Perspective on Risk - Oct. 9, 2022
Empire Central; Move Fast, Break Things; Bank of England Actions; Reserves; Treasury Market Liquidity; Interesting FSOC Quote; Bond Market Bloodbath; Corp Loan Developments; Non-Banks > Banks?; Zambia
Empire Central
First things first. Many of you know that I am a huge fan of the instrumental funk-gospel-jazz fusion collective Snarky Puppy. They’ve dropped a new album, Empire Central. I was lucky enough to sit in on three of the recording sessions (all of the songs are live and one-take). My favorite is Take It. Links are to Spotify.
Move Fast, Break Things (Fed edition)
The Fed has embraced the Zuckerburg doctrine. And as we’ve discussed before, they really, REALLY want us to believe they will not flinch from their duties once things do break.
We’ve previously highlighted Brainard’s and Kashkari’s comments. The latest comments are from Waller and Mester.
Along with the improved regulatory framework, I believe we have tools in place to address any financial stability concerns and should not be looking to monetary policy for this purpose. The focus of monetary policy needs to be fighting inflation.
We have to bring interest rates up to a level that will get inflation on that 2% path, and I have not seen the compelling evidence that I need to see that would suggest that we could start reducing the pace at which we’re going.
In addition, in the semi-annual report to Congress on monetary policy, the Fed explicitly stated:
The Committee’s commitment to restoring price stability — which is necessary for sustaining a strong labor market — is unconditional.
Powell has been explicit.
He wants positive real rates along the full yield curve. (aka “above inflation rate”)
His measure of inflation for this purpose is the core PCE (4.6% in August).
This means 1 month bills at 3.03% and 10 year bonds at 3.89% have quite a ways higher to go.
I think it’s time to start keeping track of things that have broken; these are things where the fiscal authorities or central banks have had to intervene.:
Japanese Yen
BoJ intervened at 145, pushing Yen back down to 140. But the intervention was short-lived as we are already back at the 144 level. BoJ bought more Yen in one day than they did in all of their interventions in 1998.
British Gilt market
Not clear whether any pension funds would have failed, but several may have been under-capitalized according to UK rules had the BoE not intervened.1 The BoE action was equivalent to the 2019 US Treasury intervention.
Again, what are our candidates for the next things to break? China property, EM currencies, the coming brutal European Winter of Discontent, US CRE (Manhattan in particular), residential real estate (Moody’s Analytics now predicting -10% without a recession); -20% in over-priced markets), corporate credit (while still low, corporate default rates are rising), US Treasury liquidity, non-banks (the banks, even CS and DB, are probably fine).
We should soon start to hear rumors of PE commitments being sold for 50 cents on the dollar.
What should you do?
Insure you have sufficient liquidity (measured in TIME, not quantity)
Make sure you’re not over-levered.
Watch your counterparty risk.
Bank of England Actions
Dan Davies agrees with the earlier Perspectives on Risk that the Bank’s actions were in line with the new “backstop doctrine.”
First theory, then practice. The Bank of England’s current operations in the gilt market are being made more or less exactly in accordance with the principles set out in the Discussion Paper written by Andrew Hauser (of the Bank) and Lorie Logan (of the Dallas Fed) for the BIS Markets Committee back in May.
The Logan/Hauser doctrine set out the rules of the game for the new role that central banks were increasingly being asked to play — that of “market maker of last resort” in securities markets where, for one reason or another, the normal market participants were unable to fulfil their normal function.
The Logan/Hausar paper means the Fed is LESS focused on controlling rates/money supply through bank reserves, and more on the sovereign bond/collateral market. This comes with their “ample reserves” operating model.
Reserves
Having just said that they matter LESS these days, in an “ample reserve” framework, how much is ample? A new Liberty Street blog post from the NY Fed titled Measuring the Ampleness of Reserves2 discusses demand for reserves. One of the authors is the President of the NY Fed, so probably worth reading.
In this ample reserves regime, the Federal Reserve controls short-term interest rates mainly through the setting of administered rates, rather than by adjusting the supply of reserves each day as it did prior to 2008
To assess whether the level of reserves is ample, one needs to first understand the demand for reserves. … The reserve demand curve describes the price at which these institutions are willing to trade their balances as a function of aggregate reserves. … Because the IORB rate directly affects the willingness of banks to lend reserves, it is useful to describe the reserve demand curve in terms of the spread between the federal funds rate and the IORB rate.
[T]he curve is highly nonlinear, … [is influenced by] various long-lasting changes in the regulation and supervision of banks, in their internal risk-management frameworks, … [and] may be endogenous to banks’ demand for them.
They then estimate the price sensitivity of demand, finding periods of scarce, ample, and abundant reserves.
A more detailed treatment is available in a NY Fed Staff Report, Scarce, Abundant, or Ample? A Time-Varying Model of the Reserve Demand Curve3
Treasury Market Liquidity
“Market liquidity is definitely lower,” New York Fed President John Williams acknowledged this week. But he added, “It’s still functioning.”4
Foreign central bank holdings of Treasuries in custody at the Fed has been dropping. Typically when defending their currencies they will use central bank deposits first, then sell Treasury holdings.
