US Q2 GDP: How Bad Was It?

Will we see a double-dip recession?

Advanced GDP estimates for the second quarter came in at minus 1% versus consensus estimates of minus 1.5%. While several news stories quoted various business economists declaring the end of the recession, the market reaction told a different story.  Stocks finished higher but just barely and below their pre-open futures indication before the release. More telling, while the US dollar sold off (generally a sign of increasing risk appetite), it not only sold off against commodity-bloc currencies and Sterling but also strongly against the Yen. Normally, a strengthening Yen is a sure sign of increasing risk aversion. What happened then was a general sell-off of the dollar as investors realized how weak the US economy really was. This offset any safe haven demand for dollars that was instead expressed in a repatriation of Yen.

In fact, the primary driver of GDP (final sales) was especially weak if one excludes public sector spending. In an almost exact repeat of the Q2 2008 GDP numbers, stimulus spending in the form of quick tax rebates as well as defense spending led to a large increase in government spending. Christina Romer, the Chairman of the President’s Council of Economic Advisors,  estimated the Obama stimulus program contributed 2-3% growth. However, these are largely one-off items that can be expected to disappear next quarter (taking away from growth in GDP).  The other major contributor to GDP was Exports less Imports. Exports contracted by a mere 7% while imports contracted by 15%, adding 1.5% to GDP. In other words, while the rest of the world contracted, it contracted less quickly than the US.

Against these pluses, we saw business investment contract again, personal consumption contract much more than expected,  and residential housing investment drop again (belieing any pick-up in housing). Inventory depletion, as retailers and wholesalers attempt to reduce inventory to levels that make sense compared with the much reduced level of sales, also pulled down GDP. Well-known business economists hailed the reduction in inventories declaring that inventory restocking will contribute to positive growth in Q3. However, I suspect that we may only get a modest restocking and that the effect of President Obama’s hugely expensive stimulus program will recede somewhat.

Moreover, other data showing increasing job losses and a progressively shorter work week are inconsistent with the number we saw and suggest the strong possibility of a larger negative number once revisions are made to the advance number.

Benchmark revisions to GDP that were released showed that GDP growth became negative earlier than had been previously thought, that the contraction was greater than previously thought and that growth in consumer spending has been negative since the beginning of 2008.  In fact, overstretched household balance sheets will probably restrain consumer spending for some time to come. In fact, as households continue to try to reduce the value of debt to net worth, we should see the US savings rate rocket up into double digits. Given that consumer spending makes up close to 70% of US GDP, this will put a heavy drag on GDP.

Household de-leveraging will continue for some time here in the US.  We seem to repeating the Great Depression experience in the US closely. 1930 was a year of optimism as the market seemed to have stabilized from the violent crash of late 1929. However, as the year wore on optimism faded as consumers and businesses waited for definite signs of a pick-up in the economy before spending any money themselves. We see the same thing this year. Fading optimism and no hard signs of a revival just a slow down from a heart-attack type pullback in the economy to one where we still continue to worsen. Perhaps we will see positive GDP growth in Q3.  But do not be surprised to see a double dip by late 2009.

The Sound and the Fury of the Bond Market Vigilantes

In Hamlet, Shakespeare wrote “Life is but a tale, told by an idiot, full of sound and fury, signifying nothing.” Would that it were so with the recent bond market sell-off. Instead, we see a move away from the flight-to-safety trade but also increasing inflation expectations, un-sustainable debt levels by the US government and severe distortions of the fixed income market by the Fed’s quantitative easing program. The latter has led to large amounts of convexity-related selling. These unwinds of Fed distortions have further to go, so fasten your seat belt.

Recently bond yields have been moving higher in the US. The yield curve has been steepening in dramatic fashion. Implied break-even inflation rates from the TIPS market have been rising steadily. Long-term swap spreads have begun to re-normalize. For example, the 10 year swap spread has moved from 10 bps to around 35 bps. Several reasons exist for the wild moves in fixed income markets. A continuation of these trends could stop any nascent recovery in its tracks. Unfortunately, it doesn’t look the US government or the Fed or any other governments or central banks are likely to react to these moves in the bond market until after it is too late.

