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Executive Summary

Global financial markets, and in particular the emerging markets, are frighteningly complacent about the risks that are building up and coalescing in front of our eyes. These risks present a clear and present danger of a significant asset price correction that may be more reminiscent of the 1920’s than the 1990’s.

These risks centre around four main themes:

  • The appalling structural position of global emerging markets, and in particular the explosion of bank and corporate debt that been issued in a tidal wave of fixed income borrowing.
  • The build-up of significant tail event risk in the global financial markets, that could conceivably be the catalyst for a “black swan” event, the like of which we have not seen before. These event risks are many and varied but this article deals directly with four:

o The incoming new Trump US administration;
o New debt monetization policies that could potentially be introduced in Japan, and perhaps even in the United States;
o A breakup of the European Union triggered by a rise in populism around the world, a successful Brexit, or significant economic hardship from a specific event, such as the collapse of the Italian banking system; and
o A debt or currency crisis in China

  • The decline in structural liquidity in the emerging market financial system, and the level of extreme positioning by investors in these markets who have spent nearly a decade hunting for yield.
  • The illusion of financial stability that has been created by an avalanche of largely ineffective financial regulation in both Europe and the US, which has ironically in many cases contributed to risks we now face.
    While the article does not state that a significant, perhaps catastrophic, financial crisis is imminent, it does conclude that a significant correction is inevitable unless policy makers around the world address some of these issues. The level of interconnectedness in the world, combined with the astonishing level of complacently to the risks being faced, means that participants in the financial markets should be cognizant of these risks and act accordingly in the next 1-3 years.

David Russell Thompson, December 2016
Chief Investment Officer,
The Cambridge Strategy Asset Management

 

The Coming Black Swan in Emerging Markets

 

“Oh, but you must travel through those woods again and again…said a shadow at the window…and you must be lucky to avoid the wolf every time…But the wolf…the wolf only needs enough luck to find you once.”

Emily Carroll, Through the Woods

The big bad wolf is close at hand for the global emerging markets. Its shadow is looming large and as much as many people are looking over the horizon, and envisaging a safe passage through the woods to the other side, I just cannot see the path. Or at the very least the path is very overgrown, and fading rapidly in the waning light. The consequent chances of wandering off the path are very real and getting more likely every day. The sheer complacency in the world’s financial markets is staggering, and while I read some concerned commentary, very few people seem to realise how close to the precipice we are, certainly for the emerging markets, but probably for global asset markets in general. Why such complacency? A big factor is the makeup of the current participants in the world’s financial markets, who have spent two decades learning by experience that the fairy godmother in the shape of the world’s central banks and political institutions will ignore morale hazard and bail the financial systems out despite the consequences, because the alternative is just too bad to contemplate. This combined with an almost zealous belief by politicians and regulators that the imposition of new widesweeping regulation has improved the overall wellbeing of the financial system, means that there is the misguided belief that while there are tail risks in play, the overall outcome of a sustained bout of risk aversion will probably be relatively benign.

I just do not share this opinion. I have plenty of experience to lean on. My second year in the financial markets I watched powerlessly as grown men on the Midland Montagu trading floor sat in stunned disbelief as George Soros led a successful hedge fund attack on Sterling to knock it out of the ERM. I was at the heart of Asian Currency crisis firstly with HSBC and then with AIG Trading. I had a central bank governor swear at me in an elevator for supposedly attacking his currency, and took calls from desperate bewildered sovereign weath funds, who could not believe what was happening to the value of their portfolios in 1997 and 1998. I’ve seen the imposition of draconian capital controls, unprecedented devaluations, and markets trading in the vacuum of illiquidity. Central banks buying equities and bonds directly, political upheaval, war, revolution, and unprecedented fraud. I remember trading the Thai baht with tom/next funding being two baht, or 2000%. Russia raising interest rates by 6.5% in one hike. In 1997/8 I saw the wolf close up and it was much scarier than 2008. I saw Central Banks lose control of the markets in a much more direct way than in 2008, and I fear we are potentially looking at something far worse coming over the horizon.

Why am I so bearish? I have a raft of reputable bank predictions sitting on my desk, which since 2012 have consistently said this time its different, and that in a nutshell the more flexible emerging market exchange rates, the significant improvement in central bank reserves in the last 20 years, the low level of starting interest rates in this cycle, and the improved position of the global financial system due to more financial regulation means that the ability for the global emerging markets to weather the storm is dramatically different to that of 1997/1998 and 2008. I think that is delusional. A black swan event for EM is a real and present danger. Ignore it at your peril.

“Today’s truth will be tomorrow’s lie and you will be left questioning your own sanity”.

