June 29, 2012

Quelle Surprise! Fed Economists Side Firmly With Bank Criminality Over the Rule of Law

Although Dave Dayen and Abigail Field have already given a well-deserved shellacking to a remarkable piece of bank PR masquerading as “insight” at Reuters, “Evidence suggests anti-foreclosure laws may backfire,” it merits longer-form treatment as a crude macedoine of anti-homeowner messaging.

The way Big Lies get sold is by dint of relentless repetition. In the wake of the heinous mortgage settlement, foreclosure fatigue has set in. A lot of policy people want to move on because the topic has no upside for them. Nothing got fixed, the negotiation process took a lot of political capital (meaning, as we pointed out, it forestalls any large national initiatives in the near-to-medium term), and Good Dems don’t want to dwell on a crass Obama sellout (not that that should be a surprise by now). But the fact that this issue, which ought to be front burner given its importance both to individuals and the economy, is being relegated to background status creates the perfect setting for hammering away at bank-friendly memes. When people are less engaged, they read stories in a cursory fashion, or just glance at the headline, and don’t bother to think whether the storyline makes sense or the claims are substantiated.

Just look at the headline: “Evidence suggests anti-foreclosure laws may backfire.” First, it says there are such things as “anti-foreclosure laws.” In fact, the laws under discussion are more accurately called “Foreclose legally, damnit” laws. Servicers and their foreclosure mill arms and legs have so flagrantly violated long-standing real estate laws in how they execute foreclosures that some states have decided to up the ante in terms of penalties to get the miscreants to cut it out. As Dayen points out:

No state law in this country disallows legal foreclosures. If the banks cannot substantiate ownership of the property, why is the finger pointed at the state laws that force that substantiation, and not the banks themselves? Nobody told them to lose ownership of mortgages, prompting them to falsify documents in an attempt to foreclose.

And how does a requirement to obey the law “backfire”? The claim is that it prevents foreclosures, and that in turn is keeping the market from “clearing.” Never mind that we found out how well Andrew Mellon’s “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate” prescription turned out. Notice the failure to consider alternatives besides foreclosure. The story gives one example of a borrower who got a mod in Nevada, which it suggests was due the passage of a law criminalizing improper foreclosures. But this example just hangs there, while immediately preceding it is a broker complaining how they don’t have enough properties to keep bottom fishers happy, and a defense lawyer saying he sees prospective clients trying to game the law. Each of these anecdotes has colorful quotes and align with the overall narrative.

Funny how there is nary a mention of the reasons banks have for wanting to draw out foreclosures: more servicing and late fees, deferral of recognition of losses on second liens. Nor is there any mention of how, in Las Vegas, I have been told by informed insiders that there are entire blocks in affluent areas where pretty much no one has paid their mortgage in over two years as of late 2010 with nary a foreclosure notice sent. Read that date: a lot of big ticket properties were being kept in limbo before the new law was passed. Similarly, Keith Jurow wrote in February:

In November 2011, Minyanville.com posted my 30-page New York City Housing Market Report. The report included never-seen-before charts, graphs and data that revealed what has been going on there. The banks have not been foreclosing for the past three years. This started well before the robo-signing mess. On February 7, 2012 there were a total of only 242 repossessed properties on the active MLS in Queens according to foreclosure.com. This is a borough with a population of 2.2 million.

Because of this, the number of seriously delinquent properties throughout NYC has been soaring. Based on individual charts for each borough from the NY Federal Reserve Bank which I included in my report, there were roughly 80,000 properties where the mortgage had not been paid in more than 90 days as of June 2011.

He found similar patterns in Suffolk County and Connecticut.

But what does the Reuters author Tim Reid want you to believe?

At the request of Reuters, RealtyTrac compared three states where borrower protection laws had prolonged foreclosures – Florida, New Jersey and New York – with three with fewer protections and where foreclosure completion times were shorter – Arizona, California and Virginia.

In the three states with the shorter delays, the average sale price for foreclosed properties has been trending higher, suggesting a recovery that has underlying strength.

Funny, Jurow debunked that in a May piece:

We hear that California markets are showing signs of revival and that prices are rising in certain markets. Let’s see. Here are the latest figures from trulia.com.

In Los Angeles, trulia reports that the average price-per square foot for homes sold in February through April was down 9.3 percent year-over-year for 3-bedroom homes and down 8.7 percent for 2-bedroom homes.

In San Francisco, allegedly one of the hottest areas in the nation, the 3-bedroom average price-per-square-foot was down 4.7 percent year-over-year and 1-bedroom price-per-square foot was down 8.1 percent.

Price-per-square-foot statistics are the best way to compare prices because it does not matter how large the house is. Median prices are skewed by square footage as well as by the percentage of distressed properties sold.

And that recovery in Arizona? Banks are holding properties off the market:

Take a good look at this revealing chart for Phoenix from foreclosureradar.com.

Bank repossessions in Maricopa County plunged from 3,159 in April 2011 to a mere 767 a year later. Clearly, the banks are gambling that this will help to stem the decline of home prices….

During the height of the credit crisis in early 2009, 2/3 of all homes sold in Maricopa County were repossessed properties. That percentage was down to 40 percent a year ago. Take a look at this chart from Phoenix broker Leif Swanson.

In April, only 17 percent of all homes sold in the Phoenix metro were REOs on the active MLS. Banks are hoping that this cutback of foreclosed properties for sale will steady home prices.

What about that Fed study?

A study by three Federal Reserve economists compared the foreclosure processes and outcomes for borrowers in the 20 “judicial” foreclosure states – where banks must seek court approval before they can foreclose – and the 30 “nonjudicial” ones, where such court oversight is not required…

Their conclusion? States with judicial protection over the foreclosure process or the arrears system “indiscriminately” slowed down the foreclosure process, but with no measurable benefits.

In fact, delinquent borrowers were more likely to make good on their arrears in nonjudicial states than in states where they had more time to do so. These borrowers were also just as likely to be repossessed in a judicial state than in a nonjudicial one – it just took longer.

Notice how the message is pounded in again and again: longer foreclosures are bad because they interfere with market operation. There are no offsetting considerations allowed, such as the damage to the integrity of land records in this country. (And how was this study conducted, anyhow? Did the authors adjust at all for state unemployment levels, or wage trends?)

By contrast, look at how Wall Street Examiner’s Lee Adler characterizes the situation:

Meanwhile, the mortgage servicing bankster mafiosi have figured out that by holding rather than dumping massive numbers of foreclosed properties, and even by slowing down the foreclosure process while allowing a few cramdowns in the form of short sales, the market has begun to rebound on its own. The bankster mafia know that placing massive numbers of properties on the market at once would crash the market and destroy the value of their portfolios, and essentially crash the financial system. So they have made a wise strategic decision not to self immolate.

Indeed, the Fed authors provide information that undermines their thesis:

Lauren Lambie-Hanson, one of the Federal Reserve economists, said delays in foreclosures had scared off potential buyers because prolonging the process raised doubts about how clean the title to a property was.

The “scared off” is meant to suggest that the buyers who were deterred were irrational. Hogwash. Title insurance companies have backed away from guaranteeing properties sold out of foreclosure. The truth, which the Fed economists refuse to admit, is the buyers who are concerned about title problems are clear-eyed about risk, while the economists think it’s swell to stick buyers with bum properties.

And get a load of this:

Foreclosure protection laws also probably led to an increased incidence of blight, the economists found.

Read that twice. You can’t make that sort of crap up. This claim alone makes it a candidate for the Frederic Mishkin Iceland Prize for Intellectual Integrity. (If you want to see on a textual level what a shameless piece of propaganda this article is, read Abigail Field’s shredding. She goes line by line, or at least until it becomes too painful to read it that closely.) No, it isn’t the failure of the party responsible for managing a foreclosed property, the servicer, to secure and maintain the homes, that leads to blight. No, it’s the government, erm, the law.

And that is perhaps the most remarkable bit, the failure to consider that gutting the protections to the parties to a contract undermines commerce. Borrowers in judicial foreclosure states paid higher interest rates due to the greater difficulty of foreclosure. So now they are to be denied what they paid for because the banks recklessly disregarded the procedures they set up and committed to perform? What kind of incentive system is it when we reward massive institutional failure with a bank-favoring settlement and supportive messaging from central bank economists? As Dayen stated:

So when these officials argue against laws like those in Nevada, which merely criminalize a criminal practice, or California, which provides due process for people having their homes taken from them, they’re arguing in favor of what amounts to a dissolution of justice.

June 28, 2012

Where Does Money Come From? The Giant Federal Reserve Scam That Most Americans Do Not Understand

How is money created? If you ask average people on the street this question, most of them have absolutely no idea. This is rather odd, because we all use money constantly. You would think that it would only be natural for all of us to know where it comes from. So where does money come from? A lot of people assume that the federal government creates our money, but that is not the case. If the federal government could just print and spend more money whenever it wanted to, our national debt would be zero. But instead, our national debt is now nearly 16 trillion dollars. So why does our government (or any sovereign government for that matter) have to borrow money from anybody? That is a very good question. The truth is that in theory the U.S. government does not have to borrow a single penny from anyone. But under the Federal Reserve system, the U.S. government has purposely allowed itself to be subjugated to a financial system in which it will be constantly borrowing larger and larger amounts of money. In fact, this is how it works in the vast majority of the countries on the planet at this point. As you will see, this kind of system is not sustainable and the structural problems caused by such a system are at the very heart of our debt problems today.

So where does money come from? In the United States, it comes from the Federal Reserve.

When the U.S. government decides that it wants to spend another billion dollars that it does not have, it does not print up a billion dollars.

Rather, the U.S. government creates a bunch of U.S. Treasury bonds (debt) and takes them over to the Federal Reserve.

The Federal Reserve creates a billion dollars out of thin air and exchanges them for the U.S. Treasury bonds.

So why does the U.S. government go to all this trouble? Why doesn't the U.S. government create the money itself?

Those are very good questions.

One of the primary reasons why our system is structured this way is so that wealthy people can get even wealthier by lending money to the U.S. government and other national governments.

For example, last year the U.S. government spent more than 454 billion dollars just on interest on the national debt.

Over the centuries, the ultra-wealthy have found lending to national governments to be a very, very profitable enterprise.

The U.S. Treasury bonds that the Federal Reserve receives in exchange for the money it has created out of nothing are auctioned off through the Federal Reserve system.

