Tuesday, February 7, 2012
Let’s say you earn $21,000 per year. Would your bank grant you credit and loans that total more than $600,000 to “invest” on long shot bets in Vegas? Sounds ludicrous, right? And it is, until you realize this is how our global financial system is currently structured.
Thanks to some fancy (but rigged) modeling of market instruments, market players have been able to convince some incredibly stupid people (though there are some smart ones in the bunch) that their bets will pay off. What the incredibly stupid people don’t understand is that the entire house of cards can only function if lines of credit are kept open. The problem here, as Hyman Minsky warned, is that it’s one thing to borrow when you have the assets to back things up, but it’s an entirely different thing to borrow when the collateral is full of financial holes.
This is precisely the situation Europe faces today, and why efforts to fix their banking system will fail.
Mirroring what I’ve been writing and talking about for years, Money Morning’s Keith Fitz-Gerald explains why Europe’s banks are going under, in spite of the the seemingly never ending trillion dollar rescue efforts from the U.S. central bank, and others. Specifically, Europe’s financial system is confronted by three big challenges.
UNCERTAINTY: Thanks to the murky system of cross derivative (i.e. Vegas-like) bets European Union (EU) ministers are reluctant to put money into a banking system that has the financial consistency of Swiss Cheese (why Ben Bernanke is doing it is another issue). And they should be reluctant. Because derivative markets are so murky, the ministers don’t know how much is going to be needed, or who’s going to need it.
FINANCIAL STDs: Because of the cross pollinization of derivative bets even healthy banks have been exposed to the financial STDs of the financial world. In what will (no doubt) be described as a pre-emptive effort, all banks will be provided with back up funds just in case (i.e. when) their partners drag them under. It’s kind of like an STD screening. But in this case you get the penicillin shots too (a process that resembles the U.S. banking “self-esteem” efforts too).
GOOD MONEY GOING AFTER BAD: Money from strong banks will be diverted to weaker banks. This is bad news. Why? Because in order to backstop the bad bets, even bigger (worse?) bets will be placed because they offer the promise of higher returns. This will only serve to keep the derivative lunacy going until the stupidity collapses on itself, again.
So why is this all a problem? Because the banks have lent or provided $600 trillion against market (derivative) instruments that are valued at $21 trillion. Total exposure here is 28.4-times. Go into a bank and ask them to provide you with a loan or credit totaling 28 times what you earn/own.
The bank’s rationale for rejecting you is exactly why the financial stupidity in Europe cannot be sustained.- Mark
P.S. If you want to know how derivative bets get started click here.
- A New STD (Securitization Transmitted Damages): Losses May Be In Trillions of Dollars (prweb.com)
- JP Morgan tests derivative based products for Trade Finance (thebankwatch.com)
- Revisited: Three Data Points That Prove Europe Cannot Be Saved (zerohedge.com)
- In Banco Santander, a Microcosm of Spain’s Troubles (247wallst.com)
While we wait for the employment report, there was another big story yesterday — the Fed treatment of savers.
Fed Chair Bernanke testified before the House Budget Committee, responding to some illuminating questions from Committee Chair Paul Ryan (R. WI). Joe Weisenthal, who is usually on the track of the biggest story, anticipated this one yesterday:
Here is Joe’s conclusion:
And while we sympathize with people not getting returns on their money, the fact of the matter is that the big problem we have right now is that people have too much debt, not an abundance of cash that’s just sitting there not returning anything.
The bottom line is this: Yes, it sucks that pensioners and garden-variety savers aren’t getting returns, but it also sucks for everyone in the U.S. right now, because the economic outlook seems to be so mediocre. Welcome to the club!
Until growth and inflation return to anything that looks robust, savers will have to be stuck with the same garbage returns boat the rest of us are in.
There is a lot of buzz about the role of the Fed and also the leadership of Bernanke. The leading Republican candidates all want to fire Bernanke, and some of them even want to abolish the Fed. Some of the GOP House Budget Committee members have joined the criticism.
Here at “A Dash” I focus on investments, not politics. Years ago some readers called me a “Bush apologist” and a blatant “supply sider.” I have tried to explain that I do not have a partisan perspective, but an investment perspective. I want to find the best investments no matter who is in power. My perspective changes with the evidence.
With that in mind, let me suggest a few propositions for your consideration. If these are not obvious, I recommend more research.
- Bernanke is a Republican, with a conservative background. This is typical for Fed Chairs.
- If President Bush had been re-elected, the current GOP fiscal argument would be different. There would be support for stimulus, including both tax cuts or spending. If you do not believe this, look back in history to the end of the Bush administration.
- If President Bush had been re-elected, the GOP monetary story would be different. They would be screaming for easy money, as both parties have always done, including past GOP administrations, and including Bush senior.
- Paul Ryan is an ambitious and aspiring VP candidate who has a theme that resonates — balancing the budget. It is an effective political argument — for the party out of power.
