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ECONOMICS AND ESOTERICA FOR A NEW PARADIGM

Posts Tagged ‘Lehman Brothers

As the world crumbles: The ECB spins, the Fed smirks, and US banks pillage

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by Nomi Prins
Posted November 21, 2011

OFTEN, WHEN I TROLL AROUND WEBSITES OF ENTITIES LIKE THE ECB AND IMF, I UNCOVER LITTLE OF STARTLING NOTE. They design it that way. Plus, the pace at which the global financial system can leverage bets, eviscerate capital, and cry for bank bailouts financed through austerity measures far exceeds the reporting timeliness of these bodies.

That’s why, on the center of the ECB’s homepage, there’s a series of last week’s rates – and this relic – an interactive Inflation Game (I kid you not)  where in 22 different languages you can play the game of what happens when inflation goes up and down. If you’re feeling more adventurous, there’s also a game called Economia, where you can make up unemployment rates, growth rates and interest rates and see what happens.

What you can’t do is see what happens if you bet trillions of dollars against various countries to see how much you can break them, before the ECB, IMF, or Fed (yes, it’ll happen) swoops in to provide “emergency” loans in return for cuts to pension funds, social programs, and national ownership of public assets. You also can’t input real world scenarios, where monetary policy doesn’t mean a thing in the face of  tidal waves of derivatives’ flow. You can’t gauge say, what happens if Goldman Sachs bets $20 billion in leveraged credit default swaps against Greece, and offsets them (partially) with JPM Chase which bets $20 billion, and offsets that with Bank of America, and then MF Global (oops) and then…..you see where I’m going with this.

We’re doomed if even their board games don’t come close to mimicking the real situation in Europe, or in the US, yet they supply funds to banks torpedoing local populations with impunity. These central entities also don’t bother to examine (or notice) the intermingled effect of leveraged derivatives and debt transactions per country; which is why no amount of funding from the ECB, or any other body, will be able to stay ahead of the hot money racing in and out of various countries.  It’s not about inflation – it’s about the speed, leverage, and daring of capital flow, that has its own power to select winners and losers. It’s not the ‘inherent’ weakness of national economies that a few years ago were doing fine, that’s hurting the euro. It’s the external bets on their success, failure, or economic capitulation running the show. Similarly, the US economy was doing much better before banks starting leveraging the hell out of our subprime market through a series of toxic, fraudulent, assets.

Elsewhere in my trolling, I came across a gem of a working paper on the IMF website, written by Ashoka Mody and Damiano Sandri,  entitled ‘The Eurozone Crisis; How Banks and Sovereigns Came to be Joined at the Hip” (The paper does not ‘necessarily represent the views of the IMF or IMF policy’. )

The paper is full of mathematical formulas and statistical jargon, which may be why the media didn’t pick up on it, but hey, I got a couple of degrees in Mathematics and Statistics, so I went all out.  And it’s fascinating stuff.

Basically, it shows that between the advent of the euro in 1999, and 2007, spreads between the bonds of peripheral countries and core ones in Europe were pretty stable. In other words, the risk of any country defaulting on its debt was fairly equal, and small. But after the 2007 US subprime asset crisis, and more specifically, the advent of  Federal Reserve / Treasury Department construed bailout-economics, all hell broke loose – international capital went AWOL daring default scenarios, targeting them for future bailouts, and when money leaves a country faster than it entered, the country tends to falter economically. The cycle is set.

The US subprime crisis wasn’t so much about people defaulting on loans, but the mega-magnified effects of those defaults on a $14 trillion asset pyramid created by the banks. (Those assets were subsequently sold, and used as collateral for other borrowing and esoteric derivatives combinations, to create a global $140 trillion debt binge.) As I detail in It Takes Pillage, the biggest US banks manufactured more than 75% of those $14 trillion of assets. A significant portion was sold in Europe – to local banks, municipalities, and pension funds – as lovely AAA morsels against which more debt, or leverage, could be incurred. And even thought the assets died, the debts remained.

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September 23: The beginning of the end for Merkel… and the Eurozone?

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by Tyler Durden
Posted Zero Hedge
August 8, 2011

EVERY TIME WE DISCUSS THE FUTILITY of the nth bailout of [Greece\PIIGS\Europe\the Euro] we make it all too clear  that the trade off between Germany taking on board ever more peripheral financial risk in one after another all too brief attempt to prevent the implosion of European capital markets and its currency, is not only a relentless creep higher in German default risk (and lower in the German stock market, as August has so violently demonstrated) but increasing political discontent, which after claiming countless political regimes across the world, has finally settled down on one that truly matters: that of German chancellor Angela Merkel.

