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United States The Outlook for Money and Securitization Markets Global Breakevens to Break Even Higher? View GEF Archive

		The Global Economics Team

			Richard Berner
Dick Berner is a Managing Director and Chief US Economist.
		Read about other GEF team members

Here are the conclusions; the logic follows.

First, a market call: The current liquidity/credit cycle has a way to go.   The process of writedowns and recapitalization of leveraged lenders will take time.  Compared with conditions before August 2007, I think lingering market dislocations mean that the cost of credit will stay higher and the availability of credit lower over reasonable investment horizons.  Those are key ingredients in our outlook for scant growth over the next few quarters, and for monetary policy to remain accommodative.  Wider money-market spreads and the markets’ distaste for leverage has prompted issuers to fund out their debt with longer maturities.  My colleague Jim Caron points out that, as a result, higher volatility and steeper yield curves are here to stay.

Second, the globalization of finance that has dispersed risk across borders means that it is impossible to predict where and when contagion pops up.   US mortgage problems can affect midsized German banks.  And while risk seems to be less concentrated in banks, the new complexity of financial products means that we aren’t sure whether undue concentration of risk exists there or elsewhere. 

Third, confidence is still essential for markets and leveraged institutions to function, despite the pervasive financial innovation of recent years.  Both Northern Rock and Bear Stearns demonstrate that bank runs are possible in any institutional setting. 

Fourth, the originate-to-distribute model of credit creation depends on liquid secured funding in money markets, as Fed Vice-Chairman Kohn noted last week (see “Money Markets and Financial Stability,” May 29, 2008).  The abuse of that model undermined sound underwriting and sound risk management, and both must be strengthened to reduce the risk of future systemic shocks in securitization and money markets. 

In any case, as my colleague Vishwanath Tiruppatur points out, straightforward securitization will come back.  “First-order” or traditional securitization (e.g., RMBS and credit card ABS) continues to be relevant to the process of intermediation, and likely will revive as investors and issuers sharpen assumptions about default correlations within the underlying collateral.  In contrast, securitization of previously securitized products (e.g., ABS CDOs, CDO squared) is less relevant for bringing borrowers and lenders together, and is unlikely to come back.

Fifth, banks are not irrelevant; on the contrary, the line has blurred between large banks and large nonbanks so that they look much more like each other than traditional depository institutions.  They are both equally involved in money and securitization markets and their similar activities likely will be supervised and regulated similarly.  The reintermediation process gives banks an opportunity to take back market share and to recoup lost pricing power.  But I have no doubt that this process is cyclical; another credit cycle will follow this one in which innovation and declining volatility will reverse some of the banks’ share and erode pricing. 

Sixth, market participants should count on more regulation/reporting requirements to help regulators assess risk profiles at financial institutions, especially large, complex ones.  How much capital to hold and when and how to hold it are still debatable issues, but the likely answer to the first question will be more.  That means a financial services model − and securitization markets − that involve less leverage and lower absolute returns.  Regulators are reviewing Basel II, and I would not be surprised to see them look carefully at some of its unintended consequences.  Financial regulators are already thinking hard about overseeing and assessing the risks in securitization, especially at the largest institutions, to ensure financial stability.

A brief look back at the market developments of the past ten months led me to these conclusions. 

The lingering dislocations in money and securitization markets are two sides of the same coin, or more accurately, of the same balance sheet.  Until August 2007, benign markets and policies gave comfort to market participants to add leverage in their search for yield, and to sell volatility to enhance it.  They securitized longer-term assets on the assumption that marketability would be ever present, adding embedded leverage and complexity to securities.  They leveraged or funded with money-market liabilities, backstopped by credit or liquidity lines.  And that comfort extended to the appetite for concentrating risk in a few hands − ironic for a system that was supposed to disperse it broadly and make markets more resilient.  To paraphrase Hyman Minsky, the facade of stability created fragility and instability. 

The vehicles may seem new but the themes are vintage.  In his book “The Panic of 1907,” Robert Bruner notes that complexity, buoyant growth, and rising leverage were three elements leading up to the market’s perfect storm a century ago.  The subsequent deleveraging of balance sheets was a key ingredient in that crisis, manifest in borrowers’ inability to roll over maturing short-term financing.  That was then.  Today, ironically, securitization also has been followed by a mechanism for rapid deleveraging, namely reintermediation of banks and losses among leveraged lenders.

The shock of subprime defaults triggered immediate dislocations in three key financial markets − the non-agency mortgage-backed securities market, the asset-backed commercial paper market, and the offshore Libor funding market.  These disruptions promoted a forced ‘reintermediation’ of the global banking system.  Issuers unable to roll over maturing ABCP called on their bank sponsors to absorb the commitments they made to back up CP in just such circumstances.  In turn, that has produced a pro-cyclical contraction in credit and an increase in its cost; both have tightened financial conditions. 

