In the short term don't bet against the world's central banks, but in the long term the risk is that one central bank or the other will make a mistake

05/15/2012 8:30 am EST


Jim Jubak

Founder and Editor,

The financial markets’ faith in the world central banks would be touching if it weren’t so scary.

In the late 1990s we had what was called the Greenspan put. In the dark days when the collapse of a hedge fund portfolio at Long-Term Capital Management threatened global financial markets, then Federal Reserve chairman Alan Greenspan led a massive intervention to stabilize the markets. Investors studying Fed policy concluded that the Fed would intervene to prevent any future collapse in asset prices and that therefore piling on risk was a good investment strategy. We all know how well that ended.

What progress we’ve made! It looks like we’ve replaced the Greenspan put with a global put backed not just by the U.S. Federal Reserve but also by the central banks of the United States, the EuroZone, and the People’s Bank of China. You’re entitled to worry about how this will end.

Wonder why European stocks and sovereign bonds haven’t collapsed even though we’re contemplating a Greek default (official this time), the wreck of the Spanish banking system, and another downgrade of France’s credit rating? Because of the frequently repeated belief that if worst comes to worst, the European Central Bank can print unlimited amounts of money.

Wonder why Chinese stocks—and the emerging country stock markets that rise and fall with China’s prospects—aren’t in a panic as a result of the weekend’s numbers showing slower than expected economic growth in China? Because of the almost universal belief that every bit of worse than expected economic news brings us closer to the day when the People’s Bank of China will ride to the rescue with a cut in actual interest rates.

Wonder why U.S. stocks have been hanging (until yesterday anyway) above the 1340 March lows  on the Standard & Poor’s 500 even as worries mount about a slowdown in U.S. economic growth? Because of a conviction on Wall Street that if the recovery is in real danger of faltering, the Federal Reserve will launch a third program of quantitative easing that will pump money into the economy (and the financial markets.)

These three major pieces of the global put are each constructed in slightly different ways. Understanding those different methods of construction provides some indication of how and when this global put will get resolved.

It says a great deal about how risky the overall global put has become that the U.S. Federal Reserve is now the most conservative player among developed world central banks. That’s not so much a reflection of a more conservative policy bent at the Fed as it an indication that the Fed got started earlier down this road. The Federal Reserve’s balance sheet stood at $2.9 trillion as of the week ended May 9, 2012. That’s essentially even with the balance sheet in March and only $300 billion above the balance sheet total in September 2011.

To find the big expansion in the Fed’s balance sheet you need to go back to the days before the September 2008 Lehman bankruptcy and the global financial crisis. In May 2010 the Federal Reserve’s balance sheet showed $2.3 trillion. In May 2009 it was $2.1 trillion. But in May 2008 it was just $900 billion.

Only when talking about the Federal Reserve (or the U.S. budget) does an increase from $2.1 trillion to $2.9 trillion count as not very much. But it does fall into that category when compared to the jump of $2 trillion from May 2008 to May 2012.

And what is on the Fed’s balance sheet now that wasn’t on the balance sheet in May 2008? $1.7 trillion in U.S. Treasury securities, up from $540 billion in May 2008, and $850 billion in mortgage-backed securities, up from $0 in May 2008. That increase from 2008 to 2012 is the result of the Federal Reserve’s purchase of U.S. Treasuries and mortgage-backed securities after the onset of the global financial crisis as part of its effort to drive down interest rates in order to increase growth in the U.S. economy.

The Federal Reserve paid for the assets that are now on its balance sheet by printing money--the mechanics are somewhat more complicated than that but I think the description is essentially accurate. That’s expanded the U.S. money supply, lowered interest rates, increased the short-term stability of the U.S. financial system, added something to growth, and propped up asset prices in the financial markets.

To the degree that the money that the Fed has added to the money supply hasn’t gone into investments in productive assets, and with economic growth this slow companies haven’t been rushing to expand capacity, it has gone into other assets such as stocks (either through the direct purchase of stocks by investors or through corporate buybacks and acquisitions) and bonds, (which is one reason that bond yields are so low.)

