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Eugene Linden: In a World of Underpriced Risk, What Could Possibly Go Wrong?

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Yves here. While I anticipate readers will enjoy Eugene Linden’s post, I do have a couple of quibbles. Linden comments in passing that the action of the Fed is understandable, if regrettable, given the options. I don’t believe in letting the officialdom off that easy. Japan warned the US early in the crisis not to repeat what was its biggest mistake: coddling the banks rather than forcing them to take losses. An IMF study of 124 banking crises concluded that regulatory forbearance, the term of art for letting impaired banks soldier on, found:

The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred…

And we’ve discussed long form that Obama blew the opportunity to get tough with financial services firms at the beginning of his term and instead threw his lot in with them.

In addition, it isn’t “profligate” to deficit spend when both the business sector and the household sector are net saving. But that raises the question of why more isn’t being done to get capitalists to act like capitalists. Andrew Haldane and Richard Davies have demonstrated that corporations are seeking overly high returns on investment, which leads to widespread underinvestment and also argues for a greater role for government investment given private sector mispricing. Thus the central bank efforts to force investors out the risk curve is partly in response to persistent corporate short-termism and unduly high return targets. But as the saying “you can bring a horse to water but you can’t make it drink” warns us, central bank efforts to lower risk pricing is not guaranteed to produce the behavior they want. Recent history has shown its impact on financial assets is much greater than on the real economy.

By Eugene Linden, a journalist and author of seven books who has written extensively about animal behavior, environmental issues, and markets

On a recent conference call, the strategist of a major international bank (it was an off-the-record call for clients only) laid out the bare bones of what he called the world’s “giant experiment” in debt and interest rates. Never before have so many countries maintained such low base rates for so long; never before in peacetime have so many countries had such huge deficits and debt burdens; never before in U.S. history had long term rates been so low; never before has the U.S. gone so many decades without deflation following inflation. Because we live in these unprecedented times, it’s easy to lose sight just our strange they are… and how dangerous.

Consider just one small piece of this brave new world: What happens when the huge preponderance of the global financial market under prices risk? To add to the list offered by the strategist: Never before has so much debt been referenced to benchmarks that price debt too low for their inherent risks. The distortions of this unique situation have been well-documented – underfunded pensions and impoverished retirees for instance — but reversion to the fair pricing of risk would almost certainly crater the global financial system and governments around the world.

This leaves us in an exquisitely cruel predicament. An underpinning of any sustainable financial system is the proper pricing of risk. If I am going to loan you money, the interest rate I charge will reflect what kind of return I can fairly demand (assuming that the borrower can turn to someone else if I charge too much) given all the different factors that might prevent me from being repaid in full. For any given financial instrument, these factors might include the quality of collateral, inflation expectations, the character of the borrower, and a host of other factors including the political stability of the borrower’s home country. To the degree that I charge too low an interest rate I am subsidizing the borrower, assuming a portion of risk that the borrower is not paying for, and increasing the likelihood that I will not be repaid in full.

That’s where we are right now, with every lender, depositor and investor in the developed world (which includes most of us when we consider pension funds and insurers) blithely assuming much more risk than we are being compensated for. This has allowed, actually encouraged, the entire developed world to pile on debt at levels without precedent. When events force a settling of this world-wide mispricing, we risk the mother of all financial crises. Will it be hyperinflation as governments try to devalue debt burdens, a deflationary spiral and credit freeze as floating rates soar to try and catch up, or all of the above?

Naturally, all of this has been done by design. On the one hand, central banks around the world have for years been pursuing policy rates at or near zero (nicknamed ZIRP or Zero Interest Rate Policy) since 2008 (and long before in the case of Japan), ostensibly to encourage profitable lending in order to restore vigor to economies. Through programs such as Operation Twist in the U.S. and the LTRO (Long Term Refinancing Operation) in Europe, central banks have also sought to supply liquidity and bring down long-term rates. Thus the vast universe of both high yield and investment grade bonds, priced more to their spread from treasuries than for nominal yield, underprices risk to the degree that fed actions underprice the risk in U.S. sovereign debt.

