Nothing changes. Nearly 250 years ago, in 1763, Europe’s great powers were in deep financial trouble, after fighting themselves to a standstill in the Seven Years’ War.
Louis XV’s France, very much on the losing side, was set on a trajectory which led to financial crisis and revolution. Prussia’s Frederick the Great, with Britain, won the war. But that did not stop Federick worrying about the mountain of debt he had run up.
He realised that he had to find some way of restoring financial confidence. So, to help kick-start the markets, he authorised the issue of a new instrument, called covered bonds, or Pfandbriefe, in 1769.
People agreed to use them to lend money to strapped borrowers, typically the Prussian landed gentry, in return for being offered pools of assets, often real estate, by way of security.
Even when borrowers went bust, lenders could expect to get their money back by exercising a legal claim over their collateral. They would not need to fight rival creditors for their money, as with traditional loans.
Measures like these meant Frederick, an enlightened despot with respect for the rule of law, could guide his country to financial health by his death in 1786. Economic growth led to prosperity and fresh military expansion, culminating in Prussia’s conquest of the rest of Germany. And we all know what happened next.
Seven years have now passed since the credit boom started in 2005, which initially led to a fight for market share between the banks and, ultimately, a battle for their survival.
Europe is, once again, in trouble. And Frederick’s covered bonds are the must-have fashion item among lenders desperate to preserve their capital.
In Europe, their issuance totals €2.4 trillion. Largely issued by financial institutions, they offer public assets as collateral. Issuers in the US and Asia have shown increasing interest in the concept.
The three-year lending facility to local banks, introduced by the European Central Bank, provides a different way for weaker banks to use federal support to fund their activities.
In the latest edition of its Equity Gilt Study, Barclays Capital notes the role played by “safe” assets as collateral for deals. “It has become increasingly clear that ‘safe’ assets perform a role in the financial system that is more critical than had been previously understood,” it said.
Following the eclipse of Italy, Spain and the US housing market, Barclays estimates that “safe” assets available for collateral are “only” worth $12.2 trillion (€9.2 trillion), against a broader selection worth $20.5 trillion in 2007.
The supply squeeze and unprecedented demand means we now have a bull market in safety, where UK longer-dated and inflation-linked bonds can yield zero or even less.
Defensive companies with strong balance sheets are also trading at a fat premium to cyclical or smaller stocks, leaving little room for disappointment, as Tesco found earlier this year. The certainty of income produced by tobacco stocks has become valued highly, putting medical issues on the backburner.
According to agents Jones Lang LaSalle, a flight to quality has produced an unprecedented gap between prime and secondary commercial property.
The only way the obsession with collateral and safety will come to an end is through confidence that sufficient growth can be achieved to help the west pay off its debts.
Covered bonds are an important step on this road to recovery, but they scarcely amount to the real thing. Let's hope we get lucky, like Frederick the Great.