This is part three of a ten-part economic essay. I’ll publish one scene (chapter) a day. Scene 2: It’s a Wonderful Life about the state of the US economy on the eve of the coronavirus pandemic was published on Kos on March 17, 2020. Each scene is written to stand on its own.
This chapter compares today’s fiscal crisis to the last market meltdown.
Almost all news commentary blames the newly arrived bear market on the coronavirus pandemic. While COVID-19 is a big kick in the economic pants, there are even bigger factors driving the Dow down. Things that mean this virus, nasty as it is, is not the worst of our economic troubles. I make my case in this ten-scene movie-themed economic essay.
Scene 3: Back to the future
Sometimes you need to go back in time to understand what’s coming. Unlike Marty McFly in the movie, we don’t need plutonium or a time-machine DeLorean, just a memory. So let’s turn our mental clock back twelve years.
The Great Recession was caused by reckless financial behavior combined with unnoticed systemic risks in housing and banking. Thanks to the globalization of the world’s financial system the contagion spread everywhere. It’s easy to see how it happened in hindsight. But step back and think what it looked like at the time, as the system was actually falling apart. The numbers back then said it wouldn’t be too bad.
On February 14, 2008, Treasury Secretary Henry Paulson and Federal Reserve Chief Ben Bernanke testified to the Senate Banking committee about the economy. Both said there were problems, especially with subprime mortages. But neither expected a recession. Paulson told the Senators that the economy “is fundamentally strong, diverse and resilient”. Bernanke dismissed the threat of bank failures: ”U.S. banks entered the current period of financial distress with strong capital ratios, which should reduce any potential threats to their solvency.”
Noting that a tax credit had just passed the Congress and the Fed had cut interest rates, Bernanke said he expected a ”somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt”.
But the Great Recession had already begun in December, two months earlier. Bernanke was right about traditional FDIC backed banks not melting down, but he missed that two major Wall Street investment banks were already failing. Bear Sterns was bailed-out a month later. Seven months after the hearing, Lehman Brothers went bankrupt.
Both Paulson and Bernanke were smart guys, and their actions, together with the incoming Obama Administration, kept the Great Recession from turning into a depression. It’s not their fault they didn’t know the country was already in recession, economists didn’t know it either. GDP is a trailing indicator; by the time you know you’ve got a recession, you’ve already been there a while.
The past teaches that:
· Recessions are hard to predict, in fact you can’t even see one until it’s too late.
· The thing that bites hardest is the thing policymakers didn’t see coming.
The world’s economic system is interconnected; systemic risk is reality. During the Great Recession millions of individual calamities in American housing created multiple unfolding disasters. It seems local at first, say with homeowners in Cleveland who can’t make balloon payment mortages sold by unscrupulous salesmen. Next thing you know, the banks of Iceland have collapsed and a 62 year-old landscape gardener named Mike Davis in Gloucester, England loses his £75,000 life savings.
High finance was behind it all; Wall Street created Collaterized Debt Obligation (CDO) securities — an unregulated and risky market that peaked in 2006 at $2 trillion. CDOs enabled the disaster in subprime mortages, which contributed to a bubble in the housing market. When the bubble burst the CDO market turned toxic, meaning you had a $2 trillion pile of securities that no one wanted. Key markets seized up and Bear Stearns and Lehman Brothers failed. Which meant a world-wide financial panic and voila! The Great Recession.
But didn’t we put a stop to risky financial behavior with the Dodd-Frank Wall Street Reform and Consumer Protection Act? No, we didn’t.
While Dodd-Frank was important, it only went so far and it never changed the Street’s risky bet culture. Then the GOP Congress passed new legislation in 2018 rolling back key Dodd-Frank regulations and reducing oversight of any bank worth less than $250 million, which is pretty damn big. Add in lax enforcement of financial regulations by the Trump Administration and what could go wrong?
There is no longer CDO risk; that was fixed. But we have something new called CLOs. CLO is a Collateralized Loan Obligation and while it’s different from its disgraced cousin, it shares some traits. Both are bonds used as investment vehicles. Both have an underlying asset as collateral — lots of dicey house loans in the case of CDOs. For a typical CLO these days it’s highly leveraged loans from over a hundred corporations that don’t qualify for investment grade bonds. The Collateralized Loan Obligation shares something else with a CDO; the underlying loans are sliced up, mixed together and sold as ”tranches”. You aren’t buying one or a few leveraged corporate loans. You buy pieces of lots of them. Tranches can be AAA investment grade, or something riskier but with better returns, what are known in the trade as ”Mezzanine tranche” with say a BBB or BB rating. If your curiousity is piqued, Guggenheim Investments has this excellent primer.
Proponents claim there is more oversight of CLOs, that underlying companies are monitored carefully, that the risk is minimal. They point out that no AAA or AA rated CLO tranche has ever defaulted. On the other hand, this quantity of CLO debt has never been tested in a downturn. In 2007 as the leveraged loan craze peaked, total global CLO debt was just shy of $250 billion. Much less than what we have today. There is $750 billion in CLO debt floating around the world, $90 billion of it held by US banks.
