Euro-Landia

[don]

On to the 88 Cent Euro!

Europe is Heading for a Mini-Depression

MIKE WHITNEY

Despite a nearly-$1 trillion rescue operation, financial conditions in the eurozone continue to deteriorate. All the gauges of market stress are edging upwards and credit default swaps (CDS) spreads have widened to levels not seen since the weekend of the emergency euro-summit. Libor (the London Interbank Offered Rate) is on the rise and liquidity is draining from the commercial paper and money markets. According to the Federal Reserve, the total amount of (foreign banks’) commercial paper has shrunk 15 percent or $32 billion since late April. Central bank officials insist that there's no chance of another Lehman-type meltdown, but their actions don't match their words. Apart from the massive $920 billion EU Stabilization Fund, the European Central Bank has beefed-up its liquidity facilities and is aggressively purchasing state bonds from struggling countries in the south. Without the ECB's assistance, the slow-motion slide into recession could turn into a full-blown market crash. Brussels has every reason to be worried.
From the Wall Street Journal:

"In the latest indication that European banks are in ill health, the European Central Bank warned late Monday that euro-zone banks face €195 billion ($239.26 billion) in write-downs this year and the next due to an economic outlook that remained "clouded by uncertainty....Europe's intertwined banking system remains stressed. Investors have hammered the sector, banks are stashing near-record amounts of deposits at the ECB—€305 billion as of Friday—instead of lending the funds to other institutions, risk-wary U.S. financial institutions are reducing their exposure to euro-zone banks." ("ECB Warns Write-Downs Could Reach $239 Billion" David Enrich and Stephen Fidler, Wall Street Journal)

German and French banks have vast exposure to public and private debt in Club Med countries; Spain, Greece, Portugal and Italy. When those countries finances begin to teeter, it's harder for the banks to exchange assets in the repo market where they get the bulk of their funding. They are forced to take a "haircut" on the value of their collateral which erodes their capital cushion and pushes them closer to default. This is what happened in the US when the French Bank Paribas started listing in late 2007. PIMCO's Paul McCulley explains the origins of the financial crisis in a speech he gave at the Fed’s annual symposium in Jackson Hole. Here's an excerpt:

"If you have to pick a day for the Minsky Moment [the economist Hyman Minsky wrote extensively about the modalities of economic crisis], it was August 9. And, actually, it didn’t happen here in the United States. It happened in France, when Paribas Bank (BNP) said that it could not value the toxic mortgage assets in three of its off-balance sheet vehicles, and that, therefore, the liability holders, who thought they could get out at any time, were frozen. I remember the day like my son’s birthday. And that happens every year. Because the unraveling started on that day. In fact, it was later that month that I actually coined the term "Shadow Banking System"....



“...What’s going on is really simple. We’re having a run on the Shadow Banking System and the only question is how intensely it will self-feed as its assets and liabilities are put back onto the balance sheet of the conventional banking system.....It was pretty much an orderly run up until September 15, 2008. (Lehman Bros default) And it was orderly primarily because the Fed...evoked Section 13-3 of the Federal Reserve Act in March of 2008 in order to facilitate the merger of under-a-run Bear Stearns into JPMorgan. Concurrently, the Fed opened its balance sheet to the biggest shadow banks of all, the investment banks that were primary dealers, including most important, the big five. It was called the Primary Dealer Credit Facility." ("McCulley: After the Crisis, Planning a New Financial Structure", Credit Writedowns)

So when Paribas made its announcement on August 9, the collateral (mainly mortgage-backed securities) that the banks had been using in exchange for funding in the repo market, was called into question. No one really knew what these mortgage-backed securities were worth, because many were comprised of subprime loans that would never be repaid. Thus, repo transactions slowed to a crawl, interbank lending collapsed, libor spiked to record highs, and the banking system suffered a major heart attack.


Now it's Europe's turn. But don't expect a repeat of the Fed's strategy. The member states won't allow the ECB to dictate policy without deliberation. Germany has already forbidden quantitative easing (QE) unless the funds that are used to purchase state bonds are sterilized, that is, unless the ECB soaks up the extra liquidity via some other offsetting transaction.



