Santa is finally coming to town?

ECB and the stock markets

The story I told on Monday appears to be gaining momentum. ECB announced new measures on 7 December and now the stock markets have finally picked it up. The combination of unlimited loans from the ECB and a “guarantee” from EU on government bonds has caused a stampede into short European short-term bonds, including those issued by Spain and Italy.

This is indeed very helpful in covering the short term financing needs of the European countries. And it gives the banks a healthy yield pickup, giving them a stealth, tax-payer financed contribution towards rebuilding their capital base. Wednesday’s opening of the ECB facility will give an important pointer. If the banks take upwards of EUR 250bn, it will be deemed a success and the current Santa rally can continue. Downwards of EUR 100bn will be interpreted as a failure.

I have for some time held the conviction that everything we know about pricing of risk is off the table for the moment. Except of course that bonds with a guarantee should trade at a lower yield than those without a “guarantee”. Go figure.

It is interesting that nobody really noticed ECB’s new initiatives when they were introduced. Instead markets took a great interest in guessing about the imminent Euro-zone breakup.

But heed this warning: If – and it is still a big IF – this re-evaluation of the risk situation continues to gain momentum, we are likely to see a major setback in the two kinds of assets that are the most overvalued or overbought or whatever: US T-bonds and German Bunds.

While gains in the stock market may be fun to look at, the sheer volume of the bond holdings of this world means that you should not take the eye off that ball.

Stocks are for show, but bonds are for dough – as we say on the golf course.

Positive data

Stock markets were helped by positive economic data. German business sentiment data came in strong and a report confirmed that the US construction sector is improving. Last week a rather dubious labour market report also told that the US economy is beginning to add jobs.

That the US economy continues to surprise to the upside is fully in line with Origo’s view that a rebound was due in Q4. The German data are not entirely in line with our rather gloomy view on the European situation. However, in all fairness, we are beginning to see indications that the downturn in Europe may be losing momentum.

US Banks

Somebody stole the punch bowl right under the nose of the US banks, just as a rally in bank stocks was about to take off yesterday. Rumours had it that even the US regulators are serious about demanding higher capital ratios.

Did this really come as a surprise to the markets?? Did market participants really believe that the influence of the banking sector on the politicians is so strong that the US banking sector could avoid completely sensible regulation when the rest of the world is moving that direction.

After 25 years in this business I can still get surprised at the sheer ignorance and credulity of many market participants.

Oil glut. WTF?

Yesterday’s Financial Times carried a story that began with the words “The boom in North American oil production has triggered a race to expand the US’s main oil storage centre, raising concerns among some industry executives of potential glut in capacity”.

Please read it again. It tells that there is a boom in oil production in North America. A couple of years ago an estimated 8bn barrels were found deep under the Mexican Gulf. Shale oil reserves in Colorado and other US states may match the reserves in OPEC. Is this the end of the story of the earth running out of oil.

Maybe oil does not come from dead algae, ferns, and dinosaurs. Maybe oil is formed deep in the mantle of the earth and slowly seeping towards the surface. At least that is a story worth following.

Crisis solved. Didn't you get the memo?

On 8 December ECB announced a new 3-year financing facility. It is UNLIMITED, and with a suitable weakening of the quality of the collateral for the loans, it could end up being a major game changer.

The LTRO will make possible a simple idea to recapitalise European banks: take 3-year loans from the ECB at 1% and place the money in southern European government bonds. EU has promised that banks no longer have to take losses if a European government goes bankrupt. Banks have again been given a "free lunch".

Apparently I am not alone in being able to see this simple idea. Spanish and Italian 2-year yields fell like a stone yesterday. The attached chart could be interpreted as indicating that:

• The market believes that Italy, Spain and Ireland no longer represent a bankruptcy risk.

• Portugal is on the verge but may hold on to dear life

• The conditions of the Greek debt restructuring is still not in place (personally I think that the haircut will end at 80% and not 50%)

ECB begins the new LTRO 3-year loan facility on 21 December. It will be very interesting to see how much this credit facility will be used. Rumours in the market say that banks in each country are buying domestic debt in the two-year segment in some volume, a  sign that demand could exceed expectations. If that happens, the new facility is as close to a Euro-QE as we can come without changing the charter of the ECB.

If we now try to put a positive spin on this development so it could read as follows: the ECB has with its new facilities taken big step towards disarming the liquidity crisis. The EU has with his "paradigm shift" given a guarantee for bonds issued by 16/17th of the euro zone. ESM and EFSF will operate at full volume in about two to three months.

The lower yields at the short end of the curve mean that it becomes easier for the troubled countries to achieve the goals of a budget surplus now that their refunding costs are falling.

Hey presto - euro crisis is solved! Well, maybe we still have a small growth problem here and there ...

This is of course the ultimate positive interpretation of things. However, amid all the end-of-the world headlines, we must also remember to keep an eye on the positive developments. ECB’s initiative is one of them.

Banks

Before we let ourselves be engulfed by a warm and fuzzy Christmas feeling over the Euro-zone’s step in the right direction, let us remember that the crisis is not completely gone. It will just move to where it was always going to end. At the banks.

We have heard more than enough lack of ethics and accountability in certain countries. The next theme will be that the private sector has contributed dramatically to the increase in debt / GDP in the OECD area and the banks have been the willing / necessary instrument in this wave of financial leverage. With Europe’s abysmal growth prospects, the ongoing deleveraging everywhere will continue to mean losses for banks.

Sense and sensitivity

I have been ranting against Germany's ideological crusade and their (lack of) sensitivity to the need for immediate action to disarm the crisis NOW! According to a document leaked from the EU president Van Rompuy’s office, it is clear that at tomorrow's EU summit, a small number of reasonable initiatives will be on the agenda.

I have suggested that one element in getting the crisis to go away is to convert the highly indebted countries' short-term debt to long-term debt instead. If you read the leaked document (attached), it is clear that something is happening on this issue.

EU will discuss to 1) accelerate the process to get EFSF up running with gearing and everything, 2) accelerate the ratification of ESM for this new institution to get started on long-term lending and 3) make "deposits" in the IMF, which can then lend money to European countries with large short-term financing needs.

Importantly, EFSF and the ESM could be allowed to operate in parallel for a while, increasing their lending capacity.

If carried out, it is good news. And should be received by financial markets as such. If not it hurts the poor Germans on their sensitivity.

My checklist to find out if new initiatives are useful to resolve the crisis has the following five elements:

• The ECB to act as a central bank
• The banks to be recapitalised
• Countries with huge short-term debt should have them converted to long term debt - very long term
• Germany and other countries in a good situation stimulate domestic demand and growth
• Structural development in the indebted countries (lend them money to build a bridge between some islands or similar)

This list can serve as a reality check: if new initiatives fit into one of those categories, then it is good news. If not, they are irrelevant or downright dangerous.

Fast track union changes will not help

France and Germany are pushing on with fast-track treaty changes, trying to find the loopholes that will allow the Euro-zone to impose German-style budget discipline on the other member countries without being bogged down by democratic procedure.

Presumably it means that the ECB subsequently will be allowed to act like a central bank. Or at least one hopes.

I  have come to believe that Germany still does not get it. The German policy is consistent, but wrong. The method for budget discipline now being pushed is just an über-version of the tragically mis-named “Growth and Stability Pact” (PSG), Germany’s contribution to the euro from 1997.

