The New Euro Area Ponzi becomes Operational

Further below is a brief update of our usual charts to show the recent pullback in euro area CDS and moves in associated markets. It all started with a number of 'auction successes' (as you know we think that these strings of successful auctions of troubled borrowers are a trifle suspicious) and then accelerated when it became known that Greece and other 'peripherals' may be allowed to buy up some of their discounted debt in the market with newly borrowed funds from the EFSF. There is of course a catch to this: while it would be an ingenious market manipulation maneuver from the point of view of the countries concerned, bond holders may be unwilling to participate. Among those bond holders we find the ECB, which has to be careful with the big pile of toxic assets on its balance sheet.  Says the FT:



Under a bond repurchase programme, governments would use EFSF loans to buy their bonds on the open market which, in the cases of several debt-laden countries, are currently priced at significant discounts to their face value.

Greek 10-year bonds were trading on Thursday at only 71 per cent of their face value, meaning a repurchase would cut 29 per cent off the value of Greek debt – a voluntary “haircut” for private investors who take the deal, without a messy restructuring.

The proposal has been discussed by EU policymakers for several weeks. According to a document obtained by the Financial Times, the European Commission, the EU’s executive branch, has proposed such a scheme for a new rescue fund that will replace the EFSF when it expires in 2013.

According to the document, the bond repurchase measure “could be interesting for countries for which there is a significant haircut on the secondary market”, since it would lower overall interest rates.

“This would allow the beneficiary [country] to reduce significantly its stock of debt and should therefore improve market access, by alleviating the fears on the debt sustainability,” the document, circulated January 7, reads.

Although market analysts are receptive to the idea, some question how effective it would be. Harvinder Sian, rates strategist at RBS, noted much of Greece’s debt is held by European banks or the European Central Bank, neither of whom would be willing to suffer losses in a voluntary buyback. Mr Sian estimated Greece would be able to achieve savings of about €12.5bn ($16.8bn) on its debt, which would only bring its peak debt-to-GDP level in 2013 down from 158 per cent to 153 per cent.

“It will help at the margins but is not enough to bring back confidence in Greek debt sustainability,” Mr Sian wrote in a report.”


(our emphasis)

So the catch is not only that certain bond holders would be less than happy with such tactics, but also that the effort won't really help all that much anyway. In any case, when the rumor of the plan began to make the rounds, the markets lapped it up and sent CDS spreads on Greek debt and that of the remaining members of the PIIGS stable sharply lower. All other euro area CDS spreads and even those on JGBs declined in sympathy.

The EFSF in turn had itself a wildly successful bond auction, which was almost nine times oversubscribed (obviously these bonds are a great deal safer than the ones issued by the peripherals themselves). The biggest buyer of the bonds turned out to be Japan. The 'Chief Bailout Officer' Klaus Regling was well pleased. According to Bloomberg:


“The European Financial Stability Facility attracted an “overwhelming” 44.5 billion euros ($61 billion) of orders from about 500 bidders for its inaugural bond sale intended to help fund Ireland’s bailout.

The Japanese government snapped up more than 20 percent of the 5 billion euros of five-year debt, according to the EFSF. Asian investors overall bought about 38 percent of the issue, while those in the U.K. picked up 15 percent and German buyers took 12 percent, according to two people familiar with the transaction. Investors in North America accounted for 2 percent.

“The response from international investors was overwhelming,” EFSF Chief Executive Officer Klaus Regling said at a press conference in Frankfurt today. “That is the biggest order book ever. We will check before we notify the Guinness book of records but nobody can remember anything like that in the world.”


“The demand is huge,” said Mark Dowding, a senior portfolio manager at Bluebay Asset Management Plc in London, where he helps oversee 20 billion euros in European investment- grade funds, who placed a “small order” for some of the EFSF notes. “There’s clearly very strong interest from Asia and from central banks in particular.”

Central banks, governments and agencies made up 43 percent of the purchases, said the people, who declined to be identified because the details of the transaction are private. Funds absorbed another 31 percent.

The bailout fund will disperse money to Ireland on Feb. 1, matching the country’s request for a loan of 3.3 billion euros, with the remaining proceeds retained as a cash buffer to ensure the top AAA rating, according to the statement. Ireland will pay an interest rate of about 6 percent, Regling said.”


