Fed Governor Stein's Doubts: Junk ETFs And Chinese WMPs

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Includes: HYG, JNK
by: William Gamble

Copper or better known as Dr. Copper is diagnosing something serious. Copper prices are often considered a proxy for the health of the global economy and prices are down. They have fallen by 5% in the last month and are well off their highs of 2012 and 30% lower than 2011. Inventories have more than doubled in three months, the fastest rise since demand crashed in 2008. Besides copper, earnings of European equities are also down. Fourth quarter profit at European companies fell 5.2% from a year earlier, while revenue inched up just 0.5%. Analyst forecasts last fall were for 15% growth. They now forecast just 5% growth. Yet despite the gloom equities in both Europe and the US are reaching new highs. The obvious reason is the enduring faith in central banks to provide as much money as it takes for as long as it takes. But are there some risks to this strategy? One of those central bankers certainly thinks so.

Dr. Jeremy C. Stein was, like Chairman Bernanke, a Harvard professor of economics when he was appointed to fill a vacancy on the board of governors of the US Federal Reserve. Last month he gave a speech regarding overheating in credit markets. His remarks concerned an analysis of why markets experience credit booms that inevitably end in tears. His explanation centered on the view that the main causes of these booms are institutions, agencies, and incentives, in short: the rules.

Part of the problem that economists have with credit markets is that the movements are not caused by the lenders themselves. Lenders are far more cautious with their money. Instead the risk is determined by agents in the financial community who are more interested in their own compensation rather than the amount of risk.

After every crash institutions and regulators try to protect against excessive risk taking by developing a new set of rules. But the agents have very large incentives to discover vulnerabilities in the rules and take advantage of them in ways that may bring down their organizations or the whole economy. Determining episodes of overheating is a major problem. They cannot be precisely measured like unemployment or inflation. To help identify them, Governor Stein proposed three factors.

The first is financial innovation. In the last crash the new innovation of collateralized debt obligation (CDO) secured by subprime mortgages received a lot of the blame. When used properly many of these innovations can bring enormous benefit, but since they are new and unfamiliar to both the players and the regulators their risks are not obvious, while the benefits to the agents are.

The second factor is a change in the regulation. Regulations are usually aimed at one particular evil, but often the rules or the way they are administered can result in unintended consequences. This is especially true if the rules are meant to help reform a prior system in order to bring it up to date with the requirements of a modern economy. An untested rule changes the incentives and disincentives of any transaction. Old ways of doing business may no longer be profitable and new products, especially ones that can exploit loopholes, will come into existence. Slight changes to existing instruments can conform to a new system. If they enrich agents, they will be adopted and exploited very rapidly.

The third factor that Governor Stein chose was something that must have raised the eyebrows of those among his fellow Federal Reserve members who have been advocating unlimited QE and interest rate suppression. He pointed to a change in the economic environment specifically using a prolonged period of low interest rates. A lengthy period of low interest rates confirms an assumption of little risk. This encourages agents to increase financial leverage beyond what might be considered normal or even sane. The three factors, of course, work together. Financial innovation that takes advantage of changes in the regulatory environment helps to adapt old methods to a new economic situation. The incentives are always the same: to increase the benefits to the agents.

Governor Stein apparently does not share Chairman Bernanke's calm assumptions that the risks are minimal and can be dealt with. He wisely pointed out that the ways of investment bankers and other financial players can be deep and mysterious. One of the stated objects of interest rate suppression is to encourage risk. The problem is that no one really knows the extent or form that risk will take. These risks are "often taken in opaque ways that escape conventional measurement practices." So identifying even one potential risk could merely be the "tip of the iceberg." This admonition is especially important in a global financial environment where rules and regulations are not coordinated. Quite the reverse. They are often created in competition with other rules allowing agents to shop jurisdictions to create risk instruments that conform to one set of rules only to be sold in another.

Governor Stein's analysis would be unsettling in this environment created by central banks, but it is simply theoretical without a specific real world example. Governor Stein thought of one that could potentially bring down markets. He discussed this in his speech. But there was one other that he didn't discuss.

Governor Stein's three factors set the stage for a financial crisis but there is one more aspect that can change some bad credit decisions into a disaster. Bad credit decisions in and of themselves would not cause problems. What makes the issue systemic are poor determinations of risk combined with maturity mismatches. The obvious example is the asymmetry of the banking industry. If a bank's depositors were locked into the same maturities as its debtors, there would never be any runs on banks. But banks often get funding from short term sources and lend it out for much longer maturities. When the loans become questionable, it is the investor or depositor who can convert their claims into cash first who wins: a bank run. A rush for the exit creates a fire sale of illiquid assets that often tramples the good with the bad.

The example that Governor Stein chose as having a high possibility of having a systemic impact are Junk Bond ETFs. He is right to be worried. Junk Bond ETFs have grown enormously. Their assets have grown from $300 million in 2007 to $32 billion. The reason why they are so popular is simple: yield. The most vulnerable of investors, retail investors, have invested in Junk Bond ETFs. With the Federal Reserve suppressing interest rates, many retail investors, often retirees living on income, see Junk Bond ETFs as a safe way to get a decent yield while investing in a diverse pool of assets.

