Monday, July 11, 2011

The World of Make Believe

When the debt crisis hit the US in 2008, the Mark-to-market rule for valuing balance sheets was suspended. If it had continued to be enforced, bank balance sheets would have been extremely vulnerable, despite billions of dollars of funding from the US government. As a result, the derivatives that helped ignite the crisis are still sitting in bank books, and valued as the banks would like them to be.

It seems as if the banks are waiting for asset inflation to take place, so that some one can announce, "Game Over", and every one can move into reality mode. Which is why the Fed is trying so hard to ignite inflation with its zero-interest-rate-policy, ZIRP.

Some commentators believe that recent commodity price inflation has been a result of cheap money; many believe that only supply-demand imbalances can sustain price increases. I would tend to side with the latter, while noting that cheap money penalises savers, incentivises consumption at the cost of saving and hence investment, and hence leads to higher commodity prices through the obvious demand route.

Be that as it may, when crude oil prices seemed to threaten the recovery all over again, this June, the IEA coordinated a release of 60 mn barrels from various emergency stashes. The impact on prices was sharp, but it didn't sustain very long. Interestingly, the buyers were not largely speculators or hedge funds, with the exception of a small punt by Barclays; the bulk were oil companies, suggesting that those on the ground (or below it!) are finding supply lines squeezed.

From a gaming point of view, IEA is in danger of having mis-fired - if the release of stocks was intended - even partly - to show OPEC it had some firepower, the threat may have proved to ineffective.

 The most recent egregious example of governments trying to game markets comes from the ECB. Dealing with the Greek crisis, European bankers got hit with a severe Moody's downgrade of Portuguese sovereign debt. However, since Portugal will inevitably require further funding, and commercial loans are not viable, the ECB will have to extend funds to Portugal. With the downgrade, collateral requirements will go up.

Or would, if the ECB had not decided to suspend normal rules for evaluating collateral. This suspension of reality led to the following from Bernd Volk, of Deutsche Bank:

"Given severe rating consequences for Portuguese covered bonds resulting from the downgrade of the sovereign bonds by four notches to Ba2 and also other peripheral covered bonds facing subinvestment grade risk (e.g. Greek covered bonds by Fitch in case of Greek sovereign debt rollover), we suggest a significant “Rating deleveraging” of the financial system, i.e. less use of rating requirements in laws, regulatory requirements, bond prospectuses and other contractual agreements. Instead so-called “indeterminate legal terms” (“unbestimmte Rechtsbegriffe”), to be determined by the respective institution of market participant, could be used."

Tongue firmly in cheek, no doubt.

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