How the Next Financial Crisis Will Happen

By Stephen A. Schwarzman          

June 9, 2015 7:15 p.m. ET
                                        Photo: Getty Images

After the financial crisis, a focus on safety and soundness was good medicine for the financial system. New bank liquidity and capital policies, among other initiatives, strengthened a debilitated patient. The banking system is now stronger, with more liquid assets and better underwriting standards.

Despite good intentions, however, politicians and regulators constructed an expansive and untested regulatory framework that will have unintended consequences for liquidity in our financial system. Taken together, these regulatory changes may well fuel the next financial crisis as well as slow U.S. economic growth.

The Volcker Rule, for example, bans proprietary trading by banks. The prohibition, when combined with enhanced capital and liquidity requirements, has led banks to avoid some market-making functions in certain key equity and debt markets. This has reduced liquidity in the trading markets, especially for debt. A warning flashed last October in the U.S. Treasury market with huge intraday moves, unrelated to external events. Deutsche Bank DB -2.86 % has reported that dealer inventories of corporate bonds are down 90% since 2001, despite outstanding corporate bonds almost doubling.

A liquidity drought can exacerbate, or even trigger, the next financial crisis. Sellers will offer securities, but there will be no buyers. Prices will drop sharply, causing large losses for investors, pension funds and financial institutions. Additional fire sales will aggravate the decline.

Why should we care? Because new capital, liquidity and trading rules are interrelated, and locked-up markets and rapidly falling securities prices will force banks to reduce assets and hoard liquidity in order to satisfy applicable regulatory tests. With individuals suffering losses and companies not able to raise capital, the economy will contract with layoffs, lower tax revenues and pain for middle- and lower-income Americans.

Small business owners will be particularly vulnerable because the number of community banks declined by 41% between 2007 and 2013. Recent studies by economists at the Richmond Federal Reserveand Harvard University both concluded that the 2010 Dodd-Frank financial law contributed to this decline. Dodd-Frank has disproportionately burdened community banks, despite their having no role in the financial crisis. We must revisit Dodd-Frank’s application to community banks because of their special relationship with borrowers in agriculture, small business and local real estate.

More generally, banks will not satisfy customers’ needs in a financial crisis as they have in the past. While many banks actively lent in 2008, the new capital requirements will cause banks to hoard capital with an eye toward satisfying the regulators, rather than meeting the needs of their customers.

The largest banks’ need to preserve capital will be intensified because of rules requiring them to revalue assets as they become riskier as well as decreasing their capital from unrealized securities losses. With respect to liquidity requirements, even if banks believed that regulators wanted them to drop below mandated levels, they will not want to lend because dipping below specified liquidity requirements would signal financial vulnerability to clients, investors and industry analysts.

If banks reduce their lending, customers will have little prospect of finding other funding in a declining market. While certain nonbank financial institutions would be a potential source of credit in a downturn, their overall lending capacity would not be sufficient to cover the shortfall. Indeed, corporate America’s fear that credit will not be available in times of financial distress has led many larger companies to retain unprecedented levels of cash. While certain companies have the scale and cash flow to be their own bankers, small and medium-size businesses, and the less sophisticated, do not have this luxury.

Indifference to the need for liquidity in a crisis has reached such a state that some legislators have proposed further limiting the Federal Reserve’s emergency lending powers. In a financial crisis, only the Fed, as the lender of last resort, might stand between our economy and financial catastrophe. We must leave the Fed with the flexibility to provide liquidity in order to stop a financial panic. While moral hazard is a legitimate risk, limiting the Fed’s ability to enhance systemic safety is, as former Fed Chairman Ben Bernanke has said, like shutting down the fire department to encourage fire safety.

Given the rapid expansion of bank regulation and growing liquidity concerns, regulators need to revisit whether they have overshot the mark. They need to assess the costs of liquidity regulation and take into account the perspective of consumers, businesses and other stakeholders who will depend upon access to the banking system in a crisis. This reassessment should explore countercyclical liquidity and capital strategies that encourage banks to support their customers in a crisis.

