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….

Dwight Cass

Volcker Rollback is a Camel’s Nose Under the Wrong Tent Flap

It all seems reasonable. New rules from the Fed, OCC and FDIC would only tweak technical bits of the Volcker Rule to ease bank business interactions with hedge funds and private equity. What’s wrong with that? After all, the 3 percent limit on direct ownership of these funds remains in place, ostensibly keeping banks from running amok and reviving the risky proprietary trading businesses that the rule, part of the Dodd Frank reforms passed in response to the Global Financial Crisis, effectively quashed. Banks and regulators portray the measure, out for public comment until April 1, as an exercise in fine tuning, rather than a strategic change.

That might be the case. But the rule change, along with other mods to compliance regulations related to prop trading made last summer, reflect how financial regulation is subject to its own version of the second law of thermodynamics. The regulatory trend is always toward entropy. And this is troubling.

Many at the time of its passage thought the Volcker Rule was downright draconian, separating banks from one of their core revenue-generating businesses. Hotshot traders left investment banks in droves in order to set up their own hedge funds, only to step into a decade-long performance abyss for active managers, where buying a dirt-cheap index-tracking ETF was almost always a better bet than paying 2 and 20 to some guy in red suspenders who never beat the market. The archetypical alpha chaser struggled along like a fat man running after beta’s bus.

That’s still the case. So why worry? Well, to its boosters, myself included, the Volcker Rule seemed like a step toward what the financial system really needed, which was (and is) a new Glass-Steagall Act separating banking and speculative investment businesses. When Sandy Weill convinced Bill Clinton to withdraw the Act in 1999, so the former could stitch together his shambolic Frankenstein’s monster, Citigroup, it was one step on the path toward the Financial Crisis.

During the crisis, the big commercial/investment bank hybrids essentially held their massive retail deposits hostage, forcing the government to bail them out when their “financial engineering” products started blowing up in their faces. The Volcker Rule was meant to keep banks from dabbling in novel, high-risk, nontransparent investment strategies in order to avoid this happening again.

But the banks and investment banks are still joined at the hip. In some cases, even more so. Goldman Sachs is getting into retail. Morgan Stanley is buying E Trade – admittedly, not FDIC-insured, but with over $300 billion in mostly retail assets, something the government is going to be watching closely. And there’s always Citi, with its unerring talent for stepping on every possible land mine.

Even Fitch, which did not exactly cover itself with glory during the run-up to the Financial Crisis, wrote an admirably canary-in-the-coalmine report today saying that the changes were “indicative of loosening regulation and recalibration of post-crisis regulatory rules.” The rating firm “views robust regulation and capital requirements as supportive of credit ratings; therefore relaxation would be viewed as a credit negative.”

It would be more encouraging to see bank regulators laboring to build a more robust wall between taxpayer-insured businesses and the hedge fund and private equity casinos. This mod represents a step – granted, a baby step – in the wrong direction.

Dwight Cass

Credit is the Emerging Bogeyman for Debt Dystopia

The downgrades of Macy’s and Kraft Heinz hint that the next corporate debt catastrophe might not be caused by a wall, but a cliff. The Wall of Maturities that so worried leveraged loan, junk bond and CMBS investors at various times after the Global Financial Crisis turned out to be easily vaulted. The real problem, according to an OECD report out today, might be the massive amount of debt clinging to the bottom rung of investment grade. Macy’s and Kraft Heinz lost their footing. If others follow, things could get interesting.

Wall Worriers were concerned that the junk bond and loan markets would not be able to absorb the massive amounts of debt that had to be refinanced from around 2012 through 2014 – much of it loans used to finance the pre-crisis buyout boom. The CMBS reckoning was thought to be coming a few years later.

But the Fed, ECB and other central banks came to the rescue. By driving down yields on moderate- and low-risk investments, they forced pretty much everyone to slide down the credit spectrum in search of yield. Junk issuers found plenty of indiscriminate demand, the brains on which zombie companies feed.

