It’s Not Just Whom You Sleep With

“It’s not just whom you sleep with, but also whom they are sleeping with,” Warren Buffett told investors back in 2008. He was referring to the chain of connections you are exposed to when dealing with a derivatives counterparty. His biological analogy, familiar to those studying the spread of viruses, was picked up in a speech by the Bank of England’s Andrew Haldane the following year.

The financial system resembles a “cat’s cradle of interconnections”, said Haldane. It’s an adaptive, complex network that is prone to seizing up.

Identifying and analysing the problem has proved much easier than dealing with it. One solution highlighted by Haldane in his paper—broadening the network of central counterparties and requiring intra-system netting arrangements—is a major feature of recent regulatory reform (via the US Dodd-Frank Act and its equivalent in Europe, the European Market Infrastructure Regulation).

But proposed changes in derivatives regulation have met with fierce lobbying by affected financial institutions. Banks and other dealers are reluctant to give up the fat profit margins generated by dealing on a bilateral basis and they don’t want to suffer the cost of the strict collateral requirements that a central counterparty would impose. Buffett, controversially, has been among the lobbyists, meriting accusations of hypocrisy.

Another solution to network complexity—what Haldane called “seeking actively to vaccinate the ‘super-spreaders’ of financial contagion”—is turning out to be even more difficult to deliver.

On the one hand regulators are asking so-called “systemically important financial institutions” to hold higher levels of capital than those banks that do not act as such vital nodes in the global system. “Living wills” are supposed to enable such large institutions to be wound down more painlessly in the event of failure.

At the same time regulators are under pressure to avoid too rapid a deleveraging of the financial system. Politicians and central bank heads are desperate to avoid a sharp recession. Apart from threatening incumbent governments with the likely loss of power, a recession will certainly produce a surge in debt defaults, with sovereign issuers’ creditworthiness now in major doubt too, unlike in 2008. Such considerations are undoubtedly behind recent calls from the Bank of England to ease lending rules, even if this contradicts much of the tough talk issued post-crisis.

Unfortunately, these mixed messages imply that financial market reform efforts may be heading towards paralysis. Meanwhile, markets are well on the way to forcing the issue.

As Jonathan Weil of Bloomberg pointed out yesterday, investors are already valuing a number of European banks at levels well below the net asset figures recorded on their balance sheets. In other words, those assets are being incorrectly valued, or are deteriorating in value, or both. The stock market value of UniCredit, which announced a third-quarter loss of €10.6 billion earlier this week, is only 28 percent of the bank’s book value, for example. In the US, Bank of America now trades at a very similar ratio, its stock price well south of the point at which Buffett’s Berkshire Hathaway fund made a US$5 billion preferred equity investment in late August.

These stock market valuations of banks tell us to expect a major acceleration of announcements of losses and loan writedowns. Capital will have to be raised in a hurry, while shrinking equity bases at banks are forcing them to reduce assets at an even faster rate. Banks’ loan books are shrinking, however hard politicians and regulators are trying to prop them up.

Meanwhile, it’s no surprise that institutional investors are reportedly scrambling to work out where and to whom they are carrying exposures, where their assets are being held in custody and whether they can access collateral in an emergency. The recent failure of MF Global and the ensuing tussle over missing and supposedly segregated client assets have only served to heighten counterparty concerns.

System-wide gearing and high levels of interconnectedness provide a tailwind for everyone during a debt-fuelled boom, but they are a curse when the cycle reverses, as historians of the 1930s could have told us. You can’t get out of debt without shrinking your earnings, which exacerbates the problem. And there aren’t enough truly safe havens for cash within the financial system, as Robert Dubois recently highlighted.

For various reasons, a significant part of the intensifying debate over counterparty and collateral risks in financial products has centred on ETFs. Many ETF industry insiders complain that they are being unfairly singled out for criticism, when the same or even greater risks apply in other products too.

How risks in tracker funds should be assessed in a broader context is the key theme of our upcoming webinar, to be held on December 1. Are you really at risk of financial market contagion when buying an ETF? How safe are different types of fund, and what about other funds and bank-issued investment vehicles? I’ll be joined by three expert panelists to discuss these important issues, and hope you will be able to join us.

Meanwhile, with governments now heading towards defaults, the threat of contagion in the broader financial markets is at its highest level for over 70 years. Vaccination schemes have come too little, too late, and the transmission mechanisms are too large and complex to be easily dismantled.

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