It is five years since Dodd-Frank became law, and time for a fresh look at its impact. We need a holistic regulatory review of the cumulative effect of postcrisis capital, liquidity and trading rules on the availability of credit and liquidity. Any review needs to be transparent, coordinated domestically and internationally and proactively engage a broad base of regulators, industry leaders, economists and consumers.

No one is looking to jettison the benefits of stronger capital and liquidity requirements. We just need to be careful that we don’t create bankers who, in words attributed to Mark Twain, take their lent umbrella back the minute it begins to rain.

Mr. Schwarzman is chairman, CEO and co-founder of Blackstone.

Where Did All the Construction Workers Go?

By Jeffrey Sparshott

Jun 9, 2015, 3:25 pm ET

Construction workers erect scaffolding on a new high-rise building in April 2006 in Alexandria, Va., the month employment peaked for the industry. PAUL J. RICHARDS/AFP/GETTY IMAGES

There should be plenty of workers in hard-hats looking for jobs.

From April 2006 through January 2011, nearly 2.3 million construction jobs–more than 40%–were wiped out. As of last month, the sector was still more than 1.3 million jobs shy of its bubble-era peak.

But if workers are out there, builders can’t seem to find them.

“It is just more and more difficult to get talent,” said Clay Gordon, vice president and chief development officer at Nabholz Construction.

The Arkansas-based construction and building services company has responded by offering incentives to workers who recruit other employees, improving benefits like paid time off and reducing health-care premiums. Elsewhere, there are signs wage gains are accelerating as companies compete for workers.

But that leaves one big question unanswered: Where did everyone go?
“We’d like to know that, too. We sure know a lot left,” said Ken Simonson, chief economist at the Associated General Contractors of America, a trade group.

The group’s survey last year found that 83% of construction firms reported trouble filling craft-worker positions such as carpenter, laborer and equipment operator.

Mr. Simonson notes that the industry bust started before the recession and lingered well after. The fall from peak employment in April 2006 to trough in January 2011 took 58 months. The recession spanned December 2007 through June 2009.

That lengthy stretch was simply too long for many workers to hold out and too deep to attract any new workers. Mr. Simonson guesses that many headed to the oil and gas industry—though the mining sector as a whole employs fewer than 900,000 people and didn’t add enough jobs to absorb construction’s losses— with others going back to school, to other industries, out of the country, into retirement or out of the workforce.

“The combination of having had this massive long exodus, a late pickup in hiring and now this greatly diminished pool of workers, that’s what has contractors scrambling,” Mr. Simonson said.
Home builders also lost track of a big chunk of their workforce, figuring they lost out to retirement and other industries.

“I think the older workers quit altogether,” said David Crowe, chief economist at the National Association of Home Builders. “Beyond that, I’ve heard anecdotally that many went to be truck drivers. We don’t have a good sense.”

The Census Bureau is in the process of releasing data on job-to-job flows—an in-depth look at how workers move between industries or out of the workforce—but it’s still in development.

Meanwhile, Mr. Crowe also has found his association’s members are concerned about labor shortages. “That means they are going to have to pay more, and that presents a profit squeeze,” Mr. Crowe said.

Otherwise, there aren’t any quick solutions.

“It’s going to take training. It’s going to take attracting younger, newer job entrants into the job field.

And it’s going to take higher compensation,” Mr. Crowe said.

June 9, 2015, 1:03 PM ET

Despite Turbulence, Currency Traders Stick With Strong-Dollar Thesis

ByJames Ramage

Bloomberg News
Traders aren’t thrilled with the choppiness in the currency markets these days.

But as long as the moves don’t pull them underwater on their positions, traders aren’t likely to abandon their expectations of a stronger dollar, said Richard Cochinos, head of Americas developed market currencies strategy at Citigroup Inc.

The dollar’s recent moves against rivals have been relatively large. The dollar rose 1.1% against the euro on Friday, as stronger jobs numbers persuaded investors that the Federal Reserve would be more likely to raise short-term interest rates as soon as its September policy meeting.

