IN A WORLD OF UNDERPRICED RISK, WHAT COULD POSSIBLY GO WRONG?
Monday September 17, 2012
On a recent conference call, the strategist of a major international bank (it was an off-the-record call for clients only) laid out the bare bones of what he called the world’s “giant experiment” in debt and interest rates. Never before have so many countries maintained such low base rates for so long; never before in peacetime have so many countries had such huge deficits and debt burdens; never before in U.S. history had long term rates been so low; never before has the U.S. gone so many decades without deflation following inflation. Because we live in these unprecedented times, it’s easy to lose sight just our strange they are… and how dangerous.
Consider just one small piece of this brave new world: What happens when the huge preponderance of the global financial market under prices risk? To add to the list offered by the strategist: Never before has so much debt been referenced to benchmarks that price debt too low for their inherent risks. The distortions of this unique situation have been well-documented – underfunded pensions and impoverished retirees for instance -- but reversion to the fair pricing of risk would almost certainly crater the global financial system and governments around the world.
This leaves us in an exquisitely cruel predicament. An underpinning of any sustainable financial system is the proper pricing of risk. If I am going to loan you money, the interest rate I charge will reflect what kind of return I can fairly demand (assuming that the borrower can turn to someone else if I charge too much) given all the different factors that might prevent me from being repaid in full. For any given financial instrument, these factors might include the quality of collateral, inflation expectations, the character of the borrower, and a host of other factors including the political stability of the borrower’s home country. To the degree that I charge too low an interest rate I am subsidizing the borrower, assuming a portion of risk that the borrower is not paying for, and increasing the likelihood that I will not be repaid in full.
That’s where we are right now, with every lender, depositor and investor in the developed world (which includes most of us when we consider pension funds and insurers) blithely assuming much more risk than we are being compensated for. This has allowed, actually encouraged, the entire developed world to pile on debt at levels without precedent. When events force a settling of this world-wide mispricing, we risk the mother of all financial crises. Will it be hyperinflation as governments try to devalue debt burdens, a deflationary spiral and credit freeze as floating rates soar to try and catch up, or all of the above?
Naturally, all of this has been done by design. On the one hand, central banks around the world have for years been pursuing policy rates at or near zero (nicknamed ZIRP or Zero Interest Rate Policy) since 2008 (and long before in the case of Japan), ostensibly to encourage profitable lending in order to restore vigor to economies. Through programs such as Operation Twist in the U.S. and the LTRO (Long Term Refinancing Operation) in Europe, central banks have also sought to supply liquidity and bring down long-term rates. Thus the vast universe of both high yield and investment grade bonds, priced more to their spread from treasuries than for nominal yield, underprices risk to the degree that fed actions underprice the risk in U.S. sovereign debt.
Then, as we discovered this year, LIBOR, an unofficial rate inaugurated in 1986 to reflect the price that the biggest banks pay to borrow from each other, also has been manipulated to understate the risks bank see in lending to their peers. LIBOR is the benchmark for many trillions of dollars in debt and financial instruments (estimates range up to $800 trillion, a truly ridiculous number that underscores what a monster LIBOR has become). Central bankers in the U.K. and the U.S. have known for at least five years that LIBOR was being manipulated to understate what might constitute a true interbank rate. Mervyn King, a governor of the Bank of England, witheringly described LIBOR in 2008 “as the rate at which banks don’t lend to each other.”
The authorities tolerated this manipulation because they feared then, and still do today, that the real interest rate at which banks would actually lend to each other would be so high as to cause a global panic given the impossibly huge amount to debt benchmarked to LIBOR.Between them, ZIRP and LIBOR affect financial instruments that cover most of the credit waterfront. To paraphrase Jim Grant, much of the developed world lives in a world of return free risk.
All this de facto philanthropy by investors has been a windfall some governments – including the U.S. and Japan -- allowing them to pile on debt without having to commensurately increase the amount they budget for interest. For banks ZIRP has been a mixed blessing. On the one hand, big banks have access to extremely cheap money, but, on the other, the risks of lending in a debt-burdened and bruised economy often don’t justify the meager nominal returns that can be achieved. Also, the tiny margins at the zero bound mean that the short-term collateralized lending that supports money market funds and much of the shadow banking system can become unprofitable in the blink of an eye. Thus, ultralow rates, historically associated with the risk of inflation, can actually withdraw liquidity from the market, and produce a deflationary spiral.
This is just one of the paradoxes of this strange new world. Another is that even as rates suggest that risk has been banished in the 21stcentury, the number of governments and corporations deemed risk free by the rating agencies continues to shrink. According to the New York TIMES, the number of AAA rated corporations in the U.S. has dropped from in the 60s in the 1980s to just four today. The number of Triple A-Rated sovereigns shrinks apace. One reason for the parsimony in handing out AAA ratings today comes from barn-door closing by the rating agencies after the heady days of the housing bubble when any loan had a bright future as part of a AAA-rated financial instrument thanks to the alchemy of securitization. The continuing global hangover from this historic mispricing (and miss-rating) underscores the misery that follows the misunderstanding of risk.
Why then do financial authorities persist in underpricing risk so soon after that near-death experience? Simply put, we can’t do otherwise. ZIRP and a low low LIBOR push the day of reckoning off into the future, and allow governments and investors to retain the faint hope that some yet to be identified engine of growth will save the day. If, however, interest rates were to rise to discount actual risk, debt service would soar to consume tax revenues for the U.S., Japan, and other profligate governments, a flood of insolvencies would ensue, what little mortgage lending that remains would shrink further (pushing home prices down and further impoverishing households that have seen their net worth plummet since 2008), and economic activity would shrivel throughout the developed world.
