"Funding for Lending", yet another failed central bank experiment imported from Japan

In his Wall Street Journal column, Alan Blinder makes the case for the Fed to follow the Bank of England's lead in encouraging banks to lend by starting a "Funding for Lending" program.

Regular readers know that banks are awash in liquidity and fighting to achieve meaningless bank capital ratios.

So the question that should be asked is why does anyone think that access to funding is what is restricting bank lending as oppose to financial regulators crushing lending through regulation of bank capital ratios?

As the Telegraph reports about the UK "Funding for Lending" program,

[Danny Gabay of Fathom Consulting] was sceptical about the latest growth strategy of “funding for lending” to lower the cost of credit, arguing that households needed to reduce their debt by about a third – or about £440bn in current money. 

He said: “The Government wants banks to lend more to households when house prices on most metrics are still overvalued. It doesn’t sound like sensible policy to us. We need to be encouraging households to deleverage.” 

Ms [Deanne] Julius said that although it was “worth a try” she “does not have huge hopes” for funding-for-lending. 

“I met some Bank of Japan officials who said they had tried something similar and it had been another contributory factor to their zombie banks.” 

Sir John [Gieve] welcomed the effort and the indication that policy is joined-up between the Bank, the Treasury and the Financial Services Authority, but said: “I don’t think its going to make a massive difference.”

Not exactly a ringing endorsement for a program.

WSJ confirms regulatory policy driven credit crunch in Eurozone

As the dust settles over the latest Greek bailout proposal, market participants are beginning to look at what the implications are for Eurozone banks.

Specifically, they are looking at how much more in the way of assets the banks are going to have to dispose of to still reach a 9% Tier I capital ratio by June given the hit to their Tier I capital caused by writing down Greek sovereign debt.

Regular readers know that bank book capital was rendered meaningless at the beginning of the financial crisis when regulators adopted the policy of regulatory forbearance and mark-to-market accounting was suspended.

Since bank book capital is currently meaningless, a regulatory policy of requiring the banks to reach a 9% Tier I capital ratio is meaningless for restoring confidence in the banks, but is meaningful in terms of the credit crunch it precipitates.

Frankly, Eurozone banks are not capable of internally generating capital quickly enough to offset the losses on the Greek debt or the future losses on the debt of Portugal, Spain and maybe Italy.

At the same time, due to a lack of disclosure, investors are unwilling to invest in the banks.  Would you invest in a black box and hope to see both return on and return of your capital?

What all this means for the Eurozone banks is that they have to cut back on lending.

A WSJ article confirms this regulatory policy driven credit crunch in the Eurozone

World financial markets may have breathed a collective sigh of relief over the rescue package for Greece, but European bank stocks have fallen since the announcement Tuesday. 

After a fourth quarter in which many of the Continent's banking institutions wrote down tens of millions of euros on their exposure to Greece, 2012 is likely to be a year of retrenchment as they work to meet strict capital requirements....

The €130 billion ($172.3 billion) Greek package, agreed upon on Tuesday, calls for private investors to take a 53.5% haircut, more than the 50% agreed on in October. Real losses will be as much as 70% after factoring in lower interest rates paid on new debt investors will receive in exchange for their existing Greek bonds. 

Analysts now expect banks to stay in defensive mode, hoarding cash and cutting back on their reliance on debt. Lending is likely to be limited to domestic markets. 

"Top-tier euro-zone banks are building up stocks of short-term liquidity, paring down risk assets to meet tougher regulatory standards for capital adequacy, and tightening credit standards," Standard & Poor's said in a recent note. 

The so-called Basel III rules, agreed upon by the Basel Committee on Banking Supervision, call for international banks to hold core Tier 1 capital ratios—a measure of their ability to absorb losses—of at least 7%. The rules also impose new requirements for bank liquidity and leverage. 

The European Banking Authority requires European banks to reach a core Tier 1 ratio of 9% by June 2012.