First the good news: Recent economic data releases, both in the US and abroad, support a picture of moderating economic contraction. In other words, the rate at which the real economy has been contracting is slowing even if it’s not yet expanding. In fact, some forward-looking economic releases might even signal the end of recession. Historically, an upward sloping 10 year yield less 3 month bill yield spread has been the best predictor of 1 year forward GDP growth. An unwinding of the flight to safety back into risky assets was inevitably going to lead to higher bond yields.

Now the not so good news: The sell-off got started in recent weeks when bond market investors saw that the Fed would not cap certain key yield levels by accelerating its bond purchases. Had the Fed not engaged in quantitative easing on Treasuries, these yield levels would have been breached earlier in the year. As it was, this move was simply deferred. This shows the lack of control the Fed has over longer-term rates despite its massive quantitative easing program. Only if the Fed were willing to enter into full-scale monetization of debt could yields be pegged.

More not so good news: The force of the sell-off gained pace once the UK was warned about a downgrade to its sovereign credit rating. The secret message (which the rating agencies deny) was that the US would be next. US debt-to-GDP ratios will rise less quickly than the UK’s. Nevertheless, as John Taylor, the noted Stanford University economist, has stated, debt to GDP ratios for the US are set to rise from 40% to 80% under Obama with no reduction of those numbers in sight. Niall Ferguson, the Harvard University economist, has made the point that when debt held by foreigners grows to un-sustainable levels, governments will either default or monetize the debt through inflation. Politicians are just not willing to make the sacrifices in spending or taxation necessary to pay down the debt. The one great exception, of course, would be the first US Treasury Secretary, Alexander Hamilton. Who is willing to wager that Timothy Geithner is prepared to stand up to Obama and demand that the US government end its move toward socialism and come up with a realistic plan to pay down the debt in the out years?

More not so good news: Several prominent economists including Greg Mankiw of Harvard are calling for the US government to run significant inflation in order to reflate the housing market (and devalue the debt). While this has just started, once the magnitude of the pain of paying back the profligacy is established, more voices will call for a similar policy. Perhaps US government bond holders will be excoriated for their failure to agree to “shared sacrifice” as were the Chyrsler and GM creditors. In fact, the recent run up in yields has seen longer-dated TIPS break-even inflation rates rise. In other words, nominal yields have risen much faster than real yields at longer maturities. The break-even inflation rate curve is strongly upward sloping indicating that there is little risk of inflation for now but increasing risk in out years.

More not so good news: Chinese and large sovereign holders of US Treasury debt may actually be the part of the bond market vigilante posse. There is suspicion that the recent 2 year and 3 year Treasury auctions went well, as these sovereign investors chose to invest in short-term paper, and not longer-term, Treasuries. The image of bond market vigilantes conjures up gun-slinging prop traders hailing from Montana but working on Wall Street. What if they are actually Chinese, Japanese and Middle Eastern sovereigns? The leader of the Japanese opposition has called on the government to no longer purchase dollar-denominated Treasury debt just Yen denominated Samurai bonds. While this may only be campaign talk, it does show the level of concern. During the 2004-2006, with the Chinese reminbi significantly undervalued and pegged to the US dollar and the consequently large trade surpluses being run with the US, the Chinese bought large amounts of longer-dated Treasuries. This led to an abnormally flat or inverted yield curve, one normally associated with an impending recession but in this one that instead stoked the housing market bubble.

More not so good news: Large supplies of government debt around the world are weighing on markets as almost all major developed economies look to issue debt. There are only so many buyers of this debt. Most buyers have expressed a strong preference for shorter-term maturities. However, governments can not fund themselves all in short-term debt and need to have long-term debt in order to reduce the rollover risk. In fact, European countries have been relying too much on short-term debt due to difficulties with longer-debt issues. They are expected to shift debt issuance to longer maturities in the second half of the year. This will put further pressure on long-maturity governments. So the fiscal position of the US is compounded by every nation trying to do the same thing simultaneously.

