Brave New World


Financial Globalization and the Nation State

Today’s Financial Times articles: Swiss central bank discord provides a warning bell (Feb 24),Sovereigns turn to pre-crisis financial wizardry (Feb 24)

On facing pages in the print version of the FT, the reader is invited to consider the encounter of the modern state with the modern market. On the left hand page the story is about the central bank, on the right hand page the story is about the Treasury, and on both pages the story is about the continuing reverberations of the Global Financial Crisis and the changing role of both central banks and Treasuries as a consequence of financial globalization.

In a piece ostensibly about the political trials of the Swiss National Bank in the face of losses after failed intervention to stem currency appreciation, Gillian Tett includes the following paragraph:

“But the SNB is not the only central bank that has recently taken bold gambits. The European Central Bank, for example, holds an (ever-swelling) pile of periphery Eurozone bonds; the Fed’s balance sheet has more than doubled in size, to $2,500 bn, as it has gobbled up mortgage-backed bonds and Treasuries; and the Bank of England also holds a large pile of gilts and mortgage assets.”

Tett does not say so explicitly, but the regular FT reader knows that each of these central banks is facing its own political trials as a consequence of its gambit, trials that differ according to local political configurations. Bernanke, Trichet, and King are all three facing one or another kind of attack.

The point that strikes me, however, is the commonality of the gambit. All over the world, central banks have been using techniques of war finance to support peace time capital market finance. The classic Bagehot crisis rule—”lend freely at a high rate”—has morphed into something quite new—”purchase freely at a high price”—and economic thinking lags behind economic practice. Lender of last resort has morphed into dealer of last resort.

Meanwhile, in a piece ostensibly about Portugal’s decision to post collateral for its derivative positions (just as non-sovereigns typically do), Anousha Sakoui riffs also on the uncomfortable similarity between the European Financial Stability Fund and the purportedly discredited private Collateralized Debt Obligation used before the crisis to transform low-rated private mortgage debt into AAA-rated securities.

The connection between the two is driven home by a remarkable visual, showing side by side the five-year CDS spread for various European sovereign debtors and the analogous spread for European financial institutions. Sovereigns are banks, the visual says, and like banks they are driven to use the tools of structured finance, among other modern financial wizardry, to reduce their funding cost.

Against this background, Portugal’s decision is described thus:

“The sovereign has sought to influence prices of its credit default swaps, a form of insurance against default…By posting collateral on its trades, the sovereign is seeking to drive the costs of its CDS lower with knock-on positive effects for its borrowing costs. By posting collateral, the risks are reduced for Portugal’s counterparties, lessening their need to turn to the sovereign CDS market to hedge their exposure. The likely result, bankers argue, is lower CDS prices and thereby also cheaper borrowing costs for Portugal.”

Let’s understand this.

The underlying idea is an arbitrage relationship we might call CDP, for Credit Default Parity. The price of a risky bond plus the price of credit insurance on that bond should, arguably, be pretty close to the price of a riskfree bond. But if this is so, then it must also be so that the price of the risky bond should be pretty close to the price of riskfree bond minus the price of credit insurance.

Portugal is concerned, apparently, that its derivative counterparties have been hedging their exposure by buying sovereign CDS, so pushing up the price of credit insurance and (by CDP) pushing down the price of Portuguese sovereign bonds, so increasing the borrowing costs for Portugal. Portugal proposes to bear the cost of posting collateral, as an attempt to reduce the cost of borrowing.

The point that strikes me in all this is the implicit rejection of the efficient markets hypothesis. The underlying idea is that CDS prices are in some sense wrong, an exaggeration of the true risk of lending to Portugal. Portugal is offering to post collateral as a way of improving the efficiency of CDS pricing.

Brave new world indeed. At the center, central banks use their balance sheets to prop up dysfunctional markets; at the periphery, Treasuries acquiesce to market practice.

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