Already back then, economists pointed out, that the PSG would be procyclical. It means that a country typically runs a (bigger) budget deficit in a period of slow or negative growth. The PSG was then intended to impose cut-backs on countries already having economic problems. It would deepen the problems, hence causing even bigger cyclical swings on the country in question.

We all know that the PSG was largely ignored – even by Germany, when it found it necessary.

It is correct that budget discipline and a manageable government debt are necessary for long term stability. But it will not work to impose deflationary policies on the other Euro-zone countries, when growth is desperately needed to in order to grow out of the deficit situation.

In order to balance the European economy, Germany needs to support the weaker Euro members with long term loans to the most needy and by adding to domestic German demand.

I agree with the German vision that it is better to have an economy based on producing things people actually need. But structural changes cannot be introduced quickly. Greece and Portugal will probably never be efficient producers of reliable hairdryers, much less advanced tool machines and industrial robots. Such changes take years, and in the meantime economic growth will be depressed.

So here is a yardstick by which you can measure the various ideas being touted in the press. It is good news if it brings us closer towards one of following:

• Long-term loans to the countries in problems
• Stimulation of demand in the countries that can afford it
• Co-ordination of economic policies to stimulate demand
• Help to structural development where needed
• ECB to assume the role of a real central bank.

If a new policy idea or international agreement does not bring us closer to any of those elements, it is either bad news or quite simply irrelevant.

Whether this will end in a deep depression (as the OECD warned yesterday) or a long period of slow growth, nobody knows yet. But if the scale tips towards the depression outcome, Germany will suffer more than believed today. Ouch!

12 reasons for the markets to be paranoid

I cannot really find anything interesting in today's news. So let me instead use some space to summarise my views on why it is so difficult to operate in today's markets.

I have on earlier occasions expressed that at no other point in my career have I had to dig that deep in remote corners of my memory to find tools that can help me to understand. Yesterday one had to dig into the conditions for European government bond auctions (French primary dealers must bid at the OAT auctions, German primary dealers can abstain from Bund auctions if they like).

The day before yesterday one had to understand the unique American tradition of planning government expenditure programs over 10 years - which means that one cannot really count on anything. Last week we had to go over the ECB's charter to understand whether a modification of the charter also requires changes to the Lisbon treaty. And so on.

But we take a deep breath and list the factors that currently have conspired to ruin our night's sleep:

1. A secular reversal of a 15-year trend where households in many countries have increased their financial leverage significantly
2. A normal cyclical slowdown in the cyclical upturn that began in 2009
3. Government austerity programs across Europe, beginning in 2010
4. Additional public sector cut-backs in 2011
5. A dramatic reassessment of the price of risk - and perhaps even a new understanding of risk
6. Europe's central bank does not have the necessary authority to conduct a monetary policy that can effectively help us out of the pinch
7. European banks have opposed a recapitalisation and are now zombies, are forced to reduce their balance sheets dramatically now (remember Japan!). The U.S. banks are still struggling with the aftermath of the Sub-Prime crisis
8. Strong ideological determination in Germany to use the opportunity to shape important aspects of European political cooperation after the German model
9. Southern European countries, which for years have opposed productivity-enhancing reforms and general budgetary discipline
10. Maximum increase in the number of retirees (born 1945-50) putting pressure on state finances independently of the financial markets
11. Large institutional investors are still forced to abide by the rating firms' views, even if these views are deeply compromised
12. China's growing influence on world economy and the derived effects when even China has "slow" growth

I could probably find a few more. It is not necessary. There is already plenty.

My biggest problem is not really that the situation is complex. It is that the vast majority of communications in the financial sector has been shortened to a point that it can also be read by people with profound attention deficits.

Contagion defined

While we wait for the all-encompassing, gold-plated solution to EU's institutional problems, one could reflect on the term "contagion”. The concept has been used so often in recent months that we have almost become immune to its possible meaning.

Progressive distrust
I suppose it means that distrust of one kind of assets (Greek government bonds, for example) leads the financial markets to lose confidence in other assets - such as Italian government bonds. In the financial markets it means that the price of the suspected asset drops to reflect the new perceived risk of owning the asset. Completely logical, this.

So "contagion" means that investors reassess risk on assets one by one, and it implies that prices adjust - mostly downward. Contagion is therefore a sign that the markets have begun to think. This should create some concern, since the markets not exactly known for composure when they find out that they have been wrong.

Risk reassessed
Since 1998 it has been Standard Operating Procedure that when something went wrong in the world economy, interest rates were lowered and ample liquidity was supplied to the market. Since Asia during the same period took over the production of industrial goods, this policy did not stoke inflation.

Yields on government bonds fell, and in an attempt to achieve higher returns, institutional investors around the world dramatically increased holdings of low-quality bonds and equities. As a result risk premiums fell dramatically.

A clear example is that the Italian government bond yield was less than 20bp higher than German government bonds back in 2005. A clear sign that the risk was severely underestimated and the risk premiums had fallen too far.

We think and we re-think
The banking crisis in 2008 meant that market participants again are thinking about the correct price of risk. With usual decorum and restraint, the financial markets have entered into a permanent state of catatonic shock.

In other words, the "contagion" translates into a progressive understanding that risk should be reassessed. It seems that politicians everywhere find that such knowledge must be stopped by all means before it goes too far.

A potential victim of risk re-pricing : U.S. overconsumption
Now think what could happen if the markets began to ask critical questions about the World’s largest debtor by far, the US of A.

It would mean sharply higher U.S. bond yields. The burden of debt service would force a reform of public spending and taxation. Consumers would be forced to save instead of borrowing. Businesses would have to rely more on labour instead of cheap capital.

The road to get us there would certainly not be smooth and without obstacles. But "contagion" might ultimately not be the worst outcome. 

Risk willingness increases

Despite the continued uncertainty over what will actually be done in order to stabilise Greece and the European banks, G20 meeting in the weekend 15/16 October delivered enough details and pointers that the financial markets will begin taking the risk premium out of the market. Later on, it could develop into some kind of euphoria that will turn upside down everything that has happened in the past few months. It started two weeks ago as the first rumours of a comprehensive solution began to circulate and it can continue for a while, at least.

Bank crisis solution

Our often repeated take on the situation is that at least two crises overlay each other: Greece, and a general debt crisis, which in turn reflects itself in a very unhealthy banking sector. As I have stated earlier, Greece must have a debt restructuring in order to get out of the mess, and that will lead to some serious cash injections to the banks. The US banks already got their no-strings-attached social help three years ago, and the European banks will probably receive their gift vouchers over the coming six months. 

A classic “risk-on” reaction

In concrete talk, “taking the risk premium out” means: 

• Stocks will gain, possibly lead by the bank stocks, and primarily in Europe. 
• Bond yields on higher-rated sovereigns will increase, the yield curve will steepen.
• Yield spreads of lower rated sovereigns over higher-rated sovereigns will narrow, in some cases sharply. 
• High yield bonds will see the their yield spreads over government bonds narrow but at a slower pace than what happens in the spread between high and low rated sovereigns.
• Dollar will weaken against the Euro and so will other “safe” currencies.
• Commodity currencies will increase against the USD.
• Commodities (primarily industrial commodities) will rise moderately, and oil will receive a boost.
• Gold may fall further, as the “safe haven effect” vanishes.

It may look like an asset rotation, but we not yet seen market volumes corresponding to a major move of capital between asset classes.