S&P finds Eurozone banks deleveraging despite ECB loans

A Telegraph article reports that S&P has discovered that Eurozone banks are deleveraging so as to reach the 9% Tier I capital ratio target and using the loans from the ECB for liability management.

Regular readers are not surprised as this confirms your humble blogger's predictions of a financial regulator created credit crunch and that higher capital ratios would not unfreeze the interbank or private funding markets.

In a report published on Tuesday, S&P analysts warned that "deleveraging" by European banks was one of the industry's "defining" issues and that the €859bn borrowed by lenders from the ECB had not stopped credit availability from shrinking. 

S&P points out that loans to eurozone residents shrank by 1.2pc year-on-year for the 12 months to the end of December, with Ireland, Spain, Portugal and Belgium among the countries showing a decline in loan growth. 

The declines come despite the ECB pumping €489bn into eurozone banks in December as part of a new three-year lending facility, which took the total borrowed to more than €800bn....

At the end of this month, the ECB will allow banks to borrow three-year money for a second time, with most analysts expecting lenders to borrow at least a further €500bn. 

However, S&P said this was only a form of "emergency relief" providing "breathing room" for banks struggling to find private sources of funding. 

"The pace and scope of deleveraging will be one of the defining issues of the eurozone banking industry in the years to come. Although the very large amount of loans from the ECB may slow down this process, we believe banks in Europe will use them more for liability management, namely, paying off maturing wholesale debts that fund assets already on the balance sheet," said S&P.

Bill Gross takes on Fed's zero interest rate policy

In his February 2012 Investment Outlook, Bill Gross examines the critical assumptions behind the Fed's zero interest rate policy and finds they do not hold and as a result the policy is doing more harm than good.

Regular readers know that over the last year this blog has run several posts on this topic that came to the same conclusion (see here, here, and here).  In fact, the similarities between his Investment Outlook and this blog's posts in looking at the critical assumptions behind the Fed's zero interest rate policy suggest that he too is a regular reader.

• Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside.
• Most short to intermediate Treasury yields are dangerously close to the zero-bound which imply limited potential room, if any, for price appreciation.
• We can’t put $100 trillion of credit in a system-wide mattress, but we can move in that direction by delevering and refusing to extend maturities and duration....

The transition from a levering, asset-inflating secular economy to a post bubble delevering era may be as difficult for one to imagine as our departure into the hereafter....

Yet the imagination and management of the transition ushers forth a plethora of disparate policy solutions.... 

Fed Chairman Ben Bernanke ... preannounced an awareness of the deleterious side effects of quantitative easing several years ago in a significant speech at Jackson Hole. Ever since, he has been open and honest about the drawbacks of a zero interest rate policy, but has plowed ahead and unleashed his “QE bowser” into the wild with the understanding that the negative consequences of not doing so would be far worse. 

Actually, it his belief that the negative consequences of not doing so would be far worse.

Walter Bagehot, the man who wrote the book on modern central banking, would say that this belief is not true and that the negative consequences far exceed the benefit.  Mr. Bagehot said that rates should not drop below 2% and John Maynard Keynes deferred to his judgement.

My goal in this Investment Outlook is not to pick a “doggie bone” with the Chairman. He is makin’ it up as he goes along in order to softly delever a credit-based financial system which became egregiously overlevered and assumed far too much risk long before his watch began. 

Like Mr. Gross, I do not want to step into the Bagehot/Bernanke debate.

This blog has consistently focused on the alternative to the Fed attempting to address over-leverage in the financial system through monetary policy.  The alternative is to have the banks function as a safety valve between the excesses in the financial system and the real economy.

Banks can act as a circuit breaker by absorbing the losses on the excesses in the financial system today and restoring their book capital through future retained earnings.

