19/03/2013 - 23:51

Is transformation collateral sub-prime II?

19/03/2013 - 23:51


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The rising markets may be a false dawn, with two top economists, whose warnings were ignored before the GFC, ringing alarm bells again.

The rising markets may be a false dawn, with two top economists, whose warnings were ignored before the GFC, ringing alarm bells again.

IF the stock markets of the world are used as a guide of things to come, the outlook is bright. However while rising share prices can be an early indicator of faster growth, this time around there are reasons to believe that the markets are sending false signals. reacting more to greed and hope than hard evidence of a sustained recovery.

Two well-credentialled economists are leading a chorus of voices warning that the ‘cure’ being administered by central banks in the form of low interest rates and an abundant supply of cash could turn out to be worse than the original disease that produced the 2008 GFC.

Nouriel Roubini and Gerard Minack were both saying something similar in late 2007, only to be drowned out by the cheering of the optimists who believed that the boom would last forever. It didn’t, that much we all know.

This time around Mr Roubini, a professor from New York, and Mr Minack, a corporate economist, are being followed more closely with their warnings about the dangers of loose monetary policy, asset bubbles and the ineffectiveness of repeated doses of quantitative easing (QE) - a policy designed to solve a problem by throwing vast amounts of freshly-minted cash at it.

But there is also a fresh piece of evidence emerging to demonstrate that we have learned nothing from the five-year worldwide slowdown, and European depression, which followed the bursting of the 2008 bubble.

In the banking world, a place where most people are never invited, a range of products is emerging that has ‘subprime’ written all over it, complete with the names of the same players of the original game of assembling rotten loans and pretending they have suddenly become a premium grade investment product.

Messrs Roubini and Minack have not yet focused on the new range of sub-prime investment products called ‘transformation collateral’, but they will turn their guns on it soon, especially if the wave of interest in the appalling structures being packaged and marketed by big banks continues its rapid growth.

What the two economists have said is largely a repeat of their 2007 warnings, with Mr Roubini writing in his blog that QE can deliver short-term benefits, “but if such policies remain in place for too long their side effects could be severe”.

Mr Minack, writing in his Downunder Daily note, warned that winning the current battle was not the same as winning the war. “If central banks do win this round, the next downturn could be, in my view, an omnishambles,” he says.

“The key question for investors is when and how this cycle may end. The question is whether we are now in 2003, with three-to-four years to go, or 2006 with the cycle end not imminent but not that far over the horizon.”

No transformation of collateral risk

SO much for the serial doomsay-ers; what of the backroom work in the banks, the mob that created the original sub-prime crisis and are now working on ‘transformation collateral’?

A flashback is called for before I explain what those two words mean, because there is a real sense of deja vu about transformation collateral, a term that first started to appear about six months ago and which has been gaining traction in the past few weeks.

If you look back about 10 years, when subprime mortgages were the hot

credit product from many banks and fringe lenders, there was an economic theory that argued if you bundled enough of these high-risk loans together, the good (loans made to borrowers who repaid their debt) would cancel out the bad (loans made to people who did not repay their debt).

That led to the creation of multilayered investment products such as collaterised debt obligations (CDOs), which were marketed by investment banks to their clients as a way of getting a higher yield on their funds with the stability of home mortgages.

It was a theory that failed, destroying the savings of countless investors, wiping out banks, and leaving entire countries on the brink of collapse.

Now, the same people who brought you sub-prime have come up with a repeat dose, because all that transformation collateral does is take low-grade investment products (such as B and C-grade corporate bonds) and swap them for premium-grade products (such as US government treasuries) - for a fee, naturally.

That there is a market for transformation collateral is a comment on the new wave of tougher banking regulations designed to stamp out risky bank lending - though the result seems to be exactly the opposite.

Institutions using the new system are those exposed to the derivative market, a $600 trillion black box that supposedly produces higher yields than conventional investments because of the leverage available.

Under a typical deal, a company with a portfolio of low-grade bonds swaps (or borrows) a portfolio of high-grade bonds to use the high-grade package as collateral for derivative trading positions, a process which circumvents tough new banking regulations.

Bankers, naturally, argue that the game is safe and that all that’s happening is that they have found a way to grease the wheels of the market to ensure that business continues to be written - for a fee, naturally.

Close observers see it differently. They see the same forces as subprime at work and the hunt for yield, and the use of leverage based on substandard investment products.

Fix is in on gold

ANOTHER market facing a potentially tricky time is the gold market, where investigators are starting to look at the way ‘the chaps’ in London ‘fix’ the price of the metal, and its sister, silver.

Almost a closed shop - and potentially open to the same issues which caused the interest-rate fixing crisis in London - the gold market is effectively controlled by five banks, which swap notes twice a day to set a morning and afternoon price; the so-called ‘fix’.

What the US Commodity Futures Trading Commission wants to know is whether ‘the chaps’ are colluding and manipulating the gold and silver price; a reasonable question given the clever ways in which the London Interbank Offered Rate (Libor) was rigged over the past decade.


“It is better to be envied than to be pitied.”


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