http://www.prudentbear.com/2013/06/twenty-year-anniversary-of-market.html
Twenty-Year Anniversary of Market Backstops
June 7, 2013
The global government finance Bubble has seen at least its second crack develop.
The Fed's Q1 2013 Z.1 “Flow of Funds” was notable for the surprising ongoing lackluster Credit expansion throughout much of the private-sector. Even with continuing double-digit percentage growth in Federal borrowings, Total Non-Financial Debt expanded at a 4.6% rate during the first quarter (down from Q4 2012’s 6.5%). Household debt contracted at a 0.6% rate, a reversal from Q4’s 2.2% expansion. Surprisingly, Household Mortgage Debt declined at a 2.3% pace versus Q4’s 1.0% rate of contraction. Non-mortgage Household borrowings remained relatively strong, with Q1’s 5.7% pace down only slightly from Q4’s 6.5%. Corporate borrowings slowed from Q4’s blistering 12.1% pace to 7.6%.
The federal government’s domination of U.S. Credit runs unabated. Federal debt expanded at a 10.3% rate during the quarter, down only slightly from Q4’s 11.2%. Keep in mind that federal debt expanded 24.2% in 2008, 22.7% in 2009, 20.2% in 2010, 11.4% in 2011 and 10.9% in 2012. In nominal dollars, outstanding Treasury debt increased $337bn during the quarter, with a one-year gain of $1.078 TN. Treasury debt increased a staggering $6.655 TN, or 127%, during the past 19 quarters.
In seasonally-adjusted and annualized (SAAR) nominal dollars, Total Non-financial Debt expanded $1.850 TN, down from Q4’s SAAR $2.585 TN but still relatively strong. For comparison, Total Non-financial debt increased $1.872 TN in 2012, $1.325 TN in 2011, $1.472 TN in 2010, $1.058 TN in 2009, $1.921 TN in 2008 and $2.554 TN in 2007. At SAAR $1.198 TN, federal borrowings during the quarter accounted for 65% of Total Non-Financial Debt growth. For comparison, federal borrowings as a percentage of Total Non-financial Debt growth were 61% in 2012, 79% in 2011, 107% in 2010, 136% in 2009 and 64% in 2008. During the boom years 2006 and 2007, federal borrowings amounted to less than 10% of Total Non-financial Debt growth.
There are a few striking facets of the most recent Z.1 report from the Fed. Importantly, private-sector Credit continues to struggle in the face of ongoing ultra-loose financial conditions and inflating asset markets. Surprisingly, even with mortgage rates at all-time lows (along with the reemergence of house price inflation), Total Mortgage Credit contracted 1.9% annualized during Q1 to $13.091 TN. This follows Q4’s 0.4% gain, the first positive mortgage Credit growth since Q1 2008. Both Household and Commercial mortgage Credit contracted during the first quarter.
We’ll now watch with keen interest how the significant jump in borrowing costs impacts mortgage Credit and bubbling real estate markets more generally. Even a major refinancing boom and recovery in home prices was not enough to spur even positive growth in household mortgage borrowings. For households, low returns on savings have incentivized paying down mortgage debt. While this dynamic has helped improve the Household balance sheet, it has provided ongoing headwinds against a self-sustaining private-sector Credit resurgence. Said another way, despite years of zero rates, an historic increase in government debt and massive Fed monetization there is little to indicate a sustainable private-sector Credit expansion.
Total Bank Assets expanded $186bn during Q1 (to $15.244 TN), with Reserves at the Fed surging $299bn during the quarter to a record $1.790 TN. Bank loan growth slowed to a 1.3% pace, the slowest since the recession, as year-over-year loan growth slipped to 8.4%. Mortgage loans declined $38bn during the quarter after gaining $57bn during Q4. Miscellaneous Assets dropped $63bn (to $1.208 TN). Government securities holdings jumped $38bn, the strongest increase in a year.
Away from the banking system, Securities Broker/Dealer assets contracted slightly to $2.049 TN (down 0.7% y-o-y). Funding Corp assets were little changed at $2.166 TN (up 5.4% y-o-y). Securities Credit declined $28bn to $1.485bn (up 7.9% y-o-y). Finance Company assets declined slightly during the quarter (down 4.7% y-o-y) to $1.519 TN. Real Estate Investment Trust (REIT) assets were little changed for the quarter at $797bn (up 14% y-o-y). Credit Union assets expanded at a 9% rated during the quarter to $980bn (but up 3.8% only y-o-y).
With legislation in the works that would seek to “privatize” Fannie and Freddie, it’s worth taking a look at this quarter’s GSE data. Total Agency Securities (debt and MBS) jumped $47bn during the quarter to $7.591 TN, with a one-year gain of $58bn, or 0.8%. Despite the ongoing contraction in overall mortgage borrowings, Total GSE Securities are little changed from 2010 levels. Total GSE assets (holdings) actually increased $4.4bn during Q1 to $6.300 TN. From a year ago, total assets were down 2.1%, or $133bn. GSE (insured) MBS actually increased $26bn, or 7.2% annualized, during the quarter to $1.463 TN. GSE MBS jumped $133bn, or 10%, over the past year. In three years, GSE MBS jumped $456bn, or 45%. It will be a very tall order to ever privatize a largely nationalized household mortgage industry.
