30nov09 Wilmot Shadows 2parte Cs

30 November 2009 Fixed Income Research http://www.credit-suisse.com/researchandanalytics

Market Focus Global Strategy

Contributors Jonathan Wilmot +44 20 7888 3807 [email protected] James Sweeney +1 212 538 4648 [email protected] Matthias Klein +1 212 325 1790 [email protected] Aimi Plant +44 20 7888 7054 [email protected] Wenzhe Zhao +44 20 7883 8189 [email protected]

Long Shadows: The Sequel “There can be no doubt that besides the regular types of the circulating medium ….there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper…”. Friedrich Hayek, Prices and Production 1931 - 1935. We update our estimates and analysis of the “shadow money stock” in the US. Direct bank lending only accounts for about half of total private credit, which means that incorporating shadow money and credit into traditional analysis is absolutely essential in assessing inflation and deflation risks. We draw four main conclusions: First, there is absolutely NO evidence that the unprecedented increase in public deficits and the Fed’s balance sheet has yet created an inflationary overhang of excess liquidity. The effective money stock (M2 plus shadow money) has grown only 2.5% p.a. since February 2007. Second, restoring funding liquidity to the financial system was the right thing to do, and has almost certainly prevented a deflationary disaster. Third, just as the devastating wholesale funding run on the shadow banking system prefigured a collapse in commercial bank willingness to lend, it is now leading the way in restoring credit availability to markets and the economy. Effective money growth has accelerated in the last six months. Fourth, huge volatility in the oil price over the past 18 months has led to much larger swings in the effective money stock measured in real terms. Equity prices and production have mirrored those swings quite closely. Going forward, we expect somewhat slower real growth in effective money.

Special Note: on Tuesday 1st December, Jonathan Wilmot will be a guest editor on FT Alphaville, the opinion and news blog of the Financial Times. Our posts will appear simultaneously on the global strategy blog page.

ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com.

30 November 2009

The Dark Side of the Moon In May, we showed that a rising public debt and a bigger Fed balance sheet were substituting for a collapse in private debt, lending, and leverage. We presented a framework for quantifying this and estimated that the huge expansion of the monetary base and of public debt (public shadow money) had merely offset a sharp contraction of private shadow money. This broad conclusion remains true today: our measure of the US effective money stock, which includes bank deposits (M2) plus public and private shadow money, is up 6.8% since Q1 2007, just before the financial crisis began. For comparison, nominal GDP has risen 3.4% over the same period (Exhibits 1 & 2 below). All of this modest excess growth of money reflects the 3.7% growth in effective money since April. Restoring funding liquidity has allowed private shadow money to rebound by about $1 trillion over the past six months. (Recall that it plunged some $3.6 trillion during the crisis.) Public shadow money is up just $150bn since April, after soaring $3 trillion in the crisis. Further credit healing should allow public shadow money growth to slow further, or even contract as the private balance sheet begins to function again. If we are correct, extreme opinions about both inflation and deflation are simply not supported by the facts, and stem from not understanding how the modern financial system really works, and so looking at incomplete measures of money and credit. The error involves too much focus on commercial bank assets and deposits, which no longer dominate either credit flows or liquid, money like assets. Like the dark side of the moon, shadow money is hard to see. But just because we can’t always see it does not mean we should ignore it. No scientist would make such an elementary error as ignoring the gravitational pull of invisible things, and nor should participants in financial markets. Unfortunately, a great deal of bad analysis and potentially bad investment decisions are currently flowing from making exactly this kind of mistake. Understanding what is happening to shadow money and credit is therefore of profound importance to us all.