But wait.

There is a problem.

Because the U.S. government must pay interest on the Treasury bonds, the amount of debt that has been created by this transaction is greater than the amount of money that has been created.

So where will the U.S. government get the money to pay that debt?

Well, the theory is that we can get money to circulate through the economy really, really fast and tax it at a high enough rate that the government will be able to collect enough taxes to pay the debt.

But that never actually happens, does it?

And the creators of the Federal Reserve understood this as well. They understood that the U.S. government would not have enough money to both run the government and service the national debt. They knew that the U.S. government would have to keep borrowing even more money in an attempt to keep up with the game.

That is why I call the Federal Reserve a perpetual debt machine. The Federal Reserve was created to trap the U.S. government in an endlessly expanding debt spiral from which there is no escape.

And the Federal Reserve is doing a great job at what it was designed to do. Today, the U.S. national debt is more than 5000 times larger than it was when the Federal Reserve was first created.

Another way that money comes into existence in our economy is through the process of fractional reserve banking.

I originally pulled the following simplified explanation of fractional reserve banking off of the website of the Federal Reserve Bank of New York, but it has been pulled down since then. But I still think it is helpful in understanding the basics of how fractional reserve banking works....

"If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000)."
When you put your money into the bank, it does not say there. The bank only keeps a relatively small amount of money sitting around to satisfy the withdrawal demands of account holders. If all of us went down to the banks right now and demanded our money, that would create a major problem.

If I put 100 dollars into the bank and the bank lends out 90 of those dollars to you, now it looks like there are 190 dollars floating around. I have "100 dollars" in my bank account and you have "90 dollars" that you just borrowed.

The new debt that you have taken on (90 dollars) has "created" more money. But of course you are going to end up paying back more than 90 dollars to the bank, so more debt has been created than the amount of money that has been created.

And that is one of the big problems with our financial system. It is designed so that the amount of debt and the amount of money are supposed to be perpetually expanding, and the amount of debt created is always greater than the amount of money that is created.

So is it any wonder that our society is swamped with nearly 55 trillion dollars of total debt at this point?

A debt-based financial system is unsustainable by nature because it will always create debt bubbles that will inevitably burst.

Are you starting to see why so many Americans are saying that we need to abolish the Federal Reserve system?

Our founding fathers never intended for our financial system to work this way.

According to Article I, Section 8 of the U.S. Constitution, the U.S. Congress is supposed to have the authority to "coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures".

So why has this authority been given to a private institution that is dominated by the big Wall Street banks and that has actually argued in court that it is "not an agency" of the federal government?

Thomas Jefferson once said that if he could add just one more amendment to the U.S. Constitution it would be a ban on all government borrowing....

I wish it were possible to obtain a single amendment to our Constitution. I would be willing to depend on that alone for the reduction of the administration of our government to the genuine principles of its Constitution; I mean an additional article, taking from the federal government the power of borrowing.
But instead, we have become enslaved to a system where government borrowing actually creates our money.

The borrower is the servant of the lender, and we have allowed our government to enslave us to the tune of nearly 16 trillion dollars.

There are alternatives to this system. Things do not have to work this way.

Unfortunately, the vast majority of our politicians consider the Federal Reserve to be good for America and steadfastly refuse to do anything to change the status quo.

So if you are waiting for "solutions" to these problems on the national level you are going to be waiting for a very long time.

The debt problems that the United States and Europe are experiencing did not come into existence by accident. They are the result of fundamental structural problems with the financial system.

A debt-based financial system is always going to fail in the long run. Unfortunately, most Americans still do not understand this and so we will all get to suffer the consequences.

June 27, 2012

JP Morgan Managers Being Told Trade Loss is $9 Billion

Banking competitors are trying to lure away top talent at JP Morgan by highlighting the recent prop trading losses are likely to affect bonues and Jamie Dimon isn’t being honest about how bad the loss will be. On July 13th the banking giant will announce 2nd quarter earnings and a real-time number is expected on how many billions net income gets wacked with because the London whale trade has been wound down. Last week Mark DeCambre at the New York Post wrote his JPM sources expect the loss to be between $4-6 billion – JPM’s estimate in May was only $2bn. But I heard this week JPM managing directors are being told it’s more. To the tune of $9 billion – Ouch!

That could be two quarters worth of net income and since JPM staffers are paid in part on how the whole company earns that rumor about a yearend lack luster bonus is looking more like a reality. Not good if you are killing your quota this year and working in a group that has nothing to do with the wrong way derivative trade. So a few seasoned wealth managers I spoke with are weighing competitor offers and seriously thinking of jumping ship – even if that means they give up their not yet vest $JPM stock.

Of course JPM can use accounting tricks to make the trading loss look better on final quarterly income statements. I highlighted last month how litigation reserves can be added or taken away to move the net income number around when they need it. But considering the recent news heat they’ve gotten on how low the legal reserves already are for the size of the RMBS putback problem…they’d be pretty damn arrogant to try to play with that number in the face of their regulators. Of course if their other trading departments make good on another trading bet, like being short silver, that could help offset losses. But loosing $9 billion on a single trade strategy gone so very wrong will put a lot of pressure on the White House’s favorite banker and make the Senate look even more foolish for their fluffy congressional hearings on the failed trade. If a $9bn gross trading loss becomes reality then the 3 notch downgrade by Moody’s could slid even further which increases their cost of borrowing and well – that sucks for anyone contingent on a JPM paycheck.

June 26, 2012

Forty Million Houses in the US That No One Needs?

40 million houses too many ... one explanation for falling prices ... America has too many big houses – 40 million, to be exact – because consumers are shifting preferences to condos, apartments and small homes, experts told the New Partners for Smart Growth Thursday, holding its 11th annual conference in San Diego through Sunday. Relying on developers' surveys, Chris Nelson, who heads the Metropolitan Research Center at the University of Utah, said 43 percent of Americans prefer traditional big, suburban homes but the rest don't. "That means we are out of balance in terms of where the market is right now, let alone trending toward the future," he said. He estimated that this demand suggests a need for 10 million more attached homes and 30 million more small homes on 4,000-square-foot lots or less. By contrast, demand for large-lot homes is 40 million less than currently available. "Is it any wonder that suburban homes are plummeting in price, because there is far less demand of those homes than in the past," he said. – UT San Diego

Dominant Social Theme: Another day, another market failure.

Free-Market Analysis: This article originally appeared in early February but is still being picked up around the web – and it certainly provides us with a shocking observation.

In fact, it is worth commenting on here because it is a kind of dominant social theme: Market failure provides us with these kinds of distortions. They are worth mentioning in passing but nothing can be done about them because that's the way the world works, or maybe not ...

In fact, if you multiply 40 million houses by about US$ 250,000 (the approximate average of US home prices in 2011, per US Census figures) you end up with a fairly frightening number – in the area of multiple trillions. About US$ 10 trillion, to be exact.

But McMansions are not ordinary houses. They're supersized with 3,000 to 4,000 feet of living space. And during the boom years of the mid-2000s many sold for upwards of US$ 500,000, especially on the East and West Coast. Add up the figures and that's a whopping US$ 20 trillion not US$ 10 trillion (bad enough).

That's right. Wipe US$ 20 trillion or so off the gross national product, which is somewhere in the area of US$ 12 trillion per year and you're looking at a serious market impact. Twenty trillion is no one's "small change." Here's some more from the article:

Shyam Kannan, director of the economic development practice at the Robert Charles Lesser & Co. consulting firm, said his company made its money in recent decades in advising builders of suburban master-planned communities. But that emphasis is shifting with consumer patterns.

"Many master-plan developers realize golf courses are dead and the town center is in, and they're working as hard as they can to deliver it," he said. "Unfortunately, they're bumping up against entitlement problems on the public side more often than not... We need to push public policy to keep up with the builders."

Joe Molinaro, who heads the smart growth program at the National Association of Realtors, shared the results of 2004 and 2011 consumer surveys to explain why preferences are changing.

Factors include a desire for shorter commutes, walkable neighborhoods, economic considerations and, in the case of Generations X and Y, born between 1965 and 2000, they want the non-car mobility they did not get as youngsters.

"Having the freedom not to be tied down to a vehicle all the time is a big plus to that generation," Molinaro said.

"Smart growth," loosely defined as nonsprawling developments that minimize distances, maximize public infrastructure investment returns and promote environmental sustainability, has been a buzzword in planning circles since the 1990s.

You see how matter-of-factly this disaster is being treated? We are simply supposed to accept that the market itself misjudged US$ 10-20 trillion worth of houses.

Of course, those who subscribe to Austrian economics have a different perspective. The theory of the business cycle market distortion starts with the overprinting of money and ends with greatly distorted economies.

But now we have a number – a helluva large number. It certainly puts things in perspective. When we speak of monopoly fiat distorting the economy it sometimes seems removed from reality. But US$ 10 - $ 20 trillion provides us with a fairly succinct viewpoint. An economy that has to write off this kind of figure is an economy that is not going to see "recovery" for a while.

Now, we should also point out that this number comes from a "smart growth" conference that attracts public planning types that would be biased against McMansions for a number of reasons, starting with the idea of "ostentatious consumerism."

Sometimes it seems public planning types won't be satisfied until everybody is sitting in cardboard boxes, shivering in the dark. Still, we've read enough articles about this sort of housing to know a goodly percentage probably was either marked down or destroyed.

At the top of the boom, houses were built too far from cities and the combination of taxes and costly gas made such developments unrealistic. Developers were blinded by dollar signs ... the kind of easy money that was pouring off Fed printing presses and circulating with considerable velocity.

But all that is changed now. Money is not circulating and houses in the US (and Europe, too) are not selling quickly or at top price. Many are still not selling at any price.

You would think the money men in charge of the expansion of currency would have learned their lesson. Not at all. Ben Bernanke has been printing money day and night ... and weekends, too. Congress is obviously on board as well, as the Fed can't print without congressional approval.

The same over-printing of money that caused this incredible waste is still ongoing. In fact, it is seen by the powers-that-be as the solution to the current economic crisis.

Conclusion: It is NOT the solution. It's the problem.

June 25, 2012

Battle Royale Coming Over Fed Currency Swap Lines?

