Thursday, September 13, 2012

Princeton Endowment Fearing a Liquidity Trap?

Kelly Bit and Janet Lorin of Bloomberg report, Princeton Endowment Expected to Rise Less Than 5% in Year:
Princeton University's endowment probably earned zero to 5 percent on its investments in the past fiscal year, according to President Shirley Tilghman.

The Ivy League school is expected to release returns for the year ended June 30 by next month. The endowment returned 22 percent in fiscal 2011, and 15 percent in the prior period.

“Better than we thought we were going to be, say back in January,” Tilghman said of the return range in an interview yesterday at Bloomberg LP’s headquarters in New York. “Clearly, after two spectacular years, we’re back on the ground again.”

The expected return range would mean there is no cushion this year for inflation because Princeton increases its budget by 5 percent annually, Tilghman said. Foundations and endowments produced the worst returns of any institutional investor class in the year ended June 30, gaining a median of 0.4 percent, consulting firm Wilshire Associates said Aug. 6.

Princeton’s endowment was valued at $17.1 billion in June 2011. It’s the fourth-largest in higher education in the U.S. and Canada, behind Harvard University, Yale University and the University of Texas system, according to an annual survey of endowments by the National Association of College and University Business Officers and Commonfund Institute.

Princeton’s endowment value dropped 24 percent in the year ended June 30, 2009, after the bankruptcy of Lehman Brothers Holdings Inc. in September 2008 crippled global financial markets.
Liquidity Fund

To prepare for a scenario in which assets fall to the extent they did during the 2008 financial crisis, Princeton created a liquidity fund more than a year ago, Tilghman said. The pool is separate from the university’s endowment and has about $100 million in assets, mostly invested in U.S. Treasuries, she said.

Princeton has been rebalancing its asset allocations, Tilghman said. The school, located in Princeton, New Jersey, planned to drop half of its private-equity managers, Chief Investment Officer Andrew Golden said in October 2010, a process that continues, according to Tilghman.

Princeton, one of eight colleges in the northeastern U.S. that make up the Ivy League, was founded in 1746 as the College of New Jersey. Alumni include first lady Michelle Obama and U.S. Supreme Court Justices Samuel Alito Jr., Sonia Sotomayor and Elena Kagan.
Whoah! Princeton Endowment plans to drop half of its private equity managers? That tells you endowments' love affair with private equity is over and that there is a changing of the old guard in that industry. If Harvard and Yale follow suit, will be a big blow to the industry's ego.

A brief reminder. Back in 2008, the sky fell on a lot of these alternative investments. Institutional investors who followed the mighty Harvard and Yale endowments, piling into alternatives, got decimated.  Why are endowments scaling back in private equity? Maybe because they see the flood of pension money entering the space and think it will dilute returns going forward.

Whatever the case, have no fear, Ben Bernanke is here. The Fed Chairman, who taught at Princeton for two decades before entering public service in 2005, is widely expected to announce another round of quantitative easing today.

It seems everyone has an opinion on whether or not the Fed should proceed with another round of asset purchases. The Guardian published an op-ed by Douglas Holtz-Eakin, president of the American Action Forum, claiming the Fed risks its credibility and that further expansion of its balance sheet makes the exit strategy even more complicated.

I won't bore you with the endless and often nonsensical arguments on pros and cons of QE3. It's embarrassing watching "respected" economists who don't know the first thing of QE and how it was used successfully in the past come on Bloomberg, CNBC, and elsewhere spewing all sorts of nonsense on the "perils of QE".

The bottom line is this: QE is far from perfect but if the Fed and other central banks didn't proceed with this course of action, we would have suffered another great depression. You can't have tight fiscal and monetary policy and expect to recover from the deepest  financial crisis in post-war history.

I have long maintained that the Fed and other central banks are fighting strong deflationary headwinds. They are doing, and will continue to do, whatever it takes to reflate risk assets, raise inflation expectations, bolster confidence, hoping this will allow banks to start lending again and get the economy moving again.

The problem is that the policy has thus far only benefited big banks, elite hedge funds and high frequency traders who thrive on volatility and done little to significantly boost employment growth. In other words, flooding banks with additional liquidity, as central banks have done recently via quantitative easing, has not led to much commensurate increase in bank lending or broad money.

Why is this the case? I think many of my readers should pick up a copy of an important book, Where Does Money Come From?. You can read the foreword and overview here but the key points are below:
We find that the most accurate description is that banks create new money whenever they extend credit, buy existing assets or make payments on their own account, which mostly involves expanding their assets, and that their ability to do this is only very weakly linked to the amount of reserves they hold at the central bank. At the time of the financial crisis, for example, banks held just £1.25 in reserves for every £100 issued as credit. Banks operate within an electronic clearing system that nets out multilateral payments at the end of each day, requiring them to hold only a tiny proportion of central bank money to meet their payment requirements.

The power of commercial banks to create new money has many important implications for economic prosperity and financial stability. We highlight four that are relevant to the reforms of the banking system under discussion at the time of writing:

1. Although useful in other ways, capital adequacy requirements have not and do not constrain money creation, and therefore do not necessarily serve to restrict the expansion of banks’ balance sheets in aggregate. In other words, they are mainly ineffective in preventing credit booms and their associated asset price bubbles.

2. Credit is rationed by banks, and the primary determinant of how much they lend is not interest rates, but confidence that the loan will be repaid and confidence in the liquidity and solvency of other banks and the system as a whole.

3. Banks decide where to allocate credit in the economy. The incentives that they face often lead them to favour lending against collateral, or assets, rather than lending for investment in production. As a result, new money is often more likely to be channelled into property and financial speculation than to small businesses and manufacturing, with profound economic consequences for society.

