BY TOM BUERKLE

Ray Dalio has been studying economies and markets to reveal their hidden patterns since launching a hedge fund out of his Manhattan apartment more than 40 years ago. Those efforts have served him and his investors well. Bridgewater Associates was one of the rare managers to post positive returns in 2008, and today it’s the world’s largest hedge fund with $160 billion under management.

Now he’s sharing some of the firm’s research in a new e-book, “A Template for Understanding Big Debt Crises.” He discussed the book and his outlook on today’s markets with Breakingviews Associate Editor Tom Buerkle.

You’ve written about your early mistake in expecting the Latin debt crisis to trigger a depression in 1982. What lesson did you take from that?

That the power of the Federal Reserve to lower interest rates and produce liquidity – and the power of a country’s fiscal policymakers to restructure debt if it’s denominated in its own currency – is much greater than the power of the debt to weigh down an economy, even when the debts are too large to be paid back.

The ideology in 2007, espoused by Alan Greenspan, was that policymakers can’t identify a bubble but they can clean up afterwards. Does that thinking still permeate policymakers’ minds today?

Unfortunately, yes it does. What concerns me most is that central banks don’t take responsibility for controlling bubbles when they are responsible for the debt creation that fuels them. Controlling bubbles should be as much a part of central bank mandates as inflation and growth. I’m pretty sure that the next big debt crisis will be due to one or more big bubbles that the central banks didn’t control.

I’m also worried that legislation that reduced the risks of overleverage by banks – which was good – has also reduced policymakers’ freedom to handle debt crises well. It could be against the law to do what’s necessary to save the financial system.

You mean post-crisis restrictions on future bailouts?

Exactly. There is always a group of lenders, whether it’s banks, that comes under regulation and provides protections to those who put money with them, and there is always a group of shadow banking lenders that develops outside those regulations because it’s more profitable. Existing regulations don’t make adequate provisions for handling the new forms of shadow lending and in fact restrict policymakers’ ability to handle them.

Where does debt concern you today?

I don’t see the sort of debt crisis on the immediate horizon as I saw in 2007 for 2008, but I do see serious problems two or three years down the road. The biggest risks come from multinational companies and countries that borrowed in dollars and have incomes in their local currency, so they have big asset-liability mismatches.

I think sales of U.S. Treasury bonds over the next two to three years will be so large that I find it difficult to see who the buyers will be. There are also other pockets of potential debt problems such as commercial real estate and some lower-grade corporate credits.

I’m also concerned that monetary policy won’t be as effective because the abilities of central banks to push down interest rates and push up asset values through quantitative easing will be much less than in the past. As I see it we are in about the seventh inning of this cycle so we have time, but not a lot, before the next debt crisis emerges.

The Fed’s own forecasts put the federal funds rate in the 3.5 percent range in two years’ time. A normal curve would give a 10-year yield around 5 percent. Would that be a stable equilibrium?

No. We estimate that if the bond yield was to go above somewhere in the vicinity of 3.5 to 4 percent, that would create a bear market for most asset prices and have a negative impact on the economy. I don’t think there are enough Treasury buyers in the United States, so that will mean that a large supply will have to go to buyers abroad. Most likely those sales will happen via a depreciation in the dollar. If we look two or three years out, we have a risk – a significant risk – of the markets and the economy going down because of these sorts of funding problems.

What about the risk of a Fed policy error?

I think the Fed is doing a good job in tightening cautiously. I also think that this time around, it will become a progressively more difficult job as the cycle becomes more extended. No central bank gets it perfect, which is why we always have recessions.

You write that the political consequences of crisis can be greater than the economic ones. Is that what we’re seeing with populism in the United States and Brexit in Europe?

Yes. When you have the next downturn, we will probably have greater conflict and more populism. That has historically resulted in more confrontation within countries and between countries.

Are you concerned that could happen to U.S.-Chinese relations?

Yes. Over the last 500 years, there have been 16 times when an emerging country competed with an existing power, and in 12 of those cases wars resulted. Usually an economic war precedes a military war. How the United States and China deal with the competition will be important. That’s another reason why today’s circumstances are very similar to those in 1935-40.

In the past decade, money has flowed in basically two ways: to passive vehicles and exchange-traded funds, and at the other end of the spectrum to hedge funds, private equity, private credit funds. Do you see more of the same in coming years?

These shifts look to me to be very much like the shifts between active and passive in the past. In a bull market in stocks, passive will tend to do well relative to active strategies like hedge funds or other asset strategies that don’t have systematic biases to long. Then you have a bear market and everything’s totally different and active becomes more popular.

That almost sounds like you’re wishing for a bear market.

I guarantee you that I’m not. We have equal opportunities in up or down markets. All I’m saying is every manager tends to have biases.

First published Sept. 12, 2018

(Image: REUTERS/Brian Snyder)

BY ROB COX

The biggest question left unanswered since the great financial crisis erupted 10 years ago is the following: Are some banks too big to fail? It can’t be solved because no major U.S. financial institution has come close to collapsing in the decade that followed Lehman Brothers’ failure. Only a true calamity, the conventional wisdom goes, will test the mettle of watchdogs, central bankers and politicians.

Naysayers argue that, when push comes to shove, the political and regulatory establishment will cave, resorting to variations on the taxpayer bailouts that limited catastrophes in the United States, UK and other developed economies in 2008. Supporters of reforms like the Dodd-Frank Act say the system is safer and that creditors and stockholders will bear the burden of even a mega-bank’s demise.

It’s hard to say who is right. But for first time since before things went wobbly there is some evidence to suggest one feature of the era of too-big-to-fail banks is at last coming to an end – at least in the world’s largest banking market. So far it is just a scintilla of proof contained in a recent data dump from the Federal Deposit Insurance Corp relating to the way large and small banks fund themselves.

Every quarter, the watchdog conducts an extensive crunch of numbers from all the banks whose deposits it insures. At last count, at the end of June, that came to 5,542 separate entities, a number that has shrunk every year since peaking in 1986 at more than 18,000 institutions. Back then, there were no banks with trillion-dollar balance sheets like JPMorgan, Wells Fargo or Bank of America. The 38 biggest banks, all with less than $250 billion in assets, made 28 percent of all the industry’s loans.

Over the years, through mergers and acquisitions, failures, and regulator-supervised consolidation, that has shifted dramatically. Today just nine banks control half of the entire industry’s assets. This cohort, which also includes Morgan Stanley, Goldman Sachs and Citigroup, is what regulators call systemically important – meaning they are deemed so big that the demise of just one of them might bring down the whole financial order. That’s why they received the bulk of the taxpayer-funded bailout made available during the 2008 panic.

Even though the subsequent financial reforms passed by Congress mandated they wouldn’t receive that sort of preferential treatment again, these big banks have financially benefitted from a lingering perception that they will never be allowed to go under. It is visible in what the FDIC calls their “quarterly cost of funding earning assets.” This is effectively what the banks pay for the money they use to make loans to borrowers, or to purchase interest-bearing securities like Treasury bonds.

Naturally, banks with lower funding costs should be more profitable because the difference widens between what they pay for money from depositors and investors, and what they charge for lending. Banks that do not let that so-called spread fall to the bottom line can use it as a competitive edge in the hunt for customers, undercutting banks that pay more to fund their earning assets.

For most of the contemporary history of American banking, at least as tracked by the FDIC since 1984, being bigger had no discernible benefit when it came to funding costs. Consider the first quarter of 1986, when America had a record 18,083 banks. The biggest of them, on aggregate, paid 7.59 percent to fund their businesses. Everyone else paid less, with the smallest fries paying a full percentage point less.

Apart from a few quarters in the early part of this century, that dynamic remained relatively consistent until the first cracks in the subprime mortgage market emerged. At the start of 2008, the top six banks started paying lower funding costs, at first by just a few basis points. But as the U.S. government stepped in to prop up the largest firms, that gap dramatically widened.

At the start of 2009, the six banks with balance sheets greater than $250 billion were paying just 1.06 percent to fund their assets, according to the FDIC. The 4,504 banks with between $100 million and $1 billion of assets – the largest category by number of institutions – were suddenly paying double that. The reason: Depositors and investors appeared to believe the big banks would not be allowed to fail, so their money was safer in the vaults of a JPMorgan, Bank of America or Wells Fargo.

Big bank executives made up all sorts of other reasons for the widened funding gap. It was, they argued, because big banks had vast branch and ATM networks; their mobile applications were superior; younger customers don’t want personalized customer service; and so on and so forth.

