Gambling on sovereign default may seriously disrupt equity and bond markets

IMPORTANT: Please note the disclaimer below before continuing!

Matters are coming to a head in the financial markets.

The yields on Spanish and Italian government bonds recently exceeded 6% for a while; at 7%, it is estimated, Italian public borrowing becomes unsustainable and Italy then joins Greece in the category of countries doomed to at least partially default on their obligations.

On the other hand, it's possible that the 7% point will not be reached, or if it is, not for long. So much depends on market confidence and as is well known, fear may trigger a crisis that is otherwise avoidable.

But so can the greed of speculators. While Britain's 1992 "Black Wednesday" made George Soros a reported USD $1 billion, the cost to the UK of its attempts to support the pound against his and others' shorting is estimated at over £3 billion sterling. He has since developed a reputation as a philanthropist; we could wish for a less expensive way to fund a benefactor. *

The difficulties in Europe come at a most unfortunate time for the USA, since there is now a showdown between President Obama and Congress over raising the debt ceiling for American public borrowing. The President has indicated that a deal needs to be struck by this Friday to give time for enactment by the August 2 deadline, which I guess will really mean more last-minute hard negotiating over this weekend. Brinkmanship is a dangerous game to play: it nearly blew up the world in the Cuban Missile Crisis of 1962, and then as now, everything depends on both sides remaining sane.

It's ironic that a financial elite, having looted the economy for decades and left it pretty much unworkable, then blames the losers and expects them to pay all the costs of putting things right, and that without delay. What nonsense: America's problem is private debt, which over the last 30 years has so enriched some of these born-again pecuniary Puritans. Yes, public sector workers have enjoyed great salaries and pensions compared to the People of Walmart (though please, say nothing about the top 10 hedge fund managers whose average earnings are $1.75 billion); but what fortunes have been made on the back of arranging mortgages on their increasingly crazily-priced houses? It takes two to tango; and the same number to quarrel, as we now see.

Well, the reckoning is coming, even if some won't pay their fair share of the bill. As "Mish" reported yesterday, the yield on the US Treasury 30-year bond is increasing and he is predicting a bond market revolt "sooner than anyone thinks".

And, scarcely believably, here come the speculators again. They made money packaging debt, making sausages with as much old roadkill as fresh meat in them; then they made governments pay for the consequences; now they gamble on which countries will go bust as a result. Last month, Martin Hutchinson reminded us that he'd warned in 2008 about credit default swaps, especially the ones that are "naked", i.e. insure events that would not in themselves result in any loss to the investor. This simply gambling, and it makes a bad situation worse; it did so, he argues, with Lehman Brothers and others, and will do so with Greek debt, where the loss on default will have added to it the cost of an estimated $100 billion in side bets.

Now there are those who will argue that the CDS market, though enormous ($60 trillion in 2008, half that now), isn't a dangerous one, exactly because it's a gambling operation. Loser pays winner, so it's a zero-sum game.

But it's not.

Firstly, there's the question of mispriced risk. Hutchinson explains: "Wall Street's risk management looks at normal price fluctuations and then assesses the maximum possible risk as a modest multiple of the daily fluctuation, it was completely inadequate in measuring the risk of a CDS book. That, in a nutshell, is why AIG went bust and had to be bailed out with $170 billion of taxpayer money."

Then there's the interaction between the speculators and the authorities. Goldmans Sachs was compensated by the taxpayer for losses on AIG debt, in addition to claiming on its CDS on the same. It's like getting paid twice on an auto repair job. Rather questionable, that.

And there's the risk of outright fraud, which is how rogue trader Nick Leeson destroyed Barings, Britain's oldest investment bank: he hid his losses in a secret account and increased his bets to try to recoup them. That put Barings' capital at stake in a way that the naive, old-fashioned management failed to foresee.

Which leads us to the problem of contagion. Banks can go bust, but their depositors are protected (subject to limits) by the FDIC. Not only does that puts the taxpayer on the hook, but the FDIC, being a corporation with limited assets, may itself become insolvent if the scale of losses is too great (in fact, that was the position only two years ago). We then have either partially-busted depositors, or (if politics forces it) a further burden on what under the circumstances is likely to be an already-distressed public budget.

