The Federal Reserve finally took a stand on Congressman Jeb Hensarling’s assertion that police is causing a liquidity crisis in corporate bonds.
“In recent years, market participants have been particularly concerned with liquidity conditions in the corporate bond market because the securities are traded less frequently, and the liquidity provision has relied more heavily on dealer intermediation, than in many other markets. However, a range of conventional metrics of liquidity indicates that liquidity strains in corporate bond markets have been minimal.” The Federal Reserve’s Semi-Annual Police Report stated. “shows that the estimated mean effective bid-ask spread for U.S. corporate bonds has remained low in recent years. Before the financial crisis, bid-ask spreads averaged about 1 percent of the price of the bond. This measure of trading costs skyrocketed during the financial crisis but has returned to the range seen before the crisis. Measures of the effect of trades on prices follow a similar pattern and have been fairly stable in recent years.2 In addition, other measures related to factors associated with market liquidity, such as trends in average trade size and turnover, also suggest market liquidity conditions are benign.
“Figure B shows that primary dealers’ inventories of corporate bonds (including foreign bonds issued in the United States), which are predominantly used for market making, indeed began to decline sharply following the Bear Stearns collapse in March 2008 and fell further after Lehman Brothers failed in October 2008. Such a sharp decline in dealer inventories may be the result of dealers’ actions on their own, reflecting changes in risk preferences in reaction to the financial crisis. In addition, changing regulations—such as the Volcker rule and the supplementary leverage ratio, which aimed to make the financial system safer and sounder—and changes in technology may have contributed to the continued trend of lower dealer inventories.”
The Federal Reserve report, required to be released twice a year, accompanies Yellen’s testimony to both sides of Congress, starting with the House Financial Services Committee and continuing to the Senate Banking Committee the next day.
As The Industry Spread has documented, Congressman Jeb Hensarling, the Republican Congressman from Texas who chairs the House Financial Services Committee, has repeatedly used committee hearings to ask power brokers if they believe, as he does, that the Volcker rule, and to a lesser extent other rules like Basel, have created a liquidity crisis because there are fewer banks making markets.
The Volcker rule forbids proprietary trading by banks, a term, critics say, is poorly defined and goes after legitimate market making activities.
Hensarling confronted Yellen on this issue previously, but she dodged the issue.
“Volcker rule may have serious consequences for corporate bond market functioning during stressed times.” Hensarling asked at a hearing in February.
“The evidence on this matter is conflicting.” Yellen responded.
But while the Federal Reserve seemed to now cede the point on the Volcker rule to Hensarling, it was far less alarmist in the effect.
“Overall, the degree to which dealer balance sheet constraints affect corporate bond market liquidity depends not only on dealers’ capacity and willingness to provide liquidity, but also on the extent to which nonbank financial institutions such as hedge funds, mutual funds, and insurance companies fill any lost market-making capacity.” The report stated. “Other factors such as changes in technology, risk preferences, and investor composition also interact to shape the trading environment. There are indications that market structure has changed in recent years, and trades in certain situations and market segments might have been more costly at times. But markets have also adjusted, and some measures of dislocation have lessened with these adjustments.”
Hensarling, in his five minutes of questions, did not address the report or the issue of corporate bond liquidity at all.
Instead, Hensarling took aim at “distortional economic policy”.
Hensarling first sounded an alarm previously sounded by this reporter: “Keeping interest rates artificially low for too long was a key contributing factor to the last crisis. Let’s hope it does not prove to be a key contributing factor to the next.” Hensarling stated.
The Federal Reserve was criticised for setting the catalyst for the 2008 crisis by creating loose
This reporter raised a similar point to Charles Evans, the President of the Chicago Branch of the Federal Reserve, in December 2016.
Hensarling then took aim at approximately $1.7 trillion the Federal Reserve holds in mortgage-backed securities: “Intervention into distinct credit markets like mortgage-backed securities is inherently fiscal policy, not monetary policy.”
In late 2008, responding to the mortgage crisis, the Federal Reserve began buying up bonds in Fannie Mae and Freddie Mac, to stabilise the mortgage market.
Fannie Mae and Freddie Mac are both government sponsored entities, private companies created by the government to increase the availability of credit to deserving borrowers, which they are supposed to do by securitizing mass scales of loans.
As a result of incompetence, fraud, and other illegal activities, Fannie and Freddie held trillions in so-called, toxic loans (loans which not be paid back) and they would have collapsed without Fed intervention.
Yellen said that this purchase was a one-time event in response to an unprecedented event.
“The FOMC and its principles for normalisation of monetary policy have clearly indicated that it intends to return over time to a primarily Treasury portfolio and that’s in order not to influence the allocation of credit in the economy. That said, our purchase of mortgage-backed securities took place after a financial crisis when the market for mortgage-backed securities was not working.” Chairman Yellen said.
Fannie and Freddie both survived as companies and the bonds they created stabilised but the companies continue to be hopelessly corrupt and incompetent as the accounting scandal broken by The Industry Spread in October 2016 showed.
“What has allowed the Fed’s foray into credit allocation is the policy of paying interest on excess reserves, and today, paying a premium over market. Interest on ‘required’ reserves was meant to counteract an implicit tax.” Hensarling concluded. “Interest on ‘excess’ reserves should not become a permanent tool of monetary policy. Normalisation would suggest, after setting the level of reserves, short-term interest rates be set by market forces. But today they are set from the top down by an administered rate paid on excess reserves, which again, is a premium rate resting on uncertain legal authority.”