Thursday, December 29, 2011

Today's links

Today's quote:  "Getting worse more slowly is not the same as getting better", Bradford DeLong UC Berkeley

Excerpt: The European Central Bank said overnight deposits from the region’s financial institutions increased to an all-time high.

Euro-area banks parked 452 billion euros ($591 billion) with the Frankfurt-based ECB yesterday, the most since the euro’s introduction in 1999 and up from the previous record of 412 billion euros a day earlier.

The ECB last week lent 523 banks a record 489 billion euros for three years to keep credit flowing to the 17-nation euro economy during the sovereign debt crisis. It lent the money at its benchmark rate of 1 percent. Banks are depositing excess cash back with the ECB at the overnight rate of 0.25 percent, incurring a loss rather than lending it at a better rate.

Barclays Capital estimates the three-year loans injected 193 billion euros of new money into the system, with 296 billion euros accounted for by maturing loans. Since the three-year loans started on Dec. 22, overnight deposits have jumped by 187 billion euros, suggesting banks are parking almost all the additional liquidity back with the ECB.

Excerpt: From the WSJ:

The Federal Reserve's Covert Bailout of Europe 

America's central bank, the Federal Reserve, is engaged in a bailout of European banks. Surprisingly, its operation is largely unnoticed here.

The Fed is using what is termed a "temporary U.S. dollar liquidity swap arrangement" with the European Central Bank (ECB). There are similar arrangements with the central banks of Canada, England, Switzerland and Japan. Simply put, the Fed trades or "swaps" dollars for euros. The Fed is compensated by payment of an interest rate (currently 50 basis points, or one-half of 1%) above the overnight index swap rate. The ECB, which guarantees to return the dollars at an exchange rate fixed at the time the original swap is made, then lends the dollars to European banks of its choosing.

Why are the Fed and the ECB doing this? The Fed could, after all, lend directly to U.S. branches of foreign banks. It did a great deal of lending to foreign banks under various special credit facilities in the aftermath of Lehman's collapse in the fall of 2008. Or, the ECB could lend euros to banks and they could purchase dollars in foreign-exchange markets. The world is, after all, awash in dollars.

The two central banks are engaging in this roundabout procedure because each needs a fig leaf. The Fed was embarrassed by the revelations of its prior largess with foreign banks. It does not want the debt of foreign banks on its books. A currency swap with the ECB is not technically a loan.

The ECB is entangled in an even bigger legal and political mess. What the heads of many European governments want is for the ECB to bail them out. The central bank and some European governments say that it cannot constitutionally do that. The ECB would also prefer not to create boatloads of new euros, since it wants to keep its reputation as an inflation-fighter intact. To mitigate its euro lending, it borrows dollars to lend them to its banks. That keeps the supply of new euros down. This lending replaces dollar funding from U.S. banks and money-market institutions that are curtailing their lending to European banks—which need the dollars to finance trade, among other activities. Meanwhile, European governments pressure the banks to purchase still more sovereign debt.

This Byzantine financial arrangement could hardly be better designed to confuse observers, and it has largely succeeded on this side of the Atlantic, where press coverage has been light. Reporting in Europe is on the mark. On Dec. 21 the Frankfurter Allgemeine Zeitung noted on its website that European banks took three-month credits worth $33 billion, which was financed by a swap between the ECB and the Fed. When it first came out in 2009 that the Greek government was much more heavily indebted than previously known, currency swaps reportedly arranged by Goldman Sachs were one subterfuge employed to hide its debts.

The Fed had more than $600 billion of currency swaps on its books in the fall of 2008. Those draws were largely paid down by January 2010. As recently as a few weeks ago, the amount under the swap renewal agreement announced last summer was $2.4 billion. For the week ending Dec. 14, however, the amount jumped to $54 billion. For the week ending Dec. 21, the total went up by a little more than $8 billion. The aforementioned $33 billion three-month loan was not picked up because it was only booked by the ECB on Dec. 22, falling outside the Fed's reporting week. Notably, the Bank of Japan drew almost $5 billion in the most recent week. Could a bailout of Japanese banks be afoot? (All data come from the Federal Reserve Board H.4.1. release, the New York Fed's Swap Operations report, and the ECB website.)