If this strikes you as yet another attempt to perpetuate what is a huge Ponzi scheme by adding additional layers to it , you're not alone. That's exactly what this is. In principle, the whole EFSF idea is not dissimilar from creating a CDO with various tranches of  debt seniority for people to invest in – with the added twist that central banks themselves are the biggest investors.

The 'equity tranche' of the CDO would be Irish or Greek debt itself. If you're buying bonds from the EFSF, that's the senior tranche guaranteed by all member states of the EU – including, nota bene, the insolvent states themselves. Of course it's so much easier to con the market with yet another Ponzi scheme if half of that market consists of central banks that can print their own money. Moreover, they are institutions well versed in a variation of another famous game, the Three Card Monte. They have made what in the end amounts to nothing but crude inflationism, i.e.,  money printing, into a complex operation that the average citizen is unable to comprehend and dissect without acquiring quite a bit of specialized knowledge and then spending time on trawling through the data. The fact alone that a central bank like the Fed uses e.g. treasury bonds as the main component of its asset base and then refunds the interest it receives on this portfolio after deducting its costs to the  treasury every year should give everyone pause. The coin-clipping kings of yore had nothing on these guys, that much is certain.

Speaking of the Fed…


If Commercial Banks can Hide Their Losses,  So Can We

FASB recently made the 'mark-to-reasonable-stab' policy of valuing assets of commercial banks permanent – you may recall that FASB 'temporarily' withdrew mark-to-market rules in the depths of the financial crisis to 'help restore confidence'. Bankers were jubilant – after having been more than happy to employ mark-to-market rules for many years when they artificially boosted their profits (and hence, their bonuses), something new was clearly needed when marking to market suddenly produced losses. Some of their downright Orwellian comments can be found below. Back in April 2009 Bloomberg reported:


FASB Eases Fair-Value Rules Amid Lawmaker Pressure

The Financial Accounting Standards Board, pressured by U.S. lawmakers and financial companies, voted to relax fair-value accounting rules that Citigroup Inc. and Wells Fargo & Co. say don’t work when markets are inactive.

Changes to fair-value, or mark-to-market accounting, approved by FASB today allow companies to use “significant” judgment in gauging prices of some investments on their books, including mortgage-backed securities. Analysts say the measure may reduce banks’ writedowns and boost net income. Firms could apply the changes to first-quarter results.

“Good decision,” Citigroup Chairman Richard Parsons said of FASB’s move. The market for mortgages and other assets was not working, so something had to change, Parsons said in a New York interview today. Citigroup later said in a statement the decision will have “no impact” on its financial statements.

House Financial Services Committee members pressed FASB Chairman Robert Herz at a March 12 hearing to revise fair-value, which requires banks to mark assets each quarter to reflect market prices, saying it unfairly punished financial companies. FASB’s proposals, made less than a week later, led to criticism from investor advocates and accounting-industry groups, which say the rules force firms to reveal their true financial health.

Financial shares rose after the FASB move. Citigroup rose 2.2 percent to $2.74 at 4:15 p.m. in New York Stock Exchange composite trading. Bank of America Corp. added 2.7 percent to $7.24. The KBW Bank Index earlier rose as much as 6.1 percent.

‘More Accurate’

“Today’s decision should improve information for investors by providing more accurate estimates of market values,” Edward Yingling, chief executive officer of the American Bankers Association, said in a statement. “


(our emphasis)

Not surprisingly, banks returned to reporting large profits (and paying big bonuses) in a heartbeat when these rules were changed. Note the highlighted  comments of  bankers at the time above. It is proof that the entire edifice of debt and debt-based money rests on little more then a string of deceptions designed to create the vaunted chimera called 'confidence' – a confidence that is completely unwarranted. Bank balance sheets have become even more opaque as a result.

Anyway, FASB has now finally – and quietly – relented on the issue and made this new method of valuing bank assets a permanent feature. In short, deceptive bank balance sheets are henceforth the official rule, forever and ever, or for as long as it suits the bankers.