And as Reuters reports, Merkel’s disappointing response to an ever escalating set of crises, both domestic and international, means that the beginning of her end (and by implication of the Eurozone, and of the Euro) may be as soon as September 23, when the vote over the expansion of the latest and greatest European bailout lynchpin, EFSF, will take place.

To wit: “Germany’s Angela Merkel faces the biggest challenge to her leadership since coming to power in 2005, with traditionally loyal conservative allies openly criticizing her approach to the euro zone crisis and her hands-off Libya policy in shambles….it is Merkel’s piecemeal approach to the euro zone’s worsening debt crisis that has come under fire over the past week and now threatens her iron grip on power in Germany.” The biggest problem for Merkel is that she has gone “Japanese” in the opinion of the public: doing neither nothing, nor enough, to halt the European crisis in its tracks: “For some in Germany, she has gone too far by bailing out stricken euro zone members and agreeing to intervention in the bond markets to prop them up. For others at home and abroad, she has not done enough, shirking bold steps that might solve the debt crisis because they would be unpopular at home.” This latest attempt to placate everyone, while achieving precisely the opposite, will come to a head on September 23 when the vote to expand the EFSF takes place: she is for the time being expected to have a sufficient number of votes to pass the critical for the eurozone proposal. “If it’s not enough, Merkel would be forced to resign. It would lead to a crisis.” And should there be a crisis, it will be the end for the European experiment as well, since with the political situation at the Euro’s biggest financial backer in flux, the free fall in European risk will be one that no one, certainly not the ECB, will be able to arrest. Cue even more improvised bailouts by the central banker oligarchy, yet without Germany, the credibility of any and all such deseprate measures will be nil. This incremental political uncertainty will likely make the life of the FOMC’s Sept 20-21 meeting slightly easier, as an adverse monetary announcement by the Fed, contrary to that priced in, coupled with the risk of a full blown European crisis, will be very frowned upon by the Status QuoTM.

From Reuters:

Seen for much of the past six years as a reliable, steady leader whose competence and knack for brokering deals made up for a lack of bold vision, Merkel’s image has taken a beating over the past months and polls show an increasing number of Germans view her government as directionless.

The chancellor’s troubles can be traced back to two decisions taken in March, when she abruptly dropped her long-standing support for nuclear power in the aftermath of the Fukushima disaster in Japan, and days later backed Germany’s abstention from a U.N. vote authorising military action in Libya.

Coming shortly before a crucial state election, which her conservatives subsequently lost, the steps looked to many in Germany and abroad like cynical political ploys to placate domestic opinion.

For some in Germany, she has gone too far by bailing out stricken euro zone members and agreeing to intervention in the bond markets to prop them up. For others at home and abroad, she has not done enough, shirking bold steps that might solve the debt crisis because they would be unpopular at home. This conflict will come to a head next month. Merkel’s coalition has a comfortable 20-seat majority in the lower house of parliament. But if she is hit with dissent in her own ranks, and is forced to rely on opposition parties to pass legislation to expand the single currency bloc’s rescue mechanism – the European Financial Stability Facility (EFSF) – then her coalition could collapse, sparking early elections.

“The euro crisis entered a new phase over the past week,” influential German weekly Der Spiegel said on Sunday. “Before the main question had been how the common currency could be saved. Now it is also about saving Merkel’s chancellorship. If her coalition does not deliver a majority for the enhanced euro rescue mechanism in the autumn, people close to the chancellor say, the coalition is all but finished.”

On the significance of September 23: The chances of Merkel failing to secure her own majority in the EFSF vote, which is likely to take place on Sept. 23, still seem slim.

Her Christian Democrats (CDU), hovering at a weak 30 percent in opinion polls, have little incentive right now to bring forward an election that is not scheduled to take place until the autumn of 2013. Merkel’s conservative bloc — composed of the CDU, Bavarian Christian Social Union (CSU) and Free Democrats (FDP) — has shown discipline in previous euro zone aid votes, with only a handful of lawmakers rebelling.

“I expect she will get majority backing from her own coalition,” said Gerd Langguth, a political scientist at Bonn University and biographer of Merkel, putting the number of dissenters at around fifteen. “If it’s not enough, Merkel would be forced to resign. It would lead to a crisis. No one is interested in an early election.”

