Gillian Tett of the Financial Times perhaps a bit wistfully, looks back on the days when market participants could tell themselves that everything could bubble along at a “just right” level. She now wonder whether despite the troubling prospects, we might somehow stumble through in a way that avoids the worst extremes (the equity markets seem to subscribe to this view).
Schylla and Charybdis seems a more fitting image. And we had termed the Goldilocks fantasy-past-its-sell-by-date as the Tinkerbell market, but to each his own.
Tett sounded early alarms that the debt boom could end badly, and she is similarly not optimistic about finding a clear path though the credit contraction. From the Financial Times:
In recent years, the concept of a “Goldilocks” recovery has permeated the policymaking world. For after decades of painful economic booms and busts, politicians and central bankers have become wedded to the idea of chasing a growth rate that is neither “too hot, nor too cold, but just right” …..
Instead, the hot new topic of debate in financial circles is the “l” word: namely leverage; or, perhaps more accurately, the “d” phrase – “deleveraging”, as the process of cutting debt is called.
In particular, what financiers are urgently trying to work out is whether there is a way to cut debt levels in the banking sector at a pace that is fast enough to reassure investors – but not so fast that sparks a wider market meltdown and credit crunch.
Can Wall Street, in other words, deliver a wave of “Goldilocks deleveraging” that is neither too hot, nor too cold – but somehow “just right” – or, at least not too wrong?
It seems a fiendishly difficult task. The credit crunch has demonstrated with painful clarity in recent months that the financial sector has become dangerously over-levered this decade, to a degree that almost nobody realised before – partly because the normal metrics to measure leverage are pretty useless.
Western policy makers are now eager to see this leverage reduced. And stock market investors agree: the banks that have suffered most badly in the equity markets in recent months are those – such as Lehman Brothers – which are highly levered, relative to peers.
But while deleveraging has got under way in the hedge fund world in recent weeks, one dirty secret of today’s financial sector is that most banks have not yet followed suit; on the contrary, many are still seeing their leverage levels rise because assets are rolling back on to their balance sheets on a large scale.
One obvious way to rectify this would be to raise more capital. Banks such as Lehman Brothers and UBS are now doing precisely that.
But many other banks are finding it hard to follow suit. After all, many private investors remain wary of putting money in banks.
Meanwhile, my recent conversations with US policymakers leave me convinced there is little chance of direct public fund injections either.
That consequently implies that banks will have to slash leverage the hard way: namely by cutting assets. But if the banks cut credit lines to “real economy” borrowers, this will hurt growth; and if they sell securities, this will further depress prices.
Indeed, it seems that one key reason for last month’s turmoil was that large investment banks were trying to cut leverage through the easiest route available – slashing their repo operations with credit funds.
Wall Street executives are now urgently trying to explore other options, such as copying the “ringfencing” idea unveiled by UBS this week, which would essentially spin bad assets into a separate vehicle.
Some also want to create an industry-wide fund to absorb troubled securities, which might be backed by a multilateral group such as the International Monetary Fund.
But I doubt whether these multilateral ideas will fly any time soon – or not unless another downward lurch occurs.
So the essential question remains this: can banks really cut their leverage levels effectively and calmly via furtive asset sales or ringfencing? Or are we heading for more stop-start turmoil?
Personally, I would love to believe in the Goldilocks scenario.
However, history is sadly not on the side of this fairytale. After all, very few episodes of deleveraging have occurred in the banking sector before in a manner that was “just right”.
Stand by, in other words, for plenty more market lurches – accompanied by plenty more growling from the credit bears, as investors are scalded and frozen, all at once.
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The most plausible element of a Goldilocks scenrio here (if only temporary) is simply the continued accumulation of USD reserves by Asian Mercantile, EM and GCC central banks, at once delivering copious (unsterilized?) liquidity while keeping real USD interest rates tethered to the negative side of Zero. While this may just replace the credit and asset values destroyed from recent implosion and deleveraging, this may be sufficient to stay atop the ridgeline between inflation and deflation (for the while). Such Goldilocks would be decidedly more homely than the blonde cutie in fairy tales, as it would likely be profoundly stagflationary before morphing into something more evil.
Yup, the Fed will push negative short-term real interest rates, in order to help the banks profit with a steep yield curve. I don’t know if the fed will push nominal short-term interest rates below 1% though. The money market funds start losing money with rates below 1% nominal, and they have some political pull.
