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Monday, November 28, 2011

Why You Need To Care About The EU

What seems like a million years ago - 2008 - I was an Executive Vice President for a small community bank in the SF Bay Area.  We were NOT on the Too Big To Fail list!

Our investment policy stated that we'd only buy investment securities from AAA rated companies, or from the Federal Government.  If there was an investment we wanted to put money into that didn't meet those criteria, we would buy insurance to protect us.

This insurance was called a Credit Default Swap (CDS).  We'd do research on the strength of the company issuing the CDSs to make sure that if our investment went bad, the "insurance company" had the financial strength to meet its obligations.

Something that is important to understand is that the companies that issue these CDSs have no interest or control in the securities they're insuring.  They simply create these policies out of thin air.  They are part of the greater derivatives market (a newly created financial instrument that is derived from another one).

They do research on the underlying securities (say, Mortgage Backed Securities) to determine the likelihood of there being a default on the security (like, for instance, if the people making the payments on the mortgages stop making payments).  If enough of the payment stream is disrupted, the insurance company must pay up.

Similarly, when companies issue bonds, these are essentially loans.  You give the company X dollars, and they give you a stream of payments to pay down the loan.  If the company goes teats-up, the stockholders take the first hit.  They're wiped out.  The bond holders are (usually) secured creditors.  The assets of the company are sold, and the bond holders get some of their money back.

If the bond holder doesn't get back all of his investment PLUS interest, AND he bought a CDS, the CDS issuers make up the difference.

So how does this relate to the European Union (EU)?  The short answer is, European countries and banks have issued a ton of bonds.  US banks have issued a ton of CDSs on those bonds.  If the Euro countries and banks crash, our biggest banks crash with them.

How can that be?  Surely, like a real insurance company, the banks that issued the CDSs held cash or other assets in reserve to cover losses, right?

Uhm, not so much -
Goldman Sachs and US banks have guaranteed perhaps one trillion dollars or more of European sovereign debt [Euro "treasuries" - .ed] by selling swaps or insurance against which they have not reserved. The fees the US banks received for guaranteeing the values of European sovereign debt instruments simply went into profits and executive bonuses. This, of course, is what ruined the American insurance giant, AIG, leading to the TARP bailout at US taxpayer expense and Goldman Sachs’ enormous profits.
So, if other EU countries follow the path of Greece, how are they going to fix this?  There are a couple of options, all of which are going to cost you.

The first option would be to let the EU and their banks crash, and for the US to simply back-stop our own banks.  TARP Part Two (or it is Part Three?).  Not very likely.

Another option would be for more pass-through funding like we did with the original TARP (the US gave money to US banks, who in turn laundered it and gave it to their EU counterparts).  Again, not too likely, as people in the financial press - puppets that they are - might actually ask the question about whether we're going to spend US tax dollars in EU banks, and the answer would be politically devastating.

The third option would be to use a third-party bag man to deliver the cash.  Oh, like maybe the International Monetary Fund (IMF).  We'll dump buckets-o-fiat-currency into the IMF, and they'll pass it off to the EU countries that are gasping for breath.

Along the same lines, the Federal Reserve may open up a big-assed line of credit for the European Central Bank (ECB) to keep things afloat.  Same thing as the IMF route, just using a different bag man.

Since we're not currently flush with excess cash to pay for all of this, Uncle Ben Bernanke will flip on his laptop, and just create the needed funds.  Expect lots of commas and zeroes in the number.

Also expect a further decline in the purchasing power of those green-backs you have in your wallet.

In totally unrelated news (snicker) sovereign nations went on a buying binge last quarter.  What were they buying?  It was that stuff Uncle Ben says isn't money.  Gold.
Total central-bank gold purchases in the third quarter more than doubled from the second quarter and were almost seven times higher than a year earlier as countries continued to diversify reserves, according to a World Gold Council report.

At 148.4 metric tons, gold buying among central banks was at the highest since the sector became a net buyer of the precious metal in the second quarter of 2009, according to the quarterly report.
Double the previous quarter, and seven-times the amount from the same quarter of a year ago.  There sure are a lot of stupid countries out there, huh?

Hell, even dictators are falling for it -
Amid wild celebrations, a first shipment of gold bars arrived home in Venezuela on Friday after President Hugo Chavez ordered almost all the country's foreign bullion reserves be repatriated from Western banks.

Excited crowds lined the roadside waving big Venezuelan flags and chanting "It's returned! It's returned!" as a convoy of soldiers and armored cars carried the ingots from Maiquetia airport to the central bank in Caracas.

Experts had cautioned that the operation, which will eventually transport more than 160 tonnes of gold bars worth more than $11 billion to the South American country, would be risky, slow and expensive.
So, good old Hugo doesn't trust the central banks to actually have his country's gold on-hand, so he wants it in his own greasy little paws.

Silly, silly boy.  Uncle Ben and all of the other "experts" are just laughing their asses off at all of these fools clamoring for physical gold.  Yuck, yuck, yuck...

Hey, brother... can ya spare a Kruggerand?

Copyright 2011 Bison Risk Management Associates. All rights reserved. Please note that in addition to owning Bison Risk Management, Chief Instructor is also a partner in a precious metals business. You are encouraged to repost this information so long as it is credited to Bison Risk Management Associates.


suek said...

First I've heard about this little goodie...

Chief Instructor said...

Sue, sounds like what the US did with foreign ownership of US real property. If I remember right, it's only 10% for real estate, not the 30% FACTA does. Hmm, wonder if people selling real estate right now would like to have those foreign investors back.

Actions have consequences...

BTW, your link was broken - here's the whole thing -

Anonymous said...

As you know all mortgages with less the 20% down were fully insured. Yet it was these very mortgages that caused the banks to collapse and need a bailout. It was this insurance that was underfunded and failed the causing the recession/depression. When the government bailed out the banks they did this in lieu of bailing out the insurance which would have reimbursed the banks and any other investors in those mortgages. Why this is important: because often the blame is placed on Wall street and the banks for supposedly buying and selling mortgages "they knew were bad". Of course they weren't "bad" they were fully insured. I might add that the insurance was a semi-government institution and thus the federal government was backing it. I think they choose the bailout over paying the individual insurance claims because it was faster and because it was going to be cheaper. Bottom line is the insurance failed and probably it makes no sense to even make mortgages with little or nothing down by the buyer. In a massive default situation like we had there was probably no way any insurance could have been funded enough to cover the bad loans.

Chief Instructor said...

Sue... looks like the link doesn't want to stay whole!

Anon, the Private Mortgage Insurance (PMI) that lenders get only covers the difference between the down payment and the 80% first mortgage. Homes that went into foreclosure typically had losses in excess of the 20% down payment/PMI cushion.

Anonymous said...

I think you are begging the question. Did the PMI pay the bank or holder of the mortgage? The answer is no. Why????

suek said...

Try this: