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The Shrinkage of the Shrew

Even in the darkest and most fearful times when some are huddled up in a guano-stained bunker, there is always money sloshing around. At all times there is a glop of investors that are at best confused, at worst afraid, and always directionless. If you tell a good story they will throw money at you.

Sometimes the stories are right, sometimes they are wrong. Sometimes the stories are deceptive, sometimes well-intentioned. We are not talking about Charles Dickens or David Foster Wallace or Stanislaw Lem. None of that matters. Seriously. Just off the top of your head, tally how many financial dudes have made completely, I mean 100% jaw-droppingly wrong market calls in the last few years. In the last six months. Or last Thursday. Prophecy about anything, much less markets, without divine assistance is impossible.

What matters is a meaningful story. With a good tale, some market-baller can drum up money by confirming preconceptions with vague conjecture or via an impressive array of random dart-board statistics. A story can be right in a purely self-fulfilling way: it has a capacity to reinvent entire worlds.

Think of Bill Gross’ “New Normal”. No one had ever seen anything like the events of the late 2000s before. Or imagined it. Or even tried to. Without a narrative most people’s only points of reference are the things they already know. Like a chorus in an ancient play, they act as witness to the dramatic telling. A narrative connects future aspirations with habituated behavior and move markets.

The story I tell here is called “The Shrinkage of the Shrew”.

The story starts with a reckless nobleman called Petruchio. Depending on the venue he is played by Uncle Sugar, the Troika, or any number of other similar actors. He is joined at the hip to a reckless and shrewish Katherina, played collectively by the banks of the world. The objective: marital bliss. Petruchio has a well-intentioned but ultimately clueless entourage of knaves that attempt to assist in the marital bliss. Played by a bunch of academics that know little about a balance sheet or the actual business of running a bank, they cook up a number of complicated plans that introduce the comedic element. By a series of reverse psychology moves and plenty of one-stupid-rule-after-another thrown in, the plan finally tames the shrewish Katherina. I’m still looking for a happy ending, much less some laughs.

Shed the roles: banks are staffed by dubious geniuses who created the crisis and forced the cock-eyed marriage in the first place. The noble government forces their subjects to pay for all the bank extravagance. Of course they are not happy about it. The plan is to force banks to hold a prescribed level of cash or tier I assets to offset any risk they take as a business. The idea of Basel is to capitalize banks in a prudent way, but instead it kills important parts of their business stone dead. The common man subjects can thus see no value in keeping the banks around. At all.

Even a furtive glance at Greece, far more credit-worthy emerging market debt, and global indebtedness levels make it clear that sovereigns will need to broaden demand for their bonds for years. To do it, they will increasingly look to use the infrastructure of the credit market. Recognizing the need to find buyers for large amounts of government bonds and the objective of ensuring a less risky, more robust banking system, our regulators must be sorely tempted to find mechanisms to encourage, persuade or coerce banks into owning more “risk free” government debt. Banks already needed to triple the capital they hold to support the structured credit books on their balance sheets under Basel II; now Basel III the calls for in some cases another boost of tier 1 capital.

What is a shrewish bank to do? Shrinkage.

Shrinkage means the banking system is in the midst of a painful process of deleveraging. That means fewer new loans, disposal of loans and other assets already on the balance sheet, and more capital-raising. Making a market in credit, running a structured credit book, even originating syndicated loans on a bank balance sheet can be economic non-sense.

In the world of credit, the high yield bond market has been a particular victim of the law of unintended consequences. Dodd-Frank Act, Basel III Accord and Volcker Rule all have driven dealer liquidity out of the market. In our view, banks are simply not making deep markets in the high yield space which means when there is significant selling, bids can be harder to find. Also, eventually rates must rise if only to fall again. Since higher rates have a bigger impact on high grade credit than high yield, more capital-strapped dealers will leave this business as well. Sovereign bonds, pumped by government through regulations, are the last refuge.

Is the story over? It is not over.

The happy ending goes to the knaves. All their plans lead to a boom in the market for IT, systems and operations people. Whatever we may think of the regulations, there is no doubt that implementing some of the required infrastructure improvements will require the best efforts of many increasingly expensive, highly skilled technologists. Who played a hand in writing the regulations. One could be forgiven for thinking that a small and selective group are creating a cottage industry cloaked in complicated Excel formulas and walls of manuals.

In the rush to “financial stability”, we will end up learning that the harder we try to create it, the more elusive stability becomes. A broken woman, a shadow of her former self, isn’t funny.

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