Friday, December 23, 2011

Weekend links

1--Class warfare in the eurozone, Dean Baker, Aljazeera

Excerpt:  The people who gave us the eurozone crisis are working around the clock to redefine it in order to profit politically. Their editorials - run as news stories in media outlets everywhere - claim that the euro crisis is a story of profligate governments being reined in by the bond market. This is what is known in economics as a "lie".

The eurozone crisis is most definitely not a story of countries with out of control spending getting their comeuppance in the bond market. Prior to the economic collapse in 2008, the only country that had a serious deficit problem was Greece. In the other countries now having trouble financing their debt, the debt to GDP ratio was stable or falling prior: Spain and Ireland were actually running budget surpluses and had debt to GDP ratios that were among the lowest in the OECD.   

The crisis changed everything. It threw the whole continent into severe recession. This had the effect of causing deficits to explode since tax revenues plummet when the economy contracts and payments for unemployment benefits and other transfer programmes soar. Spain was hit especially hard by this contraction because it had a huge housing bubble. This bubble fuelled an enormous construction boom that went bust after the crash....

he story here is of the incredible failure of the European Central Bank (ECB) to take any steps to rein in the housing bubbles across Europe before they grew so large that their inevitable collapse would lead to economic wreckage across the continent. This failure might make a good argument for punishing the ECB (maybe the pensions of their senior staff should be slashed), but this is absolutely not a story of government profligacy.

Even after the collapse, the ECB has exacerbated the debt problem with its wrong-headed policies. The ECB could end the debt crisis at any time by acting as a lender of last resort, as central banks are supposed to do in a crisis. This would mean making a commitment to guarantee the bonds of the heavily indebted countries. That would immediately end the runs that Spain and Italy and now other countries are seeing on their debt....

Furthermore, the ECB's commitment to capping eurozone inflation at 2 per cent makes it almost impossible for the southern European countries to regain competitiveness. They would have to see years of deflation for their economies to again be able to compete with Germany and other northern European countries.

Again, the crisis of Italy, Spain and other heavily indebted countries is absolutely not a story of the market disciplining profligate countries; it is a story of countries victimised by the mismanagement of the ECB.

To claim that it is just a case of the bond market exerting its discipline would be like saying that a sailor who died of thirst and starvation after pirates tore up his sail, smashed his motor and stole his lifeboat was just a victim of the sea. It is only because the ECB pirates have wrecked these nations' economies that they are now so vulnerable to the vicissitudes of the bond market.

People should recognise this process for what it is: class war. The wealthy are using their control of the ECB to dismantle welfare state protections that enjoy enormous public support....

This applies not only to government programs like public pensions and healthcare, but also to labour market regulations that protect workers against dismissal without cause. And of course, the longstanding foes of Social Security and Medicare in the US are anxious to twist the facts to use the eurozone crisis to help their class war agenda here.

The claim that the countries in Europe are just coming to grips with the reality of modern financial markets is covering up for the class war being waged on workers across the globe. The assertion that this crisis is about market discipline should not appear in a serious newspaper, except on the right side of the opinion page. 

2--Dark Pools, Bloomberg

Excerpt:  About a third of the turnover in equities has moved into so-called dark pools, algorithmic trading and platforms offering clients direct market access, according to analysts. Credit Suisse (CSGN) said its electronic platform generates about 40 percent of the firm’s cash equities business, a figure that will likely increase to 60 percent in the next few years.

“Execution has become more complicated and expensive,” said Julian Palfreyman, CEO and founding director of Winterflood Securities Ltd., a London-based market making firm that services the brokerage industry. “Getting access to those other venues is very expensive. For the normal brokers out there, that’s a spend that they are not used to and they are finding it very difficult.”

According to the Financial Services Authority’s latest annual report, of the 19,057 firms registered with the U.K. regulator, 955 firms are classified as trading in securities and futures, a definition that includes brokers. That, according to RBC Capital Markets analyst Peter Lenardos, is too many.

Excerpt: Four years after the banking system nearly collapsed from reckless mortgage lending, federal prosecutors have stayed on the sidelines, even as judges around the country are pointing fingers at possible wrongdoing.

The federal government, as has been widely noted, has pressed few criminal cases against major lenders or senior executives for the events that led to the meltdown of 2007. Finding hard evidence has proved difficult, the Justice Department has said.

The government also hasn't brought any prosecutions for dubious foreclosure practices deployed since 2007 by big banks and other mortgage-servicing companies.

But this part of the financial system, a Reuters examination shows, is filled with potential leads.

