CT Blue

This is a bit of a mashup from some recent posts from the ever valuable Wall Street on Parade blog.

Today's Fed may be more consumer friendly than it has been in the past 30 years, but that's apparently not saying much. The Fed has announced rules requiring the big banks to hold liquid assets, so that the next time they bring down the economy, they'll have some spare change left as a downpayment on the next bailout. The Fed has defined those assets which it considers to fit the bill. One of them is corporate bonds, with which Pam Martens of said blog has issues. You should read the whole thing. Suffice it to say that she argues convincingly that corporate bonds are not liquid in the Wall Street sense (easily convertable to cash with little or no loss of value at the time of sale) and that in the event of a market sell off, they are quite likely to spiral down in value. A taste:

Just six weeks before the Fed anointed non-exchange traded corporate bonds as liquid assets, all the way down to investment grade, the Financial Times ran this opening paragraph in an article by Tracy Alloway:

“The ease with which investors can trade corporate debt has declined sharply in the five years since the financial crisis according to research that is likely to feed fears over the prospect of an intensified sell-off in the $9.9 trillion US market.”

Then there is this 2010 paper by Jack Bao (Ohio State) Jun Pan and Jiang Wang (both of MIT Sloan School of Management), aptly titled “The Illiquidity of Corporate Bonds.” It starts off like this: “The illiquidity of the US corporate bond market has captured the interest and attention of researchers, practitioners and policy makers alike.” (Apparently, everybody but the researchers at the U.S. central bank.)

Meanwhile, the Fed has decided that municipal bonds are not sufficiently liquid to qualify.

This, rightfully, has state treasurers in an uproar. The five largest Wall Street banks control the majority of deposits in the country. By disqualifying municipal bonds from the category of liquid assets, the biggest banks are likely to trim back their holdings in munis which could raise the cost or limit the ability for states, counties, cities and school districts to issue muni bonds to build schools, roads, bridges and other infrastructure needs. This is a particularly strange position for a Fed that is worried about subpar economic growth.

Sure, there's been some municipal bankruptcies, but the fact of the matter is, those bonds are far safer than corporate debt.

So, the net effect of this is to push the bank’s money into those risky corporate bonds and out of municipal bonds. Borrowing costs will go up for cities and down for corporations. As Martens points out, this is the equivalent of the Fed imposing austerity budgets on towns and cities across America, which will likely have the same result, albeit not so starkly, as the imposition of those measures in Europe.

Martens can't understand why the economists at the Fed don't see what everyone else who has studied the corporate bond market is seeing.

Sinclair Lewis said that “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”. I would submit that it is even harder for him to understand it when his hoped for future salary depends on him not understanding it.