Wednesday, 15 August 2018

We are all junior investors now

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James Saft, Reuters Columnist

(Reuters) - If the Greek bailout has proved one thing it is this: we are now all creatures of government. The rescue itself is only of passing interest – it won’t be the last and Greece’s virtual default will become real one of these days. Instead, it is the way in which the interests of private investors have been officially subordinated to public claims that will have a lasting impact.

At the very least, expect investors to begin to demand higher returns to compensate them for these risks

Under the terms of the deal the European Central Bank and national central banks will be excused from taking any losses on their holdings of Greek debt. Private investors, in contrast, will take a loss of about 75% and are expected to be made subject to collective action clauses now wending their way through legislation in Greece. Those CACs will force investors to tender their bonds and take a hit, all while central banks skate serenely away. The ECB and national central banks will remit their profits on Greek bonds to the Greek government, a helpful gesture, but one which is cold comfort to an investor who now finds their interests subordinated.

“Of course, it is not in the politicians’ interests for the central banks to bear any losses as a result of lending to Greece and of course it is the politicians that set the legal and regulatory framework. Not only can politicians change the goalposts, they can change the ball you are playing with. Politicians, and the authorities, are exercising their imbedded power,” writes Richard Woolnough, a portfolio manager at British fund manager M&G Investments.

Woolnough objects to the deal on the grounds that, besides sparing official creditors, it rewards the “locusts” who bet against Greek debt but disproportionately punishes investors. The European Stability Mechanism, a sort of permanent bailout fund, is expected to also be awarded status senior to private investors.

Surely, after this, who on earth would be a sovereign bond investor in a similar circumstance? If this is not a practical problem for the eurozone, it is because it is old news now that no one in their right mind would invest in a peripheral eurozone bond without official backing. Eurozone officials have, in essence, acknowledged that the financing of their weaker members can only be effected with official support, and with the support of banks, who are offered privileged access to ECB funding in a tacit quid pro quo for holding government debt.

A feature, not a bug

Market distortion by official intervention has become, in other words, a feature, not a bug. At some level this was always true, but in no way were markets priced for this reality. They may now begin to be.

For some time it has been clear that banks are creatures of government, only operating at the pleasure and with the backing of their national hosts and deriving much of their ability to profit from the gift of insurance that only states can bestow. We might perhaps have kidded ourselves before 2008 that this was not true, and many banks continue to maintain that it is not, but events have amply demonstrated otherwise.

Therefore if you invest in a bank, expect your stake to be subject to heavy regulation and even confiscation. That is right and proper; under the current set-up, banks can’t exist and can’t profit without the backing of states.

What’s becoming increasingly clear is that investors are being put in similar positions. Private investors in public debt now must recognise that they are very vulnerable to having their claims shoved below those of newer investors, namely central banks or other state institutions. This is actually far more problematic than the manipulation of banking, a government-gifted franchise. It is one thing for a government to set the rates for a public utility that uses natural resources that are part of the commonwealth. It is quite another for the state to impose penalties on bond holders of that utility simply because they can.

The central question is whether investors take their experience in the eurozone and generalise it to other sovereign bonds. If this is the way business is done in Europe, with the cooperation of the IMF, why would Britain or the US be any different if similar issues arose? Really this is simply one face of financial repression, that grab-bag of techniques hard-up countries use to corral cash.

At the very least, expect investors to begin to demand higher returns to compensate them for these risks. With global interest rates low, the extra interest that investors demand may be modest now, and may be obscured by the force of official bond buying worldwide.

One hint of inflation, one tremor of a financing scare outside of the euro zone, however, and the cost of mistreating investors will rapidly mount.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

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