Sometimes an open roof is a good idea

 

    Denmark and the United States may not be comparable in terms of the sizes of their economies, but they do have one unique bond - they are the only 2 developed countries to have a debt ceiling. As I write this, the United States is caught up in political wrangling in Congress over the annual budget which, if not resolved imminently, could result in the non payment of interest on government debt, effectively putting the largest economy (and the world's "least risky" asset) in technical default. 

                 Most governments simply issue debt when the cash coming in from tax collections is insufficient to cover the bills coming due from government spending. Both the United States and Denmark however have put a dollar limit on how much debt the government can issue. This legislative limit is decided by Congress on an annual basis and the national government debt cannot exceed this level. Should this ceiling come close to being breached without being raised, as it is now, then the federal government will have to act to immediately cut expenditure to prevent such a scenario until agreement is reached on raising the limit. Such "extraordinary measures" may include the temporary shutdown of certain government run institutions. The internal revenue service (IRS), for example, could stop responding to taxpayer questions by phone while the services and activities of some other bureaus could be halted completely. 

              The idea of an absolute debt ceiling in the US came into being in 1917. Prior to that, Congress was required to approve the issuance of every additional US Treasury Bond. By passing the debt ceiling law in 1917 it enabled the federal government to issue bonds without the approval of congress so long as the total issuance remained below the preset amount. Upon approval of the budget each year, Congress would then also pass legislation increasing the size of the debt limit to allow for the additional borrowings required. This of course was never meant to be used as a political tool to hold a government to ransom and would have been seen at the time as an adequate way for Congress to keep tabs on the federal government's debt, without the need to approve every additional issuance required. This in effect is where the Danish and US models diverge. 

                 In 2010, after the financial crisis caused a large increase in government debt, the Danes reacted by doubling their existing debt ceiling, which was already far above the existing debt, to a level 3 times the debt required at the time. By doing this they ensured that there was no scope for the ceiling to limit the ability of government to function, as is currently at risk of happening in the US. 

               This is not the first time political stalemate has pushed things to the brink with no fewer than 17 funding gaps required to avoid the ceiling being breached between 1977 and 1996 alone. As recently as 2011 the US was on the brink of having to default as party politics pushed things to the wire, before a last minute temporary agreement increased the limit to a level sufficient for another couple of years. At that time the risk was deemed so great that S&P became the first credit rating agency to downgrade the US from the top ranking of AAA to AA+. Ironically, despite the downgrade, treasury yields fell as investors still flocked to the US as the safe haven (Although even S&P have questioned whether investors should pay attention to their ratings!).  

               The US debt ceiling currently stands at $16.7 trillion and most estimates believe this figure will be hit by mid-October. As a percentage of GDP, US debt is around 101%. Both of these figures could be taken as a reason to worry and indicate that potentially a ceiling and getting things in shape might not be a bad idea. However as mentioned in the article on austerity there is no substantial evidence to suggest that a debt ratio of this size is a restriction on the US economy. An increasing size of US debt, for now, is likely to be sustainable for the US due to it's ability to control and issue debt in it's own currency, nor is it having an inflationary impact at present with inflation continuing to remain well below the target 2% level. The US economy is also moving forward with it currently expected to grow at an annualized rate of 2.5% in the 4th quarter according to some estimates. 

             However Moody's Analytics chief economist predicts that a US government shutdown lasting just 2 weeks could reduce growth a 2.3% annualized rate, while a shutdown for 3-4 weeks could result in a 1.4 percentage point reduction to a rate of 1.1%. The common perception is that a last minute deal will take place before the US comes to a situation of default, but these figures indicate that the government shutdown required just to get to mid-October would in itself cause bad damage to an economy which is only just getting going. It seems very clear that for the sake of pushing, or not pushing, through the US healthcare bill, that politicians on both sides are willing to "play chicken" with the US and in effect the global economy. This in itself shows an irresponsibility of all the politicians involved. I'm not going to make a political statement on whether the Republicans or Democrats are right in their views on the Affordable Care Act, but differences on these issues should not be used to put a whole economy and economic recovery at risk. One can only hope that the politicians involved come to their senses. 

