Federal Reserve has encouraged moral hazard on a grand scale

Chair Powell has gone from preaching about credit risks to buying junk bond funds

Jonathan Tepper


We have never seen countrywide lockdowns to prevent the spread of a virus. It is right that governments compensate citizens for quarantines that prevent them from working and central banks prevent a short-term liquidity crisis from becoming a crisis of solvency.

But the response must not be a cover to bail out bust borrowers and out-of-pocket speculators.

Yet last week we witnessed unprecedented moves by the US Federal Reserve to buy low-rated bonds and even exchange traded funds of junk debt.

Markets reacted with glee at being rescued yet again. One strategist on Wall Street even called it a “gift from the Easter bunny”.

Former Treasury secretary Timothy Geithner once described Walter Bagehot’s Lombard Street as “the bible of central banking.”

According to that 1873 book, central bankers are supposed to avert panic by lending early and without limit to solvent companies, against good collateral, and at a penalty rate.

However, when it came to the crunch in 2008 Mr Geithner consciously disregarded that sacred text. He and then Fed chairman Ben Bernanke lent freely to possibly insolvent groups at zero rates. Those actions encouraged moral hazard on a grand scale. Instead of promoting prudence, central bankers since then have continuously spiked the punchbowl.
In a recent report, the IMF warned that central banks have increased financial fragility by encouraging companies to pursue “financial risk-taking” and gorging on debt. Rather than target lower debt levels, companies learned that they would be bailed out if they borrowed.
But with or without coronavirus, we would have seen a wave of bankruptcies. Corporate debt in the US has never been higher, at 47 per cent of gross domestic product. Globally, non-financial corporate debt has doubled since the last financial crisis.
Vast swaths of the economy are now inhabited by “zombie” companies, which have not generated enough cash over the past few years to cover their interest costs. Researchers at the Bank for International Settlements suggested that the proportion of zombie companies in more than a dozen advanced economies had risen from 4 per cent in the mid-1990s to more than 12 per cent by late 2018. Debt is used to finance more debt, and zombies lead to overcapacity and lower productivity.
After a decade of economic growth and generous tax relief, US companies should have held cash piles to sustain them for short periods without revenue. But most borrowed all they could and never saved for a rainy day.
Today credit spreads are increasing, indicating a higher probability of default. However, the anomaly is not the current levels of stress but the unnatural calm that came before. Research by Variant Perception shows that, historically, companies with high levels of net debt compared with their cash flows have had higher costs of funding.

But this relationship broke down after the last crisis. It is only now, during the coronavirus crisis, that fundamentals are reasserting themselves and terrible companies are seeing their spreads widen.Coronavirus business update

The stance of Fed chair Jay Powell, a governor of the central bank since 2012, should not be a surprise. Four years ago he noted in a speech that “a long period of very low interest rates could lead to excessive risk-taking and, over time, to unsustainably high asset prices and credit growth.”

Many times he warned against suppressing volatility. Yet as soon as markets swooned in December 2018, he immediately reversed course. He has gone from preaching about the risks of credit growth to providing liquidity to junk bond ETFs.

Lending to potentially insolvent companies is bad enough, but buying corporate bonds and ETFs in the secondary market is of questionable legality under Section 13 of the Federal Reserve Act, which allows for lending against collateral in “exigent” circumstances. It also does nothing to help fund the economy, and merely helps the returns of investors who have already bought corporate bonds. It is a paradise for speculators.

The obvious beneficiaries of the junk bond-buying programme are overleveraged private equity groups and unhealthy borrowers. This is not surprising. Mr Powell spent years at Carlyle, the private equity giant.

After the last financial crisis, Mr Geithner, too, moved through the revolving door to the position of president at Warburg Pincus, another private equity firm.

Investors and chief executives are learning that no matter how imprudent their borrowing in the good times, when the bad times inevitably arrive, they will be thrown a lifeline.

The writer is chief investment officer at Prevatt Capital and founder of Variant Perception, a research firm

What Happens When The Pandemic Ends?

by John Rubino

US government debt pandemic

Let’s assume that by the end of this year a combination of social distancing and some new and effective treatments convert covid-19 from existential threat to chronic nuisance and the economy starts to assume an air of normalcy.

