Credit & Capital

Is More Quantitative Easing in Sight?

Good news: U.S. banks' funding costs are falling. Bad news: the European Central Bank prepares to make new asset purchases.
David McCannJuly 29, 2019

With the end of second-quarter earnings season in sight, there is good news and bad news for the banking industry.

The good news is that the rate of change in U.S. bank-funding costs is slowing, from 50% to 60% year-over-year increases to about 30% or 40% this past quarter.

Indeed, even though the middle of the Treasury yield curve has essentially collapsed, there is no indication that funding costs are following suit. Interest rates in the United States remain buoyant, outside of the government bond market.

The bad news is across the Atlantic, where the European Central Bank is preparing to make another futile round of asset purchases as the U.K. prepares to crash out of the European Union. For those who missed the spectacle, former Goldman Sachs banker Mario Draghi, who is leaving the ECB in October, wants to provide more stimulus to Europe’s flagging economy.

“The European Central Bank on Thursday made clear it stands ready to cut rates and deliver ‘highly accommodative’ monetary policy,” reported Market Watch, “including additional asset purchases, in its effort to push stubbornly low inflation back toward its target amid signs of deteriorating economic conditions in the eurozone.”

Despite growing evidence that negative interest rates are injurious to economic growth, housing affordability, and employment, among other things, economists at the various central banks persist in calling for more of the same bad medicine.

How many times must we hear central bankers express “surprise” that inflation remains low, even as they are busily transferring resources from private savers to public sector debtors?

The only people who seem to be in favor of resuming asset purchases (aka quantitative easing) are increasingly worried equity managers. Writing in the Financial Times over the weekend, Merryn Somerset Webb, editor-in-chief of MoneyWeek, boldly chastised BlackRock executives for suggesting that the ECB should start to buy equities.

“Our senses have been dulled by increasingly extreme monetary policy over the past decade, so we must try to look afresh,” Webb wrote. “What is being suggested here is that the ECB, a publicly owned institution, prints money and uses it to buy equity stakes in private companies. In other words, the only way to save capitalism is to begin to nationalize it.”

Well, yes. The global equity manager community is positively soiling its nappies at the thought that the central banks will stop buying assets. An end to quantitative easing means an end to constantly rising asset prices. Once asset prices start to fall, as is the case with the top half of the U.S. real estate market, credit will return as an issue.

But can we actually deflate the various asset bubbles, including global equities, without causing an equally global liquidity crisis?

We tend to think that the cheering for rate cuts and resumption of asset purchases is a function of buy-side managers talking about their shrinking liquidity book. The suggestion of equity market purchases is apparently to prevent a larger, nastier repeat of the H2O investor run.

Isn’t that the point, though? Now that the Federal Open Market Committee (FOMC) has set up the global equity markets for a sharp come-down, does not that imply a whole series of new Maiden Lane-type vehicles to buy illiquid garbage and thereby provide ready cash to investors?

Short-term market liquidity aside, we suspect that the true motive of central bankers with respect to negative rates has nothing to do with growth or jobs and everything to do with the imminent insolvency of large industrial nations. Italy, Japan, and even that darling of the buy-side equity manager, mainland China, belong on this list.

Only the fact of $14 trillion in government debt trading at negative yields keeps the grim reaper of sovereign debt restructuring from its work. Yet even with negative rates, much of the debt markets is visibly mispriced, which begs the question as to when the great reset will commence.

CLOs: Falling Volumes and Loan Quality

Speaking of falling liquidity and bad ratings, ponder the world of leveraged loans and collateralized debt obligations (CLOs). Since the start of the year, the performance of CLOs and leveraged loans has been stellar, but on falling volumes of new issuance. Investors are quietly running away from the once-popular asset class.

Two interesting trends have appeared in recent weeks, according to the astute folks at TCW: (1) increased dispersion in the spreads among different sectors of issuers, and (2) a flow of decidedly lower-rated assets into new deals.

This situation is reminiscent of 2007, when the Street tried to issue just a few more private mortgage securities deals containing the worst production from the subprime sausage factory.

Funny thing about CLOs is that they tend to trade way below the prices suggested by the usual suspects in the rating agency world. Just for a bit of context, let’s have a look at the old corporate ratings scale from S&P:

AAA: 1 bp; AA: 4 bp; A: 12 bp; BBB: 50 bp; BB: 300 bp; B: 1,100 bp; CCC: 2,800 bp; Default: 10,000 bp

So, a “AAA” corporate rating is about 1 basis point of default risk, or a 1/100th of 1% probability of default. An actual default is 10,000bp, or 100%.

This is an interesting point, because if you look at the yield spreads for CLOs, the “AAA” rated paper trades about 100-130bp over the Treasury yield curve, or the spread for a “BBB” rating. The “BBB” paper trades about 300-400bp over the curve, which maps to a “B” rating. And the “B” paper trades about 1,000bp over, or about the same spread as the corporate ratings breakpoints above. So why the discount on the investment-grade-rated CLO tranches?

Could it be that investors don’t believe those “AAA” CLO ratings from Moody’s, S&P et al., even though the CLO market has rallied since January? Maybe that’s why investors continue to flee the sector.

TCW notes that mutual funds’ asset under management (AUM) dedicated to CLOs have been cut by a third since the FOMC’s December massacre. Yet loan fund outflows have apparently been offset by high-yield investors grazing on new, lower rated CLO issuance, albeit at greatly reduced volumes vs. a year ago. Maybe a new asset class that me might call “Junk CLOs”?

The biggest risk in the market today is not credit — that comes later — but rather liquidity risk. When investors head for the exits after an extended, central bank-fueled asset bubble, bad things happen.

When you see BlackRock executives openly asking the ECB to come to the rescue, it sure makes you wonder. Truth is that all of the buy-side managers want and need to be “too big to fail,” since nobody can surf the waves of volatility being created by the FOMC.

Christopher Whalen is chairman of Whalen Global Advisors, a provider of investment banking and consulting services to institutional investors and corporate clients worldwide. This article was initially published in Whalen’s online publication, The Institutional Risk Analyst. It is republished here with Whalen’s permission.

Case Study: How Edgewood Tahoe’s CFO Saved 500 Jobs From the Ashes