Haircuts can be dangerous
OK, wurfing (surfing the web at work) didn’t make it into the new edition of the Oxford Dictionary of English published today, but toxic debt and quantitative easing did.
Speaking of which, haircut was already there. Eh? Haircut, you know: “US informal: a reduction in the stated value of an asset”.
That’s one of the terms you need to understand to follow the argument in a new OECD Working Paper, “The EU Stress Test and Sovereign Debt Exposures”, on the stress tests 84 European banks passed so brilliantly in July.
Adrian Blundell-Wignall, Special Adviser to the OECD Secretary-General on financial markets, and his colleague Patrick Slovik point out that the tests only considered “trading book” exposures to sovereign debt, while over 80% of exposure is on the “banking book”.
The trading book consists of the securities a bank buys and sells regularly, even daily, while the banking book contains the products the bank would normally hold on to until they matured, including the bonds used to finance sovereign debt.
For the trading book, the haircut is around €26 bn in the stress tests. No haircut was applied to the banking book, on the grounds a default would be virtually impossible over the two-year period considered. The tests also assumed there would be no bank failures.
Blundell-Wignall and Slovik argue that these two assumptions help to explain why despite the encouraging test results (only 7 banks failed) equity markets are still performing poorly, bond spreads remain high, and banks are still reluctant to lend.
If a bank fails, it cannot hold on to the longer-term assets on its banking book, which would have to be sold for whatever they are worth on the day, even at a loss, and in fact there would be no difference between the trading and banking books. In other words, shifts in the market value of sovereign debt do matter, unless you assume that the stress-tested banks never fail.
That’s a brave, or foolish, assumption in light of what we’ve seen since the crisis broke, but the assumption of no sovereign default over the next two years seems reasonable, given the €720 bn European Financial Stability Facility (EFSF) agreed earlier this year.
The EFSF could more than cover all the funding needs of the most exposed countries, even in the highly unlikely case that no securities could be sold on the open market.
So why are ratings agencies like Moody’s worried about the sovereign debt of even the US, Germany, France and the UK, countries they consider “well-positioned at AAA” in their latest figures?
They’re not worried about the next couple of years, but many analysts foresee problems in reforming labour and pension markets to ensure sustainable growth before the stimulus packages run out. In the medium-term, budget restraints will make these reforms more difficult.
In the longer term, Moody’s is afraid of a situation where states delay pension reform for political reasons, leading to a downward spiral as they try to borrow more to finance deficits, while at the same time, conflict between younger and older generations destroys the social cohesion needed to stabilise debt. Countries in this situation would lose their triple-A rating.
OECD Insights: From Crisis to Recovery: www.oecd.org/insights/crisis
Blundell-Wignall, A., and P. Slovik (2010) “The EU Stress Test and Sovereign Debt Exposures”, OECD Working Papers on Finance, Insurance and Private Pensions, No. 4. http://www.oecd.org/dataoecd/17/57/45820698.pdf
The OECD paper on “Assessing Default Investment Strategies in Defined Contribution Pension Plans” warns that retirement income may become a “lottery” unless default strategies are carefully designed: http://www.oecd.org/dataoecd/22/63/45390367.pdf. OECD Working Papers on Finance, Insurance and Private Pensions No. 2