More not so good news: The Fed’s quantitative easing interventions in the mortgage market, through its program to purchase $1.3 trillion worth of mortgage debt, has distorted the market for mortgages-backed securities severely. By artificially lowering yields on this debt, the Fed increased refinance rates and created a shortening of effective durations, implicitly supporting the 5-7 year sector of the US Treasury curve. As yields went higher, the Fed was successful in keeping down mortgage rates. As a result of Fed purchases of mortgages, mortgage-backed pass-throughs’ option-adjusted spreads (OAS) came into to -16 bps. Because mortgages yields are more correlated to swap yields than to Treasury rates, mortgage investors often hedge their positions by paying fixed on swaps. With rates pushed artificially low, mortgage duration shortened. Hedgers needed to cut their hedges and started to receive fix. This caused major distortions in the Treasury and swap curves. 30 year swaps spreads went to negative 45 bps while 10 year swaps were at 10 bps over Treasuries even as 5 year swap spreads were at 60 bps. However, mortgage investors woke up to the unsustainability of this situation, and in a few days, mortgage yields jumped close to 50bps. This rise in yields caused OAS to increase to 1bps. The increase in mortgage yields caused effective durations of mortgages to increase significantly. In order to hedge their portfolios, mortgage investors had to pay fixed on long-dated to swaps to match this duration increase. This caused fixed rates on long-dated swaps to blow out, with 10 year swap rates moving from around to 10 to 35 bps in just a few days. 30 year swap spreads also widened to just -10bps.

More not so good news: The move to 1bps OAS on mortgages is still artificially low. Look for this to widen out significantly more, leading to more duration-related selling and yet still higher yields (as well as a steeper swap spread curve). The Fed through its purchases of mortgages has caused a massive distortion that is now being unwound. As mortgage duration extends, future mortgage purchases by the Fed will support longer maturity Treasury issues. This has caused the 5 to 7 year sector of the market, in conjunction with large issuance, to trade very cheap relative to 2 year and 3 year paper and relative to 10 years and out.

ECB’s Credit Easing

ECB Surprises the Market by Agreeing to Purchase Covered Bonds

The European Cental Bank (ECB) once again eased policy, albeit begrudgingly, cutting interest rates to 1%, leaving the deposit rate at 0.25%. In addition, they left the door open to another cut to 0.75%, extended their repo facility to 1 year from 6 months and most surprisingly agreed to purchase 60 billion Euros of covered bonds. At first blush, this would appear to be a defeat for the Bundesbank hawks led by Axel Weber. On closer inspection, however, it now appears that despite having 26 members on the Governing Council, the ECB is being run for the benefit of Germany. The bonds they are buying are heavily represented by Pfandbriefs issued by German financial institutions. This purchase of bonds will help them. Moreover, unlike quantitative easing which pushes up the supply of money, Trichet has indicated that the proposed purchase of bonds will be sterlized. In which case, no monetary easing is being accomplished, just a support of credit markets.

What the Yield Curve is Telling the Fed?

Real Yields and Breakeven Inflation Expectations are Rising

The Fed should be worried. The recent aggressive steepening of the yield curve has been caused by a combination of both rising real yields and rising inflation expectations. A quick check of the implied break-even inflation rate of the 10 Year TIPS versus 10 Year Notes shows that inflation expectations have risen from 0.11% per annum at the end of the year just after the Fed started its quantitative easing to 1.6% per annum. While this is still a modest level of inflation, the rate of increase must be worrying and will likely restrain the Fed from capping nominal yields as many were expecting. With the Fed restrained in its purchases of governments and mortgages, there is nothing to keep yields from spiking higher with a subsequent steepening of the yield curve. Morover, TIPS also show that not only have nominal yields been rising but real yields have also risen as risk aversion wanes. Eventually, rising real yields caused by excessive government issuance of debt may choke off any private sector economic rebound.

Gilts Yields Hit New Highs Even As BOE Expands Quantitative Easing

Who Still Thinks that Quantitative Easing Can Flatten the Yield Curve?

