Tag Archives: banks

When It Becomes Serious You Have To Lie: Update On The Repo Fiasco

Occasionally, problems reveal themselves gradually. A water stain on the ceiling is potentially evidence of a much larger problem. Painting over the stain will temporarily relieve the unsightly condition, but in time, the water stain will return. This is analogous to a situation occurring within the banking system. Almost three months after water stains first appeared in the overnight funding markets, the Fed has stepped in on a daily basis to “re-paint the ceiling” and the problem has appeared to vanish. Yet, every day the stain reappears and the Fed’s work begins anew. One is left to wonder why the leak hasn’t been fixed. 

In mid-September, evidence of issues in the U.S. banking system began to appear. The problem occurred in the overnight funding markets which serve as one of the most important components of a well-functioning financial and economic system. It is also a market that few investors follow and even fewer understand. At that time, interest rates in the normally boring repo market suddenly spiked higher with intra-day rates surpassing a whopping 8%. The difference between the 8% repo rate recorded on September 16, 2019 and Treasuries was an eight standard deviation event. Statistically, such an event should occur once every three billion years.

For a refresher on the details of those events, we suggest reading our article from September 25, 2019, entitled Who Could Have Known: What The Repo Fiasco Entails.  

At the time, it was surprising that the sudden change in overnight repo borrowing rates caught the Fed completely off guard and that they lacked a reasonable explanation for the disruption. Since then, our surprise has turned to concern and suspicion.

We harbor doubts about the cause of the problem based on two excuses the Fed and banks use to explain the situation. Neither are compelling or convincing. 

As we were putting the finishing touches on this article, the Bank of International Settlements (BIS) reported that the overnight repo problems might stem from the reluctance of the four largest U.S. banks to lend to some of the largest hedge funds. The four banks are being forced to fund a massive surge in U.S. Treasury issuance and therefore reallocated funding from the hedge funds to the U.S. Treasury.  Per the Financial Times in Hedge Funds key in exacerbating repo market turmoil, says BIS: “High demand for secured (repo) funding from non-financial institutions, such as hedge funds heavily engaged in leveraging up relative value trades,” – was a key factor behind the chaos, said Claudio Borio, Head of the monetary and economic department at the BIS.

In the article, the BIS implies that the Fed is providing liquidity to banks so that banks, in turn, can provide the hedge funds funding to maintain their leverage. The Fed is worried that hedge funds will sell assets if liquidity is not available. Instead of forcing hedge funds to deal with a funding risk that they know about, they are effectively bailing them out from having to liquidate their holdings. If that is the case, and as the central bank to central bankers the BIS should be well informed on such matters, why should the Fed be involved in micro-managing leverage to hedge funds? It would certainly represent another extreme example of mission creep.

Excuse #1

In the article linked above, we discussed the initial excuse for the funding issues bandied about by Wall Street, the banks, and the media as follows:

Most likely, there was an unexpected cash crunch that left banks and/or financial institutions underfunded. The media has talked up the corporate tax date and a large Treasury bond settlement date as potential reasons.”

While the excuse seemed legitimate, it made little sense as we surmised in the next sentence:

“We are not convinced by either excuse as they were easily forecastable weeks in advance.”

If the dearth of liquidity in the overnight funding markets was due to predictable, one-time cash demands, the problem should have been fixed easily. Simply replenish the cash with open market operations as the Fed routinely did prior to the Financial Crisis.

Since mid-September, the Fed has elected instead to increase their balance sheet by over $320 billion.  In addition to conducting daily overnight repo auctions, they introduced term repo that extends for weeks and then abruptly restarted quantitative easing (QE).

Imagine your plumber coming into your house with five other plumbers and a bull dozer to fix what you assumed was a leaky pipe.

The graph below, courtesy Bianco Research, shows the dramatic rise in the Fed’s balance sheet since September.

Based on the purported cash shortfall excuse, one would expect that the increase in the Fed’s balance sheet would have easily met demands for cash and the markets would have stabilized. Liquidity hole filled, problem solved.

However, as witnessed by the continuing growth of the Fed’s balance sheet and ever-increasing size of Fed operations, the hole seems to be growing. It is worth noting that the Fed has committed to add $60 billion a month to their balance sheet through March of 2020 via QE. In other words, the stain keeps reappearing and getting bigger despite increasing amounts of paint. 

Excuse #2

The latest rationale used to explain the funding problems revolves around banking regulations. Many Fed members and banking professionals have recently stated that banking regulations, enacted after the Financial Crisis, are constraining banks’ ability to lend to other banks and therefore worsening the funding situation. In the words of Randy Quarles, Federal Reserve Vice Chair for Banking Supervision, in his testimony to the House Financial Services Committee:

We have identified some areas where our existing supervision of the regulatory framework…may have created some incentives that were contributors

Jamie Dimon, CEO of JP Morgan, is quoted in MarketWatch as saying the following:

“The turmoil may be a precursor of a bigger crisis if the Fed doesn’t adjust its regulations. He said the liquidity requirements tie up what was seen as excess reserves.”

Essentially, Quarles and Dimon argue that excess reserves are not really excess. When new post Financial Crisis regulatory requirements are factored in, banks only hold the appropriate amount of reserves and are not exceeding requirements.

This may be the case, and if so, the amount of true excess reserves was dwindling several months prior to the repo debacle in September.  Any potential or forecasted shortfalls due to the constraints should have been easily identifiable weeks and months in advance of any problem.

The banks and the Fed speak to each other quite often about financial conditions and potential problems that might arise. Most of the systemically important financial institutions (SIFI banks) have government regulators on-site every day. In addition, the Fed audits the banks on a regular basis. We find it hard to believe that new regulatory restraints and the effect they have on true excess reserves were not discussed. This is even harder to believe when one considers that the Fed was actively reducing the amount of reserves in the system via Quantitative Tightening (QT) through 2018 and early 2019. The banks and the regulators should have been alerting everyone they were getting dangerously close to exhausting their true excess reserves. That did not occur, at least not publicly.

Theories and Speculation

A golden rule we follow is that when we think we are being misled, especially by market participants, the Fed, or the government, it pays to try to understand the motive.  “Why would they do this?” Although not conclusive, we have a few theories about the faulty explanations for the funding shortage. They are as follows:

  • The banks and the Fed would like to reduce the regulatory constraints imposed on them in recent years. Disruptions demonstrating that the regulations not only inhibit lending but can cause a funding crisis allow them to leverage lobbying efforts to reduce regulations.
  • There may be a bank or large financial institution that is in distress. In an effort to keep it out of the headlines, the Fed is indirectly supplying liquidity to the institution. This would help explain why the September Repo event was so sudden and unexpected. Rumors about troubles at certain European banks have been circulating for months.
  • The Fed and the banks grossly underestimated how much of the increased U.S. Treasury debt issuance they would have to buy. In just the last quarter, the Treasury issued nearly $1 trillion dollars of debt. At the same time, foreign sponsorship of U.S. Treasuries has been declining. While predictable, the large amount of cash required to buy Treasury notes and bonds may have created a cash shortfall. For more on why this problem is even more pronounced today, read our article Who Is Funding Uncle Sam. If this is the case, the Fed is funding the Treasury under the table via QE. This is better known as “debt monetization”.
  • Between July and November the Fed reduced the Fed Funds rate by 0.75% without any economic justification for doing so. The Fed claims that the cuts are an “insurance” policy to ensure that slowing global growth and trade turmoil do not halt the already record long economic expansion. Might they now be afraid that further cuts would raise suspicion that the Fed has recessionary concerns? QE, which was supposedly enacted to combat the overnight funding issues, has generously supported financial markets in the past. Maybe a funding crisis provides the Fed cover for QE despite rates not being at the zero bound. Since 2008, the Fed has been vocal about the ways in which market confidence supports consumer confidence. 

