CDOs To Buy European Bank Stocks And Other Silly Ideas

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Someone hit F9 on the random number generator that decides how much capital European banks need and now it's $115 billion, which I guess is more than it used to be, so that's a thing. As you might imagine this is a problem because who in their right mind would buy equity of a European bank? Or, in diplomatic terms:

One analyst questioned [Commerzbank’s] ability to make up the deficit through shrinkage or other means. “It certainly seems hard for them to come back with another equity raise from the market, so if all else fails it looks like the government is the answer.”

But the bank insisted this was not part of its plan. Eric Strutz, finance director, said: “We stand by our intention not to make use of additional public funds.”

So that's nice. But if you'd rather look at it in world-historical-demographic terms, it turns out you can. Because this little consulting outfit called McKinsey occasionally sends out musings to its friends and supporters, and today they've got a mammoth, slightly odd financial markets study, which the Journal has written about, concluding that nobody will buy stock anymore, especially from Commerzbank (though I may have just made that part up).

The argument combines demography - "financial assets of private investors in emerging economies will rise to as much as 36 percent of the global total by 2020, from about 21 percent today," and EM investors don't like equities for a variety of good reasons, while aging populations forced to provide for their own retirement in the developed world will also shift to fixed income investments - and the fact that recently stocks have kind of, y'know, sucked, which could lead to "a possible retreat from stocks in reaction to low returns and high volatility." Based on that, they see a $12.3 trillion "equity gap" by 2020, which "will appear almost entirely in emerging markets, although Europe will also face a gap."

It's all just a bit weird, since it seems on cursory inspection to make pretty strong assumptions about the growing desire of emerging market firms to sell equity combined with the not-growing desire of emerging markets people to buy it from them, and is unimpressed by the notion that if no one buys equities their expected returns will rise and so people will want to buy them and, um, markets and stuff. But let's go with it for a minute. McKinsey thinks that this gap will raise the cost of equity for those who need to raise it, especially banks under new capital rules, HINT Commerzbank. Also:

And, with more leverage in the economy, volatility may increase as recessions bring larger waves of financial distress and bankruptcy. At a time when the global economy needs to deleverage in a controlled and safe way, declining investor appetite for equities is an unwelcome development.

To fix this McKinsey has a bunch of solutions like better market regulation and more efficient cross-border capital flows and whatever. And they're probably right, because after all, they're the consultants.

But since our current world is probably more interested in the demand / lack thereof for European bank stocks in 2011 than it is in the demand / lack thereof for Ugandan utility stocks in 2020, let's think of maybe a different solution. I'm still hung up on this thing from earlier this week, in which a Basel liquidity buffer might be expanded to include equities as long as they have the appropriate risk buffer. I unfairly characterized that move as follows:

(1) our risk-free asset du jour, European sovereign debt, is kaput;
(2) actually available actually risk-free assets, say USTs (or gold, whatever), are in short supply; so
(3) let’s make a new risk-free asset out of a concededly risky asset. We’ll just overcollateralize it.

This is a longstanding story: people's risk preferences don't match up with the assets that they can buy. (Where "risk preferences" can mean "personal preferences that they have because they are old or young or rich or poor or Latvian or Japanese," or "allocations that they need to have because of regulation," or whatever in between.) So it occurs to someone to take the assets that exist, put them in a blender, and pour out a delicious smoothie of appropriately risked assets on the other side - while selling the foul-tasting residual risks to people who are strong of stomach and motivated by higher return expectations. One theory of the financial crisis is that bank capital rules had exactly this effect, creating a preference in banks to transform mortgages - which are risky if you're lending to, say, me - into AAA slices of CDOs, which are not risky at all provided it is 2006.

Now on the face of it it would be weird to go build a "CDO of equities" (call it a "CDO of margin loans" if you want to sound like you're at least in the right asset class, but don't get too hung up on making all the details work) to buy European bank stocks with funds provided by conservative fixed-income investors. (And it won't really happen or anything.) But I think it's fun to talk about in part because it neatly replaces an already existing thing. Part - to be fair, a small part (see chart) - of the reason McKinsey sees for the decline in demand for equities is the demise of defined benefit pensions. Nobody really gets those any more, but they do exactly the work of transmuting equity inputs (in the portfolio of the pension fund, which often holds lots of equities) into fixed-income outputs (in the portfolio of the pensioner, whose benefit is after all defined). A defined benefit pension, if you squint really hard, is a CDO of equities (and other stuff, and legal and/or moral claims on its sponsor and/or the government - but also of equities).

If McKinsey is right that trends in global demand will create demand for de-risked fixed-income thingamajigs, while all that's supplied is equities, then it seems reasonable to expect a market for a new thing that does the relevant transmuting work. So, y'know, look out for that. I'm particularly tickled by the idea of German banks investing in AAA slices of CDOs of equities that would then buy their own equities. Which, very loosely speaking, we've seen before.

European banks have €115bn shortfall [FT]

The emerging equity gap: Growth and stability in the new investor landscape [McKinsey]

Equity Gap: Companies Looking to Issue Stocks May Find Too Few Buyers by 2020 [WSJ]

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