The frantic flight to liquidity and solvency

Doom-mongering is often denigrated and it tends to silence the non-consensual and pessimistic analysis and expectations. They would break the so-called confidence and would only be self-fulfilling prophecies. I do not really agree with this view because there is nothing worse than showing a blind optimism and suffer from both lack of credibility and poor financial performances.

Again, I do not see how recording with objectivity the tremendous imbalances of our financial system could be consider as doom-mongering, let alone the non-sustainability of its financing.

Be a doom-monger is not to note that two states - relatively "small" but states anyway - of the euro zone have no more access to debt financing on normal conditions, neither through auction nor through syndication on capital markets (they can barely issue 3-6 month papers at a very high cost).

We've been experiencing a real change in the field of asset allocation and the issue today is not to decide whether we should overweight or underweight equity, bond and other financial asset class but rather how to allocate a portfolio between real assets and financial assets.

Mory Doré

Again, and all is just observations, be a doom-monger is not to note that many banks of the PIGS "zone" have no access to cash funding on normal conditions (no money market fund will subscribe to certificates of deposit, no access to the interbank market of 1-month to 12-month Euribor). The LTRO (Long Term Refinancing Operations, ranging from 3 months to 1 year) of the ECB account for 2/3 of the liquidity allocated to the banking system of the zone while the MRO (Main Refinancing Operations, ranging from 1 week to 1 month) account only for the remaining 1/3. In normal money market situations, like in 1999-2007, it was rather a 10% -90% distribution.

The ECB is concerned about potential strong competition between banks and states

It is true that we’ve been witnessing these issues and the paralysis of interbank transactions for a long time (with a greater or lesser intensity depending on the level of risk aversion of market participants). In addressing these issues, I’m not able to abstain from thinking about two key dates in the recent history of markets :

 August 09, 2007. I’ve just started my summer vacation when I’m shaken by the announcement of the NAV suspension of some dynamic money market funds of a large asset management company: the managers are simply unable to meet liquidity requirements; about 5% to 10% of bad ABS held pollutes the entire portfolio.

 September 22, 2008. One week after the Lehman’s bankruptcy, the crisis of confidence in the interbank market reaches its peak. Even the so-called simplest and least risky financial market operation: lending money for a day between banks is not possible. No DD negotiable, market operators around the world are shocked.

Be a doom-monger is not to record that medium and long term financing using bonds issuance is now primarily done through secured format such as covered bonds with around € 15 billion issued over the first two weeks of this year. Those are bonds backed by collateral of "quality": banks mortgage loans secured by mutual guarantee companies. Actually, it is very rare today to see banks issue classic unsecured senior debt backed by nothing but confidence the investor has in the system.

So much for the flight to liquidity. Moreover, in Europe, the ECB does not hide his concerns about potential strong competition between banks and states: the amount of debts maturing in 2011-2012 is about 1000 billion € for banks against 1 150 billion € for states.

Regarding the flight to solvency, many banks needed states help in fall 2008 to survive. These states are so over-indebted that banks are encouraged "for free" to hold more and more bonds issued by their own saviors: very low rate for short-term refinancing, use of papers purchased from the central bank in order to get cheap liquidity, being more flexible on the eligibility of papers used to get liquidity.

As of today, EFSF will not have enough cash to ensure the liquidity of new fragile states

To achieve a flight to solvency, some states manage to handle 2010-2012 liquidity issues but they did not solve structurally their debt issues: EFSF, EU, and IMF.

In any case, as of today, the EFSF will not have enough money to ensure, if necessary, the liquidity of new fragile states such as Portugal and Spain. That means non-conventional forms of financing and recapitalization will still be used: ECB monetization like the Anglo-Saxon, meaning without sterilization and cash withdrawal; super EFSF or Euro-Bonds or creation of a European "IMF" ... what else? All this to extend the "fateful" deadline of June 30, 2013 to 2016, 2018 or 2020?

