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Freight Trains and Steep Curves

The U.S. financial system's big gamble on perpetually low short-term interest rates

© 2003 John P. Hussman, Ph.D.

This article first appeared on July 11, 2003 as a guest perspective in Kate Welling's Welling@Weeden

"I also enjoyed John Hussman's essay.  But I'm afraid he's right."
- Jack Bogle, Vanguard Funds

T.S. Eliot once wrote "Only those who risk going too far can possibly find out how far one can go." It seems that the U.S. financial system is bound and determined to find out.

The major force shaping economic dynamics over the coming decade is likely to be an unwinding of the extreme leverage that individuals, businesses, and the U.S. itself (via its record current account deficit) have accumulated. Every past U.S. economic expansion has begun with a current account surplus, which moved rapidly to a deficit as consumption and investment soared. In contrast, eliminating a massive current account deficit will dampen future growth in domestic consumption and investment for quite a while. Individual and corporate balance sheets are no healthier, of course, and this will make the U.S. economy vulnerable to future debt crises and shifts in the profile of interest rates.

Many of these difficulties are well recognized, if not universally feared. What is not so obvious is the extent to which the U.S. economy and financial markets are betting on the continuation of unusually low short-term interest rates and a steep yield curve. This doesn't necessarily resolve into immediate risks, but it could profoundly affect the path that the economy and financial markets take during the next few years, by making the unwinding of debt much more abrupt.

In response to very low short-term interest rates, many U.S. corporations have swapped their long-term (fixed interest rate) debt into short-term (floating interest rate) debt, to the extent that an increase in short-term rates could substantially raise default risks. Similarly, a growing proportion of homeowners have refinanced their mortgages into adjustable rate structures that are also sensitive to higher short-term yields. Finally, profitability in the banking system is unusually dependent on a steep yield curve, with a widening net interest margin (the difference between long-term rates banks charge borrowers and the lower short-term rates they pay depositors) accounting for all of the strength in bank earnings in recent years.

Of course, if somebody owes short-term interest, somebody else must be earning it. In equilibrium, every security issued is matched by a holder on the other side. For this reason, the ocean of "liquidity on the sidelines" in money market funds is not a pool of money waiting to be invested in stocks or bonds, but is instead a measure of how dependent U.S. borrowers are on short-term debt.

See, if Mickey sells his money market fund to buy stocks, the securities in that money market fund have to be sold to Nicky, whose cash goes to Mickey, who uses that cash to buy stock from Ricky. In the end, Nicky holds the money market securities that Mickey used to hold, Mickey holds the stock that Ricky used to hold, and Ricky holds the cash that Nicky used to hold. In the end, there is just as much "cash on the sidelines" as there was before. Money never goes into or out of the market, merely through it.

So the real question is this: why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That's the secret. The borrowers don't actually issue it directly. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.

See, a risk-averse investor might be somewhat reluctant to lend short-term money directly to, say, General Motors. To see how the U.S. government becomes a counterparty to this debt, grab a pen.

Transforming risky debt into government backed paper

First, suppose that Citibank gets money from its depositors at a floating rate, and lends to mortgage borrowers at a fixed 6%. Now GM issues bonds yielding 7%, and enters a swap with Citibank, in which Citibank pays GM 5% fixed in return for floating. (Specifically, both parties agree on some notional principal, say $100 million, and each makes payments to the other, determined by multiplying a fixed or floating interest rate by that principal amount. The market for this sort of transaction is huge).

Well, now GM is paying an actual interest rate of floating + 2% (pay 7% to bondholders, get 5% from Citibank, pay Citibank floating). Meanwhile, as compensation for the credit risk it has accepted all around, Citibank earns a fixed 1% margin regardless of interest rate movements (pay depositors floating, get 6% from mortgages, pay 5% to GM, get floating from GM). Neat. And since Citibank is federally insured at the depositor level, and "too big to fail" at the institutional level, Uncle Sam is now a counterparty that effectively shares the risk in the case that GM or homeowners default. Similar transactions serve to swap risky corporate and mortgage borrowing into safe government agency paper issued by Fannie Mae and Freddie Mac.

Now make no mistake, there is little question that bank deposits and agency debt are safely backed by the U.S. government and that this is a good commitment. However, the holders of stock in banks or mortgage companies like Fannie Mae and Freddie Mac may not be so secure. It's just excruciatingly difficult to perfectly match risky assets and liabilities at extremely high levels of leverage. Ask Long Term Capital. Indeed, were it not for accounting rules that allow Fannie Mae to keep balance sheet losses out of earnings, it would be clearer to investors that last summer's 5-month "duration mismatch" cost Fannie nearly a year of earnings. Similar derivatives-related issues are at the core of Freddie Mac's recent difficulties.