Slim… but getting bigger:

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Saving the Euro Zone

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by Gordon Brown
Posted August 15, 2011

[I never imagined in my wildest dreams that I’d be posting a piece by Gordon, an elitist insider by some accounts, and who famously sold the UK’s gold at the lowest possible price back when he was Chancellor, but this is not bad at all, and is linked to the previous post by Jeremy Warner here on QP: Collapse in German growth will lead to Euro rebellion. – Aurick]

LONDON — How could a group of nations that came together with such promise and commitment more than half a century ago, prepared to surrender their currencies and much of their political sovereignty to strengthen integration, now find that their union has been brought to the brink by the small state of Greece, economically and geographically one-fiftieth of Europe? And how can we now prevent a European crisis from writing a new chapter in what will be called “the decline of the West”?

For months we have been told that Europe’s salvation lies in austerity, in the whole Continent applying Germany’s prescription of fiscal discipline to its deficits. We have been told that if austerity does not work it is just because there is not enough of it.

But when Chancellor Angela Merkel of Germany and President Nicholas Sarkozy of France meet in Paris on Tuesday they will find all around them evidence of what they did not expect — failing banks, waning growth and capital flight.

This confirms what many of us have argued from the outset: that Europe’s difficulties have arisen not merely from the one-dimensional issue of deficits, but from a disastrous, three-dimensional configuration that is financial and economic as well as fiscal.

These past few weeks have demonstrated that Europe has a deeply flawed banking system, a widening competitiveness gap, and a debt crisis that cannot get much better if the economy gets worse. It is an already lethal cocktail that becomes more deadly when mixed inside the euro, a currency created without the resilience to withstand difficult times and which has no structure for effective decision-making.

In the normally quiet month of August we have seen these difficulties escalate so rapidly that little now stands between Europe and a decade of low growth, high unemployment, industrial decline and popular discontent, the nearest modern economic parallel for which is the 1930s.

Some time ago I reached the conclusion that there was no solution possible within the existing euro structure. Either the euro has to be fundamentally reformed by Europe’s political leaders and the European Central Bank or it will collapse. After the events of the last few days I know for sure there is not even a chance of a middle way.

I was present at the first meeting ever held of the euro zone heads of government in October 2008, in the immediate wake of the Lehman Brothers crash. Although not a member of the euro, Britain had been invited to explain its decision to restructure and take ownership of some of Britain’s banks. I explained that Europe’s banks were under-capitalized by billions and that the prospect of them collapsing jeopardized the safety of the entire European economy — we could not run capitalism without capital.

I remember the skeptical looks when I explained that European banks were in fact more vulnerable than American banks, that they were far more highly leveraged and far more dependent on short-term wholesale funding. In fact, half of America’s toxic sub-prime assets had been bought by reckless institutions in Europe. Worse still — as we have subsequently discovered — the greater the European banks’ problems, the poorer their insurance coverage, the worse their leverage and thus the more dangerous the risk to us all.

Yet even as the crisis grew, it was difficult to get Europe’s leaders to accept that it was anything other than an Anglo-Saxon one. By convincing themselves that the problem was simply fiscal, they have drawn back from taking proper action.

Europe’s leaders are also handcuffed by an inadequate treaty of Union, by the problem of getting a coherent response from 27 different nations, and by a rise in anti-European sentiment in their home countries (particularly in Germany), which has deterred them from sanctioning collective action beyond that which protects short-term national self-interest.

The exigencies of domestic politics have locked the euro zone into an impossible set of economic constraints — no defaults, no deficits, no stimulus and, of course, no devaluations — which mean that there can also be no banking stability, no lasting growth, no sustained job creation and no boost to competitiveness from their currency.

There is no escaping the basic fact that Europe’s difficulties are indicative of deep structural defects — its declining competitiveness, aging population and persistently high unemployment. Its share of world output, which has already halved, is set to halve from 20 percent today to around 10 percent over the next two decades.

Yet as the world’s financial crash has evolved — expanding through Europe into an economic downturn, and then a debt crisis, the Continent has, at each stage of the process, remained doggedly behind the curve. Even as recently as a month ago it could have avoided the events now driving it to breaking point. A European stabilization fund of some €2 trillion could have convinced the markets that Europe meant business wherever it was confronted with problems. A Brady bond solution for Greece, Ireland and Portugal — in which private creditors restructure their holdings — might have cauterized the issue of insolvency in Europe’s periphery. (Forcing Spain and Italy to join the new precautionary facility might have worked as late as two weeks ago as a solution to the cost of financing their loans). A root and branch recapitalization of the banks would have sent out the desperately needed signal that the Continent was serious about the underlying weaknesses in its financial sector. Demanding private sector involvement not just in Greece but across Europe would have produced a lasting framework for sharing the Continent’s burdens.