In effect, it was something like a run on the small- and medium-sized banking industry. And the disparity continued, beyond the passage of Dodd-Frank, the rollout of new capital standards and the Volcker Rule prohibiting proprietary trading. It outlasted even the era of ultra-low official interest rates.

Until now. In the most recent quarter analyzed by the FDIC, banks with fewer than $1 billion of assets paid 0.63 percent to fund their books, 1 basis point less than the nine mega-banks. That hasn’t happened since the end of 2007. The trend began with the smallest cohort of banks in the first quarter.

There are a few possible explanations. Big banks face more competition, and are therefore quicker to raise rates on interest-bearing deposits as the Federal Reserve increases the official cost of money. Customers of smaller banks, many of which are in rural communities, may have fewer choices and anyway may prize more personalized service. Perhaps, but one hopeful interpretation may be that, 10 years after the chaos, the market has come to believe that all banks can fail in equal measure.

Sheila Bair, who ran the FDIC during the crisis, thinks regulators have the tools they need to allow for large institutions to go under without impeding customers seeking mortgages or small business loans. “You impose losses on the shareholders and creditors, which is how it’s supposed to work,” she told Breakingviews in the Exchange podcast to be aired later this month. “But I think you also have the problem of just too big, and too big in terms of political influence, too big an influence of your academic institutions, too big in terms of influence over think tanks, too big, frankly, an influence over some of the media.”

The numbers are moving in the right direction, one where size no longer appears to confer a specific too-big-too-fail advantage. But only the next crisis will confirm whether she’s right on the politics.

First published Sept. 11, 2018

(Image: REUTERS/Mike Segar)

A SIX-PART SERIES BY EDWARD CHANCELLOR

Part One: Trouble ahead

Back in November 2002, Ben Bernanke, then a governor of the Federal Reserve, attended Milton Friedman’s 90th birthday party. In his writings, the legendary monetarist had pinned the Great Depression on policy failures of the American central bank. Bernanke was a keen disciple and apologised to Friedman on behalf of his employer, vowing that the Fed wouldn’t make the same mistake again. Less than six years later, Bernanke found himself at the helm of the Fed on that fateful day, Sept. 15, 2008, when Lehman Brothers collapsed. Another Great Depression beckoned. But now the Fed chairman was ready to make good on his promise.

What followed has been the boldest monetary experiment in history, not just in the United States but around the world. Interest rates were held close to zero in the world’s largest economy for years, while negative rates prevailed elsewhere; trillions of dollars of debt securities, in some cases even including corporate bonds and shares, have been acquired by central banks with money conjured from thin air. The Fed’s balance sheet quadrupled to more than $4 trillion. Bernanke instituted other new practices, such as directing the markets as to the expected course of future rate changes known as forward guidance. During and after the crisis, the Fed made huge loans to foreign central banks so they could bail out domestic lenders with large dollar liabilities.

Ten years on, it’s possible to look back on some of what the Fed has accomplished. A severe market panic was quickly arrested. The Great Recession turned out to be mercifully brief. By acting as global lender of last resort, the Fed stopped the subprime mess from metastasizing around the world. True, a sovereign debt crisis in the euro zone cropped up a couple of years later. But the European Central Bank under Mario Draghi promising “to do whatever it takes” quickly put an end to that. When Bernanke’s successor, Janet Yellen, left her post earlier this year, the Fed had achieved its twin mandates of stable prices and low unemployment. The American economy is currently enjoying its longest recorded period of uninterrupted expansion.

Yet under the surface, something appeared to be going in the wrong direction. While the U.S. economy continued to hire new workers, productivity growth collapsed. Companies have been reluctant to invest. Savings have been abnormally low. Workers’ incomes have struggled to keep up with inflation. High asset prices are all very well, but the ownership of financial securities is heavily skewed towards the rich. There is a widespread political consensus on both the left and right that the post-crisis policies benefited the “haves” at the expense of the “have-nots”. Despite a swathe of new financial regulations, there are concerns that many of the unsound financial practices from before the crisis have resurfaced.

Productivity growth, inequality, financial risk-taking and asset price bubbles are mind-bogglingly complicated matters. Still, a single influence appears to have dominated in recent years. The low-interest rate policy of the Fed and other central banks has inflated a handful of speculative bubbles, thereby contributing to an increase in inequality. Easy money has created an indiscriminate search for yield that threatens financial stability at home and abroad. Low interest rates have dampened the forces of creative destruction, fostering “zombie companies”, which act as a drag on economic growth.

To understand what has happened in the post-Lehman era, it is crucial to grasp the multiple functions of interest. It governs the discount rate, which puts a value on future income streams (the so-called capitalization rate). In a capitalist economy, interest influences the allocation of resources. Interest determines the distribution of unearned income or rents between the “haves” and the “have-nots”. As the price of leverage, interest determines both the extent and quality of lending. Interest also regulates the flow of capital around the global financial system. Interest is not the price of money, as sometimes described, but the price of time. All financial and economic activities take place over time. This makes the rate of interest the single most important price in the economic system. Get that price wrong and unpleasant things are bound to happen.

This series of essays marking the 10 years since Lehman’s demise will show how the post-Lehman era of ultralow interest rates has: 1. Unleashed speculative manias, including the great crypto bubble; 2. Misallocated capital on a grand scale, creating the zombie company phenomenon; 3. Benefited Wall Street at the expense of Main Street, thereby contributing to the rise of populism; 4. Fuelled both domestic and foreign carry trades that threaten the stability of the global financial system; and 5. Produced an epic credit and real estate bubble in China, the country responsible for nearly half of global economic growth since Lehman’s demise.

First published Sept. 9, 2018

Part Two: Bubbles galore

In 1776, English man of letters Horace Walpole observed a “rage of building everywhere”. At the time, the yield on English government bonds, known as Consols, had fallen sharply and mortgages could be had at 3.5 percent. In the “Wealth of Nations”, published that year, Adam Smith observed that the recent decline in interest had pushed up land prices: “When interest was at ten percent, land was commonly sold for ten or twelve years’ purchase. As the interest rate sunk to six, five and four percent, the purchase of land rose to twenty, five-and-twenty, and thirty years’ purchase.” [i.e. the yield on land fell from 10 percent to 3.3 percent].

Smith explains why: “the ordinary price of land … depends everywhere upon the ordinary market rate of interest.” That’s because the interest rate discounts and places a capital value on future income. All the great speculative bubbles in the past – from the tulip mania of the 1630s through to the global credit bonanza of the last decade, have occurred at times when interest rates were abnormally low.

The trouble is that after the Lehman Brothers collapse, central bankers refused to accept this fact. The position of Ben Bernanke’s Federal Reserve was that the real-estate bubble was caused by lax regulation rather than his predecessor Alan Greenspan’s easy money. If this were true, then taking short-term rates down to their lowest level in history – to zero in the United States and negative in Europe and Japan – was sensible. But if Smith was correct, then monetary policy in the wake of Lehman’s bust was a case of the hair of the dog.

In the last decade the world has witnessed bubbles galore: in industrial commodities and rare earths; in U.S. farmland and Chinese garlic bulbs; in fine or not-so-fine art, depending on your taste; in vintage cars and fancy handbags; in “super-city” properties from London to Hong Kong, and across China’s tier-one cities; in long-dated government bonds; in listed and unlisted technology stocks; and in the broader American stock market.

Fed officials notoriously failed to spot the real-estate bubble until after it burst. That’s because the current generation of monetary policymakers were schooled in the belief that bubbles didn’t exist. The experience of the subprime crisis apparently left them not much wiser. In April 2016, Fed Chair Janet Yellen, flanked by former Fed chiefs Paul Volcker, Greenspan and Bernanke, denied that the United States was a “bubble economy”. A bubble market, said Yellen, was one that is “clearly overvalued” and marked by strong credit growth.

Yet at the time U.S. stocks were very expensive compared to historic levels. They are currently more overpriced on dependable valuation measures, such as total market value to GDP and on a replacement cost basis (Tobin’s Q), than at any time save for the 2000 dot-com bubble. By the end of the first quarter, U.S. non-financial stocks were 85 percent overvalued on a replacement cost basis, according to economist Andrew Smithers. American corporations have also been borrowing like there is no tomorrow.

A second technology bubble is evident in the nosebleed valuations of tech firms such as Tesla. In August, the market value of Elon Musk’s firm overtook BMW’s even though the profitable Bavarian luxury carmaker produced 30 times as many cars last year as the loss-making Tesla, whose shares have since declined. Seven of the world’s 10 most valuable companies are tech stocks, headed by the trillion-dollar Apple. Away from public markets, profitless unicorns, such as the taxi-hailing firm Uber, sport multibillion-dollar valuations. With so much dumb money about, one of Silicon Valley’s new mantras is “spray and pray”.

