The Big Picture

How Do Liquidity Conditions Affect U.S. Bank Lending?
Succinct Summation of Week’s Events 10.17.14
End of OPEC = Golden Swan
I Dare You to Try to Refinance. Go Ahead, Just Try.
10 Friday Reads
1991 Porsche 911, Reimagined by Singer

How Do Liquidity Conditions Affect U.S. Bank Lending?

Posted: 18 Oct 2014 02:00 AM PDT

How Do Liquidity Conditions Affect U.S. Bank Lending?
Ricardo Correa, Linda Goldberg, and Tara Rice
Liberty Street Economics, October 15, 2014

The recent financial crisis underscored the importance of understanding how liquidity conditions for banks (or other financial institutions) influence the banks' lending to domestic and foreign customers. Our recent research examines the domestic and international lending responses to liquidity risks across different types of large U.S. banks before, during, and after the global financial crisis. The analysis compares large global U.S. banks—that is, those that have offices in foreign countries and are able to move liquidity from affiliates across borders—with large domestic U.S. banks, which have to rely on financing raised in capital markets and from depositors to extend credit and issue loans. One key result of our study, detailed below, is that the internal liquidity management by global banks has, on average, mitigated the effects of aggregate liquidity shocks on domestic lending by these banks.

Possible Bank Responses to Liquidity Risks
Large U.S.-based banks can react to aggregate liquidity shocks by adjusting their domestic lending, their cross-border lending (for example, interbank loans or claims on other counterparties), or their internal lending and borrowing (with affiliates), or potentially make other balance sheet adjustments. The reaction to aggregate liquidity conditions could depend, importantly, on the composition and strength of each bank's balance sheet. For example, if a bank has stable deposit funding or maintains more liquid assets on its balance sheet, its lending might be less affected by aggregate liquidity shocks.

There also might be different responses to liquidity risk by U.S. banks that are domestically oriented compared with banks that are more global. Because these two types of banks have very different business models, the channels and magnitude of transmission of liquidity risks into bank lending may differ significantly. Small domestic banks have relatively strong lending responses to liquidity risks (Kashyap and Stein [2000]; Cornett, McNutt, Strahan, and Tehranian [2011]). By contrast, banks with foreign affiliates, particularly large banks, actively move funds across their organizations to offset such risks, and potentially insulate lending in their home markets (Cetorelli and Goldberg 2012). However, these same banks may decrease lending abroad as they move liquidity into their home country. For both types of banks, changes in aggregate private liquidity are likely to influence lending differently in crisis than in normal periods, in part because of the availability of and willingness to use official sector liquidity facilities in periods of aggregate liquidity stress. When banks have access to central bank liquidity facilities priced at terms below private market rates, this might relax the constraints imposed by the composition of banks' balance sheets on their access to external funding, leading to a different relationship between those balance sheet characteristics and the banks' lending (Buch and Goldberg 2014).

The Framework for Studying How Liquidity Risks Affect Bank Lending
Two methodological building blocks underlie the empirical strategy followed in our study. The first is Cornett, McNutt, Strahan, and Tehranian (2011), who examine the role of bank balance sheet composition in explaining how U.S. banks' lending reacts to changes in aggregate liquidity conditions. They posit that banks are more sensitive to aggregate liquidity conditions depending on the market liquidity of their assets, the use of stable core deposits, their capital ratios, and their funding liquidity exposure stemming from loan commitments (or new loan originations via drawdowns).

The second building block is Buch and Goldberg (2014), who integrate into this framework considerations specific to global banks, and also show the potential consequences of bank access to official sector liquidity facilities. For the global banks, strategies for liquidity management can play an important role and these strategies are reflected by the use of internal funding transactions between the head office and its domestic and foreign affiliates. The balance sheet characteristic that reflects this feature of global banks is their reported use of "net due to" or "net due from" their affiliated institutions, which refers to their borrowing from or lending to other parts of the bank holding company.

We focus on a sample of U.S. banks, using data from 2006 through 2012. We concentrate only on larger U.S. banks (with more than $10 billion in assets) and we distinguish between banks with claims booked through foreign affiliates (global banks) and those without such claims (domestic banks). These two groups of banks can lend to both domestic and foreign borrowers. In the case of global banks, lending to foreign residents can be arranged either through cross-border transactions or through their foreign affiliates (which take the form of a subsidiary or branch).