And what if insurance and pension funds have to pay out on CDS contracts? As Hutchinson points out, banks have limited balance sheets, but the funds that represent security for the nation's savers have much more to place at risk in contracts that many of the fund managers won't properly understand or calculate - which made them such suckers for packaged debt (CDOs and variants). "Fool me once, shame on you; fool me twice, shame on me." Hutchinson, who ran a derivatives desk in the 1980s, assessed CDS as a "sophisticated scam". So I should like to know the total downside of CDS for pension and life companies. Could this result in massive extra welfare support for retirees?

Derivatives are the fourth horseman in Michael Panzner's apocalypse, or "Financial Armageddon" as his March 2007 book titled it (reviewed here in May of that year). The market, recently estimated at $601 trillion, is worth some 8.75 times the world's GDP (or nearly 40 times that of the US), so a relatively small percentage imbalance as per some of the ways illustrated above, represents a huge potential problem. The subsector including interest rate and CD swaps is expected to grow by 10% within a couple of years, according to Citigroup (itself a name to conjure with, in the light of recent history).

Will the Dodd-Frank Act prevent all problems in future? Not, I'd have thought, with many of the nation's brightest brains employed on Wall Street and perpetually looking for ways to game the system. I don't know the loopholes and weaknesses, but I'm betting on that talent, human nature and the fabulous scale of the incentives involved, to find them out.

One way or the other, the money looks as though it's going to run short. This will lead to increased reluctance on the part of lenders, and so raise interest rates and tank the market in existing bonds. Coming back to Martin Hutchinson, he wrote on Seeking Alpha at the beginning of this month, predicting an "epic" crash in September or December, though if things go wrong in current budget negotiations that date could come sharply forward. It seems inevitable that such a crash would also impact on equities, what with deleveraging and the depressing effect on demand of a severe deflation.

Will a mooted QE3 help? I'm not sure. What did QE2 do? The banks got a raft of money from government, couldn't find anyone who they wanted to lend it to and parked it at the Fed to get safe interest. In effect, the State is rebuilding the banks' reserves for them, on the drip. But as real estate continues to dwindle in price, the bank reserve ratios may actually worsen despite all this help. And whatever the outcome of current budget negotiations, the private debt ceiling seems to have been reached already, so the frightened consumer is hardly likely to shore up the economy with extra demand.

I cannot envisage how this can continue for much longer*, unless the government takes back from the Federal Reserve the right to issue money, in which case rip-roaring inflation is a possibility, followed by a total reset, as in Germany in 1923. But avoiding that is surely the point of a central banking system: not to have a Chancellor Havenstein operating 2,000 presses 24/7 printing currency with face values in the billions, truckloads of which were still waiting to move out on the day he died. Dropping dollars by helicopter might work in this terrible way (though C-5s would be more commodious); shoving money into the banks hasn't done so.

Perhaps the strategy will be debt default, but again I can't somehow picture the virtuous depositors being allowed to keep their dollars and see them multiply in spending power, even though at least one New Yorker appears to hold $100 million in a checking account. Is that a vote for cash as the best asset?*

Hutchinson's latest post advocates gold (an each way bet if you think deflation ends with a currency crisis), buying a house (even though he thinks it'll go down in value) and finally, a put option on Treasuries. Like me, he's struggling, really: gold is above its long-term inflation-adjusted trend, houses seems to be a bad investment for ready cash (unless you're one of the growing number of bottom-fishers snapping up distressed properties at 40% off) and options carry counterparty risk, which is where we came in.

In the event of a full-scale disaster, all bets are off. All I can suggest is diversification among all assets, plus holding some away from banks and other fiduciary institutions. And, of course, hope. ________________________

*Though I'm confused, it seems I'm in good company here:

"...even such "legendary" hedge funds as Soros' $25 billion Quantum are about as clueless as everyone else. Bloomberg reports that "the fund is about 75 percent in cash as it waits for better opportunities, said the people, who asked not to be identified because the firm is private."

The reason: "“I find the current situation much more baffling and much less predictable than I did at the time of the height of the financial crisis,” Soros, 80, said in April at a conference at Bretton Woods organized by his Institute for New Economic Thinking. “The markets are inherently unstable. There is no immediate collapse, nor no immediate solution."

