Yellow Flag Jobs Data

By John Mauldin

As I file this letter Friday morning, people are reacting to the July jobs report.

My own reaction: The headline report is absurd. I will explain further at the end of this letter. But first, I have another topic.

Regular readers know I worry about debt, mainly that the world has too much of it.
But it’s a little more nuanced. Whether debt is excessive depends largely on what it buys.

Debt is problematic when it underwrites unnecessary consumption. Going on vacation, for instance, is generally a bad idea if it saddles you with years of credit card payments. But debt helps when used to finance productive assets. This kind of debt should, if all goes well, generate enough new wealth to pay for itself and more.

In fact, the economy needs the second kind of debt to grow. Access to credit helps entrepreneurs start businesses that create jobs and offer innovative products. The challenge is to keep it under control. Lenders and borrowers both get overextended in good times and then overcompensate. The resulting cycle is one reason we have recessions.

And that’s where we are now: in a deep recession, and facing a depression.

We’ve already seen the savings rate climb to historic highs (with help from government stimulus). Now the second part is here as economically-critical credit begins drying up, sometimes even for stable, well-capitalized borrowers.

We don’t want banks getting into trouble that would require public bailouts.

But lower access to capital is a growing problem that will extend our economic agony, above and beyond the coronavirus and everything else.

Loss Exposure

Loan delinquencies and defaults rise when the economy weakens. That’s obvious—so obvious that, in theory, it shouldn’t happen. Everyone knows good times don’t last forever. The rational course is to borrow only if you are confident in your ability to repay when normal events (like recessions) happen.

That applies to lenders, too, and maybe even more so. They are in the business of taking credit risk. That’s why they can charge more than the risk-free interest rate. Their loan books should be prudently diversified and every borrower subject to strict credit analysis. Interest rates should be high enough to keep the lender stable even when normal events (like recessions) occur.

Last month’s bank earnings reports revealed the big lenders are sharply raising their loan-loss reserves. It is also happening in smaller Banks.

Source: The Wall Street Journal

These numbers still seem low to me, so I expect them to grow.
Nevertheless, they are already trickling through the economy at a noticeable pace.

Anecdote: I have a business associate (who asked not to be named) who has excellent credit. He monitors his FICO score and it’s always north of 800. He has several high-limit credit cards he rarely uses. In the last month, seemingly out of nowhere, three card issuers cut his limit to a paltry few thousand dollars.
That’s no loss to my friend, who wasn’t going to use the cards anyway. But what made the banks do this? It makes perfect sense from their perspective.

What the customer sees as “available credit” the bank sees as “loss exposure.” At any moment, my friend could have spent to his limit and then stopped making payments, maybe even going bankrupt and leaving the bank in a bad spot.
The bank normally accepts that possibility because it sees potential revenue, too. But now the risk outweighs the benefit so better to eliminate the possibility.

Actually, it makes sense. My friend is a lousy “customer.” Even though his credit is over-the-top, he is not making the bank any money. Without knowing, I can guarantee you the cards in question have low or no fees. Yet the bank has to reserve cash in case he decides to use them. Their actual reserves are being challenged, so he is an easy target.

I, on the other hand, don’t have his pristine credit. But I only have a few credit cards, which I used to charge everything possible, and then pay them off every month. It feeds my secret fetish: airline miles. So far, bank algorithms see me as a good customer who generates fees, and have not cut my credit line.

But he illustrates a point. If even highly rated, stable borrowers are seeing their limits cut, imagine what is happening to marginal borrowers.

We don’t have to imagine. We have actual data from the Federal Reserve’s quarterly Senior Loan Officer Opinion Survey.

US banks, and particularly the US branches of foreign banks, are tightening credit in most categories. It’s worse for small firms.

In fact, banks are tightening business loan standards at the fastest pace since 2008.

Source: Rosenberg Research

The Fed survey also found lower demand for all kinds of lending except residential real estate. I don’t know of any other business where it makes sense to raise the price of your product as demand for it drops.
That banks are doing so speaks to how nervous they must be. Worse, it’s happening despite massive Federal Reserve efforts to encourage and subsidize bank lending.

Stiff Drink Time

Whether it’s a bond or a bank loan, recovery potential is part of credit analysis. Defaults usually aren’t a 100% loss. What can we expect to get back if the borrower can’t repay? If you have collateral worth, say, 70% of the loan value, then you are taking less risk as the lender and can loan more freely.

Even better is to have the federal government standing behind a portion of the loan. That’s how Small Business Administration loans work. The SBA typically guarantees 50% to 85% of a loan amount, which lets banks offer more flexible terms than many small business owners could get on their own.

Keep in mind, many small businesses are struggling now but not all. Some have new opportunities in this environment. With capital, they could expand and maybe create jobs for the millions who need them. But they need the capital first.

Last week I read and reposted a Twitter thread (you should follow me, by the way) by someone describing himself as a consultant who helps franchisees get loans, often via SBA guarantees. I asked him to contact me and was able to verify his identity, though I can’t reveal it here. He described a terribly frustrating credit environment in his space. Below is a portion of his thread. (You can read the full version here.)

The banks I work with are SBA, conventional lenders who service smaller loans under 2mm and generally smaller operators of these franchise systems, and then larger banks who provide loans to larger operators from 2-50mm. I’m short—20+ banks across ALL spectrum of SME lending.