Officials with the Bundesbank say that ECB head Jean Claude Trichet has launched a "stealth bailout" of the eurozone banks holding Greek debt. The facts appear to support the claims. Greece has already received the $135 billion bailout, enough to meet its funding needs until 2012. But the ECB has purchased an additional $25 billion in Greek debt in the last three weeks. That means the debt must have been purchased from French or German banks. It looks like Trichet is trying to pull a fast-one on Germany by secretly diverting money to underwater banks.
From the Wall Street Journal:

"ECB critics within the Bundesbank say the price of Greek bonds is now largely irrelevant to Athens, making the main beneficiaries of the bond purchases the banks that hold much of Greece's roughly €300 billion in outstanding debt.... ‘We haven't gone beyond our goal of re-establishing a more correct transmission mechanism of our monetary policy,’ said Mr. Trichet...... ‘In simple words: We are not printing money.’" ("Bundesbank Attacks ECB Bond-Buying Plan", David Crawford Brian Blackstone, Wall Street Journal)

German officials haven't been fooled by the hype surrounding quantitative easing. In a recent interview in Der Spiegel, Bundesbank chief Karl Otto Pöhl summed up the ECB's efforts like this:

"It was about protecting German banks, but especially the French banks, from debt write-offs. On the day that the rescue package was agreed on, shares of French banks rose by up to 24 per cent. Looking at that, you can see what this was really about -- namely, rescuing the banks and the rich Greeks."

This is a banking crisis not a sovereign debt crisis. Bank funding is getting more expensive because shadow banks are not willing to pay as much for collateral that looks dodgy. The problem is particular to the repo system, where the demand for triple A collateral creates a powerful incentive for ratings inflation. High ratings lead to mispriced risk and credit excesses. When the bubble finally bursts, assets prices plunge, leaving balance sheets deep in the red. If the banks had done their jobs and performed due diligence, they would have seen that Greece was headed for trouble and their bonds were a bad investment. But they purchased the debt anyway, to boost leverage and to increase short-term profitability. Now the downgrades are coming fast and furious, and the "run" on the shadow banking system is gaining momentum. Eventually, Greece will have to restructure its debt and the losses will push banks in France and Germany into default. Equity and bondholders will be wiped out or suffer big losses.


The amount of money at stake is huge, certainly enough to trigger another banking crisis. Here's an excerpt from the Wall Street Journal:

"All told, more than €2 trillion of public and private debt from Greece, Spain and Portugal is sitting on the balance sheets of financial institutions outside the three countries, according to a Royal Bank of Scotland report last week. Investors, bankers and government officials are worried that as that debt loses value, banks across Europe could be saddled with losses.


"‘Make no mistake: This is big,’ said Jacques Cailloux, RBS's chief European economist and the report's author. ‘We're talking about systemic risk [and] the potential for contagion.’” ("ECB Warns Write-Downs Could Reach $239 Billion" David Enrich and Stephen Fidler, Wall Street Journal)

EU banks are over-leveraged, under-capitalized, and too exposed to emerging market debt. In the next 12 months, they'll have to roll over more than $400 billion in loans in a market where funding is scarce and liquidity is drying up. The ECB should present a plan for restructuring Greek debt now instead of trying to keep the bubble afloat and hoping for a miracle.



The run on the shadow system is forcing more banks to seek funding from the ECB. The central bank has loaned out more than $850 billion and that figure is expected to rise. The ECB's balance sheet is proof that the wholesale funding system is broken and needs basic structural change. The EU is moving forward with a raft of regulatory reforms on everything from hedge funds to naked shorts, from corporate governance to a financial transaction tax, from tighter oversight on CDS to revamping the ratings agencies. So far, however, the shadow banking system has escaped their attention, which is unfortunate. The system is inherently unstable and will lead to more serious crises in the future. Financial institutions that act as banks (investment banks, hedge funds, insurers) must be regulated as banks, that's the bottom line. The dangers of maximizing leverage and unsupervised credit expansion, should be clear to everyone by now.