I also have no doubt that it is going to be very difficult to wean U.S. and global markets off of Federal Reserve QE liquidity. Federal Reserve assets surged $289bn, or 39% annualized, during the quarter to a record $3.244 TN. The Fed’s balance sheet surpassed $1 Trillion for the first time back in 2008. Fed assets are now on track to reach $4.0 TN near year-end.
There were a couple key aspects of past “Flow of Funds” analysis that came to mind as I made my way through recent data. I recall becoming increasingly concerned with mortgage Credit dominance over system Credit expansion back in 2005/06. And the longer that trend continued the greater my fear for the deep structural impacts that this unusual flow of finance was having on our financial system and the underlying real economy.
The dominance of Washington-based finance has similarly long overstayed its welcome. When the Fed was aggressively expanding its balance sheet in 2008/09, its purchases were essentially accommodating financial sector de-leveraging (the Fed providing a liquidity backstop for troubled banks, leveraged hedge funds, securities firms, REITs and such). Federal Reserve buying (monetization) over the past six months has been of an altogether different kind. Instead of accommodating de-risking/de-leveraging, the Fed purchases have instead incited risk-taking and leveraged speculation.
Even former Fed chair Alan Greenspan went public (CNBC) Friday with his call to begin tapering: “The sooner we come to grips with this excessive level of assets on the balance sheet of the Federal Reserve, which everyone agrees is excessive, the better… The issue is not only a question of when we taper down, but when do we turn? And I think that the markets may not give us all of the leeway we would like to do that.”
Well, the Fed is supposedly one of these days going to “come to grips with this excessive level of assets on the balance sheet.” But there’s a heck of a dilemma developing. The Fed has been using its balance sheet to stoke the asset markets, in the process incentivizing risk-taking and leveraging. If the Fed does at some point decide to restrict asset purchases, where will the markets look to for their coveted “liquidity backstop?”
I recall the 1993 bond market Bubble as if it were yesterday. I was confident in the analysis that extraordinary speculative leverage had accumulated through hedge fund trading and the derivatives markets. The Greenspan Fed’s low short-term rates and orchestrated steep yield curve created powerful market incentives and distortions. I was convinced that an inevitable bond market reversal would unleash considerable turmoil and market dislocation. And I was right, to a point. When the Fed moved to reverse its loose monetary policy in early 1994, many were stunned by the dramatic jump in market yields all along the curve. After trading at 4% in early January, 2-year yields spiked to 7.7% by year-end.
There was considerable pain and even a few fund failures. The surge in yields even precipitated financial and economic collapse in Mexico. At the same time, I was surprised that a major speculative de-leveraging wasn’t having a more profound impact on overall financial conditions. I suspected at the time that Fannie Mae and Freddie Mac purchases were providing the leveraged players an important liquidity backstop. The 1994 experience had a profound impact on my Macro Credit and Bubble Analysis framework.
“Flow of Funds” data tell the story pretty well. GSE assets surged an unprecedented $148bn in 1994, or 23%, to $782bn. With little fanfare, Fannie and Freddie had morphed from insuring mortgage securities to highly leveraged holders of mortgages and debt that were more than happy to buy huge quantities of securities (at top dollar) in the midst of acute market turbulence. And the GSEs were anything but finished in 1994.
GSE assets increased $115bn in 1995, $92bn in 1996 and another $112bn in 1997. When markets were rocked by the collapse of LTCM and attendant speculative deleveraging, the GSE’s expanded holdings an unprecedented $305bn in 1998 – followed by another $317bn in Bubble year 1999. The GSEs added another $822bn during the tumultuous 2000-2002 period. By the end of 2003, GSE assets had inflated to $2.4 Trillion, in the process playing an instrumental role in transforming the marketplace for mortgage finance, market-based Credit and speculative finance more generally.
In the late-nineties, I was explaining to anyone that would listen (basically no one) that the GSEs had evolved into quasi central banks. With the revelation of accounting fraud and malfeasance at Fannie and Freddie, the leveraged speculating community had lost their liquidity backstop. By then, however, the mortgage finance Bubble had gained such powerful momentum that a euphoric marketplace saw no reason to fret.
But as mortgage Credit came to so dominate the financial and economic systems, with each quarterly analysis of the Z.1 in the 2006/07 period I would contemplate how the system might function during the next period of market de-risking/de-leveraging. There was no doubt in my mind that the backstop function would rest exclusively with the Federal Reserve. Further, I believed a bursting of the Mortgage Finance Bubble would likely require Trillions of market liquidity support. The rest is history. I look at 2013 as nearing the “Twenty-year Anniversary of the Liquidity Backstop”
Well, this is year five of the “global government finance Bubble.” This Bubble encompasses the world’s securities markets. Having played such a profound role in fueling this Bubble, it’s not easy for me to conceptualize how central bank balance sheets will now be looked upon to backstop global markets in the next major de-risking/de-leveraging episode. A serious global de-leveraging would require multi-trillions of liquidity support, which I fear at this point might unleash currency and market chaos. Global central bankers have been doing everything possible to avoid a de-risking scenario.
The liquidity backstop issue becomes especially pertinent to the MBS marketplace. Pressure is (again) mounting for Fannie and Freddie to further shrink their holdings. It would appear they’re out of the market backstop business for good. Moreover, pressure mounts for the Fed to wind down its foray into mortgage support (“Credit allocation”). Meanwhile, as the Fed apparently prepares to back away from its historic experiment in suppressing market yields, the situation becomes only more intriguing. MBS are a particularly problematic security in a rising yield and extraordinarily uncertain market environment. Perhaps this helps explain why MBS yields are up 74 bps since May 1st and mortgage borrowing costs this week jumped to a 14-month high.
