The Volcker Rule

By: Doug Noland | Fri, Jan 22, 2010
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For the week, the S&P500 sank 4.3% (down 2.1% y-t-d), and the Dow lost 4.1% (down 2.1% y-t-d). The broader market did a little better than the major indices. The S&P 400 Mid-Caps declined 3.0% (down 0.7%), and the small cap Russell 2000 fell 3.4% (down 1.3%). The Banks slipped 0.8% (up 8.5%), and the Broker/Dealers declined 2.8% (down .3%). The Morgan Stanley Cyclicals were hit for 6.9% (down 1.7%), and Transports were down 4.4% (down 2.3%). The Morgan Stanley Consumer index dropped 2.1% (down 1.0%), and the Utilities declined 1.4% (down 3.9%). The Nasdaq100 sank 3.9% (down 3.5%), and the Morgan Stanley High Tech index fell 4.5% (down 4.6%). The Semiconductors sank 4.6% (down 8.5%). The InteractiveWeek Internet index dropped 4.2% (down 4.2%). The Biotechs declined 2.2% (up 1.9%). With bullion sinking $36, the HUI gold index was hammered for 8.6% (down 6.1%).

One-month Treasury bill rates ended the week at 2 bps, and three-month bills closed at 5 bps. Two-year government yields fell 7 bps to 0.75%. Five-year T-note yields dropped 8 bps to 2.30%. Ten-year yields declined 7 bps to 3.60%. Long bond yields declined 6 bps to 4.53%. Benchmark Fannie MBS yields decreased 2 bps to 4.35%. The spread between 10-year Treasury and benchmark MBS yields widened 5 to 74bps. Agency 10-yr debt spreads widened 2 to 35 bps. The implied yield on December 2010 eurodollar futures declined 6.5bps to 1.02%. The 10-year dollar swap spread increased 1.75 to 12.5, and the 30-year swap spread increased 1.0 to negative 10. Corporate bond spreads were mostly wider. An index of investment grade bond spreads widened 7 to 90 bps, while an index of junk spreads was little changed at 492 bps.

Investment grade issuers included Morgan Stanley $4.0bn, Bank of America $3.5bn, Digital Realty Trust $500 million, and Trans-Allegheny $450 million.

The list of junk issuers included Simon Properties $2.25bnm, Vanguard Health $950 million, Newfield Exploration $700 million, and Accellent $400 million.

I saw no convert issues.

It was another big week for international dollar-denominated debt issues. Issuers included Italy $2.5bn, Bank of Nova Scotia $2.5bn, Electricite de France $1.4bn, Nordic Investment Bank $1.0bn, BFF International $750 million, Evergrande Real Estate $750 million, MU Finance $425 million, Listrindo $300 million, Nissan $250 million, Validus $250 million and Corporativo Javer $210 million.

U.K. 10-year gilt yields dipped 2 bps to 3.92%, and German bund yields fell 5bps to 3.21%. Bond yields in Greece surged another 27 bps to 6.25%. The German DAX equities index fell 3.1% (down 4.4% y-t-d). Japanese 10-year "JGB" yields were unchanged at 1.32%. The Nikkei 225 sank 3.6% (up 0.4%). Emerging markets were under pressure. For the week, Brazil's Bovespa equities index sank 4.0% (down 3.5%), and Mexico's Bolsa dropped 4.4% (down 4.0%). Russia's RTS equities index sank 6.2% (up 2.7%). India's Sensex equities index was down 4.0% (down 3.5%). China's Shanghai Exchange dropped 3.0% (down 4.5%). Brazil's benchmark dollar bond yields rose 6 bps to 5.14%, while Mexico's benchmark bond yields dipped 3 bps to 5.12%.

Freddie Mac 30-year fixed mortgage rates fell 7 bps to 4.99% (down 13bps y-o-y). Fifteen-year fixed rates declined 5 bps to 4.40% (down 40bps y-o-y). One-year ARMs dropped 7 bps to 4.32% (down 60bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 6 bps to 5.96% (down 104bps y-o-y).