Mike Whitney lives in Washington state. He can be reached at fergiewhitney@msn.com

http://www.counterpunch.org/whitney06042010.html

[BigBagel]

Re: Euro-Landia

http://www.nytimes.com/2010/06/06/bu...ytimesbusiness

Link to a NYT article about banks sick with troubled sovereign debt. The question is who.

[oddlots]

Re: Euro-Landia

That's the best piece I've ever read by Mike Whitney. I particularly appreciated the clarity of this passage:

"This is a banking crisis not a sovereign debt crisis. Bank funding is getting more expensive because shadow banks are not willing to pay as much for collateral that looks dodgy. The problem is particular to the repo system, where the demand for triple A collateral creates a powerful incentive for ratings inflation. High ratings lead to mispriced risk and credit excesses. When the bubble finally bursts, assets prices plunge, leaving balance sheets deep in the red. If the banks had done their jobs and performed due diligence, they would have seen that Greece was headed for trouble and their bonds were a bad investment. But they purchased the debt anyway, to boost leverage and to increase short-term profitability. Now the downgrades are coming fast and furious, and the "run" on the shadow banking system is gaining momentum. Eventually, Greece will have to restructure its debt and the losses will push banks in France and Germany into default. Equity and bondholders will be wiped out or suffer big losses."

And these as well:

"EU banks are over-leveraged, under-capitalized, and too exposed to emerging market debt. In the next 12 months, they'll have to roll over more than $400 billion in loans in a market where funding is scarce and liquidity is drying up. The ECB should present a plan for restructuring Greek debt now instead of trying to keep the bubble afloat and hoping for a miracle."

"Financial institutions that act as banks (investment banks, hedge funds, insurers) must be regulated as banks, that's the bottom line. The dangers of maximizing leverage and unsupervised credit expansion, should be clear to everyone by now."

The McCulley speech he cites also states clearly something that has been rattling around in my head incoherently for some time: banks are inherently socialist enterprises for their very existence rests on the premise that there is an entity that, at times of duress, can backstop the enterprise:

"Banking is inherently a joint venture between the private sector and the public sector. Banking inherently cannot be a solely capitalistic affair. I put that on the table as an article of fact. And, in fact, speaking at a Minsky Conference, I know I’m preaching to the converted. Big bank and big government are part of our catechism. And, in fact, that’s exactly what came to the fore to save us from Depression 2.0."

The McCulley piece is worth reading in its entirety.

[medved]

Re: Euro-Landia

The McCulley speech he cites also states clearly something that has been rattling around in my head incoherently for some time: banks are inherently socialist enterprises for their very existence rests on the premise that there is an entity that, at times of duress, can backstop the enterprise

I still don't understand, why this simple fact takes so much time and effort to accept. Fine, FWIW, you arrived at it in your own way. What I still cannot understand is why people view Milton Friedman and his theories as "conservative" and "anti-socialist"? Anyone who supports the criminally insane fractional reserve banking with whatever "monetary policy" they concoct is a socialist. Any "monetary policy" by a CB is, after all , a permanent bailout. And of course, it is never enough, so we need "emergency bailouts" from time to time. This is a good example of a traditional problem of the unregulated free market exacerbated by overregulation.

[c1ue]

Re: Euro-Landia

I still don't understand, why this simple fact takes so much time and effort to accept. Fine, FWIW, you arrived at it in your own way. What I still cannot understand is why people view Milton Friedman and his theories as "conservative" and "anti-socialist"? Anyone who supports the criminally insane fractional reserve banking with whatever "monetary policy" they concoct is a socialist. Any "monetary policy" by a CB is, after all , a permanent bailout. And of course, it is never enough, so we need "emergency bailouts" from time to time. This is a good example of a traditional problem of the unregulated free market exacerbated by overregulation.

I can understand your distaste for socialism, but your linking of fractional reserve banking with socialism is very tenuous.

