European Interbank Markets Stress Rises Over Counterparty Fears

In March 2009 I had an optimistic attitude about the global economy (i.e. I was bullish). I thought stocks were underpriced and the economy would recover, albeit at a slow pace. Over the past month, however, I've become bullish. I now think the current recession will double-dip. The first dip was the plummeting global real estate market that caused bank assets to plummet, which in turn led to a credit crisis. I think the second dip will be caused by a sovereign debt crisis in Europe that causes bank assets to plummet along side a currency free fall, which in turn will cause a credit crisis. This Naked Capalism post explains the European Crisis in better detail.


European Interbank Markets Stress Rises Over Counterparty Fears: "

It’s starting to fell like 2007 and 2008 all over again: banks suddenly cautious about lending to each other, with the stress spilling into other markets. Per Bloomberg:

The cost to hedge against losses on European bank bonds is 63 percent higher than a month earlier. Investment-grade corporate debt sales in the region plummeted 88 percent last week to $1.2 billion from the prior period…

The rate banks say they charge each other for three-month loans in dollars is the highest in nine months…

The three-month London interbank offered rate in dollars, or Libor, rose to 0.445 percent last week, the highest level since August, from 0.428 percent on May 7 and 0.252 at the end of February…

Concerns have spilled into the market for commercial paper, debt used by companies and banks for their short-term operating needs. Rates on 90-day paper are more than double the upper band of the federal funds rate, about twice the average in the five years before credit markets seized up in mid-2007.

“The list of banks able to tap the three-month market remains extremely limited with access spotty and expensive,” Joseph Abate, a money-market strategist at Barclays in New York, wrote in a May 14 note to clients…..

Rates on commercial paper for 90 days are 24 basis points above the upper band of the Fed’s zero to 25-basis point target rate for overnight loans among banks. While far below the 245- basis point gap reached in October 2008, the spread is more than double the 10-basis-point average in the five years before credit markets seized up in the middle of 2007. As recently as February, financial CP rates were below the federal funds rate.

Except for banks with little exposure to European sovereign risk, banks “have found liquidity to be scarce, securing funding only one month and shorter and mostly concentrated inside one week,” Abate from Barclays wrote in the report.

Yves here. The Bloomberg piece highlights Royal Bank of Scotland and Barclays as the banks hit with the biggest rise in funding costs.

Where this all gets a bit nasty is the worries re MTM losses, not just on sovereign debt, but on other risky assets as well (and don’t underestimate the ability of a bank to have wrongfooted their currency exposures). Remember, most observers believe banks generally, and UK/European banks in particular, have not recognized the full extent of their losses from the last crisis (cheap liquidity has enabled a lot of dubious assets to be marked at levels that are questionable given their long-term prospects).

While all eyes have been on the plummeting euro, sterling hasn’t fared too well either, and a lot of my UK contacts expect it to be decline (the powers that be presumably hope that Mr. Market will take care of that, but they think a formal devaluation is not out of the cards). But the open question is whether a desired slide in the value of the pound could morph into a currency crisis. As Willem Buiter warned in 2009:

The risk of a triple crisis – a banking crisis, a currency crisis and a sovereign debt default crisis – is always there for countries that are afflicted with the inconsistent quartet identified by Anne Sibert and myself in our work on Iceland: (1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity.

The argument is simple. First consider the case where the banking sector is fundamentally solvent, in the sense that its assets, if held to maturity, would cover its liabilities…There is no such thing as a safe bank, even if the bank is sound. Without an explicit or implicit government guarantee, there is always the risk of a bank run (a withdrawal of deposits or a refusal to renew maturing credit and to roll over maturing debt) or a sudden market seizure or ’strike’ in the markets for the bank’s assets bringing down a fundamentally sound bank.

To prevent a fundamentally sound bank succumbing to a deposit run or to asset market illiquidity, the central bank has to be able to act as lender of last resort, providing funding liquidity and as market maker of last resort, providing market liquidity to liquidity-constrained banks…

The UK banking sector’s balance sheet is about half the size of the Icelandic banking sector as a share of annual GDP: just under 450% at the end of 2007 as compared to Iceland’s almost 900%…. If we exclude the Bank of England, the latest observation on the balance sheet of the banking sector and a percentage of annual GDP would still be around 420 percent. The deleveraging of the banking sector, visible at the very end of the sample period, has much further to go…..foreign currency assets and liabilities of the banking sector are very evenly matched….