The challenge for the Fed is how and when to unwind that $2 trillion addition to its balance sheet by selling the Treasuries and other securities that it bought. That would take money out of the money supply and the economy, which would slow growth. That’s tricky when the economy is growing in the recent first quarter 2012 report at a 2.2% annual rate. It’s made even trickier by the need to reduce the annual budget deficit of the Federal government, currently projected by the Office of Management and Budget at 8.5% of GDP for fiscal 2012. (To put that into context, the deficit as a percentage of GDP is two percentage points higher than Spain’s projected deficit as a percentage of GDP.) The alternative, however, is a permanent expansion of the Federal Reserve balance sheet, which would have the long-term effects of adding to inflation, weakening the credit rating of the United States, leading to the depreciation of the dollar, and, perhaps most importantly, limiting the Fed’s ability to intervene effectively in any future crisis. (And there are a few of them looming on the horizon.)

As daunting as the Fed’s task might be—and as low as the odds that the Fed can pull it off without a miscue—the job in front of the European Central Bank is much, much tougher. In part that’s because the ECB is not as far along as the Fed; in part it’s because some of the economies that make up the EuroZone aren’t nearly as globally competitive as the U.S. economy; and in part it’s because the very peculiar structure of the ECB makes it particularly easy for the central bank to wind up as on player in a very dangerous pyramid scheme.

A year ago the European Central Bank’s balance sheet looked more conservative and far less leveraged than that of the Federal Reserve. No more. At $4 trillion the ECB’s balance sheet easily exceeds that $2.9 billion on the Fed’s books. The big explosion came in December and February when the bank extended $1.3 trillion in three-year loans to European banks.

But it’s not just that the European Central Bank’s balance sheet is now bigger than that of the Federal Reserve; it’s also very different. For that last $1.3 trillion, for example, the central bank received as collateral for its loans to banks bonds, asset-backed securities, loans and, by the looser terms of the February round, just about any debt instrument that could be called “performing.” Now whatever you think of the long-term value of U.S. Treasuries, they are priced by one of the world’s deepest markets and the chance of a default by the issuer (the U.S. government) within the next three years (the term of the ECB lending facility) is miniscule. That’s not the case with the collateral offered to the ECB. Efforts were made to mark these assets to market—in some cases—but there is no guarantee that they are now—or will be over the next three years—worth what the bank and the ECB agreed they were worth. And many of these assets have a very real chance of blowing up within that time frame. The bank’s three-year loan program amounted to a massive transfer of risk from banks to the European Central Bank.

And it’s not like the European Central Bank itself wasn’t highly leveraged to begin with. As is characteristic of the limited union of the European Union, the European Central Bank relies upon its member banks for capital. How much contributed capital underpins that $4 trillion balance sheet? $14.5 billion after a December 2010 doubling of subscriptions from national central banks. What’s that? Leverage of 285 to 1.

But that may not be the most conflicted part of the relationship between the European Central Bank, national central banks, and European banks. Let me use Spain as an example. In the ECB’s $1.3 trillion, 3-year loan program, Spanish banks borrowed about $460 billion. They used that money to make up for deposits leaving their banks and to buy Spanish government debt. (Which, of course, the European Central Bank accepts as collateral for making these loans.) Purchases of Spanish government debt by the banks has enabled Spain to keep selling bonds in the financial markets. That, in turn, enables Spain to act as a guarantor for Spanish banks that need capital such as in the 2010 deal that created Bankia out of the ruins of seven failed or failing regional cajas. (Last week the Spanish government admitted that Plan A hadn’t worked and injected more capital into the bank in exchange for a 45% stake.)

But wait, the system gets even more conflicted. Under current European Union rules, sovereign debt of a bank’s home government counts as risk free capital. So by using riskier assets as collateral for loans from the European Central Bank and then using that loan money to buy Spanish government bonds, a Spanish bank could actually improve its capital position—even though, according to the market if not to bank regulators, Spanish government bonds come with significant risk.

And then, of course, there’s the little matter of the European Financial Stability Facility and its successor the European Stability Mechanism. These two EuroZone rescue funds are backed by guarantees from national governments, including Spain. So if the ECB lends money to Spanish banks that they use to buy Spanish government bonds, which keeps Spanish bonds from sinking further, Spain can still guarantee the rescue fund that its might need to bail out its banking system.

The sheer number of moving parts in the euro debt crisis makes it way more likely that the European Central Bank will make a policy error than that the Fed will. It has to balance the effects of any move not just on one economy but on all the disparate economies of the EuroZone, on all the national banks and national governments, and on all these interlocking banking systems. And that while the economies of Italy, Spain, France, and the Netherlands are all headed into (or are already in) recession.

