Can Central Banks Head Off a Credit Crunch?
August 13, 2007
By Richard Berner | New York
Risks are rising that the ongoing tightening of lending standards and the abrupt repricing of risk across several asset classes will morph into a credit crunch. If it occurred, such an event would pose clear-cut downside risks to the economy. For some borrowers, the swing from über-easy credit — especially for mortgage and commercial paper borrowing — to tougher terms may already feel like a crunch. For example, mortgage lenders who cannot sell securities in the non-agency MBS market are sharply curbing credit availability as they are constrained by the size of their balance sheets. And managers of structured investment vehicles who cannot roll over the maturing asset-backed commercial paper used to fund them are under pressure to liquidate assets.
We have a more stringent definition: A credit crunch occurs when high-quality borrowers cannot acquire credit at a reasonable price. Semantics aside, however, in today’s market setting it might not take much to transform from a volatile but manageable state to a malign one. The well-documented scramble for liquidity last week is creating fears of funding problems for some intermediaries (see “Global Turmoil: Is it Over?” Weekly International Briefing, August 10, 2007). While risks are high, we nonetheless think that aggressive central-bank action to assure the functioning of money markets will forestall such an event. And although lending standards are tightening significantly, the tipping point is not yet at hand: So far, creditworthy borrowers do have access to credit. But we’d be the first to admit that the metrics for making that judgment are far from precise and lag behind current events, so they only give a sense of trajectory rather than magnitude. And we’d readily concede that disclosure of significant institutional or market stress could quickly change that delicate balance. Yet three factors in addition to forceful Fed and ECB action give us some confidence that a credit crunch is not the most likely outcome. First, surveys of lending standards and credit availability do not yet point to such severe restraint. Second, while some markets are now illiquid and even dysfunctional, the fact that financial innovation has dispersed risk more broadly through the financial system will act to absorb these shocks better than in the past. And last, a look at history suggests that current market stress — judging by market pricing — is still far from the levels that have been associated with crunch-like conditions. There’s no mistaking the growing anecdotal evidence for tighter lending standards. The press is awash in reports of growing lender stress, market illiquidity, mortgage borrowers being denied credit, and the yield spreads on mortgages jumping significantly. Wall Street’s buyout machine has ground to a halt, and given the backlog of promised financing now on banks’ balance sheets, has little capacity for further expansion. In a more macro sense, however, three surveys may provide more comprehensive information and context than these anecdotal compilations: The Fed’s Senior Loan Officer Opinion Survey, the National Federation of Independent Business canvass, and the Morgan Stanley Business Conditions Index; we expect all to point to restraint but not yet a crunch. Investors won’t have to wait long for the latest readings on the first two of these surveys. This week, the Fed will release the results of their quarterly canvass of bank senior loan officer opinions covering mortgage, consumer and business lending, which FOMC officials reviewed at their meeting on August 7. In April, that survey showed a significant tightening of mortgage credit, especially for subprime and nontraditional credit (including exotic loans and Alt-A borrowers). In contrast, credit officers had not changed standards for commercial real estate or C&I lending. By comparison, we expect that the July results will show tighter lending standards across the board, with mortgage lending standards again showing the biggest jump. Likewise, the NFIB will release its survey this week; it probably will show that small businesses found credit harder to get; that canvass generally squares with the Fed survey of banks to small firms. Neither is likely to signal that a credit crunch has arrived or is imminent. Still, if our just-released survey of Morgan Stanley industry analysts foreshadows those two polls, the results could trigger more fears of a crunch. A special question in the MSBCI canvass already shows that three-quarters of lenders have tightened lending standards over the past three months, and that more than half of respondents who borrow — especially energy, telecommunications and utilities companies — faced tighter lending standards over that period. More broadly, our credit conditions index plummeted 14 points to 28%, the lowest level in the history of