Resilient fragility

Alexandre Lamfalussy's keynote speech to the ICMA conference ("Resilience or fragility") raised a few eyebrows today - Banks, said Lamfalussy, were "succumbing to the temptation of herd behaviour."

We've had warnings from people like Anthony Bolton and Warren Buffett, but for Lamfalussy to speak out perhaps throws things into starker light, not least when it comes a few days after Ben Bernanke's warning to US hedge funds.

"You can be sure that this golden era, will come to an end," Lamfalussy told the conference. He accused banks of being "irresponsible" and walking blind into an "opaque, uncharted and dangerous market." While risk may have been spread around, markets have become increasingly correlated, he said. And the risk of a systemic crisis had not changed. Lamfalussy is, I think right.

What's happened is that the threshold for individual crises to significantly affect the market has been raised. Credit derivatives have enabled risk to be more broadly spread, and thus made markets more resilient. But should a crisis big enough come along, then the markets will be affected in a way far worse than ever before. Such crisis always come along, says Lamfalussy - but we still think we can predict them. Bernanke voiced a similar concern when he warned of hedge funds behaving just like LTCM did.

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ICMA conference Berlin

I'm at the ICMA annual conference today and tomorrow in Berlin, so expect some really exciting posts. The scheduled talks for these things rarely throw up anything controversial, but often there's a fair bit of gossip to be had from delegates.


The programme this year seems to be very regulation heavy - not suprising given the noises coming from some EU governments recently. It's also worth noting that just after the weekend G8 leaders are going to be meeting down the road in Heiligendamm, where --alongside climate change, the African AIDS crisis and peace in the Middle East-- the assembled ministers will be tackling hedge funds and systemic risk. Woop!

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Snap! Cov-lites and subprime mortgages

The FT's special report on derivatives yesterday (in FTfm) had some interesting points to make. Paul J Davies's article about CDOs in particular:

As one London-based banker quips: "What's going on in the loan market makes ordinary junk bonds look like the quality end of the leveraged finance market."

Lots of people are indeed beginning to compare the two markets, particularly since the subprime mortgage crisis. There are easy parallels to draw between lax mortgage lending and loosening loan-covenants. The Bank of England made the comparison a few weeks ago - although many in the market dismissed it as trite.

Cov-lites and subprime mortgages are very different kettles of fish - so far, cov-lites deals have been struck only where the vendor is sure about the underlying credit quality of the sponsor - quite the opposite has been the case with subprime mortgages. The comparison is useful, however, in showing the way things may run. Both subprime mortgages and cov-lite loans are being driven by a burgeoning secondary market, which as Davies writes, is hungry for paper with high yields.

Take a look at this graph:

In the last quarter, demand for sub-investment grade loans has soared in the secondary market. It's all because spreads are getting tighter and tighter. With demand this high, there is a sense the market could diversify further. There clearly is a demand for more risk which isn't yet being met, and certainly isnt being reflected in spreads. I guess two things could happen. Firstly, the market could suffer a correction, in which case, liquidity will dry up and spreads on risky loans will widen. Secondly, if the bull run continues, I wouldnt be suprised to see new, higher risk loan products syndicated by banks. Cov-lites already carry slightly higher yields, and with CDOs diversifying and spreading risk so much, I think the loan market has a way to go before it finds it subprime mortgage equivalent.

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Not waving, but drowning

An interesting article by Hamish McRae in the Sindy suggests that national banks will need to face up to the new problem of globalised inflation.

He identifies the roots of the problem as lying in two places. Low interest rates in the developed nations and excess savings from oil rich states and Asia.

But isn't the problem also structural as well? McRae doesnt really address why liquidity has become such a global issue. For a start, the level of liquidity in the market is huge, and has been so for four years. Not only that, but market liquidity volatility is low, as the graph (bank of england stability report) clearly shows.

What marks this 'boom' out, is that it doesnt have all the unpredictable characteristics of previous booms - so far, it's been stable.

The markets are certainly awash with petrodollars and Asian savings, but crucially these are being fed through an increasingly complex derivatives network that is feeding a huge credit cycle.

In very simple terms, debt instruments such as CDOs are effectively breaking down market inhibitions and allowing capital to pour into areas which might previously have been out of bounds. The credit markets have undergone a huge growth in the past four years and are starting to develop a logic all of their own. Maybe this is why inflation in the UK's economy is proving a little more resistant to interest rate hikes than previously.

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Sound bitten

David Cameron is a consummate master of the sound bite. All the more so, because he can say, straight-faced, that he is not. “[New Labour’s] biggest mistake was to arrive in office with soundbites and slogans instead of serious policies for improving people’s lives.”

Indeed. Are the Tories making the same mistake?

