Nobody Thinks It Would Happen Again

Doug Nolan

WSJ: "Ten Years After the Bear Stearns Bailout, Nobody Thinks It Would Happen Again."
Myriad changes to the financial structure have seemingly safeguarded the financial system from another 2008-style crisis. The big Wall Street financial institutions are these days better capitalized than a decade ago. There are "living wills," along with various regulatory constraints that have limited the most egregious lending and leveraging mistakes that brought down Bear Stearns, Lehman and others. There are central bank swap lines and such, the type of financial structures that breed optimism.

March 17, 2008 - Financial Times (Gillian Tett): "In recent years, bankers have succumbed to the idea that the credit world was all about numbers and complex computer models. These days, however, this assumption looks ever more of a falsehood. For as anyone with a classical education knows, credit takes its root from the Latin word credere ("to trust") And as the current credit turmoil now mutates into ever-more virulent forms, it is faith - or, rather, the lack of it - that has turned a subprime squall into a what is arguably the worst financial ­crisis in seven decades. Make no mistake: what we are witnessing right now is not just a collapse of faith in one single institution (namely Bear Stearns) or even an asset class (those dodgy subprime mortgage bonds). Instead, it stems from a loss of trust in the whole style of modern finance, with all its complex slicing and dicing of risk into ever-more opaque forms. And this trend is not just damaging the credibility of banks, but the aura of omnipotence that has enveloped institutions such as the US Federal Reserve in recent years."

Gillian Tett was the preeminent journalist during the waning mortgage finance Bubble period. She was seemingly alone in illuminating the degree of excess in subprime Credit default swaps and structured finance more generally. By March 2008, she already recognized "the worst financial crisis in seven decades," while Wall Street was trapped in denial. Ms. Tett also appreciated the damage being done to Federal Reserve credibility. Yet no one could have anticipated the evolution of policy measures adopted by the Fed and global central bankers over the following decade. Credibility's New Lease on Life.

What I remember most vividly from the Bear Stearns episode was how well the markets took the spectacular collapse of a $400 billion Wall Street institution. After beginning 2008 at 1,468, the S&P500 closed at 1,277 on Monday, March 17. The index then rallied double-digits to 1,440 by May 19th. I recall about that time being informed that I needed to "get on with my life." Bear Stearns had been resolved. The Fed had it all under control. The crisis was over - before it even got started.

It was not over. I was convinced the overriding issue was Trillions of mispriced securities and derivatives throughout the markets - the enormous gap between perceptions and reality. Both the financial system and economy had grown dependent on rapid Credit growth. Moreover, mortgage lending had come to dominate overall system Credit, while debt growth was highly vulnerable to risk intermediation fragilities. Speculative leverage, also closely interlinked with risk intermediation, had evolved into a major source of marketplace liquidity.

Risk aversion had begun to significantly restrict access to Credit for the weakest borrowers, and home price declines had commenced in many locations. The financial system was highly levered in risky Credit, while the real economy was severely maladjusted from previous distortions in the flow of spending and investment. At the time, the Fed-orchestrated Bear Stearns bailout only reinforced the misperception that Washington could forestall financial dislocation. This ensured that the inevitable crisis of confidence would prove catastrophic.

I have long argued that a Bubble in junk bonds would not be perilous from a systemic standpoint. Only so many obviously risky bonds can be issued before the marketplace declares, "No more!" Functioning market mechanisms regulate the scope and duration of such booms, thereby limiting structural financial and economic maladjustment.

A boom funded by "money" is inherently problematic - and potentially disastrous. The insatiable demand for perceived safe and liquid stores of value creates the scope for prolonged systemic booms. So long as confidence is sustained in the underlying money-like financial instruments, ongoing monetary expansion (inflation) can continue to inflate securities and asset prices, spending, investment and economic output.

All the sophisticated mortgage finance Bubble-era Credit structures and risk intermediation distorted risk perceptions, spurring inordinate demand for Credit (and finance more generally). Underpinning all the lending, leveraging and speculation was the belief that Washington wouldn't tolerate a crisis in either mortgage finance or housing. Both the Fed and Wall Street had faith that monetary stimulus could resolve any hangover from a period of excess. This confidence was badly shaken by the crisis.

Importantly, however, 10-years of previously unimaginable stimulus measures - culminating in "whatever it takes" Trillions of (non-crisis) QE, negative rates and market manipulation - ensured that faith in central bank power reemerged stronger than ever. There is a critical lesson that went unlearned from the previous crisis episode: government and central bank-related risk distortions are fundamental to self-reinforcing Bubble inflation and resulting deep structural maladjustment.