U.S. home buyers are not alone in confronting rising borrowing costs, while MBS investors have plenty of global company when it comes to contemplating prospective market liquidity backstops. Bloomberg’s William Pesek titled his most recent article “Specter of Another Bond Crash Is Spooking Asia.” “Developing” markets were this week showing heightened instability – bonds, currencies and equities. The thesis of problematic underlying financial and economic fragility is coming to fruition.
Indonesian equities were hit for 5.2%, the Philippines 4.6% and Thailand 2.9%. South Korea’s Kospi sank 3.8%, and China’s Shanghai composite dropped 3.9% this week. India was down 1.7% and Taiwan fell 1.9%. Brazil’s Bovespa dropped another 3.5% (20-month low) and Mexico’s Bolsa fell 3.3%. And while Eastern European equities held up better than “developing” Asia and Latin America, stocks in Turkey were slammed for almost 9% after an eruption of public protests and a rather undemocratic crackdown.
Market instability was certainly not limited to “developing” markets. Currency market instability now worsens by the week. The yen abruptly surged 3% against the dollar this week. The yen has a huge hedge fund short position and has surely been a source of cheap “carry trade” finance (sell yen and use proceeds to buy higher-yielding securities elsewhere). Moreover, the notion of Japanese institutions and retail investors flooding the world with liquidity as they escape the collapsing yen has played a not insignificant role in recent Financial Euphoria.
Nowhere did the perception of boundless Japanese buying power boost market sentiment more than in peripheral Europe. Notably, when the yen launched its Thursday melt-up, Spanish, Italian and Portuguese bonds were taken out to the woodshed (yields up 25, 23 and 27 bps, respectively). For the week, Portuguese 10-year yields jumped 54 bps to a six-week high (6.14%) – having now reversed the entire “Kuroda BOJ rally". Italian and Spanish yields ended the week somewhat higher, while their equities markets came under pressure. Notably, Italian stocks were hit for 3.0%. It is worth noting that European financial Credit default swap (CDS) prices jumped higher again this week – and it appears this important risk market has turned increasingly unstable.
Returning to the Fed’s Z.1 report, the Household Balance Sheet provides some of the most pertinent Bubble economy analysis. Household Net Worth (assets minus liabilities) inflated $3.0 TN during the quarter to a record $70.349 TN. One has to go back to the Bubble year 2005 ($6.308 TN) to surpass the recent one-year $6.164 TN gain in Household Net Worth.
It’s worth pondering a few analytical facts. Never has there been such a creation of (perceived) household wealth in the face of weak economic growth. Never has there been such a divergence between stagnant private-sector Credit expansion and inflating securities and asset prices. Never has there been such a strong correlation between federal debt and securities prices. And, I would add, never has there been massive QE in a non-crisis (non-deleveraging) market environment - directly fueling asset inflation.
I have posited that the Greek/European debt crisis was the first crack in the “global government finance Bubble”. Well, we are now witnessing the next important crack unfold in the “developing” markets and economies. And I don’t think it’s a stretch to suggest that another very important crack is emerging in the U.S. bond market (MBS, Treasuries and corporates). U.S. equities markets have shown resilience, not a shocking occurrence with sentiment so bullish and near-term QE effects so powerful.
With the rapidly deteriorating global financial environment hitting an already fragile economic backdrop, it would be better for systemic stability if some air started to come out of the U.S. equities Bubble. But as Bubbles become deeply entrenched and increasingly speculative, it's more the nature of distended speculative Bubbles to disregard faltering fundamentals until it’s too late.
Above I noted the lack of a self-sustaining private-sector Credit upturn. Four years ago, I was writing that Washington’s reflationary gamble “was betting the ranch.” Increasingly, the marketplace is coming to better appreciate the fragility four years of Credit and financial excess has wrought upon “developing” economies. "Money" has begun to flee some of these markets, and the lesson of rapidly evaporating liquidity is learned the hard way - again. Confidence that large international reserve holdings would provide a Liquidity Backstop for the “developing” markets is waning. Here at home, the surge in market yields (and widening spreads) in the face of the Fed’s $85bn portends future liquidity issues.
I noted above the “Twenty-year Anniversary of Market Backstops.” I wonder if historians will look back at this period as a strange aberration in financial history. If the Fed really plans on reining in its bloated balance sheet, then the markets will at some point have to contemplate a world without liquidity backstops. From my perspective, that would ensure higher global yields, wider Credit spreads and larger risk premiums generally. In such a world, I would expect corporate profits – inflated by enormous deficits and further inflated by Fed monetization and financial engineering – would deserve higher discount rates and significantly lower equities market valuations. But for now, the focus will be on how the emerging markets dislocation and the unfolding global “risk off” play out.
The Fed's Q1 2013 Z.1 “Flow of Funds” was notable for the surprising ongoing lackluster Credit expansion throughout much of the private-sector. Even with continuing double-digit percentage growth in Federal borrowings, Total Non-Financial Debt expanded at a 4.6% rate during the first quarter (down from Q4 2012’s 6.5%). Household debt contracted at a 0.6% rate, a reversal from Q4’s 2.2% expansion. Surprisingly, Household Mortgage Debt declined at a 2.3% pace versus Q4’s 1.0% rate of contraction. Non-mortgage Household borrowings remained relatively strong, with Q1’s 5.7% pace down only slightly from Q4’s 6.5%. Corporate borrowings slowed from Q4’s blistering 12.1% pace to 7.6%.