But on Monday, the euro soared 1.6% versus the dollar as investors reversed course and booked profits on the greenback’s gains.

The dollar made similar outsized moves against the yen over the two-day period.

Still, most investors believe that the Fed will raise interest rates before the end of the year, and well before the Bank of Japan and the European Central Bank do. Higher borrowing costs make the dollar more attractive, as they boost returns on assets denominated in the U.S. currency.

But analysts said U.S. economic data must improve before the Fed will be confident enough to raise rates and set the dollar on an upward track. The U.S. economy shrank 0.7% over the first three months of the year, and consumer demand has barely budged. Through April, data for inflation and wage growth have risen slowly, even as numbers for business investment, home sales and consumer confidence have made noticeable gains.

The uneven picture has shaken investors’ faith in a stronger U.S. economy and has prompted them to carve a rollercoaster path for the greenback since mid-March.

“We’re in broad range-bound markets. That dominates the psychology of day-to-day trading. There’s more forgiveness for drift in price action,” Mr. Cochinos said. Friday’s post-jobs bounce showed “the desire to buy dollars is there so long as U.S. data remain strong,” he said.

That means that even though traders are willing to stomach the turbulence, they’re also really hoping that May U.S. retail sales — to be released Thursday — add more meat to the strong-dollar story.

Why Employment Is Scaring The Fed

  • U.S. nonfarm payrolls are improving.
  • Meanwhile, core-components of the labor market, such as wages, are not keeping pace.
  • With the Fed unlikely to raise rates in 2015 due labor market slack, the dollar could weaken in coming months.
The lending rate in the U.S. should stay low as core-components of the labor market remain weak, weighing on the value of the dollar. The U.S. currency is represented by PowerShares DB US Dollar Index Bullish (NYSEARCA:UUP).

In May, the nonfarm payrolls figure came in at an annual pace of 2.14%, above the previous month's reading of 2.11%. While employment has remained stable the past few years, it has just recently begun to accelerate higher, seen below. The internals of the labor market, however, are presenting a picture of continued slack.

(click to enlarge)
Data provided by the Federal Reserve

The Job Openings and Labor Turnover Survey is a report that details more specific data within the monthly payroll release. A key statistic found within JOLTS is the hires to openings ratio.

When employers are significantly hiring, the indicator rises, signaling a strengthening labor market.

In May, the hires to openings figure came in at an annual pace of -11.04% contraction, down from the previous month's reading of -10.48%. The indicator peaked just before the financial crisis, and in recent months began to decline further, seen below. While more job openings are a positive sign, only filling those positions can help both consumer sentiment and spending measures.

(click to enlarge)
Data provided by the Federal Reserve

Additionally, like the hires to openings ratio, wages have fallen in recent months. In May, the wage figure came in at an annual pace of 2.11%, below the previous month's reading of 2.15%.

While wages were on a slight recovery in 2014, that has been derailed, seen below. Jeffrey Gundlach, popular fund manager of investment firm DoubleLine Capital, has said that he believes suppressed wage growth will force policymakers to wait until 2016 before raising the benchmark rate.
"The odds of a September interest rate hike 'weirdly' have risen, Gundlach said. 'I would take the under on that ... I think the odds of raising rates by December is less than 50 percent,' he added. 
Gundlach said he has been closely watching the year-on-year change in hourly earnings in non-farm payroll figures. 
If the year-on-year change exceeds 1.5 percent [inflation adjusted], Gundlach said he believes the chances for the Fed to raise rates increases," according to Reuters.

As slack remains in the labor force, policymakers are unlikely to tighten monetary conditions.

While headline payroll readings are improving, the composition of the labor market remains weak. More job openings are coming about, but are not being filled at a similar pace.

Moreover, wage pressures are slowing. With lending rates likely remaining low through 2015, the U.S. dollar could weaken in coming months.

(click to enlarge)
Data provided by the Federal Reserve