The task facing the People’s Bank of China combines both the Federal Reserve and the European Central Bank’s advantages and predicaments.

Like the Fed (and unlike the ECB), the People’s Bank occupies a position of great centralized power in a national financial system, and it has the extra maneuverability that comes with an economy that is still growing at a good rate (although slowing).

However, like the European Central Bank, the People’s Bank must formulate a solution that takes into account not only the national economy but the vary precarious condition of major portions of the financial sector with quasi-official ties to the central government.

The national problem is how to stimulate an economy that shows signs of slowing more than Beijing would like. In data released Friday the government reported that industrial output grew at an annual rate of just 9.3%.  That was the slowest growth rate since April 2009. New bank lending for April, at $108 billion, came in almost 13% below projections and 30% below March levels. Money supply growth, measured by M2, was just 12.8% when economists were looking for 13.3%.

In response to this data—and to the growth rate of China’s economy slipping to 8.1% in the first quarter of 2012 (the fifth consecutive drop in growth) the People’s Bank cut bank reserve requirements this weekend by another 0.5 percentage points to 20%, effective May 18. It was the third reduction in reserve requirements in six months but the first since the People’s Bank moved in February. A reduction in the reserve ratio of this dimension frees up about $65 billion on bank balance sheets for lending.

But that’s only part of the challenge facing the People’s Bank. Like the European Central Bank, China’s central bank faces a huge bad debt problem in its banking sector.

The official estimate of bad loans in the portfolios of China’s big banks says there isn’t any bad loan problem. Non-performing loans fell to 1.15% of all loans in 2011 from 1.34% in 2010. Officially.

But nobody believes that those figures accurately state the size of the problem. Last July Moody’s Investors Service estimated that 8% to 10% of loans at China’s banks could go bad and should be classified as non-performing. That was an increase from an earlier Moody’s estimate that 5% to 8% of loans should be classified as non-performing. Among other reasons for the official underreporting, Moody’s estimated that China’s banking auditor had failed to include $540 billion in bank loans to local governments. That class of loan is likely to go bad at a high rate, I think the data shows, since local governments lack the revenue base to pay interest on the loans in the face of a slowing economy and falling land prices.

China has started to roll out a solution to this bad loan problem that it has successfully used in the past—it has started to bury the bad loans by transferring them from government-controlled banks to government-controlled special entities. Four state-controlled asset management companies-- China Cinda Asset Management, China Huarong Asset Management, China Orient Asset Management, and China Great Wall Asset Management--have been busy buying up real-estate debt assets to the tune of $8 billion so far, Caixin reports. Regulators have urged the asset management companies not to extend their buying binge too far but estimates put the appetite of these companies alone at 20 times current holdings. Much of what the asset management companies have been buying are loans extended to real estate developers who had hoped to pay their debt costs from the proceeds of future deals that haven’t materialized as China’s government has worked to slow the real estate sector.

These asset management companies are the same kind of vehicles that were used in the aftermath of the Asian currency crisis to clean up bank balance sheets in the late 1990s and early 2000s. Once transferred to the asset management companies and after enough time had passed, the banks that had sold this debt turned up as investors in the asset management companies themselves. Think of these asset management companies as very, very off-balance sheet special purpose vehicles.

The workings of these three central banks don’t mark the limits of the global put, of course. The Bank of Japan is a major player. Count the Bank of England in too.

What we know from the operation and then the failure of the Greenspan put is that these kinds of operations can indeed support financial assets for quite a long time. They can indeed produce major financial bubbles in markets that should have been deflating.

We also know that they don’t work forever. The bubbles that they produce turn out to be ultimately unsustainable even with the assets of a Federal Reserve. And I think we’re likely to discover in the current global put that the more complexity involved in the effort to support asset priced and the more moving and frequently contradictory parts, the more there is that can go wrong and go wrong sooner rather than later.

Which, of course, leaves investors in quite a fix. In the short run investors will make money by betting with the world’s central banks and not against them. In the long run the collapse of this global put will be very painful—again.

The challenge is figuring out when the long run begins. I still flag 2013. But that timetable is subject to change. My leading indicator is how the U.S. government deals with the impending fiscal cliff that the United States is headed toward in 2013. (For more on that fiscal cliff, see my post )

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 , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at
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