Current Commentary - Finance & the Economy_1

· FINANCIAL PRESS DOES THE BIDDING OF INVESTMENT FIRMS AT INVESTOR EXPENSE

By William J. Dodwell June 28, 2023

A cozy symbiosis between the financial press and the investment industry can mislead investors. This is particularly evident in the way the writers seem to downplay simple money market funds and stock index funds while spilling copious ink about more complex investment strategies that make investment firms more money, often at the expense of the investor. Considering how financial journalists and their publications depend on the firms for interviews, quotes and sponsored media events, it is not surprising that reporters play a surrogate role. They know which side their bread is buttered.

ESG excepted

To be fair, this allegiance does not apply to ESG investing about which the press, to its credit, has been increasingly critical. This exception exists because ESG is so antithetical to the most fundamental fiduciary obligation to maximize returns for investors within expressed risk tolerance. To compromise this principle through political consideration is a bridge too far. Besides, ESG is a tougher sell to investors than more credible investment strategies. There are limits to writers forsaking their readers.

Money market and stock index funds get short shrift

Today, government money market funds yield about 5%, and will offer more as the Fed continues to raise interest rates to combat inflation. What is more, these funds carry no credit, interest-rate, or volatility risk as principal remains fixed. Yet, financial writers dwell on risk-laden asset allocation strategies and exotic instruments that may not be nearly as advantageous as the combined return, safety, liquidity and stability of a money fund portfolio of short-term U.S. treasuries and agency issues, despite no FDIC deposit protection. Of course, this mundane investment commands a pittance in fees and commissions for money managers and brokers; hence the cold shoulder.

Naturally, investors of a certain risk tolerance may choose to position themselves for potential outsize returns. Perhaps they prefer promising AI companies or other individual stocks, maybe along with attendant option strategies that dwarf money market income., or not. But many risk-averse buy-and-hold investors may not be fully informed of the better suitability and possible superior returns of money funds. This is because of a seeming bias in the financial press to curry favor with the industry by skewing attention to more lucrative investment products. This prejudice also applies to passive investing through low-fee stock index funds.

For example, a cogent strategy that investment firms no doubt deplore is to simply alternate between a money fund and a stock index fund as the market changes. In the aftermath of the 2008 financial crisis, stocks generally plummeted more than 40% while interest rates declined to near-zero and held for a decade. The only refuge for a conservative investor might have been a no-yield FDIC insured bank account.

But an investment in a stock index fund at the market bottom in March 2009 more than quintupled to its apex in January 2021. When stocks began to retreat significantly thereafter as the Fed aggressively raised interest rates to thwart inflation, a switch to a money market fund became as good an investment as any. Of course, this strategy depends on optimally calling the top and bottom of the stock market index, but even being relatively close makes for a sound investment that beats most others. You do not see this simple but effective strategy touted in the press.

Yes, some investors have specific time horizons that may call for optimally capturing every turn in the market, but this can be a fool’s errand. Others succumb to greed in recognition of tremendous upside potential hawked by the investment firms and their proxies in the press. If one wants to shoot the moon, he should go to Las Vegas - no fees or commissions, and free drinks. But alternating between stock index funds and money market funds most likely promises better performance in today’s environment.

Consider the track record of staid stock index funds that money managers, brokers and their surrogates in the press largely ignore. Historically, index investing has outperformed its active alternative by a wide margin. And it has beaten hedge funds soundly for years.

Gold hype

Another dubious favorite of capital management firms seemingly protected in the press is physical gold. But a greater caveat concerns the ubiquitous media ads featuring celebrities who simply follow a script and probably do not know what they are talking about. Likely, they do it for the paycheck and the exposure. Sadly, most of the hucksters are prominent non-financial conservatives including Dick Morris, Bill O’Reilly, Newt Gingrich and Andrew Napolitano. Whenever serious inflation emerges, goldbugs come out of the woodwork to promote their wares, forewarning doomsday. Even though overall inflation has declined from 9.1% to 4.0%, advocates still promote gold as a hedge against inflation and an attendant calamitous dollar collapse.

But historically, gold has not been a good hedge against inflation. (See my article, “How About Insecticide for the Goldbugs?” https://sites.google.com/site/thecomprehensiveconservative/archives/archives_1/archives_2/archives_3/archives_4#h.kjd5fmmeerlb ) And the likelihood of a ruinous currency devaluation as predicted is very unlikely, short of several nuclear missiles exploding on U.S. soil. The growing $32 trillion national debt, as deplorable as it is, is not enough to produce apocalypse. Financial writers do not seem to say much about this reality. Maybe they fear offending their benefactors.