I fund 400-500mm in loans per year through these banks. In February we were on pace to fund well over 500mm and potentially 750mm — growing exponentially year over year. STIFF DRINK TIME. Since April 1st we have funded 5mm total through only 2 banks. Let’s dive in as to why.

SBA banks—they have lending limits to 5mm. Congress has authorized them to go to 10mm in the CARES Act but they have ignored it. This will become important later. They currently have guarantees from the govt at 80%—pretty good right? DOESNT MATTER THEY STILL WON’T LEND.

In fact, they are pushing the government to guarantee 90% of the loans (and likely on their way to 100%—see my prior posts on the de facto nationalization of the banking system). In short SBA has SHUT OFF BORROWERS waiting for more from Uncle Sam.

Current excuses ARE PLAYING BOTH SIDES (and this applies to all banking segments). A chain with increased sales since pandemic—no loan. “We want to wait to see if sales increases are sustainable.” Doesn’t matter that sales are up. They may not be “sustainable.”

On the other side for businesses with sales down—“well we just aren’t comfortable sales will rebound and we have concerns over COVID.” So, sales up = no loan. Sales down or flat = no loan. Operator size IRRELEVANT. Are some banks lending? Yes. This is 75–80% of SBA banks.

They are also being EXTREMELY selective on industries they will do. If you are an industry with “large public gatherings” you better pray to Santa Claus for money.

So, businesses with solid revenue still can’t get capital even when the government will guarantee 80% of the risk. Economic recovery will be very hard if this persists. All those loans not being made represent business activity that won’t happen, buildings not constructed, jobs not created.

It doesn’t mean the situation is hopeless. But it probably means we will be stumbling through this morass even longer.

Crowding Out

While others reach for credit, one borrower is having no trouble at all.

People are clamoring to lend even more money to the US Treasury, which is why yields are so low. Adjusted for inflation, they are paying to lend money to the government. Enormous amounts of it, too.

In the April-June quarter, Treasury borrowed $2.753 trillion in marketable debt. This week officials estimated they will issue another $947 billion in Q3 and $1.2 trillion in Q4. Q1 was $477 billion. So, for this calendar year, Treasury will have borrowed almost $5.4 trillion. Or maybe I should say “at least” since there is a very good chance these estimates will prove low.

Everyone (including me) expects Congress to pass another “stimulus” package. My best guess is it will be between $1.5 to $2 trillion. The bulk of that will be spent in 2020.

That means US federal debt will be $29 trillion and perhaps $30 trillion as we ring in the new year, or shortly thereafter. Not to mention $3 trillion in state and local debt.

It gets worse. From my friend Mark Grant (quoting Bloomberg):

Money managers just can’t get enough corporate bonds as the Federal Reserve supports the securities, and that demand is igniting the markets for issuing and trading company debt.

When Activision Blizzard, Inc. sold $1.25 billion of notes on Wednesday, the video game maker got orders for almost 10 times as many bonds. When Alphabet Inc., Google’s parent, sold $10 billion of debt securities on Monday, it garnered nearly four times as many orders. Last year that ratio averaged closer to three times. Junk bond issuance this week is at its fastest clip since mid-June.

Just last week, many dealers thought that companies were going to cut back on selling high-grade bonds, after most corporations had raised the money they needed to tide them over for the rest of the year. They expected as little as $50 billion of issuance in August, after volumes in July were down about a third from the year before.

Now the forecasts for August are increasing to as much as $75 billion, on the theory that companies might borrow more to lock in ultra-cheap borrowing costs. Yields in the $6.8 trillion high-grade bond market averaged just 1.83% on Wednesday, according to Bloomberg Barclays index data.

The Federal Reserve has basically said we are going to backstop high-grade corporate debt while doing little for small business. At least that is how lenders perceive the Fed’s action.

That’s the problem. Small businesses are the US economy’s engine and we’re starving them for fuel. People like me who worry about government debt often talk of a “crowding out” effect in which high governmental credit demand sucks limited capital away from smaller private-sector loans. Is that what’s happening now? Maybe. In theory, lenders seek the best risk-adjusted returns. They will risk loaning to unstable borrowers if they can set rates high enough. The high-yield bond market is one such segment.

So what counts is not so much the level of rates, but the spread between what a lender can make in Treasury paper vs. lending to businesses and individuals. It must be enough to match lenders who are willing to take more risk with borrowers who can pay higher rates. But other things count, too. Loan covenants, collateral, assorted other arcane details.

When Treasury yields are below zero in real terms, it shouldn’t be hard for a lender to sharply increase their income by making loans to reasonably stable borrowers at 5%, or to riskier ones at 10%. Yet it appears they aren’t eager to do that. Why?

I suspect it is because this is no ordinary recession. Its outcome doesn’t depend on normal economic forces or cycles we have seen unfold before. The economic weakness comes from a virus we can’t presently control whose presence stifles economic activity. The recession can’t end until something changes. There are three possibilities.

  • A working vaccine, deployed on a large scale worldwide,

  • Effective treatments that sharply reduce hospitalization and fatality rates, or

  • A large part of the population having been infected and survived with immunity.

When will any of those happen? We all hope it’s soon but we can’t know. This uncertainty renders normal credit analysis impossible. The restaurant industry will take years to recover. Ditto for travel and hospitality. If you’re a loan officer, lending to a restaurant or hotel right now is a pure gamble. Banks aren’t (and shouldn’t be) gamblers.