Exhibit 1: Total Effective Money Stock and Nominal GDP 35000

Effective Money Nominal GDP Ratio of Effective Money to Nominal GDP

$ Bn

2.15 2.1

30000

2.05 2

25000

1.95 1.9

20000

1.85 1.8

15000

1.75 10000

1.7 Feb-07

Jul-08

Nov-08

Apr-09

Oct-09

Source: Credit Suisse

Market Focus

2

30 November 2009

Fixing a Deflationary Hole Last spring, we described the collapse of private shadow money, which includes nonagency RMBS, CMBS, investment grade corporate bonds, high yield bonds, and other ABS. We calculated shadow money for each type of debt by multiplying an estimate of the current market value by one minus the prevailing repo market haircut. For example, we calculated that the outstanding investment grade bond stock had a market value of $5811bn and a median repo haircut of 25%, so it represented shadow money of $4359bn ($5811 * (1 – 25%)).

Exhibit 2:US Effective Money (Public versus Private) Billion $ Private Effective Money = Inside Money + Private Fundable Debt

17000

Public Effective Money = Outside Money + Government-backed Debt 16000

15000

14000

13000

12000

11000

10000 Feb-07

Jul-08

Nov-08

Apr-09

Oct-09

Source: Credit Suisse

Exhibit 3: Cumulative Change in Money Stocks Trillion $ 5

Public Effective Money

4

Inside Money (Bank Deposits minus Reserves)

3

Private Shadow Money

2 1 0 -1 -2 -3 -4 -5 Feb-07

Jul-08

Nov-08

Apr-09

Oct-09

Source: Credit Suisse

Private shadow money fell from $9.5tr to $5.9tr between early 2007 and last April. How big was this $3.6tr fall? Colossal: roughly 40% of the broad M2 money stock, which is around $8.4tr, and nearly 15% of the effective money stock. And initially at least bigger than the public sector response, leading to a slight fall in effective money.

Market Focus

3

30 November 2009

Falling debt prices, negative net issuance, and sharply rising repo haircuts caused the reduction. Before the crisis, these securities were so easy to borrow against that their owners almost didn't need cash. It is in this sense that we say these bonds were "money," and this is why the collapse of the moneyness of collateral generally posed such gigantic risks to the financial system. As Hayek (and others) knew many years ago, it is not a great logical leap to call private debt instruments money. Most of the M2 money stock is "inside money," bank debt to depositors, not claims on the government. Milton Freidman himself focused on the M2 money stock in his most famous work, acknowledging the obvious fact that private sector debt could be money (see Exhibit 4). Our framework takes account of that in a world with shadow banks, and where collateral itself can mimic money. The bank share of household credit has fallen from 79% in 1973 to 30.4% today. (See Exhibit 5.) The M2 money stock therefore once backed around three quarters of household debt, where now the fraction is nearer a third. Shadow banks have filled the breach. Just as we view credit assets as a whole without ignoring non-bank assets, we should be looking at liabilities – money – in a unified way too.

Exhibit 4: US Money Supply $Bn 9000

M2

8000

Monetary Base

7000

Inside Money = M2 - Monetary Base

6000 5000 4000 3000 2000

Outside Money = Monetary Base

1000 0 Jan-80

Jan-84

Jan-88

Jan-92

Jan-96

Jan-00

Jan-04

Jan-08

Source: Credit Suisse, Datastream

Exhibit 5: US Bank Share of Credit Outstanding 100% 80% 60% 40% 20% 0% Mar-52

Bank Share of Household Mortgage Credit Bank Share of Consumer Credit Bank Share of Total Household Credit Market Borrowing Mar-62

Mar-72

Mar-82

Mar-92

Mar-02

Source: Credit Suisse, Haver Analytics

Market Focus

4

30 November 2009

Our analysis suggests that aggregate credit has begun to recover from the crisis. This is clear either from the asset (total debt) side or the liability (funding or money) side. The return of credit began with the improvement in money markets and was clearly helped by explicit and implicit involvement of governments in unsecured lending markets. Exhibit 6 below shows the TED and LIBOR/OIS spreads have returned to normal levels quickly. The $1tr rebound in private shadow money since April has been driven by a reversal of all three factors that caused the collapse. First, prices of debt securities have risen sharply (see Exhibit 7), especially for lower corporate debt, and spreads have collapsed. Second, issuance of private sector debt has picked up for corporate bonds and some asset-backed securities. (See Exhibits 10-12.) Third, and importantly, repo market haircuts have started to come down. Although demand for financing risky debt purchases is not yet high – perhaps unsurprising with spreads still generally elevated – the availability of leverage and cash against collateral has sharply and rapidly recovered. This mimics the behaviour of call money rates backed by equity collateral after 19th century banking panics.