The Bank of England yesterday announced that they would increase Gilt purchases by a further 50bln Sterling on top of the original 75bln Sterling. Despite this Gilt yields rose yesterday to levels that were higher than before the Bank of England’s (BOE’s) quantitative easing experiment started. The huge worldwide issuance of bond,s including the gigantic supply being issued by the UK Treasury, is increasingly leading to indigestion. Meanwhile both inflation expectations and real yields are rising as risk aversion wanes. Central banks have to decide will they target monetary aggregates/inflation or the shape of the yield curve? They can not control two different targets with one policy instrument. The only way to get the yield curve to flatten is to inject far too much high-powered money. If they do this, they risk an inflationary spiral. If they target an appropriate level of monetary aggregates, they risk a sharp rise in long-term yields which may choke off any incipient global recovery. The Bank of England by acting so aggressively may be leaning toward trying to control the shape of the curve. Mr. Market is telling them it will take much larger government debt purchases to accomplish this.

Moral Hazard, Time Inconsistency and Too Big to Fail

Did Concerns About Moral Hazard Dramatically Worsen the Global Financial Crisis?

The Role of Lender of Last Resort

While in the era of modern banking, most central banks have focused on targeting monetary policy aggregates or inflation or have followed a so-called Taylor rule, a more important function for central banks was recognized back in the 19th century.  English financial writer Walter Bagehot wrote that the role of a central bank in times of a liquidity crisis is to act as a “lender of last resort”, freely lending at a penalty rate against good collateral. As we will see, this sage advice was ignored on several occasions by policy makers during the recent global financial crisis, dramatically worsening the outcome.

Moral Hazard

Until the early 1970’s, moral hazard was a little known concept in the arcane world of insurance underwriting. The concept was not new, having been developed as early as 1600. In the context of insurance, it refers to the tendency of insured parties to take excessive risk since they no longer bear the full consequences of their actions. Insurance companies have long worried about optimal contract design, adding such features as co-insurance and deductibles, to reduce the moral hazard issues in underwriting.

In the 1970’s, the economics of information was developed by prominent economists such as George Akerlof and Michael Spence. They worried about problems of asymmetric information, moral hazard and principal-agent conflicts. Over time, the economics of information became more and more influential in both the economics and finance literature. However, policy makers did not seem to concern themselves with it.

However, moral hazard was certainly a real issue. In the 1980’s, the expansion of deposit insurance in the US, from $40,000 per account to $100,000, led to S&L’s, and other thrift institutions, taking large risks in real estate development, and funding them by attracting deposits up to the new higher insurance limits. This substantially increased the ultimate S&L bailout through the Resolution Trust Corporation (RTC).

By 2007, moral hazard had slowly seeped its way into policymakers consciousness. Some worried that IMF bailouts of developing countries created incentives for these countries to take excessive risk with their finances knowing that the IMF would backstop them in a liquidity crisis. (This despite the fact that the IMF was likely going to demand draconian measures by the bailed-out country). Similarly, central bankers and finance ministers worried that “rewarding” financial institutions and their stakeholders that got into financial difficulties would lead to excessive risk-taking in the future.

The Northern Rock: The Bank of England’s Debacle

As the subprime debacle worsened, in early August of 2007, BNP Paribas announced that it was suspending redemptions on two funds that invested in structured products, as it was no longer able to accurately assess their NAVs. This led to a large scale withdrawal of liquidity in the interbank lending market, with the LIBOR-OIS spread spiking upwards. Over the next month, Northern Rock, a thrift institution which relied, for about a quarter of its funding, on wholesale funding markets came under increasing strains. However, the Bank of England was unwilling to help finance a takeover by another UK institution due to concern about moral hazard. At the end of the day, however, after the first retail bank run in the UK in 150 years, the Bank of England and the UK Treasury, in fact, did intervene to protect retail depositors and lent Northern Rock money. In fact, Northern Rock had no subprime mortgages or toxic assets. It had made prime loans on UK real estate, and at the time, UK real estate values were relatively stable.

The end result of the Bank of England’s qualms about about moral hazard were to reduce the bank’s credibility. Their stance about not bailing out financial institutions was shown to suffer from time inconsistency, in that if a large institution did fail, they would not be able to stand aside and allow it to go into liquidation.  Not only did their credibility suffer but so did the British taxpayer. What could earlier have been a sale of an ongoing business to a high street bank, with some discrete assistance by the Bank of England, instead became a bank rescue and full-scale nationalization.

