one even more important than those that have already failed partially or completely, appears to be running into counterparty risk problems.

    More generally, your dismissive attitude to Big Scary Numbers strikes me as totally misconceived. It’s already clear that the world is entering a recession worse than any since the 70s and that the financial crisis is worse than any since the Depression. The “move along, nothing to see here” attitude of regulators from the beginning of the crisis to the full-scale meltdown of September contributed significantly to the growth of the problem.

  26. Good call Ian. People who throw around around Big Scary Numbers like face value of outstanding contracts without providing the appropriate context are either being ignorant or mendacious. Fails are a good example. Just because a trade fails does not mean that it will continue to fail. A lot of trades fail because the exchange rules are lax and failing gives one party a cheap loan, others fail because of payment gridlock.

    Michael, nobody likes a sycophant 🙂

  27. Spot-on Joseph. All this talk of trouble in financial markets is, as you say, ignorant or mendacious. As you’ve been pointing out since this nonsense began, everything is going swimmingly, and there is no crisis.

    “Just because a trade fails does not mean that it will continue to fail” is perhaps your strongest point yet. Absolutely nothing to worry about, and those ignorami at Euromoney just want to sell magazines.

  28. If the firt domino only falls one way lets hope it hasn’t fallen at either of the ends.

    This is meant to be analogy for our “globalised” state controlled homogenous economy.

  29. ““Just because a trade fails does not mean that it will continue to fail” ”

    I’m just a neuroscientist but I know that when my clinical colleagues are about to remove a portion of someone’s brain they always follow the principle “Just because treatment fails doesn’t mean it will continue to fail”

    I take enormous heart in seeing that blind faith also occupies a central place in economics. 🙂

  30. “As you’ve been pointing out since this nonsense began, everything is going swimmingly, and there is no crisis.”

    I used to think that back when I was ignorant. Now I understand that the corrupt capitalist system is actually collapsing under the weight of its own evil and greed. What we really need now is a strong leader to guide us through the turmoil.

  31. “What we really need now is a strong leader to guide us through the turmoil.”

    perhaps someone with a moustache?

  32. The beauty of the domino is that each and everyone of them have the same identical rectangular shape. Its only the spots that vary.

    So the ship is the same its only the passengers that are different. Diversity whithin but intrinsically homogenous.

    I cannot understand why a diverse strategy hasn’t been used when considering how to deal with this GLOBAL financial crisis. After all it is a “unified global response” the world government keeps emphasising. It looks to me like we are all heading over the same cliff. We have no contingency plan? or do we ? The current unified strategy may fail, what then ? Wouldn’t it better to try various independent strategies in different parts of the economy or regions of the world, to minimise the risk of total failure.

    The approach is authoratarian in nature and has no respect or does not take into account the response of the behaviour of our natural systems. Man continues to live under the delusion that he can control all before him.

  33. John, there’s a middle-ground between being overly dismissive and needlessly spreading panic.

    I’ve been suggesting that the US is heading into a fairly serious recession for the past several months.

    I don’t think we should underestimate the scale of the problem, nor do I think we should overestimate it.

  34. From Joseph clark’s link:

    “Settlement fails are reported on a cumulative basis for each
    week, including nontrading days. For example, if a dealer fails
    to deliver $50 million of securities to a customer as scheduled
    on a Thursday, but makes delivery on Friday, one day late,
    then the dealer reports $50 million in fails. However, if the
    delivery is not made until Monday, four days late, then the
    dealer reports $200 million in fails ($50 million 4 days).
    Fails thus continue to be counted until settlement occurs.”

    So a $1.3 trillion reported figure for outstanding fails could represent as little as $260 billion in outstanding fails assuming they’re outstanding for the whole five days.

    “Moreover, we document significant variation in fails, with
    dealer delivery fails averaging just $3.8 billion per day
    between mid-1990 and September 5, 2001, but as much as
    $190 billion per day after the September 11 attacks and up
    to $232 billion per day in the summer of 2003.”

    Based on reading the Euromoney article and the FEd paper linked ot by Joseph it seems the current level of fails is not particularly unusual and probably no cause for alarm.

