«We haven’t had a Lehman moment yet»

Danielle DiMartino Booth, CEO of Quill Intelligence and former analyst at the Federal Reserve Bank of Dallas, talks about the Fed and the market turmoil.

Danielle DiMartino Booth is a vocal critic of the Federal Reserve. However, the former advisor to the Dallas District Federal Reserve has positive things to say about the recent measures taken by the Fed. The focus on credit markets is currently the most important thing, she says. It is crucial for the smooth functioning of the financial system. But the financial markets are not off the hook. Companies and the economy are also likely to face tough times.

Ms. DiMartino Booth, after the Federal Reserve slashed rates to zero and announced a program to buy more than 700 Bn. $ in assets, the US stock market dropped the most since 1987. Did the Fed fail?
I’m not so sure that the Fed failed. I think we could have seen more disruption in the financial markets had the Fed not done anything. The Fed was trying to make sure that only one circuit breaker in the stock market was set off, and that we didn’t hit that second circuit breaker of a 13% decline. It could have been worse.

How do you rate the action by the Fed?
The Fed was expected to come out with all of the measures that were undertaken. The market had the Fed Funds Rate going to zero already fully priced in. Additionally, there has been anticipation for some time that the Fed was going to relaunch true quantitative easing as opposed to what they call technical quantitative easing.

Were there any surprises?
I was surprised that they opened up the discount window as they did. The discount window accepts all forms of collateral. Opening it up was a pretty big step.

Banks that needed to use the discount window were stigmatized in the past, will it work this time?
There has always been this stigma attached to it. That is exactly the reason why the Fed put a statement out on Monday morning reiterating that it wanted the banks to use the window. If banks get in a tight enough spot they will have no choice.

The Fed is revisiting its playbook from the financial crisis. Does it work in this situation?
We cannot answer this question at this juncture because we don’t have all the information. The virus has not stopped spreading in Europe. In the United States, we are beginning to see how deeply it has already spread and how it is going to spread as we get the testing capabilities up and running. This is certainly not a household balance sheet type of genesis.

Will it evolve into a household balance sheet crisis?
Having such a high percentage of the workforce potentially losing their jobs in an economy that is driven by services opens up the risks that you end up having a similar type of downdraft in household balance sheets. Especially with a third of the American workforce living paycheck to paycheck.

Has the Fed still tools left?
Many different liquidity facilities were rolled out during the financial crisis. One of them is the primary dealer credit facility. And that would effectively open up to the big broker-dealers the same variety of collateral that has been opened up with the discount window.

Why has the Fed not announced these measures?
The legislation called Dodd-Frank did take away the Fed’s ability to be the lender of last resort to individual firms. We’re getting real-time clarification on the limitations that have been set out for the Federal Reserve.

Why was there illiquidity in treasuries in the last week?
There are just not that many bonds to be traded once you get past the seven-year mark on the US treasury curve.

How come?
This has been exacerbated by Fed policy as well as the policies of the European Central Bank and the Bank of Japan. Owners of longer-dated treasuries aren’t going to sell them in a million years. They’re going to keep them for the coupons in a world in which rates have been taken back down to zero.

How does it help if the Fed buys enormous amounts of treasuries then?
The Fed needs to be aggressive in buying treasuries at the shorter end, potentially even selling treasuries at the ten and or 30-year mark to put more paper into the market if that is what is missing. It would be a very tricky endeavor for the Fed to explain this to the markets without there being a perception that it was tightening. I would call it a reverse operation twist.

So it would be more like the Fed trying to be a market maker for treasuries?
More like the Fed saying: We own a security that is needed in the marketplace. So to ensure liquidity, which is part of the Fed mandate, we will give the market back what it lacks right now, which is longer-dated paper.

Is the credit market better functioning now?
I don’t know. The credit market has yet truly to be tested. The reason that we are seeing markets behave in an orderly fashion is that there is still a working assumption that the majority of defaults are going to be isolated to the energy industry. This could be a naïve way of looking at it.

