On reaching for yield and ECB QE

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I believe investors are reaching for yield and there are multiple signals indicating such. This is a direct outgrowth of easy money policies by central banks as nominal yields are at record lows and real yields are negative.

Investors, particularly pension funds, are having a hard time adjusting to the new monetary regime of financial repression and low nominal returns. Pension funds will have to reach for yield, take on risk, or run the losses from the new investing climate through the balance sheet and income statement, lowering income for the companies they are attached to.

Insurance companies can charge higher rates on policies. But pension funds have to meet the new lower nominal return environment by either moving out the risk spectrum to maintain return or by recognizing their pension actuarial assumptions are wrong. Thus far, pension funds are taking the former route. And the return on equities has helped. But when the equity market has a bad year, the lower returns in bonds will be felt in full measure.

Two articles by Tracy Alloway at the FT show us what is happening in terms of the reach for yield. First, in the subprime auto sector that I have worried about in the past, loan origination has increased. And here, we are seeing an originate to distribute type of financing. And new lenders are joining the fray as the market booms:

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Tony Reibold has been selling cars for 35 years. At the Jim Trenary Chevrolet dealership in St Charles, a Missouri town on the Mississippi River, he has seen sales of Chevy Impalas, Malibus and Silverados ebb and flow along with the wider fortunes of the US economy.

In recent years he has also witnessed the growth of a crop of new lenders, whose aim is to provide auto financing for riskier borrowers. Companies such as Skopos Financial Group and Pelican Auto Finance have mushroomed alongside more established players such as Ally Financial and Santander Consumer USA to provide loans for subprime borrowers seeking to buy cars.

Tracy goes on to show how it is investors clamouring higher yield that is driving this. After all, the lenders are not holding all the loans on their books. They are using the same model we saw with housing subprime during the housing bubble, but this time it is in auto subprime instead of housing subprime.

Sales of asset-backed securities comprised of subprime auto loans surged 18 per cent to $21.5bn last year, according to figures from Deutsche Bank. Issuance in the first six weeks of 2014 totalled $3.87bn and the bank expects sales to reach $25bn this year – not far from the $27.5bn annual peak sold before the crisis.

Then there is car rental bonds, which are another originate to distribute type of asset-backed financing vehicle, this time for rental cars. The bonds are comprised of cash flow from car leases, meaning auto financing companies don’t have to actually care about the quality of borrower they lease cars to anymore. Investors are willing to take the credit onto their books and allow the auto financing companies to concentrate on originating loans. Again, this is exactly the same kind of behavior we witnessed in housing, pre-2008.

Auto financing companies from BMW to Volkswagen are selling asset-backed securities (ABS) comprised of car leases at record-breaking pace, according to Deutsche Bank figures. Issuance has reached $8.9bn so far this year – on course to surpass the record $15bn sold during all of 2013, Deutsche analysts said.

The jump in sales marks a sharp recovery for the auto-lease ABS market, which disappeared in 2008 as worries over the fallout from the financial crisis led to a slump in demand for many types of securitisations and deterred people from buying new cars.

Bonds that bundle together mortgages not backed by the US government have yet to recover to near pre-crisis levels, but sales of other types of securitisations have revived as investors seek out higher-yielding assets.

Auto lease securitisations offer investors the chance to pick up extra returns while investing in leases made to people who are still considered relatively creditworthy.

While they are generally riskier than ABS comprised of auto loans made to prime borrowers, they are thought to be safer than investing in auto ABS made up of car loans to subprime borrowers, sales of which have also surged in recent months.

Caveat emptor.

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Look, I could give you 100 examples like this in terms of investors piling into the art market or the volume of leveraged loans or the volume of high yield bonds or the yield on peripheral sovereign bonds in Europe.

If you aren’t connecting the dots between the low interest rate environment and the reach for yield, then you are going to be blindsided by the writedowns that will result when these markets turn down. It is crystal clear that that the over-reliance on monetary policy to drive another cyclical recovery in the face of still high private debt is causing investors to take on too much risk. Easy money will result in massive credit writedowns when this credit binge ends. And we will just have to see how fragile the financial system is before we can assess how low asset prices will go in response.