The analysis of what is true and what is rhetoric spins wildly out of control when we allow our imaginations to run. This is what happens when pieces do not fit neatly into the puzzle and when sound policy decisions are subordinated to public relations sound bites. One thing seems certain, despite what we are being told, there likely something else is going on.

Of greater concern in this matter of overnight funding, is the potential the Fed and banks were truly blindsided. If that is the case, we should harbor even deeper concern as there is likely a much bigger issue being painted over with temporary liquidity injections.

Summary

In the movie The Outlaw Josey Wales, one of the more famous quotes is, “Don’t piss down my back and tell me it’s raining.”

We do not accept the rationale the Fed is using to justify the reintroduction of QE and the latest surge in their balance sheet. Although we do not know why the Fed has been so incoherent in their application of monetary policy, our theories offer other ideas for thinking through the monetary policy maze. They also have various implications for the markets, none of which should be taken lightly.

We are just as certain that we are not entirely correct as we are certain that we aren’t entirely wrong. Like the water spot on the ceiling, financial market issues normally reveal themselves gradually. Prudent risk management suggests finding and addressing the source of the problem rather than cosmetics. We want to reiterate that, if the Fed is papering over problems in the overnight funding market, we are left to question the Fed’s understanding of global funding markets and the global banking system’s ability to weather a more significant disruption than the preview we observed in September.

Collecting Tolls On The Energy Express

The recent surge in passive investment strategies, and corresponding decline in active investment strategies, is causing strong price correlations amongst a broad swath of equities. This dynamic has caused a large majority of stocks to rise lockstep with the market, while a few unpopular stocks have been left behind. It is these lagging assets that provide an opportunity. Overlooked and underappreciated stocks potentially offer outsized returns and low correlation to the market. Finding these “misfits” is one way we are taking advantage of a glaring market inefficiency.

In July 2019, we recommended that investors consider a specific and underfollowed sector of REITs that pay double-digit dividends and could see reasonable price appreciation. In this article, we shed light on another underfollowed gem that also offers a high dividend yield, albeit with a vastly different fundamental profile.

The Case for MLP’s

Master Limited Partnerships (MLPs) are similar in legal structure to REITs in that they pass through a large majority of income to investors. As such, many MLP’s tend to pay higher than average dividends. That is where the similarities between REITs and MLPs end. 

The particular class of MLPs that interest us are called mid-stream MLPs. We like to think of these MLPs as the toll booth on the energy express. These MLPs own the pipelines that deliver energy products from the exploration fields (upstream) to the refiners and distributors (downstream). Like a toll road, these MLPs’ profitability is based on the volume of cars on the road, not the value of the cars on it. In other words, mid-stream MLPs care about the volume of energy they carry, not the price of that energy. That said, low oil prices can reduce the volume flowing through the pipelines and, provide energy producers, refiners, and distributors leverage to renegotiate pipeline fees.

Because the income of MLPs is the result of the volume of products flowing through their pipelines and not the cost of the products, their sales revenue, income, and dividend payouts are not well correlated to the price of oil or other energy products. Despite a different earnings profile than most energy companies, MLP stock prices have been strongly correlated to the energy sector. This correlation has always been positive, but the correlation is even greater today, largely due to the surge of passive investment strategies.

Passive investors tend to buy indexes and sectors containing stocks with similar traits. As passive investors become a larger part of the market, the prices of the underlying constituents’ trade more in line with each other despite variances in their businesses, valuations, outlooks, and risks. As this occurs, those marginal active investors that differentiate between stocks and their associated fundamentals play a lesser role in setting prices. With this pricing dynamic, inefficiencies flourish.

The graph below compares the tight correlation of the Alerian MLP Infrastructure Index (MLPI) and the State Street Energy Sector ETF (XLE).

Data Courtesy Bloomberg

Before further discussing MLP’s, it is worth pointing out the value proposition that the entire energy sector affords investors. While MLP cash flows and dividends are not necessarily similar to those companies in the broad energy sector, given the strong correlation, we must factor in the fundamental prospects of the entire energy sector.

The following table compares valuation fundamentals, returns, volatility, and dividends for XLE and the S&P 500. As shown, XLE has traded poorly versus the S&P 500 despite a better value proposition. XLE also pays more than twice the dividend of the S&P 500. However, it trades with about 50% more volatility than the index.  

The following table compares two valuation metrics and the dividend yield of the top 6 holdings of Alerian MLP ETF (AMLP) and the S&P 500. A similar value story emerges.

As XLE has grossly underperformed the market, so have MLPs. It is important for value investors to understand the decline in MLP’s is largely in sympathy with the gross underperformance of the energy sector and not the fundamentals of the MLP sector itself. The graph below shows the steadily rising earnings per share of the MLP sector versus the entire energy sector.

Data Courtesy Bloomberg

Illustrating the Value Proposition

The following graphs help better define the value of owning MLPs at current valuations.

The scatter graph below compares 60-day changes to the price of oil with 60-day changes in AMLP’s dividend yield. At current levels (the orange dot) either oil should be $10.30 lower given AMLP’s current dividend yield, or the dividend yield should be 1.14% lower based on current oil prices. A decline in the dividend yield to the norm, assuming the dividend payout is unchanged, would result in a price increase of 13.17% for AMLP. Alternatively if oil declined about 20% in value, the current AMLP dividend yield would then be fairly priced. We consider this a significant margin of safety should the price of oil fall, as it likely would if the U.S. enters a recession in the near future.   

Data Courtesy Alerian and Bloomberg

The graph below highlights that AMLP’s dividend yield is historically high, albeit below three short term spikes occurring over the last 25 years. In all three cases oil fell precipitously due to a recession or a sharp slowdown of global growth.

Data Courtesy Alerian and Bloomberg

Due to their high dividend yields and volatility, MLP’s are frequently compared to higher-yielding, lower-rated corporate debt securities. The graph below shows that the spread of AMLP’s dividend yield to the yield on junk-rated BB corporate bonds is the largest in at least 25 years. The current spread is 5.66%, which is 5.18% above the average since 1995.

Data Courtesy Alerian and St. Louis Federal Reserve

To help us better quantify the pricing of MLPs, we created a two-factor model. This model forecasts the price of MLPI based on changes to the price of XLE and the yield of U.S. Ten-year Treasury Notes. The model below has an R-squared of .76, meaning 76% of the price change of MLPI is attributable to the price changes of energy stocks and Treasury yields. Currently the model shows that MLPI is 20% undervalued (gray bars).  The last two times MLPI was undervalued by over 20%, its price rose 49% (2016) and 15% (2018) in the following three months.

