AMERICAN FUTURE

In today’s FT, Gillian Tett contrasts how well American banks prepared for the possibility of a U.S. default last summer and how European banks are now preparing — or not preparing — for a break-up of the eurozone. The comparison isn’t reassuring.

Here’s what she says about the banks on this side of the pond:

Last summer, some of America’s largest banks secretly stocked their cash machines with the maximum possible supply of notes. The reason? In July 2011, the bankers feared that the US might be about to suffer a technical default, because Congress could not agree on measures to raise the debt ceiling.

So, they decided – after collective discussions – to keep those ATMs stuffed with greenbacks to ensure that consumers would never panic about running out of cash if that “worst-case” default scenario transpired.

In the first half of 2011, large banks such as JPMorgan and Bank of New York Mellon are thought to have each spent about $50m ensuring that their contracts were legally watertight in the event of a US default, and that repo deals and financial markets were continuing to function (along with those ATMs.)

At this week’s meeting of the World Economic Forum, eurozone leaders have stressed their commitment to keeping the single currency intact. And the consensus among senior bankers is that the most likely scenario for the eurozone for the foreseeable future is continued muddling through. Hardly anyone, however, expects a truly positive “solution” soon, and most think that a break-up or exit scenario remains entirely possible. Accordingly, most large banks are now secretly preparing contingency plans – just in case.

This time, says Tett, some large banks may be spending far more than $50 million, since the task is dramatically more complex: they have to review the fine print of all legal contracts for any euro exit, and to ensure that financial market transactions are watertight, or at least hedged. Many large banks are also trying to make sure that their liabilities in peripheral countries are matched with assets inside the same country – rather than across the eurozone as a whole.

Here’s the crux of the matter:

In Europe today, however, it appears that there is little – or no – similarly collaborative move. Or if there is, it is so utterly secret that not even senior bankers know about it yet. On an individual level, most large banks insist they are well prepared (though many express concern that the exchanges or settlement systems seem less organised). But nobody appears to have spoken extensively to anyone else, far less to any central government group.

Why? One problem is that the banking landscape in Europe is far more fragmented than in America. Another is weak European banks are now too distracted, or cash-poor, to prepare for a vague risk. There is also a deep reluctance among some eurozone bankers to admit they are preparing for a worst case, which would risk undercutting their own politicians. And some bankers argue that if a truly serious crisis materialised (such as the exit of Italy, say) it would be so devastating and complex that planning would be pointless.

Earlier this month, the European Central Bank announced an emergency loan program known as “longer-term refinancing operations,” or LTROs. The program will become operational tomorrow (Wednesday). The Financial Times says that the ECB expects strong demand for the loans, which will be available in “unlimited” quantities.

The purpose of the program, which enables banks to avail themselves of three-year loans at extremely favorable interest rates, is to ease the severe strains in the eurozone’s financial system. If demand for the loans is strong, it should reduce the likelihood that banks will substantially shrink their balance sheets (by selling assets and reducing new loans to their customers) to meet their funding needs (which are especially large in early 2012). The hope, then, is that the LTRO will improve the economic performance of countries in the eurozone. It’s important to note, however, that this provision of additional liquidity doesn’t attack the eurozone’s fundamental problem: severe and persistent balance-of-payment imbalances among its members.

The funding problem that the LTRO is aimed to ease is having a contagion effect. Asset sales by European banks have put pressure on securitized mortgage prices in the U.S. Instead of selling distressed assets in their home markets, the banks are selling assets elsewhere (as encouraged by their governments).

In combination with the sharp drop in Spanish short-term interest rates that took place today, the imminent start of the LTRO program may be responsible for the sharp rally in the U.S. equity markets. If demand is as strong as the ECB expects, contagion fears could ease, allowing for a short-term bounce in the stocks of financial institutions holding mortgage-backed securities.

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A Financial Times video explains the workings of the eurozone’s financial plumbing and how it might leak if one or more countries exit from the currency union’s membership. The hard-copy is here.

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Excerpts from an FT editorial:

Europe’s economic prospects are deteriorating frighteningly fast, and the world outlook is darkening in step with the Old World’s woes. Unless the world’s leaders manage to pull together soon, we should brace ourselves for a second phase of the credit crisis that will be even worse than the first.

[...] A credit crunch is gaining force, and Europe’s economy grinding to a halt because of it. This is making the twin crises – bank and sovereign – harder to resolve and is hitting emerging economies whose credit is drying up and whose export markets are withering. If the ECB cannot stimulate growth, governments must do so, and fast.

Today the whole world badly needs Europe to grow. Long-term growth and rebalancing are sine qua non for overcoming the debt crisis, but short-term recovery is a greater priority. Austerity by those who must should now be compensated by stimulus from those who can.

My sentiments, exactly.

In the aftermath of the 2008 financial collapse, not a single American banker has been charged with a criminal or civil crime; if memory serves me correctly, there aren’t even any active investigations into whether charges should be brought.

Considering the consequences of the collapse for millions of mostly innocent Americans, this seems outrageous.

Earlier this week, the U.K.’s Financial Services Authority (the equivalent of our SEC) issued a report on “The failure of the Royal Bank of Scotland.” The Chairman’s Forward to the report deals with the following questions:

• If RBS management errors led to failure, why has no-one been punished?
• Why has the FSA not taken enforcement action?
• Should the rules be changed for the future?
• Why were regulation and the supervisory approach deficient?
• Have changes been sufficiently radical?

While the circumstances surrounding the collapse of RBS (the closest analogy might be Bank of America’s takeover of Countrywide Financial) and the regulatory authority of the FSA aren’t identical to those of the failed American financial institutions and the mandate of the SEC, I think  the answers to these five questions shed some light on the situation in the U.S.

Continue reading ‘Why Haven’t the Bankers Been Punished?’ »

Bad signs abound: IMF warns about depression; efforts underway to water-down EU summit agreement; EFSF prospectus may warn the euro could collapse; European banks not interested in buying more government debt

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Could another Great Depression happen? The IMF thinks so:

The managing director of the International Monetary Fund has warned that the global economy faces the prospect of “economic retraction, rising protectionism, isolation and . . . what happened in the 30s [Depression]” . . .

