Dec 29th 2007
From Economist.com After CDOs and SIVs come CDSs
IF NOTHING else, 2007 has enriched the vocabulary of international investors. Think back 12 months; how many people knew what subprime loans were, or what CDOs and SIVs stood for? (For those who are still baffled, they are Collateralised Debt Obligations and Structured Investment Vehicles.) The lesson of the year, in retrospect, was that our complex, interlinked global financial system has its drawbacks. Risk was dispersed, and that was assumed to be a good thing. To some extent, it still is. But dispersion makes it hard to tell where risk resides. In many cases, as has been made clear, risk has come back to haunt the banking system. And bank failures are a huge risk for any economy, no matter how advanced.
In retrospect, it seems clear that banks were playing a sophisticated game but they ended up being “too clever by three quarters”, as was once said of Harold Wilson, a former British prime minister. They earned fees for managing and distributing complex securities, and took them off their balance sheets, freeing up precious capital. But the buyers of these securities were often dependent on finance from the banks. And as those buyers have struggled, then the banks (HSBC and Citigroup among them) have been forced to take the securities back.
As a result, one of the big risks for 2008 is that banks, suddenly saddled with this enormous call on their capital, will be less willing to lend elsewhere, notably to the consumers and companies on which economies depend. At the most extreme, the fear is that some economies will resemble Japan in the 1990s, in which interest-rate cuts fail, either because banks are unable to lend or because consumers are unable to borrow.
The dilemma facing central banks is that interest rate cuts normally take 12-18 months to have their full effect on the economy. So any changes made now will not be visible until 2009. By that time, the banking system may have recovered, and everybody will be worrying about inflation, not financial meltdown. Hence the more targeted package unveiled by central banks in mid-December that aimed to reduce the logjam in the money markets.
It is hard to believe, however, that central banks will not face renewed calls for rate cuts in the New Year. What investors want is for the Federal Reserve and the other banks to do what they did in 2002—keep cutting rates until borrowing money is dirt cheap.
That will allow asset markets to soar again, and when they do, there will be no problem in financing asset-backed securities. In 1998, central banks cut rates and helped create the dotcom boom; in 2002, they boosted the housing markets; in 2008, the next beneficiary might be emerging markets or alternative-energy shares.
This possibility is why we have not yet seen a really big downturn in the equity markets. Investors have two scenarios before them; recession, or a resurgent boom. Government-bond markets are priced for the former but equity markets are not; they are still hoping for the latter.
And until we start seeing some really, really bad news—a big bank failure, corporate defaults, a negative quarter for American economic growth—that hope will be hard to shift. After all, where else, apart from equities, can investors put their money? Government bonds offer low yields; corporate bonds would be hit harder than equities by recession, if it occurs; and commodities have already had a very good run.
Shares are thus the default asset of choice. But defaults of a different kind could be the big issue of 2008. If you want to mug up on jargon for the year ahead, then the business of insuring against bond defaults known as credit default swaps, or CDSs, would probably be the best place to start.