The Anatomy of a Financial Meltdown

The Euro debt situation continues to deteriorate and the U.S. is not far behind. All the distress that is now focused on government debt comes from excessive private indebtedness as developed world countries seek to support the private sector. This has shifted the debt burden to the government sector, and now the government is the problem, not the solution. This is the outcome of a debt-bloated economy. For more background on this topic, I recommend that you watch the splendid discussion I had with Dr. Lacy Hunt a week ago — the video, “The Morass of Debt,” is linked and posted below. It covers the extreme difficulty of resurrecting an economy that has a debt overload. Regarding the Greek debt containment status, consider the following;

The grand containment scheme — as noted in the previous two posts, “Why These People Are Smiling” and “As Greece Goes So Goes Europe: How the Unthinkable Happens” — continues to deteriorate. Cover-ups tend to unravel when there is a hole so large and getting larger relative to the resources available to fill it; this happens even faster when the cover-up involves so many moving parts and requires so many volunteers to take the hit, particularly when there are strong private incentives not to volunteer. A partial list of the unraveling of the past week is as follows:

The banks that were to rollover Greek debt at ridiculously low yields, considering their risks, have largely already dumped their bonds to get out of the charity business.

The rating agencies have shown some backbone (or creditability survival instincts) by downgrading Portugal and Ireland to junk, expanding the necessary cover-up.

Depositors are fleeing Greek banks (and probably others, as short-term funding rates in Europe rise), creating a liquidity crisis in which banks are loath to lend to other banks for fear of a default. A liquidity crisis morphs into a solvency crisis if banks are forced to dump bad assets at the already depreciated market terms and dump otherwise good assets at deep discounts to fund the deposit withdraw. Each asset sale is noted by the bank accountants as a reduction of income and capital.

Greece and other Euro banks are under a depositor flight that used to be called a bank run. The ECB is called in to lend to these banks, but the rules require investment-grade collateral for these loans. Since the banks do not have unpledged investment-grade collateral available, the ECB has indicated that it would accept virtually any opinion of quality (besides those of the three major rating agencies, which are now being realistic) to qualify as lawful collateral. The standards are depreciating, and the ECB will be left holding the bag of bad assets, adding to the loss of confidence in holding wealth denominated in the Euro.

To make matters even worse, a new bank stress test is supposedly being released that will make some ludicrous assumption of the value of government bonds. It is an intended cover-up of the situation and will add to Knightian Uncertainty —increased uncertainty from not having the facts to evaluate the risk causes depositors to flee and markets to sell off banks’ stock, making it impossible for banks to raise replacement capital of any form, except for the charity of the central bank.

In order to prevent financial insurance claims, the rules of the game are being altered. A “limited” Greek debt default is being created for the “volunteer” banks that are being forced to roll over Greece’s debt at below-market yields. The” limited” designation is to provide the basis for the argument that all other Greek debt outstanding is good, hence protecting against a financial insurance payout. We’ll see if that holds up in court as those who took out insurance want it to be paid — but that will be much later.

And now, Italy has come into focus as the second “I” in “PIIGS.” The market is turning against their bonds.Lastly the IMF, now under the former French finance minister (as of a week ago), is hardening its terms to provide budgetary help to Greece. It sea former classmate of mine, as the outgoing IMF acting managing director, pushed through a higher hurdle for Greece’s lending before the arrival of the Madame from France. Furthermore, the IMF is sticking to it as the developing countries are in the process of reining it in to prevent it from being an exclusive developed world slush fund.

There is more trouble for Greece and the PIIGS: Not only do they have debt that can’t be sold in the market and political inability to contain deficits, but the veterans of sovereign defaults from Argentina looked at the situation and claim the Greek situation is DOA (my interpretation). They point out that even if all Greek debt were somehow to disappear via default without any compensation to the debt holders whatsoever, Greece still runs a fiscal deficit.

Furthermore, in a very insightful piece, John Gilbert of GR-NEAM questions the sustainability of Greece and Portugal’s economies apart from the burden of past, present and future debt. It seems these countries have an extreme dependence on foreign energy that causes their trade deficit to balloon when oil approaches its current $100-a-barrel price tag. That is, apart from debt, these economies are toast because they can’t export enough to pay for imported energy.

Lastly, the distressed Greek assets are not finding eager buyers who are ready, willing and able to pay what Greece had hoped for.

All of the above components are the makings of a financial crisis on par with the Lehman weekend. The banks’ condition no doubt will be favorably spun with the new stress test, and the market will still run the banks. Even the Federal Reserve is making noises about the possible need for a new QE this week (what a retreat from last week), pinning the problem on slow U.S. economic growth. But the Fed’s real intention, it seems to me, is to be poised to be lender of last resort to back up the ECB as depositors flee banks here and abroad, as they did in 2008 in amounts greater than $1 trillion.

This is the outcome of a leveraged financial system that has taken a large position in an asset category (government bonds) that has subsequently been deemed to be risky: It all cascades down. The financial institution assets depreciate, and the liability side of bank balance sheets is compressed when depositors run and the banks’ capital account is written down.  The market forces them to face the reality that neither the banks nor their governments wanted to face. Financial gravity ultimately wins despite the best and deceitful government efforts.

One aside: When Mexico was faced with a similar situation in 1982, banks were failing and depositors were fleeing. The response was to beef up the containment package by requiring government permission to exchange local currency for foreign currency, and on top of that, all banks were nationalized so the government could determine who was withdrawing pesos in a capital flight. Unless you stay one step ahead of regulation, you risk becoming a “volunteer” to help out the banks. I think most have had enough of that.

Now the important and relevant question is where the private wealth will flee. It is the question of the systemic flight to quality asset. The usual response, as it overwhelmingly was in 2008, was the U.S. dollar and the U. S. Treasury — but that depends on the perceived riskiness of the U. S. situation, which is not likely to be resolved before the Euro situation comes to a head. So it appears the answer will be that wealth will not flee to the usual places even if a U.S. debt ceiling deal is done on time.

This is a vital issue and I am working on an analysis of it, as all investors need a safe haven asset if they wish to preserve their wealth. Euro bank deposits are obviously not it, and U.S. investors might be shocked to understand that the usual “risk off” asset of money market funds is also not the safe haven it once was.

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