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Tuesday, September 30, 2014 9:00 PM

Draghi Pressures ECB to Buy "Junk-Rated" Loan Bundles of Greece and Cyprus

On September 4, ECB President pulled out a financial bazooka including a pledge to build up the ECB's balance sheet by another €1 trillion.

Draghi confirmed the asset purchases would "include the real estate, the RMBS, real estate ABS. It would also include a fairly wide range of ABS containing loans to the real economy," but only "the senior tranches, and the mezzanine tranches only if there is a guarantee."

Now, just three weeks later, he wants to buy outright junk, presumably without guarantees.

Please consider Mario Draghi pushes for ECB to accept Greek and Cypriot ‘junk’ loan bundles.

Mario Draghi is to push the European Central Bank to buy bundles of Greek and Cypriot bank loans with “junk” ratings, in a move that is set to exacerbate tensions between Germany and the bank.

The ECB’s executive board will propose that existing requirements on the quality of assets accepted by the bank are relaxed to allow the eurozone’s monetary guardian to buy the safer slices of Greek and Cypriot asset backed securities, or ABS, say people familiar with the matter.

However, the idea is likely to face staunch opposition in Germany, straining already tense relations between the ECB and officials in the eurozone’s largest economy.

Bundesbank president Jens Weidmann, who also sits on the ECB’s policy making governing council, has already objected to the plan to buy ABS, which he says leaves the central bank’s balance sheet too exposed to risks.

Wolfgang Schäuble, Germany’s finance minister, has also voiced his opposition, saying purchases would heighten concerns about potential conflicts of interest between the ECB’s role as monetary policy maker and bank supervisor.

While the safer slices – or senior tranches – of Greek and Cypriot ABS only make up a tiny proportion of Europe’s securitisation market, it would free up billions in liquidity for banks in two of the eurozone’s weakest economies, and potentially boost lending to credit-starved smaller businesses in the currency area’s periphery.
Free Up Liquidity?

The idea that swapping money for junk will free up liquidity is as ridiculous as moving a rotting fish from your pantry to the living room in hopes the stench will go away.

In this case, the stench on Greek bank balance sheets will not go away. Instead, stench will also appear on the balance sheet of the ECB.

And it will not do a thing to spur lending for the same reasons as noted in ECB's €1 Trillion Stimulus Gamble: ECB Pulls Out Bazooka, Cuts Rates, Buys Assets; Will this Stimulate Lending?

Here's the key snip.
Will this Stimulate Lending?

Everyone wonders if this will work. Let me ask a different set of questions:

  1. Why should it?
  2. Does the announcement fix any structural problems with the euro?
  3. Does the announcement fix any fiscal issues in any European country?
  4. Does the announcement fix any competitive disadvantages of France vs. Germany?
  5. Does this provide any impetus for structural reforms in France or Italy?
  6. If -0.1% rates for funds parked with the ECB did not stimulate lending, why should -0.2% rates?
Draghi Creates Bond Bubble

All Drahghi really accomplished with LTRO is to make Europe the biggest bond bubble in the world.

Well bubbles can always get bigger, until they pop.

Meanwhile none of these can-kicking efforts have fixed a single structural problem. Instead, they made it easy for governments to delay needed reforms.

Forcing Banks to Lend a Huge Mistake

These attempts to force banks to lend is a huge mistake. Banks lend if and only if ...

  1. Banks are not capital impaired
  2. Banks believe they have credit-worthy borrowers
  3. Credit-worthy borrowers want credit

If banks lend in other circumstances, they will incur losses. They also incur losses if they believe they have credit-worthy customers but they don't.

The problem should be obvious. European banks lack credit-worthy borrowers who want loans, or the banks are capital impaired.

I suggest both.

And if this move by Draghi does spur more lending to small uncreditworthy businesses, the ECB will have done nothing but compound Eurozone problems greatly.
 In response to the above post, a director at a global financial company pinged me with ...
"Hello Mish,

Mario Draghi is an idiot. Banks create money when they lend. The loans create a requirement for reserves which ultimately reverts back as deposits at the ECB. The negative interest rate is therefore a tax on capital and a tax on lending. This not rocket science.

I’d start a charity whereby every newly appointed central bank board member is sent a free copy of Rothbard’s Mystery of Banking except I am beginning to doubt their ability to read.
These actions by Draghi prove he is clueless about how the system even works.

Mike "Mish" Shedlock

4:13 PM

"Come Hell or High Water" Promise Morphs Into "Infinity and Beyond"

In 2010, vice-president Joe Biden publicly vowed the US would be “totally out” of Afghanistan “come hell or high water, by 2014.”

In a few short months, 2014 will be gone. Are US troops out of Afghanistan? Nope. Iraq? Nope. Instead, we have troops in Syria.

Political Promises

Political promises should never be believed.

Today the US signed an extension allowing US forces to remain in Afghanistan until "at least" 2024.

At Least Until 2024

The Guardian reports a new Afghanistan pact means America's Longest War Will Last Until at Least 2024.

