Weekend Musings For 5/22


Weekend Musings For 5/22

Posted by Karl Denninger

So Friday we had a “flash rally” in the last 20 minutes of the day – about 20 handles (S&P points) straight up.  Will there be an “investigation” to see why that happened?

Of course not, even though I have no evidence (or belief) that it was anything nefarious.  But boy, when the bids disappear (instead of offers), that’s worthy of a Presidential Commission!

Uh huh.

El-Erian of PIMpCO had an interesting piece this morning in The Journal; some of the tidbits seemed to be worthy of comment.  A few notables:

It’s hard to forget those “Sunday night specials”—long hours spent anxiously waiting to hear from Washington on topics like Bear Stearns, Fannie and Freddie and Lehman Brothers.

Uh huh.  The parallel to a “Saturday Night Special” is unintentional, right?  Oh wait – it’s not.  There’s never any attention paid to the fundamental reasons for problems in the economy, or in the banking system.  That might be because Washington (and other governments) are inept, or it might be because fixing the problems means that we’d have to indict some banksters and break up the crony econo-fascism that has reigned over virtually the entire western world for the last 20 years.

It is absolutely critical to understand how we end up in the midst of these unsettling weekends. It’s a failure of both crisis prevention and crisis management. It happens because structural problems like excessive budget deficits are allowed to fester.

Certainly spending 11% of GDP that you don’t have, by printing up bonds and selling them, wouldn’t have anything to do with that would it?  Where has PIMpCO been in this regard over the last two years?  “Shake hands with the government“, remember?  Uh huh.  You sure those are hands you’re shaking sir?

First, is the Greek problem being treated for what it is (namely, a solvency problem) as opposed to what people wish it to be (a liquidity problem)?

Was our financial mess over here with the banks treated for what it was (and stil is), that is a solvency problem, as opposed to what people wish it to be?  Can anyone defend the FASB changes as anything other than flatly lying about solvency?  I think not.

The unwind of unstable investor positions is still in its early stages. Having over-romanced the cyclical bounce, some investors are now scrambling to reposition their over-extended portfolios now that structural problems are undeniable. The resulting unwinding of overleveraged trades will inevitably disrupt a very wide range of other assets as the good gets contaminated by the bad.

Refusal of governments worldwide to force financial institutions back into the old 12-14:1 leverage models, banning off balance sheet games entirely, forcing all credit instruments onto an exchange where cash margin must be posted and maintained is no accident.  It is an intentional act of deception played upon investors and while El-Erian may write pretty editorials he certainly doesn’t bother to come right out and say it: The entire rally off the 2009 lows was an engineered fraud predicated on covering up insolvencies and permitting the asset-stripping that banks had practiced for the previous decade to not only continue but accelerate!

Back in the early 1980s we had a similar event to today’s fun and games that occurred in Latin America.  Brazil, Argentina and Mexico all borrowed huge sums of money for various industrialization projects, much of it from large American banks.  The total outstanding reached 50% of GDP, or about $315 billion.

Mexico officially kicked off the “game on” period with an announcement that they would not be able to make service on the debt.  This formally put several large American banks in a position of being in violation of their capital ratios, since defaulted debt cannot be counted as “good” – at least not if your honest.

Volcker, who was at the time Fed Chairman, decided to allow the big banks to fudge, much as we’ve done this time.  But he attached one important condition – they had to raise capital and not pay it out in bonuses and other dilutive tactics, because his forbearance was not permanent and when it ended, if they had not cured themselves, they were finished.

Bank executives believed his threat and thus we survived to fight another day.

Now contrast this with what has happened this time around.

Banks have taken the forbearance and used it to continue to pay out huge salaries and bonuses – over $100 billion between them in 2009.

How important is this?  Quite.  See, one of the arguments against spinning off the swaps business from the big banks is that they would have to raise $250 billion in new capital.  If that’s not an admission that “we’re undercapitalized” (otherwise known as “insolvent”) “and if you force us to do this that fact will suddenly come to the fore” I don’t know what is.

Of course there’s the argument made that:

Clients who want to buy protection will see a European bank as a stronger, better-backed credit than a U.S. derivatives subsidiary, Hintz said.

Uh huh.  You mean a European bank with an unknown (and unknowable) leverage ratio that is sitting on a few trillion in derivative notional value with god-knows-what behind it?  Oh sure, if they continue to have access to bailouts whenever they want or need them, that argument might work – for a little while.  

But isn’t this entire debate about the claim of illiquidity when in fact the problem is insolvency?


So when do the lies stop?

Only when the liars are exposed and driven from the public debate, to be replaced by adults in the room who will enforce the rule of law and allow business balance to return.

The only question remaining is whether we will do it voluntarily and accept the damage that must be recognized and be worked through, or whether it will happen by force via a market collapse.