Michael R. Fletcher, Beyond Redemption

Many concerning themes around the world appear to be converging together, producing a very worrying scenario. In October 2016 the IMF issued its most recent Global Financial Stability Report[1]. They cite the worrying trend that “medium-term risks continue to build”, and are concerned about the solvency of pension and life insurance companies, the heavy corporate debt in emerging markets, and are particularly worried about the political environment. “The political climate is unsettled in many countries. A lack of income growth and a rise in inequality have opened the door for populist, inward-looking policies. These factors make it even harder to tackle legacy problems and further expose economies and markets to shocks”. The potential for event risk to derail global and in particular emerging markets has never been higher. This rise in populism has already pushed the UK out of the EU; and as Roger Bootle stated recently, “Italy is almost certain to follow.”[2] Liquidity is appalling and getting worse. Spreads in the emerging market bond markets are as poor as I can remember since 1998. The financial intermediation market is almost non existant, and old fashioned market making and the consquencial liquidity it provides has been put to the sword courtesy of Dodd-Frank. Combine this with a market hunting for yield in the emerging markets, and the staggering increase of both local and foreign issuance of debt by corporates and banks and it’s easy to see why the old adage about everyone trying to get out the door at the same time has never been more relevant. Throw into the mix a new protectionist, fiscally expansionary, domestically focused Trump administration, low commodity prices, the death of moral hazard, the lack of ammunition now in Central Bank armories, the likelihood of extreme reversals in FDI from the emerging markets due to dollar repatriation incentives, and the desperate need for structural reform around the world, and the confluence of risks starts to be very worrying indeed. I’ll deal with these risks in turn; 1. The poor dynamics in the emerging world; 2. The large event risks in the developed world, due primarily to a new Trump administration, a desperate deflationary Japan, an old EU failing political establishment and a Chinese economy fuelled by unprecedented levels of debt; 3. The extreme positioning and liquidity risks inherent in the current world financial markets and; 4. The illusion of the raft of new regulation providing a financial safety net to the world’s financial markets.

 

Risk 1 – Poor Emerging Market Debt Dynamics.

 

“Having spent 10 years studying emerging markets, I know that you have patterns repeated again and again. A bubble is like a fire that needs oxygen to continue…when you see there is no oxygen, things change”.

Nouriel Roubini

The debt dynamics are truly frightening in the emerging markets. Emerging market non-financial corporate debt has risen from $5 trillion in 2004, to $25 trillion in March 2016[3]. Recent trends are sharply up as non-financial corporates are rushing to issue debt prior to a potential Fed tightening cycle. In the third quarter of 2016 alone $84.2 billion was issued, as can be seen from the graph below[4];

 

Chart 1 – USD denominated debt issued by the emerging world since 2000[5]

The Bank sector looks no better. Bank debt has risen from $2 trillion in 2005, to over $7 trillion in March 2016[6]. In addition household debt has exploded from 15% of GDP pre-crisis, to 35% of GDP now, and now exceeds $8 trillion as at March 2016. These are worrying statistics, and show the vulnerability of the emerging markets to global interest rate rises, especially in a post Trump era of fiscal stimulus, and a protectionist administration whose priority is clearly going to be creating US jobs. But they become truly frightening when you realise that $4 trillion of the total bank and non bank debt in emerging markets is issued in foreign currency, and BIS data shows that since 2009 outstanding US dollar-demoninated credit extended to non-bank borrowers outside the US increased by more than 50 per cent from $6 trillion to nearly $10 trillion today. These numbers are unprecedented but they are understandable. If you are a corporate treasurer in Brazil why pay local debt rates, when you can raise dollar debt at close to zero per cent? In a world environment, where FDI flows are chasing yield, you are also likely to benefit from a falling USD/BRL exchange rate and the oxygen fueling emerging rates is flowing at full blast. Until someone turns it off.
What about the maturity profile of this debt? It doesn’t look good. The liquidity profile of the maturing debt is heavily skewed towards 2017. Nearly $1 trillion of debt will need refinancing next year, nearly the same in 2018, and nearly half of that is in foreign currency. The repayment of that debt could easily become problematic in an environment where FDI flows reverse, there is large scale USD repatriation, and debt market prices start to decline, as a stampede of investors hit the exit door simultaneously.

 

Risk 2 – Event Risks

 

“There is no such thing as an accident, only to recognise the hand of fate”

Napoleon

“This time it’s different.”

How many times have I heard that over the years? Well one thing I know with certainty is that this time it’s not different. Actions have consequences. Markets move in cycles, and the current market dynamics are going to produce some form of correction. It is just my belief that the consequences are more likely to be familiar to people who lived in the 1920’s, rather than the 1990’s.
The event risk headwinds facing the global financial system are truly remarkable. We have never seen their like before. I won’t even cover geopolitical risks, realpolitik risks, commodity prices, the rise of populism around the world and Russia, which are all real, and could easily act as the catalysts that spark some form of black swan event. I could write an entire book on event risks, but the four that keep me awake at night are; 1. The new US Trump Administration; 2. A desperate Japan pursuing policy that may lead to hyperinflation. 3. The break-up of the European Union and 4. The astounding rise in the Chinese money supply and the consequent debt bubble.
The risks facing the world economy from Donald Trump are hard to quantify, as details are still thin on the ground as to what policies he will actually pursue. On the surface some of his policies seem eminently sensible. Repealling the parts of Dodd-Frank that allow banks to lend again is sensible, and removing the layers of red tape that stifle business should be welcomed. However the risks from this new administration fall into three main categories.

