Australian former AIG insider warns of more collateral damage
Exclusive
Jonathan Shapiro
James Aitken spent four years at the ill-fated New York-based insurer AIG working under a character
Vanity Fair labelled The Man Who Crashed The World. This experience at the epicentre of the global banking crisis gave him profound insight into the complex plumbing that underpins world markets.
Aitken, the elder brother of Australian stockbrokers Charlie and Angus, fears that once again all is not functioning well beneath the surface. He should know. Since he left AIG, he’s built a global reputation advising the world’s largest investors on the risks in the financial system.
Today he warns clients of a potential collision between the actions of central banks and regulators as the former boost their ailing economies by draining the world of key assets and the latter demand banks stockpile these very same assets to demonstrate their solvency.
This threatens instability as banks search for good assets outside the regulated system in a process known as “collateral transformation”, a twist on the collateral debt obligations or CDOs that helped produce the 2008 global financial crisis.
“The efforts to understand all the moving parts of the financial system continue but the facts are still trying to catch up with all the innovation over the last 20 years,” Aitken told the
Weekend Financial Review from London.
“Some of it is good, a lot of it is deeply unhelpful and unsound.”
In Australia, few ring the sharemarket bell harder than Charlie and Angus Aitken. But James, the oldest of the Aitken boys, has an altogether different perspective on the financial world.
He headed to London 13½ years ago. In 2002 he landed a role at global insurer AIG’s Financial Products Group, run by a 47-year- old New Yorker, Joe Cassano, whose name would become infamous in financial markets folklore.
AIG Financial Products made money by insuring subprime bonds, writing billions of dollars of insurance without so much as a sliver of capital set aside to protect against losses. When they arrived, it triggered a destructive wave of margin calls and a scramble for assets among banks trading with AIG.
The $US85 billion 11th-hour tax-payer bailout was required to plug the hole that Cassano’s AIG FP had created.
Aitken wasn’t around to see the implosion. He and Cassano parted ways in 2006, but his four years at the unit left him with an in-depth grasp of the inner workings of the credit markets, and the role of collateral (assets pledged as security) in the provision of credit to the economy.
By September 2006 he was working for investment bank UBS, where his job involved explaining to the world’s largest investors the risks of something he knew a lot about – subprime. His ability to untangle the complexities of the financial system, and its potential to implode, earned him a loyal following among the institutional investor community.
When it did implode, the bond between banker and client solidified.
By 2008 his Rolodex had expanded to include not only the business cards of the world’s largest investors but also the powerful policymakers battling to restore faith and functionality to financial markets. He decided to go it alone and established a private consultancy – Aitken Advisors LLP, the one-man show that he runs today from the London suburb of Wimbledon.
“I want to help people be less wrong,” he says. “If we get everything right that is fantastic, but in a complex world, my aim is to be less wrong about key issues.
“It’s a work in progress and, with an ever increasing number of central banks seemingly embarking on QE forever, one has to be very humble, and very nimble.”
His communications to clients, who pay top dollar for his insights, come in the form of a daily pdf titled
Notes From a Small Island.
Aitken keeps a low public profile. His business has no website, and he has not appeared in the media. He says this serves him well. Photos of Aitken are hard to come by and he expressed surprise at being tracked down by the
Weekend AFR. But on this occasion he was prepared to share his views on the global economy as public policy and financial markets collide more violently than ever.
“Policymakers move to a slower drumbeat than investors and there is often a lag between something going wrong in the financial system and the response,” he says.
But as financial markets move deeper into the realms of the political economy, predicting market price moves has become, he says, an exercise in futility.
“What all investors, and leveraged investors in particular, have learned since the second quarter of 2009 is that it is all very well to fulminate over central bank policy, and to criticise and occasionally to excoriate [US Federal Reserve chairman Ben] Bernanke in particular,” says Aitken. “But the last thing you want to do is put on a trade where the other side of your position is a central bank with an open-ended balance sheet.”
