Monday, September 16, 2013

The Next Black Swans Are Visible

Everyone is now looking under his bed for the next bubble or black swan. Some pundits are pointing to the revival of the market for risky corporate bonds. They worry what will happen when there are defaults. Well I can tell you what will happen when there are defaults: credit spreads will widen and speculators (the people who buy speculative-grade bonds) will suffer MTM losses. Big deal; this happens all the time. No one dies from it. And yes, speculative-grade bonds are speculative.

What people die from is huge positions in low-risk instruments that overnight become toxic. That’s what happened in the subprime fiasco. Here are the criteria for such an event:

Before the event:
1. The security is seen as low risk. It is rated investment grade and is thus eligible for fiduciaries to buy.
2. The security attracts a low capital coefficient under the bank capital regime.
3. The accounting treatment is to carry the security at par.
4. Systemic exposure to the security is massive.

The event:
1. The security is downgraded to speculative grade, forcing fiduciaries to sell.
2. The bank capital regime now requires a higher capital coefficient.
3. The accounting treatment changes from cost to market (MTM).
4. Large MTM losses result, rendering the most exposed players insolvent.

What asset class meets these criteria: Club Med government bonds. In declining order of risk:
1. Spain (Baa3/Negative outlook)
2. Italy (Baa2/Negative outlook)
3. France (Aa1/Negative outlook)

I include France because it has the furthest to fall, like super-senior CDOs. Today French government bonds are a risk-free security. High ratings, zero capital coefficient, carried at par. Imagine if those factors should change: a lower rating, a higher capital coefficient, marked to market. Spain may be the next Lehman, but France could be the next WW1. If French bonds begin to decline in value, there is almost nothing anyone can do about it (besides fiddle with the accounting). It would rip a huge hole in the European banking system which would be impossible to fill without high inflation.

So while we know that Spain is on a bad trajectory, we should worry that France may be too. Spain may be Lehman; but France is civilization as we know it. The next black swans are visible.

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