Wednesday, December 14, 2011

Today's links

1--The Scramble For US Safety, As Europe Imploded, Offset The $357 Billion Plunge In Q3 Shadow Banking, zero hedge

Excerpt: Q3, US shadow banking declined by $357 billion to $15.2 trillion in liabilities, a decline of $654 billion in 2011 YTD, and a drop of $5.7 trillion from the $20.9 trillion peak in March of 2008. ...

Forget anything else you may hear about the justification for "printing money" and remember this: the Fed's one and only directive is to offset the massively deflationary and increasingly more rapid deleveraging of shadow liabilities, which incidentally consist of money markets, GSEs, Agency Mortgage Pools, ABS Issuers, Funding Corporations, Repos and Open Market Paper: these are the various components that can be tracked via the Z.1......

One key component that can not be tracked, primarily since it is domiciled in the UK due to an enabling regulatory regime, are the liabilities generated by hypo/rehypo and hyper-hypothecation, courtesy of lax UK supervision standards allowing up to infinite rehypothecation of the same asset in what could become the daisy-chain from hell of linked serial counterparty exposure. According to IMF estimates, this vehicle, which does not exist anywhere in the Z.1, accounts for an additional $4-6 trillion in shadow liabilities. Yet it is the marginal rate of change that interests us, and as such it relies almost primarily on the $9 trillion in levered hedge fund assets which subsequently are (re)hypothecated by Prime Brokers. In other words, should the hedge fund industry be decimated in 2011, as it likley will be, and if the $3 trillion or so in HF AUM collapses by a third, there goes another $3 trillion in hypo-associated shadow liabilities... with who knows how much real assets pledged as collateral. But that is a tangent to this story, which is that regardless of what is happening in the hypothecation vertical, a fascinating story in its own right, the "traditional" shadow liabilities (pardon the pun) continue to collapse and collapse. And unfortunately, in Q4 domestic offices of foreign banks will not help the US as any minute now, these same banks will be forced to commence an epic wave of deleveraging to the tune of up to €2.5 trillion... Which means that once again without halting the shadow banking collapse, it is QE (and we mean hardcore LSAP monetization - none of this sterilized amateur stuff) or bust.

2--MF Global and Rehypothecation, Calculated Risk

Excerpt: Last week reader jb sent me a Reuters article: MF Global and the great Wall St re-hypothecation scandal

By way of background, hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.

...Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal.

...[I]n the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated.

...U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules.

Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organisation.

As a followup I read an IMF working paper this weekend by Manmohan Singh and James Aitken: The (sizable) Role of Rehypothecation in the Shadow Banking System

Note: James Aitken of Aitken Advisors correctly called the subprime implosion and has been ahead of the curve on Europe too.

Rehypothecation occurs when the collateral posted by a prime brokerage client (e.g., hedge fund) to its prime broker is used as collateral also by the prime broker for its own purposes. Every Customer Account Agreement or Prime Brokerage Agreement with a prime brokerage client will include blanket consent to this practice unless stated otherwise. In general, hedge funds pay less for the services of the prime broker if their collateral is allowed to be rehypothecated.

...A defined set of customer protection rules for rehypothecated assets exists in the United States, but not in the United Kingdom. In the United Kingdom, an unlimited amount of the customer’s assets can be rehypothecated and there are no customer protection rules. By contrast, in the United States, Rule 15c3–3 limits a broker-dealer from using its customer’s securities to finance its proprietary activities.

Bruce Krasting adds: The Fed, MFG and Reg. T

I think there is sufficient evidence today to conclude that Re-Hypothecation is at the root of the customer losses at MFG. ... Let me add one additional bit of info.

The Canadian customers of MFG got their money back within 10 days of the MFG bankruptcy. The accounts that have lost money are either USA or UK based. In Canada, re-hypothecation is not permitted. I got these comments from a Canadian MFG account holder:

The trustee where segregated MF Global Canada customers' funds were held was RBC Dominion Securities. I don't think any of these funds ever left the trustee in Canada. Likelihood is if they left, the Canadian government would have made the parent Royal Bank of Canada eat up the losses and make full restitution.