While there is no net foreign exchange exposure of the banking system in the UK, banks are banks. The foreign currency liabilities of the banking system are therefore likely to have shorter maturities than the foreign currency assets. The foreign currency assets are also likely to be less liquid than the liabilities….With foreign currency assets of longer maturity and less liquid than foreign liabilities, the banks and the country would still be vulnerable to a foreign currency run on the banks (a refusal to renew foreign currency credit) or a seizing up of the markets in which the banks’ foreign currency assets are traded. The Bank of England’s foreign currency reserves are puny and the government’s foreign currency reserves are small – around US$43 billion, pocket change, really.

Yves here. You can see where this is going…the UK cannot credibly backstop its banks if they have trouble rolling their short term foreign currency borrowings. Not a pretty line of thought.

"

Should a Stock Market Decline Stop Us From Breaking Up the Giant Banks or Fu...

Interesting post from "Washington's Blog." Briefly discusses how the rich are getting richer and, by the way, they control Congress and run both the private sector and the government to build and protect their wealth.

 

 

Sent to you by Bo Howell via Google Reader:

 

 

Should a Stock Market Decline Stop Us From Breaking Up the Giant Banks or Fully Auditing the Federal Reserve?

via Washington's Blog by George Washington on 5/6/10

As of 2007, the bottom 50% of the U.S. population owned only one-half of one percent of all stocks, bonds and mutual funds in the U.S. On the other hand, the top 1% owned owned 50.9%.

From the San Francisco Chronicle:

Half of America has only 0.5% of the stocks and bonds

Source: Institute for Policy Studies

(Of course, the divergence between the wealthiest and the rest has only increased since 2007.)

As I noted in January:

Vincent Deluard - a strategist for TrimTabs Investment Research (25% of the top 50 hedge funds in the world use TrimTabs' research for market timing) - says:

We've never seen this before – such a huge rally, and the little guy is out.

In other words, the stock market rally is due almost entirely to hedgies, pension funds, banks and other institutional investors, and not every day investors.

***

TrimTabs notes that small investors pulled out $14 billion net from stock mutual funds from the beginning of last year through mid-December, on top of a net $245 billion withdrawn in 2008.

Given that, at the end of September, individuals held 80% of the $19 trillion in stock in U.S. companies, both private and public - according to the Federal Reserve (see this, for example)- recovery will not happen so long as the little guys are sitting on the sidelines.

TrimTabs notes that most of $592 billion taken out of money market mutual funds last year has gone into bond and bond-hybrid funds instead.

No wonder David Rosenberg is saying:

• "People have been lured into two bubbles seven years apart, and for a lot of them it's over."

• "The bulls say if the market is up this much without retail investors, just watch when they come in, but it isn't going to happen."

• Investors who have not been spooked or angered by the market are probably too poor to buy anyway.

Many people say that keeping the stock exchange up is important to maintaining people's wealth. But since the bottom 50% of Americans don't have much skin in the game, and the giant prop desks are probably doing most of the trading, the stock market really doesn't affect most Americans very much.

After Hank Paulson initially asked for $700 billion to bail out the banks, Congress refused. Then the stock market tanked (and Paulson said there would be martial law unless TARP was approved), and Congress gave Paulson his bailout. They said they had to do it, because their constituents were being hurt by the stock market downturn.

As I pointed out last November, there are a lot of millionaires in Congress:

A report by University of California, Berkeley economics professor Emmanuel Saez concludes that income inequality in the United States is at an all-time high, surpassing even levels seen during the Great Depression.

The report shows that:

• Income inequality is worse than it has been since at least 1917

• "The top 1 percent incomes captured half of the overall economic growth over the period 1993-2007"
  

• "In the economic expansion of 2002-2007, the top 1 percent captured two thirds of income growth."

As others have pointed out, the average wage of Americans, adjusting for inflation, is lower than it was in the 1970s. The minimum wage, adjusting for inflation, is lower than it was in the 1950s. See this.

On the other hand, billionaires have never had it better (and see this).

Of the 535 members of Congress, over 44% - 237 to be exact - are millionaires. Fifty have net worths of at least $10 million, and seven are worth more than $100 million. By comparison, around 1% of Americans are millionaires. There is no other minority group that is as overrepresented in Congress. See this.

Indeed, Herbert argues that the real reason that Congress approved the TARP bailouts is that their money was on the line. In other words, they had a lot of skin in the game, and so they voted to bail out their own assets. But they just pretended it was for the good of the American people.

Whether or not Herbert is right (Paulson did pull a bait-and-switch), the information discussed above makes for valuable background for looking at proposed reform legislation and the stock market.

