PORTFOLIO POINT: The misuse of collateralised debt loomed large in the financial crisis. Worryingly, financial witch-doctoring is making a comeback, particularly here and in China.
There are many theories about what caused the crisis of 2008, but most incorporate at least an acknowledgment that the finance industry made matters worse through shoddy financial instruments and securitisation that no amount of expensive modelling could make immune from the laws of unintended consequence.
These instruments, of which there were many, were in most cases designed to spread and mitigate risk, rather than concentrate and enhance it. Yet beyond this small, unfortunate irony, the motivating factor of greed – another popular cause of the crisis – would mean the instruments would long outlast firms like Lehman Brothers and Bear Stearns, so prominent in their making.
And so it is, four years’ older and wiser, that we not only have these economic pathogens still in our midst, but we have manufactured new, potentially deadlier ones. Although I am no luddite when it comes to financial engineering – I am a great fan of some innovations in exchange traded products, microfinance, impact investment and fixed interest – there are a few particular products that really worry me. And of these, the word 'collateral’ often appears, raising a bright crimson warning flag.
It is perhaps unsurprising, however, that many of these instruments feature the false safety of collateral, as they did in the GFC. Collateralised debt, that which is pledged against a property or asset, rather than merely the borrower's ability to repay, implies a kind of security blanket. But in many cases it is a security blanket of the flammable polyester variety: the kind that melts onto your skin whenever the heat is turned up.
Taking the focus away from the cash flow statement to the balance sheet can be a grave mistake, for if cash is king then a marked-to-market asset is fool’s gold.
Collateralised debt was in the news recently when the European Central Bank suspended the collateral of Greek bonds within the Eurosystem. Collateral has also been in the news with the global securities regulator club, IOSCO, seeking to regulate the pricing methodologies and benchmarking of oil markets; a key issue when both Brent and West Texas Crude are at nose-bleed levels, yet still trade at a $US17 spread (for more on oil prices, see Fuel for thought).
It’s not this spate of news activity that’s gotten my attention, but rather two developments that are much more germane to Australia: the collateralisation of commodities in China and the collateralisation of houses in Australia. These two phenomena, I believe, are not only interrelated but represent two sides of the same price-inflated coin.
First, some background: since the financial crisis, the world is short of reusable "pledged" collateral. The decimation of America's residential mortgage-backed securities market has coincided too with new Basel III regulatory requirements for banks on capital, leverage and liquidity.
The collateral squeeze has forced investment bankers to hatch new ways to plug the gap and keep bank profits (and bonuses) alive in a constrained world. One way is the liquidity swap, where liquid assets such as Treasury bonds are swapped with more viscous or congealed assets, such as infrastructure, from one institution to another in return for a fee. Another way is collateralised commercial paper, a new form of asset-backed commercial paper that circumvents rules designed to stop money-market funds from investing in these types of things.
Meanwhile, merchant bankers are catching on. "Collateral departments were the orphaned, red-headed stepchildren of the organisation," one executive recently told The Economist. “Now they are seen as the most interesting entrepreneurial and commercial opportunity.”
And while these markets may be in their early stages, it’s not hard to see how they could pose systemic risk in the future if the underlying collateral is not as strong as the end-product purports it to be. This, after all, was the problem with collateralised debt obligations or CDOs, one of the most controversial forms of asset-backed security ever created, where financial risk in collateralised debt – sometimes of sub-prime US mortgages – was tranched and on-sold to the market as some kind of post modern cash alternative.
Source: IMF, Global Financial Stability Report. Containing Systemic Risks and Restoring Financial Soundness, April 2008.
Yet although we’re (hopefully) unlikely to ever again see sub-prime mortgages used as the basis for a major financial product, in China we are seeing the use of an even more worrying asset: warehoused metal.
Just as financial and regulatory constraints have driven strange innovation in the West, China's own brand of draconian credit rules, coupled with an immature bond market, have famously resulted in a savings glut that, in the words of Ben Bernanke, drove excess capital into US Treasury markets, making credit cheap enough to build the great American bubble.