Consider what history will surely record as one of the most absurd speculative manias of all time: the cryptocurrency bubble. Bitcoin is pure digital fairy dust. Last year the price of the leading cryptocurrency soared nearly 20-fold, peaking at over $19,000. It’s worth around $6,250 today. The boom brought forth many imitators, including ethereum and dogecoin. Bitcoin even has its own offshoots or forks, as they are called, bitcoin gold and bitcoin cash.

At a time when central banks with their negative rates and bloated balance sheets have undermined confidence in traditional money, it’s not surprising that people should look for alternatives. But these new “currencies” couldn’t be used to buy much in the way of goods or services, or to pay taxes. Bitcoin’s technology is far too slow and energy-consuming for such practical purposes. Like the California gold prospector’s storied tin of rancid sardines, bitcoin is good only for trading.

This collection of bubbles has pushed U.S. household net worth to a record $100 trillion, the Fed reported in June. As a share of GDP, Americans are now richer than they were at the peak of the dot-com bubble and the real-estate bubble, according to the Fed. But this is not real wealth derived from savings and investment, both of which have languished in recent years. It is merely the illusion of wealth.

Former Treasury Secretary Larry Summers once observed the American economy only expands when bubbles are inflating. Both U.S. corporate profits and GDP growth are responding to changes in household net worth. It should be the other way around. Yellen was wrong. The United States is a “bubble economy”, no sounder in its fundamentals than the one which collapsed in the subprime debacle.

Since the interest rate discounts future cash flows, ultralow rates have had an outsized impact on investments whose income lies far out in the future, whether through technology companies or 100-year Austrian bonds (sold in September 2017 for a yield of just 2.1 percent). The crypto carnival could only have occurred at a time when interest rates globally were hovering close to zero.

Adam Smith would have understood this well enough. No bubble lasts forever. The main justification for the elevated level of the S&P 500 Index is that long-term interest rates remain low. But the relationship between bond and equity yields isn’t stable over time. If the Fed keeps on tightening, or if inflation breaks out and bondholders take fright, this latest and perhaps greatest of bubbles will also come to burst.

First published Sept. 11, 2018

Part Three: The Zombies

The economy is like a rubber ball. The harder it hits the ground, the faster it bounces back. That’s what normally happens. After the Lehman Brothers bankruptcy, Western economies experienced their deepest contraction since the 1930s. Yet their subsequent recovery was decidedly lacklustre. Soon after, the markets witnessed a startling rise in the number of zombie firms – marginal businesses that appear to feed and multiply on an unchanging diet of cheap capital.

It’s no secret why economies normally rebound after sharp contractions. During a downturn, many companies restructure and loss-making businesses hit the wall. As a result, capital and workers are reallocated to more productive uses. Outdated machines and old-fashioned practices are replaced by the latest technologies and new forms of organisation. More efficient businesses can invest more and produce jobs. Business failures are essential to the recovery. As the saying goes, “capitalism without bankruptcy is like Christianity without hell”. This is how famed Austrian economist Joseph Schumpeter’s creative destruction, the driving force of capitalism, is supposed to operate.

The rate of interest plays a vital role in this process. The “true function of interest”, wrote Schumpeter, is as a “brake or governor” on economic activity. By setting a hurdle rate for businesses, interest rations the use of capital. Interest sets the tempo for economic activity, says James Grant of Grant’s Interest-Rate Observer. It is like the shot clock in basketball, he argues. When the clock is ticking, there’s no dawdling. During a credit crunch, interest rates spike and creative destruction goes into overdrive. “The riches of nations can be measured by the violence of the crises they experience”, observed Clément Juglar, a 19th century economist who studied business cycles.

During the global financial crisis, interest rates on corporate debt spiked. In November 2008, the yield on U.S. junk bonds topped 20 percent. Then the Federal Reserve went into action: expanding its balance sheet, cutting the Fed funds rate to zero, underwriting toxic loans and lending money to investors to buy up distressed debt. Those panic rates soon disappeared. Once the economy recovered, credit watchers noticed something surprising. Over the course of the recession, the cumulative default rate on junk bonds amounted to just 17 percent, around half the level of the two previous downturns. “The Fed’s extraordinary intervention”, opined high-yield analyst Martin Fridson, “enabled companies [to survive] that should have failed”.

The low level of corporate failures might appear a boon. But in the past decade, U.S. productivity growth collapsed to below half its postwar average. New business formation, although recovering, has created fewer new jobs than in past upswings, according to the Bureau of Labor Statistics. The U.S. economy operated for years with excess capacity, yet fewer firms than in similar periods in the past went bust. Even though corporate interest costs had never been lower, a rising number of American companies had trouble servicing their debts. These are the corporate zombies.

Among rich nations, the OECD in 2016 estimated that 10 percent of firms qualified as zombies. For many reasons, these creatures are bad for economic growth: they invest less and create fewer jobs; they crowd out more efficient businesses and act as a barrier to entry for new firms; when industries are dominated by zombies, profitability declines and new investment is discouraged; weighed down with these firms’ bad debts, banks are hindered from making fresh loans. “When too many resources are stuck in low productivity areas and in zombie businesses”, writes economist Phil Mullan, “then the potential for the wider positive impact of particular innovative business investments will be frustrated”. And without productivity growth, there can be no sustained growth in worker incomes.

In the post-Lehman period, a close relationship exists between the rise in the number and survival rate of zombies and the decline in interest rates, according to the Bank for International Settlements. This phenomenon was first observed in 1990s Japan after the collapse of its “bubble economy” at around the time when the Bank of Japan inaugurated its zero-interest rate policy. Zombies survive for longer nowadays, says the BIS, because they face less pressure to reduce debt.

This problem has not been confined to the United States. Europe has suffered an even worse infestation. Italy has had some of the worst cases. Clothing retailer Stefanel is a prime example. Beaten up by strong competitors, such as Spanish fashion house Zara, Stefanel has produced a string of losses and faced several debt restructurings over the last decade. Still the Veneto-based firm clings onto life – its shares down 70 percent since 2014 – thanks to loan forbearance from its banks and to the ECB’s negative interest rates. Zombies are largely responsible for the mountain of nonperforming loans on the balance sheets of Italian banks, among them Stefanel creditor Monte dei Paschi di Siena.

It is conventional wisdom in policymaking circles that a repeat of the Great Depression must be avoided at all costs. That was the rationale for the great monetary experiments of the past decade. Yet contrary to popular lore, the Great Depression was not an unmitigated disaster. Nearly a quarter of a million businesses failed but the survivors, in industries such as auto-manufacturing and aerospace, were given a clear field to invest in new more productive technologies. Economist Alexander Field describes the 1930s as the “most technologically progressive decade of the century”. In the following decade, U.S. economic output returned to its pre-1929 trend. For the postwar generation of Americans, it was as if the depression had never happened.

We may not be so lucky this time. A recent paper by former Treasury Secretary Larry Summers and former IMF Chief Economist Olivier Blanchard points out that U.S. economic output (per working-age adult) was on course to recover by less than in the years after the 1929 crash. This year, economic growth has picked up and wages are also rising. But should this “Trump Bump” collapse, then the verdict of history may well be that central bankers after Lehman saved the world from another Great Depression – only to deliver the Great Stagnation.

First published Sept. 11, 2018

Part Four: Haves more

The Greek philosopher Aristotle attacked the charging of interest on grounds that lenders demanded more money in return than they supplied. This ancient prejudice against interest lingers in the French economist Thomas Piketty’s claim that inequality increases when the return on capital, a quantum which includes the rate of interest, is higher than that of economic growth. Yet the overwhelming evidence from the easy money that followed Lehman Brothers’ demise shows that inequality really takes off when interest rates are maintained at artificially low levels.

In the decade after 2008, the U.S. central bank has maintained its fed funds rate at a level below the rate of inflation. The Federal Reserve also used quantitative easing and other newfangled monetary tools to bring down long-term interest rates. This unconventional monetary policy was intended to boost household wealth and spending. It ended up inflating a handful of asset price bubbles. Since wealth is unevenly distributed, the bulk of the gains in the United States and abroad have been enjoyed by the rich.

This is what happened in the UK, where the Bank of England followed the Fed’s playbook. A 2012 study by the bank found that quantitative easing had boosted household wealth by more than £600 billion but that nearly two-thirds of these gains had gone to the richest 10 percent of households. Another study by S&P Capital IQ found that in the aftermath of the crisis the wealthiest decile of UK households had increased their share of financial assets at the expense of the poorest. As former UK financial regulator Adair Turner writes: “quantitative easing has been good for the rich, and ultra-easy monetary policy thus exacerbates inequality”. Few would disagree with this conclusion.

