Modern financial theory dictates
that sovereign bonds are the most “risk free” assets in the
financial system (equity, municipal bond, corporate bonds, and the like are
all below sovereign bonds in terms of risk profile). The reason for this is
because it is far more likely for a company to go belly up than a country.
Because of this, the entire Western
financial system has sovereign bonds (US Treasuries, German Bunds, Japanese
sovereign bonds, etc) as the senior
most asset pledged as collateral for hundreds of trillions of Dollars
worth of trades.
The “hundreds” of
trillions of Dollars of trades stems from a 2004 SEC ruling in which the SEC
ruled that broker-dealers with capital bases above $5 billion (think Goldman,
JP Morgan, etc) could increase their leverage above previously required
levels while also abandoning market
to market valuation methods (a methodology through which a security was
priced at the value that a market participant would pay for it).
So, after the 2004 ruling, large
broker dealers were permitted to increase their leverage levels dramatically.
And because they could value their trades at whatever price their in-house
models chose (what are the odds that these models were conservative?), the
broker-dealers and large Wall Street banks are now sitting on over $700
trillion worth of derivatives trades.
Now, every large bank/ broker dealer knows
that the other banks/dealers are overstating the value of their securities.
As a result, these derivatives trades, like all financial instruments,
require collateral to be pledged to insure that if the trades blow up,
the other party has access to some asset to compensate it for the loss.
As a result, the ultimate backstop
for the $700+ trillion derivatives market today is sovereign bonds.
When you realize this, the entire
picture for the Central Banks’ actions over the last five years becomes
clear: every move has been about accomplishing one of two things:
1) Giving the over-leveraged banks access to cash for immediate funding
needs (QE 1, QE 2, LTRO 1, LTRO 2, etc)
2) Giving the banks a chance to swap out low grade collateral (Mortgage
Backed Securities and other crap debts) for cash that they could use to
purchase higher grade collateral (QE 1’s MBS component, Operation Twist
2 which lets bank their long-term Treasuries and buy short-term Treasuries,
QE 3, etc).
By way of example, let’s
first consider Greece.
Lost amidst the hub-bub about
austerity measures and Debt to GDP ratio for Greece is the real issue that
concerns the EU banks and the EU regulators: what happens to the trades that
are backstopped by Greece sovereign bonds?
1) Before the second Greek bailout, the ECB swapped out all of its Greek
sovereign bonds for new bonds that would not
take a haircut.
2) Some 80% of the bailout money went to EU banks that were Greek bondholders, not the Greek economy.
Regarding #1, the ECB had just
permitted EU nations to dump over €1 trillion worth of sovereign bonds
onto its balance sheet in exchange for immediate financing needs via its LTRO
1 and LTRO 2 schemes dated December 2011 and February 2012.
So, when the ECB swapped out its
Greek bonds for new bonds that would not
take a haircut during the second bailout, the ECB was making sure that the
Greek bonds on its balance sheet remained untouchable and as a result
could still stand as high grade collateral for the banks that had lent them
to the ECB.
So the ECB effectively allowed
those banks that had dumped Greek sovereign bonds onto its balance sheet to
avoid taking a loss… and not having to put up new collateral on their
Which brings us to the other issue
surrounding the second Greek bailout: the fact that 80% of the money went to
EU banks that were Greek bondholders instead of the Greek economy.
Here again, the issue was about
giving money to the banks that were using Greek bonds as collateral, to
insure that they had enough capital on hand.
Piecing this together, it’s
clear that the Greek situation actually had nothing to do with helping
Greece. Forget about Greece’s debt issues, or protests, or even the
political decisions… the real story was that the bailouts were
all about insuring that the EU banks that were using Greek bonds as
collateral were kept whole by any means possible.
Now, Greece was always the small
player in this mess. It’s entire sovereign bond market is a mere
Spain and Italy, by comparison, have €1.78 trillion and
€1.87 trillion in external debt respectively.
I do not have an exact figure for
how much of the derivatives market uses Spanish and Italian sovereign bonds
as collateral, but I can create an estimate using the US bank data I have
In the US, we know that the top
four banks have over $222 trillion in derivatives exposure with just $7
trillion in total assets. So the leverage here is roughly 31 to 1.
Using this as a ballpark estimate
for derivatives leverage, it is very possible that Spain and Italy’s
sovereign bonds are pledged as
collateral for well over $100 trillion worth of derivatives trades ($1.78
trillion X 31 + $1.87 trillion X 31).
This is why Spain is dragging its
feet about asking for a bailout: the mess of trying to sort out the
collateral issues for €1.78
trillion in collateral that is backstopping what is likely tens of
TRILLIONS of Euros’ worth of trades is capable of causing systemic
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