Bill Gross of Pimco’s monthly newsletter, “There’s a Bull Market Somewhere?” is out and making the rounds. The title refers to a Jim Cramer dictum. The bond chief uses it to argue that asset prices are declining on all fronts, which he then contends that the US government must reverse (boldface his):
because in a global financial marketplace in the process of delevering, assets that go up in price are rare diamonds as opposed to grains of sand….
What Happens During Delevering
1. Risk spreads, liquidity spreads, volatility, term premiums – they all go up.
2. Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium.
3. The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down….
This rarely observed systematic debt liquidation is what confronts the U.S. and perhaps even the global financial system at the current time. Unchecked, it can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami. Central bankers, of course, adopting the cloak and demeanor of firefighters or perhaps lifeguards, have been hard at work over the past 12 months to contain the damage. And the private market, in its attempt to anticipate a bear market bottom and snap up “bargains,” has been constructive as well. Over $400 billion in bank- and finance-related capital has been raised during the past year, a decent amount of it, by the way, having been bought by yours truly and my associates at PIMCO. Too bad for us and for everyone else who bought too soon. There are few of these deals now priced at par or above, which is bondspeak for “they are all underwater.” We, as well as our SWF and central bank counterparts, are reluctant to make additional commitments.
Step 2 on our delevering blackboard therefore has stalled and is inevitably morphing towards Step 3. Assets are still being liquidated but there is an increasing reluctance on the part of the private market to risk any more of its own capital. Liquidity is drying up; risk appetites are anorexic; asset prices, despite a temporarily resurgent stock market, are mainly going down; now even oil and commodity prices are drowning.
Despite Gross’ lament (his firm is a big holder of Fannie and Freddie paper, so the pain must be acute), this isn’t factually correct. As readers have pointed out repeatedly, Treasuries are in what one might contend is a massive bull market, with the ten year bond trading under 4% (it was 3.74% a couple of days ago). The dollar has rallied and Gross is overselling his case on commodites. Yes, they are down markedly since July, but over the last 12 months, they are still up nicely. 30% plus gains in a year (and some indexes are up nearly 45%) is nothing to sniff at.
The next bit is a doozy:
to ultimately stop this asset/debt deflation, a fresh and substantial new source of buying power is required…..we will require policies that open up the balance sheet of the U.S. Treasury – not only to Freddie and Fannie but to Mom and Pop on Main Street U.S.A., via subsidized home loans issued by the FHA and other government institutions. A 21st century housing-related version of the RTC such as advocated by Larry Summers amongst others could be another example of the government wallet or balance sheet that is required during rare periods when the private sector is unable or unwilling to step forward.
First, the Fed has already made heroic, unprecedented interventions to shore up banks and agency paper. The Federal Home Loan Banks have also been a less visible vehicle for propping up mortgage paper. As Paul Krugman pointed out:
And the usual problem with such intervention applies: the financial markets are so huge that even big interventions tend to look like a drop in the bucket. If foreign exchange intervention works, it’s usually because of the “slap in the face” effect: the markets are getting hysterical, and intervention gives them a chance to come to their senses.
And the problem now becomes obvious. This is now the third time Ben & co. have tried slapping the market in the face — and panic keeps coming back. So maybe the markets aren’t hysterical — maybe they’re just facing reality.
What Gross ignores is that we have already gotten what Brad Setser called a quiet bailout from our friendly foreign funding sources:
The roughly $30 billion sovereign wealth funds provided to troubled US financial institutions (Citi, Merrill, Morgan Stanley) attracted a lot of attention.
The (almost) $30 billion of Bear Stearns’ assets that the Fed took onto its balance sheet (as explained here) to facilitate JP Morgan’s takeover also has attracted a great deal of attention…
The $283.5 billion increase in central banks’ holdings of Treasuries and Agencies in the custodial accounts of the New York Fed during the first half of 2008 hasn’t attracted nearly as much attention….
Not all central banks make use of the New York Fed, though someone big clearly is. The growth in the the Fed’s custodial holdings consequently is a minimum, not a maximum…..Central bank reserve growth has been very strong, most because a couple of big countries are adding to their reserves at an incredible rate. The New York Fed data tells us that a lot of that growth has been channeled into safe US assets.
Tim Duy, writing at Economist’s View, put these number in context:
In the first half of this, global central banks accumulated $283.5 billion of Treasuries and Agencies, something around $1,000 per capita…. Foreign CBs are happily financing the first US stimulus package; will they be happy to finance a second? Do they have a choice? …Do not underestimate the impact of these foreign capital inflows. If the rest of the world treated the US like we treated emerging Asia in 1997-1998, the US economy would experience a slowdown commensurate with the magnitude of the financial market crisis. The accumulation of US assets is also forcing an expansion of foreign CB’s balance sheets, creating global monetary stimulus that allows the rest of the world to decouple from the US economy, supporting continued US export growth (see point 2 above).
The US simply does not have the resources to perform a rescue operation on the scale Gross envisions. If we were to attempt it, the amount of borrowing required would push Treasury yields up, undermining (more likely, more than completely reversing) whatever benefit there was from spread reduction. We’ve already seen a some interventions not producing some of the expected benefits. The Fed had clearly hoped that its pushing down of the short end of the yield curve would provide some relief to fixed mortgage rates. Instead, they’ve gone up.
Since the US’s firepower is limited, it should be directing it to the highest-potential uses. The most successful example of a modern advanced economy pulling itself out of a major financial crisis (one big enough to be included in Kenneth Rogoff’s and Carmen Reinhart’s “big five” designation) is Sweden, which wiped out the private shareholders in failed banks and recapitalized them and had its own version of a Resolution Trust Corporation to liquidate bad assets.
Nevertheless, a research paper at the Cleveland Fed on the Swedish experience noted:
In the end, the resolution occurred much more quickly than initially anticipated, thanks to the rapid growth of the Swedish economy, which paralleled the global economic boom of the 1990s. Liquidations were completed by 1997 at a smaller cost to the taxpayers than was anticipated… That being said, the cost of the crisis to Sweden was not limited to the capital spent by the AMCs [the bad bank vehicles]. There have been significant income and output losses associated with the crisis. In the early 1970s, Sweden had one of the highest income levels in Europe; today, its lead has all but disappeared. Cerra and Saxena (2005) found that the crisis caused a permanent decline in output that can explain the entire fall in Sweden’s relative income. So, even well-managed fi nancial crises don’t really have happy endings.