Wednesday, July 30, 2008

Mysteries of bank pricing, excess deposit liquidity, Bernanke's paradox, and the next bubble

Robert Biggs of the Beacon blog recently posed this question: Perhaps someone can enlighten me. I simply don’t understand how we can have a “credit crunch” without substantial increases in real interest rates across the board.

He enumerated the following data in the same post: For months, the news media have been dispensing reports of a “credit crunch.” I have been puzzled by these reports because scarcely a day passes that I do not receive offers in the mail or via the Internet from lenders who want to lend me money to refinance my mortgage or to make purchases with a credit card they stand ready to issue me.

Having my doubts, I checked some standard interest-rate data conveniently available online at the St. Louis Fed site. ….The first series I checked pertains to the bank prime lending rate. During the latter half of the 1990s, this interest rate varied from 7.75 percent to 9.0 percent. It hit 9.5 percent in May 2000, then began a long decline, gradually reaching a low of 4.0 percent in June 2003. Afterward it climbed slowly to a high of 8.25 percent in June 2006. For the past two years it has fallen again, reaching 5.0 percent in April 2008. Given that the rate of change in the producer price index has been substantially greater than 5 percent during the past year, borrowing money at 5 percent seems to me to indicate, not a credit crunch, but a credit bonanza. A business borrows, finances inventory, holds it for a year, and earns a 5-10 percent rate of return. What could be simpler and more delightful?

But, you protest, the credit crunch is really in the housing industry. Well, let’s have a look at mortgage rates for 30-year conventional mortgages. Although rates have risen in the past few months, they still compare favorably with rates that prevailed in 2006 and 2007, and they are not more than about 1 percent higher than rates that prevailed during the housing boom in the first half of this decade. Given that the rate of inflation is greater now, present real rates may be lower than they were during those halcyon days. If a credit crunch exists, it is certainly not showing up in the mortgage-lending markets. Are we to believe that lenders are simply refusing to lend, rather than lending at higher rates to reflect a diminished supply of loanable funds?

If credit were being crunched, one supposes that lenders would be willing to pay higher rates for funds placed at their disposal. Yet six-month certificates of deposit are now yielding less than the rate of inflation—people are paying the banks to take their money!

…..Of course, lenders have begun during the past six to twelve months to awaken to the fact that for four or five years, owing to the Fed’s expansionary policies in rapidly increasing the money stock at that time, they had been making loans to nearly every sentient being who asked for one, often without the performance of due diligence and without insisting on an interest rate that reflected the true riskiness of the borrower’s repayment.

Banks and other financial institutions continue to lend, even for mortgages, to well-qualified borrowers. In any event, the real-estate-linked lending markets are only a relatively small part of the overall market for loanable funds.

True. In answer to his original question, it might be well to go back to the proverbial “the bank gives an umbrella to those who don’t need it and takes it away from those who need it”. There is a credit crunch now among sub-prime borrowers. But if you happen to be among those deemed credit-worthy, banks will still beat a path to your door. Banks have been feeling the pain of write-offs from lending to sub-prime borrowers, that there is nothing they need more now than an infusion of good accounts to get their portfolio looking healthy again. Because there is still competition from many banks, and too few good credit clients who still feel comfortable taking out more loans, the rate for these prime clients will remain attractive, and probably become even more so.

The credit crunch refers more to the banks, rather than to any inability by creditworthy companies and individuals to borrow money. And if depositors are quite willing to park their money at sub-inflation rates (this is money that can be withdrawn on demand), that only means there is a dearth of investment alternatives. That doesn’t take away from the fact that banks have already lent money that can no longer be repaid, leading to their credit crunch. Which leads us to the reason the Fed is coming in as lender of last resort.

In a related post, Biggs rants against the Fed bailout plan: Yes, what is a government for, if not to save us from the impending disaster that its own policies have produced? Thank heavens for the government!

Noting that in the bailout of Fannie and Freddie, the Fed commits to lend them at 2.25 percent for any borrowed funds: …..lending at 2.25 percent when the rate of inflation is at least twice that great means that the lender is giving away money. The real interest rate on such a loan is negative.

Worse, because the Fed itself is the lender, the loan will take the form of newly created money—that is, the loan will be pure inflation, a hidden tax on all assets denominated in dollar units, including dollar balances themselves.

True, this could be a case of where the cure could end up spreading the disease. The Fed bailout could end up saving the GSEs but destroying purchasing power for everybody else in the US economy.

Bernanke is in an unenviable position. He arrived at the Fed just when the US financial system is about to be checkmated. If he tightens money, the toxic effects of the sub-prime mess intensifies. If he loosens money, the value of the currency goes down the toilet.

Now if the US currency is expected to go down the toilet, Americans will have an incentive to send whatever money they still have abroad, and those who earn them abroad will have an incentive to keep them abroad. And this will lead to the next bubble, which could be in whatever will hedge the American slowdown – like the Emerging Markets.

Similar-themed post here .
Update: My latest thinking here and here

Monday, July 28, 2008

Federal backstop approval announcement

This is to announce the provision of

With option to buy equity shares in





With approval from

JULY 2008

Fine Print
1. To Fannie and Freddie, while we have provided an unlimited backstop, this is in fact more to placate the global financial markets than to actually provide taxpayer-provided funds to bail you out of your irresponsibility. Availment will result in nationalization and breakup, your shares of stock will be worth yesterday’s paper

2. To the financial markets, now that we have approved the backstop, you know that Fannie and Freddie debt has the full faith credit of the US Government. Get your shit together because if any more of you fail, you’re not going to get the same treatment. Moral Hazard applies to you.

3. To the mortgage borrowers, please do not just default on your obligations. We really do not want to have to take over Fannie/Freddie’s mess. We prefer that you refinance at our Federally-approved long-term fixed rate.

Friday, July 25, 2008

Naked shortselling: Is it real?

I got curious when, during last week’s Congressional testimony by Hank Paulson and SEC Chairman Chris Cox about Fannie Mae and Freddie Mac, Cox decided to focus his testimony on the presence of naked shortselling, and the ways that the SEC was using to battle it.

