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Worried that Treasuries and the U.S. economy will collapse when the Fed stops buying next week? Guess who's riding to the rescue
06/28/2011 8:30 am EST
Who will pick up the slack after the Federal Reserve ends its second program of quantitative easing at the end of June and stops buying $75 billion in U.S. Treasuries every month? Not exactly a minor question for a country running a national debt of $14.5 trillion.
The answer, investors fear, is No one. That would lead to an increase in U.S. interests rates—if the market found buyers at all, they would ask for a higher yield—just at time when the U.S. economy is slowing. The worst case scenario would be that some delay in raising the U.S. debt ceiling would create a technical U.S. default just at the same time as the Fed exits the Treasury market. That could lead to a spike in U.S. interest rates rather than a more gradual increase. Which would doom any chance for a recovery in the housing market and lead to massive losses for anyone holding a portfolio of Treasuries.
At least that’s how the worry goes.
I’ve been racking my brain to find another answer. I think QE3 is off the table. The Federal Reserve isn’t about to take on the financial and political risk of adding another half trillion or so to a balance sheet that has climbed to $2.84 trillion as a result of the central bank’s battle against the effects of the global financial crisis.
But recent decisions by the regulators drawing up the new Basel III rules for the global banking system point me to a real alternative to the disaster scenario I think markets fear for the Treasury market.
Basel III will ride to the rescue.
Basel III? Yep, Basel III, the bank regulation scheme more complicated that Ptolemy’s astronomy and much less likely to work as predicted. I don’t know that I’d call Basel III a rescue plan for the developed world’s central banks—the Federal Reserve, the Bank of Japan, the Bank of England, and the European Central Bank—because I don’t know if the regulators (including central bankers) who put together the rules intended to rescue central banks. The rescue may just be an unintended consequence of the new banking regulations.
But intended or not, plan or side effect, Basel III does promise to “solve” central bank’s big balance sheet problems—for a few years anyway.
Let me show you how this is likely to work and then run through some of the dangers that this “solution” creates.
Basel III, the aptly named successor to Basel II, is an attempt to make the global banking system less susceptible to a replay of the global financial crisis that took Lehman and Bear Stearns into bankruptcy, threatened to take down American International Group, Citigroup, and a handful of European and U.K. banks, and almost led to the collapse of the world’s financial system.
As part of that solution, banks will be required to show a higher tier one capital, or core capital ratio, than before the crisis on the theory that banks with more capital will have a bigger cushion to fall back on in the event of a crisis. The core capital ratio under Basel II was set at 4%. Under Basel III, the base core capital ratio will climb to 7%. The rules also set up capital surcharges for the 30 banks in the world that regulators have deemed systemically important to the global system as a whole. These banks have been divided into categories with the surcharge beginning with an extra one-percentage point and climbing to an extra 2.5 percentage points. There’s even an empty category with a three-percentage-point surcharge for banks that in the future exceed today’s top tier banks.
How do regulators decide which banks go in which categories? A combination of factors that include regulators’ judgments on how important the bank is to other banks, on the degree of a bank’s cross-border business, on its own sources of capital, and on the risk of the bank’s portfolio of assets.
In fact, all of the Basel III core capital ratios—even the starting 7%--are adjusted for the degree of risk in a bank’s portfolio of assets.
And this is where Basel III turns into a rescue plan for central bank balance sheets.
The riskier a bank’s portfolio is, the more capital it will have to raise. Capital isn’t cheap for banks right now because the financial markets don’t much like the effect of changes in bank regulation on future profits. The more capital a bank has to raise, the lower its return on capital is likely to be. And the less investors will pay for its stock.
But as we all should remember from the global financial crisis when AAA-rated mortgage-backed securities suddenly turned out to be extremely risky, judging the risk of a portfolio asset isn’t totally objective. And in their regulations on risk, Basel III regulators have decided—so far at least--that government debt securities will remain, as traditionally, risk free.
Yep, despite the fact that the debt-rating companies have warned that they’ve got an eye out for a possible downgrade on U.S. and U.K. debt, and despite recent even stronger warnings on Italy and Spain, and despite multiple downgrades for Greece, Ireland, and Portugal, under Basel III rules, a bank that holds sovereign debt won’t be required to adjust its core capital ratio higher to make up for any extra risk.
