Could U.S. market see a U.K.-like crisis?

Investment Analysis Clubs Macro Economic Trends and Risks
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All METARs who follow world economic news are aware that the U.K. financial market suffered a crisis of confidence last month which caused the new prime minister to fire the finance minister, reverse her policies and will probably get her fired.

After U.K. Market Blowout, American Officials Ask: Could It Happen Here?

Federal Reserve and White House officials spent last week quizzing investors and economists about the risks of a British-style meltdown at home.
Joe Rennison

By Jeanna Smialek, Jim Tankersley and Joe Rennison, The New York Times, Oct. 19, 2022

Federal Reserve researchers and officials quizzed experts from Wall Street and around the world last week about a pressing question: Could a market meltdown like the one that happened in Britain late last month occur here?

The answer they got back, according to four people at separate institutions who were in such conversations and who spoke on the condition of anonymity to describe private meetings, was that it probably could — though a crash does not appear to be imminent. …
The risk of a financial crisis has grown as central banks have dramatically raised interest rates…

Markets have been choppy for months in the United States and globally as central banks — including the Fed — rapidly raise interest rates to bring inflation under control. That has caused abnormally large price moves in currencies and other assets because their values hinge partly on the level of interest rates and on international rate differences. Stocks have been swinging. It can be hard to quickly find a buyer for U.S. government bonds, although the market is not breaking down. And in corners of finance that involve more complicated investment structures, there’s a concern that volatility could trigger a dangerous chain reaction…It is impossible to know what might break until something does. Markets are large and intertwined, and comprehensive data is hard to come by. …[end quote]

It is concerning that “It can be hard to quickly find a buyer for U.S. government bonds” since normally Treasuries are the most liquid investment in the market. It’s an indication that the ususal buyers are hoarding cash. The largest international buyers of Treasuries are Japan and China. Changes in either one might cause illiquidity in the Treasury market. The Federal Reserve would probably step in to buy if that happened, but that’s opposite to their current strategy of gradually selling Treasuries and mortgage bonds from their bloated portfolio.

The 2008 financial crisis was triggered by the failure of highly-leveraged, opaque financial products that intertwined between companies. When the Fed raised the fed funds rate in 2004 - 2006 from its abnormally low level to a more normal level, mortgage defaults began to rise in 2007, leading to the 2008 financial crisis.

The 30 year mortgage rate is currently rising faster than it did in 2006. Mortgage rates have more than doubled in the past year.

Recession Fears Hit Risky Mortgage Debt Amid Default Concerns

Faltering home prices are hurting investors’ demand for junk-rated mortgage securities sold by housing giants Fannie and Freddie

By Matt Grossman, The Wall Street Journal, Oct. 19, 2022

Investors are unloading securities sold by Fannie Mae FNMA -2.35%â–Ľ and Freddie Mac FMCC -0.96%â–Ľ that shift the risk of mortgage defaults away from taxpayers, a sign of growing concern about defaults if rising interest rates cause a severe recession.

The securities, called credit-risk transfers, could incur losses if rising defaults creep into the massive swaths of mortgage debt backed by the housing-finance giants. The Federal Reserve’s interest-rate increases have shown signs of cooling the pandemic’s roaring real-estate market, and many worry that the central bank’s inflation-fighting may cause a recession that hurts homeowners’ ability to repay their loans…[end quote]

I have never heard of “credit-risk transfers” (CRT) before. Asset managers, pensions and hedge funds all invest in the roughly $60 billion CRT market, which acts as insurance for the two agencies against defaults on slices of roughly $4.5 trillion of mortgages that would otherwise spell losses for U.S. taxpayers. CRT prices have fallen so much that judging by spreads alone, the market looks like it is preparing for a housing crisis as bad as the 2008 recession. (I buy mortgage-backed bonds on the secondary market, but they are AAA rated, not CRTs, and I always hold to maturity.)

