With the renewal of market volatility and a 10% correction in the U.S. equity markets, many dangerous ideas are taking on new life. (I wrote this before seeing what the market did on Monday, Feb. 12--as of 3 pm, it is up a lot. Happily, that does not change anything I have written.) Deregulatory ideas prevail in the U.S. Administration, but on the other side of the political spectrum, ideas to regulate anything that might be large or dangerous are taking hold. The deregulatory ideas often are misguided because they seek less regulation per se rather than more efficient regulation. We do need more efficient regulation and can achieve that by challenging whether existing regulations accomplish their purposes and whether their purposes are useful. The calls for new areas of regulation often are misguided because the proponents are searching for things that could blow up or things that could act unfairly on the general theory that technology changes everything and that such changes call for new regulations. Many things do not need to be regulated.
Examples of what worries people
To take an example of what responsible people are saying, on February 11, as reported by Bloomberg, Christine Lagarde, head of the IMF, told an international audience in Dubai:
“We need to move to regulations of activities not entities because it’s not going to be about the banks and it’s not going to be about the insurance,” Lagarde told the World Government Summit in Dubai on Sunday. “We have to anticipate where the next crisis will come from. Will it be the shadow banking? Will it be crypto currencies rising to the sky?”
On the same day, Rana Faroohar, writing in the FT about what the large tech companies are doing with their hoards of liquid assets, said:
“In the search for both higher returns and for something to do with all their money, they were, in a way, acting like banks, taking large anchor positions in new corporate debt offerings and essentially underwriting them the way that JPMorgan (JPM) or Goldman Sachs (GS) might. Since such companies were not regulated like banks, it was difficult to see exactly what they were buying, how much they were buying, and what the market implications might be. Still, the idea that cash-rich tech companies might be the new systemically important institutions was compelling.”
These are not new thoughts. I have been reading and hearing similar thoughts for some time. They appeal to people who do not quite understand financial crises and the booms and busts that lead to them. Thus anything that looks unusual financially seems like maybe it should be regulated, lest it lead to the next financial crisis.
Financial Crises mostly look alike
Study of financial crises shows, however, that they are remarkably similar. Read This Time Is Different by Reinhart and Rogoff and study its global data (no easy task). Read Misunderstanding Financial Crises by Gary Gorton to see how the process worked in the U.S. in the 19 th and 20 th centuries. Read The Money Problem by Morgan Ricks to see the theory of how financial crises occur somewhat differently. I have written about the subject both in my books and in numerous articles here at seekingalpha. (I think my review of Ricks’s book may be particularly useful.) Financial crises begin from a boom in the value of a large class of assets that are highly leveraged, with the credit that supplied that leverage being held by leveraged institutions that have mismatched their assets and liabilities. The last stage of the boom often is financed by foreign money. See here, for example. When the boom ends and prices begin to decline, the multi-tiered leverage begins to unwind, causing a cascading effect as prices decline further, loans are not renewed, and the cycle repeats itself, usually until the government, perhaps internationally assisted, steps in to socialize some of the losses and to stop the cycle. And in a large majority of cases, the original asset class was real estate, usually commercial real estate, but sometimes residential real estate.
Apple does not look like a financial crisis participant
With that background, let’s take a look at the balance sheet of Apple Inc. (AAPL), which has the largest corporate stash of liquid assets and has borrowed the most to fund its share buybacks while carrying its tax-protected assets offshore. The balance sheet at December 30, 2017 can be found on Edgar here. What we find is something that looks nothing like a bank of any kind, and even less like the investment banks that existed pre-October 2008. Apple’s net tangible capital is $140 billion on a total balance sheet of $407 billion, or about 37%, and compared with total liabilities of $266 billion, it is more than 50%. Long-term marketable securities (mostly corporate debt) was $208 billion, funded totally by the $140 billion of capital and $108 billion of long-term debt, with staggered maturities stretching out to 2047 (see note 6 to the financial statements). By contrast, commercial paper outstanding and short-term debt (including short maturities of long-term debt) was only $18 billion. There simply is nothing to run, and therefore Apple never has to sell anything under duress. Apple’s balance sheet, unlike a bank’s, is a fortress against economic downturns and interest rates risks. In short, anyone who is worrying about Apple having to play a significant role in a financial meltdown is whistlin’ Dixie. “Systemically important” indeed!