John Dizard of the Financial Times gives an early warning of a potential flashpoint later in the year: that of the Fed’s currency swap lines. In theory, this should be uncontroversial. The Fed is providing dollars to foreign central banks. Those central banks agree to return the currency at the end of the term of the swap. The foreign central bank takes both the foreign exchange risk and the credit risk of lending to banks in its purview.

The reason these foreign banks occasionally need dollars is, mirabile dictu, they make loans in the US, either directly, or as the Landesbanken did in the runup to the crisis, by buying dollar denominated bonds (to their misfortune, subprime mortgage-backed securities), to fund dollar-based transactions in their trading books, and meet swap commitments. And the so-called dollar funding gap has risen. It was about $1 trillion at the time of Lehman’s collapse. Banks skinnied that down to $500 billion near the end of 2010. Even so, some banks faced dollar funding pressure then (which is not as troubling as it might seem; liquidity is scarce at year end since a lot of institutions seek to close their books in mid December). Morgan Stanley pegs the current dollar funding gap at $2 trillion.

The sticking point is that the current Fed swap line program expires February 1, 2013, deliberately after year end in case the Fed needs to facilitate the ECB providing turn-of-the-year dollar liquidity. It would seem to make sense to get a new commitment in place, since the bigger-than-ever funding gap means the desirability of having the swap lines in place is not going away any time soon. But the ECB seems wedded to its “let’s not do anything till we absolutely have to” habits. Dizard sees the potential for the swap lines to become the focus of a huge Congressional food fight, since their renewal and/or use is likely to come up when tempers will already be high over fiscal cliff negotiations. He notes:

So on June 17, Mitt Romney announced on Face the Nation, a national CBS television talk show, that “We’re not going to send cheques to Europe. We are not going to bail out the European banks. We’re going to be poised here to support our economy. Regardless of what is happening in Europe, our banking system is able to weather the storm.”…

However, when even a sophisticated financial sector person such as Mitt Romney finds it useful to take such a shot, we could have a problem come the late fall. I’ve heard from both Democratic senators and senior House Republicans that if there is any large scale use of dollar swap lines at the time of the “fiscal cliff” budget negotiations, the reaction on Capitol Hill would be “volcanic”. As one of them told me last week, “You can expect a lot of demagoguery.”

While Dizard is correct that the currency swap lines are not a great reason for beating up on the Fed, what he is missing is that the central bank is a ripe target. It no longer is a quiet power operating largely in the background; it’s now obvious how much clout it wields via suppressing interest rates and propping up the banks (successfully so far) and the housing market (not so much). It stands firmly behind banks and financial markets, and gives no evidence of being concerned with alleviating the costs banking excesses have inflicted on ordinary citizens. If Bernanke, say, had called a meeting of bank CEOs while Dodd Frank was being drafted, and told them they had better take their lumps, cut pay, and maintain a low profile until the economy recovered, you’d see a lot less anti-Fed sentiment. But the central bank’s insistence on secrecy, its insularity, its lack of accountability, and its knee-jerk allegiance to big financial players have made it a deserving target for public anger. Romney and the pitchfork-bearing Congressmen are simply channeling that sentiment.

So I don’t have any problem with demagoguery and name calling. What I do mind is the wrath of Fed-hostile Congresscritters will probably go to waste. Those who want more accountability from the Fed should use the swap line contretemps as an occasion to revive the Audit the Fed effort, which was cut back late in the game, and to legislate more representation of people who do not have strong ties to the banking industry on regional Fed boards. As the Fed has grown even more powerful, so too does the need for real oversight, and if an opportunity arises sooner rather than later to press for it, we should seize it.

June 22, 2012

“The Eurozone’s Strategy is a Disaster”

Yves here. Mr. Market is in a tizzy today over, per Bloomberg, “concerns over the slowdown of growth”. Cynics might note that journalists have to attribute motives to market moves, when their waxing and waning often defies logic. Nevertheless, we’ve had disappointing reports out of China, a bad Philly Fed manufacturing report, a less than stellar initial jobless claims report, and not so hot housing data this AM, and more and more signs of inability to bail out the sinking Titanic of the Eurozone (a meaningless announcement compounded by continued focus on ongoing German court challenges to more aggressive support of rescues. Even if these cases lose, any uncertainty and delay has the potential to accelerate the ongoing bank run out of periphery countries).

This post from VoxEU is a good short form summary of how the Eurozone got into this fix. Its last para takes an unduly scolding tone that may turn off some readers, and does not reiterate the point made at the top, which is that the ECB needs to step up in a serious way to stem the crisis. Other remedies will take too long to implement and thus cannot change the trajectory under way.

By Charles Wyplosz, Professor of International Economics at the Graduate Institute, Geneva; Director of the International Centre for Money and Banking Studies. Cross posted from VoxEU

The EZ rescue strategy adopted in May 2010 failed to restore debt sustainability, avoid contagion, or reduce moral hazard. This column argues that a volte face is needed. The debt of Greece, Portugal and Italy – and perhaps Ireland, Spain and France as well – must be restructured to restore growth and end the crisis. All EZ nations should pay since their leaders’ decision to violate the Maastricht Treaty’s no-bail out clause is what brought us here.

Chancellor Angela Merkel has sent word that Germany cannot save the euro. She is right.

From the very start of the Eurozone crisis, it was clear that a domino game was under way and that a highly indebted German government should not be seen as the residual saviour. But keeping the euro will be costly and Germany will have to share the burden.

The solution will have to combine debt structuring and ECB lending in last resort to banks and governments. Angela Merkel needs now to lift the German veto.

All Eurozone leaders, including Mrs Merkel, are to blame for today’s predicament.

• The politically expedient decision of May 2010 – to bailout Greece but promise that it would be “unique and exceptional” – was officially sold as necessary to avoid contagion.
• Two years later, it is obvious that this has been a historical but predictable policy mistake (Wyplosz 2010).

The crisis has engulfed three small countries – Greece, Ireland and Portugal – and is now on its way towards Spain and Italy. France might well be next. These six countries’ public debts amount to 200% of German GDP. With its own debt of 80% of GDP, Germany cannot indeed stop the rot.

Moralistic rather than economic reasoning

The public debate in Germany and elsewhere is often moralistic, matching the economists’ concern with moral hazard.

• Countries that have long considered the government budget as a purely theoretical constraint cannot now simply ask for help.
• The same applies to countries that have allowed their banks to fuel a housing price bubble and now socialize the resulting private losses.

There is no case against the view that bad policies must have consequences. In this the moralisers are right.

But the issue is more complicated than meets the eye. We must ask:

• Which countries trampled the Eurozone’s fiscal discipline?
• What should be the consequences? and
• What are the costs for the monetary union as a whole?

Many ‘debt sinners’ in 2007

Right before the financial crisis of 2007-8, few Eurozone countries could claim to have been fiscally disciplined. The figure below shows that Finland, Spain and Ireland could, but not Greece and Italy. Most other Eurozone nations – including Germany – were in the grey zone. Then the wheels of fortune that drive self-fulfilling crises started to spin, leaving us with an impression that strong moral judgments have to be terribly relative.

Figure 1. Public debts in 2007 (% of GDP)

Source: AMECO, European Commission

Banking supervision laxity

As we know, poor bank supervision is what drove Ireland and Spain into the camp of guilty countries. Here again, the story is not over and several countries may soon be found guilty of forbearance.

• Top of the list are France and Germany.
• Had Greece not been rescued then some large French and German banks, already fragilised by the subprime crisis, could well have been ripe for costly bailouts.

The debt reduction scheme applied to Greece effectively provided these banks with an exit strategy, and was delayed long enough for them to dispose of a large part of their initial holdings of Greek public debt. Even so, these same banks remain on the danger list if more defaults are needed, which is in fact the case. The list of truly innocent countries includes a small number of small countries.

The consequences of bad debt and banking policy

As for consequences, the issue is incredibly difficult. Austerity has been the accepted norm for punishment.

Austerity proponents at first sought to characterise austerity as only moderately painful – and this a ‘good pain’ that would provide a useful lesson for future generations.

But the facts have now completely undermined this view.

• The myth of expansionary fiscal contractions, also known as the negative multipliers, has now been proven disastrously wrong.
• Its last proponents point to Latvia as proof that it works, but it unclear where this assessment comes from.

The Latvian public debt is still rising as a percentage of GDP and GDP is now 15% lower than in 2007 before the stabilization plan. True, this is up from a loss of 20% in 2010, but this merely illustrates how positive the multipliers are.

The costs to Latvia have been massive.

• Unemployment jumped to a rate 20% and still is at 16% and emigration has apparently been massive.
• Banks are foreign-owned and the owners decided to stay and absorb the losses.
• The only good news from Latvia is that the economic collapse only lasted three years, largely because wages have been quite flexible in this very small and very open economy, leading Blanchard (2012) to conclude that “the lessons are not easily exportable”.


The Greek experience is one of never-ending economic decline, massive unemployment and intense social hardship. Sure, the Greeks are being taught a lesson, but which one?

• Resistance to economic reforms is as intense now as it was before the crisis but xenophobia and the appeal of populist politicians is rising spectacularly.
• The multiplier debate tends to conceal the political consequences of austerity in the midst of a recession.

As economists, we also need to look slightly beyond our pond.

When these aspects are factored in, the consequences of the strategy adopted in 2010 are simply not justifiable, even on moral grounds. This is so especially as those who are punished most are not those that benefitted most from fiscal indiscipline in the run up to the EZ crisis.

The May 2010 strategy is a disaster: Admit mistakes and move on

The strategy adopted in May 2010 has not just failed to achieve its aims: restore debt sustainability, avoid contagion and reduce moral hazard. It has not produced a solution that is likely to bring the crisis to its end. A 180-degree turn is still needed.

Unfortunately it will be costly.

• A number of countries will never be able to achieve sustainable growth under the weight of their current public debts.
• This is the case of Greece, Portugal and Italy,
• The list may eventually widen to include Ireland, Spain and France.

Their governments will have to restructure their debts, totally in the case of Greece, partially – if done early enough – in the other cases.

• As the banks in these nations fail (because they did not adequately diversify their portfolios), bank bailouts will also have to be financed from outside.

Who will pay?

• Foreign banks will, of course, end up writing down the restructured sovereign debt; they, in turn, may have to be bailed out by their own governments.
• Official creditors too will suffer losses.

This includes the ECB, to the extent that it imposed insufficient haircuts in its various refinancing programs, and the shareholders of the EFSF and the ESM, which also happen to be the shareholders of the ECB.