A new Trump administration is clearly going to focus on the domestic US economy and the creation of jobs. That is the yardstick of success on which he will judged. The policies that he is likely to introduce to do this are uniformly negative to emerging markets. He will encourage a huge repatriation of US dollars from abroad. These dollars would be used to fund fiscal stimulus, hiring, and business development. Many analysts have downplayed the impact of these proposals, as many US company foreign earnings are held in dollars. So how big would the impact be? Well the facts suggest the impact would be considerable. Estimates put US foreign earnings held abroad at $2.5 trillion[7]. Presently, US Companies have double taxation on those profits if they are repatriated by paying a 35% repatriation tax. Donald Trump has proposed a one time cut in this rate to 10%. Of this $2.5 trillion, the US Congress itself estimated that only 46% of these earnings were held in US Dollars[8]. That is $1.35 trillion dollars held in foreign currency that could potentially be repatriated back to the US. It is entirely possible that the new Administration may make repatriation mandatory, but in any case the impact of these flows would obviously be very significant. In 2004, after the last legislation to repatriation US Dollars from abroad, (The Homeland Investment Act of 2004), $360bn was repatriated, and the US Dollar rose by an average of 13% against a basket of foreign currencies. It does not take a genius to combine the huge US dollar debt issuance in the emerging markets, with a significant uplift in the US dollar, to appreciate that whole sectors of emerging market corporate businesses could be wiped out from these refinancing and debt repayment risks.

 

Chart 2 – USD earnings held abroad by selected US Multinationals[9]

A second related significant event risk stems from the fiscal stimulus side of the equation. Already yield curves in the US are steepening. US interest rates, pressurised by potentially enormous fiscal stimulus are likely to rise, and the current Fed “dots” could soon be overtaken by events. With local debt markets under pressure from FDI flows reversing, and US interest rates pushing global interest rates higher, the refinancing headaches of emerging market treasurers are not only going to be confined to the foreign currency exposure, but corporate, bank and household debt could all see significant rises in local interest rates, which could choke off any favourable growth dynamics generated by an improving US economy. This risk is compounded by the fact that a new Trump administration is going to prioritise the domestic economy over the global economy, and that the classic feedback loop of US growth benefiting the emerging world economy could well be deprioritsed by Trump. This means that the favourable growth dynamics traditionally experienced by emerging market economies from improving US growth could be insulated by a protectionist, insular US administration.

A final piece of food for thought. Trump has said he will fund fiscal expansion through issuing debt. That will involve a significant increase in the money supply, as new money is created. The problem in the last decade is that the the traditional banking model for this has been via QE, where new money is swapped for balances in the reserve balances of banks. The money supply will only increase however if the banks then lend, and in both the US and Japan, repayment of borrowing is exceeding new lending. Therefore under Fishers Quantity Theory of Money, MV=PT, inflation will only increase if M increases along with V, (the velocity of money, or the rapid use of money), and the consequent multiplier effect does the rest. What is to stop Trump cutting out the middle man, the banks? Larry Summers has already called for less independence for the Fed, and to see the Fed work closely with the executive branch of US government, to monetize debt. Why doesn’t the Fed directly print money and the government receives the proceeds and uses them to fund some form of fiscal expansion? Issuing perpetual zero coupon bonds has no impact on the deficit burden and arguably does not impact on the deficit? Bernanke’s famous “helicopter money”. The Fed buys these issued bonds, and the government then spends the cash. There is no reliance on creating money from bank lending. The risk obviously is that this is an extemely radical policy, and can dramatically increase inflation because the government controls both M and V. P has to rise. This policy, as Japan has found out, is generally around the world legislatively banned, as a central bank directly funding deficits can quickly lead to hyper-inflation. I will deal with this in the discussion of Japan, but the risks are just as real in the US, perhaps even more so as the marginal propensity to consume in the US is much higher than in Japan, and therefore the effect on the velocity of money could potentially be a multiple in the US than the effect on the velocity of money in Japan.

The second significant area of risk sits with the Japanese economy. Shinzo Abe was elected in December 2012, and subsequently enacted a huge stimulus package of 28 trillion yen in August 2016. Unfortunately Japan is still in deflation. I wrote an article on the monetary transmission mechanism in Japan, and argued that the problem with Japan is “due to the poor health of the Japanese financial sector, and its inability to pass on the money created, and to therefore create excess liquidity”[10]. It is the same problem the world over. Banks are not willing to lend, and borrowers are not willing to borrow, hence countries around the world are slipping into deflation as borrowers repair their crippled balance sheets. Into this breach has stepped Ben Bernanke, and direct debt monetization. Despite the fact that direct monetization is illegal in Japan under Article 5 of the Public Finance Act, the risk is rising that Japan may consider something more radical and issue perpertual bonds, that never come due, and pay no coupons. Critics of this say this is no more than a conjouring Act[11], but nevertheless it is growing in popularity. The main argument for it is that it’s just a different side of the same coin. If debt monetisation creates illusionary money, then so does all bank lending. When a bank lends that is doing the exact same thing, just in this case the money supply boost comes directly from the government.