Whether key policymakers like Bernanke actually know what they are doing is not really the point for investors. “You have to understand why he is doing what he is doing and how it affects asset prices,” Aitken says. “The other thing is trying to work out what policymakers might not know about the workings of the financial system.”
For instance, Aitken warns that the initiative of the Group of Twenty (G20) nations to migrate much of the $US500 trillion global derivatives trading market to central clearing houses could “spark another wave of involuntary deleveraging across the system”.
Quality assets, or collateral, are poorly understood yet vital financing for global banks, which pledge them for short-term financing. As their supply shrinks, experts have warned that the ability of banks to finance themselves and to trade diminishes. The rapid shrinking of the universe of quality bonds, as investors recognise that government bonds are not as safe as once assumed, further reduces the amount of available collateral.
The International Monetary Fund estimates the pool of safe haven assets will shrink by $US9 trillion to $US74 trillion by 2016 while new banking and trading requirements will require a further $US4 trillion of safe assets to be posted. Adding to this is a concern that, as central banks embark on open-ended bond-buying progams, they are draining the world of trillions of dollars of quality assets at the exactly the time regulators are requiring more of them be held by lenders.
In response to the shortage of assets, the world’s largest custodians of investment assets, such as BNY Mellon and State Street see an opportunity to source safe assets through securities lending.
Through a process known as “collateral transformation”, banks could pledge riskier assets such as equities and corporate bonds to existing owners of government bonds. This allows banks with riskier assets to obtain the safer assets required to be accepted by central banks and clearing houses.
The rapid change in the supply and demand of the assets that underpin the global financial system could have immense consequences.
On this matter, Aitken singles out the Reserve Bank of Australia as ahead of the game. The RBA is the first central bank to publish work on the impact of a collateral crunch on the nation’s monetary system in a paper published earlier this month titled
Financial Regulation and Australian Dollar Liquid Assets.
Australia faces a particularly acute shortage, given the low stock of government bonds, of which three-quarters are held offshore.
The RBA has created a backstop lending facility to deal with the collateral shortage. But it estimates that $35 billion of high quality bonds, or 16 per cent of the total supply of government bonds, will be required to switch bank trades to a central clearing house.
The impact on of this shortfall of assets was further expanded on by RBA assistant governor Guy Debelle in a speech earlier this week that demonstrates the bank’s ability to delve into the dangers the global financial fix may throw up. Aitken describes Debelle as “one of the world’s outstanding central bankers” for his “technical expertise”.
While Aitken praises the RBA (“it’s a close call between them and the Bank of Canada for the title of world’s best central bank”), his views on the prospects of the Chinese economy upon which Australia so relies appear to diverge from that of the RBA and some of his family.
“I just sense that, as the major policy announcements from the Fed and [European Central Bank] recede into the rear-view mirror, the market is going to reassess its views on Chinese growth and how the Chinese financial system works,” he says. “If bank interest rate deregulation continues – forcing banks to compete for deposits among themselves and with other sectors – the Chinese banks will have to make sharper, more informed choices about who they lend to and at what price.”
To Aitken, “it just doesn’t feel” that China is growing at 7 per cent to 8 per cent annually and, despite the apparent scope of authorities to respond, his doubts persist.
What does that mean for Australia, which has grown prosperous on the exports of iron ore and coal required for China’s industrialisation?
“The sad fact is the only way to find out what must still be considered a hypothetical structural slowdown in Chinese growth means for Australia is when it happens,” says Aitken.
The consequence is that the RBA could cut the cash rate to levels that “strike many and perhaps the RBA itself as extraordinarily low, in order to ensure that the monetary transmission mechanism is not impaired”.
“Australia has enjoyed uninterrupted growth for over two decades and until recently has benefited from an extremely well run economy,” he says. “Betting against Australian banks, for example, or the economy as a whole has been foolish – but one wonders what excesses have been built up over the past two decades and what lies out there.
“The fact is that we don’t know yet. But we must have confidence in the likes of Debelle to get up to speed.”
The Australian Financial Review
Jonathan Shapiro