Today, the Federal Reserve announced that it will start “Operation Twist,” selling shorter term securities and buying longer term securities.
This is another in the continuing move towards ‘financial repression’ as recently discussed in a recent International Monetary Fund paper from Carmen Reinhart and Belen Sprancia . Basically, financial repression is a conscious policy by the US Government to make repayment of its massive debt load (both existing and expected) easier. This is a topic that has been discussed by PIMCO and other leading investment managers.
To summarize, financial repression consists of the following key elements:
1. Explicit or indirect capping or control over interest rates, such as on government debt and deposit rates. See today’s and prior months’ Fed actions….keep rates low for an extended period, make it easier for the government to borrow at those low rates with longer maturities, etc.
2. Government ownership or control of domestic banks and financial institutions while placing barriers to entry before other institutions seeking to enter the market. We saw this with TARP and still see this in other instances – AIG is still majority owned by the US Government and, contrary to popular opinion, not all TARP funds have been repaid.
3. Creation or maintenance of a captive domestic market for government debt achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer. For example, banks can buy USTreasuries with borrowed money from the Fed and lock in a handsome spread, while holding zero (that’s right, zero) capital against it. In fact, the Fed encourages this behavior. Talk about a high return on regulatory capital!
4. Government restrictions on the transfer of assets abroad through the imposition of capital controls. We have not seen this yet, but it is not beyond one’s imagination that we may see some of this. In fact, some may argue that the IRS’ strong moves towards requiring that US citizens report foreign holdings is a step in that direction. And certainly the conversation about requiring repatriation of cash at foreign subsidiaries of US companies could have more than corporate income tax implications.
Add in a small dose of inflation, say the authors of this study, and you have a form of taxation, designed to ease repayment of government debt. In fact, it is a form of taxation that can be done without passing one bit of tax legislation. And, it can easily lead to implicit currency devaluation.
Of course, this will help the overall economy in its long, deleveraging process. And, a devalued currency can also help the economy (something the politicos will never, ever say). However, for insurers the situation will be different.
Why is financial repression important to insurers? Primarily because It begins to throw the usual investment and reserve relationships on their respective heads.
For example, life insurers who see most of their growth through interest sensitive products will find it difficult to maintain adequate spreads between investment yields and crediting rates. Property/casualty insurers will get ‘repressed’ from both sides of the balance sheet – investments will be hard pressed to produce positive real yields, while that expected dose of inflation can wreak havoc on reserve adequacy, especially in areas such as medical inflation.
Right now, what can insurers do to prepare for continued financial repression?
One thing that should be considered…It is time to reconsider the role of the ‘risky bucket’ (investments that are not investment grade bonds) in providing income as well as the traditional less correlated, total return. (The ‘risky bucket’ is discussed in Chapter 3, Uncertain Times: A Chief Investment Officer’s Journey).
As one insurer CIO once told me, ‘you can’t eat total return’. But, you can indeed ‘eat’ the dividend or interest income portion of that return, adjusted for risk. That means considering asset classes with competitive or better yields to core fixed income alternatives, such as dividend paying equities, high yield bonds, emerging market bonds, etc. We are not advocating increasing the size of the ‘risky bucket’ to take advantage of added income, as we still believe the size of the ‘risky bucket’ must be carefully analyzed and kept within the risk appetite of the Board and senior management. We are, however, advocating taking another, systematic look at alternatives with the ‘risky bucket’.
If your firm is either a NAMIC member or a government risk pool, you may want to consider these focused events.
We think you will be hearing the term ‘financial repression’ enter the discussion about investments more and more, in the months and years ahead. It is better that we all understand what that means today and what it means for our portfolios.
As always, I look forward to your comments and questions.