What is naked shortselling? And how is it possible that it could be the reason for the spectacular collapse of some stocks in the market? As I myself have no direct experience in shortselling, the legal or the naked kind, it would be worthwhile for me to start with everybody’s definition of shortselling. This from wikipedia:

Short selling is a form of speculation that allows a trader to sell securities that he does not own, effectively taking a "negative position". They do this when they expect the value of the securities to decrease in the market, allowing them to sell securities at today's price and then buy the securities back when they decrease in value. With a large enough move in the price, the trader can purchase the securities, "covering" their position, for less money than they received for selling them earlier. The opposite case can also occur; if the price increases they will be forced to cover at a higher cost, a money-losing trade.

In order to make the initial sale, the regular method is first to "borrow" securities from a current shareholder, typically a bank or prime broker, agreeing to return them at some future date. The trader then delivers these borrowed shares to the buyer, a third party. The lender generally charges an interest fee on the share value during the time when the position is being held by the trader. When the trader wants to "unwind" the position, he buys back the shares in the market and return those to the lender. This short/borrow system ensures the trader has shares to deliver to his buyer, and the lender makes some money on a position that he was not actively trading.

Seems very straightforward to me. The way I understand how shortselling is supposed to be done, it will only work if the shorter can locate three counterparties: the person who lends him the stock, a buyer for the stock at current market price, and lastly, a seller who will sell the stock to him at a lower price later on. In short, many consenting investors should allow for the shortseller to, in a way, “test” or prove his hypothesis, that a particular stock price is supposed to be lower, or will go lower. If any one of the other parties are not available, and particularly, the seller who will sell to him at a lower price than is currently at a later date, he won’t be able to do the short, or worse, lose out on the trade.

In a nutshell, my view is that there should only be a certain amount short transactions before eventually, the shorter runs out of willing buyers (if the price is really going down), willing future sellers (if the price has already gone down too far), or even stock lenders (who would probably start selling as well, if the price is now expected to come down further). So how can shortselling be so rampant and overblown, as the SEC’s actions seem to imply? Well, there’s such a thing, apparently, as naked shortselling. Turning back to wikipedia, it’s defined as:

Naked short selling, or naked shorting, is the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed.

A trader selling shares that he has not borrowed? What happens during settlement then? Certainly, the shortseller will not have any shares for the buyer then. There will be settlement failure. explains:

What exactly are settlement failures? In a legitimate short sale, shares must be delivered within three days of the transaction. If they are not, this is called (excuse the tortured syntax) "fails to deliver." Failure to deliver -- that is, a settlement failure -- could be the result of a bureaucratic snafu or clerical oversight. But consistent failure in large volume would seem to indicate something more nefarious, or at the very least, a major bureaucratic breakdown in desperate need of repair. Failures on the scale experienced by some companies go beyond any innocent explanation.

So has there be a lot of these failures lately?

An official of the SEC said that "While there may be instances of abusive short selling, 99% of all trades in dollar value settle on time without incident." Of all those that do not, 85% are resolved within 10 business days and 90% within 20…………

.....Legal naked shorting would normally be invisible in a liquid market, as long as the short sale is eventually delivered to the buyer. However, if the covers are impossible to find, the trades fail. A sudden rise in the number of fail reports will alert the SEC that something irregular is going on. In some recent cases, it was claimed that the daily activity was larger than all of the available shares, which would normally be unlikely.

So there is a common sense way to know if someone is selling bogus stock then. Once they fail to deliver on settlement, they’re caught. But consider this testimony, as reported by, provided by. Sen. Robert Bennett in a US Senate Banking Committee hearing:

Summarizing how abusive practices might continue under Reg SHO, Bennett said: "I'm told that the way it works is that one brokerage house sells short, has 13 days under your rule under which to acquire the shares, and in that 13-day period hands the whole transaction off to another brokerage house. They just keep moving it around and nobody ever has to settle."

The Reg SHO being talked about is this: The SEC enacted Regulation SHO in January 2005 to target abusive naked short selling by reducing failure to deliver securities. It states that a broker or dealer may not accept a short sale order without having first borrowed or identified the stock being sold. The rule has the following exemptions:
1. Broker or dealer accepting a short sale order from another registered broker or dealer
2. Bona-fide market making
3. Broker-dealer effecting a sale on behalf of a customer that is deemed to own the security pursuant to Rule 200 through no fault of the customer or the broker-dealer.

The market maker exemption to the rules governing the practice is intended to allow market makers to naked short sell on a very temporary basis, in order to increase liquidity and stabilize markets.

Fools. Com article explains this further: Under the new rules, if shares haven't been delivered for 13 days after the transaction, the broker must buy them back -- with money it presumably would collect from the client who shorted the stock in the first place. So a bad actor can break the law a little bit, but if he breaks it a lot, he has to cover the short -- which he was going to have to do anyway and, since he's been manipulating the price by illegal activity, can probably be done at a bargain price. Now that's showing the bad guys! Moreover, as Sen. Bennett noted, brokers working together could get around even this restriction by passing the transaction among each other, starting the 13-day clock over again.

Now, it would seem to me that the process of covering a short negates the effects of the short. So if the stock price went down as a result of the short, covering should have the opposite effect, right? But the last part of Sen. Bennett’s testimony is bothersome. Brokers pass the transaction among each other? The article further explains:

It is the market-making exemption that still seems to me like a source of potential trouble. Market makers don't have to locate shares before executing short sales in most circumstances. Their role is to keep an inventory of readily available stock, to smooth volatility, and to manage their own risk, and this sometimes requires them to short shares. A prime example of why this is sometimes a valuable function and even protects investors can occasionally be seen with companies emerging from bankruptcy.

When US Airways was planning to re-emerge from bankruptcy in 2003, for instance, its old common stock, trading on the OTC BB, rallied -- apparently because some investors mistakenly thought the news was somehow good for shareholders in the old common stock. But the plan called for the issuance of new stock, and the old shares were to become worthless. Market makers, by shorting the old common shares, could burst a speculative mini-bubble in the making and stop more ill-informed investors from losing their shirts. (Of course, one wonders why stocks are allowed to trade at all in these situations, but that's another matter). In any case, this is an extreme example of one function legitimate market makers serve by shorting stock and why they are given an exemption to the rules.

The potential problem is that unscrupulous folks could potentially register as market makers to take advantage of the exemptions.

So in short, a consortium of “market makers” can trade the short positions among each other? But over time, you’d probably notice this suspicious trend, if only a certain group is passing a position around, right? Otherwise, at a certain price level, there could already be demand for the shares from investors outside of the consortium, won’t there?

