Thursday, September 27, 2012

Commodity Prices Will Rise

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

             There is not enough money being invested in energy to hold prices at current levels. It costs a bundle to replace depleted sources of oil and gas. The justification for increasing exploration budgets is hard to come by when countries are (effectively) nationalizing companies' projects. There is also the problem of actual production not meeting anticipated levels. And the matter - not, by any means, confined to a single industry or country - of companies not investing at all, terrorized as they are by our stark, raving, mad monetary policy.

            Andy Lees, proprietor of AML Macro Ltd., has warned the sky is falling for some time, to little avail. Two years ago, in "How to Look for a Job," I cited Andy's projection that the cost of energy will increase from 5% of the world's GDP to 16% of its GDP. Since then, investment has continued to flow into fun and finance, so both the jobs and financial resources needed to replace energy, at least in equal measure to that consumed, have probably expanded. (Fun and finance make a riveting partnership. From the September 25, 2012, Financial Times: "Wall Street financial engineers have devised... an index to add financial instruments that do not exist." This is where the nation's investment is going.)

            A sampler:

Replacing oil and gas deposits demands new capital investment. Exxon plans to spend $37 billion on exploration during 2012. Exxon's oil and gas production fell 5.5% in the first half of the year. Its earnings in the second quarter of 2012 were less than one-half of those in the second quarter 2011. Some of this was due to lower natural gas prices. Ergo, gas prices will rise.

Reuters reports Exxon's costs of exploration are soaring. The weighted price of goods sold is falling. Exxon will cancel exploration. In fact, Exxon decided to forego two of its six Polish shale-gas concessions on September 20, 2012.

This is not much in a $37 billion investment budget, but the burden of costs goes on and on. Quoting myself from 2007: "Cambridge Energy Research Associates (CERA) estimated the worldwide cost to produce oil and natural gas (labor and equipment) had risen 53% since 2004. In some cases the rising costs have led producers to scrap exploration. Exxon estimated the cost of building a gas-to-liquids plant in Qatar at $3 billion in 2004. Current estimates having risen to $18 billion. The joint project of Exxon and Qatar has been dropped." If anyone has seen a recent CERA cost index, please pass it along.

Exxon, of course, is not the only frustrated driller. Quoting Andy Lees from September 20, 2012: "Highlighting the difficulties of Arctic drilling, Royal Dutch Shell announced that it has abandoned any hope of striking oil this year after the ice moved in. Last week it was forced to unhook its drilling vessel from anchors holding it to a drill site just one day after it started drilling the first hole in the Chukchi seabed. Shell's activities in the Beaufort Sea have been hit by similar issues which have also meant they have yet to get a drill bit into the seabed. The remoteness, the extreme cold, the threat from ice crushing equipment and the shortened season makes the economics shaky. "The Arctic has a high cost of supply and it is going to take a high oil price to keep it competitive until we can drive down the costs" according to ConocoPhilips. Gazprom has also been reported to have shelved the development of the Shtokman gas field in the Arctic because of surging costs. There were also reports that natural gas bearing rock had been found off the Falkland Islands in the South Atlantic raising the possibility of the most remote LNG plant in the world being built if sufficient further gas reserves are found. Whether it is depths, distances, temperatures or darkness, the environments we have to work in are getting more and more extreme to maintain supplies."

There seems to be a consistent tendency for energy exploration projections to come up short. In 2006, Canadian tar sands production was expected to rise from one million barrels per day to 2.8 million bpd in 2012. Output has only risen to 1.6 million bpd. Another example is the large Azeri-Chirag-Gunashil oil field in Azerbaijan. After a new leg of investment was completed in 2008, production was expected to reach 1 million barrels per day (bpd). It peaked in 2010 at 823,000 bpd, averaged 684,000 bpd in the first half of 2012, and is declining at a rate of 10% a year.

            All the while, the world's economy is slowing down yet costs are rising. FedEx "an economic bellwether as operator of the world's largest cargo airline, reduced its profit outlook for the second time this year, citing a slower economy." (September 20, 2012) Fred Smith, chief executive officer of the company, said: "Exports around the world have contracted and the policy choices in Europe, the U.S. and China are having an effect on global trade." [Not a good one. My italics. - FJS] Within a day, FedEx announced it is increasing shipping rates an average of 5.9% on January 1, 2013.

            The destructive central-banking distortions retard useful investment. This is not an environment in which companies make long-term, capital-investment commitments. Instead, the Federal Reserve has placed a bid under the asset-backed securitization complex in its latest QEEEEEEE. The tapeworms did not need encouragement. International Financing Review reported on September 15: "The US structured-credit market exploded with issuance in the past week, as 24 transactions across ABS, RMBS, CMBS, and CLOs sent investors into a feeding frenzy....Twelve ABS transactions, mostly auto-related (including three sub-prime auto deals), were marketed to investors, with several achieving impressive over-subscription levels and the tightest spreads in five years." On September 7, 2012, Bloomberg posted a headline: "Goldman Sachs, Citigroup Lead CMBS Sales in Most Deals Since '07." We need go no further.