But Europe has flinched at every turn from showing the decisiveness that its problems require — and in the market panic of the last few days its leaders have been caught out once again trying to stem the fallout from yesterday’s disasters instead of planning the pre-emptive action that will avert the problems of tomorrow.

The time for extemporized solutions is gone. The Continent has to commit to a plan that accepts difficult realities and underpins the several trillions in funding needed to ensure that governments from Greece, Ireland and Portugal to Spain, Italy and Belgium are adequately funded from now to 2014.

So there is no way out except through the biggest recapitalization of the banks in European history and a wholesale reformation of the euro, which will require the coordination of its monetary and fiscal policy, fiscal transfers from rich to poor nations and a commitment to a common European debt facility.

Of course no single country, not even Germany, can afford to bail out all the banks and underwrite all their neighbors. It will require an undertaking that is pan-European, involve commitment from the private sector, and will have to draw on support from the I.M.F., and possibly China and America.

These massive guarantees will necessitate a big shift in Europe’s thinking; that if the world used to need Europe, Europe now needs the world. And this global insight is also essential to equip us for global competition ahead. We will need a repositioning of Europe from consumption-led growth to export-led growth. It will require right across Europe the kind of radical capital product and labor market reforms only a few countries have tried.

The restoration of European growth will also depend on better global coordination, in particular a G-20 agreement with America and Asia to ensure financial stability and to coordinate a higher path for global growth. But for all this to happen Germany will have to take the lead.

Gordon Brown, a Labour member of the British Parliament, was Britain’s prime minister from 2007 to 2010 and chancellor of the Exchequer from 1997 to 2007.

Collapse in German growth will add to euro rebellion

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by Jeremy Warner
from The Daily Telegraph
Posted August 16th, 2011

NEWS THAT GERMANY RECORDED ONLY MARGINAL, 0.1%, GDP GROWTH in the second quarter is not just an economic event; it is a political one too, for the German economic “miracle”, with output rebounding from its post Lehman low far more rapidly than any other advanced economy, has been about the only thing that has kept Germans onside on measures to support the euro during the last year and a half of turbulence.

Indeed, in some respects, the crisis has seemed a positive boon for German industry, for it has meant that its exports have enjoyed a far more competitive exchange rate than would have been the case had Germany still had the Deutsche Mark. Trade has boomed accordingly.

But as the world economy slows, even that advantage is beginning to fade. Now of course there are lots of anomolous reasons why the German economy would have slowed in the second quarter, not least the after effects of the Great East Japan Earthquake, which because of the disruptions it caused in the global supply chain would have hurt the German economy, with its high dependence on manufacturing industry, particularly badly.

Even so, there’s much to worry about. Consumption and investment in construction are slowing fast, and most of the forward looking indicators are turning down. If Germany isn’t even deriving a trade benefit from membership of the euro, then its support for further bailouts will begin to look more questionable still.

The European Central Bank’s decision to start tightening policy a couple of months back is looking ever more indefensible. Even in Germany, money has been contracting for some while now, yet the ECB has allowed itself to be persuaded by Bundesbank hawks into an almost suicidal approach to policy. The ECB’s actions have become dictated more by the intractable politics of the eurozone than the interests of sound policy. Thus it is that in order to quell German alarm over the way the euro is being managed, the ECB has thought it necessary to attack an imagined inflationary threat to sacred German principles of sound money.

It’s tempting to mock the piece on saving the euro that Gordon Brown, the UK’s former prime minister, has written in today’s New York Times. Why is he writing for the NYT, for heaven’s sake? Is it because he’s so discredited back here that he has to go to the US for anyone to take him seriously any longer?

The contemptuous way in which he used to treat other European policymakers and leaders certainly means that none of them will be listening to him. Yet it has to be said that this is a surprisingly good piece, which demonstrates a pretty sound understanding of the extreme nature of the threat Europe faces to its continued economic prosperity. Many will vehemently disagree with his solution, which is in essence just the European superstate the euro area seems to be careening towards in any case, but it’s well worth a read anyway.

