Explaining Southern California's economy

The investors' view on the Federal Reserve's interest rate decision

Ben Bernanke

Alex Wong/Getty Images

Federal Reserve Chairman Ben Bernanke. Will continued low interest rates lead to inflation? Some money managers don't think so.

The Federal Reserve's Open Market Committee announcement Wednesday wasn't a big surprise on the interest-rate front. The Fed has stated it intends to keep short-term rates low for the foreseeable future, in an effort to stimulate the economy and push investors into riskier assets, like stocks. A continued low-interest rate environment will also continue to bolster the housing market, where mortgage rates are at historic lows.

Fed Chairman Ben Bernanke and the rest of the FOMC annouced that they will keep rates low until unemployment falls to 6.5 percent. It will also continue to buy up mortgage-backed securities, at roughly the same rate it has been (so-called "Quantitive Easing," installment 3, or "QE3").

[UPDATE: I slightly misinterpreted what the Fed is doing on the bond-buying side. It's also worth noting that the Fed is now saying that it will keep interest rates low until unemployment hits a specified level. This is a policy departure from saying that rates will stay low until the economy improves. But anyway, bond-buying: the Fed is going to double what it's doing in the QE front and change "Operation Twist" into an extension of QE3. The older aspect of QE will still involve buying MBS. But the additions to QE3 will entail buying long-term U.S. Treasuries without selling short-term bonds. This is important as it means the Fed will be adding $85 billion per month to its balance sheet — under Operation Twist, it hadn't grown much, which was viewed as an way to "sterilize" against inflation. Former Dallas Fed President Bob McTeer has a good post about the FOMC decision at Forbes.]

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California city bankruptcies are raising questions about the municipal bond market

Muni-Defaults

Federal Reserve Bank of New York

Last month, I wrote about Moody's, one of the big ratings agencies, and its view that the municipal bond market was getting a bit riskier than everyone has conventionally thought, in the aftermath of the bankruptcies of Stockton and San Bernardino and other U.S. cities. 

At the time, I noted that between 1970 and 2011, Moody's could find only one city — Cicero, New York — "electing to default on debt not out of ability to pay but willingness to pay."

What that implies is that the now $3.7-trillion muni bond market has been a safe investment for decades. As long as you're investing in rated bonds. (And even if you haven't, but more on that in a sec.)

Now the Federal Reserve Bank of New York has offered its own take, at its Liberty Street Economics blog. It differs from Moody's in terms of the looking at the entire muni market, not just the part that's rated by Moody's and others. The conclusion is represented in the graphic above. Moody's found 71 defaults between 1970 and 2011 — and that's total defaults in its rating universe, so presumably 70 we due to inability to pay while only Cicero strategically defaulted due to an unwillingness to pay.

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Why lending can be riskier than not lending for banks

Jamie Dimon Testifies At Senate Hearing On JPMorgan Chase

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President and CEO of JPMorgan Chase Co. Jamie Dimon testifies before a Senate Banking Committee hearing on Capitol Hill June 13, 2012 in Washington, DC. The committee is hearing testimony from Mr. Dimon on how JP Morgan Chase lost what could amount to five billion dollars in complex trades.

At the L.A. Times, Michael Hiltzik has a Money & Co. post about JP Morgan CEO Jamie Dimon's congressional testimony today. Hiltzik zeroes in on an exchange between Dimon and Sen. Bob Corker of Tennessee:

Corker: "Mr. Dimon, you've said that the biggest risk a bank takes is making loans, is that correct?"

Dimon: "Yes."

Let's unpack this, just for a moment. If what Dimon says is true, he's essentially pleading that his entire industry is operated by hopeless incompetents. 

Which sounds about right. Except that it isn't. Incompetence isn't the problem. Because when Dimon says making loans is a big risk, he's not talking about the risk of losing money. He's talking about the risk of not making money.

Here's what happened with JP Morgan's now $5 billion trading loss, centered on its London office. The bank had an historically immense amount of "excess deposits" on its books — that is, deposits that it wasn't lending out, in the form of various products (Felix Salmon has a chart.). A bank can use excess deposits to "hedge" against the risk of loan defaults. And this is what Dimon says JP Morgan was doing. Because if the bank wasn't hedging but rather making bets with those excess deposits...well, that's potentially a violation, because JP Morgan's deposits are guaranteed by the FDIC. You can't play poker with taxpayer money!

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Risky investments: No way to save pension funds

CA's Gov't Pension Fund To Report Loss Of One Quarter Of Its Holdings

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The California Public Employees' Retirement System building in Sacramento, California.

Last year, I wrote about Calpers, the big California pension fund ($235 billion), and its problems with conventional investment strategies:

The investment environment for pension funds isn't actually very good right now. Bonds are yielding historically low rates and the stock market is bucking around like an old Ford pickup truck on a back road in Texas. The Federal Reserve has done everything it can to push investors into riskier assets, like stocks, but so far, the markets haven't been able to maintain any kind of sustained rally.

This means that pension funds are increasingly diversifying into high-risk/high-return stuff, like hedge funds and private-equity. This is an oversimplification, but hedge funds try to make money even when markets are going south, while private equity invests in startup companies and gets involved in the turnarounds of underperforming established ones. The payoffs can be big. But so can the losses. 

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Are you ready for a flock of black swans?

"Black Swan" encapsulates in a ballet the improbable arrival of the rare bird — and event that's become a source of great concern to companies.

I just came across this Booz & Co. white paper by Matthew Le Merle, a partner in the firm's San Francisco office. Titled "Are You Ready for a Black Swan? Stress-Testing the Enterprise with Disrupter Analysis," it expands on Nassim Nicholas Taleb's book, "The Black Swan," in which Taleb outlined the dreaded black-sawn event. In a nutshell, a black swan shocking and impactful, but — and this is a big but — it's rationalized after the fact. If we had known X,Y,Z, we could have seen it coming.

The general assumption is that black swans are rare. At one point in human history, people weren't sure black swans even existed. However, in terms of the Talebian metaphor, black swan events are supposed to be infrequent. But La Merle points out that, for various reasons, we could be looking at a future that features flocks of black swans:

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