spotfxtrader

After a pro EU piece the other week, (and by pro EU I mean anti Europe – his suggested most favourable outcome for the crisis being the introduction of a debt union, i.e. an outcome which would amount to the crushing of any democratic opposition to the EU Superstate), Mr Münchau appears to have seen the error of his ways….

As we’ve been saying all along, the ‘system’ is non-linear, and as it has now become totally unstable, the chances of the crisis being resolved in anything approaching an orderly manner are extremely slim. After considering his earlier piece pretty contemptible, I do like his description of EU decision makers as ‘serially incompetent’. I would venture that that description universally applies to the political classes throughout Europe and the US, with very few exceptions.

Ultimately he suffers from the delusion that the whole edifice could be managed if only good decisions could be made. The only good decision would be not to have attempted the creation of a superstate founded in subterfuge in the first place.

By Wolfgang Münchau

Published April 24 2011, 19:51

I was uncharacteristically optimistic last week, and had planned to end my informal series on eurozone crisis resolution with a benign scenario. The eurozone would survive in one piece; there would be no blood on the streets, just a once-and-for-all, albeit reluctant, bail-out, accompanied by a limited fiscal union. But as several readers have pointed out, my scenario is prone to a very large accident. I accept that point. Last week, we caught a glimpse of how such an accident may come about. My benign scenario looks a lot less certain today than it did a week ago.

The week began with the strong showing of two parties in the Finnish election, which are advocating a partial Portuguese debt default as a condition for a rescue package. The results triggered a renewed outbreak of the financial crisis, as eurozone spreads rose to near record levels once again.

The most disturbing news, however, was a revolt within Angela Merkel’s increasingly fragile coalition. It looks as though the German chancellor is on the verge of losing her majority over the domestic legislation of the European Stability Mechanism (ESM), the long-term financial umbrella for the eurozone. She may have to rely on the opposition to ratify the ESM, which may come at a heavy political cost. The Bundestag already postponed the vote on the ESM until the autumn, hoping to keep it clear from the controversial decision to pass the Portuguese rescue programme in May.

As opposition to the ESM mounted, German officials fell over themselves to be quoted by various newspapers pronouncing that a Greek restructuring was inevitable. Even Wolfgang Schäuble, finance minister, talked about the possibility of default. Some wily speculators unleashed the rumour that Greece would spring a surprise debt restructuring. The rumours prompted a criminal investigation. Another week in the eurozone’s debt crisis!

A monetary union is at a natural disadvantage when it comes to the handling of crises. There is no central government that takes decisions, which makes communications hard to control. What is less forgivable is the serial incompetence of the eurozone’s decision-makers, as exemplified by the perpetual eagerness to declare the crisis over the very second financial market pressure subsides. Not only do they know little about financial markets, they have surrounded themselves with policy advisers who know little too.

Their ignorance is an ideal breeding ground for quack solutions. One such is immediate default. German Christian Democrats and Finnish isolationists spent the last week trying to convince themselves that a Greek debt-restructuring would save them a lot of money.

That belief is premised on two false assumptions. The first is that a voluntary restructuring could solve the Greek debt problem. It can work in limited cases, but not when countries are insolvent. Greece, however, faces no short-term liquidity squeeze, because it is supported by the European Union and the International Monetary Fund. There is no need for any restructuring, voluntary or involuntary, right now. But Greece may need to impose a “haircut” in the future to ensure debt-sustainability. The ideal moment would be when the country achieves a primary surplus, probably in 2013.

The second wrong assumption is that the Greek banking sector would survive a restructuring unscathed. This is a conditional error. If you believe that a voluntary restructuring would be sufficient, then the Greek banking sector would indeed survive. But it would surely not survive a large and involuntary haircut. The European Central Bank would face a haircut on its direct investments of Greek government bonds, and, more importantly, much of the collateral posted by Greek banks would vanish. On my calculation, the cost of a Greek default to the German taxpayer alone would be at least €40bn ($58bn), including recapitalisation of the ECB. A bail-out would be cheaper.

A premature Greek default would change everything. As would the failure by the EU and Portugal to agree a rescue package in time; or an escalation in the EU’s dispute with Ireland over corporate taxes; or a ratification failure of the ESM in the German, Finnish or Dutch parliaments; or a German veto for a top-up loan for Greece in 2012; or the refusal by the Greek parliament to accept the new austerity measures; or a realisation that the Spanish cajas are in much worse shape than recognised, and that Spain cannot raise sufficient capital.