If MF Global moved their US client assets to their UK subsidiary (added: moved legally with client approval), and then followed the UK rules on rehypothecated assets - the client money is gone and nothing illegal happened. That would be the worst possible outcome.

3--Targeting the unemployed, NY Times

Excerpt: The House Republican leadership managed to get one thing right in its bill to extend the payroll tax cut and unemployment benefits. The bill does, indeed, extend the payroll tax cut for another year, but, beyond that, there is a lot to dislike. To help pay for the package, for instance, the bill would cut social spending more deeply than is already anticipated under current budget caps without asking wealthy Americans to contribute a penny in new taxes.

It also holds the expiring provisions hostage to irrelevant but noxious proposals to undo existing environmental protections. Worse, it would make unemployment compensation considerably stingier than it is now.

At last count, 13.3 million people were officially unemployed and 5.7 million of them had been out of work for more than six months. At no time in the last 60 years has long-term unemployment been so high for so long

4--Ben Bernanke Did Not Save Us from a Second Great Depression, CEPR

Excerpt: The Wall Street Journal felt the need to tell readers that Bernanke's action to provide liquidity to the banking system:

"may have prevented a repeat of the Great Depression."

This is not true. We know how to reinflate an economy after a collapse. It just requires massive amounts of government spending, as happened during World War II. The first Great Depression was not caused just by the failure to counter the initial financial crisis effectively. It was attributable to an inadequate policy response over theh following decade.

The piece also tells readers that Bernanke is worried that businesses are not investing because of concerns about future deficits. He would not have this fear if he looked at the data. Measured as a share of GDP business investment is almost back to its pre-recession level. This is very impressive since we would ordinarily expect that large amounts of excess capacity in many sectors would be depressing investment.

5--Bruce Bartlett Uncovers the Most Misleading Poll Question of All Times, CEPR

Excerpt: Bartlett found a poll ( I beleive an NYT poll) that asked the extent to which people agree or disagreed with the statement:

"it is the responsibility of government to reduce income differences."

Since we live in a country in which the government pursues a wide range of policies that increase income differences, most poll takers could not help but be confused by this sort of question. After all, we have a government that subsidizes Wall Street by providing too big to fail protection and massive subsidies when the doofuses bring their banks to the brink of ruin. It grants drug companies patent monopolies that raise the price of drugs by hundreds of billions of dollars above the free market price.

We have a trade policy that is designed to put our manufacturing workers in direct competition with the lowest paid workers in the developing world while protecting our most highly educated workers from the same competition. And, we have a central bank (the Fed), which deliberately acts to throw people out of work to ensure that inflation doesn't reduce profits in the financial sector.

Most people would probably be happy to have a government that did not increase income differences. Asking them about a government that reduces income differences no doubt would strike poll takers as a bizarre question.

6--English Butlers Wanted for Super-Rich Clients, Bloomberg

Video---Demand for trained butlers surges

7--EU Banks Selling ‘Crown Jewels’ for Cash, Bloomberg

Excerpt: European banks, under pressure from regulators to bolster capital, are selling some of their fastest-growing businesses to competitors from outside the region -- at the expense of future profit and economic growth.

Spain’s Banco Santander SA (SAN), Belgium’s KBC Groep NV (KBC) and Germany’s Deutsche Bank AG are accelerating plans to exit profitable operations outside their home markets. Santander, which said in October it needs to plug a 5.2 billion-euro ($6.9 billion) capital gap, sold its Colombian unit last week to Chile’s Corpbanca for $1.16 billion. Deutsche Bank is weighing options including a sale of most of its asset-management unit, while KBC may dispose of businesses in Poland.

