Wil Bernanke Policy "Destroy Credit Creation"? Bill Gross is Worried It Will--The Role of Financial Innovation

Yesterday I discussed the concern Bill Gross, founder and co-chief investment officer of PIMCO, has about the current Federal Reserve policy of keeping short-term interest rates low for the next two years.  The concern extends to the possibility that the Fed will attempt to “twist” the term structure of interest rates by buying more and more long-term government securities in an attempt to bring longer-term interest rates in line with the very low short-term interest rates.  Gross sees the efforts extending to the seven- and eight-year maturity range.

The concern Gross has is that a flat yield curve will cause banks and other financial organizations to de-leverage even further and faster than they would under conditions the of un-sustainable debt levels created by the previous fifty years of credit inflation.  Gross, in his Financial Times article (http://www.ft.com/intl/cms/s/0/04868cd6-d7b2-11e0-a06b-00144feabdc0.html#axzz1XGri4Us6), argued that the Federal Reserve consistently maintained a positive slope to the yield curve throughout this fifty year period (with the exception of periods of tight monetary policy) so that the banks and other financial institutions would continually provide “credit creation” so that the economy would continue to expand and create jobs. 

The positive slope to the yield curve provided the mechanism for this credit creation through three channels that I have written about on a regular basis.  First, the positive slope to the yield curve meant that banks and other financial institutions could borrow short at relatively low interest rates and lend long at higher interest rates.  The mis-matching of maturities increases interest-rate risk but then if the yield curve, on average, remains positive, the positive yield spread can be maintained over time.

Second, credit inflation “bails out” riskier loans so the banks and other financial institutions could lend money on riskier deals and thereby earn an even larger interest rate margin.  To paraphrase Warren Buffet…if credit inflation tide is rising, it is hard to tell bad assets from good assets.  Only when the credit inflation tide recedes and the water level drops do we discover who is not wearing a bathing suit.   Tell me about the sub-prime mortgage mess…

Third, narrow interest margins can be turned into substantial returns on equity by the use of financial leverage.  And, if competition brings net interest margin levels down, banks and other financial institutions can maintain the levels of return on equity they had previously earned by adding more and more financial leverage to their balance sheets. 

This third component of the growing risk exposure of a period of credit inflation can only succeed if the banks and other financial institutions are “liability managers”.  In terms of the last fifty years, financial institutions became liability managers through the process of financial innovation.  Most financial institutions were locked into their balance sheets before the 1960s because money and capital markets were not developed to the extent that banks and others could buy or sell all the funds they wanted a the going market interest rate.

Commercial banks, at this earlier time, could only obtain funds through “local” markets and these funds were not very interest sensitive.  Hence, these organizations were “asset managers” limited to what Leo Tilman calls “Balance Sheet Arbitrage”.  (See a review of Tilman’s book “Financial Darwinism” at http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman.) Balance sheet arbitrage is the “old” way of commercial banking where banks are “local” in nature and obtain funds from demand deposit accounts and savings accounts which pay very low interest rates and lend the funds out to borrowers, many of whom have no other sources of funding so that the interest on these loans are relatively high.  Thus, the banks worked with nice interest margins that were relatively stable and reliable. 

Liability management came into pay through the financial innovation of the 1960s.  Negotiable CDs and Eurodollar deposit along with holding company issue Bankers Acceptances became the innovation of choice in the larger banks and this freed up the balance sheets of banks so that they were no longer limited to “local” constraints on the choice of funding sources.  Funding sources became world wide and the understanding was that, at most times, banks could now buy or sell as many funds as they wanted at the going market interest rate. 

In essence, commercial banks could now “leverage up” as much as regulation…or accounting rules…would allow!

And, as regulation eased up, banks and other financial institutions got into other financial and organizational innovations.  Tilman lists these as moves into “Principal Investments” (private equity and venture capital, investments in hedge funds, or, capital allocations to internal proprietary trading desks) and “Systematic Risks” (which included interest rate risks, credit risks, currencies, commodities, and equity indices). This created an environment I have called the “New Liquidity.” (See http://seekingalpha.com/article/289579-let-s-move-on-from-keynes-and-accept-the-new-liquidity.)

The result? Bill Gross nails it in his article: “Thousands of billions of dollars were extended…” It seems as if capital requirements were non-existent.  Credit could expand almost without limit.

And, why are we interested in credit inflation and not price inflation?  Why do we focus on credit creation and not money? Focus, in the past, was placed on money because people were concerned about what was happening with consumer prices…”flow” prices.  “Flow” prices relate to the prices paid for goods and services that are consumed in a relatively short period of time.  “Flow” prices are to be differentiated from “asset” prices. 

“Flow” prices are in many ways “constructed” prices.  For example, in the construction of the Consumer Price Index, the price of a house is not included because that is the price of an asset.  The “flow” of housing services is what people consume and the “price” of this flow of services is called “rent”.  In the construction of the CPI, the “rental price” of housing services is, to a large extent, estimated.  And, as it turns out, since the consumption of housing services is such a large component of consumer expenditures, the “rent” component turns out to be the largest part of the CPI.

