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How long can the European media keep the EU credit implosion a secret?
The disgraced former IMF Director, Demonic Strauss Kahn said on Tuesday
December 12th, 2011 that No 'Firewall' Exists and Europe Has
'Only Weeks'. Of course within minutes of this
Financial Times news release which detailed his vent on EU leadership and the
perilous situation in Europe, the article disappeared.
The details of the European liquidity crisis are generally reported,
but for some reason no media source wants to pull the pieces together so
everyone can see the magnitude and futility of the crisis. A growing
Collateral Contagion is being shrouded in the apparent belief that the
solution to the European Financial and Banking crisis is a grand change in
Treaty governance. Obviously the
European Central Bank (ECB) was well aware of the reality, when it was forced
to deploy a historic and unprecedented LTRO (Long Term Purchase Operations)
on Wednesday December 21, 2011.
560 banks desperately and immediately grabbed what they could, to the
tune of €489B.
The LTRO bought the EU private banks some time. It did nothing to
solve the EU Sovereign Debt Crisis. After less than one week, the cash held
at the ECB surged €133B to a new record €347B. Since the net LTRO was only €210B, it tells you that the EU
banks not only have a cash problem, but more specifically, as ECB President Mario Draghi says : "hoarding at the ECB signals that the problem afflicting the
Eurozone is not so much about the amount of liquidity but that this liquidity
is not circulating around the region's banks".
I would argue that the problem short term is a shortage of real
collateral and that US dollar cash, versus 'encumbered' cash flow, is now
king. It is clear that the rampant advancing Collateral Contagion will
quickly eat this futile attempt like ravenous wolves. A well circulated Tweet from PIMCO bond king Bill Gross said it all: " What does LTRO stand for? 1- A shell game; 2-Cash
for trash; 3 Three-card Monti; or 4. All of the above."
Here is the stark reality of what forced the ECB to offer
unprecedented three year loans at absurd rates and most alarmingly, the
acceptance of collateral that no other financial institutions will accept.
The ECB has sacrificed its balance sheet in yet another EU "kick at the
can".
1. COLLATERAL CONTAGION: There is a cascading Collateral Contagion crisis in
which secured lending, based on sound assets, has replaced unsecured lending
based on future expected cash flows.
2. WHOLESALE LENDING: Wholesale bank lending, which is a unique
cornerstone of European banking, has completely frozen since the failure of Dexia and US Money Market Funds will no longer risk short
term capital having learned their lesson in 2008.
3. BANK RUNS: Bank Runs are quietly and insidiously occurring
throughout the peripheral EU countries as corporate and private depositors
seek safe havens for their cash holdings.
4. SHADOW BANKING SYSTEM: The European Shadow Banking System off balance
sheet and unreported leverage structures, such as SIV (Structured Investment
Vehicles) is collapsing due to non performing loans
which must finally be rolled nearly 3 years since the financial crisis began.
5. GLOBAL INVESTORS PULLING
SOVEREIGN EU INVESTMENTS: Net outflows from the
euro-zone’s financial account reached €32.1 billion in October
alone, on an unadjusted basis. The drop reflects the sale by foreign
investors of €53.3 billion in euro-zone debt instruments and €6.6
billion in equities.
6. INTERBANK LENDING: Prior to LTRO,
overnight interbank lending was impaired as LIBOR, LIBOR-OIS and TED
spread yields were going almost straight up on a percentage change basis.
7. INVERTED YIELD CURVES: Prior to LTRO, yield curves in the EU peripheral
countries were either inverted or nearing inversion prior to LTRO.
8. US DOLLAR SWAPS: A shortage of US dollar denominated loans forced
the US federal Reserve and other global central banks to intervene and offer
what is turning out to be unlimited US dollar SWAPs for minimal interest
rates and unprecedented, extended durations, not previously considered.
9. SOVEREIGN BOND MARKET: The EU Sovereign Bond Market is being avoided by
almost all Global financial institutions. The only participant
are Central Banks desperate to buy more time until confidence is
restored.
10. GERMAN BUND SCARE: You cannot have a currency without a risk free
bond. The German Bund had become a proxy for this, but recently even the Bund
has come under pressure as selling escalated in a flight from Europe.
11. YEN CARRY TRADE: The YEN Carry Trade which has been a major
financing source for the EU, even prior to its inception, is being forced to
unwind due to a significantly weakening Euro and the threat of a serious
drop.
12. BASEL BOX: The Tier 1 Core Capital requirements have forced
many banks to actually shrink lending to meet requirements. A significant
withdrawal from lending in Central and Eastern Europe and many Emerging
countries is now clearly seen as a direct result.