Waiting only raises the eventual price

The more we wait, the deeper the economic deterioration – more lending to governments and more non-performing loans in banks – and the bigger the eventual costs.

• Importantly, the list of ‘bailer outs’ shrinks as the list of ‘bailed outs’ expands, so the costs of the rescue become concentrated on a decreasing number of healthy countries.
• Waiting too long implies that there is no healthy country left or no Eurozone any more, probably both.

The moral question reconsidered

Why should German and other taxpayers, mostly from the north, pay for the others, mostly from the south? Because their governments are responsible for the disastrous situation we are in.

• The rather well-crafted Maastricht Treaty had a no-bailout clause that was designed to protect all Eurozone taxpayers from fiscal indiscipline in other countries.
• Under Merkel’s leadership, this clause was first violated in May 2010, and then again to bail out Ireland, and again for Portugal and now for Spain.

This was an economic policy ‘crime’. It looked cheap at the time, at least under the assumption that there would be no contagion.

A basic moral principle is that criminals must be held responsible for the consequences of their acts, even if those acts are unintended. Eurozone taxpayers are the victims of their elected leaders. They now face the choice between breaking up the Eurozone and paying up. Paying up still is the cheaper alternative, but not for long.

June 21, 2012

Oil Regulators Wimp Out on Requiring More Transparency

A Wall Street Journal article tonight (hat tip Joe Costello) has the whiff of disinformation about it. It dutifully reports that oil regulators have retreated in a serious way from requiring more disclosure of oil market transaction. The article never offers an explanation for the change in stance and focuses attention on actors who are highly unlikely to be the moving force.

First, on the regulatory retreat:

In an interim report to the G-20, ahead of final recommendations later this year, the International Organization of Securities Commissions, an association of global financial-markets regulators such as the Securities and Exchange Commission, retreated from an earlier proposal to set up a regulatory body to oversee the so-called physical oil market—where oil on tankers and in pipelines is traded between major oil producers and refiners such as Exxon Mobil Corp and Royal Dutch Shell PLC…

Trading in physical oil has been of particular concern to regulators, who worry that it has caused volatility and pushed up oil prices globally. Physical oil prices often act as a benchmark for the larger and more actively traded commodities-futures market, including more than 800 exchange-traded energy contracts in the U.S. alone…

“Even if this situation is not currently being abused, the potential for abuse is obvious,” said Liz Bossley, chief executive of Consilience Energy Advisory Group Ltd., a London-based consultancy.

Keep in mind that manipulation and lack of decent information have long plagued the oil market. OPEC (yes, the powerful OPEC) no longer uses the spot market as the basis for its oil pricing because it was too easily manipulated. Oil supply and demand data are dreadful. Inventory information isn’t as germane as it is in other markets because some critical inventories, like the Strategic Petroleum Reserve, aren’t included, plus (and most important) oil can be inventoried in the ground, by cutting production schedules. So more information in this murky arena would seem to be enormously valuable to policymakers and the public.

But the Wall Street Journal sidesteps the issue of who was really behind this climbdown, and instead focuses on some pretty minor beneficiaries: the information services Platts and Argus. The article brings them up early on, in the third paragraph:

This week’s report was seen as a reprieve for a group of pricing services such as Platts, a unit of McGraw-Hill Cos., MHP -0.32% and Argus Media Inc., which collect and publish prices used by the world’s oil traders. It also demonstrates the difficulty financial regulators have found coming up with ways to extend their reach throughout the murky world of commodities trading.

It isn’t until paragraph 14, when cursory readers have already checked out, that we get a mention of who really wins from the continued lack of transparency:

In an initial report in March, the organization said it was concerned prices could be manipulated if traders submit false prices or volumes. Among a list of proposals, the organization said it was considering establishing an industry regulator as well as requiring mandatory reporting of trades….

Some traders have been accused in the past of abusing the pricing system, but the number of cases has dropped significantly in recent years. In 2000, U.S. refiner Tosco Corp. sued Arcadia Petroleum, a London-based oil-trading firm, accusing it of manipulating oil prices. Arcadia later settled the suit for an undisclosed sum.

In 2007, Marathon Oil Corp. agreed to pay $1 million to settle oil-manipulation charges by the Commodity Futures Trading Commission.

Arcadia and Marathon neither admitted nor denied wrongdoing.

Now these four paragraphs are the sum total of the mentions of possible and actual abuses by traders. By contrast, the information vendors are the focus of a full eleven paragraphs of the article. The mention of fewer cases of pricing abuses being filed might be taken to mean there is less bad behavior, when it might also be a function of weaker oversight.

Readers might think I am making overmuch of this story, but it is precisely this sort of objective-sounding but substantively misleading reporting that lulls the public to sleep on important issues. A more vigilant public is less likely to be conned.

June 20, 2012

Fed Lies Unravel ... Bank Board Gave US$ 4 Trillion in Loans to Its Own Institutions

A report just released by the US Government Accountability Office explains how the Federal Reserve divvied up more than $4 trillion in low-interest loans after the fiscal crisis of 2008, and the news shouldn't be all that surprising. When the Federal Reserve looked towards bailing out some of the biggest banks in the country, more than one dozen of the financial institutions that benefited from the Fed's Hail Mary were members of the central bank's own board, reports the GAO. At least 18 current and former directors of the Fed's regional branches saw to it that their own banks were awarded loans with often next-to-no interest by the country's central bank during the height of the financial crisis that crippled the American economy and spurred rampant unemployment and home foreclosures for those unable to receive assistance. – RT

Dominant Social Theme: It is necessary for Fed board members to bail out their own banks. That's what it is there for.

Free-Market Analysis: "Quantitative Easing" ... "Operation Twist" ... "Discount Window" ... The mavens at the Fed have so much jargon at their disposal.

Not anymore. This is really simple to understand – see above.

Fed board members gave trillions to their own banks so the would survive the crisis of 2008.

They gave their own banks money. They put their own banks first. This is not hard to grasp.

It's cronyism. It's an abuse of power. It's criminal.

The Fed bankers can argue that they are SUPPOSED to hand out gobs of money. That's its public mandate.

But if they argue this way, they'll only remind the public of what they've done.

If they shut up about it, they'll look guilty as hell. As well they should.

Talk about a no-win situation.

The bankers will try to obfuscate using incomprehensible terminology. But it won't work.

Before the arrival of the Internet, the double-talk had a big impact. Nobody who was normal could understand quite what the Fed did (or central banks in general).

But all that's changed now. What we call the Internet Reformation is redefining the dominant social themes of the elite. They're losing on numerous fronts. We've been predicting it for years. Like the Gutenberg Press before it, the Internet is informing tens of millions about the Way the World Really Works.

As a result, the fear-based propaganda of the power elite is not working anymore. They are no longer able to frighten people into accepting phony globalist solutions like global warming, peak oil and water scarcity. One of the biggest memes of the elite is that the economy needs the ministrations of good, gray bankers to fix the price and volume of money.

Price fixing, in fact, never works and only redistributes wealth from those who created it to those who didn't and may not utilize as efficiently. The Fed's top bureaucrats were not prepared for the Internet or its exposure of fiat printing of money-from-nothing. Once the crisis of 2008 struck, the Fed's mavens reacted incompetently. They didn't know what to do.

Disaster struck when Rep. Alan Grayson (D-FL) grilled Fed Inspector General Elizabeth Coleman early in 2009 over some very basic questions about the trillions of dollars showing up on the Fed's expanded balance sheet. Coleman couldn't explain it.

We wrote an article then entitled "Beginning of the End? Fed Cannot Account for $9 Trillion." Here's something from the article:

By putting Coleman up in front of Congress in such an unprepared manner, the behind-the-scenes leaders of the Federal Reserve have provided an unimpeachable metaphor. Coleman's testimony punctured the veil of secrecy and her lack of preparedness lance whatever aura of competence Ben Bernanke and others have been able to conjure. Metaphors can NEVER be undone. They can be covered up over a great deal of time, perhaps, but they cannot be explained away or rationalized. They exist. That's why they're metaphors.

The economic ramifications of what is going on couldn't be more obvious either (well, to us, anyway). Post Coleman, the Fed is suddenly, inconceivably, an institution fighting for its political life. (Perhaps you read it here first ...) This financial behemoth, the most powerful single entity in the world, has likely already begun to topple. But as it is with any figure of titanic proportions, the fall is still silent to begin with for contact with the ground has not yet been made.

Central banking will likely survive in one form or another. No institution of such authority simply vanishes. The money and power of central banking guarantee that the mechanism will be perpetuated somehow – even expanded from sheer momentum. But a regrouping will have to take place. Even if central bankers are able to maintain the outward manifestation of the economic mechanism, it has begun to rot from the inside as it topples. It may take a month, a year, a decade but changes are coming.

We haven't changed our modest collective mind since then. We likened the Fed to a walking dead man and that still seems to us an apt analogy. Things are simply going from bad to worse.

If the Fed actually does get audited, as Ron Paul and Rand Paul hope, watch out! The revelations shall prove especially injurious.

But one way or another this most corrupt of all institutions is now in a battle for its life. The PR disaster of 2009 showed us clearly that the Fed's competence is a mile wide and an inch deep. Like all fakery, it's impossible to defend. No wonder so many top men are leaving.

We've predicted that monopoly fiat central banking generally is facing its largest challenge ever as a result of Internet exposure. As a result, we expect the powers-that-be to fight back by trying to change the monetary system.

Perhaps they shall try to create a world currency or a statist gold currency. It may or may not be enough to stem the damage now being done to this most important of all memes – the monetary meme.

Another possibility is that they will aggressively support the "public" banking proposed by Ellen Brown and Bill Still. The elites operate via mercantilsm, the use of government levers to benefit private agendas. Ms. Brown is unapologetically a big government type as are many other leftists and populists in the alternative media movement including luminaries such as Webster Tarpley.

Such individuals and those that support Georgism and other schemes always have a better idea. They are convinced that THEIR scheme is the correct one and that society ought to be manipulated to support it.

Here at DB, we restrict ourselves simply to observing that a private market ought to allow competitive money and that historically speaking gold and silver have proven out as monetarily popular. Silver has often been used as the people's metal and gold for the elites. The ratio between the two metals tends to signal whether any manipulation is taking place.