Federal Reserve Credit increased $5.1bn last week to a 52-wk high $2.231 TN. Fed Credit was up $181.6bn from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 1/20) declined $5.0bn to $2.946 TN. "Custody holdings" expanded $405bn, or 15.9%, over the past year.

M2 (narrow) "money" supply declined $9.4bn to $8.452TN (week of 1/11). Narrow "money" expanded 2.0% over the past 52 weeks. For the week, Currency was little changed, while Demand & Checkable Deposits dropped $49.4bn. Savings Deposits jumped $54.1bn, while Small Denominated Deposits declined $8.2bn. Retail Money Funds fell $6.2bn.

Total Money Market Fund assets (from Invest Co Inst) sank $46.0bn to $3.240 TN. Over the past year, money fund assets dropped $654bn, or 16.8%.

Total Commercial Paper outstanding declined $10.0bn last week to $1.092 TN. CP dropped $596bn over the past year (35.3%). Asset-backed CP added $3.5bn last week to $430bn, with a 52-wk drop of $319bn (42.6%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $8bn y-o-y, or 12.%, to a record $7.820 TN. China's reserves were up 23.3% y-o-y to $2.399 TN.

Global Credit Market Watch:

January 21 - Bloomberg (Matthew Brown and Daniel Tilles): "Investors are so concerned that Greece won't be able to finance its budget deficit that it now costs the government more to borrow for two years than Germany pays to raise funds for 30 years."

January 19 - Bloomberg (Simone Meier and Frances Robinson): "European finance chiefs said Greece's fiscal crisis is affecting other nations and called on the government to step up its budget-cutting efforts. 'The fate of one is the fate of all,' European Union Economic and Monetary Affairs Commissioner Joaquin Almunia said... 'This situation in Greece is having effects on other countries.' Concern that Greece and other European nations may struggle to contain their budget deficits has eroded the value of the euro and pushed up bond yields."

January 19 - Bloomberg (Jody Shenn): "Wall Street firms are loosening terms of their lending to mortgage-bond investors as markets heal, an RBS Securities Inc. executive said. Repurchase agreement, or repo, lending against the debt has expanded so much since freezing in late 2008 that some banks now offer as much as 10-to-1 leverage and terms as long as one year on certain securities backed by prime jumbo-home loans, said Scott Eichel, the Royal Bank of Scotland unit's global co-head of asset- and mortgage-backed securities. 'It's getting very competitive,' Eichel said... 'We're at the point where I don't think we would feel comfortable if things go too much further.'"

January 19 - Bloomberg (Paul Armstrong): "Prices of high-yield loans in Europe hit a two-year high... The average price for actively traded so-called leveraged loans climbed 7 bps to 96.07% of face value since Jan. 1, according to Standard & Poor's...A year ago, loans traded at 60.4% of face value."

January 20 - Bloomberg (Gabrielle Coppola and Sapna Maheshwari): "Real estate borrowers are leading the rally in U.S. corporate bonds as investors add to bets property companies will weather an increase in commercial mortgage defaults. Bonds sold by real-estate investment trusts, shopping-mall owners and office landlords have gained 3.27% this month, exceeding 3.18% for all of the fourth quarter..."

Global Government Finance Bubble Watch:

January 21 - Bloomberg (Gonzalo Vina): "Britain had a 15.7 billion-pound ($25.4bn) budget deficit last month, the most for any December since records began in 1993, highlighting the growing pressure for spending cuts to repair the public finances."

January 19 - Bloomberg (Anchalee Worrachate): "The European government debt deluge that left investors with the lowest relative returns since 1995 will continue for another seven years, say the officials in charge of bond sales from Frankfurt to Dublin to Helsinki... 'Bond issuance in the region might start to come down from 2011, but to drop to pre-crisis levels may take a while,' said Carl Heinz Daube, head of Germany's Federal Finance Agency..."

