Conventional wisdom says that the mess that the banks are in is due to a lack of regulation, which meant that banks did things that they shouldn’t really have got involved with. And they did these things with lots of leverage, just for good measure. This widely held view is true, but rather understates matters. Banks have been building up leverage for not just the last few years, but arguably for ten or even twenty years. Higher leverage was made possible by the issuance of things like Asset Backed Securities (ABS) and Mortgage Backed Securities (MBS), which in reality were just another way for banks to issue more debt, but under a different name. The concept of ABS and MBS was peddled as a new, uncorrelated asset class. Products such as CDOs were created over a decade ago, and these invested in things such as ABS and MBS. Huge demand for structured credit enabled banks to issue more and more of the stuff.
People have balked at just how much leverage banks and investment banks managed to take. Officially, a number of investment banks have leverage of some 20 times, so the value of their assets is 20 times as big as the equity that is supporting it. To put this in perspective, for a company that is 20 times levered, it only takes a 5% fall in the value of the assets for the equity to be worthless and the bank to be insolvent. (Anyone buying a house is in a similar position – if you buy a £300k house with a £60k deposit, you have £60k of equity and £240k of debt, so you are 4 times levered. If the value of the house falls by £60k, or 20% in value, then your equity is wiped out and you’re in negative equity, ie technically insolvent). It’s worth adding that the banks’ scary official leverage figures grossly understate their true positions – once you add back all the off balance sheet vehicles, some banks (who’ll remain nameless) are more than 50 times levered, so it takes less than a 2% fall in the value of their assets to make banks rush to markets for more equity (and if they can’t raise money, they go under).
The other very big part of the story revolves around how monetary policy is set. Banks were encouraged to lend even more aggressively by monetary policy being incredibly lax in 2002-2006. Central banks kept interest rates too low for too long, because they were worried about deflation. The consequence of their actions, though, was that in keeping rates artificially low to prevent deflation, central banks encouraged rampant borrowing, and caused an excessive boom in economic activity, resulting in huge bubbles in housing and commodities.
I agree that inflation is bad, and monetary policy should prevent it from becoming entrenched. However the global dynamic 5 years ago was for prices to fall, which was a direct result of the opening up of China’s economy and the dramatic fall in the prices of manufactured goods. Central banks should have let inflation fall to zero or below. By not letting that occur and keeping rates artificially low, they helped to cause both the big boom of 2003-07 and the big bust we’re now experiencing. They were petrified of the ‘Japan scenario’ of a decade of deflation and weak growth, but Japan’s decade of deflation followed their own huge real estate and stock market bubbles.
Time will tell, but in trying to prevent a Japan scenario, there is a very real risk that they have ironically caused one. The huge deleveraging that is going on right now will cause economies to shrink, and inflation to sharply fall. Ben Bernanke and the Federal Reserve have got it right – interest rates have to be slashed to avoid a depression. UK and European central banks need to follow suit, and the longer they wait, the deeper the pain.
I think it’s worth looking back at a comment I wrote in November last year on how the global economy had reached a ‘Minsky moment’. In brief, economist Hyman Minsky unerringly predicted the boom and bust of tech stocks, and events of the last few years have followed the same classic Minsky pattern. Minsky argued that periods of stability breed periods of instability, where prolonged economic stability results in investors taking on more and more risk. The economy becomes increasingly leveraged, thus making the whole system inherently unstable. The ‘Minsky moment’ is when risk appetite goes into reverse, leading to a collapse in asset values. As I argued last year, the Minsky moment occurred in July 2007, and I stated our team’s strong belief that the repricing of risk had only just begun.
We’re now more than a year down the road from when the Minsky moment occurred. Deleveraging has continued, but as Richard argued on Wednesday, leverage in the banking sector is still extremely high, particularly when you add back all banks’ off balance sheet assets. It’s the fall in the value of these assets that has caused so much distress in the banking sector over the past few days/weeks/months. The process of deleveraging will continue to cause pain, with economies shrinking, and crucially for us bond investors, inflation falling.
