12 August 2011

Paul N Goldschmidt: But who are these speculators?

The temporary ban on short selling of a limited number of financial stocks in four eurozone countries has, once again, drawn attention on “speculators”. This decision was taken after the precipitous drop in stock markets in which financials were particularly badly bruised.

After the rating agencies, “speculators” have become the subject of politicians' ire, whose declarations are disseminated and amplified by the media. The latter, through detailed explanatory descriptions of short selling, are contributing to reinforcing perceptions of the existence of a nefarious group of manipulators, selling securities (that they do not own) and responsible for the downward trend of the market.

It goes without saying, that to the extent an operator sells shares immediately prior to propagating negative news on a company – either real (insider trading) or false (fraudulent manipulation) – the full weight of the law should be brought to bear on the perpetrator. That said, it is clear that such criminal behaviour only represents an infinitesimal percentage of transactions and can, at worst, only affect significantly a very limited number of shares; nor can it be blamed for the current market volatility.

The stock market decline – and that of specific sectors in particular – must be explained by other factors, among which one can mention:

• Uncertainty, fueled by official statistics (economic activity, unemployment, inflation, deficits etc.) that contradict consistently the overly optimistic pronouncements by the authorities. Social unrest, which after having shaken Greece, Ireland Portugal, Spain and Italy, has exploded spectacularly in the United Kingdom, reinforcing a feeling of unease and generating fear and insecurity.
• The turmoil surrounding the measures designed to deal with the financial crisis: the outline of the agreement decided “unanimously” in Brussels on July 21st remains subject to detailed formulation, but it is already quite obvious that the parliamentary procedures necessary for their adoption will give ample opportunity to national opposition parties to exacerbate populist and nationalistic feelings, forcing, once again, compromises that will render the end result hardly credible to the market.

The combination of both these factors leads unavoidably to investors – in particular institution investors (fiduciary responsibility) but also private investors (capital preservation) – reducing risk exposures by seeking safe haven commitments where security and liquidity considerations take precedence over all others. Thus can be explained the “gold rush”, the preference for short-term investments and the choice of currencies deemed “safe”, such as the Swiss Franc and the Japanese Yen. The flip side is the accelerating sale of other asset classes, in particular equities, which have a far more significant impact on stock prices than the influence of “mythical” speculators.

With regard to specific sectors which have “suffered” particularly, one should pinpoint bank shares. In this regard the concept of “speculation” is perfectly justified but not in the sense in which it is normally used. Indeed, there is a broad consensus to attributing the cause of the financial crisis to excessive indebtedness which has built up progressively over the last 30 years, accelerating since the turn of the century. During this latter phase, the biggest “speculators were – by far – the banks. They invested in highly speculative products using excessive leverage, significantly endangering both their solvency and liquidity. For example, Fortis accumulated a portfolio of €50 billion of toxic products and this situation was repeated across a broad section of financial institutions.

The bail-out of the banking sector by Governments was the lifeline thrown to the real “speculators”. Having been rescued (temporarily), but having in the process engineered the 2008/9 global recession, they threw themselves into a lucrative arbitrage between unlimited cheap funding provided by Central Banks and the financing of Governments (squeezed by falling revenues and underwriting recovery programmes) or the banking sectors of eurozone peripheral countries on the basis of the explicit or implicit guarantees that each EMU Member State had provided to its banking sector. Thus developed an incestuous interdependence between the banking sector and Sovereign States, with each one holding the other hostage; large multinational banks, however, held marginally the upper hand when facing a fragmented front of 17 EMU Member States who were prone to exposeing their internal disagreements.

It is therefore hardly surprising that investors and market operators have become increasingly reticent towards exposures to the banking sector. This has been particularly visible in the evolution of the attitudes of “liquidity pool” managers (see IMF's WP/11/90 by Zoltan Pozsar) who have limited their global direct bank exposures to the amount benefiting directly from Government insurance cover (about 1/3 of their total $3.5 trillion size) and have more recently completely withdrawn from both Spain and Italy. The balance is in short-term Government securities or private credit enhanced liquid instruments. To assist banks in accessing cheap private customer deposits further, the insurance limit was quadrupled in 2008 to €100.000.

In conclusion, the so called “speculative” attacks on several financial institutions are a direct result of the loss of confidence in the solvency of the banking sector of which Governments have become the unwilling guarantors. Rather than wasting time blaming unnamed speculators or taking largely cosmetic measures such as a short selling ban, eurozone authorities should focus on speaking with a single voice, imposing their will on the banking sector and, at last, come up with credible measures capable of ensuring the long-term future of Economic and Monetary Union.

Paul N Goldschmidt, Director, European Commission (ret); Member of the Thomas More Institute

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© Paul Goldschmidt