The subtext of many of the stated worries is that there are people who do not trust corporations that have a lot of cash or a lot of market power. That is fair enough. Power can be abused. But Apple’s power comes from the market—the global market that likes and trusts its electronics. Apple can lose that trust far more easily than it gained that trust. Thus for a company like Apple, abuse will not last long.
Granted, there may be differences between Apple, Alphabet (GOOG) or Facebook (FB) or Amazon (AMZN), but all of their businesses are built on trust. If they lose that trust, their businesses will wither. Indeed, one might be right to worry about Facebook losing trust already.
The shadow and its crypto cousin
So let me turn to Christine Lagarde’s worries about shadow banking and crypto currencies. First, my prejudices: I think Lagarde is a brilliant and dedicated woman who runs a suspect enterprise. I do not trust the IMF—not so much because it is naturally duplicitous as because it is naturally inclined to be wrong. Second, I think crypto currencies, as they are structured at this time, are almost (I almost said virtually) worthless, and that that will be demonstrated with due time. Third, shadow banking has never been in the shadow and is not in the shadow today. It is regulated and watched carefully by the Fed in the U.S. and by central banks everywhere, even in China where it flourishes most openly.
The greatest factor causing crises, as the three books I referenced above demonstrate, is short-term liabilities funding long-term assets. Thus if punters are buying crypto currencies with borrowed money, they are buying a long-term asset with credit that probably is very short-term and triggered by volatility. Thus, that would be financially dangerous, if done in global-scale amounts. But that is not what is happening. As far as I can tell, no significant institution is lending against crypto. Thus, as volatile as it has been (and I think will be), crypto principally is dangerous to those who bet on its value (whichever way).
The shadow banking issues also arise because of short borrowing to fund long assets. That was a significant aspect of the Fall 2008 cascade of defaults. It involved money market mutual funds, repos, and special purpose vehicles that had (semi-surreptitiously) been guaranteed by banks. Since 2008, the money market fund problem has been cured, the repo market has shrunk (especially for anything but government securities), and the special purpose vehicles have become far less numerous, perhaps because if they are guaranteed (even subtly) by banks, the banks must count them as liabilities for regulatory capital purposes. Those changes do not assure that other entities issuing short-term obligations to support long-term assets have not grown.
In an era when the Fed and other central banks have pledged to keep short-term interest rates low (as has been the case for most of the last decade), such carry trades are hard to resist, and many hedge funds have done very well with them. Indeed, the Fed has been guilty of that carry trade itself, as it has funded its QE purchases on long-term assets with bank reserves and short-term reverse repos. Since the Fed is the Fed, however, I would not forecast a run on its short-term liabilities, even though they may well increase in price sufficiently to wipe out the value of the carry trade that has permitted the Fed to remit large amounts of money to the Treasury for several years. The hedge funds that use the carry trade mismatch are aware of what they are doing. Some may fail, but that will not create a financial crisis, even if they have to sell assets at fire sale prices—they simply are not big enough to cause a crisis.
Mutual funds and ETFs are somewhat bank-like, and they can theoretically suffer runs. Indeed, if they are large compared with the size of their asset class and the underlying securities are not liquid, they can exhibit some of the run characteristics that create or participate in debt cascades, even though they are theoretically funded by equity. Recognizing these issues, the SEC adopted a new liquidity rule in 2016. Unfortunately, the SEC focused on disclosure rather than on liquidity itself, thereby leaving open the possibility that some funds would be illiquid when they needed liquidity most. I described this defect in more detail in my Instability book published in 2017.
There also is a controversy over whether an ETF’s stock can be more liquid than the underlying assets of the ETF (The Heisenberg has written about this issue many times on seekingalpha.) I come out that the stock can be more liquid because the ETF does not have to sell underlying securities when its stock passes from one shareholder to another. Nevertheless, I admit that the market value of the ETF versus its underlying assets can get out of whack and that arbitrage is counted on to redress such discrepancies. There may be circumstances in which the arbitrage does not take place promptly because the underlying securities are illiquid, but that appears to be a short-term problem that may affect traders but should not significantly affect investors who use the ETF format largely because of its relative flexibility and low costs.