But this means the businesses which are the actual engine of growth for the economy can’t get credit. Scarce credit means scarce capital investment, and therefore little growth, if any.

Remember when we complained about GDP growing “only” 1% a year? Or, as some called it, secular stagnation? We may long for those days. They were better than we knew at the time.

The Absurd, Totally Misleading Unemployment Report

I cannot end this letter without commenting on the sheer insanity that passes for the headline unemployment report this morning. Here’s the lead.

In July, the unemployment rate declined by 0.9 percentage point to 10.2 percent, and the number of unemployed persons fell by 1.4 million to 16.3 million.

This number will be breathlessly reported in all the media but let’s look at reality on the ground.

First, Mike Shedlock offers this chart from yesterday’s continued unemployment claims.

Source: MishTalk

It certainly shows improvement over last week but this doesn’t reflect those on federal unemployment programs (again, I assume they will continue in some way).

If you add those in, you get 31.3 million workers receiving some kind of unemployment benefit.

Source: MishTalk

That is roughly double the number of unemployed that BLS reports.

The US workforce is about 160 million people so 16 million unemployed gives you the 10% unemployment number. If 31.3 million are unemployed (assuming those receiving benefits are actually unemployed, a reasonable assumption) then the unemployment rate is 19.6%.

Then add an unquantifiable number of those who don’t qualify for unemployment insurance of any kind, as in those who worked “off the books” for cash or otherwise fell through the cracks. It’s a significant number. This brings you to an unemployment rate easily 20% or more.

The BLS isn’t hiding this unemployment. They have systems developed over decades to track unemployment, and the current crisis/recession doesn’t fit neatly into that system. They do, however, track several items called “Alternative Measures of Labor Underutilization.” One of those numbers is the U-6 category, which shows 16.5% unemployment.

Source: Bureau of Labor Statistics (Click to enlarge)

Let me leave you with a final and somewhat depressing thought. Private investment fell roughly equal to federal spending last quarter. As much as it pains me to say, even acknowledging some of the stimulus money was wasted, without it the US and therefore the world would be in a deep depression.

The numbers above show we are nowhere close to “recovery.” Whatever stimulus package comes out of DC will be smaller and hopefully better targeted. But it will be absolutely necessary to keep the economy from truly collapsing.

(Just writing that forces a deep and audible sigh from me. Never once in my life did I think I would write those words. And that they would be true.)

To talk about a V-shaped or any other shaped recovery based on past history is sheer absurdity. The future recovery, and there will be one, will be unlike anything we have ever experienced, including even our (great?) grandparents (and for some of us our parents) in the Great Depression. This is a completely different economic animal.

Perhaps by understanding it, we can figure out how to get out of it for everyone’s sake, as well as determine our own individual paths forward. It will be the Stumble-Through Economy indeed.

Puerto Rico, Montana, Missing Maine, and Changing Life Habits

Week after next I will meet Shane in Missoula, Montana. I will be flying from Puerto Rico and Shane will be coming from Oregon after attending a spiritual retreat. I will be “batching” it this next week. We will then spend five delightful days with old friend Darrell Cain and some of his family at his home on Flathead Lake. The closest thing I will have to a vacation, as opposed to my permanent staycation, this year.

For the last 14 years, the first Friday of August found me at Leen’s Lodge in Grand Lake Stream, Maine. I find that I am truly emotionally missing it. Sadly, it was a major economic stimulus for that area and is now just another financial dent in what are truly small, mostly family businesses.

I have noted before how I miss my gym. It is once again closed, and in the two weeks it was open I noticed a significant drop off in attendance. It became quite easy to social distance. Then I read this note this morning from Neil Howe:

As gym owners reopen their doors, their worst fears are coming true: People aren’t coming back. Recent polls show that Americans are in no hurry to return to fitness centers. Morning Consult tracks weekly comfort levels for different activities during the pandemic. On the week of July 13, only 20% of Americans felt comfortable going to the gym. One week later, that share dropped to 18%. A different poll from TD Ameritrade found that 59% of Americans don’t plan to renew their gym memberships even once the pandemic is over.

This will play out in multiple service industries. On the flip side, I can’t get simple weights and other home workout equipment anywhere. All sold out here. Amazon won’t deliver. The barbell business must be booming. Big equipment workout iron? Not so much. I expect a lot of used gym equipment will go on the market in a few months as one gym after another goes bankrupt. Ditto restaurant kitchen equipment, hotels, planes, etc.

I hate being a Gloomy Gus, because I actually see fabulous opportunities all around me. When the world gets repriced, opportunities appear even as some doors close. Our job is to find the open doors. And with that, you have a great week!

Your home alone for the week analyst,

John Mauldin
Co-Founder, Mauldin Economics

Putting the capital into capitalism

Banks lose out to capital markets when it comes to credit provision

That explains the Fed’s response to the latest economic crisis

In renaissance italy the first modern bankers realised that they could get away with keeping only some of the gold that was deposited with them on hand, and lending out the rest.

In most countries banks have dominated lending to households and firms ever since. America has long been different, though.

Yes, banks have played a big role in economic development: John Pierpont Morgan was the muscle behind the railways rolled out from coast to coast during the 1880s and a century later Citibank was helping America Inc expand abroad as globalisation took off.

But capital markets have played a mighty role, too.

Today that is truer than ever, which in turn helps explain the stunning scope of the Federal Reserve’s response to the latest economic crisis.