The federal government’s domination of U.S. Credit runs unabated. Federal debt expanded at a 10.3% rate during the quarter, down only slightly from Q4’s 11.2%. Keep in mind that federal debt expanded 24.2% in 2008, 22.7% in 2009, 20.2% in 2010, 11.4% in 2011 and 10.9% in 2012. In nominal dollars, outstanding Treasury debt increased $337bn during the quarter, with a one-year gain of $1.078 TN. Treasury debt increased a staggering $6.655 TN, or 127%, during the past 19 quarters.
In seasonally-adjusted and annualized (SAAR) nominal dollars, Total Non-financial Debt expanded $1.850 TN, down from Q4’s SAAR $2.585 TN but still relatively strong. For comparison, Total Non-financial debt increased $1.872 TN in 2012, $1.325 TN in 2011, $1.472 TN in 2010, $1.058 TN in 2009, $1.921 TN in 2008 and $2.554 TN in 2007. At SAAR $1.198 TN, federal borrowings during the quarter accounted for 65% of Total Non-Financial Debt growth. For comparison, federal borrowings as a percentage of Total Non-financial Debt growth were 61% in 2012, 79% in 2011, 107% in 2010, 136% in 2009 and 64% in 2008. During the boom years 2006 and 2007, federal borrowings amounted to less than 10% of Total Non-financial Debt growth.
There are a few striking facets of the most recent Z.1 report from the Fed. Importantly, private-sector Credit continues to struggle in the face of ongoing ultra-loose financial conditions and inflating asset markets. Surprisingly, even with mortgage rates at all-time lows (along with the reemergence of house price inflation), Total Mortgage Credit contracted 1.9% annualized during Q1 to $13.091 TN. This follows Q4’s 0.4% gain, the first positive mortgage Credit growth since Q1 2008. Both Household and Commercial mortgage Credit contracted during the first quarter.
We’ll now watch with keen interest how the significant jump in borrowing costs impacts mortgage Credit and bubbling real estate markets more generally. Even a major refinancing boom and recovery in home prices was not enough to spur even positive growth in household mortgage borrowings. For households, low returns on savings have incentivized paying down mortgage debt. While this dynamic has helped improve the Household balance sheet, it has provided ongoing headwinds against a self-sustaining private-sector Credit resurgence. Said another way, despite years of zero rates, an historic increase in government debt and massive Fed monetization there is little to indicate a sustainable private-sector Credit expansion.
Total Bank Assets expanded $186bn during Q1 (to $15.244 TN), with Reserves at the Fed surging $299bn during the quarter to a record $1.790 TN. Bank loan growth slowed to a 1.3% pace, the slowest since the recession, as year-over-year loan growth slipped to 8.4%. Mortgage loans declined $38bn during the quarter after gaining $57bn during Q4. Miscellaneous Assets dropped $63bn (to $1.208 TN). Government securities holdings jumped $38bn, the strongest increase in a year.
Away from the banking system, Securities Broker/Dealer assets contracted slightly to $2.049 TN (down 0.7% y-o-y). Funding Corp assets were little changed at $2.166 TN (up 5.4% y-o-y). Securities Credit declined $28bn to $1.485bn (up 7.9% y-o-y). Finance Company assets declined slightly during the quarter (down 4.7% y-o-y) to $1.519 TN. Real Estate Investment Trust (REIT) assets were little changed for the quarter at $797bn (up 14% y-o-y). Credit Union assets expanded at a 9% rated during the quarter to $980bn (but up 3.8% only y-o-y).
With legislation in the works that would seek to “privatize” Fannie and Freddie, it’s worth taking a look at this quarter’s GSE data. Total Agency Securities (debt and MBS) jumped $47bn during the quarter to $7.591 TN, with a one-year gain of $58bn, or 0.8%. Despite the ongoing contraction in overall mortgage borrowings, Total GSE Securities are little changed from 2010 levels. Total GSE assets (holdings) actually increased $4.4bn during Q1 to $6.300 TN. From a year ago, total assets were down 2.1%, or $133bn. GSE (insured) MBS actually increased $26bn, or 7.2% annualized, during the quarter to $1.463 TN. GSE MBS jumped $133bn, or 10%, over the past year. In three years, GSE MBS jumped $456bn, or 45%. It will be a very tall order to ever privatize a largely nationalized household mortgage industry.
I also have no doubt that it is going to be very difficult to wean U.S. and global markets off of Federal Reserve QE liquidity. Federal Reserve assets surged $289bn, or 39% annualized, during the quarter to a record $3.244 TN. The Fed’s balance sheet surpassed $1 Trillion for the first time back in 2008. Fed assets are now on track to reach $4.0 TN near year-end.
There were a couple key aspects of past “Flow of Funds” analysis that came to mind as I made my way through recent data. I recall becoming increasingly concerned with mortgage Credit dominance over system Credit expansion back in 2005/06. And the longer that trend continued the greater my fear for the deep structural impacts that this unusual flow of finance was having on our financial system and the underlying real economy.
