|
Liquidity Crisis? A
Currency Perspective Axel Merk,
Portfolio Manager, Merk Funds September 21, 2011 www.merkfunds.com/merk-perspective/insights/2011-09-21.html In
2008, the global financial system faced a potential meltdown when funding
seized up for investment banks, ultimately leading to the failure of Lehmann
Brothers. Three years on, we have got plenty of problems, but – as we shall
argue - investors may want to differentiate between a financial meltdown and
insolvency. While complaining about policy makers and bankers may generate
animated water cooler discussions, let’s take their human (and fallible)
nature as a given, and discuss implications for investors. In this context,
we assess the U.S. dollar, currencies and equities.
In
recent months, various observers pointed to strains in the inter-bank funding
markets. Headlines warning of financial calamity resurfaced. We have a
laundry list of complaints ourselves. Remember, though, that Al Capone was
convicted for tax evasion, not for his activity as a mobster. Credit Default
Swaps (CDS) on Greece may be triggered not by Greece’s inability to pay, but
because of Finland’s insistence that collateral be posted in return for the
next tranche of European Financial Stability Facility (EFSF) payment. Along
similar lines, select banks may have funding strains, but don’t count on a
lack of liquidity breaking their backs. Anyone
who has read a basic accounting book recalls the equation Assets =
Liabilities + Owner’s Equity. While specifics might get a bit complex (they
shouldn’t, but when regulators and lobbyists collaborate, the result is not
necessarily the most obvious), banks face the same accounting realities. A
customer’s loan shows up as an asset on a bank’s balance sheet. Equity may be
paid-in capital by shareholders. And liabilities are the loans the bank
itself takes out in order to pay for (fund) its loan portfolio (assets).
Unlike non-financial corporations, banks are highly leveraged institutions
(low equity compared to liabilities); moreover, banks have an inherent
maturity mismatch. A maturity mismatch means that banks tend to borrow
short-term money, while financing long-term projects. Some of the key risks
banks face are interest risk (the risk of rising short-term interest rates
may create problems for institutions with a maturity mismatch) and credit
risk (the risk of creditors not paying back their loans). By promising to
keep interest rates low until at least the middle of 2013, the Federal
Reserve (Fed) has substantially reduced interest risk for banks. The risk of
creditors (think Greece’s sovereign debt; think sub-prime mortgage-backed securities,
to name two of the more obvious risks), however, persists. In
order to finance their loan portfolios (a bank asset), banks have substantial
funding risk. Funded can be sourced through customer deposits (a fairly
stable source of funding; a customer deposit shows up as a liability on a
bank’s balance sheet), by issuing various forms of debt (e.g. including
longer term bonds or shorter term commercial paper) or by obtaining a loan
from another financial institutions, the inter-bank lending market. The
obvious challenge in the interbank lending market is that if a bank does not
trust another institution’s financial health, they are unlikely to give that
institution a loan, even if it is just overnight. The financial institution
seeking to secure financing may have its funding costs soar as a result. The
important thing to remember, though, is that banks have access to funding
from their respective central banks. The days are over when investment banks
had neither customer deposits, nor access to a central bank window. Goldman
Sachs, as well as the other remaining large investment banks, have converted to commercial banking charters. As such,
they can tap into the same unlimited piggy bank as other banks. Importantly,
the European Central Bank (ECB) has been providing unlimited liquidity to the
European banking system. That’s unlimited, as in no limits. The banks are
depositing part of their loan portfolio as collateral; in return, they
receive cash. That cash may literally be printed out of thin air; central
banks don’t need to find that money somewhere, they just need to enter a
credit into the account that bank holds at the central bank. It
turns out the ECB model is rather flexible: when the crisis flares up, banks
require more liquidity; when the crisis ebbs down, those facilities are wound
down. The ECB has been adamant that their measures are temporary by design
and independent of its broader monetary policy. While one can argue about the
severity of the crisis or the quality of the collateral, it is correct that
the ECB approach is more robust than that of the Federal Reserve (Fed). By
buying trillions in mortgage-backed securities (MBS) and government bonds,
the Fed has a bloated balance sheet that is cumbersome to manage. In
contrast, the ECB has only printed a fraction of the money and could phase out
its facilities within months (one year for the longest facility). The ECB is
also providing unlimited U.S. dollar liquidity to European banks through swap
arrangements with the Fed in cooperation with the Swiss National Bank (SNB)
and Bank of England (BoE). Importantly, these facilities are designed to
carry financial institutions through the New Year. Towards the end of the
