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.

Post-restructuring, which future for Greece?

The events around Greece and its government debt are taking new turns every day. It understandably has the financial markets on tenterhooks. A good deal of the commotion comes from the fact that more and more economists and market participants are trying to do the math, and they end up with more or less the same conclusion: No austerity policy will make it possible for Greece to repay its debt. In particular not when the austerity measures are meeting increasing resistance from the voters.

Some of the more sanguine observers have begun to make – not entirely unfounded – comparisons between Greece and Argentina. Two decades ago Argentina introduced a “currency board” whereby the currency was pegged to the USD in an attempt to control inflation. After an initial period where exports picked up strongly, the domestic economy floundered, unemployment increased, government deficits exploded, and the current account worsened. The government debt was largely sold abroad, where investors believed in the strength of the currency board.

However, in absence of serious reform, the government deficit continued growing, and servicing the debt meant a serious further strain on public finances, and even a wave of privatisations was insufficient. In 2001 the currency board evaporated, the currency depreciated by a whopping 70%, and in 2002 Argentina defaulted on the debt. It has taken nearly a decade of economic hardship to rebuild the economy and in 2010 Argentina offered to resume paying back the debt.  

There are some eerie similarities between Greece and Argentina. Most significantly, both entered into a very rigid currency regime with an economy that was clearly not ready for such a move. The ensuing drop in interest rates mainly led to an increase in property prices and consumption. The economy did not in any way undergo a development whereby investments were made in sectors that would increase the export competitiveness.

That is the main problem with Greece. No matter what happens to the Greek government debt (my guess: debt rescheduling, followed by a small haircut, eventually default), or Euro membership (my guess: will be maintained for now), in order for Greece to move forward, some serious structural reform is necessary.

The problem here is that “serious structural reform” has a meaning that not everybody likes. I may mean that established power concentrations will have to be dissolved, labour market conditions may have to be liberalised, public sector reformed, a serious privatisation programme will have to be introduced.

All of that will upset the existing status quo and that is usually not wanted. But since Greece’s exit from the
Euro is far away, such reforms will have to be more profound, since no currency devaluation will help the adjustment. I am afraid that the full weight of the necessary changes in the aftermath of a restructuring has not yet dawned on all parties.

It is interesting to see that the European consensus of “extending and pretending” is beginning to unravel. Whereas Germany is beginning to see the advantage in restructuring Greece’s debt while Spain and Italy have strongly denied that such a thing could happen. They are obviously afraid that they will stay out of the limelight as long as EU covers up for Greece. That position becomes increasingly untenable as time passes. 

A Japanese reactor meltdown will not undermine the euro

Regional elections in Germany gave negative results for Chancellor Merkel’s Christian Democrat Union. The disaster at the Fukushima nuclear power plant has apparently given the Green party a boost, and so much so that all other parties also lost ground. In the financial press, Merkel’s weakening domestic stance is likely to be used in attempts to discredit the new European Stability Mechanism.

The arguments will be something like: Merkel is losing support. Younger generations of Germans are unlikely to accept the sacrifices imposed by the German financing of the bail-out of Southern Europe. Merkel will be less firm in her support and will try to impose further draconian measures on the countries in need of a bailout. If she does not have her will, Germany may simply withdraw from the euro. 

Given the German-bashing that in particular the London-based financial press thrives on, there is nothing new in that view. However, there are two things that need to be said in return. On 12 March 2010, German Finance Minister Schäuble published an article in Financial Times laying out the principles that Germany wanted to form the basis for any new agreements.

German policy towards the Euro crisis has been in line with Schäuble's statements. Nonetheless, there has been a lot of talk that Germany has in fact only saved her own banks and that Southern Europe/Ireland are “sacrificed” in order to avert significant losses in German banks.

Yes, German banks have certainly been exactly as greedy and silly as any other banks. And yes, there may well be an important element of self-help in the German bankrolling of the ESM.

But let us not forget that Greece had falsified public accounts to fool the world while the government tax collection was in shambles. Ireland let herself go in an orgy of cheap credit while using corporate tax rates as a means of stealing jobs from other EU-countries. Portugal studiously avoided economic reform and it it shows now, as the rest of the world is on the mend.

Still, the German policy is built on the rather healthy observation that you cannot have a monetary union unless there is some kind of cohesion in the economic policy.

As Germany is again pressured into taking out the check book, of course concessions are being forced upon the most profligate EU members in order to secure the long-term viability of the Euro project.

The far more important point is that Germany will not leave the Euro, irrespective of local election results. Membership of the Euro is one of the geopolitical imperatives Germany must live with, as it is the guarantee against ever again having to fight a two-front war. Following the defeat in 1945, clear-headed thinkers across Europe understood that in order to make Germany change her ways, it was necessary to change the strategic position, whereby Germany was facing Russia on one side and France/UK on the other side.

By tying Germany into the EU, the most important military enemy, France, was turned into an ally. When the Berlin wall fell, French President Mitterrand managed to convince (maybe even bluff) then-Chancellor Kohl that a currency union was the best way of anchoring Germany in Western Europe, now that the big enemy in the east was retreating.

