Mispriced Debt: Getting Worse, Not Better

Australia managed to dodge the worst of the global financial crisis largely because we held tightly onto China’s coat tails.
 
China launched two massive stimulus programs, one in 2008, the other in 2012. Both had a major focus on infrastructure projects, where it proposed to spend the equivalent of US$300 billion.
 
Not only did these projects require vast quantities of Australian iron ore and coal, they also underwrote the largest developmental boom in our history. The Australian government shouldered its share of the burden. But it would have been a much nastier experience had it not been for China.
 
Will we be so lucky the next time round . . . and when is that likely to be? Nobody knows, but it could be much sooner than most expect.
 
Although there were many forces involved in creating the GFC, the factors most prominent were excessive and mispriced debt, the globalisation of finance and the unregulated marketing of frequently complex and exotic financial instruments collectively called derivatives.
 
The emergence of super-banks, institutions which are regarded as too big to fail, and the related risk of moral hazard as well as the structural flaws in the euro zone also contributed.
 

How little has changed

This is by no means an exhaustive list, though it does illustrate the spread of potentially explosive risks. And how little has changed.
 
In 2007, it was the US sub-prime housing spree that set what was to be a rolling recession into motion. Low adjustable rate mortgages had funded a nationwide housing boom.
 
Cheap credit was extended to borrowers who never had any real prospect of servicing their mortgages when rates moved back towards the historic mean.
 
The level of household debt climbed to record levels. When interest rates were tightened, the sub-prime sector became the first GFC domino to fall.
 
These sub-prime mortgages were diced and then pooled into funds. Further mispricing occurred when those funds were on-sold to investors who believed the credit ratings certified by risk experts.
The explosion in derivatives was not confined to mortgages.
 
One of the most value destructive was a credit default swap.
 
European banks were active buyers of pooled American derivatives. However, what proved to be more damaging to their balance sheets were sovereign debts issued by financially strapped euro zone economies.
 
This time it was Greece that started the blaze. Greece effectively used its membership of the euro zone as collateral to fund what was a bankrupt fiscal system.
 
When this was exposed so too was the overextended nature of the European and British banking systems.
 
As Europe joined the US in recession, the financial crisis was exported around the globe.
 
China’s banking system was relatively unscathed, but it was hit hard on the trade front by the impact of the crisis on the demand for its exports.
 
Japan avoided the initial impact of the GFC because its banking system remained local in its operations, a condition attributed to the absence of English speakers amongst its
management.
 
This, however, was not enough to shield the country from the second round impact of trade contraction. Most of Japan’s exports to the developed economies were highly income elastic.
 

Slow and anaemic recovery

Officially, the recovery from the GFC began in 2009.
 
It has been a slow and anaemic recovery that has required unprecedented intervention by central banks employing unconventional monetary policies, also known as quantitative easing (QE).
 
The US, the UK, China and Japan have all gone down this path.
 
The European Central Bank has promised that it will do what is needed to save the euro zone.
 
The bankers have been forced into the front line because of the parlous condition of national fiscal accounts.
 
Another significant contributor to this state of affairs has been the absence of political action to reform the financial systems that were at the root of the GFC.
 
This attitude has to some extent been dictated by realpolitik. The politicians cannot take on their local financial systems without eroding the confidence of the electorate in the stability of the system.
 
The most effective way to strengthen the recovery would be to accelerate the deleveraging of public sector, corporate and household balance sheets.
 
That would involve restructuring loans, forcing creditors to take a haircut.
 
That’s not going to happen. Consequently, the central bankers are taking the long, slow route of financial repression – imposing an interest rate regime that effectively forces savers to
subsidise spenders.
 
However, it is evident that while QE was effective in its initial impact, it has become less so with each iteration.
 
Large-scale savers are avoiding repression by hoarding funds in other jurisdictions. That’s what happens when you have locally regulated financial systems in a globalised market.
 
Those “other jurisdictions” are not safe havens. They provide an escape hatch for footloose capital avoiding repression. Consequently, it is highly likely that the owners of such capital
have to accept a lower risk premium than a market-based system would provide.

Debt mispricing institutionalised

The mispricing of debt has actually become globally institutionalised.
 
The most important player in this field is the US Federal Reserve, which is in the process of tapering its $55 billion program of buying US Treasury and mortgage bonds by $10 billion a month.
 
If tapering continues at the present rate, the program should wind up in October.
 
A recent IMF analysis warned that if this exit proved bumpy, it could have unfortunate global implications.
 
By “bumpy” is meant a surge in US bond yields that would be transmitted in various degrees to other financial markets.
 
During the last five episodes when the 10-year Treasury rate rose rapidly, bond yields rose, on average by 73 points in Canada, 66 basis points in the United Kingdom, 60 basis points in
Germany and 36 basis points in Japan, for every 100 basis point rise in the US Treasury rate.
 
Given the extent of unconventional monetary policy now being deployed around the world, the high degree of correlation between major sovereign borrowers adds a further dimension
to the risks of mispriced debt.
 
What caused the GFC is now expected to solve it.

 

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Max Walsh

Contributor

Max Walsh was for many years one of Australia’s top economic and political commentators, highly regarded as a journalist, author and broadcaster. Throughout his career, Max was involved in all dimensions of the media industry, which has encompassed positions with two of Australia’s largest publishing companies and television networks.

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