SILICONE VALLEY BANK FAILURE RECALLS THE 1980s SAVINGS AND LOAN DEBACLE

By William J. Dodwell March 16, 2023

For some, the failure of the Silicone Valley Bank invokes an inaccurate comparison to the 2008 financial crisis. But a reasonable analogy compares SVB with the raft of savings and loan bank insolvencies in the 1980s. Let’s look at the parallels.

Silicone Valley Bank

SVB failed because of mismanaged interest-rate and duration risk from investing short-term deposits in long-term treasuries and agency mortgage-backed securities to achieve a little extra yield during a decade of very low interest rates. When the Fed eventually executed a series of ongoing rate increases to combat inflation, the value of the bank’s long-term assets axiomatically declined significantly because of their more interest-rate sensitive durations that the bank did not hedge.

Consequently, SVB raised less money from the sale of securities to satisfy deposit withdrawals. Hence, a liquidity squeeze and a run on the bank when the problem became public. What’s more, the forced selling of bank securities compounded the price declines and concomitant realized capital losses.

SVB was extremely remiss in not shortening durations in its portfolio, or adopting hedges, to avoid the inevitable capital losses on long-term fixed-income assets. The bank should have expected the losses from well-anticipated Fed rate hikes. The problem was a lapse in basic risk management, not an arcane derivative strategy gone awry or a wave of defaults like past financial fiascos.

SVB was apparently unaware of the magnitude of its unrealized portfolio losses because it classified the bulk of its securities as “held-to-maturity”. According to regulation, the bank does not have to mark these assets to market in its financial reporting.

If the bank had classified most of its bonds “available-for-sale”, regulation requires it to mark them to market. Then the significant capital losses from rising interest rates would have been transparent, prompting the bank to shorten portfolio durations and greatly avoid those losses. Since the deposit base belonged predominately to start-up technology companies in constant need of capital, SVB should have known to classify securities “available-for-sale” to correspond to deposits subject to regular withdrawal.

SVB has long touted woke policies as an advocate for ESG investing, LGBT activism, and internal obsessiveness over climate change and diversity. Many speculate whether this distraction might have been at the expense of portfolio due diligence. Astonishingly, a similarly woke San Francisco Fed did not detect the glaring anomalies in its supervisory examinations.

At present, the FDIC is trying to sell SVB via auction. If unsuccessful, it will dissolve the bank through a distribution of assets. SVB with $200 billion of assets is the largest bank failure, second to Washington Mutual with $300 billion that failed during the Great Financial Crisis. Signature Bank, also whipsawed by Fed rate hikes, is the third largest failure with $100 billion of assets.

Regional bank stocks have fallen dramatically as contagion fear generated widespread deposit withdrawals, even despite sound balance sheets. Prices will likely recover in light of regulatory sensitivity to psychological contagion. The Treasury and the Fed announced unlimited FDIC insurance and loan support afforded SVB and Signature Bank. But more bank failures could be coming. Contagion concern also has developed in Europe amid comparable anti-inflation rate hikes as in the U.S.

The savings &loan debacle

Similar to the SVB duration mismatch of assets and liabilities, savings and loan banks in the 1980s invested short-term variable-rate deposits in fixed-rate mortgages, as well as illiquid real estate. As rising interest rates lowered the value of the mortgages, and property values cratered while deposit rates rose, bank capital eroded leading to rolling insolvencies.

To overcome the inability to service deposit rate increases to remain competitive, one bank duped customers to convert their deposits to long-term bonds, surrendering their federal deposit insurance. The value of those bonds quickly collapsed leaving the bondholders devastated (until a federal bailout).

The incentive to commit to a mismatched balance sheet centered on expectations of growth and significant property appreciation that would swell bank profits. Unfortunately, the euphoria resulted in politically influenced overdevelopment and lending that dashed that prospect.

Another impetus to risky S&L investing was the increase in the federal deposit insurance limit from $40,000 to $100,000. As a result, a much higher percent of deposit accounts became fully protected. This prompted banks to invest more aggressively knowing that depositors were not at risk.

The federal government created the Resolution Trust Corporation (RTC) that took hundreds of banks into receivership for sale or dissolution over a period of several years. The debacle ultimately cost taxpayers about $125 billion (about $300 billion in today’s dollars).