The latest round of quantitative easing flows to Wall Street and feeds anxious hopes of a housing recovery. That will not happen. Prices still have along way to fall, although, in the meantime the perversions are straight out of 2007. From the September 19, 2012, Wall Street Journal: "HENDERSON, Nev.-The latest sign that the housing market is bubbling to life: The artificial waterfall at the entryway to Lake Las Vegas is again flowing. Few developments were hit harder in the real estate crash than this mixed-use project in the desert 20 miles southeast of Las Vegas. While overbuilding caused Las Vegas to collapse during the housing crash, Lake Las Vegas was hit even harder. At the height of the city's foreclosure crisis, one in every 45 homes received a foreclosure filing, compared with one in every 13 in Lake Las Vegas. .... Hedge-fund manager John Paulson's Real Estate Private Equity Group recently snapped up 530 acres of developable land in Lake Las Vegas for $17 million in cash from lenders.... During a visit earlier this summer, business was brisk at a Ravella hotel bar which has Tuscan-inspired views of manicured hedges surrounding a fire pit, with customers sipping martinis and noshing on pappardelle with veal meatballs."

            To quote the greatest perversion of 2007, celebrated former Federal Reserve Chairman Alan Greenspan offered fin-de-siecle advice in May of that year: "Enjoy it while it lasts." 

Friday, September 21, 2012

A Round Trip

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The dedicated resuscitators of the Federal Reserve are doomed to lose their battle with sanity, akin to Alexander Scriabin's fate in search of the lost chord. Chairman Ben S. Bernanke has not a clue where this will end. Our doleful fate is leading staunch establishmentarians to sink the Fed.

A group of worthies tacked a manifesto to the September 17, 2012, Wall Street Journal editorial page. The five authors are insiders; insiders being those who created and benefited from the false economic structure compounded over the past four decades. "J'accuse" should have been the title under which they charged the Federal Reserve with committing every crime under the sun.

            Before reviewing the convolutions and unaccountable chaos created by the Bernanke Fed, it is worth looking at the simplicity of the original Federal Reserve System. An above average tenth-grade student of 1913 could have understood how the Federal Reserve functioned. That being so, if the newly formed central banking system had stuck to the founders' intentions, we would not be suffering a pusillanimous satrap such as Ben Bernanke hurtling the Fed, and more importantly, the rest of us, off a cliff.

The principles upon which the central bank was founded have been jettisoned. Few know this. Students who attended Chairman Bernanke's "Origins and Mission of the Federal Reserve" lecture at George Washington University in March 2012 are still in the dark. Rereading the Chairman's lecture, he pings, pongs, and drifts in such a haphazard fashion that his knowledge of Origins and Missions remains a mystery. Once again, it is striking how little he knows - about anything.

H. Parker Willis was more than a scribe and less than the author of the Federal Reserve Act. Carter Glass, Senator from Virginia, had the vision. Willis understood the nuts-and-bolts of central banking.

            Willis was a professor of economics (Washington & Lee, Columbia University) fully versed in the English banking school, including the "real bills" monetary doctrine. The Federal Reserve Act (signed by President Wilson on December 23, 1913) authorized the Federal Reserve System to accept "real bills" from banks. Government securities were not acceptable.

The original process by which the Fed operated with banks worked as follows: An industrial or commercial concern asked its local bank for a loan. The loan was backed by short-term, fixed-maturity payments to be received by the Company (the aforementioned "industrial or commercial concern"). We will assume the payment is due in 30 days. At that point, the Company pays off the commercial loan - "commercial paper" - to its local bank. The Company is able to do so from the payments for goods it received from its customers: Real Bills for Real Goods.

On day five (of the 30-day period), the local bank needs cash. Perhaps there is a bank run, or more probably, some incident or whim of less interest to us. A guiding light before the formation of the Federal Reserve System was to provide cash to banks in such instances as a bank run.

The local bank - a commercial bank - presents the commercial paper to the Federal Reserve. (This would have been one of the 12 district banks, which operated quite independently at the beginning.) The Fed "rediscounts" the commercial paper and lends money to the local bank. The Fed holds the paper (and can demand payment from the Company's customers should the company fail.) The loan from the Fed will be repaid by the local bank when the commercial paper matures.

The commercial bank's nervous customers (during a bank run) see that the Federal Reserve is meeting the demands of any and all bank customers (depositors). The fearful customers dismiss concerns of their money being housed in a fractional-reserve operation, and depart the recently mutinous bank lobby without withdrawing their accounts. Again, it was the intention of the Federal Reserve founders to offer bank customers this assurance. The assurance was fortified knowing the Federal Reserve's balance sheet was limited to such short-term, self-liquidating loans that were backed by Real Goods.

