The real reason banks are so desperate for the ECB to start the printing presses

November 19th, 2011

Ian Fraser’s introduction: This blog was written by Golem XIV, a pseudonym for filmmaker and author David Malone. David’s core argument is that banks, not governments, are to blame for the current eurozone sovereign debt crisis. While there are some serious omissions — the article does not mention the flawed nature of EMU, which clearly exacerbated the crisis, or the role of the Basel committee, which put together the regulatory framework that encouraged banks to build up massive holdings of “risk free” sovereign debt (for more on this, see this New York Times article) or the credit rating agencies which misrepresented the riskiness of PIIGS debt — the core arguments are sound.  Attempts by banks, and their apologists, to blame governments and regulators for their own folly need to be shot down. The article was originally titled Buckle Up – Credit Crunch 2.

I am sorry this is such a lengthy article. But I offer it as an explanation and understanding of what is going on that the bankers DO NOT want you to have.

I think it may now be time to buckle up and read that little card that tells you how to assume the crash position.

In a nutshell we are already in the midst of another credit and bank funding crunch. Of course all the talk from the bankers, including Willem Buiter, chief economist at Citigroup  and the tin hat brigade at Deutsche Bank is about how it is all the fault of nations. But it’s not quite as simple as that.

Already one multi-billion dollar brokerage, MF Global, has collapsed. One trillion dollar bank, UniCredit, is teetering on the edge of collapse, and two European nations each with enough debt to bring down Europe, Italy and Spain, are desperately trying to borrow euros from the ECB and dollars from the Fed. Just this morning Spanish bond yields are shooting up into unsustainable territory. And French yields are also in motion.

Like a train sliding backwards over a precipice, as each carriage goes over so the weight pulling down grows and the weight resisting decreases. And the engine at the front, the ECB/Germany has to think ‘can I still pull all this back up or should I cut the coupling and save myself at least?’.

There is a crisis and it is in Europe , but the ‘contagion’ is not at all what the media and brain dead politicians are telling us it is. The contagion the markets are worried about is bank contagion. Nations’ borrowing woes are the radioactive material, but it was the banks that built the bomb.

Here’s what I mean. What I want to show is that what is happening is almost a carbon copy of what the banks did in the lead up to Credit Crunch 1. They have done the same again, only this time with sovereign bonds instead of American mortgages. This is another subprime and once again it has been engineered by the banks.

To understand why the rise in borrowing costs in Italy and Spain, as well as worries about Greece, have suddenly become a ‘contagion’ that the bankers speak of in apocalyptic terms we have to understand why and how MF Global imploded. This might seem like a sideways diversion but it’s not. The collapse of MF Global is our window in to what is actually frightening the bankers.

MF Global was not only a huge brokerage it was one of the gilded ‘primary dealers’. That is, the largest and most trusted banks or brokerages chosen to for their size and stability, to deal everyday with the Fed to help it sell America’s trillions of debt. MF Global was run by Jon Corzine, former head of investment banking at Goldman Sachs and one-time governor of New Jersey. But please don’t get the impression there is any sort of revolving door between finance and government.

And yet MF Global collapsed. According to the Guardian, this was because of lax oversight. Regulators didn’t mind that at the fact that at the time of its demise,

…MF Global had liabilities at the end of June of $44.4bn against only $1.4bn in equity.

The familiar trope of ‘lax oversight’ goes along with ‘rogue trader’ as an explanation that bankers can live with, and are happy for you to accept. ‘Lax oversight’ like ‘rogue trader’ scapegoats one or two people and deflects any questions of whether what happened was a direct consequence of what the banks do and how they chose to do it as a group and a profession.

