With this week’s Federal Reserve initiatives, and today’s signing into law of the coronavirus rescue package, we now have at least the first wave of US monetary and fiscal responses in place.
The biggest risk at this point is that it won’t stop. We remember all too well how the 2008 crisis era polices, especially ultralow rate policy, persisted years after the crisis was over. And that in turn left our financial system leveraged and our economy in a weakened state when the plague hit. So we not only have a health crisis but a financial crisis on top of it.
At least some of the risk in risky assets has to be realized. There have to be at least some bankruptcies, especially in the corporate sector that borrowed to buy back stock instead of provisioning for a rainy day.
If all risk capital is lost, the response has not been adequate; but if none of it is lost, it’s gone too far.
The consequence of the latter would be a permanent loss in living standards … if debt-fueled risk never loses, and capital can be thrown at any project without consequence, the capital markets lose their ability to allocate capital to its most productive uses. What brought our civilization its historic prosperity will have been trashed.
unfortunately it looks like stock-buyback management-enrichment offenders such as the airlines and boeing are going to get handouts. chapter 11 would be much more appropriate. [the airline industry has plenty of experience with this.]
the fed is backstopping the whole credit market EXCEPT FOR JUNK, and supposedly is not backstopping equities. question: when a bbb gets downrated to bb, will the fed sell into a falling credit market? color me skeptical. of course some of the credit etf’s the fed says it will buy, will be forced by mandate to do some selling for them.
Thanks for pointing this out, JK. I emphatically agree. I’ve discussed the buyback scam in previous posts, but it deserves continuing attention.
It’s no mere Monday morning quarterbacking, either. Analysts have been critical of buybacks and warning of the dangers long before anybody ever heard of the new coronavirus. Here’s just one example from SEC Commissioner Robert J Jackson, Jr.
Stock Buybacks and Corporate Cashouts
Stock buyback rules were loosened in 1982 with Rule 10b-18 granting safe harbor for buybacks under certain conditions. It was probably appropriate at the time, in the context of very low stock prices after a secular bear market. But it’s long outlived its usefulness, as stocks have long since become very high and corporate insiders have figured out how to combine them with stock option compensation to bilk their own companies out of billions of dollars.
I have no idea how the Fed bond buying will impact bonds falling from investment grade to junk, but the one clear way to avoid trouble is for the Fed not to be buying corporate bonds in the first place. If there’s any role for government in that market, it’s a fiscal role, under the jurisdiction of elected representatives. Let the Fed buy Treasuries and Congress and Treasury determine how to allocate the funds. If some investors lose money on their corporate bond positions, that’s how it should be. Investors guarding against the risk of loss is an essential check against corporate malfeasance. The Fed isn’t authorized to buy corporate bonds for good reason.
“If all risk capital is lost, the response has not been adequate; but if none of it is lost, it’s gone too far.”
risk capital? I’m not sure what you mean by that. If the stock or bond prices fall, what is lost, other than dollar denominated “value”? The underlaying assets or collateral should still be there. If they are not, what value did they have anyway? were thay not simply repriced to market?
Let now owners of the underlying physical assets take a shot at being more productive with them.
Good question, CB. By “risk capital”, I mean any investment that seeks return by taking risk. Corporate bonds for example. Corporate bonds provide higher yields than Treasuries, compensating investors for the risk they may not make all the coupon and principal payments promised.
The context here of course is bailouts. The Federal Reserve aims to buy corporate bond funds. This action is problematic because corporate bond investors reaped higher yields for taking credit risk, but are now having the risk socialized, that is covered by everybody else via the Fed. Did you take risk in corporate bonds? If not, doesn’t matter, you help pay for it anyway.
Obviously having the government forcibly shut down businesses is a risk arguably deserving to be covered by everybody, which is why corporate bond investors shouldn’t have to lose everything because of it. But if they lose nothing, the bailout has gone above and beyond that and rewards risk taking excessively.
The same could be said for other risk assets like stocks. If the Fed pushes stock prices all the way back up to where they were, it’s gone way too far. It’s a tautology … taking risk must mean accepting the possibility of taking losses.
Speaking of stocks, Boeing is a poster child for this. Boeing spent billions in recent years buying back its own stock, and now cries to the government for billions in aid. Sure, Boeing management could not have been expected to anticipate a black swan like the new coronavirus, but on the other hand, making it whole for behaving like a rainy day would never come isn’t right either. The statement sums it up:
If all risk capital is lost, the response has not been adequate; but if none of it is lost, it’s gone too far.
There is another issue. If they disallow risk-takers to rightfully lose when they should, they have in effect punished those who exercised the prudence to avoid those risks. But what’s new? They have been punishing prudence for decades.
Much agreed, CB. That’s what I meant in saying “… If not, doesn’t matter, you help pay for it anyway.”
Another issue is that part of the reason this is a problem now is because of the last rash of bailouts. Agency (Fannie, Freddie…mortgage) debt investors received higher yields due to the fact that agency debt was not guaranteed by the full faith and credit of the US government. Yet once these securities went sour, the feds retroactively applied such a guarantee, effectively turning agency debt into Treasury debt – after the fact. In light of the risk-enhanced yield margin, these securities should have received at least some haircut, but didn’t.
That’s nothing but free money for risk investors courtesy of the US taxpayer. Investors got the message.
Here’re a couple of excellent commentaries on the topic of this post. Highly recommended reading!
https://www.cmgwealth.com/ri/on-my-radar-the-end-of-the-long-term-debt-supercycle/
https://wolfstreet.com/2020/03/29/corruption-in-the-time-of-coronavirus-fed-treasury-corporate/