Then, as we discovered this year, LIBOR, an unofficial rate inaugurated in 1986 to reflect the price that the biggest banks pay to borrow from each other, also has been manipulated to understate the risks bank see in lending to their peers. LIBOR is the benchmark for many trillions of dollars in debt and financial instruments (estimates range up to $800 trillion, a truly ridiculous number that underscores what a monster LIBOR has become). Central bankers in the U.K. and the U.S. have known for at least five years that LIBOR was being manipulated to understate what might constitute a true interbank rate. Mervyn King, a governor of the Bank of England, witheringly described LIBOR in 2008 “as the rate at which banks don’t lend to each other.”

The authorities tolerated this manipulation because they feared then, and still do today, that the real interest rate at which banks would actually lend to each other would be so high as to cause a global panic given the impossibly huge amount to debt benchmarked to LIBOR. Between them, ZIRP and LIBOR affect financial instruments that cover most of the credit waterfront. To paraphrase Jim Grant, much of the developed world lives in a world of return free risk.

All this de facto philanthropy by investors has been a windfall some governments – including the U.S. and Japan — allowing them to pile on debt without having to commensurately increase the amount they budget for interest. For banks ZIRP has been a mixed blessing. On the one hand, big banks have access to extremely cheap money, but, on the other, the risks of lending in a debt-burdened and bruised economy often don’t justify the meager nominal returns that can be achieved. Also, the tiny margins at the zero bound mean that the short-term collateralized lending that supports money market funds and much of the shadow banking system can become unprofitable in the blink of an eye. Thus, ultralow rates, historically associated with the risk of inflation, can actually withdraw liquidity from the market, and produce a deflationary spiral.

This is just one of the paradoxes of this strange new world. Another is that even as rates suggest that risk has been banished in the 21st century, the number of governments and corporations deemed risk free by the rating agencies continues to shrink. According to the New York Times, the number of AAA rated corporations in the U.S. has dropped from in the 60s in the 1980s to just four today. The number of Triple A-Rated sovereigns shrinks apace. One reason for the parsimony in handing out AAA ratings today comes from barn-door closing by the rating agencies after the heady days of the housing bubble when any loan had a bright future as part of a AAA-rated financial instrument thanks to the alchemy of securitization. The continuing global hangover from this historic mispricing (and miss-rating) underscores the misery that follows the misunderstanding of risk.

Why then do financial authorities persist in underpricing risk so soon after that near-death experience? Simply put, we can’t do otherwise. ZIRP and a low low LIBOR push the day of reckoning off into the future, and allow governments and investors to retain the faint hope that some yet to be identified engine of growth will save the day. If, however, interest rates were to rise to discount actual risk, debt service would soar to consume tax revenues for the U.S., Japan, and other profligate governments, a flood of insolvencies would ensue, what little mortgage lending that remains would shrink further (pushing home prices down and further impoverishing households that have seen their net worth plummet since 2008), and economic activity would shrivel throughout the developed world.

Central bankers do have one lucky break that gives them breathing room in this ultimately unsustainable situation: inflation remains far over the horizon. All the money printed around the world really isn’t going anywhere (except to buy up the too-cheap debt issued by governments and agencies). It certainly isn’t going to wages – outsourcing has killed that legacy of the bell-bottom era – and there is plenty of slack capacity that needs to be filled before any developed world economy overheats. Nor is it going into consumption — most households are still drowning in debt, which limits their desire to spend, even if people could qualify for additional credit.

