The events of this week displayed the true colors of market participants. Finally, for better or worse, governments have come to the realization that fiscal policy will accomplish very little. Efforts to correct this fiscal grid-lock places pressure on central banks to perform. With monetary stimulus essentially exhausted (certainly in the US), central banks seized this opportunity to protect themselves against foreseeable risks.
This report is lengthy, but feel free to skip sections. If you care less about the reasoning behind the downgrades, you might want to just skim straight to the Central Bank response section.
Ratings Agencies Draw their Red Flags
S&P presented a string of bank downgrades which included Bank of America, Citigroup, Morgan Stanley, Wells Fargo, and other major players. At face value, people were quick to either panic or brush this off. The panic came from those who saw this as confirmation of a deepening crisis. Others viewed the downgrades as useless; the problems are obvious, and we saw this coming. However, both groups share the same belief that the global capital markets are entering further misery. We cannot be arrogant and place the downgrades aside without looking deeper into the reasoning behind it.
The math explains the underlying worries about further risk. Once we understand this, everything else begins to fall in place.
The ratings result from a calculation comprised of a weighted average of significant variables. These variables measure the strength/weakness of a banks' financial structure.
The Stand Alone Credit Profile (SACP) is comprised of preferred stock evaluations, combined debt ratings, and basic levels of government support. This portion of the formula is all about the bank's ability to pay back debt to stock and bond holders based on its balance sheet of deposits, returns on lending, government guarantees, etc. Bottom line - this is the overall health of the bank.
Extraordinary Support is the next variable. Simply put, this measures the bank's access to government support on extraordinary levels such as capital injections and other sorts of "bailout-style" measures. This also includes support by a group - if a bank is part of a major bank, it will receive support from greater levels.
SACP + Extraordinary Support = ICR
Issuer Credit Rating (ICR) is the result of this calculation. This is what we see as investors; the combined rating of the bank. It is important to note that the ICR takes into consideration of potential for additional direct support from the parent bank or sovereign government.
All math aside, this all shows that government support is a major component in the model used to rate banks. With the current turmoil, there is intense pressure on governments to perform. If there is uncertainty, it is reflected in the rating.
Patterns of boom/bust indicate likely government support. However, history shows that government support never solves the underlying problems. Banking crises will happen again, and these rating will continue to take this fact into account.
The recent S&P report is revised for modern times. The truth is that government support is uncertain. Governments are less able to support a range of banks because of its own balance sheet constraints. However, we are given more certainty for groups of banks with shared problems, as systemic risk on the entire system is more important for Central Banks to perform their role of ensuring price stability in the economy.
Supporting the system is one thing, but direct support will make less impact. Liquidity and capital injections are unlikely to raise SACP because of the underlying internal cash difficulties of that specific bank. There is execution risk of utilizing government funds effectively, and managing the flight back to independence is very difficult.
History shows that banks almost never reach back to a level of independence. Government support is a drug that never leaves the system. It causes market distortions that raises false expectations, creating an environment in which a completely independent bank will not be equipped to operate in (hence the fall of regional banks in the US). Depositors are propped up with artificial fiscal and monetary measures such as stimulus and low interest rates. The most striking part of government support is that banks are pressured into providing loans to industries and companies that support the growth mission of that nation. These are usually high risk loans (a repeat of the housing crisis), but the certainty of government support is priced in to these models, so it does not look as bad.
We are operating in a world of powerful zombie banks (a fancy way of saying Government Related Enterprises - GRE) that are in desperate need to become independent and correct these market distortions - thereby saving the public from underlying misery.
Central Banks to the Rescue
Market distortions aside, the Central Banks (well, the US only) seem to be saving themselves as they work to calm the financial crisis.
Eurogroup ministers held a press conference to discuss their progress in expanding the capacity of the European Financial Stability Fund (EFSF). The ministers appeared exhausted and less hopeful; but there might be good reason behind this attitude. The thought is that even if the member countries do not cooperate in getting its fiscal house in order to pay back debt, the ECB and partners would have hedged against this.
The frustration is certainly directed towards the politicians in the member countries. As Megan Greene (Economist Meg) strongly advocates in her blog, Central Banks need to protect themselves against losses on these relief funds. The use of Special Drawing Rights (SDR's - a combination of currencies), or implementing her 'Big Bazooka' plan is a way for these Central Banks to play defense amidst the political bickering. This is business!
 |
| Notice the large amounts of swaps used during the '08 crisis |
Fortunately, the US Federal Reserve understands this. Calling for global cooperation to increase access to US Dollars through currency swaps will strengthen the safety net of global banks in seek of liquidity. The idea is that a foreign bank or firm will pay their currency in exchange for borrowed dollars from the US Federal Reserve. At the end of the contract, the foreign firm or bank is obligated to repurchase their currency from the Fed at the same exchange rate. The foreign firm also pays a market based interest rate to the Federal Reserve for the liquidity swap protection. The US stands to gain from this move.
The interest rate paid to the Fed after the swap agreement (usually ranging from overnight to 3 months at most) is determined by the market, on average. The US Fed sets the Federal Funds Rate, but swap rates are left for the market to decide upon agreement between banks and firms. To influence a lower rate with the liquidity swap program, all the US Federal Reserve has to do is simply announce that their swap window is open for more business. Banks run back to price in a lower interest rate in their models, and by doing so, future liquidity increases in the entire market. Rates are expected to decrease to 0.645% from 0.805% as of Tuesday. Now, rates are hovering around 0.523%.
The Federal Reserve is artificially increasing the demand for dollars at its swap window, which will eventually send the dollar exchange rate higher. As foreign firms and banks extract greater value from our dollar, the Fed moves closer to inflating our way out of debt (paying back interest to our debt holders with a higher valued dollar is more affordable). The inflation is seen in the value of commodities such as corn, with future prices rising consistently.
No comments:
Post a Comment