Over the past few weeks, when I haven’t been tending to sick family members or fighting off a head cold, I have been noting and pointing out things in the credit/money markets that are giving me pause and reasons for concern. In my mind, there’s a lot to be concerned about and folks focusing on the long end of the curve are focusing on the wrong end, for the wrong reasons.
Why? Because simply put, we’re not through with deleveraging and the forces at work to destroy debt (deflation) will overwhelm the forces to devalue currencies (i.e. inflation). There is still too much debt that has to be repaid, and quite frankly, some of it will not be.
I talked about the credit risk in mortgages that not only exists, but is still increasing. Consider the chart I pulled from the latest Mortgage Metrics report:
Those numbers do not speak of credit risk 5 yrs away, or 10, or 30. By the time you calculate the timing of recoveries and losses, it’s apparent this is an event that is 2 yrs away, at most.
So in building out near-term interest rates, we really need to consider all of the relevant risk premia to add. Default risk, liquidity risk, reinvestment risk, credit spread, and migration risk all come to mind in the near-term as risk premia to pay attention to in this environment. Under normal circumstances, almost all of them would be zero or near zero. But in case you haven’t noticed, well, do these look like normal times to you?
So back to the table above. I can tell you there are three risks that are increasing. Default risk is increasing because of the increases we see in the 90 days delinquent bucket (technically, that’s a default) and the loans in bankruptcy. Migration risk is increasing because as more borrowers migrate from performing to non-performing, it’s another indicator of poor credit performance. Which leads us to spread risk. Because as the first two risks are elevated, spreads over risk-free debt are elevated. Remember when Paulson talked about a “repricing of risk?” Well, that’s what he was talking about. And so Mr. Market comes to a point of recognition. “Holy crap, these things may not pay out!” Thanks for that, Mr. Obvious.
Also, I found this little tidbit at Institutional Risk Analytics:
Looking at the preliminary results for the IRA Bank Stress Index for Q4 2009, we do not see any indication that the crisis affecting commercial banks is at an end. Loan loss rates among US banks continue to rise for the twelfth straight quarter in a row. Cash flows from bank loan and securities portfolios alike are still shrinking, forcing further contraction in balance sheets, loan portfolios, cash balances and new loan allocations for bank managers. This is what you call deflation.
But it’s not just the mortgage market and bank balance sheets that are experiencing heightened credit risk. The sovereign debt market has seen these things occurring, too. The PIIGS are suffering from downgrades (i.e. downward migration – a sign of deteriorating credit quality), which probably had something to do with widening spreads amongst developed countries, overall. Is this the same as default risk? No, but downward migration is an indicator that default risk might be on the rise since jump-to-default risk is relatively rare. Tracking migration is important, and having good tools to do that helps. But in looking at rising risks in the developed sovereigns, this points to higher systemic risk as a whole right now. Note that I’m not talking about a bunch of things that are far into the future occurrences, these things are happening right now. Which, again, points to heightened risk at the front-end of the curve, not the back end.
Which means liquidity and reinvestment risk are also on the rise. Because with everyone focused on the sovereign debt of the PIIGS, I’ve been looking for where signs of stress would occur. The banks with the largest exposures to those countries and other sovereign entities strike me as the ones most at risk. This graphic from Bloomberg illustrates the issue quite clearly:
So all in, there’s about $1.4Tn in credit out to borrowers in those countries, and that exposure is found in French, German, Swiss, and British banks. But in looking for signs of stress, they’re not there, yet. But I found a little-known interest rate swap that should show that stress if/when it occurs. It’s the EONIA swap curve. I attached it here so you can see exactly how it works and how it’s used:
The chart below shows what the swap curve looked like at various times throughout the past three years:
You can see that at key moments over the past 3 years, the swap curve was inverted. But in spite of all of the talk about the PIIGS/Club Med countries of Europe, the swap curve has stayed upward sloping. Which is amazing, because even with events like this…
We haven’t seen a spike in liquidity/funding pressures. The question is how long can it stay like this.
If you read FT Alphaville at all (and you should), you get the sense those nice, upward-sloping curves may be a distant memory sometime in the not too distant future. To see what I’m talking about, go here, here, here, and here. There’s an awful lot of talk about liquidity and the draining of liquidity now. China is ratcheting up reserve requirements on banks to curb lending and credit growth, which I alluded to before.
Plus, the Fed is talking about interest rate risk. As the article points out, Fed Vice Chairman Kohn said the following:
“Borrowing short and lending long is an inherently risky business strategy,” Kohn said. “Intermediaries need to be sure that as the economy recovers, they aren’t also hit by the interest rate risk that often accompanies this sort of mismatch in asset and liability maturities.”