So, the Federal Reserve continues to push out the date, currently 2015 and counting, at which they say they will wean the economy from ZIRP, and LIBOR remains surreally below a level at which banks might actually lend to each other. Given the alternative, however, who can blame the financial authorities? The only choice seems to be to hold our breath, and hope that no event or mistake causes the ping pong ball to fall on to the table full of mouse traps that now constitutes the global financial system:

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22 comments

    1. YankeeFrank

      That is what will happen, but it will be faster and more violent, because in the financial world there are many ways firms are “close” to each other: same or similar industry, similarity of investment portfolio, country where firm is located, same counterparties/insurers…

      Thus, when it starts to unravel, it will happen fast, and of course faster than these fools at the Fed will ever be able to keep up with. When they declare that they have guaranteed and backstopped the entire financial system next time, who will believe it? And yes Yves, the idea that they have no other choice is ridiculous. They could, even now, tear apart the big banks if they wanted to.

  1. Random Lurker

    I’m not so sure that the risk is “underpriced”.
    Suppose that I have 100$, and I’m not spending them today.
    Thus I lend (deposit) them to a bank. The bank lends this money to someone else, mister A, because it gains from the interest that A pays.
    [if you prefer, A gets a loan from the bank for 100$, that then puts the 100$ on my deposit in case A bought something from me, so that the "banks create money" stuff is more obvious.]
    But A has to pay some interest on those 100$. Suppose the interest is 5%, where will A get the 5$ of interest he has to pay?

    If A is a company, he will likely invest those 100$ in some capital stuff, that hopefully will give him some profit. If the profits are 5% or more, A will be able to pay interest from his profits, otherwise A will be bankrupt (assuming he has no other assets).
    This means that a bank cannot expect an interest rate that his higer than the “average rate of profits” from its corporate clients.
    But we are in a recession, so the “average rate of profits” is very low (potentially negative), so the “average rate of interest”, aka the price of money, should be very low or negative too.

    If instead A is a private guy borrowing for consumption, the interest comes from his future wages, so that the aggregate wages of borrowers have to grow faster than the interest rate or sooner or later there will be a debit crisis; the same goes for sovereigns (whose GDP has to grow). But both wages and GDP are stagnant or falling in a depression like the one we are living in, thus is very likely that the “correct” rate of interest should be very low or negative.

    1. F. Beard

      But both wages and GDP are stagnant or falling in a depression like the one we are living in, thus is very likely that the “correct” rate of interest should be very low or negative. Random Lurker

      Negative interest is paying people to borrow = giving away money.

      So why not skip the borrowing part* and just give people money? Hence Steve Keen’s universal bailout?

      *Especially since with negative interest one need not invest what one has borrowed so what’s the point of lending money that won’t be spent or invested?

      1. Susan the other

        Return was a mirage for 300 years. Growth was a religion for 10,000 years. They are both gone. The first (return) was dependent on the second which seemed eternal. And long before (and even during) that long timeframe theft and plunder created the illusion of returns. So everything is so different now we cannot fathom what to do next. Fine. Interest rates are just another growth fiction. Risk isn’t “underpriced” – risk is capitalist leverage; what this is (our present confusion) is a fulfilled growth paradigm within our current technology whereby the velocity of money plus the world population surpassed the practical technology. The real question is, Why didn’t we plan for this? Answer: We are all idiots. The superficial concept of “risk,” probably like all concepts filtered through the lens of subjective economics, is useless because it directly serves the profit of someone, somewhere. So, for now, interest rates are dead too. They do not have a life of their own. They might be dead for another 10,000 years. Caveat emptor. Funny how the last thing to die is betting. Derivatives.

  2. Clive

    Interesting and a good précis of the current situation but it doesn’t address the fraud and bubble economy which got us here in the first place — and the unrealistic expectations it set. The piece makes a more-or-less conventional economic theory model of what to do about things in as much as the author suggests tugs on the conventional levers (but does identify why they may not be connected to the same machinery as they once were and so tugging harder isn’t necessarily effective).

    That said, the article makes clear this isn’t a business cycle slump. So ZIPR, as the writer rightly concludes won’t solve anything. But then they stop short of stating what must come first — sorting out the bad actors and cleaning up their historic bad actions.