The WSJ notes that there is a 'retreat on marking-to-market':


“Accounting rule makers, bowing to an intense lobbying campaign, took a key step Tuesday to reverse a controversial proposal that would have required banks to use market prices rather than cost in order to value the loans they hold on their balance sheets.

The debate over the proposal is the latest chapter in a pitched battle pitting investors who wanted better disclosure of the value of banks' assets against the banks themselves. Banks have argued against so-called fair-value accounting, saying market prices would have left them at the mercy of volatile markets and could have caused additional strain during the financial crisis.

The Financial Accounting Standards Board preliminary vote would allow banks to continue valuing many of their loans at amortized cost, an adjusted version of their original cost, as they do now. That backtracks on an FASB proposal last May to expand fair value to bank loans. The reversal is a victory for the banking industry, which says it would have hurt lending and unfairly reduce banks' book value. Supporters of the FASB fair-value proposal say it would have improved transparency and unmasked potential weakness at banks.”


(our emphasis)

The Fed couldn't just sit still while all this happened – after all, it bought a sludge of toxic assets from the banks way back in the GFC, so why should it alone be forced to reveal losses? Clearly something needed to be done – and so it was. According to CNBC, all it took was a tweak in accounting, et voila, the losses disappear down the memory hole before they can affect the Fed's tiny capital base.


“Concerns that the Federal Reserve could suffer losses on its massive bond holdings may have driven the central bank to adopt a little-noticed accounting change with huge implications: it makes insolvency much less likely. The significant shift was tucked quietly into the Fed's weekly report on its balance sheet and phrased in such technical terms that it was not even reported by financial media when originally announced on Jan. 6.

But the new rules have slowly begun to catch the attention of market analysts. Many are at once surprised that the Fed can set its own guidelines, and also relieved that the remote but dangerous possibility that the world's most powerful central bank might need to ask the U.S. Treasury or its member banks for money is now more likely to be averted.

"Could the Fed go broke? The answer to this question was 'Yes,' but is now 'No,'" said Raymond Stone, managing director at Stone & McCarthy in Princeton, New Jersey. "An accounting methodology change at the central bank will allow the Fed to incur losses, even substantial losses, without eroding its capital."

The change essentially allows the Fed to denote losses by the various regional reserve banks that make up the Fed system as a liability to the Treasury rather than a hit to its capital. It would then simply direct future profits from Fed operations toward that liability.

This enhances transparency by providing clearer, more frequent, snapshots of the central bank's finances, analysts say. The bonus: the number can now turn negative without affecting the central bank's underlying financial condition.

"Any future losses the Fed may incur will now show up as a negative liability as opposed to a reduction in Fed capital, thereby making a negative capital situation technically impossible," said Brian Smedley, a rates strategist at Bank of America-Merrill Lynch and a former New York Fed staffer.”



Where there is a will, there is a way….the report also notes dryly that


“The timing of the change is not coincidental, as politicians and market participants alike have expressed concerns since the announcement (of a second round of asset buys) about the possibility of Fed 'insolvency' in a scenario where interest rates rise significantly," Smedley and his colleague Priya Misra wrote in a research note. “


You couldn't make this up. This is by the way a hint as to how the vaunted 'exit strategy' could become a practical impossibility. Assume for argument's sake that bond yields were to suddenly rise significantly as a result of inflation expectations becoming 'unanchored' in a hurry. This is not a prediction, we're just hypothesizing. In that case, the paper on the Fed's balance sheet would become worth much less than it was worth at the time of its purchase, so that the Fed could not possibly drain the same amount of funds from the system compared to what was previously injected by selling the paper it has bought at the time. The market may well become aware of this problem and then inflation expectations could get out of hand even faster. This scenario doesn't seem terribly likely as long as the private sector remains in deleveraging mode, but it can not be ruled out – after all, inflation expectations have indeed risen.

Mervyn King Exonerates the Bank of England

We previously wrote two critical reports on the easy money policy of the BoE, and in the meantime none other than Mervyn King himself found himself compelled to blame the crisis and the subsequent flare-up of rising prices on everyone and everything except the BoE.