In considering whether we are in some semi-stable macrofinancial equilibrium where Goldilocks can stay upright for a time, the issue is what is the mid-term trendline? What things are _better_ now than they were two weeks ago, two months ago, six months ago? I can only think of four off the top of my head, and they are comparatively minor: a) new home construction inventories have finally started to fall back even while unsold inventories continue to grow for other reasons, b) high grain prices have made US grain exports handsomely profitable helping the current accound deficit, c) BenBer’s eyepoppping 300 bp drop has kept subprime and other resets from biting hard enough to kill the banking system so far, and d) the public authorities are now acting as if they do indeed see themselves managing a major financial instability. That group doesn’t spell ‘floor’ or ‘rebound’ to me.
We have had several periodic calms over the last nine months. The level of the problem has been substantially _greater_ after each one as the backlog of problems continues to build pressure.
On the other side of the ledger, here are several things which seem reasonably probable or even well-evidenced:
—subprime mortgatge writedowns are not done
—leveraged pier loan writedowns are not done; in some cases they’re barely begun
—commercial re losses haven’t really even begun to show up though from the standpoint of overcapacity alone one can anticipate that these will be major in many markets
—what is at least a recession has barely begun to bite on unemployment, and has yet to seriously impact equity prices, though this is _certain_ to happen
—foreign private capital continues to flee the country en mass
—Japanese bankers, looking at the ongoing massacre of the yen carry trade, are cutting the US off at the loan window, period
—China has its own equity bubble collapse and quite serious political instabilities [not speaking to the morality of the issues involved] which will keep the attention of their policy makers focused on their own needs first and foremost
—major foreign concerns are beginning to resist being paid in dollars
—the Fed has already commited well over half of its balance sheet to keep the banking system from imploding before the real wipeouts have even arrived
—the Fed funds rate is so low that we flirt with the zero bound where further shifts are of no utility, again before the Big Problems have even weighed in
That list is not exhaustive; feel free to add your own.
On Goldilocks and where she stands: To me, she’s been slipped a rophie by the media and is spreadeagled horizontal on the ping-pong table as all her pursuers gather nigh. We know what comes next . . . and it won’t be pretty.
I am baffled by arguments suggesting the continued rapid accumulation of dollar reserves is in any way remotely positive for the US. It falls into the category of ‘eureka’ we will just inflating debt away. Unless there is a coming wage spiral or the global wage arbitrage is off, again zero impact. It is after all that “trade” which has perpetuated the imbalance. Printing money, then exporting the depreciating asset to the FCB/Sovs who then repatriate via treasury/GSE debt is a sad commentary on both the state of the US economy, its prospects and the future of the US consumer. It used to be that Americans abhorred subsidies, but esprit de corp seems to have come of age in the sixties and perhaps this is its logical end. Dollar export does nothing for the average Joe, who already got his plasma TV dividend, whose real asset values have decoupled from interest rate cuts; that is unless we are talking about the unnatural levitation of the equity markets, which perhaps is pricing nominally. Then again not falling is still losing purchasing power. I am sure the incremental 50K manufacturing and construction workers who lost their job this month might quibble with a policy that substitutes fiat paper export for their manufacturing job. Oh wait that is the fiancé based economy, I forgot. Somehow, the dollar still holds a monopoly, but manufacturing losses are probably a good proxy for the slow bleeding dollar, lagged of course. The US needs to be taken to the confessional (woodshed to be more blunt) with the penance being sound money repeated for a decade. Perpetuating the lie about wealth and asset values is simply horizon pushing – nothing more.
When are the media going to hold Bernanke’s feet to the fire on foreign central bank dollar recycling?
Nobody seems to ever bother asking the head of US monetary policy about this. Don’t ask, don’t tell.
“can banks really cut their leverage levels effectively and calmly via furtive asset sales or ringfencing? Or are we heading for more stop-start turmoil?”
I am leery of the banking system. I am tending to believe their grand scheme (7 yrs in the making)has backfired and they are desperate.
A tin foilist might believe the banks set off the credit bubble in anticipation of diverting social security tax receipts into their greedy hands. The plan was always to collect the fees, skip town, and let the toxic garbage blow up. By the time the S**t hit the fan, the government would open wide, swallow and recap it, just like George and Dick promised. Same with Poppy’s Carlyle group.
The American people barely reversed the disaster when Snow failed and Paulson was sent in to get the SS. Every now and then it still comes up. Wall street was counting on a fiscal bailout which the Fed can’t deliver directly.
The financial industry needs to be restructured and regulated, not just de-levered. Same with the crooked government. Here’s hoping.
Average purchase prices increased at the second-sharpest rate in the survey
history in March, as highlighted by the Global Manufacturing Input Prices
Index rising sharply to 75.9, from 70.9 in February. Cost inflation accelerated
across the majority of the national manufacturing sectors for which March
PMI data were available. The sharpest rates of increase were recorded for
the US and China, with inflation hitting a near two-and-a-half year high