Profits, not principals, move the age

Oscar Wilde was fond of saying that people rather than principles move the age. In the case of banking reform, the problem is not one of principle (in the form of regulation) nor of principal (proprietary trading), but of profitability.

Financial institutions flap around desperately in a low-return environment like fish in oxygen-starved water. That is the source of the financial crisis, and better principles can be ameliorative at best.

That is why I am mildly disappointed in former Federal Reserve chairman Paul Volcker. He is one of the wisest men I have ever met, and his contribution to saving the American economy in the early 1980s ensures him an honored place in the history books. His valedictory contribution to world financial health may be a plan to limit risk in the banking system, which he previewed on February 1 on the op-ed page of the New York Times. What he says is sensible, balanced and wise – but not directly relevant to the problem at hand.

“The point of departure” for banking reform, Volcker writes, “is that adding further layers of risk to the inherent risks of essential commercial bank functions doesn’t make sense, not when those risks arise from more speculative activities far better suited for other areas of the financial markets.”

Volcker added: “The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading – that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs. Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called Chinese walls between different divisions of an institution.”

He’s right, but it’s beside the point. What brought the banks down was not speculative bets in volatile markets but what appeared to be ultra-safe investments in the most conservative assets available, namely medium-term bonds rated Aaa/AAA by Moody’s and Standard & Poor’s, the major rating agencies.

The US Federal Reserve agreed to allow the banks to put on more leverage (that is, allocate less of their own capital against prospective losses) than they had in the past. But the Fed agreed to do this only for assets that were supposed to be virtually default-proof. The ratings agencies “sold their soul to the devil,” as a Standard & Poor’s analyst admitted in an e-mail later brought to light by a congressional investigation, in order to rubber-stamp riskier assets with the AAA label.

But that’s because the banks couldn’t find enough prime assets in which to invest and had to find subprime assets to replace them.

I documented this deterioration during 2006, as I tried to build a start-up research department at Cantor Fitzgerald, a second-tier brokerage firm. From a business standpoint, the effort fizzled, and I moved in 2007 to a credit derivatives hedge fund (we paid out our investors with profit in July 2008 and closed the doors just before Lehman Brothers went bankrupt). Some of the material below has appeared in my “Inner Workings” blog on Atimes.net, but it seems worth reviewing in context of the banking debate.

The intellectual effort of trying to establish the research department in 2006, though in vain, was rewarding. In a series of reports to Cantor Fitzgerald customers, I showed how global flows caused massive distortions in the pricing of American securities, and created demand for highly-levered structured instruments that (temporarily) provided higher returns.

There are two sides to every investment. One is the return you get; the other is the return you require. For pension funds, the hurdle rate for investments is the rate required to meet the contractual requirements of a defined-benefit pension scheme. If corporations fall behind, eventually they will have to dip into profits in order to make up the difference. Commercial banks pay a certain amount for money, and lend it out for profit. The benchmark for banks’ cost of funds is the rate for interbank loans, or the London Interbank Offered Rate (LIBOR). A few of the large banks have sufficient customer deposits to pay a rate lower than LIBOR on certificates of deposits, but that is a secondary matter.

The derivatives boom was in full flourish when I published my first research report for Cantor, on January 5, 2006. I wrote:

In CS Lewis’s Screwtape Letters, an old devil gives practical advice to a novice demon. Diabolical amounts of leverage compressed credit spreads during 2005. Wrong as the market may be about inherent risk, it is likely to stay wrong, as the Fed backs off from aggressive tightening, the threatened curve inversion fails to materialize, absolute yield levels remain low, and investors enhance returns through leverage.

Investors are not piling into levered … structures because they are complacent about credit risk. On the contrary, all the investors I know are scared to death. But as long as the average US pension fund requires returns of 8.75% to meet its long-term obligations, and the aggregate corporate bond index yields just over 5%, institutional investors will continue to pick up nickels on the slope of the volcano. Sponsorship of ever-more-esoteric structures is a failsafe symptom of yield dearth.

The insatiable hunger for savings instruments on the part of the world’s aging savers was responsible, ultimately, for the great financial crisis. Huge foreign demand for US securities pushed the returns of prime securities down to levels that made them useless to most American investors, including pension funds which have fixed return targets averaging 9%, and banks funding at LIBOR (the interbank cost of funds). Once prime assets couldn’t meet the requirements of investors, subprime assets were invented to provide higher returns.

The charts below are derived from my 2006 spreadsheets; I published versions of them in early 2006.

First, massive foreign inflows into the dollar drove US interest rates down. The change in custody holdings in the chart below is the Fed’s holdings of Treasury securities on behalf of foreign central banks. The effect was most obvious in 2003, when massive Asian central bank intervention to hold the dollar up ballooned reserves. Asian central banks stopped their currencies from rising by purchasing dollars on the open market. In turn, they invested the dollars they bought into US Treasury securities. During the early part of the 2000s, the flood of Asian central bank purchases was big enough to depress the overall level of rates.

