Daily Comment (July 19, 2016)

by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] Financial and commodity markets are very quiet this morning as the summer doldrums are starting to become evident.  However, three news items did catch our attention and are worthy of comment:

GOP Platform calls for a return to Glass-Steagall: The Glass-Steagall Act separated commercial from investment banking, preventing the creation of universal banks that can perform both services.[1]  Although political platforms have become rather inconsequential in recent years, this addition is something of a shocker.  Breaking up the banks’ commercial and investment banking operations would significantly change the landscape of the current industry.  Acquisitions of broker-dealers would become more difficult without the large balance sheets of the commercial banks.  Although most universal banks have struggled with the cross-selling concept, it remains a significant goal and potentially lucrative source of revenue.  We suspect this is a ploy by the GOP to capture the Sanders voters, who tend to believe that Clinton supports the large banks in their current form.  Simply put, if the GOP is on the side of attacking the large banks, it’s hard to see where they will find support.

The Bundesbank drops a bombshell: The Bundesbank, usually the stanch supporter of creditor interests, recently proposed reforms to improve Europe’s response to future fiscal crises.  First, the German central bank wants to broaden the European Stability Mechanism’s (ESM) mandate to a Eurozone fiscal authority, a role currently being met by the European Commission, the IMF and the ECB (otherwise known as the “troika”).  Currently, the ESM acts as a Eurozone IMF, helping countries with fiscal problems with liquidity.  The Bundesbank wants the ESM to become this fiscal monitoring body which would assess economic prospects, debt sustainability and the financial needs of nations with fiscal problems.  The ESM would also oversee aid programs, replacing the troika.  The second part is the surprise.  The Bundesbank wants newly issued sovereigns to contain clauses that would automatically extend maturities once a nation accepts ESM assistance without triggering a credit event.  This proposal has serious ramifications if adopted.  First, it renders credit default swaps (CDS) worthless, as extending maturities is a remedy for default.  By allowing that to occur without a credit event, which is the trigger for a CDS, investors would have no protection from a credit event.  Second, this action would be a forced “bail-in” by a nation’s creditors.  Third, the risk profile of Eurozone government debt would change dramatically; suddenly, a two-year note could become a 10-year one by a keystroke.  Investors would, assuming rationality, start shunning sovereigns issued by weaker nations, driving up their yields.  It is also quite possible that the ECB might avoid buying them in QE operations…or, it might not avoid them, which would support the bailout.  The creditworthiness of the G-7, or perhaps most of the G-20, sovereign debt is generally not called into question; the Bundesbank’s proposal may be the slippery slope to a form of built-in debt repudiation.  The fact that this is even being considered shows how strange conditions have become.

China’s newest export: One of the concerns we have about China is its debt capacity, which is broadly defined as the ability of an entity to issue debt relative to the growth the new debt generates.  There is ample evidence to suggest that the effectiveness of Chinese debt is waning; it appears that ever higher levels of new debt are necessary to bring smaller increments of growth.  That situation is a concern.  The other concern is that, with debt effectiveness waning, how will China be able to sell new debt without resorting to steadily higher interest rates?  The answer appears to be by selling debt to overseas buyers.  Bloomberg reports that debt from Special Purpose Vehicles, which are bonds used to fund municipal and provincial building projects, is finding its way into overseas portfolios.  It is unclear what currency this paper is denominated in; we suspect CNY, although we can’t always be sure.  In a yield-starved world, this paper is yielding 4.9%; one can imagine the sales pitch, “muni paper from China…they won’t default…stable currency, see the long-term chart…nice yield!”  If China decides to tap the international markets, it can likely expand its debt even further, even if the economic effects are small.  After all, if the economic impact is modestly positive and the default risk resides with foreigners, the political risks are small.  Caveat emptor!

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[1] The Glass-Steagall Act did not necessarily restrict interstate branch banking.  These laws were covered by the 1927 McFadden Act and the 1956 Bank Holding Company Act.  Restrictions on branch and interstate banking were completely repealed by the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994.  Interstate banking dramatically increases the ability of banks to grow, and limiting geographic scope would be the next step toward reducing bank power.