This gets more complicated. I mean, think about it. If the short position is naked in the first place, and there are no actual stocks backing the short, what happens then once there are now legitimate investors willing to buy out the position? That should bring us back to the case of settlement failures, right? Or otherwise, lead to the creation of bogus share certificates, or “phantom” stocks, which the SEC denies is possible.

So what’s the deal with naked shortselling? Is it real? Is it done rampantly? Perhaps it is, or the SEC would not be clamping down on it. But I’m very curious as to how it's actually being done.

Update: Similar-themed post here.

Tuesday, July 22, 2008

The real threat to the global economy

Two months ago, this blog was ranting and railing about global inflation. Then a month ago, the focus of my posts shifted to the US banking crisis.

Well, since two months ago, the world, in my opinion, has just about tamed inflation. Fearing the bigger spectre of a wage-price spiral, governments and central bankers in emerging economies the world over have made inflation-fighting their primary objective, as reported in this Bloomberg article.

Their monetary tightening, coupled with the rise in energy and food and materials prices, has already resulted in significant demand destruction in their local economies. Their massive populations, much of whom were just coming out of poverty and starting to demand more consumer goods, will likely stay poor for the meantime. They’ll maybe even start adding to their rolls of the poor, as demand destruction destroys livelihoods, and impacts on the middle class of these countries.

The slowdown in US demand has further dampened growth in these emerging economies. With their largest export market sputtering, their only options were either to find alternative export markets or develop their domestic market. Not everyone will be able to find a domestic market. Not when their people are staying poor.

Still, we forecast that for many firms, survival means finding a substitute local market. With the rise in oil prices increasing transportation costs, we reasoned that businesses will again be local. With the increase in energy and commodity prices increasing all input costs, we also forecast that the biggest competitors in an industry will likely weather this crisis. The resulting carnage of smaller companies will contribute to demand destruction and slowed global growth.

Now that inflation is coming under control in emerging economies, and demand in developed economies, particularly the US, also being crimped by the credit crisis, the destructive price-wage spiral seen during the 1970s hyper-inflation will likely be averted. As pointed out previously in this blog, we're all in this crisis together, and no single country will bear the brunt of inflation or economic stagnation by itself.

My opinion is that the bigger and more complicated problem now facing the global economy is in fact the credit crisis itself, and to a lesser extent, the slowing US economy.

As mentioned, the slowing US demand has already impacted the growth of mainly export-oriented emerging economies. But more than that, I believe the crisis of confidence now wreaking havoc on US financial markets could still spread like a contagion to the global financial markets. Banks, after all, are not only good intermediaries of capital, they are also good intermediaries of risk.

The American credit crisis is now imperilling US financial institutions that are widely acknowledged to be “too big to fail”. Fannie Mae, Freddie Mac, Citigroup, Lehman Brothers……..

If a major US institution falls, whose links with large institutions worldwide are too great, whether it issued a widely-held security worldwide, or is itself a large investor, banker, or counterparty in the global economy, the repercussions of its fall will be enormous. The ripples and after-effects to other economies globally could very well sink the world into a deep recession.

Much rests on the shoulders of Ben Bernanke, the Fed, and the US Treasury.

Sunday, July 20, 2008

Hyper Misery Index

The misery index is an economic indicator, created by economist Arthur Okun, and found by adding:

Misery index = unemployment rate + inflation rate

It is assumed that both a higher rate of unemployment and a worsening of inflation both create economic and social costs for a country.

To make the metric a little more comprehensive, I propose a new formulation that recognizes another major social cost. I call it the Hyper Misery Index. I propose that it be arrived at by:

Hyper misery index = unemployment + inflation + nat'l debt rate


Nat'l debt rate = Total Nat'l Debt (public & private) ÷ GDP

This metric recognizes that the more of a nation’s aggregate income goes to paying debt, the higher the misery will be. For example:
Misery index = unemployment + inflation
5 + 6 = 11
Hyper misery index = unemployment +inflation + nat'l debt rate
5 + 6 + 150 = 161!!!
This index could be useful in cases where, to add insult to people already suffering from both loss of income and rising consumer prices, everyone’s personal debt will suddenly be called by the creditor, and the government needs to raise taxes to pay down its stagerring debt.

The Hyper Misery Index. In this index, these people score the lowest misery.

Thursday, July 17, 2008

Recessionless job loss

Productivity gains of the 1990s and early 2000s led to the fairly recent economic concepts of:

JOBLESS GROWTH. Economic growth that does not result in corresponding growth in employment.
JOBLESS RECOVERY. Turnaround from a recession that does not translate to jobs growth in a meaningful way.

We are again seeing another new phenomenon. Jobs are being lost, but the loss has not corresponded to an equal decline in the economy. Again, perhaps new productivity techniques are contributing to this. Given that prospects for growth are limited, some companies have been shedding workers, and relying on less people to achieve the same output.

We need a new economic concept to define this. I think we need to define it mostly because defining it as a distinct phenomenon leads to thinking about specific measures to alleviate its effects, rather than, as most economists who focus just on GDP numbers, concluding that recession has been averted so far.

Jobs Recession? Recessionless job loss?

Anyway, if less people are earning than before, how long before it leads to an actual recession?

Tuesday, July 15, 2008

Paulson's huge bet on the economy

We saw today Hank Paulson’s true feathers as a former Wall Streeter. Currently the US Treasury Secretary , he was for a very long time a member of the financial markets, as a former financier from Goldman Sachs. His outline for helping Fannie Mae and Freddie Mac, in keeping with his trader mindset, illustrates that he is comfortable with making unhedged positions based on his readings of the market. Because now, he is making a massive bet with tax payers’ money.

His plan for Treasury to act as backstop to Fannie Mae and Freddie Mac, and his proposal from Congress to give him the authority to do so, but without any specification as to amount or limit, makes this a massive bet in the tradition of what he might have done or approved of when he was still at Goldman Sachs.

In my opinion, the options as Paulson outlines them, look very much like a modification of “prisoner’s dilemma”, as Game Theory economists would call it. In essence, Paulson is trying to avoid having to indicate a real and specified amount for government bailout right now, because he believes that he runs the risk of indicating an amount which may be construed as too small by the market. This would result in a greater run on confidence in the market, which would only make the specified bailout amount futile. However, by keeping the amount unspecified for now, but nonetheless the commitment clear, he is in effect asking for a “blank check”, as many Senators termed it, from the government to support the beleaguered institutions.