How banks are defined in America has changed over time. Between 1933 and 1999 commercial banks were legally required to be separated from investment banks, a quintet of which dominated America’s capital markets and were regulated differently.

But all these firms had elements in common.

They held only a fraction of their assets as reserves and they borrowed short-term to make long-term loans or hold long-term securities. That exposed them to runs.

Economic history is littered with the tombstones of banks that were felled when markets for illiquid securities seized up, or depositors rushed to withdraw their funds.

Most of these crises inflicted severe economic pain, not least the subprime fiasco of 2007-09.

After it the phrase “too big to fail” entered the modern lexicon—and the popular perception of leviathans pulling the strings of the world’s biggest economy took hold.

This portrait of utterly dominant and dangerous banks exaggerated their importance and today looks out of date. Banks have become safer—including the investment banks, most of which are now part of big banking conglomerates.

And they are being upstaged by a new wave of innovation in capital markets that has changed securitisation and debt issuance and led to more direct lending by other financial firms.

As a result banks’ corporate lending as a share of GDP, for example, has stagnated at about 12%, even as they have rebuilt their strength and America Inc has indulged in a borrowing boom (see chart 1).

Banks’ stagnation and their risk aversion has had consequences for how central banks respond to crises. In 2007-09 the Federal Reserve had to intervene in capital markets, but went to much greater lengths to prop up commercial and investment banks. Earlier this year, however, banks went relatively unscathed as capital markets seized up.

Rather than acting as a lender of last resort to banks, the Fed became marketmaker of last resort, intervening in credit markets with a total size of about $23.5trn. The scale of the Fed’s intervention surpasses any other in its history.

You can trace the gradual rise of America’s capital markets to the 1940s and 1950s, when the pots of money raised by financiers such as mutual-fund managers began to swell. The 1980s brought about a rush of debt issuance, especially of junk bonds, by companies. And there was a boom in household debt winding up in capital markets—and therefore in the hands of investors—via the new financial technology of securitisation, or bundling loans into bonds and selling them. Eventually securitisation helped cause the crash of 2007-09.

The crisis showed that banks remained at the centre of the financial system, acting as dealers and speculators. Subsequent rule changes have nudged them from the limelight. Legislation, including the Dodd-Frank Act in America in 2010, and national and international regulation, such as the Basel framework, have together required banks to fund themselves with more capital, and encouraged them to take less risk.

As a result, banks in America have nearly $2trn worth of core capital on their balance-sheets, almost double the amount they did in 2007. That is a meaty 12% of risk-adjusted assets. And crucially, banks’ assets are less troublesome.

The risk weight that supervisors attach to them—a measure of how racy the underlying loans and securities are—has dropped from 70% to less than 60% (these figures adjust for changes in the regulators’ definition of risk over that time).

Many of these rules have been aimed at taming the investment-banking activities that sit inside huge firms such as Bank of America and JPMorgan Chase. As all types of banks have faced tighter regulation, the last two big standalone investment banks, Goldman Sachs and Morgan Stanley, have evolved to look like banking conglomerates, too. Both have spread into sedate areas that attract more deposits, such as wealth management and retail banking.

Regulation has blunted banks’ competitive advantage. The fact that they were vertically integrated—they tended to issue loans, monitor and collect those loans, and hold the associated risk on their balance-sheets—once gave them an edge over investors and funds seeking to profit from just one slice of a transaction.

It made up for the fact that they were slow to embrace technology. But bankers now talk of their balance-sheets as a “scarce” resource.

As banks have grown risk-averse, non-banks, often tech-savvy, are stepping up. “When you regulate the banks and you leave the rest of the financial system more lightly regulated, there will be regulatory arbitrage,” says Richard Berner of New York University.

“But technology has also facilitated a shift because, particularly in the past decade, it has promoted the growth of payments and of bank-like activities outside the banking system.”

You can gauge this by looking at how the stock of lending by banks and non-banks has slowly changed. America has deleveraged since the financial crisis (see chart 2).

That was almost wholly driven by the decline in mortgage debt, held by both banks and non-banks. Corporate debt, though, has reached an all-time high, and the bulk of activity has still been facilitated by shadow banks.

Of the stock of debt that companies have added since 2012, that lent by banks has increased by just 2 percentage points of GDP. The stock that the non-bank sector holds has risen by 6 percentage points.

Even though banks are now flush with capital and liquidity it is the capital markets that have financed the bulk of the increase in corporate debt.

A notable shift has taken place in the rest of the world, where capital markets have historically played a smaller role. Since the crisis these have expanded.

In 2007 global non-bank financial assets stood at $100trn, equivalent to 172% of GDP and 46% of total financial assets, according to the Financial Stability Board (FSB), a grouping of regulators.

Now these assets, at $183trn, constitute 212% of GDP, or 49% of the world’s financial assets.

What counts as a shadow bank?

In America banks are now easy to define: they take retail deposits and are regulated by the Fed. They can park cash in accounts with the central bank, and borrow directly from it in times of stress.

The term shadow banking, meanwhile, could apply to a range of financial institutions and activities. It includes long-established institutions like pension, insurance, private-equity and hedge funds, as well as newer ones, like exchange-traded fixed-income funds, which provide a vehicle for savers to deposit cash that is then invested in government and corporate bonds.

Separating the activities of the “real” banks from shadow firms is harder. Some non-banks, such as private-credit lending arms, make loans just as banks do.