  35. Joseph, The relevant part of the article you referenced ist:

    “One ancillary cost of failing is an increase in counterparty
    credit risk. If a buyer becomes insolvent before the
    settlement of a trade, the seller will incur a loss if the price of
    the security has fallen and the seller has to find a replacement
    buyer at a lower price. Conversely, if a seller becomes
    insolvent before settlement, the buyer will incur a loss if the
    price of the security has risen and the buyer has to find a
    replacement seller at a higher price.
    In recognition of the counterparty credit risk associated
    with fails, the Securities and Exchange Commission (SEC)
    imposes capital charges on aged fails.10 Dealers have to
    maintain additional capital for fails to deliver more than five
    business days old and for fails to receive more than thirty
    calendar days old. The charges absorb capital that would
    otherwise be available to support profitable risk-taking
    activities and thus impose opportunity costs on dealers.
    Increased labor costs and worsened customer relations
    can also result from fails. Labor costs can rise as dealers
    divert back-office personnel from their usual assignments to
    efforts aimed at reducing fails. Customers can become
    unhappy when they do not receive the securities they have
    purchased, even after long delays. This leaves customers in
    the position of involuntarily financing dealer short positions
    and means that they themselves have nothing to deliver
    should they decide to sell.
    More broadly, market liquidity can be adversely affected”

  36. Whilst we go on propping up asset prices with taxpayer IOUs, not to mention trying to impose negative real interest rates on the players, is it any wonder broad market liquidity is affected? Anecdotal evidence suggests all the liquid needs is certainty about the size and soundness of the vessel and it will pour in. Hot on the heels of the NAB, QBE raise $2bill in oversubscribed equity from institutional investors to pursue further acquisitions. Tower Group(life insurance) report a 14% increase in nett profit after just absorbing Insuranceline for $136 mill and is considering growing via takeovers now that Japan’s third biggest life insurer, Dai-ichi Mutual Life Insurance, bought a one-third stake in Tower in October. As the Tower spokesman says- “Having a strong partner like Dai-ichi means it’s easier to raise capital (and) it’s good to have a player that deeply understands insurance and wants to actively support the business.” Meanwhile discretion gets the better part of valour for BHP Billiton but Chinalcorp reckon they’ll be interested in a bigger slice of Rio now. You just yell, ‘No more moral hazard and crony capitalism and it’s firesale time folks!’ and those real savings will come flying out of the mattresses and bikky tins from every corner of the globe. Too big to fail my ass. It’s just a question of letting those market price juices flow.

    Returning to the bigger picture I was struck by the poignancy of some wise words concerning an analysis of the Freddies and Fannies that started us all down the road to this mess, namely- Some institutions want to do well and some want to do good. When I hear of an institution that wants to do well and good I reach for my wallet and so should you. Somewhat elementary in hindsight, as all that karma of wellness and goodness engulfs us now. Which leads us to conclude that just like the Freddies and Fannies our central banks were given an impossible mission statement of wellness and goodness and what an inevitable disaster that’s been. A tough lesson for social democracies to learn by the looks of things, but at least we should ensure the separation of powers of wellness and goodness in future. They are of course somewhat interdependent but must always be at arms length from one another to ensure the efficacy of each. Quite a history lesson but it does give us some useful insights going forward. Something like that lesson about haste and speed you might say.

  37. re#2 – Think I have been misled, from another sceptical blog source it seems all those TARP funds have not been restoring liquidity or dealing with toxic assets but are being used by the banks to fund M&A’s of other banks. The toxic debt sludge remains and is merely being shuffled into a bigger barrel,attempting to dilute the rising bad debts and failures which are now coming in from the corporate sector, in the hope that somehow, when you too big to fail, well the taxpayer will still pay the bill or miraculously you can whip up through a M&A another source of liquidity via the others depositor base. This is more than scary, this is insanity. Why would anybody believe that the very people who created the problems, did not understand the problems now miraculously know how to fix them, it is just more of the same stupidity. As another blogger succinctly put it, Bush and Paulson have handed Obama the biggest shit sandwich ever and now with fries on the side.

  38. I tend to agree with MH.

    The potential for recovery from financial crisis as in the S&L episode, the 1987 and 1973-74 crashes is based on future economic – itself based on population growth. GDP can grow easiest if population grows.

    The reliance on fossil fuels and demand for water and food, suggest this old standby may not be as available as in the past.

    While our financial/political leaderships are playing to the media at the moment, behind the scenes they fully expect that there will be a rebound, and the cycle will roll on. Governments expressing concern about the financial crisis are still happy to plan vast useless defence purchases and grand billion dollar plans for space explorations.

    However the existance of climate change may yet restrict access to the old standby. Climate change appears to require a sustainable economy.

  39. John, if I may ask Joseph Clark whether phantom traders are a fiction of peoples imagination and do not cause market distortions?

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