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Saturday, 29 October 2011

Credibility in Markets


Italy's situation has not notably been improved by the supposed resolution of the Eurozone problem; as interest rates on Italian state debt have continued to rise. The Prime Minister who is regarded outside Italy as a buffoon remains a formidable operator within  the country: he has said that he is willing to stand down later in the year, but most observers are sceptical. Parliamentarians descended to fisticuffs while Berlusconi was in Brussels delivering a long and explicit letter to his Eurozone peers in which none of them placed complete credence.

If the politicians cannot even pretend that the Italian state is credible, how can anyone expect the herd of analysts and traders in international debt to have any faith in it? 'The markets' are just a network of websites: the avatars who inhabit them that reflect the decisions of company representatives who do not have the sort of freedom to take risks that they did in the years 2002 to 2008. Now the boards of their employing companies consciously set the parameters within which the traders can operate, and the terms in which analysts can summarise the data that they select as a basis for comment. As long as Italy is perceived as a public scandal and a rather obsecene private joke, the herd will take its cue from that assessment. Any investor who is contemplating putting money into the 're-engineered' Euro bail-out funds is advised to assess what 'the markets' indicate: and the declining valuation of Greek and Italian debt is a huge inhibiltion on the credibility of the financial engineering that was bodged in Brussels last week, The stock markets had a minor boost from the apparent solution of the problem: because companies based in Germany, France and Finland are trusted and their shares are more widely held than are industrial and bank shares in Italy and Greece, or Spain and Portugal. So over the coming weeks there will almost certainly be a bifurcation between 'northern' shares and 'southern' state stocks. The de facto division of the EU will be consolidated.


Italy will probably eclipse Greece in the analysts' comments and in reports of the markets' behaviour for a few weeks: until the desperate state of Greek politics again demands the prime attention. The Greek people have been so misled by the the state's corruption in ignoring tax obligations, and by its reckless borrowing to pay them pensions and benefits that no economy on earth has ever been able to support from its earnings, that millions of them cannot believe that the austerity package that has been imposed by the Eurozone is either necessary or desirable. They have been told by the media that foreign banks have been induced to write-off half the value of the Greek state securities that they own: so why should not all the state's creditors do the same? And why not 99%, rather than just 50%? What can foreigners do to them, if they simply tell the Eurozone to forget the past and leave their future to them? The failure of CDSs on Greek debt [see Three below] will reinforce the opinion that 'the markets' don't really matter at all.


There has been a lot of comment on the recent collapse of 'value' in CDSs on Greek debt. The media have glibly described them as 'insurance policies' - which is precisely what they are not: that misrepresentation is wildly misleading. Credit Default Swaps [CDSs] are gambling contracts, of a special type that was invented in US wholesale banks in the nineteen nineties.

The concept was massively oversold by an ill-supervised wholesale-market branch of the greatest US insurance company, AIG, based in London [well away from scrutiny by the Head Office]. This small clique of people earned huge bonuses - and big notional profits for the firm - by selling these bets to banks, who wanted to be able to dress-up their balance sheets with an 'asset' that offset the perceived risk in owning bonds issued by institutions - mostly banks and governments - whose long-term credit worthiness could become questionable. In the credit crunch of 2007-8 holders of CDSs that offset assets that lost their 'value' came for their money, in such numbers that the small funds held by AIG's London office were instantly exhausted. There was a good chance that all the real insurance policies that had been underwritten by AIG would be voided if the company failed, due to the fact that its obligations under CDSs would massively exceed its reserves. One important consideration was that AIG - American International Group - was a huge player in the emergent markets in Asia, If the company failed the reputation of the USA would massively be diminished, especially in China, which had been the main target of the company's long-term Chief Executive 'Hank' Greenberg who had received massive political backing from the US government. Welching on China was considered unthinkable; so the US Administration and Congress agreed to support AIG with as many billion dollars as was needed to settle non-insurance obligations. The AIG case, however, gave credibility to the idiotic misdescription of CDSs as 'insurance policies'.

The really bad story about CDSs began after the bail-out of AIG. Despite that disaster, the players in the wholesale financial markets saw CDSs, alongside 'derivatives', as 'products' that they could sell in massive volume as ephemeral electronic contracts out there in cyberspace. Insurers as such had never been involved in the market: it was ab initio a bankers' creation and so it remained.  Banks bought CDSs - from each other - and reported them as 'assets' that could offset the risk that might exist in holding Greek or Italian government bonds as part of their reported capital reserves. Then they started selling each other CDSs as pure gambling slips, only notionally related to 'real' obligations: and in some cases multiple CDSs were raised in a series of separate contracts which notionally covered the same perceived risks. An increasing proportion of the purported risk-cover held by banks was in this form.

Then came the Irish crisis: where the government saved the situation by accepting all the banks' debts itself, and so the CDSs held against that possible default were not activated. As the Greek crisis approached its first peak even bankers saw it coming, so they mostly sold off the CDSs that they held against Greek debt [at heavily discounted prices] on the crude assumption that it was better to have a tiny asset rather than an undeliverable promise. This made it possible for the club of banks known as the international derivatives association, which was accepted by all the member banks as having authority to say when CDSs should be activated by declaring a 'default' by the issuer of the underlying assets - in this case, Greek government debt - to declare that the 50% write-down of Greek debt was not a default, so the remaining CDSs against Greek debt could not be activated and the balance sheets of the issuers of the CDSs were unimpaired. In the immediate event, the issuing banks were protected: but the longer-term credibility of CDSs as a cover for potential losses was challenged, possibly beyond repair.

There are still trillions of dollarsworth of CDSs in existence: they are still held as balance-sheet cover for the banks' perceived risks; and they may well be useless. Casino Banking has been storming ahead even while the bankers have supposedly been in the pillory and under close examination: so much for regulation, so much for the competency of government.

The more one knows, the less one can believe.

Even if one is irritated by the inarticulate clods who are wasting their time outside Saint Paul's Cathedral, it has to be conceeded that they have a point: if only they understood it.

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