“There is no economy in the world, whether low-income countries, emerging markets, middle-income countries or super-advanced economies that will be immune to the crisis that we see not only unfolding but escalating. It is not a crisis that will be resolved by one group of countries taking action. It is going to be hopefully resolved by all countries, all regions, all categories of countries actually taking action.”

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Efforts to water-down the treaty on budget discipline proposed at last week’s EU summit have started:

European negotiators say momentum is building towards making a highly touted new treaty on budgetary discipline extremely narrow, enabling its smoother passage through national parliaments but hindering Franco-German ambitions to create a fiscal union in the eurozone.

Diplomats said several European Union countries are lining up in favour of a draft that would contain only two elements: a so-called “debt brake” obliging signatories to write debt and deficit limits into national constitutions; and a measure making EU sanctions against fiscal rule-breakers more automatic.

According to a senior German official, while France and Germany will go further in bilateral agreements, Ms Merkel now supports a treaty of only two or three pages that would not even enshrine regular eurozone summits – something Nicolas Sarkozy, the French president, has championed.

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The European Financial Stability Facility (EFSF) may insert a euro warning clause in a draft prospectus:

A draft prospectus prepared for the latest eurozone bail-out instruments includes explicit warnings to investors that the euro could break apart or even cease to be a “lawful currency” entirely.

The European Financial Stability Facility, which is creating the products to insure bonds of troubled countries against default, is debating whether the “risk factors” should be included in the final version.

In the latest draft of the prospectus, seen by the Financial Times, a summary of the dangers to investors includes: “[R]isks arising from a Reference Sovereign ceasing to use the euro as its lawful currency . . . or the cessation of the euro as a lawful currency”.

Including such a warning in an official document from the eurozone’s own rescue fund would be a surprising move. European leaders have frequently insisted that a euro break-up is unthinkable, although last month France’s Nicolas Sarkozy and Germany’s Angela Merkel accepted for the first time that Greece might leave.

The draft appears to be almost complete, ahead of the expected launch of the instruments in January. But the details of the risks of euro exit remain blank, as the EFSF debates whether to include them. Lawyers are debating the merits of including warnings about the euro in corporate prospectuses, although several London bond lawyers and bankers said they had yet to see them added.

The new EFSF products, known as Euro Sovereign Credit-Linked Certificates, are modelled on credit default swaps, a type of derivative used to protect against corporate or sovereign default. European countries hope the financial engineering will allow the EFSF to spread its limited resources more widely.

The certificates will use the standards of private-sector CDS to judge whether default has occurred – a test Greece is trying to sidestep by the use of a “voluntary” restructuring.

Earlier today, I posted a presentation prepared by the EFSF. I’m repeating it here.

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The big European banks aren’t stepping up to the plate:

Eurozone governments are facing disappointment for their hopes that banks in the region would use new longer-term finance offered the European Central Bank to buy up beleaguered sovereign bonds.

Bankers say big European banks are unlikely to buy more government debt using the three-year loans on offer from the ECB for the first time next week.

The ECB announced earlier this month that it would make three-year loans to the region’s banks, in an effort to provide a lifeline to lenders locked out of public funding markets . . .

How banks will use the new three-year loans, called longer-term refinancing operations or LTROs, has been a matter of much debate in markets. Some governments had hoped banks would use the cheap ECB money to purchase higher-yielding government bonds, earning a return and helping to prop up debt-ridden countries.

In its lead article, the Economist says that the recent EU summit was “A comedy of euros.”

Once again Europe’s leaders have failed to solve the euro crisis. The new treaty could easily be killed by the markets or by its rejection in one or more euro-zone country. The EU has suffered plenty of disappointing summits without the sky falling in—a good many of them in the past year. But unlike the marathon dispute over a new constitution, the euro is in a race against time because markets are pushing countries to insolvency. As investors and voters lose faith, the task of saving the single currency grows harder. Sooner or later, the euro will be beyond saving.

[...] [The Eurozone's] members could strike a grand bargain that deploys the ECB’s balance-sheet and some form of Eurobond in exchange for fiscal integration. The question is not whether they can save the currency, but whether enough of them are prepared to pay the price. This summit suggests not.

Elsewhere in the December 17 issue:

• “The European Union and the euro: Game, set and mismatch” — What do you get when you mix political differences and inept diplomacy? Britain’s bust-up with the rest of the EU.
• “The Euro crisis: Damned with faint plans” – Euro-zone government bonds have not been made safe—and the euro project remains in peril.
• “European banks: Staggering to the rescue” — Europe’s troubled banks and broke governments are in a dangerous embrace.
• “Economics focus: One nation overdrawn” — Lessons for Europe from America’s history
• “The coalition after the veto: State of the union” — Nick Clegg and David Cameron, and the parties they lead, are deeply divided over Europe. But the coalition is indissoluble for now.
• “Financial services in Britain: The blitz spirit” — Britain’s banks face a battalion of threats, not all of them foreign.
• “Bagehot: How Britain could leave Europe” — British grumpiness about the EU feels familiar; actually, big new dangers lurk.

“Economics focus: One nation overdrawn” provides some interesting links:

• Michael Bordo, “The United States as a Monetary Union and the Euro: A Historical Perspective” (2004)

Our historical perspective leads to the conclusion that Europe achieved monetary union much more rapidly than did the United States but that integration on the real side, especially in the labor market, which ultimately is what is required for the EMU project to be successful, has lagged way behind. The question then arises, will the necessary real side reforms required to foster greater flexibility occur at a pace that will come into play in the face of the vicissitudes of the world business cycle and changing world patterns of activity? Will political will continue to provide the glue to keep the EMU going in the face of slow integration? Will it take the equivalent of the U.S. Civil War to either destroy it or strengthen it? Or will institutional adaptation occur in a learning-by-doing process?. Will adding on 10 new countries to the EMU at much lower levels of economic development help the project like the Louisiana Purchase and the Mexican War did for the United States or will it be like the counter factual exercise of the United States acquiring Mexico and Central America? The historic events basically allowed the United States to expand its territory, provide land for new settlers, and acquire vast resources. The counterfactual exercise would involve adding on a densely populated, culturally different region, at a much lower stage of economic development.

