What If Europe "Marked-to-Market"?

“The now inevitable restructuring of eurozone debt…”

So writes Jim Millstein, Chairman of Millstein & Co. and former chief restructuring officer of the US Treasury Department. (http://www.ft.com/intl/cms/s/0/461464fa-0617-11e1-a079-00144feabdc0.html#axzz1dmPTNMw5)

Have people really come to accept this fact?

The full sentence: reads “The now inevitable restructuring of eurozone debt will result in bank capital deficiencies that the IMF estimates could exceed €300 billion.”

Now, what if we added a European recession on top of this, a recession that would slow down government receipts and increase unemployment payments and so forth?

Just out this morning: “A rebound in German and French growth propelled a modest expansion of the eurozone economy in the third quarter of this year – but failed to dispel fears of a looming recession across the 17-country region.

Eurozone gross domestic product expanded 0.2 per cent compared with the previous three months – the same pace of expansion as in the second quarter, according to Eurostat, the European Union’s statistical office. But with the escalating debt crisis already feeding into falling factory production, growth may already have gone into reverse, economists warned.” (http://www.ft.com/intl/cms/s/0/d1b0e2c6-0f5f-11e1-88cc-00144feabdc0.html#axzz1dmPTNMw5)

Are we coming to the end game?

Angela Merkel, the German chancellor, is now calling for a political union of Europe as the only way to “underpin” the euro and help the members of Europe emerge from their “toughest hour since the second world war.”

Doom and gloom seem to be all around us.  Just in the past two days we have articles like “New Austerity Incites a Bitterness the Postwar Generation Did Without,” (http://www.nytimes.com/2011/11/14/world/europe/austerity-in-europe-brings-bitterness-unknown-in-postwar-era.html?_r=1&scp=2&sq=alan%20cowell&st=cse) and David Brook’s “Let’s All Feel Superior,” (http://www.nytimes.com/2011/11/15/opinion/brooks-lets-all-feel-superior.html?hp0).  Also, this morning there is a review of Niall Ferguson’s new book “Civilization” whose subject matter is “the end of western civilization as we know it”  (http://www.nytimes.com/2011/11/15/books/niall-fergusons-empire-traces-wests-decline-review.html?ref=books).

Do these pieces of information point to the existence of a debt deflation cycle that is at the opposite end of the spectrum from the credit inflation cycle that we have been going through for the past fifty years? (http://seekingalpha.com/article/307261-debt-deflation-is-it-a-possibility)

The solutions Mr. Millstein proposes for the writing down of European sovereign debt are focused on the banking system and the estimated bank capital deficiencies.  But, part of the solution involves more debt: “a federal financial body, such as the European Investment Bank, must provide a capital backstop…”  In other words, more debt!

But, “To give it the firepower it needs for the size of the problem, the EIB must be empowered to raise debt supported by a stream of new tax revenues dedicated to retire the debt incurred.”  And, “the EIB’s capital backstop should be funded through a new federal tax on bank salaries and profits above defined levels.”

This does not seem like a solution to me.  The solution to the problem of too much debt around is not more debt and more taxes.  Yet that seems to be the best that many people can come up with.  However, this seems to me to be more of the same “thinking” that got us into this situation.

This brings me back to the opening quote: “The now inevitable restructuring of eurozone debt…”

The European problem is not a new one; it has been growing for several years now.  Government officials have just not been willing to accept the reality of the situation and economists have helped them to hide their heads in the sand by arguing that Europe’s problem has been one of “liquidity” and not one of “solvency.” 

If the problem is one of “liquidity” then a bank…or, anybody else…does not have to mark down an asset because the bank will, they say, hold the asset until it matures.  If the bank accepted the fact that the asset was experiencing difficulties then it would have to “mark” the value of the asset down.  But, this admits that something might be wrong…and people don’t like to admit that a mistake might have been made.

And, as Steven Covey has stated, “if the problem is ‘out there’, that is the problem!”  Even a month ago, European officials were still claiming that their problem was one of “liquidity” brought on by speculators and other “greedy bastards.”  And, if the problem was someone else’s fault, real solutions could be postponed.  And that is what these officials did.

“Solvency” problems, however, do not just go away.  First, “solvency” problems have to be recognized…people have to “own” them before anything can be done about them. 