Exhibit 6: Funding Liquidity Indicator (Ted Spread + Libor-OIS, Log Std Dev)

8 7 6 5 4 3 2 1 0 -1 -2 -3 86

88

90

92

94

96

98

00

02

04

06

08

Source: Credit Suisse

Exhibit 7: Leverage Loan and High Yield Price Indices 100 95 90 85 80 75

CDX HY Index Price

70

LCDX Price

65 60 10/17/07

3/12/08

7/22/08

11/25/08

4/7/09

8/13/09

Source: Credit Suisse

Meanwhile, public shadow money (treasuries, agencies, and agency MBS) growth has slowed. It has risen by just $150bn since April, compared with a $3tr increase between early 2007 and this April, reflecting the huge fiscal stimulus and the growth of the RMBS market as a proportion of total new mortgage issuance. Of course, that earlier growth in public shadow money represented a concerted effort by the public sector to fill the gaping hole opened by the collapse of private debt markets.

Market Focus

5

30 November 2009

The recent small increase in public shadow money is due to offsetting underlying factors. The treasury bond stock has increased and there have been small declines in public debt haircuts. However, the agency bond stock has declined and outstanding agency mortgages also have declined, reflecting weak demand for new mortgages. We subtract the Fed's purchases of MBS, treasuries and agencies from public shadow money because quantitative easing is a substitution of outside (base) money for shadow money, not a net creation of new liquid assets. It is good news that shadow money is recovering and the recovery is being done by the private sector, not governments. Of course, low cash rates and government intervention in some markets have been essential to stabilise the system, but if economic growth returns, these public sector crutches are unlikely to be necessary for long. Private credit markets will increasingly be able to stand on their own.

Credit Healing Led By Shadow Banks Chairman Bernanke acknowledged recently that credit was beginning to flow again in parts of the economy. "Interbank and other short-term funding markets are functioning more normally; interest rate spreads on mortgages, corporate bonds, and other credit products have narrowed significantly; stock prices have rebounded; and some securitization markets have resumed operation. In particular, borrowers with access to public equity and bond markets, including most large firms, now generally are able to obtain credit without great difficulty. Other borrowers, such as state and local governments, have experienced improvement in their credit access as well." Of course, it would be quite wrong to suggest that this improvement in securitised lending to better quality borrowers reflects a full credit recovery. It is, however, likely to “foreshadow” a more general improvement in credit conditions. For now aggregate credit demand remains weak, even as supply starts to improve. Even within the shadow banking nexus, total repo market activity has not recovered significantly in volume terms. Who needs significant leverage when yields on risky assets are still somewhat elevated? Competition to finance hedge funds has however clearly been reflected in better repo terms recently, meaning that potential leverage could increase as and if economic conditions improve further. More obviously, credit is not flowing (for both demand-side and supply-side reasons) to commercial real estate, non-agency mortgage lending, and small business lending. Of course, most commercial mortgages and small business loans, and some non-agency (jumbo) mortgages are not securitized, and so this partly reflects the commercial banks’ current extreme caution with their balance sheets. The primary reason for this, in our view, continues to be banks' concern about the value of real estate collateral (see Exhibit 11), which have now overshot their long-term trends on the downside by just as much or more than they overshot on the upside before.

