[THS] Mike Whitney: Credit Storm in Europe; Politics on Capital Hill

[The Harder Stuff in news and commentary]

http://www.informationclearinghouse.info/article25553.htm

"The credit storm in the EU has had no effect on Congress. Wall Street has won this
round. The window for real reform has closed, and now it's "business as usual" until
the next catastrophe." 


Credit Storm in Europe; Politics on Capital Hill

By Mike Whitney

May 27, 2010 "Information Clearing House" -- Credit market turmoil in the Eurozone
has ignited frenzied trading on global markets. On Tuesday, shares tumbled nearly
300 points on the Dow Jones before launching an unconvincing 257-point late-day
comeback. Wednesday the mayhem continued; all the major indexes seesawed wildly
as positive news on durable goods was nixed by reports on wobbly EU banks.

Erratic selling pushed the S&P down to 1,067 while the Dow slipped below 10,000 for
the first time since February 7.   Rising Libor is increasing volatility, a red flag
indicating trouble in interbank lending. Banks are wary of each others' collateral as
Greece and other underwater Club Med members appear to be headed for debt-
restructuring. Libor is not yet at pre-Lehman levels, but the rate that banks charge
each other for short-term loans has rocketed to a 10-month high. Improving
economic data has not eased fears of another meltdown or removed the rot at the
heart of the system. The banks are still loaded with loans and assets that are losing
value. The credit system is breaking down.

When banks post collateral overnight for short-term loans, the collateral is effectively
downgraded limiting the banks access to capital. This is what triggered the financial
crisis two years ago, a run on repo. Regulated "depository" institutions now rely on a
funding system that operates beyond government oversight, a shadow banking
system.  The banks exchange collateral, in the form of bundled securities and  bonds
with institutional investors (aka---"shadow banks"; investment banks, hedge funds,
insurers) via repurchase agreements (repo) for short-term loans. The repo market
now rivals the the traditional banking system in terms of size but lacks the guard rails
and stop signs that make the regulated system safe. The system is inherently
unstable and crisis-prone as a recently released paper by the Federal Reserve Bank
of New York  (FRBNY) admits. Moody's rating agency summarized the paper's
findings like this: the tri-party repo  "market will remain a major source of systemic
risk, especially given the current market volatility and the fact that the Federal
Reserve’s primary dealer emergency lending facilities are no longer in place...... the
market remains structurally vulnerable to a repo run...... If cash investors pulled
away in a stressed environment, the clearing banks would be faced with a choice (as
they were several times in 2008) of taking on large secured credit exposure to dealers
or severely constraining intra-day credit to them. Such market mechanics can
exacerbate the effect of a systemic and/or a dealer-specific crisis.....Until the
remaining issues in the tri-party repo market are resolved, the risk of a repo run
remains in place. (Moody's, thanks to zero hedge)

It's too bad Congress doesn't take time to read  Moody's analysis before gutting the
derivatives and capital requirements provisions in the new reform bill. It might help
them understand that by placating Wall Street they're laying the groundwork for
another financial disaster.

When Lehman failed, Fed chair Ben Bernanke stepped in as lender of last resort to
keep the banking system functioning. He deftly shifted from lending facilities to
quantitative easing (QE)--a ploy that allowed the Fed to relieve the Wall Street
behemoths of their toxic assets and non performing loans. The Fed's efforts revived
the economy but transferred gigantic losses onto its own balance sheet.   The EU
lacks the political infrastructure to enact a similar fiscal strategy. When banks collapse
in Spain or Greece, the losses must be written down, adding to deflationary
pressures. That has world leaders worried that their economies will be pulled back
into recession.  Here's a recent post from David Rosenberg which sums up the
present situation:

  "The downdraft in the market in recent weeks reflects the financial risk related to
the European debt crisis, the monetary tightening in China and the re-regulation of
the financial sector that is currently making its way through to Congress. The next leg
down in the equity market specifically and cyclical assets more generally is economic
risk. Equities went into this period of turbulence priced for peak earnings in 2011 and
with a tailwind of positive earnings revision and positive guidance ratios from the
corporate sector. If the ECRI and the Conference Board’s own index of leading
economic indicators, which dipped 0.1% in April, are prescient, then they are
portending a period of sub-par economic growth ahead." (Breakfast with Dave, David
Rosenberg, Gluskin Sheff)

The media characterizes troubles in the EU as a "sovereign debt crisis", reflecting
"deficit cutting" the political agenda of its authors. In fact, this is a straightforward
banking crisis, undercapitalized banks whose downgraded assets are leading them
towards default. The banks alone are responsible.   In the US the problem has been
resolved by the historic bank/state merger. "Too big to fail" implies that the primary
function of the state is to preserve its core financial institutions. For many reasons,
this remedy won't work in Europe. The individual countries will have to bailout banks
at their own expense or resolve them through the bankruptcy courts.

Austerity measures in the Eurozone will derail Obama's efforts to increase exports to
compensate for the slowdown in consumer spending. The administration's economic
strategy, to large extent, depends on a weak dollar, a strong EU and a prosperous
China. That plan vaporized earlier this week when Spanish regulators took over
CajaSur one of the country's biggest mortgage lenders. Spain's property crash is
intensifying the contraction and pushing banks to the brink. As credit tightens and
economic activity slows, the prospects of a strong recovery become more remote.
The downturn could last for years.