The dominance of Washington-based finance has similarly long overstayed its welcome. When the Fed was aggressively expanding its balance sheet in 2008/09, its purchases were essentially accommodating financial sector de-leveraging (the Fed providing a liquidity backstop for troubled banks, leveraged hedge funds, securities firms, REITs and such). Federal Reserve buying (monetization) over the past six months has been of an altogether different kind. Instead of accommodating de-risking/de-leveraging, the Fed purchases have instead incited risk-taking and leveraged speculation.
Even former Fed chair Alan Greenspan went public (CNBC) Friday with his call to begin tapering: “The sooner we come to grips with this excessive level of assets on the balance sheet of the Federal Reserve, which everyone agrees is excessive, the better… The issue is not only a question of when we taper down, but when do we turn? And I think that the markets may not give us all of the leeway we would like to do that.”
Well, the Fed is supposedly one of these days going to “come to grips with this excessive level of assets on the balance sheet.” But there’s a heck of a dilemma developing. The Fed has been using its balance sheet to stoke the asset markets, in the process incentivizing risk-taking and leveraging. If the Fed does at some point decide to restrict asset purchases, where will the markets look to for their coveted “liquidity backstop?”
I recall the 1993 bond market Bubble as if it were yesterday. I was confident in the analysis that extraordinary speculative leverage had accumulated through hedge fund trading and the derivatives markets. The Greenspan Fed’s low short-term rates and orchestrated steep yield curve created powerful market incentives and distortions. I was convinced that an inevitable bond market reversal would unleash considerable turmoil and market dislocation. And I was right, to a point. When the Fed moved to reverse its loose monetary policy in early 1994, many were stunned by the dramatic jump in market yields all along the curve. After trading at 4% in early January, 2-year yields spiked to 7.7% by year-end.
There was considerable pain and even a few fund failures. The surge in yields even precipitated financial and economic collapse in Mexico. At the same time, I was surprised that a major speculative de-leveraging wasn’t having a more profound impact on overall financial conditions. I suspected at the time that Fannie Mae and Freddie Mac purchases were providing the leveraged players an important liquidity backstop. The 1994 experience had a profound impact on my Macro Credit and Bubble Analysis framework.
“Flow of Funds” data tell the story pretty well. GSE assets surged an unprecedented $148bn in 1994, or 23%, to $782bn. With little fanfare, Fannie and Freddie had morphed from insuring mortgage securities to highly leveraged holders of mortgages and debt that were more than happy to buy huge quantities of securities (at top dollar) in the midst of acute market turbulence. And the GSEs were anything but finished in 1994.
GSE assets increased $115bn in 1995, $92bn in 1996 and another $112bn in 1997. When markets were rocked by the collapse of LTCM and attendant speculative deleveraging, the GSE’s expanded holdings an unprecedented $305bn in 1998 – followed by another $317bn in Bubble year 1999. The GSEs added another $822bn during the tumultuous 2000-2002 period. By the end of 2003, GSE assets had inflated to $2.4 Trillion, in the process playing an instrumental role in transforming the marketplace for mortgage finance, market-based Credit and speculative finance more generally.
In the late-nineties, I was explaining to anyone that would listen (basically no one) that the GSEs had evolved into quasi central banks. With the revelation of accounting fraud and malfeasance at Fannie and Freddie, the leveraged speculating community had lost their liquidity backstop. By then, however, the mortgage finance Bubble had gained such powerful momentum that a euphoric marketplace saw no reason to fret.
But as mortgage Credit came to so dominate the financial and economic systems, with each quarterly analysis of the Z.1 in the 2006/07 period I would contemplate how the system might function during the next period of market de-risking/de-leveraging. There was no doubt in my mind that the backstop function would rest exclusively with the Federal Reserve. Further, I believed a bursting of the Mortgage Finance Bubble would likely require Trillions of market liquidity support. The rest is history. I look at 2013 as nearing the “Twenty-year Anniversary of the Liquidity Backstop”
Well, this is year five of the “global government finance Bubble.” This Bubble encompasses the world’s securities markets. Having played such a profound role in fueling this Bubble, it’s not easy for me to conceptualize how central bank balance sheets will now be looked upon to backstop global markets in the next major de-risking/de-leveraging episode. A serious global de-leveraging would require multi-trillions of liquidity support, which I fear at this point might unleash currency and market chaos. Global central bankers have been doing everything possible to avoid a de-risking scenario.
The liquidity backstop issue becomes especially pertinent to the MBS marketplace. Pressure is (again) mounting for Fannie and Freddie to further shrink their holdings. It would appear they’re out of the market backstop business for good. Moreover, pressure mounts for the Fed to wind down its foray into mortgage support (“Credit allocation”). Meanwhile, as the Fed apparently prepares to back away from its historic experiment in suppressing market yields, the situation becomes only more intriguing. MBS are a particularly problematic security in a rising yield and extraordinarily uncertain market environment. Perhaps this helps explain why MBS yields are up 74 bps since May 1st and mortgage borrowing costs this week jumped to a 14-month high.
U.S. home buyers are not alone in confronting rising borrowing costs, while MBS investors have plenty of global company when it comes to contemplating prospective market liquidity backstops. Bloomberg’s William Pesek titled his most recent article “Specter of Another Bond Crash Is Spooking Asia.” “Developing” markets were this week showing heightened instability – bonds, currencies and equities. The thesis of problematic underlying financial and economic fragility is coming to fruition.
