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Americans are inconsistent in how they believe the budget deficit should be tackled. But growing signs of pragmatism?

It looks as if we might see a repeat of 2011′s brinkmanship regarding the US budget – remember that this game of chicken between the Republicans and Democrats was a contributory factor to S&P downgrading the US from AAA.  Few expect American politicians to make progress on debt matters until after November’s elections – but that doesn’t leave them long to prevent many automatic cuts to spending and hikes to taxes occurring in January 2013.  This fiscal cliff on 1 January will cause automatic defence spending cuts, and hikes to income, capital gains, dividends and estate taxes.  How big an impact would this have on US growth?  The Congressional Budget Office estimates it would mean that the US economy would shrink by 1.3% in the first half of 2013, but Goldman Sachs thinks that the impact could reduce first half GDP by as much as 4%.  With China slowing, and much of the Eurozone in recession, it doesn’t feel like a good time to take $600 billion out of a major economy that has at least been growing in recent quarters.

But the inability of politicians to decide how and when to tackle the US’s growing debt problem is mirrored by its population.  Here are a few opinion polls to show how it’s possible for voters to want to a) keep social security and healthcare benefits unchanged, but b) cut spending, c) not increase taxes, and d) not increase the US debt ceiling.

Which is more important: taking steps to reduce the budget deficit or keeping Social Security and Medicare benefits as they are?

Reducing budget deficit 32%
Keeping benefits as they are 60%

(Source: Pew Research Center, June 2011)

What is your favored way of reducing the budget deficit?

Spending cuts alone, or more spending cuts than tax hikes 58%
Tax hikes alone, or more tax hikes than spending cuts 23%

(Source: Reuters/Ipsos, April 2012)

In order to reduce the budget deficit do you think it will be necessary to increase taxes on people like you?

Necessary 41%
Not necessary 56%

(Source: NYT/CBS Poll, January 2011)

Would you want your member of Congress to vote in favor or vote against raising the debt ceiling?

Vote for 22%
Vote against 42%

(Source: Gallup, July 2011)

Given that Medicare, Medicaid and social security are already around 60% of government spending, it would be a tough ask to reconcile a) leaving these unscathed and b) cutting spending.  Additionally these expenses are growing at a rate far outstripping US GDP growth, so the baseline is for significant increases to these programmes rather than cuts (mainly due to the aging population and advances in medical treatments).

But perhaps there is a growing realisation that these inconsistencies need to be addressed.  Having spent a decent amount of time in the US over the past few years, we’ve found recently that it’s become difficult to keep economists, strategists and policymakers focused on our US-centric questions and away from them asking us about the Eurozone’s problems.  And with municipalities experiencing debt distress across the States already, the question “Could we be Greece one day?” is crossing into the mainstream.

So it is interesting that a couple of developments recently suggest that American voters are thinking more holistically about the future structure of their nation’s economy.  An interview in this weekend’s Financial Times with civil rights lawyer Molly Munger discussed her success in getting a proposed income tax hike onto California’s ballot paper in November.  This new tax, currently supported in opinion polls, would boost the state education fund.  Another tax hike for deficit reduction purposes is also on the ballot paper.  At the same time voters in Wisconsin last week rejected a Trade Union backed recall vote to try to eject Republican Governor Scott Walker from office after he proposed the Wisconsin Budget Repair Bill.  The Bill would have increased pension and health contributions for state employees and reduced Union powers in bargaining.  Walker actually increased his victory margin in the recall vote compared with his 2010 election, and he is the first ever Governor to keep his seat in a recall vote.

Signs of a changing attitude towards the debt burden?  Possibly, and that has to be positive – but we still expect a great deal of turbulence around the debt ceiling issue after the Presidential elections.  That turbulence will be exacerbated by a likely split between control of the Presidency and that of Congress, although some have suggested that this would be the best outcome as there will have to be a compromise in the breakdown of long term budget reduction between spending cuts and tax hikes, rather than one or the other taking all the strain.

Finally, there is increasing discussion of a nationwide consumption tax (VAT) in the US.  Even a small VAT could make significant inroads into the deficit each year.  Is this a popular view in the States?  Well when I typed “us consumption tax” into Google, the second automatically generated search is “u.s. consumption tax is tempting vat of poison” so I’m guessing that’s a “no”.  However this is a silver bullet still available to the US whereas Europe, with many nations having VAT rates already at 20% has little scope to raise additional revenues through this route.