According to the Bank for International Settlements, the U.S. interest rate swap market is about $34 trillion in size, having nearly doubled in size in the past two years. The reason this figure is so enormous is that there are usually several links in the chain from borrower to investor. A risky borrower may enter a swap with bank A, which then takes an offsetting swap position with bank B (earning a bit of the credit spread as its compensation), and so on, with a cheerful money market investor at the end of the chain holding a safe, government backed security, oblivious to the chain of counterparty risk in between.

Picture a freight train.

Aside from the risk that any particular link in this chain might be weak (know thy counterparty), the U.S. financial system has gone one step further. In order to hedge against the risk of defaults, banks frequently lay credit risk off by entering "credit default swaps" with other banks or insurance companies. These swaps essentially act as insurance policies for credit risk.

Once again, however, the iron law of equilibrium is that every risk swapped away by someone is held by someone else. According to Bloomberg, over half of the world's trading in the credit swaps market is concentrated among five banks: J.P. Morgan (26%), Citigroup (10%), UBS Warburg (9%), Bank of America (7%) and Deutsche Bank (7%). As Warren Buffett has noted, "Large amounts of risk, particularly credit risk, have been concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The trouble of one could quickly infect the others."

Picture a freight train.

In short, the U.S. financial system is in a delicate balance. On the issuer side, a great many borrowers have linked their debt obligations to short-term interest rates. This is tolerated by the financial system because the debt has been swapped out through financial intermediaries, so investors get to hold relatively safe instruments like bank deposits and Fannie Mae securities. This mountain of debt in the U.S. financial system - tied to short-term interest rates - is ultimately and perhaps somewhat inadvertently backed by the U.S. government.

On the investor side, Asian governments intent on holding their currencies down relative to the U.S. dollar have purchased a great deal of U.S. government and agency debt - effectively "buying dollars." China, for example, pegs the yuan to the U.S. dollar, and accumulates large volumes of dollar denominated securities as reserve assets. Individual investors have also been willing to hold low-yielding money market instruments because of profound weakness of the U.S. stock market and restrained inflation. A reduction of demand for U.S. short-term debt, either by foreign governments (particularly in the event that Asian governments decide to revalue their currencies) or by U.S. investors, could have very undesirable consequences.

All of which is why the U.S. is now extremely dependent on short-term interest rates remaining low indefinitely.

Near-term inflation risk, longer-term default risk

In addition to the direct effect of increasing debt-servicing costs of fragile borrowers at all levels of the economy, an increase in short-term interest rates would tend to raise "monetary velocity," resulting in an abrupt and unexpected increase in inflation. As a rule, rising short-term interest rates have historically been self-reinforcing because they trigger the delayed inflationary impact of the prior monetary easing.

Though currency and bank reserves (monetary base components) are held partly because they provide useful transaction services, they do not bear interest. An increase in interest rates therefore increases the opportunity cost of holding base money, and results in an increase in monetary velocity. Think of monetary velocity as measuring the extent to which people want to hold or get rid of liquid cash. Low velocity means that investors are clamoring for the stuff (think bank runs). High velocity means that cash is a hot potato (think rising interest rates). 

By definition, inflation equals the growth in the monetary base, plus the growth in monetary velocity, minus the growth in real output (this follows from the monetary identity PY = MV). The main way to get deflation is for velocity to plunge as a result of credit defaults and bank runs, driving investors to place a great value on cold, hard cash. The main way to get inflation is for velocity to accelerate in an environment of rapid money growth. At present, the near-term risk of inflation appears substantially higher than the risk of deflation.

To the extent that economic strength could raise short-term interest rates, velocity and inflation in the near term (regardless of Fed action), the heavy dependence of risky debtors to low interest rate credit could trigger a fresh acceleration of defaults in the longer term.

While the prospects for rapid and sustained economic growth remain questionable, there is increasing evidence that the U.S. economy may enjoy a surprising burst of strength in the second half of 2003. Given the potential pressure on short-term market interest rates (regardless of whether the Fed follows suit), a short burst of strength in the U.S. economy may ironically be the last thing that the U.S. economy needs.

John P. Hussman, Ph.D. is the President of the Hussman Investment Trust and portfolio manager of the Hussman Funds.


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