The following summarizes some of the more important pros and cons of investing in MLPs.

Pros

  • Dividend yields are very high on an absolute basis and versus other higher-yielding securities
  • Valuations are cheap
  • Earnings are growing in a dependable trend
  • Balance sheets are in good shape
  • Potential for stock buybacks as balance sheets improve and stock prices offer value

Cons

  • Strong correlation to oil prices and energy stocks
  • “Peak oil demand” – electric cars/solar
  • Sensitivity to global trade, economy, and broad asset prices
  • Political uncertainty/green movement
  • High volatility

Summary

The stronger the market influence that passive investors have, the greater the potential for market dislocations. Simply, as individual stock prices become more correlated with markets and each other, specific out of favor companies are punished. We believe this explains why MLP’s have traded so poorly and why they are so cheap today.

We urge caution as buying MLPs in today’s environment is a “catching the falling knife” trade. AMLP has fallen nearly 25% over the last few months and may continue to fall further, especially as tax selling occurs over the coming weeks. It has also been in a longer-term downtrend since 2017.  We are unlikely to call the market bottom in MLPs and therefore intend to scale into a larger position over time. We will likely buy our first set of shares opportunistically over the next few weeks or possibly in early 2020. Readers will be alerted at the time. We may possibly use leveraged MLP funds in addition to AMLP.

It is worth noting this position is a small part of our portfolio and fits within the construct of the entire portfolio. While the value proposition is great, we must remain cognizant of the current price trend, the risks of owning MLPs, and how this investment changes our exposure to equities and interest rates.

This article focuses predominately on the current pricing and value proposition. We suggest that if you are interested in MLPs, read more on MLP legal structures, their tax treatment, and specific risks they entail.

AMLP does not require investors to file a K-1 tax form. Many ETFs and all individual MLPs have this requirement.

*MLPI and AMLP were used in this article as a proxy for MLPs. They are both extremely correlated to each other. Usage was based on the data needed.

UPDATE: To Buy, Or Not To Buy- An Investors Guide to QE 4

In our RIA Pro article, To Buy, Or Not To Buy- An Investors Guide To QE4, we studied asset performance returns during the first three episodes of QE. We then normalized the data for the duration and amount of QE to project how QE4 might affect various assets.  

With a month of QE4 under our belt, we update you on the pacing of this latest version of extreme monetary policy and review how various assets are performing versus our projections. Further, we share some recent comments from Fed speakers and analyze trading in the Fed Funds market to provide some unique thoughts about the future of QE4.

QE4

Since October 14th, when QE4 was announced by Fed Chairman Jerome Powell, the Fed’s balance sheet has increased by approximately $100 billion. The graph below compares the current weekly balance sheet growth with the initial growth that occurred during the three prior iterations of QE.  

Data Courtesy St. Louis Federal Reserve

As shown above, the Fed is supplying liquidity at a pace greater than QE2 but slightly off the pace of QE 1 and 3. What is not shown is the $190 billion of growth in the Fed’s balance sheet that occurred in the weeks before announcing QE4. When this amount is considered along with the amount shown since October 14th, the current pacing is much larger than the other three instances of QE.

To put this in context, take a step back and consider the circumstances under which QE1 occurred. When the Fed initiated QE1 in November of 2008, markets were plummeting, major financial institutions had already failed with many others on the brink, and the domestic and global economy was broadly in recession. The Fed was trying to stop the worst financial crisis since the Great Depression from worsening.

Today, U.S. equity markets sit at all-time highs, the economic expansion has extended to an all-time record 126 months, unemployment at 3.6% is at levels not seen since the 1960s, and banks are posting record profits.

The introduction of QE4 against this backdrop reveals the possibility that one of two things is occurring, or quite possibly both.

One, there could be or could have been a major bank struggling to borrow or in financial trouble. The Fed, via repo operations and QE, may be providing liquidity either to the institution directly or indirectly via other banks to forestall the ramifications of a potential banking related default.

Two, the markets are struggling to absorb the massive amount of Treasury debt issued since July when Congress extended the debt cap. From August through October 2019, the amount of Treasury debt outstanding grew by $1 trillion. Importantly, foreign entities are now net sellers of Treasury debt, which is worsening the problem. For more read our recent article, Who Is Funding Uncle Sam?

The bottom line is that the Fed has taken massive steps over the last few months to provide liquidity to the financial markets. As we saw in prior QEs, this liquidity distorts financial markets.  

QE4 Projections and Updates

The following table provides the original return projections by asset class as well as performance returns since October 14th.  The rankings are based on projected performance by asset class and total.  

Here are a few takeaways about performance during QE4 thus far:

  • Value is outperforming growth by 1.67% (5.95% vs. 4.28%)
  • There is general uniformity amongst the equity indexes
  • Equity indices have captured at least 50%, and in the case of value and large caps (S&P 100) over 100% of the expected gains, despite being only one-sixth of the way through QE4
  • The sharp variation in sector returns is contradictory to the relatively consistent returns at the index level
  • Discretionary stocks are trading poorly when compared to other sectors and to the expected performance forecast for discretionary stocks
  • Defensive sectors are trading relatively weaker as occurred during prior QE
  • The healthcare sector has been the best performing sector within the S&P as well as versus every index and commodity in the tables
  • The yield curve steepened as expected
  • In the commodity sector, precious metals are weaker, but oil and copper are positive

Are Adjustments to QE4 Coming?

The Fed has recently made public statements that lead us to believe they are concerned with rising debt levels. In particular, a few Fed speakers have noted the sharp rise in corporate and federal debt levels both on an absolute basis and versus earnings and GDP. The increase in leverage is made possible in part by low interest rates and QE. In addition, some Fed speakers over the last year or two have grumbled about higher than normal equity valuations.

It was for these very reasons that in 2013, Jerome Powell voiced concerns about the consequences of asset purchases (QE). To wit: 

“What of the potential costs or risks of the asset purchases? A variety of concerns have been raised over time. With inflation in check, the most important potential risk, in my view, is that of financial instability. One concern is that our policies might drive excessive risk-taking or create bubbles in financial assets or housing.”

Earlier this month, Jerome Powell, in Congressional testimony said:

“The debt is growing faster than the economy. It’s as simple as that. That is by definition unsustainable. And it is growing faster in the United States by a significant margin.”

With more leverage in the financial system and higher valuations in the equity and credit markets, how does Fed Chairman Powell reconcile those comments with where we are today? It further serves to highlight that political expediency has thus far trumped the long-run health of the economy and the financial system.

Based on the Fed’s prior and current warnings about debt and valuations, we believe they are trying to fix funding issues without promoting greater excesses in the financial markets. To thread this needle, they must supply just enough liquidity to restore financing markets to normal but not over stimulate them. This task is much easier said than done due to the markets’ Pavlovian response to QE.

Where the fed funds effective rate sits within the Fed’s target range can be a useful gauge of the over or undersupplying of liquidity. Based on this measure, it appears the Fed is currently oversupplying liquidity as seen in the following chart. For the first time in at least two years, as circled, the effective Fed Funds rate has been consistently below the midpoint of the Fed’s target range.

