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In the wake of the global financial crisis of 2008–09, many central banks around the world eased their monetary policies in an effort to keep their economies from slipping into recession. But four major central banks—the U.S. Federal Reserve, the Bank of England (BoE), the European Central Bank (ECB), and the Bank of Japan (BoJ)—implemented measures that are particularly unconventional.
These measures included long-term liquidity provisions to encourage bank lending and asset purchases intended to lower long-term interest rates. By providing liquidity to banks and by buying specific assets such as mortgage-backed securities, these policies brought stability to financial markets and the banking sector. Monetary easing has also been aimed at boosting asset prices, including the stock market, in order to produce a “wealth effect” that would encourage consumer spending.
Now, with the exception of the Bank of Japan, these central banks may have begun to turn the corner on their unconventional policies. The Fed has begun talk of “tapering” its bond purchases, the Bank of England has not made bond purchases since July 2012, and although the ECB has said it would do “whatever it takes” to stand behind troubled eurozone debt, it has not had to make the kind of massive asset purchases undertaken by the Fed.
Still, the world’s financial system has been flooded with liquidity, and this may have various unintended consequences. Lord Abbett experts Greg Wachsman, Domestic Equity Research Analyst; Kewjin Yuoh, Partner & Portfolio Manager of Taxable Fixed Income; and Leah Traub, Partner & Director of Currency Management, weigh in on the unintended effects of these unconventional policies.
One unintended consequence of massive easing by the Fed has already received much attention. In 2010–11, prices for commodities, including food and fuel, rose to new levels, primarily due to the Fed’s policy, according to many analysts. Not everyone agreed with that assessment, however. The Fed, in fact, attributed rising commodity prices to strong demand and disruptions in supply.1
1. Banks’ balance sheets could suffer
In the view of even some Fed governors, some parts of the economy are becoming “increasingly dependent on near-zero short-term interest rates and quantitative easing [QE] policies.”2 This may be true of banks, according to the International Monetary Fund (IMF). “Ample liquidity provided by central banks is giving banks an incentive to evergreen (roll over) nonperforming loans instead of recording losses in their profit and loss accounts,” said the Fund.3
Loan-loss provisions—that is, funds that banks set aside to cover for loans that default or go into delinquency—have declined since the crisis. This suggests, according to the IMF, that “some aspects of [unconventional monetary policy] may be delaying balance sheet repair by banks.”4
The U.S. Federal Deposit Insurance Corporation (FDIC) has found similar results. In the first quarter of 2013, for example, banks set aside $11 billion for loan losses, 23% less than a year earlier. The decline marked the fourteenth straight quarter of reductions.5
It also is possible, however, that the decline in loan-loss provisions reflects the stellar quality of today’s borrowers, says Greg Wachsman, Lord Abbett bank equity analyst. Banks have become very particular about their lending, and underwriting standards are much higher than before the crisis. Loan-loss provisions typically decline as underwriting standards rise, and the current decline is in line with historical patterns, Wachsman said.
Nevertheless, it is true that banks are now being encouraged to do more lending. “On a prospective basis, the low-rate environment has created an incentive for banks to make more loans. This has led to a situation in which lending standards, while still very conservative, have been eroding somewhat,” Wachsman added.
Leveraged loans are one area in which underwriting standards have particularly eased. And in a few years, banks’ balance sheets could be affected. But “there is nothing yet to suggest that either lending standards or pricing have degraded so much that banks aren’t going to earn good returns on these loans,” said Wachsman.
2. Bank profits could shrink
Reductions in loan-loss reserves have helped drive bank profits, particularly in recent quarters. But another driver of bank profits, net interest margin, is being hindered by these unconventional policies, says Wachsman. “Bank profits are being hurt today in this low-rate environment because as rates have hit the zero bound on the short end of the yield curve,6 margins have been compressed.” And with loan-loss reserves at low levels, they can’t keep bolstering bank profits much longer.