Bear Stearns: The Fed and Treasury Engineer a Takeover

In March of 2008, a delay accepting Bear as a counterparty until the next morning, on a swap with Goldman Sachs by a hedge fund, was interpreted on the Street as a loss of confidence by Goldman in Bear as a counterparty. Hedge funds supplied significant credit to Bear through Bear’s prime brokerage business, one of the larger prime brokerages on the Street. When word got out that Goldman was no longer accepting Bear as a counterparty, hedge funds began pulling funds. Within days, Bear was forced to turn to the Fed for funding.  While Bear was a primary dealer, meaning that it could participate in the Fed’s open market repos, it could not access the discount window like a commercial bank. Hence it had no lender of last resort.  However, the Fed utilized a little known provision of the Federal Reserve Act for the first time since the 1930’s to provide funds to Bear in return for good collateral for a few days. This was the Fed acting as a lender of last resort. However, this was for just two days, not as a long-term affair. Over the weekend, the Fed and Treasury engineered a takeover of Bear by JP Morgan by agreeing to guarantee a $30 billion portfolio of structured assets against losses in excess of $1 billion.   Had Bear not agreed to the punitive takeover, it was going to have to declare bankruptcy on Sunday night as the Fed was unwilling to roll over its collateralized lending. In order to reduce moral hazard, the government decided that Bear shareholders (which included a large representation from management and employees) should be punished. They forced Bear management to accept a price of just $2 per share even though Bear stock had stop trading around $30 per share on Friday evening. The Fed then immediately created a new program to lend against collateral to non-bank primary dealers. However, this was too late for Bear. Had this program been in place before Bear agreed to the takeover,  it is certainly possible that Bear could have survived by posting collateral at the Fed.

Even more bizarrely in the case of Bear, Bear shareholders demanded a better deal. The Treasury and Fed were fiercely opposed to this, and tried to prevent JP Morgan from raising its offer, yet Bear shareholders were able to extract $10 per share from JP Morgan, indicating that the government’s price was far too low. Just as strangely, Bear preferred equity and debt holders were left whole. Indeed, Bear debt rallied since it would now be assumed by the much safer JP Morgan. Did this send the right message to the market? Or did the market draw the conclusion that while equity holders would be decimated, debt holders and preferred equity holders would take no loss and large institutions would not be allowed to fail?

Indeed, ever since the bankruptcy of Franklin National Bank in1974, senior debt holders at US banks had, in practice, been protected even though a bank was declared insolvent by the FDIC. Since Bear was a broker-dealer, it seemed that this protection was being extended to broker-dealers as well.

Fannie and Freddie are Seized

As the crisis wore on, we witnessed the saga of Freddie Mac and Fannie Mae.  Both institutions were at once, private entities with a  private profit motive, but at the same time, a Congressionally chartered institutions with a responsibility to finance residential mortgages. Both institutions operated with an implicit guarantee of the Federal government behind them. Such a guarantee was a perfect example of the kind of thing that could lead to moral hazard. Indeed, the incoming Bush administration recognized this and tried to reign both in, but they had powerful lobbyists and influential backers in Congress, notably Barnie Frank. The two mortgage agencies used this backing to run a business that was a like a highly leveraged bank all the time paying lucrative dividends to their shareholders.

By 2008, Fannie and Freddie were already insolvent based on standard generally accepted accouting principles (GAAP) accounting. However, they operated under a different set of regulatory accounting rules (RAP). They were still far from their insolvency floor, but approaching it when, in the summer of 2008,  Henry Paulson, the Secretary of the Treasury, announced a government back-up line of credit  essentially making explicit what had long been assumed by the market. However, a few months hence, in early September, the Treasury abruptly forced the boards of both Freddie and Fannie to agree to a government receivership. The Treasury claimed that both were in much worse shape than had been previously revealed. At the time, the government also provided a backup that essentially rendered not only the common equity but also the preferred stock worthless despite the fact the both Fannie and Freddie were still far from insolvent based on RAP accounting. Moreover, regulators had encouraged various banks, around the country, to buy preferred stock in Fannie and Freddie. They were counseled that it was a safe place to invest capital. Some of these banks were severely affected by the government takeover of Fannie and Freddie.

