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IN A WORLD OF UNDERPRICED RISK, WHAT COULD POSSIBLY GO WRONG?


Monday September 17, 2012

 
EUGENE LINDEN
 
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: 

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Short Take

THOUGHTS ON WHY THE EARLY IPCC ASSESSMENTS UNDERSTATED THE CLIMATE THREAT

 

An oped involves extreme compression, and so I thought I’d expand on why I think the initial IPCC reports so underestimated the threat. Make no mistake, the consensus in the summaries for policy makers in the first two assessments did underestimate the threat. The consensus was that permafrost would be stable for the next 100 years and also that the ice sheets would remain stable (there was even a strong sentiment at that time that the East Antarctic sheet would gain mass). Moreover, in 1990, the concept of rapid climate change was at the periphery of mainstream scientific opinion. All these things turned out to be wrong

Of course, there were scientists at that time who raised alarms about the possibility of rapid climate change, collapse of the ice sheets, and nightmare scenarios of melting permafrost, but, fairly or not, the IPCC summary for policy makers was and is taken to represent the consensus of scientific thinking.

In my opinion such documents will always take a more conservative (less dramatic) position than what scientists feel is justified. For one thing the IPCC included policy makers, most of whom were more incentivized to downplay the threats. For another, many of the national governments that were the customers for these assessments barely tolerated the exercise and gave strong signals that they didn’t want to see anything that called for dramatic action, and this being the UN, there was a strong push to present a document that as many governments as possible would accept.

And then there is the nature of science and the state of climate science at that point. There is an inherent structural lag built in to the nature of science. For instance, the 1980’s were marked by the rapid development of proxies to see past climate changes with ever more precision. By the mid-late 80’s the proxies and siting had been refined sufficiently that the GISP and GRIP projects could confidently get ice cores from Greenland that they felt represented a true climate record and by then they also had the proxies with the resolution to see the rapid changes that had taken place in the past. Given the nature of data collection, interpretation, peer-review and publishing, it wasn’t until 1993 that these results were published.

It took nearly another decade for this new, alarming, paradigm about how rapidly global climate can change to percolate through the scientific community, and, even today, much of the public is unaware that climate can change on a dime.

As for the ice sheets, when I was on the West Antarctic Ice Sheet in 1996, there was talk about the acceleratio of  ice streams feeding the Thwaites and Pine Island glaciers, but the notion that there might be a significant increase in runoff from the ice sheet over the next hundred years was still very much a fringe idea.

With permafrost, the problem was a sparsity of data in the 80s and early 90s and it is understandable that scientists didn’t want to venture beyond the data.

The problem for society as a whole was that the muted consensus on the scale of the threat diminished any sense of urgency about dealing with the problem. Perhaps the best example of this was the early work of William Nordhaus. Working from the IPCC best estimates in the early 1990s Nordhaus published one paper in which he predicted the hit to the US GDP from climate change in 2100 would be about ½ of 1%. Nobody is going to jump out of their chair and demand action if the hit to the economy was going to be 0.5% of GPD a hundred years laterLibertarians such as William Niskanen seized on this and testified before Congress that there was plenty of time to deal with global warming if it was a threat at all.  

And then there was the disinformation campaign of industry, particularly fossil fuel lobbyists, as well as pressure from unions (the UAW in particular) and the financial community. These highly motivated, deep-pocketed interests seized on scientific caution to suggest deep divisions among scientists and that the threat was overplayed. Little wonder then that the public failed to appreciate that this was a looming crisis that demanded immediate, concerted action.

 



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