Why is this so dangerous? Simple economics. It will undoubtedly work. Under the Quantity Theory of Money, The Bank of Japan will directly boost the money supply (M) and the Japanese government would directly influence (V) the velocity of money through huge fiscal spending, handouts to the poor, and benefits provision. That means that inflation (P) and growth (T) in the quantity theory of money will dramatically increase. The risk is that once the inflation genie is out of the bottle, it can become a raging forest fire, as inflation expectations dramatically increase. This would become self-fulfilling, as the Yen would devalue, the JGB market would collapse, and that would most definitely prompt competitive devaluation in the emerging currency markets, dramatic increases in bond yields, and a massive further reversal of funds out of the emerging markets.

The third insomnia inducing significant event risk is clearly the situation facing the European Union. Most of these risks are self evident and have been well documented. In September 2012 I wrote an article entitled “Beware the Draghi Put”. Many of the risks articulated in that article are more relevant today than ever before. The ECB has embarked on an enormous bond buying operation, and in September 2016 went through the Eur 1tn threshold of government bond holdings, many of which are periphery debt at a time when the rise of populist sentiment threatens to push several countries out of the European Union. Europe desperately needs structural reform, and one of the main risks I articulated back in 2012, was the fact that Europe is facing an economic crisis, that can only be solved by politicans who do not enjoy the mandates necessary to do what is required. Hard painful decisions have been needed, and short term career politicans have not been able to take those decisions, hence the rise of populism around the world.

Economically Europe is in serious trouble. In particular the Italian banking system is a clear systematic risk to the Eurozone. Non-financial bad debts are running at 18%, and contingency funds have only been set aside for less than half of these. Under every bad debt/NPL measurement in Italy, non-performing loans have dramatically risen since 2008, and the trend shows no sign of stopping or even slowing down. Once again therefore the thorny question of moral hazard comes up. The European Union and the Italian public have diametrically opposed vested interests here. To recapitalise these banks could cost upwards of $40bn Euro’s, but even more importantly retail investors hold huge amount of Italian bank debt, and letting Italian banks go to the wall will decimate an Italian banking system where 15% of households net worth is invested in bank debt. Bank run anyone? On the other side, the political appetite to bail out yet another banking system is de minimus, and the EU has always insisted that EU bond holders have to pay the costs of any recapitalisation. The situation is serious enough to bring about the fall of the Italian government, propelling the populist Five Star into power, and the subsequent inevitable Ixit.

 

Chart 3 – The Dramatic Rise Italian Bad Debts Since 2000[12]


Chart 4 – Italian NPL Ratio’s Compared to Other Key Eurozone Countries[13]

It gets worse. As I highlighted in my article, the EU now faces an enormous black swan event relating to the financing of its trade imbalances within the Eurozone. These flows are the infamous Target 2 balances, and while they should be adjusted by private sector capital flows, that is currently not the case in the EU, as official flows within the balance sheet of the ECB dwarf all other flows. These Target 2 balances clearly show that the Bundesbank is the de facto lender of last resort in the EU and is building up huge Target 2 balances in relation to the European periphery, and Italy in particular. The situation now means that Germany is rapidly overtaking China as having the largest “trade” surplus in the world. Why does this matter? Simply put, were Italy to leave the Eurozone, the European core, and Germany in particular would be looking at huge default risks, as these Italian liabilities have been directly financed by the Bundesbank through the Target 2 mechanism. In Germany these balances now sit at $600bn, and are rapidly rising, and you can certainly forgive the German political establishment of beginning to get very nervous.

 

Chart 5 – German Target 2 Balance Claims within the Eurozone[14]

The risks don’t stop there. Portugal, Spain and Greece all have similar issues and a successful UK Brexit could trigger a further rise in anti-EU sentiment in Europe. Greece is still a (forgotten) issue. It is ground zero for the implementation of German austerity, while at the same time being the main stepping stone for the flow of migrants leaving the war torn Middle East. The collapse of Schengen, Turkish membership of the EU, escalating terrorism risk in Europe. This list goes on and on.

Last but not least comes China. The depth and breath of China’s liquidity expansion in recent years has been quite breath-taking. Ousmène Jacques Mandeng, formerly with the International Monetary Fund, has calculated that between 2007 and 2015 China created 63 per cent, or $16.1tn, of the growth in the world’s supply of money[15]. China now has a larger supply of money than the Eurozone and Japan combined — and almost as much as the US and the Eurozone combined.[16]

The main issue is that debts are piling up almost as fast as China generates money to service them, creating what Jonathan Anderson of the Emerging Advisors Group calls a “debt funding bubble”. This is highlighted by some startling statistics. The IMF said earlier this year that $1.3 trillion of corporate loans, or 1/7th of the total are owned by companies who do not make enough profit to even cover the interest payments. Earlier this year Kyle Bass articulated that typically Chinese banks lose significantly more that 10% of assets during a bad loan cycle, and that for every 10% of assets Chinese banks lose, they will lose $3.4 trillion of equity. Non-Bank Performing Loans in China are clearly on the rise, and it is surely a matter of time until the system implodes.