Financial salvation not repression

There have been a lot of investors and commentators talking about financial repression. The fact that nominal interest rates are set at or close to zero, and the subsequent transmission of these low returns along the yield curve means that returns in both nominal and particularly real terms are historically scant. This is seen as a government and central bank policy that is punishing savers.

However, in many cases savers have been helped  and not punished by governments. Whether that be the humble saver in Northern Rock who was bailed out, or at the other extreme sophisticated funds who loaded up on debt issued by Fannie Mae or Freddie Mac in the US. These savers were not repressed but were saved as governments and central bank actions (like the implicit subsidy of banks) protected the value of their capital investments. Total returns have been boosted to savers versus a free market outcome which would have resulted in significant losses.

Commentators seem to have forgotten how much savers have been and continue to be protected by the authorities, which are providing financial salvation and not repression.  Unfortunately we may now be coming to the point where some authorities are no longer able to save the savers. Investors would then be faced with actually losing capital as opposed to getting a meagre return. That is when the salvation gets replaced with repression.


Office of National Statistics or Office of National Savings? The Future of the UK’s RPI-CPI wedge

There has at almost all times been a ‘wedge’ between RPI and CPI, given different calculation methodologies (arithmetic mean vs geometric mean, respectively), different items within each, and different weights of these different items. The long term difference has on average seen RPI at 0.5% to 0.8% more than CPI. Recent changes, though, saw the wedge widen in 2007 to more than 2%, and to almost 2% again in early 2010.

Differential between RPI and CPI

What are these changes? RPI is a much older index, originally conceived in the early 20th century to track the effect of price moves on workers during The Great War, using less up to date and less relevant averaging calculations and, arguably in some cases, weightings and items. CPI was not developed until much later, in 1996.

Since the coalition’s formation we know that the government has been attempting to change certain future liabilities’ (eg public sector pensions and benefits) indexing from RPI to CPI. Why? Simply, because this wedge of RPI over CPI means over the long term it is more expensive for the government to pay RPI than CPI. And given the long duration of these liabilities, the present value and so budgetary impact today of such changes are extremely powerful in terms of delivering on austerity. From a rather different perspective, that’s why there has been so much resistance to these changes on the part of public sector workers, amongst others.

The ONS is the body that is responsible for the classification, collection and measurement of these compensation indices – no mean task I hasten to add (see here for a video we did with the ONS last year). We have heard much in research notes and certain press articles in recent weeks about the ONS undertaking a project to eradicate the wedge entirely! What would this mean for us as investors? It would be less attractive to own UK linkers, as inflation as defined by RPI would be structurally lower than it has been. The breakeven rate (the rate between nominal gilt yields and index-linked gilt yields) would fall, meaning that index-linked bonds would underperform nominal bonds. This would be especially so at the long end, where the price or present value impact would be felt most.

I can think of 5 strong arguments against such an assault on the wedge:

1.To eradicate the wedge altogether would be tantamount to an event of default, especially if this is specifically to eradicate the structural difference between the two indices! We bought these securities on the basis that we would be paid RPI, which we know changes in terms of items and weightings on an annual basis, but according to changes in spending habits rather than Government policy. That’s fine! But the index is based on an arithmetic mean and always has been, and so will (almost always!) be higher than an index calculated according to a geometrically calculated mean. To change this, willingly and knowingly, with the purpose of reducing future outgoings of index-linked borrowing cashflows feels very similar to the altering of the War Loan’s coupon from 5% to 3.5% in 1932, or to the Greek PSI exercise of coercive write-downs, neither of which, arguably, were ‘defaults’.