If the Fed is concerned with debt levels and equity valuations and is comfortable that they have provided sufficient liquidity, might they halt QE4, reduce monthly amounts, or switch to a more flexible model of QE?

We think all of these options are possible.

Any effort to curtail QE will be negative for markets that have been feasting on the additional liquidity. Given the symbiotic relationship between markets and QE, the Fed will be cautious in making changes. As always, the first whisper of change could upset the apple cart.

Summary

Equity markets have been rising on an almost daily basis despite benign economic reports, negative trade and tariff headlines, and Presidential impeachment proceedings, among other worrisome factors. We have little doubt that investors have caught QE fever again, and they are more concerned with the FOMO than fundamentals.

As the fresh round of liquidity provided by the Fed leaks into the markets, it only further advances more misallocation of capital, such as excessive borrowing by zombie companies and borrowing to further fund unproductive stock buybacks. Like dogs drooling at the sound of a ringing bell, most investors expect the bull run to continue. It may, but there is certainly reason for more caution this time around as the contours of the economy and the market are vastly different from prior rounds. Add to this the incoherence of this policy action in light of the record expansion, benign inflation readings, and low unemployment rate and we have more questions about QE4 than feasible answers.

To Buy, Or Not To Buy- An Investors Guide to QE 4

In no sense is this QE” – Jerome Powell

On October 9, 2019, the Federal Reserve announced a resumption of quantitative easing (QE). Fed Chairman Jerome Powell went to great lengths to make sure he characterized the new operation as something different than QE. Like QE 1, 2, and 3, this new action involves a series of large asset purchases of Treasury securities conducted by the Fed. The action is designed to pump liquidity and reserves into the banking system.

Regardless of the nomenclature, what matters to investors is whether this new action will have an effect on asset prices similar to prior rounds of QE. For the remainder of this article, we refer to the latest action as QE 4.

To quantify what a similar effect may mean, we start by examining the performance of various equity indexes, equity sectors, commodities, and yields during the three prior QE operations. We then normalize the data for the duration and amount of QE to project what QE 4 might hold in store for the assets.

Equally important, we present several factors that are unique to QE 4 and may result in different outcomes. While no one has the answers, we hope that the quantitative data and the qualitative commentary we provide arms you with a better appreciation for asset return possibilities during this latest round of QE. 

How QE 1, 2, and 3 affected the markets

The following series of tables, separated by asset class, breaks down price performance for each episode of QE. The first table for each asset class shows the absolute price return for the respective assets along with the maximum and minimum returns from the start of each QE. The smaller table below it normalizes these returns, making them comparable across the three QE operations. To normalize the data, we annualize the respective QE returns and then scale the returns per $100 billion of QE. For instance, if the S&P 500 returned 10% annualized and the Fed bought $500 billion of assets during a particular QE, then the normalized return would be 2% per $100 billion of QE.

Data in the tables are from Bloomberg.  Click on any of the tables to enlarge.

QE 4 potential returns

If we assume that assets will perform similarly under QE 4, we can easily forecast returns using the normalized data from above. The following three tables show these forecasts. Below the tables are rankings by asset class as well as in aggregate. For purposes of this exercise, we assume, based on the Fed’s guidance, that they will purchase $60 billion a month for six months ($360 billion) of U.S. Treasury Bills.

Takeaways

The following list provides a summarization of the tables.

  • Higher volatility and higher beta equity indexes generally outperformed during the first three rounds of QE.
  • Defensive equity sectors underperformed during QE.
  • On average, growth stocks slightly outperformed value stocks during QE. Over the last decade, inclusive of non-QE periods, growth stocks have significantly outperformed value stocks.
  • Longer-term bond yields generally rose while shorter-term yields were flat, resulting in steeper yield curves in all three instances. 
  • Copper, crude oil, and silver outperformed the S&P 500, although the exceptional returns primarily occurred during QE 1 for copper and crude and QE 1 and 2 for Silver.
  • On a normalized basis, Silver’s 10.17% return per $100bn in QE 2, is head and shoulders above all other normalized returns in all three prior instances of QE.
  • In general, assets were at or near their peak returns as QE 1 and 3 ended. During QE 2, a significant percentage of early gains were relinquished before QE ended.
  • QE 2 was much shorter in duration and involved significantly fewer purchases by the Fed.
  • The expected top five performers during QE4 on a normalized basis from highest to lowest are: Silver, S&P 400, Discretionary stocks, S&P 600, and Crude Oil. 
  • Projected returns for QE 4 are about two-thirds lower than the average of prior QE. The lesser expectations are, in large part, a function of our assumption of a smaller size for QE4. If the actual amount of QE 4 is larger than current expectations, the forecasts will rise.

QE, but in a different environment

While it is tempting to use the tables above and assume the future will look like the past, we would be remiss if we didn’t point out that the current environment surrounding QE 4 is different from prior QE periods. The following bullet points highlight some of the more important differences.

  • As currently planned, the Fed will only buy Treasury Bills during QE 4, while the other QE programs included the purchase of both short and long term Treasury securities as well as mortgages backed securities and agency debt. 
  • Fed Funds are currently targeted at 1.75-2.00%, leaving the Fed multiple opportunities to reduce rates during QE 4. In the other instances of QE, the Fed Funds rate was pegged at zero. 
  • QE 4 is intended to provide the banking system needed bank reserves to fill the apparent shortfall evidenced by high overnight repo funding rates in September 2019. Prior instances of QE, especially the second and third programs, supplied banks with truly excess reserves. These excess reserves helped fuel asset prices.
  • Equity valuations are significantly higher today than during QE 1, 2, and 3.
  • The amount of government and corporate debt outstanding is much higher today, especially as compared with the QE 1 and 2 timeframes.
  • Having achieved a record-breaking duration, the current economic expansion is old and best described as “late-cycle”.

Déjà vu all over again?

The prior QE operations helped asset prices for three reasons.

  • The Fed removed a significant amount of securities from the market, which forced investors to buy other assets. Because the securities removed were the least risky available in the market, investors, in general, moved into riskier assets. This had a circular effect pushing investors further and further into riskier assets.
  • QE 4 appears to be providing the banks with needed reserves. Assuming that true excess reserves in the system do not rise sharply, as they did in prior QE, the banks will probably not use these reserves for proprietary trading and investing. 
  • Because the Fed is only purchasing Treasury Bills, the boost of liquidity and reserves is relatively temporary and will only be in the banking system for months, not years or even decades like QE 1, 2, and 3.

Will QE 4 have the same effect on asset prices as QE 1, 2, and 3?

Will the bullish market spirits that persisted during prior episodes of QE emerge again during QE 4?

We do not have the answers, but we caution that this version of QE is different for the reasons pointed out above. That said, QE 4 can certainly morph into something bigger and more akin to prior QE. The Fed can continue this round beyond the second quarter of 2020, an end date they provided in their recent announcement. They can also buy more securities than they currently allude to or extend their purchases to longer maturity Treasuries or both. If the economy stumbles, the Fed will find the justification to expand QE4 into whatever they wish.