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From GoldCore:

Merkel and Sarkozy plans fail to assure markets

The Merkel Sarkozy plans to centralize financial and economic governance in the EU has failed to calm markets and there is further weakness in stock markets today. A key aim of the meeting was to restore confidence in the euro. In the short term this has not been achieved and it is highly unlikely that it will be achieved in the long term. Centralised financial and economic governance will not be a panacea to the current debt crisis. It does nothing to address the root cause of the problem which is massive indebtedness and the saddling of taxpayers with massive liabilities incurred by banks. Concerns about currencies and currency debasement is leading to continued safe haven demand for gold

In this grave crisis, the world’s leaders are terrifyingly out of their depth

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by Peter Oborne
Posted August 6th, 2011

Ineffectual: an emergency telephone conference among the G7 finance ministers feels as relevant as a Bourbon family get-together in the summer of 1789

CERTAIN YEARS HAVE GONE DOWN IN HISTORY AS GREAT GLOBAL TURNING POINTS, after which nothing was remotely the same: 1914, 1929, 1939, 1989. Now it looks horribly plausible that 2011 will join their number. The very grave financial crisis that has hung over Europe ever since the banking collapse of three years ago has taken a sinister turn, with the most dreadful and sobering consequences for those of us who live in European democracies.

The events of the past few days have been momentous: the eurozone sovereign debt crisis has escaped from the peripheries and spread to Italy and Spain; parts of the European banking system have frozen up; US Treasuries have been stripped of their AAA rating, which may be the beginning of a process that leads to the loss of the dollar’s vital status as the world’s reserve currency.

There have been warnings that we may be in for a repeat of the calamitous events of 2008. The truth, however, is that the situation is potentially much bleaker even than in those desperate days after the closure of Lehman Brothers. Back then, policy-makers had at their disposal a whole range of powerful tools to remedy the situation which are simply not available today.

First of all, the 2008 crisis struck at the ideal stage of an economic cycle. Interest rates were comparatively high, both in Europe and the United States. This meant that central banks were in a position to avert disaster by slashing the cost of borrowing. Today, rates are still at rock bottom, so that option is no longer available.

Second, the global situation was far more advantageous three years ago. One key reason why Western economies appeared to recover so fast was that China responded with a substantial economic boost. Today, China, plagued by high inflation as a result of this timely intervention, is in no position to stretch out a helping hand.

But it is the final difference that is the most alarming. Back in 2008, national balance sheets were in reasonable shape. In Britain, for example, state debt (according to the official figures, which were, admittedly, highly suspect) stood at around 40 per cent of GDP. This meant that we had the balance sheet strength to step into the markets and bail out failed banks. Partly as a result, national debt has now surged past the 60 per cent mark, meaning that it is impossible for the British government to perform the same rescue operation without risking bankruptcy. Many other Western democracies face the same problem.

The consequence is terrifying. Policy-makers find themselves in the position of a driver heading down the outside lane of a motorway who suddenly finds that none of his controls are working: no accelerator, no brakes and a faulty steering wheel. Experience, skill and a prodigious amount of luck are required if a grave accident is to be averted. Unfortunately, it is painfully apparent that none of these qualities are available: Western leaders are out of their depth.

Barack Obama feels more and more like a president from the Jimmy Carter tradition: well meaning but ineffectual. And contemplate the sheer fatuity of the statement issued by Angela Merkel’s office on Friday night: “Markets caused the drama. Now they have to make sure to get things straight again.” This remark reveals in the German Chancellor a basic inability even to grasp the nature, let alone understand the scale, of the disaster facing Europe this weekend. Such a failure of comprehension is entirely typical of a certain type of leader throughout history, at times of grave international urgency.

An emergency telephone conference among the finance ministers of the G7 (membership: United States, Japan, Britain, Germany, France, Italy and Canada) has been convened. There was a time when this organisation – with its sublime pretence that financial powerhouses such as India, China and Brazil do not exist – counted for a great deal. This latest discussion feels as relevant as a Bourbon family get-together in the summer of 1789.

Another symptom of the frivolity of the European political class is that the European Central Bank is being urged to intervene in the Italian bond market to restore stability. Standard & Poor’s and Moody’s do not produce ratings for the ECB, but if they did, it would be given junk bond status, or worse. The ECB is bankrupt, and this would be evident for all to see but for the fact that it has grossly overvalued the practically worthless Greek, Irish and Portuguese bonds in its portfolio. At some point, eurozone states will be asked to fill the massive holes in the ECB’s balance sheet, and matters will then get messy. Some may plead poverty; others will point out that the constitution of the ECB specifically prevents it from purchasing national bonds, and that its market operations must have been ultra vires.