A new divergence is building

A bit further out another theme is building. The markets had not seen the sharp slowing of the global economy as late as one week before the stock markets fell out of bed in early August. “The End of the World” is still very much on everybody’s mind.

At some point the markets will realise that apocalypse is not now! Nor indeed anytime soon. The risk-on scenario will then be followed by a proper risk-rally. It will probably last for some months before the underlying longer-term problems again are taken seriously. The debt crisis has not gone away, and it will continue to subdue growth for the coming years. It will be uncomfortable (particularly if you work in a bank), but not disastrous. 

Inching closer?

It could very well be that we are in the last weeks before the Greek debt restructuring. At least we hear more and more noise from the Euro-group about the terms of the haircut private sector bond holders will have to take.

On 21 July the Euro-group members presented an agreement whereby the Greek debt would be written down by 21 per cent. It did not take long time to calculate that even with the economic reforms agreed by Greek government at that time, it would not be enough. Greece needs a combination of spending reductions and debt reduction in order to get back from the dead.

With the 21% debt write-off, it would take very optimistic assumptions about future Greek economic growth in order believe that the “primary” surplus (government revenue minus expenditure ex debt service) could be sufficient to cover the servicing of debts to the tune of 170 per cent of GDP.

Several sober estimates have consistently pointed to a haircut between 50% and 70% in order for Greece to get a fresh start. That matches exactly what we now hear from the Euro-zone, namely that “more than 50%” of the debt will have to be written off. It is a great step forward that the truth is finally being tabled.

But, it is not over yet. ECB apparently is against the idea of a Greek haircut of 66%. Instead ECB insists that the 21% “voluntary” haircut must be implemented. One could wonder why, given that a haircut of 50-70% is the only thing that makes sense. Probably it has a lot to do with politics (I will not be so mean as to suggest it could have something to do with the Greek bonds held by ECB itself!).

Let us assume that the banks take the 21% haircut. In that case they would probably need only a minor capital increase, and it would possibly be possible to find that money in the market. Shareholders would be happy and the interbank market would unfreeze rapidly. No wonder the banks endorse this strongly. It would be a carbon copy of the US “money-for-nothing” program, called TARP.

The problem is that in order to arrive at a debt reduction of 66%, EFSF and the Euro-zone countries somehow would have to finance the difference between the bank’s losses and the necessary debt reduction. One could imagine that EFSF simply would underwrite difference or take over the Greek government bonds at artificially inflated prices. This would amount to a de facto gift to Greece and/or the banks.

That would be just about the worst thing that could happen for Chancellor Merkel and the other European leaders. Their electorates could rightly claim that their governments had just rewarded Greece and the banks for their recklessness.

Let us instead assume that the haircut is fixed at 66%. The banks for sure would need capital injections from their governments. In that case the governments will be able to present the expenses as a help to domestic banks and not as a rescue of the reckless Greek. The governments would for an extended period of time take control of the banks. That would be far more palatable for the electorate.

Either way, Europe’s governments will end up having to foot the bill. The difference is in the resulting relationship to the banks and the electorate. It is easy to see why politicians prefer the larger haircut. It is equally easy to see why the banks prefer the 21% haircut. 

Could the markets have got it wrong?

It is a dangerous game to say that the markets are wrong. As JM Keynes noted: The market can stay irrational longer than you can stay solvent.

Nevertheless, there are some elements of the developments in the last week that are worth a comment.

We have heard US Secretary of the Treasury Geithner tell us that Europe is acting too slowly and that we have to act in order to avoid a disaster. We have read tons of analyses of the Eurozone debt problem, built on dubious assumptions. And we have seen economists who 3 short months ago trumpeted a return to strong growth re-brand themselves as doomsday prophets. 

The underlying economic situation is serious, but not because of the issues that are now driving the crescendo. The Western World has over the past years built a mountain of debt which is clearly unsustainable. The main culprits are the private households who in line with falling interest rates have leveraged themselves harder and harder, mainly in the property market.

Public sectors have “taken over” some of the debt during the first phase of the Great Contraction in 2009 and 2010. Countries with a weak budget discipline have been pushed in the direction of something quite unsustainable. This affects primarily the US and in second line, the UK.

The historically high Debt/GDP ratio will slowly be reduced in the coming decade. As the banks are the pivot in the debt explosion – no banks, no loans – a deleveraging will automatic lead to a shrinking of the banks’ balances. This process is progressing, but is slipping under the radar of the financial markets.

Instead, the markets are busy with something as relatively unimportant as Greece. Government after government has been lying about the real economic situation, and Greece now faces a default. It appears that the Eurozone is about to arrive at a solution that will allow an orderly default, assuming a 50-66% haircut.

This would imply a loss for (European) banks up to €130bn. A large amount, but not impossible to handle. The data released in relation to the European “stress” test showed that a default of this magnitude is possible to control.

Then we have Portugal and Ireland, which at this moment in time do not finance themselves in the open markets. They work to reduce their government deficits. Ireland has progressed nicely and is ready to try a fresh bond issue some time in 2012. There are no reason to expect that these two countries should default on their loans.

Spain is frequently mentioned, even if the country has a relatively low government debt, and a government deficit lower than those of the USA and the UK.

Italy has a government debt of some 120% of GDP, the same as 10 years ago. Reforms have been introduced that will reduce the government deficit to acceptable levels over the coming two years. There will be a significant surplus on the primary budget balance, ie. before interest payments on the existing debt.

There is hardly any reason to believe that Spain or Italy should default on their debt. However, the panic in the financial markets has reached levels that probably requires that EU provides sufficient credit facilities that both countries for a while could cover their financing needs without tapping the markets. This is not a situation based on facts, but on panic.

Then there is the interbank market. The diffuse fears of losses in the European banks have led to a freeze in the interbank market. Central banks have reacted correctly and provide liquidity in order to avoid a replay of the Lehman collapse. A further deterioration of the situation  will not come from this source.

All in all it is a complicated situation where several stories are playing out on different levels. Stock and commodities markets have reacted with a huge increase in risk averseness. A quite understandable reaction, but not particularly logical, given the facts.

But what will happen once Greece has defaulted and the European credit facilities have been increased X-fold?

Then we can return to the really ugly story, namely that OECD needs to bring the debt situation under control. As I have written before, this will imply an extended period of sub-par growth and shrinking bank balances. This problem is not isolated to Europe.

The good news is that even in such a situation, it will be possible to have well functioning markets. The bank sector, however, will see no solution to its problems with the capital base as well as with bad loans.

Fed Almighty? Erh, no...

Interestingly enough, at yesterday’s meeting, US Federal Reserve at the same time declared that significant risks threaten the economic situation AND decided not to introduce a new programme for monetising the Federal deficit. If things are bad, then why not try to do something about it?

The only logical explanation is that Fed does not find that there is a lot that a further QE-programme could really do about the economic situation in the short term. We are still in a Keynesian liquidity trap, where zero interest rates have no effect on the demand for credit, and hence does not contribute to increase the economic activity. Fed Chairman Bernanke was clear about such issues at the Jackson Hole conference in late August: “economic policies that support robust economic growth in the long run are outside the province of the central bank”.

