Monday, July 11, 2011

The Euro and You

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

Greece may seem a long way from Newport Beach, California. Well, it is. But, we live in the global village, or some other dim construction. In his June 16, 2011, edition of The Credit Strategist, Michael Lewitt explained "the interconnected nature of global financial markets render Europe's problems the world's problems.... [T]here is no longer any periphery."

Lewitt also writes: "The list of interconnections goes on and on....[G]lobal regulators... have no real sense of what type of contagion effect would occur if Greece were to default. No doubt they believe it is significant enough that they are willing to do virtually anything humanly possible to prevent this scenario from unfolding."

That is demonstrably correct. Since 2007, global bureaucrats have broken any law that has hindered their attempts to ward off our inevitable reckoning. Attempts to prevent a euro eruption have become preposterous. The European Central Bank (ECB) is clearly in extremis.

The interconnections that start with Greece and the ECB wind their way through the European, then U.S., banking systems, government bond yields, and the dollar. Extrapolating the script ("that they are willing to do virtually anything humanly possible..."), the ECB will print euros like never before (and never after, since its credibility will be nil.) Doing so, the ECB will enlighten the perplexed as to the central, financial tendency since 2007: the proportion of "money good" financial paper to the expanding universe of IOU's is dwindling. As the percentage of worthy paper declines, the relative affection for government issues that would otherwise fail a screen test are, instead, improving. Specifically, the deluge of euros will, all else being equal (an escape clause of Greenspanian inspiration), drive U.S. Treasury yields down.

A week does not go by without the ECB reducing its standards of collateral. The cost is not only its credibility as a central bank (which, in any case, it is not) but in the composition of its deteriorating balance sheet.

To make matters worse, Greece is the smallest economy among the impoverished PIIGS: Portugal, Ireland, Italy, Greece, and Spain. Since others will probably follow Greece, the current impasse is all the more discouraging. The Greek government cannot meet its July interest payment obligations to banks, central and commercial. It can no longer borrow from banks or in the bond markets. (This is also true for Ireland and Portugal, and possibly others.) The Greek government has bills and salaries to pay. The ECB is doing its all to avoid default. This presents a dilemma: the further it goes in preventing (in fact: forestalling) a default by the Greek government, the more it compromises its legitimacy by breaking its own rules and ruining its balance sheet. A credit-sensitive bystander would say the ECB's legitimacy and balance sheet are cases of the emperor wearing no clothes but conventional opinion being afraid to state the obvious.

Remembering that the euro is an experiment - a currency that is only 13-year-old and not issued by a sovereign government - the European Central Bank should, above all, adhere to the highest standards of integrity.

Let's go back a year. After a meeting at the European Central Bank on May 6, 2010, the ECB confirmed its commitment to never buy sovereign (government) and corporate debt. On May 10, 2010, The ECB announced an unlimited program of buying sovereign (government) and corporate debt. On the same day (May 10), the ECB and IMF announced a $957 billion "shock-and-awe" loan program to calm markets. Said one European Union official: "We shall defend the euro whatever it takes." The double-talk from European Union and ECB officials still pours forth. As St. Augustine or Bernie Madoff said: "Once you go down that road, you can't stop."

Market prices insist the ECB and Jean-Claude Trichet (president of the European Central Bank) are paragons. Wide-awake Europeans disagree. Donald Coxe (Coxe Advisors LLP) wrote in his May 26, 2011, edition of "Basic Points": "As the citizens of the economically strong countries (and citizens with wealth to lose across the entire Eurozone) reflected on their personal financial conditions, they recognized a new fundamental risk: Their pay-checks, pensions, life insurance, bank deposits, bond investments, and cash were euro-denominated."

The ECB's balance sheet stands behind the euro. To generalize, as long as it is trusted, the euro will trade at par in commercial transactions. (In contrast, it was common when U.S. banks issued their own currencies for businesses to apply a discount - maybe 15% - to a currency from another state: for instance, to an issue from a Cincinnati bank when used to buy onions in New York.)

On the left-side of the ledger, the ECB holds €1.9 trillion (about $2.6 trillion) of assets. On December 31, 2010, it posted €82 billion in capital and reserves. The leverage ratio is 23:1. If the value of ECB assets falls by 4.3%, it will be insolvent. ("Insolvent": the last time around (2007-2008), The Authorities successfully cooed the media into stating the financial system had "liquidity" troubles. This was true but it was a secondary problem. The primary problem was the too-big-to-fail banks that failed.)

What do those assets consist of? The ECB holds €480 billion of asset-backed securities (ABS) and €360 billion of "non-marketable financial instruments." That comes to 44% of total assets. These asset-backed securities are not the old reliables, such as the once highly-radioactive ABX.HE 07-01. That is, an index composed of sub-prime mortgages that was bundled in 2007 (the '07'), and sported a price that sank in tandem with the rising default rate of the mortgages it housed. No, these are vintage 2010 securitizations, in which year the ECB permitted European commercial banks to bundle their bad mortgages and mortgage securities, sell them at par value to the ECB, which then paid fresh euros to the banks.

