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Straight Talk On The European Financial Mess

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The European sovereign debt crisis has generated an enormous amount of nonsensical coverage by the news media.  Most of this coverage appears targeted at American investors, who are regularly assured that a Grand Solution to all of Europe’s financial problems is “just around the corner” thanks to the heroic work of European finance ministers.

Fortunately, a number of commentators have raised some significant objections about all of the misleading “spin” on this subject.  Some pointed criticism has come from Michael Shedlock (a/k/a Mish) who recently posted this complaint:

I am tired of nonsensical headlines that have a zero percent chance of happening.

In a subsequent piece, Mish targeted a report from Bloomberg News which bore what he described as a misleading headline:  “EU Sees Progress on Banks”.  Not surprisingly, clicking on the Bloomberg link will reveal that the story now has a different headline.

For those in search of an easy-to-read explanation of the European financial situation, I recommend an essay by Robert Kuttner, appearing at the Huffington Post.  Here are a few highlights:

The deepening European financial crisis is the direct result of the failure of Western leaders to fix the banking system during the first crisis that began in 2007.  Barring a miracle of statesmanship, we are in for Financial Crisis II, and it will look more like a depression than a recession.

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Beginning in 2008, the collapse of Bear Stearns revealed the extent of pyramid schemes and interlocking risks that had come to characterize the global banking system.  But Western leaders have stuck to the same pro-Wall-Street strategy:  throw money at the problem, disguise the true extent of the vulnerability, provide flimsy reassurances to money markets, and don’t require any fundamental changes in the business models of the world’s banks to bring greater simplicity, transparency or insulation from contagion.

As a consequence, we face a repeat of 2008.  Precisely the same kinds of off-balance sheet pyramids of debts and interlocking risks that caused Bear Stearns, then AIG, Lehman Brothers and Merrill Lynch to blow up are still in place.

Following Tim Geithner’s playbook, the European authorities conducted “stress tests” and reported in June that the shortfall in the capital of Europe’s banks was only about $100 billion.  But nobody believes that rosy scenario.

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But to solely blame Europe and its institutions is to excuse the source of the storms.  That is the political power of the banks to block fundamental reform.

The financial system has mutated into a doomsday machine where banks make their money by originating securities and sticking someone else with the risk.  None of the reforms, beginning with Dodd-Frank and its European counterparts, has changed that fundamental business model.

As usual, the best analysis of the European financial situation comes from economist John Hussman of the Hussman Funds.  Dr. Hussman’s essay explores several dimensions of the European crisis in addition to noting some of the ongoing “shenanigans” employed by American financial institutions.  Here are a few of my favorite passages from Hussman’s latest Weekly Market Comment:

Incomprehensibly large bailout figures now get tossed around unexamined in the wake of the 2008-2009 crisis (blessed, of course, by Wall Street), while funding toward NIH, NSF and other essential purposes has been increasingly squeezed.  At the urging of Treasury Secretary Timothy Geithner, Europe has been encouraged to follow the “big bazooka” approach to the banking system.  That global fiscal policy is forced into austere spending cuts for research, education, and social services as a result of financial recklessness, but we’ve become conditioned not to blink, much less wince, at gargantuan bailout figures to defend the bloated financial institutions that made bad investments at 20- 30- and 40-to-1 leverage, is Timothy Geithner’s triumph and humanity’s collective loss.

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A clean solution to the European debt problem does not exist. The road ahead will likely be tortuous.

The way that Europe can be expected to deal with this is as follows.  First, European banks will not have their losses limited to the optimistic but unrealistic 21% haircut that they were hoping to sustain.  In order to avoid the European Financial Stability Fund from being swallowed whole by a Greek default, leaving next-to-nothing to prevent broader contagion, the probable Greek default will be around 50%-60%.  Note that Greek obligations of all maturities, including 1-year notes, are trading at prices about 40 or below, so a 50% haircut would actually be an upgrade.  Given the likely time needed to sustainably narrow Greek deficits, a default of that size is also the only way that another later crisis would be prevented (at least for a decade, and hopefully much longer).

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Of course, Europe wouldn’t need to blow all of these public resources or impose depression on Greek citizens if bank stockholders and bondholders were required to absorb the losses that result from the mind-boggling leverage taken by European banks.  It’s that leverage (born of inadequate capital requirements and regulation), not simply bad investments or even Greek default per se, that is at the core of the crisis.

Given the fact that the European crisis appears to be reaching an important crossroads, the Occupy Wall Street protest seems well-timed.  The need for significant financial reform is frequently highlighted in most commentaries concerning the European situation.  Whether our venal politicians will seriously address this situation remains to be seen.  I’m not holding my breath.


 

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Dubious Reassurances

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There appears to be an increasing number of commentaries presented in the mainstream media lately, assuring us that “everything is just fine” or – beyond that – “things are getting better” because the Great Recession is “over”.  Anyone who feels inclined to believe those comforting commentaries should take a look at the Financial Armageddon blog and peruse some truly grim reports about how bad things really are.