In other words, he is trying to avoid committing an expensive but specific amount now, which may turn out useless if deemed unacceptable by the market, in return for an unspecified amount, which might – MIGHT – be deemed acceptable by the market, and hence, diffuse the market panic, and possibly result in the bailout becoming unnecessary.

In a Goldman context, this is an elegant solution. It is a solution based on the reading that much of the turmoil at Fannie and Freddie are also effects of market psychology. Taking away that fear, and instilling confidence back, brings capital back to these institutions, and thereby takes away the need for use of government funds.

In a Goldman context, if this thesis proves incorrect, the risk will be a significant blow to the Goldman capital exposed in this position. Since he is now Treasury Secretary, Paulson’s bet puts the entire US economy exposed. If he loses, it’ s not the capital of otherwise-rich Goldman Sachs partners that will take a hit. It will be the US taxpayer.

If his bet is unsuccessful, this could result in further fiscal problems for the US, which will be felt world-wide. l put forth my own thesis that that kind of hit to the US economy will result in a global recession.

During his testimony, many Senators asked why the Fed’s discount window is not enough to support the 2 Fs. As pointed out by both Bernanke and Paulson, the decision of how much and in what manner any bailout to these institutions is better made at the Treasury rather than at the Fed. They both say that this is more a fiscal matter than a monetary one.

It took a lot of turns for this question, and still the same answer was provided. In my opinion, a bailout is a bailout is a bailout. The main difference between getting bailout funding from the Fed, as opposed to Treasury, is that if the Fed provides the funding, the Fed will just print out more money to fund it. That makes the move inflationary. If they get the funding from Treasury, that will be real money that comes from taxpayers. This will be depressionary.

So in effect, the decision to transfer the decision of whether to help Fannie and Freddie, and by how much, to Treasury is an acknowledgement that inflation is a real threat, and more moves that could exacerbate it will only worsen the economic situation.

So we all arrive at this Paulson proposal, the bet on the market psychology proposal. A blank check, meant to be a strong signal to the market, of government’s commitment to Fannie and Freddie. A blank check, nonetheless, that comes with real commitment, which will likely be cashed in some amount, one way or the other.

Just by how much, nobody knows. Paulson says that he will ensure any funding provided by Treasury will be negotiated to ensure that the taxpayer’s interest is preserved.

But I’d like to know, and for sure, no one can answer this with any specificity. What is the limit that the government can afford to provide, before it becomes an even bigger problem for everyone? At what point do we conclude that Fannie and Freddie’s liquidity problems have just been transferred to the national government?

Then again, maybe the signal alone could be enough to placate the market, and Paulson will come out looking like a genius. Maybe Game Theory needs to come up with a name for this. How about Paulson’s dilemma?

Monday, July 14, 2008

The Great Disappearing Liability : the mother of all off-balance sheet transactions

Fair value accounting is taking over the entire balance sheet.

First, there was mark-to-market of assets. Its implication is that an adverse movement (decline) in asset prices results in lower income for an operating company, as value written off eats into the current year’s profit.

From CFOs complain that fair value accounting already affects dozens of accounting areas, and the folks who write accounting standards are adding new ones all the time. Major areas affected already include accounting for: pensions, mergers, stock options, environmental liabilities, hedging and derivatives, and uncollected debts. Some of these — for example, the value of the stock in a company's pension portfolio — can have a huge impact on a company's financial results.

Then, if you were a bank, investor, or fund, a decline in asset prices also resulted in lower equity. Hence, the equity side of the balance sheet is also subject to mark-to-market accounting.
Now - liabilities are also being targeted by the FASB, the accounting standards regulating body, as the next item up for mark-to-market treatment. News of the latest controversial discussion is reported in a recent article in titled “How Fair Value Rewards Deadbeats”. You have to read it to believe it.

In the provision, paragraph 15 of standard number 157, the Financial Accounting Standards Board’s controversial new stricture on fair-value accounting, FASB states that the fair value of a company’s liability must reflect the risk that the company won’t pay it back. Thus, as the risk that companies won’t pay back their debts rises, their reported liabilities actually decrease--and may even provide an earnings boost.


This is just the kind of news that would save the asses of the most highly leveraged firms in today’s credit crunch environment. The more debt these firms have, and the less likely they are able to pay these back, the more they can mark down their liability. And the more they are able to mark down, the greater the boost in income, as this means less implied debt servicing costs for the company.

I have to highlight “implied” though, since for sure, most prudent lenders will have ironclad agreements that make sure a borrower will actually pay back its debt. Thus, many opponents of the proposal say this will not necessarily mean companies who decide to mark down their liability can actually monetize the gain.

Nonetheless, the ability to mark down liability in itself potentially is a huge relief for a company that can foresee itself becoming illiquid, or worse, insolvent, in the future.

The proponents of the idea in the FASB say that any gain the liability side will be offset by the loss on the asset side.

To be sure… when a company’s credit risk rises, its share price is likely to fall accordingly. That suggests why the earnings boost created for some companies by the inclusion of nonperformance risk in fair-valuing liability seems so counterintuitive. But a fuller use of fair value would show that “the loss on assets would certainly outweigh the gain on the liabilities,” Petroni says.


But let me say it again. The ability to mark down liability in itself potentially is a huge relief for a company that can foresee itself becoming illiquid, or worse, insolvent, in the future.

This will be another useful tool in a corporate fraudster’s bag of tricks to lull investors into a false sense of security. I’m pretty sure that there will be many cases when a company will find that reporting a liability write-down or write-off in its notes to financial statements unnecessary as this had already been coupled with a corresponding writedown/write-off on the asset side. In a slightly exaggerated example, if a company decided to write off the billion dollar debt it incurred to fund an acquisition gone wrong, simply writing off the acquisition on the asset side automatically cleanses the balance sheet altogether. It would be as if the disastrous acquisition never took place. But guess what happens when the debt reaches maturity. The company still needs to pay back its debt.

Taking advantage of this liability writedown provision may mean a smaller balance sheet for a company. But it also means a healthier debt-equity ratio, and cleaner balance sheet with a “stronger” debt coverage ratio.

This will be the mother of all off-balance sheet transactions! And companies who effect this, ironically, will do so in compliance of best accounting practices.

If this FASB provision ever sees the light of day, we might as well forget about credit risk management techniques as we know them.

Update: Similar-themed posts here and here.

