Sunday, July 31, 2011

"USA Is 'AAA' in Label Only"

Sovereigns that bailed out banks are saddled with much greater government debt than before the crisis. In the spring of 2007, the Fed and the U.K.'s FSA reported that the degree of leverage in the global financial system was less than at the time of Long Term Capital Management, but in reality it was much greater. Global regulators are now repeating their mistakes. The risks in the interconnected global banking system have moved to currency trading and currency derivatives (remember the contribution of knock-in options to the 1995 currency crisis), leveraged loans, credit derivatives, market-linked derivatives, speculation in commodities, and both foreign and domestic government debt. Winston Churchill said we must alert somnolent authority to novel dangers; but our regulators are complacent, and the dangers are not novel.

With respect to the recent crisis, highly leveraged fixed income assets posed perils to the global banking system. When excessive leverage is combined with fixed income assets acquired at par, there is extreme risk. If the assets decline in value and liquidity becomes tight, it can cause a vicious cycle of selling that feeds on itself. If one combines that with foreign currency risk, one adds to the potential pain. If that is further accompanied by a price reduction that is due to a permanent or at least sustained price decline in underlying assets, it is virtually impossible for an undercapitalized overleveraged entity to recover from even a temporary liquidity shock. If a country cannot quickly refinance (roll financing), the collapse is quick and brutal. This isn't a new discovery, this is simply a fact. (more)