A Market Participant’s Perspective on Debt and Default
Peter is founder of the Irish Institute of Financial Trading, and was formerly chief dealer and head of treasury for Barclays Bank.
To understand the market’s perception of the current Eurozone crisis and how it might react to the eventual solution, one needs to understand the mindset of the trader. While the financial markets provide the products that industry needs to grow, and the products needed to control risk, once invented these products are subsumed by the traders in the market as a means to speculate. So despite foreign exchange being a means to eliminate risk for exporters and importers, foreign exchange turnover is dominated by speculative activity. The same goes for commodity futures, bonds, etc.
The financial market lives in a realm of perception and not reality. Traders who wait for the reality of the situation to occur have lost the profit opportunity of the journey. Reality is fully priced, whereas the move from the perception of the outcome to the reality of the outcome is where the money can be made. This is the world where speculators live. Speculation dominates the financial markets and traders have little or no sympathy for the outcome. They just want to make profits. This is a cold, calculating environment which has an effect on the world we live in. Politicians have little control over markets which can visit hardship or benefit on many. I have always maintained that the bonus culture is responsible for many of the disastrous products that financial markets invent. If you pay multi-million bonuses to individuals, they have no downside risk to their actions. It was out of this culture that sub-prime mortgages were created.
On the positive side, markets fight against poor political economic policies. Politicians have failed to understand that the markets will not be fooled by spin. If a policy is viewed as flawed, the market will attack it relentlessly and in most situations force a change. The currency crisis in Ireland in the early 1990s was a classic example. Rather than accept a 10 per cent devaluation of the punt, the authorities embarked on a ridiculous policy of defending an overvalued currency with exorbitant rate hikes. Those who remember will recall rates of 40 per cent and more being charged on corporate loan rollovers. A six-month standoff ensued before the realisation set in that to let the currency go might be the correct solution after all. Politicians lose when they take on the market with flawed policy. And the present Eurozone crisis is exactly that.
We have a Eurozone that simply has too much sovereign, corporate and personal debt. The solution being pursued to reduce the debt is austerity and economic growth. Austerity without growth leads to lower growth and increased debt. The Eurozone crisis is not a complex one but it is massive. The debt of nations is held by banks and it is the fear of sovereign default on bank balance sheets that is so serious. Weak banks cannot borrow money and therefore cannot lend. Lack of credit leads to lower economic growth which leads to increased sovereign debt and the spiral continues. No doubt the solution to the Eurozone crisis is debt forgiveness, restructuring or default. No one envisaged a haircut on sovereign debt within the Eurozone and the present market reaction reflects the enormity of such an event.
All banks are required to hold liquid assets so that they can raise money quickly in unforeseen circumstances. Historically the most liquid assets have been sovereign bonds. After the introduction of the Euro, bonds within the Eurozone could be purchased and held without the historical foreign exchange risk. For example, a bank in Ireland could hold French sovereign bonds in Euro and not francs as was the case previously. With the elimination of currency risk, the only thing that became important was the yield. Because default was never envisaged and Euro sovereign bonds were regarded as zero risk, the 20 basis points premium being offered on Greek bonds over their core European counterparts was irresistible. So began the ability for smaller nations to borrow at virtually the same price as Germany. We know it was the access to this funding that fuelled the high level of debt in the periphery countries, leading to the disaster that is now Greece and the property bubble that now defines Ireland.
Bonds are the integral part of this story and it is important to understand their various uses in bank balance sheets. Traders buy and sell bonds for speculative profits but banks also hold bonds for liquidity on what they call their back book. The important feature of a bond is that it is a negotiable instrument and is normally marked to market every day. This means that it is re-valued every day at the current price versus the original purchase price; the resulting profit or loss is set against the bond in the banks’ accounts. Bonds are issued at par. Therefore if you purchase €1 million worth of a ten-year bond with an interest rate of 5 per cent on the first day of issue it will cost you €1 million. If interest rates fall the bond will have a value greater than par due to the attractive 5 per cent rate on the bond you bought. Because interest rates move continuously, bond prices change daily. However, because banks’ back book holding of bonds were never for trading, historically they were never re-valued. The principle was that because they were zero risk, the money paid for them would be re-paid at maturity. And because they were being held for liquidity, the bank could envisage holding them to maturity. Because of this, back book bonds were not taken into account in either of the Europe-wide banking stress tests.