And just as they did before the financial crisis, banks issue shadow instruments that are allocated in capital markets, such as mortgage-backed securities or bundled corporate loans.

Banks also lend to shadow banks. This has been one area where bank lending has grown relative to GDP, and it now makes up 5% of loan books.

What we do in the shadows

Untangling these complex interlinkages is tricky. But to get an idea of how the financial landscape is changing in America, simply look across the range of typical bank activities, from the bread-and-butter work of lending to households and firms, to advisory services and market-making.

Start with mortgages.

In 2007 almost 80% of mortgages were created by banks; a decade later, more than half were originated by non-banks. Big hitters include Quicken Loans, a Michigan-based online lender, and LoanDepot, a broker in California.

Both were early to online-only mortgage lending and have invested heavily in slick websites and responsive call centres. Quicken, which is preparing to list on the stockmarket, became the largest originator of home loans in America in 2018.

Lending to mid-sized firms is also drawing in new types of institutions. The shift is mirrored by trends in the private-equity (PE) industry over the past decade or so. 

PE used to fund its takeover bids using bank loans or junk bonds.

Most credit funds at pe shops were in their infancy before the 2007-09 crisis. Today at least a fifth of funds under management at five of the largest pe firms—Apollo, Ares, Blackstone, Carlyle and KKR—are invested in credit assets.

At Apollo some $221bn of the $260bn the firm has raised since 2010 is for credit investment.

The private-credit industry as a whole has amassed $812bn-worth of credit assets that it manages. To give a sense of scale, that is equivalent to 14% of outstanding corporate bonds.

Shadow banks are also muscling into businesses that used to be the sole preserve of the giant investment banks. That includes advisory services on mergers and acquisitions—where newish boutique firms like Evercore and Financial Technology Partners have blossomed alongside established names like Lazard—to even trading stocks and bonds.

Banks were once the dominant traders of equities and fixed income. But market structure has evolved, says Paul Hamill of Citadel Securities, a broker-dealer set up by Ken Griffin, founder of Citadel, a hedge fund.

The firm is one of the largest equity traders in America. (When Slack, a corporate-messaging service, went public last year it listed directly via Citadel Securities.) Jane Street Capital, another non-bank trading firm, has also found success intermediating equity markets.

Citadel Securities has expanded into trading fixed income too, in part thanks to regulations that pushed securities like interest-rate swaps onto central clearing platforms, making competition easier. Mr Hamill says there are a few big institutions that conduct full-scale Treasury trading; all are large banks, except for Citadel Securities.

The firm may apply to become a primary dealer—ie, an institution that can buy bonds from the government and trade directly with the Fed. This would make it the second non-bank to earn the privilege: Amherst Pierpont, a smaller broker-dealer, was designated a primary dealer in 2019.

That banks have a fight on their hands is clear.

They are less profitable in a world where they must hold low-yielding safe assets and carry huge safety buffers. According to Michael Spellacy of Accenture, a consultancy, banks earn half of the roughly $1trn in annual revenues that all global firms make by intermediating capital markets.

But of the $100bn in economic profits, which take into account the cost of capital and other expenses, they capture just 10%.

For borrowers and investors, the continuing clout of capital markets and the emergence of innovative new firms has meant more competition in the financial system. Prospective homebuyers can choose the lender that offers the best services. Mid-sized firms struggling to access bank loans can turn to a wealth of newly minted private-credit funds instead.

What does the shift mean for risk in the system?

The role that banks play in maturity transformation means that they are always exposed to runs, jeopardising the provision of credit to businesses and households. Whether the evolution of the financial system is risky depends on how bank-like shadow banking is.

The FSB has tried to identify the financial firms most susceptible to sudden, bank-like liquidity or solvency panics, and which pose a systemic risk to the economy. Pension funds and insurance firms are excluded as they match their long-term liabilities with long-term assets.

Worldwide the exercise identified $51trn (or 59% of GDP) in “narrow” shadow investments, almost three-quarters of which are held in instruments “with features that make them susceptible to runs”. This slice has grown rapidly, from $28trn in 2010 (or 42% of GDP).

At the end of 2018, America’s share of the risky bucket stood at $15.3trn. Its commercial banks, with assets of $15.6trn, were only just bigger.

The riskiest types of shadow banks, says the FSB, include fixed-income funds and money-market funds, which are large in America; companies that make loans and might be dependent on short-term funding, such as retail-mortgage or consumer-credit providers; broker-dealers, which trade securities; and entities that do securitisation-based credit intermediation, such as creating collateralised-loan obligations that bundle corporate loans which are then sold to investors.

Tellingly, it was many of these markets that seized up in March and April.

With a growing number of capital-markets functions and a great deal of credit-provision to firms sitting outside the banking system, policymakers have once again found their customary tools do not work as well as they might like. In the financial crisis, both banks and non-banks were caught up in the panic.

This time there has been no concern that banks might fail. Even in the worst case dreamt up by the Fed for this year’s stress tests, core capital ratios fell from an average of 12% across the 33 biggest banks in America to a still-chunky 9.9%.

Rather than acting as a lender of last resort to the banking system, therefore, the Fed has been forced to act as a marketmaker of last resort. The crisis of 2007-09 was an audition for this role, with some experimental interventions.

Now the Fed has intruded into a bewildering array of financial markets (see chart 4). It stepped in to calm the Treasury market, and to revive the corporate-bond market, which had ceased functioning, by promising to buy bonds.