 

Chart 6 – The Growth of Non-Performing Loans in Chinese Commercial Banks[17]


Already worrying signs of Chinese capital flight are evident. Private capital flows have fallen off a cliff in the last 24 months. In 2015 the IIF estimated that “China had a little more than $250bn coming in from the surplus on its current account. It got an additional $70bn or so from from non-residents, including Chinese overseas affiliates. But those outflows were swamped by a record $550 bn in net outflows by individuals and companies inside China.”[18]

 

Chart 7 – Capital Flight in China. The Collapse of Private Capital Flows into China[19]

The Chinese authorities are already taking action. Access to gold is being restricted; state enterprises will be investigated for any foreign real estate purchase of over $1bn; and China will scrutinise any purchase of overseas companies in excess of $1bn if it is not directly related to a companies core business. The PBOC reserves have already fallen from over $4tn usd to just over $3 tn today, and calls are getting louder for more capital controls in China to stem the flow. Almost certainly China will need to recapitalise its banking system, and devalue the currency, clearly a very negative outcome for an emerging world facing all the headwinds I have already articulated in this article.

 

Risk 3 – Positioning and Liquidity

“When you’re in a pit, the first thing to do is stop digging.”

James Ellman, Seacliffe Capital

“When the music stops in terms of liquidity, things will get complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Chuck Prince, Citigroup in 2007

The mistake that many analysts and market participants make is invariably the same before all major crises. They assume the financial markets behave rationally. That they are logical, controllable and explainable. However invariably the post-crisis analysis always shows that a catalyst of some sort deprives the emerging markets of the oxygen it needs to survive, and a violent correction results. Liquidity, confidence and rational decision making can evaporate very quickly, and in the major crises, the process is exaccerbated by extreme positioning in markets where nobody is prepared to provide liquidity. Sound familiar? In 1997/1998 and especially in 2008 Central Banks where able to somewhat control the situation. The HKMA backed by the PBOC were able to hold the HK dollar peg, and write unlimited amounts of Usd/Hkd calls to the market to back up its commitment. In 2008 The Fed aggressively cut interest rates, and US Politicians abandoned morale hazard and bailed out AIG, US Mortgage agencies, and a variety of Investment Banks. However in one sense it is different this time around; the central bank armoury is bare. Balance sheets are grossly inflated, interest rates are still at historical lows, and the ability of central banks to support the financial system is severely curtailed. Ex BIS chief economist William White agrees with me. He predicted the 2008 crisis in 2005 and in speech in November 2016 said “the global situation we face is arguably more fraught with danger than was the case when the crisis first began. By encouraging still more credit and debt expansion, monetary policy has ‘dug the hole deeper’.” The move by central banks to generate a wealth effect, and encourage lending has palpably not worked. Banks do not want to lend, and people do not want to borrow. History will undoubtedly look back on the period 2008-2018 with distain. The abandonment of morale hazard and the resulting deflationary headwinds the world has faced have resulted in the equivalent of being in the pit and just digging it deeper. The sides are about to fall in.

This has predictably resulted in a potentially cataclysmic set of circumstances. We have governments around the world printing money, central banks buying unprecendented levels of debt, investors the world over chasing yield and buying high yield emerging market debt, and a decline in both the provision of liquidity and the activity of market makers and banks, and financial intermediaries in general are being forced out of market making activities by government regulation, corporate risk aversion, and general capital and balance sheet protection.

Only a few years ago it was possible to deal in $20-$25 million tickets in emerging market debt. Now tickets like that are rare. There is no appetite to clear those types of positions, and when you combine the lack of liquidty and risk taking with the fact that investors around the world are all positioned the same way round, in an environment where yields are at historic lows, and inflation pressures are building, it is enough to give you cold sweats at night.

Virtually all empirical measuremtns of liquidity are worse than at the start of this decade:
• Despite the notional size of the emerging bond markets having increased exponentially in the last decade, notional trading activity in EM debt markets remain below 2008 levels.
• Hard currency soverign bond turnover has halved since 2008.
• Trading volumes in local corporate and currency markets has declined precipitiously and is 50% and 25% of the turnover in sovereign hard currency debt respectively.
• Bid ask spreads in high yield EM bonds are 4-5 times wider than they were in 2010.

Chart 8 – Emerging Market Bid-Ask Spread in USD Corporate Bonds[20]

 

Chart 9 – Bid Ask Spreads for EM 10 Year Local Currency Government Bonds[21]