As I mentioned, markets deal in perception. Despite the authorities stating that the vast majority of banks passed the stress tests, the market’s perception was different. If you have Greek bonds on your back book, you may not be getting all of your money back this time! So despite the authorities assuring us the banking system in Europe was sound, the market speculated that it wasn’t. This is when the crisis moved from a sovereign debt problem to a banking problem. Sovereign debt can be solved over time while a banking problem is immediate. Banks are dependent on the interbank market for funding. When suspicions arise that banks may be in trouble the interbank market dries up. Confidence is hit and banks are unwilling to lend to each other as they are unsure as to who is badly affected. This leads to a credit squeeze between banks and ultimately between banks and customers.
Why did the authorities not see this coming and address the periphery bond issue earlier? Time and again, politicians and central bankers kick the can down the road, opening up opportunities for the speculators. As a trader myself I cannot complain but neither can I explain it. Most of the big successes I have had in my trading career have come from political misunderstanding and inaction. If the right decisions were made in a timely fashion, most volatility would disappear from the markets and speculation would diminish. Frankly this is unlikely to ever happen.
So where is the trader in all of this? Traders are opportunistic; they do not have a predisposed opinion on anything. Unlike economists who try to predict the future, traders react to the market in real time. While the market may go from A to B it will not do so in a straight line. So while the Euro may weaken as a result of this crisis, it is presently higher now at the time of writing (January 2012) than at the beginning of 2011. There is a saying: ‘the markets can stay irrational longer than you can stay solvent.’ Traders ignore this maxim at their peril. So the market today reflects underlying conditions today, while politicians would like the market to reflect where they believe their policies will take it in the future. This conflict is ever present and is why most politicians loathe and fear the markets.
The advantage of the trader is his/her ability to be either a seller or a purchaser, thereby having the ability to profit from a rising or falling market. Traders have a total lack of sensitivity to the direction of the market. The bonus culture overrides the fact that their actions may be affecting the performance of their pension fund. Indeed in the 1980s in Dublin you would have been hard pressed to find a trader affected by the recession. When Wall Street crashes it’s an opportunity for the trader, despite the fact that the crash is devastating dad’s equity portfolio. The mentality of the mob, some would call it. But mobs are hard to control and for the authorities they are hard to convince, especially with spin. So the market and the traders within the markets have the power to revalue equity assets, bond assets or property assets. And it is this power that will ultimately force some action to resolve the crisis.
So what opportunities exist for traders to profit from the present crisis? Bond traders are the highest paid in the financial markets. Anyone who read the book The Big Short will have some understanding of the millions these people earn. Buying bonds when yields are rising is loss-making so these traders need to be able to short the market to profit. There are two ways they can achieve this. They can borrow bonds from another institution for an agreed period of time, sell those bonds and buy them back before they have to be returned, hoping in the meantime the price of the bond has fallen. Or they can purchase a ‘credit default swap’ (CDS), which is basically an insurance premium against a default on the bond. You do not need to own bonds to purchase CDSs so the swaps can be a purely speculative instrument. The comparator would be a number of people having insurance policies on your house. Therefore the pay-out on the credit default swaps could be greater than the losses on the bonds. The point that a Greek default would lead not only to losses on the actual default but also to losses to the issuer of the CDSs is not fully appreciated.