4. Fiscal policy does not in itself result in an expansion of the money supply. Indeed, the government has in practice no direct involvement in the money creation and allocation process. This is little known, but has an important impact on the effectiveness of fiscal policy and the role of the government in the economy.

The basic analysis of this book is neither radical nor new. In fact, central banks around the world support the same description of where new money comes from. And yet many naturally resist the notion that private banks can really create money by simply making an entry in a ledger.
That's it folks, banks can easily create money but they won't lend unless they feel confident they will be repaid and that the global banking system is liquid and solvent. That's why the Fed and other central banks have been pumping liquidity into the banking system, trying to bolster confidence.

Of course,demand for credit has to be there too. If people are deleveraging, retiring, scaling back fearing they will lose their job, then all the liquidity in the world won't increase the money supply. Keep this in mind the next time someone tells you the Fed controls money supply via interest rates. Banks ration credit but consumers have to want it or else money supply will never increase. This is why I don't agree with those who think more QE means hyperinflation.

Finally, Peter R. Fisher, senior managing director and head of fixed income at BlackRock, wrote an op-ed in the Financial Times warning, Bernanke risks creating a liquidity trap:
The Federal Reserve should stop trying to engineer lower long-term interest rates. Further efforts to manipulate the yield curve by driving interest rates lower runs too great a risk of leading us into a “liquidity trap” similar to the one that has plagued Japan.

Rather than force upon us a yield curve that is low and flat, the Fed should leave long-term rates alone and hope for a yield curve that is low and steep – one that provides stronger incentives for lending and investment.

The Fed, which makes its next monetary policy decision on Thursday, and other leading central banks have courageously expanded their balance sheets over the past five years since the onset of the financial crisis.

Had they not done so, a too-rapid deleveraging of our financial system would have made the recession even worse and the recovery even slower. We should applaud Ben Bernanke, Fed chairman, and his colleagues for their actions to offset the abrupt decline of private lending.

We should not be content with the current state of our economy. The Fed should aim for more rapid growth and job creation and adopt policies that pursue these goals. But what policies are those?

If low long-term interest rates encourage borrowing, would zero long-term rates encourage even more borrowing? More precisely, if the Fed suppresses the term premium entirely would we get more credit creation and economic activity?

Of course not: we would get less because zero long-term interest rates would discourage lending. There would be no reward for those willing to give up current consumption or liquidity. At the current low level of interest rates, the Fed needs to explain why suppressing the reward for lending will lead to more lending.

In his recent thoughtful remarks at Jackson Hole, Mr Bernanke explained that the Fed has been seeking to use the “portfolio balance channel” to stimulate the economy. By selling the Fed’s short-term bonds and buying more long-term ones, the Fed’s maturity extension programme both directly drives up bond prices and brings down bond yields and, at the same time, influences other investors’ portfolios in similar ways.

As the Fed hoards Treasury and agency securities, other investors are forced to replace those assets with a comparable amount of risk, and their actions should further bring down interest rates, ease financial conditions and encourage credit creation.

But the impact on other investors’ portfolios is more ambiguous. As the Fed hoards more long-term bonds and drags rates lower, some investors can and do “chase yield” with some of their portfolio by buying other risky assets, such as high-yield bonds.

Yet with each move higher in bond prices, and lower in yields, investors and lenders of all types reasonably fear the eventual reversal of this process when bond prices decline and yields rise.

Critically, as yields move lower investors can also observe the smaller opportunity cost of holding cash. So while one might think that investors will replace the bonds the Fed hoards with ones of comparable or greater risk, as the yield differential between bonds and cash is compressed investors can also choose to replace the bonds they give up with cash and other short-term cash equivalents.

The increasingly modest yields on bonds will not compensate for their potential volatility. Although cash may have a zero yield it also has zero volatility.

The Fed’s conditional commitment to hold short-term rates down for the next several years is an important way that the Fed can try to minimise investors’ fears of rates backing up soon or abruptly. But the more the Fed drags down the level of interest rates, the more attractive cash becomes on a relative basis, leading to a less-favourable portfolio rebalancing that looks just like a liquidity trap.

At Jackson Hole, Mr Bernanke candidly discussed both the benefits and the costs of the Fed’s unconventional policies, but the one cost he did not mention was the risk that holding down long-term interest rates could reduce incentives to lend to the point where leaving money “under the mattress” becomes the more attractive alternative.

The US economy is showing remarkable resilience in the face of the European crisis and the slowdown of the Chinese and other developing economies. Of course more rapid growth and job creation would be a good thing.

But it is time to face the simple truth that, as they approach zero, lower interest rates will not automatically create more credit and more economic activity but, rather, run the significant risk of perversely discouraging the lending and investment that we need.
A thought-provoking piece which basically states the obvious, namely, there are diminishing returns to successive QE programs.But as I mentioned above, the real problem isn't the liquidity trap but deleveraging cycle which has to run its course.

Below, CRT Capital's Ian Lyngen, OneStopOption.com's Alan Knuckman and Strategas Research Partners' Chris Verrone discuss Federal Reserve monetary policy. They speak on Bloomberg Television's "Street Smart."

And authors Tony Greenham and Josh Ryan-Collins explain the thinking behind the book, Where Does Money Come From?, and summarise its main messages.

Also embedded a lecture by Josh Ryan-Collins where he explains how banks create money, out of thin air, through the accounting process they use when they make loans. He also addresses 6 common myths about money and banking prevalent in mainstream economics.