A significant side effect this week has been the complete seizing up of liquidity. Corporate bond markets have been illiquid for over a year, but this week has been truly exceptional. Anyone wanting to trade anything but the biggest, most liquid bond issues has been penalised heavily, with bid-offer spreads of up to 5% in some cases. Needless to say, the subordinated bank bonds have been particularly illiquid, and forced sellers of these bonds are in an extremely difficult position (these are bonds that we’ve been very heavily underweight, for reasons that Ben listed in August).
The seizing up of the cash bond market and the serious problems facing banks and investment banks has inevitably had an impact on the liquidity of the credit derivatives market too. Credit Default Swaps (CDS) are over-the-counter instruments, so anyone entering into a contract is exposed to counterparty risk, albeit this risk is mitigated with regular posting of collateral. Investment banks are increasingly unwilling to hedge out CDS exposures with eachother, owing to the recent increase in counterparty risk. The result of this is that liquidity in the CDS market has fallen, although the CDS market remains more liquid than the underlying cash bond market.
As I’ve already said this stance was no surprise but, I continue to find myself gob smacked by the ongoing assertion that firstly, lending to non financial corporates remains robust, and secondly that there is little if any sign of a credit crunch. Yes, lending to non financial corporates is still growing at double digits but the data is a) backward looking, b) susceptible to substitution effects and c) further inflated by companies, like Porsche, who are able to arbitrage the system; drawing down on cheap financing locked in at the height of the market (see here).
In an environment where banks are being forced to delever, are faced with huge redemption profiles and witnessing their costs of funding continuing to rise to all time highs, there has to be implications for their willingness and ability to lend in my opinion. This is how the weakness in the financial sector is already being transmitted to the ‘real’ economy in Europe and is set to continue. Admittedly, when pushed, there was some acceptance that if the current difficulties don’t pass anytime soon, then the risks of a downward spiral increase.
Personally I don’t really see an end in sight and nor do I rate my team’s chances against Manchester United in this weekend’s big game at Anfield. I hope I’m wrong about the latter.
Our chief economist, Steven Andrew, and I are just back from a research trip to Washington. To some extent our visit was overtaken by this weekend’s events and the government bailout of the GSEs (Freddie Mac and Fannie Mae), but there was tangible nervous excitement in the air that anticipated that something big was about to happen – plus we’d had the shocking rise in US unemployment out on Friday morning that took the jobless rate to 6.1%, already higher than it was during the 2001 US recession.
The majority of our conversations were not for attribution – this is election year after all, with a new boss coming in November, and nobody wants to make a career-limiting statement in today’s job market – but we saw senior officials at a number of Federal departments and the mood was one of serious fear and despair. Treasury Secretary Hank Paulson summed it up in a press conference following the GSE bailout – “This is the first time in my career I had trouble sleeping”.
Fears about inflation have quickly disappeared – the inflationary pressures of high commodity prices were absorbed into corporate profitability, which allowed the authorities to breathe a sigh of relief. Deflation talk is back, as is talk about Keynesianism and the Federal government having to embark on a Japanese style infrastructure building programme to keep people in jobs and to get a multiplier effect going. There is little hope that the boost to second quarter GDP from exports is a repeatable event given the significant slowdown in European and Asian growth in the last month or so. The scariest comment of our trip came during our most important meeting, with a senior economist. He said “This is what happened in the Great Depression. We are replaying the early stages of the Great Depression”.
