18/6/20: Cheap Institutional Money: It's Supply Thingy

In a recent post, I covered the difference between M1 and MZM money supply, which effectively links money available to households and institutional investors for investment purposes, including households deposits that are available for investment by the banks (https://trueeconomics.blogspot.com/2020/06/what-do-money-supply-changes-tell-us.html). Here, consider money instruments issuance to institutional investors alone:

Effectively, over the last 12 years, U.S. Federal reserve has pumped in some USD 2.6 trillion of cash into the financial asset markets in the U.S. These are institutional investors' money over and above direct asset price supports via Fed assets purchasing programs, indirect asset price supports via Fed's interest rates policies and QE measures aimed at suppression of government bond yields (https://trueeconomics.blogspot.com/2020/05/21520-how-pitchforks-see-greatest.html). 

Any wonder we are in a market that is no longer making any sense, set against the economic fundamentals, where free money is available for speculative trading risk-free (https://trueeconomics.blogspot.com/2020/06/8620-30-years-of-financial-markets.html)?

1/9/19: Priming the Bubble Pump: Extreme Credit Accommodation in the U.S.

Using Chicago Fed National Financial Conditions Credit Subindex (weekly, not seasonally adjusted data), I have plotted credit conditions measurements for expansionary cycles from 1971 through late August 2019. Positive values of the index indicate tightening of credit conditions in the economy, while negative values denote loosening of credit conditions.

Since the start of the 1982 expansionary cycle, every consecutive cycle was associated with sustained, long term loosening of credit conditions, which means the Fed and the regulatory authorities have effectively pumped up credit in the economy during economic expansions - a mark of a pro-cyclical approach to financial policies. This trend became extreme in the last three expansionary cycles, including the current one. In simple terms, credit conditions from the end of the 1990s recession, through today, have been exceptionally accommodating. Not surprisingly, all three expansionary cycles in question have been associated with massive increases in leverage and financialization of the economy, as well as resulting asset bubbles (dot.com bubble in the 1990s, property bubble in the 2000s, and financial assets bubbles in the 2010s).

The current cycle, however, takes this broader trend toward pro-cyclical financial policies to a new level in terms of the duration of accommodation and the fact that it lacks any significant indication of moderation.

19/10/18: There's a Bubble for Everything

Pimco's monthly update for October 2018 published earlier this week contains a handy table, showing the markets changes in key asset classes since September 2008, mapping the recovery since the depths of the Global Financial Crisis.

The table is a revealing one:

As Pimco put it: "The combined balance sheets of the Federal Reserve, European Central Bank, Bank of Japan, and People’s Bank of China expanded from $7 trillion to nearly $20 trillion over the subsequent decade. This liquidity injection, at least in part, underpinned a 10-year rally in equities and interest rates: The S&P 500 index rose 210%, while international equities increased 70%. Meanwhile, developed market yields and credit spreads fell to multidecade, and in some cases, all-time lows."

The table points to several interesting observations about the asset markets:

1. Increases in valuations of corporate junk bonds have been leading all asset classes during the post-GFC recovery. This is consistent with the aggregate markets complacency view characterized by extreme risk and yield chasing over recent years. This, by far, is the most mispriced asset class amongst the major asset classes and is the likeliest candidate for the next global crisis.
2. Government bonds, especially in the Euro area follow high yield corporate debt in terms of risk mis-pricing. This observation implies that the Euro area recovery (as anaemic as it has been) is more directly tied to the Central Banks QE policies than the recovery in the U.S. It also implies that the Euro area recovery is more susceptible to the Central Banks' efforts to unwind their excessively large asset holdings.
3. U.S. equities have seen a massive valuations bubble developing in the years post-GFC that is unsupported by the real economy in the U.S. and worldwide. Even assuming the developed markets ex-U.S. are underpriced, the U.S. equities cumulative rise of 210 percent since September 2008 looks primed for a 20-25 percent correction. 

