By James H. Nolt
This week I had intended to write about the effect of the economic crisis in China on the world economy. However, my plan changed on Monday when I picked up the Wall Street Journal after a single article caught my eye. As I thumbed through it to find the inside continuation of that article, more crisis news diverted my attention. In a single edition of that paper, without even looking hard, I found seven articles detailing aspects of the current economic crisis. I decided to review these to help interpret the news.
The article that first drew me in is headlined “BofA Home Loan: 3% Down, No FHA.” With the 2008 subprime mortgage crisis fresh in our minds because of the excellent new movie The Big Short, here comes another indication that the major banks are once again desperately hungry for risky loans. These new Bank of America mortgage loans are designed to avoid costly mortgage insurance. They join the “Rocket Mortgages” of Quicken Loans as another potentially risky mortgage product.
Financial companies are interested in accelerating the mortgage deal flow because they are mainly interested in the fees they earn on each deal, regardless of whether the mortgage will ultimately turn bad. The idea is like a game of hot potato: place risky loans into large pools and sell the risk and return to some other investor, whether wary or not. Usually, the loans themselves become the assets securing mortgage bonds which are then also used as the basis for derivative products.
The next couple articles I perused were on an inside page, “When Earnings Fall Short, Lenders Fudge Their Losses,” which is about how banks are hiding the extent of their losses suffered on loans, which of course is one reason too that they are eager to originate more bad loans to earn fee income to make up for losses on past bad loans and still show profits.
Just below that one was “More Bad News Looms at U.K. Bank,” which talks about troubles at the Asia-focused Standard Chartered Bank. Hong Kong banks like this one were in danger because of their heavy exposure to increasingly defaulted loans in China, where as much as five trillion dollars in bad loans fester now, though often concealed by accounting tricks.
Then I saw the article “More Ships Idled As Demand Ebbs,” which describes how the slowdown of China’s trade, in particular, has idled scores of huge container ships and bulk carriers that once plied Pacific waters. This is a very physical indicator of a slowing world economy.
Next I noticed another front-page zinger, “Toys ‘R’ Us Poses Test for Bond Markets.” The details are worse than the headline. This famous toy company is just one of many corporate behemoths that may be stymied in efforts to rollover tens of billions of dollars in bond debt during the coming few years. Many such companies have bonds now rated as “junk”—that is, high risk. But that article reports that the worsening credit market could make it impossible to market ever more junk bonds to replace those maturing. If no alternative is found, it could mean bankruptcy for the companies and defaulting bonds.
The next article has a less obvious connection to the developing crisis. The headline is “Central Banks Boost Fed Repo Use.” For those who do not know, a couple years ago the U.S. Federal Reserve Banks began supplementing “open market operations,” i.e., the buying and selling of Treasury bills, with a repo (short for “repurchase”) market facility. Banks can borrow short-term from the Fed by selling a Treasury security to the Fed but at the same time agreeing to buy it back later, often only a day later. The bank gets cash and the Fed holds the security as collateral for the loan. Since there is this “safe” collateral, these are very safe loans, and consequently the cost of borrowing is quite low.
The program also operates in the opposite direction, that is, banks can also make repo loans to the Fed, which is like making a one-day deposit in return for a very small interest payment, which is the difference between the cost of the security one day and the agreed repurchase the next. The article is about the tendency of foreign central banks who want a safe and liquid use of dollars they hold to “deposit” them at the Fed in the form of such repo loans. This has been attractive recently because of the extremely low yield on Treasury bills, the other common liquid means of holding dollar assets. The tendency to shift liquid dollar reserves from Treasuries to repo loans has lowered the demand for Treasuries and thus lowered their price, slightly increasing the cost of short-term borrowing for the U.S. government.
So far, the magnitude of this movement is around a quarter of a trillion dollars. This might sound like a lot, but in the world of government debt, it is not enormous. However it does illustrate that there are attractive alternatives to parking liquid reserves in Treasuries. Repo loans are a “purchase” based on an agreement to repurchase, so not the same as an outright purchase. In a crisis, there is potential for a more dramatic movement that could cause a sudden surge in government borrowing costs.
Finally, I read an article entitled, “It’s Time to Price in the Risk of Britain’s Exit from EU.” This article echoes conversations I had with two leading French historians of banking and finance during a visit to Paris recently. Many in Europe are deeply worried about the increasing prospect of Britain leaving the EU. The biggest impact could be on financial markets, especially those for circulating debt (bonds and bills).
Although the days of the British Empire are long past, London is still one of the world’s greatest financial centers. Britain’s relationship with the rest of Europe is an important factor influencing the price of debt (i.e., bond and bill prices) throughout Europe. If Britain leaves the EU, other countries might follow. Debt costs could soar, meaning bond prices crash. This could be a precipitating factor in the third wave of the world financial crisis, along with the already evident slowdown in the economies of countries like Germany and Italy because of the rapid decline in their machinery exports to China. As promised last week, I discuss more about the China dimension of the crisis next week.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Jon S]