American income inequality has been especially aggravated by the Fed’s interest-rate policy. Most executive pay is linked to share-price performance. When easy money gooses the stock market, as it did in the years after the Lehman bust, corporate chieftains and their extended retinue receive an unearned windfall. Management has also used cheap debt to repurchase shares rather than invest in new plant and equipment, as the Fed intended. Since 2013, companies in the S&P 500 Index bought back approximately $2.4 trillion of stock, helping boost share prices, according to Standard & Poor’s. The executive pay bonanza got even bigger.

Easy money has particularly aided Wall Street as it recovered from the Lehman shock. The financial sector, including insurance and real estate, soon regained its position as a U.S. economic powerhouse, accounting for nearly a third of GDP growth between 2010 to 2015, up from 14 per cent between 1998 and 2008, according to the Bureau of Economic Analysis. Bankers’ bonuses returned with a vengeance – with the average payout rising to the highest level since 2006, New York state’s comptroller estimates. These bonuses derive largely from fees levied on securities issuance, corporate-finance activity and on assets under management.

U.S. corporate-debt levels doubled since 2008, says Goldman Sachs. M&A activity soared to a record $2.5 trillion in the first half of 2018, according to Thomson Reuters. AT&T’s recent $85 billion takeover of Time Warner could generate up to $390 million in bank fees, Freeman & Co has said. Investment-management fees also picked up as the stock market rebounded after 2009. Activists have pushed venerable companies from Procter & Gamble to Campbell Soup to engage in financial engineering to increase shareholder returns, and thereby justify their management fees.

Life has been particularly sweet for the private-equity world. The current leveraged-buyout boom has been spurred on by some of the cheapest financing in history. Private-equity firms even used low-cost debt to snap up repossessed properties after the housing bust. Blackstone’s listed residential business, Invitation Homes, has become one of the country’s largest landlords. The buyout barons have never had it so good. Over the past five years, Blackstone founder Stephen Schwarzman is estimated by the Wall Street Journal to have earned more than $3.2 billion in dividends and fund payouts.

But consider how easy money has treated the not-so-privileged. The financial crisis hit them hard. As many as 10 million homes were repossessed, according to the St. Louis Fed. Since the middle classes have most of their wealth tied up in their houses, they experienced the greatest proportionate losses in the downturn. New York University economist Edward Wolff estimates that median wealth fell by a staggering 47 percent between 2007 and 2010. The surge in unemployment after the financial crisis and a weak jobs market in the subsequent years further contributed to income inequality.

Central bankers claim that ultralow interest rates have helped fix the jobs market. This year, the official unemployment rate has fallen below 4 percent, its lowest level since 1969. That’s good news, but the share of the workforce employed or actively seeking work declined after 2008 and remains depressed at below 63 percent, the Bureau of Labor Statistics reports. Unconventional monetary policies contributed to the productivity slowdown which has hurt incomes. Until their recent pickup, U.S. wages stagnated in the years after 2008.

Nor did the poor benefit directly from the Fed’s zero interest rates. In fact, interest charges for “subprime” households actually rose as banks tightened lending standards. Because the less well-off maintain a higher proportion of their liquid assets in cash, they have also suffered most from deposit rates being held for years below the level of inflation.

Most workers own financial assets indirectly through their pensions or retirement plans. The decline in long-term rates has pushed up the value of pension liabilities, more than offsetting gains from investments. A pensions crisis affecting both private and public pension plans looms on both sides of the Atlantic. Ultralow rates have sounded the death knell for the defined-benefit pensions which enabled the postwar generations to enjoy a secure retirement.

Commentators from Aristotle to Piketty have argued that high interest rates aggravate inequality. Yet the ultralow rates of recent years have made it harder for the “have-nots” to accumulate the resources to buy a home or build a nest egg. The “haves” have enjoyed soaring wealth gains. The chief beneficiaries of easy money have been those on Wall Street with access to cheap loans. Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch puts it this way: “Never in the field of monetary policy was so much gained by so few at the expense of so many.” And he’s right.

First published Sept. 13, 2018

Part Five: Carrying on

The official position of the Federal Reserve is that the subprime crisis of 2008 was largely a consequence of poor financial regulation. There’s an alternative view: That the Fed’s easy-money policy after 2002 created a desperate search for higher-yielding securities. It also encouraged banks to partake in what are known as carry trades, borrowing cheaply in dollars and lending at higher rates both at home and abroad. From this perspective, the catastrophe following Lehman Brothers’ collapse was simply a giant trade gone wrong. Even lower interest rates in the past decade have revived this lending frenzy.

There’s no doubt that financial regulation was too lax prior to the 2008 fiasco. That’s why liar loans and mortgages to uncreditworthy borrowers proliferated and Wall Street firms including Lehman and Bear Stearns were allowed to take on too much debt. The watchword since the crisis has been macroprudential regulation. This has involved thousands of pages of new financial rules incorporated in the Dodd-Frank Act and other banking regulations, policed by armies of examiners and in-house compliance officers.

Yet in the era of zero and negative interest rates, financial regulators were set an impossible task. Interest puts a price on leverage. That means high rates discourage excessive risk-taking, while low rates have the opposite effect. As a result, interest serves as a kind of omnipresent regulator of the financial system. Given the U.S. dollar’s role as the global reserve currency, the Fed’s interest-rate stance also regulates international capital flows.

New research suggests that when interest rates sink, investors compensate for a loss of income by taking on more risk. Harvard University’s Yueran Ma and Wilte Zijlstra of the Dutch Authority for the Financial Markets observe  that when the risk-free yield falls below its historic average investors’ allocation to risky assets increases in a non-linear fashion. It stands to reason, then, that when interest rates decline and investors start chasing yield, systemic financial risk also picks up.

That’s what happened in the years before the financial crisis. Subprime and other structured-finance products were Wall Street’s inventive response to investors’ craving for yield during the Greenspan easy-money era. The carry-trade mania had an international dimension. European banks borrowed dollars to buy subprime securities. They also lent heavily to countries like Spain and Ireland and across central Europe where yields were higher. This cross-border lending began to unravel in the summer of 2007 and imploded in September 2008.

Once the Fed reduced short-term rates to zero and brought down long-term rates with quantitative easing and other tricks, investors became more desperate than ever for income. American companies found a ready appetite for the bonds they issued to buy back shares and acquire other firms. Total U.S. non-financial corporate debt is up by more than $2.5 trillion, or 40 percent, since 2008, according to the St. Louis Fed.

Credit quality has deteriorated. Leveraged loans stripped of their protective covenants have become the norm, including securities being issued in a Blackstone deal to fund the buyout of a business owned by Breakingviews’ parent Thomson Reuters.

The market reopened for payment-in-kind “toggle” notes, which allow borrowers to make interest payments with more debt. Leverage multiples on some buyouts returned to their credit-bubble peak. Subprime mortgages were out, but subprime auto loans were in. Even the collateralized loan obligation, a complex structured-finance product of the type blamed for causing the financial crisis, has made a comeback.

Demand for U.S. junk bonds has been unquenchable, even as credit quality has declined. Last year the share of junkiest credits, rated Caa to C by Moody’s, reached 44 percent of total high-yield issuance, up 11 percentage points since 2012. And yields in absolute terms, as opposed to spreads, fell to record lows. The yield on European junk bonds touched 2 percent in 2017, below the rate on 10-year U.S. Treasuries.

The global carry trade rapidly rebounded after the Lehman bust, thanks to interest rates being held at zero at the heart of the international financial system and the dollar weakening under the impact of quantitative easing. Hyun Song Shin, head of research at the Bank for International Settlements, refers to this development as the “second phase of global liquidity”. This time around, however, hot money found its way into emerging markets rather than the periphery of Europe.

Corporations in these developing countries have borrowed heavily, issuing both local- and hard-currency bonds. Firms in China and other emerging markets have been directly involved in the cross-border carry trade, issuing dollar bonds through foreign subsidiaries and investing the proceeds back home at higher yields. Over the past decade, emerging-market corporate debt has roughly doubled from around 50 percent to 100 percent of GDP, according to the BIS.

Borrowing binges in emerging markets often come to a sudden stop when U.S. monetary policy tightens. The first sign of vulnerability appeared in mid-2013, when the Fed announced a lower level of future asset purchases. That so-called taper tantrum exposed several emerging markets, among them Brazil and Turkey. The Fed’s successive interest-rate hikes since 2015 have tightened the screws.