2. The Statistics and Registration Service Act that covers changes to RPI states that any changes to the index must be carried out in consultation with the Bank of England as to whether the changes are fundamental and materially detrimental to holders. If the BoE decides that both of these conditions are met, then the changes to RPI cannot go ahead without prior approval of the Chancellor. Well, given the changes Mr Osborne has been trying to make elsewhere in his search for austerity, might he simply approve the changes in the index? Well this would not be without significant risks, electorally, and it would have a fundamentally and materially detrimental impact on the ability of the DMO to borrow through the linker market, which we will touch on in a moment. But perhaps it would be open to legal challenge? Consideration of this last issue involves looking into the contractual protections embedded within the old-style 8 month index-linked gilt prospectuses. It turns out that these documents state that if both the conditions of a change to the index above are met in the opinion of the BoE, HMT will inform bond holders of this, and offer them the right to redeem their stock. So the next issue for holders is: at what price can I put my bonds? The prospectuses state that “the amount of principal due on repayment and of any interest which has accrued will be calculated on the basis of the index ratio applicable to the month in which repayment takes place”. Thus, in current markets, with substantial negative real yields, the protection provided in these old style bonds is not sufficient to compensate holders fully, as it only pays accrued inflation. As a result of this, holders are going to be very sensitive to any chatter about substantial changes to the index. And this will have pretty major consequences. For instance, looking at the 4.125% gilt linker of 2030, the current price of the bond (given by current accrued RPI relative to RPI at the date of issue, along with future assumed inflation of 3% per year, positive real coupons, and negative real yields) is 316.5. To take this bond and assume we put the bond in the event of a change to the RPI, we multiply par (100) by the index today (242.5) over the base RPI at issue (135.1) to arrive at a price of 179.5. A holder would be set to lose 137 points, or 43% of the bond’s current value!

3. It would also serve to ruin the RPI linker market, at least for a long while. The uncertainty from recent headlines cannot be helping sentiment among the linker buyer base at the moment, and this has been an extremely important source of funding for our high levels of borrowing in the UK in recent years. It would be unwise to annoy these buyers, as it will only serve to increase the costs of issuance (through demanding higher real yields), irrespective of the final outcome of the ONS’ project to lower the paid level of inflation. Indeed, this begs the question as to whether to make the change to linkers from the perspective of our financing position would be to shoot ourselves in the foot?

4. The ONS states on its website under its ‘Vision and Values‘ that: “Our mission is to improve understanding of life in the United Kingdom and enable informed decisions through trusted, relevant, and independent statistics and analysis” (my emphasis added). To target the structural and total eradication of the RPI-CPI wedge would in my opinion clearly be an impeachment of its independence, and would see huge criticism about the political motivations of such a change in the index. This could perhaps lead to legal challenge.

5. Could this not be interpreted as an attempt to specifically and deliberately conceal high levels of headline inflation, Argentina style? Or, if not, to artificially and deliberately manage UK inflation down? It is not just pensions and benefits that are linked to inflation, but wages and commercial contracts, which all have significant impacts on the economy’s overall level of inflation. To change the major index underlying all these contracts from RPI to CPI (the logical equivalent of making RPI CPI) would be to manage inflation down, at a time when so many are concerned about stubborn inflation in recent years, as well as the effects of super-accommodative monetary policy on future inflation. What would this tell us about our politicians’ and policymakers’ inflation targeting attitudes and indeed capabilities?

As a result of these arguments, I personally find it difficult to believe that this is the intention of the ONS or of its project to examine the wedge. I believe instead that the review is targeted at removing some of the anomalous sources of the wedge, which resulted, in no insignificant part, from a change in measurement that took place in 2010 that particularly impacted the wedge between RPI’s clothing price level and CPI’s clothing price level.

Year-on-Year RPI vs. CPI clothing and footwear

Indeed, the clothing and footwear components of RPI and CPI alone represented 60% of the total wedge between the two indices! This kind of change would be justifiable in my opinion. Anything else would at best be ill-advised, and at worst would be mismanagement on a major scale.


High Yield Default Rates Finally Starting to Rise

Default rates for high yield bonds have started to rise from a low level over the past few months. The trailing last 12 month default rate for Global High Yield was 2.7% in April, having bottomed out at 1.8% in October 2011 according to data from Bank of America Merrill Lynch.  This in itself is not unexpected as default rates were running at historically low levels, helped by very loose monetary policy, markets that were willing to refinance many companies and some positive underlying earnings growth.