The Federal Reserve was to be a non-inflationary central bank. In fact, all central banks were non-inflationary (over periods of time) in 1913. "Price stability" did not need to be defined. Our ancestors of 1913 would not have been able to comprehend a banker, an economist, a public servant: that is, serving the public, who would announce "price stability" means 2% inflation. (Nor comprehend that when 2% is no help "we'll-make it-4%-then-8%-then-12%." Adam Posen at the Bank of England has rolled out the 12% possibility.)

It was non-inflationary because the credit extended by the commercial bank matched the level of business in the economy. This was a fairly simple business.

In the December 1915 Political Science Quarterly, Willis published "The First Year of the New Banking System." Being a professor, he could not abstain from instructing his readers: "Under the provisions of the Federal Reserve Act it is required that loans be made upon paper protected by warehouse receipts, and such provisions have been made by the Board in the circular relating to commodity paper (Circular No. 17, Series of 1915)." Government bonds need not apply.

World War I disrupted this arrangement. The Great War also deranged the world's financial system when it was found necessary to decapitate the International Gold Standard. As mentioned above, in 1913, none of the world's central banks were inflation-producing operations. Since 1914, not a single central bank has accomplished much else.

The fledgling Federal Reserve did what it was told to support the doughboys. The Fed's Annual Report of 1918 noted the institution's "duty to cooperate unreservedly with the government [i.e., the Treasury] to provide funds needed for the war." Duty bound, the Fed was a full-fledged participant in the U.S. Treasury war-bond market.

In the June 1920 issue of Proceedings of the Academy of Political Science in the City of New York, Willis discussed "The Federal Reserve and Inflation." The professor admitted the Federal Reserve System had diverged from its original purpose "as a system for the accommodation of business and for the discounting of paper of fixed maturity growing out of industrial, commercial, and agricultural operations." At that moment the Federal Reserve "was carrying in its portfolios about $1,500,000,000 of so-called war paper."

The only question to Willis, in his 1920 paper, was when and how the Fed would divest itself of war paper, otherwise known as government securities. He hardly needed to say why, but, being a professor, mentioned "in so far as the Federal Reserve banks continue to retain this volume of paper in their portfolios, they would be contributing to the maintenance of inflation and would be aiding to sustain the existing level [of inflated - FJS] prices." Another problem was holding "loans on non-liquid security [that is loans not backed by the liquidation of industrial, commercial, or agricultural inventory: the security of which beat war paper any day - FJS], including Government bonds and other obligations." Note that government bonds were not liquid. Their composition and properties are far inferior to the short-term, self-liquidating commercial paper.

Professor Willis attempted to resurrect the old religion when he wrote The Theory and Practice of Central Banking in 1936. This was the same year John Maynard Keynes's General Theory of Employment, Interest, and Money was published. Professor Willis (a native of Weymouth, Massachusetts and son of suffragist Olympia Brown) dropped dead in 1937. This may have been caused by a broken heart after Keynes's tome won the beauty contest, but confirmation requires further research.

The world has changed. Economics professors have concocted a theory that hinges on government bonds being "risk-free." The risk-free professors handed each other medals and entered astonishingly lucrative consulting and publishing arrangements. The gist of their so-called theory has anchored every pension plan, endowment, and financial adviser's risk-return selection model. The consequences continue to unfold. (See: "It's Over" and "Scarlett O'hara's Risk-Free Rate.")

Even today, with European sovereigns beyond hope of borrowing in an unrigged market, the academic grip remains. As for the United States risk-free premise, it will turn to "risk-fraught" when the Federal Reserve is no longer permitted to own U.S. Treasury securities. That day will come. H. Parker Willis will be vindicated.

The September 17, 2012, edition of the Wall Street Journal, unleashed "The Magnitude of the Mess We're In," by authors George P. Shultz, Michael J. Boskin, John F. Cogan, Allan H. Meltzer and John B. Taylor.
The rebels opened: "Sometimes a few facts tell important stories. The American economy now is full of facts that tell stories that you really don't want, but need, to hear."
Among the ugly truths (and I'm only addressing a small number within their lengthy list), Schultz & Co. ask: "Did you know that the Federal Reserve is now giving money to banks, effectively circumventing the appropriations process?" In other words, if money is to be given by the government to an industry, this is a decision of Congress, not the Executive, not the Supreme Court, and certainly not a panel of bureaucrats. Of course, it is Congress's duty to retain control of its own responsibilities. Congress is negligent in not taking administrative or legal action to prevent the Federal Reserve from acting outside the law.
Another unwanted, but important story: "The Consumer Financial Protection Bureau is also being financed by the Federal Reserve rather than by appropriations, severing the checks and balances needed for good government." This only hints at the much larger intrusion by the Fed. It has no budget. It can buy whatever and whomever it wants. The Schutzstaffel never had such latitude.