The evidence so far suggests that the best case scenario is guarded optimism. A more likely outcome based on the European response to the recent world downturn is probably not so rosy.

• Michael Bordo et. al., “A fiscal union for the euro: Some lessons from history” (2011)

The history of fiscal federations provides us with a number of conditions necessary for a fiscal union to function smoothly and successfully and thus also the monetary union on which the fiscal union is based. The first and probably the most important condition is a credible commitment to a no-bailout rule for the members of the fiscal union. The second one is a degree of revenue and expenditure independence of the members of the fiscal union reflecting their political preferences. The third condition is a well-developed transfer mechanism to be used in episodes of distress. This transfer mechanism can be facilitated by the establishment of a common bond. The fourth condition is a capacity to learn from past mistakes and adapt to new economic and political circumstances.

The Eurozone was created without an effective fiscal union. The institutions that were established to serve as the foundation for the fiscal union (the Maastricht Treaty and the Stability and Growth Pact) – to discipline domestic fiscal policies – did not function as planned as revealed by the crises and recession from 2007-2009 and onwards. The lessons from the historical experience of the five federal states surveyed by us could be helpful for the Eurozone to avoid disintegration.

Round 2 of Reactions to the EU Summit (and some other stuff)

The consensus:

The title of the FT’s editorial — “Europe fails to reach summit” — says it all:

It should have been the climax to Europe’s thriller, a summit that would kill off the sovereign debt crisis with a salvo of confidence-restoring measures. But, apart from Britain’sdramatic exit, last week’s European summit was entirely predictable in its inconclusiveness.

To be fair, it is good news that even modest steps were taken towards closer fiscal integration. But the real, comprehensive fiscal union needed to restore faith in the euro, as opposed to a few new rules, remains elusive.

More urgently, the deal that was struck does nothing to resolve the immediate crisis. Moves to bolster the International Monetary Fund and hints of more support next year for Europe’s two bail-out vehicles are neither big enough nor fast enough to deal with the titanic task of funding peripheral countries’ debt until confidence returns.

Hopes in the existence of a big bazooka proved misplaced. Mario Draghi, European Central Bank president, on Thursday quashed hopes that he would launch an unlimited bond-buying programme to help indebted sovereigns, as European rules do not allow this.

Now there is the suggestion that the ECB has a cunning plan to give the bazooka to Europe’s banks, which will be lent bags of cheap money, with which to buy their own countries’ debt.

The argument is tempting. Friday’s summit declared that there will be no more haircuts on sovereign debt. So if banks can get three-year ECB money at 1 per cent and buy Italian bonds at 6 per cent, this could help cut debt costs while bringing seemingly risk-free returns. This is not contrary to European rules and it could be in both parties’ interests. If the sovereigns go, Europe’s banks are front line victims.

However, there are many reasons to be wary of such a solution, not least because it fools no one. The ECB would in effect be funding sovereign debt through Europe’s banks. This is hardly in the spirit of the European treaty. Second, shareholders might rightly question why banks, which have been shedding periphery bonds despite having had the arbitrage opportunity for some time now, were suddenly scooping them up. Most importantly, if the current crisis was sparked by the link between sovereign and bank risk, does it make sense to intensify that link? Right now there may be no alternative to save the euro. But it amounts to little more than sleight of hand in a crisis where clarity and resolve would do much more to restore confidence.

Unsurprisingly, the FT’s Wolfgang Munchau agrees:

. . . the decision to set up a fiscal union outside the European treaties will do nothing whatsoever to resolve the eurozone crisis . . . this is not something you would wish to do outside European treaties. The existing treaties form the legal basis for all policy co-ordination of monetary union. It gets very messy when you try to circumvent them.

[...] A fiscal union set up outside the European treaty would face severe legal and practical limitations. Unless a trick is found, it cannot make recourse to the resources and institutions of the EU. Nor can it issue eurozone bonds. The only conceivable counterparty for a eurozone bond is the EU itself.

More important even, a fiscal union created through a legal trapdoor would not help solve the crisis. The eurozone is facing a generalised loss of confidence. Investors no longer trust its crisis management, the solidarity of its citizens, even the ability to conduct sensible economic policies. The EU is not going to restore confidence through legal gimmickry that will face numerous court challenges.

Leaders should have admitted on Friday that the summit had simply failed, or perhaps have given it a few more days. Negotiations might have produced a compromise. With the fake pretence of another treaty, that is no longer possible.

Remember what everybody said a week ago? To solve the crisis, the eurozone requires, in the long run, a fiscal union with a prospect of a eurozone bond and, in the short run, unlimited sovereign bond market support by the European Central Bank. What we now have is no treaty change, no eurozone bond and no increase either in the rescue fund or in ECB support.

Policy changes the ECB announced last week will help banks directly and governments indirectly. But the EU fell short on every element of a comprehensive deal. On Friday, investors reacted positively to what was sold to them as a “fiscal compact”. But once the implications of a separate treaty are understood, I fear disillusionment will set in.

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The rating agencies are equally unimpressed.

In its Weekly Credit Outlook, Moody’s says that “Pressure Remains on Euro Area Sovereigns in Absence of Decisive Initiatives” and “European Bank Recapitalization Plan Is Credit Positive, but Encourages Deleveraging”:

Pressure Remains . . .

. . . the [EU summit] communiqué reflects the continuing tension between euro area leaders’ recognition of the need to increase support for fiscally weaker countries and the significant opposition within stronger countries to doing so. Amid the increasing pressure on euro area authorities to act quickly to restore credit market confidence, the constraints they face are also rising. The longer that remains the case, the greater the risk of adverse economic conditions that would add to the already sizeable challenges facing the authorities’ coordination and debt reduction efforts.