the survey. Fully 44% of analysts reported that obtaining financing has become more difficult over the past three months. According to our survey tighter lending standards have hurt at least one group in every sector, and the plunge in the MSBCI headline index to an historical low of 31% signals that such restraint may be having an impact on activity (see “Business Conditions: Credit Crunch Worries,” Global Economic Forum, August 10, 2007). A second factor that makes a credit crunch less likely is that financial innovation has dispersed risk more broadly through the financial system, which will act to absorb the kinds of financial shocks that triggered the current liquidity squeeze better than in the past. To be sure, that dispersion of risk is a two-edged sword: It may diffuse credit risks across markets and may tend to reduce risk concentration by putting such risks in the hands of those who want and are better equipped to hold them. But the catch in structured subprime and other forms of credit is that the structure makes it appear that such securities carry less risk than the underlying collateral, encouraging investors to increase leverage. The current turmoil will certainly test which side of this debate is the right one. A final factor suggesting that a credit crunch is not inevitable is that stress in money markets, while rising sharply, is well below levels seen in earlier period of turmoil, such as following the LTCM blowup in 1998. We hasten to add that the market developments of the past few days do pose significant risks, that it is still very early days in this liquidity event, and that further dislocations are likely. Indeed, metrics that show real-time or up-to-date pricing in markets evince a significant scramble for liquidity, as anecdotes of fund losses and redemptions and dislocations in the non-agency MBS market produced a flight to safety and a re-intermediation to banks. No sooner had the ink dried on our forecast update than a variety of money-market measures showed that the stress was far more than the “mild strain” we described in spreads. For example, the 3-monthTreasury-Eurodollar (TED) spread soared by 60 bp in two days, and AA-rated asset-backed commercial paper rates jumped by about 50 bp in the past few days. As the scramble for liquidity intensified, the Federal funds rate rose by more than 25 bp above the Fed’s 5¼% target level. But two days of escalating injections of liquidity finally softened the pressure by week’s end, making good on the Fed’s promise that they stood ready to provide liquidity “as necessary to promote trading in the federal funds market at rates close to the …target rate,” at least for now. Stepping back from the carnage in money markets suggests that so far, the moves in a variety of such metrics are far smaller than in 1998. Moreover, by week’s end, the pressure on some had receded below their peak levels in the week. For example, A1/A2 commercial paper spreads tumbled late Friday (for a review as of Thursday, see “G10: That Was Then, This is Now,” FX Pulse, August 9, 2007). Beyond the Fed’s aggressive open market operations and its stated resolve to do what it takes to bring order to money markets, the US central bank has at least two other weapons in its arsenal. First, under current discount-window operations, the rate at which banks can borrow involves a 100 bp penalty above the funds rate. Cutting that rate to the same level as the funds rate would encourage banks to take advantage of the Fed’s willingness to provide “primary credit” to the system. Moreover, the Fed could decide to accept as eligible collateral for open-market operations securities other than Treasuries, agencies, or agency MBS. And the Fed could activate “swap” lines of credit with other central banks to help them meet demands for dollars when the Fed is not open. Finally, of course, the Fed can ease monetary policy. Having just indicated that inflation remains their predominant concern, however, it would take a clear move to credit crunch territory to persuade the Fed to exercise that option soon. For investors, our two most robust conclusions remain the same: Bet on a steeper yield curve and elevated volatility. The Treasury yield curve has steepened significantly, but likely will steepen further. A flight to quality or signs of economic weakness may give way to a renewed bull steepening, but bear steepening may also recur as volatility rises. Spreading risk aversion won’t likely fade quickly and market volatility will persist. Indeed, volatility could remain elevated as portfolios are marked to market and redemptions occur. The interplay between tighter lending standards and precautionary demands for liquidity probably will remain intense. Those demands won’t ebb soon, but we have no doubt that the Fed will quash money-market pressures. Nonetheless, abrupt short-covering rallies and vicious selloffs are equally likely to continue.
