Mauldin Economics' Patrick Watson bemoans that massive central bank intervention in financial markets allows zombie companies to stand in the way of progress and creates meaningless market pricing

Mauldin Economics' Patrick Watson bemoans that massive central bank intervention in financial markets allows zombie companies to stand in the way of progress and creates meaningless market pricing
Image: 'The Walking Dead.', AMC.

By Patrick Watson*

The novel coronavirus is destroying human lives: almost 170,000 worldwide as I write this, including 40,000+ in the United States.

These aren’t just numbers. They were people who were loved. Now they are gone. Next to that, all other effects are secondary.

But some are still serious. For one, government actions and consumer choices are pushing an already-weak economy into deep recession.

I said in a video interview last week (watch here) the world economy we knew three months ago won’t be back, ever. It is gone. After a transition period, we will find something different, whose contours are not yet known.

That makes the debates over the stock market a little strange. It doesn’t matter what markets do when we don’t even have “markets.”

A market is where buyers and sellers meet. But that’s not what happens anymore.

Fire hose Fed

Not so long ago, Wall Street was complaining about the Federal Reserve’s tighter monetary policies. Now the Fed is doing the opposite, having opened a fire hose in the last few weeks.

In fact, even that metaphor fails. It’s more like Jerome Powell blew up an entire dam.

Photo: pxfuel.

In partnership with the Treasury Department, the Fed is gearing up to spend about US$4.5 trillion on private assets, via bond purchases and other transactions.

For perspective, in 2019, US companies issued a total of US$1.41 trillion in corporate bonds last year. And all outstanding commercial and industrial loans totaled US$2.35 trillion as of year-end.

The Fed’s staggering new spending power is on top of its existing programs to buy Treasury and agency securities, which are trillions more.

Executing all these purchases falls on the New York Fed’s trading desk—a task now so huge that the desk is outsourcing some work to BlackRock.

But in any case, the Fed is ultimately in charge. And it sometimes reveals clues about its activity, with press releases saying it plans to buy this or that.

For instance, here’s one from March 26.

The Desk will conduct its first purchase of agency CMBS on Friday March 27, 2020 with a deadline to submit offers to its investment manager at 11:00 am ET.

In this operation, the Desk will purchase up to $1 billion of fixed rate Fannie Mae Delegated Underwriting and Servicing (FNMA DUS) pools, with a 10 year loan term, a yield maintenance protection term of 9.5 years (FNMA DUS 10/9.5), and a weighted average life greater than or equal to 7 years.  The Desk, through its investment manager, will solicit offers from primary dealers and will purchase up to $1 billion in total, subject to reasonable market prices.

Notice a couple of things here.

First, the desk is highly specific about what it wants to buy—I suspect because it knows some liquidity-starved institution owns those particular securities. The press release is a hint: “Hey guys, let us help you.”

Second, what does that “subject to reasonable prices” part mean? Is the Fed bargain hunting? Unlikely. Right now, the goal is to inject money, not save it.

There is no “reasonable market price” in this situation because there is no market. The Fed simply uses its unlimited balance sheet to dictate the desired price for these bonds no one else wants to buy.

market price would be what actual investors are willing to accept, given real-world conditions. That’s not how it works when the Fed is involved.

This little story is being repeated thousands of times, in a wide range of debt securities. The Fed hasn’t yet brought stocks into the program, but I think it eventually will. And even now, the liquidity injections have an indirect impact on stock prices. That’s why the Dow rises every time the Fed announces a new program.

Photo: Pixabay.

No consequences

If you are an investor, this activity should alarm you. It means your account statement, and therefore your net worth, is an illusion. The assets you own probably have some value, but you can’t be sure what it is—or would be if the Fed wasn’t sticking its nose into everything.

If you’re not an investor, it should still alarm you. Maybe you’re a firefighter who plans to retire someday with your department’s pension. The pension plan probably owns bonds on your behalf. What are they really worth? No one knows.

Officially, the Fed is doing all this because it needs to keep capital markets and banks functional. But in fact, the Fed is saving over leveraged private companies from the consequences of poor decisions.

The better move would be for these companies to go bankrupt. We have courts that can sort out the liabilities and reach a fair, transparent compromise. There are ways to do this without laying off workers, too. It happens all the time.

But it’s not happening now, perhaps because bankruptcy would reduce these companies’ share prices to their actual market value, which in many cases is zero.

That would hurt investors, but the long-run harm is even greater. Financial markets don’t work when people feel no consequences for bad decisions.

Of course, no one knew the coronavirus was coming. But the business cycle isn’t new. Wise managers prepare for bad times because bad times always come.

So now, we are going to have even more zombie companies standing in the way of progress, and Potemkin markets whose prices are meaningless.

That scheme will reward some people. But probably not you.


*Patrick Watson is senior economic analyst at Mauldin Economics. This article is from a regular Mauldin Economics series called Connecting the Dots It first appeared here and is used by interest.co.nz with permission.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

We welcome your comments below. If you are not already registered, please register to comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.