Meanwhile, the Fed is doing a good job of ignoring politics and focusing on the economy.
I continue my plea: Look beyond politics. Most recently, look beyond the popular ploy of making a villain out of the Fed.
The Fed has a dual mandate including both price stability and employment. Here is the official statement:
The Congress established two key objectives for monetary policy–maximum employment and stable prices–in the Federal Reserve Act. These objectives are sometimes referred to as the Federal Reserve’s dual mandate.
There are many who have criticized the US approach suggesting that there should be only a single mandate – price stability.
So let us all be clear about this — very clear.
The Fed has no Third Mandate. There is no interest rate guarantee for savers!
It is difficult enough to balance economic growth and price stability. The idea that the Fed should be judged by a third criterion — maintaining interest rates for savers — is misguided, politically biased, displaying favoritism for one group, and basically wrong.
More importantly, it is not going to happen. Our investment decisions should be based upon reality, not the wishful thinking of those with a partisan agenda.
I understand the plight of savers and senior citizens. I work with such investors every day, helping them find a combination of a bond ladder, dividend stocks, and enhanced yield. Those who do not have a job at all face a more difficult problem. Until we have a stronger economic recovery, we are all in this together.
Read more: BI
- Bernanke vs. Ryan: A lesson in monetary policy (theglobeandmail.com)
- DEAR SAVERS AND RETIREES: Stop Whining About Those Lousy Rates You’re Getting From The Bank (businessinsider.com)
- Bernanke defends Fed policies against GOP critics (seattlepi.com)
- Bernanke: Recovery ‘frustratingly slow’ (thehill.com)
- Budget Committee Lawmakers Question Fed’s Dual Mandate (usnews.com)
Oil surged above $100 a barrel on speculation supplies will be disrupted after a report that Iran will hold drills to close the Strait of Hormuz and that the Federal Reserve may announce additional stimulus measures.
Crude advanced as much as 3.6 percent after the state-run Fars news agency reported the military maneuvers will be “soon,” citing Parvis Sorouri, a member of the parliament’s national security and foreign policy committee. The Strait of Hormuz is a bottleneck for oil exports from the Persian Gulf. The Fed is scheduled to release a statement on monitory policy later today.
“There have been a number of rumors floating around the market today,” said Tom Bentz, a director with BNP Paribas Prime Brokerage Inc. in New York. “I saw the Iran story yesterday but those headlines seem to have got traction this morning. There are also rumors for further action by the Fed, but where they come from I don’t know. In this electronic world things can jump quickly and trigger stops.”
Crude for January delivery gained $1.91, or 2 percent, to $99.68 a barrel at 11:07 a.m. on the New York Mercantile Exchange. Earlier, futures touched $101.25 a barrel. Prices have risen 9.1 percent this year.
Brent oil for January settlement increased $2.07, or 1.9 percent, to $109.33 a barrel on the London-based ICE Futures Europe exchange.
“There are no headlines to explain this move,” said Stephen Schork, president of Schork Group Inc. in Villanova, Pennsylvania. “One has to look at the usual suspects. It was probably a fat-fingered mistake or a margin call.”
Crude pared gains after an Iranian Foreign Ministry spokesman said the Strait of Hormuz isn’t closed. The comments on the strait were made by people who don’t have an official title, said Ramin Mehmanparast, the spokesman.
Sorouri, in comments that first appeared yesterday on the website of the state-run Iranian Students News Agency, said “if the world wants to make the region insecure, we will make the world insecure.”
About 15.5 million barrels of oil a day, about a sixth of global consumption, flows through the Strait of Hormuz between Iran and Oman, according to the U.S. Department of Energy.
“This is the kind of story that sends a shock wave through the market,” said Richard Ilczyszyn, chief market strategist and founder of Iitrader.com in Chicago.
The market also rose on speculation that the Fed will announce a third round of bond purchases in a tactic that has been dubbed quantitative easing. The Fed bought a total of $2.3 trillion in bonds in two rounds of quantitative easing from December 2008 until June 2011.
Fed Chairman Ben S. Bernanke and his policy-making colleagues plan to meet today to discuss the outlook for an economy that has strengthened since their November meeting, lowering the jobless rate to 8.6 percent from 9.1 percent.
- Oil surges on speculation of supply disruption (business.financialpost.com)
- Oil Surge Begins (mb50.wordpress.com)
- Iran Military Practicing Straits Of Hormuz Closure (zerohedge.com)
- Crude shoots up along with stock rally (seattlepi.com)
- Report: Iran To Practice Closing Strait Of Hormuz (jhaines6.wordpress.com)
For a few years now, the banking industry has shouldered much of the blame for the massive financial crisis that is threatening the health of the global economy, while many others have been quick to point out the glaring lack of financial regulation. But, interestingly, there is now a growing awareness of what is known as the “shadow banking system” and findings have shown that they may have been the ones who caused the crisis after all.
