Bad Collateral: How the Sovereign Debt Crisis Crash Begins

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If you’re at all worried about the title, don’t be. There’s some good news too. It will hit your inbox at around 2pm today.

It’s pretty tough to figure out when a financial crisis will hit, but they have an odd habit of being triggered by a certain event. And that event involves the failure of collateral.

The problem is that the collateral shaping up to fail this time around would also bring down governments, not just financial institutions. That kind of disaster in Europe is actually a golden opportunity for Australians savvy enough to know it’s coming and how to profit from it. But we’ll leave that to this afternoon.

This Daily Reckoning focuses on how the crisis will begin.

Collateral is an asset you give to someone that they only get to keep if you don’t hold up your end of the bargain. When you get a loan to buy a house, the bank puts a mortgage on your home. If you default, the bank gets the house. So the house is the collateral.

Collateral is used right through the financial system to shore up agreements. It reduces the risk of dealing with a business you don’t know the financial position of. If they go bankrupt, or don’t pay up, you’re left with an asset you can sell to protect yourself from the loss.

The sub-prime crisis in America began when the collateral in lending agreements (the houses) fell in price. It wasn’t the inability to pay mortgages that triggered the collapse. If house prices had continued rising, people who couldn’t afford their mortgage would just sell and pocket the capital gain from rising house prices. They could repay the loan with the cash from the sale and everyone walks away happy.

But once the collateral (house) prices fell, all hell broke loose in financial markets. Suddenly, people’s ability to repay their debts mattered, because simply selling the house could leave them short of funds to repay the debt.

Banks stopped lending because collateral values were falling, making lending far more risky. Borrowers stopped borrowing because falling house prices meant they had no safe collateral to pledge with lenders. And people stopped refinancing their loans because house prices weren’t rising, which meant they couldn’t top up their loan for extra cash.

The sub-prime crisis spread around the economy via collateral, too. Lehman Brothers and Bear Stearns failed because the assets they used as collateral to borrow money began falling in price.

People who used to lend the financial institutions money didn’t accept as collateral what they had accepted before. And so Lehman and Bear were starved of funding, just like home owners.

The interesting thing here is that the risk in financial markets isn’t what you think it is. It’s not about people borrowing too much. It’s not about bank runs or failed investments. It’s about collateral.

That’s because, if you’ve got the right collateral in your relationship with someone in financial markets, your risk is very low. That’s the point of having collateral in the first place. A bank doesn’t have to worry about borrowers repaying their loans if the house is worth more than the loan.

But when collateral goes wrong, suddenly everyone is left with risks they didn’t expect.

Europe’s Collateral Crisis

The latest collateral story is that of sovereign debt. You see, sovereign debt is supposed to be so safe that everyone will accept it as collateral. So if you have some government bonds lying around, people will usually be willing to lend you money if you pledge those bonds as collateral with them.

For example, central banks traditionally require banks to pledge sovereign bonds as collateral in exchange for emergency lending. If your bank doesn’t have sovereign bonds to pledge as collateral, it might not be granted emergency lending.

But the European sovereign debt crisis has turned this on its head. Most private lenders to financial institutions aren’t willing to accept the sovereign debt of countries like Greece, Spain, and Portugal as collateral any more. At least, not on favourable terms. The only lending institution still happy to take those government bonds as collateral is the European Central Bank.

It might be difficult to understand just how ridiculous this is. There is a financial crisis going on at Europe’s banks largely because the sovereign bonds they own are not safe investments.

But the collateral being used to secure emergency lending from central banks to stop the crisis is the very asset that’s causing the problem in the first place. Collateral is supposed to be safe, not dangerous.

The only reason central banks are dumb (or cunning) enough to agree to accept such terrible collateral is that their rules say they should. Rules which were written by the bankrupt governments trying to issue the sovereign bonds.

The Collateral Fraying at the Edges

The inherent problems with all this are already fraying the edges of the system. German newspapers recently claimed that the ECB is breaking its own rules by accepting collateral it shouldn’t be. Spanish government bonds aren’t safe enough to be acceptable as collateral under the ECB’s rules, but the ECB was accepting them anyway.

The Germans don’t like this because it leaves the ECB with dodgy collateral, something the Germans could be on the hook for if Spain defaults and the ECB needs bailing out.

At first, the accusations were dismissed. But then ECB President Draghi admitted the breaches of rules had occurred. This basically means that the ECB is willing to bend rules to help out banks and governments.

This is just the kind of thing that gets German knickers in a twist, because it means that the ECB is not governed by law. The Germans can’t control it.

At some point, the collateral system for sovereign bonds will break down completely. Just as falling house prices triggered the sub-prime crisis, falling sovereign bond prices will trigger a new crisis. Remember though, this will happen when sovereign bonds are no longer accepted as collateral.

It doesn’t matter that Greece will have to default at some point. The USA can’t repay its debts either. What matters is confidence in the asset of sovereign bonds, and whether they are acceptable as ‘no-questions-asked’ collateral.

As long as they are, sovereign bonds can be pledged as collateral for emergency funding. That makes them valuable. Without that feature, they are just plain old risky assets.

All this is a complete sham, made possible by the inherent contradictions in the financial system. To learn how to profit from it, keep an eye on your inbox at 2pm today.

Until next week,

Nickolai Hubble.
The Daily Reckoning Weekend Edition

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Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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