At Play In The Fields Of The Frontier Markets

banker 3Repeat: One man’s debt is another man’s asset.  Repeat: The higher the yield the higher the risk.  The higher the risk the more likely something will go haywire.  And, why repeat these boring bits? Because,  if one is sitting in Nevada (or Florida, or Arizona) and still looking at an economy which is sluggish for the average family and volatile for the 0.1% investor — The Players Are At It Again.

Some time in the future — one can only hope it isn’t soon — the term  “Frontier Market” is going to come back to haunt someone, and we might wish to pray that not only is the backwash not immediate, but also that it doesn’t repeat the last financial debacle.

Tucked into Reuters’ reporting of market news was this article which may prove altogether too prescient:

“With the world’s biggest central banks driving yields on safe assets to near zero, some investors are tossing caution to the wind and rushing to buy illiquid and previously overlooked bonds sold by countries with no capital markets track record.”  [Reuters]

If this sounds too familiar, it should — it should have reminded someone of Argentina (1992-2002) the Asian financial calamity (1997) and the mess in Russia (1998) which brought down Long Term Capital Management.  We ought to take a second look at what happened in the LTCM mess:

“Long-Term Capital was advised by finance quants, or quantitative analysts, who made a number of unsound, esoteric bets, including investments in interest rate derivatives. When Russia’s inability to pay its debts roiled global markets, the fund, saddled with high-leverage and off-balance-sheet obligations, was near collapse.

Because Long-Term Capital owed large sums to banks and other financial institutions, the Federal Reserve Bank of New York organized a consortium of companies to buy it out and cover the debts. Alan Greenspan, then the Fed chairman, eased monetary policy to restart capital markets, which were starting to freeze up. Long-Term Capital’s shareholders were wiped out, but none of the creditors took losses.”  [NYT]

Quick summary:  A large hedge fund, guided by quantitative analysis (but not exactly a boatload of common sense), took positions in debt issued by Russia.  Because the hedge fund owed large amounts to “other financial institutions” (read: banks and other funds) when the Russian economy collapsed the Big Hedge Fund blew up, and the creditors (those other banks and investment firms) were about to get not only a hair cut, but possibly get their heads shaved.  Not surprisingly the financial markets began to “freeze up” (Does this sound familiar?)  Enter the first big government bail out of the Era of the Financialists.

This wouldn’t be the first or last time the bankers blew it.  Consider Mexico in 1994, those investors bought Mexican debt in pesos and were repaid in dollars — but the Mexican government didn’t have sufficient reserves to keep up the fixed rate repayment.  At this juncture a sentient creature might have wanted to ask: Why am I buying debt without checking to see if the nation in question has ample reserves to repay it?  Not enough investors (and their institutions) ask the question, and the result was messy.  The U.S. ended up buying pesos on the open market, and then added loan guarantees  to the tune of some $50 billion.

So, now let’s add “investors” interested in buying Paraguayan, Bolivian, and Honduran debt in 2013.  Just for good measure we can toss in some Vietnamese and Romanian debt as well.  These nations are issuing debt (bonds) and “investors” are buying it up.

Paraguay offered bonds at 4.65% interest (yield) on January 17, 2013.   Reuters reported: “Paraguay, one of South America’s poorest and most unstable nations is expected to see a strong economic rebound this year and the government is keen to tap increased investor interest in smaller emerging market issuers.”

U.S. Treasury bonds are currently going for 1.95% for ten years.  [Treasury] thus for the Greed Is Good Crowd that 4.65% might be very appealing?  However, that “poorest and most unstable nation” thing might give a few individuals pause.

Honduras was rated B+ by S&P when it issued its international bonds at 7.5%, mature in 2024.  They are involved in a $205 million lawsuit concerning a state owned logging company which caused Barclay’s to pull out of the deal. [Bloomberg] But Gee! doesn’t that interest rate look enticing? There’s just a bit of a problem — Honduras has “gang problems,” $6 billion in foreign debt, and an internal debt that’s tripled since 2010.  [AJTV] What could possibly go wrong?

Guatemala entered the lists: “Guatemala, rated two steps higher than Honduras at BB, sold $700 million of 2028 bonds to yield 5 percent on Feb. 6, according to data compiled by Bloomberg. The yield on the bonds has fallen to 4.95 percent since they were issued.” [Bloomberg] The fact that 54% of the nation’s citizens are living in poverty ought to be some kind of clue about its economy, and the fact that  the highest income earners are responsible for 42+% of the nation’s consumption might also be a sticky point. [CIA]  The State Department offers this caution: “Guatemala continues to face major challenges to successful development, including poverty, malnutrition, and vulnerability to economic fluctuations and natural disasters. The Guatemalan government also faces the challenges of corruption and the presence of transnational organized crime.”

Just imagine for a moment if Burnham Down & Crash LLC,  bought up some Paraguayan, Honduran, and Guatemalan bonds, which they mixed with some U.S. bonds (1.95%), some bonds from Great Britain (1.95%), and some German bonds (1.37%).   A bit of careful slicing, dicing, and repackaging could be used to manufacture “Unlimited Horizons” — a bond offering for “investors” (read: Other Bankers).  Incorporate a touch more Magic Hands and the bonds from “Unlimited Horizons” could be repackaged with bonds from “Blue Skies” yet another mixture of national paper, and an admixture of really good investments piled in with some really questionable ones.  Is this sounding familiar yet? Clue: Think Housing Bubble.

How many of the bonds from the shaky sources have to default before the investors are looking at the financial equivalent of Sweeney Todd’s barber shop?  How many investment houses are going to be involved in the purchase of these bonds and their derivatives before the Major Bankers “have to step in” and announce austerity measures so that the small debtor nations can repay the investors?  Clue: Look at Greece? Cyprus?

How many of us on this planet would be just as happy if the bankers had not decided to play in those debt markets in the first place?

It isn’t as though the bankers didn’t learn anything from Argentina, Mexico, the Asian markets, and Long Term Capital Management — from Lehman Brothers, or from the Mortgage Meltdown — it really doesn’t look like they’ve learned anything.

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