Such sales risk hurting long-term profit, just as Europe enters recession, investors say. It’s the unintended consequence of the decision by European regulators to make banks increase core capital to 9 percent by June instead of 2019. Unwilling to raise equity because their share prices are too low, lenders are selling profitable assets because they’re struggling to find buyers willing to pay enough for their troubled loans to avoid a loss that would erode capital. Investors say the sales risk leaving banks focused on a stagnant economy and deprive them of economic growth from outside the region.

“These are the most profitable parts of their business,” said Azad Zangana, European economist at London-based Schroders Plc, the 200-year-old British asset manager, citing Spanish and Portuguese banks selling assets in Latin America. “They’re being forced by regulators to sell them off. You begin to become a less profitable organization. Your business model stops working if you’re being forced to lend only to an economy that’s going through a very deep recession.”...

The divestitures are likely to hurt banks’ profitability in coming years, analysts say. Shrinkage will cut their return on net asset value by 1.5 percentage points on average, according to a Dec. 6 report by Huw van Steenis, a Morgan Stanley analyst in London. Return on asset value at Frankfurt-based Deutsche Bank will shrink by almost 1 percentage point and at Santander by about 0.8 percentage point because of deleveraging, he said. The shrinking economy will help cut returns by an additional 2.5 percentage points, he added.

‘For banks, selling assets has become a cheaper way to raise capital than selling new stock after their shares tumbled. The Bloomberg Europe Banks and Financial Services Index (BEBANKS) has slumped 33.5 percent this year, leaving bank stocks trading at an average of 63 percent of book value.

“Many of those banks are trading at 50 percent of their book value, so if you can sell an asset at more than that, it’s a cheaper way to raise capital,” said Symon Drake-Brockman, former chief executive officer of Royal Bank of Scotland Group Plc (RBS)’s global banking and markets in the Americas and now managing partner of private-equity firm Pemberton Capital Advisors LLP in London.

‘Adverse Selection’

Banks across Europe have pledged to cut more than 950 billion euros of assets over the next two years, according to data compiled by Bloomberg. About two-thirds of that will come from sales of profitable units and performing loans, said van Steenis. Sales of distressed assets and souring loans will account for just 4 percent, or about 100 billion euros, he said...

“If they raise capital by selling crown jewels, the market will reward them in the short term because they’ll meet the regulator’s timeframe,” said Will James, who runs the 632 million-pound SLI European Equity Income Fund at Edinburgh-based Standard Life Plc. “That begs the longer-term question: How do you grow in an environment where customers are unwilling to borrow. That’s the missing piece from the puzzle. In a low- growth or no-growth environment, banks that have sold good assets will continue to struggle.”

8--China's housing bubble is losing air, LA Times

Excerpt: Home prices and sales plunge after China's government intentionally slams on the brakes. Some recent buyers stage demonstrations, destroy real estate offices and demand refunds of up to 40%.

Home prices nationwide declined in November for the third straight month, according to an index of values in 100 major cities compiled by the China Index Academy, an independent real estate firm. Average prices in the Shanghai area are down about 40% from their peak in mid-2009, to about $176,000 for a 1,000-square-foot home.

Sales have plummeted. In Beijing, nearly two years' worth of inventory is clogging the market, and more than 1,000 real estate agencies have closed this year. Developers who once pre-sold housing projects within hours are growing desperate. A real estate company in the eastern city of Wenzhou is offering to throw in a new BMW with a home purchase.

The swift turnaround has stunned buyers such as Shanghai resident Mark Li, who thought prices had nowhere to go but up. The software engineer closed on a $250,000, three-bedroom apartment in August, only to watch weeks later as the developer slashed prices 25% on identical units to attract buyers in a slowing market.

9--Retail Inventories Flat Ahead of Holiday Season, WSJ

Excerpt: Inventories of U.S. retailers were flat during October despite solid sales, a sign that merchants were guarded going into the critical holiday shopping season amid concerns about the overall economy.