SVB ‘s extreme exposure to interest-rate risk created losses, insolvency and illiquidity that precipitated a run on the bank. The savings and loan experience was similar where contagion took hold. In both cases, banks mismanaged the balance sheet. Whereas the S&L crisis resulted in a cost to taxpayers, the SVB losses are borne by the bank with help of a loan facility from the Fed, and by the FDIC, that is funded mainly by large banks. But if many more bank failures ensue, the taxpayer will pay once again.

The 2008 financial crisis

The SVB and savings and loan failures were caused by excessive exposure to interest-rate and liquidity risk arising from mismanagement of the asset/liability structure. By contrast, the Great Financial Crisis centered on default risk flowing from lax mortgage lending standards, mainly predicated on federal affordable housing policy aimed at enabling lower income borrowers to achieve home ownership.

An overly long period of low interest rates and a politically induced relaxation of mortgage lending standards caused home prices to soar. When massive defaults ensued because of so many unqualified borrowers, those prices plummeted leaving homeowners with mortgages that exceeded their home values. As such, the home as collateral was “under water”, no longer adequately securing the mortgage.

Multiple trillions of dollars of impaired mortgages circulated throughout the financial system through their packaging into mortgage-backed securities and their subsequent trading. Actual and anticipaed defaults created systemic capital losses because of the intricate interconnectivity of financial institutions. The loss of confidence in the quality of bank-issued mortgage-backed securities, compounded by grossly inflated grading by the rating agencies, triggered massive selling. Agency MBS were guaranteed against default risk by the government which wound up bailing out Fannie Mae and Freddie Mac through an equity contribution of some $190 billion, which was fully repaid.

Like the MBS selling contagion, the SVB crisis displayed to some extent an irrationally driven panic among depositors seeking to withdraw all their funds. But that fear subsided when Treasury Secretary Yellin decided to remove the $250,000 FDIC cap to fully protect all accounts of the failed SVB Bank and Signature Bank. The Fed also pledged loan relief to prevent the banks from having to incur losses in the sale of bonds to meet withdrawals.

Whether this accommodation extends to additional bank failures remains to be seen. Before the FDIC and Fed relief, depositor concern precipitated a massive shift to government securities as a safe haven, bringing down yields a full percentage point.

Of course, the Great Financial Crisis was much larger in scale than the SVB and Signature Bank failures. It involved trillions of dollars of losses in a wide range of asset classes for institutions and individuals. By contrast, the current debacle affects mostly companies and employees in the technology sector, mainly venture capital start-ups and crypto currency investors.

FDIC bailout and moral hazard

There is room for a little schadenfreude here. Some might take delight in the fact that most of the current bank failure victims are from Big Tech. Perhaps this class experienced some bad karma for colluding with government to suppress conservative content in social media. But the removal of the FDIC deposit cap renders this poetic justice academic.

SVB and Signature Bank depositors are largely wealthy technology companies and their employees who donate handsomely to the Democrat Party. Reportedly, they pressured the Biden administration for FDIC relief. One wonders if the Treasury would have extended the deposit insurance accommodation to other classes of victims.

The rescue has spurred debate about the propriety of bailout, especially considering many of the victims are very wealthy risk-taking businesses and individuals who can afford their losses. What’s more, about 90% of SVB depositors had uninsured deposits in excess of the $250,000 FDIC limit. One company kept nearly $500 million on deposit. Should they not be responsible for mismanaging their funds?

Gratuitous government intervention fosters dangerous moral hazard. It engenders expectations of future relief as needed, incentivizing wasteful risky bank investing and relaxed due diligence. However, damage on the scale of the SVB failure could precipitate contagion that poses a systemic threat to the financial system if rules are not bent. Dodd-Frank aimed to prevent the need for bailouts among the largest banks, but nobody anticipated smaller regional bank failures also could be systemically precarious. We learn that they also can be too big to fail.

Moral hazard notwithstanding, special fiscal and monetary liquidity infusions in dire emergencies can save the financial system and the economy. Certainly, that is true in the wake of the 1987 stock market crash, 9/11, the 2008 financial crisis, and, albeit overdone, the Covid pandemic.

The FDIC will conduct the bailout, depending mostly on big bank contributions to the fund. If recipients deplete the fund, taxpayers will cover the remaining claims. To have the ability to insure deposits in the future, possibly under a more accommodating claim standard, banks will pay higher FDIC fees that they will pass on to customers in the form of new bank charges and reduced services.