Which is to say that people go back to traveling and eating out and buying Chinese-made things they don’t need with money they don’t have.

Are we really home free? Or will some other, even bigger black swan come in for a landing?

To put this question into context, it helps to look at how the world got here. In extremely brief form:

We engineered a tech stock bubble in the 1990s that burst in 2000, requiring drastically lower interest rates and truly insane speculation in housing to rescue the big banks.

When that bubble burst in 2008, interest rates had to fall even further and even more debt – ranging from government to student to subprime auto (and, yes, mortgage) — had to be taken on to save Wall Street. Hence the term “everything bubble.”

Then came the pandemic, which burst the everything bubble and has convinced the world’s governments that truly astounding amounts of new debt are required to bail out all the parts of the private sector that have more-or-less ceased to exist.

Here, for instance, is the Fed’s balance sheet, which is a proxy for the amount of new currency the central bank has created out of thin air and dumped into the economy.

The blue line is GDP growth and the red line is Fed currency creation.

Note that more and more currency has to be created to maintain the same anemic growth trend:

Fed balance sheet pandemic
And here’s the federal government’s debt. Note the same situation as with the Fed: ever-greater borrowing is necessary to maintain a diminishing rate of growth.

Now back to the original question: What happens when the pandemic is over and we try to resurrect something like normal life?

The answer is that we run head-on into the one crisis that was completely foreseeable, which is demographics.

Unlike housing busts and pandemics, the number of retirees who will need ever-higher government benefits is right there in pretty much every study of US population trends.

The number of people over 65 (and therefore eligible for generous Medicare and Social Security benefits) will surge from about 35 million today to over 80 million by 2050.

The possibility of us ever being able to scale back our borrowing is thus zero.

US retirement age population pandemic

Looked at this way, the financial side of today’s crisis is actually the new normal.

No matter if or when movie theaters, restaurants, and cruise ships fill up again, debt will continue to soar because reining it in is politically impossible.

With the government having lost fiscal tightening as a financial management tool, all the pressure will be shifted to currencies, which historically speaking are a very weak reed. Google “list of hyperinflations” … actually, don’t bother, here’s the list that pops up:

list of hyperinflations pandemic

These countries did pretty much what we’re doing, which is to say they responded to crises of one kind or another by running the monetary printing presses.

In each case their currencies collapsed due to oversupply and/or loss of faith in government.

The difference between this and those previous hyperinflations is that the latter were isolated crises in a sound-money world.

Today everyone is doing it, which means the coming crisis will be global, and therefore just as devastating as any pandemic.

The Myth of the Middle East Regional Powers

By: Hilal Khashan

In an April 10 teleconference meeting among Turkey, Azerbaijan, Kazakhstan and Kyrgyzstan, Turkish President Recep Tayyip Erdogan predicted the emergence of a new world order in the aftermath of the coronavirus pandemic.

However, the events that have left the world mostly unprepared to deal with the virus do not support Erdogan’s prediction.

Some indicators suggest that a post-coronavirus world order will reflect post-World War I Europe, in which nation-states rose out of the ruins of empires.

Indeed, in the United States and Europe, nationalism appears to be growing.

But no matter how the world changes, the grouping of countries that Alfred Thayer Mahan first referred to as the Middle East in 1902 will likely continue to be defined by the power vacuum that has dominated the region since World War I.

After a history of several millennia of imperial rule, today’s Middle East state system was created by Western powers and Russia, and they continue to oversee it.

The coronavirus pandemic is in many ways revealing why this is the case.

Historical Rivalry in the Middle East

For more than three millennia, competing empires ruled the region now known as the Middle East.

The Battle of Kadesh in 1274 B.C., which took place in modern-day Syria between Pharaonic Egypt and the Hittites of the Anatolian highlands, brought stability and affluence to the Nile River Valley.

In 605 B.C., Egypt lost its influence in the Near East after being defeated in the Battle of Carchemish, again in Syria (known as Babylonia in ancient Mesopotamia). The Byzantine-Sasanian War of 602-628 weakened both Byzantium and Persia, and not long after, Muslim armies from the Arabian Peninsula seized Greater Syria from the Byzantines between 634 and 638 and defeated the Persian army in Iraq in 636. They also brought Egypt under their full control by 646 after defeating the Byzantine army there. By 651 B.C., the Sasanian Empire had fallen to Arab-Muslim troops.

