2011 was a tumultuous year characterized by wild swings toward a near-total loss of confidence in governments and financial institutions, followed by a rapid return to "risk on" behavior patterns, often in response to frequent doses of liquidity and hot air served up in equal measure by central bankers. Despite its gyrations the S&P500 remains flat for the year, while VIX and other gauges of investor fear have calmed significantly from recent highs. Investors, soothed by the waves of liquidity emanating from the ECB, now seem to be discounting a return to relative stability.
As identified by behavioral finance practitioners such as Nassim Nicholas Taleb, the core assumptions about the nature of risk relied upon by the mainstream financial industry can often experience devastating breakdowns during rare or extreme adverse events (which consequently are both much more extreme and much less rare than these investors can anticipate). I would argue that today is identifiably a situation where the potential outcomes are becoming more binary, more uncertain, and more extreme, creating a very substantial degree of real risk with a potential magnitude that has been (and to a great extent continues to be) poorly and incompletely anticipated by most market participants.
Reflections on reflexivity - identifying potential catalysts for a self-reinforcing loss of confidence
In The Alchemy of Finance, George Soros attributed his formidable ability to forecast certain currency crises and other macroeconomic events to his so-called "theory of reflexivity," a fancy way of saying that he identified instances where several potential sources of instability could become self-reinforcing. Today’s environment certainly has no lack of potentially "reflexive" destabilizing factors.
As is already becoming apparent, a growing loss of confidence in the risk-free nature of European sovereign debt has continued to exacerbate a self-fulfilling slide in bond prices, driving up yields paid by governments to more and more unsustainable levels. In turn, the deteriorating market value of sovereign debt adds to growing pressure on the highly leveraged balance sheets of European banks, leading to forced asset sales causing yet further pressure on bond prices, and to cutbacks in regional lending exacerbating the economic slowdown and damaging the tax base necessary to support debt service. The need to refinance large impending debt maturities at escalating interest rates will impose growing costs on indebted governments at precisely the wrong time.
European austerity: Too much, too late
Scrambling to restore market confidence given the obvious failure of many European governments to stay within past debt and deficit targets, politicians are imposing austerity measures which will prove unable to make any significant headway at actual debt reduction, but will be more than enough to inflict severe pain on an already weakened economy. Far from restoring confidence or actually paying down debt, current attempts at austerity are likely to call attention to the unsustainability of the existing debt burden, exacerbate a growing economic downturn, and make debt/GDP ratios and bank balance sheets look even worse.
None of these measures addresses the core problem of a lack of growth driven by structural uncompetitiveness in the vulnerable southern European economies. Trapped inside the Eurozone by the high costs of exit, the inherent inflexibility of a multinational currency removes an important stabilizing mechanism for less competitive nations to relieve unsustainable deficits through exchange rate devaluation.
In a fragmented Europe of heterogeneous democratic societies where much of the populace has become more accustomed to easy credit than to hard decisions, the behavioral and human consequences of attempted austerity cannot be ignored. As the downturn wears on, current policies are going to create serious unrest, likely pushing peripheral countries into actual default as voters reject what they interpret as an aggressive power grab by Germany. Ironically, attempts to restore confidence through a show of resolve have a high probability of backfiring; demonstrating instead that many European nations simply cannot sustain (for both economic and political reasons) the crushing degree of long-term austerity needed to repay their debts.
Banking on a prayer
Perhaps most importantly, the presence of excessive degrees of leverage within a complex and interconnected financial system clearly was a central factor exacerbating the scope of the mortgage crisis, yet a dangerously high level of leverage remains concerningly widespread, particularly among some European institutions.
Studying the positions taken by members of the European establishment can prove illuminating. The hard line taken against activating credit default swaps during what is already effectively a Greek default, or on recognizing any private or public sector losses in a restructuring of Irish debt, as well as the surprising apparent laxity of criteria used in ostensible "stress tests" of European banks, each represent telling revelations that belie the vulnerability to default of leveraged creditors in the politically dominant core European countries, chief among them the large French and German banks.
