Why does Bad News Increase Volatility and Decrease Leverage?

On November 16, Ana Fostel came to Rutgers University to present her latest paper entitled “Why does Bad News Increase Volatility and Decrease Leverage?” (co-written with John Geanakoplos).

Building on literature that in order to explain pro-cyclical leverage assumes that bad news increase volatility, the authors try to explain why we should use this assumption.

With this purpose in mind, they built a general equilibrium model with endogenous leverage and agents with heterogeneous beliefs.

They found that in their model, in equilibrium, the agents mostly invest in projects that become volatile with bad news.

The authors get to this conclusion by generalizing the three period economy that they built. However, it is belief that they should also had ran a Markov chain Monte Carlo, in order to provide some evidence for their theoretical results. This could be done as long as we are willing to impose a distribution on the utility and endowment of the agents. With this we could check if the results of the model resemble the data that is presented in the paper.

Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility

The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility was a lending program created by the Federal Reserve Board in September 19, 2008 to provide liquidity to money market mutual funds.

Since at the time, many money markets were very illiquid, the Fed created this funding facility to provide non-recourse loans at the primary credit rate to US depository institutions and bank holding companies in order to allow them to buy high-quality asset-backed commercial paper from money market mutual funds.

This program aimed to help the money funds to meet demands for redemptions and hence prevent default.

“All U.S. depository institutions, bank holding companies (parent companies or U.S. broker-dealer affiliates), and U.S. branches and agencies of foreign banks are eligible to borrow under this facility pursuant to the discretion of the Reserve Bank” were eligible to borrow.

This lending facility borrowing peak in October 8, 2008 at $145.890 billion. (Additional source: http://www.research.stlouisfed.org/fred2/series/WABCMMF)

The program, that had started operating in September 22, 2010, was ended in February 1, 2010, since the Fed did not to extended it anymore.

This lending program seems to have been important to provide liquidity to the MMMFs and hence reduced stress on the financial markets.

CoVaR

Today I will be presenting on the paper CoVaR written by Tobias Adrian and Markus Brunnermeier.

Everybody who is interested can download the slides here.

Seminar presented by Tobias Adrian

This week, I had the pleasure to attend a seminar at Rutgers University in which Tobias Adrian (Federal Reserve Bank of New York) presented his work on “Funding Liquidity and the Cross-Section of Stock Returns” (written with Erkko Etula).

In this paper, the authors created a a funding liquidity model, because they believe that funding liquidity risk is important to explain  returns in equity cross-sections. This model is a three-factor model, with the variables capital ratio of broker-dealers (inverse of the financial leverage), scaled capital ratio (ratio of broker-dealer equity to non-broker-dealer equity, multiplied by the broker-dealer capital ratio) and wealth ratio (ratio of broker-dealer equity to non-broker-dealer equity).

Adrian and Etula tested their model using the data available on Kenneth French’s data library. In the 30 industry portfolio, the model showed a very good explanatory power, since it has a adjusted R-squared of 49%. Not surprising, it performed far better than the Fama-French three factor model (it is not hard to beat a model that only explains 9% of the cross-sectional variation). The surprising part of the results is that their funding liquidity model is only slightly worst than the Fama-French three factor model in the cross-sections of 25 size and book-to-market portfolios, 25 size and momentum portfolios and 25 size and long-term reversal portfolios that have been tailored to fit the Fama-French model.

It might be a whole new beginning for asset pricing theory!

Seminar presented by Markus Brunnermeier

Last Monday (9/13), the Department of Economics at Rutgers University held a highly participated seminar in which Markus K. Brunnermeier presented his latest work on “A Macroeconomic Model with Financial Sector” (written together with Yuliy Sannikov). Even though, the time available was too little to get into the necessary detail, some important and interesting ideas were introduced.

With the liquidity and credit crunch of 2007-09 in mind, they created a macroeconomic model to replicate some of the potential consequences that frictions in the financial sector can have in the economy. To do this, they used recursive methods, instead of log-linear approximations, because they believe that crises with high volatility (as the current one) are non-linear and hence, the log-linear approximations fail to show those effects.

To introduce such frictions, they introduced heterogeneous agents and leverage in the model. There are two types of agents: experts (who have a superior ability to manage assets) and households (that are less productive asset managers). In their model, the former borrows from the latter.

Furthermore, they allow the agents to lever their investment, which leads to an amplification of the shocks and therefore, to a more instable system. This happens because the agents lever too much and have a too risky portfolio, which in turn leads to excessive borrowing, leverage, volatility and maturity mismatch. This way, the experts generate an externality on the real sector of the economy (mostly on the labor market) because they do not correctly account for the costs of adverse economic conditions that result from crises.

This last result leads the authors to recommend that the financial regulators, in order to solve these problems, should try to internalize these externalities.

Federal budget deficit

 

Elias Tsepouridis has a recent post, where he expresses his concerns regarding the increase of the federal budget deficit. However, I think he forgot to mention something important. As we can see in his graph, since 1982, the US has only had four years with a budget surplus. So more than the current size of the deficit, I think we should look at the size of the public debt, because if the debt was low, then the deficit (used as a way to fight the current crises) would be fairly sustainable. However, that was not the case in 2007, when the federal debt as percent of GDP in 2007 was already at 50%. So now, we have to somehow balance the economic need for stimulus with the sustainability of public finance.

The public deficit is unsustainable, not because of its size, but because it has already drove the debt to GDP ratio to over 92%, and counting. Anybody want to guess when we get to 100?

Government Spending

 

Recent posts by Menzie Chinn about the “ever-expanding” government have been highly criticized for having some spin on the data or being bias (hysterical comments accusing him of being naive, dishonest as Krugman put it).

However, if we check the data, it is clear that both Federal Non-Defense and State and Local spending have been fairly stable since 1976, as it is showed by Calculated Risk.

Furthermore, by analyzing the data from the US Department of Commerce, we can see that the Federal Non-Defense consumption and investment from 1976 to the present has been stable, being always within the range 2.0 (1988 III, 1998 III and 2000 IV) to 2.9 (1980 III) percent of the GDP.

Likewise, we can also notice that the State and Local consumption and investment has also been fairly stable in the range 10.7 (1984 II) to 12.6 (1976 I).

It is the National Defense spending (that was excluded from Chinn’s analysis) that has had a large fluctuation throughout this timeframe. After picking in 1986 III (7.6), it had a significant drop until 2000 (3,7 in I,III and IV), only to start gradually increasing up to the present.

 

Even though the federal deficit is at an all time high, the spending relative to GDP seems at a reasonable value. Hence, most of the adjustment on the fiscal deficit should be done from the taxes side. Something to think about now that the Bush taxes cuts are expiring.