All of which suggests that the financial bubbles are (a) wide-spread and (b) massive in magnitude, while (c) being caused by the historically unprecedented and over-extended monetary easing. The next crisis is likely to be more painful and more pronounced than the previous one.

9/2/18: Markets Mess: Sunday Business Post

My Sunday Business Post article from last week on the beginnings of the stock markets troubles: https://www.businesspost.ie/business/markets-mess-unable-take-decisive-much-needed-downward-correction-yet-equally-unable-push-valuations-much-higher-408224.

As predicted: we had a messy week, with no catalyst to inflict a real, much needed and deeper correction onto grossly overvalued markets.

My next instalment on the continued mess is due this Sunday. Stay tuned.

3/1/17: Dead or Dying... A Requiem for the Traditional Banking Model

Earlier today, I briefly posted on Twitter my thoughts about the evolving nature of traditional banking. Here, let me elaborate on these.

The truth about the traditional banking model: it is dead. Ok, to be temporally current, it is dying. Six reasons why.

1) Banks can’t price risk in lending - we know as much since the revelations of 2007-2008. If they cannot do so, banks-based funding model for investment is a metronome ticking off a crisis-to-boom cyclicality. That policymakers (and thus regulators) cannot comprehend this is not the proposition we should care to worry about. Instead, the real concern should be why are equity and direct lending - the other forms of funding - not taking over. The answer is complex. Informational asymmetries abound, making it virtually impossible to develop retail (broad) markets for both (excluding listed equity). Tax preferences for debt is another part of the fallacious equation. Habits / status quo biases in allocating funds is the third. Inertia in the markets, with legacy lenders being at scale, while challengers being below the scale. Protectionism (regulatory and policy) favours banks over other forms of lending and finance. And more. But these factors are only insurmountable today. As they are being eroded, direct financing will gain at the expense of banks.

The side question is why the banks are no longer able to price risks in lending, having been relatively decent about doing so in previous centuries? The answer is complex. Firstly, banks are legacy institutions that have knowledge, models, memory and intellectual infrastructure that traces back to the industrial age. Time moved on, but banks did not move on as rapidly. Hence, today's firms are distinct from Coasean transaction cost minimisers. Instead, today's firms are much more complex entities, dealing with radically faster pace of innovation and disruption, with higher markets volatility and, crucially, trading in the environment that is more about uncertainty than risk (Knightian world). Here, risk pricing and risk management are not as closely aligned with risk modeling as in the age of industrial enterprises. Guess what: if firms are existing in a different world from the one inhabited by the banks, so are people working for these firms (aka banks' retail customers). Secondly, banks' own funding and operations models have become extremely complex (see on this below), which means that even simple loan transaction, such as a mortgage, is now interwoven into a web of risky contracts, e.g. securitisation, and involves multiple risky counterparties. Thirdly, demographic changes have meant changes in risk regulation environment (increased emphasis on consumer protection, bankruptcy reforms, data security, transparency, etc) all of which compound the uncertainty mentioned above. And so on...

2) Banks can’t provide security for depositors - we know, courtesy of pari passu clauses that treat depositors equivalently with risk investors. The deposits guarantee schemes are fig leaf decorations. For two reasons. One: they are exogenous to banks, and as such should not be used to give banks a market advantage. Of course, they are being used as such. Two: they are only as good as the sovereign guarantors’ willingness / ability to cover them. Does anyone, looking at the advancement of the cashless society in which the state is about to renew on its own promissory fiat at least across anonymity and extreme risk hedging functions of cash, really thinks the guarantees are irrevocable? That they cannot be diluted? If the answer is no, then that’s the beginning of an end for the traditional deposits-gathering, but bonds-funded banking hybrids.

