Unfortunately, the near free money environment has gone on for much longer than anyone anticipated, and we seem incapable of easing ourselves off the life support
There are lots of people and organisations credited with perfect foresight of the financial crisis, and even more who claim they saw it coming when careful reading of their work at the time shows that in fact they didn’t.
What is more, many of those who did accurately forecast some kind of a financial and economic storm tended to do so for the wrong reasons. It’s not clear that this really counts as a successful prediction. But credit where credit is due, one organisation that did genuinely come quite close was the Bank for International Settlements (BIS).
It is part of the BIS’s job to monitor the build-up of credit risk, so maybe it’s not so surprising that it was more on the ball than others. The shock would have been if it had failed to notice. However, many of those with more direct responsibility for financial stability did indeed fall into this category, including the International Monetary Fund (IMF), the US Federal Reserve, the European Central Bank (ECB) and the Bank of England.
So when the BIS’s Claudio Borrio warns about the return of “search for yield”, everyone should sit up and take notice.
The BIS’s latest quarterly review points out that yield compression is back with a vengeance, and in some respects is actually now worse than it was in the lead-up to the crisis. With interest rates at rock bottom, lenders are again throwing caution to the wind, and investing indiscriminately. There was a brief return to saner conditions last summer when the Fed suggested it might end quantitative easing, but the consequent widening of spreads was viewed as so alarming by policymakers that the threat was soon withdrawn, and now we are back to where we were.
Remarkably, leveraged loans are now a higher proportion of new signings than they were before the crisis. Corporate credit spreads have sunk to record lows, debt funding for private equity takeovers is once more on a strongly rising trend, and mortgage real estate investment trusts, which fund long-term mortgage assets with short-term money, have come surging back.
The search for yield is also evident in renewed investor appetite for “payment in kind notes”, a form of credit that gives the borrower the option to repay lenders by issuing additional debt. Roughly a third of those who issued such debt in the run-up to the crisis ended up defaulting, yet this has failed to act as a deterrent. New issuance of these instruments rose by a third in the first three quarters of this year.
Unconventional monetary policy is meant to work on the “hair of the dog that bit you” principle. By fighting a crisis caused by too much money with yet more money, the central bank hopes to restore the economy to a “normally” functioning machine, at which point saner voices are meant to take over and a more sustainable form of growth establishes itself.
Unfortunately, the near free money environment has gone on for much longer than anyone anticipated. What’s more, we seem quite incapable of easing ourselves off the life support.
Every time central bankers try, the economy stalls anew and they are forced to backtrack. Capital misallocation and asset bubbles are just some of the side-effects. We inhabit an Alice Through the Looking Glass world in which – bizarrely, in view of the depth and length of the recession – ultra-low interest rates have helped to contain default rates at close to pre-crisis levels. In the eurozone, default rates have actually fallen during the recession of the past two years, the very reverse of what you would expect and indeed what is needed for the economy to reboot and start growing again. This in turn has encouraged investors to think of what is essentially junk as comparatively risk-free, and spray their money around accordingly. Policymakers find it progressively more difficult to re-establish normality monetary policy for fear of the en masse rise in defaults that would follow.
Mr Borrio also draws attention to a number of the other curiosities that spring from this unprecedented era of cheap money. Investors are, in any case, much more wary than they were of funding banks, but search for yield has reinforced this aversion. In looking for supposedly safer returns, investors have turned instead to corporate bond markets, where they have been extending credit on progressively looser terms to increasingly risky propositions.
Those companies with access to credit markets have done well out of the phenomenon. Corporate bond issuance in Europe has been booming. But it has been very bad for the banks, which have no long-term future without the sort of funding advantage they once enjoyed over their clients.
Many will think this a positive development given what bankers supposedly did to the economy. The problem is that many SMEs are too small to gain access to corporate bond markets and therefore find themselves ever more squeezed by banks that are themselves being starved of market funding. Thus does unconventional monetary policy stifle the new in support of the big and weak. It is also making it much tougher for banks to break free from central bank funding.
The problem is particularly acute in the euro area, where markets have eclipsed banks as a source of corporate funding. This in turn has starved many bank-dependent SMEs of credit.
The ECB hopes to break this cycle of decline with a planned asset quality review, which it hopes will convincingly demonstrate which banks are solvent and which not. Undercapitalised banks can then be dealt with accordingly.
There’s a lot riding on the outcome, not least the ECB’s reputation as a credible supervisor. Previous stress tests of the eurozone banking system have been comically deficient, resulting only in the answers that national governments wanted to hear.
In the first of these European-wide tests, for instance, Ireland’s two largest banks were judged perfectly solvent. The ECB needs to do a proper job this time if confidence is to be restored, but in so doing it will very probably exhaust the capacity of some governments to pay off the bad debts.
Furthermore, the review is confined to just 128 of the largest players (admittedly covering 85pc of eurozone banking assets), and is not due for completion for nearly a year. The review is both too narrow and too long.
In the meantime, the ECB is the only institution standing between Europe’s experiment in monetary union and oblivion. In keeping the show on the road, unconventional monetary policy has become a substitute for meaningful financial system reform. What’s so frightening is we’ve yet to hear anyone articulate a credible strategy for freeing advanced economies of their addiction to central bank money.
Mr Borrio diplomatically expresses no opinion on whether the current combination of tight spreads and low default rates is sustainable, so let me do it for him; no it is not.
source : telegraph.co.uk