Please, click here to read this article in pdf format: february-11-2010

The world is speculating on the outcome of the meeting of European leaders later today, in Brussels. In the meantime, yesterday Mr. Bernanke made clear his intention to raise the discount rate, sooner than later. Furthermore, yesterday also, the 10-yr $25BN US Treasuries auction was weak. It’s true, there were a lot of other problems markets were focused on, including the weather on the east coast, but then again, are Treasuries not supposed to act as a safe haven in times of chaos? We took note of this and of the fact that yields rose in parallel (shift upwards), with the 2y10y curve ending at 281.1bps, flat. We will be watching this market closer as well as its impact on swaps and Agencies, for we feel this may be signaling an upcoming tectonic shift. It’s pure intuition for now, we acknowledge, but sometimes intuition has merits too…

On another note, we continue to insist with the view that Europe is facing an institutional crisis, rather than the short-term liquidity crisis seen by so many mainstream analysts. What is the difference? Here is a defining point:

If the crisis was indeed about short-term liquidity (with long term solvency concerns), then it should not matter whether it is the IMF or the European Union that bails out stressed peripherals. If the problem was only short-term liquidity, form should be subordinated to facts. Yet facts are subordinated to form. It is precisely because nobody seems to be able to come up with a sustainable and acceptable “form”, that we see no facts! (Facts = Risk mitigating actions, like loan guarantees)

If the crisis was only about short-term liquidity also, the Euro should have not been impacted as it has. How measurable is the impact of the liquidity situation in California on the USD? How can therefore Greece have such an impact on the Euro? It is the very sustainability of the European Union that is at the core of this crisis.

Why is this relevant? Because it tells us something: Today, it is likely that no long-term credible path will be announced.

Lastly and related to this crisis too, we want to draw collective attention to an issue that in our view has not received enough consideration. Much has been made and written on financial regulation necessary to prevent financial crisis. We, at “A View from the Trenches” have also written many times that regulation is useless and counterproductive, for the root of the problem is the monetary system that the world is embracing. A central banking system is intrinsically weak, arbitrary and leveraged, and attacking the distributors of a currency (i.e. financial institutions) will not make the system any stronger. However, there are other issues regulators can positively address, which we think have not been addressed yet. One of those is the potentially destructive nature of sovereign credit default swap contracts, which are currently booming.

In our opinion, these swaps are true weapons of mass destruction. Essentially, if a sovereign defaults, the party that bought protection should be compensated for the loss on the corresponding reference securities. But who thinks any counterparty would have enough liquidity to honor these contracts, if say, we see a default in the US or the UK, for instance? What would be the value of billions of credit protection on US sovereign risk sold by Citi or Goldman, if the US defaulted on its debt? What would be the value of credit protection on German sovereign risk sold by Deutsche Bank, if Germany or France actually defaulted? Zero! Given the fiat monetary system we live in, no financial institution would be able to have enough liquidity to fund the increasing margins, even before such defaults are declared, because the value of the collateral denominated in USD or Euros would drop materially, as jump-to-default risk rises. Under such scenario, things would spiral out of control and it would be evident that either central banks end up bailing out both the financial system and the sovereign, triggering a massive hyperinflation in the process, or the biggest of all depressions would be upon us.

Restrictions on this market would be useless, because they would not acknowledge the intrinsically leveraged nature of the contracts. The solution, in our opinion, is that counterparty risk be collateralized with gold, instead of fiat currency, for those sovereigns with the strongest currencies (=the most leverage!).

Martin Sibileau