Foreclosure-related case files in just one New York federal bankruptcy court, for example, hold at least a dozen mortgage documents known as promissory notes bearing evidence of recently forged signatures and illegal alterations, according to a judge's rulings and records reviewed by Reuters. Similarly altered notes have appeared in courts around the country.

Banks in the past two years have foreclosed on the houses of thousands of active-duty U.S. soldiers who are legally eligible to have foreclosures halted. Refusing to grant foreclosure stays is a misdemeanor under federal law....

The Justice Department doesn't disclose pending investigations, making it impossible to say if other criminal inquiries are underway. Officials in state attorneys' general offices and lawyers in foreclosure cases say they have seen no signs of any other federal criminal investigation.

"I think it's difficult to find a fraud of this size on the U.S. court system in U.S. history," said Raymond Brescia, a visiting professor at Yale Law School who has written articles analyzing the role of courts in the financial crisis. "I can't think of one where you have literally tens of thousands of fraudulent documents filed in tens of thousands of cases."

Spokesmen for the five largest servicers - Bank of America Corp., Wells Fargo & Co., JP Morgan Chase & Co, Citigroup Inc., and Ally Financial Group - declined to comment about the possibility of widespread fraud for this article.

Excerpt: How to save the euro? Some believe that the European Central Bank is the key to any solution. Others think that the euro zone should be contracted and the weak members squeezed out. SPIEGEL spoke with two leading German economists about the currency's future. Their one area of agreement? Something must be done quickly.

SPIEGEL: Mr. Starbatty, Mr. Bofinger, can the euro still be saved?

Starbatty: All of the measures that are currently planned take effect in the long term. But rescue measures are needed now. That's why many politicians want to pull out the so-called bazooka and inject money into the market through the European Central Bank (ECB) or introduce euro bonds. Both are deadly sins. It would be better to shrink the monetary union to a hard core that can sustain the euro.
Bofinger: That would be a disaster. But I agree with you that time is of the essence. The highly indebted countries must be able to borrow at moderate interest rates so they don't go bankrupt. This could be achieved with euro bonds. And if they can't be implemented that quickly, the ECB has to stabilize the system. In doing so, it would not create inflation but would in fact avoid deflation....

Starbatty: We had a fixed rule: the no-bailout clause…

SPIEGEL: …which states that no euro country can be liable for the debts of another.

Starbatty: But this rule has been pushed aside. Madame Christine Lagarde, the former French finance minister, says that we violated the treaty to rescue the euro. And that would happen again.

Bofinger: I don't think so, not if the rules are well made.

Starbatty: I think you're a little naïve. People will introduce new budget rules to get euro bonds, and as soon as they have them, they'll forget about the rules the next time there's a problem....

Starbatty: Inflation is always the long-term consequence of government financing through the central bank. If the ECB takes the same amount of paper and simply prints larger numbers on it, it is tantamount to counterfeiting.

Excerpt: The European Central Bank has launched the biggest lending operation in its history, and banks pounced on the offer on Wednesday, borrowing almost a half-billion euros for three years at a low interest rate. Governments hope the banks will use the cash to buy sovereign bonds, but critics warn the ECB's strategy is risky and could stoke inflation....

Central bankers tend to be diplomatic and cautious in their public statements, so the dramatic wording the European Central Bank (ECB) used this week to warn about an escalation of the euro crisis was indeed striking.

Tensions in the financial markets had "intensified to take on systemic crisis proportions not witnessed since the collapse of Lehman Brothers three years ago," the ECB warned in its latest report issued on Monday.
ECB President Mario Draghi told a committee of the European Parliament that Europe's banks faced major dangers in the coming months. "The pressure that bond markets will be experiencing is really very, very significant if not unprecedented," Draghi said.

It will be a tough year for banks. In 2012 overall they will have to pay back €725 billion ($953 billion) in debt, of which €280 billion will fall due in the first quarter alone. They will have to borrow fresh money to service this debt, but it's almost impossible for them to raise that money in the private market. Most of them have large holdings of European government bonds on their balance sheets, so they don't have the mutual trust necessary to lend each other large sums of money.

"The interbank market is pretty shut," said Dieter Hein, a finance expert at Fairesearch, an independent research company for institutional investors, banks and brokers. "Virtually no one outside is lending any money to euro-zone banks any more."...