So far this year the Turkish lira has fallen by nearly 40 percent against the dollar. Turkey’s President Tayyip Erdogan rails against interest rates which he calls “the mother and father of all evil”. But Turkey is suffering because interest rates globally were too low for too long. Turkish banks, construction companies and energy firms have gorged on cheap foreign-currency loans.

Foreign lenders have financed Turkey’s real-estate bubble, leaving the country in a similar position today as Spain and Ireland found themselves 10 years ago. Claudio Borio, head of the monetary and economic department of the BIS, fears that the contraction of global capital flows could trigger an “epoch-defining seismic rupture”. Under this scenario, capital controls could become widespread.

The 2008 maelstrom showed that when the Fed keeps interest rates too low, investors respond by taking on more risk. Unfortunately, central bankers failed to heed this lesson. They argued that financial regulation should operate independently of monetary policy. Yet financial players will always find ways to evade the rules when the price of leverage is mouthwateringly cheap. An appropriate level of interest rates is required to ensure financial stability. That’s because, as former Fed Governor Jeremy Stein nicely puts it, only interest rates “get into all the cracks”.

First published Sept. 14, 2018

Part Six: Chinese import

Interest rates in China may never have turned negative, as they did in neighbouring Japan. Yet China’s economy has also become distorted by the decade of easy money since the 2008 financial crisis. As in the West, low interest rates in China are responsible for inflating asset prices, misallocating capital, aggravating inequality and undermining financial stability.

With the yuan pegged to the U.S. dollar, Beijing could not avoid the impact of the Federal Reserve’s monetary easing after the Lehman Brothers collapse a decade ago. In December 2008, by which date the Fed funds rate was already at zero, the People’s Bank of China slashed its lending rate. Over the following five years, the policy rate averaged just 0.7 percent after adjusting for inflation, and remained far below annual GDP growth. For a developing economy, like China, monetary policy was extremely loose.

The result has been a bewildering number of bubbles inside of China. A stock market boom burst in 2008; not long after another bubble inflated and then popped in mid-2015. There have been bubbles in Chinese art and even in the local bubbly, known as Moutai.

By far the most important bubble, however, has been in real estate. China’s property market rebounded strongly in 2009, spurred by massive lending growth and cheap mortgage rates. By 2014, rental yields in Beijing and Shanghai fell below 2 percent, making property in these cities more expensive than in San Francisco, according to the National Bureau of Economic Research.

When monetary policy was further loosened in the wake of the 2015 stock market bust, the bubble really took off. Beijing house prices rose 33 percent in 2016. In parts of Shanghai, land prices started selling for more than neighbouring buildings – giving rise to the saying, “flour is more expensive than bread.” China’s total real estate was worth $43 trillion by the end of 2016, according to Savills, equivalent to 375 percent of GDP – on par with the aggregate value of Japanese property at the peak of its speculative fever in 1990.

Over the past decade China has experienced an extraordinary investment boom. Spurred by Beijing’s stimulus package, launched in November 2008 to mitigate the impact of the Lehman fallout, investment as measured by gross domestic fixed capital formation averaged around 45 percent for five years after 2008, according to the World Bank.

The Middle Kingdom was quickly fitted out with the world’s most extensive high-speed railway and longest bridge. Between 2011 and 2013, China poured more cement than the United States did during the entire the 20th century, the United States Geological Survey estimates.

Property investment has been the main driver of economic growth. Measured in terms of residential space, by 2013 China was building every fortnight the equivalent of modern Rome. Dozens of “ghost cities,” of which Ordos Kangbashi in Inner Mongolia is the most notorious example, have sprouted. This building boom has continued. At the start of this year, some 25 skyscrapers taller than New York’s Empire State Building were under construction.

Cheap loans from state-controlled banks to state enterprises have produced a capital glut in industries ranging from glass manufacturing to shipbuilding. The country is infested with zombie companies. Surplus capacity in the steel industry has given rise to another saying: “steel is cheaper than cabbage.” Julien Garran of MacroStrategy estimates that 40 percent of recent Chinese investment will have to be written off.

At the time of Mao’s death, the People’s Republic was one the most equal societies on earth. Today, it is one of the most unequal. Bank deposit rates below the rate of inflation have depressed household incomes. Millions of farmers have been forced off their land to clear space for development. The infrastructure spending spree has fuelled public corruption, despite Beijing’s endless purges.

The real estate bubble has minted vast fortunes for developers, including China Evergrande founder Xu Jiayin, estimated to be worth nearly $40 billion. Meanwhile, buyers of overpriced properties have been transformed into “mortgage slaves,” a Chinese expression referring to homeowners who spend two thirds of their income repaying loans.

Over the past decade, China has witnessed one of history’s great credit booms. Data collected by the Bank for International Settlements are staggering. Nonfinancial debt has grown by more than 100 percent of GDP – a far greater increase in debt than Japan experienced in the 1980s or the United States prior to 2008 – but on par with Spain and Ireland’s debt binges in the years leading up to the financial crisis. Corporate debt has climbed to 170 percent of GDP. Household debt as a share of GDP has more than doubled.

Despite low interest rates, the cost of servicing China’s debt mountain now exceeds the level of the United States 10 years ago. Autonomous Research banking analyst Charlene Chu estimates that up to a quarter of bank debts are nonperforming. Much new credit is being used to roll over bad debts, a practice known as “evergreening”.

Low rates on bank deposits have encouraged savers to seek higher returns elsewhere. As a result, China has developed its own shadow banking system, comprised of wealth-management products, trust funds, entrusted loans, online peer-to-peer lending, and debt receivables. By the end of 2016, these opaque and potentially illiquid nonbank liabilities amounted to 71 percent of GDP, according to the BIS.

China’s shadow banking “eerily resembles” Wall Street practices in the run-up to the Lehman crisis, says hedge-fund boss George Soros. The late economist Hyman Minsky noted that when the financial system comes to depend on rising asset prices and new debt issuance, there is a heightened risk of collapse. Last year, departing PBOC chief, Zhou Xiaochuan, warned that China faces a “Minsky moment.”

After the collapse of Lehman, confidence in Western-style capitalism took a hit. Many commentators have hailed Beijing’s alternative growth model. It has even been said that China is exempt from normal economic laws.

Yet China’s so-called economic miracle, coming over the last decade from a combination of low interest rates, massive debt issuance and a giant property bubble, closely resembles any number of former Asian success stories which ended in disaster. On most measures China’s bubble economy looks far more extended than Japan’s did in 1990. Some insist that this time is different. Then again, some always do.

First published Sept. 17, 2018

BY ROB COX

Over the next few weeks, Breakingviews will publish columns and features, produce a series of podcasts and hold a special live event to mark the 10-year anniversary of the global financial crisis. Some readers may consider this overkill. We beg to differ, for a simple reason: When people forget what went awry in 2008, they risk repeating the errors of the past.

In that spirit, welcome to “Ten Years After,” a multimedia editorial package that officially kicks off this week. Our inaugural column reflects on how little home-loan reform has been accomplished since Washington took over Fannie Mae and Freddie Mac, the mortgage-finance giants whose demise preceded Lehman Brothers’ bankruptcy by mere days. And in our first podcast, Columbia University history professor Adam Tooze joins the dots from the 2008 collapse to Brexit and the election of Donald Trump to the U.S. presidency.

This Breakingviews series will retrace some of the frightening days of 2008, when nearly every morning’s market open brought worries of a bank, investment fund or insurer going under. Ultimately, the crash led to almost 9 million job losses and millions of home foreclosures in the United States alone. It cost the country some $30 trillion in lost GDP, according to the Federal Reserve, and brought the global economy to its knees.

As you will read and hear in our conversations with policymakers, regulators and bankers caught in that maelstrom, we will also reflect on lessons learned. The hope is that by revisiting the crisis today, the more robust global financial system that emerged in its wake will endure. For that to happen, however, policymakers, investors and watchdogs need to continue to investigate the causes and examine the lingering impact of the 2008 fiasco.

To that end Edward Chancellor, financial historian and founding Breakingviews columnist, will examine five critical, still unresolved, problems stemming from the crisis response, particularly the move by global central banks, led by the Federal Reserve, to drastically lower interest rates to zero. These include speculative financial bubbles, widespread misallocation of capital, the return of the so-called carry trade, China’s shaky finances and the rise of populism due to wealth inequality.