High Yield Default Rate Starting to Increase...How far default rates will rise from henceforth is the real question. Some of the elements that helped keep default rates low over the past 2 years are unsustainable or unrepeatable. For instance the huge fiscal easing from many of the G8 economies that spurred a lot of the bounce back in 2009 is not an option available to many governments today. Likewise, underlying earnings growth in today’s world of austerity and uncertainty is much harder to come by. Finally, whilst the credit markets are willing to finance good businesses with sensible balance sheets, it’s far more discriminating when it comes to businesses that are struggling to grow or have too much debt.

The bottom line is that we think the next few years will be a tough environment for highly leveraged issuers and that in the absence of a dramatic pick up in growth or a very dramatic policy response (full Eurozone QE and Eurobonds anyone?), bearing in mind the huge range of potential outcomes in the European economy, our best guess is that default rates in the European high yield market will average 6% per annum for the next five years.

One area of the market which could see a marked impact is the short dated or short duration high yield strategy. This type of strategy has performed very well in the past few years in terms of providing reasonable returns but with much lower volatility than conventional high yield strategies. The benefit of a low default rate over the past 2 years has been a key element of this performance. However, as the number of defaults starts to increase, this following wind will disappear and the scope to deliver similar levels of risk adjusted returns becomes much harder.  At the end of the day, your downside risk in a default is the same if you hold a 2 year bond or a 10 year bond.

The good news is that valuations in the broader high yield markets already compensate you for a default rate of a little over 8% p.a. over the next 5 years, so there is already a lot of bad news in todays’ prices. There are also many ways to mitigate the risks of default when taking on high yield risk (active stock selection, sticking to defensive industries and focusing on regions that have healthier economies for instance). Nevertheless, as default rates start to rise, we think investors need to tread with a degree of caution.

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Bail-ins: Damned if we do; damned if we don’t

We have written on numerous occasions about the hitherto inseparable links between sovereigns and banks, and we have also written about the benefits of writing down bonds to create capital  (see The New Era for Bank Bonds: Send In The Clowns? and Equitisation of bank capital bonds) . In 2007 the global markets woke up to the fact that the US subprime market was blowing up, and in 2008 realised that due to financial engineering and securitisation, both of which were preposterously known at the time as ‘risk dissemination and minimisation’, banks the world over had major solvency issues as vast quantities of investments plummeted in value. This, in turn, led to a liquidity crisis as the investment markets shunned investment in banks and the interbank market froze over.

The crisis we are in today is the same crisis we were in 5 years ago. Sovereigns had to step in to guarantee their banking systems, so as to enable debt to be rolled over and confidence to return. In the short term the most important thing was to provide liquidity, which we saw through government guaranteed debt issuance and secured funding directly with central banks in the UK, US and more recently Europe. Next, sovereigns had to buy huge volumes of illiquid assets from their banks (US), or provide direct capital injections to support their solvency (US and UK), as the perception dawned that the liquidity crisis was caused by a solvency crisis.

All this time, the inevitable link between sovereigns and banks was becoming more and more deeply intertwined. And whilst it may feel that the Great Recession has metamorphosed from a banking crisis to a sovereign one, it hasn’t really: sovereigns took on increased liabilities to protect their banking systems and now find themselves in the ‘limelight’. It’s the same crisis, with a different focus.

Many European banks, though, remain substantially undercapitalised. Hence, the system is still overwhelmingly dependent on central banks to provide them with liquidity at an affordable cost. All the time the sovereigns providing liquidity are becoming more and more tied to the health or otherwise of their banks and the assets they are taking from them as collateral.

Has the time come for this cycle to end? Might the severance of this link bring the beginning of the end of the sovereign crisis? Many European banks are still on 24 hour life support, saddled by enormous levels of liabilities that are cutting off new lending and suffocating new investment through the multi-year crisis in confidence in lending to and investing in banks.

So how will this occur? Well my sense is that there’s abundant liquidity at the moment after all the LTROs, inter-central bank funding lines, secured lending facilities and covered bond new issuance. The problem is far more one of solvency and capital adequacy in Europe, where the very worst of the banking crisis continues today. For sovereigns to provide their national banks with the recapitalisations they need, via wholesale nationalisations, would only see a worsening of the sovereign debt crisis, as the funds would have to come from somewhere. So this approach doesn’t really work. And is it really desirable from the perspective of the taxpayer?