“When say I want ‘zero tolerance of disruptive pupils’, it is not some sound-bite – it is a call to action backed by specific measures,” says Cameron in the Mail on Sunday. But what is a good sound-bite other than a glib “call to action” backed by measures, specific only in their specificity? Cameron promises to “shake up the system” and establish “motors of aspiration for the brightest kids from the poorest homes.” Apparently, the devil is in the detail.
Those things Cameron does elaborate on are classic Tory policies. The grammar school furore is not a divorce from traditional Conservative policies at all. If anything, it’s spinning them afresh.

Cameron advocates zero-tolerance for disruptive pupils. He plans to “shake-up” and “turn around” the failing system that deals with them. By getting rid of it. In its place, “social enterprises” such as the Amelia Farm Trust in Wales or the Lighthouse Group in Bradford will be able to “do the job properly” with state funding. This is all penned straight from a very familiar Conservative song sheet.

The grammar school's debate is not the Tory's "clause IV moment" - as Cameron himself admits. Resignations and protests will only strenghten Cameron's hand, however, for they show that he is in command of a reformed and reforming party. While that frothy sense of change carries the media along, however, the substance stays the same.

What makes Cameron different is that rather than define his conservative principles in the cast-iron terms that Thatcher did, he is defining them by what they’re not and by the society he wants to exist around them. He’s painting a picture of the mould rather than the statue, and so far it seems to work. Rather than shout about what the state can’t do, Cameron’s shouting about what others can.

Killing off the safety-net of the state and fostering a creative “social enterprise” are, for Cameron, two sides of the same Tory coin. In place of the state, not Thatcher’s anti-society of families and individuals alone, but a flourishing polity of “voluntary organisations led by parents, charities, social enterprises, churches and private schools.”

This philanthropic Thatcherism is a clever ruse: It’s a deft parry against the tarnish of the ‘nasty party’ and recasts the agenda not as budget-cutting and safety-net slashing, but as civic pride and charitable enterprise. And it cuts to the core of New Labour’s failure as a target-setting behemoth.

The problem, of course, is that philanthropic Thatcherism is hardly the business of government. It’s stargazy madness to suggest that social enterprise and charity will flourish to replace the state. Taking away welfare safety nets is classic Thatcherism. It’s pure artifice and spin to suggest otherwise.

Who will regulate these outreach projects? Who will ensure parity of care from area to area? How could you possibly ensure fairness? These are questions which neither the electorate nor Cameron want or need to answer. For now, the sound-bites sound good, and until the Tory’s win power, there won’t be any need to test their substance.

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Barking mad

Yesterday the BNP delivered some flowers to Margaret Hodge.



A fitting thank you, perhaps, since as cllr. Barnbrook (BNP) says, Hodge's comments in the Observer last week were "an absolute gift for us".

It has been an absolute PR coup for the far-right nationalists, the video above testament to this. Hodge overstepped the mark and the fact that she continues to defend her poor judgement is risable. I don't think she's been racist - as some of her colleagues in the party are insinuating - but she is pandering to racists.

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Banking on uncertainty

It doesn't really surprise me that banks are using credit derivatives as speculative levers to ratchet up their profits - as reported by the FT. It's something the industry has been doing since the market took off in the 1970s - from the liar's poker of the Solomon bond desks through to the calculated hubris of LTCM (and their starry-eyed bankers) in the 1990s.

Trading for CDS contracts has indeed been bullish, and I suspect it will only get more so with the launch of the LCDX - an index of loan credit default swaps - this week. The launch of the Index has been on the cards for some time - details were fleshed out at the LSTA conference in London mid March. It all points to even higher-liquidity levels in the secondary market.

However, the banks' growing participation in the CDS market could have more to do with the syndication process than it does with speculation. 92% of all European CDOs (the main buyers of syndicated debt) use synthetic structures - whereby the banks use CDS to transfer the risks but not the actual paper to the CDO portfolios. Thus as the syndicated market grows, so too does demand for CDS contracts.

I suspect most of the speculation being done by the banks is in arbitraging between inefficient prices in all these new instruments.

Merton - for all his skillful evasion about LTCM in the recent FT interview - was right when he said: "Derivatives are like anti-lock brake systems in a way - there is no question that they can make things safer, but only if people choose to use them that way. Often they don't - they might choose, for example, to drive faster in worse weather. Often we have chosen to use these tools not to decrease risks but to increase the benefits of taking the same risks."

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The buck stops where?

Some of the hysteria around the current mergers boom is making headway in the national press. Since Anthony Bolton's speech a couple of weeks ago, there's suddenly been a lot of interest in covenant-lite loans.

But I think a lot of the coverage has done them a disservice. For a start, it won't be the banks that suffer if a default occurs, contrary to what the business pages are saying. Most covenant-lite loans are syndicated - sold on - by the banks in lucrative deals that allow for arbitrage. "We don’t hold onto any of ours. Of the deals done so far? 100%, they’re all syndicated,” I was told by the head of loan syndication at one of the big US banks.
The buyers of this loan debt aren't exactly unaware of the risks, however. They're hedge funds, CDOs, pensions funds and the like, who actively seek out risks to make money from the high-yields. As yield spreads go down, they're looking for new areas to invest in.