Where do you expect defaults?
We won’t know until the bailout requests are starting to roll in. Airlines have made a request. They might be seen in the interest of national security as being a potential candidate for a federal bailout.

Could you say the same thing of a vacation cruise line or a hotel chain?
We will get into uncharted territory.

Where else do you see exzessive leverage?
A lot of movie theatre chains have taken on too much debt. They have lower credit ratings as well. The cruise lines also have a lot of debt and lower ratings. Many restaurant chains that will be stressed in the coming weeks and months have also become over-leveraged. It’s not reasonable or realistic to suggest that every single industry is going to be a candidate for a bailout.

What are your expectations regarding the economy?
Some analysts think that the second-quarter GDP could contract somewhere between 3 and 5%. Given how messy the data coming out of China is, I think that it could get worse. I caution those who think that there’s going to be a V-shaped recovery, and that the United States economy is going to come roaring back in the third quarter.

Why won’t there be a fast recovery?
There will be changes in our culture. In the aftermath of this virus, a lot of households could be more frugal. I wouldn’t say we’ll see a permanent hit to demand, but we might see a shift in the way Americans perceive how much they should consume. We should expect depressed economic growth until the end of the year.

How will banks behave in such times?
A lot of companies are going to be looking for cash flow and credit at a time when banks are very uncertain about creditworthiness. And banks are looking at the federal funds rate which is zero. So it’s extremely difficult for a bank to lend in this environment.

Are you worried about the banks?
We’re going to see very quickly how well-capitalized they are. The largest banks aren’t necessarily at risk, even though their share prices suggest that some of them are exposed to bad credit. I worry about the mid-size and the smaller US banks. Many have loaded up on energy as well as commercial real estate loans throughout this entire economic cycle. Post-crisis regulations became so expensive that they ended up making loans that they otherwise would not have made, to cover that extra cost of compliance. The discount window is targeted at small and medium-sized banks.

Is there a need to close markets?
As long as the markets are declining in an orderly fashion, closing the markets would be akin to yelling fire in a crowded theatre. I would be very careful about it. The last time markets were closed was after 9/11 that was a national tragedy, and the functionality of the financial markets was in question at the time. That is not what we’re dealing with today. Proactively close the market might induce more panic.

What is the most pressing matter right now in the markets?
The most pressing matter right now is that there won’t be any kind of disorderly unwind in the credit markets that were to reveal where systemic risk lies. You never know where the systemic risk lies until it stands up and punches you in the face. That is one of the reasons why central bankers all over the globe are acting right now. Poland just did a repo operation. We’ve officially seen it all. And Egypt lowered rates by 300 basis points. There is this deep-seated fear of credit volatility coming unleashed, as was the case with German Landesbanks holding subprime US mortgages. But as bad as things are right now: We haven’t had a Lehman moment yet.

Do you expect such a Lehman moment?
We have seen some hedge funds blow up, but nothing disruptive. As far as a Lehman moment, it’s difficult to say. Banks have theoretically better prepared themselves for this moment.

What about other financial institutions?
It is critical to closely monitor the other big players in the financial system, such as fund companies that are now some of the biggest holders of bond inventory. And who knows how states and municipal finances will fare given a handful of the weakest players have deeply underfunded pensions. The Fed knows it is its responsibility to try to prevent a meltdown in the financial system. That is why it is flooding the system with liquidity in any and every form it can legally deploy.

Is the financial system better prepared than before the financial crisis?
There is more leverage than we had when we headed into the last crisis.

Is it all crowded onto bank balance sheets or more widely dispersed in the financial system?
It’s hard to say how this will play out, given the structural shifts in lending markets.

But central banks are acting swiftly. It looks like they have learned their lessons from the financial crisis.
In terms of their reaction function, they have, but the fact that they created this bubble is indicative that they didn’t learn a thing.

But to address that it’s too late.
It was too late a few years ago. It was too late in the year 2000 and too late in 1996, when Alan Greenspan made his irrational exuberance speech. It is getting tiring, as Jim Grant always says, to be witnessing the Fed being both arsonist and firefighter.