The Fed is sensitive to market returns, and while they may not want excessive valuations to keep rising, they will do anything in their power to stop valuations from returning to more normal levels. We do not think investors can blindly buy on QE 4, as the various wrinkles in Fed execution and the environment leave too many unanswered questions. Investors will need to closely follow Fed meetings and Fed speakers for clues on expectations and guidance around QE 4.

The framework above should afford the basis for critical evaluation and prudent decision-making. The main consideration of this analysis is the benchmark it provides for asset prices going forward. Should the market disappoint despite QE 4 that would be a critically important contrarian signal.

QE By Any Other Name

“What’s in a name? That which we call a rose, By any other name would smell as sweet.” – Juliet Capulet in Romeo and Juliet by William Shakespeare

Burgeoning Problem

The short-term repo funding turmoil that cropped up in mid-September continues to be discussed at length. The Federal Reserve quickly addressed soaring overnight funding costs through a special repo financing facility not used since the Great Financial Crisis (GFC). The re-introduction of repo facilities has, thus far, resolved the matter. It remains interesting that so many articles are being written about the problem, including our own. The on-going concern stems from the fact that the world’s most powerful central bank briefly lost control over the one rate they must control.

What seems clear is the Fed measures to calm funding markets, although superficially effective, may not address a bigger underlying set of issues that could reappear. The on-going media attention to such a banal and technical topic could be indicative of deeper problems. People who understand both the complexities and importance of these matters, frankly, are still wringing their hands. The Fed has applied a tourniquet and gauze to a serious wound, but permanent medical attention is still desperately needed.

The Fed is in a difficult position. As discussed in Who Could Have Known – What the Repo Fiasco Entails, they are using temporary tools that require daily and increasingly larger efforts to assuage the problem. Taking more drastic and permanent steps would result in an aggressive easing of monetary policy at a time when the U.S. economy is relatively strong and stable, and such policy is not warranted in our opinion. Such measures could incite the most underrated of all threats, inflationary pressures.

Hamstrung

The Fed is hamstrung by an economy that has enjoyed low interest rates and stimulative fiscal policy and is the strongest in the developed world. By all appearances, the U.S. is also running at full employment. At the same time, they have a hostile President sniping at them to ease policy dramatically and the Federal Reserve board itself has rarely seen internal dissension of the kind recently observed. The current fundamental and political environment is challenging, to be kind.

Two main alternatives to resolve the funding issue are:

  1. More aggressive interest rate cuts to steepen the yield curve and relieve the banks of the negative carry in holding Treasury notes and bonds
  2. Re-initiating quantitative easing (QE) by having the Fed buy Treasury and mortgage-backed securities from primary dealers to re-liquefy the system

Others are putting forth their perspectives on the matter, but the only real “permanent” solution is the second option, re-expanding the Fed balance sheet through QE. The Fed is painted into a financial corner since there is no fundamental justification (remember “we are data-dependent”) for such an action. Further, Powell, when asked, said they would not take monetary policy actions to address the short-term temporary spike in funding. Whether Powell likes it or not, not taking such an action might force the need to take that very same action, and it may come too late.

Advice from Those That Caused the Problem

There was an article recently written by a former Fed official now employed by a major hedge fund manager.

Brian Sack is a Director of Global Economics at the D.E. Shaw Group, a hedge fund conglomerate with over $40 billion under management. Prior to joining D.E. Shaw, Sack was head of the New York Federal Reserve Markets Group and manager of the System Open Market Account (SOMA) for the Federal Open Market Committee (FOMC). He also served as a special advisor on monetary policy to President Obama while at the New York Fed.

Sack, along with Joseph Gagnon, another ex-Fed employee and currently a senior fellow at the Peterson Institute for International Economics, argue in their paper LINK that the Fed should first promptly establish a standing fixed-rate repo facility and, second, “aim for a higher level of reserves.” Although Sack and Gagnon would not concede that reserves are “low”, they argue that whatever the minimum level of reserves may be in the banking system, the Fed should “steer well clear of it.” Their recommendation is for the Fed to increase the level of reserves by $250 billion over the next two quarters. Furthermore, they argue for continued expansion of the Fed balance sheet as needed thereafter.

What they recommend is monetary policy slavery. No matter what language they use to rationalize and justify such solutions, it is pure pragmatism and expediency. It may solve short-term funding issues for the time being, but it will leave the U.S. economy and its citizens further enslaved to the consequences of runaway debt and the monetary policies designed to support it.

If It Walks and Quacks Like a Duck…

Sack and Gagnon did not give their recommendation a sophisticated name, but neither did they call it “QE.” Simply put, their recommendation is in fact a resumption of QE regardless of what name it is given.

To them it smells as sweet as QE, but the spin of some other name and rationale may be more palatable to the public. By not calling it QE, it may allow the Fed more leeway to do QE without being in a recession or bringing rates to near zero in attempts to avoid becoming a political lightening rod.

The media appears to be helping with what increasingly looks like a sleight of hand. Joe Weisenthal from Bloomberg proposed the following on Twitter:

To help you form your own opinion let’s look at some facts about QE and balance sheet increases prior to the QE era. From January of 2003 to December of 2007, the Fed’s balance sheet steadily increased by $150 billion, or about $30 billion a year. The new proposal from Sack and Gagnon calls for a $250 billion increase over six months. QE1 lasted six months and increased the Fed’s balance sheet by $265 billion. Maybe its us, but the new proposal appears to be a mirror image of QE.

Summary

The challenge, as we see it, is that these former Fed officials do not realize that the policies they helped create and implement were a big contributor to the financial crisis a decade ago. The ensuing problems the financial system is now enduring are a result of the policies they implemented to address the crisis. Their proposed solutions, regardless of what they call them, are more imprudent policies to address problems caused by imprudent policies since the GFC.

Who Could Have Known: What The Repo Fiasco Entails

Imagine approaching a friend that you think is very wealthy and asking her to borrow ten thousand dollars for just one night. To entice her, you offer as collateral the title to your 2019 Lexus parked in her driveway along with an interest rate that is 5% above that which she is earning in the bank. Shockingly, your friend says she can’t. Given the risk-free nature of the transaction and excellent one-day profit, we can assume that our friend may not be as wealthy as we thought.

On Monday, September 16th, 2019, a similar situation occurred in the overnight repurchase agreement (repo) funding market. On that day, banks were unwilling or unable to lend on a collateralized basis, even with the promise of large risk-free profits. This behavior reveals something very important about the banking system and points to the end of market stimulus that has been around for the past decade.

The Plumbing of the Banking System and Financial Markets

Interbank borrowing is the engine that allows the financial system to run smoothly. Banks routinely borrow and lend to each other on an overnight basis to ensure that all banks have ample funds to meet daily cash flow needs and that banks with excess funds can earn interest on them. Literally, years go by with no problems in the interbank markets and not a mention in the media.

Before proceeding, what follows is a definition of the funding instruments used in the interbank markets.

  • Fed Funds are uncollateralized interbank loans that are almost exclusively done on an overnight basis. Except for a few exceptions, only banks can trade Fed Funds.
  • Repo (repurchase agreements) are collateralized loans. These transactions occur between banks but often involve other non-bank financial institutions such as insurance companies. Repo can be negotiated on an overnight and longer-term basis. General collateral, or “GC,” is a term used to describe Treasury, agency, and mortgage collateral that backs certain repo loans. In a GC repo, the particular securities backing the loan are not determined until after the transaction is agreed upon by the counterparties. The securities delivered must meet certain pre-defined criteria.

