Tuesday 14 December 2010

Low rates environment and the risk of evergreening à la Japanese

In this new environment, corporate balance sheets appears to be in outstanding shape whereas banks balance sheets still appears to be bloated with toxic assets (non-performing loans).

This is can be reflected in the massive divergence between the Itraxx 5 year CDS Main index in Europe (125 CDS names) versus the Itraxx Financial Senior 5 year index:

As you can see the spread is now at around 62 bps between both indices.

UK Banks sub debt is as well following the trend for wider SUB CDS 5 year spreads, as of the 12th of December as indicated below:

As illustrated below, some corporate CDS 5 year spreads are tighter than both sovereign as well as banks senior CDS spreads, in this example, large European Chemicals versus Banks Senior 5 year CDS spreads:

It is interesting to see that Rabobank being one of the only AAA rated bank in the world, is trading wider than single A rated BASF as well as Dow Chemical currently rated BBB- by S&P, the lowest investment-grade rating.

Reason being is the following, corporate leverage has continued to decline in the third quarter of 2010, approaching its lowest level in two decades. In addition to this, large corporations are sitting on very high level of cash. They have been hoarding cash.

U.S. companies are hoarding almost 1 trillion USD in cash!

As per Reuters:
Cisco Systems (CSCO.O) has the largest cash balance, at 39.86 billion USD, Microsoft (MSFT.O) is second with 36.79 billion USD according to Moody's. Google (GOOG.O) has the third-largest balance with 30.06 billion USD, followed by Oracle (ORCL.O) with 23.64 billion USD and Ford Motor Co (F.N) at 21.89 billion USD.

Technology companies held the most cash as a sector, at $207 billion, followed by pharmaceuticals with $124 billion, energy at $105 billion, and consumer products with $101 billion, Moody's said.

They are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty.
Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet.

These are effects you can see in a balance sheet recession as I posted earlier in "Honey I shrunk the balance sheet"

The deleveraging process will take years.

In relation to the title of the post, in the latest speech of the Governor of the Bank of Canada (thanks TPC for posting the link on your site pragcap.com), Mark Carney clearly highlights the risk of a prolonged low rates environment and the risk of creating asset prices inflation (a must read):

"Past experience has shown that low policy rates allow “evergreening,” or the rolling-over of non-viable loans. The classic example was Japan in the 1990s when banks permitted debtors to roll over loans on which they could afford the near zero interest payments but not principal repayments. By evergreening loans instead of writing them off, banks preserved their capital, but this delayed necessary restructuring of industry. Moreover, the presence of non-viable (or “zombie”) firms limited competition, reduced investment and prevented the entry of new enterprises."

Spot on Mark Carney! What crucified Japan in its lost decade were its zombie banks evergreening their toxic assets. It is better to restructure and fast. As I blogged about Ireland in September (Zombieland 2...The sequel...), Ireland is impaired by its zombie financial system.
In relation to the current predicament of US banks, I have argued as well the need for a new Resolution Trust Corporation (RTC II), similar to the one established following the Savings and Loans Crisis in the nineties.

What is as well outstanding from the speech from the Governor of the Bank of Canada is how well Canada has managed its financial sectors using strong regulations and using "selected use of macro-prudential measures" as a third line of defense. I hope the FED and Bank of England are taking notes. Outstanding work. Canada is indeed Canada, a great exemple of successful structural reforms and efficient banking regulation.

"In broader asset markets, counter-cyclical capital buffers can be deployed to lean against excess credit creation. Importantly, following the agreement of G-20 leaders in Seoul, the Basel Committee endorsed the Canadian-led proposal for this framework."

The role of Central banks as so clearly illustrated by Canada should be extended to prevent the creation of credit bubbles. Alan Greenspan, Ben Bernanke please read carefully, you might learn something...

"In the housing market, the Canadian government has already taken important measures to address household leverage. These include a more stringent qualifying test that requires all borrowers to meet the standards for a 5-year fixed-rate mortgage as well as a reduction in the maximum loan-to-value ratio of refinanced mortgages and a higher minimum down payment on properties not occupied by the owner."

As a reminder about the Austrian Business Cycle Theory:


"Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.

According to the Austrian School business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "credit-fuelled boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. Economist Steve H. Hanke identifies the financial crisis of 2007–2010 as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by Austrian school economic theory."

Quod erat demonstrandum

In the post "The inflation debate or why you can have inflation in a deflationary environment", I reviewed the Austrian Business Cycle Theory in conjunction with Fisher's formulation of debt deflation and the following chain of consequences.

Those who cannot remember the past are condemned to repeat it."
George Santayana (16 December 1863 – 26 September 1952)

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867
I used this quote in "Creative destruction and the Minsky moment" in May 2010, at the start of the Greek sovereign crisis.

Financial fragility levels move together with the business cycle.

In relation to banks current conundrum with their impaired balance sheets bloated with toxic assets, Mark Carney stated in his speech: "For example, over the past year and a half, banks have used low short-term funding rates to rebuild capital by investing in long-term government bonds. This strategy is effective to a point, provided complacency does not set in over the duration of low policy rates. Making consistent positive carry may diminish the sense of urgency with which banks reduce leverage or write down bad assets. Financial institutions may also take this game too far, underestimating the risks."

It is therefore critical to avoid evergreening à la Japanese, the sooner the restructuring of debt, the better and the faster the economic recovery.

I will conclude this post quoting again the Governor of the Bank of Canada, "a massive deleveraging has barely begun across the industrialised world."

"Cheap money is not a long-term growth strategy. Monetary policy will continue to be set to achieve the inflation target. Our institutions should not be lulled into a false sense of security by current low rates."

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