A Commerce Department report Tuesday showed overall inventories of businesses in the U.S. increased by 0.8% to a seasonally adjusted $1.546 trillion. While retail stockpiling was unchanged, inventories of manufacturers and wholesalers surged.

The 0.8% gain was in line with expectations by economists surveyed by Dow Jones Newswires, and followed a flat reading during September.

Sales of U.S. businesses in October rose by 0.7% to a seasonally adjusted $1.218 trillion, after climbing 0.6% in September.

Spending by consumers and businesses sped up in the third quarter, with the economy accelerating at its fastest pace of the year, and reports of Black Friday sales were positive. However, earlier Tuesday, the government issued a disappointing report on retail sales for November that suggested consumers were cautious amid unease about economic growth. Unemployment is high and expected to remain so for some time. The housing sector is sluggish, with an uncertainty about the direction of home prices. The stock market has been volatile amid worries over the European debt crisis

10--CFOs Less Optimistic About 2012 Growth, WSJ

Excerpt: Financial chiefs at U.S. companies are less optimistic about economic growth in 2012 than in previous years, however, the majority don’t expect work force reductions next year, according to a recent chief financial officer outlook survey by Bank Of America Corp.

According to the annual latest survey of 600 executives by Bank Of America Merrill Lynch, 38% of respondents said they expect the U.S. economy to grow in 2012, down from 56% a year ago and 66% the prior year.

CFOs rated the economy a score of 44 out of 100 — its lowest score in the survey’s 14-year history. A year ago, CFOs gave the economy a score of 47.

However, the majority of CFOs didn’t expect their companies to reduce the work force next year. About 48% of executives expected their companies to maintain the current number of employees, while 46% said they expected to hire employees. Bank of America said both responses were similar to last year’s results. Only 7% of respondents predicted layoffs, compared with 6% a year ago.

11--European Banks Taking Cash From Governments Seen Sparking ‘Vicious Cycle’, Bloomberg

Excerpt: European banks turning to their governments to raise required capital could trigger a downward spiral of declining sovereign-debt prices and further losses for the lenders.

The European Banking Authority ordered the region’s banks on Dec. 8 to raise 115 billion euros ($154 billion) by June. Faced with dwindling profits and unable to tap capital markets to sell new shares, firms may be forced to seek government help. About 70 percent of the capital requirement falls on lenders in Spain, Greece, Italy and Portugal, countries struggling to convince the world they can pay their debts.

“If the Southern governments put money in their banks, their sovereign debt will go up, exacerbating their problems,” said Karel Lannoo, chief executive officer of the Centre for European Policy Studies in Brussels. “Then the banks’ losses will rise because they hold the government debt. That’s a vicious cycle. It’s hard to know which one to stabilize first, the sovereign bonds or the banks.”...

Spanish lenders also have 176 billion euros of loans and mortgages that soured after the nation’s housing market collapsed, the central bank estimates. Spain’s newly elected government, which takes power later this month, is considering setting up a bad bank to absorb those toxic assets. Capitalizing the banks to meet EBA requirements and shouldering the bad mortgages could raise Spain’s debt by as much as 20 percent of gross domestic product. It’s now more than 60 percent....

“The EFSF doesn’t have enough money to support Italian and Spanish sovereign debt as well as put money into the European banks,” said Desmond Lachman, resident fellow at the American Enterprise Institute in Washington. “It just can’t do all of that.”

The EU banks’ capital holes are bigger than the EBA’s latest estimate, Lachman said, citing a September IMF estimate of a 300 billion-euro risk based on more favorable prices for government bonds at the time.

Because banks can’t raise capital from the market and some governments can’t afford to provide cash, compliance most likely will be through asset sales and reduced lending in the region, said Lannoo of the Centre for European Policy Studies. The EBA has told banks not to meet the new capital requirements through such measures, instead asking them to refrain from paying dividends.