On September 16th, overnight GC repo traded as high as 8%, almost 6% higher than the Fed Funds rate, which theoretically should keep repo and other money market rates closely tied to it. The billion-dollar question is, “Why did a firm willing to pay a hefty premium, with risk-free collateral, struggle to borrow money”?  Before the 16th, a premium of 25 to 50 basis points versus Fed Funds would have enticed a mob of financial institutions to lend money via the repo markets. On the 16th, many multiples of that premium were not enticing enough.

Most likely, there was an unexpected cash crunch that left banks and/or financial institutions underfunded. The media has talked up the corporate tax date and a large Treasury bond settlement date as potential reasons. We are not convinced by either excuse as they were easily forecastable weeks in advance.

Regardless of what caused the liquidity crunch, we do know, that in aggregate, banks did not have the capacity to lend money. Given the capacity, they would have done so in a New York minute and at much lower rates.

To highlight the enormity of the aberration, consider the following:

  • Since 2006, the average daily difference between the overnight GC repo rate and the Fed Funds effective rate was .025%.
  • Three standard deviations or 99.5% of the observances should have a spread of .56% or less.
  • 8% is a bewildering 42 standard deviations from the average, or simply impossible assuming a traditional bell curve.

What was revealed on the 16th?

The U.S. and global banking systems revolve around fractional reserve banking. That means banks need only hold a fraction of the cash deposits that they hold in reserve accounts at the Fed. For example, if a bank has $1,000 in deposits (a liability to the bank), they may lend $900 of those funds and retain only 10% in reserves. This is meant to ensure they have enough funding on hand to make payments during the day and also as a buffer against unanticipated liquidity needs. Before 2008, banks held only just as many reserves as were required by the Fed. Holding anything more than the required minimum was a drag on earnings, as excess reserves were unremunerated at the time.

Quantitative Easing (QE) and the need for the Fed to pay interest on newly formed excess reserves changed that. When the Fed conducted QE, they bought U.S. Treasury, agency, and mortgage-backed securities and credited the selling bank’s reserve account. The purpose of QE1 was to ensure that the banking system was sufficiently liquid and equipped to deal with the ramifications of the ongoing financial crisis. Round one of QE was logical given the growing list of bank/financial institution failures. However, additional rounds of QE appear to have had a different motive and influence as banks were highly liquid after QE1 and had shored up their capital as well. That is a story for another day.

The graph below shows how “excess” reserves were close to zero before 2008 and soared by over $2.5 trillion after the three rounds of QE. Before QE, “excess” reserves were tiny, measured in the hundreds of millions. The amount is so small it is not visible on the graph below. The reserves produced by multiple rounds of quantitative easing may have been truly excess, meaning above required reserves, on day one of QE. However, on day two and beyond that is not necessarily true for any particular bank or the system as a whole, as we are about to explain.

Data courtesy: St. Louis Federal Reserve

The Fed, having pushed an enormous amount of reserves on the banks, created a potential problem. The Fed feared that once the smoke cleared from the financial crisis, banks would revert to their pre-crisis practice of keeping only the minimum amount of reserves required. This would leave them an unprecedented surplus of excess funds to buy financial assets and/or create loans which would vastly increase the money supply with inflationary consequences. To combat this problem, they incentivized the banks to keep the reserves locked down by paying them a rate of interest on the reserves that were higher than the Fed funds rates and other prevailing money market rates. This rate is called the IOER or the interest on excess reserves.

The Fed assumed banks would hold excess reserves because they could make risk free profits at no cost. This largely worked, but some reserves were leveraged by the banks and flowed into the financial markets. This was a big factor in driving stock prices higher, credit spreads tighter, and bond yields lower. This form of inflation the Fed seemed to desire as evidenced from their many speeches talking about generating household net worth.

From the banks’ perspective, the excess reserves supplied by the Fed during QE were preferential to traditional uses of excess reserves. Historically, excess bank reserves were invested in the Treasury market or lent on to other banks in the Fed Funds market. Purchasing Treasury securities had no credit risk, but banks are required to mark their Treasury holdings to market and therefore produce unexpected gains and losses. Lending reserves in the interbank market also incurred counterparty risk, as there was always the chance the borrowing bank would be unable to repay the loan, especially in the immediate post-crisis period. Additionally, as QE had produced trillions in excess reserves, there was not much demand from other banks. Therefore, the banks preferred use of excess reserves was leaving them on deposit with the Fed to earn IOER. This resulted in no counterparty risk and no mark to market risk.

Beginning in 2018, the Fed began reducing their balance sheet via QT and the amount of excess reserves held by banks began to decline appreciably.

Solving Our Mystery

It is nearly impossible for the public to figure out how much in excess reserves the banking system is truly carrying. Indeed, even the Fed seems uncertain. It is common knowledge that they have been declining, and over the last six months, clues emerged that the amount of “truly excess reserves,” meaning the amount banks could do without, was possibly approaching zero.  

Clue one came on March 20th, 2019 when the Fed said QT would end in October 2019. Then, on July 31st, 2019, as small problems occurred in the funding markets, the Fed abruptly announced that they would halt the balance sheet reduction in August, two months earlier than originally planned. The QT effort, despite assurances from Bernanke, Yellen, and Powell that it would be uneventful, ended 22 months after it began. The Fed’s balance sheet declined only $800 billion as a result of QT, less than a quarter of what the Fed added to their balance sheet during QE.

Clue two was the declining spread between the IOER rate and the effective Fed Funds rate as the level of excess reserves was declining, as seen in the chart below. The spread between IOER and the Fed Funds rate was narrowing because the Fed was having trouble maintaining the Fed Funds rate within the targeted range. In March 2019, the spread became negative, which was counter to the Fed’s objectives. Not surprisingly, this is when the Fed first announced that QT would end.

Data courtesy: St. Louis Federal Reserve

The third and final clue emerged on September 16, 2019, when overnight repo traded at 7%-8%. If banks truly had excess reserves, they would have lent some of that excess into the repo market and rates would never have gotten close to 7-8%. It seems logical that banks would have been happy to lend on a collateralized basis at 3%, much less 7-8%, when their alternative, leaving excess reserves to the Fed, would have earned them 2.25%.   

Further confirmation that something was amiss occurred on September 17th, 2019, when the Fed Funds effective rate was above the upper end of the Fed’s target range of 2-2.25% at the time. This marked the first time the Fed Funds rate traded above its target since 2008.

On September 17th, the Fed entered the repo markets with a $53 billion overnight repo operation, whereby banks could pledge Treasury collateral to the Fed and receive cash. The temporary liquidity injection worked and brought repo rates back to normal. The following day the Fed pumped $75 billion into the markets. These were the first repo transactions executed by the Fed since the Financial Crisis, as shown below.

These liquidity operations will likely continue as long as there is demand from banks. The Fed will also conduct longer-term repo operations to reduce the amount of daily liquidity they provide.