Specifically, I have seen many questions on well-known financial sites asking whether today's plunging stock market is related to top Senators' decision today to audit the Federal Reserve and break up the giant banks (and see this).

I have no idea whether there is anything to this question. But I do know that the economy can only be stabilized if the history of what happened is fully revealed.

And the Fed is an important part of what happened.

And I know that the economy can only recover long-term if the giant banks are broken up.

So ignore the short-term stock market scares. Fully audit the Fed and break up the mega-banks ... or the economy will never really recover.

 

 

Things you can do from here:

• Subscribe to Washington's Blog using Google Reader
• Get started using Google Reader to easily keep up with all your favorite sites

 

 

Market Update

 

 

Sent to you by Bo Howell via Google Reader:

 

 

Market Update

via Calculated Risk by CalculatedRisk on 5/6/10

There are two rumors: The first is that there was a trading error (fat finger of a E-mini SP future order), the second is that Euro banks are having a liquidity problem of some sort. Neither is confirmed.

Click on graph for larger image in new window.

The first graph shows the S&P 500 since 1990 (this excludes dividends).

The dashed line is the closing price today. The S&P 500 was first at this level in April 1998; over 12 years ago.


The second graph is from Doug Short of dshort.com (financial planner): "Four Bad Bears".

Note that the Great Depression crash is based on the DOW; the three others are for the S&P 500.

 

 

Things you can do from here:

• Subscribe to Calculated Risk using Google Reader
• Get started using Google Reader to easily keep up with all your favorite sites

 

 

Yes, Virginia. There is a Difference Between Greece and the US

 

 

Sent to you by Bo Howell via Google Reader:

 

 

Yes, Virginia. There is a Difference Between Greece and the US

via New Deal 2.0 by Marshall Auerback on 5/6/10

If we learn the wrong lessons from Greece, our social safety net may wind up in tatters.

Many market analysts, commentators and economists claim to be having a hard time finding a metric in which the US is in better financial shape than Greece. Ken Rogoff, for example, recently warned that a Greek default would usher in a series of sovereign defaults, and suggested recently on NPR that the crisis also had implications for the US. The historian Niall Ferguson made a similar claim a few months ago in the Financial Times. The cries of the deficit hawks grow louder: Repent all ye fiscal profligates, before the "day of reckoning" comes.

Let's dial down the Biblical hysteria a wee bit while there's still time for rational debate. The market's recent response to the intensifying pressures in the euro zone suggests that investors are beginning to differentiate between countries that are sovereign issuers of currency, such as the US or Japan, and non-sovereign issuers, such as Greece or any other nations in the euro zone. The US dollar is rising in value, notwithstanding the federal deficit, while debt distress in the so-called "PIIGS" countries, especially Greece, are intensifying, thereby driving down the euro to fresh 12 month lows against the dollar.

The relative performance of various currencies against the US dollar is highly instructive in this regard. Over the past 3 months, the Australian, New Zealand and Canadian dollars have all registered gains of some 4% against the greenback. The worst performer? Not surprisingly, the euro, down 6.3% over that period. Whether consciously or not, the markets are demonstrating that they understand the distinctions between users of currencies (who face an external funding constraint), and those nations that face no constraint in their deficit spending activities because they are creators of currency.

That the US has the reserve currency is an irrelevant consideration here. The key distinction remains user vs. creator. The euro zone nations are part of the former; Canada, Australia, the UK, Japan and the US are representatives of the latter.

Using "PIIGS" countries as analogues to the US or the UK, as Rogoff, Ferguson and countless other commentators do, is wrong. Their faulty analysis comes as a result of the deficit critics' failure to distinguish between the monetary arrangements of sovereign and non-sovereign nations. Any sovereign government (none within the EMU enjoy that status any longer) can deal with a collapse in revenue and an increase in outlays from a financial perspective without invoking the sort of deadlocks that are now crippling the EMU zone. That is why, for example, the Japanese yen is not in freefall against the dollar, despite having a public debt to GDP ratio in excess of 200%, almost 2.5 times that of the US. In fact, over the past few days the yen has actually appreciated against the dollar. Now why would that be, if the lesson we were supposed to learn was the evils of "unsustainable" government deficit spending?

Fiscal sustainability has no relevance in a system where there are no operational constraints on the ability of a government to spend. US Social Security checks will not bounce. Nor will the Canadian or Japanese equivalents. Similarly, their bonds will always be able to pay out interest.

