THERE is something appealing about random musings. Here are mine for the day – the first in what will become an occasional series.
1. Governments don’t have unlimited borrowing capacity. At some point, the markets will stop extending loans to them. Countries such as Greece are starting to be penalised by investors and the credit default swaps (CDS) markets. Italy’s budget deficit is set to hit 127.3 per cent of GDP in 2010, which is too high. Unlike the UK, the Italian government can’t just print money to get itself out of trouble as it doesn’t control the euro. Unless deficits are brought back under control, government debt could eventually become the new toxic asset which brings down the writers of CDSs and investors who assumed they were buying into a risk free asset.
2. Property – commercial as well as residential – is very risky. It is the asset class which has caused the most damage during this current crisis. As the collateral of choice, it is at the heart of the modern business cycle. Never, ever believe anyone who tells you that property will always go up over time and that it provides a risk-free investment (and by the way, there is absolutely no such thing as a risk free investment). Any institution exposed to the property market – be it through regular mortgages, commercial property lending, sub-prime, CDOs, CDSs or whatever – has been hammered since 2007.
3. Many more industries were bailed out that usually meets the eye. Take insurers: they held vast amounts of bank debt which would have collapsed in value or been rendered worthless had more banks been allowed to go bust. The same is true of many other institutional investors, including pension funds. The banks were merely the tip of the iceberg.
4. Leverage is useful but ultra-dangerous. Yes, everybody knows that – but when you have a balance sheet of $1 trillion (£603bn) and capital of $40bn, you just need a surprise 1-2 per cent drop in the value of your assets to be in crisis. Yet that is little more than a rounding error, white noise that cannot be avoided. In the real world, it would make more sense to plan against a 15 per cent shock. We need less leverage and more (and better) capital. There is still a long way to go.
5. It is wrong to view all of the consumer debt build-up in Britain since the 1970s as a bad thing. The democratisation of credit has been hugely beneficial, allowing people to spread their lifetime income and expenditure better, make homeownership more easily available and allowing the creation of small businesses. But there is a big difference between that and people on incomes of £25,000 a year routinely running up £10,000 credit card bills – or homeowners relentlessly remortgaging to spend their all their home equity on consumer goods. We didn’t get the balance right during the bubble – and still haven’t. People need to save much more, reduce their unsecured debt and build up equity in their homes. Everybody needs more capital – banks and consumers alike.
6. Credit default swaps (CDSs) are a useful form of insurance. Yet issuers should be required to hold reserves to cover losses or other claims as they would if they were selling regular insurance policies. AIG’s customers – or counterparties – assumed that a highly rated insurance giant deemed almost as creditworthy as governments at the time it wrote the CDSs would be able to pay any claims that arose. How wrong they were: you can’t insure yourself against all risk.