That deleveraging process, extended broadly, spread to other money markets and thus to the securitization markets they funded.  The effects differed by security, as collateralized markets like repo were less affected than unsecured markets like those for interbank lending.  But deleveraging affected term repo and deposit markets with equal intensity, as uncertainty reduced the willingness to extend term funding.

Reintermediation promotes a pro-cyclical credit contraction in three ways.  First, credit concerns triggered liquidity backstops for conduits and SIVs, forcing a shift from a funding source that requires no capital to one that does.  Inherently, that reduces leverage in the financial system.  Second, in classic pro-cyclical fashion, banks have raised the cost of new liquidity and credit facilities.  Finally, this shift to put higher-risk-weighted assets back on bank balance sheets may boost capital requirements for some banks. 

The nuances in this reintermediation process matter for the degree to which credit may tighten.  First, in my view, such accommodation absorbs capacity to extend credit on favorable terms for new lending.  Second, therefore, the cost of credit is also rising.  Banks are sellers of ‘options’ or ‘insurance policies’ for their borrowers, and good times compressed the pricing of those options.  Now, banks want to be paid at the margin for renting out their balance sheets as liquidity grows scarce − just as property insurance companies acquire new pricing power after a hurricane.  So they have honored existing commitments, but funding new ones involves tapping the markets − markets that are still in varying degrees dislocated. 

Fed actions to restore market functioning have helped significantly, in my view, despite some academic evidence to the contrary.  However, a key market that remains dislocated is the interbank lending or Libor market.  Libor is a benchmark for loan pricing.  Despite the Fed’s efforts to provide liquidity to banks through the expanded Term Auction Facility, Libor rates remain elevated at 68 bp over OIS, and that market is still in disarray.  There is a quality tiering underway in the Libor market which makes it less a wholesale market than a market of many, where the cost of funding for many institutions is higher.

There may be some truth to the allegations that banks reporting Libor at the fix aren’t representing what they would charge to lend to other banks, especially because markets are thin at the three-month tenor.  Our traders think that the rate is probably determined by conversations with brokers about where the market is and not where the reporting bank is willing to lend/borrow.  We don't agree with the idea that credit default swaps provide insight on where such rates are; large US banks have access to dollar-denominated funding and to the Fed’s discount window that other banks may not.  In particular, we believe that funding pressures at European banks are one source of wider interbank lending spreads. 

Importantly, in my view, this new pricing regime is not simply a cyclical development and won’t evaporate any time soon.  That’s a reflection of the economics of bank capital.  By using banks for backstop facilities or lines of credit, borrowers in effect buy call options on such capital.  The fact that new loans come at a higher price implies that returns must be high enough so that banks can attract incremental capital for balance sheet expansion.  Since the turmoil began, we estimate that banks globally have raised $219 billion in new capital, but it has come at a price.  The probability of a "capital call" by borrowers has moved higher, changing the price of those options, or what William Dudley of the New York Fed calls the shadow price of bank balance sheet capacity (see “May You Live in Interesting Times: The Sequel,” May 2008). 

That helps explain why, despite the Fed’s aggressive actions to provide liquidity to money markets and enable banks and primary dealers to finance securities by exchanging high-quality for lower-quality collateral on favorable terms, some money-market spreads − especially unsecured interbank lending spreads − remain wide.  Through its innovative liquidity facilities, the Fed has helped make orderly the reintermediation and deleveraging process.  And while I cannot prove it, the liquidity backstop those facilities provide in the money markets has helped market functioning even when observed activity is subdued.  But it cannot create bank capital or directly ease balance sheet strains.  What the markets consider normal interbank risk premia won’t go back to the narrow levels prevailing until last summer.  As a result, Libor-OIS spreads are unlikely to return to the levels now implied by longer-dated Libor forwards. 

Payment of interest on reserves would help the Fed meet future needs to expand its kit of liquidity facilities.  It would eliminate the constraint on the Fed’s balance sheet that arises from its liquidity-providing operations.  The Fed through the TAF and PDCF provides liquidity to money markets by allowing banks and primary dealers to access cash on a collateralized basis.  These operations boost reserves so the Fed must sterilize them to maintain a given funds rate target.  Even with reciprocal currency swaps in place with European central banks, the Fed is still called on to meet the demand for dollar-denominated liquidity early in the day.  If that demand fades in the afternoon, it becomes hard to hit the funds rate target.  And if the need to expand these operations increases, the balance sheet becomes a constraint.  Paying interest on reserves − both required and excess − would allow the Fed to expand its balance sheet while limiting the decline in the funds rate to the rate paid on reserves.  A redeposit facility would achieve the same goal. 

