Liquidity Crisis? A Currency Perspective
In 2008, the global financial system faced a potential meltdown when funding seized up for investment banks, ultimately leading to the failure of Lehmann Brothers. Three years on, we have got plenty of problems, but - as we shall argue - investors may want to differentiate between a financial meltdown and insolvency. While complaining about policy makers and bankers may generate animated water cooler discussions, let's take their human (and fallible) nature as a given, and discuss implications for investors. In this context, we assess the U.S. dollar, currencies and equities.
In recent months, various observers pointed to strains in the inter-bank funding markets. Headlines warning of financial calamity resurfaced. We have a laundry list of complaints ourselves. Remember, though, that Al Capone was convicted for tax evasion, not for his activity as a mobster. Credit Default Swaps (CDS) on Greece may be triggered not by Greece's inability to pay, but because of Finland's insistence that collateral be posted in return for the next tranche of European Financial Stability Facility (EFSF) payment. Along similar lines, select banks may have funding strains, but don't count on a lack of liquidity breaking their backs.
Anyone who has read a basic accounting book recalls the equation Assets = Liabilities + Owner's Equity. While specifics might get a bit complex (they shouldn't, but when regulators and lobbyists collaborate, the result is not necessarily the most obvious), banks face the same accounting realities. A customer's loan shows up as an asset on a bank's balance sheet. Equity may be paid-in capital by shareholders. And liabilities are the loans the bank itself takes out in order to pay for (fund) its loan portfolio (assets). Unlike non-financial corporations, banks are highly leveraged institutions (low equity compared to liabilities); moreover, banks have an inherent maturity mismatch. A maturity mismatch means that banks tend to borrow short-term money, while financing long-term projects. Some of the key risks banks face are interest risk (the risk of rising short-term interest rates may create problems for institutions with a maturity mismatch) and credit risk (the risk of creditors not paying back their loans). By promising to keep interest rates low until at least the middle of 2013, the Federal Reserve (Fed) has substantially reduced interest risk for banks. The risk of creditors (think Greece's sovereign debt; think sub-prime mortgage-backed securities, to name two of the more obvious risks), however, persists.
In order to finance their loan portfolios (a bank asset), banks have substantial funding risk. Funded can be sourced through customer deposits (a fairly stable source of funding; a customer deposit shows up as a liability on a bank's balance sheet), by issuing various forms of debt (e.g. including longer term bonds or shorter term commercial paper) or by obtaining a loan from another financial institutions, the inter-bank lending market.
The obvious challenge in the interbank lending market is that if a bank does not trust another institution's financial health, they are unlikely to give that institution a loan, even if it is just overnight. The financial institution seeking to secure financing may have its funding costs soar as a result. The important thing to remember, though, is that banks have access to funding from their respective central banks. The days are over when investment banks had neither customer deposits, nor access to a central bank window. Goldman Sachs, as well as the other remaining large investment banks, have converted to commercial banking charters. As such, they can tap into the same unlimited piggy bank as other banks. Importantly, the European Central Bank (ECB) has been providing unlimited liquidity to the European banking system. That's unlimited, as in no limits. The banks are depositing part of their loan portfolio as collateral; in return, they receive cash. That cash may literally be printed out of thin air; central banks don't need to find that money somewhere, they just need to enter a credit into the account that bank holds at the central bank.
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It turns out the ECB model is rather flexible: when the crisis flares up, banks require more liquidity; when the crisis ebbs down, those facilities are wound down. The ECB has been adamant that their measures are temporary by design and independent of its broader monetary policy. While one can argue about the severity of the crisis or the quality of the collateral, it is correct that the ECB approach is more robust than that of the Federal Reserve (Fed). By buying trillions in mortgage-backed securities (MBS) and government bonds, the Fed has a bloated balance sheet that is cumbersome to manage. In contrast, the ECB has only printed a fraction of the money and could phase out its facilities within months (one year for the longest facility). The ECB is also providing unlimited U.S. dollar liquidity to European banks through swap arrangements with the Fed in cooperation with the Swiss National Bank (SNB) and Bank of England (BoE). Importantly, these facilities are designed to carry financial institutions through the New Year. Towards the end of the year, a lot of window dressing takes place, where financial institutions like to show "good" securities on their books. As a result, every year, there is concern that those issuing less desirable securities might get squeezed from the funding markets. While not without political risks in the U.S., it shows the determination of central banks to keep plenty of liquidity in the markets, and is a key reason why we believe a liquidity driven financial meltdown is off the table.