Then there is the downgrade threat for French sovereign bonds. I recall asking a French official about this, and getting the smug answer that the rating agencies could hardly downgrade France if they maintained a triple A rating for the US. That was before last week. By extension, France must also now be in danger. A downgrade would destroy the logic of the European financial stability facility. It is built on guarantees by the triple-A countries. Without France, the lending ceiling of the EFSF would melt down further.

The list of potential accidents is long, but they share a joint theme – serial political crisis mismanagement. We saw another glimpse of that last week. If we go down the route of premature default, and allow the True Finns and the true Germans to run the show, the eurozone as we know it will be finished.

paraphrased from the Daily Crux…(I think).

The World’s Third-Largest Bank is Bust

The Fed is a bank with $2.55 trillion of assets. Only BNP Paribas, and Royal Bank of Scotland are larger. It’s way too big to fail.

When it goes bust, it will be bailed out. And Ben Bernanke, chairman of the US Federal Reserve, will have no choice but to fire up the printing presses all over again.

However, first let’s examine exactly how banks make money. And how they go bust…

How banks make money

Let’s start with the balance sheet. A bank’s assets are mainly loans made to individuals, businesses, even governments. Loans are assets because they are money owed to the bank.

Now let’s talk about the other side of the balance sheet – the liabilities. Most of the money a bank lends to customers comes from money that the bank itself borrows. It can borrow from you and me through the savings we deposit. It may also borrow from companies that place cash on deposit. And the bank may borrow from investors – insurance companies, pension funds, even other banks. All of these are liabilities – debts the bank owes to someone else.

The other main item on the liabilities side is capital. Suppose the bank collected all the money owed by the borrowers. And then repaid all the money it owes. Capital is the money left over. It is the bank’s true value.

The balance sheet must always balance. So capital + debt = assets.

Banks make money by lending at higher interest rates than they pay to borrow. Borrowers want long-term loans, usually at fixed interest rates. On the other hand, depositors want easy (short-term) access. And depositors often prefer variable interest rates.

So this is the crucial role banks play in the economy. They take short-term variable rate savings, and recycle them into longer-term, fixed-rate loans.

And this is where the problems of the world’s third-largest bank start.

How a bank goes bust

From the point of view of a bank, when interest rates rise, the value of a fixed-rate loan falls. The bank receives less income from that fixed-rate loan than it could now get elsewhere.

And interest rates on US ten-year government bonds have indeed been rising. Since last August, they’ve risen by about one percentage point.

Now, accounting rules dictate what happens next. Under certain conditions, banks must mark down the value of these loans. That’s called ‘marking to market’. And when it happens, capital also falls – otherwise the balance sheet doesn’t balance any more.

But the Fed, the world’s third-largest bank, doesn’t follow the same accounting rules as every other bank. It refuses to restate the value of its assets. That’s why they’re surely worth less than the reported figure. In fact, if I’m right, the bank has no capital left. It has zero value. It’s bust.

I can’t prove this. But here’s why I think I’m right.

$1.14 trillion (45%) of the Fed’s assets are fixed-rate loans of ten years or more. Let’s suppose the ten-year bonds pay interest of 4%. If the yield rises to 5%, the price falls by about 8% (bond prices fall as yields rise). If yields rise to 6%, the price falls by 16%.

I don’t know exactly when the Fed made these loans. So I don’t know the current yields or prices. But I do know that US government bond yields have risen by one percentage point since last August. And I think they’ll keep going up.

So it’s a fair bet that the Fed’s ten-year loans are worth less than it paid for them. An 8% loss on $1.14 trillion is $91 billion. And that excludes any losses on the $1.41 trillion of shorter loans that it holds, which are also affected.

The Fed has been lending like the credit crunch never happened

Of course, bank capital (as well as loss reserves) is designed to cushion against such losses. Since the credit crisis, most banks have reduced their lending, boosted reserves and raised more capital.

But not the Fed. It carried on lending like the crisis never happened. Worse still, it has no loan loss reserves. And it’s not raised a cent of extra capital.