On we go: "And the Fed's Operation Twist, buying long-term and selling short-term debt, is substituting for the Treasury's traditional debt management." U.S. Treasury Secretary Timothy Geithner holds responsibility for managing the nation's debt. It is his duty to midwife the structure of U.S. debt securities. A few years ago, a Treasury Secretary stopped issuing 30-year bonds. After a bit, a different Treasury Secretary decided to issue 30-year bonds again. Whether either decision was good or bad is not the point. The Treasury Department, within the United States' government's Executive Branch, controls the structure of U.S. Treasury securities. The Federal Reserve has no business treating the size of the two- and ten-year Treasury market like an accordion for testing failed theories.

The conflict of using the Federal Reserve balance sheet as custodian of U.S. Treasury securities is apparent: "Did you know that annual spending by the federal government now exceeds the 2007 level by about $1 trillion? [R]evenues are little changed. The result is an unprecedented string of federal budget deficits, $1.4 trillion in 2009, $1.3 trillion in 2010, $1.3 trillion in 2011, and another $1.2 trillion on the way this year."

            The latest Monthly Treasury Statement shows $179 billion of Receipts in August 2012 and $369 billion of Outlays: inflows of 48 cents for every $1.00 spent. August either signals a disintegrating trend or was an off month. Over the first 11 months of this fiscal year (October 2011 through August 2012), the Treasury Department received 65 cents for every one dollar spent. Really now, how can the credit agencies still call the United States a AAA or even AA credit?
The Federal Reserve's forays into fiscal policy destroy its "apolitical" claims. On August 31, 2012, Chairman Bernanke told legislators how to construct budgets: "It is critical that fiscal policymakers put in place a credible plan that sets the federal budget on a sustainable trajectory in the medium and longer runs. However, policymakers should take care to avoid a sharp near-term fiscal contraction that could endanger the recovery." Again, these escapades are not only Bernanke's fault; it is Congress's job to shove a rag in his mouth.

In a practical sense, the Fed now plays a critical role in the nation's fiscal incontinence. If not for the Federal Reserve's day-in and day-out purchases of Treasury securities, the Federal government would be firing every other worker (using the simplifying projection of 48 cents of receipts for every dollar spent). It is not the Fed's job to finance salaries and departments. Schultz, remind us: "Did you know that, during the last fiscal year, around three-quarters of the deficit was financed by the Federal Reserve? Foreign governments accounted for most of the rest, as American citizens' and institutions' purchases and sales netted to about zero. The Fed now owns one in six dollars of the national debt, the largest percentage of GDP in history, larger than even at the end of World War II."

            No one pretends the federal government will ever pay down its current debt, of which the Fed may soon be the sole net purchaser. The accounts of Japan and China are turning over (see  "Peak Imbalances Are Falling") and will probably soon be consistently (rather than occasionally) net sellers of Treasury securities.

Simple Ben has announced open-ended buying of any-and-all securities, forever. He is bidding for mortgages. Next week, it could be pawn-shop loans. He, and the Fed, will be retired at some unknown date. Copies of the The Theory and Practice of Central Banking will be in every school child's hands and the General Theory will broil on the bonfire of insanity. 

Friday, September 14, 2012

No Limits

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

            The European Central Bank's latest maneuvers jettison limits to the expansion of its balance sheet. The ECB's manner of improvisation is reminiscent of Federal Reserve Chairman Ben S. Bernanke's dismissal of legal restrictions in 2008, when Bernanke talked his way around the law before pliant, ignorant, and frightened politicians.

European Central Bank President Mario Draghi's abandonment of monetary restrictions would be, in due time, an incitement to unlimited price inflation. This is also true for the United States. However, practical matters (discussed below) will restrict this central bankers' nirvana. After watching how swiftly opposition to the ECB's latest decrees melted away, Ben Bernanke may feel reassurance of his freedom to roam. However, he too can only go so far. Maybe he'll be stoned to death.
So, buy gold, silver, and gold and silver stocks.

It was not just Alan Greenspan. Now, central bankers the world round draw greater devotion than Britney Spears (who, according to Forbes magazine's 2012 rating, is the world's sixth most powerful celebrity, demonstrating once again that no matter how egregiously these mystical abstractions behave, they can do no wrong). On September 6, 2012, "Mario Draghi's press conference was covered as if it were a soccer match. We are told that all across Europe shop stalls and bistros had TVs showing his presentation," reported Art Cashin at UBS. (Cashin's Comments, September 7, 2012). Comparisons with the waning of the middle ages are apt.

            The European Central Bank president, wearing an "immaculately tailored dark suit," delivered an address that left no doubt he will do whatever it takes to preserve the euro. "I am what I am," Draghi warned his Frankfurt audience, which was sitting (and possibly shaking) within a stone's throw of the Bundesbank.