Note that this doesn't mean that there are no real resource constraints on government spending. Let's be clear: anyone who advances the use of fiscal policy as an effective counter-stabilization tool is always careful to point out that these interventions can come at a cost. That cost could well be inflation if, as a result of the fiscal expansion, we reach full employment, resource constraints begin to appear, but the government continues to spend. But if the economy recovers, tax revenues will increase and safety net spending will fall. In the US, that means we will likely be back to "normal," with deficits around 2-4% depending on the state of the economy, which is where we've been for the past 30 years aside from 1998-2001.

Why won't these deficits be inflationary? As Professor Scott Fullwiler noted in a recent email correspondence with me, once the recovery is underway and the economy gets to a significantly higher capacity utilization where price pressures could emerge, the deficit will be declining substantially. It will also be at least a partially offset by a fall in discretionary spending on social welfare. It's axiomatic that the faster the economy grows, the smaller the deficit becomes, unless the government continues to spend recklessly–which we certainly do not advocate.

And by the time we get to a point where we might have inflation, the deficit is back to 2-3%, which again is where we've been for the past 30 years, while average inflation has been about 2%. Note: inflation does not equal default. You and I could well buy credit default swaps on any country in the world, but we are unable to collect if any of the relevant countries register a positive rate of inflation — even a double digit rate of inflation — because inflation is not tantamount to default. Nor do the ratings agencies recognize default in this manner. Default is defined as a failure to perform a task or fulfill an obligation, especially failure to meet a financial obligation. Inflation is not incorporated into the definition when it comes to questions of national insolvency.

By contrast, the talk of Greek default is prevalent across the markets, and that is a reasonable concern in the context of the euro zone. The default option is considered a foregone conclusion, even allowing for the massive 110 billion euro bailout, which was designed to inspire "shock and awe" among investors but instead has simply engendered shock. If Greece costs 110 billion euros to bail out, how much next time for Spain, Italy, or even France?

If the markets have concerns about national solvency, they won't extend credit. And that is the problem facing all of the euro zone countries. Greece, Portugal, Italy, France, and Germany are all users of the euro-not issuers. In that respect, they are more like any American state or municipality, all of which are users of the US federal government's dollar.

And deficits per se will not create the conditions for default in the US. If the US continues to run net export deficits (all the more likely given the ongoing fall in the value of the euro), and the private domestic sector is to net save, the US government has to net spend–that is, run deficits. That is a basic accounting identity, nothing more, nothing less. If the US government tries under these circumstances to run surpluses, it will first of all force the private domestic sector into deficits (and increasing debt) and ultimately fail because the latter will eventually seek to increase their saving ratio again.

And the same logic applies for Greece. The call is for the IMF/EU package to reduce its budget deficit as a percentage of GDP from the current 13.6% to 8.1% in 2011. How will they achieve that? Trying to engineer a reduction in the deficit via austerity programs (or freezes or whatever else one might like to call them) at a time when private spending is still insufficient to maintain adequate real GDP growth is a recipe for disaster. It will increase the deficit.

Consider Ireland as Exhibit A in this regard. Ireland began cutting back deficit spending in 2008, when its banking crisis began to spread and its budget deficit as a percentage of GDP was 7.3%. The economy promptly contracted by 10% and, surprise, surprise, the deficit exploded to 14.3% of GDP. We would wager heavy odds that a similar fate lies in store for Greece, given the EU's inability to understand or recognize basic financial balances and the interrelationships among the various sectors of the economy. Neither a government, nor the IMF, can predict with any certainty what the outcome will be–ultimately private saving desires will drive the outcome, as Bill Mitchell has noted repeatedly.

Why do we have huge budget deficits across the globe? It's not because our officials have all suddenly become Soviet-style apparatchiks. It is largely because the slower global economy has led to lower revenues (less income=less taxes paid, since most tax revenue is based on income, and lower tax brackets) and higher spending on the social safety net. Gutting this social safety net because we extrapolate the wrong lessons from the euro zone's particular (and self-imposed) predicament constitutes the height of economic ignorance. It also reflects a transparently political agenda, which the US would be ill advised to embrace. The rescue packages, the IMF intervention and all the talk about orderly defaults cannot overcome the EMU's fundamental design flaw. Let neo-liberalism die with the euro.

Roosevelt Institute Senior Fellow Marshall Auerback is a market analyst and commentator.

 

 

Things you can do from here:

• Subscribe to New Deal 2.0 using Google Reader
• Get started using Google Reader to easily keep up with all your favorite sites