Want to guess how much capital the Fed holds against its $2.55 trillion in assets? $53 billion. That’s just 2% of total assets. So a 2% fall in the value of those assets would wipe out every last dollar of capital. So it may already be insolvent. If not, it soon will be.

The US Federal Reserve Bank is bust – and that’s not just my opinion

This is serious. It may be the US central bank, but it’s still a bank like all the rest.

Most of its assets are US government bonds, bought as part of its quantitative easing (QE) programmes.

Its liabilities include about $1 trillion of notes and coins in circulation. There are also $1.4 trillion of deposits owing to US commercial banks, which are required to hold reserves at the Fed. There are also some deposits owed to the US Treasury. And there’s $53 billion in capital.

So the Fed can go bust just like any other bank. And I’m not the only one saying it. William Ford, a former president of the Atlanta Federal Reserve, one of the 12 member banks of the Fed itself, broke ranks to warn about it on 11 January.

Ford points out that the Fed can hide insolvency because it does not mark its assets to market. So we’ll only know that it’s bust when it sells some bonds. Only then would it have to take the losses from selling them for less than it paid.

Of course, the Fed going bust would be very embarrassing. So you can be sure it will be quietly bailed out behind closed doors. In fact, if the bail-out is timed to coincide with the losses, we might not even notice.

Who will bail out the Fed?

Why does this matter to you? Well, guess who would rescue the Fed? The US Treasury, a department of the US government, would have to inject extra capital to restore solvency. But the US government is not exactly flush these days.

So how would they get the money? They’d issue more bonds. And the Fed would buy them as part of its QE programme.

So let’s be clear. The Fed goes bust. So it lends money to the US government (i.e. it buys US bonds), and the US Treasury gives it back to the Fed as capital. So the Fed is printing money to bail itself out. What do you think this will do for investor confidence in the US government and the dollar?

I’m pretty sure that the value of US Treasury bonds and the dollar will be worth less afterwards. And that’s why you should have 8-12% of your portfolio in gold. It is sound money in an era when most currencies are not. It is insurance against further debasement of paper money.

As reported in the Telegraph by Emma Rowley.

http://www.telegraph.co.uk/finance/currency/8427703/One-in-seven-chance-that-nations-will-abandon-euro.html

‘One in seven’ chance that nations will abandon euro

The risk is roughly one in seven that Europe’s ongoing debt crisis will push member nations to abandon the shared currency, raising the spectre of the “effective end of the euro area,” the Economist Intelligence Unit has warned.

Attempts to restore investors’ confidence in debt-laden nations’ ability to honour their commitments could see the weaker eurozone members grow ever wearier of the demands placed on them, according to a new report from the research body.

Meanwhile, those countries whose finances are in better shape could lose patience with propping up other member nations, in this worse case or “ultimate risk” scenario.

The pressure on politicians from voters at home to leave the shared currency could then become “irresistible”, resulting in either stragglers like Portugal or Ireland or a robust economy such as Germany deciding to leave, before other members follow suit.

“This scenario posits that sooner or later, the cement that has held European countries together for decades cracks and the progression towards ever-closer union comes to a spectacular halt,” said researchers, who gave it a likelihood of 15pc.

The report’s central scenario – put at a 50pc probability – is that the eurozone will muddle through the crisis, with the most indebted countries accepting the harsh reforms needed to cut their deficits and stronger members reluctantly offering enough support to contain the crisis.

However even this relatively benign resolution of the crisis expects some countries to default on their debt, with Greece seen as the most likely. The least probable scenario, put at a 10pc likelihood, is that the eurozone will undergo a resurgence as countries manage to rein in their public finances, researchers thought.

The European Central Bank is on Thursday expected to raise interest rates to fight inflation across the eurozone, but there are fears it will make conditions even harder for the struggling periphery.

There was no mention of the probabilty that the politicians responsible for this will face any criminal charges for their unconstitutional and anti-democratic actions in attempting the euro project in the first place. OK, I added that last bit. But these people are wholly culpable for the extensive misery the whole euro project has caused to millions of people across the continent.

But raising interest rates in euro land is the correct thing to do to prevent hyperinflation and maintain sound money. The peripheral countries will be forced to leave… the 15% probability assigned to this outcome is wishful thinking.

If (when) rates rise, the Euro (i.e the Deutschmark in disguise) will rapidly strengthen.