            Draghi's announced a new acronym OMT, (Outright Monetary Transactions). Henceforth, the ECB will buy unlimited quantities of "sovereign bonds in the euro area." In the not-too-distant future, the betting line here is an expansion beyond sovereign bonds, to suit an unknown (as this is written) but a greater crisis. Draghi's declarations on September 6 addressed the current meltdown of falling European sovereign bond prices - particularly those issued by Spain and Italy. Yields are rising and buyers at auctions are disappearing, so the ECB will buy and hold yields below an unstated ceiling.

            This objective is clearly outside the ECB's sole mandate to maintain price stability. Draghi's description of how his actions are consistent with the ECB's function is a monument to bureaucratic malfeasance. His rationale of the compatibility between unlimited money printing and price stability was explained in a three-step syllogism: [Step 1:] "We aim to preserve the singleness of our monetary policy and to ensure the proper transmission of our policy stance." [Step 2:] "OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro." [Step 3:] "Hence, under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area." [My italics. - FJS] If the Greeks were in a surplus position, they might tutor Draghi on his misconstruction of logic.
Draghi let his audience know there will be no expansion of the money supply. If this is so, inflationary tendencies from his newest initiatives will be second-order consequences. The press release from the ECB that accompanied Draghi's speech states: "STERILIZATION: The liquidity created through Outright Monetary Transactions will be sterilized." That is the full statement. The ECB established an airtight condition: For every sovereign bond the ECB takes in-house, it will sell a bond of equal price.
This being true, the ECB's buying operations are not unlimited. But hark! Draghi squirmed out. The September 7, 2012, Grant's Interest Rate Observer reports Draghi told euro zone officials if the debt matures within three years, it does not "constitute the act of monetarily financing a government."

The importance here is not so much the specific ukase, but that by Draghi stating such, it is so. Flipping through October 2008 archives is a reminder of expedient decrees in the United States. In the here and now, the ECB can do what it wants on the fly: so watch out. For instance, no private bondholder - pension fund, insurance company, hedge fund - should accept Draghi's word that it holds equal footing with the ECB in a sovereign workout.

Back to the specific "three-year rule," it is a short step for the ECB to declare (since the purchase of these particular sovereign bonds does not constitute the purchase of a sovereign bond) the requirement to sterilize Outright Monetary Transactions of three-and-under bonds does not apply. And, even if the ECB attempts to live by its promise of sterilization, the poor quality of its balance sheet will restrict such operations. There will be no buyers for the unspeakable trash it is hiding.

At the press conference, Draghi once again loosened the ECB's requirements of what constitutes acceptable collateral. At this stage, it would be more helpful to produce a summary of what is not acceptable: a very short or non-existent list. Here lies the greatest problem of all, that of trust. European banks already restrict their overnight lending to the ECB. If they decide the solvency of the European Central Bank is untrustworthy, the ECB, Fed, Bank of England, and Swiss National Bank may fall like toy ducks in a shooting gallery.

In any event, Mario Draghi has put the ECB in a position of no return. He must now "do whatever it takes," meaning engage in "unlimited" purchases, or he, and the euro, will lose all credibility. In 1957, Federal Reserve Chairman William McChesney Martin found himself in the same position. The U.S. Senate lobbied the Federal Reserve to cap interest rates. Should it accept the mission, Martin's Fed would buy U.S. Treasury bonds with newly created Federal Reserve notes and institute a ceiling on rates. Martin knew better. He told the U.S. Senate Committee on Finance, on August 13, 1957:

"It has been suggested, from time to time, that the Federal Reserve System could relieve current pressures in money and capital markets without, at the same time, contributing to inflationary pressures. These suggestions usually involve Federal Reserve support of the Unites States Government securities market through one form or another of pegging operations. There is no way for the Federal Reserve System to peg the price of Government bonds at any given level unless it stands ready to buy all of the bonds offered to it at that price. This process inevitably provides additional funds for the banking system, permits the expansion of loans and investments and a comparable increase in the money supply - a process sometimes referred to as monetization of the public debt. This amount of inflationary force generated by such a policy depends to some extent upon the demand pressures in the market at the time. It would be dangerously inflationary under conditions that prevail today. In the present circumstances the Reserve System could not peg the government securities without, at the same time, igniting explosive inflationary fuel."  

Martin was unschooled in economics. He made it through life with only a baccalaureate degree, in English and Latin. 

Friday, September 7, 2012

Over and Out

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

           A collapsing order will do what it takes to retain power, no matter its abuse of law or decency. Writing in Die Zeit on August 29, 2012, European Central Bank president Mario Draghi wrote (in German): "[I]t should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens. This may at times require exceptional measures. But this is our responsibility as the central bank of the euro area as a whole."