Moral hazard from bailouts can eventually invite recklessness, fraud and inflation that give rise to more catastrophes and rescues. Bank safety requires vigilance and accountability on the part of banks, regulators and customers to prevent bank failure in the first place. Then massive expensive bailouts become moot.

This government intervention has stanched contagion fears so far. But it remains to be seen whether more banks failed to manage their interest-rate risk in the face of the Fed’s inflation-fighting tightening. If so, more bank runs may be in store and taxpayers will be on the hook if FDIC funds run out.

GROUP-THINK RE UK FINANCIAL JOLT HAS IT WRONG

By William J. Dodwell October 20, 2022

Wrongheadedness

Most reporting on the quasi-financial panic in the UK cites former Prime Minister Liz Truss’s tax cut policy as the culprit. It was not, at least not primarily. Rather, it was a derivative hedge strategy of pension funds that went awry in reaction to rising interest rates. The development triggered collateral calls that forced a massive sale of government bonds which created capital losses in investment portfolios writ large. Sadly, this wrong-headedness about Truss’s tax cuts among investors, the public and even the Conservative Party has resulted in Ms. Truss’s resignation.

The wayward derivative strategy

Chronically low interest rates caused the present discounted value of future pension liabilities to increase on balance sheets. At the same time those low rates significantly restricted returns on pension assets, thus producing outsize funding deficits. This led to more required pension contributions to narrow the funding gap that seriously strained operations, even to the point of bankruptcy.

The derivative strategy was designed to overcome this problem and was predicated on the assumption that low rates would continue for a long time. (Modern Monetary Theory at work.) When rates rose precipitously to combat inflation, the protection dissolved prompting collateral calls involving huge sales of government bonds. The ensuing portfolio losses affected bonds, stocks and the pound. The Bank of England has intervened temporarily to purchase bonds to stabilize the markets.

Tax cuts are good

Ms. Truss announced her proposed tax cut to stimulate the economy. Unfortunately, everyone blamed the market havoc on it instead of the pension problem, of which few seemed to be aware. The group think says the tax cut would exacerbate the budget deficit, thus worsening inflation and devaluing the pound, while adding to the excessive debt. But the tax cut, coupled with deregulation, is eminently sound as a supply-side initiative to incentivize production. This capital investment also would contribute to growth which would curb inflation, now 10.1% year-over-year in the UK.

Sadly, Ms. Truss limited the benefit of her tax cut by also proposing government subsidized caps on energy prices and more spending. On this, the reaction of the masses is justified as that policy would worsen inflation and hamper growth. But, absent the pension derivative strategy, that concern would not have triggered the financial bedlam that occurred.

Deja' vu

This event is reminiscent of the U.S. derivatives debacle in 1994. The Fed raised interest rates in quick succession after years of near rock-bottom levels precipitating a mass failure of derivative strategies. Among the casualties were a PaineWebber money fund that “broke the buck” and the bankruptcy of Orange County, CA. This is not an indictment of derivatives, but they can be disastrous in the face of unexpected events.

GET THAT ESG CRAP OUT OF MY PORTFOLIO

By William J. Dodwell October 17, 2022

The backlash against ESG

Surprisingly, disaffection with the ESG craze is mounting fast. I expected the mass disillusionment to last much longer. I refer to the political left prevailing on asset managers and brainwashing individuals into investing trillions of dollars according to environmental, social and governance criteria. If only the climate change canard met such resistance early on, the country would not be facing the ludicrous Green New Deal movement that promises to wreck the economy. Somehow, people’s heads clear when politics intersects with their money.

Consider the following sampling of headlines concerning ESG protestations:

- ESG Can’t Square With Fiduciary Duty

- Arizona Defends Retirees Against ESG

- Climate Change Brings a Flood of Hyperbole

- Biden’s ESG Tax on Your Retirement Fund

- End the Fed’s Mission Creep

- Texas Blacklists Firms For Alleged Energy Bans

The hidden agenda

The ESG movement aims to incorporate climate change, diversity, equity, LGBTQ and a range of stakeholder interests into corporate policies and culture. It is a Marxist ruse to co-opt the business sector as the Left is doing in the military, and has done in academia, media, Big Tech, and entertainment. The ultimate goal is to tear down our institutions as a prelude to creating a new socialist order. Besides, the typically lower returns of ESG investments conflict with the fiduciary obligation of money managers to pursue maximum returns for clients. And investors are speaking out.