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Review and Preview
August 13, 2007
By Ted Wieseman & David Greenlaw | New York
In an extremely volatile week, the Treasury curve steepened sharply as the risk-reduction/flight-to-safety trade initially eased significantly over the first part of the week, even as the Fed provided no indication that it was considering the near-term rate cut many investors were hoping for but then came back with a vengeance Thursday. This was after a freezing up of the European commercial paper market put huge demands on banks for short-term funds, driving up overnight funding rates globally. By week-end, investors were pricing in a reasonable possibility of a Fed rate cut at any time, but before the Fed even thinks about cutting rates, it first needs to be more successful in halting the unintended hike in effective rates seen late in the week. In response to spiking overnight rates Thursday and Friday, the Federal Reserve in Washington claimed that the Federal Reserve would “provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee’s target rate of 5-1/4 percent”. The New York Fed had mixed results in injecting sufficient reserves to accomplish this goal. Effective fed funds traded at 5.41% Thursday and even after three rounds of open market operations had averaged 5.42% on the day through 5:00 Friday according to ICAP’s calculations before finally collapsing in very late trading to drop the average for the day down to 5.12% at 6:00. This clearly was not a helpful time to permit an unintended hike in the fed funds rate on Thursday and most of Friday, but the Fed’s announcement and the energetic efforts by the New York Fed’s trading desk to get the funds rate back under control after it had opened at 6% Friday morning, with the highly unusual three rounds of RPs, did have some calming effect. A decision by the White House to refuse to allow any easing of caps on the growth in Fannie Mae and Freddie Mac’s retained portfolios was also damaging to market sentiment and liquidity. Fannie and Freddie have made clear that they are eager to inject desperately needed liquidity into the currently largely frozen non-agency MBS market. Mortgage giant Countrywide noted “unprecedented disruptions” in the non-agency mortgage market a week after major lender Indymac’s CEO stated that “right now, other than the GSEs and Ginnie Mae, the private secondary market is not functioning”. Lenders can continue making non-conforming loans and holding them on their balance sheets, but balance sheets are obviously limited and this could soon become a binding constraint on the ability to make such loans. As a result, jumbo mortgage rates are already spiking as lenders have to assume that, for any such loans they make, they won’t be able to sell to be securitized and will have to hold on their balance sheets. Despite these severe dislocations, the White House said that it would not consider allowing Fannie and Freddie to provide liquidity to this sizable section of the mortgage market until regulatory reform is passed. House Financial Services Committee Chairman Barney Frank described this decision as “ludicrous”. The signs of cash hoarding and commercial paper illiquidity — real and significant, at least temporarily, in Europe, much less so in the US, though with significant fears of Europe’s problems arriving here and some major widening in CP spreads between higher and lower-rated credits — that helped drive the spike in short-term lending rates that the Fed, ECB, Bank of Japan et al. tried to fight through significantly stepped up open market operations, combined with the ongoing collapse in a significant portion of the mortgage market, had investors convinced at week-end that a rate cut could come at any time and certainly no later than the September FOMC meeting. Before the Fed can reasonably consider a rate cut, it first needs to more successfully keep the actual fed funds rate down in line with the 5.25% target and avoid a continuation of the unintended tightening of Thursday and much of Friday. We suspect that the Fed may be considering a reduction in the discount rate from 6.25% to or close to 5.25% if these disruptions continue, which would put a cap on the fed funds rate and prevent the spikes seen in recent days. Only after returning stability to the overnight lending market will the Fed be in a position to judge whether more drastic measures are called for. The justifications for any actual rate cut would likely remain the same as those spelled out recently by St. Louis Fed President Poole, who will be the longest-serving FOMC member when Chicago Fed President Moskow retires at the end of this month. According to Poole, unless the recent market problems “change the probable course of economic growth and inflation, then the fed funds futures market will reverse course and the expected policy easing will disappear”. On the other hand, “if evidence accumulates that the inflation picture remains benign but the outlook for the economy next year appears likely to be significantly weaker than the current best guess, then the market will deepen its conviction that the Fed will be cutting its fed funds target”. In Poole’s view, the “Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment, or when financial market developments threaten market processes themselves. The Fed should not try to substitute its judgments for the market’s judgment on appropriate security prices”. We’re certainly not there yet, in our view, but both of Poole’s possible reasons for a rate cut did move closer in