The longest war in American history will last at least another decade, according to the terms of a garrisoning deal for US forces signed by the new Afghanistan government on Tuesday.

Long awaited and much desired by an anxious US military, the deal guarantees that US and Nato troops will not have to withdraw by year’s end, and permits their stay “until the end of 2024 and beyond.”

The entry into force of the deal ensures that Barack Obama, elected president in 2008 on a wave of anti-war sentiment, will pass off both the Afghanistan war and his new war in Iraq and Syria to his successor. In 2010, his vice-president, Joe Biden, publicly vowed the US would be “totally out” of Afghanistan “come hell or high water, by 2014.”

Under the Bilateral Security Agreement’s annexes, the US military will have access to nine major land and airbases, to include the massive airfields at Bagram, Jalalabad and Kandahar, staging areas not only for air operations in Afghanistan but the US drone strikes that continue across the border in tribal Pakistan.

The additional bases – in Kabul, Mazar-i-Sharif, Herat, Helmand, Gardez and Shindand – ensure the reach of the US military throughout Afghanistan.

US defense leaders greeted the signing of the accord with enthusiasm.
Enthusiasm of Defense Leaders Soars

Opium Connection

To help highlight the absurdity of US policy in Afghanistan, please consider U.S. Turns a Blind Eye to Opium in Afghan Town
KABUL, Afghanistan — The effort to win over Afghans on former Taliban turf in Marja has put American and NATO commanders in the unusual position of arguing against opium eradication, pitting them against some Afghan officials who are pushing to destroy the harvest.

From Gen. Stanley A. McChrystal on down, the military’s position is clear: “U.S. forces no longer eradicate,” as one NATO official put it. Opium is the main livelihood of 60 to 70 percent of the farmers in Marja, which was seized from Taliban rebels in a major offensive last month. American Marines occupying the area are under orders to leave the farmers’ fields alone.
Opium Production at Record High

That story was from 2010. An article from January of 2014 highlights the "success" of US opium strategy: Afghan opium production on the rise despite U.S. troops, inspector says
Citing the United Nations Office of Drugs and Crime, Sopkp said the cultivation of poppy plants — used to make opium and its derivative drugs such as heroin — is greater today than in 2001 when the United States invaded Afghanistan.

Indeed, he said it’s the highest in modern history.
Afghanistan Absurdities

  1. US troops protect the Afghanistan poppy harvest to aid local farmers in the battle against the Taliban.
  2. That battle has been so "successful" that the Taliban Storms Afghanistan and is on the march towards the capital.
  3. Meanwhile, drug agents attempt to intercept heroin before it hits the US.
  4. The effort to stop smuggling pushes up the price of heroin to the explicit benefit of drug lords who do get some of it through.
  5. Those drug lords are apt to be the Taliban.
  6. Drug money goes to buy weapons for the Taliban.
  7. To counteract the rise of the Taliban, we train "moderates" to fight the Taliban.
  8. We also give weapons to "moderates" to fight the Taliban.
  9. Unfortunately, we cannot successfully identify moderates. Many US weapons fall into the hands of the Taliban.
  10. Ultimately US weapons as well as weapons purchased with drug money are used to kill US soldiers and fight the puppet regime the US seeks to protect.

The above process necessitates keeping US troops in Afghanistan to 2024, if not infinity and beyond.
Thus, the Battle for Perpetual War is Won.

Is it any wonder the process has garnered rabid enthusiasm of the defense industry?

The only missing ingredient of the warmonger's ultimate fantasy is multiple wars on multiple fronts with a large power like Russia.

Mike "Mish" Shedlock

12:35 PM

Reader Question on a Credit-Based Society: Can Interest Ever Be Repaid?

Reader Mike wonders how interest can ever be repaid in a credit-based economy.

Hi Mish,

I wonder if you would be able to comment on this from Bill Gross in For Wonks Only:

"A credit-based financial economy (as opposed to pure cash) depends on an ever-expanding outstanding level of credit for its survival. Without additional credit, interest on previously issued liabilities cannot be paid absent the sale of existing assets, which in turn would lead to a vicious cycle of debt deflation, recession and ultimately depression.

Put simply, if credit needs to expand at 4.5% per year, then the private and public sectors in combination must create approximately $2.5 trillion of additional debt per year to pay for outstanding interest.

This seems to correlate to reality 100% but the implications are stunning. It means that assets must increase in value at the rate of the original loan plus all interest payments ever made. It also means there will be a very major reversal at some point as there will be a moment when the last loan that someone will actually pay gets written and the system will not be able to expand. I always assumed that debt levels would just reach a very high plateau and stay there but Gross is saying that is not possible.

If the system we have requires the interest to be created every year (in the form of new loans) to survive that seems like the very definition of a ponzi scheme.

Do you know the mechanical reason why the interest payments need to be created by issuing new debt? It is possible, of course, that you disagree with Bill Gross but he probably knows more about how debt works than any man alive so my assumption is that you agree with his viewpoint.

I'm sure you get endless requests for articles but this is such a fundamental question I would be extremely grateful (as I'm sure would many other people) if you are able to write a reply as an article.