  Deteriorating conditions in Europe have set off alarms at the Fed. For Fed chair Ben
Bernanke, the trouble in the EU money markets and commercial paper markets, must
seem like a recurrent nightmare, Lehman all over again. Bernanke wants to stop the
repricing of bank assets that would trigger firesales and another round of deflation.
So, he's reopening "swap lines" to help EU banks roll over their short-term loans. His
proposal would slash rates to near-zero and make the Fed liable in the exchange of
questionable loans and assets, putting both the taxpayer and the dollar at risk. Here's
a clip from the Wall Street Journal:

 "The Federal Reserve has a lever it can pull to help European officials combat a
worsening financial crisis: Reducing the interest rate it charges on U.S. dollar loans it
makes through the European Central Bank to dollar-starved commercial banks in
Europe....

The loans currently are priced one percentage point above a market rate called
Overnight Indexed Swaps (OIS), which tracks the expected path of the Fed's
benchmark federal funds rate. The loans are set above OIS to discourage foreign
banks from using the government program too aggressively. But the Fed could
reduce that penalty to encourage more borrowing and ease some of the financial
strain on foreign banks in need of dollars....Many European banks, and their U.S.
branches, need dollar funds because they hold U.S. dollar assets. But lenders have
become more wary of extending them the cash. That's made dollar loans more costly
for European borrowers and the funding they do get is has been for shorter
maturities." ("Fed's Next Move Could Be Reduced Rate on Dollar-Euro Swaps", Jon
Hilsenrath, Wall Street Journal)


   The Fed is operating far beyond its mandate to maintain price stability and full
employment. It's applying its own arbitrary pricing mechanism and usurping the
authority of the EU central bank.   Here's how Clifford Rossi explains the Fed's action
in a recent post on Institutional Risk Analysis:

  "The mechanism for the bailout of Europe is the Fed's provision of dollar credit in
virtually unlimited amounts via central bank swaps lines.....the Fed swap lines help
the bankrupt nations of the EU ignore their mounting fiscal problems......Fed
Chairman Ben Bernanke is engaged in a little geopolitical engineering in Europe --
and the people of the EU do not yet realize that a political change in control has
occurred.... the leaders of Europe now find themselves beholden to the Fed for their
continued political existence.... Chairman Bernanke and the FOMC have but to
terminate the Fed's swap lines with the various central banks of Europe or start
selling the MBS portfolio in the US, and governments from Washington to Berlin will
start to fall." ("More fed swap Lines for Europe and the End of Globalization", Clifford
Rossi,  Institutional Risk Analysis)


  The swap lines are designed to keep asset prices artificially high, so the contagion
doesn't spread to the US where accounting gimmickry helps to hide bank losses.
Bernanke is perpetuating the repo-scam, by assisting banks and other financial
institutions to amplify crumbs of capital into humongous  bubbles which can take
down the whole economy. The Wall Street Journal exposed a similar repo scam this
week in an above-the-fold article on Wednesday. Here's an excerpt:

  "Three big banks--Bank of America, Deutsche Bank, and Citigroup Inc.—are among
the most active at temporarily shedding debt just before reporting their finances to
the public, a Wall Street Journal analysis shows. The practice, known as end-of-
quarter "window dressing" on Wall Street, suggests that the banks are carrying more
risk most of the time than their investors or customers can easily see....


Over the past 10 quarters, the three banks have lowered their net borrowings in the
"repurchase," or repo, market by an average of 41% at the ends of the quarters,
compared with their average net repo borrowings for the entire quarter, according to
an analysis of Federal Reserve data. Once a new quarter begins, they boost those
levels...

The data suggest "conscious balance-sheet management," said Robert Willens, an
accounting specialist who heads Robert Willens LLC. If there are big gaps between
average quarterly and quarter-end data, he said, the quarter-end numbers "are at
best meaningless and at worst misleading and disingenuous." ("Banks trim Debt,
Obscuring Risks", Michael Rapoport and Tom Mcginty, Wall Street Journal)

So the banks are intentionally masking their leverage to conceal their true condition
to investors. And its all done with derivatives and repo; the lethal combo that led to
the crisis of '08. Unfortunately, Wall Street's lobbying campaign has been so
successful that, even now, real change is unlikely.  In fact, House Financial Services
Committee Chairman Barney Frank openly opposes  Blanche Lincoln's comprehensive
derivatives legislation saying that it "goes too far". Frank has signaled that the bill
would be killed or rewritten in committee. Derivatives trading is a main profit-center
for the nation's largest banks and they have spent millions to preserve the status quo.

"I don't see the need for a separate rule regarding derivatives because the restriction
on banks engaging in proprietary activities would apply to derivatives as well as
everything else," Frank said on Monday.

Even without Frank's support, the bill would have faced fierce resistance from a
contingent of Wall Street Democrats who were planning to strip the critical provisions
from the legislation.

Rep Michael McMahon (NY-D) defended the banks saying, “The House bill is based
on principles on how to reduce risk and make the system more transparent, it’s not
based on wiping out the system or destroying the system and that’s what the
provision does."

The credit storm in the EU has had no effect on Congress. Wall Street has won this
round. The window for real reform has closed, and now it's "business as usual" until
the next catastrophe.