We also had meetings with private sector bodies, including both right and left wing think tanks (one of which will be the economics brain of Barack Obama if he gets elected). We talked about the possibility of a bailout for the GSE’s. One view (from the right) was that support for senior debt holders in Freddie and Fannie would have to materialise – not because the government thought that this would stimulate domestic demand or stop house prices from falling, but to stop capital flight from the United States. The big holders of senior debt in the GSEs are the Asian Central Banks, who believed that this stuff was as good as US Treasuries, but with a slightly higher yield. Increasing nervousness that this was not the case could have jeopardised not just the mortgage backed markets, but also led to a flight out of US assets full stop, including the dollar and government bonds (who pays for the Keynesian economics if nobody buys US Treasuries?). The events that transpired perhaps support this idea; only senior debt holders should feel completely comfortable, and there is little prospect of the rescue plan significantly increasing the supply of mortgages to the US housing market. This saves the overseas investors, it helps the US banking system which also owns senior GSE debt, and it allows the government to fund itself in future – but it doesn’t do anything for the US consumer.
A topic that we tried to investigate was the potential for the United States to lose its AAA credit rating given the massive increase in fiscal spending that comes as tax revenues start to collapse (income tax receipts are down 3% so far this fiscal year, and corporate receipts down 15% already – see the CBO’s website for more details). There was little support for this view (and the head of bond trading at an investment bank told us that the stupidest trade he sees all day long at the moment is people buying protection of the US government (paying 20 bps a year as insurance against a US sovereign default). His point was that if the US government isn’t there to pay its debts, his investment bank will have long gone bust! Remember that Japan was downgraded from AAA to A+ during it’s long deflation, but although the prospect of US deficits of $600 billion a year is a real one, the deficit probably still needs to be twice that to be in as bad a state as Japan. Also remember that Japanese bonds rallied down to 0.5% yields, despite those downgrades!
Finally, something from the best thing on the internet, The Daily Mash. Here’s its take on the GSE crisis: “US becomes world’s biggest council estate“.
1) Putting aside the question of why on earth would Alistair Darling publicly predict the worst economic downturn for sixty years, the more interesting question is how does he come to that conclusion? No other forecaster is predicting such a disaster, and they all have exactly the same economic inputs as the Chancellor (he might get the official statistics a couple of days earlier than us, but it’s a fairly level playing field). So what does Darling have that we don’t have? What is his edge, his inside information? Well the only thing he will know that the market as a whole doesn’t know is the true state of the UK banking system, and just how fragile it is right now. We therefore need to be even more worried about the banks than before.
2) I talked recently about the state of the UK public finances, and how this might lead to a steepening of the UK yield curve. RBC Capital Markets have predicted that gilt issuance will rise to about £100 billion next year. So I’m bearish on long gilts – but here’s why I’m bearish on short gilts too. Overseas holdings of the gilt market have risen from around 17% back in 2000, to around 32% now. The marginal buyer of the gilt market is no longer the traditional pension fund or insurance company, it has become the Asian and Middle Eastern Central Banks. These Central Banks have been awash with liquidity as oil and commodity demand has rocketed, and the earnings have been recycled into western capital markets through purchases of government bonds. Whilst the pound remained strong, this was a good bet, but over the past year its trade weighted value has fallen by about 15%. If the overseas Central Banks decide that sterling isn’t a good store of wealth anymore it could leave a big hole to be filled in the government’s gilt issuance programme. Central Banks have a strong preference for short dated gilts (sub 5 years to maturity) and this is the area that would be hit by any fall off in demand. That’s one reason why our long duration, bullish gilt positioning is based at the ten year area of the yield curve.
3) Finally freight. I’ve long noticed a good relationship between the price of shipping goods around the globe, and the level of the gilt market. Freight pricing seems to anticipate the level of global economic demand more quickly than most other economic indicators. I look at the Baltic Dry Index (BDIY Index GP for Bloomberg users). The charts show that freight prices peaked in mid May this year. Since then the price has fallen by 43%. This chance in freight sentiment began about a month before the gilt market started to reverse from a bear trend to a bull trend, and yields fell from 5.25% to 4.45% now. If you believe in the predictive powers of freight pricing there more bad news ahead of the global economy – it continues to make new lows – but more good news for the gilt bulls.