              Of crucial importance once any decision is reached is to remove the possibility of such a scenario happening again. This should be done by either removing the debt ceiling completely or, following Denmark's lead, acting in a bipartisan manner to set it at a level far beyond that which could effect the day to day running of government. There is still plenty of scope then for party politics in the US to disrupt the Affordable Care Act or any other piece of legislation should they so wish, but at least with an open ceiling, or with a high ceiling, such divergent issues won't impact the essential requirement of the Treasury to pay the bills which already exist. 

"There is something rotten in the state of Denmark" remarked Marcellus to Horatio in the first Act of William Shakespeare's Hamlet. Perhaps if the bard was around today he would be tempted to look to Capitol Hill for inspiration, as modern era Denmark on this occasion has shown the way. Let us hope the US has the sense to follow.   

Another day in September to remember, but how long to forget?

 

What is it about September and October?

Maybe it's the thought that it's straight after the end of the holiday season. The realisation sets in that the next real break from it all is still over 3 months away. Maybe this then leads to an early onset of the "winter blues" and a fear of armageddon as the days draw ever shorter and the weather ever colder. Then every now and again this end of days fear results in an end of days moment. Whatever the reason may be, September and October have proved to be the dark days through history for the economy and the markets, the time when everything seems to just come to a head.

• September 18th 1873 - Black Thursday - triggering the panic of 1873
• The Panic of 1907 reached a climax in October.
• October 24th 1927 - Black Thursday - and October 29th 1927 - Black Tuesday - saw the great Wall Street crash and the onset of the depression.
• October 19th 1987 - Black Monday - when global markets collapsed and the Dow Jones fell over 22% in one day.
• 16th September 1992 - Black Wednesday - when an attack on sterling by speculators forced it to withdraw from the ERM.
• 15th September 2008 - Lehman Brothers declares bankruptcy causing global market panic and the onset of the Great Recession.

                The most recent of those days is approaching it's 5th anniversary on Sunday and we are still scrabbling around hoping we are moving beyond the green shoots of recovery to a more stable global economy. As many commentators have written, that fateful day in September was not the cause of the current financial crisis, but it pushed it over the edge as the fear that gripped threatened to collapse the whole financial system and with it the world as we knew it.

                Even in hindsight that moment was not inevitable for those on the outside or the inside of the firm. The moral hazard had been set by the Fed assisted bailout of Bear Sterns by JP Morgan and the government bailout of Fannie Mae and Freddie Mac as well as others. The market anticipated the same result for Lehman even as it sent its share price plummeting ever faster towards zero. Even on the Friday before there was seemingly a knowledge for those of us inside the firm that we would still be walking through the same doors on Monday morning, it was just very likely we'd be working for new masters. Barclays and Bank of America we were told were the suitors and one of those was likely to take over by the end of the weekend. The Fed was calling all the heads of the major banks together to work through a solution which would save the company from bankruptcy in a way which would prevent an outright collapse in the markets. This had happened before when the behemoths of the financial world had got together and worked to ensure the world kept turning. In 1907 the eponymous banker JP Morgan had locked all the chief financiers of the time in a room until they came to a solution to bailout the Trust Company of America. In 1998, as the hedge fund Long Term Capital Management tinkered on the brink of collapse, threatening to drag others with it, a similar plan was drawn up for all the major banks at the time to cough up the money to stave off the $3.625bn collapse (intriguingly also in September!).