Furthermore, it is unclear to whom the ECB – whose dodgy accounting, reckless investments and contemptuous disregard of banking standards make even the most irresponsible Mayfair hedge fund look like a model of propriety – is ultimately accountable. The idea that it can step effectively into the Italian bond market, whose total value of around 1.8 trillion euros makes it larger by far than Greece, Portugal and Ireland combined, is a joke.

Wake up: the eurozone is very close to collapse. It will come as no surprise if some Italian and Spanish banks are forced to close their doors in the course of the next few weeks. Indeed, British holidaymakers on the Continent should be advised to take care: hold only the minimum of the local currency, and treat with especial suspicion euro notes coded Y, S and M (signifying they were printed in Greece, Italy and Portugal respectively). Take plenty of dollars with you, which shopkeepers will certainly accept if there is a run on the banks, or if euros suddenly cease to be legal currency. The precautions may not prove necessary, but there is no point in taking risks.

Where does this leave Britain? First of all, there is no point intruding on private grief. Nothing we can do or say will solve the problems of the eurozone. George Osborne does, however, face one overriding imperative: he must maintain the British national credit. Fortunately, the Chancellor grasps this essential point very clearly. After last year’s general election, he took exactly the right steps to cut the deficit. He must not be driven off course, or the markets will refuse credit to Britain as well (a point that Ed Balls, Labour’s economic spokesman, appears not to understand). An economic firestorm is heading our way, and Britain will be doing very well just to survive.

Merkel faces a Hobson’s choice on eurozone

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by Philip Aldrick
Telegraph Economics Editor
Posted 06 August 2011

Muggings have been on the rise on the streets of east London, Scotland Yard said this week. And blood-stained necklaces have been turning up in pawnbrokers with alarming frequency. It’s no coincidence, police claimed. The surge in snatch-and-grab is all to do with the soaring price of gold.

GOLD HAS BEEN HITTING RECORD HIGH AFTER RECORD HIGH because the precious metal is considered the ultimate safe-haven by nervous investors. And there are a lot of nervous investors in the markets. This week gold struck another record, at $1,681.67 an ounce. Nick Bullman, managing director of ratings agency CheckRisk, reckons it will not stop until breaking its inflation-adjusted peak of $2,300.

It’s not just the shoppers of Canning Town who are getting a mugging. Fear is stalking the markets. Fear of a US downturn, fear of a sovereign debt crisis in Italy or Spain – countries considered “too big to bail”, fear of another global recession. As those fears gathered into panic this week, the world witnessed an extraordinary series of events.

Stock markets did not just crash, they crumpled. Some £149bn was wiped off the value of Britain’s blue-chip stocks as the FTSE 100 suffered the fifth largest fall in its history. Trading in the shares of the country’s biggest banks were suspended after dropping more than 10pc. In just seven trading days from July 26, $4.5 trillion was wiped off the value of equities worldwide.

As investors fled to traditional safe-havens of the Swiss franc and the Japanese yen authorities were forced to act. So strong had panic buying made their currencies that it threatened growth. Both nations intervened. Japan sold about ¥4 trillion (£30bn) of its yen reserves and did ¥10 trillion of quantitative easing (QE). Switzerland cut rates to zero and launched Sfr50bn (£40bn) of QE. The moves bought temporary relief.

The hunt for safety created other bizarre distortions. Yields on US treasury bills – short-term government debt – turned negative. Similarly, Bank of New York Mellon, America’s biggest custodial bank, started levying a fee on deposits of over $50m as it was flooded with cash. Market norms were turned on their head. Investors were paying to lend money. “When you do that, you are saying everything else is just too scary,” said Mr Bullman.

What had the markets spooked was the dawning realisation that Spain and, in particular, Italy may not repay their debts. If that happened, the world would suffer another seizure. “It would be Lehman Brothers on steroids,” as some traders have put it. Italy has been worrying markets since mid-June, a month after Standard & Poor’s put its credit rating on watch. Its benchmark 10-year bonds have been creeping higher ever since – the clearest sign of a looming crisis.