What is undeniable is the massive leverage. Now we need to ask what underpinned this leverage. For that we turn to a report from AP which I picked up via Business Insider with the headline, “MF Global Is The First Big US Victim Of The Europe Crisis”. The article began the ‘it’s a crisis of European nations’ story-line. It begins with the statement,

“The European debt crisis has claimed its first big casualty on Wall Street…”

But how exactly? Much later in the article comes this:-

MF Global had amassed net exposure of $6.29 billion in debt issued by Italy, Spain, Belgium, Portugal and Ireland. Of that, $1.37 billion was from Portugal and Ireland, which already were bailed out by European authorities. More than half was from Italy, whose borrowing costs increased in recent days as investors grew concerned about its finances. (My emphasis)

Now no-one had forced MF Global to buy these bonds. MF Global could just as easily have bought German bonds. Only they would have given less of a return. What MF Global had been doing was buying up dodgy bonds on the secondary market that other people were selling. It was picking them up cheap in the expectation they would be bailed out.

So now we have massive leverage resting on subprime assets, this time bonds not mortgages, which the company had specifically sought out. And it sought them out for the same reasons that subprime mortgages were sought after – their high risk made them more lucrative than safe ones. Same greed, same idiocy. Same people.

But Corzine wasn’t done yet. Oh no, not by a long way.

MF Global was also following the exact same funding model that Bear Stearns did, that Lehman Brothers did, that Northern Rock did and that countless others did. It relied for a huge part of its day-to-day funding on short-term borrowings. Why go for short-term borrowing which in retrospect seems so unstable – given that as soon as you have a problem you have so little time to sort it before you run out of money? Why? Because it’s cheap. Of course. So you buy risky because it’s cheap to buy and offers high return (until it explodes that is) and then you borrow short also because its cheap but unstable. Banking genius at work having ‘learned those lessons’ from the crash of 2008!

But wait there’s more as explained here by professional accountants in forensic detail. I will give you the short version.

MF Global was borrowing short to finance itself, but with what collateral? Remember Lehman Brothers and their infamous Repo 105? For those who don’t, repo (short for “repurchase agreement”, is where you ‘sell’ as asset but with a fixed agreement to buy it back at an agreed slightly higher price at a set time. So although it is ‘sold’, it is actually a loan, since the asset comes back and the money is returned with interest.

Lehman’s was using Repo but exaggerating the worth of its assets to ‘borrow’ more than they were worth. The investment bank came unstuck when creditors would no longer accept its valuations of assets or, in fact, accept them at all. MF Global was using its dodgy European bonds as collateral. It was marking them to mythic – sorry – model valuations and repo-ing them.

But it gets better. The particular type of repo it was using was ‘repo to maturity’. Which simply means the agreement was that the short term repo was to be rolled over and renewed all the way until the bond matured. This is legal though I should  point out the the law was written by the financial firms themselves.

The key fact is that repo to maturity is supposed to be done ONLY with absolutely ‘AAA’ rated bonds such as US Treasury bonds. MF Global was using ersatz triple A or worse including Italian, Greek and Spanish bonds. It was pretending they were ‘AAA’, despite the fact it was buying them up at prices that illustrated they were a very long way indeed from being ‘AAA’. And the regulators, auditors, accounting standards boards turned a blind eye.

Now what this meant was that MF Global was showing the repos as actual sales. Naughty, yes, but terrible? Well, yes. Terrible enough that much of it was hidden off balance sheet. You see by booking them as a sale the company was claiming that the risk associated with them (remember these were dodgy bonds from struggling countries) was also gone. Sold to the ‘buyer’. But there was no buyer. They were only repo’d.

I say ‘only’ but in fact MF Global was happy they were only repoed. It was more lucrative than selling them. And in fact this is in may ways the point of the deal MF was doing. You see the ‘interest’ MF was getting on the bonds, because they were dodgy, was quite high. This was its reason for buying them. Whereas the interest charged on short term repo is quite low.

So MF Global was buying dodgy bonds which gave high interest and using them to borrow at a lower rate. Not only did this borrowing enable it to leverage itself to an even greater extent, but it was even making money on the deals; from the fact that the interest it was getting on the bond was higher than it was paying to borrow, using them as collateral. It seems convoluted and it is. But this is what the bankers call arbitrage and is why they think they are so clever. Understand it and you too could be a proper banker.

