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. “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%.

  2. 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.

  3. 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 🙂

  4. 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.

  5. 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.

  6. ““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. 🙂

  7. “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.

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

    perhaps someone with a moustache?

  9. 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.

  10. 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.

  11. 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.

  12. 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”

  13. 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.

  14. 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.

  15. 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.

  16. 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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