Monday 24 October 2016

Market wobbles as past catches up with bad banks

Published 18/02/2016 | 02:30

Michael Lewis - the only man who can make a collateralised debt obligation funny - must be having a right old chuckle. Just as the film based on his book of the same name, 'The Big Short', is showing in cinemas, the financial markets are having a Big Wobble.

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There is even more fun - though that is hardly the right word - to be had from the fact that the biggest a wobble is at Deutsche Bank, where shares have fallen to the levels of 1984. The bank features prominently in the book and the movie.

The film makes an entertaining, although probably unsuccessful attempt, to explain mysterious initials like CDO and CDS in its story of what caused the financial crash and the handful of people who saw it coming and made lots of money placing large bets on the outcome.

One of them worked for Deutsche in the USA and has a starring role in the film. But it skips over Lewis's reporting that some of the wiseguys in the New York investment houses called Deutsche "stoopid Germans" for its fondness for buying debt, however complicated and doubtful the structure.

And so to today. The movie ends by making the perhaps obvious point that nothing much seems to have changed in the financial world. Even were it not obvious, the headlines outside the cinemas make the point.

There is one big difference between then and now, however. Few seem to have foreseen the scale and nature of the crash - although there may be people in finance, regulation and government who did but, for various reasons, said nothing.

This time, everyone knows there is a problem but nobody seems to know what to do about it.

Part of the reason for the shortage of ideas is precisely that so little changed after the crash. European banks still have €1,000bn of non-performing loans as a result of that crash.

Markets have begun to ask how banks are going to make the kind of profits, or raise the kind of capital required, to cover the losses when they finally accept that most of these loans will not be repaid.

As for similarities with 2007, one cannot avoid feeling queasy on seeing the big shipping company Maersk reporting falling business and profits, or the doubling in the cost of insuring against debt defaults via the mysterious CDS (credit default swaps). Shipping business woes were one of the early harbingers of doom and exploiting bubble level CDS rates was key to the Big Short

Why now? The root cause of this episode is the problems encountered in China and other emerging markets. That has been going on for some time but, for whatever reason, February 2016 has seen the development of possible dire consequences.

One key moment was the testimony before the US Congress of Federal Reserve president Janet Yellen.

She appeared to flirt with the idea of "negative interest rates", where banks would pay the US government for the privilege of lending it money, rather than receiving interest, however tiny.

The ECB, along with the Banks of Japan and Switzerland, is already doing that to some degree

If this seems bizarre, it is. But some think it could get more bizarre still.

Analysts at investment bank JP Morgan suggest that, not only will central banks go down that road, but could go down it very far.

They anticipate negative rates (let's say "charges") of 4.5pc in the euro-area and 1.3pc in the US.

On the experience of the last few years, one might have expected suggestions of such dramatic monetary stimulus to cheer markets, but the opposite seems to have happened.

As Morgan said, there seems no chance that banks can pass such charges on to ordinary customers, so the profits in their debt-laden accounts get squeezed even harder.

Whether their prediction turns out to be correct or not, the smell of fear is unmistakable.

While the printing of money under "quantitative easing" may have helped stave off depression, it seems incapable of restoring sustainable growth. That leaves only untried methods to deal with the next recession.

Among the few who saw the crash coming and said so was William White, then chief economist at the Bank for International Settlements (BIS) - the organisation representing central banks - and now chairman of the OECD Review Committee.

One of the many peculiarities of the early 2000s was that the BIS was warning of the dangers while its member central banks were playing footsie round the issues.

At last month's global gathering in Davos, Switzerland, Mr White said no one could know what would trigger the next recession. He may turn out to have been such a trigger himself.

In an interview with Britain's 'Daily Telegraph', he was positively apocalyptic; noting that central banks and governments are now out of ammunition to deal with another recession and that debt, public and private, keeps growing.

The figure for the OECD better-off countries is now approaching 270pc of GDP. Ireland of course, despite dramatic progress due mainly to its surging GDP, remains at the top of the league, with debt of over 300pc.

Mr White's opinions are now listened to more seriously than in 2005. We should certainly take seriously his prediction of "an avalanche of bankruptcy" if there is a serious downturn.

Some may be cheered by the enormous burning of creditors which this implies (especially since one technical term is "debt jubilee") - but it rather depends on where the flames lick.

The damage to hopes of selling off the Irish banks and recouping taxpayers' capital are already clear.

But if the same banks were forced by international conditions to have their own debt jubilee for property purchasers, both residential and commercial, the taxpayer could be on the hook again.

It comes down to a choice of who should lose, between creditors and debtors - since at least the time of the Sumerians, according to Mr White. The 2008 attempt to protect creditors until things improve may have failed but the final losses can fall in unexpected ways.

In Ireland, widespread forgiveness of unaffordable mortgages, for instance, might have been the right thing to do but it would have been expensive and hugely unpopular.

It wasn't done, which may, like much else, turn out to have been a big mistake.

It goes without saying that the Big Wobble makes the election campaigns look even more fanciful.

All are based on the notion of an uninterrupted golden few years of growth.

To base tax and spending plans on that is the opposite of a Big Short. It is a Big Put.

Very few in the markets are betting that way at present. It might be wise of the new government to display similar caution.

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