Finally, this shift to put high-risk-weighted assets back on bank balance sheets may impart a pro-cyclical boost to future capital requirements for some banks over the credit cycle.  That’s because the good times in capital markets prompted banks to push the assets carrying the highest risk-weighted capital requirements into SIVs and conduits off the balance sheet.  Charles Goodhart, a former adviser to the Bank of England, is concerned that the return of those assets to bank balance sheets will increase risk-weighted capital requirements.  I am too.

Let me conclude by making three observations about regulation.   The first concerns mark-to-market accounting.  Paul Volcker in his recent speech at the Economic Club of NY noted that mark-to-market accounting is critical for hedge funds and investment banks, but might not be suitable for heavily regulated, well-capitalized institutions like banks.  He’s on the right track, but I would shift the conversation away from institutions and to activities.  Trading activities must be marked to market, regardless of venue.  Heavily-capitalized and regulated investment and lending activities, especially those for which marketability is an issue, are different. 

Second, three issues are critical in designing new standards for risk management:  How much capital and/or initial margin should market participants hold and in what form?  Correspondingly, what is the appropriate degree of leverage in each activity?  And how should we evaluate funding and liquidity risk under a broad range of circumstances − broader than encompassed by any model? 

Vice-Chairman Kohn raised these questions last week and I think he would agree that we don’t yet have the answers.  I have one comment on the capital question, however.  At first blush, proposals such as those from Goodhart and Calomiris to have capital requirements move counter-cyclically are attractive.  They seem to offer a buffer against excessive leveraging in good times.  But letting capital recede in bad times seems to me unwise.  Moreover, such arrangements seem predicated on our ability to predict accurately market direction.  Better to have capital requirements or initial margins adequate to provide institutions the buffer they need when the good times turn bad.  Determining appropriate margin requirements, which determine trading leverage, is just as important as capital requirements to build stronger shock absorbers before the next financial crisis.

Finally, the financial infrastructure matters.  Many recommendations of the Counterparty Risk Management Policy Group II with respect to counterparty and operational risk still must be implemented.  Organizational structures to facilitate the clearing of over-the-counter derivatives will help reduce the likelihood that financial shocks will escalate into systemic problems.  In designing a new regulatory architecture, regulators and market participants should look to basic principles for the management and supervision of large and complex financial institutions.  Among them: The determination of appropriate governance, risk management, and risk appetite; identification of triggers for contagion; and embracing enhanced oversight.  All will provide a foundation for stronger financial shock absorbers.

(Note: This is adapted from comments at the Federal Reserve Bank of New York and Columbia Business School Conference on the Role of Money Markets, New York, New York)

Global
Breakevens to Break Even Higher?
June 05, 2008

By Manoj Pradhan | London

There has been considerable talk about inflation recently on Wall Street and on High Street. Word of these conversations seems to be reaching inflation markets slowly, with the US 10-year breakeven inflation rate rising by some 25bp to about 2.5% since the end of March. Measured by the difference between nominal and real bond yields, breakeven inflation provides compensation for expected inflation as well as inflation risk − the uncertainty surrounding where inflation will go. With headline inflation poised to move above 5% later this year according to our US team, and upside surprises to inflation springing up globally, investors wonder what it will take to move breakeven inflation structurally higher. In this note, we argue that a critical signal is an uptick in the volatility of core inflation. Our statistical tests suggest that a higher volatility of core inflation is a harbinger of a similar reaction in headline inflation volatility, implying that headline inflation could print in a wider range in the future. Investors in inflation markets demand a premium for this ‘inflation risk’, pushing breakeven inflation rates higher. In an earlier note, we argued that breakevens have not yet ticked up due to safe-haven buying of nominal Treasury bonds and a misplaced confidence in the willingness of central banks to rein in inflation at the expense of growth (see Joachim Fels and Manoj Pradhan’s The Inflation Conundrum, April 30, 2008). Here, we argue that, additionally, breakeven markets seem to be waiting for core inflation volatility to signal that inflation risks are indeed going to be structurally higher.

Inflation volatility and breakeven inflation: Volatility of core CPI inflation (defined here simply as the 5-year rolling standard deviation of inflation) does a remarkably good job of tracking the structural trend in US 10-year breakeven inflation. As far as structural trends go, inflation volatility does a better job of explaining the evolution of breakeven inflation than headline CPI inflation, the index to which inflation-protected securities are linked.