Of course, there is a profit motive too. Asset-management firms charge outsize fees for ESG designated funds that many starry-eyed investors or their surrogates seek. These investments have been under public and regulatory scrutiny as to whether they really represent what they claim. Furthermore, ESG measurement methodologies are inconsistent and dubious. The room for fraud is boundless.

Larry Fink and BlackRock

The poster-boy for this nefarious political hijacking is Larry Fink, founder and CEO of BlackRock, the largest asset-management firm in the world with some $9 trillion under management and advisory. He has pressured companies to go woke by suggesting that his firm would steer client funds away from their stocks if they do not cooperate. In particular, he strives to defund oil and gas companies in the effort to curtail the production and consumption of fossil fuels and eventually terminate that industry. In a panel discussion on video Fink said that voluntary compliance with ESG is not enough and that investors have to be “forced” to embrace the woke through his coercion.

Fink also uses BlackRock’s heavily weighted proxy share voting power to incorporate ESG in the corporate actions of thousands of investee companies. Fink even gets other money management firms to do likewise through interlocking boardships and equity stakes.

Pressure on corporations is also coming from the Fed and the SEC as they contemplate cumbersome ESG disclosure requirements beyond their historical mandates. In addition, the NASD requires the boards of member firms to meet prescribed diversity standards. Furthermore, some private-equity investors are linking portfolio managers’ compensation to the ESG compliance of investee companies. Credit rating agencies now incorporate ESG factors in their ratings in the form of a credit impact score.

The bogus climate change premise

Concerns about climate change constitute the greatest impetus of the ESG movement. The issue is commonly expressed through the apocalyptic and bastardized term, “sustainability”, supposedly referring to the sustenance of the planet whose advocates believe is under serious threat from carbon emissions.

Climate change naysayers, called “deniers” by the Left, do not believe man-made agents, such as CO2, cause climate change, at least not more than an inconsequential infinitesimal degree. Nor do they believe man can change climate, which has morphed naturally for ions, sometimes catastrophically. The best one can do is prepare for the natural effects of extreme weather and anticipated calamities, such as hurricanes and earthquakes.

Thus, the effort to minimize carbon emissions by eliminating fossil fuels is a fool’s errand, especially considering the enormous economic and social costs. Many climate scientists agree but mainstream media suppress them, or they remain silent for fear of losing their research funding or their jobs.

The constant faux media alarm is just so much propaganda. The environmental movement is ultimately about redistributing global wealth through taxation, fines and legal settlements in a massive one-world socialist transformation. In fact, the earth is not fragile. It has withstood natural shocks and disasters forever, certainly anything man could throw at it.

Now the Federal Reserve requires banks to disclose climate change threats to the financial system, such as systemic loan defaults resulting from potential regulatory sanctions, carbon transition risk, lawsuits and disabling physical damage incurred by borrowers.

ESG exposed

Of late, Fink of BlackRock has been in the hot seat as pension fund managers, corporate Treasurers and state AGs protest ESG tactics. In reaction, Fink recants, saying his fiduciary duty to clients is sacrosanct. But he got caught with his pants down and now he is backpedaling. Increasingly, clients are not buying his equivocations. Recently, a few institutional investors withdrew over $1 billion of holdings. Many more ought to follow suit.

ESG investors may indulge their climate change and social justice fantasies as desired but they should know whether money managers really direct their investments to those purposes. Even so, those investors should realize they are empowering authoritarian government and fostering the emergence of a new socialist order.

To be sure, ESG investing is still expanding more than contracting. But increasingly, the public is getting wise to the environmental charade, especially as it impacts their pocketbook. Resistance is becoming more acute in view of inflation arising in part from unnecessary government restrictions on fossil fuels and nuclear production while alternative energy sources still prove unreliable.

Social and governance initiatives undermine the meritocratic model that built the nation, and create division and resentment at the expense of productivity. Wokeness spawns tyranny that stifles growth and prosperity. ESG investing is part of the problem.

COVID-19 FINANCE: A REVIEW AND ASSESSMENT

By William J. Dodwell April 13, 2020

The 2008 financial crisis centered principally on the housing and financial sectors that spawned the subprime loan debacle in all its ramifications. By contrast, the novel coronavirus crisis cuts across all economic sectors that produce and consume goods and services. What’s more, the economic impact is more extensively global than the Great Financial Crisis. Hence, the historical scale and scope of the fiscal and monetary stimulus implemented by the U.S. Treasury and the Federal Reserve Bank.