One can age the mortgage finance Bubble period at about six years, commencing around governor Bernanke's 2002 "helicopter money" speeches and the Fed's focus on mortgage Credit as the expedient for (post-"tech" Bubble) systemic reflation. It would not, however, be unreasonable to date the Bubble genesis back to 1994/95, with the rapid expansion of GSE and Wall Street Credit.

We'll soon be approaching 10 years of what I back in 2009 labeled the "global government finance Bubble." Importantly, this Bubble originated at the heart of "money" and Credit only to metastasized into the risk markets. The abuse and impairment has been unprecedented. 
Government debt and central bank Credit were expanded with reckless abandon. Insatiable demand for "money" granted governments at home and abroad blank checkbooks. Central banks have monetized about $15 TN of government debt, flooding speculative global securities markets with excess liquidity. Securities values have inflated to unprecedented levels. The more Credit supplied the greater its price - and the price of virtually all assets.

Stocks rallied back (post-Bear Stearns bailout) in the spring of 2007, with players confident the Fed would backstop market liquidity. Despite widening cracks and mounting signs of looming crisis, markets were emboldened. I have argued that the collapse of two Bear Stearns structured Credit funds in the summer of 2007 was a key Bubble inflection point. I would argue further that market complacency surrounding the Bear Stearns corporate collapse ensured a catastrophic crisis of confidence. Faith in liquidity backstops and bailouts blinds the markets to risk and impedes the ability to self-adjust and correct.

"I would buy king Dollar and I would sell gold." Larry Kudlow, March 14, 2018

March 14 - Bloomberg (Jeanna Smialek and Alister Bull): "The Federal Reserve's independence and monetary-policy approach had a White House ally in Gary Cohn. His successor Larry Kudlow may be a different story. 'Just let it rip, for heaven's sake,' Kudlow said of economic growth in the U.S., during a more than hour-long interview Wednesday on CNBC. 'The market's going to take care of itself. The whole story's going to take care of itself. The Fed's going to do what it has to do, but I hope they don't overdo it.'"
The current backdrop beckons for humility. It has now been almost a decade of experimental massive expansions in both government debt and central bank Credit. The economy is strong, and the financial system appears robust. Through the prism of the 2008 crisis, the big financial institutions today have less risk and more capital. But that's not the appropriate prism. Government debt and central bank Credit have been this cycle's prevailing source of Bubble fuel. Securities market inflation has been a primary inflationary manifestation. For the most part, private-sector lending is not today's pressing issue.

I understand why Mr. Kudlow would say "buy king dollar" and "sell gold." Washington is on a trajectory of dollar devaluation, with massive twin deficits stoking the risk of a crisis of confidence in the dollar. A loss of faith in the U.S. currency would spur selling in U.S. financial assets, certainly including Treasuries and corporate Credit. Interest rates would spike higher, revealing the scope of speculative leverage that has accumulated over the past decade. And a crisis of confidence in financial assets would surely create a boon for gold and precious metals. Washington, of course, wants none of that. Inflate Credit while saluting king dollar.

Kudlow is seasoned, articulate and media savvy. He knows Washington, Wall Street and propaganda. "Just let it rip, for heaven's sake." Over the years I've felt Kudlow would say just about anything. At times I respect his analysis; too often over the years I've grouped him with the other charlatans.

He's an ideologue with an enticing message: "Just cut taxes." Kudlow is considered a "supply-side" free market proponent, but I've always viewed him more as an inflationist. A conservative that seemingly has absolutely no issue with loose "money;" never a Bubble he doesn't adore. And to say he was detached from reality during the critical late-stage of the mortgage finance Bubble is an understatement. He was blinded by his deep ideological biases. 
His sight remains distorted.

Wall Street takes comfort from the notion that Kudlow might be able to pull the President back somewhat from major tariffs and trade confrontations. He is certainly a master of touting the stock market. He, as well, seems the obvious perfect spokesman for "Phase 2" of the Trump tax cuts. Why not slash capital gains rates and make individual tax cuts permanent? Deficits don't matter. Lower taxes will spur growth and pay for themselves - with plenty to spare for infrastructure and a military buildup. There is no doubt about this; no open discussion or dialogue necessary.

