To Infinity and Beyond.

Time to put Buzz in charge

Repetition is reinforcement: all financial crises begin with the failure to provide for liquidity. All financial crises end when liquidity has been restored, and losses have been identified and distributed. How big the losses turn out to be depends on the scale and scope of the liquidity operation: the central bank provides the liquidity and the state takes the losses. And losses will be big, but the sooner we deal with them the smaller they will be. The Fed’s reduction of administered interest rates to zero, the resumption of QE, the extension of liquidity provision from overnight to 90 days are all encouraging signs. 

Fiscal policy has to come into the frame because direct government funding channels bypass the financial system and the banking system’s normal credit granting processes. Credit evaluation and solvency determination present unwelcome frictions to delivering timely economic support. Changes are underway across economies and across the political divide which is welcome, but deployment of the fiscal channel is moving more slowly than the deployment of monetary policy. 

Some political leaders need to step aside, as it is time put Buzz Lightyear in charge and take policy support to infinity and beyond. The Covid-19 health crisis has stimulated a financial and economic crisis spread along the space time continuum. The authorities need to move very fast relative to all others and so far, they have moved with impressive speed.

Look out below

A global recession like no other in size and duration has begun, but the financial crisis is incipient, and its power to disrupt is immense. Compared to 2008-09, the potential systemic financial weakness is not located in the banks, and a run on the banking system is unlikely to be the first mover. Rather, finding weaknesses requires sifting through the corporate sector to see which corporates have the earliest and highest probability of default given the demand shock. The explosion in investment grade and high yield credit default swaps, CDS shows investors are scrambling to protect their positions. 

The increase in corporate leverage in the post 2008-09 period has been significant, and total debt world wide has doubled since 2009 accroding to the IIF. While corproate debt it is the centre of concern, it is by no means the only place to look. Leverage and illiquidity, with eerie echoes of 2008-09, have migrated to the insurance sector as an important and timely Fed paper has flagged.[i] The insurance industry has responded to low risk free rates to support annuity returns by turning to Special Purpose Vehicles, SPV’s, to achieve maturity and credit transformation and enhance yield by directing exposure to real estate and private equity. If you try to capture the illiquidity premium you had better have access to emergency liquidity. This should be top of investors' watch list if they fear debt default blow-back to the banking system.

Leverage and value

The Modigliani-Miller theorem, a centre piece of financial economic analysis, states that the capital structure of a company makes no difference to its assigned value and risk. Corporates have systematically issued debt to reduce equity, becoming more levered in the process. The cost of debt has been lower than the cost of equity so saving on the cost of capital.

However, the more leverage a company has, the smaller the available capital to absorb losses, so individual shareholders should know that while the value of the equity may rise as equity units are withdrawn and replaced with debt, they are shouldering a higher potential risk of loss per unit of equity. Levered gains can quickly swing to levered losses.

In the financial crisis of 2008-09, the markets seized up because of excess leverage and uncertain value of the levered assets. For example, the later stage issuance of RMBS CDO’s and CLO’s had increasing shares of poor-quality mortgages, and implied very large losses from default if house prices declined. 

The issue for investors was really one of the “money goodness” of the asset which many banks then owned. Markets went on a search and destroy mission to size the debt, locate the debt, and avoid the bank that owned it.   

Funding for levered SPV’s dried up because no one knew where the losses were and how big they might be. As bad debt fears rose, lenders raised repo haircuts which touched-off massive deleveraging, rendering the securitized asset market dysfunctional.  It’s as if the market were playing a hand of the card game hearts and suddenly realized that the deck contained more than one Queen of Spades. The players then simply threw in their cards and walked from the game rather than play a game where losses could be taken by chance.

In the current situation, corporate bond holders fear default, as the sudden-stop to corporate revenues from the demand shock could see corporates unable to service their debts. The issue is not one of uncertainty over the value of the asset because of unknown potential loss, but actual default.

Blowback to the banks

Canada’s 2008-09 asset backed commercial paper (CP) debacle featured issuing conduits without a back-up line of bank credit. Well rated CP always has a back-up line of credit in case of market dysfunction and forced intermediation of the banking system as creditor of last resort. The issuer can continue to service its debt with bank credit in the event of temporary withdrawal of market financing. Look for forced reintermediation here.

The impact on commercial banks today is once-removed. Many US corporates have large cash holdings – either in money market funds or deposits -- that will tide them over for a while to maintain solvency if the debt market withdraws funding. However, the cash holdings are unequally distributed, so some corporates will feel encroaching insolvency earlier than others. Moreover, Basel III required not just that banks have higher capital ratios, but they must hold at least 30 days worth of high-quality deposits. Problems for banks will begin when the deposits start to decline. 

Banks are going to get squeezed from two sides, as bank lines will be drawn at the same time as corporates run down their deposits reducing the stability of the deposit base. Regulators do not want banks increasingly turning to wholesale funding markets so discount window borrowing must be ample and termed-out.  The Fed has extended, or termed-out, discount window borrowing from overnight to 90 days.

Clearly central banks are on top this, and we should be aware that any central bank, as lender of last resort, can create infinite amounts of liquidity through reserve creation. We should not worry about a liquidity squeeze in the banking system so long as central banks provide the needed level of reserves. These can be injected into the banking system instantaneously on any given day once the decision has been made.

About two-thirds of US corporate funding takes place outside the banking system, and in 2008-09 the banking system was not able to play the middle man to pass-on central bank liquidity to corporates. Commercial banks also feared default, and at times wouldn’t even lend against general collateral!

The challenge for the central bank was to reach over the banking system to get liquidity where it was needed, and the central bank bowed to the need to allow access to the discount window to non-banks.  For the first time central banks accepted non-government collateral and took credit risk. This served up an alphabet soup of programs to meet each urgent situation as it arose.

Interestingly, as time proceeded and the crisis stabilized, corporates who were on the inner circle of aid had narrower spreads than those who were on the periphery looking in. We cannot repeat this a second time around. Introducing a haphazard industrial policy should not be an unintended consequence of emergency intervention.

This time policy makers know what they have to do: all corporates need access to bridge financing regardless of circumstance, and if there are losses to be taken then this can be processed once the emergency is over. We cannot avoid the fact that losses will fall on the state, and will have to be absorbed and distributed, but this is the price to be paid to ensure the basic economic infrastructure remains intact so that life can return to normal. 

This time is different

Vince Reinhart, former FOMC secretary under Greenspan, noted that the phrase “this time is different” contains the four most dangerous words in the English language. And we should take heed.

The 2008-09 financial crisis was deepened and its stabilization delayed because of policy confusion, hesitancy and inadequate political leadership. Hesitancy adds to uncertainty when intervention should reduce it. 

Our leaders at the time were the policy experts and the technocrats that fashioned the policy response, and so they will prove to be again. Following an initial and halting political response, the political leadership eventually got behind the technocrats and supported their actions.

Technocratic cooperation in central banking internationally is already clear, and this is encouraging. What is different this time is fractured political coordination. Politicians across the globe need to come together to support their institutions and be cooperative. In the midst of what is likely to be the biggest economic shock in our lifetimes, and with a lengthening shadow of a fast-moving financial crisis being cast behind us, some political leaders have threatened to sideline their technocrats. This is beyond appalling, threatening the central technocratic figures attempting to stabilize an unstable situation in the absence of political leadership is beyond the pale. 

To coin a phrase, stabilizing intervention is always profitable, and while this time the outcome is less certain, stabilizing intervention today is a matter of economic survival. No small profit.

[i] Capturing the Liquidity Premium, Foley-Fisher, Heinrich and Verani, February 2020, Federal Reserve Board.