The solution? We need new capital, in substantial scale, and fast. The time may have come to sever a significant part of the link between a sovereign and its banks. Unsecured bank bonds in peripheral Europe where the sovereigns are struggling under high borrowing costs, and so where the cost of providing guarantees and funds to their banks are painful, should now be written down in certain cases. Both subordinated debt and senior unsecured bonds would see defaults, in some cases even to zero. This would generate huge amounts of capital (which writing down only subordinated debt would not achieve on its own), and does not involve the troubled sovereign having to borrow more from the markets or seeing debt / GDP levels spiralling. Yes this is painful for investors and to risk-taking savers who are exposed to bank bonds in their pensions and so who suffer losses there. But the write downs are taken. Capital is generated. Deleveraging of the system occurs quickly and substantially (at last!). And the severance of this part of the sovereign-bank link (deposit guarantees must remain in place)  means that the banks might just stop dragging the sovereigns down with them.

Policymakers and politicians must be aware (and I’m assuming they are already) of the benefits of this first step towards cleansing the system. If this doesn’t work, then nationalisation is the last resort, and the taxpayer must step in one last time. But this situation of creeping nationalisation where taxpayers provide 24 hour life support in European banks through emergency policy response after emergency policy response, at the expense of much higher tax and lower quality of life across all citizens for a very long time feels wrong, at least before the risk-takers have suffered. Could now be the time for bank bondholders to see defaults, where they are needed? There are countries where these dramatic measures aren’t needed, as well as individual banks where they won’t be needed within troubled systems. The process will be painful for bearers of risk (investors and savers), but it might, more importantly, provide the capital the system so needs to start restoring confidence in the banks, and the sovereigns would benefit from cutting the tie with the non-deposit banking system. So policymakers have to work out whether society overall would be better off with this new approach than the current one. They may very well conclude that the present situation of taxpayers being subordinate to bank bond holders, rather than vice versa, is a morally repugnant system.

Some of us are damned if we change tack and take this approach. All of us are damned if we don’t.


Eurozone heading for breakup

We’ve had a huge number of requests for an update on our thoughts on what’s going on in Europe.

Attention has suddenly focused on deposit flight and the risk of bank runs in the Eurozone.  Deposit flight is an entirely rational response to the perceived increase in risk of the single currency disintegrating, since presumably the new Deutschemark would immediately appreciate dramatically against a new Greek Drachma or new Spanish Peseta.  Deposit flight is also indicative of investors pre-empting the strict capital controls that would need to be implemented immediately prior to the currency breaking up.  Such capital controls would prevent individuals from withdrawing money from savings accounts or transferring money to another currency, and were previously put in place in countries such as Malaysia in 1997 in the aftermath of the Asian financial crisis and in Argentina following default in 2001.

However while the pace of deposit flight has accelerated recently, this is not new news.  The Eurozone has been experiencing a slow motion bank run ever since Greece started getting into trouble at the beginning of 2010, with deposits leaving banks in peripheral Europe and heading towards the core.  This is something that we were very aware of and has been a significant factor in our avoiding peripheral Eurozone sovereigns and financials the last few years.

The acceleration of deposit flight is of course exceptionally worrying, since in the absence of guarantees, a bank run can quickly develop into a bank and sovereign collapse.  The problem that Eurozone countries face is the lack of a backstop.  The ECB could step in, however it is very concerned that any guarantee of either peripheral sovereign debt or peripheral banks creates rampant moral hazard.  Peripheral European nations would respond by refusing to implement painful reforms safe in the knowledge that they’ll be bailed out as soon as they get into trouble.  The ECB is also limited in what it can do given that it is formed of individual countries’ central banks, which ultimately belong to the taxpayers of those countries.  And the German taxpayer, who would have a major responsibility for additional future bailouts, will be unwilling to send funds to southern Europe if there is no reform in return.

The medicine dished out so far has failed to alleviate the problem. Firewalls that had been half-heartedly built have long collapsed; EFSF/ESM did not prevent even the relatively small Irish and Portuguese economies requiring a bailout.  Neither did the ECB’s Securities Market Program, and the massive ECB liquidity injections have failed in anything other than the short term because the problem is one of insolvency, not illiquidity.