Our measures of aggregate liquidity strains in financial markets are the rates that banks use when lending to one another, known as interbank spreads (such as the London interbank offered rate over the overnight indexed swap, known as the Libor-OIS spread). As shown in the chart below, these rates spiked during the financial crisis as U.S. and European banks became less willing to lend to one another and liquidity dried up, especially at maturities beyond a few days.

Our tests take into account banks' use of official sources of liquidity. In 2008, the Federal Reserve announced a number of extraordinary official liquidity facilities to relieve the strains in U.S. financial markets during the crisis. Because the cost of funds at official facilities was at times lower than private market rates, we allow for a different response of individual banks to aggregate prices of liquidity during periods when the bank taps official sector facilities. Thus, our analysis incorporates information by bank on when institutions accessed the Term Auction Facility (TAF) and discount window, and incorporates the balance sheet characteristics of these same financial institutions as well as their global nature to understand differences in the transmission of liquidity risk to loan and credit growth.

What Matters for the Effects of Liquidity Risk
We find that elevated levels of liquidity risk, as measured by interbank spreads, have significant, but different, effects on lending growth across different types of large U.S. banks. The balance sheet characteristics that matter for these different responses depend on whether the banks are global. For large, non-global banks, the key balance sheet characteristic that explains the impact of a funding shock on loan growth is the share of core deposits in bank funding. The economic impact of having more core deposit funding during a crisis is large: a bank with core deposits representing roughly 76 percent of its total liabilities (in the 75th percentile of the in-sample distribution for this ratio) would lend $211 million more in domestic commercial and industrial (C&I) loans in a given quarter (about 9 percent of domestic C&I loans of the median bank) than a bank with a core deposit share of liabilities of 58 percent (in the 25th percentile of the distribution), after a 100-basis-point increase in the Libor-OIS spread.

By contrast, we find that for global banks, the impact of liquidity shocks depends more on their liquidity management strategies, as reflected in outstanding internal borrowing or lending between the head office and the rest of the organization. Net internal borrowing (liabilities from the head office to its affiliates minus claims by the head office on those affiliates) increases in periods with heightened liquidity risk for the U.S. banks that have higher outstanding unused commitments and lower Tier 1 capital ratios. This higher net internal borrowing is associated with relatively more growth in domestic lending, foreign lending, credit, and cross-border lending. The economic magnitude of the effect of net internal borrowing on domestic C&I loans is also large: a bank that finances 6.6 percent of the head office liabilities (in the 75th percentile) with internal net borrowings would lend $800 million (or 5 percent of domestic C&I lending of the median bank) more in a given quarter than a bank that only finances 1.2 percent of its liabilities (in the 25th percentile) with these funds, after a 100-basis-point increase in the Libor-OIS spread.

We find that cross-border lending and internal borrowing and lending tend to be more volatile than domestic lending and lending conducted through U.S. bank affiliate offices abroad. The model we estimate explains some of the observed changes in domestic loan growth, as well as changes in internal capital market positions, but doesn't capture as much of the volatility in cross-border lending growth of U.S. banks. At the same time, cross-border lending appears to be sensitive to more bank balance sheet characteristics than any of the other forms of lending. Regardless of the form of lending, the role of bank balance sheets is diminished when liquidity risks increase substantially and the banks access official sector liquidity. Thus, official sector liquidity moderates the effects of private sector liquidity risk on both domestic lending and cross-border flows.

Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Ricardo Correa is a section chief in the Board of Governors of the Federal Reserve System's International Finance Division.

Linda Goldberg is a vice president in the Federal Reserve Bank of New York's Research and Statistics Group.

Tara Rice is a section chief in the Board of Governors' International Finance Division.

Succinct Summation of Week’s Events 10.17.14

Posted: 17 Oct 2014 01:00 PM PDT

Succinct Summations of Week ending October 17^th

Positives:

1. Initial jobless claims came in at 264k, their lowest numbers since 2000.
2. Gasoline prices fell to their lowest levels since 2011.
3. Russell 2000 actually finished up 2.8% on the week.
4. U of M consumer confidence came in at 86.4, the best since 2007.
5. Housing starts rose to 1.017mm, slightly better than expected thanks to strong multi-family starts.
6. Philly Fed index came in at 20.7, the fourth straight month above 4 for the first time since 2004.
7. Refinance applications rose 10.6%, the highest since June.