Central bankers do have one lucky break that gives them breathing room in this ultimately unsustainable situation: inflation remains far over the horizon. All the money printed around the world really isn’t going anywhere (except to buy up the too-cheap debt issued by governments and agencies). It certainly isn’t going to wages – outsourcing has killed that legacy of the bell-bottom era – and there is plenty of slack capacity that needs to be filled before any developed world economy overheats. Nor is it going into consumption -- most households are still drowning in debt, which limits their desire to spend, even if people could qualify for additional credit.
So, the Federal Reserve continues to push out the date, currently 2015 and counting, at which they say they will wean the economy from ZIRP, and LIBOR remains surreally below a level at which banks might actually lend to each other. Given the alternative, however, who can blame the financial authorities? The only choice seems to be to hold our breath, and hope that no event or mistake causes the ping pong ball to fall on to the table full of mouse traps that now constitutes the global financial system:
[Mild spoiler alert: the book is a fictionalized exploration of a girl who falls under the spell of a Manson-like cult. We all know how that story unfolded. In this Short Take I’ll be offering my reactions to the protagonist, Evie Boyd.]
The Girls offers as bleak a view of the amorality of American youth as I have ever encountered. In a review of my first book, I was called “Intolerably apocalyptic,” but I can’t hold a candle to Ms. Cline. The book is a novelistic attempt to try and understand how some of the privileged young women of the late 1960s could commit unspeakable acts while under the sway of a Manson-like psychopath.
Thus we meet Evie Boyd, a fourteen year-old growing up amid relative affluence in Petaluma California. She’s directionless, with no apparent passions, self-conscious about her looks, emotionally needy, alienated from her parents (who get divorced), but possessed of a tough inner core and a rebellious streak. She’s enthralled when she encounters Suzanne, a wild, charismatic 19 year-old who seems to be a composite of Patricia Krenwinkel and Leslie Van Houton, and Evie is honored when Suzanne pays her some attention. Events bring her to the cult’s squalid ranch, and for some weeks, Evie maintains a dual life, throwing herself into the life of the cult, while returning home enough not to galvanize her mother, who is pre-occupied with a rebound relationship with Frank, an entrepreneur who comes across as a hustler with a heart of gold.
Evie is so smitten by Suzanne that she doesn’t notice as the cult spirals down from talk of love and freedom to episodes of paranoia, back-biting and revenge. Along the way, Evie has her first sexual adventures, and enters sufficiently into the spirit of the cult that she brings them to the house of the family next door (which they descrate), even though she has known the family all her life and has no score to settle. Later, Evie talks her way into joining Suzanne as she and others set off to inflict mayhem on a Dennis Wilson-like figure, but Suzanne kicks her out of the car before they begin a horrific rampage.
Did Suzanne do this to protect Evie from what she knew was about to happen, or because she felt that Evie wasn’t a murderer and would become a liability? That’s left unanswered, but the bloodbath that Evie missed is so depraved – including the slashing apart of a toddler – that no human with a soul could find that earlier gesture redemptive … except for our Evie, who still feels the tug of Suzanne’s power, even after she learns every gory detail of Suzanne’s actions.
It’s several months between the time of the murders and when the cult is finally caught. During this time, Evie keeps her mouth shut about what happens and meekly allows herself to be shipped off to boarding school to resume her comfortable existence, though as a wreck, not a spirited teenager.
That’s when I decided Evie was a worthless human being. Sure, she was terrified that the cult would come after her, and there’s some honor on not squealing, but Evie had to know that the cult would likely kill again, and that made her an enabler of whatever they did subsequently.
The book interweaves the present and the past and so we learn how these events haunted Evie’s life. But there’s no redemptive moment, no act where she summons the courage to do the right thing, or rises above her own self-absorption. Even in the present, when the psychopath-in-the-making son of a friend and his underage, impressionable girlfriend crash at her digs, she can only summon a half-hearted (and failed) attempt to save the girl from following the path that so grievously sidetracked her own life.
All the men in the book are either pathetic or pigs of various shapes and forms – except for a premed student named Tom, who sees the cult for what it is, but who Evie rejects as a dork. Towards the end of the book, Evie ticks off a long list of subsequent experiences with awful men that could summon in her the hatred to commit horrendous crimes, seeming to imply that with the right mix of events, she too might have become a Suzanne, and, by implication, so could enormous numbers of other young women.
My first reaction was to call “Bullshit!” Were all young women potential Suzannes, we would have seen endless repeats of the Manson horrors in the nearly 50 years since the events. Instead, those murders still stand as a touchstone of horror because nothing since has eclipsed their mindless violence.
The Manson cult was at the far far end of the normal curve during truly abnormal times. In just the two years leading up to the murders, we had the huge escalation of a senseless war, the explosion of the anti-war movement and counter-culture, a breakdown of generational trust, my generation’s first experiences with powerful, mind-altering drugs, and a sexual revolution. In a country of more than 200 million people, that roiling stew of disruptive forces bubbled to the surface about 20 broken souls, deranged by drugs and in the thrall of a false prophet.
On reflection, however, maybe Ms. Clein was making a different point. All we have to think of are the teenage executioners of Pol Pot’s Cambodia or the child soldiers of Africa to recognize that the capacity for evil lies latent in the young. And, while in fiction we want our protagonists to find redemption or transcend their flaws perhaps Evie’s failure to rise to the occasion was making the point that a civilization that keeps our murderous impulses in check is not innate, but something external that has to be actively inculcated and supported. That’s something to keep in mind amid the current insanity of gun violence, and as more dark clouds gather on the horizon.