Chris Martensen is back. And he's not optimistic.
Get Ready: We’re About To Have Another 2008-Style Crisis
Well,
my hat is off to the global central planners for averting the next
stage of the unfolding financial crisis for as long as they have. I
guess there’s some solace in having had a nice break between the events
of 2008/09 and today, which afforded us all the opportunity to attend to
our various preparations and enjoy our lives.
Alas, all good things come to an end, and a crisis rooted in ‘too
much debt’ with a nice undercurrent of ‘persistently high and rising
energy costs’ was never going to be solved by providing cheap liquidity
to the largest and most reckless financial institutions. And it has
not.
Forestalled is Not Foregone
The same sorts of signals that we had in 2008 are once again
traipsing across my market monitors. Not precisely the same, of course,
but with enough similarities that they rhyme loudly. Whereas in 2008
we saw breakdowns in the credit spreads of major financial institutions,
this time we are seeing the same dynamic in the sovereign debt of the
weaker European nation states.
Greece, as expected and predicted here, is a right proper mess and
will have to leave the euro monetary system if it is to have any chance
at recovery going forward. Yes, all those endless meetings and rumors
and final agreements painfully hammered out by eurocrats over the past
year are almost certainly going to be tossed, and additional losses are
going to be foisted upon the hapless holders of Greek debt. My
prediction is that within a year Greece will be back on the drachma,
perhaps by the end of this year (2012).
Greek default spectre turns material
The weekend Greek revolt against the austerity measures imposed on
its economy in return for eurozone funding has elevated the prospect of a Greek default on its debts or a chaotic exit from the eurozone.
The collapse in support for the mainstream parties that had reluctantly accepted the austerity program and the vehement opposition to the measures by the radical left party that finished the runner up in the weekend’s elections has made it almost impossible for a coalition to be formed that would persevere with the program.
It is likely new elections will have to be held next month but given
the degree to which Greeks have protested against the harsh eurozone
prescriptions – and the 20 per cent shrinkage in GDP and 20 per
cent-plus unemployment that has accompanied them – it is
improbable that Greece will continue with the reforms it agreed in
return for the next $300 billion tranche of eurozone funding.
If it does walk away from that commitment there will be chaos in Greece and, to a lesser extent, elsewhere. Greece would inevitably default on its debts and could be forced to quit the eurozone.
(Source)
There really is no choice for Greece but to leave the euro, and the
sooner, the better. Even then, there is a lot of hardship coming their
way. But in my estimation, that’s better than the imposed austerity that
is a guaranteed torture chamber. The institutions that avoided taking
losses on their Greek debt on the first pass through, due to their
preferred status in the process (the ECB among them), are almost
certainly going to eat big losses this time, perhaps a full 100% of
them.
Leaving the euro is going to be quite a process, and the ripple
effects are going to be large and somewhat unpredictable. I found this
description of what will happen within Greece and its banking system to
be well on the mark:
The instant before Greece exits it (somehow) introduces a new
currency (the New Drachma or ND, say). Assume for simplicity that at the
moment of its introduction the exchange rate between the ND and the
euro is 1 for 1. This currency then immediately depreciates sharply vis-à-vis the euro
(by 40 percent seems a reasonable point estimate). All pre-existing
financial instruments and contracts under Greek law are redenominated
into ND at the 1 for 1 exchange rate.
What this means is that, as soon as the possibility of a Greek exit becomes known, there will be a bank run in Greece
and denial of further funding to any and all entities, private or
public, through instruments and contracts under Greek law. Holders of
existing euro-denominated contracts under Greek law want to avoid their
conversion into ND and the subsequent sharp depreciation of the ND. The Greek banking system would be destroyed even before Greece had left the euro area.
There would remain many contracts and financial instruments involving
Greek private and public entities denominated in euro (or other
currencies, like the US dollar) that are not under Greek law. […] Widespread defaults seem certain.
Euro area membership is a two-sided commitment. If Greece
fails to keep that commitment and exits, the remaining members also and
equally fail to keep their commitment. This is not just a morality tale.