Instead he, and with him a number of other high profiled officials have lately been very clear that cleaning up the mess is a responsibility of the elected governments. IMF Chief Lagarde, World Bank Chief Zoellick, and several other central bankers from across the globe have issued statements that closely match Bernanke’s explanation at the same meeting:

“To allow the economy to grow at its full potential, policymakers must work to promote macroeconomic and financial stability; adopt effective tax, trade, and regulatory policies; foster the development of a skilled workforce; encourage productive investment, both private and public; and provide appropriate support for research and development and for the adoption of new technologies (...)  Although the issue of fiscal sustainability must urgently be addressed, fiscal policymakers should not, as a consequence, disregard the fragility of the current economic recovery. Fortunately, the two goals of achieving fiscal sustainability--which is the result of responsible policies set in place for the longer term--and avoiding the creation of fiscal headwinds for the current recovery are not incompatible. Acting now to put in place a credible plan for reducing future deficits over the longer term, while being attentive to the implications of fiscal choices for the recovery in the near term, can help serve both objectives”.

And there is more: “Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions”.

There you have it: Fed does not feel that it can do an awful lot more. It is up to US lawmakers to pull up their socks and act in order to bring the economy back on an even keel.

However, the European sovereign crisis, the increase in the price of credit risk and the fear of having government debt downgraded have led to a resurgence in fiscal conservatism at the wrong moment. Simple recklessness on the part of US Republican lawmakers does not make it better. Just a few months ago, governments in the entire OECD area seemed bent on making things worse by introducing austerity programs. Since then, the sharp deceleration in economic growth and renewed market turmoil has led policy makers to ease the foot away from the brake, sort of.

It is perhaps symptomatic that the markets have lost confidence in politicians to a degree that central bankers’ statements are studied more closely than anything else. But Fed’s lack of action clearly indicates that there is not an awful lot more central bankers can do.

What next, then? With politicians constantly on the verge of committing major policy errors and central banks with only little dry powder left, what will create the growth the world so badly needs? It has been said before and I repeat: A period of sub-par growth while fiscal balances are redressed. 

A word of reason

Beginning in 2008, I have several times pointed out that banks would come out of this recession downsized and with dramatically lower profitability than has been the case in the past two decades.

For a while it appeared that panic-stricken politicians had given banks yet another opportunity to consolidate and get even bigger – and even more unlikely to be allowed to fail.

Now, it appears that the UK is leading the way in how to get out of the mess. The Independent Banking Commission delivered its proposal for a bank reform yesterday, and it makes a lot of sense.

Instead of breaking up the banks, the Commission suggests to consider banks as two different businesses. 

One, the sexy one, is investment banking, securities trading, and all that. The other is the boring part of banking: savings, lending, payments services. We could call it a utility.

The utility part of banking is the services that are absolutely indispensable to a society, and the banking commission suggests that this part of the banking sector is “ring fenced” by higher capital requirements and in essence kept separate from the investment banking activities.

That would turn the utility banking into a dull, but safe economic activity. It would prevent the banks from using the capital base from utility banking for funding of investment banking activities. It makes a lot of sense – and it harks back to the US Glass-Steagall act from the ‘30s, which even legally separated the two kinds of activities. The introduction of that act marked the beginning of the longest period of the US without banking failures.

The recommendations from the UK banking commission make an awful lot of sense. It recognises that the society needs banks, but not all activities currently categorised as banking. It makes it clear that the profitability of the utility banking will be (much) lower – just like that of water supplies, telephone services, electricity etc. It makes it clear that the banking industry finally will have to pay the price for two decades of foolish greed.

For a second – in 2009 – I had started to have my doubts as bonuses in the banking sector again took off into the stratosphere.

Predictably, the UK banking sector is already lobbying heavily to avoid the “disaster”. But I am afraid that the lobbying will not work any longer. One of the members of the Commission, Martin Wolf, Economics editor of Financial Times is quoted for saying:  If you live in a world in which the real rate of interest on safe government bonds, bonds that the world regards as safe, is about half a percent or less, you might wonder whether you can reasonably expect a reasonably safe return of 15 percent on equity in a bank.

An equally simple word of reason from a man who cannot in any way be accused of left-leaning tendencies, UK Chancellor George Osborne: We should not confuse the interest of bank shareholders with those of British taxpayers.

So right. In America, Jamie Dimon, CEO of JP Morgan Chase, made a rant against the proposed Basel III capital requirements, qualifying them as “anti-American”. His concern is that the Basel rules will force the banks towards deleveraging and lower profitability. Obviously, US banking lobbyists are not as successful in Basel as they are in Washington DC, so Dimon suggests that the USA withdraws from Basel-based BIS altogether to avoid such disasters.

In Europe, the banks are in no position to tell the politicians what to do. With an impending bankruptcy in Greece and still carrying huge losses forward, many European banks are or will be de facto insolvent. They will depend on government support going forward. It might be that the Eurozone governments let themselves be inspired by the UK thinking.

Utility banking may be the right solution, as well as a healthy way of thinking. Contrary to what the banks have tried to make us believe, it will not be the end of the world as we see it if the banks are forced to downsize. Unfortunately, the banking lobby is still strong enough that it can persuade politicians to wait and postpone, which only delays the necessary.

Will it ever get better?

So the economic slowdown is upon us. Everybody is busy revising estimates for economic growth and company earnings downwards. And the talk of the town is: will we end in a recession? That question is probably misleading. There is not a huge difference between a growth rate of 0.1% and one of -0.1%. Neither will feel good and neither will generate jobs or an investment boom.

The financial markets have (finally) adjusted. As far back as in mid-July, the stock markets were still humming along, convinced that company earnings could only continue to grow linearly. Bond markets were as usual negative and yields had reached new low levels that were only compatible with – recession. Corporate bonds were firmly in the camp of the stock markets.

Now, six weeks later, the bond market again proved right. Stocks and corporate bonds have fallen off a cliff, and nobody can apparently find any good news that will turn the market mood around. It will probably take some weeks before this can happen, and weeks are an eternity in market time.

It is my conviction that markets react stronger to surprises than to anything else. Most market participants feel good about being part of the great big market consensus, and it is only when this consensus is disturbed that something has to change.

Forecasts are coming down, and in all experience it will mean that we will soon have a situation where market consensus undershoots the economic development. My guess is that by mid-September this process will have run its course. The markets will by then be ready to be taken by positive surprises.

In the current gloomy mood, nobody can see what would create growth. However, there are several elements that could turn positive. First, we have negative real interest rates. Former chairman of the US Council of Economic Advisors, Christina Romer, in academic works showed how low interest rates eventually end up by supporting the housing market. Negative real interest rates also push capital out of cash and short-term bonds, lowering the price of capital for companies. Consumers who have postponed purchases of cars and other durable goods will have a pent-up demand. Similarly, companies will have a greater need for investment after a long period of no investments. Inventories will have been brought down or written off.

And finally, austerity measures will be if not postponed, then at least delayed. Reality is finally about to win over ideological arguments that deficits will have to be cut dramatically here and now. It is slowly becoming clear that austerity will hamper growth.

So if – and that is still a BIG if – nothing goes wrong in the European banking sector, we are setting the scene for the stock markets to be positively surprised, even if economic growth will remain weak for a while.

At Origo, our work with market risk indicators has led us to precisely track the gap between economic downturn and unfounded optimism in the stock markets. We will report back here when the opposite scenario begins to unfold.

Ben did not deliver, but Wolfgang did

 US Fed Chief Ben Bernanke’s speech at the annual meeting of central bankers in Jackson Hole ended up by being an anticlimax. Before the speech we were told that the markets would collapse if he did not announce a large-scale bond purchase program. He did not, but he did repeat that in case the (US) economic situation did deteriorate, Federal Reserve will do something. So at the end of the day, the stock markets chose to interpret the lack of announcement as a positive statement that the economy is not that bad, after all. Confused? You are not alone. But you have just witnessed one of those episodes that demonstrate why central bankers rarely speak plainly.

