Saturday, April 14, 2012

The European Central Bank, Draghi eurozone's gambler of last resort....

The European Central Bank, "Super Mario Draghi" Eurozone's gambler of last resort....

Central banking as sport....
By Chan Akya

About 10 years ago, at the time global markets came to grips with the significant frauds at the heart of various organizations such as Enron, WorldCom and Tyco, it was said repeatedly that accounting had become the most adventurous profession on earth, belying the general social classification of accountants as boring middle-aged men wearing glasses.

Indeed, the spectacle was unexpected by the markets to the point that some accounting firms such as Arthur Andersen and to a lesser extent Grant Thornton were pitchforked out of town as a result of these scandals.

At the heart of the accounting scandals that felled the mighty Arthur Andersen was the inherent conflict of interest between firms retained on behalf of shareholders to verify the veracity of financial statements (auditing) and firms that looked for ways and means to improve the financial performance of these very companies by effecting organizational changes, cost cutting and strategic acquisitions (consulting).

Over a period of time it became obvious for accounting firms that their consulting divisions were far more profitable - by a factor of 10 times or so - compared to the drudgery and resource intensiveness of auditing.

Boring middle-aged men wearing glasses they may have been, but accountants were also numerate enough to work out which way to lean between auditing and consulting practices; and whenever a conflict presented inevitably due to little details on the auditing side, they chose to side with the strategically more profitable consulting division, thereby allowing financial scandals to slowly fester under their very noses.

It was thus that when the scandals broke loose various regulatory agencies and social grandees gathered up the pitchforks and attempted to set right the conflicts of the accounting department.

That in effect meant that auditors, instead of standing on the sides and providing a watchful eye on proceedings at companies, themselves became part of the action. An analogy would be for a football (soccer) referee to start playing for one of the teams right in the middle of the game, even as he attempted to call off-sides and dish out yellow cards for foul tackles along the way. Conflicts of interest are much worse in the world outside sport, but are unfortunately not as easy to spot.

The new accountants
What accounts for the volatility in markets for the past few days, barely a few weeks after central bankers claimed to have created enough impetus for an economic recovery globally? At the heart of the volatility is the market's fear about central bankers becoming sportsmen rather than staying as regulators of the system.

Specifically, the fear is that both the Federal Reserve and the European Central Bank have abrogated their responsibilities towards monetary policy and are instead fully political arms of their respective member governments.

Consider the Federal Reserve: two massive injections of quantitative easing (QE and QE2) aside, the Fed has also been active in providing easy liquidity to both US banks and European banks that need US dollar funding.

By far the biggest one though is the man I called the "master of illusion" (see
Draghi: Europe's master of illusion, Asia Times Online, January 21, 2012), and referred to (albeit tongue in cheek) as the Man of the Year 2012 in January itself. The reason for that bit of irritation with Maro Draghi, president of the European Central Bank since last November, was of course the idea that instead of serving as a central banker he had become a full-fledged market participant himself.

Consider the famous "LTRO" or Long-Term Repo Operations that the ECB took up. These were essentially below-market rate loans to European banks (and a host of non-euro area banks that bothered to have convenient branches inside the eurozone) against secured collateral. The trade worked for a bank as follows:
  • Buy three-year local government bonds yielding say 5% (Italian and Spanish banks could easily achieve this earlier in the year thanks to the sovereign bond crisis at the time).
  • Take the securities over to the ECB, which would lend you money for three years at say 1%.
  • Banks would then post 4% profit on the deal for the three years.

    This is pure arbitrage - and that is how the markets saw it. With a capital gap of over US$150 billion, according to the European Banking Authority (EBA), in effect the granting of around $1 trillion by the ECB in two tranches (the first in December and the second in February) provided European banks with "guaranteed" profits of over $40 billion annually for three years, ie a net benefit of $120 billion. So, European capital problem solved and off to the races we go: at least that was the market's opinion in January, which is why we had a great stonking global risk asset rally in the first quarter of the year.

    Except when stuff doesn't actually follow the script: the problem with the referee also doubling as the center forward (going back to my soccer analogy) is that sometimes they get tackled by the opposing center forward and then can hardly get up, dust themselves off and flash a yellow card. Not that notions of propriety ever stopped central bankers, as Exhibit A: the Swiss National Bank and its duffer-style peg of the Swiss franc to the euro at 1.20 shows; the existence of such a rate simply invites market participants to keep kicking it and so they have with the level being penetrated this week.

    In Exhibit B, the problem with the LTRO for European banks is of course that in order to make the extra money that boosts their capital, banks have purchased the debt of risky European governments. Its not a problem if you purchase bonds of France of Germany, but then there isn't much money to be made between the yields of French and German government bonds against the borrowing rate from the ECB.

    Thus the ECB action essentially pushed a lot of European banks to purchase the debt issued by the likes of Italy, Spain and Portugal, accounting for the strong performance of the bonds of these countries even as the Greek sovereign bond tragedy worked its way through the markets in the first quarter of this year.

    That is where the ECB fails as the central bank - instead of being on hand to protect the stability of the banking system it supposedly has responsibility for ultimately, the central bank has instead emerged as a gambler of last resort, pushing banks to take on irresponsible risks for short-term benefits.

    The risk for unsecured creditors - for example holders of senior bank debt - has increased as a result of ECB actions because any losses on government bond holdings will not affect the ECB (as a secured creditor) but rather hit bondholders and equity holders.

    Thus, the quality of capital provided by central bank actions has been exceptionally poor; and this is the "foundation of tofu" on which global risk assets today find themselves resting on.

    People of the American persuasion shouldn't exactly feel smug about any of the above. If anything, the Fed has been a worse culprit for the past three years by taking a series of actions intended to preserve the fake valuations rampant across mortgage-backed securities in the books of US banks.

    Indeed, it was actions such as TARP that helped to ramp up the staffing levels of US banks after 2009 with the resulting round of firings in 2011 and this year heaping significant restructuring costs on their operations.

    It is with some irony therefore that I note the outlook for financial system stability in both the US and Europe is seriously clouded by the bankers' strategies resulting from central bank initiatives. I believe that the case for gold as a hedge against global financial system collapse has been vastly strengthened by the actions of the Fed and the ECB over the past few months....

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