FM: Traditionally sovereign debt — whether U.S. or non-U.S. — has been the most solid, most conservative part of a portfolio. What has been the impact of the loss of confidence of sovereign debt?
PF: There are two questions to take up there. One is looking at the peripheral debt or the very weak sovereigns. There, the bonds have gone from being treated as a de facto risk-free asset — the preferred asset of the banking system — and fallen all the way [down] to being an impaired credit asset, so that is a very big jump. The jump to weak credit status from being treated as a slightly higher spread version to German government securities has had a profound effect on big portfolios, many of whom simply stopped holding them entirely. Not so much because they consciously thought there was a risk of default but mostly because they just don't hold bonds for the purpose of this much volatility. Now more fundamentally, people talk about the role of the risk-free asset and is it really a risk-free asset? Treasuries, bonds have never been risk free; they have had a lot of duration risk in them. What we are really looking at when we look at what we call a risk-free rate, we are looking at the best expression of the time value of money that we can find. We are using the sovereign curve — the Treasury curve, the bund curve, the gilt curve — as a way of measuring the time value of money. The question is, are we going to come up with anything else? We though for some time over the last 15 years or so that maybe the interest rate swap curve could be a substitute for sovereigns. But the more we look a financial sector that trades them; the counterparty risk imbedded in trading interest rate swaps looms a little large.
If the world is a riskier place than you thought, then you hold more of the lower risk asset, which turned out was Treasuries. Clearly the low level of yields we are looking at is a form of risk aversion. Just like the low P/Es we [see] in the equity markets, the high bond prices/low yields reflect a lot of investors' anxiety about the world and they want to hold — even if it is a lower yielding-asset — a lower-risk asset.
FM: What is your opinion of credit default swaps (CDS's)? Are they useful tools or something very dangerous? Should additional restrictions be put on them?
PF: Clearly CDS's are both useful and dangerous. The dangerous part is where we don't get enough bilateral margining. One of the behaviors that built up several years ago was no two-way margining, which has been a mistake. Frankly, the futures industry got this right a long time ago with more disciplined bilateral margining and margining against the clearinghouses and the over-the-counter (OTC) market — while I have always been a fan — I always thought we should have much more disciplined two-way margining. If you get that then you'll hold down the level of leverage implicit in the CDS market and drive to much better behavior.