Lehman’s collapse sits at the epicenter of the tumult a decade ago. As Antony Currie will explain, its bankruptcy offers a sobering lesson in the destructive power of hubris. Chief Executive Dick Fuld and his lieutenants had successfully navigated several earlier financial crises. That bred overconfidence, prompting them to ignore their own risk-management tenets, not to mention the critiques of short-sellers, while regulators stood idle.

The consensus today is that banks are more stable, largely thanks to the failure of Lehman and others, prompting lawmakers and regulators to demand institutions hold more capital. But for investors in some of the companies that limped out of the crisis that’s of little comfort. American International Group, for one, still isn’t back to profitable growth, and the insurer trades at a discount to book value. As Richard Beales will observe, “Investors don’t yet accept that the company’s dismal recent past is behind it. Maybe that’s something AIG can achieve in 2019, its centennial year.”

Peter Thal Larsen reflects on how the loss of confidence in bankers sparked a broader crisis of trust that has since afflicted economists, politicians and the media. Edward Hadas writes that the crash taught excessive credit growth is dangerous but it left many big questions unanswered. For instance, what drives inflation? Are big trade deficits dangerous or irrelevant? Are derivatives and hedge funds evil, irrelevant or stabilizing?

The news isn’t all gloomy. Our columnists examine the institutions that emerged from the crisis with smart deals under their belts. Buying troubled lenders Washington Mutual and Wachovia transformed JPMorgan and Wells Fargo, respectively, into national retail-banking giants. Santander advantageously gobbled up UK lenders. And Mitsubishi UFJ Financial’s September 2008 decision to buy a 20 percent stake in Morgan Stanley has yielded a good financial and industrial return for the top Japanese lender.

And for the first time since the subprime mortgage crisis began, small banks in America are now paying about the same amount to fund their businesses as the biggest ones, those once deemed be too big to fail. That fact, revealed in a recent Federal Deposit Insurance Corp study, is one piece of evidence to suggest the market has confidence regulators could unwind a large financial institution without resorting to a taxpayer-funded bailout.

Though regulators may have the tools they need to approach another crisis, the profound influence of the financial industry may prevent them from using them. That’s a point Sheila Bair, who ran the FDIC, makes in our “Ten Years After” Exchange podcast series. Similarly, former Bank of England Deputy Governor Paul Tucker argues that preserving central bankers’ independence requires a fundamental rethink of the limits of their power.

These conversations will be released twice a week through the middle of October. They include key figures, such as former U.S. legislator Barney Frank, whose name adorns the primary Wall Street reform act. He believes regulation has made finance substantially safer, but politics could make it more fragile. Frank argues that the swift, bipartisan response that met the near-collapse of the financial system would be impossible today.

Democratic Congresswoman Maxine Waters tells Washington columnist Gina Chon lawmakers had no Plan B when they voted for the $700 billion bailout package to save the U.S. economy in 2008. She discusses the emergency education she received about derivatives and other complex financial instruments. If she becomes head of the House Financial Services Committee after November’s midterm elections, she vows to tackle some unfinished business from the crisis.

Greg Fleming, who engineered the sale of Merrill Lynch to Bank of America on the same day Lehman went bust, argues the system is more robust. Yet he has shifted his career away from capital-dependent businesses and towards offering advice, now as the head of a new venture with the Rockefeller family. So, too, has Vikram Pandit, who led Citigroup through the crisis and into recovery. Pandit has been investing in financial startups taking on the big banks, including the one he formerly ran, with better technology and a focus on customer service.

These candid podcast conversations, insightful views and feature and more will be available on Reuters Breakingviews as the world reflects on the events of 10 years ago. Those clients who need something stronger can attend a Reuters Newsmaker one-on-one live discussion with Gary Cohn, the former Goldman Sachs president who recently left his role as Trump’s chief economic adviser. Drinks will follow. Happy anniversary.

First published Sept. 6, 2018

(Image: REUTERS/Jonathan Ernst)

CONTENTS

THE EXCHANGE: KEVIN RUDD

THE EXCHANGE: ANSHU JAIN

THE EXCHANGE: HOWARD MARKS

THE EXCHANGE: JEFF LACKER

THE EXCHANGE: NEEL KASHKARI

THE EXCHANGE: SHEILA BAIR

CHINA IS FEELING THE AFTERSHOCKS OF 2008, AGAIN

THE EXCHANGE: VIKRAM PANDIT

MERRILL LYNCH DEAL A QUALIFIED SUCCESS FOR BofA

BANKS WERE FIRST TO FALL IN DECADE OF LOST TRUST

BREAKINGVIEWS TV: CRISIS FITNESS

BREAKINGVIEWS TV: COHN’S CHOICE

HADAS: ECONOMISTS TRAPPED IN PRE-CRISIS FOGS

THE EXCHANGE: A CHAT WITH GARY COHN

FINANCIAL CRISIS MOSTLY PUT “D” IN DEALMAKING

THE EXCHANGE: CONGRESSWOMAN MAXINE WATERS

AIG’S LOST DECADE IS NOT YET BEHIND IT

THE EXCHANGE: GREG FLEMING

LEHMAN IS LONG-TERM CHAMPION IN WALL STREET HUBRIS

FIREFIGHTERS OF LAST CRISIS SEE SMOLDERING DANGER

SPECTRE OF THE LATE 1930S HAUNTS RAY DALIO

COX: TOO-BIG-TO-FAIL BIAS JUST NOW FADING AWAY

THE EXCHANGE: FRANK ON FINANCE

CHANCELLOR: THE LEGACY OF ULTRALOW INTEREST RATES

TIME BREATHES LIFE INTO AMERICA’S MORTGAGE ZOMBIES

THE EXCHANGE: FROM SLUMP TO TRUMP

REVIEW: CITIGROUP’S 2008 BAILOUT WON’T BE ITS LAST

WHEN COMMEMORATING CRISES, THINK 20 NOT 10

SUMMER LULLS OFFER FALSE SENSE OF SECURITY

RISING U.S. NONBANK MORTGAGE RISK RECALLS CRISIS

REVIEW: THE LEHMAN SAGA TOLD BY ITS BROTHERS

INDYMAC COLLAPSE STILL RESONATES IN TRUMP ERA

BEAR STEARNS IS USEFUL LESSON IN HEALTHY CONFLICT

NO, WAIT, THIS IS THE REAL CRISIS ANNIVERSARY

CRISIS ANNIVERSARY OFFERS $30 TRLN SANITY CHECK

BY MARTIN HUTCHINSON

If history is any guide to the future, Citigroup will be in the middle of whatever financial crisis Wall Street manages to cook up next. Or so say James Freeman and Vern McKinley in “Borrowed Time: Two Centuries of Booms, Busts, and Bailouts at Citi,” a new book examining the $180 billion bank’s troubled past. The institution bailed out in 2008 has suffered repeated failures of over-aggression and lack of foresight, while Uncle Sam’s open wallet has blocked meaningful reform.

In its early days, Citi was a politically connected bank with poor lending practices controlled by a management team with alcohol problems. The bank came close to failure in the Panic of 1837, but was bailed out by John Jacob Astor, the beaver-pelt mogul who installed a capable top executive. For the next 72 years, Citi was capably run and grew to be the nation’s largest bank, albeit with only one branch, taking on deposits in “panics” because of its perceived solidity.

Readers of “Borrowed Time” can play an amusing parlor game identifying the most misguided of those who led Citi in its problematic second century. Frank Vanderlip, the originator of many of Citi’s long-term problems, tops the list. Like several of his successors, Vanderlip was not professionally a banker – he was a journalist and U.S. Treasury official. He focused his tenure by doing much to create the half-baked Federal Reserve system rather than a single central bank, which would have decimated Citi’s correspondent-banking business.

Vanderlip then decided that a period of catastrophic world war was ideal for a single-branch bank, with no internationally experienced staff, to embark on building a global network of over 100 branches, half of them in Cuba. That combined with a push into domestic brokerage to cause Citi to require a $144 million bailout from the New York Fed in 1920 and to continue recording its Cuban sugar loans and holdings as current throughout the 1920s.

President Roosevelt partly blamed Vanderlip’s successor, “Good time Charlie” Mitchell, for the Great Depression. This was only a little harsh; he was just a high-powered salesman who got carried away. In building loan volume, Mitchell didn’t bother to ensure that the credits were economically useful. Brokers’ loans, used for stock speculation, comprised 65 percent of the bank’s total loans in March 1929. The result was the collapse of Citi’s brokerage affiliate, Mitchell’s ouster and a government bailout with $50 million of preferred stock.

