DANGER WARNING: WHEN BOND ISSUERS PLAY FOR TIME

The famous British economist A.C.Pigou, whose equilibrium theories became part of the neo-conservative view of monetarism, was a KGB agent-recruiter and passionate climber. He knew it can be as dangerous in deciding how to descend a difficult mountain as to climb it; the inclination is to use the same hand and foot holds coming down as were made going up. All holds that sap your strength or might give way under strain have to be correctly judged as merely temporary, not a fit subject for betting on the better purchase value of delaying decisions. When poor health meant he could no longer risk taking potential recruits climbing he entertained them instead to cream teas by the river as his suitability test. In both tests he who hesitated was lost.
A STITCH IN TIME SAVES NINE
Bank and Corporate bond issuers are repeating the mistakes of the credit crunch by hoping for lower spreads if they delay a few weeks or months! This is irresponsible and dangerous! How did such postponements trigger the credit crunch and recession?
One analogy comes from the question behind Obama's health care reform: if medicines cost money and are expensive, and instead of taking doses regularly as prescribed do you save money by waiting longer between dosages; do you risk a worse sickness?
It is inevitable that in business the main medicine is money, and the medicine cabinet is the bank.
Just as many medicines deal only with symptoms while buying time for the body to heal itself, so too does borrowing buy future time to pay for investments made now. As the world trade imbalance became extreme between credit-boom economies, that ballooned household debt backed by rising property wealth, and export-led economies, that suppressed household wealth and lent heavily to industrial companies, banks in both types of economy became over-lent, one to property, the other to production. We know how household and finance lending grew enormously in credit-boom economies, but so did it too in export-led economies e.g. Germany. Germany and China with the world's highest trade surpluses and described as awash with savings, do not have great financial resources internally. Their banks are also vulnerable from lending too much to business as UK and US banks lent too much to property. China has desperately tried to maintain its growth by expanding credit and now is rightly frightened about this, about how poorly Chinese manufacturers can service their debt and is cutting back. The credit crunch put a stop to the previous extreme imbalance in the pattern of world trade and its deficit financing. In credit-boom economies the banks went global, serving an international market (globalisation) that is only partly evidenced by banks' assets in ratio to home country GDP.BANKS POSTPONE DECISIONS AND FALL INTO WORSE LOSSES: examples
1. Economists saw the economic cycle peaking in 3Q 2005 and cyclically turning down a year later. To global macro-economists (of which there are precious few) the extreme imbalances in world trade were obviously unsustainable for much longer. Investment returns in property especially fell below bank deposit rates, and GDP growth in credit-boom economies slowed. Property markets peaked: sales dried up; prices falling patchily at first, then nationwide in the USA. Bankers smoothed the problem by upping issuance of securitised bonds to make mortgage lending self-financing short term and in credit derivatives leveraged up to chase paper-profits in unrealised asset gains as net disposable incomes and savings fell. Any banks who could borrow more by issuing bonds did so. They postponed the onset of 'Anglo-Saxon' credit recession by 1-2 years.
2. US and UK banks had $30 trillions of foreign balance sheets a ratio of 50% to world total output and 100% of world trade - that dominated the world's trade imbalances financing and international funding of banks round the world. They postponed withdrawing that liquidity until 2008-09 when it shrank by $3 trillions. The following graphic only shows the dominance of UK and US banks in private customer lending.3. After June 2007, when asset backed securities issued by banks were day after day downgraded following Moody's fixing its false ratings model. Moody's had graded half of all securitised asset-backed loans. Fixing its model and then regrading all of these sent the market values of the banks' bonds tumbling and directly triggered the credit crunch of interbank lending becoming too expensive to sustain banks' interest margins. Banks needed typically 1.5% lending margins. When margins fell to 0.5% (50bp), the banks sought 150bp from fees alone from lower quality tranches ABS. When the quality of bank bonds became exposed, bank shares weakened internationally and continued falling for 22 months. From August 2007 the interbank market for financing banks' funding gaps became expensive. 4. In Summer '07, Northern Rock with £110bn assets and the highest funding gap (between deposits and loans) based on growing aggressively several times faster than the growth of deposits, found, like many banks, that it could not book forward refinancing at rates to maintain its aggressively low interest rate margin and tried to postpone doing so in hope that funding rates would soften, but its board insisted on going to Bank of England for liquidity support - that became public thanks to the BBC. There was a run on the bank that became a worldwide news spectacle.