Fast forward to A.D. 1514, and the Ottoman Empire had gained dominance in much of the region.

The Ottomans defeated the Safavids in the Battle of Chaldiran in west Azerbaijan and kept them out of the Middle East, which the Ottomans conquered shortly afterward.

The Ottomans also clashed with the Qajars, who inherited the Safavids, before settling their territorial divisions in the treaties of Erzurum of 1823 and 1847.
The Ottoman Empire, 1683
(click to enlarge)

However, the 19th century brought the terminal decline of the Ottoman Empire, which Russian Tsar Nicholas I in 1853 named the “sick man of Europe.”

In Egypt, Muhammad Ali created a modern state with French assistance, and in 1831, his son Ibrahim Pasha invaded Syria and defeated the Ottoman army in the 1832 Battle of Konya. In 1839, the Ottomans attempted to retake Syria, but Ibrahim Pasha defeated them in the Battle of Nezib.

However, at this point, the British and Austrians intervened to prevent the collapse of the Ottoman Empire — at least until they could decide how to partition it. They forced Egypt to abandon its claim to Syria in the 1840 Convention of Alexandria.

The convention also coerced Egypt to slash its army, terminate its military industry and relinquish its territorial expansionism.

The Qajar Empire did not fare better than its Ottoman rival in the 19th century, and it lost sizable territory to Tsarist Russia in the 1826-28 Russo-Persian War.

By the mid-1800s, the United Kingdom and Russia had begun to truly dominate the politics of the Middle East.

Western Intrusion and New Regional Arrangement

The time for Europe to fully dismantle the remnants of the Ottoman Empire arrived in 1915 when the Ottomans aligned with Germany and the Austro-Hungarian Empire in World War I.

In 1916, the French and British reached the Sykes-Picot Agreement to seize Iraq and Syria.

A year later, the British government issued the Balfour Declaration, which promised to create a Jewish homeland in Palestine.

The United Kingdom granted Egypt, which it had occupied in 1882, its independence in 1922 and gave Iraq its independence in 1932, but it maintained military and political dominance over them.

In 1943, the United Kingdom also pressured the government of Free France to grant independence to Syria and Lebanon.

After the state of Israel was established in 1948, it reached armistice treaties with its Arab neighbors in 1949. And in 1950, U.S., British and French foreign ministers reached a Tripartite Agreement for the Middle East in which they committed to maintaining the region’s existing state order and military balance.

Notably, they understood military balance as meaning Israel’s ability to defeat the combined Arab armies. In 1955, Egypt signed a deal with Czechoslovakia to obtain modern military hardware, and from then until June 1967, Egypt worked to build itself up as a major regional power, despite a military defeat in the 1956 Suez War.

Meanwhile, in the Six-Day War of 1967, Israel demonstrated powerfully that it had no Arab military competitor. However, Israel’s title as a regional power is fairly erroneous; it is less a regional power than a Spartan state that aggressively and mercilessly defends its national interests. Its peace with Egypt and Jordan is cold and hardly goes beyond security arrangements and intelligence cooperation.

And its clandestine diplomatic ties, especially with the countries of the Gulf Cooperation Council, do not qualify it to claim a leadership position or political superiority.

The Syrian Uprising Debunks the Myth of National Regional Powers

The Iranian Revolution of 1979 introduced Iran as a new Middle East regional power — especially after it involved itself in the Arab-Israeli conflict by establishing Hezbollah and sponsoring Hamas and the Palestinian Islamic Jihad.

The U.S. invasion of Iraq in 2003 gave strength to Tehran’s claim as regional power.

But Iranian leaders neglected to understand the implications of eliminating Iraq, which had defeated them in the 1980-88 war, as a regional competitor. (Iraqi President Saddam Hussein had miscalculated when he thought his victory against Iran entitled him to make Iraq a dominant military power in the Middle East. He developed ambitious nuclear and missile programs during the war years with Iran and expected to get away with them. The Iranians are now doing the same.)
In 2012, Iran prodded the Syrian regime to militarize the country’s uprising and transform it into a war against radical Islam, which threatened to derail Iran’s Shiite Crescent project through Iraq, Syria and Lebanon — an essential part of Iran’s strategy to secure prominent regional power status.