On a daily basis, we are being told not to worry about Europe’s sovereign debt crisis because of the heroic efforts to keep it under control.  On the other hand, I was more impressed by the newest Weekly Market Comment by economist John Hussman of the Hussman Funds.  Be sure to read the entire essay.  Here are some of Dr. Hussman’s key points:

From my perspective, Wall Street’s “relief” about the economy, and its willingness to set aside recession concerns, is a mistake born of confusion between leading indicators and lagging ones.  Leading evidence is not only clear, but on a statistical basis is essentially certain that the U.S. economy, and indeed, the global economy, faces an oncoming recession.  As Lakshman Achuthan notes on the basis of ECRI’s own (and historically reliable) set of indicators, “We’ve entered a vicious cycle, and it’s too late: a recession can’t be averted.”  Likewise, lagging evidence is largely clear that the economy was not yet in a recession as of, say, August or September. The error that investors are inviting here is to treat lagging indicators as if they are leading ones.

The simple fact is that the measures that we use to identify recession risk tend to operate with a lead of a few months.  Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness.  As a result, there is sometimes a “denial” phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007 (see Expecting A Recession ), the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high.

At present, the S&P 500 is again just 10% below the high it set before the recent market downturn began. In my view, the likelihood is very thin that the economy will avoid a recession, that Greece will avoid default, or that Europe will deal seamlessly with the financial strains of a banking system that is more than twice as leveraged as the U.S. banking system was before the 2008-2009 crisis.

*   *   *

A few weeks ago, I noted that Greece was likely to be promised a small amount of relief funding, essentially to buy Europe more time to prepare its banking system for a Greek default, and observed “While it’s possible that the equity markets will mount a relief rally in the event of new funding to Greece, it will be important to recognize that handing out a bit more relief would be preparatory to a default, and that would probably be reflected in a failure of Greek yields to retreat significantly on that news.”

As of Friday, the yield on 1-year Greek debt has soared to 169%. Greece will default. Europe is buying time to reduce the fallout.

As of this writing, the yield on 1-year Greek debt is now 189.82%.  How could it be possible to pay almost 200% interest on a one-year loan?

Despite all of the “good news” about America’s zombie megabanks, which were bailed out during the financial crisis (and for a while afterward) Yves Smith of Naked Capitalism has been keeping an ongoing “Bank of America Deathwatch”.  The story has gone from grim to downright creepy:

If you have any doubt that Bank of America is in trouble, this development should settle it.  I’m late to this important story broken this morning by Bob Ivry of Bloomberg, but both Bill Black (who I interviewed just now) and I see this as a desperate (or at the very best, remarkably inept) move by Bank of America’s management.

The short form via Bloomberg:

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation…

Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC.  About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.

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This move reflects either criminal incompetence or abject corruption by the Fed.  Even though I’ve expressed my doubts as to whether Dodd Frank resolutions will work, dumping derivatives into depositaries pretty much guarantees a Dodd Frank resolution will fail.  Remember the effect of the 2005 bankruptcy law revisions:  derivatives counterparties are first in line, they get to grab assets first and leave everyone else to scramble for crumbs.  So this move amounts to a direct transfer from derivatives counterparties of Merrill to the taxpayer, via the FDIC, which would have to make depositors whole after derivatives counterparties grabbed collateral.  It’s well nigh impossible to have an orderly wind down in this scenario.  You have a derivatives counterparty land grab and an abrupt insolvency.  Lehman failed over a weekend after JP Morgan grabbed collateral.

But it’s even worse than that.  During the savings & loan crisis, the FDIC did not have enough in deposit insurance receipts to pay for the Resolution Trust Corporation wind-down vehicle.  It had to get more funding from Congress.  This move paves the way for another TARP-style shakedown of taxpayers, this time to save depositors.  No Congressman would dare vote against that.  This move is Machiavellian, and just plain evil.

It is the aggregate outrage caused by the rampant malefaction throughout American finance, which has motivated the protesters involved in the Occupy Wall Street movement.  Those demonstrators have found it difficult to articulate their demands because any comprehensive list of grievances they could assemble would be unwieldy.  Most important among their complaints is the notion that the failure to enforce prohibitions against financial wrongdoing will prevent restoration of a healthy economy.  The best example of this is the fact that our government continues to allow financial institutions to remain “too big to fail” – since their potential failure would be remedied by a taxpayer-funded bailout.

Hedge fund manager Barry Ritholtz articulated those objections quite well, in a recent piece supporting the State Attorneys General who are resisting the efforts by the Justice Department to coerce settlement of the States’ “fraudclosure” cases against Bank of America and others – on very generous terms:

The Rule of Law is yet another bedrock foundation of this nation.  It seems to get ignored when the criminals involved received billions in bipartisan bailout monies.

The line of bullshit being used on State AGs is that we risk an economic crisis if we prosecute these folks.

The people who claim that fail to realize that the opposite is true – the protest at Occupy Wall Street, the negative sentiment, the general economic angst – traces itself to the belief that there is no justice, that senior bankers have gotten away with economic murder, and that we have a two-tiered criminal system, one for the rich and one for the poor.

Today’s NYT notes the gloom that has descended over consumers, and they suggest it may be home prices. I think they are wrong – in my experience, the sort of generalized rage and frustration comes about when people realize the institutions they have trusted have betrayed them.  Humans deal with financial losses in a very specific way – and it’s not fury.  This is about a fundamental breakdown of the role of government, courts, and leadership in the nation.  And it all traces back to the bailouts of reckless bankers, and the refusal to hold them in any way accountable.

There will not be a fundamental economic recovery until that is recognized.

In the mean time, the quality of life for the American middle class continues to deteriorate.  We need to do more than simply hope that the misery will “trickle” upward.


 

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