Friday, September 7, 2012

Over and Out

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)

           A collapsing order will do what it takes to retain power, no matter its abuse of law or decency. Writing in Die Zeit on August 29, 2012, European Central Bank president Mario Draghi wrote (in German): "[I]t should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole."

            Dropping the dead fish on Berlin, Draghi reminded Germans he is not a man to be messed with. That is why he was awarded the presidency of the ECB at such a desperate moment. On July 26, 2012, Draghi pledged: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

            "Within our mandate" is defined by Draghi. He lifts restrictions on ECB legal authority at a moment's notice. This is exactly as the bureaucrats prefer. The sinecures in Brussels will be selling dead fish rather than dining on prawns and apricot soufflĂ© at Comme Chez Soi if Draghi fails. Europeans and foreigners with securities invested in European markets should consider the possibility of confiscation or lengthy sequestration.

            European leaders, on the whole, will not object to shutting markets. Some obvious difficulties will arise, but the alternative - a trip to the guillotine - is more unattractive. The leaders are ignorant of the functioning of markets so it is a small matter to shut them. They regard markets solely as instruments of their policies: raise or lower taxes, save or shelve the national airline, raise or lower stock markets. Federal Reserve Chairman Ben Bernanke employs this mode of thinking. He reminded his guests of his fatuous pretensions at Jackson Hole, Wyoming, on August 31, 2012. Praising himself for the Fed's buying of market assets, Bernanke preened: "[Asset purchases] have boosted stock prices.... [I]t is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC's decision to greatly expand securities purchases. This effect is potentially important because stock values affect both consumption and investment decisions." There is no evidence to support his boost-the-economy contention, yet, Simple Ben contended: "Econometric....[m]odel simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy." He really believes these models, which produce the results he predetermined. Similarities to the final, paranoid proclamations of superiority by the Kremlin are obvious.

            Whether one prefers Mario Draghi's brass knuckles or Ben Bernanke's harebrained approach to playing puppeteer of the masses (both received economics Ph.D's at M.I.T.; both theses under the tutelage of Nobel prize winner Robert Sobel), it should not be forgotten those in charge fully support such expedients. Sarkozy, now Hollande, Merkel, and Obama have aggressively pursued criminals who engage in markets. No, not Jon Corzine, but the widows and orphans who find it difficult to eat on zero-percent interest rates.

Aside from Draghi's warning that he will crush anyone in his path, Germany's position, as backstop to the euro is important and it is clear Germany will not protect property rights. On May 19, 2010, "German Chancellor Angela Merkel laid out proposals to gain control over 'destructive' financial markets, after she imposed a unilateral ban on naked short-selling that sent stocks sliding.... 'The lack of rules and limits can make behavior in financial markets driven purely by the profit motive destructive and lead to an existential threat to financial stability in Europe and even the world,' Merkel told lawmakers in Berlin today. 'The market alone won't correct these mistakes.'" (Bloomberg)

Merkel's attack on naked short-selling deserves a sympathetic ear or two (though, the actions taken, and others threatened, were designed to crush a larger carrier battle group), but the Chancellor is prone to think closing markets will solve the euro's troubles. The Happy Dreadnaught's public statements betray no reservations about shutting markets. On January 16, 2012, S&P downgraded the EFSF from AAA to AA+. On the same day, the Financial Times reported: "Ms Merkel said she would consider calls from her party colleagues for legislation to bar institutional clients such as insurance companies from selling bonds when ratings were downgraded, or fell below investment grade." Presumably, the cohort in question were European, including German, insurance companies. When the time comes, protestations by Fidelity or Goldman Sachs are unlikely to open markets.

Merkel was thwarted in this effort, which would have caused untold havoc. In their corner of the world, insurance companies prevented from selling bonds when their price was falling would have seen prices of insurance-company stocks, bonds, credit-default swaps, and insurance policies sinking to previously unplumbed depths.

January, 2012, turned out not to be the proverbial Armageddon that looked so dire on January 16. The reckoning has been delayed but not solved by eurocrats who have done so by preventing market discovery of real prices. Such repugnant acts as proclaiming the European Central Bank senior creditor (above private bond holders) betrays a willingness to substitute vocabulary for legal rights.

Other subterfuges to deceive the public fall under the heading of manipulating markets to jam their failed policy down Europeans' throats. In August, PriceWaterhouseCoopers reported non-performing loans at European banks have doubled since 2008, to over $1 trillion worth. Very little of that amount has been written down. Capital as well as collateral at European banks is a joke. That includes commercial banks, national central banks, and the European Central bank. The latter's portfolio is quite weak since it bought assets that even the eurocrats would not permit to be pledged as collateral. Interbank overnight lending operates through the ECB since the banks no longer trust each other. Why they hold the ECB in high regard is only by the latent trust in central banks, since the ECB balance sheet has so deteriorated. (Adding to the perplexity of today's financial discussion is the angst about Libor when its existence as the interbank rate is extinct.)