The genesis

Government-mandated lockdowns to contain the spread of the COVID-19 virus have frozen the national economy. As a consequence, businesses, as well as states and municipalities, have to frantically raise cash to cover operating losses and debt service in the face of dramatic revenue shortfalls. And in the process, tens of millions of furloughed workers lose their income. What’s more, investors, besides liquidating stocks, initially generated a massive sell-off of Treasuries that led to serious illiquidity throughout the credit markets shutting off desperate borrowers.

Then the Federal Reserve rode to the rescue with a mammoth liquidity infusion that has stabilized the credit markets, and might have started a growing investor rotation from bonds back to stocks. In addition, ultra-low interest rates attendant to the new liquidity prompt extensive business borrowing to raise cash.

The Fed stimulus

The Fed, with the help of a $30 billion equity investment from the Treasury’s Exchange Stabilization Fund, has provided a $2.3 trillion package of loans in response to the economic ravages of the coronavirus crisis. All loans are issued by banks which can sell them to the Fed while retaining a required 5% interest. Fed accommodations include the following:

- A 1% cut in the benchmark interest rate to near zero.

- Additional lending to the financial sector through more reverse repurchase agreements.

- Expanded securities purchases (quantitative easing) beyond traditional Treasuries and agency mortgage-backed securities, now to include municipal bonds, as well as below-investment grade corporate bonds and ETFs.

- Loans to businesses with up to 10,000 employees and less than $2.5 billion of 2019 revenue, along with a one-year deferral of principal and interest payments.

- Purchases of corporate commercial paper to backstop inadequate market participation.

- Loans to finance investor purchases of AAA rated asset-backed securities through the Term Asset-Backed Securities Loan Facility (TALF). This program, revived from the 2008 crisis, supports the securitization of auto loans, credit card receivables, trade receivables, leases and student loans affecting a cross-section of economic activity. The facility also finances the purchase of AAA commercial mortgage-backed securities (CMBS) and collateralized loan obligations (CLOs).

- Temporary relaxation of a regulatory capital requirement; banks may omit Treasuries and central bank deposits from the leverage ratio (core capital/assets).

The Treasury stimulus

At the same time, Congress passed the Coronavirus Aid Relief and Economic Security Act (CARES), a $2.2 trillion initial spending and loan package for individuals, municipalities, and businesses of all sizes to reignite consumption and production. It includes the following:

- A one-time cash payment of up to $1,200 to workers and retirees.

- Bank loans to small businesses to finance payroll that are forgiven if employees are retained..

- Bank loans guaranteed by the SBA to shore up operations.

- Payroll assistance and loans to the hard-hit airline industry, partially in consideration of disputed stock warrants.

- Loans to states and local governments serving populations over 500,000.

- Expanded unemployment benefits, some of which match or exceed lost salaries.

And more is coming, subject to Democratic extortion to add sundry unrelated special-interest spending. President Trump has proposed an additional $250 billion for small business. Also under discussion is a proposal for guaranteed private company paychecks. The Treasury, that is taxpayers, will absorb defaults of its loan, as well as those of the Fed. But even with government aid, companies face a liquidity squeeze from radical revenue declines. CFOs are issuing bonds, extending credit lines and cutting costs to get by.

How is so much government debt affordable? Financial markets presume that the historical good faith and credit of the U.S. government always will attract global investment in Treasuries and thus enable federal borrowing on demand at reasonable cost. In addition, the Fed has always been able to create money by fiat to ensure currency with which to buy the debt while usually avoiding serious inflation through robust economic growth. Witness the dramatic rise in federal debt to fund the wars in Iraq and Afghanistan, as well as the recovery from the 2008 financial crisis. While the COVID-19 emergency may justify the current government extravagance, and the inherent power of the economy permits certain excess, there is a limit to a nation’s means and the ability to live beyond it.

Inflation

At some point the new liquidity could unleash dangerous inflation. Surprisingly, it did not materialize from the monetary stimulus following the 2008 financial crisis. That is because that money redounded to the financial sector creating inflated financial assets instead of overpriced goods and services in the real economy as investors sought to escape near-zero interest rates. (Also tempering inflation have been global competition and productivity from technological advances and deregulation.) But in the long-term that capital will migrate from the financial sector to the real economy, perhaps to create inflationary pressures.