Banks typically fund their lending via deposits and supplement that with short-term borrowing. Normally, deposits are the less expensive of the two, but with short-term interest rates falling to near zero, the two funding costs are nearly equal. Banks also can’t cut the interest rate they pay on deposits because that rate is already almost nil. Thus, banks have been left without their traditionally cheap funding source. And as the interest rates on loans and securities have come down, the net-interest margin—that is, the difference between the rate banks pay on their funding (deposits and short-term loans) and the rate they receive on their lending—has been compressed, lowering profitability, said Wachsman. (See Chart 1.)
Net interest margin (first quarter 2007 to first quarter 20 13)
Source: Federal Deposit Insurance Corporation, Quarterly Bank Profile, March 31, 2013. For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any specific investment.
3. Bank lending could decline
One of the purposes of the unconventional central bank policies was to increase bank lending. By making large purchases of government securities, central banks lowered interest rates, making borrowing cheaper for consumers and businesses. But massive bond purchases by the Fed in particular could cause lending to decline.
Total holdings of government bonds at the Fed, the Bank of Japan, the ECB, and the Bank of England amount to about $5.2 trillion, and that number is on track to reach $6.5 trillion by the end of 2013, with the Fed and the BoJ accounting for most of the increase.7 Bond-buying by the Fed and the BoJ could exceed new bond issuance by those governments by at least $100 billion in 2013, according to some reports.8
And if existing holdings by central banks and commercial banks are added to that, then there is not much left for others. Existing holdings include an estimated $8.7 trillion held by central banks around the world as a way to hold cash reserves, and $10 trillion held by commercial banks in developed economies.9
Regulatory changes are also creating additional demand for these bonds. These reforms require that banks hold more capital and that certain derivatives be traded on exchanges—an arrangement that will mean high-quality securities such as government bonds will be needed as collateral.
Some observers believe a shortage of Treasuries could eventually cause bank lending to shrink. Banks use these types of securities as collateral to obtain funding from pension funds, hedge funds, money market funds, and insurance companies. The banks then use this funding to support their lending activity. So, if there is a shortage of these securities, bank lending could suffer. Studies by the IMF suggest that the shortage of cash needed by banks could run as high as $5 trillion.
But if there is going to be a shortage of collateral, Kewjin Yuoh, who manages the Lord Abbett U.S. Government & Government Sponsored Enterprises Money Market Fund, hasn’t seen it yet. Data from the Treasury Department show that, as of December 2012, the amount of Treasury debt outstanding was $11.1 trillion, up from $5.8 trillion in 2008. But holdings by the Fed were $1.6 trillion in December 2012, up from $0.5 trillion in 2008, or about $1.1 trillion. So while the supply of Treasuries has risen by $5.3 trillion, the amount held by the Fed has grown by approximately 20% of that, Yuoh noted.10
Even though the Fed has been buying Treasuries at the rate of $40 billion per month ($480 billion per year), a shortage of government issuance is unlikely even with a shrinking federal deficit, which is still expected to hit $642 billion in fiscal year 2013.11
“Interest rates are low, but it’s not because of a shortage of collateral,” said Yuoh. “It’s because the Fed has set interest rates at the short end so low.” Moreover, banks have large amounts of excess reserves, so there’s no shortage of funds to lend. The problem is mostly on the demand side, and on the part of lenders who still have very high underwriting standards (as reflected in the Fed’s quarterly Senior Loan Officer Survey on Bank Lending Practices), according to Yuoh.
4. Financial risks could shift to the shadow banks
Excess liquidity and extremely low interest rates in the world’s financial system, combined with stricter regulatory oversight of banks, may cause risks to move to the “shadow banks”—the pension funds, hedge funds, money market funds, and insurance companies that lend banks the money they need to carry out daily operations. This could create risks that threaten financial stability, according to the IMF.