Let me illustrate:
So easy, even a banker can do it. But there’s one problem:
Lending to whom? And through what vehicle? It’s not loans to consumers and businesses, which is actually a prudent decision because you don’t save drowning victims by turning on a hose. Plus, credit demand is down. Sure some people say they can’t get credit, but that’s because you have to do more than merely turn oxygen into carbon dioxide to get a loan now. And so, the banks are buying long-dated Treasuries.
So Kohn is worried about funding costs staying as low as they are, for as long as they have. Funding costs/risks are the mirror image of reinvestment risks because with reinvestment risk, the focus is on sustaining the yields you received. Funding risk is the possibility that you’ll have a higher cost of funds tomorrow than you do today. Kohn also had this shot across the bow about losses due to interest rate risk:
“Banks and other investors cannot count on a repeat of the most recent experience — the absence of capital losses when short-term rates rise,” he said.
So if you put together the chart with Kohn’s statement, and you come away with one distinct impression: the Fed is unsure what will happen to the shape of the yield curve when they stop purchasing MBS, and they are openly wondering if the yield curve will invert. From FT Alphaville:
Securitization is fundamentally about one thing: liquefication of the balance sheet. It lowers liquidity risk. So the Fed, through its special programs was aiming to improve market liquidity, which would improve credit conditions overall.
Because liquidity and credit are very much the same issue: the best case scenario is that you get your money back. It’s just with a credit risk issue, it’s a question of repayment over years. For liquidity, it’s a question of repayment over days or weeks. So when viewed in that context, the Fed’s premise is simple: provide ample liquidity at the front end of the curve to instill confidence further and further out. If you take care of the liquidity issues, credit should take care of itself.
But I want to go back to Chris Whalen’s Institutional Risk Analytics piece for a minute because he had two very good points. First one is on what the Fed needs to do:
First, we believe that the Fed should end asset purchases in March as planned and then begin to aggressively make a two-way market in all of the securities it holds. The Fed needs to stop pretending to be an “investor” in these securities and start to redefine the private market for MBS by example. As other dealers begin to follow the lead and trade this paper with greater confidence, the Fed can stand back from the markets gradually. The objective here is not to sell the portfolio per se or even make a profit, but merely to restore the secondary market trading and thus improve pricing.
I think this is absolutely correct, but I have my doubts about whether the Fed will succeed in something like this. Because the securitization market is still frozen. Just because you’re the buyer of last resort doesn’t mean the market functions. And why not (emphasis mine)?
To date the entire focus of Fed policy efforts has been to temporarily spare the largest dealer banks from losses on securities and not helping the real economy. This fact is illustrated by the $2 trillion in Fed asset purchases to date. While Fed Chairman Ben Bernanke and his colleagues on the Federal Open Market Committee claim that these MBS and Treasury purchases have helped to keep domestic mortgage interest rates low, there is little indication that these operations are supporting actual credit availability for consumers and businesses at these yield levels. The only “winners” from QE are the financial institutions and foreign governments in Europe and Asia which forced the Fed to repurchase these assets at above-market prices.
Could very well be a mirage…
Because if the Fed can’t get ask prices that are even close to the bid they put into the market, they stand to lose money. A lot of it. And that balance sheet expansion they underwent would be seen as a total farce.
Which could drive liquidity premiums higher…
And would have some nasty, unintended, and unforseen consequences on the front end of the yield curve as well. And think about this for a second: a 25 or 50bp move will hurt more when your rates are near zero than it will when your rates are at say, 10 percent. It’s a law of large numbers effect.
So back to Chris Whalen’s piece (emphasis mine, again):
As noted above, if the Fed does not soon allow interest rates to rise so that banks and other investors may earn a positive return on assets, the natural process of re-pricing of assets will soon wipe-out any subsidy from the Fed’s ZIRP approach. In a fiat money system, ZIRP implies that paper assets have no value. If the Fed wants to break the deflationary cycle that now threatens the global economy and truly restore investor confidence, then it is time to let interest rates start to rise.
Which I believe is needed, but it won’t be easy, and it sure won’t be smooth. The time for low volatility has passed:
Volatility is returning. Which is something the Fed hates, as this oral testimony from then Fed Governor Laurence Meyer attests to. My comments are in green and I highlighted some important portions:
So needless to say, I’m much more interested with the front end of the curve than the back end because as this should make it clear, the yield curve has been distorted and should still be downward sloping. If you believe this to be the case, there’s really only one question left to ask…
How high will the front end get?
Credit Crunch version 2.0 sure looks primed and ready for release in the coming months. And just think? If this was software, you can’t blame Bill Gates and Steven Ballmer if it fails.