At a much lower-profile economic conference at the St Gallen university in Switzerland, Germany’s Finance Minister Schäuble made some statements that were far clearer. He bluntly stated that the global programs of fiscal consolidation create a risk that the global economy faces a period of seven lean years in terms of economic growth. He also said that structural economic reform is necessary in four EU member countries and that governments should take a greater responsibility in fighting the global economic crisis.

Note that Schäuble is a politician who is not facing an election anytime soon, he is not trying to become Germany’s next Chancellor, and he has a reputation for speaking his mind – he did after all state that the previous US Quantitative Easing Programme was “clueless” and that it was a proof of how the US did not know how to solve its crisis.

Readers of this blog will not be surprised that I share Schäuble’s point of view. It is just rare to hear it stated so clearly from a senior politician in one of the large global economies. I believe that there is a risk of a period of slow growth because of the ongoing unwinding of the debt global debt bubble.

Quietly, consumers in many OECD countries have increased their savings rate significantly. It means that traditional measures to stimulate demand – lower taxes – will not work as it will only increase the savings. In itself it is enough to warrant a period of slow growth. Now this is being compounded by fiscal austerity measures that will only extend the period of slow growth further.

At the beginning of 2009, I used the same biblical metaphor of the seven lean years. That is soon three years ago. With another four years to go, I still may be right. That economic growth will be back on track by 2016 instead 2018 as implied by Schäuble.

However, there are still some structural problems where I do not see any signs of improvement. They may still derail any well-meant attempt at letting short-term pain be a mean to achieve long-term gains.

I am talking about the fact that there are countries, where the access to consumer loan finance is easy and considered almost a human right, and the biggest of them is the US. In Europe, UK is the main representative of this attitude. It could happen that there is a political backlash waiting from consumers (voters), who get fed up with having to save. 

There is no political gain to be had for anybody to try and fix this by introducing legislation or regulation that puts a limit on the access to loans. No, I do not mean quantitative restrictions, but something as simple as requesting that consumers are able to make a reasonable down payment on house or car before financing the rest. Banks should be forced to make a minimum verification of borrower’s credit worthiness before extending a loan. And so on.

I know, it is not very likely. Politicians have a tendency to think in terms of elections, and that is bad news for structural reform. But then we can hope for something else – the continuation of the current trend towards forcing the banks to have a far more significant capital base. It will cut the banking sector down to size, it will reduce the profitability of the sector, it will reduce its political influence. And at the end of the day, this deleveraging will contribute to extending the period of below-trend growth. Meaning that Schäuble may end up being right that 2018 is a likely time for return to trend growth.

There are many aspects of the cleaning up after a debt bubble that burst. Schäuble did not touch upon them all. But at least he has the political courage to speak up.

Look out for more surprises

In March I argued in a blog post that the stock markets were setting themselves up for a fall. I used the opportunity to explain how to use the Economic Surprise Indicators as some kind of composite indicator that has at least some value in predicting the future market mood.

An Economic Surprise Indicator measures if data releases are on average better than, in line with, or worse than consensus estimates. The indicator reached a peak in March this year and has been falling in a straight line ever since. This is pretty much in line with my explanations of 5 months ago, and certainly, the markets have heeded the call:

“Markets do not really react to good or bad news. Markets react to surprisingly good or bad news. Markets react to change rather than predictability.

Despite decades of economic research on the formation of economic expectations, most economists and stock market analysts display “adaptive expectations”: if they are surprised positively, they revise forecast upwards. If they are surprised negatively, they revise downwards.

So now that we have all been surprised positively for some months, you can be absolutely sure that forecasts are now being adjusted upwards. At some point in time they will have caught up with reality. From that point on, we will begin to have negative surprises. A new revision cycle will begin and the market mood will again turn.”

The question is where we are now, 5-6 months later? The Economic Surprise Indicator nosedived as the economy began to slow. Somewhat belated, stock markets found out on 1 August and we have had quite some market mayhem since then.

Economists and Analysts are beavering away on their forecasts of economic growth and company earnings. We are seeing a wave of downgrades. The term “Recession” is back in fashion. At the same time the Economic Surprise Indicator has stabilised at a very low level, indicating that economic surprises are still negative.

The indicator is not the answer to everything. But once the wave of forecast downgrades are over – and believe me, the downgrades will be aggressive – the market will suddenly begin to receive positive surprises. The most likely result is that the current negative sentiment will change. Market participants will convince themselves that it is not quite as bad as they thought. The “hidden factor” in the equation is to understand that the underlying consensus estimates are moving as a result of positive or negative surprises.

The important thing here is that in order to stabilise the market sentiment, it does not matter that we are looking at 5 years of below trend growth. It matters that the market somehow adopts it as a consensus. At that point in time, risk willingness will increase again.

When it will happen? I don’t know for sure. But it is typical that a cycle from exuberance to despair and stabilisation takes some six months. So sometime in September, maybe. Or it could be that downgrades are dramatic enough to stabilise sentiment earlier. 

It is tough to be a stock market dealer

Among bond dealers, it is a well-known fact that the stock markets cannot concentrate on more than one thing at a time. So it must be tough to be a stock dealer or advisor these days. There are so many things to worry about.

Maybe one should not be too tough on the market participants when they are being interviewed for TV or press. With a significant slowdown looming, downgrades falling hard and fast and something wrong in the Euro-zone, it really is possible to be quite confused.

Stock markets tell us that the S&P downgrade of the US Treasuries ushered in a period of grave turmoil in the stock markets and that further debt trouble in Europe makes it worse. One more downgrade would bring more chaos. So how come that those incompetent politicians are just sitting on their hands instead of doing something??

Please! Let us try and go as far back as to 1 August. Europe had just announced a clever Greek restructuring plan that avoided what everybody feared, a default event. Italy had approved a significant program to cut its government deficit. In the US, the debt ceiling had just been lifted after weeks of undignified brinkmanship. That should be what every stock market would need to create a solid rally.

In the event, the opposite happened. The bond markets had already given clear indications months in advance: Economic growth had shifted down a gear or two. Suddenly the stock markets began to fall on fears of a recession that would for sure hit company earnings. Pure logic, except one could speculate why the stock markets’ Wile E Coyote moment had lasted that long.

And then S&P announced its downgrade. Since that moment stock markets have traded sideways under high volatility. Bond yields have fallen as more evidence of the economic slowdown came in. In other words, there has been NO effect of the S&P downgrade.

But since the economic slowdown was now sort of old news, the stock markets had to find something to rationalise the palpable fear. Maybe France will lose her AAA-rating (quickly denied in unison by the tree big ratings agencies)? Maybe Italy will collapse (with a government debt at the same level as 8 years ago)? Maybe Spain may not be able to cut it (with a budget deficit and a government debt lower than that of the USA)? The Euro, then? Will it collapse (it has traded in a narrow range over the past weeks)?

Everywhere we look, things look pretty much the same as they did 4 months ago. Some uncertainties have been removed (the Greek restructuring) and some new uncertainties have appeared (the slower growth worldwide). For investors with a longer memory than 2 market days, it is obvious that the moment where the stock market discovered the slower growth, something was bound to happen.