With short-term interest rates remaining near zero, money market mutual funds are posting low or negative returns. In an attempt to increase their returns, some funds have upped the amount of credit risk they’ve taken on. The risk is that investors could become afraid that in another crisis, these funds would “break the buck”12 as one did during the subprime crisis, and this could result in a run on these funds.
But in response to the crisis in 2008–09, the Securities and Exchange Commission (SEC) tightened the regulations governing the amount of risk money market funds can take on, with regard to both maturities and credits, according to Yuoh. At least 10% of a money market fund must be in cash, Treasuries, or securities that can be sold in one day. In addition, at least 30% must be in securities maturing in 60 days or less. And although funds are allowed to own maturities as long as 397 days, the weighted average maturity13 for a fund as a whole must be 60 days or less. In addition, there are mandates for credit and diversification as well as SEC reporting. These restrictions mean a fund’s exposure to risk is minimal.
Some money market funds have seen outflows recently as investors have left in search of higher returns. But if investors fled en masse, the financing that these funds provide to banks could disappear. “Once started,” writes the IMF, “a run [on money market funds] may accelerate because investor guarantees that were established in the wake of the Lehman Brothers bankruptcy have been removed, and the Dodd-Frank Act14 precludes the Federal Reserve from unilaterally stepping in to provide liquidity to the sector.”15
Fed governor Daniel Tarullo and others have called for the SEC to give greater scrutiny to the $2.5 trillion money market fund industry. The SEC has proposed two reform plans, but no legislation has passed.
One proposal would require that the net asset value (NAV) of a money market fund be allowed to float with the market value of the fund’s holdings. But one consequence of this would be a reduction in the amount of commercial paper that money market funds buy. Valuations of commercial paper, short-term borrowing that corporations engage in, can be volatile compared with more liquid assets such as Treasuries, and this could contribute to volatility in money market NAVs as well, making the funds less attractive to investors. If money market funds back away from the commercial paper market, corporations could pay higher short-term funding rates, according to Yuoh.
Wachsman believes that some money market regulation may be inevitable, but that the shadow banking system already presents less of a threat today than it did before the subprime crisis. This is largely due to the collapse in issuance of subprime mortgage-backed securities.
Moreover, some of the bank reforms already passed will help reduce risks, even in the shadow banking system, according to Wachsman. Securitization, for example, in which mortgages and other loans are packaged together, sliced into various “tranches” with different credit ratings and yields, and then sold as securities, is now subject to tighter rules. Securitization made up a large part of the shadow banking system because it created many of the asset-backed securities that, like Treasury securities, were used as collateral by hedge funds and other borrowers in the system.
The capital adequacy rules in the Basel III16 banking regulations and in the Dodd-Frank Act require that a portion of certain higher-risk securitized assets be retained on the issuing bank’s balance sheet and that a larger amount of capital be held against them in case they go bad. The more onerous capital requirements will make securitization of some assets somewhat punitive, according to Wachsman, which will restrain issuance.
Still, it’s important to monitor the risks in the system, said Wachsman, because “we’re operating in a sort of artificial world [due to quantitative easing]. So you have to make sure you’re cognizant of the risks and what could happen if the artificial world goes away. But today things are not stretched to the point that they were before the crisis.”
5. Volatility and risk-on/risk-off could return
A final unintended consequence arises more from the coming exit from global monetary easing than from the easing itself.
Much of the postcrisis period has been marked by high correlations within and across asset classes. This has meant that stocks, bonds, currencies, and other assets have traded largely not on their fundamentals but on “macro forces,” as indicated by the latest economic data or the most recent Fed pronouncement. These market conditions have been characterized as “risk-on” and “risk-off.”
But risk-on/risk-off conditions changed about a year ago, according to Leah Traub, who manages the Lord Abbett Emerging Markets Currency strategy. That’s when ECB president Mario Draghi announced that he would do “whatever it takes” to keep the eurozone together. This led markets to believe that the ECB would backstop the debt of Spain, Italy, and other troubled eurozone members. Yield spreads on this debt shrank, and calm was restored to European markets.
