Page 1 of
3 CREDIT BUBBLE
BULLETIN Tighter days
ahead Commentary and weekly
watch by Doug Noland
There were important
developments last week in the realm of market risk
dynamics, developments that increased the
likelihood that problematic
de-risking/de-leveraging dynamics have begun to
gain a foothold.
Let's start with Europe.
First, the Greek elections have created great
uncertainty, hence, market risk. Voters hammered
the two establishment parties, the main New
Democracy and Pasok parties that were responsible
for negotiating the two European
Union/International Monetary Fund/European Central
Bank Greek bailouts.
Fully 70% of the
votes were cast for parties committed to
abrogating European-imposed austerity measures.
The surprise beneficiary was Syriza, the "Party of
the Radical Left", having
placed second to New
Democracy. Syriza is led by the radical and
charismatic Alexis Tsipras, who this week gained
additional support with his message that previous
agreements are "null and void" and that Greece is
well-positioned to call Europe's bluff (blackmail
the blackmailer, some have suggested).
With leaders from the top three parties
each individually failing to formulate a coalition
government with sufficient seats to hold a
majority in the Greek parliament, it now appears
likely that new national elections will be
necessary (most-likely in mid-June). Polls this
week showed Syriza building on recent momentum, so
it is unlikely a coalition government can be
created without Tsipras taking a leading role.
The markets had been somewhat heartened by
the prospect that new elections might be avoided.
Now markets will likely face six weeks of
uncertainty leading up to the next election. And
while the Greeks for the most part state their
desire to remain in the eurozone, there is little
support for implementing austerity measures
negotiated by previous governments. It's very
difficult at this point to envisage a favorable
market scenario.
And while the majority of
party leaders prefer to stick with the euro, it is
also clear that a strong political consensus has
developed that Greece must at the minimum
renegotiate previously made commitments. Various
European officials, including German Finance
Minister Wolfgang Schaeuble, have made it clear
that the Greek government must remain committed to
previous agreements.
At this point, the
Greeks lack credibility, and EU officials'
patience has worn past quite thin. So, a dangerous
game of chicken has begun, and contingency
planning for a Greek exit from the euro will now
command great attention. Such uncertainty supports
risk aversion.
Now that a Greek exit
appears unavoidable, it has become popular to
surmise that this could be done without
unmanageable financial and economic dislocation.
Yet no one has a grasp of the consequences and
ramifications for Greece, the euro, Europe, the
markets, international finance and global economic
prospects. It is very unfortunate Greece did not
exit two years ago.
On Friday from Fitch
Ratings: "In the event of Greece leaving EMU,
either as a result of the current political crisis
or at a later date as the economy fails to
stabilize, Fitch would likely place the sovereign
ratings of all the remaining euro-area member
states on rating watch negative as it re-assessed
the systemic and country-specific implications of
a Greek exit. ... A Greek euro exit would 'break a
fundamental tenet' of the currency union, which
was designed to be irrevocable ..."
Along
the lines of happenings in the periphery country
Greece, things are also going from bad to worse at
a European core country, Spain. After promising
that no additional public money would be used to
bailout Spain's troubled banks, Prime Minister
Mariano Rajoy was forced to backtrack this week
with the nationalization of the fourth-largest
Spanish bank, Bankia. And Friday's widely
anticipated announcement of plans for addressing
banking system issues was less than confidence
inspiring.
Confidence in the Spanish
banking system, saddled with enormous real estate
loan portfolios, is quickly evaporating. Analysts
talk of the need for a massive (Irish-style)
recapitalization program (US$150 billion-$200
billion), an enormous sum for an already troubled
sovereign borrower. Spain's credit default swap
prices jumped another 36 basis points (bps) this
week to a record 517 bps. Last week provided added
confirmation that the European crisis has
decisively infiltrated the "core".
And
especially now that a Greek euro exit is on the
table, banking system and sovereign debt
fragilities take on new urgency. Importantly,
markets have returned to a crisis-prone backdrop
where I expect capital flows both between euro
zone nations and out of the euro to become
critical issues.