It is particularly interesting to hear market participants now quickly turning into experts on German domestic politics. They are now looking for shards of evidence that Chancellor Merkel may throw overboard well-established (and healthy) policy principles in order to calm the nerves of stock market participants who have already forgotten everything that has happened over the past month.

I am not trying to say that everything is OK. Even if I disagree with the sometimes brutal austerity programmes and believe they will cost economic growth in the future, a lot of things are being done in Europe to fix the situation.

Unfortunately, structural problems in the Eurozone cannot be fixed within a 24-hour news cycle. Germany will eventually cave in to Eurozone bonds. But only after a revision of the EU Treaty that gives real teeth to a European fiscal authority and only after several countries have had the time to amend their constitutions in order to implement the new treaty in local legislation. That will not happen anytime soon.

We will hear more nonsense from the stock markets. The best antidote is to try and keep the focus on what is the real driver of events: it’s the economy, stupid.

Why Germany will not accept Eurozone bonds

There is a lot of guesswork going on in the financial press about Germany’s apparent refusal to condone the issue of Eurozone bonds. Such bonds are bonds, issued by a relevant institution of the EU, underwritten by every member state, and the proceeds of the sale of such bonds could then go to member countries that have problems borrowing money in the financial markets.

Financial journalists have a tendency to dismiss politicians as bumbling idiots because they do not do everything the markets demand. In this case, we hear that the market wants bonds issued with complete, gold-plated German guarantees.  Germany is not likely to accept that.

It is not because European politicians are incompetent. It is because the “battle to save the Euro” is played out on many levels. The upper level is where the panic has been: Something was needed to “rescue” Greece.

At a deeper level, it is about sovereignty. And about moral hazard – again. A look at history gives some important clues

Since Germany accepted the principle of a monetary union in connection with the German reunification, nothing has been more constant than the German unwillingness to underwrite moral hazard. Early on, Germany had spotted that the Monetary Union would give countries such as Italy the possibility of profiting from lower interest rates while maintaining the right to flood the market with government bonds denominated in EUR. As a result, Germany pressed hard to have a “stability pact” that would put at least some limitations on the more irresponsible governments in the Euro-zone.

As we all know now, nobody took the Stability Pact seriously, and it was never enforced. Germany’s nightmare came true.

The Stability Pact was only a second best. Germany, already familiar with a federal structure, would have preferred a Euro-zone fiscal authority. In the ‘90s this was unthinkable, as the governments jealously guarded their prerogative to collect taxes and decide government spending. It is after all one of the key elements in politicking.

Now, almost two decades later, Germany’s attitude is fundamentally the same. Germany will not underwrite Eurozone government bonds unless moral hazard is taken off the table. Germany will not bail out government after government because they have behave recklessly with their own public finances.

Under the impression of the market turmoil several countries are increasingly understanding that it is impossible to have a monetary union without adequate institutions. As a result, ECB has been permitted to expand its activities way beyond what its charted allows it to do. Some governments are ready to consider some kind of federalism in fiscal matters.

France resists any such idea. President Sarkozy has repeated what every president before him has stated. The prerogative to decide on taxes and spending lies with the French government.

In my view, France is playing with high stakes here. The French economy has not been “liberated” from the government influence and is increasingly lagging behind the German export locomotive. Nevertheless, France insists on being treated on a par with Germany. In Berlin this is accepted because membership of the Eurozone is a geopolitical imperative, and a Eurozone without France AND Germany is irrelevant. So France is playing on Germany being willing to go further in saving the Eurozone than has already been the case.

I would not bet on that happening. After all, the basic tenet of German policy towards the economic policy in the Eurozone has remained unchanged for a very long time. It makes complete sense that one country should not write blank cheques to everybody else. The financial markets may rail against German inflexibility as much as they like.

But there is no reason to expect that Germany should listen. Money talks. It is Germany holding the purse strings, and that gives a guarantee that Europe will listen.

In case anybody wants to have a short summary of Germany’s position, Finance Minister Schäuble laid it out clearly last year in Financial Times. It is worthwhile reading again.

Thrift's Paradox or how economics can be made simple

We are all slaves to dead economists, the (late) British economist JM Keynes famously stated. A lot of politicians on both sides of the Atlantic have committed mistakes that indicate that they could need a hefty dose of pre-Keynes thinking. I am talking of the Thrift’s Paradox, first formulated by Mandeville in 1714. Put briefly, it states that if we all save to become richer, we all end up poorer.

It is a brief statement, and to most people without understanding of economics, it seems like simple nonsense. If something works for me (saving to improve my financial situation) it must also work for the government.

It sounds obvious. But it does not make it any more correct. If I save, it means that somebody else’s business will suffer a lack of demand. And if a lot of consumers decide to hold back on consumption, it will mean that a lot of demand disappears. In the end it is felt all the way down to the producers and they will respond by reducing output and laying off staff.

This simple mechanism is one of the most misunderstood issues in economics. It is also one of the most misused. It is easy to make political soundbites by comparing the public sector to a household. It is difficult to catch voters’ attention while trying to explain why it is wrong.

In the current situation, households on both sides of the Atlantic are saving in order to improve their balance sheets. That leads to lower demand. It would only be normal if the government sectors would do the opposite, spend in excess of the revenue, in order to keep the economy going during the transition. The public sectors can then – later – concentrate on improving its balance sheet. Usually, the governments are then also helped by a sprinkling of inflation reducing the real value of the debt.

Because of the suddenness and the depth of the economic setback in 2008/2009, many governments are running sizeable deficits – induced by lower tax revenue and increased spending related to unemployment. Since late 2010 significant efforts have been made to reduce government deficits. That austerity hits us now.

In the US, a weak president has left the field open to voodoo economics espoused by an uncompromising Tea Party. In Europe, the strongest economy, Germany, is also the one least inclined to add stimulus. And Germany will not “save Europe” until Europe’s institutions have been reformed – which is being blocked by France.

Central banks are the only ones left holding the rope. They do not have an awful lot of rope to give. Economic growth estimates will be adjusted downwards in the near future. A period of slow growth seemingly lies ahead. A lot of it caused by a wrong policy reaction, caused by the wrong political philosophy at the wrong time.

For once I will quote from the Economist's Free Exchange Blog. (Article from 28 July 2011). It reads:

“The challenges facing Europe and America are big, but they're not mysterious. In Europe, the issues are sovereign debt, vulnerable banks, and a poorly designed currency area. It's not tricky to see what must be done. Peripheral debts should be addressed through austerity, sure. But unsustainable debt loads need to be written down. Banks should be recapitalised to prevent trouble in financial markets. Emergency funds should be bolstered to fight sovereign and banking contagion. And substantial fiscal integration must take place, including fiscal transfers to support peripheral economies while they get their budgets in order. The central bank should also stop fighting the phantom of accelerating inflation.(...) “Again, it's not like the correct policy path is incredibly complicated. Here, I'll sum it up in three quick steps:

Don't cause a major crisis.
Do spend more and tax less for the next year or so.
Do spend less and tax more after that.”

Wonder how far stock markets will have to fall and unemployment will have to increase before politicians get it. If they don’t, well...

It's the debt, stupid

Stock markets are plunging on an unappealing cocktail of worries about economic growth, the handling of sovereign debt problems, the apparent inability of politicians to bail out the markets when the markets really want it, and a handful of other assorted ailments. 