Friday, July 11, 2008

Speculations on bank strategy: Capital Adequacy perspective

On the whole, I see banks lending out much less in the foreseeable future.

Everybody already knows that, you say? Well, I’m not just talking about the deleveraging currently going on in the banking sector. I’m talking about bank prospects long after the current economic downturn and bank crisis are long gone.

That’s my prognosis, at least, if the securitization market does not go back, not to the same extent it was before this mess.

For a long time, securitization provided US banks with a cheap way to lend money. For much of the world, where the market for securitization was not as deep, banks have had to contend with the credit-tightening effects of the Basel II requirements for bank capital adequacy.

In a nutshell, Basel recommends banks to have at least a 10% capital-to-risky assets ratio. That means, a bank needs to have at least 10% as much in capital as the amount of risky assets it invests in. By risky assets, we mean all bank lending and investments in risk-weighted assets. By capital, we mean equity capital. This in now way includes funds coming from bank deposits or bank borrowings.

Generally, the riskier an investment is, the more risk-weight it is given by Basel. A credit-grade mortgage loan will be given 50% risk weight, while a credit-grade regular consumer or corporate loan will be risk-weighted at 10%. Only investments in relatively risk-free government securities are given zero risk weight. For a good summary of the capital adequacy rule, click here.

That means, the more a bank allocates its funds to risk-weighted loans, the more it needs to have in terms of capital. So in fact, the more successful a bank is in raising its deposits, the more it needs to raise equity capital, so that it can in turn be able to lend out these deposits as risk-weighted loans.

The more loans in a bank’s books, the higher its equity capital needs to be to maintain a capital ratio deemed adequate by Basel standards. A necessary metric to ensure that banks have enough capital on hand to absorb potential loan losses, it nonetheless increases the costs of lending, regardless of the credit-worthiness of the borrower.

As mentioned, US banks were able to circumvent the need for capital adequacy because they did not keep a large portion of their loans on their books. No, they securitized a lot of these assets which would otherwise have necessitated the banks to provide additional capital buffer on their books.

For as long as there was a ready market that invested in securitized loan assets, banks could go on recycling money by reinvesting securitization proceeds into newer loans. And for as long as the bank was able to securitize loans, there was no need to raise new capital. Any profits earned at the end of the year were dividended out, because there was no need to maintain increasing amounts of capital in their books.

Now that the securitization market has gone away, and I believe that it won’t be as big as it was when it comes back, banks now have to face the full effects of the capital adequacy rule.

What are the repercussions?

Well for starters, as I mentioned, there will be less bank lending. Banks will naturally gravitate more to assets with less risk weight. That means more investment in government securities, in place of the decreased lending.

There will be less bank stock dividends. As mentioned, the more banks lend out, the more capital it needs in its books. Therefore, as long as the bank’s assets are growing, there will less dividendable earnings at the end of the year (Less than what we saw in the last decade).

Because lending will become more expensive for banks, it will need to cut costs in other ways. The most obvious cost cuts will be in general operating costs. That means less investments in upgrading facilities, paying employee salaries, maybe less marketing expenses.

We will see more banks raising capital, long after the credit writedowns are gone. In fact, in the future, those banks most successful in growing their asset base will have to raise capital on a regular basis. In a way, this might be good for the market. Instead of looking at institutional investors as investors to prey on, banks will look to these as potential shareholders. There could be more transparency as a result.

To offset the higher costs, banks will need to have greater economies of scale. As a result, we will see more bank mergers. Smaller banks will no longer be as attractive an investment on a stand alone basis. The need for greater capital to maintain adequate capital ratio will make these unsustainable on their own. But when merged with a larger entity, the combined firm will be able to cut redundant costs. With a bigger market reach, the combined bank might be able to earn a return acceptable to shareholders.

So we might see lending more and more concentrated in the larger banks, which are able to afford the higher lending costs that come with Basel compliance, while the much smaller banks will become more adept at investing and trading government securities.

That’s my fearless forecast. Then again, these are mere speculations on my part. For all I know, the securitization market will go back, bigger and deeper than we ever saw. Or even better yet, banks might figure out another way around the Basel standards. Whatever that innovation will be, for sure it will involve re-packaging assets so they are assigned lesser risk-weights.

In an alternate future, will we see loans repackaged as government securities? It might sound ridiculous now, but even twenty years ago, I’m sure people would have found the concept of packaging good and bad loans together and selling the pool at credit-grade just as absurd.

Update: Similar-themed post here.

Thursday, July 10, 2008

Do we need more financial regulation? : The Hank and Ben Show

A lot of good points were raised in today’s joint Congressional testimony by US Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke.

I think that Paulson’s main point, and the one that we should all take away, is that banks and financial institutions should be allowed to fail. The practice of bailing out institutions in financial distress undermines market discipline, and creates the moral hazard that these firms will continue to take ever-larger risks in the future.

Ben Bernanke’s main point is that the Fed needs additional authority to deal with these situations. Dealing with and bailing out non-bank financial institutions are outside the Fed’s current mandate and regulatory authority. He wants more regulatory authority so that in the future, he can prevent from happening another situation where a non-regulated institution that is too large to fail will need Fed funding.

Bernanke is correct in saying that if the Fed had not done what it did in the Bear Stearns case, the fallout throughout the rest of the financial community would have been much larger and more adverse. Credit tightening would have been worse, which would have had worse effects for regular people and their ability to access loans and capital. Bernanke adeptly turned around a congressman’s questioning, and complaint about a constituent not being able to access loans for education into a strong point to strengthen his position. It is in keeping with the Fed’s mission to ensure liquidity and credit availability in the financial market that the bailout of Bear Stearns happened.

Despite questions from several congressmen to concretize the regulatory changes being proposed by both Paulson and Bernanke, no specific points or timelines were provided. As mentioned by Paulson, these are unusual circumstances, and more time is needed to think about the specifics of the changes that need to be made in the system.

In the end, I think Congressman Ron Paul made the best point when he said that increasing regulation has never solved the problems of fraud and mismanagement in the financial market. After Enron, a lot of changes were legislated, specifically those contained in the Sarbannes-Oxley act, but they only ended up making it worse for businesses in general to conduct their affairs. Despite that act, we still see a lot of financial mismanagement.

Paul indicated that it is the loose monetary policy that led to the environment where real interest rates are much lower than inflation that is the cause of this current problem. Because banks were provided more liquidity than what the market can absorb into real business activities, they ended up having to lend these into less and less viable outlets.