Indonesian equities were hit for 5.2%, the Philippines 4.6% and Thailand 2.9%. South Korea’s Kospi sank 3.8%, and China’s Shanghai composite dropped 3.9% this week. India was down 1.7% and Taiwan fell 1.9%. Brazil’s Bovespa dropped another 3.5% (20-month low) and Mexico’s Bolsa fell 3.3%. And while Eastern European equities held up better than “developing” Asia and Latin America, stocks in Turkey were slammed for almost 9% after an eruption of public protests and a rather undemocratic crackdown.
Market instability was certainly not limited to “developing” markets. Currency market instability now worsens by the week. The yen abruptly surged 3% against the dollar this week. The yen has a huge hedge fund short position and has surely been a source of cheap “carry trade” finance (sell yen and use proceeds to buy higher-yielding securities elsewhere). Moreover, the notion of Japanese institutions and retail investors flooding the world with liquidity as they escape the collapsing yen has played a not insignificant role in recent Financial Euphoria.
Nowhere did the perception of boundless Japanese buying power boost market sentiment more than in peripheral Europe. Notably, when the yen launched its Thursday melt-up, Spanish, Italian and Portuguese bonds were taken out to the woodshed (yields up 25, 23 and 27 bps, respectively). For the week, Portuguese 10-year yields jumped 54 bps to a six-week high (6.14%) – having now reversed the entire “Kuroda BOJ rally". Italian and Spanish yields ended the week somewhat higher, while their equities markets came under pressure. Notably, Italian stocks were hit for 3.0%. It is worth noting that European financial Credit default swap (CDS) prices jumped higher again this week – and it appears this important risk market has turned increasingly unstable.
Returning to the Fed’s Z.1 report, the Household Balance Sheet provides some of the most pertinent Bubble economy analysis. Household Net Worth (assets minus liabilities) inflated $3.0 TN during the quarter to a record $70.349 TN. One has to go back to the Bubble year 2005 ($6.308 TN) to surpass the recent one-year $6.164 TN gain in Household Net Worth.
It’s worth pondering a few analytical facts. Never has there been such a creation of (perceived) household wealth in the face of weak economic growth. Never has there been such a divergence between stagnant private-sector Credit expansion and inflating securities and asset prices. Never has there been such a strong correlation between federal debt and securities prices. And, I would add, never has there been massive QE in a non-crisis (non-deleveraging) market environment - directly fueling asset inflation.
I have posited that the Greek/European debt crisis was the first crack in the “global government finance Bubble”. Well, we are now witnessing the next important crack unfold in the “developing” markets and economies. And I don’t think it’s a stretch to suggest that another very important crack is emerging in the U.S. bond market (MBS, Treasuries and corporates). U.S. equities markets have shown resilience, not a shocking occurrence with sentiment so bullish and near-term QE effects so powerful.
With the rapidly deteriorating global financial environment hitting an already fragile economic backdrop, it would be better for systemic stability if some air started to come out of the U.S. equities Bubble. But as Bubbles become deeply entrenched and increasingly speculative, it's more the nature of distended speculative Bubbles to disregard faltering fundamentals until it’s too late.
Above I noted the lack of a self-sustaining private-sector Credit upturn. Four years ago, I was writing that Washington’s reflationary gamble “was betting the ranch.” Increasingly, the marketplace is coming to better appreciate the fragility four years of Credit and financial excess has wrought upon “developing” economies. "Money" has begun to flee some of these markets, and the lesson of rapidly evaporating liquidity is learned the hard way - again. Confidence that large international reserve holdings would provide a Liquidity Backstop for the “developing” markets is waning. Here at home, the surge in market yields (and widening spreads) in the face of the Fed’s $85bn portends future liquidity issues.
I noted above the “Twenty-year Anniversary of Market Backstops.” I wonder if historians will look back at this period as a strange aberration in financial history. If the Fed really plans on reining in its bloated balance sheet, then the markets will at some point have to contemplate a world without liquidity backstops. From my perspective, that would ensure higher global yields, wider Credit spreads and larger risk premiums generally. In such a world, I would expect corporate profits – inflated by enormous deficits and further inflated by Fed monetization and financial engineering – would deserve higher discount rates and significantly lower equities market valuations. But for now, the focus will be on how the emerging markets dislocation and the unfolding global “risk off” play out.
Guest Post: Why the Fed Can't Stop Fueling The Shadow Bank Kiting Machine
- AIG
- American International Group
- Bank Failures
- Central Banks
- Commercial Paper
- Counterparties
- Countrywide
- Excess Reserves
- Fail
- Fannie Mae
- Federal Reserve
- Fractional Reserve Banking
- Freddie Mac
- Gross Domestic Product
- Guest Post
- Lehman
- Lehman Brothers
- MF Global
- Moral Hazard
- Nationalization
- None
- notional value
- Quantitative Easing
- Repo Market
- Shadow Banking
- Too Big To Fail
Submitted by Bill Frezza via Menckenism blog,
Fractional reserve banking is unlike most other businesses. It's not just because its product is money. It's because banks can manufacture their product out of thin air. Traditional commercial banks essentially create money through a well understood and time honored pyramiding of loans. Depositors who understand that their deposits are thereby placed at risk choose their banks accordingly.
Under the bygone rules of free market capitalism, only one thing kept banks from creating an infinite amount of money, and that was fear of failure. Failure occurs when depositors come to believe that their bank has lent out too much manufactured money to too many dodgy borrowers and may not be able to cover depositors’ withdrawals. When this happens, depositors rush to reclaim their money while there is still some left, leading to the bank’s collapse.