We observe in the graph below a nearly perfect inverse relationship between the change in foreign central banks’ holdings of US Treasury securities (measured by the custody holdings for foreign central banks at the Federal Reserve) and the two-year Treasury yield:

Change in foreign central bank Treasury investments (custody holdings) vs 2-year Treasury yield:

In 2003, the Federal Reserve misinterpreted this phenomenon. Future Fed chairman Ben Bernanke and then Fed chairman Alan Greenspan fretted that the US economy might be in the grip of deflation and kept interest rates too low for too long. That contributed to the housing bubble. But something even pernicious was underway.

Banks borrow at LIBOR and lend at a margin above LIBOR. With the flood of global savings pouring into American markets, prime investments began to yield less than LIBOR for the first time. The most important instrument for commercial banks next to loans is mortgage-backed securities. Mortgages are complex instruments because homeowners can prepay their obligations if rates fall; what matters to banks in the return on such securities is the return after the cost of hedging for the effect of interest rate changes. By industry convention, this expected return is measured as an option-adjusted spread above LIBOR.

Shown below is the LIBOR option-adjusted spread (that is, the expected excess return over LIBOR after taking into account the value of embedded interest-rate options) for a typical agency pass-through – that’s prime mortgages (guaranteed by a federal agency). This went from 80 basis points to zero between 2003 and 2005, as massive buying by Asian central banks and related agencies pushed down the expected return to levels never before seen.

For that matter, the interest on high yield debt, adjusted for “expected loss” (the average loss rate over the preceding 20 years) went to zero. And at the same time, the yield on speculative grade (high yield) bonds adjusted for long-term default rates also went to zero.

Expected return above LIBOR of mortgage-backed securities after hedging costs (LIBOR option-adjusted spread) vs high yield return adjusted for expected loss.

The sort of bonds that banks typically bought for their own portfolio were paying the cost of funds or less, which meant, simply, that the banks couldn’t make a profit.

We can see how foreign inflows caused the collapse of agency spreads during 2003-2007. Below are reported net foreign purchases of securities issued by Federal agencies (Fannie Mae and Freddie Mac mainly), against the LIBOR spread of these securities. Foreign central banks were willing to buy these securities at LIBOR minus 20 basis points because they had cash burning a hole in their pockets and didn’t need to worry about funding costs. But every other institution that funded at LIBOR watched spreads fall with dismay. They simply couldn’t buy prime assets, given their own funding costs.

Yield of federal agency securities falls with higher foreign purchases.

As the funding costs of the federal agencies collapsed, they bought more mortgages, and as they bought more mortgages, LIBOR option-adjusted spread shrank, as per the second chart in the series. The close relationship between the LIBOR funding costs of the federal agencies and mortgage-backed securities is shown below.

Spread to cost of interbank funds of federal agency (government-sponsored enterprise) securities drives down expected return of mortgage-backed securities.

That’s why investors went to subprime. Structured securities backed by subprime debt could be had with an undeserved AAA rating paying LIBOR +20 basis points or LIBOR +25. The likes of Citigroup vacuumed them up in huge quantities and stuck them in special investment vehicles with a paper-thin margin of capital to cover losses. AAAs weren’t supposed to have any losses, so the Fed went along with it.

This created egregious mis-pricing of the whole credit market. I wrote on January 27, 2006, “We do not value pigs by the attractiveness of their physique, nor for the nobility of their character, but for their suitability for sausage. In a credit market dominated by the CDO (collateralized debt obligation) bid, the most valuable securities are the ones that offer the most yield relative to default rates projected by the models that rating agencies use to rate CDOs.”

The financial crisis may have calmed down, but the sources of the crisis remain unchanged: the industrial world is unable to fund the greatest retirement wave in history at current returns. Everything that seems to offer yield turns almost instantly into a mini-bubble.

Banking reform doesn’t address the problems of the banks today. The commercial and industrial loan book of American banks has fallen by 20% in the past year. They are earning less interest overall, and the delinquency rate on their remaining loans has tripled since 2007. They can’t find mortgages to buy, given the continuing depression in the housing market. What they can buy is US Treasuries, and they are buying them in huge numbers.

Banks buy Treasuries to replace loans and other securities.

There is nothing wrong in principle with Paul Volcker’s call for banking caution. But the problems of the banking system can’t be separated from the larger economic picture. Without a way to match the aging savers of the industrial world with the young workers and entrepreneurs of the global south, banking problems will persist no matter what regulatory regime prevails.

Spengler is channeled by David P Goldman, senior editor at First Things. From 1998 to 2002 he was head of credit strategy at Credit Suisse, and from 2002 to 2005 he directed global fixed income research at Bank of America.

https://web.archive.org/web/20100920040908/http://atimes.com/atimes/Global_Economy/LB02Dj01.html