- Zero Hedge
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INVESTMENT DISCLOSURE: None, except for (UK) NS&I Index-Linked Savings Certificates (similar to US TIPS). Otherwise, still in cash, and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

A reply from Mr Allister Heath, and my attempted rebuttal

Following my recent needling of Mr Allister Heath at City AM in response to his article calling for a new Ronald Reagan, he has kindly responded thus:

I agree with you that monetary policy was too loose in the US and in the UK (disastrously so under Lord Lawson in particular). However, I was focusing on Reagan's fiscal policies and didn't mention his monetary policy in my piece. While the latter was bad, it was no worse than what we have seen later and still see today - so I don't think it's an especially anti-Reagan point (we also saw far worse prior to him; in fact, the history of modern monetary policy has been one of failure in almost all economies). In fact, it is simply wrong for you to claim that monetary over-expansion started in the 1980s - we have been plagued by it ever since fiat money (and even before, for example when gold was brought back in large quantities to Europe by Latin American explorers).

As to the statistical dispersion of post-tax incomes you refer to, I agree that it has increased since the 1980s - but I do not believe inequality of outcomes as a goal, evidently unlike you. I do not believe that this kind of inequality causes crime. I'm much more worried bythe fact that some groups and individuals in society lack opportunity, for example because of poor state schools or because of perverse incentives created by the benefits system. But I think that low marginal tax rates maximise opportunities and economic growth, and hence welcome what Reagan did on that front.

To which I have framed a reply, as follows:

Dear Mr Heath

Thank you for responding. I am sorry to reply late but must plead pressure of work. May I perhaps take up a couple of your points?

1. I accept that Reagan's successors tended to permit the same disastrous over-expansion (I said "acceleration") of the money supply that, I must insist, did indeed begin on his watch. I shan't bore you with the graphs but the facts are undeniable. Yes, the money supply has had previous bursts - e.g. in the lead up to the 1929 debacle (and I'm familiar with the gold-supply-boosted inflation of the 16th century) - but 1980-ish was definitely a watershed in the postwar era. It's reaching a bit too far back to make tu quoque an excuse. However, I certainly don't exonerate his successors, either.

2. I also accept that when tax rates are high, tax cutting does help increase tax revenue as well as stimulating enterprise. But I'm not sure how much more tax rates should be cut from the 15% or so that effectively the American rich are currently paying. At the other end, I seem to recall research by - was it the IFS? - that shows the poorer sort are paying proportionately nearly as much tax as the middle class (something like 40%), thanks to indirect taxation.

3. You don't have to be a socialist - and I am certainly not - to query how (for example) the top ten US hedge fund managers can now be averaging $1.75 billion earnings p.a. This sort of thing is hardly the only alternative to "equality of outcome", a phrase whose implications are somewhat mischievously deployed by you in a discussion that ought really to be rather more nuanced.

4. Fiscal policy that focuses solely on State spending and debt is what has led us to this pretty pass. The Flow of Funds data shows that US local and national government debt declined from 52% of total credit market debt in 1952, to under 15% in 2007. That is not what has blown up the economy. Australian economist Steve Keen maintains, plausibly in my view, that what we have seen is a private debt crisis, not a public one. And this was stoked by the ability of banks to inflate asset prices through reckless lending; as well as government interference in the housing market, on both sides of the Atlantic. The failure to control the egregious greed of bankers must be laid at the door of governments, who doubtless saw votes for themselves in an overstimulated financial environment.

5. As the late Sir James Goldsmith (no slapstick socialist he, either) observed as long ago as 1993 when GATT was under way, it is globalisation that is destroying opportunities for those sectors of society for which you express some concern. Indeed he foresaw the breakdown of social cohesion in the West which we are now beginning to witness, and which the extremely high and growing disparities of wealth and income are doing nothing to heal. Certain clever and unscrupulous individuals have exploited the massively enriching (to themselves) opportunities latent in this situation, so I think it's fair to suggest that there is a causal relation between the prosperity of the super-wealthy in the modern financialized economies, and the impoverishment and social decay in the same.

6. You say that poverty does not cause crime (though recent UK statistics are showing a significant increase in burglaries). I would suggest that the underclass has, to some extent, been bought off by the payment of various kinds of social benefits, although there has been a concomitant deterioration in morale and behaviour, the effects of which are becoming increasingly difficult to manage and which is breeding a growing number of angry and confused children. Schools are doing what they can, but people must have hope of a better life and the prospects of meaningful employment and self-determination. This is unlikely to be achieved when our government exploits economic migration to hold down wage rates. More exam passes (inflated grades or no) may merely create a class of Eliza Doolittles with attitude.