But by 2015, despite massive Iranian military support, the Syrian government and its many Iranian-funded Shiite allies had failed to defeat the rebels.

Russia’s active military intervention in the Syrian armed conflict beginning in September 2015 tipped the balance of power in favor of President Bashar Assad’s regime. Moscow had emerged as the decisive military and political player in the Syrian conflict, dwarfing the influence of regional players Iran and Turkey.

A few years later, Iran’s weak military response to the January 2020 U.S. killing of Qassem Soleimani, the chief of the al-Quds Brigade of the Islamic Revolutionary Guard Corps, further demonstrated the fragility of Iran’s claim to the title of regional power.

It is not an exaggeration to assert that, as a result of its direct military intervention in Syria, Russia — more than Iran, Turkey or Egypt — has become the dominant regional power in the Middle East. In February 2020, Erdogan failed to drive the Syrian army out of Idlib in northwest Syria after warning that no heads “will remain on their shoulders” if the Syrian troops did not comply with his ultimatum.

The Turkish president bit the bullet after making the statement and ended up alienating himself from the United States. Erdogan is aware that there are limitations to Turkey’s regional power ambitions in the Middle East, and he does not trust Russian President Vladimir Putin, especially since Turkey has no institutional relationship with Russia.

Erdogan chose to pursue a more pragmatic policy line in the Western Balkans. In October 2017, he visited Serbia and received a warm welcome from President Aleksander Vucic, who seemed quite willing to open up to Turkey and forget the bitter memory of the 1389 Battle of Kosovo, which resulted in an Ottoman victory and later served as the spark that ignited Serbian nationalism.

Erdogan’s venture into the European Union’s backyard has already drawn sharp criticism from French President Emmanuel Macron, who warned Turkey that the Western Balkans is off-limits.

The Coronavirus Pandemic and What’s Next

At various times in modern history, Turkey, Iran and Egypt have presented themselves as regional powers in the Middle East, but they are not strong enough nations to avoid the political and military influence of more powerful countries.

Even though the Egyptian economy is improving, the majority of Egyptians are getting poorer because economic expansion occurs mostly in the oil and gas sectors, which employ only a small percentage of Egypt’s labor force.

The coronavirus threatens to destroy Turkey’s emerging economy, which has only recently started to recover from the financial crisis of 2018. Meanwhile, the Iranian economy is shattered. The virus is wreaking havoc on the Middle East’s already flagging economies, and wild protests are likely to spread to the area’s core countries after the pandemic abates.

Coronavirus Cases in the Middle East, as of April 14
(click to enlarge)

The upheaval resulting from the virus has brutally exposed the structural weaknesses of the Middle East’s inherently rigid political systems, which have failed to address their unprecedented national emergencies, instead approaching the virus with denial, blame and misinformation.

Lack of transparency and suppression of medical reports about the extent of the spread characterized the initial response of the Turkish government. A reluctant Turkey waited until March 11 to report its first confirmed case of COVID-19 and even then declined to inform the public about its location.

Neither Turkey nor Iran has yet managed to flatten the curve of the virus’s exponential growth. (The fact that Turkey is having difficulty containing the virus did not seem to prevent Erdogan from airlifting medical aid to Italy, Spain and the Western Balkan countries.)

The Egyptian government, meanwhile, has taken an official stance of belittling the virus’s impact.

This approach has contributed to a nonchalant public attitude and has resulted in a country with no clue about the real extent of the virus’s (seemingly rapid) spread within it.

In Iran, President Hassan Rouhani has warned his people that they have to live with the virus for an extended period, and Supreme Leader Ali Khamenei did not hesitate to accuse the United States of launching biological warfare in his country.

Rouhani is reluctant to declare a national lockdown partially because, in addition to the devastating economic implications, it would commit the armed forces to the streets and give additional leverage to the conservative clerics who control them.

Authoritarianism, which is rampant in the Middle East, increases in times of societal crises such as natural disasters, economic collapse and wars. These crises further aggravate existing imbalances in civil-military relations and increase executive power at the expense of the legislature and civil society.

