This encouraged us to participate in the academic debate on causes of the crisis and the challenges we would face in the foreseeable future. All our findings were bundled in a book “The Future of Finance: a New Model For Banking and Investment.”
In brief we warned that nothing was done about the real issues, such as the systemic risk in the financial industry via its exposure on derivatives, the destabilising forces of central banks and governments, and last but not least the colossal debt built up both at the private and public side. All this would trigger a currency crisis which in the end would result in a global sovereign crisis. Hence, investment portfolios should have been protected against this by avoiding certain currency zones and sovereign creditors (cfr. The Rings of Fire) and searching for hard underlying assets.[1]
However, like so many out-of-the-box thinking economists, we were spit out by the system as being too cynical, doom-and-gloom and in the end we ended up shouting in the desert.
The last few months have been particularly interesting. From our desert we have seen the clouds packing together again and noticed a perfect storm is in the making: a sovereign crisis going hand in hand with a banking and currency crisis.
The interesting part is not because we warned for all this back in 2009, but due to the same indecisive approach and ostrich behaviour by our political leaders who still don’t seem to realize that the can they have been kicking down the road is about to hit a brick wall.
In this respect it would be worthwhile to update some of the data we referred to back in 2009-2010 and point at the mounting challenges we are facing.
One of the eye catching data back then was the total global outstanding derivative exposure. After reaching a peak of approximately $ 683 trillion mid 2008 the Great Credit Crisis caused a significant reduction in volume due to the deleveraging that was triggered through the market, however since 2010 volumes picked up again. At the end of June 2010 the exposure was around $ 583 trillion to rise further to $601 trillion by the end of December 2010 (see also most recent data of Bank of International Settlements (BIS))(cfr. Table 3.).
To give the reader an idea of the systemic risk, within the US banking system only 96% of the US outstanding derivative exposure is in the hands of only 5 US banks: JP Morgan, Citi, Bank of America, Goldman Sachs and HSBC Bank USA National Association.
Table 1: Derivative exposure by US commercial banks
Source: Office of the Currency Controller, 2011
The argument that these data are gross numbers, not taking into account the bilateral netting effect among banks and as a result are not representative to outline the risk, does not stand. The issue here is that bilateral netting assumes that in an orderly credit event the issuing bank will honour all its outstanding contracts. Back in 2008 with AIG the market was already confronted with this problem and trillions of dollars threatened to become worthless within a few hours, as those who had bought protection from AIG were at risk to be left empty handed, as Goldman was the only player that was hedged by buying protection on AIG itself.
Until today nothing has done about this issue either. On the contrary it hangs over the market as a very dark cloud. This risk is eminent as European, and among them especially French, banks are in the eye of the storm of the recent European sovereign crisis.
This brings us to our second issue: a perverse and vicious mechanism between a European banking sector which is in principle bankrupt and Euro sovereigns that face the same problem. Deteriorating mark-to-markets of Euro sovereign bonds is pushing banks deeper into insolvency.
Two of our favourite analysts, John Mauldin and Michael Lewitt, point at a too-big-to-rescue issue where European banks hold as much as $55 trillion of assets. This is four times larger than the U.S. banking sector as European banks surprisingly are more leveraged. Until now nothing has been learned from the past on how to fund this enormous position. Back then we made suggestions on proper ALM management that banks should take into account. The major principle in all this is becoming less dependent on wholesale or interbank funding. This has been further worked out more in detail by my co-author, Prof. Dr. Moorad Choudhry, in his recent book “The Principles of Banking” . [2]
Unfortunately European banks are still funding themselves for a large part via the interbank market, which is less stable than deposit money. From this $ 55 trillion almost $30 trillion has to be raised by European banks in the interbank market. Bear in mind this is roughly 10 times more than U.S. banks. As we have seen over the last several weeks, this market dried up completely for European banks, which forces them to pay back this wholesale funding by internal generated cash flows.
Michael Lewitt argues further that this wholesale funding has on average a three year maturity. This means that European banks need to generate approximately $830 billion each month to fund maturing wholesale money. It goes without saying this is not a situation that can take too long which is also indicated by the markets. The CDS market for European banks for example is back at or above the peak levels seen during the 2008 financial crisis. [3]
We could very quickly come into a situation where many other banks face a similar future as Dexia, i.e. nationalization. The problem however here is that governments’ balance sheets are stretched as well. This brings us to our last item of data to be updated, that is total outstanding debt of nations. Remember back then we referred to the famous Rings of Fire of Bill Gross of Pimco.
A similar exercise has recently been done by BIS and they came up with the following numbers:
Table 2: Total debt as a % of GDP
Compared to the exercise Pimco did back in January 2010 there is a striking difference that much more countries are clustering together in a dangerous debt zone of + 330% of GDP. The only similar conclusion compared to back then is that Japan is still like a bug looking for a windscreen.