January 20 - Bloomberg (Veronica Navarro Espinosa): "Latin America emerged from the global financial crisis without a large increase in its debt level, Moody's... said. 'Latin America and the Caribbean have come out of the crisis with relatively little new debt, especially when compared to more developed parts of the world, leaving the region in a good position at the start of 2010,' Moody's said... 'For the first time in years, if not decades, a major crisis has passed without substantial increases in the regional debt burden or a fall in international reserves.' ...Public debt will average more than 118% of gross domestic product in the Group of 20 advanced economies by 2014, up 40 percentage points from 2007, the IMF said... Governments around the world borrowed record amounts last year, led by the $1.44 trillion in new cash raised by the U.S...."

Currency Watch:

January 19 - Bloomberg (Veronica Navarro Espinosa): "Brazil's success in curbing the rally in the real by imposing a tax on foreigners' purchases of stocks and bonds is a 'scary' and 'dangerous' precedent, said Citigroup Inc. equity strategist Geoffrey Dennis. The success of the tax may encourage officials to adopt more measures to stem the currency's appreciation, Dennis said... 'It's kind of scary because it might mean that the government wants to do more things over time should the currency stay strong,' Dennis said."

The dollar index gained 1.3% this week to 78.29. For the week on the upside, the Japanese yen gained 1.0% For the week on the downside, the New Zealand dollar declined 3.7%, the South African rand 3.0%, the Brazilian real 2.9%, the Canadian dollar 2.7%, the Swedish krona 2.4%, the South Korean won 2.4%, the Australian dollar 2.3%, the Mexican peso 2.3%, the Norwegian krone 2.1%, the Danish krone 1.8%, the Euro 1.7%, the Swiss franc 1.5%, the Singapore dollar 1.0%, and the British pound 0.9%.

Commodities Watch:

January 21 - Bloomberg: "China, the world's second-largest energy user, refined a record volume of crude oil last year as a recovering economy increased demand for fuels. Oil processing rose 7.9% to 374.6 million metric tons, or 7.5 million barrels a day...China also refined a record 34.6 million tons in December, up 25% from a year earlier and topping the previous high in November... Chinese refineries, with an annual processing capacity of about 510 million tons, may increase volumes to 400 million tons this year, according to...the Web site of China Petrochemical Corp..."

The CRB index dropped 2.1% (down 2.8% y-t-d). The Goldman Sachs Commodities Index (GSCI) sank 3.6% (down 4.4% y-t-d). Gold lost 3.2% to $1,095 (down 0.3% y-t-d). Silver was down 7.3% to $17.08 (up 1.4% y-t-d). March Crude dropped $4.18 to $74.19 (down 6.5% y-t-d). February Gasoline sank 4.2% (down 4.5% y-t-d), while February Natural Gas increased 2.1% (up 4.3% y-t-d). March Copper declined 0.7% (down 0.1% y-t-d). March Wheat fell 2.3% (down 7.9% y-t-d), and March Corn lost 1.8% (down 12.0% y-t-d).

China Bubble Watch:

January 21 - Bloomberg: "China's growth accelerated to the fastest pace since 2007 in the fourth quarter... Gross domestic product rose 10.7% from a year before, more than the median forecast of 10.5%... Asset-price gains, particularly in property, are creating problems for the government to guide the economy..."

January 20 - Bloomberg: "China has told some banks to limit lending and will restrict overall credit growth in the nation to 7.5 trillion yuan ($1.1 trillion) this year, banking regulator Liu Mingkang said. Some lenders were asked to rein in credit because they failed to meet regulatory requirements... New loans in the first 10 days of this year were 'relatively high,' he told the Asian Financial Forum."

Japan Watch:

January 21 - Bloomberg (Aki Ito): "Japanese demand for bank loans dropped the most in more than five years as companies cut spending, a central bank survey showed...."

Asia Bubble Watch:

January 21 - Bloomberg (Shamim Adam): "Developing Asian economies face the risk of asset bubbles or overheating as the region's growth outpaces the rest of the world this year, the World Bank said. Developing East Asia... will expand 8.1% this year... South Asia will grow 7% in 2010, it said."

January 19 - Bloomberg (Jason Folkmanis): "Vietnam's economy may expand 7.5% this year, PXP Vietnam Asset Management said, which would be the country's fastest pace of growth since 2007."

