Thursday 2012-11-01

The Money Market by Marcia Stigum

Excellent introduction to the various money market securities and their trading in the United States.

First and most obvious, it (the money market) is not one market but a collection of markets for several distinct and different instruments. What makes it possible to talk about the money market is the close interrelationships that link all these markets. ...
The most appealing characteristic of the money market is innovation. Compared with our other financial markets, the money market is lightly regulated. If someone wants to launch a new instrument or try brokering or dealing in a new way in existing instruments, he does it. And when the idea is good, which it often is, a new facet of the market is born.
-- Introduction
"All of this," noted on US banker, "has created a menu for corporations that is much more efficient than just borrowing your currency from your bank. Thanks in part to the elimination of withholding taxes, US and other corporations now have access to yen, Swissy, and other national capital markets; they can, for example, issue yen commercial paper hedged. The development of the swap market [interest rate and currency] was teh piece that made the opening of tehse national barriers interesting -- that made borrowing French francs interesting when you wanted dollars in the end. All this, together with currency hedging mechanisms, has created a global market."
-- The Banks: Domestic Operations
Business 1 (of a bank) might be called the portfolio or Treasury business. This is the business of asset (or position) accumulation and funding. ...
Business 2 is corporate finance -- the investment banking business that is emerging out of old-style lending. ...
Business 3 is trading. Banks have always been in trading as part of us-first banking, but now they need to be in trading more for market making and liquidity than in the past. For example, a part of the strategy of money center banks today is to aggressively make loans with the notion that they will sell off, to investors at a slight markup, participations in those loans. ...
Business 4 is distribution. Banks have long had sales forces to sell their own paper and the exempt securities -- governments, agencies, general obligation munis, BAs, Euro CDs, and other money market paper -- that banks are permitted to trade.
-- The Banks: Domestic Operations
The tenacity with which banks have fought to gain a toehold in the commercial paper market is easily understood. "Things were getting to the point," observed one banker, "where a corporate treasurer needed a bank only for things such as a line of credit, money transfers, custodial services, and letters of credit, but not for financing. The focus of the banks in fighting for the right to do commercial paper was to get bank commercial customers who had been walking out on the banks.
-- The Banks: Domestic Operations
The attitude that prevailed among bankers toward the capital adequacy question is well illustrated by the words of one bank president: "Back in the credit crunch of 1974, because of inflation and an insatiable demand for credit, we got to the point where equity was about 4% of assets, so we had leverage of 25 to 1. At the peak, we and a lot of bankers asded how far can this go, and we dedided we had better slow down and tighten up. So we set a leverage maxiumum of 25 to 1." In the next breath, the same banker added: "We of course have to forget all about that standard when we deal with foreign banks. The leading Israeli banks have about 1% capital ratios, and in Japan the figure is 1 or 2%." In effect, this banker and other US bankers measure capital adequacy in domestic and foreign banks by differing standards, a practice that suggests they have no absolute notion of what capital ratios should be.
-- The Banks: Domestic Operations
Lest anyone think that layers of regulation preclude bank failures, we cite several numbers: in the US in 1989, there were 200 bank failures and 21 federally assisted sales of failed banks.
-- The Banks: Domestic Operations
"Governments, when they borrow, are likely to be open about making a currency decision if we show them that by doing so they can lower their all-in cost of borrowing. As sovereign, like the Kingdom of Sweden, is used to borrowing in a lot of different currencies, because they couldn't just borrow krona even if they wanted to [the market would not absorb that much krona debt]. Corporates, in contrast, are more difficult. They do not like to make currency decisions. They have certain exposures in certain currencies, and they tend to borrow what they need to cover those cash flows."
-- The Banks: Euro Operations
With high-cost money rolling in, S&L's (Savings and Loans) ventured into ever-riskier, higher-yielding investments. It wasn't uncommon for a once-sleepy S&L with a balance sheet whose footings were 5 or 10MM to explode suddenly into a billion-dollar-plus institution thtat was financing a collection of speculative investments: huge GNMA portfolios repoed to the hilt (a bet on future interest rates), franchises, no-money-down real estate loans, junk bonds, and so on.
A number of entrepreneurial souls, not all Simon pure, saw the S&L game for precisely what it was: a chance to gamble with other people's money on attractive terms -- heads I win, tails FSLIC loses. With odds like that, it made no sense to bet 100MM if one could bet a billion. Also, if traditional managers lacked sufficient imagination to see the possibilities, developers and other high-flyers who invaded the industry did, especially those who bought and bloated the balance sheets of little S&Ls in Florida, Texas, and California, where real estate speculation was rampant.