More fundamentally, consider corporate governance structure of a traditional bank. Board and executives preside (more often, executives preside over the board due to information asymmetries and agency problems). Shareholders are given asymmetric voting rights (activist institutional shareholders are treated above ordinary retail shareholders). Bondholders have direct access to C-suite and even Board members that no other player gets. And the funders of the bank, the depositors? Why, they have no say in the bank. Not even a pro forma one. This asymmetry of power is not accidental. It is an outrun of the centuries of corporate evolution, driven by pursuit of higher returns on equity. But, roots aside, it certainly means that depositors are not the key client of the bank's executive. If they were, they would be put to the top of the corporate governance pyramid.

Still think that the bank is here to protect your deposits?

3) Banks can’t provide efficient platforms for transactions - we know, courtesy of #FinTech solutions. Banks charge excessive fees for simple transactions, such as currency exchanges, cross border payments, debt cards, some forms of regular utility payments, etc. They charge to issue you access to your money and to renew access when it deteriorates or is lost. They charge for all the things that many FinTech platforms do not charge for. And they provide highly restricted (i.e. costly) platform migration options (switching banks, for example). Some FinTech platforms now offer seamless, low cost migration options, e.g. aggregators and some new tech-enabled banks, e.g. KNAB. Anecdotal evidence to bear: two of my banks on two sides of the Atlantic can’t compete on fees and time-to-execute lags with a small firm doing my forex conversions that is literally 10 times cheaper than the lower cost bank and 5 days faster in delivering the service.

If you want an analogy: banking sector today is what music industry was just at the moment of iTunes launch.

4) Banks can’t escape maturity mismatch and other systemic risks - we know, courtesy of banks' reliance on interbank lending and securitisation. The core model of deposits being transformed into loans is hard enough to manage from the maturity mismatch perspective. But when one augments it with leveraged interbank funding and securitisation, we end up with 2007-2008 crisis. This is not an accident, but a logical corollary of the banking business model that requires increasing degrees of leverage to achieve higher returns on equity. Risks inherent in lending out of deposits are compounded by risks relating to lending out of borrowed funds, and both are correlated with risks arising from securitising payments on loans. The system is inherently unstable because second order effects (shutdown of securitised paper markets) on core business funding dominate the risk of an outright bank run by the punters. Worse, competitive re-positioning of the financial institutions is now running into the dense swamp of new risks, e.g. cybercrime and ICT-related systems risks (see more on this here: http://trueeconomics.blogspot.com/2017/01/2116-financial-digital-disruptors-and.html). No amount of macro- or micro-prudential risk management can address these effects. Most certainly not from the crowd of regulators and supervisors who are themselves lagging behind the already laggardly traditional banking curve.

As an aside, consider current demographic trends. As older generations draw down their deposits, younger generation is not accumulating the same amounts of cash as their predecessors were. The deposits base is shrinking, just at the time as transactions volumes are rising, just as weak income growth induces greater attention to transactions fees. Worse, as more and more younger workers find themselves in the contingent workforce or in entrepreneurship or part time work, their incomes become more volatile. This means they hold greater proportion of their overall shrinking savings in precuationary accounts (mental accounting applies). These savings are not termed deposits, but on-demand deposits, enhancing maturity mismatch risks.

5) Banks can’t provide advice to their clients worth paying for - we know this, thanks to the glut of alternative advice providers, and passive and active management venues. And thanks to the fact that banks have been aggressively ‘repairing margins’ by cutting back on customer services, which apparently does not damage their performance. Has anyone ever heard of cutting a value-adding line of business without adversely impacting value-added or margin? Nope, me neither. So banks doing away with advice-focused branches is just that - a self-acknowledgement that their advice is not worth paying for.

Worse, think of what has been happening in asset management sector. Fee-based advice is down. Fee-based investment funds (e.g. hedge funds) are shrinking violets. But all of these players bundle fees with performance-based metrics. And here we have a bunch of useless advice providers (banks) who supposed to charge fees for providing no performance-linked anchors?