    Personally, I’m not sure how that will ever be possible. Business “leaders” — certainly those I’m familiar with — are *still* suffering from what I call the Linda Evangelista complex (the supermodel who famously wouldn’t get out of bed for less than $10,000). They won’t commit capital for a less than 10% p.a. return. Unless it’s forced upon them that the outsized returns were only possible and underpinned by dubious and sometimes unlawful rent extraction, they’ll constantly hark back to the Good Old Days.

  3. financial matters

    “”Also, the tiny margins at the zero bound mean that the short-term collateralized lending that supports money market funds and much of the shadow banking system can become unprofitable in the blink of an eye. Thus, ultralow rates, historically associated with the risk of inflation, can actually withdraw liquidity from the market, and produce a deflationary spiral.”"

    “”If, however, interest rates were to rise to discount actual risk, debt service would soar to consume tax revenues for the U.S., Japan, and other profligate governments, a flood of insolvencies would ensue, what little mortgage lending that remains would shrink further (pushing home prices down and further impoverishing households that have seen their net worth plummet since 2008), and economic activity would shrivel throughout the developed world.”"

    First of all, home prices need to come down to be affordable for first time home buyers. That is a place to start for a reality check.

    Sovereign nations should spend money into the economy without interest supporting community efforts/employment (thus staving off deflation) rather than continuing to reward financial executives.

    Private banks should raise interest rates to support money market funds and make their certificates of deposits more attractive for conservative investors.

    The stock markets current huge bias toward management which rewards them for raiding their companies makes this a poor tool for a retail investor to try and invest in the long term productive performance of corporations.

  4. WorldisMorphing

    Good post.
    I feel old and weak this morning, and for some reason, I didn’t feel any outrage as I read the article.

    I felt for a brief moment a slight terror at the thought of what things could come to in the coming months and years.
    I live alone and very rarely see my family, even though I live in the same city. I don’t connect well with people in general. I don’t consider myself a misanthrope, but I’m not a ray of sunshine either. Yet I feel the system will sooner or later contrive me to actions that will no doubt be out of my comfort zone.
    Will those actions be ultimately constructive and meaningful in the grand scheme of things or will they simply be “reactionary activism” or just plain involvement in the “community”(whatever that is), I haven’t the faintest of clues.
    I can imagine and strangely enough, gladly accept eating less meat. I wont accept living in a shithole for much longer under this premise of land rent theory…

  5. Trish

    First of all I think this is a thinly veiled article for raising interest rates. Why? So pensioners and widows can earn decent returns on their hard earned savings, not that those that have gamed the system and are now sitting on the cash can sit idly by and earn big fat returns while the system falls apart. No mention here of the nominal rate of interest versus the real rate of interest and the reality that most lenders in the marketplace are lending at rates that far exceed their level of risk. The irony is that when the system tolerates usurious interest rates, it raises the risk that debt will never be repaid. In other words higher interest rates contribute to risk. The mis-pricing of risk has nothing to do with interest rates and everything to do with the fact that too big to fail financial entities know that they can take outrageous risks and governments will bail them out.

    1. F. Beard

      So pensioners and widows can earn decent returns on their hard earned savings, Trish

      Well, that’s the breaks, isn’t it?

      But why not instead have the monetary sovereign (e.g. US Treasury) provide pensions to the population so that no one has to depend on usury to retire comfortably?

      1. Trish

        That is the argument that those advocating higher interest rates make and that is not the argument that my comment is making. Read the rest of the sentence. It is obvious that this comment does not support usurious or higher interest rates.

    2. Susan the other

      I think it is more an argument for abolishing interest rates altogether. We pensioners caught in this end-of-cycle trap need to be helped; policy can adjust for the generation to come.

  6. F. Beard

    If I am going to loan you money, the interest rate I charge will reflect what kind of return I can fairly demand (assuming that the borrower can turn to someone else if I charge too much) Eugene Linden [emphasis added]

    The above assumes a single money supply for private debts. Why should that be? Cui bono and why should they?

  7. be'emet

    ’twas a time when capital was invested to create value. quash the Fractional Reserve System, and with 100% reserves, capital concentrations will have to place real money in productive use.