I am still not convinced that we have arrived at that point.  Yes, we have an editorial piece in the Financial Times that declares that “the inevitable restructuring of eurozone debt” must take place.  However, eurozone governments, I don’t believe, generally accept this conclusion. 

Until eurozone officials do accept the fact that “all” eurozone debt must be restructured, the problem will still be that these officials do not accept the fact that their debt must be restructured.  And, this is no solution.    

Fed Interested in "Cash" at Foreign-Related Financial Instituions

Seems like the Fed is interested in something I have been writing on for at least four months: the cash assets that “foreign-related (financial) institutions have been accumulating during the period referred to as QE2. (See http://seekingalpha.com/article/287494-foreign-related-financial-institutions-continue-to-suck-up-u-s-excess-reserves.)

Reporting this morning in the Wall Street Journal, David Enrich and Carrick Mollenkamp claim that the“Fed Eyes European Banks,” (http://professional.wsj.com/article/SB10001424053111904070604576514431203667092.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj). “Federal and state regulators, signaling their growing worry that Europe’s debt crisis could spill into the U. S. banking system, are intensifying their scrutiny f the U. S. arms of Europe’s biggest banks…”

“Officials at the New York Fed ‘are very concerned’ about European banks facing funding difficulties in the U. S…the worry is that the euro-zone debt crisis could eventually hinder the ability of European banks to fund loans and meet other financial obligations in the U. S.  While signs of stress are bubbling up, the problems aren’t yet approaching the severity of past crisis.”

Up to now, borrowing dollars hasn’t been a problem.  “Thanks partly to the Federal Reserve’s so-called quantitative easing program, huge amounts of dollars have been sloshing around the financial system, and much of it has landed at international banks, according to weekly Fed reports on bank balance sheets” 

This is just what I have been reporting since early this year. 

“Regulators are trying to guard against the possibility European banks that encounter trouble could siphon funds out of their U. S. arms.”

“Part of what is unsettling regulators and bankers is the speed at which funding can reverse direction.  This spring, foreign banks were able to build up ample cash cushions, thanks largely to quantitative easing…”

In July, 2010, non-U. S. banks had $418.7 billion on reserve and collecting interest at the Fed, according to Fed data.  By July 13 of this year, the total more than doubled, to about $900 billion.  Some major European banks were among the main drivers of this trend, according to their U. S. regulatory filings.”

Again, you could have read it here first.

“In recent weeks, though, the cash piles at foreign banks’ U. S. arms have diminished…foreign banks’ overall U. S. cash reserves fell to $758 billion as of Aug. 3, the latest data available.”

One note on this, the figures on cash assets at these foreign-related financial institutions can swing fairly dramatically from week-to-week and August, in banking non-seasonally adjusted statistical series, can be very interesting. 

Also, the buildup in cash assets at these foreign-related institutions began early enough this year that they could have been used for the “carry trade.”  Interest rates were so low in the United States that borrowing here and investing at the higher interest rates that could be found throughout the world was being done by most of the large financial institutions in the world. 

On June 28 of this year I wrote, “In essence, it appears as if much of the monetary stimulus generated by the Federal Reserve System went into the Eurodollar market. This is all part of the “Carry Trade” as foreign branches of an American bank could borrow dollars from the “home” bank creating a Eurodollar deposit. This Eurodollar deposit could be lent to foreign banks or investors and this would not change the immediate dollar holdings of the American bank. This lending and borrowing in Eurodollar deposits could then multiply throughout the world. And, the American bank might be the ‘foreign-related” institution mentioned above and included in the statistical reports.

Note that the original dollar deposit created by the Fed is still recorded as a deposit at one Federal Reserve bank no matter how much shifting around the borrowing and lending in the Eurodollar market occurs.

Thus, it appears as if the Federal Reserve pumped one-half a trillion dollars off-shore since the end of 2010!”  (See http://seekingalpha.com/article/276909-federal-reserve-money-continues-to-go-offshore.) 

So, there may be more than one reason for the build up of cash assets at the foreign-related institutions.  This is why we need to keep our eyes open and look at a wide-range of data. 

It’s interesting to me that the Fed did not seem worried at all about this cash buildup earlier this year even though the foreign-related institutions seemed to be siphoning off a lot of the funds the Fed was supplying to the banking system that was supposed to go into bank lending to get the economy moving again.