The contribution of regulatory factors and changes in market structure should not be underestimated in this context. I deal with this in the next section, but as the IIF stated in a recent report, “regulatory changes—particularly capital charges and limits on proprietary trading activity—have driven up the cost of holding inventory for broker-dealers and reduced dealer risk tolerance. The classic rule of unintended consequence from ill thought out legislation. As a result, primary dealers’ appetite for facilitating secondary market bond transactions has been substantially reduced in many mature markets. Given that a significant proportion of transactions in EM hard currency debt is handled by international broker-dealers domiciled in mature markets, intermediation of EM debt securities has been affected by the same change in incentives—for example, while the share of foreign bookrunners in EM bond markets has recovered in recent years, it remains below pre-crisis levels. Of note, U.S. dealers have reduced their corporate and foreign bond holdings by more than 65% since 2007, reflecting reduced market-making in EM markets. Primary dealers in EM local currency sovereign and corporate debt markets also include subsidiaries of major foreign banks headquartered in mature markets, though to a varying extent across countries depending on foreign banks’ presence in emerging markets and regulatory restrictions across jurisdictions. As part of overall de-risking and deleveraging efforts, many of these international bank subsidiaries have allocated less capital to market-making activities in EM debt markets. Higher capital charges on bank holdings of EM bonds, as part of international regulators’ efforts to reduce systemic risk since the crisis, have also contributed to the pullback. The rapid development of EM local currency corporate bond markets has far out-stripped the growth of secondary markets and these markets remain largely illiquid”[22].

 

Risk 4 – The Illusion of Financial Stability

“Like love, we cannot get enough safety, but not the kind we are used to – what would happen if every day were Valentines Day? So flooded are we with contrived and controlling safety that it is becoming dangerous.”

Andrew Lang, Scottish Poet

After the 2008 financial crisis, politicians the world over enacted a bewildering array of financial regulation that was intended to make the world financial system stronger. These included Basle III in 2010 (bad debt and liquid assets), MiFID 2 in 2011 (investor protection and market transparency), CAR in 2014 (capital adequacy) and stress testing (scenario testing). Amongst many others. The perceived wisdom was that the root of the problem was an unregulated financial system that allowed banks and other financial entities to run amok and bring about the 2008 crisis. The clearest expression of this wisdom was the 2010 Dodd-Frank Act, which contains a huge amount of regulation covering things as diverse as corporate governance, executive renumeration, financial transparency and market practice. The problem with this school of thought is of course that it is pure rubbish.

The housing crisis in 2007/2008 had its roots first in the Clinton, and then George W. Bush administrations that actively encouraged reckless lending by banks. These policies unleashed a flood of easy credit, despite an already heavily regulated banking sector, and encouraged lending to poor credit, self certified borrowers. All that in the face of a raft of regulatory provisions, the PATRIOT Act and Sarbanes-Oxley to name but two, and the Treasury Department issuing more than 500 new rules on average per year during the 2000’s, and the SEC issuing an average of 74 new rules each year over the same period.[23]

The Clinton administration certainly played a significant part. In 1992 Clinton proposed “Putting People First”, which essentially motivated private pension funds to invest in government priorities such as affordable housing. While the overall initiative went nowhere, it was a direct precursor to the rewriting of the Community Reinvestment Act in 1995, which put added pressure on banks to lend in low income neighbourhoods. Bank regulators were forced to pressure banks to make subprime loans, and banks were given a grade based on the level of CRA loans. Banks could not essentially grow businesses without having a passing CRA grade, and Alan Greenspan in front of Congress in 2008 said that “the early stages of the subprime market…essentially emerged out of the CRA”.

From 1993, the 1992 Housing Bill also required Fannie Mae and Freddie Mac to make 30% of all loans to the affordable market sector. This was raised in 1996 to 40%, and 60% in 2000. George W Bush kept the trend intact and by 2008 the quota was at 56%. In 2002 George W Bush introduced a plan to increase the number of minority homeowners by 5.5 million. He introduced affordable housing incentives. He followed on from Clinton in insisting that Fannie Mae and Freddie Mac meet new aggressive goals for low income lending. Bush pushed through legislation to help first time buyers with down payments and closing costs, and he pushed for first time buyers to qualify for government issued mortgages with no money down. He pushed financial institutions to come up with innovative new ways of lending “Corporate America has a responsibility to make America a compassionate place”. Therefore under all measurements both Administrations placed an extremely high value of giving low income buyers the opportunity to own their own homes. The rest is history and the years since 2008 have seen an avalanche or regulation to fix a broken regulatory system, when in reality fixing a broken policy making political machine would have been much more effective, and would certainly have really contributed to improved financial stability and security.

Dodd Frank is a great case in point. It was enacted to help the United States avoid future financial crises by filling supposed regulatory gaps and to rectify a perceived lack of federal regulation. As the narrative above shows, this lack of regulation has subsequently proved to be false. In an excellent paper on the imposition and consequences of Dodd-Frank, Charlotte Twight[24] Professor of Economics at Boise State University, and Brandt Professor of Free Enterprise Capitalism argues that “although the Dodd–Frank Act of 2010 was promoted as an antidote to insufficient federal oversight, scholars have shown that it was in fact misuse of existing government power over U.S. financial institutions and housing markets that led to and exacerbated the 2008 crisis. Indeed, U.S. statutory and regulatory developments over many decades had created both the governmental context and the private incentives that gave rise to the crisis. From the Federal Reserve Act (1913), the Federal Housing Administration (1934), and the Federal Deposit Insurance Corporation (FDIC), made permanent in 1935, to authorization of government sponsored enterprises (GSEs) Fannie Mae (1938) and Freddie Mac (1970), creation of the Department of Housing and Urban Development (1965), and enactment of both the Community Reinvestment Act (1977) and the Federal Housing Enterprises Safety and Soundness Act (1992), a web of government powers over U.S. financial institutions and housing markets had emerged, powers whose exercise created public and private incentives for the imprudent borrowing and lending that undergirded the debacle in 2008”.