It is today perfectly
rational for wealthy holders of euro deposits -
along with risk-averse corporate Treasurers
managing cash holdings - in periphery banking
systems to shift these funds to more stable core
institutions (or perhaps even out of the euro
altogether). If Greek and euro troubles further
escalate, there will be increased economic impact
as corporations move to more aggressively manage
business risks in various economies.
Apparently, the issue of "Target2"
(Trans-European Automated Real-time Gross
Settlement Express Transfer System) balances now
garners considerable attention in the German
media. Recall that "Target 2" refers to the
eurozone's inter-central bank payment system used
for settling cross-border trade and financial
flows. This system has not functioned as designed
(trades have not fully settled) since the eruption
of the financial crisis back in 2007.
Instead of private financial flows
counterbalancing trade imbalances (the settlement
of cross-border obligations), these days trade
imbalances and financial outflows from the
periphery combine to create enormous and mounting
IOUs from periphery central banks to the German
Bundesbank. With euro stability now a serious
issue and capital flight out of even "core"
banking systems a definite possibility, the
Target2 drama is poised to create only greater
intrigue.
I could be off-track on this,
but I just don't believe it is mere coincidence
that JPMorgan dropped its bombshell $2 billion
loss announcement in the middle of market worries
regarding Greece, Spain, the euro and European
bank stability - and I know that in the grand
scheme of JPMorgan's business, balance sheet,
capital levels and EPS, $2 billion is indeed a
"rounding error".
This news will certainly
intensify the Volcker rule debate and there are,
of course, very important longer-term issues to
contemplate. But I think much of what I've been
reading and hearing misses a key point with
immediate market ramifications.
JPMorgan
is a leading player in credit insurance and prime
brokerage. Their "synthetic credit securities"
positions are integral to their business
operations with hedge funds and the "leveraged
speculating community." Furthermore, derivatives
reside at the epicenter of the dysfunctional
global "risk on, risk off" market dynamic. And
it's also been my premise that "risk on" has been
showing heightened vulnerability.
I'll
assume that JPMorgan's enormous derivative
portfolio was constructed with a particular
market/risk environment in mind. It would make
sense to me that JPMorgan has been comfortable
building massive risk exposures throughout various
markets, anticipating a relatively sanguine "risk
on" landscape.
Management was comfortable
with the view that global policymakers had things
under control - and were confident that global
markets would remain abundantly liquid. They
likely viewed the hedge fund community as
relatively stable and likely to successfully work
through recent challenges. And I will further
presume that developments in Europe, throughout
global markets and with the global leveraged
players had recently made them much less confident
in previous assumptions. It would make sense if
they've decided to start hunkering down.
I'll guess that top JPMorgan management
was forced to respond to recent changes both in
the marketplace and in prospects for the market
risk/liquidity backdrop more generally. Recent
developments and the abrupt return of
de-risking/de-leveraging dynamics significantly
changed the risk-profile of their positions and
market insurance products more generally. They bet
big on "risk on" but now must work to position for
the likelihood of "risk off".
In
discussing credit insurance and derivative markets
over the years, I've invoked an analogy of writing
flood insurance during a drought. It's a truly
wonderful business - that is until torrential
rains arrive and the complacent community of
highly-speculative (and thinly capitalized)
insurers flood the insurance market as they
desperately attempt to offload ("reinsure") the
risk they accumulated during the profitable
drought-period boom. Those seeking long-term
survival (as opposed to the crowd trying to make a
quick buck) better have a superior ability to
discern weather patterns.
If I were
JPMorgan top management, I'd surely be moving
today to reduce the company's risk profile -
especially with respect to myriad global market
risks. The clouds are darkening and much better to
move before the heavy downpours commence (and
buyers, along with their liquidity, run for the
hills).
While I will give no credit for
its self-serving self-flagellation, JPMorgan is a
savvy group that has demonstrated its ability to
manage through crises. Certainly, writing credit
and market risk insurance has, again, become a
risky proposition. And I'll assume that JPMorgan's
market-making operations will be reined in
throughout various risk insurance markets - and
I'll assume a similar change in tack will be afoot
by the cadre of major derivatives operators.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