Fractional reserve banking existed long before central banks, and even before federalist governments.

Failed banks have not always been bailed out by governments - even in the United States in the Federal Reserve era, this has been true.

Study for a bit the history of banks in the United States and their roles in the many panics between the Civil War and the onset of the Federal Reserve.

[medved]

Re: Euro-Landia

I can understand your distaste for socialism, but your linking of fractional reserve banking with socialism is very tenuous.

Fractional reserve banking existed long before central banks, and even before federalist governments.

Failed banks have not always been bailed out by governments - even in the United States in the Federal Reserve era, this has been true.

Study for a bit the history of banks in the United States and their roles in the many panics between the Civil War and the onset of the Federal Reserve.

cue, you just continue ignoring what we already discussed at length in other threads. I don't link fractional reserve banking with socialism, I link central banking (and therefore "monetary policy") with socialism. Banks (and whoever preceded them) always engaged in fractional reserve banking. Before the CBs it was some barely legal but widely accepted practice. After CBs it became The Law (rather than enforcement of the formally existing gold standard). This is where socialism comes in. And once it comes in it goes further, and there is no end to it. Dogoodniks never rest.

[oddlots]

Re: Euro-Landia

I still don't understand, why this simple fact takes so much time and effort to accept. Fine, FWIW, you arrived at it in your own way. What I still cannot understand is why people view Milton Friedman and his theories as "conservative" and "anti-socialist"? Anyone who supports the criminally insane fractional reserve banking with whatever "monetary policy" they concoct is a socialist. Any "monetary policy" by a CB is, after all , a permanent bailout. And of course, it is never enough, so we need "emergency bailouts" from time to time. This is a good example of a traditional problem of the unregulated free market exacerbated by overregulation.

Here's my question: how would credit work in a world without fractional reserve banking? Pardon my ignorance but aren't fractional reserves the foundation of credit? Or do you see this as the central fallacy from which all else follows?

Or put another way, is McCulley's tale about the social good at the heart of both banking and central banking simply a trojan horse to confuse the issue and make it appear that fractional reserve banking and credit are inseperable? (I don't mean consciously on McCulley's part obviously.)

[ThePythonicCow]

Re: Euro-Landia

... aren't fractional reserves the foundation of credit?

Credit up to some limit can be extended from existing savings. I could lend to you the money I have saved, but not yet spent. No fractional reserves are required in that case.

More substantial amounts of credit represent an exchange of future value not yet present in the system (not someone else's savings yet) for present value.

That future, not yet saved, value has to be entered into the system somehow, in order that it can be lent out. It can be extended against various future incomes (or past liabilities not yet paid.) A nation or other polity can lend against future tax revenue (e.g., U.S. Treasuries.) A bank or other depository institution can lend out some multiple of its present deposits, expecting not to have to payout all those deposits at once (aka fractional reserve lending.) A corporation can issue stock against dividends on its future earnings. A nation or other polity can issue fiat currency in exchange for public works, with only the promise that the currency issued will be accepted later in settlement of tax bills.

This exchange of future for present value can be as debt or equity. If the future obligation requires some specific payback, at risk of default and perhaps loss of borrower's collateral, then it's called debt. If the future obligation is some portion of future earnings (perhaps none, perhaps grand as for early Microsoft investors) then it is equity. Typically, debt involves payment of interest as an incentive to the lender to part with present value in exchange for less certain and delayed future value. Typically equity involves some control (such as stock voting rights) by the extender of present value, that they may insure they will be able to extract those future earnings.

So ... I would not say that fractional reserve lending is inseparable from credit in the general, abstract case. There are other ways, besides fractional reserve lending, to obtain or realize the present value extended in credit.

However in the practical case of the current world monetary system, these are strongly connected, yes.

[c1ue]

Re: Euro-Landia

cue, you just continue ignoring what we already discussed at length in other threads. I don't link fractional reserve banking with socialism, I link central banking (and therefore "monetary policy") with socialism. Banks (and whoever preceded them) always engaged in fractional reserve banking. Before the CBs it was some barely legal but widely accepted practice. After CBs it became The Law (rather than enforcement of the formally existing gold standard).