US banks are in a better situation than they were during the housing bust. European banks are less well-positioned. But I don’t have a feel for how much residual risk these companies are carrying and how much lending will freeze up when assets do start to fall due to increased credit writedowns from easy-money induced risky bets gone bad.

Now in Europe, with the Fed, the Bank of England and the Bank of Japan having done QE, everyone is clamouring for the ECB to follow suit. Will they? Well, Mario Draghi certainly didn’t sound like he was prepared to go that direction in the lead up to today’s ECB rate decision. The ECB kept interest rates in the euro zone unchanged, with the main refinancing rate at a record-low 0.25%. Cutting the rate from here will not have a measurable impact on credit growth in the eurozone. So, eyes have turn to augmented easing policy options like a tax on ECB bank reserve deposits or ECB QE.

There are two issues here. First, and I think most important, is the still high interest rates for business lending in peripheral Europe. If you recall, the ECB’s prior extraordinary measures were predicated on the inability of the ECB to transmit monetary policy fully into the periphery. At the time, the ECB used the high spreads between bonds in Germany, Austria, the Netherlands and Finland and bonds in the periphery to demonstrate that the ECB’s accommodative monetary policy had not been fully transmitted to all areas of the eurozone.

In hindsight, this campaign was successful because peripheral sovereign yields are at eurozone record lows. And spreads have collapsed. So far, so good. Nonetheless, the remaining problem now is that despite the fall in sovereign yields, yields for private business in the periphery are still high and credit to small-and medium-sized business is tight.

Now, this bifurcation is not unique to the eurozone. In Britain, for example, the Telegraph recently highlighted how SMEs were being pushed into the arms of alternative funders. 35% of loan applications by SMEs are still being rejected. And that tells you lending is not just a demand-side problem but a supply-side one as well. These SMEs have turned to funding vehicles like crowdfunding, Peer-to-peer lending or invoice financing to make ends meet. That’s great for innovation but bad from a regulatory perspective and will almost certainly end in tears.

In Ireland, economist Morgan Kelly is now warning that the credit problems in Irish banks could cause small businesses across Ireland to close. He says that cleaning up Irish banks would further restrict credit to these SMEs, forcing them into liquidation.

So that’s the picture here. And that is what ECB QE is going to have to work against. If the ECB were to go QE, it would need to buy private sector credit. But because Europe’s credit markets are more bank-financed, that limits the number and types of bonds the ECB could buy. If the ECB starts buying private sector bonds, expect those bonds to rise a lot because of their relative dearth and the influx of a deep-pocketed buyer.

The second reason for QE is because of deflation. The ECB inflation numbers don’t leave any room for monetary policy to remain effective if the economy is hit by an exogenous shock like a financial crisis from contagion from a civil war in Ukraine. But this is largely a byproduct of eurozone policy. The internal devaluation tactic is inherently deflationary. We should have expected prices to decline in the periphery due to the cut in wages and government spending. So I don’t see how this is any reason for the CB to intervene. ECB intervention due to austerity-induced deflation would be another example of tight fiscal and loose monetary policy as an offset, which is part and parcel of the asset-based economic model which has led to destabilizing asset bubbles.

I don’t see the ECB doing QE unless they absolutely must. Therefore I expect credit growth to limp along until something forces the ECB’s hand. And by then it will probably be too late because peripheral spreads will re-widen and the ECB will be forced to use sovereign credit as a vehicle for QE, something that is not going to help business. At a minimum, however, the fact that the European bailout fund is now cleared to directly recapitalize banks will break the bank – sovereign nexus that has plagued Europe when spreads rose but that is now buoying bank capital as yields fall.

We are still a long way off from ECB QE in my opinion. In the meantime, let’s see if the reach for yield becomes acute in Europe as it has in the US.

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