Having suffered two near-death experiences in a decade, Citi was at least conservative for a generation. The next bailout came courtesy of Walter “countries don’t go bust” Wriston in 1982, when Citi, heavily over-leveraged, lost well over 100 percent of its capital in loans to Mexico, Brazil and Argentina. This time, the regulators’ response was to provide liquidity and pretend the loans were solid, which worked until the end of the decade, when the Latin American bad loans were joined by dud real-estate loans (including a heavy exposure to developer Donald Trump). Citi was described as “technically insolvent” by the House Commerce Committee chairman in 1991 but was privately rescued by an injection of preferred stock from Saudi Prince Alwaleed bin Talal.

The authors describe in detail Citi’s successful attempt to re-integrate commercial and investment banking with its Salomon Brothers merger in 1998, followed 10 years later by the collapse of its balance sheet once again, this time with problems appearing in domestic mortgages, investment-banking products and international banking. Citi was bailed out again, with the total exposure from various government loan funds reaching an astounding $517 billion in January 2009.

Freeman and McKinley strongly suggest Citi should not have been bailed out, but do not address how another bank failure in 2008 even larger than that of Lehman Brothers would have bolstered global investor confidence. However, a third alternative to Lehman-style bankruptcy existed: the nationalization of the bank, with shareholders being wiped out, followed by rapid liquidation and asset sales, while paying creditors in full. That rough justice might have restored more confidence in the U.S. financial system than a government bailout.

It surely would have wiped out a bank culture that had repeatedly brought losses and bankruptcy, and would have forced its perpetrators to find new employment. Eliminating a bank with Citi’s long track record of failure would also arguably have removed moral hazard from the banking system. “Borrowed Time” argues that Citi – having been left mostly intact after 2008 – will be at the heart of whatever future financial crisis awaits. History makes that a good bet.

First published Aug. 24, 2018

Image: REUTERS/Brendan McDermid

BY ROB COX

The wedding-industrial complex tries to convince couples to celebrate their nuptials every year with a traditional gift. The quality of each present increases with longevity. In year one it’s just paper for the spouse. After 50 it’s glittering gold, and so on. The same could be said for commemorating financial crises: The further away from the anniversary, the more valuable the lesson to be learned.

In that sense, recalling Long-Term Capital Management’s implosion in 1998 may be more worthwhile than dwelling on next month’s anniversary of the collapse of Lehman Brothers. The financial and economic fallout that followed the Wall Street firm’s bankruptcy in 2008 was certainly larger and more severe than the one that preceded it by a decade. But as the world discovered to its dismay 10 years after LTCM, some of the glaring deficiencies that led to that crisis were repeated – and at scale.

The key takeaway is simple, if somewhat meta: There are always blind spots. Whatever regulators, bankers, policymakers and investors think they learned during the last crisis may not be correct at all – or may simply be forgotten. That may not be comforting. But greater humility is always preferable to excessive confidence.

A more specific lesson, though, is the recognition that without sharp regulation, leverage tends to increase in the system until it becomes so interconnected that emergency measures become the only feasible way to contain the damage. Secondly, though reforms are often rolled out in the heat of panic, they historically do little to radically change the structure of the financial industry. Banks may have more capital today, but they still marry riskier activities with the potential to upset their more normal ones – lending and transactions management – in ways that pose a danger to the economy.

Take a journey back to the summer of 1998. As “The Boy Is Mine” by Monica and Brandy topped the Billboard Hot 100 charts, Russia’s economy was melting down. On Aug. 17, Moscow devalued the ruble and, in a surprise move, defaulted on its domestic debt. Investors dumped risky assets, like developing-country securities, which are often thinly traded. And they piled into safer ones, like U.S. Treasury bonds, which can be bought and sold with relative ease.

The reaction to Russia’s default upset the trading strategy of a hedge fund in Greenwich, Connecticut founded by John Meriwether. As a jacked-up version of the arbitrage desk of his former employer Salomon Brothers, LTCM made its name exploiting inefficiencies in the prices of assets that, over time, should naturally converge. Sometimes these discrepancies, say in a bond coming due in 30 years compared to another maturing in 29-1/2 years, were minuscule.

To magnify the difference, LTCM had to pile on debt. As Roger Lowenstein wrote in “When Genius Failed,” his chronicle of LTCM’s rise and fall, one of Meriwether’s first trades was to borrow 25 times the firm’s capital to structure a trade that took advantage of the difference between two nearly identical U.S. government bonds with slightly different maturity dates. And as the boss of a big, prestigious fee-payer to Wall Street banks, he could tap into their greed, and their fear of missing out, to play them off against each other – usually keeping them in the dark about their rivals’ involvement as well as the full scope of LTCM’s trades.

Markets, though, are not always as efficient as LTCM’s smarty-pants partners believed. Especially when fear runs riot, as was the case following the Russian meltdown 20 years ago this Friday. By the start of September 1998, the market turmoil had caused a $2.5 billion loss, or half of LTCM’s capital, as investors piled into liquid securities and dumped riskier ones. Over the ensuing weeks, LTCM was forced to dump assets at fire-sale prices to meet collateral requirements, incurring greater losses still.

Within a month of Russia’s default, Meriwether and his traders – including Nobel Prize-winning economists Myron Scholes and Robert Merton – were facing insolvency. After a series of private investors baulked, the New York Federal Reserve pulled together a consortium of investment and commercial banks who rightly feared what might happen if LTCM was forced to liquidate its $125 billion portfolio, not including the derivative positions it held off its balance sheet.

Fourteen banks pooled their money, injecting just over $3.6 billion of fresh capital into LTCM and parachuting in a team to oversee the fund’s liquidation.

Here is where a critical lesson should have been imparted to the financial industry. Instead, many of those banks who saw firsthand how leverage kills spent the next decade effectively transforming their own balance sheets to mimic the one that crushed LTCM. The Securities and Exchange Commission aided and abetted by relaxing capital requirements for investment banks early in the new millennium.

Maybe the fact that the banks ultimately got their money back convinced them of the merits of LTCM’s model – along with the false surety that, though their employees lacked Nobels in economics, they were savvier traders. Perhaps it was the comforting spectacle of seeing the Fed spring into action, coordinating the operation and swiftly cutting interest rates days after the bailout that led them to believe that whatever happened with their own trades, there would always be a lender of last resort.

Funnily, two of those called upon by the Fed to lend a hand, Lehman Brothers and Bear Stearns, kicked up a fuss over participating. That has fueled speculation ever since they both went under that their rivals – or even the Fed – had it in for them.

Whatever the case, it took another decade, and the Lehman catastrophe, for the broader banking industry, its watchdogs and policymakers to get the bigger message on the danger of leverage. Banks are now loaded up with capital. But the need for that was crystal clear in 1998, too. Which raises a question: What lesson should have been obvious from 2008, but has not yet been imparted or ignored? Maybe there isn’t a very satisfying answer, apart from simply recognizing what 20 years of hindsight teaches: We don’t yet know.

First published Aug. 15, 2018

(Image: REUTERS/Kevin Coombs/Files)

BY ANTONY CURRIE

August can arouse fear in the most seasoned Wall Street hands. If a crisis is going to hit, there’s a good chance it’ll come at the height of the northern hemisphere’s summer – usually after a couple of weeks of market torpor. That’s what happened with the Russia default and LTCM crash 20 years ago. And sudden crises in the past few years, like China’s 2015 devaluation, have forced financiers to scramble back from their holidays. But there’s one notable exception: August 2008.

Granted, it was a stressful time. Lehman Brothers executives were desperately trying to find new capital. The UK’s Northern Rock Building Society needed another taxpayer bailout. And plenty of investors and bank bosses were still trying to work out how much exposure they had to mortgage bonds and the cratering U.S. housing market. Yet those 31 days were surprisingly uneventful.

The respite gave the Federal Reserve space to work out whether its $900 billion balance sheet could handle more bailouts and how to reduce systemic risk. But the board of governors was almost as worried about rising inflation; one, Richard Fisher, even wanted to raise interest rates, as the European Central Bank had done the previous month.

Elsewhere, many lapsed into complacency. General Motors boss Rick Wagoner claimed the automaker was over the worst of its job cuts and pension and healthcare pressures.

Citigroup’s then-Chief Administrative Officer Don Callahan proclaimed that it was “among the best capitalized banks in the world,” in a letter responding to a Breakingviews article arguing it was too big to succeed, or fail. Barclays argued it needed a Tier 1 capital ratio of only 5.25 percent; it now sports more than double that.

Some boom-time spirit was still palpable, too. Buyout shops KKR and Apollo were ramping up plans to take their companies public. Merrill Lynch handed over a $40 million guaranteed five-month pay deal to lure ex-Goldmanite Tom Montag.