Market Focus

6

30 November 2009

Exhibit 8: Average Existing House Prices 7.6

Real Average Existing House Price (log scale)

7.4

Real Case-Shiller Composite Index (log scale)

7.2

Real OFHEO/FHFA House Price Index (log scale)

7.0 6.8 6.6 6.4

Trend = 1.5% per annum

6.2 Jan-68 Jan-72 Jan-76 Jan-80 Jan-84 Jan-88 Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Source: Credit Suisse

Exhibit 9: US Bank Assets: Loans and Leases 7400 7200 7000 6800 6600 6400 6200 6000 1/5/07

7/5/07

1/5/08

7/5/08

1/5/09

7/5/09

Source: Credit Suisse

Indeed, if you look at average existing house prices in real terms, they recently bottomed out some 5 standard deviations below their 40-year trend. Nothing remotely like the recent crash has occurred before, reflecting the much greater proportion of foreclosures and forced sales when securitised loans go bad. It will take time to chew through the backlog of potential foreclosures, and many analysts, including commercial bank economists, think this supply overhang will lead to renewed price falls. Against that there is increasing awareness that renting the house back to troubled borrowers is often a better solution for both lender and borrower than foreclosure, and affordability has never been higher. For our purposes, however, the key point is that traditional commercial bank lending – even to small businesses - will only recover properly if and when house prices rebound more decisively. That in turn will take a combination of time to work through the bad mortgage pool with improving income growth and job prospects as other parts of the credit system start functioning again.

Market Focus

7

30 November 2009

Exhibit 10: Auto Loan and Credit Card ABS Issuance 35,000

Auto Loan ABS

30,000

Credit Card ABS 25,000 20,000 15,000 10,000 5,000 Q1 2007

Q3 2007

Q1 2008

Q3 2008

Q1 2009

Q3 2009

Source: Credit Suisse, SIFMA

Exhibit 11: US Investment Grade Issuance US IG

350

$bn

I

300 Oct/Nov pace 250 200 150 100 50 0 Q1-2001 Q1-2002 Q1-2003 Q1-2004 Q1-2005 Q1-2006 Q1-2007 Q1-2008 Q1-2009 Q1-2010

Source: Credit Suisse

Exhibit 12: US High Yield Bond Issuance High Yield Issuance ($mn, 4WMA)

9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 8/26/05

2/26/06

8/26/06

2/26/07

8/26/07

2/26/08

8/26/08

2/26/09

8/26/09

Source: Credit Suisse

Market Focus

8

30 November 2009

The charts above illustrate that this is happening, and rather faster than most people expected. There are other hopeful signs too. Private equity activity is showing signs of picking up. A wave of mergers is expected. IPO activity has increased sharply in the past few months and strong private debt issuance has meant larger companies have made significant progress in terming out their debts, and indeed are paying down less ”reliable” bank loans. In many cases, large companies also seem to be financing their smaller suppliers directly, and non-bank pools of capital are seeking opportunities where banks remain reluctant to lend. The emergence of a bigger ABS market for repackaged small business loans would certainly help the process. SBA loans with government insurance are already a major market, but we would like to see securitization used more thoroughly in this sector. If banks remain structurally unable or unwilling to do this lending, then shadow banks should step in, perhaps with some government assistance. Meanwhile, we consistently hear from institutional investors struggling with low nominal yields that they would like to buy newly issued ABS securities, if only the volume were there. To begin with, the securitised markets had needed Fed or government help to recover, but that no longer seems to be the case. If risk averse banks are unable to absorb new credit supply, it should surprise no one if new shadow bank debt (asset backed securities) is issued to fund an increase of lending to these sectors. That means more mortgage, credit card, and instalment loan-backed ABS. Improved financing for all these types of debt bolsters demand and creates moneyness in the new securities. A further increase in the effective money stock, especially if it occurs via an expansion of private shadow money, would be very beneficial for growth and would help lead the economy to more normal levels of growth. There are thus parallel money and credit universes currently. One includes mostly securities and has rebounded sharply. The other includes mostly loans and has not. Depending on one's perspective, credit markets might now look depressed, recovering, or schizophrenic. But the bottom line is actually very straightforward: it is the shadow banking system that is leading the recovery in credit supply to markets and the economy. And the further this goes, the more likely that house prices will recover and the more conventional forms of bank lending will recover also.

