Economists are predicting loan activity to rise at a more modest pace in 2022 than we’ve seen in 2021. Blake Hastings, my colleague and former senior leader at the Federal Reserve Bank of Dallas, expe...
“These things gotta happen every five years or so, ten years. Helps to get rid of the bad blood. Been ten years since the last one.” - Pete Clemenza, “Capo” Corleone Family
If one questioned the current state of our financial markets, the near panic that ensued following this past Wednesday’s FOMC meeting was all you needed to see. The Fed’s mere mention that perhaps we could see one policy rate hike, from ZERO to 25 basis points in 2022, as opposed to 2023, and that perhaps it was time to start THINKING about tapering the $120 billion a month quantitative easing purchases sent equities spinning and longer-dated Treasury yields plummeting.
I am reminded of the human growth hormone-fueled home run era for Major League Baseball in the 1990s. Perhaps the high mark (or low mark, depending on your point of view) was when Brady Anderson, an above-average major leaguer, known more for his excellent defense and speed on the base paths, managed to hit an astounding 50 home runs in 1996.The mark of 50 home runs was once the sacred realm of baseball immortals like Babe Ruth. The all-time home run king up to that point, Henry Aaron, never hit 50 or more home runs in a season.
Suddenly, Brady Anderson, a player that had never hit more than 21 homers in a season hit 50! Up until 1996, Anderson hit a homer about 2.5% of his plate appearances. In 1996, that figure skyrocketed to 7.3%! In 1996, baseball had a problem, however, the “problem” was making the league gobs of money. Therefore, the ugly ramifications and reckoning were put off a few more years, after three players smashed the sacred single-season home run record of Roger Maris. The embarrassment and revenue loss came later.
It is abundantly clear that our financial markets have been, as they used to say, “on the juice” since at least 2009 and at most since 1987, when the Fed slashed rates in response to the “Black Monday” stock market crash. Does the Federal Reserve’s infamous dual mandate address ensuring that high levels of risk-taking never have to answer what should be the high cost of failure? They did not write that into the mission of the Federal Reserve back in 1913, but in 2021, it seems that this is what the Fed’s overriding mandate is.
Think about it. From the junk bond blow up in the late 1980s-early 1990s to the Asian Currency/Long Term Capital crisis of 1997-1998, to the Dot Com explosion in 2000, to Enron and World Com in 2002, to the Subprime crisis of 2007-2009, and now with COVID, the Fed has taken upon itself to really care almost exclusively about protecting investors and institutional players from themselves. The Federal Reserve has, from its founding, stated that it has a dual mandate to achieve long-term price stability and maximum sustainable employment. What we continue to see, however, is a mandate to maintain the “price stability” of financial assets that seem to defy reason and the maximum employment of those who create and manage those assets.
Everything we saw in March 2020 should have shown the Fed that a great portion of the financial markets were priced at ridiculous levels and were relying on leverage and liquidity that disappeared in a flash. While it is true that the COVID Pandemic’s economic shutdown was an event that was nearly impossible to predict, the Fed saw what herculean steps it had to take to stop a complete collapse. The Federal Reserve once again seemed either unwittingly or willfully blind to the risks. A great example of this was Federal Reserve Chairman Jerome Powell’s view on the Collateralized Loan Obligation (CLO) market in 2019. From Reuters News:
While conceptually similar to the collateralized debt obligations that spread bad mortgages throughout the financial system, Powell said CLOs “are much sounder than the structures that were in use during the mortgage credit bubble.” In addition, the fact that only $90 billion of the roughly $700 billion CLO market is held by large commercial banks is “good news,” with less risk to the companies at the core of the financial system.
Firstly, the CLO market in 2019 was dramatically different than the one in 2007-2009. Secondly, a much greater percentage of syndicated loans were “covenant light,” meaning lenders had far less control over the borrowers' use of funds, not to mention an increased lack of access to valuable collateral. Thirdly, the number of borrowers who either had negative cash flow after debt service, or even before debt service, increased substantially. Finally, to just look at the CLO market without considering the other $400 billion or so of syndicated loans that resided in supposedly liquid vehicles like open-end mutual funds and exchange-traded products (ETFs and ETNs) or the $200 billion syndicated loans that were held, with a high degree of leverage (provided by the banking system) by hedge funds, was crazy.
The banking system and a broad swath of the financial markets were very exposed to high-yield syndicated loans, as well as high-yield bonds and many other risk markets. If the Fed did not step in on March 23, 2020, to announce that they would use their infinite balance sheet to do whatever it takes, the financial system was indeed imperiled. Once again, just as they did in previous crises, the Fed bailed out risk-takers and then, after bailing them out, did not present them with the bill for the bailout. That is why, post-March 2020, the bail-out markets are more leveraged up and risky than they were before the bailout.
It seems that the Fed has an opportunity here to start normalizing monetary policy to actually fulfill their actual mandates to achieve long-term price stability and maximum sustainable employment. If that causes a serious correction in risk assets, so be it. As Fat Pete said, you need this every few years to get rid of the bad blood.
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