My intent really is to alert you, the reader, to the significant costs that may be ahead for a global economy and financial marketplace still functioning under the assumption that cheap and abundant central bank credit is always a positive dynamic. When interest rates approach the zero bound they may transition from historically stimulative to potentially destimulative/regressive influences. 

Much like the laws of physics change from the world of Newtonian large objects to the world of quantum Einsteinian dynamics, so too might low interest rates at the zero-bound reorient previously held models that justified the stimulative effects of lower and lower yields on asset prices and the real economy. 

It is instructive to mention that this is not necessarily PIMCO’s view alone. Chairman Bernanke and Fed staff members have been sniffin’ this trail like the good hound dogs they are for some time now. In addition, Credit Suisse, in their “2012 Global Outlook,” devoted considerable pages to specifics of zero-based money with commonsensical historical comparisons to Japan over the past decade or so. The following pages of this Outlook will do the same.  

At the heart of the theory, however, is that zero-bound interest rates do not always and necessarily force investors to take more risk by purchasing stocks or real estate, to cite the classic central bank thesis.  

First of all, when rational or irrational fear persuades an investor to be more concerned about the return of her money than on her money then liquidity can be trapped in a mattress, a bank account or a five basis point Treasury bill. But that commonsensical observation is well known to Fed policymakers, economic historians and certainly citizens on Main Street.  

What perhaps is not so often recognized is that liquidity can be trapped by the “price” of credit, in addition to its “risk.” 

Capitalism depends on risk-taking in several forms. Developers, homeowners, entrepreneurs of all shapes and sizes epitomize the riskiness of business building via equity and credit risk extension. 

But modern capitalism is dependent as well on maturity extension in credit markets. 

No venture, aside from one financed with 100% owners’ capital, could survive on credit or loans that matured or were callable overnight. Buildings, utilities and homes require 20- and 30-year loan commitments to smooth and justify their returns. Because this is so, lenders require a yield premium, expressed as a positively sloped yield curve, to make the extended loan. 

A flat yield curve, in contrast, is a disincentive for lenders to lend unless there is sufficient downside room for yields to fall and provide bond market capital gains. This nominal or even real interest rate “margin” is why prior cyclical periods of curve flatness or even inversion have been successfully followed by economic expansions. Intermediate and long rates – even though flat and equal to a short-term policy rate – have had room to fall, and credit therefore has not been trapped by “price.” 

When all yields approach the zero-bound, however, as in Japan for the past 10 years, and now in the U.S. and selected “clean dirty shirt” sovereigns, then the dynamics may change. Money can become less liquid and frozen by “price” in addition to the classic liquidity trap explained by “risk.”  

Even if nodding in agreement, an observer might immediately comment that today’s yield curve is anything but flat and that might be true. Most short to intermediate Treasury yields, however, are dangerously close to the zero-bound which imply little if any room to fall: no margin, no air underneath those bond yields and therefore limited, if any, price appreciation. 

What incentive does a bank have to buy two-year Treasuries at 20 basis points when they can park overnight reserves with the Fed at 25? What incentives do investment managers or even individual investors have to take price risk with a five-, 10- or 30-year Treasury when there are multiples of downside price risk compared to appreciation? At 75 basis points, a five-year Treasury can only rationally appreciate by two more points, but theoretically can go down by an unlimited amount.  

Duration risk and flatness at the zero-bound, to make the simple point, can freeze and trap liquidity by convincing investors to hold cash as opposed to extend credit.  

Where else can one go, however? We can’t put $100 trillion of credit in a system-wide mattress, can we? Of course not, but we can move in that direction by delevering and refusing to extend maturities and duration. 

Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside. Still, zero-bound money may kill as opposed to create credit. 

Developed economies where these low yields reside may suffer accordingly. It may as well, induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper. 

Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. 

We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.

Despite ECB's efforts, Europe heads into credit crunch created by the bank regulators

According to a Bloomberg article, Eurozone banks are now depositing almost all of the money borrowed under the ECB's 3 year financing program back with the ECB.

