France & Belgium Front-Run Germany; More Evidence for the Malmgren Hypothesis

The markets went vertical yesterday, after the Financial Times printed an article in the final hour of US trading that suggested Europe was close to a bailout solution for its larger banks. A careful read, however, suggests it confirms more the Malmgren Hypothesis (namely, a German withdrawal from the EU and EMU) than an imminent agreement on the EFSF. From the euphoria-inducing FT (emphasis ours):

EU examines bank rescue plan

By Peter Spiegel and Alex Barker in Luxembourg

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European Union finance ministers are examining ways of co-ordinating recapitalisations of financial institutions after they agreed that additional measures were urgently needed to shore up the region’s banks.

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Although the details of the plan are still under discussion, officials said EU ministers meeting in Luxembourg had concluded that they had not done enough to convince financial markets that Europe’s banks could withstand the current debt crisis.

“There is an increasingly shared view that we need a concerted, co-ordinated approach in Europe while many of the elements are done in the member states,” Olli Rehn, European commissioner for economic affairs, told the Financial Times. “There is a sense of urgency among ministers and we need to move on.”

“Capital positions of European banks must be reinforced to provide additional safety margins and thus reduce uncertainty,” Mr Rehn said. “This should be regarded as an integral part of the EU’s comprehensive strategy to restore confidence and overcome the crisis.”

...

In a sign that European governments were preparing to act, Wolfgang Schäuble, the German finance minister, said Berlin could, if necessary, reactivate support mechanisms it put in place in 2008 to recapitalise the banks. The mechanisms had expired and the German government had until now insisted they were not needed.

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Markets have been unsettled again this week by troubles at Dexia, the Franco-Belgian lender, which holds €3.5bn in Greek bonds and €15bn in Italian bonds and has been struggling to raise enough short-term cash to run its day-to-day operations.

The French and Belgian governments said they would take “all necessary measures” to prop up Dexia.

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Some European officials had hoped to avoid a large-scale effort to shore up eurozone banks until the bloc’s €440bn bail-out fund is formally given powers to recapitalise financial institutions in countries not covered by bail-out programmes.

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But the process of getting the fund new powers has proved slower than expected, with three countries – including Slovakia – yet to approve the EFSF’s overhaul. Because the EU risked being overtaken by events, Mr Rehn said finance ministers meeting in Luxembourg agreed on the need to act through national capitals while co-ordinating their approach.

A first step would likely be to ensure all countries have mechanisms in place to prop up their banks.

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Mr Rehn cautioned that while there was “no formal decision” to begin a Europe-wide effort, co-ordination among EU’s institutions – including the European Central Bank, European Banking Authority and the European Commission – on necessary measures had intensified.

...

The last quoted paragraph's mention of the ECB notwithstanding, we read these developments as a fiscal bailout of the troubled Euro banks, not a monetary one. Meaning, no money printing, more good money being sent after bad, and no bailout of the periphery.

Here are the details of the Dexia bailout by France and Belgium from WSJ Marketbeat blog (via ZeroHedge):

• Franco-Belgian lender Dexia is set to park assets worth in excess of EUR180 billion into a so-called bad bank, a vehicle backed by guarantees from the French and Belgian governments, in an effort to disentangle itself from gripping liquidity strains, people familiar with the matter said Tuesday.
• The bad-bank plan is part of a deeper makeover under which Dexia is considering selling all its core units and which may effectively lead to a dismantling of the lender.
• Under a plan submitted to Dexia’s board on Monday, the bank would ring fence into a special vehicle all the assets it inherited from an aggressive expansion push early in the past decade as well as units that can’t be sold under current market conditions, the people familiar with the matter said.
• These assets would include a portfolio of bonds worth EUR95 billion and about EUR30 billion in loans deemed non-strategic, they said. Dexia Crediop and Dexia Sabadell, the bank’s municipal lending units in Italy and Spain, respectively, would also be folded into the bad bank, the people familiar with the matter said. The European sovereign debt crisis has cast a cloud on most financial assets in Southern European countries, making it virtually impossible for Dexia to find buyers for the two units.
• Over the past year, Dexia had succeeded in reducing short-term financing needs stemming from its large portfolio of long-term bonds. Yet, in recent weeks, the bank was increasingly struggling to raise funding at affordable costs. With little hope that liquidity strains would ease in the short term, management came to conclusion that Dexia could no longer carry the oversized bond portfolio alone, one person familiar with the matter said.
• In a first step, Dexia may continue to carry the bad-bank vehicle on its books, but France and Belgium will give its guarantee to securities the bank must issue to meet refinancing needs, the people familiar with the matter said. Longer term, Dexia may transfer bad bank ownership to France and Belgium, these people said

