In his investment outlook for January, Bill Gross told the world to buy corporates, munis, bank preferred stock, and other risky assets. I wrote that he was “ignominiously wrong” – that myriad risks beset such assets during the immediate weeks ahead. In his February investment outlook, posted this morning, he demands that the government boost asset prices:

PIMCO’s thesis for several years has held that the levered global economy long ago morphed from a banking-dominated regime to one that hid behind securitized lending and structures resembling a “shadow banking” system. SIVs, hedge funds, CDOs and increasingly levered mortgage and investment banks fueled asset appreciation in all investment markets, which in turn propelled real economic growth and employment to unsustainable levels. But, with U.S. housing prices as its trigger, the delevering process did a Wile E. Coyote and headed over the cliff in mid-year 2007, dragging down almost all asset prices except government bonds. The real economy followed shortly thereafter, not just in the U.S., but globally, proving that linkages work on the “down” as well as the upside. To PIMCO, the remedy for this deflationary delevering and mini-depression is simple and almost axiomatic: stop the decline in asset prices. If that can be done, the real economy will level out as well. When home prices stop going down, newly created households will be more willing to take a chance on ownership as opposed to renting. If stock prices consolidate, recently burned investors will be more willing to invest, as opposed to stuffing their 401(k) mattresses with Treasury bills. Business investment, jobs, and profits should follow quickly behind.

Wrong again. Undervalued assets are what make it possible for the banks to earn enough income to recapitalize themselves over time. The cheaper, the better, at least for the time being.  This is bad for money managers like PIMCO, but poor returns for PIMCO have no systemic consequences.

Gross makes an important point, though, parallel to what I wrote last week in Asia Times under the headline, “Fixing the Bank Crisis is the Easy Part.” Gross writes,

…the levered global economy long ago morphed from a banking-dominated regime to one that hid behind securitized lending and structures resembling a “shadow banking” system. SIVs, hedge funds, CDOs and increasingly levered mortgage and investment banks fueled asset appreciation in all investment markets, which in turn propelled real economic growth and employment to unsustainable levels. But, with U.S. housing prices as its trigger, the delevering process did a Wile E. Coyote and headed over the cliff in mid-year 2007, dragging down almost all asset prices except government bonds….Those who argue strongly for a recapitalization of the banking system, however, may be missing the distinction between the banking system as we once knew it, and the “shadow banking” system that superseded it. Jim Bianco, who heads up the research tank bearing his own name, brought the difference to mind in a recently produced piece entitled, “When Will The Banks Start Lending?” His conclusion was that banks already were – lending – but it was the “shadow system” (my words) that was holding up the parade. According to his analysis, shown in Chart 1, securitization has for several years exceeded bank loans as a percentage of private credit market debt. In contrast to recent headlines, however, banks have been picking up their lending, but it has been the “shadow banks” that have faltered.

That’s correct, and you read it here last week. The fact is that the Fed has expanded its balance sheet by $1.4 trillion precisely in order to buy such assets. The banks are buying such assets hand over fist. Again, here’s what I wrote last week:

Commercial and industrial loans at US banks rose through the present recession. During the previous recession of 2001-2002, they began falling and kept falling until 2004. The banks are lending. Not only are they making loans, but they also are buying securities.

What has happened, rather, is that the market’s willingness to buy credit-sensitive American bonds has collapsed. Between the first quarter of 2007 and the third quarter of 2008, mortgage-backed securities issuance dropped by roughly half, corporate bond issuance by three-quarters, and asset-backed issuance by more than nine-tenths.
 

$US bn	Municipal	Treasury	Mortgage Related	Corporate	Agency	Asset Backed
Q107	107.6	188.5	540.4	305.6	265.4	323.2
Q2	123.6	184.4	628.2	345.8	234.1	329.1
Q3	93.4	171.1	485.4	239.4	185.8	139.3
Q4	104.7	208.3	396.3	236.7	256.5	110.0
Q108	85.0	203.8	391.5	213.1	432.4	59.7
Q2	144.5	219.8	437.8	333.3	387.9	69.7
Q3	89.6	244.8	286.6	82.6	198.8	23.5

Prior to the credit crisis, the US imported a trillion dollars a year of capital to finance the housing bubble and related consumer credit expansion, as well as the application of corporate leverage through leveraged buyouts and speculative-grade bond issuance. Global demand for such securities (and the structured vehicles into which they were packaged) collapsed after the subprime collapse of mid-2007. That is not the fault of the American banking system, but a violent allergic reaction against American risk on the part of the world market.

Hedge funds, whose assets have shrunk violently from US$1.9 trillion in the middle of 2008 to only $1.4 trillion at year-end, have had to sell enormous quantities of securities. Banks used to allow hedge funds to lever such assets many times over. They no longer are willing to provide leverage, and regulators wouldn’t allow them to if they wanted to.

The customers who bought all of these securitized assets at par, hedge funds and foreigners, are either burned out, or burned up. The whole point of the exercise is to return lending to the banking system’s balance sheet where it can be regulated. And it will return at a fraction of its previous price.

The fact is that bond performance managers like PIMCO just aren’t needed in the cowardly new world of banks-as-utilities. Mark-to-market accounting and total-rate-of-return performance are things of the past. The watchword for today is: hold to maturity and lie about the price.

This entry was posted on Thursday, January 29th, 2009 at 8:25 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.