In fact, we’re not particularly pessimistic; we believe that markets, at least the bond and money markets, do not just normally work for a number of participants. We’re in a crisis of finance and financial markets operations such as the ones we taught and we have practiced for long. We’ve been experiencing various occurrences of crisis: subprime, securitization and rating agencies crisis in 2007; investment and some universal banks crisis in 2008; some sovereign debts crisis in 2009-2010. Anyway, we are only recording dysfunctions and imbalances, and everyone with enough common sense should understand that for over 2 years the flight to liquidity to survive the end of the month / quarter / year, and the flight to solvency are not possible for some states and banks via the normal and regular market operations:

• Off-market banks recapitalization at the end of 2008
• Outstanding liquidity supply from 1 month to 1 year to banks by the ECB for 3 ½ years
• Creation of pan-European structures to handle peripheral debts crisis by pooling as much as possible European sovereign credits

U.S municipal bonds are still raising concerns

The needs for liquidity and capital are enormous and we should avoid unanticipated needs to worsen situation. (I do not even think about prudential regulations). We must then monitor three types of risks:

 The extension of liquidity and refinancing issues to new banks and the contagion of peripheral debt crisis to other Eurozone’s states.

 The situation of U.S. municipal bonds remains a concern and we do not know today what would be the impact of a municipal bond crash on U.S. banks assets depreciation and the contagion effects in Europe, meaning unexpected additional recapitalizations needs. You should know today that these municipal bonds are no longer guaranteed by a bond insurer (the famous Monoline). The original business of these insurers was to guarantee these bonds, but they soon become too greedy by expanding their guarantees to the most toxic structured credit. Result: they have all disappeared, from CIFG to Ambac (last victim) including FSA and MBIA.

Instead of focusing only on the analysis of U.S. and European data .... I would advise to spend more and more time to analyze the changes in balance sheet of Asian central banks and the changes in their monetary reserves, but also the evolution of various contributors to China's growth

Mory Doré

 We often talk about the evolution of the growth model of emerging economies in general and the Chinese economy in particular. It seems difficult to expect a major change of this growth model in the next month. We should nevertheless bear in mind that the transition from a growth model based on exports to a growth model based on domestic consumption would potentially have devastating consequences on the flow of international funding : first a drop in Chinese trade surpluses and thus a reduction of global excess savings that would lead to a rise in long-term rates around the world; second there will be no need any more to intervene in the foreign exchange market in order to keep exports competitive but also no need to keep accumulating government securities in USD, GBP and EUR (here again a risk of sharp rise in bond rates).

It will certainly not happen next week but we must now anticipate that the markets will start pricing it soon. It is important not to be swayed by Asian ads about their support to peripheral Europe debts: it is more about using part of monetary reserves in euro of central banks in Asia. Thus no significant changes to expect on the parity of euro against other major currencies; it is also a political signal intended to "intimidate" Uncle Sam. Anyway, the story is much more an inevitable future repatriation of Asian savings surpluses than a reallocation of savings invested in U.S. government securities to savings invested in securities of peripheral and eurozone core countries.

Significant price increases in the cost of liquidity, debt and capital for the next decade

So instead of focusing on the analysis of U.S. and European data (such as U.S ISM, Eurozone PMI or even U.S job creation and retail sales) that had been unavoidable market movers for long, I would advise to spend more and more time to analyze the following elements: changes in balance sheet of Asian central banks, changes in monetary reserves of these central banks; evolution of various contributors to China’s growth (exports, investment, consumption ...). What a program and a deep intellectual change to cope with.

To conclude this paper, in a context of frantic flight to liquidity and solvency ratios consolidating, we confirm that we’ll experience in the coming decade is a significant increase in the cost of liquidity, debt and capital. This means that, taking apart the short-term cost of money "managed" by central banks, we should expect within 6-18 months sustained and structural sharp increases of all medium and long-term refinancing cost: rise in rates on government bonds in the euro zone Core, UK, U.S.; rise in rates on government bonds of the eurozone peripheral countries (specific risk + global risk); rise in spreads on corporate investment grade and high yield debt; rise in spreads on senior bank debt and of course on subordinated debt on banks and insurance companies; and finally fall in equities as a result of extensive issuance programs.

We clearly see a real change in terms of asset allocation and the issue today is not to decide whether we should overweight or underweight equity, bond and other financial asset class but rather how to allocate a portfolio between real assets and financial assets. Taking into account what we wrote above, we would significantly underweight financial assets. :

 Finance is experiencing a structural crisis. Thus confidence crisis and risk aversion will sustainably penalize the profitability of all financial assets (stocks, government bonds, corporate credit as the cost of the issued capital and liquidity borrowed will rise, and at the same time the money market will not deliver anytime soon);

 Moreover, the expected changes of the growth model of emerging economies will lead to a more restrictive global monetary policy and a macro liquidity squeeze (the end of the high rate of growth of monetary reserves of Asian central banks).

All this should raise questions about an investment strategy based on real assets (real estate, mining and agricultural commodities). A program we will have the opportunity to discuss during this year and years to come