“That’s when volatility just collapsed,” said Traub, “and we started to see some divergence across asset classes. Securities started trading on their idiosyncratic stories again, on their fundamentals, instead of being correlated with all other securities. And that had been the case for about a year.”
The Fed’s unlimited QE plan, involving the purchase of Treasuries and mortgage-backed securities totaling $85 billion a month, also brought some confidence to the markets.
VIX Index17 (January 3, 2012–June 6, 2013)
For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any specific investment.
But volatility appears to be returning once again. With Fed chairman Ben Bernanke and other members of the Fed now talking about “tapering” the bond-buying program, the central bank has reintroduced uncertainty, and markets are again trading on the basis of macroeconomic data, or, more accurately, on the basis of what the data suggest the Fed’s next move will be.
“What the Fed has done,” said Traub, “is put a lot of uncertainty into the markets, and we’re seeing this increase in volatility all across the board, not just currencies. Now, everything is data-dependent. With every data print, or release of economic data, we’re seeing these market gyrations. You’re seeing it in Treasuries, you’re seeing it in stocks, and you’re seeing it in currencies.”
And because the Fed has made its tapering plan dependent on how the economy progresses, market volatility is likely to continue, according to Traub. “The program is data-dependent; it doesn’t have specific thresholds that will trigger an adjustment. But the problem is that this introduces a lot of uncertainty. I don’t see this environment changing anytime soon.”18
—Reported by Ron Vlieger
Leah G. Traub, Ph.D., Partner & Director of Currency Management
Ms. Traub is the lead Portfolio Manager of the emerging market currencies strategy and Director of Currency Management. Ms. Traub joined Lord Abbett in 2007, and was named Partner in 2012. Her prior experience includes: Research Economist at Princeton Economics Group; Research Assistant at the National Bureau of Economic Research; Research Assistant at Rutgers University; and Capital Markets Assistant at The Federal Reserve Bank of New York. Ms. Traub received a BA from the University of Chicago, an MA and a Ph.D. from Rutgers University, and has been in the investment business since 2001.
Kewjin Yuoh, Partner, Portfolio Manager
Mr. Yuoh is a Portfolio Manager for the taxable fixed-income strategies. Mr. Yuoh joined Lord Abbett in 2010, and was named Partner in 2012. His prior experience includes: Senior Vice President – Director of Fundamental Research and Senior Portfolio Manager at Alliance Bernstein, LLP; Vice President – Senior Portfolio Manager at Credit Suisse Asset Management; and Mortgage-Backed Securities Portfolio Manager at Sanford C. Bernstein & Co., Inc. Mr. Yuoh received a BS from Cornell University and has been in the investment business since 1994.
Gregory M. Wachsman, CFA, Research Analyst
Mr. Wachsman is a Research Analyst for the Domestic Equity Research team. Mr. Wachsman joined Lord Abbett in 2010. His prior experience includes Investment Analyst at UBS Global Asset Management and Senior Analyst at Chase Securities. Mr. Wachsman earned a BA from Northwestern University and an MBA from the University of Chicago. He also is a holder of a Chartered Financial Analyst designation, and has been in the investment business since 1997.
Risks to Consider: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Mortgage-backed securities may be subject to prepayment risk. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. The use of leverage may cause investors to lose more money in adverse environments than would have been the case in the absence of leverage. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. Foreign currency exchange rates may fluctuate significantly over short periods of time. They generally are determined by supply and demand in the foreign exchange markets and relative merits of investments in different countries, actual or perceived changes in interest rates, and other complex factors. Currency exchange rates also can be affected unpredictably by intervention (or the failure to intervene) by U.S. or foreign governments or central banks, or by currency controls or political developments. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
An investment in a money market fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.
Diversification does not guarantee a profit or protect against loss in declining markets.
The market may not perform in the same manner under similar conditions in the future.