We offer no complex schemes, no complex arguments, no rigid mandates, no endless dissertations, no damnations of this or that strategy or utilization of interest ... no determination, in other words, that people be forced to use this or that formula. We don't "know best" though many others now commenting on money (and attacking free-market thinking) have it all figured out apparently. If you simply do as they say (and you better!) then all will be well.

We're not so smart, but we do know this: Money is actually pretty simple. One of Murray Rothbard's best books, "What has government done to our money?" is also his shortest. It ought to be read for its elegance and directness and also for its analysis of fiat monopoly central banks.

Today, in fact, central banking is under attack as never before, and for some of the reasons that Rothbard anticipated. Forcing people to use a certain currency or monetary methodology can never be justified, morally, financially or in any other way.

It's also an invitation to abuse. Power corrupts and absolute power corrupts absolutely. Doesn't matter if the scheme is "public" or "private" ... or whether the government is run by the "people "... or little green men from Mars. This is what's happened with the current form of central banking.

And that is why the Internet era has thrown such a spotlight on it, and we doubt it will survive the scrutiny. It is infinately corrupt. A handful of men can be seen divvying up trillions to benefit their own interests. There is no justification. Not even the fanciest words can explain it.

If central banking does survive, it will be likely in a much different form. This biggest of all sinecures for the power elite will be a less dependable source of revenue in the future. The ramifications are profound.

Conclusion: The 21st century is not the 20th. And the Internet is a process not an episode.

June 19, 2012

Did the Federal Reserve Survey on Wealth Exclude the Top 400 Wealthiest People in America?

The recent Federal Reserve analysis of the effects of the Great Recession on household wealth and income was a doozy, showing that median income dropped 7.7% and median net worth fell by 38.8% from 2007-2010. But that may not be the whole truth – the Fed might actually be leaving a very significant group of people out of the sample – the top 400 wealthiest people, or the 0.0000035%.

Someone brought this part of the the Fed study to my attention (note to self, always read the section on methodology).

Second, a supplemental sample is selected to disproportionately include wealthy families, which hold a relatively large share of such thinly held assets as noncorporate businesses and tax-exempt bonds. Called the “list sample,” this group is drawn from a list of statistical records derived from tax returns. These records are used under strict rules governing confidentiality, the rights of potential respondents to refuse participation in the survey, and the types of information that can be made available. Persons listed by Forbes magazine as being among the wealthiest 400 people in the United States are excluded from sampling.

This passage describes how the Fed got the information on wealth and income., and I’ve bolded the relevant sentence. The Fed can easily get data on the non-wealthy, because the non-wealthy don’t have very much. Most people, to the extent they own anything, have some home equity, a bank account and perhaps a few mutual funds, with most wealth concentrated in housing. So the Fed researchers can essentially look at homeownership rates and figure out how much the non-wealthy people own, and how much they’ve lost or gained. But the wealthy are different, and here’s where it gets tricky. The wealthy own lots of illiquid assets, everything from priceless paintings to private multi-billion dollar companies. So the Fed does a separate survey just on the wealthy. Only, as the researchers say, “analysis of the data confirms that the tendency to refuse participation is highly correlated with net worth.” The rich aren’t just rich, they are secretive. And apparently the super-rich are super-secretive. And for some reason, these researchers just didn’t include the Forbes 400, the very richest of the rich.

You might say that the exclusion of 400 people isn’t significant; after all, it’s just 400 people. How big a difference could that really make? Well, it turns out, as of 2011, that the top 400 people in America own more than the entire bottom 60% of Americans. So this is not a trivial exclusion. The Fed claims in the report that it has a method for adjusting for rich people who don’t respond to their survey. Why the Fed has just not included the Forbes 400 is not clear, and I’m curious how they adjust for leaving out Mr. Gates and Mr. Buffett and company. I’ll send an email to the Fed to find out.

June 18, 2012

Dimon Redux: Why Bank Risk-Taking = Risk Making

In case you haven’t had enough of Congresscritters lobbing softballs at Jamie Dimon, the JP Morgan CEO is appearing before the House Financial Services Committee on Tuesday. There have been a number of suitably scathing accounts of how members of the Senate Banking Committee fawned over Dimon, with Matt Taibbi pointing out that Dimon was actually not terribly persuasive, stumbling and mumbling over the parts of his defense that were a stretch. But most important, they had an opportunity to demand explanations, such as of what the trade actually is, who was involved in approving it, when did it start to go awry and when did management realize there was a problem, and muffed it. For the overwhelming majority of the legislators, that was no accident.

As we wrote, Dimon took what is actually an indefensible position: that any bank risk taking should be permitted, so long as it will arguably do well when there is a crisis (watch for this to be broadened to merely be a bet to improve bank profits when its regular businesses are under stress). We pointed out that this logic would justify engaging in systemically destructive activities like the Magnetar trade, and that with government backstopping behind it to boot. And that is a bigger risk than it might seem at first blush.

Let’s go back to Dimon’s defense. It boils down to “we got on top of this pretty quickly, we’re a big bank and this isn’t much of a loss, shit happens and we’ve learned from this ‘mistake’.” In addition, Dimon claimed the underlying portfolio (as in the $370 billion of securities in the CIO, as opposed to the derivatives positions they also took) weren’t all that risky, because, among other things, it had an average rating of AA.

That sounds pretty tame, right? Well actually, JP Morgan was taking more risk in its CIO that any of its peers were. Per a May Bloomberg article:

JPMorgan Chase & Co. (JPM)’s biggest U.S. competitors say their corporate investment offices avoid the use of derivatives that led to the bank’s $2 billion loss and buy fewer bonds exposed to credit risk.

Bank of America Corp., Citigroup Inc. (C) and Wells Fargo & Co. say the offices don’t trade credit-default swaps on indexes linked to the health of companies. JPMorgan is said to have amassed positions in such indexes that were so large they drove price moves in the $10 trillion market…

JPMorgan’s competitors confine corporate-level trading mostly to interest-rate and currency swaps — the most common derivatives — and put a greater percentage of funds into U.S. government- backed securities such as Treasury bonds.

“Traditionally, banks use government bonds, because they’re safer,” said Ray Soifer, a former Brown Brothers Harriman & Co. bank analyst who’s now chairman of Green Valley, Arizona-based Soifer Consulting LLC, which advises banks and investors on strategy and risk management. “JPMorgan is going down the credit spectrum from U.S. Treasuries, because they’re reaching for yield.”…

About half of the $381.7 billion in JPMorgan’s chief investment office portfolio is in company bonds, asset-backed securities and mortgage debt not backed by the U.S. government, according to a March 31 filing. That compares with 7.7 percent at the end of 2007..

Similar assets at San Francisco-based Wells Fargo (WFC) represent 34 percent of a $230.3 billion portfolio. It’s 11 percent of New York-based Citigroup’s $270.6 billion book, and 10 percent of the $297.1 billion pool of securities at Charlotte, North Carolina-based Bank of America.

JPMorgan has about 30 percent of its holdings in U.S. Treasuries and bonds issued or guaranteed by U.S. government- backed agencies, according to its filings. That compares with 87 percent at Bank of America, 50 percent at Citigroup and 47 percent at Wells Fargo.

JP Morgan is taking more risk in its CIO than its competitors deem necessary or prudent. And also keep in mind: JP Morgan has also shown the fastest deposit growth of the major banks. As Amar Bhide has pointed out, the sort of “excess deposits” that the CIO deploys are not the funds of ordinary individuals, but hot international money. Remember, some banks (Bank of New York, for instance) are actually discouraging deposit inflows. It’s pretty likely that JP Morgan is getting more than its share of these funds because it wants them.

In addition, even though the CIO is clearly engaged in hedge-fund type activities, which are exactly the sort of thing the Volcker rule was designed to squash, let’s take Dimon at his word, and assume he really only wanted to insure against tail events, like another crisis. Surely that’s a good idea, no?

Actually, it’s a bad idea. The reason is that sort of trade is subject to what traders call “wrong way risk”: that the catastrophe you were insuring against is pretty likely to blow up your insurer, leaving you unprotected. That’s why, for instance, the Goldman defense that it didn’t need the AIG bailout, that it had bought CDS on AIG, is patently ridiculous. If AIG had gone down, the domino effect of its failed trades would have almost certainly knocked out many, potentially all, of Goldman’s counterparties. And the worst of this sort of insurance is that too many market participants think it works. That means they assume their failure prone hedges have lowered they risk, and they fail to do the foolproof but more costly preventive measures, namely, selling down positions.

And more generally, Dimon’s position is that all is fine in risk taking as long as the bank can absorb losses. And he continues to maintain JP Morgan didn’t need any bailouts in 2008, when in fact JP Morgan got more than just TARP monies (most important, it continues, like all the big banks, to benefit from the tax on savers known as ZIRP). And let’s not kid ourselves. JP Morgan is a major derivatives clearer. If AIG or another big broker dealer had gone down, JP Morgan most assuredly would have been damaged, likely consumed, in the ensuing firestorm.

But as Andrew Haldane pointed out, the payoff to banks and their executives is now like an option. The downside is contained. And the way to increase the value of an option is to increase volatility. Thus banks taking on more and more risk, willy-nilly, is completely rational given their incentives. In fact, from their perspective, there is no limit on how far they should pursue this strategy. Banks have done this not simply by levering up their businesses, but also via increased complexity (which increases fragility) and the explosion of derivatives (which also increase leverage, both in the banks and system-wide, in ways that are difficult to measure with any precision).

So the brouhaha about the failed CIO trade is well warranted. It provides a window into undue risk-taking at JP Morgan, and a generalized industry policy of pushing the envelope, which is the right thing to do if you have managed to set up “heads I win, tails you lose” wagers with deep-pocketed chumps. Unfortunately, that sorry fact is almost certain not to be aired at this week’s House hearings.

June 15, 2012

Germany's Backing of Redemption Pact Signals End Game for Europe?

Germany signals shift on €2.3 trillion redemption fund for Europe ... the German government has begun opening the door to shared debts for the first time in a profound change of policy, agreeing to explore proposals for a €2.3 trillion stabilization fund in order to stop the eurozone's crisis escalating out of control. Officials in Berlin say privately that Chancellor Angela Merkel is willing to drop her vehement opposition to plans for a "European Redemption Pact", a "sinking fund" that would pay down excess sovereign debt in the eurozone. – UK Telegraph

Dominant Social Theme: One way or another, the EU and euro shall be salvaged.