The decision to, in effect, wipe out, not only the common equity holders, but the preferred equity holders as well, was done with the idea of moral hazard in mind. However, the message to investors was loud and clear. If the Treasury was hell-bent on wiping out preferred equity holders of a government charted institution, investors certainly could no longer expect protection at a purely private institution. This hit to preferred holders closed off to the banks, including Lehman Brothers, the possibility of raising additional Tier I capital by issuing preferred stock.

Lehman Bankruptcy: A Failure of Leadership or A Mis-Placed Concern over Moral Hazard?

A week later, Lehman was forced into emergency negotiations for funding.  Once again, just as the Bank of England, a year earlier, had refused to help fund the takeover of Northern Rock, the Fed and Treasury inexplicably refused to assist in facilitating any suitor taking over Lehman. Rather than act as a lender of last resort to prevent bankruptcy and a fire-sale, the Fed, in conjunction with Treasury, took a hard line. During tense negotiations over a weekend, Barclays and Bank of America who had both been circling decided to pass. Lehman was allowed to file for bankruptcy. Lehman’s bankruptcy caused illiquid Lehman debt holdings to be dumped onto the market causing an additional downward spiral in prices. A CDS auction to price the recovery on senior debt indicated that  such debt was valued at just 9 cents on the dollar. A global plunge in equity markets, world trade, business investment and consumer confidence ensued. Trillions of dollars of productive output were lost in order that Hank Paulson take a principled stand against his old competitor on the basis of moral hazard.

Senior debt holders, who would have come out whole in the case of a takeover, instead, faced a very low recovery on assets. Senior debt holders in other financial institutions would now have to worry that their holdings were not safe.  Within two days, as a result of the Lehman bankruptcy, AIG found itself with numerous large collateral calls on credit default swap (CDS) protection.  The Fed and Treasury saw AIG as an institution that was too big to fail (and one that owed Hank Paulson’s former employer Goldman Sachs lots of money) and provided emergency funding in return for a very high percentage of the equity.

So we have seen 3 important ocassions where policy makers, in their new found obsession with moral hazard, failed to act as lender of last resort and compounded the crisis. The ultimate cost on all three ocassions was far higher than the steps necessary to keep these companies afloat. As Lehman showed, large inter-connected financial institutions really are too big to fail. In the case of Lehman, the disruption to financial markets was so high as to send the global economy into a tailspin.

Large Financial Institution Regulation and Moral Hazard

After the Lehman debacle, central banks, no matter what they say, will be forced to intervene if they think a large financial institution might fail. Their threats to not support it will be deemed as not credible. So how should central banks deal with the problem of too big to fail? One way is to force the breakup of  large financial institutions into smaller organizations. This might help somewhat. These institutions can be wound down by the FDIC with relatively little disruption to the markets. However, they may not have the scale to compete with the remaining large foreign banks. The other way forward is through better prudential regulation of banks. Large institutions that are deemed too big to fail should be heavily regulated to prevent their taking advantage of this status. Such proactive regulation will largely eliminate the moral hazard that policy makers have worried so much about without hobbling their ability to act in a crisis.

Chrysler Bankruptcy: Raising the Cost of Capital for US Issuers?

Government Control over Senior Creditors’ Committee Risks Increasing the Cost of Capital for US Issuers

Even the New York Times commented on the extraordinary intervention of President Obama in the reorganization negotiations for Chrysler, when he critcized the actions of the small number of bond holders who were holding out for better term, which  ultimately contributed to the government decision to put Chrysler into bankruptcy.  Characterizing them as renegade speculators, he pandered to his base. He will undoubtedly win political points for his stance. However, he neglected to mention that the government wished to offer senior creditors a far smaller recovery on their debts than it was offering the junior claimants, the United Auto Workers union. Of course,  the bondholders produced far fewer votes for Mr. Obama than did the UAW.