6) Banks can’t keep up with the pace of innovation. How do we know that? Banks are already attempting to converge to FinTech platforms (automatisation of front and back office services, online banking, e-payments, etc,). Except they neither have technical capabilities to do so, nor integration room to achieve it without destroying own legacy systems and business, nor can their investors-required ROE sustain such a conversion. Beyond this, banking sector has one of the lowest employee mobility rates this side of civil service. Can you get innovation-driven talent into an institution where corporate culture is based on being a 'lifer'? Using Nassim Taleb's term, bankers are the 'IBM men' of today. Innovation-driven companies have none of these. For a good reason, not worth discussing here.


So WHAT function can banks carry out? Other than use private money to sustain superficial demand for overpriced Government debt and fuel bubbles in assets?

It is a rhetorical question. Banks, of course, are not going to disappear overnight. Like the combustion engine is not going to. But banks’ Tesla moment is already upon us. Today, banks, like the car companies pursuing Tesla, are throwing scarce resources at replicating FinTech. Most of the time they fail, put their tails between their legs and go shopping for FinTech start ups. Next, they will fail to integrate the start ups they bought into. After that, we will see banks consolidation moment, as the bigger ones start squeezing the smaller ones in pursuing shrinking market for their fees-laden services. And they will be running into other financial sector players, with deeper pockets and more sustainable (in the medium term) business models moving into their space - insurance companies and pension funds will start offering utility banking services to vertically integrate their customers. Along this path, banks' equity capital will be shrinking, which means their non-equity capital (costly CoCos and PE etc) will have to rise. Which means their ROEs will shrink some more.

Banking, as we know it, is dying. Banks, as we know them, will either vanish or mutate. If you are investing in banking stocks, make sure you are positioned for an efficient exit, make certain the bank you are investing in has the firepower to survive that mutation, and be confident in your valuation of that bank post-mutation. Otherwise, enjoy mindless gambling.

7/10/15: Bubbles Troubles and IMF Spectacles

As was noted in the previous post (link here), IMF is quite rightly concerned with the extent of the global financial bubbles that have emerged in the wake of the years-long QE waves.

This chart shows the extent of over-valuation in sovereign debt markets:

But the following charts show the potential impact of partial unwinding of the bubbles. First up: bonds:

Then, equity:

Per IMF: “The scenario generates moderate to large output losses worldwide” as chart below shows changes in the output in 2017 under stress scenario compared to benign scenario:

And here’s what happens to projected Government debt by 2018:

         Toasty!

7/10/15: On the Illusion of Financial Stability

IMF’s Global Financial Stability Report for October 2015 is out, titled, predictably “Vulnerabilities, Legacies, and Policy Challenges: Risks Rotating to Emerging Markets”.

It is a hefty read, but some key points are the following.

“Th e Federal Reserve is poised to raise interest rates as the preconditions for liftoff are nearly in place. This increase should help slow the further buildup of excesses in financial risk taking.” As if this is something new… albeit any conjecture that the Fed move will somehow take out some of the risks built up over years of aggressive priming of the liquidity pump is a bit, err… absurd. The IMF is saying risk taking will slow down, not abate.

“Partly due to con fidence in the European Central Bank’s (ECB’s) policies, credit conditions are improving and credit demand is picking up. Corporate sectors are showing tentative signs of improvement that could spawn increased investment and economic risk taking, including in the United States and Japan, albeit from low levels.” So, as before, don’t expect a de-risking, expect slower upticks in risks. The bubbles won’t be popping, or even deflating… they will be inflating at a more gradual pace.

All of which should give us that warm sense of comfort.

Meanwhile, “risks continue to rotate toward emerging markets, amid greater market liquidity risks.” In other words, now’s the turn of EMs to start pumping in cash, as the Fed steps aside.

In summary, therefore, that which went on for years will continue going on. The shovel will change, the proverbial brown stuff will remain the same.