Latin America Bubble Watch:

January 21 - Bloomberg (Camila Fontana): "Brazil's Finance Ministry is considering anti-inflationary measures to prevent interest-rate increases by the central bank, O Estado de S. Paulo reported... Among measures under consideration are cuts on import taxes for products with increasing prices, lower fuel taxes and the elimination of tax incentives to stimulate consumer spending..."

January 19 - Bloomberg (Daniel Cancel): "Venezuelan Trade Minister Eduardo Saman said the government began to expropriate six Hipermercado Exito stores today after President Hugo Chavez said the French-Colombian owned retailer broke the law by raising prices. The government plans to convert the retailers into 'socialist mega-stores' administered by the state and Exito workers, Saman said."

Unbalanced Global Economy Watch:

January 19 - Bloomberg (Jennifer Ryan and Svenja O'Donnell): "The U.K. inflation rate jumped in December by the most since records began in 1997, posing a challenge to policy makers... Consumer prices climbed 2.9% from a year earlier..."

January 21 - Bloomberg (Simone Meier): "Expansion in Europe's service and manufacturing industries unexpectedly slowed in January, adding to signs the pace of the economy's recovery may weaken."

January 19 - Bloomberg (Kati Pohjanpalo): "The Nordic economies will grow faster this year than previously forecast, fuelled by rising exports and consumer spending, Nordea Bank AB and DnB NOR ASA said. Sweden's economy will grow 3.2% this year and 2.4% in 2011..."

January 21 - Bloomberg (Paul Abelsky): "Russia must take steps to prevent the overheating of assets in the first half amid 'an obvious excess of liquidity' in the economy, German Gref said. 'Today the herd instinct in the presence of an utterly excessive money supply is leading to the artificial pumping up of the price of the stock market and all types of commodities, and it's obvious that we're going to see another expansion of this bubble," the OAO Sberbank chief executive officer told a conference..."

U.S. Bubble Economy Watch:

January 21 - Bloomberg (Jason Kelly and Cristina Alesci): "JPMorgan Chase & Co. and Goldman Sachs Group Inc. may have to sell some private-equity businesses and stop investing in buyouts under a proposal by President Barack Obama to limit bets made by banks with their own capital. Obama asked Congress... to prohibit banks from owning or making investments in private-equity and hedge funds that "are unrelated to serving customers."

Central Bank Watch:

January 19 - Bloomberg (Jennifer Ryan): "Bank of England Governor Mervyn King said 'undesirably low' money supply growth will curb inflation and return it to the 2% goal, suggesting he's not yet ready to unwind emergency stimulus. 'Provided monetary growth remains well under control --and remember at present it is undesirably low -- inflation should return to target in the medium term,' King said... The recent pickup in inflation 'should be temporary,' he said."

Fiscal Watch:

January 20 - Bloomberg (Dawn Kopecki): "The Federal Housing Administration is raising insurance rates and tightening credit-score rules to combat a rise in delinquencies, making a government-guaranteed mortgage more expensive for U.S. homebuyers. The premiums FHA charges to insure mortgages will rise to 2.25% from 1.75% this year... Borrowers who have credit scores below 580 will also have to make down payments of at least 10%, and allowable seller concessions will be cut by half... The U.S. housing market has been kept alive by low interest rates, cheaper homes, a homebuyer tax credit, FHA-related lending and financing initiatives through Fannie Mae and Freddie Mac. The FHA, along with federally controlled finance companies Fannie Mae and Freddie Mac, accounted for more than 90% of all U.S. home loans in the first half of 2009. The FHA's net capital ratio... fell to 0.53% in the year ended in September, from 3% in fiscal 2008 and 6.4% in 2007..."

Real Estate Watch:

January 19 - Bloomberg (Sarah Mulholland): "Sales of commercial mortgage-backed securities will likely remain below $15 billion in 2010 as borrowers struggle with declining property values, according to analysts... Debt sales backed by skyscraper, hotel and shopping mall loans may be as low as $10 billion this year, according to Alan Todd, a JPMorgan analyst..."