Covenant-lite loans are senior debt anyway, which means in relative terms they're less risky that a lot of the debt products out there that have been available for a long time. From senior debt you can expect an average 78% return of your investment in the event of a bankruptcy. If you'd invested in second-lien loans, bonds, mezzanine debt or equity, you could expect between 0-30%.

Sure covenant-lite loans are risky, but I don't think they're the "iconic catchphase for the peak, or near-peak, of an over-exuberant buy-out boom" the FT says they are.

The real problem with all of this, is that the banks' own desks are getting too involved in the secondary market themselves. Through their hedge-funds, they're making a lot of money, but they're also exposing themselves to the risks they're supposed to have diced up and safely resold on their syndication desks. It's all got the ring of systemic failure to it. Like the reinsurance crisis that brought down Lloyds, I wonder whether the banks are being a little too naive about the state of risk in the market at the moment. Someone has to be holding it.

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Where'd all the risk go?

An article i wrote recently... quite generalistic, but it gives a good impression of the way debt markets seem to be behaving at the moment.


SAID Ralph Emerson, “in skating over thin ice our safety is in our speed.”

Global debt markets are indeed, skating at speed. M&A deals topped $3600 billion in volume last year, fuelling the debt free-for-all. The takeoff of complex credit derivative instruments over the past few years has created a staggering global market.

Buying into risky loans, repackaging them and farming out the risk in new and innovative asset classes has been the golden goose since the unnerving effects of the technology bubble in 2000.

Yet something is awry. Bankers talk as if the risk is all but gone, so hedged are their investments. Complexities, however, don’t help with clarity. With debt levels so high, a few lone voices have been cutting an angry and ever more voguish path in the US media. Financial Armageddon, they say, is just around the corner. The outlook from most mainstream analysts, however, is rosy.

The big question between both camps - the elephant in the room that few seem willing to acknowledge - is: where has all the risk gone?

Banking with Ben

Debt, of course, is not necessarily a bad thing and despite leveraged debt levels at the highest they’ve ever been, and rising, most bankers are confident that companies can support their loans.

The US Federal Reserve is confident too. Ben Bernanke once piqued critics when he said that a “helicopter drop of money” from the Fed would be enough to shrug off any sharp deflationary trend.

Helicopter Ben, as his detractors know him, has bigger fish to fry at the moment. Inflation continues to dog him. Debt and risk, for the time being, are thus not pressing issues.

Despite warnings to the worse, the subprime crisis has hardly triggered the broader debt-market panic some thought it would either. Instead, in its wake, institutional investors feel confirmed in their beliefs that the market has the power to weather such storms.

But all this overconfidence might not be such a good thing.

A fistful of dollars…

With all this in the air, doomsayers are quick to jump onto regulators warnings and cast a pall over the market.

Rating agencies predict defaults to rise and the IMF’s stability report points to “fragility” in the face of heavy debt. Leveraged finance is “approaching the limits of prudence” says the UK’s Financial Services Authority, with warnings of a “hard correction” in 2007.

But jeremiahs are indeed overplaying the danger the markets face. Risk has seemed to evaporate from most investors’ minds precisely because in most cases, it has been cut up and sold off so effectively, through complex derivative packages.

Nonetheless, it has not disappeared.

Credit derivatives are no silver bullet – and the doom crew are right in one respect: the market is certainly giddy with its own success.

The market, faced with problems, is not adjusting itself to suit them, but speeding up to outpace them.

According to the FSA, “effective defaults where companies are starting to have difficulty meeting their commitments are being masked by ‘involuntary refinancings’ which are being undertaken when a default is imminent.”

In other words, the rules are being bent to stay ahead of the risk. The IMF’s latest financial stability report also points to a worrying “weakening of loan covenants and credit discipline.” Due diligence is becoming less of an issue too, the fund warns.

Companies are farming out their risk, and their responsibility to boot.

So where has the risk gone? Nowhere, it seems to just be lagging behind. As long as the market stays one step ahead; ever more innovative and ever wilier; the threat of correction is staved off. In the meantime, a lot of money is made.
The cost is that, like the skater on thin ice, there is no option but to go ever faster. An external event; a China market crash, for example, would bring things sharply to a halt. What then?

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Through a glass, darkly

What has happened overnight? The government seems to have decided that the citizens of Great Britain should wake up on this sunny May morning to a smeary cavalcade of shit. John Reid, now with added inhumanity, is too idiotic to be true. Derogate from the ECHR? I don't think even the Daily Mail has ever gone that far. (Well ok, maybe they have) Add to this the fact that Goldsmith is considering ditching contempt laws and it's all a bit grim.

How could any government possibly be proud of all this rubbish? They really do seem to be just chasing the headlines. They make a huge mess of control orders, three people run off, and the response is to declare a national state of emergency and suspend the peoples' right to liberty. It does seem just a little bit disproportionate.

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