Still, at the very least, the IMF is more realistic than the La-La gang of european politicians and investors. Here are some warning signs:

1. “Legacy issues from the crisis in advanced economies. High public and private debt in advanced economies and remaining gaps in the euro area architecture need to be addressed to consolidate financial stability, and avoid political tensions and headwinds to confidence and growth. In the euro area, addressing remaining sovereign and banking vulnerabilities is still a challenge.” You wouldn’t know that much, but the idea of rising rates and rising cost of funding has that cold steely feel to it when you think of your outstanding mortgage…
2. “Weak systemic market liquidity… poses a challenge in adjusting to new equilibria in markets and the wider economy. Extraordinarily accommodative policies have contributed to a compression of risk premiums across a range of markets including sovereign bonds and corporate credit, as well as a compression of liquidity and equity risk premiums. While recent market developments have unwound some of this compression, risk premiums could still rise further.” Wait a second here. We had years of unprecedented money printing by the Central Banks around the world. And we have managed to inflate a massive bubble in bonds markets on foot of that. But liquidity is still ‘challenged’? Oh dear… but what about all this ‘credibility’ that the likes of ECB have raised over the recent programmes? Does it not count for anything when it comes to systemic liquidity?..
3. The system is far from shocks-proof, again contrary to what we heard during this Summer from European dodos populating the Eurogroup. “Without the implementation of policies to ensure successful normalization, potential adverse shocks or policy missteps could trigger an abrupt rise in market risk premiums and a rapid erosion of policy con fidence. Shocks may originate in advanced or emerging markets and, combined with unaddressed system vulnerabilities, could lead to a global asset market disruption and a sudden drying up of market liquidity in many asset classes. Under these conditions, a signifi cant—even if temporary— mispricing of assets may ensue, with negative repercussions on fi nancial stability.”

In summary, then, lots done, nothing achieved: we wasted trillions in monetary policy firepower and the system is still prone to exogenous and endogenous shocks.

“In… an adverse scenario, substantially tighter fi nancial conditions could stall the cyclical recovery and weaken confi dence in medium-term growth prospects. Low nominal growth would put pressure on debt-laden sovereign and private balance sheets, raising credit risks.

• Emerging markets would face higher global risk premiums and substantial capital out flows, putting particular pressure on economies with domestic imbalances. 
• Corporate default rates would rise, particularly in China, raising fi nancial system strains, with implications for growth.
• Th ese events would lead to a reappearance of risks on sovereign balance sheets, especially in Europe’s vulnerable economies, and the emergence of an adverse feedback loop between corporate and sovereign risks in emerging markets. 
• As a result, aggregate global output could be as much as 2.4 percent lower by 2017, relative to the baseline. This implies lower but still positive global growth.”

Note, the IMF doesn’t even mention in this adverse scenario what happens to households up to their necks in debt, e.g. those in Ireland, the Netherlands, Spain, and so on.

So let’s take a look at a handy IMF map plotting their own assessments of the financial systems stability in October 2015 report compared to April 2015 report. Do note that April 2015 report covers the period right before the ECB deployed its famed, fabled and all-so-credible (per IMF) QE.

Just take a look at the lot. Market & liquidity risks are up (not down), Risk Appetite is down. Macroeconomic risks improved, but everything else remains the same. That is a picture of no real achievement of any significant variety, regardless of what the IMF tells us. Worse, IMF analysis shows that risk appetite deteriorated across all 3 sub-metrics and as chart below shows, market & liquidity conditions have deteriorated across all 4 sub-metrics.

Meanwhile (Chart below), save for household risks, all other credit-related risks worsened too.

Meanwhile, markets are sustained by debt. That’s right: stock prices remain driven by debt-funded net equity buybacks and domestic acquisitions:

Meanwhile, Government bonds are in a massive bubble territory, especially for the little champions of the Euro:

You can see the extent of IMF’s thinking on the topic of just how bad the financial assets bubbles have grown in the following post.

The basic core of the IMF analysis is that although everything was made better, nothing is really much better. In the world of financial stability fetishists, that is like saying we have a steady state of no steady state. In the world of those of us living in the real economy, that is like saying all that cash pumped into the markets over the last seven years and across the globe has been largely wasted.