This week’s panic, though, was the culmination of weeks of frayed nerves and political paralysis. “Politicians keep scaring the hell out of people as they seem to be burying their heads in the sand,” Mr Bullman said. Which is why, if there was an original tipping point, it can be traced to July 21. That was the day the second Greek rescue was agreed and further measures unveiled to prevent another eurozone country being sucked into the crisis – following Ireland and Portugal as well as Greece. The backstop was dangerously weak, though. The size of the eurozone bail-out fund, the European Financial Stability Facility (EFSF), was increased from €250bn to €440bn and the terms of its operations broadened to make it more nimble. But the agreement needed a vote, due in September, and seemingly ignored the risk of a Spanish or Italian crisis.

To provide a real firebreak, the EFSF needs about €2 trillion, analysts reckon. Italy’s national debts are €1.8bn, the third largest debt market in the world behind the US and Japan. Spain’s are €640bn. An EFSF with €440bn was woefully inadequate. Europe’s leaders, though, simply closed their ears to the siren voices and turned to planning their summer holidays.

Alarm bells should have already been ringing. At 4.8pc on June 21, Italian bonds had surged to 5.68pc shortly before the Greek bail-out. The lesson from Greece, Ireland and Portugal was that once bonds top 5pc, they soar to 7pc within 30 to 60 days without intervention. At 7pc, the debt problem becomes a full-blown crisis – as markets decide the country can no longer pay its bills. With no credible backstop, market fears were allowed to burn out of control.

Already wearied by the drawn-out deal to raise the US debt ceiling, which only entrenched political cynicism, and unnerved by evidence that the global recovery is stalling, the second tipping point came this week. First the President of the European Commission, José Manuel Barroso admitted in a letter to European heads of state that the size of the EFSF needed to be increased. Hours later, the European Central Bank intervened in the markets – but instead of buying distressed Spanish and Italian debt it targeted Portuguese and Irish bonds. Seemingly, political divisions within the ECB were neutering its powers.

Holger Schmieding, economist at Berenberg Bank, said the ECB’s move “may go down in history as its worst blunder yet”. “What would we make of a fire brigade that responds to a major emergency but then drives to the wrong place and refuses to turn around and douse the real fire?” Traders scented weak political will and rounded in fear on Italy. Its bonds rocketed to 6.189pc – a fresh euro record.

If it can’t raise funds, Italy has until the end of September before it runs out of cash or Europe comes to its aid. Spain has until February. The problem is now purely political. Italy needs more austerity to reduce its debt burden, and to push through structural reforms to make its labour market more competitive. Spain must recapitalise its banks, and accelerate its own austerity plans. In return, Europe has to make the EFSF a viable safety net.

As usual in Europe, it all comes back to truculent Germany. Only Berlin can provide the guarantees needed to restore confidence. But it is too late to buy confidence cheaply. Angela Merkel, the German Chancellor, faces a classic Hobson’s choice. Put taxpayer money on the line and lose her job, or risk a catastrophe. That’s a mugging in all but name. Unsettling parallels are being drawn between the current panic and the market meltdown in 2008.

Then, as now, oil had blown sky high. It hit $145 a barrel in July 2008 before coming back down. This time it struck $125. Inflation, too, was out of control – at around 5pc – in line with most economists’ forecasts for the next few months. Stock markets had moved sharply lower and growth had started to slow.

More pertinently, the country had been wrestling with a looming crisis for months – that time with the banks. Seized by similar indecision, policymakers took five months to nationalise Northern Rock and failed to recapitalise other lenders until too late. Then, a political decision not to bail out Lehman Brothers triggered panic that paralysed markets. This time, it is again in politicians hands. The parallels are not surprising. Ultimately, the current crisis is the latest manifestation of the last one.

A “Lehman Moment”

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by Doug Noland
Posted June 17, 2011

http://quintet.prudentbear.com/index.php/creditbubblebulletinview?art_id=10543

ISN’T IT INCREDIBLE THAT THE FAILURE OF ONE FIRM, Lehman Brothers, almost brought down the global financial system?  It is equally incredible that, less than three years later, a small country of 11 million has the world teetering on the edge of another systemic crisis.  Today’s circumstance is a sad testament both to the instability of the international Credit “system” and to the lessons left unlearned from the previous crisis.

For about 15 months now my analysis has attempted to draw parallels between the initial subprime eruption and last year’s Greek debt crisis.  Both were the initial cracks in major Bubbles (“Mortgage/Wall Street Finance” and “Global Government Finance”).  These two weakest links – due to their role as the marginal borrower exploiting a period of system market excess – were extremely poor Credits.  On the one hand, the systemic vulnerabilities associated with a potential bursting of major Bubbles elicited aggressive policy responses to the initial subprime and Greek tumults.  On the other hand, policy had no constructive impact on the underlying quality of the debt – while significantly inciting market excesses (market price distortions, Credit and speculative excess, etc.) that exacerbated systemic fragilities.