Free-Market Analysis: Is the Euro-crisis finally coming to an end? Just yesterday, we pointed to the intractability of the larger European position regarding any EU "bailout."

But we have also previously covered Ambrose Evans-Pritchard's reporting on the so-called sinking fund that has been proposed – and increasingly this seems to be a solution that may be headed for adoption. You can see our previous article here: "Nothing But A Full Union Will Do..."

It is an intriguing concept, not least because it involves gold. Ironically, it is also illegal.

Basically, a fund such as this would supposedly allow European countries to guarantee each other's debt even though individual countries would be responsible for payment.

For proponents – and Evans-Pritchard seems to be one – a sinking fund provides a certain level of constitutionality in large part because it would be backed by a good amount of gold. "Italy and other states would have to pledge gold and other forms of collateral equal to 20pc of their debt in the fund," he announces.

In fact, as the article itself points out, a sinking fund such as this provides the appearance of legality but not the letter. Like everything else Eurocrats try to do, it stretches the letter of the law and more importantly the spirit. Here's some more from the article:

The Redemption Pact covers all public debts of EMU states above the Maastricht limit of 60pc of GDP, roughly €2.3 trillion. It is modeled on Alexander Hamilton's Sinking Fund in 1790 to clear up legacy debts after the American revolutionary war ...

It is not yet clear whether Chancellor Merkel can persuade her own party to support the Pact. Her own finance minister Wolfgang Schäuble poured cold water over the idea earlier this week. "This fund is not feasable because it breaches with the European treaties and the `no bail-out' clause, which says countries cannot be responsible for the liabilities of another country ...

Mrs Merkel rejected the Redemption Pact last November as "totally impossible", even though it was drafted by Germany's Council of Economic Experts or Five Wise Men and is widely-viewed as the only viable route out of the current impasse.

Jose Manuel Barroso, the European Commission's chief, warned that Europe faces a "social emergency" . Countries sticking to reforms are engulfed by forces beyond their control. "We must recognise that we have a systemic problem. I am not sure the urgency of this is fully understood in all the capitals," he said in a thinly veiled attack on Berlin.

Evans-Pritchard is positively chirpy about the evolving solution. He writes, "The idea is to treat the first decade of monetary union as a learning experience -- with mistakes made all round – and allow a fresh start. The excess debt would be paid down over twenty years. ... The beauty of the proposal is that would return Europe to the Maastricht discipline where each state is responsible for its own debts. It is the exact opposite of fiscal union."

We beg to differ. There is nothing beautiful at all about the increasingly authoritarian and undemocratic European Union and there is nothing especially savory about "saving" said Union with a fund that proposes joint liability but pretends that it is no such thing.

Ironically, top Eurocrats are turning to gold as the key to unlock this endless "sovereign" crisis. Having blasted gold as a "barbaric relic" for most of the past century, it now seems that gold has become the indispensible metal. No gold, no assurance of solvency and no sinking fund.

But there is gold, apparently – a good deal of it in central bank coffers. And there appears to be a willingness to create such a fund, as well, one that would provide over US$ 2 trillion worth of solvency.

According to Evans-Pritchard, a major potential problem – the resistance of Germany's constitutional court to such a fund – has been neutralized without a shot being fired. He writes that those at the top court "say it appears compatible with the country's constitution -- unlike eurobonds."

Why? Well, there would be a fixed limit to costs and the fund would not "endanger the tax and spending sovereignty of the Bundestag." Funny, it seems to us that a shared-liability is a shared liability.

Later on, Evans-Pritchard writes: "The fund would entail sacrifices for Germany. The country would no longer enjoy safe-haven borrowing costs − curently 1.48pc for 10-year Bunds − on a quarter of its total debt. A study by Jefferies Fixed Income concluded that it would cost Germany 0.6pc of GDP each year."

How this is "constitutional" as regards Germany is beyond us. Evans-Pritchard continues to gloss over the issue by writing that the anti-constitutional argument overlooks "tough conditionality" ... "The assets could be taken from the country's currency and gold reserves. The collateral nominated would only be used in the event that a country does not meet its payment obligations."

Additionally, he writes, Berlin would have veto lockhold, able to ensure discipline in a way that it cannot do with the European Central Bank where it has just two votes.

Details? The debt would be covered by "joint bonds" and each country would be responsible for its own share of debt in the fund – Italy €960bn, Germany €580bn, France €500bn and so forth.

Again, a joint bond is a joint bond is a joint bond – and the fund is only going to be insured via gold to 20 percent of its value.

What is happening here is that the German constitutional court is using a technical argument to get out of the way of a metaphorical onrushing train. It is perhaps likely that such a fund – backed by yet another tax – will be sizable enough to get the job done.

It seems obvious to us that this deal is outside both the letter and spirit of the law. But that has never yet stopped the Brussels criminal element.

The power elite that set up the EU to begin with as s steppingstone to world government may have their euro after all, provided those involved can move fast enough and politics don't prove an insurmountable obstacle.

Evans-Pritchard seems relieved. He's spent a number of years as a principled opponent of the EU, but we've detected a substantial change of tone in his articles of late. He writes:

Any ... costs will be outweighed by massive relief as Europe finally breaks the logjam of the last two years and offers southern Europe a chance to claw its way out of perpetual depression. Mrs Merkel is beginning to agree.

As we have written in the past, Merkel never DISAGREED. She is a bought-and-paid for agent of what has been termed the "new world order" and the problem that Merkel has had in the past stems from the larger reluctance of German voters to be potentially liable for the debts of most of the Southern part of the EU.

Conclusion: The average German may yet retain these doubts but from what we can tell this "sinking fund" may be deployed aggressively to assuage them.

June 14, 2012

Investors In Hedge Funds Are Starting To Head For The Exits

There are signs that investors are becoming increasingly impatient with hedge funds and that 2012 will be an important year for this very rich $2 trillion industry.

Investors pulled $5.1 billion from hedge funds in April, according to BarclayHedge and TrimTabs Investment Research, and more than $12.7 billion flowed out of the hedge fund industry between May 2011 and April 2012. There were net outflows in 6 of those 12 months.

The simple reason investors are redeeming cash: performance. The average hedge fund lost money in 2011 and some of the industry’s biggest stars like John Paulson got crushed, while the U.S. stock market eked out a tiny gain.

The industry again trailed the S&P 500 stock index for the first four months of 2012, returning 5% versus a 11.2% gain for the S&P 500, TrimTabs and BarclayHedge reported. Those broad U.S. stock gains have evaporated for 2012, but that’s not necessarily a good thing for the hedge fund business.

Indeed, the same volatile market environment dominated by an unpredictable European debt crisis that proved so hard for hedge funds to navigate in 2011 returned in May. The early signs are that many hedge fund investors again had a tough time managing money through the volatility. Hedge fund titans like William Ackman and Dan Loeb saw their funds perform poorly in May. Research firm HFR recently said hedge funds on average lost money for the third straight month in May, although the major stock indices at least performed worse for the month.

Citigroup’s prime brokerage business claimed on Tuesday that hedge fund industry assets could double by 2016 to $5 trillion due to demand from pension funds, endowments and other institutional investors looking for new places to park their money. But it seems like those institutional investors might have second thoughts on jumping into the hedge fund pool if the the current crop of hedge fund managers don’t turn performance around soon.

June 13, 2012

How Wall Street Hustles America’s Cities and States Out of Billions

Yves here. While the municipal swaps fiasco may seem like old news, this piece discusses a post-crisis type of swap which is even more appalling. The old scam was to talk local and state authorities who would have been far better served with old-fashioned fixed rate financing into doing floating rate financing and entering into a series of swaps to get a fixed rate deal, with a supposed improvement in funding costs. The problem is that many of those floating rate deals were auction rate securities, and when that market failed in early 2008, the borrowers were doubly hosed. The ARS went to penalty rates. In addition, payments on the swaps often kicked up shortly thereafter (due to the slow-motion failure of monoline guarantors, which was the hidden trigger behind both events. The downgrade of the monolines de facto downgraded the municipality, which led to increased payments on the swaps).

The latest scam is more appalling. Municipal authorities would borrow fixed rate, then enter into a variable rate swap on the side. Earth to base, no responsible manager wants uncertain funding costs on a long-term capital investment. This is tantamount to the owner of a candy store borrowing money at a fixed rate from his bank to finance an expansion of his business, then betting at the racetrack to try to lower his costs. Not surprisingly, many of these swaps have proven to be costly time bombs.

Many powerful interests have jumped at the opportunity to use the crisis to eviscerate what’s left of the welfare state.

We all know that America’s cities and towns are in the throes of a deep financial crisis. And are told, over and over, what’s supposedly behind it: unreasonable demands by grasping state and municipal workers for pay and pensions. The diagnosis is a grotesque cartoon. Many of the biggest budget busters are on Wall Street, not Main Street.

In a country as big and locally diverse as the U.S., any number of wacky pay and pension schemes are likely to flourish, though some of the most outrageous turn out to cover not workers, but legislators. But overall state and local pay has not been growing faster than in the private sector for equivalent work for many years now.

What has driven cities and towns to the brink is not demands from their workforce but the collapse of national income and the ensuing fall in tax collections. Or, in other words, the Great Recession itself, for which Wall Street and the financial sector are principally to blame. But many powerful interests have jumped at the opportunity to use the crisis to eviscerate what’s left of the welfare state, roll back unionization to pre-New Deal levels, and keep cutting taxes on the wealthy. The litany of horror stories that now fills the media is ideal for their purposes.

The selective character of this press campaign became obvious last week. As the latest wave of stories started rolling in the wake of elections in California and Wisconsin, a striking piece of evidence surfaced that flies in the face of the conventional narrative. The Refund Transit Coalition, a coalition of unions and public interest groups, put out a study that documented in stunning detail how Wall Street banks have for years been hustling American cities, states, and regional authorities out of billions of dollars. But save for Gretchen Morgenson’s “Fair Game” column for the New York Times, the study drew almost no attention.

At a time when cities and states are taking hatchets to services and manically raising fees and fares, the group’s analysis merits a closer look and a much, much wider audience.