It has highly practical implications. When Greece can exit, any country
can exit.
As soon as Greece has exited, we expect the markets will
focus on the country or countries most likely to exit next from the euro
area. Any non-captive/financially sophisticated owner of a
deposit account in that country (or in those countries) will withdraw
his deposits from banks in countries deemed at risk - even a small risk -
of exit.
Any non-captive depositor who fears a non-zero risk of the future
introduction of a New Escudo, a New Punt, a New Peseta or a New Lira (to
name but the most obvious candidates) would withdraw his deposits from the countries involved at the drop of a hat and
deposit them in the handful of countries likely to remain in the euro
area no matter what - Germany, Luxembourg, the Netherlands, Austria and
Finland.
The ‘broad periphery’ and ‘soft core’ countries deemed at any risk of
exit could of course start issuing deposits under English or New York
law in an attempt to stop a deposit run, but even that might not be
sufficient. Who wants to have their deposit tied up in litigation for months or years?
(Source)
The Greek banking system will be destroyed immediately upon Greece’s
exit from the euro, but the banking system there is already all but dead
anyway. Best just to sweep the floor clean and start over. The idea
is easy enough to understand; if your bank is about to go under, it is
best to get your money out before that happens.
The only mystery to me is why so many people have left their money in
the Greek banks this long. I suppose they were waiting for a clearer
signal? Well, it would seem that the signal has now been sent and
received:
Greek Depositors Withdrew $898 Million From Banks Monday
Greek depositors withdrew €700 million ($898 million) from the
country's banks on Monday, fueling fears of a bank run amid the growing
political disarray.
With deposits falling, Greek banks become even more dependent on the European Central Bank to meet their funding needs, exposing the central bank to potentially huge losses if Greece leaves the euro area.
Monday's deposit withdrawal far outpaced Greek banks' steady decline
in deposits since the start of the country's debt crisis in 2009, as
depositors withdraw cash and transfer funds overseas. In the
past two years, deposit outflows have generally averaged between €2
billion and €3 billion a month, though in January they topped €5
billion.
The latest data from the Greece's central bank show that total deposits held by domestic residents and companies stood at €165.36 billion in March.
(Source)
Again, the real mystery to me is who still has 165 billion euros in
Greek banks at this stage of the game? Also a mystery is why Greece has
not yet imposed a withdrawal moratorium and capital controls? It is
only a matter of time, perhaps days, before they do.
Of course, it is the contagion effect that most worries the market,
because the same dynamic of utter insolvency leading to the intractable
nature of Greece’s dilemma applies to Spain, Portugal, and Italy.
Indeed, the market is already adjusting to this possibility, as evidenced by the spikes in the yields of those country’s bonds:
Contagion Fears Hit Markets
LONDON - Investors battered European stocks, dumped the bonds of
Spain and Italy, and bid the euro down against the dollar Monday after
the collapse of weekend coalition talks in Greece edged that country
closer to an exit from the euro zone.
The sweeping market action dealt a blow to hopes that the
damage of a Greek exit, should it occur, could be comfortably contained.
In the market carnage, Greek stocks fell to two-decade lows,
and Spanish bond yields leapt to levels not seen since the panic of last
November. Shares of a big Spanish lender dropped 8.9% on the
Madrid bourse, pulling the benchmark index down 2.7%. The Italian market
also fell 2.7%, and the euro slid to $1.2845 late Monday in London, its
lowest level in four months.
(Source)
The worry and the carnage are both running deep. And they should.
Everything is now interlinked to such a degree that there is no possible
way for a run on Greek banks or continued declines in the value of
sovereign debt to be anything other than exceptionally destructive.
Everybody owes everybody, and there’s not enough productive economy to mask the insolvency of the system any longer.
We saw this as Spain’s sovereign yields vaulted, Spanish bank shares
plunged, a not-so-happy linkage courtesy of the LTRO funding which
enabled (and encouraged) Spanish banks to load up on Spanish debt. A
virtuous circle morphed into a vicious spiral, each element weakening
the other all the way down.