For the Eurozone to remain a whole in the long term, it requires total fiscal unity and effectively the abolishment of individual sovereignty.  But if anything, Europe seems to be moving in the opposite direction.  At the heart of the problem in the Eurozone, as we and many others have long argued, are the significant current account imbalances and competitive disparities between Eurozone member states.  These need to be eliminated.  Up until now, the plan has been to reduce the imbalances via austerity, which reduces imports and restores the trade balance, but has the severe side effects of killing domestic demand, causing recession, and resulting in much higher public debt levels. The plan is clearly failing.

Another way the competitive imbalances could be eliminated is via higher inflation rates in the north than the south.  The ECB’s inflation target for the Eurozone as a whole is 2%, and for competitiveness problems to be eliminated, inflation rates in Germany or the Netherlands need to be as high as 5 or 6% while inflation rates in peripheral Europe are 0-1%.  Germany appears totally resistant to this.

The only other alternative to avoiding a disintegration of the Eurozone would seemingly be outright default within the euro.  So far only the countries that have borrowed too much have been punished, why not those who have lent too much?  However, again, northern Europe has been unsurprisingly resistant to this given that they are the ones who have excessively lent.  (In their defence though, default would be unlikely to lead to reform, and while cutting southern Europe’s stock of debt would help, it’s quite likely that the current debt crisis would simply replay in the not too distant future).

So the disintegration of the euro looks to me to be the most likely outcome.  This would be very expensive and disruptive in the short term.  Some estimates put the costs at over €1tn, but in reality it’s utterly impossible to say and would depend on whether it’s a messy breakup, a very messy breakup or an unthinkably messy breakup. At least if the authorities are discussing the risks of a disorderly breakup, it should by definition become more orderly.

We may get some temporary respite from the panic if Greece manages to form a government, but this will surely just prove temporary as further austerity leads to continued recession, civil discontent and greater support for extremist political parties (which is already scary – 1 in 14 Greeks just voted for a neo-Nazi party).  The ECB very probably has more tricks up its sleeve, which may be LTRO 3 or perhaps some form of Quantitative Easing (e.g. purchasing a GDP weighted portion of member states’ government bonds).  But these measures will again fail to address the underlying imbalances at the heart of the Eurozone.

It’s hard to see how the Eurozone debt crisis isn’t going to get worse before it eventually gets better. Dismantling the currency union, which seems to be the best long term solution, will clearly be far more complicated than the many historical precedents of fixed exchange rates being unfixed.  But the good news is that countries typically see a significant economic recovery after unsustainable fixed exchange rates are abandoned – just look at Asia in the last decade.


Brazil – a video from Sao Paulo. Hot money, an aggressive central bank and 140 kms of traffic jams.

I joined 20 million other people in Sao Paulo last week on my first trip to Brazil.  I made a short video of a few thoughts on the economy and the challenges faced by emerging market economies now deemed to be “the new risk free”.  Brazil was the last of the BRICs that I’ve visited – it also turned out to be my favourite.

Erratum: in the video I mention that I’d spotted a footballing talent who might well break through to the big time.  To much ridicule from the team it appears that he is not quite the unknown I’d imagined.  Here is Neymar scoring the FIFA Goal of the Year 2011.  It is, with hindsight, unlikely that Nottingham Forest will be signing him up.


From The Politics Of Economics To The Politics Of Society

As we had a three day weekend last week I used the opportunity of an extra day off to catch up on some reading. One of the pieces I read struck me as particularly pertinent given the elections on the continent last weekend. Woody Brock, the founder of the economic advisory service Strategic Economic Decisions (SED), regularly puts out thought provoking research reports discussing various topics encompassing economics, politics and philosophy. In his latest piece he has pulled all three strands together to discuss the conditions that are necessary for an ideal society.

The report is a fairly long piece but I will do my best to summarise. Dr Brock argues, and I tend to agree, that much of the debate about the current state of the world is too focused on creating an ideal economy. From the relative merits of western capitalism vs Chinese state capitalism to austerity vs growth policies in Europe the arguments are regularly hammered out in economic terms – potential GDP growth, inflation outcomes, effects on bond yields and so on. Whilst all these factors are important to our well-being they are not the entire story, one must also look to other elements that make up a society – politics and philosophy.