Asset Sales

European banks have already announced 1.2 trillion euros of asset sales as they try to reach a 9 percent capital ratio by June, according to data compiled by Nomura Holdings Inc. The shrinking of bank balance sheets in the region may reach 3 trillion euros, Barclays Plc (BARC) estimates.

One European bank executive who requested anonymity because plans weren’t public said his company intended to comply with requirements of the stress tests by lending less in 2012. By giving the banks six months to comply, the EBA has provided a go-ahead for deleveraging, an EU official said, asking not to be identified to avoid interagency conflict.

The EU leaders’ agreement for tougher budgetary discipline coupled with banks cutting lending will cause a “huge recession” in Europe, AEI’s Lachman said. The result of the stress tests will be constrained lending, especially in the Southern countries, which will make their economic rut even worse, Lannoo said

Death Spiral’

The size of potential losses at European banks has scared away short-term creditors, squeezing the region’s lenders. The European Central Bank has stepped in to replace funds being withdrawn, providing unlimited cash and lowering requirements on the quality of collateral it will accept.

“We’re in a death spiral,” said Andy Brough, a fund manager at Schroders Plc in London. “As the yields on the peripheral bonds increase, value of the bonds decreases and the amount of capital the bank has to raise increases.”

12--Moody's: Pressure remains on euro sovereigns despite summit deal, Reuetrs

Excerpt: Moody's Investors Service said on Monday it still expects to review its ratings on all European Union sovereign credit in the first quarter of next year, adding that last week's agreement by European policymakers offered few new measures to resolve the region's debt crisis.

Twenty-six of the 27 European Union leaders on Friday agreed to pursue stricter budget rules for the single currency area and also to have euro zone states and others provide up to 200 billion euros (171 billion pounds) in bilateral loans to the International Monetary Fund (IMF) to help tackle the crisis.

"In substance, however, the communique offers few new measures, and does not change our view that risks to the cohesion of the euro area continue to rise," Moody's said in its weekly credit report.

"As we announced in November, unless credit market conditions stabilise in the near future, our ratings of all EU sovereigns will need to be revisited. The communique does not change that view, and we continue to expect to complete such a repositioning during the first quarter of 2012."

The communique reflects the continuing tension between euro area leaders' recognition of the need to increase support for fiscally weaker countries and the significant opposition within stronger countries to doing so, Moody's noted.

"Amid the increasing pressure on euro area authorities to act quickly to restore credit market confidence, the constraints they face are also rising. The longer that remains the case, the greater the risk of adverse economic conditions that would add to the already sizeable challenges facing the authorities' coordination and debt reduction efforts."

13--No Draghi Ex Machina, Paul Krugman, NY Times

Excerpt: So last week European leaders announced a plan that, on the face of it, was pure nonsense. Faced with a crisis that is mainly about the balance of payments, with fiscal crisis as a secondary consequence, they supposedly committed everyone to severe fiscal austerity, which would guarantee a recession while leaving the real problem unaddressed.

But all this was supposed to work, according to many observers — and, briefly, the market — because the pain would provide the cover the ECB needed to step in and buy lots of Italian and Spanish bonds. In effect, the plan is supposed to rely on a Draghi ex machina, which turns contractionary policies expansionary.

It’s actually quite remarkable how many sensible people base their analyses on the presumption that the ECB will do what has to be done. Barry Eichengreen, who is a genuine expert on all things euro, starts his analysis of prospects for 2012 with the confident assertion that Draghi will ride to the rescue.

But as far as anyone can tell, the monetary cavalry aren’t coming. And the bond market has figured this out.

What Anglo-Saxon economists need to understand is that the Germans and the ECB really, really don’t share our worldview; they really do believe that austerity is all you need. And all indications are that they will cling to that belief, even as the euro falls apart — an event they will insist was caused by the fecklessness of the debtors. Given a choice between saving Europe and remaining righteous, they’ll choose the latter

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