As a reminder, here are some excerpts from the Malmgren Hypothesis, wherein the EU member states support their own banks to the exclusion of the broader institutional Euro framework:

The Germans have already concluded that if they are going to write any further checks then they are going to write them to their domestic institutions and protect their domestic investors. Necessarily, this means that many Eurozone countries will default on their debt. It now seems this will happen within a matter of days. Germany has, therefore, already announced its intention to ring-fence and support their own banks and only their own. This may ultimately involve the nationalization of some or even all the German banks. This is necessary because a falling Euro will further weaken the ability of the other Eurozone members to meet their commitments and thus increases the risk of multiple sovereign defaults. Eurozone countries that are going to default will do so virtually simultaneously rather than sequentially.

...

The nationalization of the German banks, or the creation of a purely German Bailout mechanism, will immediately cause the markets to blow out the spreads on all debt instruments around the world with the possible exception of certain G7 countries like the US and the UK. Note that even the UK has massive bank exposures to the continent especially in Ireland. Ireland may get a bailout from the UK (again) but it is hard to imagine the UK writing a check to anybody else. This would force other Eurozone members to consider how to deal with their own bank debt problems: France, Italy, Belgium all leap to mind but the market will be bound to pressure others from Cypress and Eastern European countries to Bank of America. In fact, the entire banking and payments systems will be subject to entirely unknown shocks and logistical problems should this announcement be made.

Greece defaults and Germany will shore up the German banks. Other countries will either have to do the same or the market’s will discern which countries cannot bailout their banks due to lack of funds. The UK will be asked whether it is going to support the Irish banks. I suspect the UK will say yes but they may not be ready to answer the question when it comes. Any delay will force the UK government to reveal that the UK banks are cash rich. This will raise questions about their lack of lending. Bank failures will probably occur. Small institutions may bring significant consequences. We will see if the French have the resources to manage their banks. Christian Noyer insists that they do, but he would.

Accordingly, it appears France and Belgium have front-run the Germans to ring-fence Dexia ahead of a similar announcement (regarding Deutsche Bank or Commerzbank, for instance). Who will be next: Italy (Unicredit, Intesa Sanpaolo), Spain (Sabadell, Banco Popular, Bankinter), Austria (Raiffeisen), Norway (DnB NOR), Switzerland (UBS), or France again (Soc Gen, BNP)?

Attack on Bank of New York Mellon Continues; US & Schneiderman File Suit Over Forex Fees

From the New York Times (emphasis ours):

U.S. and New York Sue Bank of New York Mellon Over Foreign Exchange Fees

By ERIC DASH and PETER LATTMAN

Published: October 4, 2011

The New York attorney general and the United States attorney in Manhattan filed separate lawsuits on Tuesday against the Bank of New York Mellon, accusing it of cheating state and other pension funds nationwide out of foreign exchange fees over the last decade.

In a civil lawsuit filed in state court, the attorney general, Eric T. Schneiderman, said that the Bank of New York Mellon had consistently overcharged customers for processing foreign currency transactions. He is seeking about $2 billion, which is the ostensible ill-gotten profits that the bank generated over the last decade.

Preet S. Bharara, the United States attorney in Manhattan, filed a civil complaint in Federal District Court in Manhattan that also charges the Bank of New York Mellon with defrauding its customers in the foreign exchange markets. Whereas Mr. Schneiderman is seeking redress on behalf of state pension funds, Mr. Bharara is seeking hundreds of millions of dollars in penalties on behalf of the United States.

...

Mr. Schneiderman’s lawsuit charges that the bank guaranteed that customers would receive the most competitive or attractive rates available on any given trading day. In reality, the lawsuit says, the Bank of New York Mellon provided the opposite: the worst or nearly the worst of the rates available to the bank. Then it earned nearly $2 billion — or as much as 75 percent of its foreign exchange revenue — by pocketing the difference, the suit contends.

The New York attorney general’s action comes after similar moves by authorities in California, Florida, Massachusetts and three other states that are looking into the foreign exchange practices of the Bank of New York Mellon and one of its main competitors, the State Street Corporation. The Securities and Exchange Commission and Justice Department are also in the middle of investigations, according to corporate filings from the banks.

The inquiries began almost two years ago when a group of whistle-blowers made up of plaintiffs’ lawyers and Harry M. Markopolos, the financial investigator who first sounded the alarm about Bernard L. Madoff’s Ponzi scheme, sought out the New York state attorney general’s office to bring lawsuits against the bank.