January 21 - Bloomberg (Daniel Taub): "Apartment rents and occupancies declined throughout the U.S. West and South in the fourth quarter... The average asking rent fell to $933 from $965 in the third quarter and $994 a year earlier, according to... RealFacts, which surveyed owners of more than 12,600 apartment complexes. The average occupancy rate dropped to 91.3% from 91.7% in the third quarter and 92.2% in the prior-year period."

California Watch:

January 19 - Bloomberg (Daniel Taub): "Southern California house and condominium prices rose last month for the first year-over-year increase since 2007 as sales of foreclosed homes declined and more properties sold in pricier coastal markets. The median price was $289,000 in December, up 4% from a year earlier...MDA DataQuick said."

Speculation Watch:

January 20 - Bloomberg (Saijel Kishan): "Hedge funds' best year in a decade is giving little comfort to Jason D. Papastavrou. The founder of New York-based ARIS Capital Management LLC, which has about $250 million invested in hedge funds, is still waiting to get back $155 million from 22 managers that restricted withdrawals in 2008. 'We don't object to the illiquidity,' Papastavrou said... 'We object to how some managers are abusing the situation and holding investors' money hostage to generate fees.'"

 

The Volcker Rule

When Paul Volcker's term as Chairman of the Federal Reserve ended, total U.S. Credit market debt outstanding tallied around $10 TN. Broker/Dealer assets ended 1986 at $185bn. Funding Corporations stood at $146bn. GSE assets were at $364bn, with $352bn of outstanding GSE-guaranteed mortgage-backed securities (MBS). The asset-backed Securities (ABS) market, at $75bn, was hardly a force. REITs were only $15bn. The Federal Reserve's balance sheet ended 1986 at $275bn. There were $1.80 TN of outstanding Treasury Securities and $808bn of Agency Securities. Total Commercial Bank assets stood at $2.621 TN, with miscellaneous bank assets of $741bn. Total U.S. Mortgage Debt was just under $2.70 TN.

Fast-forward to Q3 2009. Total Credit Market Debt Outstanding had ballooned more than 5-fold to $52.617 TN. Broker/Dealer assets ended September at $2.062 TN (after surpassing $3.0 TN in 2008). Funding Corporations stood at $1.338 TN. GSE assets had ballooned to $3.126 TN, with outstanding GSE-guaranteed mortgage-backed securities (MBS) at $5.30 TN. The asset-backed Securities (ABS) market ended the third quarter at $3.650 TN. REITs were $266bn. The Federal Reserve's balance sheet had swelled to $2.180 TN. There were $7.520 TN of outstanding Treasury Securities and $8.123 TN of Agency Securities. Total Commercial Bank assets stood at $14.2 TN, with miscellaneous bank assets of $4.027 TN. Total U.S. Mortgage Debt ended the quarter at $14.42 TN.

The Washington Post went with the headline "Volcker Rule Shifts Power from Geithner." Secretary Geithner is perceived as more of a New Era Wall Street-type - a tenuous position to find oneself these days. Paul Volcker is the consummate tough, no nonsense Old School financial regulator. Mr. Volcker is an anachronism from a different era - or so the markets had thought until yesterday. The general perception was that he had lost touch - and was basically out of touch with the White House. Yet the great American statesman has made a dramatic return to the center stage.

As much as the new Administration had been badgering and threatening the "Wall Street fat cats," the marketplace had assumed that this was mostly political bluster. At the end of the day, Washington needs Wall Street to ensure strong markets and a sustainable economic recovery. After unprecedented fiscal and monetary stimulus - not to mention scores of bailouts - the Street can't be faulted for assuming it was back to business as usual. That was before yesterday.

While certainly not without faults, the financial system back in the Volcker era was more stable. The ABS market barely existed. The Wall Street firms were not major factors in system Credit creation. The banking system dominated the extension of private-sector Credit. Derivatives markets were in their infancy - and certainly didn't dominate the financial world. Outside of some GSE MBS, mortgage Credit was in the form of bank loans. There were only a handful of hedge funds - not thousands. Leveraging marketable debt instruments wasn't The Game.