As a result, the communiqué does not change our view that the crisis is in a critical, and volatile, stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While our central scenario remains that the euro area will be preserved without further widespread defaults, shocks likely to materialise even under this ‘positive’ scenario carry negative credit and rating implications in the coming months. And the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.The credit implications of these and further measures likely to be announced in coming weeks require careful consideration against the backdrop of decelerating regional economic activity, fragile banking systems, partly dysfunctional credit markets, and the varying degree of success of country-specific measures aimed at structural change and fiscal consolidation. But in the absence of credit market conditions stabilising, the system remains prone to further shocks which would likely lead to selective rating changes. More broadly, in the absence of any decisive policy initiatives that stabilise credit market conditions effectively, our intention as announced in November is to revisit the level and dispersion of ratings during the first quarter of 2012.

European Bank Recapitalization . . .

Additional capital is credit positive as it enables banks to cope with increased stress. However, there is a risk that tighter capital requirements will encourage further deleveraging, thereby increasing the risk of a credit crunch and additional impairments.

The establishment of a sovereign exposure buffer follows criticism that the EBA’s stress test earlier this year inadequately reflected the true value of, and impairments in, banks’ sovereign exposures. Disclosures in banks’ interim statements also point to inadequate evaluation and provisioning and, in some cases, a failure to comply with international accounting standards.

[...] Supervisors are not simply seeking to achieve higher capital ratios, but also higher capital. Nevertheless, the incentive for banks to deleverage remains high and will only be exacerbated by higher capital requirements. More fundamentally, higher capital buffers cannot address the underlying cause of the disruption to the funding markets which is the sovereign debt crisis.

Fitch says that the “Summit Does Little To Ease Pressure on Eurozone Sovereign Debt”:

After the latest EU crisis meeting it is clear that politicians are responding to the eurozone sovereign debt crisis through incremental improvements. It seems that a “comprehensive solution” to the current crisis is not on offer.

This Summit demonstrated strong political support for the euro, and that its members are putting in place the institutional and policy framework for a more viable eurozone and ultimately greater fiscal union. But taking the gradualist approach imposes additional economic and financial costs compared with an immediate comprehensive solution. It means the crisis will continue at varying levels of intensity throughout 2012 and probably beyond, until the region is able to sustain broad economic recovery.

In the short term we predict a significant economic downturn across the region. The eurozone faces intense market pressure, which is triggering loss of business and consumer confidence, and weak industrial activity and retail sales. Our forecast of 0.4% eurozone GDP growth next year and 1.2% in 2013 would be significantly higher if there was a comprehensive solution to the crisis. The lack of a comprehensive solution has increased short-term pressure on eurozone sovereign credit profiles and ratings.

The latest EU Summit, like others before it, has resulted in some positive developments. There is an extra EUR200bn of funding for the IMF, the ESM has been brought forward, and there has been policy change on private-sector involvement in any future sovereign crisis. As with all Summits there is execution risk.

The extra resources for the IMF are welcome but it is not clear how and under what circumstances they would be deployed. The move away from requiring private-sector involvement (PSI) as a condition for ESM programmes is clearly positive for bondholders. The European Commission said it will “strictly adhere to the well established IMF principles and practices.” PSI has been a feature of past IMF programmes, but the Fund sets out to attract private capital to sovereigns and can be expected to use PSI as a last rather than a first resort.

Separately, the ECB also announced changes to its repo schemes that will aid bank liquidity, such as three-year liquidity lines and looser collateral requirements for structured finance. This could be positive for eurozone sovereigns if it eases pressure on them to introduce or re-activate bank debt guarantee schemes.

The Summit’s conclusions show a longer-term desire to move towards some form of fiscal integration in return for enforced fiscal prudence. We believe that most of the vulnerable eurozone countries are already implementing aggressive austerity programmes, and some are already changing their national constitutions. It is too early to judge how effective the fiscal compact will be due to the uncertainty regarding how it will be implemented.

We still believe the ECB, either directly through its sovereign bond purchase programme or indirectly by allowing the EFSF/ESM to access its balance sheet, is the only truly credible “firewall” against liquidity and even solvency crises in Europe.

Hopes that the ECB would step up its actions in support of its sovereign shareholders as a quid pro quo for institutional and legal changes that gave the ECB greater confidence in the long-run commitment of eurozone governments to fiscal discipline appear to have been misplaced.

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Lurking in the background, according to the Wall Street Journal, is an old nemesis: credit default swaps, which have been used in copious quantities by European banks:

Dozens of banks across Europe have sold large quantities of insurance to other banks and investors that protects against the risk of ailing countries defaulting on their debts, the latest illustration of the extensive financial entanglements among the continent’s banks and governments.

New data released last week by European banking regulators suggest the risks of banks suffering losses tied to European government bonds could be higher and more widespread than previously realized.

The numbers show European banks have sold a total of €178 billion ($238 billion) worth of insurance policies, in the form of financial derivatives known as credit-default swaps, on bonds issued by the financially struggling Greek, Irish, Italian, Portuguese and Spanish governments. If those bonds default, as some investors fear they might, banks could be on the hook for making large payments to the holders of the swaps.

The banks have at least partly insulated themselves from such potential losses by buying large quantities—roughly €169 billion worth—of credit-default swaps tied to the same bonds, apparently in large part from other European banks, according to European Banking Authority data.

Some analysts and investors say they had assumed that sovereign credit-default swaps, known as CDS, were primarily sold by giant global investment banks in the U.K., France and Germany, as well as in the U.S. Those banks sell the swaps to big corporate clients and other banks and institutions.

But the new EBA data show a surprising breadth of large and small European banks—at least 38 of them—have sold instruments that protect against potential losses on Greek, Irish, Italian, Portuguese and Spanish government bonds.