            Dropping the dead fish on Berlin, Draghi reminded Germans he is not a man to be messed with. That is why he was awarded the presidency of the ECB at such a desperate moment. On July 26, 2012, Draghi pledged: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

            "Within our mandate" is defined by Draghi. He lifts restrictions on ECB legal authority at a moment's notice. This is exactly as the bureaucrats prefer. The sinecures in Brussels will be selling dead fish rather than dining on prawns and apricot soufflĂ© at Comme Chez Soi if Draghi fails. Europeans and foreigners with securities invested in European markets should consider the possibility of confiscation or lengthy sequestration.

            European leaders, on the whole, will not object to shutting markets. Some obvious difficulties will arise, but the alternative - a trip to the guillotine - is more unattractive. The leaders are ignorant of the functioning of markets so it is a small matter to shut them. They regard markets solely as instruments of their policies: raise or lower taxes, save or shelve the national airline, raise or lower stock markets. Federal Reserve Chairman Ben Bernanke employs this mode of thinking. He reminded his guests of his fatuous pretensions at Jackson Hole, Wyoming, on August 31, 2012. Praising himself for the Fed's buying of market assets, Bernanke preened: "[Asset purchases] have boosted stock prices.... [I]t is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC's decision to greatly expand securities purchases. This effect is potentially important because stock values affect both consumption and investment decisions." There is no evidence to support his boost-the-economy contention, yet, Simple Ben contended: "Econometric....[m]odel simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy." He really believes these models, which produce the results he predetermined. Similarities to the final, paranoid proclamations of superiority by the Kremlin are obvious.

            Whether one prefers Mario Draghi's brass knuckles or Ben Bernanke's harebrained approach to playing puppeteer of the masses (both received economics Ph.D's at M.I.T.; both theses under the tutelage of Nobel prize winner Robert Sobel), it should not be forgotten those in charge fully support such expedients. Sarkozy, now Hollande, Merkel, and Obama have aggressively pursued criminals who engage in markets. No, not Jon Corzine, but the widows and orphans who find it difficult to eat on zero-percent interest rates.

Aside from Draghi's warning that he will crush anyone in his path, Germany's position, as backstop to the euro is important and it is clear Germany will not protect property rights. On May 19, 2010, "German Chancellor Angela Merkel laid out proposals to gain control over 'destructive' financial markets, after she imposed a unilateral ban on naked short-selling that sent stocks sliding.... 'The lack of rules and limits can make behavior in financial markets driven purely by the profit motive destructive and lead to an existential threat to financial stability in Europe and even the world,' Merkel told lawmakers in Berlin today. 'The market alone won't correct these mistakes.'" (Bloomberg)

Merkel's attack on naked short-selling deserves a sympathetic ear or two (though, the actions taken, and others threatened, were designed to crush a larger carrier battle group), but the Chancellor is prone to think closing markets will solve the euro's troubles. The Happy Dreadnaught's public statements betray no reservations about shutting markets. On January 16, 2012, S&P downgraded the EFSF from AAA to AA+. On the same day, the Financial Times reported: "Ms Merkel said she would consider calls from her party colleagues for legislation to bar institutional clients such as insurance companies from selling bonds when ratings were downgraded, or fell below investment grade." Presumably, the cohort in question were European, including German, insurance companies. When the time comes, protestations by Fidelity or Goldman Sachs are unlikely to open markets.

Merkel was thwarted in this effort, which would have caused untold havoc. In their corner of the world, insurance companies prevented from selling bonds when their price was falling would have seen prices of insurance-company stocks, bonds, credit-default swaps, and insurance policies sinking to previously unplumbed depths.

January, 2012, turned out not to be the proverbial Armageddon that looked so dire on January 16. The reckoning has been delayed but not solved by eurocrats who have done so by preventing market discovery of real prices. Such repugnant acts as proclaiming the European Central Bank senior creditor (above private bond holders) betrays a willingness to substitute vocabulary for legal rights.

Other subterfuges to deceive the public fall under the heading of manipulating markets to jam their failed policy down Europeans' throats. In August, PriceWaterhouseCoopers reported non-performing loans at European banks have doubled since 2008, to over $1 trillion worth. Very little of that amount has been written down. Capital as well as collateral at European banks is a joke. That includes commercial banks, national central banks, and the European Central bank. The latter's portfolio is quite weak since it bought assets that even the eurocrats would not permit to be pledged as collateral. Interbank overnight lending operates through the ECB since the banks no longer trust each other. Why they hold the ECB in high regard is only by the latent trust in central banks, since the ECB balance sheet has so deteriorated. (Adding to the perplexity of today's financial discussion is the angst about Libor when its existence as the interbank rate is extinct.)