Given that analysts now realise that growth in 2H of 2011 is going to be slower, they are working overtime to adjust earnings estimates. Those estimates will invariably be lower than the pie-in-the-sky estimates of just two weeks ago, and the assumed valuations of the stock markets may take a serious blow.

How come that the adjustment to slower growth has come so quickly? At my company, Origo, we have warned about the “soft patch” ahead since late March, when early indicators showed that the US economy was in for a slowdown. European indicators have been unequivocal since April. That was also the month when commodities took notice.

On the other hand, bond markets have been right on the ball this time. Bond yields of high quality sovereign debt have fallen in the past months, giving another clear indication that something was afoot.

However, indicators of (stock) market euphoria have shown the increasing divergence between the optimism in the stock markets and the increasingly gloomy economic background. The speed of adjustment indicates what has been obvious for some time: stock markets have been living in their own little bubble for a while, and that bubble has now burst.

Summing up all these indicators, we arrive at a picture of the best announced stock market correction for a decade. The stock markets have yet again failed to predict important economic trends. Now they are rapidly adjusting and “Double-dip Recession” is now a favourite buzzword.

Which brings me to my point. For those who believe that the decline in the stock market reliably predicts a new recession, remember the famous dictum of the late economist Paul Samuelson: “The stock market has predicted nine of the last five recessions.”

I do not think we are heading into a global recession, i.e. a new period of negative growth. But I do believe that we are heading into a period of growth below trend. Remember that this economic crisis is not your standard run-of-the-mill recession. We are cleaning up after a major debt-fuelled party. It means that households, particularly in the US and the UK have to redress their balance sheets. It takes time to bring down debt, and in that period consumption has to be lower. Obviously it also hurts the banks that have financed the party.

It would not have taken more than a few years if the public sectors were in a position to let their balance sheets deteriorate for a period. That has historically been the role of the public sector in smoothing out economic cycles. But many countries were not in that position when the downturn started in 2008. Public sector finances in USA, UK, and some smaller European countries were hit full force.

At the same time the countries that could have afforded to expand their balance sheets were gripped by fiscal conservatism. The results have not been encouraging. We now have a situation where both private and public sectors are working to consolidate their balance sheets. That leaves the monetary policy to do the job of getting the economy moving.

It can’t. Monetary policy can only create the conditions for growth, and central banks have certainly done so. But when the consumers and business leaders are more focused on reducing debt than increasing loans, adaptive monetary policy won’t work. In such a liquidity trap, the money created by central banks in all likelihood fuels speculation in financial assets instead.

Oh, and in the longer term, it may be inflationary. Some voices are already afraid of an impending hyperinflation. In the big picture, however, such fears are pushed aside as asset reflation is supposed to make consumers feel better and hence more prone to consumption.

Central banks can reliably be counted upon to support the stock market this time around, too. It does not change the fact that we probably are heading into that period of below-par growth that may last for quite a while. It may not be a recession, but growth will be slow enough that it feels like one. I don’t know who came up with the expression “the new normal”.  But I do think that it is what we are looking at now. 

Will China speed up a floating of the CNY?

It is interesting to observe China’s government join the chorus in demanding that the US government clean house and get back to a situation where economic policy is based on facts rather than woodoo and political blackmailing.

I could not agree more, but it is fascinating to hear China indicate that unless something happens, the country will have to reconsider its position as the world’s largest holder of US treasury bonds. Either it is complete nonsense, or else the Chinese authorities are telling us something. The timing is impeccable.

With everybody being busy panicking it is a good time to make important political statements that will not be seized upon by protectionist US politicians.

To repeat the obvious: as long as the Chinese current account is in surplus AND as long as the Chinese government opts for a (very) slow appreciation of the CNY against USD, China has no choice. The Central Bank is forced to purchase USD denominated assets in order to avoid an appreciation of the CNY. As long as the currency peg is maintained, Chinese worries about the value of the dollar are just theatrics.

China has no effective mechanism for absorbing the boost to domestic liquidity that comes when Chinese exporters exchange their dollars for CNY. This huge boost to the domestic liquidity is easily the most difficult issue for Chinese policy makers to control as it drives domestic inflation upwards. It forces the central bank to increase interest rates, when in fact the correct thing to do would be to sell CNY-denominated government bonds to the public.

As long as China does not change her currency policy, the harsh words about the US government and the need to replace to dollar with another reserve currency are simply noise, aimed at positioning China favourably towards their own constituency, a large number of developing countries. But the words will not be followed by actions.

However, something else may be brewing. In a series of articles, Yu Yongding, currently President of the China Society of World Economics, and a former member of the monetary policy committee of the Peoples' Bank of China as well as Director of the Chinese Academy of Sciences Institute of World Economics and Politics has indicated that the Chinese government is ready to move a bit faster towards letting the CNY free itself from the peg to the USD.

There is no doubt that the Chinese leadership finds itself in a dilemma. The USD peg has been instrumental in building up Chinese exports and has created a huge flow of investments into China. But now that policy creates other, insidious domestic problems. Yu Yongding’s articles indicate that a serious discussion is going on inside the corridors of power in China.

Yu Yongding is adamant that a currency reform must happen on “market terms”. Translated to plain talk it means: We will not do it if it can be seen as a result of American pressure.

While this kind of exegesis may seem irrelevant as the stock markets are taking a pounding, it is worth noticing that the symbiosis between US deficits, Chinese surplus and a CNY-USD peg has allowed us all to have lower interest rates than we have really needed. It has been one of the important elements in creating the debt-fuelled boom that burst in 2008 (of course, bad regulation and plain greed were other important drivers).

So if China is now signalling a further, more significant step away from the need to buy USD treasury bonds, the world better sit up and listen. The impact would be far bigger than further downgrades of US debt. The ensuing increase in bond yields would be sufficient to actually force the savings balance of the USA towards an improvement. Not a bad idea. But it would help to keep US growth below trend growth for a decade or so. And the rest of us certainly would not like that.

S&P downgrades the US and their own importance

So Standard and Poor’s has stripped the USA of the AAA rating for its federal debt. A lot of media attention is paid to this fact and legions of experts are being asked by serious-looking news presenters: Is this really the end of the world?

Fortunately it is not.

My initial reaction was that if Standard and Poor’s put the same good analysis into the US government debt as they put into the analysis of Sub-Prime Mortgages, we are probably fine. Readers are reminded that Standard and Poor’s together with Moody’s and Fitch were caught pants down having essentially eschewed even a minimal research effort in order to maximise revenue when CDO’s were all the rage at 5 years ago.

Since then, the three US government chartered ratings institutions have done quite some work to re-establish their tarnished image and - one presumes – their revenue. They have not really succeeded.

It is a fact that the ratings institutions are home to a series of conflicts of interest that would have clients run away screaming. Their business model is that they are paid by the issuers of the bonds to be rated. They cannot be sued for damages in case they are mistaken, since they simply get away with invoking the First Amendment to the US Constitution: Their expensive analyses are simply expressions of the right to free speech. They have a government-approved monopoly on the rating of nearly anything. Like auditing companies it is considered suspicious if an issuer terminates the contract with them. They do not shy away from rating a whole “production chain” of derivative products, including the insurance companies.

Despite an appalling track record, these institutions still hold considerable power. It is because pension funds and other institutional investors across the globe have given themselves internal guidelines that essentially dictate the portfolio composition on the basis of the ratings of the bonds.

Doing so of course frees the institutions of the responsibility for having an informed opinion about the assets they hold. That reduces the cost of running an investment department considerably.