             This time however it was not to be. No agreement could be reached in a weekend as to how to save the firm or how to unwind it in an orderly fashion. Bank of America went to Merrill Lynch's rescue, stepping in before they could become the obvious next victims, whilst Barclays (whether stopped or not by the FSA at the time) decided against buying the firm and instead picked up the New York side of the franchise post bankruptcy, the piece they most desired. Lehman Brothers was thus left to file for the largest bankruptcy in history ($681bn if you're interested, 5 times that of Worldcom the previous largest) sending the financial world into chaos as the house of cards began to collapse across the globe. Governments were forced to act to stop the rot immediately and ended up acting to save the majority of financial institutions through the very bailouts they sought to avoid giving to Lehman Brothers. The markets plunged all around and the supply of credit ground to a halt as every institution was afraid to lend fearing their counterparty was next to fall. (As for me and the rest of the Lehman employees on that Monday morning, we were left to scratch our heads (or mostly hold head in hands) walking out the building with boxes of belongings (whose belongings in some cases is questionable!) wondering where we would go to next. Some of us got lucky while others didn't. But I'll save you the personal stories and recollections for a later age when I feel fit to write my memoirs.).

           Now that we're 5 years on from that headline event of the financial crisis, the question on everyone's lips is could it happen again or are we doing enough to stop it. 

           For the majority of the populations of the countries affected there is a feeling of animosity towards the banking industry as governments from the UK, Iceland, Ireland, the US and many many others were forced to pump trillions of dollars (that's thousands of billions) into the banking industry preventing it's collapse. There's no doubt in my mind that the actions of both governments and central banks were necessary to avoid the world hurtling towards another great depression. That these actions themselves may have created a moral hazard for the future remains a fear. 

         The banks themselves still remain leveraged to a degree which, in the result of a similar withdrawal of funds from the bank due to some panic, whether by retail depositors or the withdrawal of short term funding (as was the case for Lehman and Bear Sterns), would still leave them needing rescue either by peers or the government. Lehman was leveraged at it's peak by 44 to 1 (Goldman and Morgan Stanley at the time had ratios in the 20s or 30s). Whilst now Morgan Stanley is estimated to be leveraged 14-1, a drastic reduction, a similar sudden shock for them would leave them desperately scrabbling around for further capital. They are not alone in this respect. Under banking regulations known as Basel III, proposals have been drawn up for banks to increase the amount of assets they hold and the strengthen the quality of those assets, but it will take several years for many banks to get to those levels and it's effects, at least in the short to medium term, may serve to curtail bank lending at a time when the economy would benefit from increased lending. Barclays, for example, recently announced rights and convertible bond issuances to help raise £8bn of the £13.8bn pounds they require to get to the required levels, as well as talking about reducing its balance sheet.  

                 What about one of the other major causes - the use of certain derivatives and their inter-connectivity in the market? Even here global regulators are struggling to come up with robust rules to try and ensure there is enough regulation and tracking of these products that it is easier to ascertain who holds what, where they hold it and, if the music again stops, which firms are going to be left with the toxic time bomb this time. Each region has been working hard to draw up their own rules and try and make them as coherent as possible. The Dodd-Frank Act passed in the US has tried to ensure all derivative transactions are centrally reported on the day of transaction, whilst also seeking to settle more and more OTC derivatives, such as Credit Default Swaps, through centralised clearing houses. The idea with these requirements is to increase the transparency of trading in these products and to reduce counterparty risks by having them settled through a central area where netting can be carried out if needs be in the case of disaster. The European Market Infrastructure Regulation (EMIR) seeks to implement a similar exercise in Europe. Both these pieces of legislature go some ways to improving the risks imposed by certain forms of derivatives, but there still remains doubt as to whether this will prevent issues caused by the more complex financial products similar to those which played a part in the crisis. Financial innovation has and will continue to play a part, and in most cases an important part, in providing new ways of financing and hedging for companies and banks alike. Some of these will seek to find a legal way around tax, accounting or other regulations. The relevant authorities, be it the PRA in the UK, CFTC or SEC in the US or the EU bodies, will need to ensure that they keep apace with developments in the market to seek to understand the products as and when they evolve. They will need to act to amend legislation at the time the products are in their infancy to ensure future risks are mitigated long before they happen.  

              The banks themselves of course having been bitten so badly and left with so many bad debts are also ensuring, for now, that those they lend to will on, the whole, have the ability to pay it back. The idea of lending money to someone with no income, no job or Assets (NINJA) is at this time a thing of the past and one which banks are unlikely to want to take up again in a hurry. Meanwhile discussions continue apace globally about what further measures to put in place to ensure banks don't end up in a similar situation again. 