For regular readers, this is no surprise as it was predicted on this blog.

• The Eurozone interbank lending market is frozen.  No banks trusts in the solvency of any other bank.

• At the same time, Eurozone banks are shrinking so they can meet the 9% Tier I capital ratio target set by the regulators.  One look at what happened to UniCredit, off 60+% when it raised capital, is more than enough to encourage management to find other alternatives, including shrinking the loan portfolio, for hitting the capital ratio.  The result is a credit crunch.

In Europe, we have a situation where not only is monetary and regulatory policy not coordinated, but it is actively working against each other.  Monetary policy is trying to promote growth while regulatory policy is limiting access to the loans needed for that growth.

I don't want to single Europe out as somehow unique.  In the US, the Fed oversees both monetary and regulatory policy.  

The Fed could require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details (no ultra transparency, no access to myriad Fed programs).  The requirement of ultra transparency would trigger banks realizing the losses currently hidden on their balance sheets.  

This includes their losses on residential real estate.  Once the losses are recognized, the banks then have an incentive to pursue one of the courses of action laid out in the White Paper on the housing industry Chairman Bernanke sent to Congress.

As Chairman Bernanke pointed out, until the housing industry is addressed, the full benefits of current monetary policy will not be achieved.

Banks are hoarding the European Central Bank’s record 489 billion-euro ($625 billion) injection into the banking system, thwarting attempts by policy makers to avert a credit crunch in the region. 

Almost all of the money loaned to 523 euro-area lenders last month wound up back on deposit at the Frankfurt-based central bank instead of pouring into the financial system, ECB data show. 

Banks will use most of the three-year loans to meet their refinancing needs for this year and next, analysts at Morgan Stanley and Royal Bank of Scotland Group Plc estimate. 

“It’s illusory to think that the measure will translate into credit generation,” Philippe Waechter, chief economist at Natixis Asset Management in Paris, said in an interview. “It will assuage some of the anxiety banks have regarding their liquidity needs. But they’ve engaged into a massive overhaul of their strategy and shrinkage of their balance sheets, which is, coupled with the deteriorating economy, not compatible with increasing credit.”...

Governments are urging European banks to keep lending to companies and individuals while requiring them to raise an additional 114.7 billion euros of core capital by June to weather a deepening sovereign-debt crisis. 

Instead of raising equity, most lenders across Europe have vowed to meet capital rules by trimming at least 950 billion euros from their balance sheets over the next two years, either by selling assets or not renewing credit lines, according to data compiled by Bloomberg.... 

Banks account for about 80 percent of lending to the euro area, making them “crucial to the supply of credit,” according to recently installed ECB President Mario Draghi. By contrast, U.S. companies rely more on capital markets for financing, selling bonds to investors.

The ECB lending, and a follow-up loan offering on Feb. 28, won’t ease the pressure on banks to shrink, say analysts including Huw van Steenis at Morgan Stanley in London. 

“The ECB loans will largely be used to pre-fund 2012 and some of 2013’s bank refinancing needs, but it will not stimulate lending,” Van Steenis said. They will “just stop it falling off precipitously.”... 

With the ECB’s injection, “deleveraging may happen in a more orderly way, but it doesn’t mean it will be painless,” said Alberto Gallo, head of European credit strategy at RBS. Banks are faced with high long-term financing costs, a deteriorating economy and difficulties raising capital, he said. “It’s what I call the double punch: A combination of negative growth and banks’ deleveraging will affect lending activity.” 

Even the ECB’s Draghi, who has made it one of his priorities is to keep credit flowing into the economy, said the central bank’s loan offerings may fail to achieve that goal. 

“Monetary policy cannot do everything, but we’re trying to do our best to avoid a credit crunch that might come from a lack of funding,” Draghi said Dec. 19 at the European Parliament in Brussels. “We have to be extremely careful here, because there may be other reasons that create a credit crunch.”...