Of the total protection that European banks have written on government bonds in Europe’s five most-stressed countries, nearly one-third originated from German banks.

The diverse array of banks in the sovereign CDS market means that risks can spread more quickly through the financial system. It also means it is harder to predict how losses would ricochet among institutions and countries, analysts say.

The banks and some analysts argue that the industry’s actual exposure is far less than the €178 billion of swaps they have sold because the banks have purchased €169 billion in similar protection from other sources, which can offset the exposure. Many of Deutsche Bank’s purchases and sales of CDSs, for example, are with the same counterparties, with whom the German bank has legally enforceable netting agreements in place.

But some experts say it is risky to assume that all banks’ CDS transactions neatly cancel each other out.

“Netting is all very well provided that you trust your counterparty,” said Jon Peace, a Nomura Securities banking analyst. But in a crisis situation, “what you thought was net could tend toward your gross exposures” because certain sellers of the default insurance could themselves go bust.

For example, two of Italy’s biggest banks, UniCredit SpA and Banca Monte dei Paschi di Siena SpA, have sold a total of about €5.3 billion of protection against the risk of an Italian sovereign default, according to the new EBA data. The problem is that, in a default scenario, both banks likely would be in trouble themselves due to their huge holdings of Italian government bonds and the fact that their businesses are largely concentrated in Italy.

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While the Organisation for Economic Co-operation and Development (OECD) hasn’t issued a statement setting forth its view of the results of the EU summit, the Financial Times reports that it “will warn in its latest borrowing outlook, due to be published this month, that financial stresses are likely to continue with the “animal spirits” of the markets – their unpredictable nature – a threat to the stability of many governments that need to refinance debt.”

For the foreseeable future it will be a “great challenge” for a wide range of OECD countries to raise large volumes in the private markets, with so-called rollover risk a big problem for the stability of many governments and economies.

Rollover risk is the threat of a country not being able to refinance or rollover its debt, forcing it either to turn to the European Central Bank in the case of eurozone countries or to seek emergency bail-outs, which happened to Greece, Ireland and Portugal. The OECD says the gross borrowing needs of OECD governments is expected to reach $10.4tr in 2011 and will increase to $10.5tr next year – a $1tr increase on 2007 and almost twice as much as in 2005. This highlights the risks for even the most advanced economies that in many cases, such as Italy and Spain, are close to being shut out of the private markets.

While borrowing was higher in 2009 and 2010, the risks are greater than ever because of rising borrowing costs in turbulent, unpredictable markets.

The OECD says that the share of short-term debt issuance in the OECD area remains at 44 per cent, much higher than before the global financial crisis in 2007. This, according to some investors, is a problem as it means governments have to refinance, sometimes as often as every month, rather than being able to lock in more debt for the longer term that helps stabilise public finances.

The OECD also warns that a big problem is the loss of the so-called risk-free status of many sovereigns, such as Italy and Spain, and possibly even France and Austria. The latter two have triple A credit ratings but investors no longer consider them risk-free.

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Contagion from the eurozone crisis appears to be spreading to emerging markets: Indian industrial production dropped by 5.1 percent in October. From the Financial Times:

“The data are way worse than we were expecting,” said A Prasanna, economist at ICICI securities in Mumbai. “Usually output is lower during the months of October and November as there are fewer working days due to the festival season but a 5.1 per cent drop is significantly more than we predicted,” he added.

Manufacturing output, which represents about 76 per cent of industrial production, dropped 6 per cent in October, compared with a year ago and capital goods production, which is considered to be a key barometer of investment sentiment in the country, fell 25.5 per cent. Meanwhile, mining production was down 7.2 per cent, as a series of scandals in the sector and continued uncertainty over the outcome of a long-awaited mining bill hurt the industry.

At 174 pages, this is the most thorough, enlightening (and longest) financial and economic review and outlook I’ve run across.

If you’re put off by the size of this tome, the FT Alphaville blog focuses in on what it considers to be “the most important chart in the world,” which can be found on page 143 of the report:

[This chart] shows how the world’s outstanding stock of safe haven assets denominated in either dollars or euros has evolved, adjusted to account for the Fed’s purchases of US Treasuries and other assets in recent years as part of quantitative easing.

You can see just how impressive the decline has been since the end of the crisis, and we’d also note that if Credit Suisse had been feeling uncharitable, they would have been justified in excluding French sovereigns.

The chart helps explain much of what’s happening in global financial markets now, especially in Europe (not on its own, mind you — we said “helps” explain):

– Begin with the ongoing collateral crunch, and how the decline of safe assets is directly tied to the dramatic fall in the availability of high-quality collateral in European lending markets. So much of it is now encumbered via direct bilateral funding agreements or by sitting at the central bank drawing liquidity.

Now, if you’ve read your Manmohan Singh [Footnote 1] (or your Izzy Kaminska [Footnote 2] or your Tracy Alloway [Footnote 3]), you’ll know that this availability is the first of two parts of the collateral shortfall effect. The other part is the shortening of “re-pledging chains”, otherwise known as a reduction in the velocity of collateral and which Singh explains thusly:

Intuitively, this means that collateral from a primary source takes ‘fewer steps’ to reach the ultimate client. This results from reduced supply of collateral from the primary source clients due to counterparty risk of the dealers, and the demand for higher quality collateral by the ultimate clients.

And why does it matter? Singh again, emphasis ours:

The “velocity of collateral”—analogous to the concept of the “velocity of money”—indicates the liquidity impact of collateral. A security that is owned by an economic agent and can be pledged as re-usable collateral leads to chains. Thus, a shortage of acceptable collateral would have a negative cascading impact on lending similar to the impact on the money supply of a reduction in the monetary base. Thus the first round impact on the real economy would be from the reduction in the “primary source” collateral pools in the asset management complex (hedge funds, pension and insurers etc), due to averseness from counterparty risk etc. The second round impact is from shorter “chains”—from constraining the collateral moves, and higher cost of capital resulting from decrease in global financial lubrication.