Interesting FSOC Quote
Treasury Secretary Yellen called a session of the US Financial Stability Oversight Council on October 3rd. Interesting tidbit in the readout. Highlighting is mine.
During the executive session, the Council heard presentations from the Federal Reserve and Commodity Futures Trading Commission staff on global financial market developments, energy markets, and U.S. financial vulnerabilities, including some tail-risk scenarios for banking organizations.
FSOC was also recently briefed on the risks from the FHLB system. Policymakers have obsessed about this for years, but the FHLBs have been a helpful, non-stigmatized source of funding during past crisises.
Bond Market Bloodbath (in one chart)
Corporate Loan Market Developments
Prices are falling …
and the banks keep getting stuck with off-market loans.
Brightspeed scraps leveraged loan, bond backing Lumen deal5
In another sign of how risk-averse investors have become, Brightspeed has withdrawn a proposed leveraged loan and high-yield bond package in connection with Apollo Global Management’s acquisition of the incumbent local exchange carrier (ILEC) assets of Lumen Technologies, “in light of market conditions,” according to a company statement.
The debt comprised a $1.865 billion offering of seven-year (non-call three) senior secured notes, and a $2 billion, seven-year term loan B. Initial price thoughts for the bonds were tipped with a 10% yield, inclusive of an original-issue discount, while price talk for the loan of Sofr+CSA+500, with a 0.5% floor and an OID of 92, indicated a steep yield to maturity of 10.63%.
Morgan Stanley-Led Banks Face $500 Million Loss on Twitter Debt6
Their losses would amount to $500 million or more if the debt were to be sold now, according to Bloomberg calculations. They agreed to fund the purchase whether or not they were able to offload the debt to outside investors, according to public documents and lawyers who have looked at them.
The banking group originally planned to sell $6.5 billion of leveraged loans to investors, along with $6 billion of junk bonds split evenly between secured and unsecured notes. They are also providing $500 million of a type of loan called a revolving credit facility that they would typically plan to hold themselves.
Of the more than $500 million of losses that the banks are estimated to have on the Twitter debt, up to about $400 million stems from the riskiest portion, the unsecured bonds, which have a maximum interest rate for the company of about 11.75%, Bloomberg reported earlier this year. The losses exclude fees the banks would usually earn on the transaction.
Non-Banks > Banks?
It seems that way.
We previously discussed the BIS paper by Logan and Hausar that essentially advocates more aggressive open-market operations and lending programs to stabilize asset markets. The Fed has created the RRP facility to fund treasury collateral from bank and non-bank entities.
Now, the NY Fed has gone in an interesting direction with their choice of a new General Counsel.
It may be nothing more than he was the best qualified candidate (I have not spoken with my Fed whisperer on this … yet). Or it may be an indication that the economy, and the financial stability risks, now are driven by entities outside the regulated banking sector.
Zambia
Zambia? Who cares about Zambia?
Well, lot’s of EM bond funds and bank lenders certainly do, as does the IMF and numerous central banks, but most importantly, the Chinese. Brad Setzer (always worth reading) has this interesting writeup, Zambia’s chance to set the global financial architecture7, of Zambia’s negotiations with creditors. If we see more sovereign defaults, perhaps associated with China’s Belt and Road funding, knowing these rules of the road will be crucial.
Zambia … went on a borrowing spree, with three bond issues and a massive splurge on Chinese backed infrastructure projects jacking up its public external debt up to $20bn at the end of 2021. … By any realistic standard Zambia took on more debt than it can service — and in 2020 it finally defaulted.
A surge in lending by Chinese state institutions has disrupted existing norms and institutions for co-operation. There is not full agreement on even basic questions like whether Chinese lenders are public or private.
Zambia’s slow restructuring is a direct consequence of the absence of functional agreement around the right process for working through debt problems in low income countries when concessional lenders, China policy banks and high coupon bonds all have overlapping financial claims.
Some possible new norms thus have been set even before any financial terms have been agreed. … China won’t be part of the Paris Club, but it will negotiate alongside the Paris Club; all Export-Import Bank of China lending and all other Chinese bank lending that has an export credit agency guarantee will be “official bilateral” debt; the IMF will define public sector debt broadly and sweep in large state firms and the IMF won’t start lending until it gets financing assurances from both the Paris Club creditors and China.
In Other News
It’s Been XX Days Since [Incident]
Podcast recommendation:
If you are a US insurer, and don’t think this can happen to you, think again. While you may not face the immediate regulatory capital effects, your year-end disclosure will show the economic effects of the rate rise. What will be the market reaction to your net economic value disclosures?
Afonso, La Spada, & Williams, Measuring the Ampleness of Reserves, Liberty Street blog
Afonso, La Spada, & Williams, Scarce, Abundant, or Ample? A Time-Varying Model of the Reserve Demand Curve, NY Fed Staff Report #1019
McCormick, Treasuries Liquidity Problem Exposes Fed to ‘Biggest Nightmare’, Bloomberg
Lewis, Brightspeed scraps leveraged loan, bond backing Lumen deal, Pitchbook
Seligson, Scigliuzzo & Lee, Morgan Stanley-Led Banks Face $500 Million Loss on Twitter Debt , Bloomberg
Setzer, Zambia’s chance to set the global financial architecture, FT