-- The Treasury and Federal Agencies
The Treasury wants to cut back on agency borrowing to pare the government deficit and the amount of government debt offered in the market. Treasury officials also argue that off-budget expenditures and guarantees distort the federal budget, an important function of which is to act as an allocation index for resources used by government.
Congress sees things differently. For congressmen, making sharp distinctions among direct government expenditures, agency loans, and agency guarantees is hard; they think of guarantees in particular as the government just giving a little aid. The unsurprising outcome is that guarantee programs have gown by leaps and bounds.
-- The Treasury and Federal Agencies
The more plausible explanation for the Fed's shift in policy ( to monetarism in 1979) is political. The wide acceptance that monetarism was gaining -- among the public, the press, and politicians -- put the Fed under pressure to give it a try. Congress, in particular, was taking on an increasingly monetarist cast; and each year, it appeared to be coming a little closer to circumscribing the Fed's autonomy. By taking the initiative in October 1979, the Fed was able to implement monetarism on its own terms. ...
On this interpretation, the volatility of interest rates from 1979 to 1982 was an essential part of the Fed's strategy. Had the new operating procedures produced high but stable interest rates, the Fed would have been hard put to argue that it had no control over interest rates. However, by allowing rates to lurch about month to month, the Fed created a convincing picture of an economic variable beyond its control; this picture, perhaps disingenuous, served its purpose. It allowed the Fed to keep rates high enough to cool the engine of inflation, which had been building up steam for years.
-- The Most Watched Player: The Fed
( if it works, great! if not, then the uncertainty helps kill inflation, great! )
"Most portfolio managers would describe themselves as 'conservative', by which they mean that teh correct way to anage a portfolio is to look to your accounting risk and reduce that to zero. Teh opportunities thereby foregone are either ignored or more frequently not even perceived." Many short-term portfolios are poorly managed, most are not managed at all.
The Investors: Running a Short-Term Portfolio
Many banks, S&Ls, and other institutions that would never use repo to meet a temporary cash need or to lever will reverse out securities they they intend to hold indefinitely, probably to maturity, to pick up, say, 50 bp on a short-term arbitrage. ...
In one riskless-to-both-sides trade that a dealer made with a sleepy S&L, there was an $8,000 profit to be divvied up. The dealer set the reverse rate so that $5,000 went to him, $3,000 to the S&L doing the arb. Had the S&L treasurer known how to calculate the dealer's break-even reverse rate, he would have been in a position to bargain for a a more equitable arrangement. Probably, he could have captured another $3,000 of the profit to be made on the trade, leaving the dealter with $1,000 -- not bad pay to dealer for selling a security at the bid side of the market and writing a few tickets.
-- The Investors: Running a Short-Term Portfolio
"I repo the portfolio as an arbitrage technique everyday and probably run the biggest matched sale book in American industry. We repo anything we can, even corporates. In doing repo, I am either financing something I have or buying something I don't have any money for. We take the repos off for quarter ends because they might compromise the aesthetics of our statement." Avoiding repos across the quarter ends is common among those corporations that use repos, so it is impossible from looking at corporate financial statements to determine who does it.
-- The Investors: Running a Short-Term Portfolio
This (monetarist contemporaneous reserve accounting) was a naive notion based on some Econ 101 text's outmoded description of banking: a bank gets a deposit, and says, "Gee, I automatically make a loan."
In real life, banks did not and do not operate that way. When loan demand was strong, money center banks adjusted their loans not to what deposits they received, but rather to the level of loans that their valued creditworthy customers demanded of them; these banks then funded their loans, to the extent necessary, by buying money in the money market.
-- The Fed Funds Market
Amusingly, the big New York banks, which had all supplied thier computer systems with emergency generators years ago, woke up one day to ask, "What the hell would our computer centers, humming away in the midst of a blackout, be working on with the rest of the bank shut down in darkness?" So they supplied auxiliary power to all the major departments that provide inputs to their computer system: check collections, money transfer, and the trading room.
-- The Fed Funds Market
(best read while a major storm shreds NYC)
In particular, after the stock market crash in October 1987, there was tremedous volatility in the money markets and a marked widening of quality spreads; nonetheless, all sectors of the commercial paper market continued to display tremendous liquidity. ...
For all practical purposes, the US money market is, today, commercial paper, T bills, and term repo; these three instruments dwarf all else in outstandings.
-- Commercial Paper: Domestic and Euro