Germany has not at any point – irrespective of whether the foreign minister came from CDU, SPD, FDP, or indeed the Green Party – questioned Germany’s Euro membership. No matter whether this week-end’s skirmishes will eventually undermine Chancellor Merkel, whoever succeeds her as German Chancellor must accept the geopolitical situation and embrace the EU solution of having a single currency.

However expensive it is to support the Euro’s continued existence, the alternative to doing so would be a major transformation in Germany’s geostrategic situation. It would require a complete political about-face and would mean that Germany again had to ready herself for a two-front war, as the demise of the EU would follow. Given the price of this alternative, Germany will remain a firm supporter of the Euro. But will of course not be willing to be taken for granted to pay for the foibles of everybody else.

Three weeks into the market correction, dynamics may be changing

The guessing game has been on for some days now: Will the Japanese disaster be positive or negative for the world economy. Personally, I believe that initially it will be negative and then turn positive as the efforts to rebuild gathers steam. But it really is anybody’s guess, and to be cynical about it, it does not really matter. At least not for the financial markets. So while my thoughts go to all those who have lost lives and property in the disaster, the markets are more interested in the global policy reactions.

In that respect it looks fine. Japan finally joined the club of countries embarking on “Quantitative Easing”, also known as monetising public sector deficits. G7 and others are intervening in order to drive down the JPY, which adds strength to the monetary initiatives already taken. It all looks good and the markets have taken their cue from the developments. Stock markets will profit in the short term.

Over the past five-six months the stock markets have been supported by the fact that global economic data have surprised on the upside, indicating that the world economy is doing a good deal better than expected around the middle of last year.

This will not continue. 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, they will begin to have negative surprises. A new revision cycle will begin and the market mood will again turn.

On 22 February I wrote that the market had a set up for a correction. Not because of overvaluation or what not, but simply too many had become complacent about risk. I thought the unrest in North Africa and the Middle East would be the trigger. In the end it was a combination of that and the Japanese disaster that caused the markets to run for cover. The policy reaction around Japan has already taken some of the uncertainty way. I am not sure that it is enough to put an end to the current market correction.

More on the New Inflation

In a recent article in New York Times, Christina Rohmer, former chairwoman of the Council of Economic Advisors to President Obama, describes a debate that limits Fed’s ability to act decisively to support economic growth. It is between “empiricists”, i.e. those who want to see solid evidence of inflationary pressures before they begin to rein in the monetary policy, and the “theorists”, who claim that one has to step on the brake in rational expectation of future inflationary pressures.


It is Rohmer’s claim that the schism between these two approaches effectively paralyses Fed at a point in time when it needed to do more to stimulate the US economy. She lays out the most important channels through which low interest rates stimulate the economy. Courteously, she remains silent on the theories that would be used to explain to explain the emergence of inflation when a large excess capacity is available.

Rohmer should know what she is talking about. A scholar renowned for her studies of the Great Depression in the 30’s, her contention is that by keeping the interest rates low, the interest sensitive sectors of the economy will eventually pick up. Manufacturing (cars!), construction etc. will all be strengthened as a result of lower interest rates. Just like it happened in the 30’es.

By making it clear that deflation will be fought at almost any cost, real interest rates are reduced. Since the difference between present nominal interest rates and expected inflation is reduced. That reduces the perceived financing cost and stimulates investment.

Given the recent data from the US housing market, there is no doubt that Christina Rohmer has a strong point. House prices are still falling, and sales of repossessed property are a significant part of the overall turnover in the market.

At the same time, there are no signs of inflationary pressures. And yet we see that across the world, central bankers are now beginning to worry about inflation creeping upwards. As I wrote in my blog earlier, it has to do with your definition of inflation. As long as one only considers “core inflation”, I share Christian Rohmer’s view.

But there is a little snag. In the 30’s the financial markets were not as developed and integrated as now. Financial institutions could not freely invest abroad. Commodities markets were largely reserved for those who needed the physical product. I need not describe how that has all changed. Just note that banks and other financial institutions are now major players in the commodities markets.

We know that the QE programs have given the banks access to tons of liquidity that they have not passed on the consumers. It seems fair to assume that the money instead has remained within the financial sector, invested in stocks, bonds, and commodities worldwide. Given that the commodities markets are the smallest by volume there is every reason to assume that the combination of monetary policies and the freeze in the normal credit markets has led to significant asset reflation. Even Ben Bernanke has stated this publicly. And of course it has also been a contributing factor that the Asian economies have recovered nicely from the downturn.

US monetary policy has contributed in a significant way to the headline inflation through the price increases in food and energy, the two “volatile elements” of inflation.

It has already given Rohmer’s “theorists” more reasons to be aggressive about reining in the monetary policy prematurely. Same situation in Europe where Axel Weber’s withdrawal from the race to become ECB’s next chairman has left the situation wide open. Prospective candidates are now jockeying for position by improving their hawkish profile, well knowing how tough talking on inflation could garner support from Germany.

So the situation is that the spill-over into the commodities markets from the US monetary policy is now leading central bankers everywhere to indicate that monetary tightening should be just around the corner. That would not be the right thing to do just yet.