But they are not that safe. Junk bonds do not trade on a regular basis. They are often illiquid and obscure. The largest Junk Bond ETFs (HYG and JNK) are coupled with the iBoxx High Yield Index which is screened for liquidity. Still the very size of these products would make it difficult for the ETFs to adjust if there was even a slight change in expectations. The trigger could be a sign that the American economy is getting healthier. This would eventually lead to an inevitable rise in interest rates. With Junk bond yields at record lows, they would be one of the first things that investors would sell. A dramatic run for the exits in an illiquid product is exactly the type of situation that could result in a systemic collapse.

The issue is not academic. Investments in ETFs can be both short and long. Shorting Junk bond ETFs enables investors to protect their portfolios from an unexpected move in interest rates which is always a possibility since those rates are set by institutional and not market forces. With some doubts, thanks in part to Governor Stein's remarks, short interest in the two largest Junk bond ETFs hit their highest level since October 2007, the last time American equity markets were this high. Although both of the large Junk bond ETFs did survive the 2008 melt down they were about a hundred times smaller.

The Federal Reserve Board of Governors are meeting this week and they are presented with a dilemma of their own making. It appears from recent numbers that employment in the US is getting better, but there are areas of weakness. So they might either keep trying to suppress interest rates in the hope that continued stimulus will attempt to encourage more hiring.

There are risks. If they continue the program, more money will continue to flow into Junk Bond ETFs and other risky investments. Money flows into junk bond mutual funds have hit their highest rates this year. The larger the funds, the higher risks whenever the Fed eventually has to end its programs.

In the alternative the Fed could announce a slowing or termination of the QE program. This will slow or stop money into ETFs, but it might provoke a sharp correction. The question is whether they will try to take the risk now or later. Either way they may find that deflating a balloon is much harder than blowing one up.

But there is one example that Governor Stein did not discuss although it fits his description perfectly: China. The three factors in Governor Stein's analysis (financial innovation, change in regulations and a prolonged period of easy money) all exist in China. China, like other central banks throughout the world has been flooding its economy with money since 2009. The recent difference has been where the money is coming from. Up until 2012 it came mostly from loans from state owned banks, but there has been a change in regulations.

In attempt to reform its financial system, the Chinese regulators have been far more tolerant of different financial products. Usually the Chinese banking system has been insulated by captive depositors. These depositors had few other choices. So if the state banks chose to pay low interest rates to increase profits in order cover loans losses, there was little the depositors could do. There weren't many alternatives, until now.

As the regulations changed, so did the financial products. Rather than straight deposit accounts, Chinese banks could offer Wealth Management Products (WMPs). WMPs were originally tolerated, but not sanctioned. So a vast shadow banking system grew up. Since the exact numbers are not available it exactly represents an example of Governor Stein's fears about the tip of an iceberg.

The one thing that we do know is that it is a very large iceberg. It is estimated to be about Rmb 13.6 trillion ($2 trillion) or nearly 50% of GDP. The back bone of this system are trusts, which were allowed as a way to increase lending to municipalities and real estate developers with loans that are off the bank's balance sheets. These trusts had over Rmb 3 trillion ($1 trillion) under management at the end of the third quarter of 2012. This is a 54% increase since 2011 and a 500% increase since 2009.

When regulators started to restrict trust activities, Chinese agents did what all financial agents do. They went around them. They started moving money into brokerage houses that passed them on to other borrowers. By the beginning of this year Chinese brokerages had Rmb 2 trillion ($320 billion) of entrusted funds. This is a 7 fold increase since the beginning of 2012. They received Rmb 1 trillion in the fourth quarter alone.

So the shadow banking system created new financial products helped by an era of changing regulations in an environment of cheap money. All of the ingredients according to Governor Stein save one: maturity mismatch. But this exists as well.

The new financial landscape allowed banks to funnel money to trusts often through brokerage firms. The trusts make high yield loans to companies such as property developers considered too risky for regular bank loans. Besides the developers are off the banks' direct loan approved list, because the Chinese government is trying to cool an overheated real estate market. These loans are not short term. They are multi year. But the WMPs sold to investors are. The durations are for just one to three months. Like the CDOs supported by subprime loans, they are considered very safe investments.

Like the Junk Bond ETFs the duration mismatch is not an issue. As long as there is a continuing demand for WMPs to pay off the maturing ones, just like a Ponzi scheme, there will not be any problem. But if investors began to question the safety of WMPs and stopped buying them, then the whole scheme might explode.

When and whether Junk Bond ETFs or Chinese WMPs cause a new collapse will be clear probably within a few months. Whether there is a general meltdown from these or other products Governor Stein's warning is clear and simple. Government policies and regulations have three very real limits. First, the limitations arise because of inherent fallibility of regulation as a tool in a world of regulatory arbitrage. Second, the scope of regulations cannot foresee all the ways that its impacts will change the financial system. Finally, regulations may ultimately be destructive because risk taking is structured in ways that are not clear. So by the time the elements of a collapse are obvious it is already too late.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.