It has provided funding to the repo market—where Treasuries are swapped overnight for cash—as it did in September 2019, when the market sputtered. It is providing liquidity to money-market mutual funds, which take cash from individuals and park it in very short-term investments like Treasury bills, in the hope that investors can be paid promptly when exiting such funds.

And it has bought up mortgage-backed securities—the ultimate output of retail-mortgage providers.

The cold light of day

The Fed was able to soothe investors through the power of its announcements; it has so far lent only $100bn through its schemes. But Stephen Cecchetti and Kermit Schoenholtz, two scholars, have calculated the scale of each of the implicit guarantees.

Adapting their figures, we estimate that the Fed has promised to lend, or to buy instruments, to the tune of more than $4trn in credit markets with a total outstanding value of $23.5trn.

That is backed by a $215bn guarantee from the Treasury, potentially exposing the Fed to losses.

The sheer breadth of the intervention takes the Fed into new territory.

As the Bank for International Settlements, a club of central bankers, noted in its recent annual report, the consequences of bailing out capital markets on such a scale could linger.

“The broad and forceful provision of liquidity has stemmed market dysfunction, but it has also shored up asset prices across a wide risk spectrum. This could affect the future market pricing of risk.”

Banks’ stagnation may be no bad thing: credit provision has grown more competitive, and is probably becoming less reliant on a handful of large risky institutions. But when banks malfunction, regulators at least know where to look.

When so much activity takes place in the shadows, they risk fumbling in the dark.

German Health Expert Karl Lauterbach

"The Authorities Should Focus Their Efforts on Super-Spreaders"

German parliamentarian and health expert Karl Lauterbach says Germany's coronavirus strategy must change. Instead of contact tracing, he demands that more attention be focused on super-spreaders.

Interview Conducted by Markus Feldenkirchen

Foto: Andreas Gora/ ddp images

DER SPIEGEL: Mr. Lauterbach, what is your greatest concern these days?

Lauterbach: The second wave.

DER SPIEGEL: Will we have one?

Lauterbach: It's already developing. We rode out the first one reasonably well. We would have done even better if we had continued the lockdown for another two to three weeks. Now, we are at the beginning of the second wave. To manage this one, we urgently need a change of strategy when it comes to battling the pandemic.

DER SPIEGEL: What could we do to prevent a sharp increase in the number of infections this fall?

Lauterbach: We can't afford another strict lockdown. That would be terrible. But we also have to assume that people won't be as disciplined - practicing social distancing or wearing masks – as they were during the first wave. As such, the health authorities and their strategies will be decisive.

DER SPIEGEL: Thus far, the authorities have been tracking all the contacts from new infections in order to break the chain. What's wrong with that strategy?

Lauterbach: This approach is totally inefficient; we're on the wrong track. Instead of contacting each individual contact by phone, the authorities should focus their efforts on so-called super-spreaders, those few highly contagious cases that often infect dozens of people in group situations. They alone are the driving force behind the pandemic. We now know that individual transmitters have almost no effect on the exponential growth. If we don't change course on this issue, the second wave will be intense.

DER SPIEGEL: Why is the strategy being followed thus far so inefficient?

Lauterbach: It is a huge amount of work that uses a massive number of personnel that has almost no effect. We are unsuccessfully trying to catch up with the pandemic. Patients are isolated at a time when they are hardly contagious any longer. By then, they have long since passed the virus on to others.

Those who fall ill typically go to the doctor on the second day of exhibiting symptoms. That is frequently the fourth day of the infection, since the first two days tend to be free of symptoms. By the time the test results come back from the laboratory, two more days pass, sometimes more.

On average, then, patients are isolated six to seven days after becoming infected. The quarantine comes too late to break the infection chain. The individual contacts that are then examined are no longer contagious by then. We have to become faster.


Lauterbach: I am in favor of adopting Japan's strategy, which has proven most effective in the fight against super-spreaders. The Japanese didn't impose a strict lockdown during the first wave, but they were roughly as successful as we were. That is exactly what we need for the second wave. The virologist Christian Drosten (one of Germany’s leading figures in the COVID-19 crisis) also sees this strategy as the correct course of action.

DER SPIEGEL: What would that mean for Germany's health authorities?

Lauterbach: When someone is tested, they must be systematically questioned with the help of a form whether they were present at a potential super-spreader in the preceding days -- a choir event, a wedding -- or if they are a teacher in a school.

If the test is positive, all other participants in the event must be immediately quarantined without delay, even before they are tested. That is the only way to prevent them from passing the virus along during the period in which they are contagious.

DER SPIEGEL: What if someone in a class at school becomes infected?

Lauterbach: Then all students in the class and their families must be quarantined for a week. That is the only way to prevent classrooms from becoming super-spreader sites. More than a week of quarantine, by the way, isn't necessary. Positive cases are hardly ever contagious for longer than that, even if they are still sick.

DER SPIEGEL: What would then happen with positive cases who haven’t attended group events?

Lauterbach: Health officials would no longer have to pursue their contacts because they are irrelevant for the development of the pandemic. Agencies and laboratories would then have sufficient capacities to concentrate on the super-spreaders. What we have done so far is a pure waste of resources. The strategy pursued thus far by health officials has also long since been scientifically invalidated. We are no longer keeping up with the research.

DER SPIEGEL: Would it be better to reimpose the ban on large groups?

