Greenspan sees productivity gains - in the future

Thursday, May 05, 2005

A higher than expected productivity gain of 2.6 (previous 2.1) percent in the first quarter of 2005 was partially offset by 2.2 (1.3) percent higher labor costs in the corresponding period, the Bureau of Labor Statistics reported today. The consensus estimate had been 1.9 and 2.0 percent respectively. Together with slightly higher jobless claims that came in at 333,000 after a revised figure of 322,000 the week before and an uninspiring speech of Fed chairman Alan Greenspan on derivatives markets markets have been going nowhere so far, seemingly waiting for new reasons to move from the employment report on Friday. While Greenspan's speech gave no indication about his expectations for macroeconomic developments, Bloomberg TV reported that Greenspan did elaborate on further productivity gains.
The Fed chairman is obviously not pleased to see productivity recovering only slowly after recording better levels between 2.8 and 5.5 percent since 2001. According to Bloomberg he said he sees an uppick in productivity although he could not say at what time this is going to happen.
Trying to read the mind of the Fed chairman, who has to save the global economy another 271 days before he retires and is doing this with a lot of comments on the soundness of the economy in the short term, I begin to wonder whether Greenspan is not mostly preoccupied with the exchange rate of the dollar that has not been able to move away significantly from the six-week threshold at 1.31 Euros, despite two rate cuts since. Does the investing world shift to the historically correct view that higher rates mean more risk and not more attractiveness? After all we must not forget that the current leader in the White House has not stepped on the triple deficit brakes yet and does not even include such a move in his most recent longterm budget forecasts. See also this post. As a quick glance on earlier budget proposals of this government shows, the White House seems to have seriously underestimated its tax receipts on a constant basis. Money was, is and will be politics. Only this time it all looks as it will put a lot of debt on the shoulders of Americans yet too young to be able to understand what's going to burden them in the next decade. I hope to come up with an analysis of these earlier projections and the implications this might have for the three future budgets George W. Bush will have to draft while in office, over the weekend.
Greenspan and his concerns on the interest rate derivatives market
Problems do not stop here, Alan Greenspan warned bankers in his speech about derivative markets. If you want to spare yourself reading the whole very technical speech, a short summary of mine includes his concern about the concentration of huge risks in very few hands. This could lead to market illiquidity in stress situations and result in counterparty risks. Greenspan lauded derivative issuers for the improvement of their risk models but stressed that the growth of hedge funds as primary investors in OTC derivatives could result in huge imbalances when markets take a sharp turn into one direction.
He did not advocate more supervisory regulation as issuers were better in monitoring their potential risks themselves. But as derivatives become ever more complex, issuers could still lag behind in their risk assessment capabilities.
According to Greenspan there is no reliable data about the volume invested in hedge funds, but estimates are running as high as one trillion dollars. That is about one tenth the size of the US stock market.
A compilation of the most important paragraphs of his speech:
Concentration in the OTC options markets raises at least three specific concerns. First, market illiquidity may result from a leading dealer's exit and that illiquidity has the potential to adversely affect Fannie and Freddie and other hedgers of mortgages and MBS(mortgage backed securities). Second, meeting the demands for options by mortgage hedgers involves market risk to dealers, a concern that has been heightened by the fact that the notional value of options sold by dealers significantly exceeds the notional value purchased. Third, the failure of a leading dealer could result in counterparty credit losses for market participants...
The potential for a dealer's exit to adversely affect mortgage hedgers is dependent upon hedgers' diversification of counterparties, the way in which hedgers use options, and the underlying reason for such an exit. Fannie and Freddie have about twenty dealers as options counterparties, including investment banks and foreign banks as well as U.S. commercial banks. However, only about five or six of them have direct access to the supply of options from debt issuers; the others must depend on the interdealer market for a substantial portion of their supply. The exit of one of these five or six may or may not adversely affect market liquidity, depending on the reason for the exit and on the way in which other dealers react. If a dealer is forced to exit because of a credit problem unrelated to its options dealing, other dealers are likely to take its place quickly. If the exit is the result of losses from options dealing, possibly in difficult market conditions, other dealers with similar positions are likely to be pulling back as well, which could leave the options markets quite illiquid...
Stress tests do not fully capture counterparty risk
In summary, as we have come to understand more clearly how participants in the OTC interest rate options markets use those markets and manage the risks associated with their use, wariness about concentration in these markets, though diminished, has not disappeared. The Federal Reserve remains concerned that the stress tests that some large participants are using to evaluate potential losses in the event of a large participant's default do not fully capture the potential interaction of counterparty credit risk and market risk, especially in concentrated markets...
...some observers argue that what is good for the banking system may not be good for the financial system as a whole. They are concerned that banks' efforts to lay off risk using credit derivatives may be creating concentrations of risk outside the banking system that could prove a threat to financial stability. A particular concern has been that, as credit spreads widen appreciably at some point from the extraordinarily low levels that have prevailed in recent years, losses to nonbank risk-takers could force them to liquidate their positions in credit markets and thereby magnify and accelerate the widening of credit spreads...
Some legitimate concerns have been expressed about the possible adverse effect of hedge funds' activities on market liquidity in some circumstances. One such concern is the potential for rapid outflows from the sector in the event that returns prove disappointing. Disappointments seem highly likely given the number of recent investors in this sector, all seeking arbitrage opportunities that of necessity will diminish as more capital is directed to exploiting them. Furthermore, some (perhaps many) hedge fund managers are likely to prove incapable of delivering the returns that investors apparently expect. Indeed, investors have already forced many hedge funds to fold after producing disappointing returns...
Recently there have been reports that competitive pressures have resulted in some weakening of risk-management practices...
The review noted some remaining weaknesses. First, because many fund managers are reluctant to provide banks with complete information about their portfolios or with forward-looking measures of the risks that the funds are assuming, the banks often cannot fully evaluate a fund's risk profile. Banks sometimes tighten collateral requirements and other credit terms to compensate for this lack of transparency, but most banks' policies could be improved by the establishment of clearer and firmer links between credit terms and transparency. Second, banks do not always aggregate stress test results across hedge fund counterparties to assess concentrations of exposures in volatile and illiquid markets. Third, and perhaps of greatest concern, in certain highly liquid markets, especially OTC interest rate swaps and repos, there are signs that competitive pressures may be eroding the protection that banks achieve through collateral requirements by reducing the initial margins that they obtain from hedge funds.
Last anecdotal note: Greenspan has always been stressing that bubbles could not even be determined after they had happened. In his speech he abandoned this remark, saying, "Inflows to hedge funds have been especially heavy since 2001, as investors have sought alternatives to long-only investment strategies in the wake of the bursting of the equity bubble."

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