When you hear concerns that the ECB has lost some control over monetary policy because of a liquidity-starved credit channel — or indeed when you hear Draghi himself say that he’s cognizant of the “scarcity of eligible collateral” – this is why.

– As was perhaps inevitable, the decline in safe assets has come at a time when investor demand for these assets has only climbed for them and as the deep freeze in European unsecured lending has meant a big shift towards collateralised lending. Hence the widening discrepancy in repo prices for different types of collateral (also noted by Draghi) and, in particular, the negative spread between Libor and the secured repo rate, on which Izzy superbly elaborates. For all but the strongest banks, i.e. those with surplus cash reserves, the ECB is increasingly the only shop still open.

– There are future policy considerations here as well. Back to Singh one last time:

Recent regulatory efforts will require significant collateral on many fronts—Basel’s liquidity ratios, EU Solvency II and CRD IV, and moving OTC derivatives to CCPs. Unless there is a rebound in the pledgeable collateral market, the likely asymmetry in the demand and supply in this market may entail some difficult choices for the markets and the regulators.

It stands to reason that the collateral grab has been exacerbated as financial institutions anticipate the onset of these regulations. This has already led to much talk about a burgeoning collateral transformation industry, though apparently there remain questions as to how big it will get and what kinds of unintended systemic risk could result.

– A somewhat obvious and related point here, but the loss of “safe” status for so much debt contributes to the deleveraging burden of European banks and their American subsidiaries; by definition it means higher risk weightings for these assets.

Declining asset quality is surely also one reason that European banks had trouble funding themselves in US repo markets, and the resulting stress in the currency basis swap markets as banks sought dollars elsewhere led to last week’s intervention.

And it’s probably why US money market funds, worried about what the absence of safe asset holdings at European banks means for their stability, have continued retreating as a source of wholesale funding, and why the American subsidiaries of these banks are now liquidating their dollar reserves to make up for it.

– Another obvious and related point, which is that the ECB is now accepting everything but your dirty socks as collateral. Not much choice in the matter, we suppose, if it wants to ease the liquidity strains caused by the broken interbank market. What else can it lend against?

– Historically, a Triffin Dilemma — and that’s kinda what this is — leads to funky innovations in the shadow banking system and all the complications that such innovations bring. Will the whispers of new kinds of financial alchemy get louder?

– You can see in the chart that before the crisis, US Treasuries were an important but minority amount of the world’s stock of safe haven assets. Treasuries are now the vast majority of such assets. But this is because of the extraordinary decline in the other kinds of assets and because of quantitative easing by the Fed, not because the outstanding stock of Treasuries has increased by so much.

Issuance in recent years hasn’t been nearly big enough to make up for the decline in other kinds of safe assets or, certainly, to correct the imbalance between investor demand for safe assets and outstanding supply. We’re not saying it should have been — only that this further confirms how absurd it is that the US government has spent so much time this year bickering over deficits rather than economic growth, and that the US economy confronts a fiscal drag beginning next year.

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Footnote 1. Manmohan Singh, “Velocity of Pledged Capital: Analysis and Implications,” IMF Working Paper, November 2011.

Abstract: “Large banks and dealers use and reuse collateral pledged by nonbanks, which helps lubricate the global financial system. The supply of collateral arises from specific investment strategies in the asset management complex, with the primary providers being hedge funds, pension funds, insurers, official sector accounts, money markets and others. Post-Lehman, there has been a significant decline in the source collateral for the large dealers that specialize in intermediating pledgeable collateral. Since collateral can be reused, the overall effect (i.e., reduced ‘source’ of collateral times the velocity of collateral) may have been a $4-5 trillion reduction in collateral. This decline in financial lubrication likely has impact on the conduct of global monetary policy. And recent regulations aimed at financial stability, focusing on building equity and reducing leverage at large banks/dealers, may also reduce financial lubrication in the nonbank/bank nexus.”

Footnote 2. FT Alphaville, “Draghi: ‘We are aware of the scarcity of eligible capital,” posted December 1, 2011.

The ECB’s Mario Draghi gave a speech to the European Parliament on Thursday, making some of the following key points:

RTRS – DRAGHI-DOWNSIDE RISKS TO ECONOMIC OUTLOOK HAVE INCREASED
RTRS – DRAGHI-ECB TEMPORARY MEASURES ONLY LIMITED
RTRS – DRAGHI-ECB AWARE OF CONTINUING DIFFICULTIES ON BANKS
RTRS – DRAGHI-AWARE OF MATURITY MISMATCHES, STRESSES ON BANK FUNDING
RTRS – DRAGHI-CHANGES IN STRAINED COUNTRIES HAVE NOT YET HAD IMPACT ON FRAGILITY OF FINANCIAL MARKETS
RTRS – DRAGHI-CREDIBLE SIGNAL NEEDED TO GIVE ULTIMATE ASSURANCE OVER THE SHORT TERM

Another point also raised (but not flashed by Reuters for some reason) was that authorities are aware of the scarcity of eligible collateral in some financial segments. This in our opinion is a key issue and one which cannot easily be fixed by ECB purchases.

As Draghi noted:

Dysfunctional government bond markets in several euro area countries hamper the single monetary policy because the way this policy is transmitted to the real economy depends also on the conditions of the bond markets in the various countries. An impaired transmission mechanism for monetary policy has a damaging impact on the availability and price of credit to firms and households.

Furthermore, it echoes Draghi’s comments from November 18, when he said:

We are aware of the current difficulties for banks due to the stress on sovereign bonds, the tightness of funding markets and the scarcity of eligible collateral. We are also aware of the problems of maturity mismatches on balance sheets, the challenges to raise levels of capital and the cyclical risks related to the downturn.

In the money market, we see rising spreads between secured and unsecured segments, and a widening of repo prices between different types of collateral. Interbank activity remains subdued and concentrated in the very short-term maturities. This limited activity is reflected in increased recourse to our liquidity-providing operations, as well as to our deposit facility.