5. Q1'08 Bear Stearns collapsed when it failed to meet collateral margin calls. Other banks like Citicorp, HBoS, UBS, WaMu, M-L, and others face short-seller attack based on rumours they cannot economically refinance their borrowings at a price needed to maintain their lending margins, especially in corporate loans.6. Many banks bet that the fall in bank shares and in asset backed securities and credit derivatives would be temporary because underlying net cash flows remained strong e.g. Lehmans and RBS buying more stressed assets because they looked cheap, and Barclays trying to do so but luckily failing! UBS dumped loss-making assets into customers' 'profits-only' savings accounts! But they were wrong and had under-estimated the impact on their balance sheets and capital of write-downs and growing loan-loss provisions. Some banks had backed their contrarian wishful thinking by maximising their leverage to the extent of breaking the rules and limits on capital reserves and risk diversification, most especially Lehman Brothers. September '08, Merrils, AIG, Lehman Brothers, and HBoS, followed by RBS and Fortis, and others need emergency saving; they have hit absolute cash-flow insolvency. Lehman (with £0.8tn of claims against it) is allowed to collapse and $2.5 trillion of failed trades (were sellers had gone short) hit money markets. Central banks have to balloon their balance sheets (both sides) to save national and international banking system.
7. The inter-bank funding market spread, already expensive but slowly falling, in Q3 & Q4 '08 spiked and funding dried up almost totally - The Credit Crunch - requiring central banks to step in and replace private funders by taking banks' loanbooks (securitised or simply 'covered) as collateral for central bank counterparty assets.
At the time I said, and in hindsight it became clear, that had banks accepted the higher cost of funding refinancing as their notes became due, which would have proved temporary, their realised profit fall or losses (also temporary) and capital reserve loss, would have been a mere fraction of the losses they did incur.
The banks would have had to rapidly and radically adjust their business models. They resisted this or simply did not know how to or even lacked the management authority within their sprawling financial conglomerates to do so?
CORPORATE BOND ISSUERS
Denied bank loan growth and suffering balance sheet deteriorations, corporate borrowers found themselves having to offer junk bond rates at 9% typically, or double the spiked rates that the banks had refused to accept! Since April 2009 equities began recovering and bank funding rates softened, but in expectation that rates will significantly fall further, now many companies are deferring the renewal of committed revolving credit facilities.
Instead of simply accepting the price today, they are speculating, betting, living in hope that an improving market leads to better pricing, terms, and maturity. They have rapidly it seems failed to draw the lessons of, or forgotten, how at the peak of the credit crisis, revolving credit facilities - to fulfill their purpose as standby liquidity in the case of unforeseen events or to maintain the current balance of both sides of their balance sheets. As companies faced acute operating stress,drying of the bond, securitization and commercial paper markets, that meant changes in bank lending capacity and behaviour, revolving credit became the most critical factor in
corporate liquidity, just as it did for banks.
Draw-down of revolving credit commitments was historically considered a red flag viewed as a precursor to bankruptcy. As bank credit tightened and undrawn overdrafts were cut in the credit crisis, covenant violations, revolving credit maturities, or simply the capacity and willingness of banks to fund their commitments undermined the accepted practice of incorporating undrawn revolving credit capacity into an aggregate liquidity number.
As the uncertainties of the crisis grew, drawing down on revolving credit agreements became more commonplace and was often viewed as a prudent strategy as opposed to an unequivocal warning sign. At the depth of the crisis, revolving credit commitments extended by the banks became often limited to 364-day or two-year facilities as a result of bank capital ratio stress and negatively viewing corporate credit risk.
Corporates found that bank facilities only provided short-term liquidity protection and added to refinancing risks that in a prolonged period of high uncertainty (in trade, business and capital markets) undrawn credit facilities no longer offered long-term standby liquidity to weather the economic cycle and/or other credit risks.
BANKS RESTRUCTURING (SHRINKING) BALANCE SHEETS
Banks' balance sheets behave pro-cyclically, ballooning in cycle peak years, then suddenly shrinking in recession shcok and being slow to grow again in recovery years.
In the initial two years of the economic upswing after 2001 it was not loan demand, but reduction in bad loss provisioning that drove banks' earnings, followed by sharp rises rising on the warm air of the newsflow on corporate profits, plus aggressive cost-ratio cutting.
The rise then levelling out of loan demand and credit defaults falling to low default rates (dramatically lower default risk, easiest to achieve when new loans are easy or cheap), junk credit spreads fell from around 20% to below 8%. Unsurprisingly, bank share prices doubled in 2003 in six months, smartly outperforming the broader market.
Capital investment and bank lending to support this grew in the export-led countries. Utilisation rates in the US, Germany and Japan all moved higher along with profits for the corporate sector.