To summarize how I personally think about the situation, a little regulation may be good, but by itself, will not be the solution to avoid this problem in the future. There are indeed activities that need to be monitored by the Fed if it wants to avoid another instance in the future where it needs to step in and intervene the way that it did with Bear Stearns. But to be able to this monitoring adequately, the Fed will have to drastically increase its personnel. It needs to do so to beef up its expertise in watching over securities firms, whose activities are geometrically more complicated than what the Fed has been used to regulating - the commercial banks. More actively regulating investment banks and securities firms will only increase the federal budget, and yet, in my opinion, those who wish to circumvert the Fed will always be one step ahead of the regulator. Investment banking activities are not as codifiable as commercial banking, and hence, espouse a more "anything goes" culture.

It would be better to take from Cong. Paul’s point, and to ensure that the over-all environment where these financial institutions take part does not provide incentives for excessive risk-taking or misdirected enterprises. In the end, the market will always decide what is best, based on the over-all environment that it finds itself in. It will respond according to the incentives provided it.

If the monetary environment does not pump excess liquidity into the market, it will not foster a market culture where money is thrown at any activity that calls itself a business enterprise. After all, a financial institution’s function is to allocate capital. If there is too much capital, there is opportunity cost if an institution will just sit on that capital without recycling it back into the economy.

Fed activities which end up leading to this loose liquidity environment, therefore, should be re-thought. Too much money supply growth can lead the market right back to a Bear Stearns scenario at some point in the future, albeit at a new iteration.
Beyond rethinking monetary policy, selective regulation coupled with allowing insitutions to fail, could be the best option we can have. Hank and Ben, please show us more.

Wednesday, July 9, 2008

Global Carbon Trading: Proposals from Down Under

There is good debate going on down under about creating a workable incentive/cost structure to reduce global carbon emissions. Australian economist John Quiggin started off a fertile thread of debate in his blog about the latest proposals for a global trading mechanism for carbon permits/tax.

Now that nearly everyone is agreed on the need for a market-based policy instrument to reduce CO2 emissions, the biggest unresolved question is whether to implement carbon taxes, tradeable emissions permits or some hybrid of the two.

I support tradeable permits...I have three main reasons for preferring permits, which I will list in order of significance
First, while the natural starting point for both systems is one in which the government collects the entire implied value of emissions, either as tax revenue or as the proceeds from auctioning permits, the emissions trading system allows for (but doesn’t require) free allocation of some permits. Particularly in transitional stages when not all sources are covered, this can be used to offset unanticipated distributional consequences of the scheme, and thereby increase its political feasibility.

Second, since we are uncertain about the elasticity of demand for emissions we are faced with a choice between allowing this uncertainty to be reflected in uncertainty about reaching the targeted level of reductions in emissions, uncertainty about the price, or some mixture of the two. Given the risk that we will fail altogether if individual countries fall short of their targets, I’d prefer some uncertainty about the price.

Third, and most importantly, the ultimate solution has to be an international agreement to reduce emissions in the most cost-effective way possible. The obvious way to do this is through the creation of international markets for emissions permits. Although a full-scale global market might be some way off, regional or multiregional markets linked through something like the existing Clean Development Mechanism could be set up reasonably easily. By contrast, I can’t see how, in a world of sharply varying exchange rates, it would be possible to set up a co-ordinated global system of carbon taxes.

Warwick McKibbin, another economist, has a more fleshed out proposition.

I agree that we need a world price for carbon. This can be achieved by picking arbitrary targets for each country and then having each country trade until a world price is reached. Problem with this is that if one major country pulls out the global market will be undermined – or in the European ETS analogy if one country over-allocates the system price will collapse (not hypothetical). The reason that attempts through history to have a single world currency has never worked is because money is the promise of a government and difference governments have different degrees of credibility.

The alternative is for all countries to have a domestic carbon price either from a domestic carbon tax, some other price mechanism or a hybrid carbon market along the lines that Wilcoxen and I have proposed.

Create a long term permit like a long term bond with diminishing annual permits for each year reflecting this long term target. Give these long term permits to all citizens and industry within a country. Trade these in a flexible domestic market like a long term bond market. A central bank of carbon issues annual permit announcing a price for each of the next 5 years. Anyone who can’t hit their annual commitment from owning or buying long term permits or buying annual coupons from long term permits can buy an emission permits from the central bank of carbon. The price of annual permits is therefore capped and constant for 5 years. This is adjusted domestically based on a mix of science, the global policy situation or by international agreement if there is a global system. The long term permits are flexibly priced within a domestic market. No one can manipulate the short term market price. Each country runs their own market so the existing domestic institutions can run the market. Different countries will do better and worse jobs but the cross border damage is limited within countries. The world coordinates on the same annual permit price in each country if a global regime can be negotiated. Think of this as a global cap and trade market with clear rules on compliance based on no country having to bear an unfair burden of cost relative to other countries where this is measured as the carbon price reached in any year. Two targets (long term emission reduction, equalizing short term economic costs across countries) and two instruments, the short term and long term carbon price.

I find taxes very opaque. How long would a tax reform take in the real political situation we face. The lobbying would be non stop over time whereas my system only faces a one off allocation fight. In a carbon tax world there is no constituency to prevent future politicians from cutting taxes but if people own the long term carbon rights then they will not like politicians changing the policy and debasing the carbon market.

See the entire article and debate thread in the link.

I agree with Warwick that having a global trading platform might be too cumbersome, and breakdown in compliance in one country undermines the entire system. Domestic trading platforms might work better. But I also have an issue with issuing long-term permits.

The possibility of local politicians altering carbon tax based on political convenience gives rise to fluctuations in value of the permits already issued. If a newly elected government will increase carbon taxes, then that increases the value of a permit issued during a lower tax environment. Vice-versa, if taxes are slated to go lower, an already issued permit will be priced lower, as companies that need to buy permits will be able to buy them at a lower price.

The existence of these arbitrage opportunities ensures that before long, financial speculators will come to dominate the markets, as opposed to the real carbon-based entities. Who knows, if implemented, we could one day see a bubble in carbon credits.

A trading platform creates a scenario whereby Warwick’s concept of “ownership of long term carbon rights” becomes fluid and arbitrary. Ideally, a strategy of developing a trading platform should be coupled with a fixed carbon tax program that should be upheld regardless of change of government. But if this is not possible, I guess we will have a new playground for the financial markets.