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It is not the first time Mr. Schneiderman has squared off against the Bank of New York Mellon. He recently moved to block a proposed $8.5 million settlement involving the bank and the Bank of America over troubled loan pools issued by Countrywide Financial. The suit accuses the Bank of New York Mellon of fraud in its role as trustee overseeing the investment pools, a claim the bank has denied.

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Solvency Crises Coming to a Head; Brace Yourselves for BAC Restructuring and Possible German Exit from the Euro

History tends to makes fools of those that speak of "imminent" institutional collapse. It's much safer to use the time-unconstrained term "inevitable" and wait for the eventuality. The inertial resistance to structural change is difficult for most to fathom. Yet, there are those fleeting and few-between periods when resistance snaps on multiple fronts, and a new global reality emerges. Here are two shoes waiting to drop:

1) Europe (to be, or not to be a union):

http://www.pippamalmgren.com/77.html (htRobertWenzel)

Were she not a major insider, we would tend to dismiss the leading bullet points from her article of September 13, 2011 as a bit hyperbolic.

News to expect in the coming days and weeks:

• Greece defaults
• Germany protects German banks but other countries cannot do the same thus quickly provoking multiple sovereign defaults and or bank failures, all of which may easily lead to a payments crisis in the global banking system. Derivatives are particularly at risk in terms of operation and execution.
• The Euro falls in value especially against the US dollar
• The Germans announce they are re-introducing the Deutschmark. They have already ordered the new currency and asked that the printers hurry up.
• The Euro falls even more on any news that Germany is withdrawing from the Euro.
• Legal wrangling begins as to the legality of Germany’s decision. Resolution takes years.
• Germany insists that the Euro continues to exist even they do not use it any longer. They emphasize that European unification will continue and suggest new legal instruments to strengthen European Unification including new EU Treaties.

Read on, though (and you should read every word), and the supporting information and logic is robust (brackets and emphasis ours):

The Germans have already concluded that if they are going to write any further checks then they are going to write them to their domestic institutions and protect their domestic investors. Necessarily, this means that many Eurozone countries will default on their debt. It now seems this will happen within a matter of days. Germany has, therefore, already announced its intention to ring-fence and support their own banks and only their own. This may ultimately involve the nationalization of some or even all the German banks. This is necessary because a falling Euro will further weaken the ability of the other Eurozone members to meet their commitments and thus increases the risk of multiple sovereign defaults. Eurozone countries that are going to default will do so virtually simultaneously rather than sequentially.

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Eurozone countries may or may not have the resources to nationalize their banks. Therefore, we have to expect that bank failures are a real possibility. Apparently, the Europeans are warning the US to come up with a plan to nationalize Bank of America given that it is already in a precarious position, despite the injection of capital from Warren Buffet. The multiple lawsuits against Bofa and other banks alone will render the US banking system vulnerable to any dramatic announcement out of Europe. But, no doubt US banks have immense exposures to European institutions and some may even have sovereign credit risk directly on their balance sheets.

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It is hard to overestimate the shock that this will bring to the financial markets. Risk aversion will set in quickly as people start to consider the multiple possible consequences, some unintended, of such a decision. Huge fortunes will be made and lost in this moment in history.

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It is worth providing a review of the evidence that led me to this conclusion.

Next, she enlightens with several facts and dispels many myths. First, no check is coming:

Christine Lagarde’s speech at Jackson Hole revealed the recognition that there was a risk that Germany might not “write a check” to bailout the Eurozone members. She said, to paraphrase, “somebody needs to write a check or we are going to have historic multiple bank failures.” Everyone in the audience understood that no check is coming. The ESFS is not yet funded and a number of the contributors will not hand over cash if there is no collateral.

The German court decision was not a bailout approval:

The Federal Constitutional Court Press Release[viii] has also been misinterpreted by those who want to believe that bailouts will occur. The FT reported that the court ruled in favor of Chancellor Merkel. But, the reality is that the court took the authority to decide away from the Chancellor and gave it to the Budget Committee in the Bundestag. This committee has 48 members and each is certainly driven by the polls and cares about re-election. The Budget Committee is deeply likely to oppose any bailouts that will cost German taxpayers, just as Dr. Issing says.

The real reason the Swiss pegged to the Euro:

If any doubts remain about the German inclination to return to the DMark then consider these announcements. Switzerland announces a peg to the Euro. It was crystal clear at Jackson that the Swiss leadership expected an historic event to occur which would culminate in a rush into Swiss Francs. They tested the water by announcing a “fee” which would be applied to all non-Swiss purchasers of their currency. Within a few days they announce the peg. In short, Switzerland knows what is coming and has just barred the door to anyone who might try to escape the demise of the Euro by leaping into Swiss Francs.