Having just read 3 books about interest rates and markets, I’m concerned that higher rates may indeed cause a crisis, although it would take time to work its way through the system.

  1. Zombie companies, which can barely cover their interest payment even when rates are ultra-low, will gradually fail as their debts mature and need to be rolled over. According to the Fed, 10% of listed companies are zombies.

  2. Failures caused by mortgage-backed securities. Outstanding (as of 4Q21) $12,201.6 billion – an enormous amount, equal to about 50% of U.S. GDP. These are often highly leveraged – the trigger of the 2008 financial crisis.
    US Mortgage Backed Securities Statistics - SIFMA - US Mortgage Backed Securities Statistics - SIFMA

I would like to call attention to one of the most insightful essays in the financial press, John Mauldin’s “Fingers of Instability,” written in 2006. It may be relevant for our current situation when the sandpile of stressed debt is growing ever higher and put under more stress by rising interest rates. Mauldin has just written a new insight, “Pension Sandpile.”

The trend has decisively shifted from stability to instability. Be careful out there.
Wendy

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I thought the issue in UK was a major tax cut to stimulate the economy in a period if high inflation. To be funded by additional borrowing in a period of rising interest rates. Markets responded by selling the British pound. To close to parity with the dollar.

None of this seems to be on the table in the US. Raising interest rates to slow inflation is the priority.

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That’s only part of the problem. The root cause of the problem is here I believe…

From the Linked article:

Ben methodically explains how years of falling interest rates raised pension liabilities—a big problem for plan sponsors and managers. Lower interest rates reduced the return on the bond portion of a pension fund. In a world of zero and negative interest rates, pension funds simply couldn’t make their target returns (typically 7% and sometimes more) when 40%+ of the portfolio was making 2‒3% (at best!).

Consultants then pushed them toward something called “Liability-Driven Investment” or LDI, basically a leveraged hedge fund strategy betting interest rates would keep dropping. They showed data that for the last 30 years the trade ALWAYS won. Except the last 30 years was a period of falling rates and inflation, which everyone assumed would continue. It worked well until rates went higher… or, as Ben says, “until the math broke.” Now they all want to exit at once.

In effect, UK pensions are in a solvency crisis. Giant debtors are in danger of not being able to meet their obligations—not the pension benefits years from now, but margin calls due immediately. They are thus frantically trying to raise liquidity. Their combined efforts to sell UK government bonds all at once raised rates even further, aggravating the problem and creating new ones. The word “cascade” is quite accurate. Each step leads to another one, bigger than the last. As of this morning, it looks like the Bank of England is calming the market, but it serves to demonstrate how fragile the debt/leverage system is. We will know more next week.

'38Packard

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It’s true that the problem that precipitated the UK crisis (cutting taxes in a period of high inflation) wouldn’t happen in the U.S. – or at least, I hope not. However, the root cause – ultra-low interest rates for a long time followed by rapidly rising rates which exposed pension funds to margin calls – are similar to problems in the U.S.

Please read the linked articles, including the article that is linked within the Mauldin article.
Wendy

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Well now the US Treasury read admin and the FED are laying their plans of combat. Not sure we will need another answer.

The question is how much is the price tag?

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I think the “voodoo economics” of the early to mid 1980s tax cuts was very much intended to act against Volcker’s tightening. However, as it came toward the end of the tightening period, and with a rising US dollar, it was accepted rather than fought. The Plaza Accord soon after was another sign that the dollar was considered too high and an expansionary policy was viable. It helped that oil was falling, and that the emerging market crisis kept the focus on investing inside (rather than outside of) the US.

About the UK funds - were the LDIs their primary investment? I’ d like to know more about the composition of those funds.

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In the 80s the top bracket earned income tax and the corporate tax rate were dropped early on to recapitalize the country. The pensions had in fact put much of corporate America into insolvency. The pension liabilities were outracing the corporate profits because the pensions were holding 2% coupon treasuries.