Lauterbach: We need to do all we can to prevent large gatherings by imposing bans and severe penalties. Bundesliga football matches with spectators should not be allowed. People who go to parties and do not observe social distancing rules, such as at the large party recently in Berlin's Hasenheide park, must be penalized with fines in the hundreds of euros – fines that must actually be imposed.

DER SPIEGEL: What role do you believe the Robert Koch Institute (RKI) should play?

Lauterbach: It must become much more involved in the strategy for battling the second wave. The RKI has delegated too much to local health officials, who are overwhelmed by the work, though they are working extremely hard. We now need more than daily appeals from the RKI to maintain social distance and wear masks, as correct as such appeals may be. We need clear and helpful plans.

Karl Lauterbach, born in 1963, is a health expert with Germany's Social Democratic Party and has been a member of German parliament since 2005. Lauterbach is a medical doctor, having studied medicine in Aachen, Texas and Düsseldorf. He also studied epidemiology and health economics at Harvard University. From 1998 to 2005, he was director of Cologne University's Institute of Health Economics and Clinical Epidemiology.

Preventing a Global Education Disaster

The education losses resulting from the COVID-19 pandemic are invisible, but will leave millions of the world’s poorest children carrying the scars of diminished opportunity for the rest of their lives. The world can – and must – take immediate steps to mitigate the damage.

Kevin Watkins

watkins20_ JOSEPH EIDAFP via Getty Images_child in school

LONDON – “The beautiful thing about learning,” the great blues guitarist B.B. King once wrote, “is that no one can take it away from you.” Born and raised in poverty, King understood the value of education as a force for change. If only political leaders responding to the COVID-19 pandemic had an ounce of his insight.

COVID-19 is now mutating into a global education emergency. Millions of children, especially the poorest and young girls, stand to lose the learning opportunities that could transform their lives. Because education is so closely tied to future prosperity, job creation, and improved health, a setback on this scale would undermine countries’ progress, reinforcing already extreme inequalities. Yet this emergency has yet to register on the pandemic response agenda.

Lockdowns have shut more than one billion children out of school. For an estimated 500 million, that means receiving no education at all. A Save the Children survey in India found that two-thirds of children stopped all educational activity during lockdown. The danger now is that a perfect storm of lost schooling, increased child poverty, and deep budget cuts will lead to unprecedented reversals in education.

This is an emergency layered on a pre-existing crisis. Even before the pandemic, 258 million children were out of school, and progress toward universal education had stalled. Now, increased child poverty alone could result in ten million children not returning to school. Many of these children risk being forced into child labor or early marriage (in the case of adolescent girls). Meanwhile, already abysmal pre-pandemic learning levels, which left half of all children in developing countries unable to read a simple sentence by the end of primary school, are set to worsen.

Pathbreaking research on the impact of the 2005 earthquake in Kashmir, Pakistan captures the risk to learning. Schools were closed for three months. When they reopened, attendance quickly recovered. But four years later, children aged between three and 15 who lived closest to the fault line had lost the equivalent of 1.5 years of learning.

Imagining that outcome on a global scale gives a sense of what is at stake. Education empowers people, reduces poverty, and improves health, and the human capital that it generates shapes the destiny of countries. Lost education will erode that capital, effectively placing the 2030 Sustainable Development Goals beyond reach.

Governments should now be investing to prevent that outcome. Unfortunately, education budgets are being hollowed out by recession and the diversion of public spending – and international aid – to health care and economic recovery. As a result, governments in low- and middle-income countries could end up spending $77 billion less than planned on education over the next 18 months.

So, what can be done to avert disaster? In its new global Save Our Educationcampaign, Save the Children has set out a three-part agenda for recovery.

The first priority is to keep learning alive during lockdowns. Governments should do all they can to reach children through radio, TV, and remote-learning initiatives. Countries such as Ethiopia, Uganda, and Burkina Faso have developed ambitious national distance-learning programs. They and others need more donor support to implement them at scale.

Second, the pandemic creates an opportunity to address the wider learning crisis. Too many children are being taught at the wrong level, owing to schools’ rigid application of poorly designed curricula. Every child returning to school should undergo a learning assessment aimed at identifying those in need of support. Remedial teaching programs such as those pioneered by organizations like BRAC and Pratham can then prevent these children from falling further behind, thereby reducing the risk of future dropout.

Third, increased international financing is critical. Most of the world’s poorest countries, especially in Africa, entered the economic downturn with limited fiscal space. That room for maneuver is now shrinking further as recession bites and external-debt problems intensify.

Rich-country governments have responded to the COVID-19 crisis by tearing up their fiscal and monetary policy rulebooks and underwriting ambitious national recovery plans. They should be equally bold in supporting education in developing countries.

More effective leveraging of multilateral development bank balance sheets is an obvious starting place. The Education Commission has advocated establishing an International Finance Facility for Education to provide loan guarantees, thus enabling the World Bank and other institutions to borrow cheaply on international markets and lend the funds to developing countries. Every $1 of guarantees under this scheme could unlock $4 of financing for education. This approach, which would include rigorous debt-sustainability evaluations of recipient countries, could mobilize resources on a scale commensurate with the crisis. Aid donors and the World Bank should support it.

To its credit, the Bank is front-loading resources already allocated to the International Development Association, its concessional lending arm. But an unprecedented crisis surely demands more than that. The Bank should establish a supplementary IDA budget of at least $35 billion and step up its support for education.