Exponential Math

We are in this mess precisely because of fractional reserve lending and never-ending policy of inflation by central banks that do not seem to understand the long-term ramifications of exponential math.

I have covered the exponential math aspect before. For details, please see Money as Communication: A Purposely "Non-Educational" Fallacious Video by the Atlanta Fed.

Credit in a Gold-Backed World

There is nothing wrong with credit expansion used for productive purposes. If we had a 100% gold-backed dollar without FDIC, bad debts would be extinguished automatically.

Interest rates would be low for low-risk ventures and high for high-risk ventures, with lenders (depositors willing to lend money) taking the risk.

On high risk ventures, some projects would lose and some win, as it should be.

Importantly, no money held for safe keeping (checking deposits), would ever be at risk in 100% gold-backed system. Nor would there be any mathematical need for credit to expand exponentially forever and ever without end.

30-year mortgages might not even exist, but that would not cause any problems.

Deflation (a natural state of affairs because of rising productivity) would provide price stability central bankers now claim they want.

But that is not the world we live in.

Fiat World Math

Unfortunately, we live in a fiat world, not a 100% gold-backed dollar world. We have fractional reserve lending, and a huge mismatch in duration. Banks borrow short and lend long. It's a recipe for disaster.

Thanks to central bank encouragement and unnaturally low rates for a fiat scheme, credit is out of hand. Loans that have been made cannot possibly be paid back. Unproductive zombie companies survive only because they can roll over debt while expanding it. Covenant-lite debt now accounts for 50% of new debt issuance.

Worse yet, real wages are falling because of central bank inflationary policies in a productivity-driven world increasingly dependent on robots, not human labor.

Minimum wage laws, Obamacare, Congressional fiscal policies, Fed interest rate policies, public unions, and inflationary policies in every phase of government make it likely that companies use robots at a far faster pace than they would otherwise.

Something has to give and it will.

Debtberg Malinvestments and the Zero-Bound Problem

I asked my friend Pater Tenebrarum at the Acting Man blog to chime in on this situation. Pater writes ...
Interest is basically nothing but the discount of future goods vs. present goods. At its root, interest is actually a non-monetary phenomenon. In the modern-day fractionally reserved fiat money system, it has become possible to expand money and credit at immense rates. The reason why the debtberg was able to grow to such immense proportions is that interest rates fell for over 30 years. But now we have arrived at a critical juncture, because interest rates can no longer go any lower. The possibility to refinance existing debt again and again to lower its cost has come to an end.

The size of a debt is immaterial if the debt has been used for productive purposes and is so to speak 'self-liquidating'. Imagine you are a company that borrows $200 million at 3%. If you employ this money to produce goods that have a net profit margin of 6%, the repayment of the debt plus interest poses no problem.

But a lot of debt in the system today is a "dead weight" that will produce nothing. All extant government debt is only a reflection of past spending, and the funds have been 100% consumed. The same obviously holds for consumer debt, but consumers at least have an income based on production (i.e., their work will create value in the future). The government's income relies on the production of others, which is coercively appropriated.

In the realm of corporate debt, which may be considered productive in principle, there is the problem that many of the investments that have been undertaken are really malinvestments, as economic calculation has been falsified by monetary pumping. Debt that has funded capital malinvestment is a dead weight as well, although this may only become obvious at a later stage.

So the situation is now this: debt service will now grow with every new addition to existing debt, as interest rates have arrived at their absolute lows. Given total credit market debt of $60 trillion in the US alone, it will become more and more difficult to actually produce the added value required to service this debt. There is indeed an incentive for many to play a kind of Ponzi scheme that is very similar to the government debt Ponzi. Many companies, especially the junk credits, can only survive by rolling over their debt when it comes due.

Nevertheless, Gross' calculation may be a bit too simplistic. After all, if you are a creditor and get paid interest and principal, money is only moving from A to B. It is still there, only its ownership has changed hands. The problem is that central banks believe in inflating debt away and keeping prices "stable".

In a free market economy, prices would not be stable, they would in fact decline. Thus, interest would be quite low to begin with, and every dollar would be doing more work over time (i.e., could be exchanged for more real wealth/goods/services as time passes).

So we currently have a systemic bias toward more and more debt expansion. Obviously, debt service costs in this system are slated to rise, while an offsetting creation of wealth is no longer guaranteed. You can see this from the fact that more and more new debt is added per dollar of GDP growth. So Gross is quite correct that there is a problem - the problem is the ongoing bubble. Such a bubble does indeed require a constant acceleration in debt and money supply to keep going.

Seems to me that it is a system that is coming ever closer to a cliff.
On the Edge of a Cliff

  • Japan is on the edge of a cliff
  • Europe is on the edge of a cliff.
  • China is approaching the cliff, if not already on the edge.
  • US is approaching the cliff.

No one can be sure when some country is going to fall off that cliff, but exponential finance, Ponzi financing schemes, and zero-bound interest limitations suggest the outcome is sooner rather than later. As I have stated before, a global currency crisis awaits.

Mike "Mish" Shedlock

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