Levels like these are unsustainable not only because, as Reinhart and Rogoff concluded, for each 90% of debt in terms of GDP one full percentage of GDP growth is lost. Then we are challenged with the ageing of society which is going to put further pressure on both pension fund managers, who will not be able to realize the over ambitious returns their models are counting on, and public finances of our economies.
To solve this more drastic and structural changes will be necessary. It goes beyond doubt this will take political courage and leadership to say that we all have to make sacrifices and most probably have to take a step back from our current living standards.
My co-author, Prof. Dr. M. Choudhry, and I are preparing an academic paper which will focus on these structural changes we need to push through in the very near future and we will keep you updated on this via our Givanomics newsletters.
To give you a brief indication into which direction we are looking for, we argue that it will be as drastic as the events like Breton Woods (1944), the end of it in 1971 and the Plaza Accords (1985).
It will question our current capitalistic free market model where banks and central banks are the corner stones of the model. In the financial system as we know it we aim for stability. Central banks play a pivotal role in all this to guarantee this stability. In a stable environment liquidity is not an issue and central banks are not on the radar screen. Only in times of shocks one is challenged. The problem however is, there are different kinds of shocks. The question is when or where do we draw the line to step in and guarantee stability again. This is once again the moral hazard issue.
There are shocks of technical nature (such as the potential Y2K event 11 years ago) or geo-political nature (events such as 9/11) or international nature (retreatment of international capital flows such as the Asian and Russian crisis) and corporate nature (such as LTCM, Bear Stearn and Lehman).
We think there is a broad consensus that in principle in case of a corporate shock, we should not use tax payers’ money, as we should not throw good money after reckless behaviour. Unfortunately we let it come way too far as this is an impossible task nowadays due to the interconnectivity of our financial system. We do believe though a great opportunity was missed back in 1998 with LTCM not to do anything about it.
The Fed should not have come to the rescue and should have given an example that a liquidity shock, due to a corporate event, would be something a central bank should step in for. Or, after the rescue of the banks from LTCM one should have done something about the systemic risk in the market, which only grew exponentially since then. Table 3 gives a very good indication on this subject in respect to the rise of derivatives over the last 13 years. The question will be though where to draw the line? Do we only exclude a corporate shock, or even at an international level, such as the examples of Russia, Asia and now Greece etc….?
Table 3: Rise of Derivatives
Source: BIS
Then we also come to our paradox, as in our aiming for financial stability we created central banks. Remember that back in 1907 the US went through a similar deep recession and after the collapse of the Knickerbocker Trust Company, liquidity dried up and there was a run on the banks. It was the late J.P. Morgan himself who put his own private money and that of other fellow competitor bankers on the table to guarantee liquidity and avoid a further collapse of the system. This because of the simple reason, there were no central banks. It was due to this event that two years afterwards the Federal Reserve was founded.
However due to the creation of this type of institution, in order to safeguard financial stability, one put in place public financial safety nets, which are an incentive to moral hazard behaviour, which on its turn is just the very reason why financial instability is created. This is quite of a paradox.
Maybe we should go back to a system as in 1907, where banks had to put a pool of money together themselves to rescue each other. By doing this, you automatically take away the public floor or safety net from underneath the market. From the moment that banks have skin in the game, they probably will be more cautious towards each other when it comes down to wholesale funding and leverage, which were/are one of the major reasons why a liquidity crunch takes place when we are talking about a shock of corporate nature. In case something would go wrong and a bank has to turn to this facility pool, there would be a penalty involved where the bank is absorbed by the others.
This will not be the only challenge. As back in 1944 when Breton Woods was negotiated, we urgently need a new monetary order which would issue new rules on how we deal with global financial and commercial relations and the currency risk that is closely related to this. A question we will ask ourselves is whether abandoning the fiat currency system, which was introduced at the Plaza Accord in 1985, would reduce the leverage in the system.
These are according to us the topics that should come on top of the agenda of G20 summits. Unfortunately these discussions are being avoided and it is far more popular to pin point on a round of bankers bashing or focussing on marginal discussions like abandoning short selling. The longer this discussion is postponed the deeper the crisis will become. We can only hope one does not make the same mistake as President Hoover and his generation did back in the 1930s, which made the crisis even worse. We all know by now what price we had to pay for that.
[1] See also Bill Gross, The Rings of Fire.
[2] Prof. Dr. Moorad Choudhry “The Principles of Banking: Capital, Asset-Liability and Liquidity Management”, Wiley Finance, 2011
[3] Michael Lewitt, “It’s all Greek to me”, Newsletter, November 2011
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