As all major financial markets – stocks, currencies, commodities, and bonds – continue to be highly volatile and risk averse, investors’ mood, and even that of real economy players, is getting nervous and gloomy. Both the masters of the universe at Davos and corporate CEOs have an uncharacteristically subdued outlook for the upcoming year.
But the open question is how much financial market stress transmits into the financial system and/or the real economy. The portents do not look good. Yesterday Ambrose Evans-Pritchard tried arguing cheerfully that the stock market rout was a good thing, since it takes out the unwarranted premium in equity prices in a time of earnings growth almost entirely dependent on stock buybacks, and that cheap oil was good for consumers. But it’s one thing when a downdraft corrects froth. It’s another thing entirely when it is a symptom of years, actually decades, of bad policies.
What should trouble commentators and analysts most, and this is implicit in the market upheaval, is that the officialdom, most importantly central bankers, who have developed the bad tendency to assign themselves the role of economic first responders (when they would in cases have been better served to sit on their hands and force governments to step to the plate to do more spending) have no idea what to do now. From John Authers of the Financial Times:
The sense that central banks can no longer be relied on as the ultimate backstop for the system has helped trip markets into something close to panic
Authers ascribes the funk to reflexivity, which is Soros’ concept that in financial markets, investor actions and beliefs can be self-reinforcing, in a seemingly positive (momentum trades) or seemingly bad way (self-reinforcing panic). The reason this simple idea is important is that economists have fetishized the idea of equilibrium, which denies the idea the feedback loops of the sort that Soros has used to make himself rich exist.
But it’s worse than that. Authers describes multiple examples of how official actions have not just produced unintended consequences but backfired. Yellen wanted to “normalize” rates to help banks but (among many other things) flattened the yield curve, which makes their lives even worse than they were before. Another is the way Bank of Japan moved to negative interest rates. Its main purpose (as we discussed) given that it was designed to have as little impact as possible on banks and depositors, was to weaken the yen. But the yen instead surged.
This is replay of a pattern we saw in the runup to the last crisis, and that Richard Bookstaber warned about in his classic book, A Demon of Our Own Design. In tightly-coupled systems, and our system of large interconnected global banks and high levels of cross-border capital flows is a tightly-coupled system, measures intended to reduce risk typically wind up increasing them because no one really understands how it operates. He warned that the only way to reduce risk is to reduce the tight coupling. We see very little evidence that anything of the kind has happened much, and the increase in concentration at the biggest banks suggest if anything that it could be worse.
And the central bankers’ reflexes of what to do next are poor.
— Ari Andricopoulos (@ari1601) February 12, 2016
We’ve said that negative interest rates are a terrible idea. Super low rates are already slowly killing life insurance companies and pension funds. Negative rates will do them in even faster and will do serious harm to banks, as we explained longer form earlier this week.
Banks in the US were pushing for higher interest rates, one assumes understanding the transition costs (banks are structurally long, so even if they trade cleverly, they’ll suffer losses on all but their shortest-term assets). The reason is that they face a long-term profit squeeze at super low rates and they need to get out of the corner the Fed painted them in in the course of rescuing them.
Now given the temper tantrum by investors since the Fed nudged rates up in December, Gillian Tett of the Financial Times reports that 2/3 of money managers expect the central bank to reverse course, and the fact that the Fed included negative interest rates in its upcoming stress tests leads them to think this might be next hat trick they try, particularly now that, as former central banker William White pointed out yesterday, 1/4 of the advanced economies are now in negative interest rate territory. The one bit of good news on this front is that Yellen was raked over the coals in House hearings earlier this week on several issues, one of them being negative interest rates.
But its utterly stunning to see this move not only being treated as a sound poilcy option, but actually being implemented. Deflation is the worst possible place to be in an economy with heavy debt levels. Economists have managed to forget the most basic lesson of the Great Depression, and tell themselves the bizarre story that putting money even more on sale will lead people to borrow and spend. Earth to central bankers: they won’t if they are worried about their future. What is needed is more demand, which means more fiscal spending and better incomes for workers, which means more labor bargaining power. Yet orthodox policymakers are deeply allergic to both ideas.
The intersection of weak institutions and poor policymaking is most acute in the Eurozone. And by “weak institutions” we mean both the governance structures of the Eurozone and the Eurobanks themselves. Even though it’s been said so often that it is virtually a cliche, the US forced its banks to clean up a good bit more than the Europeans did after the financial crisis, most notably, in making them increase their equity levels.
But there’s a deeper pathology underlying the difference in responses. In the US, for better or worse, we’ve moved more of our credit extension off bank balance sheets and into capital markets than has taken place across the pond. That means our banking system as a percentage of GDP is much smaller than in Europe. To put it another way: given the fact that each individual country is the ultimate backstop for its banks under Eurozone rules (save for extremely limited exceptions), and that Maastrict rules limit deficit spending, the big Euroobanks do not have credible backstops.