HONG KONG – With world leaders meeting at the end of this week at the G-20 summit in Cannes, France, the next economic minefield that they will face is already coming into view. It is likely to take the form of an opaque global credit glut, turbocharged by the fragile mixture of too-big-to-fail global banking with a huge and largely unwatched and unregulated shadow banking sector.
To be sure, that is not what many see. Federal Reserve Board Chairman Ben Bernanke and others have blamed the financial crisis of 2008 on a global savings glut, which fuelled flows of money from high-savings emerging-market economies – especially in Asia – that run chronic balance-of-payments surpluses. According to this school of thought, excessive savings pushed long-term interest rates down to rock-bottom levels, leading to asset bubbles in the United States and elsewhere.
But Claudio Borio and Piti Disayat, economists at the Bank for International Settlements, have argued convincingly that the savings-glut theory fails to explain the unsustainable credit creation in the run-up to the 2008 crisis. They have shown that the major capital inflows were not from emerging markets, but from Europe, where there was no net balance-of-payments surplus.
The alternative theory – of a global credit glut – gained more ground with the release last week of the Financial Stability Board’s report on shadow banking. The FSB report contains startling revelations about the scale of global shadow banking, which it defines as “credit intermediation involving entities and activities outside the regular banking system.”
The report, which was requested by G-20 leaders at their summit in Seoul last November, found that between 2002 and 2007, the shadow banking system increased by $33 trillion, more than doubling in asset size from $7 trillion to $60 trillion. This is 8.5 times higher than the total US current-account deficit of $3.9 trillion during the same period.
The shadow banking system is estimated at roughly 25-30% of the global financial system ($250 trillion, excluding derivatives) and at half of total global banking assets. This represents a huge regulatory “black hole” at the center of the global financial system, hitherto not closely monitored for monetary and financial stability purposes. Its importance was exposed only by analysis of the key roles played by structured investment vehicles (SIVs) and money-market funds (MMFs) in the 2008 meltdown.
The shadow banking system is complex, because it comprises a mix of institutions and vehicles. Investment funds other than MMFs account for 29% of total, and SIVs make up 9%, but the shadow system also includes public financial institutions (such as the government-backed mortgage lender Fannie Mae in the US). They are some of the largest counterparties with the regular banking system, and their combined credit creation and proprietary trading and hedging may account for much of the global liquidity flows that make monetary and financial stability so difficult to ensure.
The trouble is that, by 2010, the shadow banking system was about the same size as it was just before the 2007 market crash, whereas the regulated global banking system was 18% larger than in 2007. That is why the FSB report pinpoints the shadow banking system, together with the large global banks, as sources of systemic risk. But the global problem is likely to be much larger than the sum of its parts. Specifically, global credit creation by the regular and shadow banking systems is likely to be significantly larger than the sum of the credit creation currently measured by national statistics.
There are several reasons for this. First, credit that can be, and is, created offshore and through off-balance-sheet SIVs is not captured by national balance-of-payments statistics. In other words, while a “savings” glut may contribute to low interest rates and fuel excess credit creation, it is not the main cause.
Second, the volatile “carry trade” is notoriously difficult to measure, because most of it is conducted through derivatives in options, forwards, and swaps, which are treated as off-balance sheet – that is, as net numbers that are below the line in accounting terms. Thus, in gross terms, the leverage effects are larger than currently reported.
Third, the interaction between the shadow banking system and the global banks is highly concentrated, because the global banks act as prime brokers, particularly for derivative trades. Data from the US Comptroller of Currency suggest that the top five US banks account for 96% of the total over-the-counter (OTC) derivative trades in the US.
Indeed, the nightmare scenario haunting the world is the collapse of another shadow banking entity, causing global trade to freeze, as happened in 2008. The Basel III agreement on capital adequacy and other recent reforms still have not ring-fenced trade financing from these potential shocks.
We urgently need to monitor and understand the role of shadow banking and the too-big-to-fail banks in creating the global credit glut. Obtaining a full picture of global monetary and credit numbers and their determinants is a vital first step.
So far, the G-20’s call to “think globally” has turned into “act locally.” We hope that the G-20 leaders will think systemically at Cannes, and act nationally and cooperatively to defuse the global credit glut minefield.
By Andrew Sheng
Copyright: Project-Syndicate, 2011
Andrew Sheng is President of the Fung Global Institute, a new Hong Kong-based think tank that seeks to understand global issues from Asian perspectives. He was Chairman of the Hong Kong Securities and Futures Commission and is an adviser to China’s Banking Regulatory Commission.
- China’s Shadow Banking System: The Next Subprime? (blogs.wsj.com)
- G20: Merkel desperate to solve Greek debt crisis (guardian.co.uk)
- Craig Stephen’s This Week in China: Beijing talks tough on European debt (marketwatch.com)
- Shadow banking tops pre-crisis level (theglobeandmail.com)
- Why 2012 will be a repeat of 2008 (wealthmans.wordpress.com)