That the US stock market is only down less than 5% from recent highs
is a testament to the power of the liquidity that the Fed and US banking
system have directed at keeping things elevated. However, this cannot
last, at least not without another big quantitative-easing (QE)
injection from the Fed. Without such an infusion, I am calling for
another 2008-2009-style market rout of at least -30% but possibly as
much as -50%.
QE, stat!
The reason we need another QE injection is that the same dynamic of
debt destruction is again stalking the markets. As expected, the Fed
has been waiting for a clear signal that it is time for more thin-air
money, and again they are going to wait too long to prevent more damage
from occurring.
This time I am expecting a coordinated central bank action that will
involve most or all of the major central banks of the OECD: Japan, UK,
US, and Europe.
One day, we will wake up to find some global message about the need
for a coordinated response to a major crisis, and each of the central
banks will be issuing some massive new amount of thin-air money. Of
course the programs will be called something fancy that will require
shortening to an acronym and will involve buying some form of debt
(sovereign debt, but maybe also bank debt), and we’ll track this via
central-bank balance-sheet expansion.
Perhaps we’ll see this line go up a little steeper, or perhaps the same trajectory will be maintained a little longer:
Regardless, more printing is on the way, because the alternative is
the utter collapse of the entire Western banking system. And quite
probably a few governments, too.
To me, that is an unthinkable outcome, and one that I have every
faith will be avoided at any every cost. It is the main reason that I
am quite content to hold onto all of my gold at this juncture. Anybody
selling physical gold here is either broke (and needs the money) or is
just not paying attention.
To drive the point home, consider this picture posted on Zerohedge
taken from a German television production purported taken of the
Ministry of Finance in Athens. A picture is worth a thousand words:
By the time the Ministry of Finance is storing records in garbage
bags and shopping carts, perhaps, just maybe, one might become a little
concerned about loaning money to the Greek government. One hopes.
If You Think Greece is Bad
Greece, of course, is tiny compared to Spain or Italy. The situation
in Spain -- which is big enough to matter -- is truly dire, very large,
and getting worse.
Spain has been playing fast and loose with the numbers, and that fact
has now been revealed to the world. It’s not a pretty picture.
Spain Underplaying Bank Losses Faces Ireland Fate
May 10, 2012
Spain is underestimating potential losses by its banks,
ignoring the cost of souring residential mortgages, as it seeks to
avoid an international rescue like the one Ireland needed to shore up
its financial system.
The government has asked lenders to increase provisions for bad debt
by 54 billion euros ($70 billion) to 166 billion euros. That’s enough to
cover losses of about 50 percent on loans to property developers and
construction firms, according to the Bank of Spain. There wouldn’t be anything left for defaults on more than 1.4 trillion euros of home loans and corporate debt.
Taking those into account, banks would need to increase provisions by as much as five times what the government says, or 270 billion euros,
according to estimates by the Centre for European Policy Studies, a
Brussels-based research group. Plugging that hole would increase Spain’s
public debt by almost 50 percent or force it to seek a bailout, following in the footsteps of Ireland, Greece and Portugal.
“How can you only talk about one type of real estate lending when
more and more loans are going bad everywhere in the economy?” said
Patrick Lee, a London-based analyst covering Spanish banks for Royal
Bank of Canada. “Ireland managed to turn its situation around after
recognizing losses much more aggressively and thus needed a bailout. I don’t see how Spain can do it without outside support.”
(Source)
And this is just the losses that Spanish banks face on their
real-estate portfolios. They are also now facing losses on all the
Spanish sovereign debt that they bought with their LTRO funding as well.
Very simply, Spain now needs a massive rescue, and soon.
Meanwhile German citizens are all done with helping their southern
neighbors. Merkel has used up all of her political capital on the
rescues performed to date, and it is far from clear that any more help
is politically doable here. The only way that I can see such help
coming is under some terms other than drawing upon the savings of
Germany’s citizens. Printing, perhaps, but even that is a dicey
political proposition here.
If Spain drops here, then you can just set an egg timer for when
Italy will go. And then France. The dominoes will rapidly fall from
there.