Theoretically, the price of an ‘asset” (the price of a house) should be equal to the discounted present value of the future cash flows relating to the purchase of the housing services provided by the house (the rent or rental value of the housing services).  In the world these two prices can differ from one another for a substantial amount of time as they did during the 2000s where housing prices were severely inflated and estimates of rental values lagged far behind. 

This is true of other asset categories like equity shares that are traded on the stock markets (take for example the Internet bubble of the 1990s).

Thus credit and credit inflation are of crucial interest to the behavior of prices…all prices…in the economy.  And this is why we must be interested in cumulative credit inflations that become unsustainable and turn into cumulative debt deflations that create a “formidable headwind” (thank you Mr. Bernanke) that must be overcome by any fiscal or monetary policy hoping to stimulate growth in the economy. 

The problem seen by Mr. Gross, however, is that the monetary policy now being followed by the Mr. Bernanke and the Federal Reserve that promotes a flat yield curve will just exacerbate the situation because it will accelerate the debt deflation taking place.  One could also argue (ala Mr. Gross) that the situation created by recent financial innovation, the “new liquidity”, will further add to the volatility of the whole situation. 

Will Bernanke Policy Actually "Destroy Credit Creation"?

PIMCO’s founder and co-chief investment officer Bill Gross presents an interesting perspective on the US government’s policy of credit inflation policy over the last fifty years in the Financial Times this morning. (http://www.ft.com/intl/cms/s/0/04868cd6-d7b2-11e0-a06b-00144feabdc0.html#axzz1XGri4Us6)

“Borrowing short-term at a near risk-free rate and lending at a longer and riskier yield has been the basis of modern-day finance.” 

This statement captures two of the three major fundamental components of the government’s policy of credit inflation that has existed since the early 1960s.  The first is that in a period of credit inflation, financial institutions are willing to take on “riskier” assets because the inflation that is created helps to “buy” them out of riskier deals. 

The second fundamental component is that the financial institutions finance these “longer and riskier yields” with “short-term” funds “at a near risk-free rate.”  That is, the financial institutions mis-match credit risks and maturities on their balance sheets. 

Gross does not ignore the third component: this component is financial leverage.  This financial leverage can, of course, turn a modest yield spread that is present in the yield curve into a very lucrative return on equity.  And, the more leverage used the higher the return on equity can become.

The consequence?

“Thousands of billions of dollars of credit were extended on this basis, some of it as short as a one-week or one-month maturity extension, but all of it—almost everywhere , nearly all the time—on the basis of a positive yield curve…”

And, there you have the scenario for the credit inflation of the last fifty years. 

Mr. Gross points out that the post-Keynesian economist Hyman Minsky identified this problem in the model developed within the Keynesian “neo-classical” synthesis.  Minsky’s concern, and this was one reason he is considered to be a post-Keynesian economist and not a Keynesian economist, was that leveraging this way resulted in a build up of excessive amounts of debt in the economy.  In this Minsky drew on the work of the economist Irving Fisher who wrote about credit inflations and debt deflations. 

Minsky, like Fisher, argued that during the period of credit inflation the cumulative build up of debt would at some point become unsustainable and the debt load would have to be reduced.  This would lead to a cumulative contraction of debt, or the period of debt deflation.  

That is, regardless of the fiscal policy of the government, the build up and contraction of credit in the economy would cause major economic restructuring, both on the upside and the downside.  That is, credit cycles would result from a government policy that supported s positive slope to the yield curve. 

Within this framework, the financial collapse of the 2008-2009 period can be thought of as the culmination of the “credit inflation” cycle.  Debt burdens became excessive and, with the ultimate break in the cycle, the period of de-leveraging began. 

We now find ourselves in the period of financial de-leveraging…the period of debt deflation. 

What is of concern to Bill Gross is that the Ben Bernanke and the Federal Reserve may be acting in a way that might exacerbate the period of debt deflation. 

Whereas Bernanke has attempted to avoid a second Great Depression by throwing everything he and the Fed could against the wall to see what stuck and to avoid a second 1937-38 depression by throwing everything he and the Fed could against the wall to see what stuck, (http://seekingalpha.com/article/290416-quantitative-easing-theory-need-not-apply), Gross is arguing that Bernanke and the Fed may be doing just the opposite in the latter case.

In essence, Gross is arguing that in attempting to keep interest rates so low for such a long period, the Fed is creating a “flat” yield curve and this, according to the ideas presented by Minsky, may result in the further de-leveraging of the financial system which would be detrimental to an economic recovery.

In other words, “the posit of American economist Hyman Minsky of an unstable financial system based on the leveraging of a positively sloped yield curve—and de-leveraging when it was not—would be obvious for all to see.”