Debt relief is another potential source of financing. The G20’s Debt Service Suspension Initiative for IDA members (the world’s 73 poorest countries) is a small step in the right direction. Unfortunately, private and Chinese creditors, which account for over half of these countries’ debt-service payments (about $25 billion this year) have shown scant interest in participating. As a result, countries like Cameroon, Ethiopia, and Ghana are currently spending two or three times more on debt service than they do on primary education.

In effect, countries are meeting short-term debt payments by eroding long-term human capital. Allowing the claims of private creditors to rob children of their right to an education is morally indefensible and economically ruinous. That is why Save the Children has proposed a mechanism through which debt obligations can be converted into investments in children.

We can measure the health impact of COVID-19 on adults by tracking infection rates and deaths, and we can gauge its economic effects in terms of lost GDP, higher unemployment, and rising public debt. The education emergency is less visible to policymakers. But it will leave millions of the world’s poorest children carrying the scars of diminished opportunity for the rest of their lives. We can – and must – protect their future.

Kevin Watkins is CEO of Save the Children UK.

Start-ups for silver surfers

The pandemic has forced more over-65s online quickly — and entrepreneurs will be keen to cash in

Gillian Tett

© Shonagh Rae

Last week an 85-year-old friend of mine raised a new investment fund. No surprise there, perhaps: Alan Patricof has spent 50 years working in venture capital and remains determined to stay in the game in a way that reflects New York’s hyperactive work culture.

But his latest initiative has a Covid-19 twist. The Primetime fund, launched with business partner Abby Levy, plans to invest in start-ups that are serving the “elderly”, defined as those aged over 65. (Never mind that this no longer looks so terribly “old” today.)

But both Patricof and Levy think it is an underserved market since, they say, about 10,000 Americans turn 65 each day, the elderly already account for more than half of spending and the west has an ageing demographic. The US Census Bureau calculates that “seniors” account for 15 per cent of the population today, but will reach 22 per cent by 2050. “[This is] a sector that has long been ignored by venture capital money,” says Patricof.

In a wider sense, what makes this move interesting is what it says about the potential behavioural impact of Covid-19. A decade ago, it was widely presumed that old people would head to nursing homes when they became infirm.

As many of these homes have been a hotspot for the pandemic, it is likely that more people will now choose to “age in place” — ie at home — and they will need support. Nursing homes that do continue to operate will have to overhaul services considerably.

Moreover, Covid-19 has forced the elderly to embrace digital technology to an unprecedented degree, whether to shop, seek entertainment or simply see friends and family.

This marks a striking shift from the past: in 2017 according to a Pew Research survey, “many seniors remain relatively divorced from digital life”, since “one-third of adults aged 65 and older say they never use the internet, and 49 per cent say they do not have home broadband services”. But if seniors are rushing into tech, the leaders of the Primetime fund hope this will create demand for new types of elderly services, which entrepreneurs could tap.

It’s too early to say whether this will actually happen on the scale they hope. Nonetheless, the move is thought-provoking — even cheering — for at least two reasons. First, it illustrates that Covid-19 is not just unleashing terrible economic pain (which I fear we have not seen the worst of yet), it is also opening pockets of entrepreneurial activity. While the latter is unlikely to offset the former, it is fascinating to consider how this may reshape the economy and create a spirit of adaptation.

You can already see this in a physical way in New York: when I returned to the city this week, I was startled to see restaurants operating out of hastily erected al fresco spaces in streets. Someone I know who used to work in the hospitality business has hustled his way into a job selling face masks; a former chef has become an expert on staging digital events; a teacher is doing online lessons. Reinvention, though born of necessity, is the theme of the day.

The other reason Patricof’s thesis is thought-provoking relates to productivity — and how digital innovation might now boost this in an economic sense. One of the mysteries that has blighted the economies of the US and Europe since 2000 is that productivity growth has slumped: In the US, it fell from 2-3 per cent in the second half of the 20th century to 0.4 per cent in the five years up to 2016.

This looks strange, given that Silicon Valley has been churning out innovations that are supposed to make our lives more — not less — productive. Some economists blame the decline on the problems that statisticians face in counting all the “free” activity that happens online (such as using a search engine). If these activities were included, real growth might be slightly higher, economists at the Fed have calculated, which would make those productivity statistics look better.
Another factor that might help solve the mystery is a time lag effect: the adoption of tech innovation in recent years has been very uneven among consumers and companies, as the OECD — and Andy Haldane, chief economist at the Bank of England — have pointed out.

That gap between laggards and leaders may have contributed to dragging down the productivity statistics — on top of any inaccuracies in the data. Some (such as ride-sharing companies) have become hyper-productive with tech; others (nursing homes, say) have not. Meanwhile, seniors have badly lagged millennials in this arena, as the Pew data shows.

Until recently, it was hard to imagine this uneven picture changing rapidly. But Covid-19 may now force tech into all manner of unexpected places, from education to food and elderly care, of the sort Primetime is betting on.

It will not be easy to reap all the potential productivity benefits of this unless there is a greater effort to instil digital literacy and infrastructure too; rolling out good broadband to rich and poor populations will be key in this respect.

But if digital innovation is suddenly spreading, productivity may rise too; or at least it could when the shock of the Covid-19 economic slump comes to an end. What this new cadre of “silver surfers” does next could be rather cheering in economic terms — never mind those sharp-eyed venture funds.