Bank leverage: forever blowing bubbles part two

You have heard me use the phrase “liquidity is seeking return” to describe the increase in the price of riskier assets due to monetary stimulus. The Bloomberg News video clip below points to an increase in lending for buyers of riskier loans like high yield and mortgage bonds.

The blurb below from the associated article at Bloomberg’s website makes a more complete picture. Afterward, I have a few comments.

Banks are increasing lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007.

Credit Suisse Group AG and Scotia Capital, a unit of Canada’s third-largest bank, said they’re offering credit to investors who want to purchase loans. SunTrust Banks Inc., which left the business last year, is “reaching out to clients” to provide financing, said Michael McCoy, a spokesman for the Atlanta-based bank. JPMorgan Chase & Co. and Citigroup Inc. are doing the same for loans and mortgage-backed securities, said people familiar with the situation.

“I am surprised by how quickly the market has become receptive to leverage again,” said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said.

Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6.

The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn’t available.

How could investors return to shades of irrational exuberance so quickly?


James Montier, now at Jeremy Grantham’s GMO, wrote a research paper at the beginning of June when he was at SocGen called “Forever blowing bubbles: moral hazard and melt-up.” Using research from Vernon Smith, he demonstrated that while experienced investors resist the temptation to reflate a bubble, excess liquidity can fool investors into jumping in nonetheless.

At present, monetary policy is extremely loose globally. So, the excess liquidity of which Montier speaks is at play right now. Nevertheless, consumers in much of the world are overly indebted and are loath to spend more as a result of this money. We may be in a liquidity trap.  Nevertheless, this liquidity being pumped into the system has landed on bank’s balance sheets and is looking for a home.

Hence the phrase “liquidity is seeking return,” which Stephen Roach first used a few months ago.

From an Austrian School economics perspective, this is what would commonly be known as malinvestment.  The excess liquidity being pumped into the system by the world’s central banks is inflation, pure and simple.  This inflation is now manifest in the extraordinary rise of asset prices, particularly assets of lower quality and higher risk.  However, eventually the fundamentals will re-assert themselves once the malinvestment is discovered. Let’s hope the economy is on sounder footing when this occurs.

One last thought: this policy response does seem very much like the 2001-2003 deflation-fighting campaign by the Federal Reserve which brought us the housing bubble – only on a grander scale. Are we forever blowing bubbles?

  1. hbl says

    Troubling. To put it in quantifiable historical context, do you happen to know which “Federal Reserve data” the article is based on? (I’m guessing somewhere here but can’t search now).

    TOTBKCR (one of the weekly updated series) doesn’t yet show marked reflation in TOTAL bank credit… but of course that isn’t the only type of lending and the total could mask a growing trend within the finance portion.

    1. Edward Harrison says

      Hbl, I haven’t had a chance to look at the Fed data yet but reflation is not
      working because the FDIC reports that the bank sector is still reducing

      So one could view this in the light I suggest, namely we are seeing a
      re-allocation of resources from less to more risky assets as the low
      interest rates have caused inventors to need to increase risk profiles to
      generate the return they seek.

      But just like in prior episodes, this is likely to end badly as the excess
      return means excess risk that will become evident only during the next
      downturn. It seems this crisis has meant we have collectively learned

      1. hbl says

        Good clarification… re-reading I see that asset choice was your main point. I think I was responding more to the tone of the article you linked titled “Leverage Rising on Wall Street at Fastest Pace Since ‘07 Freeze”.

  2. Anonymous says

    Sadly, it seems our Fed is a one-trick pony: the only way it knows to foster growth is to blow bubbles. One might have hoped Bernanke had learned something from the Greenspan bubble debacle, and might hint at raising rates, or at least try to talk down the markets — but this does not seem to be the case. He doesn’t see any inflation beyond the CPI. This is a colossal and dangerous intellectual failure.

    When will the markets understand that there is nothing fundamental underpinning this rally, that it is only a monetary reflation? Can we as a nation afford the collapse of yet another bubble? This doesn’t promise to end well.

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