ECB Becomes Banks' Lendor of Last Resort

That's why the ECB has become the lendor of last resort for many banks. Ever since the start of the 2008 financial crisis it has kept on supplying the banking sector with fresh cash, for up to one year in some cases. On Wednesday, it launched the biggest lending operation in its history, and banks responded by borrowing €489 billion in the ECB's first ever offering of three-year funding -- at an interest rate of just one percent initially...

Despite all the risks, the plan seems to be working in the short term. In recent days the risk premiums on high-debt euro member states have fallen significantly. Spain was able to borrow twice as much in the market as originally planned, and at relatively low interest rates. The banks are evidently buying bonds again in anticipation of receiving ample ECB assistance.

But the impact could prove short-lived. Experts believe that banks have recently been buying bonds mainly to use them as collateral for borrowing from the ECB. Once they get the central bank cash, the buying spree could quickly evaporate. After all, the financial sector still regards bonds issued by ailing euro-zone states as toxic for balance sheets.

Excerpt: In recent weeks, a broad range of data — like reports on new residential construction and small business confidence — have beaten analysts’ expectations. Initial claims for jobless benefits, often an early indicator of where the labor market is headed, have dropped to their lowest level since May 2008. And prominent economics groups say the economy is growing three to four times as quickly as it was early in the year, at an annual pace of about 3.7 percent.

But the good news also comes with a significant caveat. Many forecasters say the recent uptick probably does not represent the long-awaited start to a strong, sustainable recovery. Much of the current strength is caused by temporary factors. And economists expect growth to slow in the first half of 2012 to an annual pace of about 1.5 to 2 percent.

Even that estimate could be optimistic if Washington lawmakers fail to extend aid for the long-term unemployed and a payroll tax cut for the United States’ 160 million wage earners.

At stake is about $150 billion, the bulk of which would go to middle-class families and the unemployed. If Congress does not pass the measures, economists say, it would significantly weaken growth from already-damped levels anticipated early in the new year...

There are two reasons for the renewed pessimism. First, economists say that temporary trends increased growth in the fourth quarter and may not continue into next year. Second, the economy faces significant headwinds in 2012: some from Europe’s long-lingering sovereign debt crisis, and some from domestic cutbacks beyond the control of President Obama, whose campaign would like to point to a brightening economic picture, not a darkening one. Even the Federal Reserve is predicting that the unemployment rate will remain around 8.6 percent by the time voters go to the polls in November.

The fourth quarter benefited, for instance, from wholesalers restocking inventories of goods like petroleum, paper and cars, giving a jolt to growth.

“We had lean inventories, so those required additional production to satisfy demand,” said Gregory Daco of IHS Global Insight. “But once inventories are restocked, there is no need to restock them anymore. That means there’s going to be less production,” he said.

Consumers also pulled back on their savings, helping to finance a recent spurt in spending. a trend that forecasters doubt will continue...

Most worrying is the prospect that Congress will drop aid for the long-term jobless and allow payroll taxes to rise to 6.2 percent from the current level of 4.2 percent, amounting to a $1,000 tax increase on the average wage earner. Macroeconomic Advisers, a prominent forecaster, estimates that the expiration of the two provisions could cost the economy 400,000 jobs and cut growth by half a percentage point next year.

7--Fewer Ports in a Global Storm, David Wessel, WSJ

Excerpt: World's Supply of 'Safe' Assets Runs Short: The world economy faces a shortage of super-safe financial assets, bonds for which there is almost no risk of default and for which the market is so big that investors can buy and sell them readily. When anything is in short supply, its price rises. The bond market is no exception. It has been pushing up the price of U.S. Treasurys, still seen as safer than nearly all alternatives. That has pushed down the yield, the rate at which the U.S. government borrows, to extraordinarily low levels. Persistent shortages prompt lasting change. The hard-to-answer question: What changes will a persistent shortage of these risk-free assets provoke?

This phenomenon, more pronounced lately, predates the financial crisis. For years, high-saving economies like China and others bought dollars to keep their own currencies from rising in foreign-exchange markets. This yielded ever-larger piles of dollars to invest. In the mid-2000s, this money flowed into U.S. Treasurys and other AAA-rated dollar securities, depressing long-term yields even when the Federal Reserve was trying to boost them. Then-Federal Reserve Chairman Alan Greenspan called this "a conundrum;" his successor, Ben Bernanke, "the global savings glut."...

"In the financial system," says Mohamed El-Erian, co-chief investment officer of bond-market heavy Pimco, "you cannot replace something with nothing." For now, this benefits governments in the U.S. and (to the consternation of France) the U.K., which can borrow cheaply because they are drawing so much frightened money. Bill Gross, the other half of the Pimco team, describes the U.S. Treasury as "the cleanest shirt in the dirty-laundry pile."