Bubble Talk and Regulatory Risks This means, in effect, that the very system that collapsed before with such devastating consequences is now the main hope for recovery! That is both deeply confusing and a source of concern to many people. The common political mantra is that Main Street needs to be protected from the greed of Wall Street. While that may have had some truth to it before, it is not the issue now. The next wave of securitization will be better priced and better rated than the old, and the collateral behind those loans is for the most part cheap or very cheap, rather than expensive. Faulty assumptions are much less likely next time around. And euphoric lending conditions, of the type we saw in 2006/7, seem many years away at least. Of course, there are those who contest this: the air is thick with talk of new bubbles and the ”unjustified” recovery in the stock market. Most of this chatter is misconceived in our view: indeed talk of bubbles is itself becoming a bit of a bubble.

Market Focus

9

30 November 2009

None of the metrics we have always looked at to identify major overshoots in assets prices indicate that house prices, credit, or equities are expensive. Quite the opposite in fact, especially for house prices, as noted above. Simple as they are (they mostly rely on looking at outsized deviations from long-term trends) these indicators flashed strong warning signals for equities in 1999/2000, and for both housing and credit in 2006/7. The grain of truth in the bubble discussion has to do with the possibility of overvaluing far distant cash flows when the appropriate discount rate is very low. For example, where expected long-term earnings growth for a technology stock, or for emerging equities is way above long-term bond yields (think China where the government has just issued a 50-year bond with a nominal yield of 4.3%), simple arithmetic pushes towards extremely high valuations, which will be highly vulnerable either to a small downward revision to expected earnings growth, or a modest increase in the discount rate. So while it may be true that low interest rates and bond yields create an underlying tendency for bubble valuations to arise, there seems to us to be absolutely no clear evidence that this has already happened for the most important asset classes in the US. Nor that it is likely any time soon. A rather greater threat to the markets and the economy right now, in our opinion, is that the political climate and partial understanding of how the financial really works could lead to well intentioned but harmful regulation or new legislation. One example is a proposal recently introduced to Congress to limit the government’s exposure to the guarantees of any financial institution or bank that should fail in the future. The idea is that any lender to that institution or bank would have to take the first 20% of any loss, with the government liable for the remaining 80%. While this may seem sensible and prudent at first sight, the way the legislation seems to be drafted suggests that repo transactions would be included under this general provision. So the legislation could be interpreted as mandating a 20 percentage point increase in haircuts on virtually all private repo transactions! That could have a devastating effect on the recovery in funding liquidity, and the ability of the shadow banking system to function as a conduit for credit. Or to put it differently, it would be the equivalent of slashing the shadow money stock at the stroke of the pen, and in principle could restart the debt deflation spiral. At the limit, therefore, this kind of legislation might just be the modern day equivalent of the Smoot-Hawley Act in 1930, or the Fed’s 1931 decision to hike interest rates to defend the dollar in the midst of the depression. Fortunately we think there is enough understanding of the issues at stake in Washington to make it very unlikely that the proposal will pass, but it does illustrate the potential dangers of not understanding the shadow money story. Revisiting the Pigou Effect Finally, it is worth saying something about the effect of oil prices on the shadow money story. Arthur Pigou (1877-1959) was a friend and mentor of Keynes, but also a fierce intellectual critic of his General Theory. Though primarily a disciple of Alfred Marshall and welfare economist, he is best known among macro-economists for his “classical” argument against Keynes’s idea of the possibility of persistent under-employment. The idea was that with unemployed resources, prices would fall and the real value of money balances would rise, leading to higher spending and thus eventually to a recovery in employment and income. (Curiously enough, a version of the Pigou effect plays an important role in providing a solution to the problem of price level indeterminacy in some modern New Keynesian models!) Market Focus

10

30 November 2009

Because oil prices have been so volatile in recent years, so has headline inflation, veering between five percent and minus 2 percent within the space of eighteen months. The timing of these swings, moreover, means that the swing in the effective money stock, when measured in real terms, was considerably larger than the swing in the nominal effective money stock. In effect, the Pigou effect actually deepened the deflationary shock to effective money in the run-up to the crisis, and has led to a sharper rebound since. From February 2007 to November 2009, the real effective money stock fell by 10% - but since last November, has rebounded by somewhat more, helped by the sharp fall in inflation, to stand just above its pre-crisis level. The chart below plots the real effective money stock against the S&P 500, but could equally have been plotted against industrial production or real GDP with very similar results.