Nevertheless, many studies of the international cost of capital have pointed to a lower cost of capital in countries where the legal system enforces and protects the right of corporate claimants. In some cases, this means that outside shareholders are treated equitably versus insiders. One advantage the United States has long had over many other jurisdictions is a well understood and tested bankruptcy code presided over by an independent judiciary free of political influence. Under a Chapter 11 bankruptcy, a company is given the opportunity to reorganize. The various creditor classes each form committees. However, the priority claims of the classes are recognized in a bankruptcy and it is nearly unthinkable that junior claimants would come out of this process with a greater recovery on their claims as compared with senior creditors. Yet this is exactly the proposal the Obama administration proposed. No wonder then that senior bondholders, with a fiduciary duty to their investors, objected.  What is stunning is that senior creditors that are also TARP recipients were all willing to accept a deal where they would be paid less than junior creditors.

The clear implication is that in bankruptcy, the TARP recipients, who will control the senior creditors’ committee, will do what they are told by the administration, rather than maximizing recovery for their shareholders and accept a plan substantially similiar to that that was offered by the administration. This corruption of the bankruptcy process still has the effect of removing the protections that senior creditors have long come to expect. In the future, when bond investors consider buying senior debt, will they demand greater spreads for supplying capital, since they can no longer be sure that their priority in the capital structure will be respected? Will the President of the United States denouncing private investors, who have kept Chrysler afloat until the government intervened a few months ago,  encourage investors to supply capital to another politically sensitive company? I think that is hard to imagine investors such as sovereign wealth funds or other high profile foreign investors wanting to get involved with such a company.

Quantitative Easing: Will It Work?

Bond Market Reaction to Quantitative Easing (QE)

Long-term bond yields around the world have been rising recently. Is this because the “green shoots” of recovery are apparent and  investors are moving to increase exposure to risky assets or  is it possible that despite the very low short-term overnight rates being set by major central banks around the world investors are choking on bond supply?

Several governments have started down the route of quantitative easing led by the US Federal Reserve.  A notable exception has been the European Central Bank (ECB), where the unwieldy nature of the Governing Council has led to speculation of bickering and deadlock, with some members pushing for more aggressive policy while those from the Bundesbank school are fighting to hold off cutting rates below 1% or moving to aggressive non-standard measures.

Quantitative easing is a policy that was developed as a response to a significant increase in real interest rates that occured in the United States during the Great Depression. As has been widely studied by economists, starting with Milton Friedman and Anna Schwartz in A Monetary History of the United States, the large contraction in money supply in the US during the 1930’s and the failure of the Federal Reserve System to counteract it, was largely responsible for the depth and length of the depression.

While, in recent history, central banks have preferred to target money supply growth through targeting of official overnight rates (allowing daily monetary aggregates to fluctuate rather than allowing interest rates to fluctuate), economic historians observed that nominal interest rates might approach zero but with deflation, real interest rates might be quite high, inhibiting a recovery in the real economy. In fact, just this problem came about again in the case of the bursting of the equity and property bubble in Japan. Japan was slow to adopt more aggressive monetary easing. Only after it bailed out its banks and followed a policy of quantitative easing did the Japanese economy begin to recover. In the meantime, Japan suffered the lost decade of the 1990’s.

Fed Reserve policymakers, especially Chairman Bernanke, an economic historian who had studied credit intermediation during the depression, were very aware of the problems that Japan had jump-starting its economy. The Fed even held a symposium on this topic at one of their annual Jackson Hole retreats.  During the Japanese experiment with QE, the government was successful in flattening out the yield curve lowering longer-term interest rates. However, it has been criticized for injecting money into the banks which then hoarded cash.

The Fed decided to go about QE in a different way by purchasing debt in the secondary market. First they started with mortgage paper. This has been followed up by the purchase of government securities concentrated in the 2 to 10 year sector. Much blather has been written about the negative implications of the central bank  (whether in the US or the UK) monetizing debt. In fact, the Fed and Bank of England have simply been increasing money supply through open market operations just as they would have if they had been targeting overnight interest rates. The only difference is that when targeting overnight interest rates, central banks are constantly entering the repo market to increase or decrease money supply to keep rates nearly fixed. However, once interest rates are pegged near zero, they must instead target money supply directly.

The Taylor rule, a rule developed by John Taylor of Stanford University, describes both how central banks typically act and as a prescriptive formula for how they should act. Fed staff currently believe that the Taylor rule, given current economic conditions,  would imply a negative 5% overnight interest rate were that possible. So quantitative easing is absolutely necessary to increase money supply sufficiently to stave off a deflationary downward spiral accompanied by a  surge in real interest rates.