Monday, July 7, 2008

Tough days for Ben Bernanke and the World's Central Bankers

Let me see if I got this right. I’ve been trying to think about the difficulties the world’s Central Bankers might be having now with this global chaos we are seeing. In particular, I want to see if I can understand the factors that might be bedevilling US Fed Chairman Ben Bernanke.

To increase rates or to lower rates? Inflation or stagflation? Higher unemployment or higher prices? Overheating economy or disappearing credit?

Just what the heck is the real earth-shattering problem of the world?

Let’s start with Bernanke. The US economy is currently soft. With the sub-prime blowout and the resulting deleveraging, its economy is faltering. Ideally, rates should fall.

But then, there’s also rising inflation world-wide. Commodity prices are soaring, leading to increasing costs of doing business. If prices continue to rise, real interest rates will continue to decline, making it less favourable for people to save money. If people use money to pay for goods now instead of save, it can damage the economy. Hence, rates should be increased to tame inflation.

The rest of the world does not have the sub-prime problem. Well, they got it a bit in Europe, but they don’t have that problem in Asia. Hence, without the soft economy problem, everybody’s going gang-busters with growth. And that’s contributing to the continuing commodity inflation. Hence, in the rest of the world, the balance is tipped more in the favour of increasing rates. Still with me?

But what happens then, if you’re US Fed Chairman Bernanke, and the rest of the world is increasing rates to tame inflation, while you stay put or even lower your own rates?

Your currency goes down when compared to other currencies. Much lower it goes as more investors go to the stronger currencies with the stronger economies and the more favourable rates. What happens then to the US economy?

With a depreciating dollar, inflation becomes more of a problem for Americans, as imported commodities become more expensive. Which only further exacerbates their already soft economy.

But with other countries having no other choice but to raise rates, both to contain inflation in their own economies, and also, in effect, to contain inflation worldwide, their currencies become stronger. With that, their stronger currency enables their economies to nullify the effects of the higher interest rates. Hence, many credit-worthy businesses continue to invest, leading to more inflation.

With more global inflation and a still falling dollar, the US economy gets even weaker. What's a Central Banker to do?


Sunday, July 6, 2008

Sub-prime CDOs and the mark-to-market rule

S@rzi of Investment Banker on Life blog made a pointer to this New York Times article on an ongoing debate about the possible effect of the mark-to-market accounting rule on the current writedowns on Wall Street. The debate is currently being led by private equity financier Stephen Schwarzman. Excerpts from the article:

FAS 157 represents the so-called fair value rule put into effect by the Federal Accounting Standards Board, the bookkeeping rule makers. It requires that certain assets held by financial companies, including tricky investments linked to mortgages and other kinds of debt, be marked to market. In other words, you have to value the assets at the price you could get for them if you sold them right now on the open market.

The idea seems noble enough. The rule forces banks to mark to market, rather to some theoretical price calculated by a computer — a system often derided as “mark to make-believe.” (Occasionally, for certain types of assets, the rule allows for using a model — and yes, the potential for manipulation too.)

But here’s the problem: Sometimes, there is no market — not for toxic investments like collateralized debt obligations, or C.D.O.’s, filled with subprime mortgages. No one will touch this stuff. And if there is no market, FAS 157 says, a bank must mark the investment’s value down, possibly all the way to zero.

That partly explains why big banks had to write down countless billions in C.D.O. exposure. The losses are, at least in part, theoretical. Nonetheless, the banks, in response, are bringing down their leverage levels and running to the desert to raise additional capital, often at shareholders’ expense.

Mr. Schwarzman and others say FAS 157 is forcing underserved write-offs and wreaking havoc on the financial system. There is even a campaign afoot in Washington to change the rule.

Some analysts, even insiders, say banks like Citigroup and Lehman Brothers marked down some of their C.D.O. exposure by more than 50 percent when the underlying mortgages wrapped inside the C.D.O.’s may have only fallen 15 percent.

This is a loaded debate that could go on until we know for sure what the real value of these CDOs loaded with sub-prime mortgages are. And that can only happen once the last of the underlying assets pooled into these CDOs reaches maturity. Otherwise, no one can know for sure how much of the underlying assets will eventually default. Hence, the only proxy to value them now is the current market price of the assets, which at this point, is largely diminished, both because of the current deleveraging going on throughout Wall Street (the largest potential buyer for these assets) and the current flight to security by all investors in general, away from risky assets like the CDOs.

But I see the merit with arguing against the single-minded implementation of this accounting rule. Some of these accounting regulators could be mistaking non cash-generating assets, i.e., broken equipment, which can theoretically have zero value if nobody will buy them in the market - with cash-generating assets, like securities, which at the end of the day, are still worth something for as long as they earn some income from their underlying assets. The latter cannot be marked down indefinitely, or at some point, you create incentives for company insiders to buy them out from the company at the under-valued prices. After all, insiders are in the best position to determine the creditworthiness of these securities going forward.

S@rzi says that we are, in fact, seeing that happening now: Yesterday, for instance, I read about former Lehman officers who set up a hedge fund which bought up Lehman CDOs. Well, it could be just an accounting hocus-focus to help Lehman's bottom line (a suspicion which was raised by the writer because he doubted whether this was really an arms-length transaction), but then again it might be a truly profitable arbitrage deal for the ex-Lehman officers.

More from the NYT article: For Mr. Schwartzman’s part, he says that that (most) banks haven’t been willing to unload the investments at the distressed prices. Besides, the diligence required for most buyers is almost too complicated.

Hence, we are now in a situation where the banks have designated a price for these assets in their books, but a price where, for most as we’ve seen, there are no willing sellers or buyers. How can we say that CDOs have been properly marked-to-market then?

If the mark-to-market rule’s objective is to provide transparency in the valuation of securities, have we actually attained this objective with the current level of writedowns at the banks? Or has it done more bad than good?

From Mr. Schwarzman in the same NYT article: “The concept of fair value accounting is correct and useful, but the application during periods of crisis is problematic. It’s another one of those unintended consequences of making a rule that’s supposed to be good that turns out the other way.”

Update: Similar-themed posts here and here.

Thursday, July 3, 2008

Rating agencies and conflict of interest

According to a Bloomberg news that came out yesterday, Moody’s fired the head of its structured finance unit and said employees violated internal rules in assigning ratings to some of last year's worst performing securities.