But the multi-trillion dollar coronavirus monetary and fiscal stimulus is more targeted to industry and impacts all sectors of the real economy making eventual goods inflation seemingly compelling. In the extreme, this would engender growth-stifling taxes and interest rate hikes that could lead to government and corporate ratings downgrades and more burdensome debt service. Highly indebted companies that cannot roll over coronavirus debt could precipitate widespread defaults and bankruptcies that further suppress the economy. On the other hand, some additional inflation would be salutary in that it eventually forces up interest rates to normal levels. That outcome has eluded the Fed for over a decade.

Recovery

The coronavirus bailout and GDP decline will likely raise the federal debt to GDP ratio to approximately 120%, up from about 40% before the Great Financial Crisis. At the same time, demands on Social Security and Medicare escalate sharply as legions of baby-boomers retire. One has to wonder how much all this fiscal drag will affect future growth. And conservatives worry about the increasing interventions of the Fed and Treasury in the private sector that foster growing dependence on government, and perhaps a societal appetite for socialist policy.

Pre-crisis prosperity and the government backstop against coronavirus losses during the downturn suggest the economy’s ability to rebound fairly quickly in the short-term in a V-shaped or U-shaped recovery. But, while pent up demand will create an initial spark, some consumers may hold back until they make up lost income. Likewise, some employers may not rehire all employees as a cost-saving measure. In addition, depleted investment portfolios may have a reverse wealth-effect that deters normal spending. If these factors combine with a recurrent coronavirus outbreak, a longer term W-shaped recovery is more likely.

More importantly, the long-term outlook could be plagued by growth-sapping deficits and debt, taxes, suppressed corporate earnings and muted stock valuations that preclude a return to normalcy that was the Trump economy. The solution is a strong pro-growth agenda that supports investment and innovation, principally through tax incentives and regulatory relief. But that prospect is doomed if President Trump is not reelected in November. In any case, government spending has to be reigned in significantly to generate the growth that can enable meaningful debt reduction. No president has been inclined to do that for some time

William J. Dodwell is a retired corporate executive, management consultant and financial writer in the finance industry with particular expertise in the capital markets. Mr. Dodwell has written in professional journals, the trade press and corporate publications. He is a Certified Public Accountant (Inactive) licensed in the State of New York.

BELOW-MARKET INTEREST RATES DISRUPT THE REPO MARKET

By William J. Dodwell January 14, 2020

Much has been written about anomalies in the repo market since a sharp spike in the rate last September. Repos (repurchase agreements) are instruments by which financial institutions lend or borrow cash (up to 180 days) to/from one another in exchange for Treasury securities collateral. Indeed, repos are a $5 trillion market that is crucial for funding bank trading and investment activities.

Inter-bank cash shortages and Fed intervention

But banks also rely on this facility to shore up brief cash shortfalls created by a raft of withdrawals from the financial system. They include large scale collective payments, such as corporate taxes and Treasury auction settlements that transfer cash out of banks to the Treasury. Banks use repos to borrow cash to satisfy more stringent post-crisis regulatory net capital and liquidity requirements. These thresholds are particularly sensitive at year-end because they may determine whether banks have to raise additional capital to qualify for Fed approval to pay dividends or buy back shares.

Of late, a paucity of capital in the repo market has caused short-term rates to rise creating upward pressure on the Federal Reserve Bank’s federal funds overnight rate which is supposed to be the designated benchmark for all other short-term rates. In order to keep this rate at the Fed’s desired economically optimal level, the Fed has been infusing liquidity into the financial system through repo loans of its own to borrowing banks needing cash. This reduces the repo rate to slightly above or below the fed funds rate.

Various forces have created tightness in the repo market causing rate increases and volatility that prompt Fed intervention. Since repo activity worldwide is highly concentrated in just four U.S. banks, inter-bank repo lending diminishes when they hoard cash to meet regulatory requirements, or when they opt to invest in Treasuries instead of repo loans. Similarly, many small dealers have stopped repo lending because post-crisis regulation has made cash generally scarcer and thus more costly and onerous to acquire. And, when cash shortfalls in banks arise causing them to scramble for liquidity, the resulting volatility further increases the cost to borrow by repo. In addition, strong demand for cash from hedge funds and money market funds has made it less available for banks, sometimes straining operations.