The coronavirus pandemic has redefined the meaning of power and introduced the quality of the public health sector as a key independent variable in assessing the strength of a country. (Military might, after all, has proved useless in fighting the virus.)

Rule by fear and excessive coercion are exacerbating authoritarian tendencies in the Middle East, and further alienating the people from the state. Public apathy and antipathy toward the ruling elite do not bode well for the future of the region.

The leading countries of the Middle East may hope that in the wake of the coronavirus pandemic, a new world order will allow one of them to become a true regional power.

But right now, their weaknesses, combined with the historical strengths of Western and Russian powers, suggest that much will remain the same. 

Banks Can Only Guess at Ultimate Virus Fallout

JPMorgan Chase and Wells Fargo have set aside billions of dollars to cope with the coronavirus fallout, but that may be far from enough

By Telis Demos

JPMorgan Chase Chief Financial Officer Jennifer Piepszak on Tuesday said more provisions are highly possible in the coming quarters. / Photo: JPMorgan 

Two of the largest U.S. banks have set aside billions of dollars to cover loan losses related to the new coronavirus crisis. Unfortunately, that may only be enough under a rosy scenario.

For the first quarter, JPMorgan Chase JPM -2.30%▲ added nearly $7 billion to its loss reserves, while Wells Fargo WFC -3.99%▲ put aside almost $3 billion. These are extraordinary amounts, especially against the placid credit markets of the past several years. But as the banks acknowledge, it may not be reflective of what is coming down the road in more dire scenarios. That could be particularly the case for risks to corporate borrowers.

At JPMorgan, the bulk of the new provisions were for credit-card loans, $3.8 billion out of the total $6.8 billion. That makes sense, given the fact that cards are unsecured by collateral, and with the unemployment rate—a primary driver of card losses—feared to jump to 10%, if not double that, in the coming months, according to JPMorgan’s economists. Including other adjustments related to new accounting rules, overall allowances for loan losses now represent 9.7% of retained credit-card loans, up from 3.4% at the end of last year.

JPMorgan also put aside an additional $2.4 billion for wholesale loans gone bad for the first quarter. But as a proportion of total loans, the allowance ratio moved in the opposite direction. Allowances for loan losses as a percentage of retained wholesale loans are now 0.87%, down from 1.02% at the end of last year. That is partly a result of the new loan-accounting standards, as well as the fact that corporate lending had an extraordinary growth surge in the first quarter.

But it also is a reminder that the risks to companies are more complex and may take longer to play out. In the first quarter, corporations made a historic grab for liquidity, which has for now put many on sounder footing.

Companies drew down on some $50 billion on credit lines at JPMorgan, and some at-risk companies were approved for $25 billion in new credit. JPMorgan also led a quarterly record amount of investment-grade corporate-debt issuance.

Overall commercial and industrial lending grew 23% from year-end. By contrast, consumers actually borrowed nearly 10% less on their cards at JPMorgan over that time.

Both banks called out the oil-and-gas industry in particular as driving higher provisioning in the quarter. This sector is in trouble almost regardless of what happens with the pandemic and social distancing, given where the price of oil is expected to be.

But the ultimate potential effects on airlines, hotels, retailers, commercial real estate and so forth are much more in flux. Ratings downgrades on wide swaths of borrowers picked up pace only late in the quarter, pushing much of the possible pain into the next quarter.

On Tuesday, JPMorgan Chief Financial Officer Jennifer Piepszak repeatedly emphasized that the outlook is uncertain and that more provisions are highly possible in the coming quarters. Much will depend on the success of various government programs intended to keep consumers and small and large businesses afloat, she said.

“Everything is incredibly fluid,” she said. “We really need to learn a lot about the ultimate impact of these programs because they are extraordinary and should have an extraordinary impact.”

Similarly, Wells Fargo said the extent of losses would depend largely on the effectiveness of the government’s stimulus measures for both consumers and businesses.

JPMorgan said in its most extremely adverse scenario for how coronavirus plays out, credit costs could hit $45 billion in total this year, just shy of the $47 billion increase following the 2008 financial crisis. A sharper recovery could mean things stop well short of that point.

But an extended major downturn would mean the provisions taken by banks so far are only the beginning.