What about those so-called ”mezzanine CLOs” which are especially risky in a downturn? Or the Japanese banks that may own one-third of all CLOs? Is that a liquidity risk in a downturn? The Bank of Japan thinks so, warning that even AAA tranches “could fall substantially” in a recession. Norinchukin Bank listened and stopped buying CLOs in November. They aren’t the only ones. The Wall Street Journal reported an October sell-off in the CLO market.
In addition to CLO debt, there’s a large corporate leveraged loan market — also known as ”junk bonds” that is twice the size of CLOs and very risky. The Bank of England estimates that U.S. leveraged corporate debt is $2.2 trillion. BOE also helpfully points out that this is comparable to the size of the CDO market when it imploded in 2005. Analysts say these loans represent poor quality investments and that ratings agencies are going easy on the companies loading up on risky debt.
The debt of large US companies has reached $10 trillion — one-half of GDP — and the total corporate debt-load is $15.7 trillion when you add small, medium and family business. US corporate debt equals 74% of GDP.
The collapse last fall of Thomas Cook, the British travel firm, demonstrated what can happen with risky debt. Twenty-one thousand employees lost a job. A half-million travellers had holidays ruined and many other businesses that depended on Thomas Cook may go under. The company had a £3.1 billion deficit thanks largely to a £1.7 billion debt burden. Thomas Cook loaded up on debt during a disastrous 2007 merger with a competitor. Brexit was the final blow. It shows that a hard-up company can’t handle hard times.
It’s not just corporations. According to the Federal Reserve, household debt is $15.8 trillion while total government debt is $21.4 trillion and rising by about $1 trillion a year. The U.S. government has a printing press and can handle the load. But households? Their debt is 75% of GDP and these are good times. No wonder 56% of American adults lose sleep worrying about money.
Here’s something else to keep you up at night. Last September 18th, a funny thing happened as the Federal Reserve met to talk about lowering interest rates again. The funny thing was not President Trump attacking his hand-picked Fed head, Jay Powell, for having ”No ‘guts,’ no sense, no vision!” (Trump wanted interest rates chopped to zero or less and Powell wouldn’t do it).
No, the funny thing was that just as the Fed was talking about dropping interest in fed funds to 1.5%, it suddenly shot to 2.3%. Well above the 2% target. Who knew the Fed didn’t actually control interest rates?
The culprit was something called the repo market, an inter-bank overnight lending market worth $1 trillion a day. For reasons no one can explain, repo interest suddenly hit 10%, which forced the fed target up as well. The New York Fed intervened and things settled down. But soon it happened again. Intervention by the New York Fed became standard practice. In mid-October the Fed also began buying Treasury bonds to calm the markets, because just pumping money into the repo market wasn’t fixing the problem. They claimed it wasn’t quantitative easing (QE). Others said ”it walks and talks like QE”. Whatever you called it, the Fed spent $260 billion last year doing it. Throw in the New York Fed restuffing cash every day into the temporary overnight repo operations and the bailout reached $320 billion in December.
Now that the stock market is suffering a coronavirus triggered crash, the New York Fed is feeding the repo market $500 billion a day, while the Federal Reserve has ramped up its QE program to $700 billion. The Fed is also launching something called the “Primary Dealers Credit Facility” to buy the commercial paper used by corporations in their daily operations; these are short term loans that no one wants to touch during a crisis.
Before this, no one even knew what repo was except Wall Street types (unless you’re talking repossessing cars). But when money stops moving it sure gets people’s attention. Now everyone knows the repo market is a key part of the world’s financial plumbing; The last time the fed intervened in this market was a decade ago, right before the financial crash. Some say it means that banks are short on cash, which would be a very bad sign if true. But the fact is no one knows what the repo market breakdown means. Just that it means something. The recent massive Federal Reserve interventions are akin to a doctor hauling out defibrillation paddles. Not a good sign.
In Back to the Future, Marty McFly went to the past to learn about his present. What can we learn by cranking our time machine clock back to 2007? That was when debt markets seized up and things started going whacky, as the first of the Bear Stearn funds went bust. A few called it — not without merit — ”The Panic of 2007”.
For insight into what went wrong, look at the 2007 Financial Stability Review of The European Central Bank. Here’s the key takeway:
Empirical evidence shows that when short-term interest rates are low, banks relax their lending standards and grant new loans with higher credit risk, but reduce the associated loan spreads. This suggests that low interest rates increase banks’ appetite for risk.
Same conditions apply now. Interest rates are dropping, while yields narrowed last fall between investment grade and high-risk bonds. Were we already in the middle of a financial crisis and didn’t know it? Back in September of 2007, the investor Howard Marks penned a brilliant memo to his clients at Oaktree Capital Management:
The bottom line of it all: high leverage, untested vehicles and inadequate preparedness for adverse developments. Little awareness of risk, low credit standards, slender risk premiums and little margin for error. In short, a recipe for possible disaster.
Everything on that list applies today, meaning we didn’t learn a damn thing.
Written by Kent Moorhead © 2020 by Passage Film, Inc.
Coming tomorrow: Scene 4: 9 to 5
Scene 1: Twister was published on Kos on March 16, 2020.
Scene 2: It’s a Wonderful Life was published on Kos on March 17, 2020
Don’t want to wait for the next scene? The entire essay is available on Medium. Spoiler: it’s a damn long read and you might prefer getting it in installments.