Artificial rates and moral hazard

The result of liquidity infusions by the Fed is to produce artificially low short-term rates which further discourage banks from lending to each other in the repo market. Once the Fed repo stimulus wears off, market forces raise the rate again to natural and more profitable levels based on the supply and demand for money. This invites the Fed to intervene yet again and again in a tug of war fashion with the market to lower the rate to maintain its desired fed funds level. The Fed set the current fed funds rate at the 1.5% - 1.75% target range which in real terms (after inflation) is slightly negative. This, while the economy is relatively robust with unemployment at record low levels. Why is the Fed keeping rates so low when the market seems to call for higher rates? Is the Fed skittish about disturbing stock and bond markets? Is it intimidated by President Trump’s jawboning for minimal rates?

Superficially low rates created by the Fed’s accelerated repo operations induce banks to retain cash in their riskless interest-bearing excess reserves held at the Fed. Ordinarily, the banks would lend to other banks via higher-yielding repo which carries a modicum of counterparty risk. This partial bank withdrawal from repo lending causes rate volatility that raises funding costs which crimp bank net interest margins.

Fed intervention in the repo market is analogous to its much larger quantitative easing program aimed at suppressing long-term mortgage rates in the aftermath of the Great Financial Crisis. The resulting low long-term rates have encouraged investors to seek higher returns in riskier assets such as stocks, high-yield foreign bonds and private-equity. This practice has misallocated capital to inflated financial assets at the expense of higher-interest bank deposits and business investment that support the real economy of goods and services. Suppressed long-term rates also have encouraged dangerous debt accumulation by government, businesses and consumers.

Artificially low short-term rates cause a dearth of inter-bank lending, the lifeblood of the financial system. Consequently, uneven cash flows among banks are insufficiently corrected causing the Fed to lend repeatedly in the place of other banks in order to maintain operating stability. The repo assets on the Fed’s balance sheet and the income that flows from them ordinarily reside with the banks to the benefit of their shareholders and the economy. That income should not accrue to the Treasury via the Fed. Likewise, the Treasury and mortgage securities the Fed owns as a result of quantitative easing could belong to the banks.

Thus, the larger the Fed’s balance sheet, the more distorted the financial markets become to the general economy’s ultimate detriment. Right before the financial crisis the Fed’s balance sheet was $900 billion. It subsequently rose to $4.5 trillion through post-crisis quantitative easing. Then the Fed reduced it to $3.8 trillion as it stopped QE in 2017 and allowed the portfolio to run off as securities matured, a process that helps to normalize long-term interest rates. However, in a later stimulus the Fed discontinued the unwinding in 2019 causing its securities portfolio to rise to $4.2 trillion today, including about $250 billion of repo loans (reverse repurchase agreements) to financial institutions to correct their cash shortfalls.

In a free market the cost of funds should be determined by private-sector lenders based on their risk-return calculus. The Fed’s job is to ensure short-term interest-rate stability through temporary intervention as needed. Even the salutary long-term intercession during and after the financial crisis should end eventually. Ongoing repo loans from the Fed to banks are a crutch for a systemic problem that suggests that short-term interest rates set by the Fed are too low. The central bank should not become a permanent substitute for financial market participants because this distorts interest rates and asset price discovery. In case of the repo market, the Fed has become the lender of last resort. Ongoing market desperation is not healthy.

Correctives

There are proposals to revamp the repo architecture to improve the availability of cash to cover bank shortfalls. One is to establish a facility that triggers an automatic release of funds from a bank’s own excess reserves at the Fed when needed. However, such reliance probably would invite a stigma akin to borrowing from the Fed discount window. Another idea is to require banks to transact repos through clearing houses like Dodd-Frank mandates for swaps. However, the added cost is likely unwarranted given that repos are fully secured and mainly about liquidity risk. By contrast, minimally secured swaps involve more dangerous market risk associated with hedging and speculation.

Nevertheless, the current problem in the repo market suggests that post-crisis short-term interest-rate normalization has to resume. The Fed’s fear of roiling the stock and bond markets from rate hikes must not impede that necessity. Those asset prices are currently susceptible to some correction because they are inflated by below-market general interest rates. Stock prices hit record highs throughout 2019 despite negative earnings growth all year. And a near-flat, and sometimes inverted, yield curve does not seem consistent with a reasonably growing U.S. economy, notwithstanding the influences of slow global growth.

Below-market interest rates have created inflated financial assets for some time. Now they contribute to dislocations in the repo market which cause repetitive operating cash shortfalls at some banks. The Fed needs the fortitude to resist political pressures and normalize rates. Recall the courage of former Fed Chairman Paul Volcker in the early 1980s in raising rates to record levels to extinguish hyper-inflation.