While Dr Brock feels that the optimal economy is one which essentially displays the characteristics of perfect competition he also accepts that government intervention is required to provide public goods (say the police) and to correct for negative externalities (e.g. pollution). Brock believes that the level of government involvement should be determined by the checks and balances written into a nation’s constitution/fundamental laws, or the collective philosophy of the people of the nation. In short, the constitution/courts are there to limit politicians’ powers to those that the people want to grant them, and politics is there to regulate the economy based on those parameters.

The conclusion that Brock comes to is that the optimal society is one in which these various spheres overlap as little as possible – politicians should leave the economy to its own devices as much as they can and not amend the constitution/laws that govern their own behaviour unless with good (social) cause. I’ve lifted the below diagram straight from the report to demonstrate this more clearly.

SED – The Ideal SocietyIt struck me as I was reading the report that if SED’s analysis is correct France has taken a step away from becoming an ideal society after electing Francois Hollande. He ran with a brazenly socialist platform – lowering the retirement age, creating subsidised jobs for the unemployed and creating 60,000 new teaching jobs.


RBA slashes interest rates – the lucky country is getting nailed

Today the Reserve Bank of Australia (RBA) surprised markets by cutting official interest rates by 0.5% to 3.75%. Weaker inflation data out last week and a deluge of soft economic data has got the RBA rattled. We’ve discussed bubbles down under on this blog before and think that a combination of a falling terms of trade, a current account deficit, a deleveraging consumer, below target inflation, a softer labour market and a housing bubble will see the RBA retain a bias to cut interest rates further.

Dylan Grice from Societe Generale recently wrote a piece that rather nicely added to the debate:

“Australia has five of the world’s 15 most expensive cities (on a median price to median income ratio), has seen household debt levels explode in recent decades, and even has a current account deficit despite the windfall terms of trade improvement caused by the commodity bull market. This is not a robust base from which to weather a Chinese hard landing, if and when it comes”…”When you scratch the surface of the Australian ‘miracle’ you don’t just find an unmiraculous commodity super-cycle: you also find an equally unmiraculous credit super-cycle as well. A credit bubble built on a commodity market built on an even bigger Chinese credit bubble, Australia looks like leveraged leverage, a CDO squared.”

The RBA is hoping that interest rate cuts will boost the flagging economy. We are not so sure. The Australian economy has already received two interest rate cuts in November and December last year. The impact of these cuts on the real economy has been muted to say the least when we look at key consumer indicators like retail trade and consumer confidence.  The problem is the major banks have not passed on the interest rate cuts to the heavily indebted consumer. A standard variable loan in November 2011 was 7.80%. Today, the same loan will cost 7.55%. And it doesn’t look likely the banks will pass on today’s cut either (at least not all of it), as they are likely to continue to point to higher funding costs as a reason to retain higher interest rates and hence protect profits.

So what is happening down under? Here are a few key data points that have raised our eyebrows:

  • One in seven Australian taxpayers own an investment property.
  • Australian housing credit is at its weakest level in 35 years.
  • New home sales are an at 18 year low.
  • House prices are down 10% in real terms from the June 2010 peak and nominal prices have been falling for 15 months, which is the longest downturn in a decade.
  • 63% of property investors reported a taxable loss in 2009-10 according to the Australian tax office.
  • 74% of those making a loss on their investment property earned less than $80k AUD per year (the average full-time adult earns around $70k AUD per year).

The housing bubble shouldn’t be the only thing keeping the RBA up at night. At least until very recently, the Australian Dollar has held up surprisingly well in the face of falling bond yields, most likely thanks to the world’s infatuation with Australia’s debt. This doesn’t look sustainable.  Most recently, we talked about the worrying and dramatic rise in foreign ownership of the Aussie government bond market and figures recently released show that foreigners bought another A$16bn of Australian government bonds, the second biggest amount ever, eclipsed only by the previous quarter’s $20.8bn surge. Foreign ownership increased from 80.4% at the end of Q3 to a record 84% at the end of Q4 (see attached graph).