the latest week. The spike in overnight lending rates, problems in the commercial paper market in Europe, and apparent heavy hoarding of liquidity in the US, started to suggest the possibility of a threat to “market processes themselves” if this recent deterioration were to intensify and especially if the problems in Europe’s CP market were to continue and cross over to the US. And if the blocking of the hoped for liquidity injections by Fannie and Freddie into the struggling non-agency MBS market leads to a continued sharp tightening in lending terms and availability in that substantial part of the mortgage market (there are about US$4 trillion in agency MBS outstanding, and that market is still functioning quite normally, and US$2 trillion in non-agency MBS) the relatively small direct impact of the subprime meltdown will by no means be able to be considered “contained” anymore. For the week, the Treasury curve steepened dramatically, with 2s-10s and 2s-30s hitting two-year highs. The 2-year yield dipped 2bp to 4.44% — after trading as high as 4.68% Wednesday and as low as 4.34% Friday — while the 3-year yield rose 3bp to 4.47%, the 5-year yield 5bp to 4.57%, the old 10-year 9bp to 4.80% and the old 30-year 15bp to 5.02%. The refunding did not go well at all, with the 30-year auction on Thursday in particular one of the worst auctions we can remember, so apparently the risk-reduction trade has seen some extension in long-duration assets even with no credit risk. The new 10-year closed at 4.776% after being auctioned Wednesday at 4.855% and the new 30-year ended the week at 5.006% after being auctioned Thursday at 5.059% (which was a whopping 6bp tail relative to pre-auction levels). There was a very heavy move into cash that collapsed short bill yields. Unlike a few months ago, when we saw sharp drops in bill yields when supply was sharply falling, this was purely a demand-driven move, as we are in a very heavy seasonal period for bill issuance. The 4-week bill yield plummeted 59bp to 4.33% and the 3-month 30bp to 4.54%. There was a huge increase in near-term Fed rate cutting expectations even as medium-term views didn’t move much and were actually scaled back starting in the second half of next year. So if the Fed is forced into emergency cuts, as the market now thinks is highly likely, a reversal is expected before too long. In the short term, the August fed funds contract gained 2bp to 5.205%. That’s open to a variety of interpretations and is sensitive to how effective fed funds ultimately settles out Friday, but it could be consistent with a 25% chance of a rate cut as early as Monday. If not inter-meeting, a rate cut by the September FOMC meeting is fully expected now, with the October contract gaining 13bp to 5.005%. A second cut by the December FOMC meeting is just almost fully priced in after the January contract gained 12.5bp to 4.785%. Short-term eurodollar futures contracts gained in line with these adjustments, but losses started with the Sep 08 contract and increased moving out the curve, tracking to some degree the Treasury curve moves. The low rate June 08 contract gained 3bp on the week to 4.725%, pricing in only about a toss up over whether there will be another cut next year on top of the 50bp reduction in the funds target expected by year-end. Key risk markets ended mostly stronger on the week, but only after major improvement through Wednesday was partly reversed after fears were revived by the liquidity squeeze that started Thursday. The S&P 500 gained 1.4% on the week after being up 4.5% at Wednesday’s close. Credit markets ended considerably stronger on the week, and saw relatively small reversals off their best levels hit Wednesday, a potentially quite encouraging sign. The 5-year Hi-Vol CDX index improved to 164bp from 189bp, only backing off 9bp from Wednesday’s close of 155bp. The investment grade index improved to 68bp from 81bp after reaching 62bp Wednesday. The high yield index improved to 426bp from 480bp after closing at 404bp Wednesday. Performance by the leveraged loan LCDX index was similar, rallying to 94.88 (270bp) from 93.80 (307bp) for the week after a relatively contained reversal from Wednesday’s 95.78 (241bp close). The subprime mortgage market was mixed. After falling hard Monday, performance was generally strong through Wednesday, with the AAA index leading the upside on hopes for support from Fannie Mae and Freddie Mac. Note that Freddie Mac already has large holdings of MBS backed by AAA rated subprime mortgages (US$120 billion at the end of May) and might have been inclined to add holdings in this beaten down sector if given the opportunity by the Administration. Investors apparently weren’t giving up on the possibility of a change in the White House’s stance on the GSE’s portfolios, however, as while the AAA index pulled back from Wednesday’s close after President Bush’s announcement, it still significantly outperformed on the week, rising to 91.50 from 90.63. All the other ABX indices were down on the week, with the AA index (78.33 versus 83.14) hit particularly hard. There was little economic data of any consequence the past week, the most notable release being productivity and unit labor costs. Non-farm business labor productivity rose at a 2.1% annual rate in 2Q, as output jumped 4.2% in line with details from the GDP report, and hours worked advanced 2.3%. With compensation per hour up 3.9%, unit labor costs rose 2.1%. Significantly negative revisions to prior data as the GDP benchmark was incorporated resulted in a much lower recent trend