13. CREDIT DOWNGRADE
ONSLAUGHT: S&P placed the
long-term sovereign-debt ratings of 15 euro-zone nations, including
struggling Italy and Spain, on negative watch. That typically means there is
at least a 50% chance of a downgrade within 90 days. France is likely to soon
lose its coveted AAA rating, which will impact the European Financial
Stability Fund (EFSF) borrowing costs.
The list is even longer, but it will need to suffice for this shorter
article.
The above issues suggests, minimally, an immediate €4-8 Trillion EU problem.
The EU has no ability to solve this problem short of simply printing
Euros, which unlike the US Federal Reserve, Bank of England and Bank of
Japan, the ECB presently (I stress
presently) refuses to do.
Let's briefly discuss a few of these so we can appreciate the
seriousness of the EU problem and what lays behind a first half 2011 surge of $107 TRILLION
in derivative SWAPS.
COLLATERAL CONTAGION
Collateral is the grease that oils the lending
system.
Large banks typically reuse securities held by them
on behalf of large institutional investors such as insurers, pension funds
and hedge funds. Banks pledge the assets through various mechanisms such as
the securities lending market or the repo market. It is the reuse of
securities that lubricates the global financial system.
This reuse, which often cascades through the system, is referred to as
"chains of collateral".
According to a recent working paper from the IMF entitled "Velocity of
Pledged Collateral: Analysis and Implications", the chains of collateral have become shorter
and there has been a significant decline in the source of collateral. In
fact, it is presently estimated that the overall reduction in collateral is
between $4T and $5T. According to the IMF, it has been reduced from a peak in
2007 of approximately $10T to $5.8T in 2010. This is no doubt even lower when
the final numbers are in for 2011, due to the collapse of European sovereign
bonds.
The "turns" or velocity of the movement of this collateral
has been reduced from an average of 3 times before the 2008 Lehman collapse
to 2.4 times at the end of 2010.
There are a number of reasons for this which include:
1. Significantly more collateral is being entrusted to global central banks for safe keeping,
2. Counter party risk is now seen to be of paramount
concern due to a breakdown in trust perceptions,
3. Mounting concerns with creditworthiness of
counterparties,
4. Focus on how partners might use the collateral
assigned to them,
5. Risk manage where financial institutions are
'clipping' or taking 'haircuts' on collateral to create a 'margin of safety'
and
6. Higher core capital banking ratios and changing
derivatives trading collateral requirements placed on banks.
 
There are both less and less collateral of high quality available
along with a dramatically increased demand for collateral.
We have witnessed a shift from unsecured cash flows as sources of
collateral to the requirement for 'secured' collateral. Triple A sovereign
debt is no longer considered risk free.
As a result of the above, the transmission mechanism for monetary
policy has broken down, fundamentally due to a shift in trust perceptions.
Additionally, risk has increased in the system, because risk has been
transferred through new and untested instruments such as 'Liquidity SwapsCollateral
Transformation
There is now a massive demand for fresh cash in the EU in the form of
€1.7T in maturing debt (ignoring interest payments). When it comes to
cash 'supply' or issuance of unsecured debt, the market is now completely and
totally dead.
Even as soaring debt, interest rollover and
redemption demands mean huge amounts of debt have to be raised.
"Term bank funding
issuance has dried up. We are concerned there has been a step change in the
availability and pricing of senior unsecured funding given such elevated
euro-zone uncertainty and the knock-on to assets supported by unsecured
funding." Zero Hedge
In other words: there is no more debt available which is
"guaranteed" simply by promises of future cash flow: investors
demand asset collateralization for the simple reason that fewer and fewer
believe that assets are able to generate the amount of cash represented by a
conflicted underwriter syndicate.
Unfortunately, there is nowhere near enough hard assets to fund
secured assets at even modest LTVs, and it will only get worse and worse as
less and less cash actually goes to regenerating a rapidly depreciating and
amortizing asset base.
WHOLESALE LENDING
The first nail in the EU coffin was the failure of Dexia, a major Belgium - French bank. Dexia is
representative of the Wholesale banking structure so prevalent across Europe.
To understand the significance of Dexia, consider
the following.
There are approximately
$55T of banking assets in the EU. This compares to only $13T in the US. Bank Assets in the EU are 4 times as
large as the US.
In the US, debt held by the bank is smaller because
retail deposits are a primary source of funds. EU banks use wholesale lending
and, as a consequence, the debt held by banks is closer to 80% versus less
than 20% by US banks.