As for "non-marketable financial instruments," these presumably include the Portuguese government bonds issued in 1943 and due for repayment in the year 9999. The bankers in Lisbon surely broke out a vintage port when they unloaded the 1943's that settle 8,000 years from now. What else did European banks jettison, accepted at par by the ECB? After ridding themselves of €480 billion - one-half a trillion - of their worst mistakes, how can the banks still be in such bad shape?

Another peculiar "non-marketable financial instruments" are the "own-use" bonds sold by Irish banks to the ECB. These are bonds that Irish banks issue to themselves and then sell to the ECB in return for euros. This arrangement may be difficult to grasp at first since it is so new. An example: Allied Irish Bank (AIB) issued a €2.87 billion "own use" bond on April 26, 2011. (The Bank of Ireland wrote a €2.0 billion own-use bond on the same day and followed with a € 2.2 billion offering (sic) the next day. The program is scheduled to last through August 2011.) By issuing this bond, AIB owes itself €2.87. The €2.87 was used as collateral for cash - euros - wired from the ECB. The Irish government provides the collateral by guaranteeing these bonds. The Irish government has no money and it cannot print euros. Only the ECB can authorize money printing. In what must be quite an understatement, the Irish Independent observed: "Own-use' bonds are popular with banks because they can continue to access funding at the ECB's one percent interest rate even when they have run out of the high-quality collateral typically demanded in Frankfurt." For its part, the ECB insists all of these loans are properly collateralized. One understatement follows another: "This makes some eurozone states uncomfortable, since any losses on the money advanced by the ECB would have to be funded by all 17 states."

This refers to the ECB relationship with the central banks of the countries feeding at the euro banquet. The national central banks must pony up for any losses incurred by the ECB: How long will Trichet and entourage collect ECB paychecks after the call goes out for emergency funding? Again: "they are willing to do virtually anything humanly possible..."

The other 56% of the assets on the balance sheet (there may be some double-counting here) includes loans of €106 billion to the Irish central bank. On its December 31, 2010 balance sheet, the Irish central bank showed €70 billion in an "Emergency Liquidity Assistance" account, funds forwarded from the ECB.

At the end of 2010, the ECB also held outstanding loans of €92 to the Portuguese and Spanish central banks (€48 billion and €44 billion, respectively). More collateral (the Colossus of Rhodes?) stood behind the €90 billion in Greek assets held by the ECB.

The list of unconscionable deceits by the Euro authorities is long, but that may be enough to indicate the euro is heading south. That is before looking at the European banking system which has already suffered from bank runs, depositors have withdrawn money and caution builds in the interbank lending market (one reason U.S. Treasury yields remain so low.)

Here, specific and vulnerable bank exposures will be ignored and attention directed to one term: credit-default swaps. Nobody knows who owes whom what. This is 2008, again. Since then, United States politicians passed a financial reform bill that is taller than the Washington Monument, but credit-default swaps remain unregulated, uncollateralized, unmonitored, and requiring no capital. They may be bought, sold, and traded by, between, and among banks, insurance companies, pension funds, endowments, and hedge funds.

Credit-default swaps are the reason various parties want the negotiaition of Greek debt to avoid a "credit event." If a credit event is triggered, the insurer pays the owner of the CDS. Leaving European banks aside, U.S. banks have written $34.1 billion of credit-default insurance on Greece, $54 billion on Ireland, and $41.2 billion Portugal sovereign debt.

Europe has an additional problem, not of prominence in 2008. Once triggered, the vintage 2011 CDS need to be settled in euros, not dollars, as was generally true when Lehman and AIG were on the front page. Federal Reserve Chairman Ben S. Bernanke has magnanimously announced the Fed has opened unlimited swap lines should Europe need them. (On our behalf: there is no recourse by the Fed if another central bank fails to pay us back. Thank you, Marshall Auerbach, for explaining this and other peculiarities.) However, Simple Ben cannot advance euros. Only the ECB can do that (through the national central banks).

To sum up, if an agreement cannot be reached to resuscitate Greece, the ECB will print billions of euros so that banks can settle CDS claims. To prevent this hypothetical Greek failure - really, to avoid a CDS credit event - the ECB may need to buy up the Greek debt. (Unintended consequences for doing so may spring to mind. The list is longer than that of scorned securities currently accepted by the ECB.) In either case, the world will be plastered with a new batch of euros, with any nervous investor noting the rapidly sinking proportion of trustworthy collateral. Thus: the case for U.S. Treasury bonds, which are backed by a central bank and Treasury with no more credibility than Trichet's horde. Simple Ben will not let the opportunity of international panic pass without matching new euros with new dollars. This is why gold and silver were invented.

It is possible The Authorities can squeak through now, hand Greece a bridge loan, and claim the paper chase is not a credit event. It will be a bogus claim, but so far, the majority has been willing to go along. That won't last, though. In fact, doing so makes matters worse. Greece will be loaded with even more debt it cannot repay, reducing the proportion of money-good paper in the world. The same is true for the other PIIGS.