The rumours are swirling. Top of the list is “re-hypothecation”. Next is German bank re-capitalization. And last is an IMF Europe bail out fund.
At the end of the US trading day came a report from the Japanese press that the G20 were going to set up a $600 billion rescue fund for Europe. American markets shot up. American markets may like it but given that IMF funding is mainly American, it means American tax payers would be on the hook. Unless the G20 change the power structure within the IMF. China might agree to stump up a far larger share of the funding but only if they are given an accordingly larger share of the power and control. The only other option, and the more likely one, is that the G20 gives the IMF the go-ahead for expanding its own IMF bond sales to back up its own lending. Which would preserve US control but relieve them of the politically damaging accusation that the US tax payer is bailing out European banks. Of course what would get little mention is who exactly would be buying these bonds and with what?
Everybody needs to sell their bonds/debt literally trillions over the next two years. My guess is they will all agree to buy each other’s bonds allowing everyone to claim to be fine, just fine. It is the classic life boat full of sailors drinking each others piss. Every morning everyone is dying of thirst but what do you know, every morning everybody has a full bowl they can generously offer to a friend.
But none of those details worry the markets who whose only concern is how much short term profit can I make. That was the big news last night. But in my opinion was not the most significant. For me it was the news reported in Germany’s Handelsblat that the German finance minister, Wolfgang Schäuble, was going to force German banks take government money to recapitalize.
As far as I can make out the Minister is saying that any bank he and SOFIN (the German Bail out fund) do not think is well enough capitalized, will be forced to accept state money probably in return for shares. In other words part nationalization. Commerzbank is the obvious candidate but I also think Germany will attempt to buy back from UniCredit , by force if necessary, the very large Bavarian bank HVB. I think several Landesbanks would also find themselves being nationalized. None of them want to be nationalized because it dilutes their share holders, spooks the markets and in the case of the Landesbanks, transfers jealously guarded regional banking power and prowess to the Federal government.
But more interesting to me is that the German government should allow rumour of this now just as the ratings agencies are saying that Germany’s AAA rating could be downgraded on fears of the level of German debt. One of the reasons German state debt is low is Germany has not, unlike other nations, recapitalize its banks. If it did so its sovereign debt level would jump from where it is now about 70% GDP to about 84% GDP. Which would almost guarantee the loss of Germany’s AAA rating. It would also leave Germany far LESS able to foot the bill for a wider pan-Europe bail out fund.
So the question for me is, is this rumour/news a hint that Germany is deciding it is a better plan and safer plan for Germany to back away from a European bail out and concentrate its available fire power on saving its own highly indebted and insolvent banks. In other words, is this Germany pulling up the draw-bridge? I can’t decide. The article talks about the recapitalization happening by 2012. I don’t believe that time scale. If they’re talking about it now, at such a dangerous and sensitive moment, it says to me it would happen a lot faster.
Which begs the main question, what has happened to precipitate such rumours and possible plans? Which brings us to ‘re-hypothecation’. As is so often the case it has been ZeroHedge who broke the story last night and followed with another article this morning. Followed this morning by Reuters.
The first ZeroHedge article seems to suggest what I also believe, that the ‘re-hypothecation’ story is at least part of why the German’s seem to have hit the panic button.
First what is re-hypothecation’. As usual it is not complicated, just stupid.And as always it is defended on the grounds that it ‘provides liquidity’ to the markets. Sadly it is supremely unstable liquidity which when it goes wrong does so massively. Hypothecation is very like repo agreements when an assets it ‘sold’ but with the guarantee to be ‘sold’ back for a given price on a given date. Leading to the obvious conclusion that it was not actually a sale at all – just a loan. But a loan disguised in ways that allow banks to lie . Which leads to the further question why invent Hypothecation if you already have repo? And the answer is Hypothecation is far worse. Here is a good description of it from the Reuter’s article,
…hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.
Why do this? It’s in part about who gets to show what assets as still being on their books while others get to use said assets as collateral for their own loans. Which brings us to ‘re-hypothecation“. Who says an asset that has been “hypothecated” once can’t be “re-hypothecated”? Well actually no one. The UK and the US authorities have spent a decade removing any restraint of Hypothecation to bring us to where we are now.
So, Bank 1 has an asset. It badly needs cash because it’s nearly broke. It hypothecates its asset to bank 2. Bank 2 also needs/wants a loan.So it turns to bank 3 and says, I happen to have a lovely asset which I hypothetically control, would you like it? Bank 3 says great. So bank 2 gets its loan which it probably uses to make other loans, while the asset it got from bank 1 is re-hypothecated to bank 3. Now bank 3 hypothetically controls the asset. Bank 3 turns to bank 4 and does the same. We now have 4 banks three of whom hypothetically control the original asset which is in fact still where it started, in bank 1 – a bank which was in such trouble it had to hypothecate its assets. Along the way, however, three banks have used the asset to get themselves loans and all of those loans rest on hypothetical control of the original asset. A pyramid of loans and obligations rest on a single asset whose control is now not at all clear should any one along the chain need to assert their control or need it bank to pay off their debts – should anything go wrong in the the ventures into which they put the money they borrowed on the strength of the ‘asset’. And THAT my fellow citizens is why the bankers insist they get paid so much.
So now we have a whole new bag of questions. What assets do you think have been hypothecated and rehypothecated recently? European bonds perhaps? And which banks might be heavily involved and exposed to the trade? German banks and British Banks? French banks. American Banks?
The collapse a few weeks ago of MF Global which I wrote about at the time was the first thunder-clap from this rapidly approaching storm. It will not be the last.
Wells Fargo has been of recent times one of the large suppliers to Europe of short term loans – liquidity. And what is the classic defence of the use of hypothecation and re-hypothecation? Oh, I remember, it was that it provides liquidity. I wonder if Wells Fargo has quite a few assets it ‘hypothetically’ controls? I wonder if Deutsche or Commerz or Soc Gen have more? And the British banks and brokers? Well London is the centre of the ‘re-hypothecation’ trade.
Cameron and Osbourn go off to Brussels with a trumpety trump like two bumptious Eton fifth formers, cock-sure arrogance and ignorance mixed, all puffed out cheeks and rehearsed school boy bluster. They are so behind the curve it makes me cringe.