Rating agencies have a major role in the bond market. They are tasked by the market to provide a rating on sovereign, bank and corporate bonds. Traders have limits on the type of bonds they can buy, so the rating of the bond has primary significance. Rating agencies have extraordinary powers and have in the past been heavily criticised for their performance. In the sub-prime mortgage meltdown of 2008 rating agencies had attached AAA ratings to mortgage portfolios which clearly were anything but AAA. They are playing a big part in the present crisis when adjusting ratings on sovereign debt. No doubt the authorities would like them to go away but this is unlikely to happen.
Traders can also profit from selloffs in the equity markets. Although there is a short selling ban on many financial stocks, that does not prohibit traders from profit opportunities. Banks are the engine room for any economy and any weakness in bank shares generally feeds into other areas of the market. Therefore even when traders cannot speculate on individual financial stocks, shorting indexes can still lead to handsome profits. Other markets open to speculation include foreign exchange, commodities and options. In all of these markets it is easy to be long or short and given the liquidity that is available it affords flexibility on risk. Traders can be bearish but swing to bullish easily if circumstances change. It is this flexibility that sets traders apart from traditional investors who by their long-only strategies get killed in bear markets.
So what is the trader’s analysis of the current Eurozone crisis? Most traders think in the short term: weeks rather than months. The bigger hedge funds, because of their size, need to position themselves structurally long or short. This means they have to take a longer view of the market, much like economists do. If we take the longer-term view first, the Euro can only survive with closer economic integration. We need to become more like the United States, with one central authority overseeing economic policy for all the regions. Whether this will be politically acceptable to the diverse countries of Europe is a big call. Ireland, Portugal and Greece may accept this outcome because we are small and the fear of going it alone is too great. Italy may think differently.
The single currency has proven extremely unsuitable for small open economies like Ireland and Greece. The access to cheap funding was the cause of the debt problem. Time and again the European Central Bank (ECB) has set policy which is suitable to the core of Europe. Ireland, a small exporting economy, would prefer a weaker exchange rate and adjustable interest rates to control its boom and bust cycles. That will not be possible going forward and as closer integration comes the policies dictated to us will be designed to prevent us from being a problem rather than what is best for us as a nation. The call on whether the Euro survives will be a political one. The current policy of austerity and the hope for growth will fail for the periphery economies. The strains at political level are already starting to surface. Germany and France are dictating the strategies they feel will fix the problem. Smaller countries are expected to row in and have had little input of late. The main issue is not whether Greece will default – that is almost certain – but how will Italy fund itself at bond yields double last year’s levels. To most commentators the problem is simple: there is too much debt. Either the Germans show resolve to keep the Euro by back-stopping the European Financial Stability Facility and let the ECB monetise sovereign debt, or the Euro is finished. This is a major policy shift but is the only sensible workable solution.
So is the Euro worth that much to Germany? Re-unification cost them €2 trillion and saving the Euro could cost them the same. You can be sure of one thing – if the Germans finally decide to back-stop the Euro it will come at a cost to the other members of the Eurozone. Germany is not going to allow a write-down of debt without the safeguard that it can never happen again. So the Euro can only survive if we hand over control to a central European authority that controls our finances, including our budgetary process. Will this be politically acceptable? I doubt it.
As you work through this argument most traders will reach the same conclusion. The Euro will not survive in its present form, if at all. Rather than showing unity, politically we are drifting apart. Ireland might be the good boy in the class but Greece and Italy are becoming pariahs. Will disharmony tear down the Euro and send us back in time? It would be a calamitous set of events. Prior to the Euro, banks were very insular because of the foreign exchange risk associated with cross-border deals. French banks tended to lend in France, and so on. With the introduction of the Euro, borders were blurred and now bank balance sheets resemble spaghetti in regard to where they have lent and borrowed. Unwinding these transactions after a Euro collapse would be a monumental task. Converting state balance sheets back to domestic currencies would be as daunting. Maybe the seriousness of the situation can drive the correct solution in the end.