However, they ignored one thing. The same thing that Lehman Brothers ignored. No matter what accounting trickery they used, the bonds were not sold, they were repo’d which meant the risk (of the bonds declining in value) ultimately remained with MF Global. In fact the risk was amplified. Not only was there the original risk of the dodgy bonds losing value, they now had an additional, greater risk because they had taken out further loans using the dodgy bonds as collateral. And from the leverage we looked at earlier know just how much MF Global had multiplied the risk.

So when the value of Italy’s and Spain’s bonds began to decline, their value as collateral declined and MF Global was asked to provide additional capital/cash to make up the difference. This is what is called a ‘margin call’. And these margin calls were what killed MF Global. It couldn’t come up with any more cash because it had none (it had spent it all on buying dodgy bonds) and couldn’t borrow any more because all it had were those bonds whose value was going down and an insane degree of leverage which geared those losses up till they had the power to crush.

So now we have almost every aspect of the original sub-prime credit crunch reproduced by the same people who did it the first time and were never prosecuted, punished or even rebuked, but instead were allowed to continue rewarding themselves with millions in bonuses.

So to summarize, MF Global invested in subprime. Only this time subprime bonds not mortgages. It leveraged them hideously, pretended it had off-loaded the risk when it hadn’t and then got caught when the value of the bonds went down and couldn’t pay the debts it had taken on using the bonds as collateral. Sorry to labour the point but I want you to see how this really is subrpime all over again.

And as with the original subprime, when one tainted bank goes down it leaves all those to whom it owes money, with their own losses — and causes general panic based on mistrust across the financial markets.

So now let’s move on from MF Global, because you never find just one cockroach in a dirty kitchen. Which logic nearly killed a second brokerage, Jefferies. Its stock collapsed on the rumour that it too had bought up lots of European bonds. Jefferies had to take the amazing step of publishing every single position in bonds that it had. Only then did its stock recover.

Since then other banks have been less transparent about their exposure, including Goldman Sachs and JP Morgan. They are not so much suspected of owninglots of European bonds themselves but of having provided the one part of the whole subprime crisis I  have not so far mentioned, credit default swaps (CDS). Goldman Sachs and JP Morgan are among the world’s largest derivatives traders. And they revealed that between them they have sold ‘protection’ on over $5 trillion globally. No one knows how much of this is on dodgy European debt and neither Goldman nor JP Morgan is saying.

In subprime credit crunch 1 it was AIG that provided much of the short term funding and insurance protection. This time who knows who are the main providers. But you can be sure there was a great deal of it sold. Because it would have been sold using the same logic which inspired MF Global to buy the debt. The logic which said, these are countries too big to fail so in the end they will be bailed out even if democracy has to be  suspended to ensure it.  If you believed that logic then you would have sold CDS protection and spent the premiums.

So that, I believe is all aspects of subprime accounted for. You can now see that while sovereign bonds and debts may be the fissile material the bomb itself and its explosive potential was constructed by the banks just as they did last time following the same blue-print and same greed.

And how soon might it go off? For that we need to look at the Italian basket case bank UniCredit. Last quarter the trillion euro bank suddenly posted a ‘surprise’ €10.6 billion loss in just this last quarter! It’s bonds are now trading as junk while it faces having to raise another €51 billion to re-finance its debt in just the next year. That, to me spells BOOOOM! It is only the first. It certainly won’t be the last.

Why did UniCredit suddenly make such a loss? What was happening during the last quarter? Well Spanish and Italian bonds have lost a lot of value. What, might UniCredit have been holding a lot of them? Surely not I hear you cry. Who would be so stupid. UniCredit blames the loss on its Kazakhstan and Ukraine units. What would those units have been doing to wrack up such monumental losses? UniCredit is now trying desperately to sell bits of itself.

The banks know what is going on. They each know the risks and losses they are hiding and know if they have them then so do the others. Exactly as in credit crunch1 interbank lending is frozen with both Libor and repo markets in disarray.

I suggest these are the real reasons the banks are in an absolute panic and are shrieking about how the ECB must print and print now and why elections and  voting of any kind at all must NOT be allowed to upset the smooth imposition of the bank’s required plan. There is contagion but it is bank contagion, its subprime greed and failure all over again.

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