Foreign ownership of Australian government bonds is worryingly higher

But as we argued in January, if China wobbles or the Australian housing market starts to correct then the RBA will be forced to cut rates which will reduce the Australian Dollar’s appeal.  This interesting bloomberg article gives a great insight into what’s driving the flows – foreigners are piling into Australian government bonds as a carry trade and as a means to gain exposure to the currency.  If the yield pick up diminishes and/or the currency falls, then the huge number of foreign investors will start to leave, which will put further downward pressure on the currency.  Australia isn’t as bad as Ireland – the government won’t go bust as it can print its own currency, but the banking sector is obviously vulnerable.  It’s easy to see how a nasty downward spiral can quickly develop.


The “safety race”: the systemic implications of the bank asset grab

Anyone monitoring the risks in the global financial system knows that those of us who lend to banks are increasingly asking for some kind of security in order to do so. Issuance volumes for covered bonds have increased and more countries have recently passed covered bond laws or are in the process of debating legislation. Andrew Haldane, Executive Director for Financial Stability at the Bank of England, raised greater asset encumbrance at banks as a serious concern in a recent speech.

The speech outlines three “arms races” that banks have been or are now engaged in. One of these is a “safety race” in which investors all want to be first in the queue in case of liquidation. It is true that this “race” to the front of the queue has intensified in the past several years, but many forms of bank lending or trading have only been done on a collateralised basis for some time in the form of repo or derivatives trading with collateral posting requirements. The race for safety has only intensified as many banks have been forced to substitute collateralised central bank funding for other sources of funding that have been more difficult or too expensive to access. In the speech, the topic of pledging assets to receive central bank funds – in many countries the biggest reason for higher and higher encumbrance – is referred to. Repo, derivatives and covered bonds are not mentioned by name, but are implicitly involved in the “safety race”.

Certainly the thesis that investors are less and less willing to provide unsecured financing to the banking system is not new or controversial. That said, if you ran a poll as to the reasons investors have on balance pulled back, we strongly suspect the average investor would cite bail-in proposals and resolution regimes as being at least as important as encumbrance, since under the pre-Lehman assumption of state support the question of asset encumbrance and recovery rates didn’t really come up: the expectation (made explicit in ratings pre-crisis) was that the liquidation of systemically important banks was almost purely hypothetical.

Haldane proposes in the speech that, along with sensible macroprudential measures to curb systemic leverage and risk-taking as well as the speed of trading, regulators look to limit the amount of asset encumbrance at banks. How that sits with a central bank’s liquidity provision against collateral makes for an interesting thought experiment, but the more serious implication is that the real limits on pledging collateral could (if they emerge as policy proposals) be found in the new attempts to bring the repo market out from the shadows, which will form the subject of discussions being carried out by the FSB, EU, IOSCO and other bodies over the course of 2Q and 3Q 2012. Another area limitations may emerge is in covered bond regulations, which are constantly evolving. (Note that the US and Canada, both with longstanding deposit insurance arrangements, already limit the amount of covered bonds that banks can issue, even though neither country has a legislative covered bond framework yet.)

It’s worth thinking about whether limits on asset encumbrance actually benefit senior unsecured bank bond investors. There is at least a case to make that more of the benefits would accrue to shareholders, since leverage without asset pledges should still, all else being equal, increase returns to them, whereas senior unsecured investors, even having potentially better recovery prospects, would have to resort to pushing harder for faster implementation of the Basel III leverage ratio in order to gain protection. Current covered bond issues, at the margin, may be relatively more attractive than they already are, if there were to be a possibility of regulatory limits on issuance.

Finally, what about creditor bail-ins? Discussion continues about how this will be implemented in the EU. If it turns out that new “senior” debt, that explicitly allows write-downs, has to be issued to meet a bail-in debt requirement, it’s hard to argue that any investor would buy it without significantly more information on asset encumbrance. Investors would have to stand a chance of attempting to work out a recovery rate on their debt if they were to commit to automatic write-down in the event of resolution. The paradox is that the more serious regulators have become about bail-in, the more counterparties and lenders have grabbed collateral. The only obvious pressure valve is pricing, which makes it logically very difficult to argue that unsecured bank debt will see a significant rally in the near future.

Asset encumbrance remains a topic to watch, certainly, and it presents more evidence that bank balance sheets remain in a state of flux, so talk of a recovery in the senior unsecured market remains premature.

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