What is collateral, anyway? The Latin etymology suggests it is something standing side by side with something else, like Collingwood fans sticking together to defend the Magpie name. But in the financial world, we take collateral to mean property, or something equivalent, deposited with a creditor to guarantee the repayment of a debt. The collateral gives the lender security against the risk that the borrower is unable to repay.
Why the language diversion to begin today’s Markets and Money? Well, we have a hunch that much of the banking system of the Western world is stuffed with garbage collateral. And meanwhile, banks are forced to provide real tangible collateral to get loan from the central bank of central banks (the Bank of International Settlements). If the garbage collateral really is garbage, the banks are more poorly capitalised than previously imagined, and may want some of that gold back. But how about some details?
Just for some context, remember last week when we mentioned that Australian mortgage rates may be pushed up regardless of Reserve Bank’s manipulation of the cash rate? The argument is that in a global financial market, the Reserve Bank isn’t really in control of the price of money, especially if Australian banks are borrowing that money somewhere else, where some other suit with an inflated sense of self belief is fixing the price of money.
The main point is really an argument that we believe the price of money, as expressed via long-term interest rates not set by central banks, is going up. One reason for that is that so many corporations and governments are due to refinance loans and lines of credit taken out at the height of the credit boom years, when interest rates were low and money seemed free.
Nothing is ever free, or at least without the cost being born by someone. Except perhaps solar radiation. It rains down on the planet every day. It’s what keeps the Earth from being a closed energy system. If we could just turn more of that free solar income into an energy stream, everything really would be fine.
But right now, at least in the world of European banks, matters are less than fine, although perhaps they are finely balanced between seeming normality and real chaos. Eurozone banks must refinance nearly $1.65 trillion in debt in the next 18 months, according to the Wall Street Journal. With all that European money and American investor money currently pouring into short-term U.S. government notes and bonds, the Europeans better start hustling, jiving, busking, and pan-handling for all the credit they can get.
But from whom will they borrow (each other?) and what can they pledge as collateral against a default?
That is not a rhetorical question.
Of course the government could guarantee that debt. But what does the government pledge as collateral when it borrows in the bond market? Nothing, really. Or more specifically, you. A continuous stream of tax revenues – property tax, income tax, corporate tax, GST, payroll tax, death tax – is why the government usually pays lower interest rates to borrow than corporations.
Corporations must make a profit in order to pay bond holders. To make a profit you have to actually provide the consumer of your good or service with something he wants. And you have to do it cheaper and better than your competitors. And you have pay your bills and your employees, whereas when the government needs money to pay bondholders it can just take it from someone else or print it.
A key point: every dollar taken from the private sector to pay a government bondholder reduces private demand. You could argue that interest on government bonds is somebody’s income. But the money multiplier suggests if you really wanted to stimulate the economy, you wouldn’t borrow money to give it away. You’d just let people keep more of what’s already there’s and spend less. But we digress.
Europe has large borrowing needs. So does America. So does Japan. Australia’s borrowing needs, by comparison, are more modest. But it’s going to have to get in line. It can jump the queue by offering higher yields to prospective investors/savers. But that’s going to push up mortgage rates. And now, we’re not just making this up.
Today’s Australian Financial Review has a story from Stephen Shore in which he reports that Australian corporations-not including the Big Four banks-have roughly $124 billion in debt which must be refinanced over the next three years. That figure comes from a GoldmanSachs JBWere estimate. It reflects maturing debt facilities.
It’s possible – in a deleveraging world – that corporations will not utilise or even have on hand debt facilities, meaning the $124 billion figure could be lower. But according the GSJBW there are, “42 companies with loan facilities maturing in the next two years that was greater than or equal to 20 per cent of market capitalisation. Of these, one-third were real estate investment trusts, five where infrastructure companies and four were utilities.
The worry is that falling asset values (provided they are revalued properly in the first place) and new bank capital regulations would force these companies to pay much more to refinance their debts and lines of credit. It kind of makes you wonder if there’s not a lot more fallout to come in those sectors of the Aussie economy that levered up during the credit boom.
And don’t think we don’t know who you are, highly geared sectors of the economy. We do.
This brings us back, in a roundabout way, to gold. It fell last week while we were in Sydney, seemingly confirming the gleeful speculations of the unimaginative investment establishment that gold was in a bubble. Morons. All of them.
The story that took a bit to digest was that some commercial banks have essentially pawned their gold holdings with the Bank of International Settlements in exchange for cash. Since December, some 349 metric tonnes of gold have been deposited as collateral by commercial banks in exchange for bright paper things. So why did the banks do it? And why did gold go down?
The answer to the first question is that the best time to borrow against the value of an asset is when the asset is worth a lot. Does this means commercial banks are borrowing against the value of their gold now because they believe it has reached a peak and they can buy it back later at a cheaper price (although we’re not certain that’s how the swaps work).
Or does it mean banks are so desperate from cash they can’t borrow in the open market at attractive prices that they’re literally hawking the family gold to stay liquid?
The gold market freaked out because – and we’re just guessing here – it viewed the 349 metric tonnes of gold as the sort of inventory that could be dumped on the market to suppress prices. The fact that gold has remained at or above the US$1,200 figure shows you how strong the support for gold is.
Commercial banks are hoping the value of their loan portfolios – collateralised by government debt, commercial real estate, and residential estate – improves. In the meantime, they’re willing to pawn the one real tangible asset they own to raise cash. It shows you how stupid some bankers continue to be and just how little the financial system has recovered from the leveraged boom of the last 30 years.
Of course there’s a chance that in the coming bust the price of gold falls. But is it a bubble? No. The morons who are saying that believe, among other things, that paper is money and that it’s the job of central banks to support asset prices and that central banks can actually do so. This is the position taken by imbeciles. The price of their ignorance will be very high.
In the meantime, evidence is mounting that no matter how lucky this country is, it cannot escape what’s going on. In late June, Westpac raised $800 million in five-year funding at a price 35 basis points higher than a deal seven months earlier, according to today’s Australian. You can bet the banks don’t want to raise mortgage rates faster than the cash rate before the election. But you can also bet that what an Australian bank charges you for money will be determined by the global cost of capital, not the RBA’s cash rate.
Except in a world of fiat money with fractional reserve banking, nothing cannot come from nothing. You can pretend that it does, but only as long as everyone pretends along with you. When the pretending stops, what will you have left to hold onto?
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