But these distortions didn't just do that. China economic sceptics, such as me, see the results in an epic middle-class property bubble – far in excess of China's needs, despite a rapidly urbanising population – and a massive overhang of capital investment, financed through non-commercial loans extended to GDP-obsessed local government bureaucrats. Stranger still, however, is a market for collateralised commodities – copper in particular – which has distorted global markets and underwritten a potential bubble that most of Australia has considered to be not only sustainable, but long-term (the Treasury, for instance, still doesn't believe we need a sovereign wealth fund).
I’ve written about collateralised commodities before (see Shock and ore), but now there are signs that this opaque market is facing a dÃ©nouement, with Bloomberg reporting that some Chinese banks are now refusing loans for companies that are using warehoused copper receipts as collateral. As the Financial Times has previously reported, it is difficult to measure the market for such collateralised lending, but some estimates last year suggested bonded-warehouse holdings were four times Chinese copper inventories otherwise tallied by the Shanghai Futures Exchange.
Currently, Shanghai-monitored stockpiles sit at over 221,000 metric tonnes, the highest level since January 2003, according to Bloomberg data. By contrast, London Metal Exchange inventories are at their lowest level since August 2009. If China’s collateralised commodity market is still as big an issue now as it was last year, the outlook doesn’t look good for Australian miners.
Against this backdrop, a concurrent development in Australia – the distributed collateralisation of housing stock through a resurgent residential mortgage debt market – looks particularly scary, especially if you believe, as I do, that Australia’s exorbitantly expensive house and land prices are in part due to the China-derived resources bull market and are too widely levered as a proportion of both GDP and household income (see Property boom’s Chinese foundations and Banks: duck and cover). Residential mortgage backed securities constituted 77% of Australia's entire asset-backed securities market as of December 2010, according to Austrade. And now there’s the dangerous argument by some originators that the government should increase its support of the sector through increased US-style RMBS repurchasing. We may not have much of a market for collateralised mortgage paper yet, but you can see it as a logical sequence in the current debate.
Equally scary is the ASX’s new daily house price index that has been launched as a possible precursor to exchange-traded housing futures. Beyond the obvious statistical risks of being able to impute a daily movement in the value of Australia's housing stock when data is so notoriously difficult to collect (even the widely-quoted RP Data statistical series, on which the index is based, has its vocal detractors), there's the risk that by investing in paper houses, as it were, investors may be setting themselves up for a bigger self-fulfilling bubble than the A-REIT or the timber plantation sector ever experienced.
John Maynard Keynes, the British macroeconomist whose ideas have come back into vogue since the crisis began, is well known for views on monetary policy, the business cycle and political economy, but less so on financial mathematics and econometrics, which he described, "so far as I can understand the matter", as "all hocus." For the man who also popularised the term "spurious correlation" and “the slippery problem of passing from statistical description to inductive generalisation,” we can only guess at what Lord Keynes would have thought on the subject of a daily house price index.
Most of all, while not a collateralised debt product, if the Australian property sector were to experience a substantive correction, the existence of a tradable index, which presumably superannuation funds and other non-bank institutions would be invested in, would only exacerbate such a crisis across the wider financial sector – not to mention the holdings of personal and super investors, in much the same way as CDOs did when the sub-prime market fell apart. Furthermore, the existence of a tradable index only invites short-sellers to speculate on the major assets of the majority of Australian families. Housing for most people is a personal asset, not a tradable financial instrument, and presumably this is why such an index has not been engineered with such gusto anywhere else in the world.
Although it’s probably too early to really take this development to task, considering that no securities are yet traded, investors should consider themselves pre-warned. The alchemists of the financial netherworld are back and their cauldrons are bubbling red hot. The last financial crisis was exacerbated, if not caused, by collateralised debt instruments and similar products. It looks like the next one could be as well.