Oh Canada (and Japan):

The statement by the central bank in Canada is similar. I happened to be in Canada when the statement was made. Canadians were deeply confused. After all, to paraphrase, the central bank said, “all the bad things we thought might happen, are now happening, so we are going to maintain a highly defensive position”. In other words, Canada is also gently warning the markets that it will do what it has to do to prevent the currency from suddenly accelerating in the event of a European currency implosion. The Japanese are hinting at this as well. According to Reuters the Finance Minister, “Azumi also said he was ready to step into the currency market to counter speculative moves, although Japan would likely struggle to gain G7 support for intervention.”[xi]

Who will benefit?

It therefore seems likely the US Dollar and US Treasuries will be a major net beneficiary of any failure to bailout Europe. As an aside, this means the market would undertake QE3 as it were. The Fed won’t have to do “operation twist” or consider QE3. [This was written before the September 21, 2011 FOMC meeting, in which OT was announced, but no balance sheet expansion (QE3).] They will be able to focus their attention on the inflation “target” and finding ways to justify letting it rise.

People read the Stark resignation wrong:

It is fascinating that Jurgen Stark’s resignation[xii] has caused people to think the chances of a bailout are increased when in fact his resignation signals that the risk is increased that no bailout will occur AND Germany will withdraw from the Euro. Stark has been a board member at the ECB until his resignation.

...

But, that was not enough to stop Stark’s resignation. When we look back in history we will see that all the important German policymakers resigned from the ECB before Germany formally returned to Deutschemarks, just as one would expect. It also seems too much of a coincidence to my mind that former Head of the Deutcshe Bundesbank and ECB board member Axel Weber leaves the ECB just before all the proverbial starts hitting the fan, goes to UBS as Chairman, and the next thing you know that describes the ways in which countries could leave the Euro including the potential costs if Germany left.

Bernanke's dream come true:

The Federal Reserve will have no choice but to make unlimited liquidity available to the market. They won’t need to announce QE3. The market will do it for them. But, the Chairman really wants to announce QE3 and may use these events as a reason to do so. [Oh, does he ever.]

Other market predictions:

Gold, diamonds, agricultural assets, energy prices and mined asset prices will rise. Default reduces the debt burden and allows growth and inflation to return. If central banks (other than the ECB) throw huge liquidity out into the market because of this event then the liquidity is going to lean away from paper financial assets other than the most trusted and liquid (US Treasuries), and lean toward hard assets.

She concludes that stagflation will accelerate:

The world is about to experience deeper stagflation. The cost of living will now rise even more but growth remains stunted. Policymakers will start to veer back and forth between dealing with unemployment and dealing with inflation. The years ahead will be referred to as “stop go” years because policy will at times try to stop price hikes and at other times policy will try to push growth. Luckily, the world has seen this movie before in the 1970’s. Hopefully, we have learned something from the past and it ends rather more quickly this time around.

Here is the official ECB legal counsel's policy paper on withdrawal and expulsion from the EU and EMU:

http://www.ecb.int/pub/pdf/scplps/ecblwp10.pdf (htTradeWithDave)

Bottom line: an exit from the monetary union, whether unilateral, coordinated, or forced, requires withdrawal from the European Union itself. Thus, if Malmgren is correct about Germany's return to the DMark, it is a de facto withdrawal from the EU under current agreements, despite what the politicians and pundits might say. [Interestingly, the paper notes that this would not preclude continued use of the Euro as a currency, secondary or otherwise.]

2) North America (Bank of America):

http://us1.irabankratings.com/pub/IRAstory.asp?tag=496

Some excerpts (brackets ours) from another must-read by RC Whalen (emphasis and brackets ours):

...The reference to DeMarco is regards his willingness to support the object of the [Soros-]Boyce-Hubbard-Mayer paper on widespad home refinance. We seem to recall a jazz band with a similar name. Actually it is streamlined home refinance. Read the BHM paper and you will understand why the economy is foundering and why the Obama/Geithner binary consciousness won't ever get it.

While the Fed can make a great fuss about intervening in the long end of the government bond market, the central bank cannot get liquidity into the consumer sector unless and until we restructure BAC and other large lenders. Our view is that "twist" by the FOMC is a response to the unwillingness of the Obama White House to embrace mass refinancing of performing mortgages a la BHM. Remember, psident Obama is the puppet and Wall Street as personified by Robert Rubin is pulling the strings.