No matter the legalistic interpretation, the Fed is, working through the ECB, bailing out European banks and, indirectly, spendthrift European governments. It is difficult to count the number of things wrong with this arrangement.

First, the Fed has no authority for a bailout of Europe. My source for that judgment? Fed Chairman Ben Bernanke met with Republican senators on Dec. 14 to brief them on the European situation. After the meeting, Sen. Lindsey Graham told reporters that Mr. Bernanke himself said the Fed did not have "the intention or the authority" to bail out Europe. The week Mr. Bernanke promised no bailout, however, the size of the swap lines to the ECB ballooned by around $52 billion.

Second, these Federal Reserve swap arrangements foster the moral hazards and distortions that government credit allocation entails. Allowing the ECB to do the initial credit allocation—to favored banks and then, some hope, through further lending to spendthrift EU governments—does not make the problem better.

Third, the nontransparency of the swap arrangements is troublesome in a democracy. To his credit, Mr. Bernanke has promised more openness and better communication of the Fed's monetary policy goals. The swap arrangements are at odds with his promise. It is time for the Fed chairman to provide an honest accounting to Congress of what is going on.

Excerpt: Even after the European Central Bank doled out nearly half a trillion euros of loans to cash-strapped banks last week, fears about potential financial problems are still stalking the sector. One big reason: concerns about collateral.

The only way European banks can now convince anyone—institutional investors, fellow banks or the ECB—to lend them money is if they pledge high-quality assets as collateral.

Now some regulators and bankers are becoming nervous that some lenders' supplies of such assets, which include European government bonds and investment-grade non-government debt, are running low.

If banks exhaust their stockpiles of assets that are eligible to serve as collateral, they potentially could encounter liquidity problems. That is what happened this fall to Franco-Belgian lender Dexia SA, which ran out of money and required a government bailout.

"Over time it is certainly a risk," said Graham Neilson, chief investment strategist for Cairn Capital Ltd. in London. "If banks don't have assets good enough to pledge as collateral, they will not be able to tap as much liquidity...and this could be the end-game path for a weaker bank."

The ECB earlier this month moved to address the collateral shortages; Mario Draghi, the central bank's new president, announced it would accept a wider range of assets as collateral for ECB loans, which have become a primary source of funding for many European banks.

The looser rules, which will allow some corporate bonds to be used, kick in early next year, in time for banks to pledge the assets in exchange for three-year loans that the ECB will offer on Feb. 29.

Some bank executives, regulatory officials and other experts are optimistic that will largely solve the problem.

"The ECB is being much more generous. We think there's enough [collateral] to exceed European banks' funding needs for the next year," said Jacques Cailloux, chief European economist at the Royal Bank of Scotland Group.

In one sign that the ECB move has eased market strains, even if only modestly, Italian borrowing costs dropped sharply Wednesday as the country successfully auctioned more than €10 billion, or $13 billion, of short-term debt. Average yields on six-month bills were 3.251%, half that of an auction a month ago and even below those in October, although yields on 10-year benchmark bonds worryingly remained just below 7%. Last week, Italian banks borrowed more than €110 billion of the three-year ECB funds, some of which might have been used to purchase the country's sovereign bonds.

Other market watchers, however, remain concerned. In addition to fears that the banks might simply run out of eligible collateral, some bankers and regulators worry that the banks' growing reliance on "secured lending" will make it harder for the industry to return to its past practice of funding itself by issuing unsecured bonds. That could result in a permanent funding scarcity.

It is tough to tell how big a problem this is. European banks generally don't disclose how many assets they have on their balance sheets that would be eligible as collateral, either to pledge with the ECB or to package into "covered bonds," another increasingly popular type of secured lending, and aren't already earmarked for other purposes.

The Bank of England is among those ringing alarm bells. Officials are worried that the growing reliance on secured lending like "covered bonds," which are secured by mortgages or, in some cases, municipal loans that remain parked on the banks' balance sheets, has left increasing portions of bank assets "encumbered," or otherwise committed. That means they wouldn't be available to unsecured creditors if the bank collapsed.

