The Next Financial Crisis & the EU

"So if 2009 goes horribly wrong it’s probably because there’s a run on a major currency or a Government bond market than because of wide scale corporate defaults. At the moment the UK remains the lowest hanging developed market fruit. For those of us living in the UK it remains scary how exposed we are to the full force of this credit crisis.", Jim Reid of Deutsche Bank

It all starts with Gordon's celebrated raid 1997 raid on the pension funds by abolishing the dividend tax credit. This also hit those holding equities in PEPs. As a result pension funds received less income from their equity investments making equities as an asset class less attractive to pension funds. Now as pension funds were the largest holders of equities the demand for equities was less, their price fell and so hence so did the value of the pension fund itself, a vicious circle, leading to the underfunded pension fund corporate scenario and the Equtable Life bust.

As always Gordon responded with more regulations to curb these naughty fund managers and thus arose the MFR rules in which R Maxwell, deceased, played no small part. So the new investment paradigm of asset liability matching became the fashion and as bond interest is tax deductible for corporates and is paid gross to pension funds, corporate bonds became the asset of choice for pension funds. Boots PLC was one of the first into this bond/equity switch and did very well out of it.

Unfortunately the UK corporate bond market is neither very big or very liquid. At the same time Gordon's coffers were awash with cash from the sale of mobile phone licences so not a lot of gilts were being issued either. Gordon was working hard to rectify that by thinking up all sorts of igenious ways to spend our money of which more later.

Never ones to let a sucker go unsatisfied the US investment banks spotted an opportunity. If they lent money as mortgages to the great US house aspirant, then parcelled up these mortgages as nice little bite sized chunks, stuck a seal of good housekeeping approval, called a credit rating on the package, easy as they paid the credit rating agencies, then offer these tasty morsels with a much more attractive yield than gilts or corporate bonds to pension funds then bingo they just flew off the shelf. For the investment banks who were raking in huge fees it was a licence to print money.

But as always it was too good to last, The need to issue more mortgages lead to a drop in the ability of the mortgagee to repay, some did not. A default ensued and questions started to be asked. Gordon however had now got his gilt issuance firing on all cylinders helped by the credit crunch and the need for cash to nationalise these banks who may be holding these securitized, now rechristened, toxic assets. And who was buying Gordon's new gilts? Why the pension funds of course.

But again as we approach 2009 there is a snag, the UK pension funds cannot now supply Gordon's gargantuan appetite for cash. These will have to sold to non-UK funds. Hence the Treasury's laid back attitude to the fall in Sterling. Sterling is now low enough to assure foreign buyers, after a stabilisation period at this low level, that their risk of Forex loss on buying gilts is minimal and indeed they may gsin on the deal. Hence the 10 year Gilt-Bund spread has come down from 50 bps to around 20 bps in the last 2 months. Johnny Foreigner wil save the pound despite Gordon!

Compare this with what has happened to Greek and Italian bonds. The Greek -Bund spread has gone out from 90 bs to 225 bps in the same period and the Italian from 75 bps to 135 bps. Unlike Gordon neither of these countries as members of the Euro can print the money to repay or service this debt. The are in the hands of the ECB.

The markets know this and going forward into 2009 will not be keen to buy Greek and Italian sovereign debt, Civil unrest will spread throughout Greece and into Italy as these governments struggle to finance their debt and will threaten to default. If this happened it would be the end of the Euro. The EU cannot let this happen and will have to step in. They will do this by either underwriting Greek and Italian bonds or more likely issue EU bonds whose proceeds can be lent on to Greece and Italy. This is the real danger in 2009. Once this happens the EU is effectively a sovereign country and pressure to increase its tax base will increase dramatically. Increasing amounts of the UK tax take will be hypothecated to the EU. We lose a bit more of our independence and the power of Brussels grows yet more.