Exhibit 13: Real Effective Money vs. S&P 500 140

1500

Real Effective Money

138

1400

S&P 500 (RHS)

136

1300

134

1200

132

1100

130

1000

128

900

126 124

800

122

700 600

120 Feb-07

Jul-08

Nov-08

Apr-09

Oct-09

Source: Credit Suisse

The good news is that the real effective money stock has so far recovered more fully than either the equity market or production and GDP, suggesting some room for catch-up. The potentially less good news for asset markets is that the rebound in oil prices and headline inflation will soon be slowing down the recovery in real money balances, as indeed will a gradual move towards winding down QE. Equally, however, should the Saudis decide to increase oil production in an effort to cap prices, and even bring them down a little, that may be just as important at the margin in supporting further recovery in consumer spending and real incomes as what the Fed does. From now on, we will be closely monitoring the effective money stock in both nominal and real terms. Any serious approach to inflation and deflation demands nothing less.

We thank Carl Lantz of the US Interest Rates Strategy Team for his continued contributions.

Market Focus

11

30 November 2009

Exhibit 14: US Public Credit Market Debt Issuance- Annual $ Bn 2500 2000 1500

Treasuries

4500

Agencies

4000

Agency MBS

3500

T t l 'P bli '

3000 2500 2000

1000

1500 1000

500

500 0

0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 YTD

Source: Credit Suisse, SIFMA

Exhibit 15: US Private Credit Market Debt Issuance -Annual 1200

$Bn

$Bn

Corporate Debt Convertible Debt ABS Non-Agency MBS Total Debt, RHS

1000

3000 2500

800

2000

600

1500

400

1000

200

500

0

0 1999

2001

2003

2005

2007

2009YTD

Source: Credit Suisse, SIFMA

Exhibit 16: US private Credit Market Debt Issuance - Monthly 200

Total Monthly US Private Credit Market Debt Issuance (Includes Corp Bonds, Convertibles, MBS, ABS)

180 160 140 120 100 80 60 40 20

Oct-09

Sep-09

Jul-09

Aug-09

Jun-09

Apr-09

May-09

Mar-09

Jan-09

Feb-09

Dec-08

Oct-08

Nov-08

Sep-08

Jul-08

Aug-08

Jun-08

Apr-08

May-08

Mar-08

Jan-08

Feb-08

0

Source: Credit Suisse, SIFMA

Market Focus

12

FIXED INCOME GLOBAL STRATEGY RESEARCH Jonathan Wilmot, Managing Director Chief Global Strategist +44 20 7888 3807

Bunt Ghosh, Managing Director Global Head of Fixed Income Research +44 20 7888 3042

LONDON Paul McGinnie, Director 44 20 7883 6481 [email protected]

NEW YORK James Sweeney, Director 1 212 538 4648 [email protected]

One Cabot Square, London E14 4QJ, United Kingdom

Aimi Plant, Associate 44 20 7888 7054 [email protected]

Wenzhe Zhao, Associate 44 20 7883 8189 [email protected]

11 Madison Avenue, New York, NY 10010

Matthias Klein, Associate 1 212 325 1790 [email protected]

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Investment principal on bonds can be eroded depending on sale price or market price. In addition, there are bonds on which investment principal can be eroded due to changes in redemption amounts. Care is required when investing in such instruments. When you purchase non-listed Japanese fixed income securities (Japanese government bonds, Japanese municipal bonds, Japanese government guaranteed bonds, Japanese corporate bonds) from CS as a seller, you will be requested to pay purchase price only.