The blatant dishonesty in European finance may be even worse than the Paulson-Geithner-Bernanke model across the ocean. European banks did not recapitalize to the same degree as U.S. banks after 2008. Yet, their practices and leverage were as aggressive. In the boom, larger European banks met capital adequacy requirements by purchasing credit-default swaps (CDS) on collateralized-debt obligations (CDO) sold by AIG. That was reported in the fall of 2008. Like so much else that went awry, the consequences seem to have evaporated in the mist.

Only to reappear. A parallel to the CDS-CDO-AIG nonsense is the current minefield of a Greek default. To pretend they are still solvent institutions, European banks have written (that is: the bank is the insurer) of credit-default swaps on Greek sovereign debt. (Not to be forgotten is the North American banks - yes, Canadian banks are none too sturdy - that have written CDS on European sovereign debt. American banks have shredded this risk, but what remains? CDS can be traded, bundled - oh, you know the hopelessness of bank balance sheets today.)

The deceptions run wide and deep - more evidence of the dysfunctional European financial system. Europe seems to have bettered Americans at cumulative weirdness. A personal favorite, from Bloomberg, August 30, 2007: "Landesbank Sachsen Girozentrale, the German state-owned bank ravaged by investments in U.S. subprime mortgages, had 'secret' investments of up to 46 billion euros ($63 billion), Sueddeutsche Zeitung said, citing Saxony's government finance committee. In addition to off-balance sheet investments in Dublin, SachsenLB also created so-called conduits in Leipzig in 2003 under the code name 'Dublin II,' the newspaper said...." Secret Squirrel never had this much fun.

In fact, the Landesbanken stench floated to Ireland via Hypo Real Estate where its Irish subsidiary, Depfa Bank, is hiding (the following is a conglomeration of estimates) between $1 to $3 trillion (with a 't') of trade receivables that are over 270 days past due. These dead loans (over-270-days-past-due are not repaid) were somehow plucked from European banks. This is one more layer in the dissolving European Project that will receive its day of reckoning.

Those who hold European securities (U.S. money-market funds were large investors) own (to what degree is it "ownership"?) paper floating in a sea of chaos. As the financial institutional framework cracks, the informal - and, non-taxpaying - economy replaces it. The Mafia is now Italy's biggest 'bank,' according to James Mackenzie at Reuters. Mackenzie reported this non-bank bank is "squeezing the life out of thousands of small firms.....Organized crime now generated annual turnover of about 140 billion euros ($178.89 billion) and profits of more than 100 billion euros," which equals 7 percent of Italy's national output. Here we see the legitimacy of the eurocrats as well as local government authority flickering before the final gale.
The Troika (European Union, or, more particularly, European Commission, ECB and IMF) has thus far forestalled panic in the markets by changing rules, a process that has degenerated as the preventive measures grow more desperate. We are closing on a day when non-government investors, as well as the masses, say: "Enough." With any luck, that will be ahead of a general sequestering of their assets.

Tracing the deterioration of collateral is an avenue to clarity. From Bloomberg on June 25, 2012: "Residential mortgage backed-securities and loans to small and medium-sized enterprises rated at least BBB- by Standard & Poor's will now be accepted with a valuation haircut of 26 percent.... In the case that the ECB Governing Council [approves] this, 'it would reduce the widely criticized influence of Standard and Poor's, Moody's and Fitch,' one euro zone central bank source who spoke on condition of anonymity said. 'On the other hand, this could also expand the shrinking pool of collateral which banks in troubled countries have available.' The ECB declined to comment." This story is a prime instance of institutional confusion. First, "the ECB declined to comment," yet a "euro zone central bank source" was extensively quoted. Where does he work? In the ECB's pâtisserie? Second, as much as the rating agencies are widely criticized, the obvious ploy to include dead-fish securities as proper collateral makes a sham of the ECB.

The trustworthiness of collateral can only be manipulated so far. It is a point of observation in human inertia that trust has not already been extinguished, but, it required a trigger with Bear Stearns and Lehman Brothers.

A few more changes to acceptable collateral that were publicly announced and duly reported:

(Bloomberg, June 28, 2012): "ECB to accept certain mortgage-backed securities, car loans... leasing, consumer finance-backed securities, as collateral. Measure to come into effect when adopted in legal act June 28."

Andy Lees (AML Macro Ltd.), July 31, 2012: The ECB is considering unsecured bank debt as collateral.

Bill King (The King Report) wrote on June 20, 2012: "The EU put on its clown shoes and stated that it would no longer use rating services and would issue its own ratings."

June 22, 2012: Not to be outdone, IMF synchronized swimming champion Christine Lagarde put on her clown shoes, whinnying "for the ECB to be more inventive" in aiding the eurozone to beat the debt crisis. The currency union needs a "creative and inventive" monetary policy." This criticism was uncalled for. The Draghi ECB may lack many attributes, but creativeness and inventiveness are its forte.