The Fed can continue to resort to the pre-QE era tactics and use temporary daily operations to help target overnight borrowing rates. They can also reduce the reserve requirements which would, at least for some time, provide the system with excess reserves. Lastly, they can permanently add reserves with QE. Recent rhetoric from Fed Chairman Powell and New York Fed President Williams suggests a resumption of QE in some form may be closer than we think.

Why should we care?

The QE-related excess reserves were used to invest in financial assets. While the investments were probably high-grade liquid assets, they essentially crowded out investors, pushing them into slightly riskier assets. This domino effect helped lift all asset prices from the most risk-free and liquid to those that are risky and illiquid. Keep in mind the Fed removed about $3.6 trillion of Treasury and mortgage securities from the market which had a similar effect.

The bottom line is that the role excess reserves played in stimulating the markets over the last decade is gone. There are many other factors driving asset prices higher such as passive investing, stock buybacks, and a broad-based, euphoric investment atmosphere, all of which are byproducts of extraordinary monetary policies. The new modus operandi is not necessarily a cause for concern, but it does present a new demand curve for the markets that is different from what we have become accustomed to.

Summary

Short-term funding is never sexy and rarely if ever, the most exciting part of the capital markets. A brief recollection of 2008 serves as a reminder that, when it is exciting, it is usually a harbinger of volatility and disruption.

In a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.”

Much more recently, Jay Powell stated, “We’ve been operating in this regime for a full decade. It’s designed specifically so that we do not expect to be conducting frequent open market operations to keep fed fund [sic] rates in the target range.” 

Today, a decade after the financial crisis, we see that Bernanke and Powell have little appreciation for the inner-workings of the financial system. 

In the Wisdom of Peter Fisher, an RIA Pro article released in July, we discussed the insight of Peter Fisher, a former Treasury, and Federal Reserve official. Unlike most other Fed members and politicians, he discussed how hard getting back to normal will be. As we are learning, it turns out that Fisher’s wisdom from 2017 was visionary.

“As Fisher stated in his remarks, The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.”

Prophetic indeed.

Surging Repo Rates- Why Should I Care?

A subscriber emailed us regarding our repurchase agreement (repo) analysis from Tuesday’s Daily Commentary. Her question is, “why should I care about a surge in repo rates?” The commentary she refers to is at the end of this article.

Before answering her question, it is worth emphasizing that it is rare for overnight Fed Funds or Repo rates to spike, as happened this week, other than at quarter and year ends when bank balance sheets have little flexibility. Clearly, balance sheet constraints due to the end of a quarter or year are not causing the current situation.  Some say the current situation may be due to a lack of bank reserves which are used to make loans, but banks have almost $2 trillion in excess cash reserves. Although there may likely be an explanation related to general bank liquidity, there is also a chance the surge in funding costs is due to a credit or geopolitical event with a bank or other entity that has yet to be disclosed to the public.

Before moving ahead, let us take a moment to clarify our definitional terms.

Fed Funds are daily overnight loans between banks that are unsecured, or not collateralized. Overnight Repo funding are also daily overnight loans but unlike Fed Funds, are backed with assets, typically U.S. Treasuries or mortgage-backed securities. The Federal Reserve has the authority to conduct financing transactions to add or subtract liquidity to ensure overnight markets trade close to the Fed Funds target. These transactions are referred to as open market operations which involve the buying or selling of Treasury bonds to increase or decrease the amount of reserves (money) in the system. Reserves regulate how much money a bank can lend. When reserves are limited, short-term interest rates among and between banks rise and conversely when reserves are abundant, funding costs fall. QE, for instance, boosted reserves by nearly $3.5 trillion which enabled banks to provide liquidity to markets and make loans at low interest rates.

Our financial system and economy are highly leveraged. Currently, in the U.S., there is over $60 trillion in debt versus a monetary base of $3.3 trillion. Further, there is at least another $10-15 trillion of dollar-based debt owed outside of the U.S. 

Banks frequently have daily liquidity shortfalls or overages as they facilitate the massive amount of cash moving through the banking system. To balance their books daily, they borrow from or lend to other banks in the overnight markets to satisfy these daily imbalances. When there is more demand than supply or vice versa for overnight funds, the Fed intervenes to ensure that the overnight markets trade at, or close to, the current Fed Funds rate.

If overnight funding remains volatile and costly, banks will increase the amount of cash on hand (liquidity) to avoid higher daily costs. To facilitate more short term cash on their books, funds must be conjured by liquidating other assets they hold. The easiest assets to sell are those in the financial markets such as U.S. Treasuries, investment-grade corporate bonds, stocks, currencies, and commodities.  We may be seeing this already. To wit the following is from Bloomberg:  

“What started out as a funding shortage in a key U.S. money market is now making it more costly to get hold of dollars globally. After a sudden surge in the overnight rate on Treasury repurchase agreements, demand for the dollar is showing up in swap rates from euros, pounds, yen and even Australia’s currency. As an example, the cost to borrow dollars for one week in FX markets while lending euros almost doubled.”

A day or two of unruly behavior in the overnight markets is not likely to meaningfully affect banks’ behaviors. However, if the banks think this will continue, they will take more aggressive actions to bolster their liquidity.

To directly answer our reader’s question and reiterating an important point made, if banks bolster liquidity, the financial markets will probably be the first place from which banks draw funds. In turn, this means that banks and their counterparties will be forced to reduce leverage used in the financial markets. Stocks, bonds, currencies, and commodities are all highly leveraged by banks and their clientele. As such, all of these markets are susceptible to selling pressure if this occurs.

We leave you with a couple of thoughts-

  • If the repo rate is 3-4% above the Fed Funds rate, the borrower must either not be a bank or one that is seriously distressed. As such, is this repo event related to a hedge fund, bank or other entity that blew up when oil surged over 10% on Monday? Could it be a geopolitical related issue given events in the Middle East? 
  • The common explanation seems to blame the massive funding outlays due to the combination of Treasury debt funding and corporate tax remittances. While plausible, these cash flow were easy to predict and plan for weeks in advance. This does not seem like a valid excuse.

In case you missed it, here is Tuesday’s RIA repo commentary:  Yesterday afternoon, overnight borrowing costs for banks surged to 7%, well above the 2.25% Fed Funds rate. Typically the rate stays within 5-10 basis points of the Fed Funds rate. Larger variations are usually reserved for quarter and year ends when banks face balance sheet constraints. It is believed the settlement of new issue Treasury securities and the corporate tax date caused a funding shortage for banks. If that is the case, the situation should clear up in a day or two. Regardless of the cause, the condition points to a lack of liquidity in the banking sector. We will follow the situation closely as it may impact markets if it continues.

The Bankers Vig And The Price We Pay: The Economic Cost Of Repealing Glass-Steagall

When one bets on a sporting event the facilitator of the bet, referred to as a bookie, charges the winner of the bet the vigorish. The vigorish, commonly known as the vig, is a fixed percentage of the bet that serves as compensation to the bookie for providing numerous betting options (liquidity) and the financial surety of collecting on winning bets.

