The allure of easy gains without apparent risk is a captivating one. Who wouldn’t want beauty without blemish, joy without sorrow, or favorable returns without the associated dangers? Likewise, who wouldn’t jump at the opportunity for slightly higher yields over the 10-year Treasury bond, without any additional risk?
In pursuit of this elusive goal, many finance enthusiasts chase innovative solutions with relentless enthusiasm. The prevailing belief is that if risks are sufficiently diluted, they vanish as if by magic. In essence, proponents argue that dilution offers the antidote to pollution.
In this spirit, a plethora of new financial instruments emerges into the marketplace. Yield-seeking investors purchase these debt products, often bundled with a small premium above standard offerings, in order to satisfy their insatiable demand for returns.
However, as economic growth continues—especially one prolonged by the Federal Reserve’s inexpensive credit policies—these new financial products become increasingly tainted with risk. The method of spreading risk ends up contaminating the entire liquidity pool.
At this juncture in the business cycle, after a drawn-out bull market in both stocks and bonds, the consequences of the greater fool theory have become evident. This theory is exemplified by bonds that offer negative yields, where investors accept guaranteed losses on coupons, hoping instead to profit from potential capital gains as yields decline. Yet, as yields begin to rise, that strategy collapses.
Moreover, the greater fool theory extends far beyond negative-yielding debt, encompassing the murky realm of corporate borrowing as well.
Wreckage from the Past
The unfolding of a credit crisis typically starts with an immediate shock, which is then followed by deeper, more troubling revelations. This initial disturbance serves as a turning point for banks and financial institutions in their approach to risk and opportunity. The promise of easy rewards quickly transforms into hazardous liabilities.
Financial innovation tends to work flawlessly—until it doesn’t. Unfortunately, the mistakes of the past have resurfaced in today’s financial ecosystem. The Bank for International Settlements (BIS) outlines these dynamics in its September 2019 Quarterly Review:
“Collateralised debt obligations (CDOs) that invested in subprime mortgage-backed securities (MBS) were central to the Great Financial Crisis (GFC). Although the issuance of subprime CDOs ceased post-GFC, other forms of securitisation, particularly collateralised loan obligations (CLOs), have seen substantial growth. CLOs predominantly invest in leveraged loans—bank loans to companies that are heavily indebted, have considerable debt service ratios relative to their earnings, and are typically rated below investment-grade.”
“The leveraged loan market has recently expanded to roughly $1.4 trillion, with about $200 billion denominated in euros and the remainder in US dollars. This quick expansion has been paralleled by the securitisation of leveraged loans into CLOs. As of June 2019, over 50 percent of outstanding leveraged loans in US dollars and about 60 percent in euros had been securitised through CLOs.”
“The rapid rise of leveraged financing and CLOs bears similarities to the events in the US subprime mortgage market and CDOs leading up to the GFC… This includes factors that could trigger financial distress. Concerns include declining credit quality of CLOs’ underlying assets, the obscurity of indirect exposures, significant concentration of banks’ holdings, and the precarious resilience of senior tranches, which heavily depend on the correlation of losses among the underlying loans.”
What should we conclude from this?
Is the Fed Secretly Bailing Out a Major Bank?
You are likely already aware of the challenges in the overnight funding market, which we have discussed previously. In a nutshell, between the night of September 16 and the morning of September 17, the overnight repurchase agreement (repo) rate surged to 10 percent, indicating a breakdown in short-term liquidity markets.
After experiencing several technical issues, the Federal Reserve conducted its first repo operation in a decade—injecting $53 billion into the market to stabilize interbank funding. Since then, daily repo operations have become commonplace, growing to levels exceeding $120 billion and continued indefinitely.
Despite the Fed’s attempts to remedy the situation and the efforts of economists to downplay concerns, something is clearly amiss. Why else would the Fed need to conduct such massive, repetitive overnight repo operations to manage interest rates?
Could it be possible that the Fed is discreetly providing support to a major U.S. or foreign bank, or another financial institution? It’s a possibility worth considering. The New York Fed has recently stated it would not reveal the banks receiving repo cash for at least two years to avoid inciting panic among depositors.
In the meantime, with some imagination, the ongoing issues in the repo market may signal that CLOs are becoming increasingly problematic, potentially triggering the next financial crisis. There’s a distinct possibility that a bank or financial institution lacked adequate high-quality collateral to participate in private repo markets, leading to the steep rate spike and subsequent Fed intervention.
In summary, we may be on the brink of witnessing a large bank fail with little warning.
In a separate context, Deutsche Bank recently reported a net loss of 832 million euros—approximately $924 million—for the third quarter of 2019.
Sincerely,
MN Gordon
for Economic Prism
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