I have over the years discussed ramifications associated with the transformation of contemporary finance from bank loan dominated to marketable security dominated. I have contrasted the "staid" bank loan with the advent of the dynamic marketable debt instrument. The bank loan sat unassumingly on the bank's balance sheet until it was repaid - all under the watchful eye of the traditionally conservative bank loan officer. The marketable security, on the other hand, could be created by virtually anyone (the aggressive mortgage banker cold-calling from the rented office suite!) and held by a Wall Street proprietary trading desk, a hedge fund, or exist as part of a collateralized debt obligation. The marketable security could be "marked to model" - for some nice profits and/or bonuses - and, importantly, leveraged. And the more marketable debt securities created the higher their market values.

This marketable debt security provided leveraged players an almost guaranteed spread to short-term interest rates or Treasuries. Even better, its value would be expected to go up in the event the Federal Reserved responded to systemic stress by aggressively slashing rates. And for years, Fannie and Freddie would be gluttonous buyers of these securities in the event of a marketplace liquidity problem - providing the leveraged speculators a wonderful "backstop bid." The Federal Reserve had never had such a powerful monetary tool. These potent Credit dynamics were at the heart of the U.S. Credit Bubble.

But the Wall Street/mortgage finance Bubble eventually burst and almost brought down the entire Credit system and economy. This, of course, woke up the regulators. But serious financial reform was put on hold, as policymakers waited anxiously for a sustainable recovery to take hold.

Political considerations notwithstanding, it is difficult to argue against the premise that it's now time to begin addressing serious financial reform. Moves to rein in bank proprietary trading, hedge fund investments, and private equity are reasonable. Focus on protecting the FDIC/taxpayer is vitally important. And the Moral Hazard and "Too Big to Fail" issues are about as important to our nation's economic future as any. If we could just go back to the old days of Chairman Volcker and the sedate bank loan.

I have hypothesized that the underlying structure of the U.S. Bubble economy requires in the neighborhood of $3.0 Trillion annual non-financial Credit growth. An especially protracted period of financial excess inflated asset prices, incomes, corporate cash flows, government receipts and expenditures, trade and current account deficits, the general price level, and spending patterns throughout the entire economy. Since after the crisis's onset, the massive expansion of federal government finance (primarily Treasury and agency securities) has been sufficient to stabilize the system.

I remain skeptical that the private sector Credit mechanism can recover sufficiently to allow the Federal government to back away from massive deficits and guarantees. With Wall Street trading profits and hedge fund returns bouncing back so quickly, market optimism for the emergence of a self-reinforcing Credit cycle has been seemingly justified. Bolstered by near zero short-term rates and the Fed's "quantitative ease," security issuance - federal, agency, state, and corporate - has been massive. Meanwhile, though, bank lending has remained stagnant.

The Fed needs to commence its exit strategy - and private sector Credit is going to have to take up some of the slack. The uncertainty that has erupted with the introduction of the "Volcker rule" and the prospect for more stringent financial reform would not seem to support the rejuvenation of private sector lending. Uncertainties related to the futures of Dr. Bernanke, Fannie and Freddie don't help market confidence either. The Administration's solution would be for the banks to step up and lend money more aggressively. It's just been a long while since that was their main focus.

The markets have been much too complacent when it comes to the vulnerability of this Credit recovery. I wish we could simply go back to simpler financial times - back to when the bank loan was king; back to when the economy wasn't so dependent on massive ongoing Credit creation; back to when financial speculation wasn't such a commanding force for global markets and economies. In the past two decades the entire financial apparatus was transformed.

One of the big problems today is that there are tens of Trillions of marketable securities out there - and their value depends greatly on the ongoing creation of Trillions more. Our system needs major financial reform - no doubt about it. From today's Wall Street Journal: "The White House's relationship with Wall Street is close to the breaking point." A war on Wall Street would put Credit growth, asset markets and economic recovery all at risk.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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