Financial institutions, like bookies, are intermediaries. They link borrowers with lenders and investors and provide financial security similar to bookies. The fees, or vig, they charge can be thought of as a tax on capital transactions and thus a tax on the economy. If the vig is excessive, individuals, businesses, and the government are unnecessarily sacrificing capital and wealth to bolster the profits of financial institutions.

Regulation is a form of interventionism representing a direct or indirect tax on the economy. More often than not, regulations are sand in the gears of the economic engine with few redeemable benefits and a multitude of unintended consequences. However, sometimes regulation is well worth its cost as it provides benefits that outweigh the economic tax and the burden put on others. 

The Glass-Steagall Act of 1933 was one such example. While the act narrowed the lines of business in which banks could participate, it protected the banks and, more importantly, the nation’s populace from economic depression. Many factors have weighed heavily on the economy in recent years, and in our opinion, the repeal of Glass-Steagall is one of them. Its repeal in 1999 provides a clear breakpoint in the history of financial institutions and the activities this regulation once restricted.  

Removing the Handcuffs

Financial institutions serve as a crucial cog in the economic engine by allowing capital to flow more efficiently. Consider how hard it would be to get a mortgage or auto loan if you had to go to family and friends to borrow money. The task is infinitely complicated when one considers companies and governments that seek hundreds of millions, billions and even trillions of dollars.

Financial institutions that facilitate capital transactions of all sorts are paid fees in various forms. When a financial institution acts as a broker in the trading of secondary market securities, they are typically rewarded with a bid/offer spread or a commission. In the case of new equity and debt offerings, they are paid a fee by the issuing entity. Interest rates on traditional loans to individuals and businesses are typically offered at a spread to the institution’s cost of borrowing, thus ensuring compensation for the financial institution providing the loan. Financial institutions require these fees to incent them to commit their capital and, equally importantly, to protect them from the financial risks embedded within these transactions.

The Glass-Steagall Act of 1933 was enacted to combat over-reaching banking activities that led to financial instabilities and fueled the Great Depression. The act’s primary purpose was to prevent another banking collapse like the one that was crippling banks and leaving depositors penniless at the time.  The legislation’s main thrust was to separate traditional banking activities from trading and investing practices. From 1933 until its repeal in 1999, banks taking deposits were prohibited from trading and underwriting in non-government and non-investment grade securities. The act did not prevent financial crises from occurring, but it certainly prevented a crisis anywhere near the magnitude of the Great Depression. 

In 1999, Congress passed the Gramm-Leach-Bliley Act (also comically known as the Financial Services Modernization Act of 1999) which repealed Glass-Steagall. The repeal, heavily lobbied for by the banking sector, was promoted to the public as a means to unleash bankers’ ability to provide more capital and liquidity to spur economic activity. Less than ten years after the Gramm-Leach-Bliley Act was signed, financial institutions imploded to a degree not seen since the Great Depression. Without the lifeline of massive tax-payer funded bailouts, unprecedented monetary policy, and questionable accounting standards changes, the financial carnage from the crisis of 2008 might have equaled or even surpassed that of the Great Depression. 

The VIG

Many experts warned at the time that the repeal of Glass-Steagall was another instance of greedy bankers looking for a way to pad the bank’s bottom lines and their paychecks with little consideration for the financial stability of their institutions or the potential economic consequences. The bankers won the battle and, as expected, profits in the financial industry soared almost immediately.

The graph below plots quarterly annualized financial corporate profits from 1948 to current. The data is separated by color to highlight the periods before and after the repeal of Glass-Steagall. Additionally, the red dotted regression trend line, showing trend profit growth pre-repeal, serves as a useful gauge to estimate the financial benefit to the banks of repealing Glass-Steagall.

Data Courtesy: St. Louis Federal Reserve (FRED) (NIPA profits with IVA and CC adjustments, Domestic – BEA)

As seen by the gap higher in profits in 1999, and how profits reset to an approximate 50% premium to the pre-1999 trend line, the repeal of Glass-Steagall was a windfall to the financial industry.

The financial industry claims that the significant jump in profits, post-repeal, is not just good for them but indicative of the benefits they deliver to corporate America and the economy. Ignorantly, such arguments fail to consider the massive costs shouldered by the citizens of the United States as a result of bailouts and the massive monetary stimulus that continue in unprecedented fashion to this day.

Measuring the Vig

Excluding the 2008 bailouts, whose costs are measured in the trillions, we attempt to quantify how much the repeal of Glass-Steagall is costing or benefiting economic activity. Said differently, how has the Vig, or economic tax, changed since 1999.

If the bankers are correct that deregulating financial institutions increased economic growth, then we should see an uptick in economic growth commensurate with the increased banking profits as shown above. As highlighted in the graph of GDP below, economic growth did not benefit. In fact, over the last 16 years, the GDP growth rate has been about 2.50% less than the pre-Glass Stegall era. Further, there has not been a quarterly increase in GDP higher than the average growth rate of the prior 50 years.

Data Courtesy: St. Louis Federal Reserve (FRED)

To further highlight the discrepancy claimed in the chart above, the graph below plots financial institution profits as a percentage of GDP.

Data Courtesy: St. Louis Federal Reserve (FRED) (NIPA profits with IVA and CC adjustments, Domestic – BEA)

Since 1999, bank profits (green) as a percentage of GDP are running about 1% higher than the red trend line of the prior 50 years. Our blunt take based on the graph above is that the repeal of Glass-Steagall effectively increased the VIG on the economy by 1%.

Furthermore, the collapse in profits in 2008 and 2009 was more than restored to financial institutions through the bailouts and extraordinary monetary policies used in the post-financial crisis era. As discussed above, those policies amount to massive subsidies coming at the cost of taxpayers and savers. They are directed at the banks, allowing them to quickly recoup self-inflicted losses.

Corporations are the heart and soul of the economy. They produce our goods, offer our services, pay our wages, and invest in productivity-enhancing projects. Therefore the capital flows of these companies are an important factor in economic growth. The more efficiently they can borrow and invest, the more innovation they can generate.

Before Glass-Steagall was abolished, financial institutions accounted for 20% of total corporate profits. Over the last 18 years, that amount has doubled to 40%. We remind you that banks do not innovate; their profits represent a missed opportunity for someone else to innovate.

Summary

When banks take a bigger share of the economic pie, labor, investment activity, corporations and shareholders suffer. The removal of Glass-Steagall has resulted in a large shift of capital from those that consume and innovate to the financial intermediaries or the economic bookies. You may think it a trivial matter that financial institutions are subsidized and profit at the expense of others. After all, those additional bank profits accrue to shareholders who in turn invest the capital back into the economy. While plausible, the fact of the matter is banking stocks have not reflected the higher profits. 

The KBW Bank Index has risen about 1% on an annualized basis since the Gramm-Leach-Bliley Act was passed. In other words, the shareholders have not been the beneficiaries of the enormous profit growth. Therefore, the riches graphed above have largely gone to those executives and other highly paid employees of these institutions. These circumstances have also widened the wealth imbalance that is so prevalent in the working population today.

If you happen to be one of the beneficiaries of the policies aimed at the financial industry, then you probably have done very well and had no complaints. For the other 99% of the working class, there may be some resentment to the fact that they were not only left behind but that they subsidized the policies fueling the wealth of the top 1%.