for productivity and much higher trend for unit labor costs. For all of 2006, productivity growth was revised down to +0.9% from +1.6% and has slowed further since to +0.6% year/year in 2Q. Meanwhile, unit labor costs were revised up to +4.1% from +4.0% in 2006 and have further accelerated to +4.5% year/year in 2Q, a seven-year high. In other data, wholesale inventories rose 0.5% in June, above the 0.2% rise BEA assumed in the advance GDP report. Combined with previously reported figures from the June factory orders and construction spending reports, we now see 2Q growth being revised up to +3.7% from +3.4%. The key event of the coming week is probably going to be where overnight rates open up globally Monday morning and how, if necessary, central banks respond to judge whether this rush for liquidity is abating or intensifying. Economic data are obviously of very limited importance at this point, but the coming week does have a busy calendar, with retail sales and business inventories Monday, PPI and trade Tuesday, CPI, Empire State and IP Wednesday, housing starts and Philly Fed Thursday, and Michigan consumer confidence Friday: * We forecast a 0.3% decline in overall retail sales in July but a 0.3% increase excluding autos. Another fall-off in the auto dealer category is expected to drag down headline retail sales this month. In other categories, we look for a price-related drop in gas station sales and another downturn at hardware stores to be partially offset by an iPhone-related surge in the home electronics sector. Also, our translation of the monthly chain store reports suggests that a solid gain in the general merchandise component will be partially offset by some further softness at apparel outlets. * The previously reported readings for the manufacturing and wholesale sectors, together with an expected moderation in non-auto retail stockpiles, points to a gain in overall business inventories of 0.4% in June, close to the recent trend. Meanwhile, the I/S ratio is expected to rise slightly to 1.27. * We look for a 0.4% rise in the overall producer price index in July and a 0.1% rise ex food and energy. Even though gasoline prices have been trending lower for the past couple of months, the PPI survey is based on quotes obtained during a relatively narrow window in the early part of the month. In this case, the timing is likely to lead to a reported increase in gasoline prices. A rebound in the food component is also likely to help push up the headline this month. Meanwhile, the core is expected to show a bit of moderation, although this outcome is largely tied to an assumption of a somewhat tamer result for the motor vehicle category. This category has exhibited bizarre month-to-month gyrations for quite some time now and represents the key wildcard every month. * We look for the trade deficit to widen US$3.5 billion in June to US$63.5 billion, with exports down 0.4% and imports up 1.5%. On the export side, industry data and factory shipments figures point to a drop in capital goods, led by aircraft and high-tech, and little change in other categories. A good gain in services implied by the GDP figures should provide a positive offset. On the import side, rising prices should lead to a further decent rise in recently surging petroleum products, a pick-up in North American auto assemblies should lift autos, and a pick-up in growth in inbound container shipments through the key West Coast ports, corroborated by continued strong China export figures, points to a good gain in other goods imports. Note that our forecast is about US$2.5 billion worse than BEA assumed in preparing the advance 2Q GDP estimate. * We forecast a 0.1% rise in the consumer price index in July, overall and ex food and energy. A further pullback in gasoline prices should help hold down the headline CPI this month. Meanwhile, the core is expected to register a high +0.1% (+0.13% on an unrounded basis), helped in part by a modest pullback in hotel rates following some unsustainably sharp gains in prior months. Also, we expect to see further evidence of some underlying moderation in the key OER category. On the upside, apparel is likely to register a modest seasonal correction and education should rebound from an abnormally low result in June. If our estimate for the core is close to the mark, the year/year rate should tick down another tenth to +2.1%. * We look for a 0.2% rise in industrial production in July. The employment report showed that hours worked were flat in the factory sector during July. However, productivity still appears to be holding up reasonably well in the factory sector, and motor vehicle assemblies posted another sharp jump as automakers gear up for labor negotiations. So, we look for the key manufacturing category to be up 0.6%. A sharp weather-related decline in utility output is expected to help hold down the rise in overall IP. Finally, we suspect that this report may include at least a modest upward revision to June — as the initial readings for both motor vehicle production and electric utility output appear to have been too low. * We expect housing starts to fall to a 1.40 million unit annual rate in July. Starts registered a surprising uptick in June, but a still high backlog of unsold new homes points to a need for a further sharp reduction in homebuilding. Based on the recent slide in the NAHB index and the downtick in hours worked within the construction sector (as seen in the jobs data), we look for about a 4.5% drop in July starts.
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