The blatant dishonesty in European finance may be even worse than the Paulson-Geithner-Bernanke model across the ocean. European banks did not recapitalize to the same degree as U.S. banks after 2008. Yet, their practices and leverage were as aggressive. In the boom, larger European banks met capital adequacy requirements by purchasing credit-default swaps (CDS) on collateralized-debt obligations (CDO) sold by AIG. That was reported in the fall of 2008. Like so much else that went awry, the consequences seem to have evaporated in the mist.

Only to reappear. A parallel to the CDS-CDO-AIG nonsense is the current minefield of a Greek default. To pretend they are still solvent institutions, European banks have written (that is: the bank is the insurer) of credit-default swaps on Greek sovereign debt. (Not to be forgotten is the North American banks - yes, Canadian banks are none too sturdy - that have written CDS on European sovereign debt. American banks have shredded this risk, but what remains? CDS can be traded, bundled - oh, you know the hopelessness of bank balance sheets today.)

The deceptions run wide and deep - more evidence of the dysfunctional European financial system. Europe seems to have bettered Americans at cumulative weirdness. A personal favorite, from Bloomberg, August 30, 2007: "Landesbank Sachsen Girozentrale, the German state-owned bank ravaged by investments in U.S. subprime mortgages, had 'secret' investments of up to 46 billion euros ($63 billion), Sueddeutsche Zeitung said, citing Saxony's government finance committee. In addition to off-balance sheet investments in Dublin, SachsenLB also created so-called conduits in Leipzig in 2003 under the code name 'Dublin II,' the newspaper said...." Secret Squirrel never had this much fun.

In fact, the Landesbanken stench floated to Ireland via Hypo Real Estate where its Irish subsidiary, Depfa Bank, is hiding (the following is a conglomeration of estimates) between $1 to $3 trillion (with a 't') of trade receivables that are over 270 days past due. These dead loans (over-270-days-past-due are not repaid) were somehow plucked from European banks. This is one more layer in the dissolving European Project that will receive its day of reckoning.

Those who hold European securities (U.S. money-market funds were large investors) own (to what degree is it "ownership"?) paper floating in a sea of chaos. As the financial institutional framework cracks, the informal - and, non-taxpaying - economy replaces it. The Mafia is now Italy's biggest 'bank,' according to James Mackenzie at Reuters. Mackenzie reported this non-bank bank is "squeezing the life out of thousands of small firms.....Organized crime now generated annual turnover of about 140 billion euros ($178.89 billion) and profits of more than 100 billion euros," which equals 7 percent of Italy's national output. Here we see the legitimacy of the eurocrats as well as local government authority flickering before the final gale.
The Troika (European Union, or, more particularly, European Commission, ECB and IMF) has thus far forestalled panic in the markets by changing rules, a process that has degenerated as the preventive measures grow more desperate. We are closing on a day when non-government investors, as well as the masses, say: "Enough." With any luck, that will be ahead of a general sequestering of their assets.

Tracing the deterioration of collateral is an avenue to clarity. From Bloomberg on June 25, 2012: "Residential mortgage backed-securities and loans to small and medium-sized enterprises rated at least BBB- by Standard & Poor's will now be accepted with a valuation haircut of 26 percent.... In the case that the ECB Governing Council [approves] this, 'it would reduce the widely criticized influence of Standard and Poor's, Moody's and Fitch,' one euro zone central bank source who spoke on condition of anonymity said. 'On the other hand, this could also expand the shrinking pool of collateral which banks in troubled countries have available.' The ECB declined to comment." This story is a prime instance of institutional confusion. First, "the ECB declined to comment," yet a "euro zone central bank source" was extensively quoted. Where does he work? In the ECB's pâtisserie? Second, as much as the rating agencies are widely criticized, the obvious ploy to include dead-fish securities as proper collateral makes a sham of the ECB.

The trustworthiness of collateral can only be manipulated so far. It is a point of observation in human inertia that trust has not already been extinguished, but, it required a trigger with Bear Stearns and Lehman Brothers.

A few more changes to acceptable collateral that were publicly announced and duly reported:

(Bloomberg, June 28, 2012): "ECB to accept certain mortgage-backed securities, car loans... leasing, consumer finance-backed securities, as collateral. Measure to come into effect when adopted in legal act June 28."

Andy Lees (AML Macro Ltd.), July 31, 2012: The ECB is considering unsecured bank debt as collateral.

Bill King (The King Report) wrote on June 20, 2012: "The EU put on its clown shoes and stated that it would no longer use rating services and would issue its own ratings."

June 22, 2012: Not to be outdone, IMF synchronized swimming champion Christine Lagarde put on her clown shoes, whinnying "for the ECB to be more inventive" in aiding the eurozone to beat the debt crisis. The currency union needs a "creative and inventive" monetary policy." This criticism was uncalled for. The Draghi ECB may lack many attributes, but creativeness and inventiveness are its forte.