This happens even as the MPC gains a second hawk, shortly before the news hit that the U.K. economy is back to slumping even while price inflation has begun to soar. We know this combination from the 1970's, when it was dubbed 'stagflation'. This by the way provides empirical proof for our contention that the so-called 'output gap' is no reason not to expect rising prices if the central bank pursues an extremely inflationary policy. According to the BBC:


“Bank of England policymaker Martin Weale has joined Andrew Sentance in voting for an interest rate rise.

Minutes of the Monetary Policy Committee's most recent meeting show members explicitly discussed the case for raising rates in January. For most members the risks to inflation "in the medium term had probably shifted upwards," the minutes said. But this was before Tuesday's shock news that GDP growth has contracted and a warning that inflation could hit 5%.

Six members voted to hold rates and Adam Posen repeated his earlier votes to re-start the policy of money creation known as quantitative easing. "For two members, the evidence suggested that the balance of risks was already sufficiently clear to warrant an immediate increase [in interest rates]," the minutes said.”


“Meanwhile, the MPC minutes also showed that Adam Posen repeated his call for a £50bn expansion to the Bank of England's quantitative easing programme. “


So it's now two to one against Posen who wants to expand the money printing operation dubbed 'quantitative easing' even further.

Back to Mervyn King, here is a link to his speech (pdf). We quote a few pertinent snips below:


If the MPC had raised Bank Rate significantly, inflation might well have started to fall back this year, but only because the recovery would have been slower, unemployment higher and average earnings rising even more slowly than now. The erosion of living standards would have been even greater. The idea that the MPC could have preserved living standards, by preventing the rise in inflation without also pushing down earnings growth further, is wishful thinking.”


Translation: we did our best to trade short term gain for long term pain. It's what we do.


“Monetary policy cannot be based on wishful thinking. So, unpleasant though it is, the Monetary Policy Committee neither can, nor should try to, prevent the squeeze in living standards, half of which is coming in the form of higher prices and half in earnings rising at a rate lower than normal. That is why the MPC, despite vigorous debate and perfectly reasonable small differences in view on policy, was unanimous in recognising the need for an exceptional policy response to the banking crisis and the subsequent downturn in the UK and world economy. Even if we had known a year ago that 2010 would bring further increases in food, energy and other import prices, as well as a rise in VAT, it would not have been sensible to pretend that a tightening of monetary policy to offset those upwards pressures on CPI inflation was consistent with aiming to keep inflation at the target in the medium term.

Looking ahead, the strength of monetary policy is that it can be re-evaluated each month in the light of new information. Within the MPC there is always an active discussion of the path of monetary policy. At some point Bank Rate will have to return to a more normal level.”


The conceit that one can 'plan' monetary policy depending on 'incoming data' is mentioned by the FOMC at every rate decision meeting as well. The fact of the matter is that the bureaucrats can not possibly know what the originary, natural interest rate should be. They can not know that because only market processes can determine this rate – and central banks are by definition 'outside of the market', merely observing it and manipulating it.  In other words, monetary policy is nothing but wishful thinking.

As to the contention that there is a need to drive interest rates to extremely low levels when a crisis hits – a crisis that has been engendered by previously keeping interest rates too low for too long – it is absurd. By definition, in a crisis liquidity is scarce – to draw investors and savers out, interest rates need to rise, not fall. This is in fact precisely what we observe with market-based rates during a financial crisis – 'spread product' (every type of corporate debt, asset backed bonds, etc.) goes to extremely high rates, which then serve to bring the 'value buyers' into the market – those who have prudently kept their powder dry during the bubble and like to buy when there's 'blood in the streets' as the old saying goes. Central banks are attempting to counter this natural market process by means of extreme monetary pumping , and as King mentions, they don't care if that means that prices will later soar.

Once again, this is trading short term gain for long term pain – the exact opposite of what should be done. In fact, it would be best if these market-distorting institutions did not exist at all. As to the insolvency of large banks during the GFC – rest assured the world would have kept turning if the biggest gamblers among the banks had been forced to restructure and let their shareholders and bondholders eat a loss. Alas, everywhere in the world, 'no bank bondholder left behind' interventions have been instituted instead – with the end result that the 'too big too fail' molochs have become even bigger.