Moody's is currently reeling from a credibility crisis after it had been established that it awarded Aaa ratings to at least $4 billion of sub-prime mortgages, before these securities lost as much as 90 % of their value.

"Some of the investors getting involved with (these complex structured assets) that relied on the agencies may not trust them again,'' said Steven Behr, global head of principal strategies at Royal Bank of Scotland Group Plc in London, Britain's second-biggest bank. ``They have a serious credibility issue in admitting to flaws.''

Moody's said that employees, not the company's practices, were to blame. Hence, the firing of the structured finance head, and the possible sacking of many others involved in said practices.

Credibility problem solved? I don’t think so. The article goes on to say that investors think the company is just looking for a scapegoat.

How could something like this have gone on for so long, and for so much, without senior management having known of such practices? Were the employees so good at hiding their practices, or senior management just bad at monitoring how their staff did their job?

When a new security is being contemplated by an issuer, who are there in the negotiating table right from the very beginning, together with his banker and lawyer? That’s right. The independent accountant and the rating agency.

Their purpose there is to jumpstart the due diligence process, so that by the time the issue is offered to the investor, all the kinks and wrinkles have already been identified, and a suitable opinion or rating produced for the benefit of the buyer.

What happens then if enough wrinkles are identified so as to kill the transaction?

Very often, the rating agency is paid a percentage based on the amount of financing. Without an actual financing, therefore, no fee for the rater. Sure, a minimum fee might be negotiated to pay for the rater’s cost and time expenses. But these are minuscule, and does not provide outstanding returns for the rating agency’s own shareholders.

Is it any surprise then that many of the large corporate implosions of recent memory included these supposed guardians of the investing public in the cast of characters?

Arthur Andersen was there every step of the way when Enron was structuring and executing many of its off-balance sheet transactions. Andersen was also there when Worldcom was misreporting its earnings. Both companies garnered good health reviews from the auditing firm. As a result of the blowups from these episodes, Andersen is no longer with us.

Now, with the implosion of the sub-prime market, we see a similar situation happening, with the rating agencies as major players.

These rating agencies were supposed to be the eyes and ears of the investors. They were supposed to sound the alarm bells at the first hint of mismanagement. Are these guardians confronted with conflicts of interest right from the start? After all, who pays for their services? Who shoulders their fees year after year? Who gives them repeat business year after year?

It’s not the investors, for sure, the ones whom they’re supposed to protect. The auditors and rating agencies are paid for by the very same companies and issuers they are supposedly guarding with a hawk’s eye. Where else will you see this kind of conflicted arrangement?

Do you see policemen’s salaries paid for by the criminals they’re supposed to go after? Or for that matter, are our nation’s soldiers paid for by the country’s foreign adversaries? No, and never will be.

Their services can and will only be paid for by those who require their services, the ones who commissioned them for protection. We all know what happens when these protectors start getting payoffs from those they are supposed to go after.

More from the same article:
Moody's said on May 21 that it had begun a review of its CPDO ratings after a report by the Financial Times said some senior staff were aware in early 2007 of a computer error. The glitch gave the top Aaa rating to CPDOs that should have been ranked as much as four levels lower, the FT said. Moody's altered some assumptions to avoid having to assign lower grades after fixing the error, the FT said.

The rating agency changed its assumptions to avoid assigning a lower grade to a transaction? Should a doctor change his diagnosis to avoid telling you that you’re sick?

Under company guidelines, a committee may only ``consider credit factors relevant to the credit assessment and may not consider the potential impact on Moody's, or on an issuer, an investor or market participant,'' Moody's said.

Should a doctor's decision to diagnose illness be determined by the chance to prescribe expensive medicine or major surgery to the patient?

It’s obvious a change in business model is in order for the rating agencies. The change should involve aligning their interest and compensation more with good service to the investor. Also, it is clear that compensation should not significantly change, depending on the outcome of their rating evaluation.

Advising investors is a public service. Perhaps significant income spikes for these “public servants” should be a major concern in the future.

Wednesday, July 2, 2008

Fed bailouts and moral hazard

US Treasury Secretary Hank Paulson said today in a talk that the Fed does not have the authority, nor has the mandate to, bail out non-bank financial institutions that find themselves in financial distress.

In a trend that started with Long Term Capital in 1998, to Bear Stearns early this year, financial markets have come to expect the Fed to come and bail out troubled large financial firms institutions, with the rationale that there are firms too big to fail. With the financial markets more inter-connected than ever, there is widespread belief that a failure by a large counter-party is bound to spread to the rest of the financial system, and hence, widespread sentiment that prudent policy dictates lifelines be extended during times of trouble for said privileged firms.

As Secretary Paulson correctly points out, this has created a breakdown in market discipline, as market participants took on larger and riskier bets, with the expectation of benefiting from the higher potential up-side, while being bailed out by taxpayer money in the event of a down-side. A moral hazard, in short.

This mentality is reflected in the compensation structure of many of these larger firms, where top traders are paid out a percentage of profits, but do not share in the losses when markets turn against their positions.

Secretary Paulson then went on to explain that there should be a mechanism in place that would preserve market stability during times of financial downturns, while at the same time not contribute to the breakdown of market discipline and engender a sense of riskless betting in the market.

Specifically what he points out is that US banks (and particularly non-bank financial firms) should be allowed to go into bankruptcy, and the Fed should no longer be expected to automatically inject money to save them. This will allow the courts and the markets, rather than policymakers, to make the crucial decisions of allocating capital in distressed situations.

I couldn’t agree more. This policy decision may have repercussions and backlashes in the near-term, as many investment banks face the prospect of bankruptcy, given the turbulence ahead. This will, however, reduce the risk-taking appetite of the market and engender a more prudent investment culture among investors and bankers.

There can be no way out of bad decisions. Bad decisions made by financial institutions are no exception. They will have to suffer the consequences so that in the future, they will learn to stay clear of unmanageable risks, and cut losses immediately once internally-acceptable risk parameters are breached.

As a Treasury Secretary who used to be part of the financial system that created this market culture, it is good to know he has this stand. No longer should already scarce government funds be used for bailout, and no longer should the already suffering taxpayer be forced to pay for failure caused by unrelenting greed and carelessness of a small group.

Banks will be allowed to fail. I can almost hear the most speculative funds scampering away from investment banks as I write these lines.

We all await Secretary Paulson’s further elaboration of this new policy direction.