INVESTMENT DISCLOSURE: None. Still in cash, and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Some European debt ratings

CMA Datavision reports on credit default swaps for sovereign debt and so its information, based on market rates, is not quite so compromised as that of some major rating agencies. The global rankings are for 67 countries. The eurozone includes 4 of the 6 best, and 3 of the 4 worst. It is not surprising that the euro garment cannot fit all sizes in this range and the problem was identified by some commentators over a decade ago when the Euro was introduced.

Note: Spain is the 21st worst - consider it deep orange!

INVESTMENT DISCLOSURE: None. Still in cash, and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Obscene inequalities

http://www.alternet.org/economy/151569/how_dracula_hedge_funds_are_sucking_us_dry_/

The end of democracy

I often read on the Net that "the people" won't stand for this or that. Fantasy. As I have commented elsewhere:

How would the people raise a hue and cry?

- The papers and TV don’t represent us, we are merely a market sold to their advertisers
- MPs and Lords similarly have little interest in us, pursuing their own agendas and in some cases actually bought and paid for by powerful interests such as the EU with its revokable pensions
- Americans can demonstrate outside the White House but here it is now against the law to do so (even peacefully, such as reading aloud the names of recent war dead) within a measured distance of Downing Street
- public houses are no longer the gathering places and discussion centres they were
- the market places have been replaced by one-stop, fast-moving commercial fleecing operations like Tesco (when is the last time you stopped for a good natter and grumble there, on the way to the checkout? We stand in line like immigrants at the airport and are processed in near-silence).
- Internet, email and phone calls are mass-scanned by powerful computers for any sign of dissent.

Any means by which people used to assemble, discuss and become collectively activated has been neutralised. Most of us bloggers don’t know each other, where we live or what we look like. We merely raise a feeble protest and the powers that be, knowing that many of us are of a demographic that will not trouble them for many more years, permit our impotent grumbling.

I shall continue, not in hope that it will change things much, but as a standing reproach to those who have sold the freedoms that took our predecessors centuries of blood and toil to achieve.

A reply to Mr Allister Heath

UPDATE: No answer as at 12 July. Are journalists even more arrogant than politicians?
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Allister Heath at City AM has written a piece in praise of Ronald Reagan and tax cuts. I have emailed him as follows and look forward to his rebuttal:

Dear Mr Heath

Bring back Reagan? You'd have to be amazingly selective about which policies. It was under him and Mrs Thatcher that the reckless acceleration of monetary expansion began, and if you track money supply against GDP you'll see that the response of the latter, though statistically significantly positive, was also significantly less than the increase in the money supply. We got roaring inflation, but this time in the stockmarket and housing, turn and turn about. These two and their successors have led us to the present, tragically debt-laden pass.

We also got, thanks to the cuts in income tax, an enormous increase in inequality, now the subject of much well-informed comment in the USA. We'll be lucky if we don't end up with a Colombia-type society where the rich live in gated compounds (sorry, "communities") and go shopping in armoured cars, though that appears to be trending here.

I don't suppose that either the affable Reagan or the honourable and principled Thatcher, both of them fervent patriots, intended any of this, but their financial naivety was grossly exploited by the money men.

Perhaps you could submit something on how "conservatives", aren't. Or how politicians generally need to be taught far more thoroughly on the E bit of PPE.

Yours faithfully

Rolf Norfolk

INVESTMENT DISCLOSURE: None. Still in cash, and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Liberty, subjection and destruction

Happy Fourth of July, America!

The same date is also the anniversary of the battle of Mantinea (362 BC), in which the Theban leader Epaminondas inflicted his second (after Leuctra) decisive defeat on the Spartans. A victory, one could have hoped at the time, for the democratic city-states of Attica and Boeotia.

Previously, warlike Sparta had overcome Athens and gone even further, crossing the Hellespont and seizing Persian territory in modern Anatolia. Now they were bottled up again in their Peloponnesian peninsula.

Bur alas for Thebes! Epaminondas died at Mantinea, together with his two possible successors, and when the weakened city of Thebes requested the help of the Macedonian Philip II in the quarrel with their neighbouring Phocians, they found an ally more dangerous than their foe.

In Athens Demosthenes, the greatest of orators, stirred his fellow citizens to resist Philip and persuaded Thebes to join them. Thus Athens lost her liberty; but it was worse for the Thebans, who when they revolted in 335 BC were all slaughtered or enslaved, and the city razed.

Who today is Sparta, who Thebes, and who the Macedonians? And who are the fatal orators?