Longer term? That's hard to know.

Excerpt: Who says the ECB can’t keep up with the Fed. As the euro crisis has caused liquidity for euro zone banks to dry up, the ECB has taken on the intermediation role. In essence, they have taken on the dollar liquidity function that the US money markets used to provide via its bank liquidity operations and currency swaps with the Fed.  (must see" chart)

Excerpt: Re-hypothecation is a revelation in financial leverage. Most readers understand “hypothecation,” even if they never heard the word. Elias explains: “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.” An example would be an investor who holds a margin account with a broker. If the value of the assets (shares of IBM) fall to a certain point, the broker requires that the investor put more money into the account. If the client does not put the required money into the account, the broker has the right to sell shares of IBM. The cash received in the sale restores the minimum level of equity required by the broker.

Elias explains the process as follows: “In the U.S., this legal right takes the form of a lien…. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default.”

Now we get to the scary part. Re-hypothecation, explains Elias: “occurs when a bank or broker re-uses collateral posted by clients… to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal.” He quantifies the legal scam: “Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as ‘churn’), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation.”

Hot off the press (dated December 2011) is an IMF report: The Nonbank-Bank Nexus and the Shadow Banking System Authors Zoltan Pozsar and Manmohan Singh give an example of how re-hypothecation works (on page 11 of the paper). A dealer holds a Treasury security as collateral which “comes with the rights for the dealer to repledge it.” The dealer uses this collateral as his (the dealer’s) collateral with an asset manager. The asset manager “may re-use the Treasury security to post collateral with another dealer…” On it goes, each party in turn using the same Treasury security as collateral. The IMF authors proffer: “Since these transactions are underpinned by a single piece of collateral, such daisy-chains may be referred to as dynamic chains.” They may also be referred to as an illusion of credit that nonetheless has inflated asset prices from Shanghai apartments to Apple common stock to European and U.S. Too-Levered-To-Die Banks. Pozsar and Singh write the traditional thinking of how banks fund themselves “ignores the significant funding that banks receive from the asset management complex” that permit “both individual banks and the banking system as a whole [to] quickly lever up.”...

A down drift of collateral values, which should be expected since there is no value to the compounded layers, may be a reason European banks are in such dire straits. (European Central Bank President Mario Draghi to the European Parliament on Thursday, December 1, 2011: “We are aware of the scarcity of eligible collateral.”)

Bloomberg reported on December 13, 2011: “EU Banks Selling ‘Crown Jewels’…” The banks are selling some of their most profitable arms (lines of business) to raise cash. Is this the fire sale of the century? Probably not. Selling profitable lines at discounts to their fair value today drags down prices which may lead to another round of discount sales, at even lower prices tomorrow.

Distorted pricing of assets by a leveraged financial system with few real assets has led to some strange observations. Izabella Kaminska reports in the Financial Times (alphaville) that it is not regulators or authorities, but “the markets themselves… [that] are demanding a re-collateralization in all funding areas.” She notes: “[T]he latest trend towards gold collateralized bank loans shows in some ways the market is demanding the recollateralization of credit with gold.” Kaminska notes: “Gold is switching places with [U.S.] Treasuries as the ultimate form of security.”

It is surprising U.S. Treasuries still hold that princely position. The FDIC is now guaranteeing $53 trillion (not billion, but: trillion) of Bank of America’s (transferred from its Merrill Lynch subsidiary) credit default swaps. This maneuver was executed by the Federal Reserve. This is both reprehensible and meaningless. Assume a 25% default rate on the credits and that Bank of America also defaults. A $13 trillion tax on Americans to make good on our guarantee is meaningless, other than to induce an immediate credit downgrade to F-...

ould the parties mentioned miscalculate and not act in time to pump up the sinking structure of leveraged ether?

Possibly so. There is precedence. Benjamin Anderson, economist at the Chase Bank from 1920 to 1939, wrote about two such misjudgments in the 1930s, in his highly recommended book, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914-1946.

On May 12, 1931, “there came an unexpected run on Oesterreichische-Credit-Anstalt,” a large Austrian bank. To be noted: (1) Oesterreichische-Credit-Anstalt was forced into a merger with a weaker bank in 1929. This might be analogous to Bank of America’s acquisition of Countrywide Financial, and, (2) quoting Anderson: “The Austrian government guaranteed certain of the investments.” (Oh, those government guarantees again!), but “the merged bank had been inadequately financed… the big merged institution was still insolvent.” Just as in Europe today: how good is the credit (collateral) of the guarantor? The bulk of a sovereign state’s collateral is future tax revenues. From Greece to the United States, this does not inspire confidence today.