year, a lot of window dressing takes place, where financial institutions like
to show “good” securities on their books. As a result, every year, there is
concern that those issuing less desirable securities might get squeezed from
the funding markets. While not without political risks in the U.S., it shows
the determination of central banks to keep plenty of liquidity in the
markets, and is a key reason why we believe a liquidity driven financial
meltdown is off the table. In
the 1990s, the Bank of Japan showed that even a technically insolvent banking
system could be kept afloat. Similarly, there may be solvency issues at some
institutions, but central banks can keep them afloat. When
funding costs are too high, financial institutions have to de-leverage or
raise more capital. The former can be expensive; indeed, banks have great
leeway with regards to keeping securities at cost on their books, rather than
adjusting them to market value. Part of the rational
behind such regulation is that the maturity mismatch inherent to the banking
industry means banks should be able to take a longer-term view. The markets
have shown they have little sympathy for such twisted logic. The trouble is
that, if indeed banks de-leveraged, they would have to recognize their
losses, possibly wiping out substantial portions of their capital. The
latest round of European stress tests did something fabulous: the stress
tests provided unprecedented transparency, listing the sovereign debt
holdings of financial institutions. The market doesn’t need the regulator to
tell them what’s good or bad; the market needs transparency. The market is
now able to target what are deemed weaker institutions and “encourage” them
to raise more capital or de-leverage. That ‘encouragement’ by the market is
what has been driving both policy makers and bank executives. In many ways,
it’s a wonderful dialogue. Policy makers and CEOs may be able to influence
the timing of when governments and banks clean up their books / get their act
together, but the action is firmly driven by the bond markets. However, there
is one region where this “reform process” is sorely lacking with regards to sustainable
fiscal policy: the U.S. It’s not a coincidence: the bond markets in the U.S.
have not forced policy makers into action. Obviously it would be preferred to
have policy makers and bank CEOs be ahead of the curve. When
it comes to financial institutions, the inherent design of bank regulation
carries much of the blame. It’s not just the fact that banks are not required
to mark down assets to market value; it’s also that national regulators
typically consider their own government debt risk free. In the U.S.,
Treasures are risk free by regulation. Similarly, European banks ought to
carry much of their capital in sovereigns, as those securities are acceptable
to comply with capitalization rules; in contrast, corporate securities must
be heavily discounted. In a world where some corporations may be less risky
than their governments, those rules are outdated. Indeed, at times, there is
a risk that inter-bank lending of corporate (financial institution) paper
dries up, because regulation discourages taking on the counter-party risk of
a bank and incentivizes more risky government securities instead. In Europe,
where each Eurozone government regulates its own
banking system, it’s urgently necessarily to centralize bank regulation, so
that each member country’s bank is not ex-ante over-exposed to their own
government paper. Naturally, the respective governments are opposed to such
moves, as it may increase the cost of government funding if banks actually
had to evaluate (and take seriously) the creditworthiness of their own
governments. What
does it mean to investors?
Manager
of the Merk Hard, Asian and Absolute Currency
Funds, www.merkfunds.com Axel
Merk, President & CIO of Merk
Investments, LLC, is an expert on hard money, macro trends and international
investing. He is considered an authority on currencies. Since the Funds primarily
invest in foreign currencies, changes in currency exchange rates affect the
value of what the Funds own and the price of the Funds' shares. Investing in
foreign instruments bears a greater risk than investing in domestic
instruments for reasons such as volatility of currency exchange rates and, in
some cases, limited geographic focus, political and economic instability,
emerging market risk, and relatively illiquid markets. The Funds are subject
to interest rate risk, which is the risk that debt securities in the Funds'
portfolio will decline in value because of increases in market interest
rates. The Funds may also invest in derivative securities, such as for- ward
contracts, which can be volatile and involve various types and degrees of
risk. If the U.S. dollar fluctuates in value against currencies the Funds are
exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in
exchange traded funds ("ETFs"). Like stocks, ETFs are subject to
fluctuations in market value, may trade at prices above or below net asset
value and are subject to direct, as well as indirect fees and expenses. As a
non-diversified fund, the Merk Hard Currency Fund
will be subject to more investment risk and potential for volatility than a
diversified fund because its portfolio may, at times, focus on a limited
number of issuers. For a more complete discussion of these and other Fund
risks please refer to the Funds' prospectuses. |