It was honest to recapitalize corporate America. The later Reagan tax cut around 1987 was based on a greedy lie. And if it worked once we can scr$w them again.

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Seems that tax cuts for the “JCs” are the panacea for all supposed ills. Some of the cuts seem to be offered “just because”, if they can’t find an excuse. The transcript of that Concord Coalition conference from years ago apparently is no longer on the net, so I will summarize the comments of one participant “I don’t know where to even start looking for any justification for the second cut (of the early 2000s)”

By the way, Truss’ Home Secretary resigned today. She had violated a security reg, and promptly resigned, and took a blistering swipe at Truss, at the same time.

The business of government relies upon people accepting responsibility for their mistakes. Pretending we haven’t made mistakes, carrying on as if everyone can’t see that we have made them, and hoping that things will magically come right is not serious polities. I have made a mistake; I accept responsibility: I resign.

Meanwhile, there was confusion whether the party Whip had resigned. The UK is looking increasingly rudderless.

Steve

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Yep, the problem with tax cuts for the US or UK would solely be the timing in the economic cycle. Meaning the US and UK have an opportunity to become much greater manufacturing powers. The UK threw that in the garbage heap two weeks ago in favor of crony capitalism. The national debt in the USA would be put at risk with tax cuts. Such a move would be much more damaging in the USA. It threatens our credit worthiness when we our deep in debt because of supply side econ where we stripped out a lot of our manufacturing base.

Higher corporate taxes incentivize corporations to reinvest. Reinvesting and committing to R&D are tax deductible. Successful efficient corporations paying workers more drives up consumer demand which in the long run is a virtuous cycle. Efficiency spells lower inflation much longer term. It is only one force in the economy but it can play a much more significant role from here. The R&D also drives down prices longer term. Greater investment in manufacturing drives down prices even more so.

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Actually, I’m thinking that, unless they are inflation adjusted, inflation and hiigher rates may help pension funds as they will have to make payouts in lower-valued dollars and wiill be able to recoup some of their deficits by investing at higher interest rates. I guess it all depends on how they are currently allocated and how leveraged they are.

Jeff

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*BREAKING NEWS

Truss has resigned. The party has been selecting steadily worse candidates. May begot Johnson. Johnson begot Truss. Who is next/worse?

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Mauldin walks around with a black cloud over his head at all times. Listening to him is like getting a weather report from an inmate at a prison without windows. It might be right once in a while, but overall, not a great source to use to inform your decisions.

“ Mauldin: The Man Who Cries Bear

John Mauldin, former print shop professional and current perma-bear investment strategist, unfortunately seems to have taken a page from Aesop’s book by consistently crying for a market collapse. After spending many years wrongly forecasting a bear market, his dependable pessimism eventually paid dividends in 2008. Unfortunately for him, rather than reverse his downbeat outlook, he stepped on the pessimism pedal just as the equity markets have exploded upwards more than +80% from the March lows of last year. Mauldin is widely followed in part to his thoughtful pieces and intriguing contributing writers, but as some behavioral finance students have recognized, being bearish or cautious on the markets always sounds smarter than being bullish. I’m not so sure how smart Mauldin will sound if he’s wrong on the direction of the next 80% move?”
John Mauldin: The Man Who Cries Wolf | Investing Caffeine

But rather than just attack him for his permabear attitudes, let me sum up the article, in which he uses very many words to explain:

  1. Markets are complicated.

  2. They are really, really complicated.

  3. We don’t understand them fully, and

  4. Probably never will.

  5. But it’s enough to know that they can be, and often are, unstable.

  6. They overshoot and undershoot.

  7. So be careful.

  8. And also, sand piles can collapse if the right triggers happen.

Think that about covers it. Oh: and we are in a period now where we can’t predict the future, like always, and bad things can happen at any moment, like an avalanche in a sand pile. So don’t play in the sandbox unless you’re prepared to find a little sand in your trousers.

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