Wholesale bank lending in the EU approximates $30T
versus only $3T in the US, a 10 X differential.
Wholesale lending is fundamentally borrowing from
money market funds and other very short term, unsecured instruments. The
banks borrow short and lend long. It all works until short term money gets
scarce or expensive. Both have occurred in the EU and this recently placed
DEXIA into bankruptcy, forcing them to be taken over by the Belgium and French
governments. The unsecured bond market fundamentally closed in the EU in Q3
2011, as fears mounted that an EU solution was not forthcoming.
Assuming $30T of loans is spread over three years,
EU banks have a requirement for $800B / Month of rollover financing for
wholesale lending outstanding.
Where is this money going to come from? No one is
waiting around to find out as there will be cascading counterparty failures
soon surfacing. Banking money in Europe is fleeing to custodial and official
accounts of the ECB, the US Federal Reserve and any other central Bank
willing to accept their cash. The chart below graphically shows this flight
to perceived central bank safety.
The latest charts show an increase of $4.5T in a one
week period.
BANK RUNS
There are, as yet relatively unreported, insidious
and persistent bank runs occurring across the EU, as money flees the GIIPS and
moves to perceived havens of
capital safety.
Until recently the safe havens were the EU core and
more specifically Germany. That has now changed.
What has not changed is the increasing momentum of
the flight of capital and depositor savings. You can't expect governments,
banks or regulators to even hint at such actions. It is only through thorough
analytics that you can see what is happening.
The chart to the right was put together by the
Council of Foreign Relations where they felt that the level of Credit Default
Swap pricing was an early indicator of what lay below the headlines. They
used Ireland as a benchmark and related it to the possibilities of what might
be occurring in Spain.
The second chart (below left) shows the contraction
in deposits in Greece and early signs of changes in Italy. Both these charts
are seriously outdated.
The chart (below right) of plummeting Italian M1, M2
and M3 Money Supply gives a more up to date indication, but still dated.
Below is a chart of M1 (bank deposits) where all the
GIIPS are compared. DEPOSITS ARE
PRESENTLY FLEEING THE GIIPS AT AN ACCELERATING RATE.
SHADOW BANKING SYSTEM
As alarming as the following Shadow Banking are,
it must be realized they are for only the US. We need to fully appreciate that
the US was a factory producing the toxic debt that was at the center of the
2008 Financial Crisis, but the product of these factories was shipped and
sold by the 'boatloads' to the EU. It is so broad based, that I wrote a
number of research papers in
2010 pointing out the degree
to which litigation over them was being seen quietly across Europe at
ALL levels of government, which could not absorb the losses they were
creating.
If the US Shadow banking has seen liabilities collapse by $5T, surely
the EU is this and more likely a multiple larger.
As Bloomberg and Zero Hedge pointed out, the loosening of rules on ABS as
collateral, loosening of collateral criteria for loans, going to 2-3 year
loans for banks and allowing more uncovered bonds as collateral for the LTRO
was driven by a European Shadow Banking system in "tatters" and imploding.
GLOBAL INVESTORS PULLING INVESTMENTS
The euro zone swung back to a current-account
deficit in October after one brief month of positive inflows, as foreign
investors continue to relentlessly shed European debt and stocks. The euro
zone’s current account — the balance of payments between the
17-member currency bloc and the rest of the world — was a seasonally
adjusted deficit of €7.5 billion in October, compared with a €2.2
billion surplus in September.
Net outflows from the euro zone’s financial
account reached €32.1 billion in October, on an unadjusted basis. The
drop reflects the sale by foreign investors of €53.3 billion in
euro-zone debt instruments and €6.6 billion in equities.
This is collateral that is lost to being 'chained'
in collateral chains.
INTERBANK
LENDING
PARIS 12/05/11 - MERKOZY SUMMIT
“NO HAIRCUTS”
INTERBANK LENDING IS NEARLY FROZEN
INVERTED YIELD
CURVES
Over the last six weeks, sovereign bond yields,
spreads and risk metrics have surged to unprecedented and unfundable
levels.
Only recently, with the anticipation of workable
solutions coming out of yet another EU Summit on December 9th, 2011 and
further ECB buying, have yields fallen back somewhat.
However, the fact is alarming that yield curves
across the GIIPS are now inverting.
Money is no longer available to sovereigns even in
the short term at acceptable rates, as €300B of debt roll-overs alone
come due across the EU.
The scare that is starting to sink in is that there
may now be insufficient liquidity in the system to in fact fund rollovers and
new sovereign funding requirements in the EU.
Additionally, the ECB is not seen to be injecting
sufficient liquidity fast enough.