The early years of the inflation market were plagued by a lack of liquidity and a learning process regarding the structure of the market. The result was a higher risk premium for real yields and, therefore, lower breakeven inflation. Since that teething period, however, long-horizon breakevens have been following the inflation volatility script very well. There have been two large moves in core inflation that have been faithfully picked up by our inflation volatility metric. The first of these was the deflation scare during the 2001 recession that took inflation volatility higher. The second was the economic recovery-led bounce-back in core inflation to nearly 3% that kept inflation volatility high. Since then, core CPI inflation has moderated and is currently at a critical point, in our opinion. The current ultra expansionary monetary policy and global inflationary forces have set the stage for headline and core inflation to tick up higher. On the evidence, breakevens are likely to follow.

Some caution in interpreting the findings. Our metric of inflation volatility examines a 5-year rolling sample period. Changes in this metric therefore occur slowly, are persistent and can show base effects. For example, even a rise in core inflation in the next few months will tend to dampen our inflation volatility metric because of the base effects. Similarly, using a shorter period over which inflation volatility is measured weakens the strength of the relationship but retains the fundamental essence. However, even this relatively weak relationship between the 2-year volatility metric and breakeven inflation is an improvement on the relationship between headline inflation and breakeven rates where no long-run cointegration can be found.

What information does inflation variability give inflation markets? The relationship of long-maturity breakeven inflation with the current inflation print is rather less convincing than its relationship with inflation variability. This implies two things: i) the current inflation print is not a very reliable indicator of the long-term expected inflation that is relevant for such long-maturity breakevens; and ii) the volatility of inflation is better suited to provide investors with a range within which inflation could fluctuate in the long term. Breakeven investors accordingly demand greater compensation when the risk that inflation could trade in a wider range rises.

But why is there a relationship between breakevens and core CPI rather than headline CPI? Coupons on inflation-protected bonds are priced off the headline CPI index, not the core measure. Yet, the relationship between the headline CPI volatility and breakevens is hardly convincing. Why? The answer lies in the forward-looking nature of asset markets. Breakeven inflation investors use forward-looking indicators to gauge where headline CPI is going. Our statistical tests suggest that the core CPI measure plays just such a role, giving an indication of not just where headline CPI inflation is going to go but, more importantly for structural views, giving us a range within which headline CPI could print in the future.

Core CPI is a leading indicator of headline CPI… Our statistical tests confirm the conventional wisdom that core inflation is a leading indicator of headline inflation. The two measures are involved in a long-run relationship − specifically, an econometric long-run relationship called Cointegration. (For the technical reader, we use the Johansen-Juselius structural procedure, allowing the data to tell us the direction of causality (in the sense of weak-exogeneity.) Headline inflation does the adjusting in this relationship. Our results weigh in on the ongoing debate over the leading properties of core inflation but must be interpreted carefully. For example, headline inflation may be seen to do most of the adjusting by our statistical tests simply because headline inflation is more volatile than core, leading to a statistical conclusion that it is ‘returning’ to the long-run equilibrium relationship. In line with our results, Blinder and Reis (The Greenspan Era: Lessons for the Future, August 2005) find core CPI inflation to be a better predictor of headline CPI than headline CPI itself. Recent work by Crone et al. (Core Measures of Inflation as Predictors of Total Inflation, May 2008), however, finds little support for such a hypothesis. This is undoubtedly a vital debate, given the current economic conditions, but the real relationship of interest for our argument is between the volatility of these indices.

…and, more importantly, core CPI volatility is a leading indicator of headline CPI volatility. The real structural information content in the core CPI numbers that breakeven markets seek is in the volatility of core inflation and, consequently, the implications for the volatility of the headline numbers. A Cointegration relationship also exists between the volatility of the core and headline measures with the volatility of the headline measure doing most of the adjusting. Thus, whenever the volatility of the core measure moves in a particular direction or to a particular level, headline inflation volatility follows suit, albeit very slowly, given that our volatility metric moves slowly. The important implication here is that higher core inflation volatility suggests that headline inflation could print in a wider range in the future, a risk that would require investors to be compensated via a higher inflation risk premium. Breakeven inflation markets in the US seem to have recognised this implication very well.

The next big move in breakevens. In a previous note, we discussed reasons why breakeven inflation was not yet reflecting inflation risks that were already in the prints and in our economists’ forecasts. There we argued that safe-haven buying of nominal Treasury bonds had kept yields lower and breakevens tighter, and that perhaps too much weight was being given to the willingness of central banks to raise rates quickly to fight inflation. Here we highlight another reason: sophisticated investors are waiting for core inflation volatility to show signs of moving higher, implying that headline inflation could print in a wider range in the future. The increased inflation risk will require a higher risk premium as compensation. History suggests that breakevens are likely to provide this premium and move higher.

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