"There are already market concerns about the degree to which banks' assets are 'encumbered'," the Bank wrote in its Financial Stability Report in December. "Higher levels of, or greater uncertainty about, encumbrance increase the probability of a creditor run, making the institution more vulnerable to liquidity risk.... It can lead to the emergence of adverse feedback loops, whereby funding-constrained banks seek to tap secured markets only to see their access to unsecured funding markets reduced further."

Officials also are nervous that some banks, particularly smaller ones, could exhaust their supplies of collateral that can be used for covered bonds or with the ECB, according to people familiar with the matter.

"Recent market intelligence suggests this is a growing concern for investors," partly because of the dearth of publicly available data, one person said.

The U.K.'s Financial Services Authority recently conducted a confidential survey of British banks to gauge the degree to which their assets are encumbered. The Bank of England is in the early stages of reviewing the data and hasn't yet reached any firm conclusions, said the people familiar with the matter.

Since this summer, it has been virtually impossible for banks to issue unsecured bonds, because investors view European banks as risky investments.

In the second half of 2011, European banks issued a total of about $80 billion of senior unsecured bonds, according to data provider Dealogic. That compares to $240 billion in the same period last year and $257 billion in 2009.

Banks have had to turn to other sources for funding. Banks in Spain, Italy and France, among others, have borrowed hundreds of billions of euros from the ECB on a short-term basis, posting items including government bonds—often from financially weak countries such as Greece and Ireland that helped precipitate the crisis—as collateral.

For longer-term financing, banks have been issuing covered bonds. European banks have issued about $334 billion of these bonds this year, up 8% from last year and 24% from 2009, according to Dealogic.

But there is a finite supply of mortgages and municipal loans that banks can bundle together for such bonds—and there are signs that it is running thin.

In some cases, banks are weighing new types of collateral to back covered bonds. Some smaller German banks, which are burning through their supplies of high-quality mortgages to use as collateral, are looking at using loans to small and medium-sized businesses to back their bonds instead.

"You are basically taking an asset class known as being plain vanilla and going back to more complex products," said a London-based bond executive at a major international bank.

Some banks have been engaging in financial gymnastics to come up with scarce collateral. A group of Italian banks, for example, last week got the Italian government to guarantee about €38 billion of newly created bonds, thereby making them eligible to serve as collateral for ECB loans.

Instead of selling the bonds to investors, however, the banks simply stashed the bonds on their own balance sheets.

The reason, according to multiple Italian bank executives: They were running out of normal collateral.

"The collateral of the Italian banks is very limited right at the moment," said an executive at an Italian bank, who added that he is optimistic that the ECB's looser collateral requirements will ease the problem in 2012.

Excerpt: Italy faces a crucial test tomorrow as the technocrat government of Mario Monti launches its first big auction of long-term bonds since a disastrous upset a month ago.

The outcome will set the tone for a string of debt sales through early 2012 that risk stretching the eurozone bond markets to breaking point.

The EU authorities are hoping commercial lenders will use last week’s flood of cheap liquidity from the European Central Bank to soak up southern European debt and bring yields back under control, starting with Italy’s €8.5bn (£7.1bn) sale of 10-year bonds today. The country must raise €440bn in debt in 2012, beyond the current fire-fighting power of Europe’s bail-out machinery.

The flight to safety exceeds the most extreme moments of the Lehman crisis in 2008. Although the picture may have been distorted by the Christmas holiday, it is clear large parts of Europe’s financial system remain under acute stress.

Excerpt: The dollar reasserted itself as the global reserve currency of choice in 2011, despite concerns about US debt.

Worries over borrowing in recent years have seen the dollar weakening, despite successive Treasury Secretaries repeating their mantra that the country has a "strong dollar policy". However, as a lack of safe-haven alternatives and a liquidation of risky assets unfolded, the US currency rallied sharply in the last few months of the year. The dollar index, which tracks the greenback against a basket of currencies, jumped by about 9pc from its lows earlier in the year.