The UK and USA household credit cycle peaked in 2005. When recession was obvious by end of '07 and into '08, corporate debt expanded for a while even when the household sector's began to slow and residential property prices fell. Then, beginning with property developers, corporate debt looked very risky. But, the embarrassment of the corporate sector appears deeper but shorter lived than the household sector. UK and
US house prices appear now in Q1 '10 to be slowly on the rise. With greater backlog of orders, US firms are no longer cutting working hours, and unemployment rates are only edging higher after having moved up substantially in '09. In the UK, unemployment is a third less than normally be expected.
Some rise in consumer confidence is feeding through to the housing market, but based on a preponderance of buying properties at heavy discount and a lot of bank-owned properties being held off the market. Home sales are off their lows and, most importantly for banks, house prices appear to be forming a bottom. With a sharp reduction in loss provisioning, bank earnings ought to rise through 2010.
The steep yield curve is currently exceptionally helpful for the banks; about half of bank assets are lent at long- term rates, and 3-month LIBOR is c.50bp. As banks hold the line against growing loans (that fell 8% in 2009 by US and UK banks), banks can add to their Treasury holdings to further benefit from the yield curve. UK and USA Bank holdings of Treasuries have risen by $half a trillion over the past year and will increase substantially more to build up capital buffers.
In doing so, however, shrinking their loan books, the banks are not helping economic recovery. They are putting their narrow interests first and using new regulatory requirements to do so. Corporate bond issuers appear to be joining in the deleveraging, which means delaying capital investment, and now on top of this also delaying new net corporate bond issues?

EUROPEAN MONETARY FUND

European Commission President Jose Manuel Barroso at a media conference on Europe 2020 at EC HQ Brussels, March 3, 2010. The European Commission will eventually announce ways to safeguard the stability of the 16 nations that share the euro, to stem problems such as Greece's debt crisis from threatening Europe's currency union.
16 states are in the Euro Area (also called Eurozone) and are requested by Germany and France to consider creation of a "European Monetary Fund," a fund that could help euro-member countries converge more on the Maastricht Treaty criteria, which apply as ceilings for all EU members, not just those in the Eurozone. Germany and France first announced they were considering a European Monetary Fund on 8th March, describing this thinking as seeking new safeguards against the kind of eurozone instability created by Greece’s debt crisis. Support for an EMF for the Euro Area to be modelled on the IMF, was revealed at the weekend by Wolfgang Schäuble, German finance minister, who told Welt am Sonntag newspaper that Berlin wanted more eurozone policy co-ordination. This is absurd from a practical economic perspective - if all Euro countries followed Germany's policy lead i.e. export-led growth, then unemployment will remain high and Germany's policy would have to change.The idea of EMF is a good political move! It heads off the embarrassment to the Euro Area Council and the ECB of Greece seeking help from the IMF, and if any other Euro Area states, such as Portugal, Ireland or Spain, do the same. It also heads off criticism especially of the European Central Bank (ECB), which ought to be fulfilling that same function, and provides another route for funding by EU states and private banks to route soft loans indirectly. All expect sovereign crises to be inevitable, the inevitable result of governments taking on some of the burdens of private over-indebtedness.
Sovereign debt crises are associated with countries that have very high national debt to GDP ratios. But that is not the issue; it is trade deficits and private and government cross-border borrowings i.e. loan pricing pressures from lenders. Japan’s debt ratio of about 190%/GDP is very high, but because it is has a large trade surplus it is a net creditor nation. The US with National Debt of 83%/GDP with most of the world's trade deficit is a debtor nation, but secured by the $US dollar's global currency role denominating more than half of all trade and international financial transactions. The Greece crisis is also deficit-led, but small in EU or global terms. It will not cause lasting damage to the Euro or European Monetary Union, but ushers in some long-run changes within the Euro Area that may go in one of two ways, either towards severe growth tightening or towards more flexibility? The Euro Area as a whole has a 'national' debt ratio of 78%/GDP (the line towards which the UK is now headed). But those above that line that have high trade deficits (not Italy despite its over 100%/GDP debt ratio) i.e. Spain, Ireland and Greece (which may be joined by the UK) all planning unprecedented tightening - the next five years will be a test of political-economic courage for all European leaders. So far they do not appear to be able to disengage from domestic sabre-rattling or flag-waving - it is like an economic phony war. Will it turn into a real ideological war over economic policy and beggar-the-neighbours or cutting off noses to spite faces real economic damage? The IMF has been given such a role by G20 in which the EU is a full participant. nevertheless it is embarrassing for the Eurozone to be shown politically prevented from helping member states in difficulty while the IMF can do so. The Greece sovereignty crisis is probably only the first of several.
