Buy the dip no longer sounds sufficient to calm fears, nor will forward guidance. Jerome Powell will...
Can the Central Banks Keep Us Safe?
05/15/2012 9:00 am EST
The financial markets are holding their own these days, based on the idea that the Fed and other central banks will save us from the worst. But what if they can't? MoneyShow's Jim Jubak, also of Jubak's Picks, explores what could happen.
The financial markets' faith in the world's 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 as if we've replaced the Greenspan put with a global put, backed not just by the US Federal Reserve, but also by the central banks of the eurozone and the People's Bank of China.
You're entitled to worry about how this will end.
Betting on Stimulus
Wonder why European stocks and sovereign bonds haven't collapsed, even though we're contemplating a Greek default (an official one this time), the wreck of the Spanish banking system, and another downgrade of France's credit rating?
Because of the belief that if worse 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 latest 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 interest rates.
Wonder why the S&P 500 is stubbornly hanging around 1,340, even as worries mount about a slowdown in US 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).
Each of these three major pieces of the global put is constructed in a slightly different way. Understanding those different methods of construction can provide some indication of how and when this global put will be resolved.
The Fed's $2.9 Trillion Dilemma
It says a great deal about how risky the overall global put has become that the US Federal Reserve is now the most conservative player. That's not so much a reflection of a policy bent at the Fed as it is 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. 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 before the September 2008 Lehman Brothers bankruptcy and the global financial crisis. In May 2008, it stood at just $900 billion. In May 2009, it was $2.1 trillion. In May 2010, the Federal Reserve's balance sheet showed $2.3 trillion.
Only when talking about the Federal Reserve (or the US 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 with the total 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 US Treasury securities—up from $540 billion in May 2008—and $850 billion in mortgage-backed securities, up from zero in May 2008.
That increase from 2008 to 2012 is the result of the Federal Reserve's purchase of US Treasuries and mortgage-backed securities after the onset of the global financial crisis. The Fed did this buying as part of its effort to drive down interest rates, in order to increase growth in the US economy.
The Federal Reserve paid for the assets now on its balance sheet by printing money (the mechanics are somewhat more complicated than that, but the description is essentially accurate). That expanded the US money supply, lowered interest rates, increased the short-term stability of the US financial system, added something to growth, and propped up asset prices in the financial markets.
To the degree that the money 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. These include 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 it has bought. That would take money out of the money supply and the economy, which would slow growth.
With the economy was growing at just a 2.2% annual rate in the first quarter, that’s tricky—and it's made even trickier by the need to reduce the federal budget deficit, currently projected by the Office of Management and Budget at 8.5% of gross domestic product for fiscal 2012. (To put that into context, the deficit as a percentage of GDP is 2 percentage points higher than Spain's projected deficit.)
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 important, limiting the Fed's ability to intervene effectively in any future crisis. (And there are a few of them looming.)
Europe's Bigger Challenge
As daunting as the Fed's task might be—and as low as the odds are that the Fed can pull it off without a miscue—the job before 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 Eurozone economies aren't nearly as globally competitive as the US 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 one player in a 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 now 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 most recent $1.3 trillion, for example, the central bank received as collateral 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 US Treasuries, they are priced by one of the world's deepest markets...and the chance of a default by the issuer (the US government) within the next three years (the term of the ECB lending facility) is minuscule.
That's not the case with the collateral offered to the ECB. Efforts were made to mark these assets to market value—in some cases—but there is no guarantee that they are, or will be over the next three years, worth what the bank and the ECB agreed they were worth.
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 as if the European Central Bank itself wasn't highly leveraged already. As is characteristic of the limited union of the European Union, the European Central Bank relies upon its member banks for capital.
So how much contributed capital underpins that $4 trillion balance sheet? Just $14.5 billion, after a December 2010 doubling of subscriptions from national central banks. That represents leverage of 285 to 1.
But that may not be the most conflicted part of the relationships among the European Central Bank, national central banks, and European banks. Let me use Spain as an example.
In the ECB's $1.3 trillion, three-year loan program, Spanish banks borrowed about $460 billion. They used that money to make up for deposits leaving their balance sheets 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 "cajas," regional lenders. (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 holding 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, 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 it might need to bail out its banking system.
The sheer number of moving parts in the Eurozone debt crisis makes it way more likely that the European Central Bank will make a policy error than the Fed will. It has to balance the effects of any move on not just 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.
China's Crunch Is Complex
The task facing the People's Bank of China combines both the Federal Reserve’s 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 additional maneuverability that comes with an economy that is 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 very precarious condition of major portions of a 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 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%; 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 0.5 percentage points, to 20%, effective May 18.
It was the third reduction in reserve requirements in six months, but the first since 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 a problem. Nonperforming 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. In July 2011, Moody's Investors Service estimated that 8% to 10% of loans at China's banks could go bad and should be classified as nonperforming. That was an increase from an earlier estimate that 5% to 8% of loans should be classified as nonperforming.
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 show, because 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 to the tune of $8 billion so far, business news outlet 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 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 failure of the Greenspan put is that these kinds of operations can indeed support financial assets for quite a long time. They can produce major financial bubbles in markets that should have been deflating.
We also know 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 prices and the more moving parts, the more there is that can go wrong—and go wrong sooner rather than later.
This, of course, leaves investors in quite a fix. In the short run, investors will make money by betting with the world's central banks. In the long run, the collapse of this global put will be very painful.
The challenge is figuring out when this long run begins. I still flag 2013. But that timetable is subject to change.
My leading indicator is how the US government deals with the impending fiscal cliff that the United States is headed toward in 2013. (For more on that fiscal cliff, see my recent column.)
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. For a full list of the stocks in the fund as of the end of December, see the fund’s portfolio here.
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