Fixing the banks may set off sparks in other sectors

on the money

Michael Coote

The dizzying speed of official attempts worldwide by government authorities to bail out the banking systemic crisis has meant that few people have stopped to ask questions about where it will all lead.

Every day a new announcement is made by authorities in the US, the UK, and Europe of another rescue package worth tens or hundreds of billions of dollars, pounds or euros.

How will the total bill for socialising the costs of the global banking crisis be met?

How much money will end up being thrown at the problem; where will the funds come from; and who will ultimately pay?

Some answers came from a remarkably prescient paper published in September by an analyst at Pimco, the world’s largest bond manager.

In a paper entitled Thanks for the duration, but is it time to say goodbye?, Vineer Bhansali questions whether it will be worth owning US bonds very soon.

According to Mr Bhansali, the US government is going to have to churn out bonds and simply print money on top of that to cover the cost of its continuing bank rescues.

It is a fair bet other countries engaged in socialising bank losses will have to do the same.

Global financial markets could be flooded with devalued bonds and debased currencies.

Under Mr Bhansali’s analysis, the world is headed for higher inflation and rising long-term interest rates as a result.

The real payers will be all those who bear the costs of this impending inflation and interest rate explosion – in other words, just about everyone.

“Greed and fear can drive security prices to extremes,” writes Mr Bhansali.

“In 2007, greed drove US house prices to all-time highs and tightened credit spreads to historic levels.”

“Now, fear has driven US long-term yields to around 4%, making the cost of hedging against a bond bear market (by not buying Treasuries in the first place) inexpensive.”

“When inflation is reading around 4%, a 4% yield on a long [US Treasury] bond only makes sense if a depression-like abyss is looming for the US economy.”

Part of Mr Bhansali’s point is that real long-term interest rates in the US are now essentially zero and he believes he has worked out what comes next.

“While sustained yield levels below 4% are possible, they are not probable given the risk premium that Treasuries will require in light of:

1) An expanding US government balance sheet
2) An increase in the supply of government debt
3) Historically low bond yields in the face of ‘in’-credible monetary policy”

The consequences are a US bond market that has taken on an air of surreality.

“Long-end Treasury yields are currently very low,” writes Mr Bhansali, “because they’ve gone from pricing in credit risk to pricing in liquidity risk and now to pricing in insolvency risk, all of which are likely to be cyclical, rather than secular, phenomena.”

“And assuming the debate over inflation risks versus deflation will end in a draw, yields can rise by an unbounded amount but can only fall to zero percent. The asymmetry of the situation is stunning.”

Mr Bhansali argues that risks to holding US Treasuries are on the rise.

“First,” he writes, “the US Federal Reserve is now accepting all sorts of collateral in exchange for hard cash, effectively creating a moral hazard call option for risk takers that is financed with taxpayers’ and foreign investors’ dollars.”

“Second, as a net borrower, the US will depend on foreigners who will increasingly become aware that their investments are being diluted.”

“And third, the US has a strong incentive to inflate its way out of its debt problems, and that is the primary reason fixed income assets could depreciate.”

A return to deliberately inflationary policies by the US (and implicitly by other countries rescuing their banks) is the likely outcome.

“We know that we cannot pay our debtors back in current dollars,” states Mr Bhansali, “so we will likely attempt to pay them back in cheaper, or deeply discounted, dollars.”

“Corporations default by refusing to pay interest and/or principal, but sovereign nations default by inflating away their obligations.”

There is method in the madness of frantic publicly-funded bailouts, according to Mr Bhansali.

“Facing a meltdown in the US financial industry, the government has responded by converting private sector risk into public sector risk, simultaneously converting the credit crunch’s risks into inflation risk.”

“While the government cannot lose because it can simply print more money to meet its obligations, the holders of the government’s debt can and will likely lose.”

A new set of systemic financial risks seem likely to arise if Mr Bhansali is correct, even if banks become “safe” in the process.

If major economy governments produce higher inflation and engender rising long-term interest rates on their debt, risk premia will have to increase for other types of assets.

These assets include debt issued by smaller countries such as New Zealand and also corporations, who will both need to offer higher spreads over major economy bond rates and might also find that their credit ratings slide.

Equities will need higher risk premia as well, depressing their prices.

Property is another class likely to be affected, because its value is discounted by a risk premium over long-term bond rates.

Moreover, mortgage rates tend to be priced by adding a margin to the likes of US 10-year bonds.

The rising tide of increasing risk premia will cause many asset prices to sink beneath its spreading waves.

By Mr Bhansali’s logic, one systemic risk, concentrated in the banking sector, will be addressed by creating another, dispersed across investment markets.

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