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Money For The Rest Of Us Podcast
Episode 155: Clues to the next financial crisis
J. David Stein
April 26, 2017 distribution date
Length of podcast – Approx 34 minutes.
Overview – How panic caused the great financial crisis and what to look for to see if it is happening again.
Signs go unnoticed by most investors.
Financial advisors job is to notice things that matter.
Spreads/incremental yields on commercial paper relative to Treasuries widen. Dislocation in Short term credit market. These offer clues as to when things are brewing.
Commercial paper is short term debt less than 9 months. An attractive way to fund operations. Yields are low and they don’t have to register the securities with SEC as long as they are less than 9 months. Used by corporations. Unregulated in the same way bonds are regulated.
Investors use commercial paper as a cash equivalent. The par doesn’t/isn’t supposed to fluctuate over the near term. They usually trail short term. It’s convenient place to park cash to get a bit more yield than short term treasuries.
Institutional investors can buy commercial paper directly. Individuals get them through money market funds. So they are liquid cash like products with little fluctuations.
Commercial paper is all part of the shadow banking system. Book by Morgan Ricks Vanderbilt University. Policy advisor to the Fed. He writes that a shadow bank is not a chartered bank. They use large quantities of short term debt to fund a portfolio of financial assets. They finance short term to invest long term.
A traditional bank (The Money Problem book by Ricks), don’t collect deposits and then make loans. It’s the opposite. They make loans and then do accounting entries to create the deposit. Loans create deposits. Episode 94 of the podcast gets into the details.
Shadow banks can’t create money like commercial banks. Shadow banks short term borrow to invest long term in structured investment vehicles (SIV’s) asset backed commercial paper. Issue CP, backed by financial collateral including mortgage backed securities and it is remarkably profitable because they keep the spread.
In the Money Problem, shadow banks operate outside regulatory oversight. The financial crisis is impacted by shadow banks and commercial paper. $1.97 trillion CP in 2007. $689 billion in 2005. Only $416 in 2009 after the collapse.
CP has short maturity. Investors have the constant question, “Should I renew or redeem it?” In August 2007, treasuries over 5% yields (on 30 day paper). Two Bear Stearns hedgies go under and the unwind started. This caused investors to doubt the collateral on MBS. So the holders of ST Debt wanted to redeem for cash rather than roll over. This caused a run.
As long as each account holder thinks it is unlikely that others will redeem, there is no reason to redeem. But once a run starts, then everybody yanks at the same time.
Spreads widen, yields on CP rise while treasuries don’t (or fall). There is the ability to actually lose money in CP if the backer can’t pay (like Lehman). So they are cash substitutes but in reality aren’t stable in value when it counts (like cash should be). Hence money market funds can break a buck.
Fire sales can start. Yields can skyrocket. Rise in interest rates make it difficult for companies to fund operations and day to day business. The ability to households and businesses to buy via borrowing goes up. Output declines. Business produce less while consumer buy less. GDP contracts. Recession begins.
1873 in the book Lombard Street – in a panic, central bankers should lend as much as necessary in all sorts on all types of securities. That’s what our central bank did during the collapse in 2008. The fed’s started buying commercial paper in the billions as the buyer of last resort. By January 2009 they were the biggest buyer of commercial paper (22% of the market).
Central bankers step in and are willing to buy everything to prevent a further fire sale. That helped solve the panic but the recession existed with a contraction. We are still recovering as some things never climbed back to those pre-recession levels.
Economy normally goes up at a certain pace but then there is a contraction with a follow up recovery. This creates an output gap (or should create an output gap).
We find little support that output rises faster then trend immediately following recessions to close the output gap. If anything, post trough growth is slower. Economists lower the trend by reducing expectations not reality. There is benefit of avoiding recessions.
The growth in the 19th century had more panics and recessions than the 20th century. The recessions that made it look like the growth was slower but it was more the results of these panics and recessions that were deep. Otherwise growth was similar.
These are all clues to the next recession and crisis. Despite Dodd-Frank and regulations there hasn’t been anything that will solve the core issues of panic, shadow banks, and leverage. The solution has always been central banks. But there are risks to this because of moral hazard. Investors and companies start to behave as if there is always somebody behind them to clean up the mess of problems so they take too much risk.
Repo agreements and cash equivalents are the kindling to financial crisis’ as long as people believe they are cash equivalents (which they aren’t when it counts).
What should we be looking for as signs of stress? First, the spreads that show distress between CP and U.S. Treasuries bills. Absolute spreads. We can look at LIBOR/IOR spreads overnight swap rate. A widening means banks are more afraid of lending to one another. Second is comparing the yields on credit default swaps to treasury yields.
CDS are contracts between investors (derivatives) used for investors to protect themselves against defaults. The yields should be close to the option adjusted spread. But if yields widen, then take notice because it is either an arbitrage opportunity or a sign of distress. These are private agreements between investors so if the yields go up, then investors are getting more worried.
Clues should emerge over time to give all of us a heads up to a full on brewing crisis.