Its starting point will be familiar to anyone who recalls the debate over financial “reform” of the last few years. In the bad old days of pre-2008 deregulated finance, bankers started pedaling hot new “structured finance” products that they claimed were perfect for the needs of clients who had thrived for decades using cheaper, plain vanilla bonds and loans. The new marvels – swaps and other forms of so-called “derivatives” whose values changed as other securities they referenced fluctuated in value – were often complex and frequently not priced in any actual market. Their buyers thus had difficulty understanding how they really worked or how they might be hurt by purchasing them.

In many documented cases, buyers also had only faint ideas about how profitable these products were to the houses selling them. One befuddled Pennsylvania school board, for example, diffidently quizzed J.P. Morgan Chase: “The school-board official knew they were getting $750,000 for entering into a ‘swaption’ with J.P. Morgan Chase & Co. They wanted to know what was in it for the bank. They wanted to know the price. They seem like reasonable requests. ‘I can’t quantify that to you,’ the banker told them. ‘It is not a typical underwriting and I can’t quantify that for you and there’s no way that I can be specific on that.’”

One popular product involved an “interest rate” swap built into a bond deal. In these, as the Transit study explains, some hapless municipal authority brings out a bond and commits to making fixed payments to buyers. That sounds like any other old fashioned bond offer. But here’s the twist. In the swap version, the bank offers, for a handsome charge, to pay a variable fee to the issuer of the bonds. The idea was that the money could be used to make payments owed to the bond buyers. Payments were supposed to vary with the course of interest rates. The contrivances were heralded as protecting issuers against a rise in rates and saving them money on their payments.

But there was a catch: If rates fell, then banks could make out big, while issuers faced disaster, because the latter still had to make the fixed payments on their bonds, while the banks’ payments would shrink as rates fell. In effect, issuers were gambling on interest rates and betting they somehow knew better than the banks what was going to happen. And, ah, yes, the final touch: With old style bonds, you could refinance if rates fell; with the new fangled derivatives, the banks made sure to impose huge termination fees.

The result, for years now, has been literally billions of dollars of losses for cities, states, and other local authorities, including school boards and state college loan agencies. Locked in by the termination fees, they can stay in the swaps and pay and pay as the banks’ payments to them dwindle. Or they can buy their way out of the swaps at preposterous prices – Morgenson indicated that New York State recently paid $243 million dollars to get out of some swaps, of which $191 million had to be borrowed.

The Refund Transit study concentrated on local transit systems. Some of its numbers are stunning. The study pegged annual swap losses at the Massachusetts Bay Transportation Authority (Boston area) at $25.8 million and suggested that the MBTA will “lose another $254 million on these swaps” before they lapse. The study added that the MBTA was losing money on swaps even before the crisis, with total losses running in the “hundreds of millions” of dollars.

In Charlotte, site of the Democratic Convention, the study suggests that swaps with Bank of America and Wells Fargo cost the area transit system almost $20 million a year – something to think about as the President gives his scheduled acceptance speech at Bank of America Stadium.

Other localities that the study suggests are wracking up big annual losses include Chicago ($88 million), Detroit ($54 million), frugal Chris Christie’s State of New Jersey ($83 million), New York City ($113.9 million), Philadelphia ($39 million), and San Francisco ($48 million).

The study includes a useful table of the main banks benefiting from these arrangements. They include all the usual suspects: Besides Bank of America and Wells Fargo: Citigroup, Morgan Stanley, Goldman Sachs, J. P. Morgan Chase, UBS, and AIG, among others. Most were recipients of TARP funds, while all have profited from super cheap Federal Reserve financing, Fed, Freddie, and Fannie purchases of mortgage backed securities, and extended deposit guarantees as well as tax concessions granted by the Treasury in the wake of the 2008 disaster.

Given all the other advantages conferred on our Too Big To Fail Banks by the government and both major political parties, it would be a stretch to argue that the toleration of these swaps by federal, state, and local authorities – and the press, which in virtually all areas has defaulted on reporting the basic facts – constitutes the greatest outrage of all. But it is high time that they came in for full public scrutiny. These products were obviously very risky; few agencies that bought them appear to have understood this.

Despite some reforms aimed at eliminating crude “pay for play” deals, state and local finance remains a area rife with conflicts of interest. The whole series of deals needs to be investigated, the advisers who recommended them to the authorities need to be identified, the full losses added up, and responsibility fixed for the continuing series of bad decisions. Many State Attorneys General and general counsels also need to explain why they have not more aggressively publicized these arrangements and challenged them in court. (A New York court ruled that such deals were private contracts, not securities; that should have brought forth howls of protests and immediate legal fixes.) It is high time citizens, instead of banks, start occupying the transit authorities, school boards, and other state and local entities that are so vital to communities and real people.

June 12, 2012

Credit Suisse Explains "The Real Issue", And Why There Is Two Months Tops Until France Is In The Bulls Eye

Credit Suisse's William Porter is strangely laconic and oddly brief in his latest issue of the European Credit Flash titled "The Real Issue":

"It’s all about Spain”, so now we are cutting to the chase. Recapitalization of the banks versus funding the sovereign is of course a semantic issue given the nature of the interplay. But it enables the attempted finesse we describe below.

"Portugal cannot rescue Greece, Spain cannot rescue Portugal, Italy cannot rescue Spain (as is surely about to become all too abundantly clear), France cannot rescue Italy, but Germany can rescue France.” Or, the credit of the EFSF/ESM, if called upon to provide funds in large size, either calls upon the credit of Germany, or fails; i.e, it seems to us that it probably cannot fund to the extent needed to save the credit of one (and probably imminently two) countries that had hitherto been considered “too big so save” without joint and several guarantees.

The issue can be finessed for a while by addressing the issues as bank issues and recapitalizing the banks by bond transfer. This hides from the (primary) market and is simply another manifestation of the “Sarko trade” given by the LTRO. That rally lasted four months. Given the market’s adaptive learning behaviour, we suspect that this finesse might last two. The eventual denouement should be flagged by symptoms of the failure of the credit of EFSF/ESM and/or France.

And there you have it. As evidenced by today's reaction to the bailout, which had a half life of 2 hours, and was a complete failure in 6, the market is learning much, much faster than expected. Which also means that Porter's estimate for the length of time before the next wave of the contagion tsunami strikes somewhere in the middle of the 8th arrondissement is furiously optimistic, but we agree: 2 months tops.

Which is in keeping with the Soros' estimate of T minus 3 months before the Eurozone ends without a major intervention by Germany (which will eventually happen, courtesy of a Berlin-funded DIP loan, but purely on Germany's terms), but also that of Christine Lagarde who just doubled down on Soros' three month estimate as well.

June 11, 2012

The Spanish Bank Bailout: A Complete Walk Thru From Deutsche Bank

Over the past 24 hours, Zero Hedge covered the various key provisions, and open questions, of the Spanish bank bailout. There is, however, much more when one digs into the details. Below, courtesy of Deutsche Bank's Gilles Moec is a far more nuanced analysis of what just happened, as well as a model looking at the future of the pro forma Spanish debt load with the now-priming ESM debt, which may very well hit 100% quite soon as we predicted earlier. Furthermore, since the following comprehensive walk-thru appeared in the DB literature on Friday, before the formal announcement, it is quite clear that none other than Deutsche Bank, whose "walk-thru" has been adhered to by the Spanish government and Europe to the dot, was instrumental in defining a "rescue" of Spain's banks, which had it contaged, would have impacted the biggest banking edifice in Europe by orders of magnitude: Deutsche Bank itself.

From DB: Spain: the mechanics of “recap only” loans

The guidelines for an EFSF bank recap are quite precise. There will be no conditionality on fiscal policy or structural reforms. The loan will also sit on Spain's balance sheet, meaning the volume of recapitalisation – to be established after a new, independent stress test – will be crucial: it needs to be big enough to convince the market that Spain's banking issue, which has been festering for three years, is addressed in a credible manner, while not being so large as to jeopardize Spain's public debt sustainability. We model possible trajectories for Spanish public debt for various recapitalisation volumes. In an intermediate recap scenario of EUR80bn, Spain could realistically, in our view, keep public debt below 95% of GDP at peak and bring it back below 90% by 2020.

What would Spain need to do to access the "recap only" EU loan?

The "recapitalisation tool" created in July 2011 is normally open to countries "when the origin of the financial distress is strongly anchored in the financial sector and not directly fiscal or structural". In addition, "a beneficiary country will have to demonstrate that it has a sound policy record, such as the respect of its SGP commitments". The first condition would normally be met by Spain: while in-built issues, such as poor fiscal coordination between the regions and the central government, or the extreme rigidities of the labour market, have been revealed and magnified by the current crisis, the point of origin of Spain's difficulties clearly stem from the need to absorb the property boom of the early 2000s and the subsequent need to de-leverage. The second condition may seem more difficult to meet, but the EFSF guidelines make it plain that "countries under excessive deficit procedure would still be eligible (...) provided they fully abide by the various Council decisions and recommendations", which is still the case for Spain after the Council agreed to relax the fiscal targets for 2012. EC Commissioner Olli Rehn's mention of the possibility to give Spain an extra year to reduce its deficit to 3.0% of GDP is another sign that, at least at this stage, there is no open conflict between Madrid and its European peers on fiscal policy.

As a first step, a country triggering a "recap only" loan will submit to the EU a list of "institutions in distress". In principle, the only eligible institutions should be "systematically relevant or posing a threat to financial stability". This may be a problem since Spain would probably include in such a list a number of smaller Cajas. However, a movement of concentration has already started last year and the government can argue that "interconnectedness", one of the criteria for the assessment of the "systemic dimension" mentioned by the guidelines, could justify a sweeping recapitalisation.

Once the request has been formally made, Spain would lose control over much of the process.

First, a joint assessment of the country's eligibility will be conducted by the European Commission, in liaison with the ECB and where appropriate with the relevant banking supervisory bodies such as the EBA. They will in particular decide whether or not the "recapitalisation pecking order" has been respected. Indeed, the guidelines specify that the private sector should be first to bear the costs of a recapitalisation, followed by the national government and only in last resort the EFSF/ESM. As far as private sector participation is concerned, only "shareholders", and not bondholders, are mentioned. The text refers to "special crisis management and resolution intervention powers for national supervisors which could expand the possibilities for the private contributions via mechanisms such as bailing-in bondholders IN THE FUTURE". As it stands today, the "recap-only" loan does not trigger bailing in. Note that under the EC's proposal on crisis prevention, management and resolution, released on 6 June, unsecured debt would not be bailed in as part of the "default" bank restructuring before 2018.