In the 1990s, the Bank of Japan showed that even a technically insolvent banking system could be kept afloat. Similarly, there may be solvency issues at some institutions, but central banks can keep them afloat.
When funding costs are too high, financial institutions have to de-leverage or raise more capital. The former can be expensive; indeed, banks have great leeway with regards to keeping securities at cost on their books, rather than adjusting them to market value. Part of the rational behind such regulation is that the maturity mismatch inherent to the banking industry means banks should be able to take a longer-term view. The markets have shown they have little sympathy for such twisted logic. The trouble is that, if indeed banks de-leveraged, they would have to recognize their losses, possibly wiping out substantial portions of their capital.
The latest round of European stress tests did something fabulous: the stress tests provided unprecedented transparency, listing the sovereign debt holdings of financial institutions. The market doesn't need the regulator to tell them what's good or bad; the market needs transparency. The market is now able to target what are deemed weaker institutions and "encourage" them to raise more capital or de-leverage. That 'encouragement' by the market is what has been driving both policy makers and bank executives. In many ways, it's a wonderful dialogue. Policy makers and CEOs may be able to influence the timing of when governments and banks clean up their books / get their act together, but the action is firmly driven by the bond markets. However, there is one region where this "reform process" is sorely lacking with regards to sustainable fiscal policy: the U.S. It's not a coincidence: the bond markets in the U.S. have not forced policy makers into action. Obviously it would be preferred to have policy makers and bank CEOs be ahead of the curve.
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When it comes to financial institutions, the inherent design of bank regulation carries much of the blame. It's not just the fact that banks are not required to mark down assets to market value; it's also that national regulators typically consider their own government debt risk free. In the U.S., Treasures are risk free by regulation. Similarly, European banks ought to carry much of their capital in sovereigns, as those securities are acceptable to comply with capitalization rules; in contrast, corporate securities must be heavily discounted. In a world where some corporations may be less risky than their governments, those rules are outdated. Indeed, at times, there is a risk that inter-bank lending of corporate (financial institution) paper dries up, because regulation discourages taking on the counter-party risk of a bank and incentivizes more risky government securities instead. In Europe, where each Eurozone government regulates its own banking system, it's urgently necessarily to centralize bank regulation, so that each member country's bank is not ex-ante over-exposed to their own government paper. Naturally, the respective governments are opposed to such moves, as it may increase the cost of government funding if banks actually had to evaluate (and take seriously) the creditworthiness of their own governments.
What does it mean to investors?
- Banks that are under-capitalized may not lend as much, reducing economic activity. That may be a negative for equities. For currencies, however, it depends. In Japan, the yen has been benefiting from economic contraction: in the absence of a current account deficit, consumers save more as economic activity slows down. In the U.S., it's the opposite: it's easier to finance the current account deficit with economic growth, providing an incentive to policy makers to grow at just about any cost. Looked at it differently, the U.S. dollar may be much more sensitive to a misbehaving bond market; while it is behaving for now, the U.S. dollar may be under pressure should the market take a different view on long-term fiscal sustainability. Caught in the middle is the euro: with the current account roughly in balance, the euro can fare okay in an environment where banks restrict their lending and economic activity stalls.
- Volatility is likely to remain elevated as long as investors remain skittish regarding the amount of liquidity provided. However, keep in mind that central banks can act much faster than politicians. As liquidity concerns are addressed, the market will move towards focusing on solvency issues. The lines may be blurred at times because of above mentioned regulations and lack of transparency. It would be most helpful if policy makers decided to embrace transparency. Note, by the way, that there is nothing inherently bad about a bank de-leveraging; but by postponing the inevitable, stress is created in the system that benefits no one (except those shorting those banks, I suppose, which is then made banned by the regulators…but I digress).
Because of the scale of the issues, policy makers have taken an ever more active role in the markets; we don't see that trend abating. As a result, securities may increasingly be trading based on the next perceived move of policy makers, rather than on fundamentals. It's a key reason why we focus on currencies, as, through the currency markets, investors can take positions on what we call the mania of policy makers. This Thursday, September 22, 2011, we are hosting a webinar discussing how investors may be able to manage the currency risk of their U.S. equity portfolio (click here to register). According to our analysis, investors may be able to improve risk-adjusted equity returns by taking a pro-active approach to currency risk (please also read our white paper on the topic).
We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund. To learn more about the Funds, please visit www.merkfunds.com. Please sign up to our newsletter to stay in the loop as this discussion evolves.
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