Bernanke and King both are responsible for having created an 'echo bubble' in the wake of the GFC,  the coming demise of which may well involve an even bigger crisis. Then the same litany of excuses will once again be used to justify doing it all over again. This, in a word, is insanity.

As an addendum to this, it has been reported that German import price inflation has just hit a 29 year high. The reaction of the ECB? You have one guess.


“With Europe’s debt crisis showing no signs of abating, ECB council member Ewald Nowotny said yesterday that policy makers won’t consider raising borrowing costs in the first half of this year.

Fellow council member Jozef Makuch said today that faster inflation is “temporary.” The rate is likely to fall back into line with the ECB’s medium-term goal in the second half of the year, he said.


All these sharply rising prices are deemed 'temporary', and most importantly, no central bank anywhere in the developed world is even pretending to be concerned and planning to do something about them.  This is fertile ground for an erosion in the citizenry's trust in the purchasing power of the money they issue. Initially, many people will still believe in the 'temporary character' of the monetary expansion. Eventually though that faith may be seriously disturbed by evidence that prices keep rising and are not coming down as expected. Once the inflationary policy is unmasked as deliberate and permanent, the money concerned can lose its purchasing power rather quickly. As it were, the central bank's expansionary monetary policies following the collapse of a boom are unfortunately wildly popular. To this Mises noted in 'Human Action', chapter XX:


“The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and poIitica1 institutions. He does not blame the authorities for having fostered the boom. He reviles them for the necessary collapse. In the opinion of the  public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.


(our emphasis)

As to King's and the ECB's assertions that central bank policy has nothing to do with the sudden surge in the general price level in both their jurisdictions: this has been disproved eons ago. There are no non-monetary explanations for such phenomena, even though people have tried to make assertions of this sort many times.

Disturbances in Shanghai

We quickly wanted to point to two articles written by Joseph Cotterill at the FT Alpha blog regarding recent surges in repo rates and Shibor in Shanghai. It appears that the recent wild lending spree combined with another hike in reserve requirements has left the Chinese banks in dire need of liquidity. As a result, interest rates in China's interbank funding markets are spiking relentlessly. The moves are enormous. Read 'Chinese plate-spinning' and  'Chinese plate-smashing' for more details and a look at the requisite charts. It seems to us things are way out of kilter if such huge spikes in short term market rates are occurring. It looks for all intents and purposes like an imminent reversal of the boom is at hand, as a sharp rise in short term interest rates is a fairly typical phenomenon at the end of a major boom. We recommend keeping a close eye on these developments.


On to the charts:


1.    CDS – prices in basis points, color-coded


5 year CDS spreads on Portugal, Italy, Greece and Spain – a big retreat from the wides reached early in the year. They have begun to bounce, but it remains to be seen if the correction is over – click for higher resolution.



5-year CDS on Ireland's sovereign debt, the senior debt of Bank of Ireland, France and Japanese JGBs. All still in correction mode, but not as pronounced. A bounce seems to be beginning here as well – click for higher resolution.



5 year CDS spreads on Austria, Hungary, Belgium and Romania – also all in correction mode for now – click for higher resolution.



A weekly candlestick chart of the Markit SovX index of CDS on 19 Western European sovereigns. This puts the correction into perspective. It remains a bullish chart – click for higher resolution.



2.     Euro Basis Swaps


One year euro basis swap – recovering in concert with the retreat in CDS – click for higher resolution.



5 year euro basis swap – click for higher resolution.



3.    Other charts



CDS on Australia's 'big four' banks – continuing to come in after the spike early in the year – click for higher resolution.



The SPX , the gold-commodities and gold-silver ratios, and T.R.'s proprietary VIX-based volatility indicator. Gold-silver begins to look a bit precarious, but after yesterday's Fed announcement, both metals rose strongly from their earlier lows – click for higher resolution.



The SPX vs. the AUD-JPY cross rate – still a growing divergence in evidence – click for higher resolution.


Gold – beginning to bounce after the FOMC reassures everyone that nothing will change in the money printing department. It is notable that bullish sentiment on gold and gold stocks has been eradicated by this fairly routine correction. E.g. the Rydex precious metals fund recently lost over 40% of its assets in the span of a few days – click for higher resolution.



Charts by: Bloomberg,



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