Perspective on Risk - June 5, 2022 (Pt.2)
You've Never Been Through QT; What is the Effect of QT?; Collateral Chains; Office Real Estate Apocalypse; Counterparty Default?; Lee Buchheit Says Its A Mistake To Force A Russ; Putin is a Monetarist
Here is part 1. Read that first. Again, sorry for being long.
You’ve never been through QT.
High yield credit spreads have widened, but are not yet indicating distress.
The real question is how the reduced liquidity will play through the bank credit channel to the real economy. Liz Ann Sonders points us to a Bloomberg graph highlighting the growth in the number of firms with negative operating profits.
A similar thought was expressed by Bridgewater’s Greg Jenson on a recent Odd Lots podcast, where he opined:
You see how many stocks needed that liquidity because they needed new buyers. And right now we'd calculate about 40% of the US equity market can only survive essentially with new buyers entering the market because they're not cashflow generating themselves. And that's near a historic high, that's like basically right in line with ‘99, 2000. And it exists because, because the Fed produced liquidity for so long, you had declining, real rates, high levels of liquidity. You get the reverse. And you're seeing that squeeze the stocks that need that liquidity are getting hit the hardest. And that's happening quite quickly. You also see that to some extent you need constantly new buyers in the crypto space as well. And just the removal of macro liquidity is starting to affect the entities everywhere that need the liquidity the most.
What is the Effect of QT?
Crawley, Gagnon, Hebden, and Trevino from the Fed’s Board of Governors has written Substitutability between Balance Sheet Reductions and Policy Rate Hikes: Some Illustrations and a Discussion provides an estimate:
The model implies that a one-time permanent reduction in the Federal Reserve's holdings of 10-year equivalent Treasury securities equal to 1 percent of nominal GDP raises the term premium on a 10-year Treasury security by about 10 basis points, all else equal.
Overall, the model predicts that reducing the size of the balance sheet by about $2.5 trillion over the next few years, as opposed to maintaining the size at its peak level, would be roughly equivalent to raising the policy rate a little more than 50 basis points on a sustained basis.
Manmohan Singh of the IMF has penned an intriguing piece in the FT, We need new financial pipes, where he notes:
After ticking up a little from the post-crisis doldrums, the collateral velocity fell back to 2.1 last year.
He asserts, without specifics:
Factors like the European crisis, quantitative easing (central bank bond purchases restricted the availability of good collateral) and regulations that now restricted dealer banks’ intermediation capacity have had a big impact.
Collateral constraints in some jurisdiction (such as the eurozone) mean we will need to revisit dealer balance sheet constraints, as repo markets will need to move in tandem with rate hikes. Basically, the “old pipes” are maxed out, so new pipes are needed to augment the traditional ones, and bring the global financial plumbing into the new century.
I’m really skeptical of this piece. How exactly are the “old pipes” maxed out? What in the prime brokerage, clearing and settlement system is not working?
One can alternatively read the data to indicate that there is discipline among the prime brokers on leverage granted to their customers, and that a low level of rehypothecation actually is indicative of a safer, if possibly less efficient, system.
If anyone is seeing signs of pipes clogging, could you send me a note?
Work From Home and the Office Real Estate Apocalypse
Abstract (link to paper)
We study the impact of remote work on the commercial office sector. We document large shifts in lease revenues, office occupancy, lease renewal rates, lease durations, and market rents as firms shifted to remote work in the wake of the Covid-19 pandemic. We show that the pandemic has had large effects on both current and expected future cash flows for office buildings.
Remote work also changes the risk premium on office real estate. We revalue the stock of New York City commercial office buildings taking into account pandemic-induced cash flow and discount rate effects. We find a 32% decline in office values in 2020 and 28% in the longer-run, the latter representing a $500 billion value destruction. Higher quality office buildings were somewhat buffered against these trends due to a flight to quality, while lower quality office buildings see much more dramatic swings. These valuation changes have repercussions for local public finances and financial sector stability.
On Chris and Dave’s point around the idea of ‘defaulters pay’. I get that. Love that, right. And that works really well for guys who are in big shops, because they never default. They want to tell you they never default. And we’re just going to call that out at the moment. At the beginning of the pandemic — I’m not going to name the person, but they’re in the room - there was a technical issue. Point: he doesn’t have to worry about that in the proposed model, right, that’s not there. But it would’ve been cataclysmic at that moment in time. We knew the issue, to Gerry’s point about know-the-customer. We knew where it was. And we chose to give the appropriate amount of time not to dislocate the market and create a bigger stress on that.
Lee Buchheit Says Its A Mistake To Force A Russian Default
By preventing Russia from making payments through the contractually-mandated payment procedures in the bonds, the US Treasury may have unwittingly given the Russian Federation a legal defence in any bondholder enforcement action.
Both UK and US law recognise as a defence a situation in which it has become impossible or illegal to perform the contract. It is hard to predict whether courts would recognise the Russian situation as a genuine case of impossibility. The general rule is that the party claiming the defence cannot itself have been the cause of the difficulty.