We're now well into the high-risk phase of the boom cycle. The February blow-up of the "short vol" funds marked an inflection point, one I have compared to the collapse of Bear Stearns structured Credit funds in the summer of 2007. Ten-year Treasury yields have jumped 44 bps so far this year, and the dollar has been under pressure. The VIX, Treasury market and greenback have calmed down of late, which has supported an equity market recovery. Corporate Credit, however, has been notably less resilient.

March 15 - Bloomberg (Molly Smith, Brian Smith and Austin Weinstein): "For years, investors have gorged on corporate debt. Now they're showing signs of being full. Fewer orders are coming in for new bonds, relative to what's for sale. Companies that sell notes are paying more interest compared with their other debt, according to data compiled by Bloomberg, and once the securities start trading, prices by one measure have been falling about half the time. It's the latest signal that the investment-grade debt market is losing steam after years of torrid gains, as rising rates and talk of tariffs weigh on the outlook for corporate profit. 'Investors are starting to be a little more disciplined,' said Bob Summers, a portfolio manager at Neuberger Berman… 'They aren't just waving in every deal now." Money managers' restraint amounts to more pain for companies. The average yield on corporate bonds is around its highest levels since January 2012…"
March 15 - Reuters (Richard Leong): "A gauge of stress in the U.S. money markets grew to its highest level in more than six years on Thursday, bolstering the risk of further increase in the costs for banks and other companies to borrow dollars. The spread between the three-month dollar London interbank offered rate and three-month overnight indexed swap rate widened to 50.65 bps, a level not seen since January 2012. At the end of 2017, it was 27.83 bps."

And a Friday headline from Bloomberg: "Libor-OIS Spread Expands to Widest Level Since May 2009." LIBOR - a benchmark short-term interbank lending rate - is increasing (27 straight sessions) and rising more rapidly than the overnight indexed swap (OIS) rate (indicative of a risk-free borrowing rate). Essentially, short-term borrowing rates are rising while Credit risk premiums are increasing. Liquidity is becoming less abundant, and there are numerous explanations posited: The Fed is raising rates and reducing its balance sheet, massive T-bill issuance, tax cuts have incentivized U.S. multinational repatriation of funds (selling short-term instruments in the process) and less QE from the ECB.

I suspect this rate and spread development is not unrelated to the rising costs of hedging currency exposures. When markets are placid and leverage is expanding, liquidity remains abundant and cheap market hedges/protection readily available. But when markets turn more volatile and less predictable, sellers of risk protection turn more cautious. Hedging costs rise, a dynamic that reduces the attractiveness of underlying securities and derivative holdings, especially those held on leverage. In particular, the rising cost to hedge dollar exposures reduces the attractiveness of U.S. fixed income investment by foreign investors/speculators. Less demand for T-bills, overseas inter-bank dollar balances and dollar LIBOR contracts manifests into rising short-term rates and expanding spreads. As we've seen, bank funding costs begin to rise. On the margin, there is less impetus to embrace risk and leverage.

The big unknown is the scope of financial leverage and embedded leverage in derivatives markets that have accumulated over this long boom cycle. The dynamics of this Bubble contrast meaningfully from than the last. The big financial institutions are not sitting on huge holdings of potentially toxic securities and mortgage-related derivatives. Myriad risks these days are more complex and concealed - and, importantly, even more esoteric.

I would argue that the Bubble in government finance has distorted pricing and liquidity throughout the securities and derivatives markets. Securities markets have succumbed to systemic mispricing, a circumstance fostered by liquidity misperceptions and readily available market risk "insurance." The previous cycle's "Moneyness of Credit" evolved into central bank-induced "Moneyness of Risk Assets." And while virtually everyone takes comfort from the apparent soundness of financial institutions, crisis lurks in the tangled world of securities and derivatives markets liquidity.

About a decade ago, runs on Bear Stearns and then Lehman fomented the '08 market crisis. I suspect the next U.S. crisis will unfold with "runs" on stocks and corporate Credit. We've already witnessed how quickly the VIX and equities derivatives markets can dislocate. I'm curious to see how interest-rate and Credit derivatives perform in a backdrop of faltering equities, illiquidity and derivatives market stress. And considering the direction of policymaking in Washington, don't be all too surprised by an unexpected bout of market tumult for Treasuries and the dollar.

Larry Kudlow's "king dollar" and "let it rip" might play well domestically, surely in the oval office. But I suspect it's not confidence inspiring to our lowly foreign creditors. We're at the stage of the cycle that would seem to beckon for caution, contemplation and prudence. How much trouble could Team Trump and Kudlow provoke? There's ample arrogance and ideology to risk plenty.

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