“The ECB loans are a kick-the-can measure that doesn’t fix the banks’ structural problems,” Gallo said. “Deleveraging needs to happen.”

Hostage to mountains of debt, economies and banks become zombies

The Wall Street Journal talked with Bridgewater Associates Robert Prince about his views on where the economy is headed.  His focus was on how working through the mountains of debt is effectively turning the economies and banks of the US, UK and Europe into zombies.

Despite the fact that Japan is already in its third lost decade from its credit bubble, Mr. Prince thinks that the western economies have only 10 to 15 more lost years to work through their credit bubble.

As ZeroHedge likes to phrase the problem of the mountain of debt

the greatest threat to the modern financial system: a debt overhang so large, at roughly $21 trillion, that one of 3 things will have to happen: a global debt restructuring/repudiation; global hyperinflation to inflate away this debt, or a one-time financial tax on all individuals amounting to roughly 30% of all wealth. That's pretty much it, at least according to mathematics.

Regular reader know that your humble blogger thinks that the best and fastest way to fix the financial system and work through the debt bubble is ultra transparency.

Specifically, by requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, the distortion in asset prices caused by regulatory forbearance is eliminated.

With this information, market participants will value every exposure for each bank.

As a result, the focus of banks changes from hiding losses (think extend and pretend) to addressing their bad debt and minimizing their losses.

The alternative to ultra transparency that has been tried unsuccessfully in Japan, the US, UK and Europe is to continue hiding the debt in the financial system and try to inflate it away.  This alternative has numerous problems, not the least of which is that it results in both the economies and banks being zombies.

Bridgewater Associates has made big money for investors in recent years by staying bearish on much of the global economy. As the new year rings in, the hedge fund firm has no plans to change that gloomy view. 

Robert Prince, co-chief investment officer at Bridgewater, and his managers at the world's biggest hedge fund firm are preparing for at least a decade of slow growth and high unemployment for the big developed economies. Mr. Prince describes those economies—the U.S. and Europe, in particular—as "zombies" and says they will remain that way until they work through their mountains of debt. 

"What you have is a picture of broken economic systems that are operating on life support," Mr. Prince says. "We're in a secular deleveraging that will probably take 15 to 20 years to work through and we're just four years in." 

In Europe, "the debt crisis is [a] long ways from over," he says. The economic and financial morass will mean interest rates in the U.S. and Europe will essentially be locked at zero for years....

In a conference room at Bridgewater's headquarters, where the water from the Saugatuck appeared to almost lap at the glass walls, Mr. Prince paints a grim picture of the challenges facing the U.S. and European economies. 

Recent better-than-expected news on the U.S. economy is unlikely to be the start of a healthy expansion, he says. The uptick in economic growth has been fueled by a decline in the savings rate, which, without material income and employment gains, is unlikely to be sustainable as long-term credit growth also remains weak, he says. 

The problem for the U.S, says Mr. Prince, is that it is on the wrong side of a long-term debt cycle. 

"We were in a leveraging-up period for 60 years, from the early 1950s to 2008," he says. This debt bubble was self-reinforcing on the way up, and "when it tipped over, it set about a self-reinforcing process on the way down." 

As evidence for the long slog facing the U.S economy, he notes that the level of leverage, as measured by comparing household income to net worth, is still higher than it was before 2008.
"The most likely environment is moderate growth with wiggles up and down and this is one of those wiggles up," he says.... 

Europe, meanwhile, is headed into a potentially deep recession, with policy makers boxed in by an interconnected banking and sovereign-debt crisis. 

"You've got insolvent banks supporting insolvent sovereigns and insolvent sovereigns supporting insolvent banks," he says.

This is where ultra transparency and a credible deposit guarantor come in.  With ultra transparency, the banks can absorb the losses on the insolvent sovereign debt.  With the deposit guarantor, the banks can continue in operation while they rebuild their book capital.