I recently discussed the concern that Bill Gross, founder and co-chief investment officer of PIMCO, has about the current Federal Reserve policy of keeping short-term interest rates low for the next two years. The concern extends to the possibility that the Fed will attempt to “twist” the term structure of interest rates by buying more and more long-term government securities in an attempt to bring longer-term interest rates in line with the very low short-term interest rates. Gross sees the efforts extending to the seven- and eight-year maturity range.
The concern Gross has is that a flat yield curve will cause banks and other financial organizations to de-leverage even further and faster than they would under conditions the of un-sustainable debt levels created by the previous 50 years of credit inflation. Gross, in his Financial Times article, argued that the Federal Reserve consistently maintained a positive slope to the yield curve throughout this 50-year period (with the exception of periods of tight monetary policy) so that the banks and other financial institutions would continually provide “credit creation” so that the economy would continue to expand and create jobs.
The positive slope to the yield curve provided the mechanism for this credit creation through three channels. First, the positive slope to the yield curve meant that banks and other financial institutions could borrow short at relatively low interest rates and lend long at higher interest rates. The mismatching of maturities increases interest-rate risk but then if the yield curve, on average, remains positive, the positive yield spread can be maintained over time.
Second, credit inflation “bails out” riskier loans so the banks and other financial institutions could lend money on riskier deals and thereby earn an even larger interest rate margin. To paraphrase Warren Buffett, if credit inflation tide is rising, it is hard to tell bad assets from good assets. Only when the credit inflation tide recedes and the water level drops do we discover who is not wearing a bathing suit. Tell me about the sub-prime mortgage mess.
Third, narrow interest margins can be turned into substantial returns on equity by the use of financial leverage. If competition brings net interest margin levels down, banks and other financial institutions can maintain the levels of return on equity they had previously earned by adding more and more financial leverage to their balance sheets.
This third component can only succeed if the banks and other financial institutions are liability managers. In terms of the last 59 years, financial institutions became liability managers through the process of financial innovation. Most financial institutions were locked into their balance sheets before the 1960s because money and capital markets were not developed to the extent that banks and others could buy or sell all the funds they wanted a the going market interest rate.
Commercial banks, at this earlier time, could only obtain funds through “local” markets and these funds were not very interest sensitive. Hence, these organizations were “asset managers” limited to what Leo Tilman calls “Balance Sheet Arbitrage." Balance sheet arbitrage is the “old” way of commercial banking where banks are “local” in nature and obtain funds from demand deposit accounts and savings accounts which pay "very" low interest rates and lend the funds out to borrowers, many of whom have no other sources of funding so that the interest on these loans are relatively high. Thus, the banks worked with nice interest margins that were relatively stable and reliable.
Liability management came into play through the financial innovation of the 1960s. Negotiable CDs and eurodollar deposit along with holding company issue Bankers Acceptances became the innovation of choice in the larger banks and this freed up the balance sheets of banks so that they were no longer limited to local constraints on the choice of funding sources. Funding sources became worldwide and the understanding was that, at most times, banks could now buy or sell as many funds as they wanted at the going market interest rate.
As regulation eased, banks and other financial institutions got into other financial and organizational innovations. Tilman lists these as moves into “Principal Investments” (private equity and venture capital, investments in hedge funds, or, capital allocations to internal proprietary trading desks) and “Systematic Risks” (which included interest rate risks, credit risks, currencies, commodities, and equity indices). This created an environment I have called the “New Liquidity.”
The result? Gross nails it in his article: “Thousands of billions of dollars were extended …” It seems as if capital requirements were non-existent. Credit could expand almost without limit.
Why are we interested in credit inflation and not price inflation? Why do we focus on credit creation and not money? Focus, in the past, was placed on money because people were concerned about what was happening with consumer prices: Flow prices, which relate to the prices paid for goods and services that are consumed in a relatively short period of time. Flow prices are different than asset prices.
Flow”prices are in many ways constructed prices. For example, in the construction of the Consumer Price Index, the price of a house is not included because that is the price of an asset. The flow of housing services is what people consume and the price of this flow of services is rent. In the construction of the CPI, the “rental price” of housing services is, to a large extent, estimated. As it turns out, since the consumption of housing services is such a large component of consumer expenditures, the “rent” component turns out to be the largest part of the CPI.
Theoretically, the price of an asset (the price of a house) should be equal to the discounted present value of the future cash flows relating to the purchase of the housing services provided by the house (the rent or rental value of the housing services). In the world these two prices can differ from one another for a substantial amount of time as they did during the 2000s where housing prices were severely inflated and estimates of rental values lagged far behind.
This is true of other asset categories like equity shares that are traded on the stock markets, like the Internet bubble of the 1990s. Thus credit and credit inflation are of crucial interest to the behavior of all prices in the economy. This is why we must be interested in cumulative credit inflations that become unsustainable and turn into cumulative debt deflations that create a “formidable headwind” that must be overcome by any fiscal or monetary policy hoping to stimulate growth in the economy.
The problem seen by Gross, however, is that the monetary policy now being followed by Bernanke and the Federal Reserve that promotes a flat yield curve will just exacerbate the situation because it will accelerate the debt deflation taking place. One could also argue, a la Gross, that the situation created by recent financial innovation, the new liquidity, will further add to the volatility of the whole situation.