This EMF idea comes hard on the heels of Greece saying it will appeal for IMF help if Euro Area states and the ECB cannot help it with loans. Some €26bn of ECB short term (1 year) loans were provided to Greek banks. They have to be repaid starting in June, and cannot be simply rolled over because the ECB decided to stop issuing any more such short term loans in December last. Further loans have been agreed but on conditions of public sector spending cuts that are causing protest riots and strikes almost daily in Athens and elsewhere. Greek banks and the central bank need about $200bn to cover trade deficit and funding gap financing. US commercial banks hold $156bn of Greek banks' notes. Private sector borrowing should not be confused with public sector, or the latter if it is high looked at without considering the context, such as the tag placed on this chart. If structured like the IMF, the EMF could provide some stability tools that the euro needs, and that the ECB in Frankfurt is, for political rather than economic reasons, constrained from providing. The European Bank for Reconstruction and Development (EBRD) in London seems to be overlooked in this? EMF is also a sign of Europeans wanting to decouple from what they perceive to be Anglo-Saxon finance and economics.
The Greek crisis has weakened the Euro. If more Euro states seek loans from the IMF that is a further threat to the Euro.
When the currency was born in 1999, it was obvious to all that one weakness was the lack of a federal political entity supporting the ECB. To fill this gap in terms of states' budget deficits and debts, all EU states signed the Maastricht Treaty that set limits of 3% ratios to GDP as the ceiling for annual budget deficits. But, enforcement penalties were ambiguous. The markets are finding a way to exert the punishment and still arbitrage between different EU and Euro Area members even though a single ECB central rate and single currency denominated bonds was supposed to stop markets from differentiating and attacking any of the member states individually - that was the purpose of the Euro. It is not working so long as the ECB is not acting on behalf of the whole Euro Area regardless of different budget settings and different growth strategies. Policy differences should be addressed outside of the ECB, not inside. Would an EMF be any different; would it be less picky and less political?
The problem boils down to some countries pursuing export-led growth (mainly Germany) and others credit-boom growth rquiring them to finance rising trade deficits e.g. Grece, UK, Ireland, Spain. While Germany focused on integrating its Eastern regions and on exports, but doing nothing otherwise to stimulate domestic growth, other countries grew by bank borrowing and lending secured by rising property values and needing to sell securitised banking assets and borrowing to finance their trade deficits, of which Greece had proportionately the highest. From the perspective of Portugal, Spain, and Greece, and a few others, they considered themselves to be in economic catch-up mode, and following the example of Ireland's property credit boom.Note the stagnant and falling property prices of Germany showing how it traded the idea of household home-ownership and household wealth for export-led growth i.e. keeping domestic consumer demand depressed, going for high savings and international creditor status instead of what might be called democratic prosperity - the stated goal followed by USA, UK etc.
Yet, so long as this seemed to be working, the credit boom economies of Spain, Greece, Ireland were praised for their above average contribution to total EU and Eurozone growth. There was no concern expressed in EU economic reports about these countries trade deficits or eventually unsustainable housing booms until the asset bubbles burst. A clear demarcation arose between the centre of the EU and its periphery. But this is no different from the picture worldwide, and where cerdit-boom economic growth translates not into high public sector or national debt, but very high private sector debt - that is the real long term problem that economics and its politics have to now consider centre-stage and not leave lingering in the background as hitherto.
When you click on the next graphic to see it full size, you should be amazed to see the differences in size of countries dictated by how much has been loaned to, borrowed by, private sector. Note how small countries are proportionate to their population and economic size e.g. even Japan and shockingly China (which since this graphic has doubled private sector loans, but still this remains small. Proportionately small lending to the private secotr shows economies that are externally very dependent and that have done relatively less or little in deepening and broadening their domestic economies in terms of per capita incomes and actual per capita household wealth. Europe's Mediterranean countries - now called the "PIGS" (Portugal, Italy, Greece and Spain) - are accused of having less fiscal discipline than Germany. This is unfair in the case of Italy, whose problems derive from opposite reasons to the others; Italy did not follow credit-boom growth, but at the same time found it could not generate an export-led growth model like Germany's. Italy, like France, kept its external account roughly in balance. The 'I' in PIGS should stand for Ireland. The advent of the euro gave Ireland, Spain, Greece and Portugal low real interest rate shocks, that fuelled credit-booms - and were for years highly beneficial, but could not continue in 2008 and 2009. The result was gigantic housing and other property asset bubbles. Italy had modest productivity performance and grew its economy to overtake that of France in GDP and trade, if falling behind Germany at a rate of almost 3% a year. Italy's budget discipline was good, but carrying a high national debt ratio. Its banks remained extremely prudent - too much so! Greece (and Cyprus), with the far to go to catch up with the EU GDP per capita average did so rapidly. But the result was a trade deficit approaching 20% ratio to GDP, by far the highest in the OECD.