The OECD report highlights another big problem, and one that central banks will not be able to solve. This is simply that the flood of nonfinancial corporate bonds – some $2.1 trillion was issued in the wake of the Fed’s dovish turn in 2019 alone – is near junk. “Just over half (51%) of all new investment grade bonds in 2019 were rated BBB, the lowest investment-grade rating,” the report states. This is even more dismal that before the financial crisis, when only 39% of investment grade issues were rated BBB.

The proportion of junk bonds has also increased, to 25% of nonfinancial corporate issuance last year, and over 20% since 2010. That’s the longest period of high volumes of low-quality issuance since 1980, and, the OECD says, “indicates that default rates in a future downturn will likely be higher than in previous credit cycles.”

If more economic stalwarts like Macy’s start to circle the drain, or the coronavirus so messes up supply chains and distribution lines that many marginally investment-grade companies run into trouble, large numbers of issuers could cross the line into junk status, forcing investors who cannot hold high yield instruments to sell. Large-scale forced selling of distressed assets – that has an unpleasant ring to it.

Dwight Cass

Foundering Fed Fires Final (Fiscal) Flare: An Epitaph for the Greenspan Put

It was bracing to hear Fed boss Jerome Powell admit this week that the Greenspan Put is kaput. When its namesake began propping up crisis-wracked markets in the late 1980s, the Fed quickly became risk-taker of last resort, making Maestro Alan the hero of Wall Street. Granted, this led to quick rebounds from the Black Monday crash, the early ‘90s junk bond and real estate downturns, the Mexican, Asian, and Long-Term Capital Management crises, the Dotcom bust and even 9/11. But when lenders and investors realized that the Fed would always bail them out, it created the “heads I win, tails you lose” ethos and moral hazard that set the stage for the Great Recession.

Powell finds himself in his current straits because the Fed broke with tradition and did not unwind the policies – low rates and massive asset purchases dubbed Quantitative Easing – that it implemented in response to the Great Recession. This was a crucial mistake, though perhaps an understandable one, especially after the Fed’s announcement that it would slow its pace of asset purchases in 2013 led to a market backlash dubbed the Taper Tantrum.

The Greenspan Put was a confidence building measure, more effective psychologically than economically. It was meant to spur markets to recover, not to force them. And while Powell and his predecessors have tweaked rates and QE here and there, the Fed still has its policy gas pedal stomped so far down there’s little it can do to accelerate the economy out of the next downturn. Worse, everyone knows it.

That’s why it seemed so extraordinary when Powell on Tuesday told the House Financial Services Committee, “The current low interest rate environment also means that it would be important for fiscal policy to help support the economy if it weakens.” This was like telling the markets that Santa Claus doesn’t exist. Bloomberg nailed the Fed’s predicament: “After three reductions last year, the Fed’s target for short-term interest rates now stands at 1.5% to 1.75%, less than half the 500 basis points in cuts it has made to fight past downturns.”

So much for market psychology. In fact, there’s a real risk of investors’ inner dialog becoming a self-destructive spiral: “If the Fed can’t step in, if the Greenspan Put no longer works, we have to rely on Trump’s Tammany-on-the-Potamac and the Congress that just impeached him to come up with TARP 2.0 or some kind of New New Deal? We’re doomed! Sell!”

Also, aside from the fact that fiscal policy is a political issue outside the ostensibly independent Fed’s mandate, it is no substitute for monetary policy. Fiscal policy acts more slowly, unevenly and uncertainly. Take the fiscal policy response to the Great Recession. In the immediate aftermath of Lehman Brothers’ collapse in September 2008, Congress approved the $700 billion Troubled Asset Relief Program, meant to stabilize the financial sector and spur economic activity.

But the effect was negligible. Banks used the government’s capital to buy back their shares at depressed prices, rather than to expand lending. The money for infrastructure mostly went to existing projects, instead of new ones that would have boosted employment and spending. Despite being used to bail out two of the big three US automakers, only about $430 billion in total was disbursed.

Despite the Great Recession, there are some Great Moderators still out there. Sixteen years after Ben Bernanke credited central bank wisdom with “taming the business cycle,” you can find people who believe that the Great Recession was just a regrettable blip in the economy’s Great Moderation, devised and directed by central bank wonks. It is encouraging that Powell does not. But he still has his work cut out for him.