Accidents, and particularly street and highway accidents, do not happen – they are caused.
Accidents in the financial markets do not just happen either. They often result from conditions that persist for quite some time before some seemingly insignificant bend in the road causes us to veer off course and wind up in a ditch. How long did a chorus of critics warn of a bubble in the U.S. housing and structured finance markets before it actually popped?
In traffic parlance, a rollover accident is one in which a vehicle ends up on its roof or side, usually as a result of one of these factors: excessive cornering speed, tripping, collision with another vehicle or object, or traversing a critical slope, such as when a vehicle crosses a ditch.
Rogoff and Reinhart, authors of the book This Time Is Differentobserve that “what one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble.” (I'll have a full review of the book for you on Friday.)
Bonds Keep Rolling
When companies or governments issue bonds, they mature on a given date. Some are very short term, maturing in only 30, 60, or 90 days. Other maturities can range from 1 to 30 years. Once the bonds mature, the corporation or government must pay back the bondholders' principal in full. Next, the borrower will usually look to “roll over” those bonds by issuing new ones in order to fund their continuing operations. It's sort of like how you need to refinance your mortgage once your term is up.
This is the proverbial bend in the road. Accidents can happen here. One of the problems is that banks and governments will be vying for financing at the same time, and this could raise the cost of capital for everyone, including small businesses and consumers. If fewer investors want to buy those bonds for whatever reason, the price will fall and the yield will rise, raising the cost of capital. In extreme situations where buyers refuse to step up to the plate at all, we would have a full blown credit freeze on our hands. We've seen what that looks like already and I'll go out on a limb and say that no one wants to go there again.
When the European sovereign debt crisis was coming to a boil a few months ago, many worried that European countries and their banks would not be able to roll over their significant debt issues. The New York Times reported: Crisis Awaits World's Banks as Trillions Come Due. “Banks worldwide owe nearly $5 trillion to bondholders and other creditors that will come due through 2012, according to estimates by the Bank for International Settlements. About $2.6 trillion of the liabilities are in Europe.” U.S. banks will need to refinance about $1.3 trillion over the same period of time. That's a lot of paper for the bond market to swallow.
China has traditionally been a huge buyer of U.S. debt, but they have recently sold some of their holdings. Some worry that this means there will be less demand for the massive quantities of debt the U.S. will need to issue. A recent article from The Daily Reckoning explains why that may not necessarily be the case.
Will Short-Term Gains Lead to Long-Term Pain?
One of the recent borrowing trends is for banks to borrow money for shorter periods of time. By accessing the next-to-free short term money made available by global central banks, many financial institutions have been able to work on improving their balance sheets. They borrow money at near 0% rates and lend it out to individuals and businesses for longer terms at higher rates. It's a great racket, if you can get into it.
According to the New York Times article, “government bank guarantees extended in response to the crisis also inadvertently encouraged short-term lending. The guarantees were typically only for several years, and the banks issued bonds to match.” What happens when those government guarantees expire? Governments can extend them, but what if the market loses confidence in the balance sheets of those governments? Many of the countries offering such guarantees aren't exactly swimming in black ink themselves. That includes the U.S. and the U.K..
Why the Infatuation with Bonds?
The European stress test results seemed to defuse worries about a rollover accident, although many (myself included) felt that those tests were less than rigorous, to put it mildly. In the meantime, it seems that investors, both retail and institutional, can't get enough bonds. Many reports point to rivers of capital flowing out of equity funds and into bond funds. As long as this continues, rolling over debt may not be a problem.
A recent Globe and Mail article inquired Whither the Bond Vigilantes? (The title was later revised to “Where Are the Bond Vigilantes?”, but I much prefer the original.) Bond vigilantes are supposed to hold governments accountable for their debt loads by demanding higher rates in return for putting their capital at risk. Not only have the bond vigilantes gone missing in action, but there seems to be a mob of bond groupies forming that just can't buy enough debt to sate it's appetite.
Jeremy Siegel recently warned that the bond market is a bubble. Wall St. Cheat Sheet begged to differ. Regardless of who's right, bubbles can continue to inflate much longer than anyone thinks they can. This particular bubble is backed by the full faith and credit of the U.S. government. The Federal Reserve recently outlined its own rollover plans: it will use proceeds from maturing mortgage-backed securities that it holds to buy U.S. Treasuries.
It would be folly for any trader to fade the Fed. So with fixed income short sellers on a leash, the Fed providing the incentive for investors to continue to buy bonds, and most investors turned off by the stock market, it seems that the U.S. government will have no trouble issuing the trillions of dollars of debt it will require to finance itself – until it does have trouble. I'll leave you with one last quote from Reinhart and Rogoff in which they explain “why financial crises tend to be both unpredictable and damaging“:
“Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence – especially in cases in which large short-term debts need to be rolled over continuously – is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! – confidence collapses, lenders disappear, and a crisis hits.”
They admit that economic theory doesn't provide very much insight into the exact timing or duration of such crises, but when all of the elements are there, it's pretty likely a crisis will occur at some point. It's doubtful whether even the Federal Reserve can hold off real market forces forever – if such forces have not yet been permanently been relegated to the realm of folklore and mythology.
Do you think the market is headed for a rollover accident?