It is hard to know how the next crisis could unfold. As that Japanese bond trader was saying while the bond bubble holds people are making money on their mark to market positions (and a lot of money at that). Having the European and Japanese Banks on the other side of the trade all the time must be like a dream for the people who have their teeth stuck into these bond markets. Imagine that there is always a buyer for your favourite stock. This would just encourage more buying as the price goes up and up without relent.
All remains fine until there comes a time that someone who has their teeth stuck into the pie is forced to let go. Let's imagine hypothetically (because I don't know the truth) that Deutsche Bank (or some other large and influential financial institution) has their teeth heavily stuck in this pie. They would be sitting on substantial unrealised profits from their positions in the European and Japanese bond markets (note the reference by Deutsche's Bank CFO Marcus Schenck on Wednesday “What we do not disclose, and can’t disclose, are additional reserves” that may come from moving profits at subsidiaries or re-valuing assets on Deutsche Bank’s balance sheet).
Now imagine that Deutsche's business isn't doing so well because of falling revenues in other areas and they need to raise capital to maintain their reserve ratio (by law). We've seen several banks in Australia raise recently to comply with new regulations. That Bloomberg article was basically saying that Deutsche will need to find assets before it can do a bond issue but their balance sheet at the moment is not strong enough to pay the coupons (interest) on the bonds so the German regulators won't allow it.
What if the only answer is to unwind their "profitable" sovereign bond positions to find the reserves to stay afloat? Problem. When they start to sell they'll start to increase the yield on those bonds and decrease the spread between government bonds and corporate bonds which could push the yields up on corporates as well (ie a sell off on corporates as they become more risky). Also the sovereign bonds form a big part of the very important repo markets where people use bonds as collateral and swap bonds for cash at a price for a fixed period of time.
"Why Should We Care about the Tri-Party Repo Market?
The importance of this market was highlighted by the recent financial crisis. As noted above, the tri-party repo market took on particular importance in relation to the failures and near-failures of Countrywide Securities, Bear Stearns, and Lehman Brothers. “The potential for the tri-party repo market to cease functioning, with impacts to securities firms, money market mutual funds, major banks involved in payment and settlements globally, and even to the liquidity of the U.S. Treasury and Agency securities, has been cited by policy makers as a key concern behind aggressive interventions to contain the financial crisis,” according to the Task Force Report.
The tri-party repo market is very large. At its peak in 2008, about $2.8 trillion of securities were funded by tri-party repos. Volumes shrank to $1.6 trillion in the second half of the financial crisis, and have been steady around that level since. The size of individual portfolios being financed in this market is also very large. At the peak, some dealers were financing portfolios of $450 billion in the tri-party repo market, mostly overnight.
While a large fraction of the assets financed in the tri-party repo market is liquid and of high quality, available tri-party repo data show that some less liquid assets are also financed in this market. The share of less liquid assets has decreased since the market peaked in 2008."
A sharp downward revaluation of sovereign bonds has potentially big impacts in the repo markets because sovereign bonds are the main form of collateral in these short term cash markets on which the system relies. If there is a liquidity event in these markets, with the main form of collateral being difficult to value as people turn rapidly from buyers to sellers overnight then it has a big effect in these important markets and what's more causes runs (downward) as all forms of subordinate collateral are also re-valued. ( "A repo resembles a collateralized loan but its treatment under bankruptcy laws is more beneficial to cash investors: in the event of bankruptcy, repo investors can typically sell their collateral, rather than be subject to an automatic stay"). You see if the contracts go bad the courts can't implement stays so people sell, sell, sell. So if it happens like last time you first get a drying up of short term money lending and a cascade of collateral downgrades through the whole financial system. The difference between last time and this time could be that the "junk" collateral that brings everything down is the junk printed by governments (government debt) and so you can't print more of this junk to save the system. The only thing that can happen IMO is that that junk gets re-valued, sold off until a buyer steps in. Every open market has its price and no one could argue that anyone state in this world is completely bankrupt as governments always have the power to tax. When sovereign bonds are sold off hard this would typically mean rising interest rates but in this brave new world it is hard to know what a true collapse would look like.