There is a limit. However much investors are willing to accept the EU clown court, after the solvency of a financial institution is past slavation, heroes are not rewarded for tossing a lifeline. Recent examples of vaporizing trust were Bear Stearns and Lehman Brothers. A clearinghouse survives by retaining trust. LCH.Clearnet, the largest clearinghouse in Europe, served notice on June 4, 2012, that it might require additional collateral on Spanish government debt held by banks. On June 20, the clearinghouse raised the margin requirements for Spanish sovereign debt used in short-term funding (repos) from 13.6% to 14.7% on certain maturities (it varies). This looks like a compromise. Clearnet raised the percentage, but not enough to upset the distribution of Spanish bonds. To retain confidence, the clearinghouse may be forced to act decisively, in the not too distant future.

In the not too distant past, LCH.Clearnet announced it would accept unallocated gold as collateral for margin cover purposes (starting on August 28, 2012). The CME announced that it, too, would start accepting gold as collateral for margin requirements on August 28, 2012. Markets are racing back to the nineteenth century faster than central bankers can destroy their credibility in the twenty-first.

Another limit was noted in June by the Bank for International Settlements (the central banker's central bank). The BIS warned of "asset encumbrance," that is, the current need for European banks to pledge so large a portion of assets for collateral is weakening banks' liquidity needs.

These limits are a reason ECB President Mario Draghi has served notice the ECB will decide whether "irrational fears.... require exceptional measures." The world awaits the German Constitutional Court's decision, scheduled for September 12, 2012, of whether Germany can participate in the ESM's (European Stability Mechanism) bailout of countries.

Since Germany is already the "transfer union" of funds to the rest of Europe (TARGET2 - not discussed here), its participation will be fundamental. Draghi muscles opponents into Jimmy Hoffa's locker so may not wait for, or possibly ignore, the court's decision. In any case, the €500 billion ESM (which does not exist) is not large enough to hold Spanish and Italian sovereign bond premiums to a ceiling of 200 basis points above German government bonds. That is only one of the current mandates shouted from the balcony of the Palazzo Venezia and Draghi knows this. Merkel, Monti, and Hollande know it, too. Thus, the hope the ECB will call the non-existent ESM a "bank" to leverage the €500 billion into bank loans. Bank lending to companies in the eurozone has fallen 43% this year, so the wonders of fractional-reserve lending would not seem to apply.

Market participants are heading to the exits. As alluded to above, U.S. money market funds have sold European securities. How much, and how the funds would post a daily price if assets are frozen, are question that lead to a slew of other questions.

Europeans, too, are transferring money. On July 31, 2012, Reuters reported outflows from Spanish banks at €41.3 billion ($50.6 billion) in June and €163 billion from January through May: an accelerating pace. To fill the void, Spain's banks borrowed €50 billion euros from the ECB (that is: Germany) in June, and a total of €204 billion between February and June.

Shell "is cutting back its exposure to European credit risk in the worst-hit economies and putting a higher price on doing business with the region's peripheral nations...[T]he Anglo-Dutch oil major would rather deposit $15bn of cash in non-European assets, such as US Treasuries and US bank accounts." (Daily Telegraph, August 6, 2012) U.S. banks "are telling counterparties and borrowers to restructure contracts or find another bank as they prepare for the potential exit...from the eurozone. Using hedges, such as credit-default swaps [Yikes! - FJS], U.S. banks have reduced their net exposure to troubled eurozone countries. But they are also engaged in more work behind the scenes to ensure that if a country leaves the eurozone they will not have to receive payment in a devalued drachma or peseta." (Financial Times, August 6, 2012) Some companies are "sweep[ing] cash out of euros nightly to reduce foreign-exchange exposure, while others are looking at alternative payments in case customers flee the euro or run out of cash." One company "has been preparing a version of the company's pricing list in pounds...." (Wall Street Journal, August 14, 2012)

The counterattack is mounting. In fact, nationalization of assets has recent precedent. When its banking system collapsed in 2008, the Icelandic government "ring-fenced domestic accounts and shut out international creditors. Iceland's central bank prevented the sell off of krona through capital controls, and new banks were created that were controlled by the state. Then the government and the state-controlled banks agreed that amounts in excess of 110% of home values would be forgiven on mortgages." Iceland is not a euro participant, has a population of 300,000, so did not endure complications that European renegades will face.

A boatload of restrictions on money flows have washed across Europe over the past three years. Many are petty and simply an excuse for bureaucrats to collect a paycheck, but the mandarins in Madrid locked Spaniards in chains in late June (recall the acceleration of money fleeing, above) by instituting a minimum fine of €10,000 for taxpayers who don't report their foreign accounts and the prohibition of cash transactions greater than €2,500 for individuals and firms. Looking at flow data in Spain, this does not seem to have accomplished its goal, but simply reading numbers, without context, can be misleading.

All in all, LCH.Clearnet and the CME are ahead of a mad rush.