My bottom line on mutual funds and ETFs is that in crisis—or even an incipient crisis—liquidity pressures and temporary anomalies can occur, but they are not likely to become a major part of the cascade of defaults, mainly because investment company leverage is limited. There are investment companies that use derivatives to gain more significant leverage, and those companies probably are far more exposed and might well be part of such a cascade. At the present time, it appears that such highly-leveraged investment companies are small in comparison with the market as a whole, and therefore they are unlikely to play a material role in beginning a crisis cascade.
But perhaps the shadow bank phenomenon outside the U.S. is far more dangerous than it is inside the U.S., and as to that Ms. Lagarde may be right to worry. The theory of what to worry about is there. It is not being Chicken Little to worry about it. But in light of the details of the dangerous phenomena now being so well known to central bankers, I think someone in Ms. Lagarde’s position should be more explicit about what worries her.
Volatility itself is not a problem for markets in general
It also seems to me that the current spate of volatility is not cause for greater alarm. Everyone knew that low volatility was not a permanent condition, and that some day the markets would turn volatile again. As I wrote at seekingalpha in September 2017, contrasting stock and bond market declines with financial crises:
At this point, one should observe that there is a qualitative difference between investors suffering losses, on the one hand, and a financial crisis on the other. Financial asset prices appear to be high in most parts of the world - and that is true for debt, equity, and derivatives. That set of conditions should mean that at some point, investors in many asset categories will suffer large losses. Investor losses in themselves do not, however, constitute a financial crisis. A financial crisis occurs when the credit or transactional system of a jurisdiction seizes up and ceases to function in the interests of the economy. And, a very high percentage of financial crises are triggered by a real estate boom and bust or the credit default of a sovereign. Stock market or bond market booms and busts, in the absence of a substantial real estate component or excessive buying of stocks on margin, do not usually create financial crises. That is one of the lessons of comparing the Dotcom bust with the GFC.”
A longer-term U.S. stock market decline beginning now seems even less likely to me than it did in September because Congress, through reduced taxes and increased spending, has added so much stimulus to an already strong economy. Writing in the NY Times on February 9, economist Neil Irwin explained:
In almost any economic model you choose, the new era of fiscal profligacy will create a near-term economic boost. For example, Evercore ISI, the research arm of the investment bank Evercore, estimates that the combination of tax cuts and spending increases will contribute an extra 0.7 to 0.8 percentage points to the growth rate in 2018, compared with the policy path the nation was on previously.
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’Some people assume that because this was a bad process and the tax bill is really regressive that it won’t have a short-term growth impact, but I think that’s wrong,’ said Adam Posen, president of the Peterson Institute for International Economics. ‘We shouldn’t confuse whatever distaste one has for the composition of the package for totally overwhelming the multiplier effects.’”
Set against these financial stimuli are increasing interest rates and the reversal of QE. But it appears that the size of the stimulus, coupled with recent increases in take-home pay pretty much guarantee a renewed period of a strong U.S. economy.
But the day of reckoning always comes eventually
But when the day of reckoning comes—as it always comes when a boom is funded by debt (in this case, increased government borrowing)—it may come with a vengeance that need not have been so severe had we been satisfied with slower, steadier growth that, frankly, I liked better, as I said here last September. I do not think the U.S. will be like Greece, but the way we are funding growth looks an awful lot like the way Greece funded its apparent growth in the early years of the century, and that does concern me.
In theory, stock markets anticipate recessions, falling well before the recession actually begins and perhaps deepening it as a consequence. On the other hand, recession forecasting is notably difficult for economists, so I do not put a great deal of trust in the stock market to forecast any better. With that warning, my best current guess is that we have a year or two to party, then Katy Bar The Door. When the recession appears on the horizon, the President (perhaps assisted by the Fed that he appointed) will seek to keep the party going by adding further stimulus. But I do not pretend to see that far.
Disclosure: I am/we are long AAPL, GOOG, FB.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.