Such hubris was quashed the following month when Lehman went under and Merrill was rescued by Bank of America. By November Citi had been bailed out twice and the ECB had to cut rates; four months after that Wagoner was ditched with GM on the verge of bankruptcy. Bumper bonus guarantees are now all but extinct – though Montag remains at BofA, as chief operating officer. He’s the rare survivor of 2008’s far from august August.

First published Aug. 10, 2018

(Image: REUTERS/Nacho Doce)

BY GINA CHON

The increasing role of non-banks in the U.S. mortgage market sparks memories of the 2008 financial crisis. As the likes of Citigroup, Bank of America and JPMorgan have cut home lending and servicing, specialists have stepped in, but they lack bank-like capital cushions. Government-owned Ginnie Mae, guarantor of $2 trillion in mortgage-backed securities, is particularly exposed, as are the mainly lower-income Americans it is supposed to help.

Ginnie Mae outsourced oversight to regulators like the Federal Reserve when banks were its main securities issuers and servicers. But a post-crisis crackdown caused them to shrink those businesses. In 2017, four of the top five issuers of Ginnie Mae-backed single-family MBS instruments were non-banks, with PennyMac Loan Services and Lakeview Loan Servicing in the two top spots.

Meanwhile, Ginnie Mae’s guarantee book has ballooned to almost five times its size in 2007, putting it in the same ballpark as government-sponsored Freddie Mac. But Ginnie Mae has only about 140 direct employees, compared to more than 6,100 workers at Freddie Mac.

That’s partly because Freddie Mac buys and owns mortgages as well as guaranteeing them, but the huge disparity in resources means Ginnie Mae, which supports mortgages for veterans, lower-income individuals and minority groups, can’t adequately police the non-banks whose borrowers’ performance it essentially guarantees. A September audit supported that finding.

Non-bank lenders and mortgage servicers often rely on the kind of short-term funding that proved so vulnerable during the crisis. Furthermore, non-banks are largely regulated by state watchdogs, which have varying standards.

U.S. Housing Secretary Ben Carson, who oversees Ginnie Mae, is positioned to sound the alarm but he is one of the less visible members of President Donald Trump’s cabinet and has little experience in mortgage finance. Lawmakers have not managed to comprehensively reform Fannie Mae and Freddie Mac, but at least they are currently on a tight leash. Ginnie Mae is essentially untouched, and its size and non-bank ecosystem rarely come up as concerns.

Michael Bright, Trump’s nominee to lead Ginnie Mae, told lawmakers at his confirmation hearing on Tuesday that rising interest rates made financial stress among non-bank mortgage lenders and servicers his biggest worry. He offers a rare and lonely warning that swaths of the home-loan market escaped post-2008 reform.

First published July 25, 2018

(Image: REUTERS/Mike Blake)

BY PETER THAL LARSEN

In September it will be a decade since Lehman Brothers collapsed. While many recall the Wall Street firm’s dramatic failure – and the global crisis it unleashed – few know how it began. A dazzling new production of “The Lehman Trilogy” examines that story through the eyes of its founding siblings and the dynasty they created. It’s America’s economic history distilled into a family drama.

The chronicle of a collapse foretold begins in September 1844 when Henry, the oldest Lehman, arrives in the United States from Bavaria. He settles in Montgomery, Alabama and opens a store selling clothing and farming tools, where he is joined by his two brothers. The immigrant ethos of self-reliance and hard work is strong. Financial innovation begins early. The brothers buy cotton from local farmers and sell it to factories in the north. “We’re middle men,” the youngest, Mayer, explains to his sceptical future father-in-law.

As the family’s wealth grows, traditions fade. When Henry dies, his brothers close the shop for a week to mourn. By the time Robert “Bobbie” Lehman, the last family member to run the firm, passes away more than a century later, his colleagues barely pause. Markets no longer have time for sentiment.

With assimilation comes financial abstraction. The brothers move to New York and trade commodities such as coffee, coal and iron but no longer handle the actual goods. Investigating an opportunity to finance a railroad, Emanuel Lehman is shocked that the business consists of nothing more than a line drawn on a map. His son Philip sees the potential profit: he’s interested in numbers with lots of “zeroes, zeroes, zeroes”.

The detachment from reality is complete when the firm embraces computerised trading. The giant panoramic screen behind the stage – which first displays Alabaman cotton fields and then the New York skyline – becomes a digital blur. The play does not attempt to explain how subprime mortgages were repackaged into the supposedly safe bonds that helped trigger Lehman’s demise in 2008. There’s no need: the scope for self-delusion is clear.

The history – adapted by Ben Power from Stefano Massini’s play – is punctuated by crises, most of which Lehman turns into opportunities. After a massive cotton fire, the brothers finance new crops. Following America’s destructive civil war, the firm secures state funding to start a bank. During the Wall Street crash of 1929, Lehman survives by bringing in partners from outside the family.

The story is told by three actors who are on stage for the play’s three hours. As well as portraying the brothers, they switch into a range of other characters – children, girlfriends, wives, business partners, rabbis – all the while dressed in the original black garb of the founders. This is funny but also serves as a constant reminder of the firm’s origins.

The action takes place in a large, rotating glass-and-steel box that is part corporate boardroom, part executive office. It’s filled with stacks of cardboard boxes like the ones Lehman’s employees used to carry their belongings after the bank collapsed. As the action unfolds in a single-room Alabama store, or the racecourse where Bobbie Lehman watches his horses, this backdrop is an intimation of the firm’s ultimate fate.

The play pays little attention to the firm’s modern history. It summarises the battle for control between banker Pete Peterson and trader Lewis Glucksman, both sons of immigrants, and suggests the latter’s victory over the former helped determine the bank’s course. Lehman’s sale to American Express and subsequent spinoff in 1994 barely warrants a mention. Dick Fuld, the firm’s final chief executive, only makes a brief appearance.

Director Sam Mendes achieves something more important, though, by forcing his audience to re-examine a familiar story through fresh eyes. “The Lehman Trilogy” reduces the complexities of finance to their human essence: ambition, inspiration, trust, greed, and hubris. The story will resonate when memories of Lehman’s failure are as faded as the pictures of the brothers who founded it.

First published July 20, 2018

(Image: REUTERS/Kevin Lamarque)

BY ANTONY CURRIE

The collapse of a Pasadena mortgage lender with 33 branches sounds like an odd choice for one of the seminal moments of 2008. Plenty of far bigger, more complex and consequential institutions hit the wall during that tumultuous year – from Lehman Brothers to AIG to Fannie Mae and Freddie Mac. IndyMac, which failed 10 years ago on Wednesday, wasn’t even the largest thrift or retail-bank downfall. And another 460 went under by the end of 2012. Yet its fate resonates in Donald Trump’s deregulatory era.

The most obvious reason is Treasury Secretary Steven Mnuchin. He gathered together the group of private-equity firms which six months later bought the bank’s assets out of conservatorship at the Federal Deposit Insurance Corp for around $1.3 billion. He also served as chairman and, initially, chief executive. Five years later, the investors sold it for $3.4 billion. That made the buyer, CIT, the first bank to cross the $50 billion asset threshold regulators had set to denote systemically important institutions. Mnuchin bagged over $100 million. That’s around a third of his current net worth, according to Forbes.

The other is Joseph Otting, who Mnuchin hired as chief executive of OneWest, IndyMac’s new name. He’s now a top U.S. bank regulator, serving as the comptroller of the currency. The 2009 deal with the FDIC became the template for other such sales. Current Commerce Secretary Wilbur Ross, for example, was one of the buyers of BankUnited, another lender that went bust a few months later.

IndyMac, though, offers a textbook case of why it’s not just the big banks which need alert regulators. It quickly grew to $32 billion in assets by selling risky mortgages and relied heavily on loans from the Federal Home Loan Banks and brokered deposits, both expensive. Throw in the worst watchdog of the lot – the now-shuttered Office of Thrift Supervision – and it couldn’t get much more chaotic.

Banks around this size, and even a bit bigger, are getting most of the regulatory relief from the White House and Congress. That’s understandable, to a degree: many of the post-crash rules targeted the mega-banks but snared their smaller cousins in bureaucracy.

But even the minnows can cause trouble. By the end of 2012, the failure of lenders that followed IndyMac into receivership had cost the FDIC more than $90 billion. That’s roughly what Washington spent on preferred stock to bail out Bank of America and Citigroup. Ensuring both types of calamities are avoided requires vigilant oversight across the entire banking industry.

First published July 11, 2018

(Image: REUTERS/Danny Moloshok)