Equities

Dwight Cass

Fed Brings Knife to Gunfight

The Fed is not only no longer a credible player, it’s actually causing measurable harm. Investors, hoping for something useful to come out of the G-7 conference call this morning, reacted to the central bank’s 50 basis point rate cut by driving the Dow and S&P down 3.5 percent by early afternoon. It would have been wiser for Powell and Friends to keep silent, sequestering their dwindling monetary ammunition for another day, when it might have done some good.

Even stock market investors understand that the Fed is making a category error. The Fed boss may have a hammer, but this crisis isn’t a nail. Specifically, unlike the Global Financial Crisis, when rate cuts helped ease pressure on bank balance sheets, Wall Street just isn’t the problem this time around. The industry’s solipsism makes it hard for bankers, and by extension, the Fed, to understand this. But this time, the trouble stems from events outside their purview. As Wolf Richter put it in a post earlier today, “Disappointed the Fed didn’t print antibodies?”

Worse, the Fed’s move could contribute to trouble in bank-land. In a note out yesterday, Fitch analysts warned that a rate cut could hurt bank profitability. With historic levels of marginal investment-grade debt about to slide off the cliff, and the leveraged markets looking increasingly parlous, banks don’t need this kind of trouble:

Fitch sees near-term downside to profitability due to asset yield compression while the yield curve falls at a historical pace, with the 30-year rate hitting an all-time low, as the Fed indicated that it would use necessary tools to support the economy. While we expect that banks will attempt to be quick in their response to cut deposit and other funding costs accordingly, these actions will not likely be to the same degree that asset yields compress, resulting in lower margins and reducing overall profitability, at least in the near term. Fitch notes the 30-day LIBOR forward curve dropped 25 bps during February, which could significantly affect loan yields during 1Q20.

That’s not apocalyptic, but it’s not great news, either, especially as the biggest US bank dealers – the eight so-called systemically important ones – boosted their equity holdings by 20 percent last year, to $454.5 billion, according to Risk. Luckily, they increased their stock of Treasuries by 28 percent, to $345.4 billion. The latter are rallying.

It is almost a relief to see the Fed out of the game, like a tennis star who has missed an easy volley staring dumbly at his racket, looking for the hole. The invective spewed at the Fed by Trump and his Tammany-on-the-Potamac enablers was dispiriting before; now it is a policy-ossifying distraction. On to the next bad option.

Dwight Cass

Of Falling Knives and Vicious Circles: Will the Corona Crisis Spread Like the 2008 Crash?

Catching a falling knife? Check. Rushing the exits? Yup. Vicious circle? Yeah, that one too. Market clichés last heard during the 2008 Financial Crisis are back in vogue among the financial commentariat. But there are important differences between that disaster and the market meltdown unfolding this week. It’s unlikely the Corona Crisis will metastasize in the same way.

The 2008 crisis had several novel characteristics. A significant driver was incorrect risk management assumptions about the correlations among assets. When mortgages proved to be more correlated than models assumed, mortgage-backed securities bombed. More broadly, entire bank business models based on the assumption that diversification was an unchallengeable law became fountains of red ink when different types of assets began declining in lockstep.

Two related factors meant to improve risk management ended up acting as vectors of contagion, turning a housing problem into a disaster for the bond and equity markets, too. The first were regulatory capital rules, which require banks to set aside more capital against high-risk assets than they set aside against safer ones. The second factor is the market practice of requiring a firm to stump up more collateral when a trading position declines in value.

These all sound sensible. But if the assets becoming riskier (mortgage-backed bonds in 2008) cannot be sold easily, banks have to get the money to pay their capital and collateral requirements by selling other types of assets, like stocks, Treasuries and corporate bonds. Banks started pouring these assets into the markets in 2008, driving down prices on the securities, some of which they retained in their portfolios, triggering the need for yet more capital and collateral, and so on – the archetypical vicious circle.

As these assets fell in price, potential buyers stepped back, not wanting (as the pundits put it) to try to catch a falling knife. So prices of all types of assets plunged further. The result was the worst multi-asset market meltdown since the Great Depression.

The Corona Calamity looks different, so far. If it does become an undifferentiating multi-asset meltdown, it will be because the coronavirus wreaks terrible havoc on the world’s economies, and not because of the types of unanticipated structural links that spread woe in 2008.

There are some positive signs. The negative correlation among asset classes, described by old wives as not keeping all your eggs in the same basket, and finance professors as diversification, appears to be back. The Fed’s abuse of savers through ultra-low rates forced investors to take more risk in the equity markets than they really wanted. Now that stock prices are dropping, “safe haven” assets like Treasuries are in demand. Stocks go down, Treasuries go up – just like the textbooks say should happen.

Regulatory capital rules are still problematic, forcing banks to pony up capital at what appears to be just the wrong times – when the value of their assets are falling. But the Dodd Frank and Basel Committee rules implemented since the Financial Crisis boosted the core capital requirements, so firms are better capitalized from the start. That should give them a bigger margin of error and reduce the chance of igniting a (sorry) run for the exits. And, assuming the Fed’s brain trust doesn’t gut the Volcker Rule, banks are barred from dabbling in ultra-risky proprietary trading, which should help to keep collateral calls to a manageable level.

This means the Corona Crisis could remain an equities problem. Sure, corporations could fail due to supply chain disruptions or falling sales, and so bond investors could take a bath on the squillions they have invested in junk and marginal investment-grade securities. Banks, meanwhile, might have a lot of senior loan write-offs in their future. But equities aren’t principally held by banks, so the regulatory capital and collateral issues should not act as vectors of contagion the way they did during the Financial Crisis.

The Financial Crisis was so pernicious, in part, because it was accelerated and magnified by structural and modeling issues that had never been tested – new product technologies, newish regulatory capital rules, new risk management models. The current meltdown appears to be a refreshingly straightforward catastrophe, with an obvious exogenous trigger and reasonably straight causal lines to be drawn from independent to dependent variables. But I vaguely remember thinking that in early 2008, too….