There is a limit. However much investors are willing to accept the EU clown court, after the solvency of a financial institution is past slavation, heroes are not rewarded for tossing a lifeline. Recent examples of vaporizing trust were Bear Stearns and Lehman Brothers. A clearinghouse survives by retaining trust. LCH.Clearnet, the largest clearinghouse in Europe, served notice on June 4, 2012, that it might require additional collateral on Spanish government debt held by banks. On June 20, the clearinghouse raised the margin requirements for Spanish sovereign debt used in short-term funding (repos) from 13.6% to 14.7% on certain maturities (it varies). This looks like a compromise. Clearnet raised the percentage, but not enough to upset the distribution of Spanish bonds. To retain confidence, the clearinghouse may be forced to act decisively, in the not too distant future.

In the not too distant past, LCH.Clearnet announced it would accept unallocated gold as collateral for margin cover purposes (starting on August 28, 2012). The CME announced that it, too, would start accepting gold as collateral for margin requirements on August 28, 2012. Markets are racing back to the nineteenth century faster than central bankers can destroy their credibility in the twenty-first.

Another limit was noted in June by the Bank for International Settlements (the central banker's central bank). The BIS warned of "asset encumbrance," that is, the current need for European banks to pledge so large a portion of assets for collateral is weakening banks' liquidity needs.

These limits are a reason ECB President Mario Draghi has served notice the ECB will decide whether "irrational fears.... require exceptional measures." The world awaits the German Constitutional Court's decision, scheduled for September 12, 2012, of whether Germany can participate in the ESM's (European Stability Mechanism) bailout of countries.

Since Germany is already the "transfer union" of funds to the rest of Europe (TARGET2 - not discussed here), its participation will be fundamental. Draghi muscles opponents into Jimmy Hoffa's locker so may not wait for, or possibly ignore, the court's decision. In any case, the €500 billion ESM (which does not exist) is not large enough to hold Spanish and Italian sovereign bond premiums to a ceiling of 200 basis points above German government bonds. That is only one of the current mandates shouted from the balcony of the Palazzo Venezia and Draghi knows this. Merkel, Monti, and Hollande know it, too. Thus, the hope the ECB will call the non-existent ESM a "bank" to leverage the €500 billion into bank loans. Bank lending to companies in the eurozone has fallen 43% this year, so the wonders of fractional-reserve lending would not seem to apply.

Market participants are heading to the exits. As alluded to above, U.S. money market funds have sold European securities. How much, and how the funds would post a daily price if assets are frozen, are question that lead to a slew of other questions.

Europeans, too, are transferring money. On July 31, 2012, Reuters reported outflows from Spanish banks at €41.3 billion ($50.6 billion) in June and €163 billion from January through May: an accelerating pace. To fill the void, Spain's banks borrowed €50 billion euros from the ECB (that is: Germany) in June, and a total of €204 billion between February and June.

Shell "is cutting back its exposure to European credit risk in the worst-hit economies and putting a higher price on doing business with the region's peripheral nations...[T]he Anglo-Dutch oil major would rather deposit $15bn of cash in non-European assets, such as US Treasuries and US bank accounts." (Daily Telegraph, August 6, 2012) U.S. banks "are telling counterparties and borrowers to restructure contracts or find another bank as they prepare for the potential exit...from the eurozone. Using hedges, such as credit-default swaps [Yikes! - FJS], U.S. banks have reduced their net exposure to troubled eurozone countries. But they are also engaged in more work behind the scenes to ensure that if a country leaves the eurozone they will not have to receive payment in a devalued drachma or peseta." (Financial Times, August 6, 2012) Some companies are "sweep[ing] cash out of euros nightly to reduce foreign-exchange exposure, while others are looking at alternative payments in case customers flee the euro or run out of cash." One company "has been preparing a version of the company's pricing list in pounds...." (Wall Street Journal, August 14, 2012)

The counterattack is mounting. In fact, nationalization of assets has recent precedent. When its banking system collapsed in 2008, the Icelandic government "ring-fenced domestic accounts and shut out international creditors. Iceland's central bank prevented the sell off of krona through capital controls, and new banks were created that were controlled by the state. Then the government and the state-controlled banks agreed that amounts in excess of 110% of home values would be forgiven on mortgages." Iceland is not a euro participant, has a population of 300,000, so did not endure complications that European renegades will face.

A boatload of restrictions on money flows have washed across Europe over the past three years. Many are petty and simply an excuse for bureaucrats to collect a paycheck, but the mandarins in Madrid locked Spaniards in chains in late June (recall the acceleration of money fleeing, above) by instituting a minimum fine of €10,000 for taxpayers who don't report their foreign accounts and the prohibition of cash transactions greater than €2,500 for individuals and firms. Looking at flow data in Spain, this does not seem to have accomplished its goal, but simply reading numbers, without context, can be misleading.

All in all, LCH.Clearnet and the CME are ahead of a mad rush.