    As Beardo suggests, our govmint can issue new money for pensions as well for teachers’ pay and public safety, these projects are shovel ready already.

    still, one percent return ten times over isn’t so bad is it?

  8. Stallworth

    At 7.x billion poeople of humans, decreasing energy on energy invested rates, falling soil yields, etc. how much longer until there is not enough surplus to pay interest on loans?

    “How did a population of millions of people disappear? How did the kings and nobles fail to recongnize and solve these seemingly obvious problems(overpopulation, deforestation, soil erosion, increased warfare, climate change) undermining their society? Their attention was evidently focused on their short term concerns of enriching themselves, waging wars, erecting monuments, competing with each other and extracting enough food from the peasants to support all those activities. Like most leaders throughout human history the Maya kings and nobles did not heed long term problems in so far as as they perceived them” (J. Diamond – Collapse: How societies choose suceed or fall)

  9. Richard Kline

    Yves: “Andrew Haldane and Richard Davies have demonstrated that corporations are seeking overly high returns on investment, which leads to widespread underinvestment and also argues for a greater role for government investment given private sector mispricing. Thus the central bank efforts to force investors out the risk curve is partly in response to persistent corporate short-termism and unduly high return targets.”

    I’m unconvinced that the actual mission of the Fed et. al. is to push risk out the curve. The Fed’s mission is to protect asset prices, and indeed to keep them rising.

    I don’t say this lightly; moreover, this is historically a new program even if not actually new. The function of central banks and large government treasuries for much of the 20th century was to backstop employment as a way of supporting demand. This became the function through hard learned experience, and not through any love for ‘the little people’ on the part of central bankers. Some success at stimulating demand and the manifest evidence of the effects of demand collapse had central bankers an many key policy makers get religion. This began to change in the late 1980s. Alan Greenspan didn’t invent ‘assets first’ monetary policy, but his putative success in his early years in the 1990s made it easier to sell that program. Japan has had significant success at protecting asset values too. Not that assets haven’t declined there relatively, but the absolute collapse that should have followed the speculation has been staved off—and the cost of suppressed employment, but hey, the little people don’t count in the new paradigm.

    We are all Japan now. The belief that the core mission of central banks is to protect asset prices is absolutely in force. Forget whatever Bernanke and others _tell themselves_ they are doing, what they are in fact doing is trying to ringfence the financial assets of the plutocracy and target a value of same to support. In short, demand support has been thoroughly JUNKED. Nobody atop the system cares if unemployment rises and stays high, _so long as central governments and their actors protect the asset values of the rich from price declines due to demand declines_. The poor can eat chips; indeed, unemployment is good, say the billionaires, something to induce a little wage discipline on the masses. The rich and the central bankers only supported employment under duress. Now, the wealth is figuring simply to save their own assets and let the rest of society slump.

    I’m quite serious in this view. And in fact, the program isn’t new in and of itself. What we really see is a return in the broad picture to the ‘hard money’ policy of major 19th century banking, when credit rationing was intended to restrain non-insider speculation and thereby preserve access to and prices of the assets favored by the richest. What is very new since Greenspan turned his hand to it is the use of massive central banks money drops via ‘moneys of account,’ that is money simply created at a keyboard at the discretion of central bankers and their designees. Looking at what Greenspan did, he was a serial bubble blower of speculation with the idea that he could clean up any peripheral erosion by printing money and giving it to the rich, directly or indirectly. Let’s leave aside discussion of the extent to which he succeeded in the latter; he certainly succeeded in the former.

    But the new policy has really taken hold, now. Every major economy is on it: pixelate money under the veil of ‘liquidity’ and let it loose, ideally targeted to support financial assets of the elite. The idea of ‘stimulating the larger economy’ just isn’t on: NOBODY at the top CARES. They are not hurting. Their political rigged game isn’t threatened by unemployment. Policy makers are far more threatened by teetering oligarchs who would either throw their support to some other polished flunky or crash over taking down all. Thinking over four centuries of modern financial markets, we have _never_ had a condition where all major government or quasi-government actors are hellbent on flooding money to their respective wealth classes to prop up asset prices (because let’s be frank folks this is EXACTLY what is going on now). Historically, this would have caused flight from the assets involved to ‘less risky ones.’ But there’s nowhere to go with every sovereign money issuer pixelating money out the door for all they are worth.