Dodd Frank is a an extremely complex and arcane piece of legislation, and I am not going to cover it in detail here, but Ms Twight’s conclusion is damning:

“Despite explicitly stated legislative intentions to the contrary, the powers of the DFA’s Financial Stability Oversight Council, Orderly Liquidation Authority, Office of Financial Research, and Consumer Financial Protection Bureau are expanding and reinforcing the very structural elements that contributed to the financial crisis of 2007–2009”.

She shows that:
• “implicit government guarantees of private firms continue, with a mere change in label as the new SIFI appellation has superseded former “too big to fail” terminology”.
• government policies fostering “affordable housing” remain intact, with a shift in predominant backing of mortgage loans from Fannie Mae and Freddie Mac to the FHA
• new strategies such as risk retention to curtail risky mortgage lending have been eroded”

Do we really think that our financial system is any more secure now than it was in 2007?
This all just goes to show that no regulatory environment in the world in going to protect investors, borrowers, households and savers from poor public policy. To think that a Tier 1 capital requirement, combined with stress testing are going to be sufficient is pure lunacy. As I mentioned earlier, regulation will not help in a market environment which ceases to behave rationally and logically. Under Dodd-Frank a CET capital ratio of 4.5% is required along with a Tier 1 capital ratio of 6%, and a total capital ratio of 8%. Banks create money. That is the whole point. They operate liabilities well in excess of assets as they create money by taking investor deposits and lending them out. Even taking into account bank borrowing, the process adds to the money supply, and banks have always been vulnerable to disorderly markets. So performing stress tests on banks with scenario’s looking at hypothetical unemployment rates, falls in asset prices and declines in house prices misses the point. Looking at the lessons from 2008, runs on banks are due to crises of liquidity. Any leverage is dangerous, and they will never be able to account for a systematic failure of the financial system. These failures always come from exogenous factors, and very often have their roots in poor long term government policy.

Since 2008 banks and financial institutions have been forced to increase Tier 1 capital, undergo regular stress tests, dramatically reshaped corporate goverance, executive pay, and obey often draconian market practice regulation. However, the subsequent years have proved that all this addiitional regulation just proves the rule of unintended consequences. Capital charges and limits on proprietary activity have meant that the risk appetite in the financial intermediation business has sharply declined since 2008. What is the unintended consequence? As I mentioned in the previous section it is a dramatic decline in liquidity provision, right at the time that the financial system needs it the most.

The US is not alone here. Europe has enacted its own new regulation with similar consequences. A good example of this is Basle III. Basle III applies a Bank’s Tier 1 capital to the balance sheet of each bank which has been weighted by a risk adjustment factor. Assets on the balance sheet are assigned a risk factor, which when compared to the ratio of Tier 1 capital gives a regulator some idea of a bank’s financial strength. Is this really the best we can come up with? It has become a corner stone of financial regulation but it is clearly flawed. On the surface the assets on a bank’s balance sheet are backed by between 12% and 15% of Tier 1 capital but in reality the capital adequacy is nowhere near that. As Thomas Hoenig Vice Chairman of the FDIC has shown in recent paper[25], the level of reported capital under Basle III, our most recent and comprehensive update to capital adequacy requirements is “illusionary”.

Here is how the illusion is created. “We know from years of experience using the Basel capital standards that once the regulatory authorities finish their weighting scheme, bank managers begin the process of allocating capital and assets to maximize financial returns around these constructed weights.”[26] The name of the game is to get the numerator (Tier 1 capital) as high as possible and the denominator (risk adjusted assets) as low as possible. Managers therefore try to maximize a firm’s return on equity (ROE) by managing the balance sheet in such a way that risk-weighted assets are reported at levels far less than actual total assets under management. This results in the illusion that banks are more highly capitalised that they are in reality. For the largest global financial companies, risk-weighted assets are approximately one-half of total assets. This “leveraging up” is endemic in the banking world, and the whole framework gives a complete false of security.

Hoenig argues that supervisors and financial firms should use a different ratio known as the tangible leverage ratio to judge the overall adequacy of capital for a bank. This ratio “compares equity capital to total assets, deducting goodwill, other intangibles, and deferred tax assets from both equity and total assets”. In includes only loss-absorbing capital, and makes no attempt to predict or assign relative risk weights among asset classes. Using this tangible leverage ratio instead of a risk adjusted Tier 1 capital ratio, assets funded by tangible equity capital are about 75% lower than a risk adjusted ratio at around 4%. An astonishing difference and far far less than required under the Basel standards.