Under free market capitalism, banks compete along a spectrum of risk and reward.Conservative banks offer a higher degree of safety by maintaining larger reserves, thereby manufacturing and lending out less money. Through word and deed they let depositors know that they lend to only the most creditworthy borrowers, who generally must post valuable collateral. These banks remain profitable because they successfully attract prudent depositors willing to accept lower rates of interest.
Banks of a more speculative bent offer a lower degree of safety, maintaining smaller reserves to create and lend out more money. Seeking higher returns, they often lend to less creditworthy borrowers who may put up poor quality collateral or none at all. These banks attract risk-taking depositors looking for a higher rate of interest. They can be very profitable during periods of economic expansion but often fall into distress during economic downturns.
Periodic bank failures remind depositors of the connection between risk and reward.When caveat emptor rules, smart depositors who pay attention make money and dumb depositors who don't lose theirs.
Because the latter outcome is intolerable in a democracy, we have government-provided deposit insurance and other taxpayer-financed backstops that shield most depositors from the risk of loss. In theory banks pay premiums to fund this insurance. In practice these premiums are not risk-based. Banks are not penalized for making riskier loans, in turn often leaving the premiums too low to finance payouts. This creates a huge moral hazard, as it frees depositors to seek the highest return without regard for safety.
Worse, it removes conservative banks’ competitive advantage. Under a government-guaranteed deposit insurance regime, conservative bankers who want to stay in business must take on more risk in order to pay the higher interest rates necessary to attract depositors. This often sets off a race to the bottom, which results in periodic banking crises.
After each of these crises, politicians promise taxpayers that it will never happen again. And each time it does, the government creates a new set of labyrinthine regulations that attempt to mimic the business judgment of conservative bankers. Minimum reserve requirements are established, which normally become the maximum as there is little advantage in exceeding them. And both depositors and the bankers themselves become complacent about the banks’ investments because it is so easy to privatize gains and socialize losses.
Banks also learn that competitive advantage can be obtained by either gaming the regulations or having cronies write them. As regulations get more intrusive and complex, politicians discover that they can be used to advance social policies, such as increasing home ownership among voters with poor credit, thereby increasing the risk on banks’ loan books.
This mixed economic system is the one that replaced free market capitalism in hopes that it would prevent bank failures. Despite, and some even say because of, a regulatory regime that discouraged conservative banking and rewarded reckless mortgage lending, the banking system crashed - again - in 2007-2008.
What is not widely appreciated is that the ensuing government bailouts allowed an underlying shadow banking system to not only survive but grow even larger. It is called the shadow banking system because it operates outside most government-regulated banking laws. This is primarily because regulations and accounting standards haven’t caught up with the practices of these banks, which are relatively new and poorly understood.
It was the seizing up of the commercial paper and repo markets that funds the shadow banking system that abruptly halted the flow of liquidity that kept the mortgage bubble propped up. This revealed the underlying insolvency of Fannie Mae, Freddie Mac, and many commercial banks stuffed with subprime mortgage securities accumulated under the mixed economic system described above.
Powered by an exclusive club of primary reserve dealers, a group that once included high flyers like Lehman Brothers, MF Global, and Countrywide Securities, these shadow banks work hand in glove with the Federal Reserve to manufacture money by pyramiding loans atop the base money deposits held in their Federal Reserve accounts.
To the frustration of Keynesians, and despite an unprecedented Quantitative Easing (QE) by the Federal Reserve, conventional commercial banks have broken with custom and have amassed almost $2 trillion in excess reserves they are reluctant to lend as they scramble to digest all the bad loans still on their books. So most of the money manufactured today is actually being created by the shadow banks. But shadow banks do not generally make commercial loans. Rather, they use the money they manufacture to fund proprietary trading operations in repos and derivatives.
Where does the pyramiding come from if shadow banks aren’t making loans that get redeposited to fuel the cycle? Securities held as collateral by counterparties in a repo contract can be rehypothecated by the lender to obtain additional loans. (So can securities held in customer accounts, unless their brokerage agreements expressly prohibit it. This was an unwelcome discovery by MF Global’s hapless clients, who saw their assets whooshed off to London where different brokerage rules allow such hypothecation.) Loans made against securities held as collateral can then be used to either buy more securities, which can be fed back into the repo market, or trade a bewildering array of complex synthetic derivatives.
If this sounds like circular check kiting that’s because it is, especially when you add in the issuance of commercial paper required to grease the wheels. The biggest difference is that an embezzler kiting checks does not have the support of a central bank providing steady injections of liquidity, beefing up balance sheets that create confidence in their debt instruments.
How much of the original high quality collateral must shadow banks hold in reserve should some of their derivatives implode, as many did during the last crisis? Zero. By repeatedly spinning the wheel, the top 25 U.S. banks have piled up over $200 trillion in leveraged bets atop a thinning wedge of collateral, claims to which are spread across an opaque and complex chain of counterparties residing in multiple legal jurisdictions. These collateral claims are co-mingled with an estimated $400 trillion to $1.3 quadrillion in notional outstanding derivatives made by other banks around the world, altogether amounting to more than 20 times global GDP.
Due to the fact that accounting standards have not kept up with these innovative practices,banks are not required to report the gross notional value of the outstanding derivative contracts on their books, only their net asset positions. These theoretical Value at Risk positions, which would only be netted out if all the contracts were unwound in an orderly manner—as one might unwind a check kiting scheme before getting caught—can only be realized in a liquidity crisis if the counterparty chains across which these contracts are hedged hold up.