                 It is a slow process, but gradually the pieces are coming together to help reduce the likelihood of the same mistakes being made again. Therein however in the solution and the potential solutions lie the answer about whether this could happen again. The authorities can look back at the last crisis and its causes and devise many ways in which to mitigate it happening in the future, but it is very hard to put in place laws which will restrict the next crisis from happening when, as Donald Rumsfeld might put it, it is likely to be an unknown unknown which triggers it. One of the main factors in the cause of the crisis which is very difficult to mitigate against in the future is the one which links many of those affected and involved in the crisis, that of greed. Greed is a human trait which has become more and more prevalent in human society in the 20th and 21st centuries, the need to want more. Whether it was in the banks seeking to sell more and more products to inflate profits and bonuses, or the man in the street seeking to borrow money they couldn't afford to buy a bigger house or car, the wish for more of the good things in life even when it should be beyond our reach is ultimately what pushes things over the edge. The truth is if the roles of the 2 examples before were reversed both would still act in a similar vein, it's unfortunately part of most of our natures. 

            This crisis and the housing bubble in it's lead up were no different in that respect to any of the previous bubbles. Whether it was the dotcom bubble, the tulip bubble of the 17th century or the recent property bubbles, bubbles form because people see an asset rising steadily in value and they want a piece of the action and get "their share" of the profit. The issue with a bubble is that most can't see it ending before it bursts and as a result plenty get burnt. This time the fire was hotter and more people got burnt as a result. The consequences of the 1929 crash and the depression remained etched in the memory for decades precisely because the repercussions were so immensely bad. The solutions put in place at that time eventually did the best to ensure the same wouldn't happen again, although it took a long time to find the right solutions. After a long lapse though inevitably more bubbles came and went, even if not to the same extent, as the memories faded and the exuberance returned. 

                The response and speed of response to the current crisis have meant, so far, we've not been faced with another great depression. As markets already look to have bounced back, and house prices rise again, the fear becomes that it won't take long to forget the excesses of 5 years ago and the bubbles will return, spurred on by the greed of those that have already forgotten. It won't be the same as before, it rarely is, and we can hope that the remedies put in place this time can stave off a similar size of crisis for the foreseeable future. Eventually though, memories will fade of the consequences of the past and there will be further boom followed by just as great bust. That is capitalism I'm afraid and all that can be done is to try to soften the blows that arrive, preferably before they arrive. But even when it does happen again, we still may never know for certain why the darkest financial days seem to occur as the sun itself begins to fade. 

Should the markets fear conflict in Syria?

            

                 As the US and other nations size up whether they are going to bomb Syria, potentially risking a wider regional war, equity markets took fright last Tuesday and recorded a 1-2% drop across Europe and the US as this prospect looked an inevitability. Oil began rising quickly over the fear any conflict could affect supplies whilst some investors began going long on Gold, the traditional safe haven, pushing the price up. Whilst the immediacy of any action has reduced slightly over the last couple of days, leaving markets to concentrate on the economic recovery and Fed tapering, the likelihood is still there that some form of action will soon be upon us. The market slide on Tuesday got me thinking as to whether investors really weigh up the implications or they just automatically sell at the fear of war.

                          As with all events, investors want to make sure they are betting on the right side. In 1815 Nathan Rothschild posted his own messengers on the battlefield of Waterloo in order that he could know as soon as possible who the victors were. In fact his messengers arrived back to London a full day before the official British messengers enabling him to take advantage in the markets (although the extent to which he profited from this event versus the losses he occurred on other long term bets is disputed). Nowadays traders get real time information (and misinformation) direct from their Bloomberg terminals and 24 hour news channels with the likelihood for any competitive advantage significantly reduced. But is there really the need for investors to fear action in Syria or is any sell off in advance of military action a pointless gesture when measured in it's real impact on the fundamentals in the market?