Switzerland (which is not a member of the Eurozone and hence is less constrained) was the only European country to deal frontally with the risk of its outsized banks. When it had to bail out UBS, it not only forced the bank to make an account, in public, of the specific management failures that led to the losses (a step taken nowhere else), it forced its banks to get to 19% equity levels. Period. No excuses. UBS flailed around with trying to move its headquarters to another country, which we predicted would be a non-starter (who would have them?). UBS and Credit Suisse have skinnied down considerably, with both largely exiting investment banking and retreating to their traditional business of being a safe haven for dirty money, um, being private banks.
The rest of Europe coddled its overweight, incompetent, and often miscreant banks, yet has tried to pretend that they are on their own. As readers know well, official bailouts of Ireland, Greece, and other periphery countries were actually rescues of banks. That still might have been defensible if loans had been written down, bank managements and boards purged, and shareholders wiped out (or crammed down by giving the government bailing out the banks upside at the expense of shareholders, say through options).
The current policy Rube Goldberg to pretend that banks are on their own (or more on their own than before) is not working at all well. The Eurozone has adopted some clever-sounding ideas that do not work at all well in practice. They appear to be based on the flawed Greenspanian notion that if investors are given incentives, as in they are at risk if banks get in trouble, they’ll do a better job of monitoring them and keeping them on the straight and narrow. In fact, when Greenspan admitted to a flaw in his theories, it was that of investors acting as overseers and enforcers.
Two of the too-clever-by-half Eurozone ideas were depositor bail-ins and contingent convertible bonds, called cocos. The bail-in provision, which is now in place all across the Eurozone as part of the new EU banking rules that became effective January 1, is supposed to occur only when national deposit guarantee funds fail, and those are supposed to cover deposits of up to €100,000. There is a EU-wide second layer of insurance that is being implemented in phases, but it is more fig leaf than real. We’ve mentioned that there is a slow motion bank run underway in Italy, reflecting the fact that alert large depositors (and perhaps even smaller ones) recognize that they are at risk. Anyone with an operating brain cell will move their money out in part or in whole if they think their bank is at risk. Thus bail-ins increase the odds of bank runs, the last thing a regulator wants to have happen.
The coco bonds looked like a way for banks to plug their capital holes on the cheap and had the added advantage of reducing the number of times the officialdom would have to roll up its sleeves to deal with a sick bank. Coco bonds had a variety of different provision, but the high concept was that they would morph in some manner that would bolster bank equity if certain triggers were hit. But even before coco bonds went from being darlings to dogs in 2016, some experts saw the potential for trouble. From RBS analyst Alberto Gallo in the Financial Times in 2014:
But there is more than one catch. First, cocos are highly complex. Some come with mandatory coupons, others with discretionary interest payments. All cocos, however, take losses contingent on one or more trigger events: for example, the issuing bank falling below a preset capital threshold, or a decision by regulators. The triggers can push some cocos to convert into shares, while others instead write down to zero.
There is a second catch: risk. In good times, cocos behave like a normal high-yield bond, but in falling markets they expose investors to equity-like losses and volatility. In financial jargon this is called negative convexity, or “death spiral” risk: losses accelerate as things get worse.
As we’ve pointed out, investors are spooked about Deutsche Bank, which is the most undercapitalized major bank, and its coco bonds are being whacked. This Bloomberg articles describes the cliff risk in these instruments that has investors worried:
“CoCos are a perfect pro-cyclical storm — you can sell billions of them when investors are yield-chasing and thus careless of risk,” said Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics. “In a yield-chasing stampede like that of the last few years compounded by ultra-low rates for other bank funding sources, banking-system risk is dramatically heightened.”
The yield on Deutsche Bank’s 6 percent CoCos in euros rose to more than 13 percent from 7.5 percent at the start of the year. The bank’s shares are down 40 percent in the same period…
Deutsche Bank last month posted its first full-year loss since 2008, and its shares have plunged. Credit Suisse Group AG’s shares slid to their lowest level since 1991 after the Swiss bank posted its biggest quarterly loss since the financial crisis.
We must point out that some analysts argue that the panic is overdone:
The lowest-priced CoCo bonds are now pricing in an average of three years of skipped coupons, according to analysts at JPMorgan Chase & Co. in London.
“The market is forecasting that banks will have credit losses greater than their reserves, and large enough to hit capital buffers,” said Mark Holman, chief executive officer of TwentyFour Asset Management in London. “You’d need an awful lot of bad news to justify prices being where they are now.”
