Anthony Peters, SwissInvest Strategist
I WAS REMINDED recently of a fierce sales lady I used to work with – or against, as it often seemed at the time – called Felicity Blair. Flick, as she was known, was of strong opinions, to put it mildly, and I recall a run-in with her over the question of whether markets are always right.
What brought her to mind was a conversation with a portfolio manager friend who has helped me keep up to date on what is going on out there while I sit with my leg up, recovering from surgery.
I was struck by the way in which the Bund/OAT spread, the bellwether of the eurozone core, has contracted to 70bp and the way the bond markets had moved in the past three months.
Bunds rallied to 1.17% twice in the period as fear took hold, although, in mid-June, they were trading north of 1.60%. The movements of early June and those of the past 10 days look remarkably similar and it was in this context that I was wondering whether the markets were right or not.
It was my PM chum who assured me that the markets were always right and I knew I had heard that line somewhere before.
BUT ARE THEY? If they were, then we would never have been trading Triple A mortgage bonds at near Libor flat ahead of the great credit crash of 2007–08.
The fact is that an artificial market had been created by what became known as the shadow banking system – the term used to describe the unregulated credit markets which sprung up around structured credit and the abstraction of the relationship between borrowers and lenders.
There is a law in physics which determines that you can convert energy but that you cannot destroy it. The same rule can be applied to credit risk. No matter how many layers of structuring you apply, if a borrower defaults, someone is going to lose money, irrespective of how many layers of abstraction have been packed around the original risk. The core of the credit crisis was that even if we knew who was defaulting, we could never find out who was going to lose and it was this uncertainty which prompted the so-called “credit crunch”.
Now that ECB president Mario Draghi has declared that the euro will be defended at all cost, I begin to wonder whether we might not be about to be treated to the alter ego of shadow banking, namely shadow central banking.
No matter how many layers of structuring you apply, if a borrower defaults, someone is going to lose money
By way of the many bailout vehicles which have been set up over the past two and a half years since the eurozone crisis began to take hold, the authorities are trying to find a means to stabilise markets and in doing so have created an alphabet soup of vehicles worthy of the structured credit markets at their best.
In declaring he’d do “whatever it takes”, Draghi has offered up the prospect of unlimited leverage which, in the private sector, was the root cause of getting to where we are today.
But left pocket/right pocket central banking no more changes the dynamics of the borrowing and lending process than does packing corporate risk in a CDO-squared or sub-prime mortgage risk in an RMBS.
I recall that when the EFSF was set up, many observers questioned whether it was anything other than one large CDO. The rather weak official counter-argument was that it couldn’t be because it didn’t have tranches. But that did not change the fact that it is a highly structured lending vehicle.
Those officials who wish to offer it (or the ESM) a banking licence so that it can borrow directly from the ECB would make the inventors of the old Cayman Islands SIVs and credit conduits look like spotty-nosed boy scouts.
IF YOU ARE Greek or Spanish, you might by now be beginning to wonder whether the price you will be paying for generations to come is really worth the benefits which you are supposed to be enjoying but are no longer sure that you are. With 55% of your under-30s unemployed, how are you to believe that you are defending the best of all possible worlds? If you are German, you might be asking the same questions, should you be allowed to.
One has to feel sorry for Draghi as he wriggles around trying to find the solution to an insoluble equation. The ECB’s much-vaunted independence is gone. And all the while, the debt mountain is showing no signs of wanting to shrink or deficits of wanting to be meaningfully cut or even turned into primary surpluses.
The shadow banking system was the creative result of orthodox banks’ desire to optimise capital usage, to create lending capacity where none was left. Citibank’s Alpha, Beta and Gamma were the vehicles which launched a 1,000 ships, most of which ended up on the rocks. What is there to assure us that, in the fullness of time, the shadow central banks will not end up making the same navigational miscalculations?
As one high-net worth individual said to me: “It’s hard to argue with what you say. All we can hope is that you are wrong.”