Solving a “balance sheet recession” (eg. one started by deteriorating assets sitting on IB balance sheets), is all about slowing the deleveraging process. That at least is the view of Morgan Stanley’s interest rate strategy team.
In fact, they call what is happening a type (IV) crisis - where capital injections are the only possible solution. Accordingly, the current path being taken by authorities is the right one. As they explain:
Core View: Public sector efforts to relever and reflate assets will work to slow and ultimately stabilize private sector delevering and deflation of assets. To be sure, this will take time, but ultimately we think that the public sector will prevail.
Where We Differ: Economic turmoil has been properly diagnosed as a balance sheet recession. This is significant because it means market support facilities are thus rightly designed to address the problems. Dislocations in many assets do not appropriately reflect the possibility of a positive repricing of risk assets.
“Thus, we see this as a type (IV) crisis in which capital injections and equity stakes are required from the public sector to bolster bank balance sheets. This is happening now. It acts to stem the tide of liquidations of nonperforming loans (NPLs), which creates a vicious cycle of asset deflation followed by less demand for funds (leverage) which deflates assets further and so on and so forth.”
So, in their opinion, not only will the action taken by authorities likely work, asset valuations may have been overdone to the downside.
Furthermore, excess liquidity is being created because M1 growth has started to rise at a time when GDP growth is decelerating, something Morgan Stanley only sees continuing further.
•By flooding banks with excess reserves (’quantitative easing’), central banks have provided banks with plenty of wherewithal to create new deposits by lending to non-banks or buying securities.
•By targeting mortgage rates and other private sector lending rates directly through purchasing asset-backed securities (the Fed now prefers to call this ‘credit easing’ rather than as per Chairman Bernanke’s speech), the Fed is supporting credit demand, which in turn supports deposit growth.
A positive outlook indeed. But is it really that simple?
Not really, according to Pimco’s Bill Gross, who takes on the balance sheet support and deleveraging issue in his latest missive.
In order to slow the deleveraging process he says authorities will have to target more than just liquidity and a return to lending at traditional banks. They also desperately have to address the emergence of a new ’shadow’ banking sub-sector. As he explains:
Recapitalisation of the banks has been the major thrust, in the hopes that banks would extend credit which would reinvigorate asset pricing. Those who argue strongly for a recapitalisation of the banking system, however, may be missing the distinction between the banking system as we once knew it, and the “shadow banking” system that superseded it. Gross refers to research by Jim Bianco, which highlights that while banks are indeed beginning to lend again, it is this shadow system - made up of the hedge funds, private equity groups and structured financial conduits - which is ‘holding up the parade’, so to speak.
In short, while fresh Tarp capital has made it possible for banks to continue making loans despite tighter lending standards, the shadow banks - unable to benefit from government funds - have no choice but to continue deleveraging.
In the case of Goldman Sachs and Morgan Stanley, Tarp funds were only provided on the condition the banks downsized and degeared on their way to becoming regular banks, something which has cut their holdings of assets significantly in percentage and actual dollar terms.
Conclusion? This is not a ‘mission completed’. Until shadow banks stop deleveraging, asset prices will inevitably continue to drop.
That is not to suggest the Obama administration should create a bailout package for risk-taking hedge funds, CDOs and private equity houses. What Gross proposes instead is that the government prepares to step in to support the assets these institutions can no longer uphold. As he explains:
It’s not so much that the stock market needs to go back to 10,000. That would be nice for millions of 401(k)s that have been cut in half over the past 12 months, but it is not likely. Rather, asset prices securitising commercial real estate and credit card receivables, as well as plain old-fashioned municipal bonds, must stop going down if the real economy has any chance to revive by 2010.
PIMCO’s advice to policymakers is as follows: you can’t bail out everyone, yet economic recovery is not possible unless certain critical asset sectors are not only reliquefied, but rejuvenated in price. The prior Administration’s focus on the banks has been critical but unidimensional.
Capitalism at its philosophical and practical centre depends on credit, and while new loans can be and are being advanced via the banking system, it’s a much more difficult task to force shadow banks to lend. That lending depends on securitisation which in turn depends on stable and eventually higher asset prices than currently exist.
To demonstrate the level of asset- support needed Gross refers to a chart drawn up by colleague Ramin Toloui. He correlates the contraction in household debt to the decline of the securitisation market and concludes as much as another one trillion dollars may be needed to fill this so-called sinkhole.
So, if tackling deleveraging really is the solution, as Morgan Stanley suggests, it is likely only achievable via asset as well as liquidity support.
In short, through the revival of the Tarp’s original asset-based focus (not just GSE MBS, but credit card-backed securities, etc.).
Related links:
‘Banks well capitalised’ - FT Alphaville
Tangled tangibles - FT Alphaville
Wanted: $1,000,000,000,000 to bailout the financial system - FT Alphaville
