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):
http://www.bankofcanada.ca/en/speeches/2010/sp131210.html

"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:

http://en.wikipedia.org/wiki/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."

Honey, I Shrunk the Balance Sheet...

This crisis is very acute because it is a Balance Sheet Recession and the implications will be severe for many years to come, given the extent of the repairs that needs to be achieved following the catastrophic damages inflicted by the cheap credit fuelled bubble we have been victims of.

The Balance Sheet Recession:

http://www.ft.com/cms/s/0/3d89a930-220d-11de-8380-00144feabdc0.html

In an article published by Roger Altman (chairman and CEO of Evercore Partners and former deputy Treasury secretary in the Clinton Administration) in the Financial Times, we have a very good summary of the damages inflicted to Households and the implications for the recovery.

"What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. These weaknesses mandate sub-normal levels of consumer spending and overall lending for about three years.

In contrast, most postwar recessions had a different sequence – rising inflationary pressures, a monetary tightening to counter them and, then, a slowdown in response to higher interest rates. This was the pattern of the sharp 1980-81 slowdown.

None of that happened here. Instead, we saw a housing and credit market collapse that caused enormous losses among households and banks. The result was a steep drop in discretionary consumer spending and a halt to lending. To see why recovery will be slow, we can look at the balance sheet damage. For households, net worth peaked in mid-2007 at $64,400bn (€47,750, £43,449bn) but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big – especially when household debt reached 130 per cent of income in 2008."

You can clearly see in the graph below the severity of the damages inflicted to US households in the current recessions compared to previous ones:



Furthermore on Balance Sheet Recession:

http://www.adamsmithesq.com/archives/2009/04/the_balance_sheet_recessi.html

"Recessions as described or dissected by Econ 101 are income-shock driven, not balance-sheet shock driven. Typically, rising inflation compels the Fed to tighten money and raise interest rates and the predictable slowdown follows as (a) business investment contracts because of higher funding costs (b) causing all the industries and suppliers associated with that investment to contract (c) laying off their workers and cutting their orders to their own suppliers (d) leading to further employment contraction (e) decreased consumer spending (f) decreased demand for business products and services, and so on until inflation is tamed and the Fed can ease off the brake and back onto the gas.

Alternatively, of course, a single sector can become a bubble unto itself (the dot-com boom or the S&L crash of the 1980's) or an exogenous shock (the OPEC price spike of the early 1970's) can prompt a recession, but the single-sector bubbles are typically self-contained and parochial in scope and the exogenous shock bring forth a plethora of innovation and plain old readjustments (turn down the thermostat and stock up on sweaters?) that hasten recovery.

This time is different.

This time everyone--households, small businesses, big busineses, banks, investment banks, and yes, law firms--has seen their net worth hosed. The problem with recovering wealth is that it takes so much longer than it does to recover income."

The fall in networth implies that everyone is working hard to repair balance sheets.
This produces weak demand for funds and credit. It will take years to go through the deleveraging process.
Households and Companies are moving from profit maximization to debt minimization.
Everyone is hoarding cash. Cash is king. According to the Federal Reserve, businesses are hoarding about 1.8 trillion USD in cash.





Consumer Credit Collapsing and Banks Hoarding Cash as well:



David Rosenberg in his Breakfast with Dave article on the 16th of August, analyses the cash hoarding situation and implications:

https://ems.gluskinsheff.net/Articles/Breakfast_with_Dave_081610.pdf

"BANKS LENDING ALL RIGHT ... TO UNCLE SAM!"

"The banks are still sitting on an unprecedented cash hoard and doing nothing with it. Consider that on a 13-week rate change of basis:
•
C&I loans are down at a 1.2% annual rate.
•
Home equity lines of credit are down at a 4.1% annual rate.
•
Residential mortgages are down at a 2.9% annual rate.
•
Commercial real estate loans are down at a 9.2% annual rate.
•
Credit card loan balances are down at a 6.7% annual rate.
Meanwhile, cash on bank balance sheets have expanded at a 10% annual rate over this time frame and purchases of government securities have ballooned at a 21.3% annual rate. In fact, since the end of June, the banks have bought a huge $83 billion of government/agency bonds, the third most over such a short time frame. Just in case you were wondering who has been the culprit behind this phenomenal rally in the Treasury market."


