A pithy phrase that had made rounds last year during the credit crises-induced bailout packages was: "socialising losses, privatising gains". Then, it made intuitive sense when one witnessed the banks being paid out large amount of monies to rebalance their balance sheets.

Today, a more insidious form has taken place. But like all truths, it comes hidden. Two concomitant forces have obscured the key fear that worries the market. One, the credit default swap (CDS) premiums on sovereign bonds have begun to rise. Two, gold has become a viable and much trusted investment alternative for fund managers.

While these two may seem like divergent market realities. the underlying epiphenomena remains the fear of sovereign default that runs across the market. In essence, the "socialising of losses" has dramatically led to increased fears that sovereigns across industrialised world have taken upon themselves debt burdens that are unsustainable.

As if to lay it thick on the market suspicion, the Bank of International Settlements recently issued a report that pretty much makes it as official as it gets. As Robert De Niro remains the "actor's actor," the BIS — the agency that coordinates between central banks — is called the "central banks' central bank".

By increasingly taking on new risks through the process of buying the toxic assets of the banks with monetary funds that the central banks are yet to "print", the central banks have in turn endangered the intrinsic reliability of sovereign governments.

While there are no explicit measures to capture this idea, the markets implicitly reveal its prejudices. A CDS is an insurance contract wherein one party pays a premium for a specified period, and in case of any event, the insurer pays out the claim.

In the credit derivatives market, such insurance contracts are written on the underlying bonds, that is, in case the bonds default, the insurer pays. It is in this kind of environs that the premium used to insure sovereign bonds has begun to rise.

Rising CDS premiums

As markets tend to accumulate information about the rising likelihood of sovereign default, the underlying CDS premium on bonds have increased. There were two methods by which central banks intervened.

One, the composition of their assets was changed, from shorter-term liquidity provisioning the banks took on longer-term liquidity provisioning roles. This is over and beyond the increase in what was considered as the range of eligible collateral.

Also, the central banks lent substantive amounts of its Treasury holdings to the banks, which could then use these securities to improve liquidity ratios in their financial statements. By the end of 2009, the banks had actively begun to intervene in unprecedented fashion. This manifested most fundamentally with central banks creating new facilities for lending, creating special purpose vehicles to buy commercial paper and getting foreign central banks to actively to participate in dollar swap markets.

On the liabilities side, the increased usage of deposit facilities, the issuance of supplementary bills and other examples have all been seen as temporary interventions. This would have been true had banking activities in stalled sectors resumed. While banks have increasingly bounced back, there is lack of clarity if banks would want to return to their previous historically-evolved roles of intermediation.

To buttress the point about deteriorating sovereign credit quality, the rise of gold as an investment alternative is a key indicator. Typically, gold has been seen as a hedge against inflation, which Milton Friedman said was "always and everywhere a monetary phenomenon".

Yet, as historical reading from Ming China onwards and below reveals that inflation is directly connected to monetary debasement. In ancient times, one added silver or copper to gold; today we print money to existing monetary bases.

All of this is done to avoid default by governments who have been profligate in their spending. The rise of gold as an investment is an indicator that the investing crowd wants assets that don't have counterparty risk; and that are likely to survive their own government.

As the quip goes, the path to hell is paved with gold. Perhaps, some unwitting central banker might as well have coined it.

 

The columnist works for a major European investment bank in New York City. You can follow his tweets at: http://twitter.com/ks1729