These counterparty chains froze in spectacular fashion during the last financial crisis. After the collapse of Lehman Brothers and with the insolvency of AIG looming, a chorus of politicians, bankers, and bureaucrats browbeat the government into delivering a system-wide bailout. As a result, many reckless banks and bankers that should have been driven out of the market are back doing business as usual.
The largest banks learned that they need not worry about the possibility of bankruptcy. When the next crisis hits, all they have to do is shout “systemic collapse” and another bailout will appear. Being Too Big To Fail, they can maximize profits without having to hold reserves against the risk of counterparty failure, knowing that the taxpayer will always be there to make them whole.
The solution is not more regulations, which will never keep up with the financial wizards whose lobbyists end up writing these rules anyway. In addition, trades can be made anywhere in the world, so to be effective the regulations would have to be global. As long as governments continue to prop up failing banks, regulation will always be inadequate to mitigate the moral hazard that accompanies bailouts. And, ironically, the added costs of regulatory compliance will make it harder still for smaller and more prudent banks to compete.
True to form, Congress has not solved the TBTF problem but has actually made it worse, loading ever more regulations on commercial banks through Dodd-Frank. Meanwhile, taxpayer exposure to the banking system has grown even larger.
Optimists believe that as long as everyone remains calm and keeps believing everything is fine, then everything will be. Central planning advocates hope that the kiting scheme can be unwound by extending banking regulations to cover the shadow banks while the Fed somehow weans them off of Quantitative Easing. Cynics believe that asking Washington to get the situation under control is a hopeless quest, especially since few Congressmen have a clue what is really going on.
Meanwhile uncertainty hangs over the systemsince bankruptcy laws, which differ from country to country, have not kept up withhyper-hypothecation. Moreover, the government’s handling of the auto bailout shows that investors cannot rely on existing bankruptcy law even when it speaks clearly on an issue. Therefore, no one really knows who will have first dibs on the collateral when the music stops. And just what are those high quality assets? Sovereign bonds and mortgage CDOs, which are themselves subject to precipitous losses.
As the debate drags on and global economic conditions worsen, the growing pyramid is being kept afloat by the easy money policies of central banks too frightened to withdraw their support lest a stock market correction trigger a cascade of margin calls that brings down the whole system—much like last time.
All this money creation has not yet generated much visible consumer price inflation. This is partly because official inflation measures are suspect but mostly because the bulk of the new money being created is flowing into financial assets and not the consumer economy. This has inflated asset bubbles to levels impossible to justify based on underlying economic conditions, in particular the stock market where investors have fled in search of yield. No one knows when the bubble will pop, but when it does a donnybrook is going to break out over that thin wedge of collateral whose ownership is spread across counterparties around the world, each looking for relief from their own judges, politicians, bureaucrats, and taxpayers.
When that happens and the clamor for regulation, nationalization, confiscation, and demonization arises there is only one thing we can be sure of. The disaster will once again be blamed on a free market capitalism that has not existed in this country for over 100 years.
Bill Gross Says Jobs Report Suggests Fed Won’t Taper Bond Buying
Bill Gross, manager of the world’s biggest bond fund, said the Federal Reserve is unlikely to reduce its asset purchases after the unemployment rate climbed from a four-year low in May.
“I don’t think today’s report says anything about tapering at all with unemployment going higher and metrics in terms of the work week and wages being very dour,'' Pacific Investment Management Co.’s founder Gross said in a radio interview on “Bloomberg Surveillance” with Tom Keene and Mike McKee. Fed Chairman Ben S. Bernanke “won’t taper. But I think ultimately in order to get a more normal economy, the Fed has got to move interest rates up to more normal levels.”
This Bloomberg item was posted on their website at 8:15 a.m. MDT yesterday...and I thank Ken Hurt for today's first story.
Greenspan: Taper Now, Even if Economy Isn't Ready
Former Federal Reserve Chairman Alan Greenspan told CNBC on Friday that the central bank should taper its $85 billion a month bond buying even if the U.S. economy is not ready for it.
"The sooner we come to grips with this excessive level of assets on the balance sheet of the Federal Reserve—that everybody agrees is excessive—the better," he said in a "Squawk Box" interview. "There is a general presumption that we can wait indefinitely and make judgments on when we're going to move. I'm not sure the market will allow us to do that."
Greenspan said he's not sure the markets will allow an easy exit. "Gradual is adequate, but we've got to get moving."
This CNBC interview was posted on their website early yesterday...and I thank U.A.E. reader Laurent-Patrick Gally for sending it our way.
Nigel Farage: Greece has been sacrificed on the altar of the failed euro experiment
In June 2011, I stood in front of the assembled ranks of Eurocrats – Barrosso et al – with a copy of the IMF charter in my hand and read it out. The IMF expressly rejects the idea of supporting currencies; it is there instead to support countries.
Now, exactly two years later, we find that the IMF – with the support of the political establishment of the European Union, including our own George Osborne and David Cameron – was preparing to gamble billions of pounds on a lie.
This gamble has resulted in liabilities being run up that will take generations to pay back. It has resulted in the destruction of millions of lives and the colonial depredation of a once-proud nation.
Nigel is never one to pull his punches, gild lilies, or suffer fools gladly...and his commentary here is typical Nigel Farage. It's worth reading...and I thank London, U.K. reader Iain Doherty for sharing this story from yesterday's Telegraph with us.
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