Panic at the ECB?
From Far Faraway Land, I hear that the Asian markets were up overnight, share prices in London have bounced this morning and Morgan Stanley has this morning put out a recommendation that it’s time to buy equities again.
So that’s alright then: panic over; normal service can be resumed for global financial capitalism.
The European Central Bank has today made its third consecutive daily injection of cash into the European banking system, bringing to almost £140bn its aggregated support for eurozone banks (though today’s injection can be seen as a slight reduction in ECB support). And lesser amounts of cash have been provided to financial institutions in the US and Japan.
Even if Morgan Stanley is right and this bull market has another couple of years to run, globalised capitalism will change a bit.
Here’s how and why.
As I wrote last Thursday, the ECB’s intervention was designed to stem contagion from a US debacle, viz imprudent lending to American housebuyers with poor credit histories, known as sub-prime lending.
European institutions are exposed to losses on these sub-prime loans in a whole variety of ways. Here are just some:
1) They might be owners of mortgage-backed securities, or bonds created out of the repackaging of these sub-prime loans for consumption by investors.
2) Or they might be owners of collateralised debt obligations, bonds created by another process of deconstructing and re-engineering the mortgage-backed securities.
3) Or they might be exposed to hedge funds suffering losses on direct or indirect exposure to sub-prime loans.
In fact, the most plausible way in which most European institutions have been hurt is through the transmission and amplification of sub-prime problems to other financial markets.
Here are a variety of ways in which that would have happened, most of them due to “leverage”, or the fact that hedge funds take out loans to finance part of their investments:
a) When a hedge fund suffers losses on sub-prime loans, for example, the collateral backing its borrowings falls in value. Under the terms of the borrowing agreement, the hedge fund would then be forced to sell assets. But if there is insufficient liquidity in markets, as there was last week, the forced sale of these assets would lead to a downward spiral in asset prices – which in turn would force the hedge fund, and possibly other hedge funds, to sell yet more assets. And so on and so on, until we’re all bust.
b) Investors caught in this vicious spiral of declining prices would not just sell the sub-prime and related products, they would sell anything that could be sold. Which is why share prices have been pummelled.
c) Finally, when liquidity dries up in this way, all sorts of “normal” relationships between different classes of assets change. And that can lead to unexpected losses for many different institutions, especially those which trade on the basis of computer models created from processing past inter-relationships between markets or securities. Just this morning Bloomberg has reported just such losses for funds managed by Goldman Sachs.
If you want to see how market-turmoil can generate losses in the strangest of places, just look at poor old Mitchells & Butlers, the FTSE100 company which owns pubs and bars. It recently announced it was sitting on a £60m post-tax loss relating to a complex financial transaction or hedge. It had taken out this hedge to facilitate a £4.5bn deal transferring its properties to a special new company that would be jointly owned with Robbie Tchenguiz, the billionaire financier.
That deal has been suspended, because the cost of raising the necessary £4bn of debt has become too expensive. Unfortunately, M&B had already taken out the hedge – probably a foolish thing to do – against inflation and rises in the price of debt.
Foolish or not, the hedge should not have cost it money if the traditional linkage between inflation expectations and government bond yields had held. Usually, when investors expect inflation to be on a rising trend, the price of long-term government bonds falls. But in the past few weeks, investors have sought the safety of government bonds, because of their fear that everything else – from sub-prime securities to equities – was vulnerable. So long-term government bond yields have actually fallen, at the same time as inflation expectations have risen.
After the mayhem of last Thursday and Friday, M&B’s notional loss on the hedge will be even greater than £60m.
The point is that if there is a loss of this sort at somewhere as unexpected as M&B, who knows where the next splurge of red ink will be found?
But let’s say, for the sake of argument, that systemic crisis has been averted. What then follows?
Well there are big implications for the eurozone, the European Central Bank and Brussels.
The big fact is that the Bank of England dispensed precisely zero pounds on propping up the City through the turmoil, compared with spectacular sums made available to banks by the ECB.
That means one of two things.
Either the problems at continental banks are significantly greater than for British based ones. Or the ECB simply did not have enough hard fact on the health of European institutions and panicked.
Whichever turns out to be the case, it suggests that risk-controls at continental banks are inadequate and regulatory oversight is lamentable.
And here’s what should really turn the ECB red with shame. Just possibly it has needlessly bailed out the global hedge-fund industry.
It has signalled to the hedge funds and the giant investment banks servicing them that they can take all the mindless risk they like – because if they suffer a dose of the sniffles, the ECB will turn up quick-as-a-shot with the medicine.
What worries me is that ECB and Brussels politicians will become so embarrassed by their neurotic intervention that they’ll learn the wrong lessons.
The correct response would be to improve information-gathering on the hedge-fund and associated banking industries.
The wrong, futile and more likely response would be to attempt to shut down the hedge-fund industry in the eurozone.