July 28, 2011

Even the safest haven could become dangerously overcrowded

Sir, Richard Milne’s “Beware of safe havens when seeking next financial crisis” July 28, makes reference to the truth that “Risky assets do not cause crises. It is those perceived as being safe that do” and to the immense regulatory bias in favor of the “not-risky”, especially the good sovereigns and the triple-A rated, and against the risky, like the small businesses and entrepreneurs.

(Mr. Milne must know, because of the emails he has received, that those arguments is part of the criticism that, at no irrelevant personal cost, I have for many years voiced quite lonely about the bank regulations that came out of Basel II. In this respect I must say that I am indeed surprised and disappointed that he makes no reference to that in his article. Had I been a PhD from his own Alma Mater, he would not have dreamt of ignoring me.)

His analysis is quite accurate and so I guess the cat is out of the bag. How on earth can the bank regulators explain what they did pushing dangerous “safe assets” and, especially, how can they defend that they mostly want to insist in doing just the same?

That said the article fails to point out the real fundamental mistake committed by the regulators and which is that they blithely ignored the fact that the markets already clear for the safe-haven perception when it sets the risk adjusted interest rate. And so, when the regulators also based their capital requirements for banks on exactly the same safe-haven perception, they turned what is a natural and reasonable pursuit of a safe haven, into an unnatural and unreasonable stampede in search of a safe and profitable haven… and even the safest haven can turn into mortal traps, if they become overcrowded. Milne mentions “Follow the debt” as to where investors should be looking for trouble. I have since 2003 told regulators “Follow the AAAs” as to where the next bank crisis will be.

Milne quotes Professor Geoffrey Wood of Cass Business School calling the “push by regulators for banks to own sovereign debt” as “premeditated theft”, but in my AAA-Bomb blog I have for a long time called sheer communism.

Finally what Milne also fails to point out, perhaps because the implications are so frightening is that, given that huge regulatory bias in favor of sovereign debt, we really do not know what the underlying real interest rates of public debt are… and so we are in fact flying blind with dysfunctional instruments.