“The further out the Fed moves the zero bound towards a system wide average maturity of seven to eight years (through an interest-rate “twist” policy) the more credit destruction occurs, to a US financial system that includes thousands of billions of dollars of repo and short-term financed-based lending that has provided the basis for financial institution prosperity.” 

Carrying this argument one step further, Gross could be arguing that by following its policy of extremely low interest rates for an extremely long period of time, Bernanke and the Federal Reserve are risking a second dip in economic activity akin to the 1937-38 depression. 

Mr. Bernanke and the Federal Reserve want to preserve the commercial banking system and get the banking system lending again.  Their policy efforts have been to flood the financial system with so much liquidity that bank failures can be handled effectively and smoothly without disrupting the whole banking system and that so much liquidity will be around that commercial banks will eventually begin to loosen up their lending again. 

What Gross is arguing that the banking system will not begin lending in an aggressive way with the yield curve as flat as it is and if the flatness of the yield curve extends out to seven and eight years, very little lending will take place at all.  Taking on riskier loans just does not pay in such an environment and the mis-matching of maturities produces only a minimal spread.  In order to achieve competitive returns on equity, given these spreads, financial institutions would have to take on massive amounts of leverage…something that the banks themselves don’t want to do right now and something that the regulators would not allow them to do.

Mr. Gross closes by saying that Mr. Bernanke needs to be careful keeping interest rates so low and trying to “twist” the yield curve to reduce longer-term yields to the levels now seen in the short-term end of the market.  The fear is that Bernanke may produce, not a “take-off” but a “crash.”

Why Bet on Treasury Securities?

First Warren Buffet and now Bill Gross, of Pacific Investment Management Company, have publically stated that buying United States Treasury securities is not a good bet. (See http://www.bloomberg.com/news/2011-03-31/gross-echoes-buffett-saying-treasuries-have-little-value-on-debt-dollar.html.)

Gross wrote, in his most recent monthly investment outlook, that Treasuries “have very little value.”

One could couch this in other terms: “What is the probability that long term interest rates will go up over the next twelve months?”; and “What is the probability that long term interest rates will go down over the next twelve months?”.

How many people do you know that believe that the higher probability can be applied to the second of these two questions?

Most people I know and respect are arguing over whether the probability that long term interest rates will go up is 75% or 80% or higher.

The only significant argument I hear about falling interest rates on long term Treasury issues is that the Eurozone might collapse and there will be a “run to quality”, a run to United States government securities. Almost all other arguments go the other way.

The economic recovery, however weak, is continuing. The banking system (and the housing industry) is not going to collapse even though the banking industry is going to continue to grow smaller and smaller in terms of the number of commercial banks that are in the system while the biggest banks, including large foreign banks, are going to control more and more of the banking industry itself. The Federal Reserve will continue to keep money flowing into the banking industry so as to keep banks open while the FDIC makes sure that the banking industry shrinks in an orderly fashion.

Are we going to get QE3? Depends upon the rate at which insolvent banks can be closed without disrupting the financial system. The strength of the economic recovery is not the issue. The issue, to me, depends upon what the FDIC can achieve.

The federal government is going to continue to add more and more debt to the total already outstanding.

There just is no credibility in Washington, D. C. concerning the reduction in the cumulative deficits over the next ten years or so. I still believe that the government will add another $15 trillion or more to the federal debt outstanding over the next ten years.

The Libyan situation is a case in point. The federal government is so over-extended fiscally that other demands on its resources are just going to stretch budgets even further and keep the cumulative deficits at near-record levels. Then the government ends up doing two things, neither desirable: the government is limited in what it can do in very important situations; and even if the government cannot do much, whatever it does will increase the cumulative deficit.

Then there are other issues, like the boom in commodity prices worldwide, the acceleration of the merger and acquisition business in America, Europe, and the emerging countries, and currency speculation throughout the globe.

As a consequence, I see no reason to back off my earlier thoughts on the future of the interest rate on long term U. S. Government securities. See http://seekingalpha.com/article/250838-long-term-treasury-yields-and-inflationary-expectations. This post was written when the yield on the 10-year Treasury security was 3.48 percent, roughly two months ago at the beginning of February. Yesterday the 10-year Treasury closed at about 3.46 percent.

At that time I claimed that a forecast of 5.00 percent to 5.50 percent was not out of reason for a Treasury security of this maturity somewhere in the next 12 to 18 months.

The basic reasoning for this: my estimate of the expected long run “real” rate of interest is roughly 3.00 percent, (Similar, I found out, to the belief of the Wharton School’s Jeremy Siegel.)

I further believe that investors will come to build in a premium for inflationary expectations in longer term interest rates in the neighborhood of 2.00 percent to 2.50 percent.

How strongly do I feel about this prediction? I believe that the odds are in the neighborhood of 3- or 4-to one that rates will move into this range over the next 12 to 18 months.

Thus, I would have to agree with Bill Gross (and Warren Buffet) that Treasuries “have very little value” and are not a good “buy and hold” at this time.