Households in the US are deleveraging big time:



And they are deleveraging at an incredible fast rate:



How far will debt to income fall?



We can see a big surge in the amounts in personal savings in the US:





At the same time the government is trying to make up for the big drop in consumer spending by running a huge deficit!



What are the implications of a Balance Sheet Recession and why Japan is a very bad exemple to follow in a Balance Sheet Recession:

In his latest weekly letter, John Mauldin quotes Charles Gave, writer as well as founder of the excellent Macro Research house Gavekal:

http://www.2000wave.com/article.asp?id=mwo091010

"The only way that one can expect Keynesian policies to break the 'paradox of thrift' is to make the bet that people are foolish, and that they will disregard the deterioration in their balance sheets and simply look at the improvements in their income statements.

"This seems unlikely. Worse yet, even if individuals are foolish enough to disregard their balance sheets, banks surely won't; policies that push asset prices lower are bound to lead to further contractions in bank lending. This is why 'stimulating consumption' in the middle of a balance sheet recession (as Japan has tried to do for two decades) is worse than useless, it is detrimental to a recovery.


TPC from the excellent website "The Pragmatic Capitalist" does a great job as well in analysing the deleveraging process induced by this acute Balance Sheet Recession:

http://pragcap.com/the-deteriorating-macro-picture

Businesses and consumer are using their surpluses to pay down their debts and increases their savings due to the damages they have suffered in the dowturn as well as increased uncertainties instead of spending or investing.





Keynes argued that in a liquidity trap, consumers and businesses are so fearful to spend or invest that they hoard cash, this is excactly what is happening right now. And because the Federal Reserve cannot lower interest rates below zero, it runs out of room to force more money into the economy.

What could be a solution to reverse the course?

How could the Balance Sheet be rapidly repaired?

Tax cuts stimulate the economy when they involve reductions in tax rates!

Permanent cuts in marginal rates of the payroll tax, capital gains tax and double taxation of dividends could be positive to stimulate investment as well as employment.
The negative dynamics such as anticipated future tax increases are the main reason why consumers and companies are hoarding cash.

Instead of having an already inefficient stimulus, how about 1 trillion USD in tax cuts? Would we need more? Would that restore confidence? Entice people to invest and recruit? Would that help small businesses to drag us out of the recession given they have always pulled the economy out of a recession when they thrive?

Tax cut would be appropriate given it would increase consumer's credit lines. The consumer would either consume more or save more (and maybe buy Goverment bonds in the process...).

Economic 101 reminder:
GNP = C + I + G + NX

where:

C = consumption spending by individuals
I = investment spending (business spending on machinery, etc.),
G = government purchases
NX = net exports

Consumer spending typically equals two-thirds of GNP.

Reducing taxes, pushes out the aggregate demand curve as consumers demand more goods and services with their higher disposable incomes. Supply side tax cuts are aimed to stimulate capital formation. If successful, the cuts will shift both aggregate demand and aggregate supply because the price level for a supply of goods will be reduced, which often leads to an increase in demand for those goods.

How about cutting corporate taxes?

Here is what Peter Ferrara in Forbes, thinks about it:

http://www.forbes.com/2009/02/04/tax-cut-stimulus-opinions-contributors_0204_peter_ferrara.html

"Here are the components of a plan that would work to restore economic growth precisely because they do focus on governing economic incentives. America's corporations suffer from a federal corporate tax rate of 35%, close to 40% with state taxes. This is the second-highest rate in the industrialized world, just a bit behind Japan, which may cut its rate soon. The European Union cut its average corporate tax rate from 38% in 1996 to 24% in 2007. Germany and Canada each recently adopted a top corporate rate of 19%, with Canada's slated to fall further to 15%. India and China have lower corporate rates as well.