The Europeans would probably consider that Bankia's flotation last summer, which did not raise enough capital to deal with the company's shortfall, allows Spain to tick the first box. For the second box, they will have to consider that the current market conditions would make it impossible for the Spanish sovereign to issue enough debt to recapitalise banks in a credible manner.

Second, the amount of capital needed would be determined by a stress-testing exercise, which will be conducted by the national supervisor (i.e. the Bank of Spain), but also involving the EBA and "national experts from supervisory authorities from other member states". This means that once the process is underway Spain will lose control over the final loan amount. Note however that the guidelines offer the possibility of a twostep procedure, with a first estimate being confirmed by a more comprehensive analysis "at a later stage". The assessments provided by Oliver Wyman and Roland Berger, which are more a valuation exercise than a proper “stress test”, and more particularly by the IMF, could provide a first basis. The IMF's FSAP (Financial Sector Assessment Program) is due for publication on 11 June.

The conditionality attached to the loan would be limited to the recapitalised institutions themselves and financial system reforms in the beneficiary country. No conditionality on fiscal policy or structural reforms pertaining to non-financial system issues is needed - apart from continued compliance with the European Council's recommendations already enforced under the Excessive Debt Procedure framework. The "institutionspecific" conditionality will pertain to EU's state-aid rule, as well as the obligation for every recapitalised bank to be restructured. So-called "horizontal" conditionality pertains to financial supervision, corporate governance and domestic laws on crisis prevention, management and resolution.

The final decision will be made by the Eurogroup under the EFSF, or by the ESM board if, by the time the full procedure is completed, the change-over has taken place. The IMF’s involvement in the process – always a touchy political issue – would be minimal. The guidelines only point to an “additional assessment of the quality of national supervisory practices by the IMF”, which needs to be “actively sought” by the beneficiary member state while the package is being implemented. The Fund is not supposed to be involved in the approval of the package itself, even if the FSAP will probably be an important input in the EU’s assessment of the recapitalisation need.

The monitoring of Spain's compliance with the conditionality to such a package would be the responsibility of the European Commission, the ECB and the EBA. The guidelines specify that "these institutions must be granted the right to conduct on-site inspections in any beneficiary financial institutions". They will have the possibility to involve other relevant experts, "such as external auditors or monitoring trustees". Note however that, in practice, the recapitalization funds are provided upfront. Therefore the effectiveness of the monitoring may be somewhat diminished.

What would be the consequences for Spain?

The current rules are unambiguous: “The beneficiary member state will remain the ultimate liable counterparty”. In our opinion, ideally such a provision should be changed, to help stopping the “sovereign/banks loop”. Still, the probability to change the ESM terms in order to allow direct recapitalisation, i.e. without raising the receiving country’s public debt, is low for now in our view. Note that a “federalization” of bank recapitalisation would always come with tricky moral hazard issues. At the very least, the receiving country would have had to offer a “first-loss guarantee” to the EFSF/ESM to protect the European peers from the financial consequence of failing recapitalisation/restructuring. This means that in any case the receiving country would still have to stomach an increase in its contingent liabilities.

Political opposition in some core countries, lack of time and daunting legal complexities are the main reasons why Spain will probably have to trigger the system as it is today. Indeed, to allow direct recapitalisation, awkward questions on the relationship between bailed-out banks and the ESM would need to be sorted out very quickly. The current guidelines state that the “capital injected… is expected to be of the highest possible quality”. Under Basel III, common equity will be the highest form of capital. Hybrid debt would not qualify. The choice for the ESM would be difficult: either inject common equity and get involved in the banks’ governance – which would entail very rapidly the creation of a federal agency with the relevant staff and expertise – or take shares stripped of their voting power, but then the ESM could neither control the banks’ management nor hold a claim on the assets. This would put the European rescue mechanism in a fragile position In any case, the possibility to change the ESM’s rules of engagement without renegotiating the entire ESM treaty – with the subsequent parliamentary ratification process in all member states – is not clearly established.

True, Article 19 of the treaty allows the ESM board to “review the list of financial instruments provided for (...) and make changes to it”. On the face of it, another instrument, specifically allowing for a “recapitalisation only loan” which would bypass the sovereigns could be added. However, this could be seen as too blatant a contradiction with the initial spirit of the treaty as well as to letter of its article 3, which describes the ESM’s purpose as “mobilise funding and provide stability support to the benefit of ESM members”.

The ESM members are the contracting parties, i.e. the governments. It is a very gray area, but that a full revision of the treaty would be needed seems to the position of the German government, as well as the ECB’s interpretation, as stated by Mario Draghi this week “the ESM forbids direct recapitalisation”.

Spain therefore has, in our view, a high probability of triggering a “recap only” loan under the current system. Discussions reported in the Sueddeutsche Zeitung and the Financial Times about the possibility to channel the funding via the FROB, Spain’s recapitalisation vehicle, would not change the fact that the loan would appear on the government’s balance sheet. It would simply help the Spanish government to “sell” the deal to its public opinion, by highlighting the fact that the EU loan would be strictly earmarked to recapitalise banks, contrasting with the “full program” approach, covering the government’s “ordinary” funding needs in Greece, Ireland and Portugal.

The size of the “recapitalisation loan” is going to be crucial to Spain. It has to be large enough to convince the markets that it will address the country’s banking issue in a credible manner, while not being large enough as to jeopardize debt sustainability.

Some estimates are already available. Fitch for instance considers in a base case that a recapitalisation effort of EUR50bn would be needed, EUR 100bn in an adverse scenario. Since the announcement that Bankia alone – c.13% of all real-estate related assets - needed an additional EUR 19bn, out of which EUR 15bn for credit impairment, the market is probably expecting large numbers, even if it would be wrong to extrapolate from Bankia, which tends to concentrate the worst risks.

According to El Pais on Thursday, quoting “parliamentary sources”, the Bank of Spain considers that two other nationalised banks, CatalunyaCaixa and Novagalicia need additional capital to the tune of EUR 9bn. The Spanish press on Thursday (El Pais, ABC) was mentioning a range of EUR40-80bn for the IMF’s assessment, to be published on Monday.

We calculate here different trajectories for Spanish public debt for three different recapitalisation scenarios: EUR 50bn, EUR 80bn and EUR 120bn. See box next page for the details of the calculations.

Under the EUR 120bn scenario (see Figure 1 in the last page of this article), Spanish public debt would remain at peak marginally below 100% of GDP (97.2% in 2014 and 2015). That would still be significantly below Italy, but Spain would be unable, in our model, to bring back by 2020 its debt below the 90% of GDP threshold which Rogoff suggests is associated with adverse macroeconomic consequences.

A figure above EUR 120bn for the recapitalisation need could become an issue for the “recap only” approach, since the guidelines make it clear that the size of the loan should remain consistent with a “sound fiscal position” for the receiving country. The risk then is that the country would be pushed in a “full program”. Another risk would also be to see Spain pushed below investment grade status by rating agencies. Fitch’s “top range” for the state-funded recapitalisation stands at EUR 100bn as they downgraded on 7 June the sovereign by 3 notches to BBB with “negative outlook”.

In the other two scenarios, however, Spain would be in the same “club” as France.

Naturally, this type of models does not take into account the risk of “market over-reaction”, where interest rates climb further so that the sustainability conditions can no longer be met. We note incidentally that it may make sense for Spain to trigger the support under the EFSF scheme, before the ESM takes over in July. Indeed, EFSF loans are pari passu, while ESM loans – except for the countries currently under program – are senior.

Since ordinary investors could be spooked by the “subordination risk” post-ESM funded recap, it would make sense for Madrid to hurry. Also it would be reasonable to expect the ECB to be more aggressive in its support of Spanish banks and sovereign following a recapitalization effort that it has consistently called for.

Still, as we stated in Focus Europe last week, we think that resorting to the euro rescue mechanism is the only option for Spain to ultimately regain credibility in the market, by giving the banks the financial strength which will allow them to precipitate the fire sales (accompanied by a further significant fall in prices) which will start clearing the housing overhang. In the meantime, Spain will have to convince on its capacity to reduce its deficit. The latest data – completely ignored by the market in the midst of the “recap drama” – are somewhat encouraging. Correcting for the acceleration in transfers to the regions to help them cope with their refinancing issues (0.7% of GDP) as well as the anticipation in the VAT paybacks (0.1%) of GDP, among others, the central government deficit for the first four months of 2012 stood at 1.4% of GDP against 1.5% in the same period of 2011. This makes the official target of 3.5% for the whole year not out of reach. The regions, also correcting for the acceleration in transfers from the central government, have reduced their deficit to 0.45% of GDP in Q1 2012 from 0.75% in Q1 2011, before some of the most important measures (50% increase in university tuition fees, cuts in healthcare) actually kicked in.

Another crucial issue, in terms of market perceptions of the fiscal adjustment’s feasibility, will be the growth outlook. The effort is obviously daunting, but we think that our assumptions there are reasonable. The impact on GDP growth of the fiscal retrenchment would peak at 1.8 pp in 2012, using the Bank of Spain’s multiplier, which takes into account the lagged impact over three years of the fiscal stance. Our headline GDP growth forecast for this year is - 1.5%. In other words, our assumption for “underlying growth”, i.e. the pace of activity, stands at +0.3%, which in our view reflects the very negative impact of construction. However, after 3 years the impact of the fiscal retrenchment would fade significantly. The scenario we describe here does not sentence Spain to “eternal austerity”. The effort would be concentrated on three years. We note as well that the unlocking of arrears accumulated by the regions worth 3.1% of GDP this year, under a syndicated loan with the main Spanish banks, should have a mitigating impact on the recession.

However, credibility has been dented in Spain. We therefore think it is going to take time for the non-residents to flock back to the sovereign bond market. Regional finances, for instance, looked fine according to the figures published in the first three quarters of 2011 before revealing a massive slippage when the annual data came up. In the meantime, local banks will need to take the slack.

Reassurance on the capital position could encourage them to support the sovereign market further, but as we suggested several times in Focus Europe these last few weeks, another round of long term liquidity by the ECB would be welcome. A credible recapitalisation of Spanish banks was probably one of the conditions for the central bank to contemplate further quantitative action, but Draghi’s press conference this week suggested that a third LTRO was not yet a possibility. It may take a few more months of sluggish credit origination to prompt the central bank into more action.