                                   In the more recent past, evidence seems to suggest the economic impact on the main western economies of military conflict is relatively minor. The economy appears to plug along regardless of what the military forces of the UK, US or France might be involved in and the initial market fear is usually quickly erased. It is of course difficult to completely isolate the impact made by conflict, and the other consequences of those actions, on the market itself, but it is useful to look at how the market performed during similar military confrontations over the last 25 years. The market reaction to military intervention in general tends to show a similar pattern of showing fear (even if limited) in the lead-up, but by the time the bombing or conflict begins the impact has been weighed up as ineffective on the wider economy and so investors carry on as normal and return to focus on everything else. In the days leading up to NATO bombing in Kosovo, for example, the S&P 500 fell 3.4% but this level was recovered within days. With the Iraq War in 2003 the S&P 500 saw a fall of 9% between the day in October 2002 that the Senate passed a resolution authorising force in Iraq until 11th March 2003, a few days before the start of the conflict. This was entirely reversed however just over a week later by the time the conflict actually started on March 20th. Meanwhile the impact of the start of bombing on Libya in 2011 on the market was virtually no reaction whatsoever. Whilst the S&P 500 was seen to be down as much as 13% during the course of the Libya campaign this was due to the ongoing economic issues from the recession and bore no impact from the consequences of military action.

                    So if the recent past seems to indicate limited impact from the involvement of the US and UK in the end, why then are we seeing market jitters at the hint of action (from the US even if the UK opts out)?

                      As always with the market, it's the fear of the worst from some, and the fear of missing out (FOMO - more technically known as herd behaviour) of others not wanting to get left holding the the wrong assets should things deteriorate, which is causing the additional drag. There is no doubt that there are substantial risks associated by any Western attack on Syria, the main one from an economic point of view being the potential for regional destabalisation, in particular the involvement of Iran. Syria itself has limited impact on oil supplies, but should Iran feel the need to get directly involved (as opposed to using proxies such as Hezbollah) it could potentially disrupt oil supplies in the Straights of Hormuz which in itself would force the price of oil up further. This increase in oil price, especially for a sustained period of time, would put pressure on the economic recovery across the globe and would also directly hurt households with increased petrol and heating costs potentially right as winter approaches. The First Gulf War back in 1991 had a similar impact in it's lead up following Iraq's invasion of Kuwait on 2nd August 1990. Back then spiraling oil prices actually pushed the US back into recession with equity markets also falling up to 16%. The downturn was however shortlived with markets recovering within 8 months of the initial invasion by Iraq once the conflict had started, while the oil fears were reduced by Saudi Arabia providing additional supply within a couple of months of Iraq's initial invasion.

                        The lead-up to the 1991 Gulf War can be seen as an example of where the fear of the worst can itself have drastic consequences, even when the end result from the conflict shows those fears as being overblown. With the markets returning to their levels before the invasion within a relatively short space of time for such a steep decline (16%), investors who would have panicked and sold equities in fear on the downward spiral and only gone back in once the war was over, as I'm sure several did, would have suffered financial losses as a result (in addition to their costs of having to execute the transactions) as opposed to those who held on in anticipation of a swift recovery.

                    The benefit of hindsight is always wonderful in these situations. The world at that time was only just out of the cold war, and had recent memories of the effects of the oil crises of 1973 and 1979 to drive it's fear that the effects of conflict with Iraq may not be as short and successful as it turned out. Saudi Arabia itself after all was seen as a next potential target as well. More recently however interventions in these conflicts have become more regular, with western intervention to various extents in Bosnia, Kosovo, Afghanistan, Iraq and Libya all coming within the last 20 years, and as we've seen with only relatively brief, if any impact on equity markets. The likelihood is here too that any intervention in Syria will remain brief and localised. There are prospects of Iranian involvement, but again this matters only to the markets in as much that it will disrupt factors which effect the economy. For any medium or long term investors in equity it would seem good enough to sit and watch any market volatility in the lead up to conflict, in the knowledge that markets will revert once it becomes apparent there is no real economic impact in the West. The real focus from an investors perspective, should be whether the current levels of growth will gain speed, that too will become more apparent in the coming weeks.