Ireland adopted a 12.5% corporate rate in 1988, when it had the second-lowest per capita income in Europe. Today, Ireland enjoys the second-highest incomes in Europe, and it raises more in corporate taxes as a percent of gross domestic product than the U.S. does with a tax rate three times higher.

For the U.S. economy to remain internationally competitive, the federal corporate rate should be slashed to 20%. The heavily burdensome federal corporate capital gains rate should also be cut from 35% to the current individual rate of 15%, and that individual rate and the dividends tax rate of 15% should be made permanent. The capital gains tax is a second level of taxation on capital, not a loophole providing lower rates for capital income."

We need to do whatever we can to boost the private sector:

"The reduction in rates improves incentives for savings, investment, business creation and expansion, job creation, entrepreneurship and work by allowing people to keep a greater percentage of the reward produced by these activities."

Also Peter Ferrara makes a very important point:

"In addition, America needs deregulation to unleash the private sector to produce more oil and natural gas, from offshore and onshore, and to build more nuclear power plants. This would build a powerful energy industry, adding to GDP and creating jobs."

Why America needs urgent deregulation and massive investment from the private sector in the Energy sector?

John Mauldin told us why in his latest letter:

http://www.2000wave.com/article.asp?id=mwo091010

"If the US is going to really attempt to balance the budget over time, reduce our personal leverage, and save more, then we have to address the glaring fact that we import $300 billion in oil (give or take, depending on the price of oil).

This can only partially be done by offshore drilling. The real key is to reduce the need for oil. Nuclear power, renewables, and a shift to electric cars will be most helpful. Let us suggest something a little more radical. When the price of oil approached $4 a few years ago, Americans changed their driving and car-buying habits.Perhaps we need to see the price of oil rise. What if we increased the price of oil with an increase in gas taxes by 2 cents a gallon each and every month until the demand for oil dropped to the point where we did not need foreign oil? If we had European gas-mileage standards, that would be the case now.

And take that 2 cents a month and dedicate it to fixing our infrastructure, which is badly in need of repair. In fact, the US Infrastructure Report Card (www.infrastructurereportcard.org), by the American Society of Civil Engineers, which grades the US on a variety of factors (the link has a very informative short video), gave our infrastructure the following grades in 2009: Aviation (D), Bridges (C), Dams (D), Drinking Water (D-), Energy (D+), Hazardous Waste (D), Inland Waterways (D-), Levees (D-), Public Parks and Recreation (C-), Rail (C-), Roads (D-), Schools (D), Solid Waste (C+), Transit (D), and Wastewater (D-).

Overall, America's Infrastructure GPA was graded a "D." To get to an "A" would requires a 5-year infrastructure investment of 2.2 trillion dollars.

That infrastructure has to be paid for. And we need to buy less oil. And we know price makes a difference. The majority of that 2 cents would need to stay in the states where it was taxed, and forbidden to be used on anything other than infrastructure.

(And while we are at it, why not build 50 thorium nuclear plants now? No fissionable material, no waste-storage problem, and an unlimited supply (at least for the next 1,000 years) of thorium in the US. The reason we chose uranium was to be able to produce nuclear bombs, among other reasons.) We'll get into this and more when we get to the chapter on the way back for the US."

Why not try something else rather than pointless Government spending, which is no substitute for real growth coming from a repaired private sector.

As a conclusion let me quote Brian S. Wesbury and Robert Stein in an article published in Forbes:

http://www.forbes.com/2008/12/08/friedman-cut-taxes-oped-cx_bw_rs_1209wesburystein.html

"There are many positive alternatives that are not being formally discussed. This is a mistake. And more to the point, the last time the government tried to bail out the economy with drastic action, we ended up in the Great Depression. If we really want to "change" the way government and the private sector interact, why is the U.S. government still trying the same old policies that failed in the past? Tax cuts have worked before, so if deficits don't matter, why not try a different kind of surge--a private-sector, incentive-creating one?"