He’s trying to get a point across. Not only is the ECB arguably losing control, it’s trying to flag up that the chaos is the result of messed up transmission mechanisms in dealer markets more than the result of a changing view of Eurozone credibility.

No wonder the reaction in the German bund market has been as follows:

RTRS-GERMAN 5-YEAR GOVERNMENT BOND YIELDS FALL 6 BPS ON DAY TO 1.113 PCT

RTRS-GERMAN ONE- TO SIX-MONTH GERMAN TREASURY BILL YIELDS DIP FURTHER INTO NEGATIVE TERRITORY AFTER DRAGHI COMMENTS

Even if the ECB broadens the criteria on the collateral it acccepts — and remember it already accepts some of the poorest quality collateral in central banking circles — that won’t necessarily solve the problem in the public bilateral markets where only top quality bonds will do. And it’s what is happening in the bilateral and interbank markets which is determining the fate of the eurosystem.

Footnote 3. Financial Times, “Financial system creaks as loan lubricant dries up,” November 28, 2011.

Whoosh! That’s the sound of up to $5,000bn worth of collateral draining from the financial system. And it is not a reassuring one.

Large banks typically reuse securities handed over to them by big investors such as hedge funds, insurers or pension funds. They do so by pledging the assets out through the so-called repo or securities lending markets, generating a return for themselves and their clients but, in the process, also helping to lubricate the global financial system.

Since the financial crisis, though, these “chains of collateral” have become much shorter, meaning securities including government or mortgage bonds are not being recycled through the system as much as they used to be.

While that might help reduce overall risk, by limiting leverage, it has important implications for the way the system works and the global economy.

Some analysts believe that this fall in collateral use could actually serve to increase “hidden” risk in the financial system as the market devises new ways of tackling the shortage.

One reason collateral use has fallen is that market participants are more vigilant about the creditworthiness of counterparties and how business partners might use collateral sent to them.

Financial institutions are also increasingly trying to manage risk by taking “haircuts” – clipping some of the value on assets being traded to add a bigger safety cushion. That, in turn, limits the extent to which securities can be recycled just as the pool of available collateral is shrinking.

More collateral is also being tied up at the world’s central banks, and especially at the European Central Bank, as commercial lenders turn to them for financing. The ECB’s balance sheet has ballooned to more than €2,000bn as the region’s banks exchange their assets, such as bank bonds or bundled loans, in return for central bank funding.

The lack of financial lubricant has important consequences. It may, for example, be one reason why businesses and households have not felt the full effect of monetary easing by central banks, analysts say. Financial lubricant is needed to transmit rate cuts and boost the economy.

Regulatory reforms, including new capital rule for banks and moves towards central clearing of derivatives trading, are expected to intensify the chase for “decent” securities, potentially clogging the system further by locking up more collateral. One result of all this has been a boom in specialist collateral management services. So-called “collateral transformation” is being marketed to derivatives users as a way for them to obtain the cash or government bonds they will need for central clearing. Liquidity swaps, where banks exchange illiquid assets for more liquid ones, are also being used by banks to help meet the new requirements on capital.

These kinds of services may help to keep the world’s financial plumbing in good running order. However, many market participants still expect demand for collateral to exceed supply. Moreover, some argue that such services place a question mark over whether risk is being reduced or simply shifted around the system, potentially flowing into less regulated areas as it did before the 2008-09 crisis. The concern over such flows is that the effect, should there be another bout of severe market turmoil, could be similar to the rise of the “shadow banking system”, which thrived on leverage in the run-up to the financial crisis and helped cause the huge losses at Lehman and others.

Germany isn’t the only member of the eurozone to have taken a hardline on bailing-out the profligate “Club Med” countries. The Netherlands has been in the German camp since the beginning of the crisis. For this reason, it’s noteworthy that the ING Group,one of, if not the most important of the country’s financial institutions, has gone public with its fears of the consequences of a collapse of the euro.

On December 1, De Volksrant — a leading Dutch newspaper — published a letter to the editor from ING chief economist Mark Cliffe in which he said that the collapse of the euro would have a particularly disastrous effect on the Netherlands. On the same day, ING published a lengthy report titled “EMU Break-Up: Pay Now, Pay Later.”

The letter, with my emphases:

Calls for tough sanctions against weak eurozone countries are growing. Forcing a country to leave the currency union is no longer a taboo subject. However understandable this position may be, ejecting countries from the euro would be a very expensive mistake, leading to financial and political chaos. In this scenario, the open Dutch economy would be disproportionately affected.

The chaos that would ensue from a forced or unforced exit from the euro is almost impossible to comprehend. If a country were to be ejected from the euro, bankruptcy would be inevitable. This is because the ejected country would be forced to reintroduce its old currency, which would immediately fall in value against the euro owing to a lack of confidence. Old debts in euros could not be repaid and creditors would not see most of their money. In addition, the introduction of a new currency would be a logistical and legal nightmare. The financial system of the departing country would collapse. Savers in that country would cause a run on the banks to withdraw their savings, as a result of which banks would fail. This would create a downward spiral of weakening economic growth and a fall in the price of shares, bonds and other securities, making the introduction of the currency a nightmare.

Social unrest

Capital market interest rates for the departing country would rise steeply and would force the government to make even more painful cuts. The social unrest we have witnessed in recent months in some of the weak eurozone countries would reach new heights.

The spread of panic to the other weak eurozone countries would be virtually unavoidable because savers and investors would be asking themselves: ‘Who is next?’ The current debt crisis has shown how great the danger of contagion is. Several eurozone countries saw interest rates on their loans rise to unprecedented levels and were forced to go knocking on the door of the European emergency fund.

The departure of one or more weak countries would also have a significant impact on the remaining eurozone countries. The euro would see a sharp rise in value against the new currencies. Exports would become too expensive at a time when demand is already under pressure from the economic slump. Exports from the remaining eurozone countries to the countries that had left the European currency would collapse.