On May 14, 1931, the Bank for International Settlements coordinated support by central banks. “This made a great show of international cooperation… but the effect was bad when eleven central banks were providing among them only $5.6 million. Creditors grew more frightened, rather than less. If the thing were to be done at all, it should have been done adequately. The first principal of bank loans in a crisis is that if the borrower needs $100,000 to save him, you give him $100,000 or you give him nothing at all. You don’t give him $20,000.”...

Anderson observed (literally: he was confidant to participants) that “governments move slowly and politicians look to the next election.” He concluded: “If the governments had acted that winter, Hitler would never have come to power, and we should have saved the democratic regime of Germany.” This was an unknown unknown.

Excerpt: As Wessel explains:

In the mid-2000s, this money flowed into U.S. Treasurys and other AAA-rated dollar securities, depressing long-term yields even when the Federal Reserve was trying to boost them. Then-Federal Reserve Chairman Alan Greenspan called this “a conundrum;” his successor, Ben Bernanke, “the global savings glut.” Demand was so strong that Wall Street manufactured billions of mortgage-linked securities for which it won the top AAA rating. In 2008, it became clear those bonds were “far riskier than had been believed,” Carl Lantz of Credit Suisse wrote in a recent client note. Then the debt of Fannie Mae and Freddie Mac “became too politically complicated for many (foreign) reserve managers to continue buying,” he said....

You have to consider that leading up to the Fed’s rate hiking cycle which started in June 2004, the US Treasury market was still feeling the effects of the debt frugality regime of the Clinton administration — the amount of US Treasuries outstanding from 1996-2001 had stayed pretty constant, creeping only marginally higher from $5,225bn in 1996 to $5,807bn in 2001.

From 2001-2004 the amount of Treasuries outstanding grew from $5,807bn to $7,379bn.

Over the course of the rate hiking cycle, meanwhile, the amount of Treasuries outstanding rose from $7,379bn to $9,007bn.

And yet despite all that additional supply, longer-dated bond yields remained suppressed — fueling Greenspan’s famous conundrum. Many theories have been proposed as to why that happened, though in our opinion Ben Bernanke’s “savings glut” explanation is one of the most compelling — especially when tied to China’s rampant (currency-depreciation linked) Treasury purchases at the time.

Given what we’ve all come to know about outright bond purchases by central banks, one can safely conclude that these moves injected liquidity directly into the US system, suppressing yields. In fact, one might even say, it was a type of stealth QE operation by the Chinese (and the Japanese), focused on stimulating American demand for their own export-led economies. The side-effect — the accumulation of all those Treasuries — however, also presented these central banks with the ability to challenge the Fed’s monopoly power over the Treasury market and to quasi dictate rates themselves....

Coupled with demand from western pension funds and asset managers, there was simply not enough safe US Treasury assets to go round. The more the Fed tried to raise rates, the more the yield curve inverted. The Treasury, meanwhile, was presented with extremely favourable rates to issue more long-term debt (a natural reaction to the overwhelming demand for its product).

According to Richard Duncan (and others) it’s one reason why so much money ended up flowing into GSE paper — the next best thing in the eyes of the Chinese. This understandably helped to fuel the US real-estate bubble....

The point we’re trying to make is that central banks, even those as hefty and powerful as the Fed, may have accidentally given away much of their power to foreign institutuions whose holdings of Treasury securities surpassed their own.

More importantly, does that mean western central banks are now facing an existential crisis as a result?

Or did QE, in a way, re-establish some of that control by allowing central banks to start matching the holdings (of their own domestic securities) of foreign central banks?

The simple point being — if you have no domestic assets, you can’t raise rates effectively. Lowering rates, on the other hand, is much easier, since all it takes is hoarding of domestic assets at the central bank....

The takeaway being: it was the shortage of Treasuries which created the impetus for increased Treasury issuance — to keep rates in check with policy decisions — not the ‘debt-binge’ mentality of ordinary Americans, i.e. it was China’s fault. Not vice versa.

Given that, should we be surprised that Treasuries are correlating ever more with Chinese markets rather than US ones? Does China now have the ultimate say over global rates?

And in an interesting twist, is this why market forces are arguably compelling the PBOC to begin offloading some of its hoarded foreign government debt rather than do the opposite?

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