Greek banks became heavily borrowed and invested strongly in bank subsidiaries in SE Europe to whom the banks lent about $150bn. Other EU countries' banks also invested in growing banks in central Europe and Russia, providing total liabilities of about $1.5 trillions. The EBRD, ECB and others are much concerned about how the central European economies are performing and whether the banks are remaining solvent.
With the EMF proposal, it should be possible to design a fund that solves this problem - but, only if it is able to build up a substantial balance sheet of probably at least €500 billions, when it would overtake the EBRD and rival the ECB in funding.
If the EMF behaves like the IMF (and World Bank) it could force Greece and any other country that needs loans from the fund to restructure their economies and budgets. This would involve cutting back the public sector, capping wage rises, undermining labour unions, and possibly privatizations of public utilities - condiions that would do more than blow the froth of economic growth! The second achievement of such an EMF could be the creation of a bank bailout process that is at least as onerous as required by European Commission rules to protect fairness in the Single Market. There is an irony here that the Single Market and a single currency do not allow member states (regions) to divert from a rigid average or lowest common denominator norm.
Last week, ECB decided to maintain some support for the Euro Area banking system in light of the Greece controversy. ECB President Jean-Claude Trichet said, "We considered it was exactly appropriate taking into account the present situation." When pressed on what present situation he meant, he said he meant concerns over Greece. For at least the next 7 months, funds to keep banking operations running smoothly over seven-day periods would continue to be available in unlimited quantities at the ECB's rate, currently 1pc. But that does not change the repayment deadlines of the Greek banks! Athens' need to raise €20bn (£18bn, $27bn) in April and May to finance expiring debt is likely to widen spreads above the 300bp that Greek bonds incur above equivalent German Bunds.
On ECB overnight money, Trichet said the rate banks charged each other would not rise much in the short run. The overnight rate is currently at 0.32pc and the ECB regards this as very cheap money. Actually, of course, the insurance spreads on Greek debt and bank debt remain high at about 300-400bp, and while they should fall over the years, they may rise again in the coming months. Although bond spreads have narrowed since the launch of the latest austerity package that is the cause of splits within the governing party, street protests and Thursday's strikes, Greece currently has little choice but to pay 300bp more than the equivalent German bond – a premium that Greek government officials rightly say is unsustainable.From next month the ECB will return to the pre-crisis practice of offering three-month loans to the banks at a variable, instead of a fixed rate. When the 7 months are up, the ECB will decide whether and how to bring overnight rates back to normal condition of slightly above the benchmark rate. By then the banks aided by the ECB will have to have financed the ECB's "exit" strategy - of particular importance to Irish banks, the heaviest users of ECB loans of more than €50bn(January). As ECB soft loans end, interbank interest rates will rise before the ECB raises its own rate.
Irish banks used last 12-month loan at a fixed 1pc offered by the ECB in December. Banks must repay the first of these fixed loans in July - a total eurozone repayment to the ECB of €442bn, actually a reverse swap, taking collateral back and giving back ECB bills plus interest and fees. From other sources at the same time they will need to borrow finance to fill their funding gaps at that time, which will have grown by over €400bn.
The ECB described this process as a new stimulus measure, described as lending back "covered bonds" it bought during the crisis, saying this will help banks borrow funds on the market. If Orwell was alive and writing today he would describe such language-spin of the banks as 'newspeak'. The credit crunch was essentially banks unable to use their covered bonds to borrow against from other banks at economically viable rates i.e. at margins below what they can safely lend to customers at. The banks have to hope that for some reason interbank lending will in the next few months turn positive from negative and at spreads that are realistic for borrowers to accept.With the bonds markets continuing to be jolted by sovereign risk news, part of the recovery in equities has to be a flight from bonds? The long 9 months of recovery in fixed income assets prices extending to sub-investment grade and sub-prime RMBS has come to an end. Price spread volatilities including credit risks are 15-40%.
The media are complicit in such misdirections. The Bank of England decided this month, for a second month, not to resume what the media persist in calling its "money-printing" programme of buying government debt from banks. Apart from the purchases being designed not to be from banks, having called its actions as Quantitative Easing, it may be no wonder that the news media try to explain this by calling by the misnomer "printing money".