Worries over eurozone sovereign debt prompted the dollar gains, as did the removal of the Swiss franc as an alternative safe haven currency in September....

The Japanese central bank was also forced to intervene this year, selling yen to protect its exporters. At the end of October, the bank sold $100bn (£64bn) worth of yen. However, dollar strength at the end of the year meant that the Japanese currency weakened against the dollar. As we enter 2012, City strategist expects the dollar and yen to continue to strengthen.

Excerpt: European banks are making great use of the ECB’s overnight deposit facility. Last night they parked $590 billion at the ECB breaking the record they had set the night before. They are clearly unwilling to lend to other European banks, highlighting the distrust and fear in the interbank marketplace. While the ECB’s lending initiative calmed the markets somewhat, it apparently has done nothing to free up the logjam blocking interbank lending.

The distrust on the streets is said to be growing also. Barroom gossip says that safe-deposit boxes are in a demand that borders on frenzy. They allow you to take your Euros and covert them into something of value (gold, Swiss Francs, etc.) and sock it away in a safe place.

Others are said to be buying property in London and elsewhere lest you awake one day and discover that your Euros have reverted to drachmas or lira.

Savvy bankers are said to be setting up personal and communal trusts domiciled in places like the Bahamas, the Caymans or the Isle of Jersey. Some banks are offering depository accounts denominated (and repayable) in alternate currencies like the dollar or the yen.

We think a Lehman-like event would most likely be triggered by a run on a bank or a series of banks. The scramble for currency (value) protection among the public could turn into that bank run in the same way that a crowd can instantly turn into a mob. Watch the money flows out of Greece and Italy very carefully. The pot continues to bubble

Excerpt:  I already wrote a big post about yesterday's SOPA markup day one. While we're moving forward on day two, I wanted to call out one key point that was really made clear by an amendment offered by Rep. Jared Polis late in the day yesterday, which hasn't received nearly enough attention. As you may recall, with the "manager's amendment" version of SOPA (i.e., SOPA 2.0), the "notice-and-shut off funding" section of the private right of action in Section 103 was removed. This was good, because we've seen how the notice-and-takedown provision of the DMCA has been widely abused. 

However, what most people missed was that the bill effectively sneaks this back into the bill in a much worse form in Section 105, which supposedly grants "immunity" to service providers for taking voluntary action to stop infringement. The true impact of this section was only made clear by Rep. Polis' attempt to limit it, as he highlighted how this broad immunity would likely lead to abuse. That's because this section says that anyone who takes voluntary action "based on credible evidence": basically gets full immunity. Think about what that means in practice. If someone sends a service provider a notice claiming infringement on the site under this bill, the first thing every lawyer will tell them is "quick, take voluntary action to cut them off, so you get immunity." Even worse, since this is just about immunity, there are no counternotice rules or anything requiring any process for those cut off to be able to have any redress whatsoever. 

This is scary. 

Excerpt: Key euro zone bank-to-bank lending rates fell for the fifth session running on
Wednesday, pushed down by a funding glut after banks took almost
half a trillion euros at the European Central Bank's first-ever
injection of 3-year cut-price loans.
    Euro zone banks received 489 billion euros last Friday in
the first of two opportunities to access this longer-term money
- operations the ECB hopes will encourage banks to unclog
lending to each other and then onto customers in spite of the
region's debt crisis.
    But despite being awash with liquidity, banks still appear
distrustful and prefer to deposit their money at the ECB's
overnight facility rather than lend to each other.
    Latest figures show banks deposited 452 billion euros at the
central bank -- a record high. Emergency overnight borrowing
also remained high at above 6 billion euros.
    The intensification of the euro zone debt crisis has left a
growing pack of banks virtually locked out of open funding
markets and reliant on the ECB. In response the ECB has already
reinstated some of its most potent crisis-fighting tools.
    Last week's bumper liquidity boost was the ECB's latest and
most dramatic effort to bolster banks' finances, while ECB
Governing Council member Ignazio Visco hinted in a weekend
newspaper interview that the bank could cut interest rates
further if the euro zone economy continues to decline.

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