Let’s leave the question of just how smart this decision is aside for the moment and look at its effects.
Let’s say a bank wants to lower the amount of core capital it has to raise to meet Basel III rules instead of paying the price to raise more capital or taking the hit that more capital would bring it the bank’s return on capital. It could, of course, shrink its balance sheet by selling off assets. There’s probably not exactly a rip-roaring market for the kind of assets that it would most like to sell—those with high risk, according to regulators. Selling would trigger a write-down in many cases since banks haven’t marked down the price of many riskier assets to market values. Or the bank can lower the risk on its balance sheet by buying and holding assets judged risk free by Basel III regulators. Plenty of sovereign debt to go around these days so it’s not hard to buy as much as you want. And while the less risky of this sovereign debt doesn’t yield much, it’s not like these banks are turning away more lucrative commercial loans. Deposits at U.S. banks exceeded loans by a record $1.45 trillion in May, according to the Federal Reserve. (In the 10-years before the financial crisis in 2008, loans exceeded deposits by an average of $100 billion.) As long as the lending market remains in its current near comatose state, buying sovereign debt seems like a no-brainer.
How big could the bank appetite for Treasuries be? It’s already quite healthy. Banks have increased their holdings of Treasuries and other government-related debt to $1.68 trillion in May from $1.08 trillion in early 2008, according to Bloomberg. Barclays Capital estimates that Basel III calculations of risk could reduce core capital ratios for the median U.S. bank by 3 percentage points. If banks were to make up that core capital ratio shortfall by raising capital alone, they’d have to raise about $250 billion in new capital, Barclays calculates. Adding Treasuries to a portfolio would reduce that need for new capital.
I’d say that the appetite for Treasuries from U.S. banks would be enough to pick up a great deal of the slack from the end of QE2.
But remember, we’re not talking about just a problem for U.S. banks. Basel III is a set of global rules and banks everywhere face the same challenge of higher core capital ratios. So you’ll see banks in the EuroZone and Japan and the United Kingdom buying Treasuries along with their U.S. counterparts.
And they’ll be buying the sovereign debt of Japan, and the United Kingdom, and France, and Italy, and Spain too as long as the final Basel III rules and regulations give a thumbs up to the concept of risk-free sovereign debt. Which is a huge boon to the central banks of the United Kingdom and Japan—which have both expanded their balance sheets in the fight to stabilize their own banking systems and economies. At one further remove it will be a boon to the European Central Bank, which will be able to garner more support for its own expanded balance sheet from EuroZone central banks. The European Central Bank relies on contributions from EuroZone member states for its funding. So far the EuroZone doesn’t issue its own common debt but I think the Greek crisis and Basel III are likely to push the monetary union toward some kind of Eurobond.
The dangers in this “solution” should be pretty clear to anyone who has been following the Greek debt crisis.
First of all, it’s not really a solution. It merely kicks the problem down the road (as the proposed Greek “solution” would do) with a hope that economic conditions will be better in 2013 or 2014 or … for an actual solution.
Second of all, it involves exactly the same kind of debt-rating deception that was at the heart of the U.S. mortgage-backed securities collapse and that contributed to the Greek debt crisis. Calling sovereign debt risk free and incentivizing banks to buy this debt exposes them to potentially crippling losses if the debt turns out to be something other than risk free. I think it’s naïve to assume that banks will resist these incentives. They certainly didn’t resist the incentives of higher yields and AAA-ratings in the run up to the mortgage-backed securities collapse.
Third of all, this “solution,” if it works, comes with its own built in time limit. Banks will only find the minimal yields of U.S. Treasuries attractive as long as the loan market remains in the tank. When loan demand picks up, the Treasury market is likely to see increased selling by banks eager to get back into the banking business. That could accelerate the pace at which Treasury prices fall and yields climb in any U.S. economic recovery.
Basel III, in short, may rescue the Treasury market in the short term, but it’s also just another reason to worry, if not about 2011, then about 2013.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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