There was heightened fear this week that the “Greek” crisis was evolving into Europe’s “Lehman Moment.”  Recalling back to 2008, the Lehman collapse was the catalyst for a crisis of confidence throughout the expansive universe of “Wall Street” risk intermediation.  Importantly, market confidence in the willingness and capacity for policymakers to backstop this multifarious system held steady virtually until the moment the Lehman bankruptcy was announced.  The marketplace had appreciated the enormous risks associated with a potential crisis of confidence throughout the securitization and derivative marketplaces, yet assumed that policymakers would simply not tolerate a failure by one of the major players in this financial daisy chain.  The global financial system almost imploded when this precarious “too big to fail” assumption was debunked.  

I have posited that the global policy response to the 2008 crisis only expanded and solidified the market’s notion of “too big to fail.”  Most in the marketplace believe that policymakers now recognize that allowing Lehman’s failure was a major policy blunder.  The expectation today is that the EU, ECB, IMF, Germany, China and the Fed will not tolerate a Greek debt default.  This faith had better not be misplaced.

While the Lehman failure proved the catalyst for the 2008 crisis, it was definitely not the root cause. The problem was instead the Trillions of unsound debt underpinning Trillions of leverage, Credit insurance, and sophisticated risk intermediation that, through “Wall Street alchemy”, had transformed really bad loans into seemingly appealing (“money-like”) debt instruments.  As soon as the market began to back away from these structures (commencing with subprime concerns), the downside of a (Hyman Minsky) “Ponzi Finance” scheme was set in motion.  And as the Bubble began to falter, the market increasingly valued huge amounts of debt based on the perception of a system backstop rather than on the fundamentals of the underlying debt instruments (largely, increasingly vulnerable mortgages).

If authorities had moved to save Lehman back in September of 2008, it would have bought some extra time – and would have changed little.  Trillions of unsound debt, distorted asset and securities markets, and a severely maladjusted economic structure ensured a major crisis.  It was only a matter of the timing and circumstances as to how the widening gulf between distorted market prices and the true underlying value of the debt was resolved.  As we are witnessing with Greek, Portuguese and Irish debt (and CDS) prices, market troubles often manifest when unanticipated policy uncertainties force the marketplace to take a clearer look at the fundamentals underpinning a debt structure – only to grimace.

The problem today is not really Greece.  A dysfunctional global Credit “system” has created tens of Trillions of unsound debt – and rapidly counting.  Aggressive “activist” policymaking has been at the heart of this unprecedented Credit inflation, and the markets today fully expect policymakers to ensure this Bubble’s perpetuation.  And, importantly, for better than two years now global fiscal and monetary policies have incited another huge round of global speculation and leveraging.  This latest Bubble gained considerable momentum with last year’s European Greek bailout and implementation of the Fed’s QE2 program.

Policymaking gave a new – and egregiously profitable – lease on life to the “global leveraged speculating community.”  Given up for dead in late-2008, hedge funds, proprietary trading desks and others have been able to exploit government-induced market distortions like never before.  With confidence that massive fiscal and monetary stimulus would ensure economic expansion, abundant marketplace liquidity, and strong inflationary biases for global securities and commodities markets, the global “risk on” trade proliferated near and far.  Re-risking and re-leveraging – through the creation of new market-based debt and attendant liquidity – fueled a self-reinforcing speculative boom.  QE2 (and other central bank liquidity operations) coupled with re-leveraging dynamics bolstered the perception that the markets had commenced a cycle that would prosper in liquidity abundance for an extended period.  Fragile underpinnings, especially in the U.S., seemed to ensure years of policy largess.

There is a big problem any time the leveraged speculating community begins to question core assumptions – certainly including the capacities of policymakers to sustain Credit booms, ensure liquid and continuous markets, and to contain Credit stress.  Think of it this way:  Enterprising market operators are incentivized into leveraged (“risk-on”) trades when they discern that policymaking is providing both a trading edge (generally an inflationary bias or predictable spread) in the marketplace and a favorable liquidity backstop availing an easy exit when necessary.  I would argue that huge speculative positions have accumulated over the past two years on assumptions that are increasingly in doubt.  This has quickly become a major market issue, and largely explains recent market action.

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