And in addition to yield-hungry institution investors, retail chumps have also been buyers of cocos.
Now why have banks stocks in Europe, and as a result coco bonds, been going south in a big way? This is only a partial list of reasons:
Underlying legacy loan losses. The Eurobanks have lots of corporate loans on their books, many of which are getting worse and worse due to poor growth in the European economy. The officialdom is believed not to have been all that aggressive in making banks recognize losses, and any over-valued sick loans have to be sicker now.
New loan losses. A Reuters story estimated that losses on energy loans across Eurobanks were on the order of €100 billion. Eurobanks are exposed to other now-bad-looking credit risks, including Eastern Europe, other emerging markets, and commodity producers.
Sovereign wealth fund sales. In the last crisis, sovereign wealth funds took stakes in some floundering banks, thinking they were getting a good deal (none of these investments had a happy ending). Instead of being a source of emergency capital, Middle Eastern sovereign wealth funds have been selling assets to shore up their national budget, and historically, they were big buyers of bank stocks.
Doom loop dynamics may be returning. Italy and Portugal (although Portugal stood down on Thursday) have been pressing the Eurocrats for more spending relief, as in more ability to deficit spend. Italy cannot credibly support its “bad bank” vehicle in the abseence of more budgetary headroom. The ECB had thought it had solved the problem of the connection between sovereign debt (which Basel II rules had encouraged banks to buy) and bank solvency. But Italy’s and Portugal’s bond yields have risen….
The final set of reasons why European banks are likely to be the breaking point if economic and marker conditions continue to deteriorate is Europe’s poor policy choices. Europe is firmly dedicated to deflationary policies: an explicit policy of reducing wage rates and labor bargaining power; Germany’s continuing contradiction of not wanting to finance its trade partners, yet continue to run trade surpluses with them; and the Maastrict restrictions on deficit spending, when deficit spending is what is most needed.
A near term risk is a Chinese currency depreciation. China is spending nearly $100 billion a month defending its currency. Experts vary on how long it can keep this up. Even though China reported $3.2 trillion in foreign exchange reserves at the end of January, it may be closer to a breaking point than most observers realize. From Forbes:
…the central bank has been trading derivatives, especially forwards, to mask the decline in its currency position, much like Brazil did in 2013. The stratagem permits the PBOC, as the central bank is known, to effectively sell dollars without reporting a decrease in its holdings of foreign currency. When these short-dollar positions are unwound, as they eventually must be, China’s reserves will plunge dramatically.
And tightening of capital controls may not be as effective as they appear either:
At this moment, there has been a “surge” in China’s “errors and omissions” entry. Charles Collyns of the Institute of International Finance told the Telegraph that the increase is “ominous.” That suggests, despite everything, many in China are getting their money out through illegal channels.
According to Bloomberg’s Fielding Chen and Tom Orlik, if capital controls work, China needs only $1.8 trillion in reserves, according to an IMF formula that suggests countries hold in their reserves an amount equal to 10% of annual exports, 30% of short-term foreign debt, 20% of other foreign liabilities, and 5% of M2. At the current rate of depletion and assuming Beijing has reserves in the amount reported, the central bank can defend the renminbi for more than a year.
If, however, China’s restrictions begin to fail, then Chen and Orlik calculate the PBOC needs $2.9 trillion in reserves. In this case, China could fall below this level before the end of Q2.
A fall in the renminbi would send another deflationary pulse through financial markets, and would show up in the real economy over time through even lower demand for commodities. This has to blow back to the already fragile Eurobanks. How badly is anyone’s guess.
And we need to underscore a bigger set of issues looming behind all of these problems. With the new set of EU banking rules and gee-whiz fixes like coco bonds, the European officialdom has taken the public position that it has fixed its banking problems. And due to Germany’s anathema for having the ECB engage in anything that might be stealthy fiscal action, or in having Eurozone member states stray outside their spending limits, the Europeans are not set up ideologically or operationally to respond to a crisis, even the sort of slow-motion crisis now underway. Draghi has been a master of letting clever talk substitute for action, but it’s not clear what moves he could make if conditions devolve, particularly since faith in central bankers is on the wane and QE and further rates cuts won’t remedy the underlying pathologies.
On a much higher level, no one has been willing to confront the basis conundrum: a functioning payments system is essential to modern commerce. Bank regulators and central bankers understand that; that’s why they are so desperate to keep it working when things look dire. But the fact that a payments system is essential infrastructure and thus will (presumably) be backstopped also means it has no business being operated with few constraints by private parties. At a minimum, core payments systems functions need to be nationalized or operated like a utility, with very strict oversight and curbs on profits. But it will probably take another crisis before the political classes are willing to cross that Rubicon.