Negatives:

1. S&P 500 sliced right through the 200-day moving average and took out its August lows.
2. The 10-year yield briefly dipped below 2% as investors panicked into safety — the largest one-day decline since 2011.
3. Retail sales came in weak, core was down 0.1% m/o/m vs expectations for a 0.4% rise.
4. S&P 500 fell as much as 9.8% from its all-time highs set 4 weeks ago
5. The VIX rose to its highest levels since 2011.
6. A really lousy few weeks for European equities. Greek stocks fell 5.7% on Wednesday, the worst day since June 2013.
7. China CPI rose by 1.6% y/o/y, the slowest increase since 2010.
8. NAHB home builder index fell to 54.
9. NFIB small business optimism index fell to 95.3, a 3-month low.

Thanks, Batman!

End of OPEC = Golden Swan

Posted: 17 Oct 2014 10:30 AM PDT

Could the Dissolution of OPEC Become a Golden Swan?
Fifty-four years of inflated energy prices may be coming to an end.
Doug Kass
Real Money Pro, October 8, 2014 | 7:31 AM EDT

We all know that I’m bearish.

To me (at the current time), this is a stock market with no memory, no momentum and no motivation. It is a foundering market that appears to be waiting for trouble to arrive on a Black Swan landing strip.

But, as always, it’s important to recognize that I don’t have a concession on the truth. I can be — and have been — (very) wrong in the past!

This morning and in the day’s ahead I will discuss some potential Golden Swans that could be viewed as an important and incremental positive for the markets and for the global economies.

The first Golden Swan that I will discuss this morning is the possible dissolution of OPEC.

OPEC (Organization of the Petroleum Exporting Countries) is an intergovernmental organization that was created at the Baghdad Conference in September 1960 by Iraq, Kuwait, Iran, Saudi Arabia and Venezuela. Later Libya, United Arab Emirates, Qatar, Indonesia, Algeria, Nigeria, Ecuador, Angola and Gabon joined.

OPEC’s mission was to coordinate the policies of the oil producing countries. Its goal is to secure a steady stream of oil income to the member states and to collude in influencing the world oil prices through economic means. Because OPEC is an organization of countries (not oil companies), individual members have sovereign immunity for their actions, meaning that OPEC is not regarded as being subject to competition law in the normal way.

While OPEC was established in 1960 it did not become an impactful force in the market until 1973 when its policies caused a four-fold increase in the price of oil (from about $2.63 a barrel to $11 a barrel, helping to cause a serious global recession and a devastating bear market in stocks.

OPEC operated as a classic cartel, utilizing artificial means to raise the price of its product. While economic theory teaches that cartels are transitory, OPEC has had staying power. Virtually every investment professional managing money today has done so under the influence of OPEC on the oil market.

Indeed, it is hard, if not impossible, to imagine a world without OPEC. But just as we are constantly trying to find Black Swans before they appear, if OPEC ceases to function or its influence wanes, it could be a possible “Golden Swan” that no one sees coming. The ramifications of this would be profoundly positive for global economies and markets.

Powerful forces are now forming to suggest OPEC’s days are numbered and that, at the very least, its impact will wane.

The Growing Influence of the U.S. on Energy Production — The U.S., through hydraulic fracking, has become a major oil producer and our imports have fallen, helped by secular efficiency in consuming energy.
Subpar Global Economic Growth — A global slowdown (influenced by structural headwinds) has served to reduce oil demand, particularly in Europe and China. Oil is priced in U.S. dollars and the dollar rise has made oil more expensive and has moderated consumption.
Leading Suppliers Are Raising Production — A few major producers are motivated to increase production and steal share rather than cut production (the usual OPEC strategy in times of slack demand). Saudi Arabia did so last week. Stability of its budget requires maintaining oil revenue (at about $90 a barrel on previous production) rather than cutting it. If prices fall below $90 a barrel, the Saudis indicated last week they will cut price to maintain revenue, worsening any supply glut.
Russia’s Economic Woes — Russia (not a member of OPEC) has deepening financial troubles. Oil is its principal export. Its currency is falling and its oil is priced in U.S. dollars. Logic suggests Russia will desperately raise production.
Others Have Issues — Three producers with excess capacity have issues. Iran and Iraq are Shiite entities. If the Saudis surrender share to them, it will help their cause. This seems unlikely. The Arab Spring has left Libya in shambles and it is producing to rebuild.
Venezuela Is a Wild Card — Venezuela could usually be counted on to withhold production. Due to its inflation and recession that is unlikely to happen.
It looks increasingly possible that OPEC has wandered into a perfect storm.

