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Summary: The financial sector has strong interest in a QExit, which may give tapering the decisive thrust it needs. The dynamics behind this interest are embodied in the "Bankers' Dilemma".

Introduction:

During the depths of the 2008 financial crisis, the banking system was essentially insolvent if assets were marked-to-market. The main issue with QE early on was getting people to believe that the central bank would be standing behind asset prices.

After 5 years of QE and anchored QEinfinity expectations, the Fed faces a different problem. I call it the "Bankers' Dilemma". Note that the term "banker" in this article refers to someone who works at a financial institution with substantial credit holdings and has some discretion over said positions. "Bank" would refer to a financial institution with such holdings.

The Bankers' Dilemma

Source: Author

In a bullish environment, bankers are faced with a dilemma: (1) either chase yield for short term personal gain, inevitably leading to yield spreads being compressed to the point where bad deals start accumulating, OR, (2) don't chase yield, which may help their company weather bad times better but has the downside risk of potentially getting themselves fired due to underperformance.

From the perspective of bankers as a whole, it'd be better if no one had to chase yields to unsustainably low levels, but without an effective arbiter, that's what happens, because it's impossible to predict how long the current environment will persist, while missing out leads to underperformance and the worst risk of all: getting fired.

However, there have been some changes since the 2008 financial crisis:

1) Massive unhedgable risks

The amounts at risk due to the unravelling of yield chasing are huge. $7 trillion of mortgages have been originated or refinanced since 2009.

(click to enlarge)

Source: MBA, FHFA, Goldman Sachs Research

US investment grade corporate bond issuance has exceeded $1 trillion this year and in the previous year. Junk bond issuance is already over $300 billion for 2013. That's even before the hundreds of billions that flowed into emerging market bonds since 2009 ($40 bn alone went to South African government bonds, half of total net new issuance). Even without crunching all the numbers, it's obvious that there have been trillions of dollars of long-term credit instruments issued at low rates.

The risk posed by a sharp rise in interest rates is unhedgeable. Hedging only works when the counterparty can pay out. In practice, this requires an interest rate environment where movements are moderate. Assume an abstract, homogeneous $1 trillion 10 year fixed 5% debt is owned by major financial institutions. An increase in 2% in the risk-free rate and another 1% increase in the risk premium for a total 3% increase in the yield implies a 20% loss in the value of said debt. That's a $200 billion hit. I doubt any counterparty can pay out that much, not to mention that's only for $1 trillion in debt.

This may be why the Bank of International Settlements repeatedly admonitioned that "Interest rate risks expressed as potential losses relative to (economic output) are at a record high in most advanced economies, and these losses when they do occur will be spread among financial institutions, households and industrial firms. Sophisticated hedging strategies may shift these risks across institutions, but they don't eliminate them."

Source: Mortgage-x.com

This time, banks are unlikely to be overly optimistic like the forecasts of only a $100 bn fallout from subprime losses, or hoping that bond insurers would pay out. With trillions at risk, bankers have an incentive to preempt any trouble.

2) Perception of risk

The perception of risk pre-2008 was shaped by the experience of rising asset prices and sporadic but not fatal bear markets since the early 1980s. As long as you were not wiped out during the bad times, taking risk would usually be rewarded.

In fact, acting based on this perception would have led to fat gains for a participant at almost any point in this period. This eventually spiraled out of control and $2 trillion of mortgages were made with high loan-to-values to poor credits.

Since then, attitudes toward risk have become more nuanced. Hardly a year has gone by without some sort of financial crisis around the world and vigilance has been high. Heightened risk perceptions are likely to make bankers more worried about the long term viability of yield chasing, increasing the perceived negative payoff of everyone chasing yield.

3) Increased influence of management

During the go-go years, stakeholders were largely apathetic and internal considerations were paramount, which means top-level management pretty much let everyone else have their own way. Excessive risk taking was making money and there wasn't much management could do to stop it without risking their own positions.

Nowadays, regulators, shareholders and the public in general eye the financial sector a lot more warily. Demand for financial services has also stagnated, causing many layoffs. These give top management a stronger position with which to limit risk-taking down the chain of command, since the risk of someone usurping them by promising unfettered risk taking and bonuses is a lot lower.

Putting it all together

Massive unhedgeable risks pose an existential risk for major financial institutions. The bad news is that the longer a zero rate environment continues, the stronger yield chasing behavior becomes and the more risk is accumulated. This gives bankers like Jamie Dimon a strong incentive to lobby for higher rates. Any gain from a frothy market is likely to be transient while the potential losses when rates do normalize are tremendous.

However, with the increased influence over their organizations and the more nuanced view of risk-taking inside and outside the financial sector, top management at financial institutions is in a position to take the long-term view without worrying about some ambitious upstart taking over.

Conclusion

Simply put, major financial institutions have the incentive and the capability to express a wish for higher rates. This is likely to be a strong, if not determining force, for an eventual QExit.

Though I mistakenly believed a taper would occur last September, I believe the fundamentals have not changed and QExit is inevitable, whether next week or next March. In fact, I would argue that Ben has a personal incentive in pushing for a December taper, so he closes his term with the first step (and credit) towards normalizing monetary policy. This will somewhat relieve the helicopter stigma associated with QE.

However, the short-term impact of a taper is hard to fathom. Conditions in emerging markets (NYSEARCA:EEM) are no longer as panicky as they were in September. US stocks (NYSEARCA:SPY) are in a strong uptrend and have behaved erratically towards good economic news (witness how the S&P rallied hard after the strong NFP data on 12/6). There lacks a catalyst for any large-scale panic in EM from a taper, so I'm positioned neutral for the short run. Nevertheless, longer term implications are still stark for EMs running current account deficits at 6-7% of GDP, so I'm watching that carefully.

Source: The Bankers' Dilemma And The Fed's Inevitable Taper