Hardly - because you refuse to accept that your views are not the same as others.

You clearly stated a relationship between fractional reserve banking and a central bank, and thence to socialism.

I've clearly demonstrated before that both central banks and fractional reserve banking existed long before socialism of any type.

In this latest incarnation, you conflate fractional reserve banking with the present problems. But again this is a simplistic and likely wrong statement.

The creation of money without sufficient assets can be accomplished in myriad ways - from TPC's bond sales securitizing future tax revenues and stock issues for cash, to cash for future crops, from shaving silver coins to oversubscribed letters of merchant credit.

Socialism itself has nothing inherently to do with any of these behaviors.

Secondly your assignation of the 's' word to all present activities is equally curious given that the net effect of government activities today is clearly not to redistribute from the wealthy to the masses - but rather the opposite.

From my point of view - what we are seeing today is far more akin to the feudalism of the Norman era than anything else: in the Norman era, the building castles for security then harassing the populace until it acquiesces to paying protection money has been supplanted by building a FIRE economy and allowing the populace (and nations) to get into debt until most of the PC economy is subservient.

FIRE tactics didn't work in the Norman era because the sovereigns then recognized that ultimately bankers have no armies; the sovereigns today by and large lack the will to do the same.

In turn fractional reserve lending and central banks are merely tools to accomplish the goal much as armored knights on horseback and castellation were features of feudalism, but not the core.

[oddlots]

Re: Euro-Landia

Thanks PC. Generous of you to spell that out. The McCulley piece is an appeal to first principles and I found that head-clearing. Likewise your clarification.

I think there are a couple of threads of thought that I could follow here, either to address a) why I thought the McCulley piece was of value b) Medved's criticism c) your clarification of the difference between savings as declined income leading to investment versus fractional reserve based banking.

The clarifying moment in McCulley's piece to me was the observation that private credit markets will eventually need central banks but can never create central banks. It's a very similar story to Hobbes Leviathan: individual actors will, in the end, create an aggregate situation that defeats all their strivings. There is a need for a Leviathan (read state or judiciary) to impose limits on individual actors such that their actions do not become self-defeating. In this way law proceeds commerce, even if it is historically the follower.

The way McCulley plays out this Hobbesian dynamic is as a choice: if we want the benefits of private credit it can only be had, in the long term, with a regulatory burden. The point of the McCulley piece: we ran astray as soon as we failed to recognise the "specialness" of banking. By treating loans like widgets we failed to recognise that "confidence" is part of the commons. It implies regulation just as the law implies judgement and punishment.

You can't get more statist than Hobbes but I think it's worth taking it to the extreme in order to rescue first principles from being seized by partial and incoherent analysis. (I'm hoping. Let's see.)

That's too abstract. Here's why I think it's relevant. We seem caught in a vice that all our thinking seems to tighten. (I don't count myself as apart from that. I'm as confused as anyone.)

On the one hand you have Hendry, Roubini and Hudson (to name a few) arguing that the debt-crisis must inevitably lead to haircuts for debt holders and restructuring. Honoring the debt above all will only make the creditors less able to pay.

On the other hand you have Stiglitz, Sachs etc. arguing that it's all hysteria created by interested parties and that if everyone listened to their Hour with Big Brother broadcasts and bought into what their governments were telling them we'd all be better off and Greece would be able to finance its deficit easily and the whole problem would eventually go away.

Given the choice between these worldviews I'd definitely "bet" (as Hendry put it) with the former, but not because he represents the "free market" approach but that he's saying that the free market requires a bailiff (government) that imposes discipline across the creditor/debtor divide and his bet is that eventually such a mandate will be forthcoming because there's no alternative.

I don't know how that addresses my perennial disagreement with Medved or the points you raised... but it's all I can come up with tonight. ZZZ But again, thanks for your efforts.