34 Comments

36
up

All of these companies including bank , airlines , corporate, should have been allowed to go broke in 08 , bailouts have led to this ludicrous situation. Capitalism died in 08 I don't know what you would call what we are seeing now it's not intelligent enough to be called socialism either . Imagine if some of these trillions were directed to the people that need them or even towards environmental issues

25
up

Its a new form of communism in my opinion. It appears to be private ownership but in reality central banks and government are pulling the strings via fiscal and monetary policy. This latest episode its going to become obvious - in the past it was lurking in the shadows, but now its going to be open for everyone to see.

Capitalism, if we want a capitalist system, needs to be let to run its course. But it would appear that to let it run its own course would result in self destruction - like a man addicted to drugs, we have created a system addicted to debt and it can't function without ever more increasing amounts of it - but too much and it destroys itself.Its unsustainable.

If we want regulated capitalism, we need to get the sticks and carrots right. But we haven't - we've rewarded excessive risk and greed, not prudence. And timeless principals say that prudence wins in the long run over excessive risk and greed - but central bank/government intervention has given carrots and sticks to the wrong people/groups - hence the mess we find ourselves in.

"And timeless principals say that prudence wins in the long run over excessive risk and greed"
In the last six months and more there has been innumerable articles stating categorically the opposite view in terms of kiwi saver all from high respected person in the field.
It is a waist of time arguing with them with the point of view that if the risk is calculated correctly, over the long term returns should be exactly the same. But of course as the nature of our system is to try and bet on the up.

Not sure I completely agree. You referring to Martin Hawes specifically or just generally?

I think if you're looking 20-30 years then I think they're right.

But as Martin was pointing out the other day, if you intended to use your kiwisaver to buy your first house in the near term, but you were in a growth fund...well that probably isn't the best place to be.

And if you look at Robert Shillers CAPE modelling, the P/E of the share market was at 1929 and 2000 levels, so returns (historically) were on a probability basis going to be poor this next 5-10 years.

How do you mean that over the long term returns should be exactly the same?

Whats most laughable is the way fund managers market individual funds as 'growth', 'defensive', etc, as if only by their special genius you can tailor a specific rate of future risk/reward. The fact is 'active' fund managers underperform the indeces they aim to beat or equal due to the cumulative long term effect of their fees, and their combined inability to consistently pick winners. Most people would be better off buying a global combination of low cost ETFs regularly. Or not trust other people with their savings at all.

You're on the money.

These middlemen guarantee nothing other than fees for themselves (regardless of performance), which are excessive. What other business gets away with this? Time the government allowed the customer more in control of their kiwisaver account, especially in a low return environment.

I inquired at Craig Investment Partners, who are the only provider giving their customers the ability to chose investments. This flexibility comes at a higher cost management cost of 1% (yet you are doing the management - go figure) on top of loaded broker transfer fees, and the choices to invest are limited. Where annual returns are small (as in now), its a tails they win heads you lose.

The Australia Government offers the flexibility to self manage their government super, and its a high time our government step up to the plate here too. Overseas Owned Banks, which dominate fund managers, make enough profit ($5 billion) without this additional fee rort they have going.

It’s nothing less than a kleptocracy.

Whatever you call this, crony capitalism or some other term, it seems likely/certain to end badly at some point. But, how, when and with what result?
Will the US dollar implode and what could replace it? The yuan couldn't, so what could? A multi-government cryptocurrency? I wish I was smart enough to know.
I do however feel pretty certain that the banking system must be changed. Globally, we must totally separate deposit takers from all other activities. The first would do nothing else, have 100% asset backing and be tightly regulated. The executives would be reasonably well paid, but without bonuses, options, or anything else. All other activities would be done by lightly regulated banks with NO possibility of tax payers' money in the event of failure. The executives could earn unlimited amounts.

Have you had a read of this yet from Dalio?

https://www.linkedin.com/pulse/big-picture-ray-dalio/

Written 3 years ago, and suggesting that things would take a turn for the worse 'in a couple of years time'
And here we are - in the thick of 'a couple of years time'

Yip - that was the first warning so I stayed invested but when the 2/10 inverted then it was time to start taking profit.

Just working my way through this now:

https://www.linkedin.com/pulse/money-credit-debt-ray-dalio/?published=t

Not sure whether he is trying to say he expects some form of military type conflict between US and China if things don't work out well? i.e. China is/will be the new world power.

In open conflict with full NATO backing my money would be on the West to take out that conflict. Watching the USA shift focus in a wartime situation on the technology front from products and services, to malware and hacking would be fearsome. Not to mention Israel's technological capacity to deal damage. Sure, China produces all global tech hardware, but all the IP comes from the USA. China would be mad to pick that fight.

There are plenty of countries that would love to become the worlds factory. Much easier just to move production elsewhere and cold war destroy China that a hot war with China. Personally, I would put my money on cold/trade war escalation and a mixture of localisation and withdrawal from China to other locations.