In allegedly prudent and cash-flush Germany, Deutsche Bank is levered an astonishing 37 to 1, holding next to no tangible equity against nearly 1.3 trillion in assets, many of which include Eurozone sovereign bonds that are deteriorating sharply in value and which have yet to be written down. The German state-affiliated Landesbanks look particularly vulnerable -- in pushing for lax criteria for stress tests and capital requirements, rather than increasing confidence in banks politicians have lost credibility and called more attention to the real fragility inherent in the system.
Heading into a period of growing asset price instability, multiple large financial institutions remain leveraged on a dangerous scale, and are now suffering from their inattention to the flaws of another convenient myth of the financial industry; that investments in sovereign debt necessarily represent a risk-free return -- while as James Grant trenchantly observes, much of it may be more accurately described as a return-free risk.
Getting carried away - MF Global on a global scale
In an attempt to put off the day of reckoning, the ECB is actively encouraging banks to load up on a massive carry trade in European debt; making 3-year money available at nominal rates against a reduced quality of collateral. It's the kind of trade Jon Corzine would have loved (and in fact did in spades).
If you or I (or Corzine) were the equity owners of a European bank that we knew to be basically insolvent It might appear to us that there was nothing to lose and everything to gain -- the risk is all borne by others (who, unfortunately, do have a very great deal to lose.) Tempted by more of the inexpensive leverage that got them where they are today, many of the most vulnerable European banks are going to "go all in", and like Corzine close their eyes and pray no one looks too carefully at their balance sheet.
Unfortunately, like austerity, the carry trade does not resolve the real-world issues of excessive debt levels, structural uncompetitiveness, and anemic growth that make sovereign debt burdens virtually impossible to actually repay. It is less likely to repair balance sheets than to transiently postpone the recognition of public and private sector insolvency, making the problem worse in the longer term. If an approach of "stealth money printing" were actually to help nations repay their debts and relieve uncompetitiveness, it would need to result in inflation on a massive scale that Germany would simply not accept. As the Cato Institute's Jagadeesh Gokhale writes, "The average EU country would need to have more than four times (434 percent) its current annual gross domestic product in the bank today, earning interest at the government’s borrowing rate, in order to fund current policies indefinitely."
In the end, the carry trade builds on the instability inherent in the system as banks further increase their current overexposure to sovereign debt, and the ECB balance sheet swells with exposure to vulnerable institutions. Lending money to yourself is not going to solve the problem off too much leverage, but may help keep up appearances and restore confidence for possibly quite a while.. until someone sneezes and the bond market has a bad day, Italian yields go up to 8%, and European banks suddenly begin to wonder whether borrowing billions to buy more at 6% a few weeks ago really was such a great way to shore up their balance sheets.
Italy alone is going to have to roll over a massive amount of debt in 2012; and it's not clear where external demand could be coming from -- European banks are going to be expected to swallow most of it while becoming increasingly reliant on short term credit from the ECB. At the same time, European banks will have to roll over an estimated 200 billion Euros of their own debt in the first 3 months of 2012. With both bank and public sector balance sheets already under stress, Eurozone governments will have little ability to respond to a Lehman-scale crisis with yet another bailout. Deutsche Bank’s balance sheet alone is nearly half of German GDP, giving an entirely new meaning to the platitude "too big to fail."
The White Swan of 2012
All of the above may sound apocalyptic and complex, but the complex interdependencies in the system enable a simple conclusion: there are a large number of ways for things to go very wrong, very quickly. The bottom line is that the high degree of leverage present in the system creates an inherently unstable environment, where even a mild external shock or transient loss of investor confidence can have unpredictable consequences that rapidly spiral out of control. Multiple interlocking and self-reinforcing sources of instability are undeniably present, to a degree that could once again totally invalidate the conventional models of risk used in mainstream finance.
Carried away by the carry trade to a world where problems have no consequences as long as they can be postponed, many investors apparently perceive that the degree of systemic risk is low. For those more skeptical of easy solutions, the recent short-term relief rally and associated decline in put premiums are again presenting what is perhaps a transient opportunity to effectively buy insurance at reasonable prices.
As Nouriel Roubini and others have forcefully pointed out, the allegedly efficient markets appear to have learned little from recent history. With the example of 2008 so close behind, the potential for a recurrent and extremely severe credit crisis can no longer be called a mysterious and unobservable Black Swan.