However, the bond market has seen yields backing up, not just in the US, but around the world. The only historical evidence that quantitative easing can affect the shape of the yield curve was the experience in Japan. Earlier academic studies of  “Operation Twist”, conducted during the Kennedy administration, came to the conclusion that trying to change the shape of the yield curve was ineffective. A basic tenet of economic policy is that one needs as many tools as policy targets. Given only a single tool of monetary policy (i.e. the supply of high-powered money) which is targeting an increasing in money supply, it seems unlikely that it could also control a second variable like the shape of the yield curve.

Instead, what seems likely is that the recent bear steepening of yield curves around the world is a reaction to the massive and simultaneous deficit financing by every major industrialized country.  It is hard to find a comparable period in the past where every government has tried at the same time to massively increase debt. Moreover, these increases in debt dwarf the quantitative easings being undertaken.

We do know, however, what happens when governments increase debt issuance. We have only to look at the experience of German re-unification. This was a hugely expensive episode for Germany with the issuance of large amounts of Treuhand bonds. In order to attract capital to purchase these bonds, real yields in Germany rose. The value of the Deutschemark also rose in the foreign exchange markets as investors bought Deutschemark’s in order to capture these high yields. Now imagine a situation of a couple of orders of magnitude greater than that. We may see the biggest debtor nations (including the UK and the US) see their currencies appreciate and their bonds yields rise significantly. Both effects will lead to a significant drag on any recovery, in turn making their deficits worse.  Meanwhile those countries like Germany that have been reluctant to spend on stimulus will still reap the spillover benefits of stimulus in other countries, while enjoying lower domestic bond yields and a weaker currency. Of course, given the current inaction of the ECB, Germany may need the weaker currency and lower bond yields.

German Toxic Debt

More than $1 trillion of Bad Debt in German Banking System

A leaked report in the Sueddeutsche Zeitung today indicates that there is over $1 trillion of bad debts in the German banking system with the landesbanks looking like they may all be insolvent. Just as has been speculated in Spain, where the Spanish savings banks, which lend to residential construction, perhaps all being bailed out by the government, a similar disaster appears to be developing in Germany.  The two largest commercial banks may also need some help. Commerzbank apparently has a large toxic asset portfolio. Deutsche Bank has very low levels of reserves relative to non-performing loans.

The government appears to be upset that the information was leaked to the market. Once again, we see that governments’ real motivations are not to clean up the system but to hide the extent of the problem. Cleaning up the system would be much more costly. However, cleaning up the banks and recapitalizing is what is needed to start growth again. European banks appear to be far more leveraged than their US counterparties and far more exposed to eastern Europe. The cover-up of true conditions at banks is what has made the banks reluctant to lend to each other.

The FED’s Stress Tests

Stress Tests to Reveal Substantial Increases in Capital?

The Fed released its much anticipated paper on the stress tests at the nation’s 19 largest banks (those with assets of greater than $100 billion) on Friday. What is was not in the paper was at least as interesting as what was in it. In particular, the Fed failed to lay out the specific loss assumptions it was making with regard to different types of collateral and counterparty risk. Moreover, the Fed was silent about how many banks have problems that require significant additional capital. Some bank analysts have estimated that new capital needed could be as high as $1 trillion. Even if this comes out to be grossly overestimated, we are likely to see Citigroup, BofA and  Wells Fargo needing additional capital as well as several regional banks with large commercial real estate loan portfolios.

Those banks which are deemed to need additional capital under the most adverse scenario (which is only a bit worse than private sector economists’ base case) will have 6 months to obtain new capital from the market. A big question is will that capital be forthcoming and will the Treasury actually be in a position to provide sufficient additional capital if the banks are unable to obtain it from the private sector.  The Treasury has almost depleted the TARP funding. And rather than obtain additional funding for the banks, the Obama administration instead chose to spend its political capital getting things passed for its constituencies. Indeed, the Obama administration went on its own Wall Street bash whipping up the flames of passion on this issue and virtually guaranteeing no further Tarp money.

Without strong recapitalizations, is the US doomed to repeat the lost decade of Japan in the 1990’s?