Disastrous

This is where the strength of the Dutch economy would take a hit. As a prime exporter, we would be dealt a hefty blow. In the past twenty years, virtually no other country has profited as much from the euro and the European internal market. In 2010, the Netherlands exported EUR 244 billion to the rest of the eurozone – virtually half of our GDP. The collapse of the euro would therefore have a disastrous effect on Dutch business and the economy.

The departure of a weak eurozone country would also have a major impact on our pensions and other savings. Dutch banks, pension funds, insurance companies and investment funds have invested almost EUR 850 billion in the eurozone. This means that our country is more exposed to external developments than any other key eurozone country. The impact of falling share prices, write-downs and defaults by bankrupt countries would be anyone’s guess.

Furthermore, large Dutch companies, particularly the multinationals, operate throughout the eurozone. Their operations are international, with different business units in various countries. If the euro comes under significant pressure, the question is where would their operations and investments be running risks? Until this question is answered, new investments would in all probability be postponed.

The single currency has greatly benefitted the Netherlands. The euro has allowed us to boost our competitive position in the eurozone. In the past, some of our trading partners devalued their currencies, which meant that their prices were immediately more competitive.

Export success

This option was lost with the advent of the euro. We would not have had such great export success with the guilder and this would have had a significant impact on employment; just over one hundred thousand fewer jobs, as a result of which unemployment figures would be up by one third.

Calculations have shown that the euro has increased productivity in the Netherlands by approximately two per cent. Given the ageing population, this is a welcome boost to government coffers.

Of all the eurozone countries, the Netherlands has the greatest interest in saving the euro. However expensive it is to keep the weaker countries afloat, the collapse of the eurozone would be far more costly.

The report:

A link to the report, titled “What Are the Risks of €1.5-2.5tr Deleveraging?,” is available at ft.com/alphaville.

Two quotes from the report:

• We still see multi-year balance sheet retrenchment and challenging fundamentals – with risks to credit supply,bank earnings, ability to achieve new capital ratios and economic recovery.

• A key issue is that we think policy makers – and some investors – have underestimated the importance of bank funding on banks’ ability to lend profitably. Regular readers will know that we argue funding is as big a concern as asset quality given the €1.7 trillion of bank funding rolling in the next three years, which is a remarkable challenge to achieve in today’s market. Simply put, the euro-zone sovereign crisis is repricing all bank liabilities – from equity to repo, with major knock-on implications.

This post is a veritable potpourri of worries. Be warned.

With the landslide victory of Mariano Rajoy’s center-right Popular party, the government of the Spanish Socialists has become the fifth victim (after Ireland, Portugal, Greece and Italy) of the eurozone crisis. As have the leaders of the other recently-installed governments, Mr. Rajoy has promised to enforce budgetary austerity.

No matter. Despite the Popular party’s victory, yields on Spanish sovereign debt rose today; the ten-year bond yield reached 6.6 percent. Yields on the sovereign debt of other “peripheral eurozone” countries also jumped, as did the yields on “core” countries debt.

Undoubtedly, a report from Nomura — “Currency risk in a Eurozone break-up — Legal Aspects” contributed to today’s indigestion in the eurozone bond markets. The report deals with a subject — “redomination risk” — that has evidently not previously been on market participants’ radar screens: not knowing which euros will stay euros.

It is now obvious that the widespread electoral success of parties committed to fiscal rectitude isn’t sufficient to ameliorate, much less bring to a halt, the crisis by improving investor confidence. That this has become self-evident further undermines confidence, as what was once thought to be a solution has turned out not to be. More than ever, all eyes are turned toward the European Central Bank, with the hope that the ECB will, at long last, overcome its reticence and become the eurozone’s lender of last resort. As yet, there’s no evidence whatsoever that the ECB will undertake what would be an about-face of epic proportions; last Friday, the ECB’s president said that the crisis required a political solution and that the ECB wouldn’t bailout anybody. This situation will persist unless and until Germany performs its about face. But that isn’t happening; if anything, the Germans are digging in their heels.

No wonder, then, that commentaries on the crisis are becoming increasingly strident and downright panicky.

Wolfgang Munchau, writing in the Financial Times, uses the words “insane” and “depression”:

The consensus view in Brussels and Berlin is that the crisis can be solved by technocratic governments imposing structural reform and austerity. That proposition is, in my view, insane . . . We have gone way beyond the point at which this crisis is solvable by standard instruments of economic policy. The survival of the euro will now depend on whether Ms Merkel or Mr Draghi, or both, will blink.

This may yet happen, but not right away. The ECB is facing more formidable legal constraints than those who call for an intervention acknowledge. The bank is technically allowed to engage in secondary bond market purchases, but not with the aim of helping governments incur deficits or roll over debt. Article 123 of the Treaty for the Functioning of the European Union says the ECB shall give no overdrafts to governments. Clearly, the euro was sold on the grounds that the ECB would never do what it is being asked to now. Such a law is testimony to a lack of realism, especially given what we know about the history of financial crises.

[...] The eurozone has already entered a recession, driven by three factors, each serious on its own and lethal in combination: a slowdown of the global economy; pro-cyclical fiscal austerity programmes; and a much larger than expected deleveraging of the financial sector. If present policy prevailed, the eurozone would be in danger of falling into a depression.

[...] In present market conditions, a leveraged EFSF is unrealistic. So how long can this policy vacuum be sustained? So far, the speed of the crisis has exceeded the speed of the political response. The next political turning point will come at the European Council meeting in December, which will need to decide something more substantial than previous summits.

If that does not happen, we will be getting closer to the point where member states – confronted with an unsustainable funding position – could rationally conclude that the political and financial costs of staying in the eurozone may well exceed the costs of an exit. This is not a proposition anybody would want to test. Once the eurozone goes down that road, it will not come out of this crisis in one piece.

The moment will arrive, probably sooner rather than later, when Mr Draghi and Ms Merkel will have to blink simultaneously. The odds of that happening are neither low nor high. They are indeterminate. It is the worst kind of uncertainty imaginable.

George Soros describes the current situation as “a perfect vicious circle”: