Below is a final draft of a research note that will be posted on www.kbra.com later today. See final for chart & notes.
It seems pretty clear that the initial reaction of the Federal Open Market Committee under Chairman Ben Bernanke helped to reduce credit spreads and
restore function to the bond markets.
The massive asset purchase operations that followed, however, have
distorted credit spreads and asset prices across most asset classes.
Witness the falling kitchen knife if the form of the market for mortgage servicing
rights or MSRs, which peaked around 5x cash flow during the height of
quantitative easing. Today that market
has fallen through 2x and seems headed back to the historical level close to
one time cash flow. Liquidity has
disappeared in the MSR market, but the consultants still mark these payment
intangibles looking at accelerating prepayment rates.
How is this helpful? Isn’t QE supposed to
help housing finance?
And of course oil is now back in a contango market as distributors drown in excess
All this courtesy of the FOMC.
Bail-Ins and Financial Stability
In our last macro research note, Italy Slowly Moves Toward Comprehensive Bank
Rescue, we argue that the European Union must eventually support Italy’s banks
or risk the specter of financial contagion. Several readers questioned why
Kroll Bond Rating Agency (KBRA) is sufficiently optimistic to predict this
positive outcome, especially given that since the 2008 crisis Italy and other
EU nations have done little to address the festering situation in Europe’s
banking system. The mounting political and economic pressures in Europe are
another concern frequently cited in our discussions with investors.
The simple answer is when all of the alternatives are considered, KBRA believes
that the leaders of the EU will make the
same judgment as the U.S. leaders did in 2008,namely that bailouts of existing
investors in the debt of large, systemically significant financial institutions
are far less costly and destructive to society as a whole than engaging in a
forcible debt liquidation. By responding to sudden financial crises with
benevolence rather than retribution, we can collectively avoid the worst
aspects of future financial disruptions. This very choice now faces the leaders
of the EU, but only time will tell if they will make the right decision.
It is self-evident that, throughout history, financial fraud often has been the
underlying cause of serious market disruptions. When deception is used to conceal risk the
eventual revelation of that risk causes investors to react with surprise and
fear, and rush for the exit. Systemic risk is when markets are caught unawares,
as in the case of the BREXIT vote in the United Kingdom and the failure of
Lehman Brothers in 2008. When a systemic event occurs, the cost of credit
intermediation (CCI) increases dramatically, decreasing market liquidity and
the effective leverage in the global economy. One measure of CCI is the
difference between investment grade and non-investment grade credit spreads.
Chart 1 below depicts the high yield and “BBB” option adjusted spreads from 1997
KBRA believes that one of the reasons the U.S. economy rebounded following 2008 was
the fact that the Federal Open Market Committee, under Chairman Ben Bernanke,
understood the crucial importance of CCI and restoring normal credit spreads.
The contraction of wealth creation capacity that occurs following a systemic
“surprise” to the markets reduces overall economic growth and feeds a spiral of
debt deflation described by Irving Fisher in 1933.
Chart 1 also illustrates the near-catastrophic increase in CCI following the collapse
of Lehman Brothers and Washington Mutual in beginning of Q4 2008. These were
events that led to the failure of a number of other private and
government-supported financial institutions. When it comes to CCI and credit
spreads, up is bad and down is good for the markets and the economy. Following
the 2008 crisis, credit spreads spiked, causing CCI to increase and reducing
the capacity of the global economy to generate wealth and growth. But in the
years that followed, credit spreads fell back to normal levels, allowing the
U.S. markets for corporate debt and asset-backed securities to bounce back
The U.S. approached the post-crisis clean-up quickly, using a combination of
traditional resolution measures and public bail-outs for several large
financial institutions, including American International Group (NYSE:AIG),
Citigroup (NYSE:C), Fannie Mae and Freddie Mac (together the GSEs). These moves to “bail-out” the debt investors
of large financial institutions provoked widespread political condemnation in
the U.S. and elsewhere, but in fact helped to compress credit spreads, reduce
CCI and slow the debt deflation that threatened the global financial markets.
Hundreds of smaller U.S. banks and non-bank financial institutions failed as a result of
the 2008 financial crisis, ending up in receivership or bankruptcy. Debt and
equity investors frequently took significant or total losses as a result of
these failures. On the other hand, in the case of AIG, Citigroup , and the
housing GSEs, debt and equity investors were bailed-out at public expense. The
equity holders were subject to severe dilution but were ultimately spared the
total loss borne by equity investors in smaller financial institutions. The
creditors of these institutions were rescued entirely and at public
Nationalization cum Monetization
In Europe, the EU member states have moved slowly to address bank solvency issues.
As KBRA noted in a previous report Will Negative Interest Rates Save Europe’s
Banking System?, the total of bad assets still unresolved in the EU banking
system is probably a multiple of the official total of €1 trillion. This
suggests very strongly that many financial institutions in Europe will need to
be recapitalized, a view that has been recognized for years by institutional
investors. The uncertainty with respect to the actual condition of EU banks is
the single biggest obstacle to raising new capital funds. But given that many
EU banks are trading at a fraction of book value in the global equity markets,
raising new equity in the private capital markets seems to be problematic.
Unresolved bad assets also constrain economic growth.
As in the case of the U.S. rescue of AIG and Citi, the only way to stabilize the
situation facing a number of EU banking institutions is for the respective
nations to first extend direct sovereign support in order to restore some
degree of confidence among investors and the public. Together with the
substantial liquidity being provided by the European Central Bank (ECB), direct
state support for troubled banks in Italy and other EU nations can eliminate
the immediate risk of systemic contagion. These banks would then need to write
down bad assets, a painful but necessary process that would then open the door
for new private capital inflows as equity valuations rise and credit spreads
fall. KBRA believes the act of public support will allow a smooth transition
from public support back to private ownership once institutional investors
regain confidence in the asset quality of EU banks.
It is important to note that simply converting debt to equity, a process that is
commonly referred to as a “bail in,” is not sufficient to address the trouble’s
in Europe’s banking sector and could lead to a systemic catastrophe unless
preceded by other measures. The leadership of the EU has been demanding that
Italy, for example, convert existing debt in that nation’s banks held by retail
investors to equity before any state support can occur. Converting debt to
equity is merely an adjustment to the balance sheet that does not provide new
funds to the troubled bank.
KBRA believes that the first step to addressing Europe’s banking crisis must involve
a credible extension of state support to troubled banks to alleviate public
fears and allow for an orderly restructuring process to move forward.
“Nationalization cum monetization” is the only way to bridge the gap between
insolvency and systemic risk - and financial stability. Direct governmental
support, combined with the liquidity support already available from the ECB,
should enable the governments of the EU member nations to avoid a financial
calamity and recapitalize troubled banks.
Many European financial institutions will ultimately need fresh capital to address
their financial problems and eventually regain the trust of investors. Again,
the U.S. experience with the public rescue of C, AIG and the GSEs is instructive
here and provides a practical roadmap for the political leaders of the EU to
follow. KBRA believes, the leadership of the EU can gain the time needed to
address the asset quality issues facing Europe’s banks only by first addressing
the immediate threat of systemic risk.
One of the unfortunate political side-effects of providing state support to large
banks and other financial institutions is that it generates anger and
resentment on the part of the public. Sensing this angst, political leaders
hesitate to take the steps necessary to avoid a repeat of past debt-deflations
of 2008 and, more appropriately, the 1930s. In Italy, for example, an explicit
bailout of the country’s banks would likely give greater impetus to populist
political forces seeking broader debt cancelation for private individuals and
companies. Yet the price of political inaction is an increased likelihood of
financial contagion, a result that will only make the present global trend
towards political radicalization accelerate.
For example, it is no accident that both of the major political parties in the U.S.
have adopted platforms that call for radical new regulation of large banks,
including the return of the Depression era Glass-Steagall laws separating
depositories from securities dealing and other commercial activities. KBRA
believes that advocates of such policies should recall that when Glass-Steagall
was adopted in 1933, the U.S. economy was on its knees and the law was
essentially adopted by Congress without debate. We believe that, at the end of
the day, the leaders of the EU will avoid financial contagion and eventually
make the difficult choices needed to avoid a repeat of the 2008 market crisis.
By embracing benevolence rather than retribution, the leaders of the EU can
avoid contagion and thereby increase the probability of a successful resolution
of the dangerous predicament now facing the European banking sector and also
improve prospects for economic growth.