Why I Am Nervous These Days
In describing JPMorgan’s recent $2 billion (or is it $20 billion…or
more?) trading losses and Jamie Dimon’s (the CEO of JPM) awkward
explanation of how certain hedging operations went wrong, the author of
this next piece asks the obvious question:
Does Jamie Dimon Even Know What Hedging Risk Is?
But wait a minute? If you’re hedging risk then the bets you make will
be cancelled against your existing balance sheet. In other words, if
your hedges turn out to be worthless then your initial portfolio should
have gained, and if your initial portfolio falls, then your hedges will
activate, limiting your losses. That is how hedging risk works.
If the loss on your hedges is not being cancelled-out by gains in your
initial portfolio then by definition you are not hedging risk. You are speculating.
(Source)
We still don’t know the exact dimensions of JPM’s losses here (my
expectation is that more bad news will follow soon enough), but we can
be sure that the big banks have not learned from the mistakes of the
past and are still engaged in risky practices involving derivatives.
Whatever JPM was up to (and I am still not entirely clear on what
that was), it was not classic hedging, which serves to minimize losses,
but something far more speculative.
The reason this gives me such cause for concern is that it once again
exposes a small portion of the derivative monster that will certainly
be awakened when the European situation goes into full meltdown over the
Greek, then Spanish, the Portuguese, then Italian situations.
While derivatives are, in theory, a zero-sum game, and therefore
could, in theory, be forgiven and forgotten in a pinch, the reality is
that they’ve been used to pretend that risk did not exist and therefore
losses don’t exist.
The ugly truth here is that we are at the tail end of a most
unfortunate credit bubble -- four decades of global excess by the OECD
countries -- and there are massive losses to account for. Just as the
offsetting counterparties involved in the subprime CDO and CDS mortgage
crisis did not zero out because the losses they were allegedly papering
over were all too real, the same will prove true of the derivative paper
allegedly covering sovereign and corporate debts.
Remember, the biggest holder of derivatives is the company that just
demonstrated that it doesn’t really understand the concept of hedging.
Overall derivatives, especially interest-rate-linked derivatives,
have increased by over $100 trillion since the crisis began. As JPM
just evidenced, and as hinted at by the interminable hand-wringing over
allowing Greece’s paltry $78 billion in credit-default swaps to be
triggered, real dangers lurk here.
I wish I could analyze the situation better than the rest of the
crowd that either screams catastrophe looms or coos that everything is
safe, but I cannot. The situation is too opaque, too convoluted, and
too complex to tease apart. I simply don’t know what the true nature of
the risk really is -- and the truth is, nobody really does. You might
as well ask these analysts to tell you the exact size and shape of the
first ten waves that will hit Laguna Beach exactly one year from now
beginning at 12:05 p.m.
Instead, what I can offer to you is the idea that instead of reducing
(let alone eliminating) risk, all that derivatives have done is
mask
risk. This means that whatever losses are resident in a system with
four decades of debt-fueled malinvestment and overconsumption are still
there just waiting to be realized.
It is this certainty that the losses remain, the risk is masked, and
the bets have only grown larger that makes me very nervous these days as
I contemplate the possible implications and repercussions of a Greek
exit from the euro.
To Sum Up Part I
Given this environment of massive, rapidly-accelerating, and obfuscated risks, the prudent among us are undoubtedly wondering,
How the heck is this going to play out? And how do I prepare for it?
In
Part II: What To Do When the Central Banks Blink,
I lay out my forecast for how low asset prices will sink before the
central banks once again attempt to ride to the rescue with gargantuan
liquidity measures.
But this next time won't work as it did in 2008, in my estimation. I
see central banks being near the end of their ability to influence
developments at this point. More liquidity will affect different asset
classes differently, and for the first time raise real (and valid)
concerns about the widescale debasement we are witnessing across the
world's major fiat currencies.
Putting your capital into those resources best positioned to appreciate most as the result of money printing
and hold or increase their purchasing power in such an environment should be a top priority for every concerned investor.
Click here to access Part II (free executive summary; paid enrollment required for full access).