It is not because of the quality of their analysis that ratings matter. They matter because they have become a convenient replacement for independent thinking. And because of the way huge amounts of money may move as a result.

The US government and congress of course now protest: S&P are wrong. So did the Greek government and parliament as the ratings downgrades fell thick and fast over Greece the past 15 months. They know very well that money may move out of their assets as a result, pushing up interest rates in the process.

Fortunately there are signs that the financial markets have learnt to take the ratings with a pinch of salt. After some noise, investors probably will conclude that there are no compelling reasons to reshape portfolios on the basis of the downgrade alone.

The only alternative is of course to modernise the ratings institutions. They should be made liable for their own mistakes (well, not exactly in fashion in the financial sector these days). More ratings agencies should be established. Government licensing should be withdrawn and new entrants should be given easier access. Government or supranational institutions should get involved. That would be the only way of putting an end to the political meddling and abuse of monopoly powers so blatantly displayed by the ratings institutions.

Greece vs. Lehman? Look for the next AIG instead

Much of the discussion about how to restructure Greece’s debt has focused on the banks and other institutions that will take a hit when the unavoidable happens. It is in fact pretty simple. As a sovereign issuer, Greece of course knows precisely how much debt is outstanding. Regulators in other countries have a pretty good idea who own the debt, since they can force the banks to disclose their holdings. So when politicians are negotiating, they know who will lose. It is just not good style to tell.

The fact that 100’s of banks would take a hit has led to comparisons with Lehman. That is a wrong comparison. When Lehman blew up as a direct result of their own incompetence, the real surprise was that AIG blew up as well. The culprits were of course CDS’s.

Buyers of CDS’s buy insurance against a credit default – lyrically referred to as “protection”.  One does not need to have given credit, i.e. to hold bonds in order to buy CDS’s. Buying or selling CDS’s has become a simple speculation in a default with volumes of "protection" traded often massively exceeding the volume of underlying bonds. As the Lehman/AIG debacle showed, if too many have speculated in a default happening and on the other side we find only one major seller of CDS’s, the situation can become unmanageable.

A combination of gaping holes in the accounting rules, a complete lack of transparency, and plain incompetence and greed created a situation where the US government chose to simply pour billions of dollars into AIG. The purpose was to make sure that the buyers of CDS’s on Lehman debt did not end up in a situation where the “protection” they had bought did not vanish. It is by now a well-known story that a bank like Goldman Sachs received cash compensation to the tune of USD 14bn directly from the US government via AIG’s accounts.

Back to Greece. It is obvious that a debt restructuring is necessary, and Germany has suggested a voluntary maturity extension. It had to be “voluntary”, i.e. the holders of Greek debt would have to accept swapping short term debt for long term debt without saying: “hey, you are forcing me to do this, it means Greece has defaulted on the short term debt. That is a credit event”.

The important term here is “credit event”.  What constitutes a credit event is not defined by politicians but by ISDA, the International Swaps and Derivatives Association. It is a private organisation which serves as the financial market’s own watchdog over OTC transactions. In other words, even if European politicians were hoping to construe a maturity extension as voluntary, ISDA could simply say that they were having none of it and define it as a credit event.

In that case, all the CDS’s bought and sold on Greek government debt would have to be settled, the credit default protection would be activated. And here lies the rub.

Despite several well-meaning political efforts to force open the CDS market, it is still largely unknown how many CDS’s have been established on Greek debt. Nor do we know for certain who are the holders and who are the issuers.

Whereas holders of Greek government debt are relatively simple to identify, it is close enough to impossible to find out who is sitting with the CDS risk. It may be banks. It may be commercial companies. In other words, there is a sizeable risk that the holders of Greek debt will not be alone in taking a loss. Issuers of default protection will also take a hit, and they may or may not have enough capital to survive a credit event. This uncertainty could indeed create a new freeze in the money markets. We know what that leads to.

If that were to happen, it would be the second time in three years that the CDS market proved dysfunctional. Which leads me to my real point.

Since 2001 corporate bonds and particularly junk bonds (conveniently renamed “High yield bonds”) have been very strong performers across the world. This is partly due to the existence of CDS’s , which have allowed the treasurers of the corporate world to have the illusion of being able to manage the default risk on the issuer of the corporate bonds.

If Greece fails (as I believe it will), it could lead to a major blowout of CDS’s, where nobody would know who would be hit. And in the after math, it could lead to a major loss of confidence in a system which has blown itself up twice. The effect could very well be a visible widening of credit spreads worldwide.

I have earlier written that I believe risk is priced way too cheaply. It has become cheaper since back then. A “credit event” on Greece could be one step in the direction of normalising the price of risk. But it would not be pretty.

The value of implicit bank guarantees

In an event little noticed outside of Denmark, the Danish FSA and the finance ministry let the country’s former fifth largest bank, Amagerbanken, go bust . This happened after a couple of attempts at recapitalising the bank. Remarkably, the holders of Amagerbankens’s bond debt were told that they could line up with other creditors to get their money back.

It has created quite uproar in Denmark’s financial sector, where previous bank collapses had been handled with “due respect” for the interest of bond holders. 

As a direct consequence, the international (read: the US) rating agencies have downgraded Danish banks several times since then, most recently at the end of May.

Predictably, Danish banks are lamenting the fact that the government has shown its willingness NOT to compensate bond holders.

Their spin is that the lower ratings mean higher funding costs and thereby a competitive disadvantage for Danish banks. So we are to believe that the FSA and the finance ministry willingly have weakened the position of the country’s own banks?

One could look at it differently. I have several times wondered why simple capitalist principles were not applied when it came to the banking sector. The answer is that a) the banks were much weaker than anybody outside the sector had expected and b) the banks have been very good at making politicians believe that it would be the end of civilisation as we know it if banks and their owners/creditors were to shoulder the burden of their own greed and recklessness.

If we look at it this way, Denmark is the first country that has shown the way forward (well, Iceland sort of did, too). If banks cannot survive with the capital they have, they go under. Those who had lent them money should take the losses, since money lending inherently is a risky business. That seems a very healthy principle for “bank resolution”, i.e. dealing with dead banks. And by the way, it was exactly what Sweden did during its systemic banking crisis in the early ‘90s.

But what about the increased funding costs, stemming from the absence of a government guarantee to the lenders?? 

The right way to look at this is not to bemoan the situation of the Danish banks, but instead look at the difference in funding costs as the market value of the implicit government guarantees. We are in a situation where banks in other European countries have higher ratings than Danish banks, simply because the governments are expected to pick up the pieces if another bank blows up. It could hardly be unhealthier.

I quote former US Secretary of the Treasury and Chief Economic Advisor to President Obama, Larry Summers, who in 2000 said:

“While conditioned, precautionary financial support is constructive in some cases, the risk inherent in systematic availability of unconditional credit to countries can be summarized in two words: moral hazard. ... It is certain that a healthy financial system cannot be built on the expectation of bailouts.”

Summers later minced his words in a quite spectacular way and helped engineering the biggest giveaway of taxpayer money in modern history. But that does not make his statement of 11 years ago wrong.

Banks’ funding costs should not be based on implicit guarantees. They should be based on the availability of a capital base sufficient for their activities. Incredible that it is so difficult to get this simple message across to the banks.

Well, an implicit guarantee does not weigh on the balance. It allows a higher financial leverage. And it creates the possibility of higher return to the shareholders and fatter bonuses to the bank management. Go figure.