"The short-term cycles of ups and downs typically last about eight years, give or take a few. The timing is determined by the amount of time it takes the stimulant to raise demand to the point that it reaches the limits of the real economy’s capacity to produce. Most people have seen enough of these short-term debt cycles to know what they are like—so much so that they mistakenly think that they will go on working this way forever. They’re most popularly called “the business cycle,” though I call them “the short-term debt cycle” to distinguish them from “the long-term debt cycle.” Over long periods of time these short-term debt cycles add up to long-term debt cycles that typically last about 50 to 75 years.[2]Because they come along about once in a lifetime most people aren’t aware of them; as a result they typically take people by surprise, which hurts a lot of people"

Not sure why but the 'property doubles every 10 years' brigade come to mind.

Yeah, very much looks like we have been in the "pushing on a string" end of the long-term debt cycle (as seen and described in the early 1930s). And also, we have achieved the same extreme inequality of wealth that was last seen then. We have also seen the rapid rise in political instability as last seen then. All of which, Ray Dalio describes and which I wholeheartedly agree with (which is incredibly depressing).

What I don't agree with entirely is his minimisation of the psychological factor in Depressions. He assigns almost all of the causes for everything, from Depressions, wars and empires rising and falling to monetary policy and/or government fiscal decisions but I personally think that the psychology of fear/greed plays a much, much bigger role than he suggests.

It doesn't need to be either or, especially when you have to admit that governments are also motivated by psychological factors themselves! If you look at it from an Evolutionary Psychological perspective then money represents survival (food) and fear/greed also represents survival (evading/defeating predators or dominating territory to monopolise resources). In addition, we evolved as a highly social species because we would have been incapable of surviving in isolation or small family groups, we optimised our survival by living in small bands (100-150 people), where we could develop specialisms, making more efficiencies in labour and skills and we are hard wired to be driven by group sentiment.

All that has changed is that the systems are just bigger and more complex now. Our tendency to act on fear/greed are as prevalent as they ever were.

I see Patrick read my comment earlier this week and turned it into an article.

10
up

The same thing could be said about the housing "market".

Totally manipulated by crooked central bankers.

10
up

Is NZ government not putting 50 million in a bail out of media. Is this not a criminal activity. 10K donation to party that's not declared makes us jump out of our undies.

26
up

My taxpayer dollars being used to bail out OneRoof and Anne Gibson.

FML

Excellent article. True reflection of the economy.

Iceland policy in GFC in 2008.

Unlike the U.S., which treated major financial institutions as being “too big to fail,” Iceland treated its banks as being “too big to save.” All three banks collapsed. Iceland's currency, the krona, lost 50% of its value between 2007 and 2010. ... Now, a decade later, Iceland has risen from the wreckage of the crisis.Sep 12, 2018

The tide isn't just going out, the whole ocean is being vaporised by the WuFlu atomic warhead. How far is this going to go? Complete collapse of fiat currency?

The past 7 years, RE/properties market has risen investment/savings to about 70% - is that correct?
If this is true, then the F.I.RE economic path chosen by Neoliberal entities in NZ - is the correct investment for the country as it can act for buffer to be usage in unprecedented country economic hardship, OZ Banks are in the perfect position to shed their social acumen by deflating the balloon air out, for the whole nation to breathe

In the GFC the National Party made a political decision to save the investors in just one finance company: South Canterbury whose investors were in effect bailed out by the taxpayer to the tune of about 1 1/2 billion. National let the investors of all the other finance companies go to the wall. So, in effect, National set the trend for Government bail outs of any description.

Are you sure it was only SCF? I think you will find they guaranteed around $5b of finance company deposits in all. All to pretty dubious finance companies. And by the way it was Michael Cullen who signed up the finance company guarantee scheme. National inherited the liability Labour signed the taxpayer up to.

Great article.

Have we really had open markets ever? I think not, well not since the great depression and maybe even before then we didn't. I tender that we are now in the early dawn of western socialism as the efficacy of 'elected' democratic governments has clearly diminished and will only continue to fade away. It may not necessarily be a bad thing in the long run....

Governments can't print Bitcoin. Buy Bitcoin.

The governments cannot print camel dung either .. therefore ..

The camel market is popular this year.

This is largely happened overseas, but one couldn't help to draw the similarities with NZ/OZ lack of regulations:
https://watchdocumentaries.com/inside-job/
https://www.scoop.co.nz/stories/HL1507/S00101/the-fire-economy-new-zeala...
https://tinyzonetv.to/watch-movie/watch-the-china-hustle-2018-free-59408...
Notice in less than a year of advocating regulatory measures? all gone; LVR, FHB dep, CAR, TD guarantee etc.

In NZ, any neoliberal politicians heavily indebtedness into F.I.R-E economy - will always opt for QE, future tax payers bail out - NZ young generation? those already educated to the very highest level? you knew what to do.