An inherent problem with a risk-weighted capital standard is that the weights reflect past events, are static, and mostly ignore the market’s daily judgment about the relative risk of assets. It ignores current volatility and liquidity, and balance sheet optimisation can subsequently be done by bank managers, prior to window dressing the balance sheet for the next financial year. It also introduces the element of political and special interest into the process, which affects the assignment of risk weights to the different asset classes. Banks are incentivised to get lower risk weights on asset classes that they are more likely to hold in a purely artificial exercise to boost illusionary equity coverage of the balance sheet assets. The result is often to favour one group of assets over another, thereby redirecting investments and encouraging over-investment in the favoured assets. The effect of this managed process is to “increase leverage, raise the overall risk profile of these institutions, and increase the vulnerability of individual companies, the industry, and the economy”.

As Scottish poet Andre Lang so eloquently put it, we live in a world where “so flooded are we with contrived and controlling safety that it is becoming dangerous.” Exactly right.

“In the beginning you must subject yourself to the influence of nature. You must be able to walk firmly on the ground before you start walking on a tightrope”.

Henri Matisse

“Double, double toil and trouble”.

William Shakespeare

We live in an increasingly interconnected world. The risks are ever greater, and our global financial system, like anything else, is clearly subject to the laws of nature. But we have not yet learned how to walk “firmly on the ground”, let alone the tightrope. To do this we learn from our mistakes, and from our experiences. We have not done that since 2008. I am afraid that we are about to enter a very steep learning curve indeed. A huge fixed income bubble, complacency, illiquidity, poor macro public policy, a lack of morale fibre in not exercising morale hazard when it would have made a difference, dramatically opposing global interests across key players in the global financial markets resulting in high event risk, and the rise of populism around the world are key ingredients in the witches cauldron of financial meltdown that we seem to be brewing for ourselves.

I understand many of the key rebuttal arguments too many of the points raised:
• USD strength is self-correcting, and that a strengthening dollar is effective tightening and removes the incentive for the Fed to hike, and therefore underpins the global bond markets. In any case Trump will deliver on only a fraction of his election promises, and a major fiscal expansion is unlikely;
• Recent moves by OPEC are a game changer for commodity prices, and the fact that China is no longer exporting deflation eases the balance sheet on the emerging world significantly;
• Corporates and banks in the EM are hedged to adverse FX and rates moves;
• Abe is distancing himself from debt monetization and would never implement it;
• Populist sentiment is temporary, and the core European countries will ultimately compromise on austerity and pursue aggressive fiscal and structural reform;
• China has the ability to absorb significant shocks. Large levels of reserves, little foreign currency debt and a strictly controlled currency allow it to comfortably absorb even a major deterioration in Non-Performing Loans.

I could refute all these of these arguments, and I certainly accept a “black swan” triggered crash is not inevitable. I am not saying the catalyst for a really significant correction is imminent. But it is coming and the longer it takes, the harder will be the fall when it arrives, unless politicians and central bankers around the world make some key proactive decisions in the near future. An acceleration of the normalisation of interest rates would undoubtedly help, but for now this article is dealing with the symptoms not the cure. Good luck out there. You will need it.

David R Thompson, December 2016

1. Global Financial Stability Report. A Report by the Monetary and Capital Markets Department on Market Developments and Issues. October 2016.
2. Italy needs reform and a euro exit is inevitable. Roger Bootle. Telegraph 28 November 2016.
3. EM Debt Monitor. Intstitute of International Finance. March 2016
4. Wall Street Journal. October 6th 2016
5. Wall Street Journal. October 6th 2016
6. Em Debt Monitor. Institute of International Finance. March 2016.
7. Dollar to Benefit if $2.5 Trillion in Cash Stashed Abroad Is Repatriated. Wall Street Journal. Chelsea Dulaney.
8. Congressional Research Service report 2011.
9. Wall Street Journal. October 6th 2016
10. The Road Less Travelled. David Russell Thompson 2014.
11. Helicopter Money – The biggest Fed Power grab yet. David Stockman. July 14th 2016
12. Forbes. These are the 5 Biggest Risks That Could Break Up the European Union. March 2016
13. Why Italy’s banking crisis will shake the Eurozone to the core. Daily Telegraph. July 2016
14 The German balance of payments quandary. FT July 10th 2016
15. FT – China’s liquidity flood stirs memories of the Mongols and Mao. December 2016
16. FT – China’s liquidity flood stirs memories of the Mongols and Mao. December 2016
17. China’s Non-Performing Loans are rising fast. Price Waterhouse Cooper December 2015
18. China’s Capital Flight Bloomberg Businessweek. January 2016
19. China’s Capital Flight Bloomberg Businessweek. January 2016
20. Market Liquidity in Emerging Markets. How bad is it. IIF June 2015
21. Market Liquidity in Emerging Markets. . How bad is it? June 1 2015. CMM Research Note. IIF.
22. Market Liquidity in Emerging Markets. How bad is it? June 1 2015. CMM Research Note. IIF.
23. The Queens Business Review 2012. The Illusion of Dodd Frank
24. Dodd-Frank. Accretion of Power, Illusion of Reform. The Independent Review 2015.
25. Basel III Capital: A Well-Intended Illusion. Thomas M. Hoenig. April 2013
26. Basel III Capital: A Well-Intended Illusion. Thomas M. Hoenig. April 2013

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