For one reason or another (some discussed above), members are unlikely to cooperate in withholding production to maintain price. Over the next 1-2 years the price of oil may move below the marginal cost of production. This could translate into sharply lower energy prices and consequently higher consumer real incomes (and spending) than anyone is forecasting. IF this happens, the overall market should be ignited to the upside, with particular strength in the consumer and transportation sectors and with weakness seen in energy production and exploration issues. The relatively positive action of the retailers over the last week or two might be an early signpost that the role of OPEC is diminishing and that the price of energy products might continue to decline.

The bottom line is that a lengthy period (54 years) of the pain of inflated energy prices may now be coming to an end in what might be called a Golden Swan of Lower Oil Prices.

To say the least, the OPEC meeting late this month should be interesting.

Position: None

Douglas A. Kass
Seabreeze Partners Management Inc.

411 Seabreeze Avenue
Palm Beach, Florida 33480
Telephone: (561) 805-7457
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I Dare You to Try to Refinance. Go Ahead, Just Try.

Posted: 17 Oct 2014 07:00 AM PDT

The bond market seems to have had its own flash crash this week. The yield on the 10-year U.S. Treasury bond dipped briefly below 2 percent, as panicked equity sellers looked for a safe place to park their cash. Treasuries, of course, are the world's option of choice, the safest and most liquid port during the storm.

Demand for bonds has helped drive down mortgage rates as well. Bloomberg News reported that "U.S. mortgage rates plunged, sending borrowing costs for 30-year loans below 4 percent for the first time in 16 months, as signs of a slowing global economy drove investors to the safety of government bonds." Almost immediately, lower rates worked their way through the entire credit complex.

The average rate on 30-year fixed home loan is now 3.97 percent. To put this into context, the median U.S. home price is $219,800. Put down 10 percent and that $200,000 mortgage costs the homebuyer $951 a month. A decade ago the same mortgage would have cost this buyer as much as 6.34 percent. The monthly payment would have been more than 25 percent higher at $1,243.

The chart below shows the long decline in rates:

Under normal circumstances, this decrease in rates should have far reaching and beneficial effects on the economy. It would spur increased investment in real estate. Mortgage refinancings also would rise, and that would put a little more discretionary cash in the hands of consumers each month.

Continues here

10 Friday Reads

Posted: 17 Oct 2014 05:00 AM PDT

I have been traveling the past few days — did I miss anything? Once again, morning train reads:

• Bargain Hunters Pounce on Panic (WSJ) see also Citigroup Sees $1.1 Trillion Stimulus From Oil Plunge (Bloomberg)
• People think CEO pay is out of control. The truth is much worse than they know. (Vox)
• Bill Gross' Former Fund: Too Big to Succeed? (Barron’s) see also Fears That Pimco and Other Big Firms Could Be Unable to Unload Risky Bonds (Dealbook)
• Quant Blogs Check Out List (Alpha Architect)
• Bill Gates: Why Inequality Matters (Gates Notes)

Continues here

1991 Porsche 911, Reimagined by Singer

Posted: 17 Oct 2014 03:00 AM PDT

Jay Leno’s Garage:

1991 Porsche 911, Reimagined by Singer. Feast your eyes on Singer Vehicle Design’s meticulously restored and optimized air-cooled Porsche icon.

Source: WSJ

From WSJ:

The legendary Porsche 911, introduced by the Stuttgart-based carmaker in 1963, is in many ways the archetypal sports car: long snout, slanted rear, two front seats with tiny spaces behind each, wickedly fun to drive and instantly recognizable, even if, according to Dickinson, the later models with their liquid-cooled engines have lost some essential, visceral Porscheness. Air-cooled Porsches, which include the original 911 (made from 1963 to 1989), the 964 Series (’89 to ’93) and the 993 Series (’94 to ’98), are considered by Dickinson (and many other purists) to be “real” Porsches. “Don’t get me wrong; the new Porsches are great cars, wonderful, but they’re touring cars,” he says, and then he hurls what he intends as the ultimate insult: “They might as well be Jaguars.”