    We don’t have financial ‘anti-gravity’ in my view. But the volume of hot air being blown can keep asset prices hovering over the abyss and societies stultified for an undefinable period of time. NOT indefinite, in my view, but I couldn’t say how long. Ten years? Twenty? (Doesn’t seem likely.) But I agree to this extent with the anonymous strategist Linden cites above: we are in a new age, truly one never before seen. Governments everywhere are acting with all the powers at their disposal to ‘save the assets’ of the rich and let societies suffocate, especially at the bottom. This isn’t about ‘stimulating investment,’ I don’t care what lies central bankers tell themselves to justify the unjustifiable. Perhaps the real notion they swap in the executive washroom is that if the wealth at the center of society is preserved, those societies can be kept intact until ‘growth’ organically returns. Or at least societies can be kept intact, no nasty revolutions or political sweep-outs or expropriations or the like back when governments pretended that the situation of ‘the little people’ mattered a damn. But this new program of asset protection isn’t stimulative in intent, so forcing investment changes is not it’s primary focus. Saving the assets and the social dominance of the oligarchy IS this program’s true intent. I suspect it will be an accident or error of some kind which precipitates a catastrophic state-change of this unprecedented monetary policy. What happens then is hard to say other than that the mess will be of historically salient scale.

    We are all Japan. Employment is so 20th century. Investment is so 19th century. This is Century 21 baby, where the government just prints money and hands it to the rich, so who needs investment, employment or taxes. . . . Now I think one sees the Republican political program in capsule. How long can they keep this up? Five years and counting, and we’ll see from here. But let’s not delude ourselves that central banks are doing anything AT ALL other than protecting major financial assets: this is the new supra-normal.

    1. Nathanael

      Mostly correct. Here’s the thing: the elites are stupid.

      You can’t prop up the value of paper assets while their real value is dropping.

      And their real value depends on consumer demand.

      So this entire scheme for propping up asset values is *doomed to fail* until average people have enough money to buy stuff.

  10. Fiver

    Agree with Richard (above) that Bernanke and other CB’s have acted only to preserve the positions of the wealthy and powerful. I would amplify that by adding they absolutely do know that their policies actually hurt far more people than are helped (with an even worse impact abroad due to literally killer food and fuel prices) but simply do not give a shit.

    Re the article:

    1) I would’ve hoped someone who labels himself an “environmentalist” would’ve placed this discussion within the larger context, and much larger crisis, that is the human economy’s horrific impact on the biosphere it is absolutely dependent upon. Had he done so based on the latest evidence available across the spectrum of relevant areas of study, he’d have asked not how long this vile Fed/CB game can last (not even another 5 years), rather how long THIS kind of economy could last even supposing it was “fixed”. The answer is not 20 years in either instance – rather, a good deal less.

    2) With respect to 1 comment from Yves, that “it isn’t “profligate” to deficit spend when both the business sector and the household sector are net saving.”:

    I have to insist that any honest, objective observer looking at current US government spending across all programs would conclude that at least 90% of military/security spending is a total waste, and that the numbers for other programs, though not quite so grotesque, are nonetheless unbelievably wasteful, and quite deliberately so given how much of the money is directed into pockets that don’t actually need it, or into programs aimed at NOT succeeding, eg., reglation and enforcement activities – the term “profligate” actually badly understates the case now – very difficult indeed to see how further “borrowing” from the privately-owned Fed in order to hand most of the money to people who already have money would be less so.

    1. Nathanael

      Quite right. The horrible thing, of course, is that the demented right-wing morons who go on about “government spending” generally attempt to cut the lowest-budget, most efficient government programs while protecting the biggest, most wasteful oinking porky giveaways.

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