Bond traders in the US are apparently terrified by “the ghosts of ‘94” — a reference to a Fed rate hike that caused catastrophic losses — according to an interactive splash on the FT website.
The veterans of 1994 are right that many of the conditions are similar today: early signs of economic recovery, a possible shift away from fixed-income markets and a generation of bond traders who have forgotten that interest rates can go up as well as down.
But they only skirt around the real problem: financial institutions that are incapable of absorbing the losses they incur as an inevitable result of excessive leverage.
The surprise in the mid-1990s was not that the Fed hiked interest rates — it was the market’s reaction to the hike that caught people off guard.
“The size of the shock came as a surprise because most people were unaware how sensitive the positions of many derivatives investors were to the Federal Reserve’s policy,” according to Anat Admati, a finance and economics professor at Sanford, and Martin Hellwig, an economics professor and director of a research institute in Bonn, writing in a new book titled The Bankers’ New Clothes.
Some of the biggest losers in 1994 included Procter & Gamble, Orange County, Credit Suisse First Boston and Salomon Brothers. They had misunderstood (or ignored) the risks they were taking by betting against a rate hike.
Shoot forward to today, and the Fed hasn’t hiked rates since its ill-advised tightening in the summer of 2008 — and it hasn’t tightened over a sustained period for more than a decade. But, unlike in 1994, the veterans warn that bond markets are now much bigger, and products such as exchange-traded funds have made it easier for ordinary investors to plough cash into the bond market.
At some point, the Fed’s asset purchases will start to be unwound and record-low bond yields will reverse. This so-called Great Rotation could cause another spate of losses for unprepared fixed-income investors.
Many will see this as the Fed’s fault; a product of excessive quantitative easing. But for Admati and Hellwig, the real problem is a financial system that remains dangerous and distorted, despite the wake-up call provided by the worst banking failure since the 1930s.
“Today’s banking system, even with proposed reforms, is as dangerous and fragile as the system that brought us the recent crisis,” they write in their introduction.
The book is subtitled: What’s wrong with banking and what to do about it. What’s wrong, they argue, is too much debt — and what should be done about it is forcing banks to hold more equity, among other things.
Bankers tend to balk at such suggestions. Jamie Dimon, J.P. Morgan’s chief executive, complained last September that banks would “have their capital cups running over” by 2014 or so. “They're not going to use all that capital,” he told an audience at Barclays’ global financial services conference. “They'll be hitting their targets and there is going to be no way to put it all to use.”
This is a strange argument. As the authors point out, equity capital is not a rainy day fund that has to be set aside. In fact, it is simply the proportion of bank funding that is not borrowed. And, as with a homeowner, more equity means greater protection from changes in the value of a bank’s assets.
The capital structure — the mix of debt and equity — has no effect on a bank’s ability to lend. If a bank were forced to fund with 20% or 30% equity, it could issue additional shares and use the capital raised in any way it wanted to.
Another popular canard is that equity is expensive. But compared to what? If equity is so costly, why aren’t Apple shareholders demanding that the company increases its paltry borrowing? Or are banks somehow different to every other type of company?
Well, yes, in a way. “One difference that is important for bank funding costs became evident in 2008,” write Admati and Hellwig. “If an important bank gets into trouble and comes close to defaulting on its debt, there is a good chance that the government or the central bank will support it to prevent default.”
In other words, bank debt is cheap because of an implied guarantee. This is a good deal for bankers and a bad one for taxpayers — particularly so because the subsidy penalises loss-absorbing equity and encourages banks to rely even more heavily on borrowing. It is a perverse incentive.
UBS positions itself as one of the world’s best-capitalised banks, as part of a strategy to reassure its high-net-worth depositors that their money is safe. Its funding comprises just 13% equity. This is far lower than most non-financial companies, but in the banking industry represents a “fortress balance sheet” — a term that Dimon likes to use to refer to J.P. Morgan’s 10% equity.
To make matters worse, these numbers are calculated using a bank’s book value. Since the crisis, most of the big banks have been trading well below book, which means their equity cushion is actually even smaller than it appears.
The consequences of all this debt are magnified by the global, interconnected nature of the financial system. Yet the banks are now bigger than ever, with debts in the trillions of dollars. Far from fixing the problems that led to the crisis, they are now even worse.
The solution that Admati and Hellwig provide is more complicated than simply raising additional capital and, notably, does not focus on deposit-taking institutions alone. AIG, Lehman, Bear Stearns and LTCM had no depositors between them, but all posed systemic risks.
Getting politicians to take their proposals seriously is a different matter — a reality that even the authors are willing to concede in the final line of their book: “We can have a financial system that works much better for the economy,” they write. “[But] the critical ingredient — still missing — is political will.”
Never mind the ghosts of 1994, we haven’t yet shaken off the zombies of 2008.