The funding requirements are also significantly US
dollar denominated, which the ECB cannot address without global dollar swap
arrangements with other global central banks.
As a result, a massive
intervention happened on November 30th to address this urgent
problem.
The intervention did not fix the yield curve
inversion nor the collateral requirements to access
these dollar swap funds.
CONCLUSION
It is very hard to conclude anything other than:
1- EURO BELOW
1.20: The Euro currency is exposed against most currencies and likely
headed for a currency cross of less than 1.20 against the US dollar. A cross
of 1.15 to 1.20 would not be a surprise. We have already seen technical
'death crosses', suggesting this is in the works as the Euro has broken below
its 200 DMA in a downward trend channel.
 2-
ECB LEVERAGE
471:1: The ECB borders on insolvency. It cannot monetize
sovereign debt (print money for sovereign debt) by treaty law and its stake
holders have insufficient assets to pledge in which to place the ECB on sound
financial footing.
The ECB's balance sheet is now beyond bloated and is
realistically insolvent based on the quality of its collateral.
The paid up Capital of
the ECB is €5.2B as of January 2011. The Balance sheet currently
approximates €2,450B. This is 471:1. Even using the pledged capital of
€10.76B expected to be paid in by 2012, it is still 228:1
Considering a significant amount of the debt is of
poor quality and worth significantly below its purchased price, the ECB is
technically insolvent.
Even if we were to be ridiculously conservative and
use €65B of GIIPS bonds bought by the ECB in 2010 and assuming only a 10% devaluation, we have €6.5B, losses which is
more than the paid up capital of the ECB. The insolvency is orders of
magnitude worse than this, but you get the point. The ECB cannot withstand
much further stress before all of this is called into question.
The argument is always that the ECB cannot be
insolvent because it can always print more Euro's.
The question I would therefore raise is what is the Euro really worth then?
Whether: YOU
BUY ASSETS,
or you: LEND
MONEY ON QUESTIONAL COLLATERAL & LEVERAGE,
the
ECB'S BALANCE SHEET SHOWS WHAT IS REALLY GOING ON.
Is the ECB realistically solvent - The 'controlling'
German and French owners are incapable of supplying more capital!!!
3- YEN CARRY
TRADE - A FORCED UNWIND:
When you appreciate that the YEN Carry trade was a
huge financier of the EU and the Euro, you can appreciate why the above
problems has resulted in the Euro plummeting against the YEN. This is forcing
unwinding of the Carry Trade, as the currency impact losses are too large to
be contained without massive adjustments in OTC SWAPS.
Is this what explains the $107
TRILLION increase in OTC Derivative SWAPS in the first half of Q1 and
$88T in interest rate SWAPS alone?
FINANCIAL
REPRESSION
Let us close by saying that it is critical that you
fully appreciate that which would appear as a chaotic situation in Europe is
in fact a very well crafted and executed global
central bank strategy, using the macro prudential practice of Financial
Repression in an attempt to achieve Global Re-Balancing and adjustments in
standards of living. I lay all this out in "Thesis
2012: Financial Repression".
Sign-Up for your FREE copy of "Thesis 2012: Financial
Repression" that lays bare how this is being executed and what lies
ahead in 2012 and 2013.
Full of Holes,
Engine-less, No Life Jackets,
AND
Too Many Captains,
Gordon T. Long
Tipping
Points
Mr. Long is a former senior group
executive with IBM & Motorola, a principle in a high tech public start-up
and founder of a private venture capital fund. He is presently involved in
private equity placements internationally along with proprietary trading involving
the development & application of Chaos Theory and Mandelbrot Generator
algorithms.
Gordon T Long is not a
registered advisor and does not give investment advice. His comments are an
expression of opinion only and should not be construed in any manner
whatsoever as recommendations to buy or sell a stock, option, future, bond,
commodity or any other financial instrument at any time. While he believes
his statements to be true, they always depend on the reliability of his own
credible sources. Of course, he recommends that you consult with a qualified
investment advisor, one licensed by appropriate regulatory agencies in your
legal jurisdiction, before making any investment decisions, and barring that,
you are encouraged to confirm the facts on your own before making important
investment commitments.
© Copyright 2010 Gordon T Long. The information herein was
obtained from sources which Mr. Long believes reliable, but he does not
guarantee its accuracy. None of the information, advertisements, website
links, or any opinions expressed constitutes a solicitation of the purchase
or sale of any securities or commodities. Please note that Mr. Long may
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respect to any particular security. You should consider this possibility
before investing in any security based upon statements and information
contained in any report, post, comment or recommendation you receive from
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