BAC, Wells Fargo ("WFC"/Q2 2011 Stress Rating: "A") and other large servicers are not going to allow loans in portfolio or owned by investors ppay if they can at all avoid it. Fannie Mae and Freddie Mac, both big owners of high SATO paper, likewise are dragging their feet on refinancing. But the impending insolvency of BAC provides a catalyst to begin the restructuring of the US housing sector and the economic recovery. And yes it is very doable.

On the restructuring:

The answer is that consumer payments, swaps, taxes, interest and principal, FX and all of the other financial operations of BAC will continue uninterrupted. The banks, broker dealers and other operating affiliates of BAC do not file bankruptcy, but the debtor parent does ask for the court to protect the operations of the entire group. We've got some of our cash sitting in the El Segundo branch of Bank of America, N.A., BTW. We aren't moving.

So long as the subsidiary banks of BAC are book solvent and stable, these businesses can continue to operate and, most important, contribute income to the parent. Regulators led by the FDIC and Fed are going to support the restructuring because a commercial reorganization is clearly pferable to a Dodd-Frank resolution, for reasons we have discussed pviously.

...

Taking an aggressive approach to cleaning-up the subsidiaries of BAC could yield enormous operational savings and leave the restructured bank vastly more liquid and profitable. Let’s assume for this discussion that we write-down the bank level TCE and intangibles, and an additional $100 billion in parent equity downstreamed to banks, for $250 billion total bank level asset reductions/cleanup. We then recap the banks with new debt and equity raised by the parent.

Once these tasks are done, we can move to Pro-forma 2, which is BAC on exit from bankruptcy. In the table we show $1.4 trillion in total consolidated assets on exit, including some $1 trillion in bank assets, $200 billion in parent level TCE, no intangibles and $100 billion in new debt. This works with or without Merrill, which is said to be worth in the $30 billion range and could be sold during the restructuring.

BAC management then does the biggest IPO in US history for the most profitable and liquid large bank in the world. BAC's peers would be forced to restructure more rapidly just to remain competitive, but probably via debt conversion and without a bankruptcy. Credit creation in the US economy again becomes positive. Mission accomplished.

So, perhaps the White House and the Fed are not sleeping together after all, which we had agreed with here. If the mortgage refi plan mentioned by BHO is the new Freddie Mac Standard Mod, which rolls out today, October 1, then we could hardly characterize it as "massive" or "streamlined". It's the Classic Modification with lipstick. In particular, these requirements will prove major obstacles to widespread use:

• Borrowers must document an eligible hardship that is causing or expected to cause a permanent or long-term increase in expenses or decrease in income. (Unemployment and other temporary hardships are not eligible hardships.)
• Borrowers must have verified income available to make the modified mortgage payment. (Unemployment benefits are not an acceptable source of income.)

To get a bit wonkish again, see also the new servicing proposals by the FHFA here. The more "radical" of the two proposals would separate (bifurcate) the representations and warranties of the seller and servicer, and would allow for a fixed fee for servicing rights with a separate interest only (IO) security that is not tied to the mortgage servicing rights (MSRs). The former is a step in the right direction, but the latter simply seems to be a workaround to avoid Basel III capital requirements on MSRs for the big banks that are also mortgage servicers. Again, nothing revolutionary.

Bottom line: the current and future contemplated policies in the US are insufficient to deal with the fundamental insolvency of the large banks and with the pent-up dysfunction in the mortgage industry. With the big bank state attorneys general settlement now facing resistance from California, and New York Attorney General Eric Schneiderman continuing to turn the screws on Bank of America and Bank of New York Mellon, a major market-clearing event could be around the corner in the US, even if the EU survives.

As we write, the fingers of instability are mounting and, while the world might just manage to kick the can once more, there is a growing likelihood that the next phase of crisis is upon us. Brace yourselves, as when it comes, it will be necessarily worse than 2008.

Battle for the City of London Tips in Favor of the Queen; Poland to the Rescue

A short time ago, the financial relevance of the UK seemed in jeopardy, but two events announced only yesterday suggest the Square Mile will remain a major player in international trading, at least for the time being. First, the board of LCH.Clearnet, the country's largest counterparty clearinghouse, announced it had approved a buyout offer from the London Stock Exchange, edging out a materially lower offer from Markit, with a shareholder vote to determine the final outcome. Jeremy Grant explained a salient point earlier in the month in the Financial Times (emphasis ours):

But what about SwapClear, the over-the-counter (OTC) interest rate swaps clearing service under LCH.Clearnet?

While LCH.Clearnet books OTC derivatives revenues on its accounts from the SwapClear service, this does not tell the full story on where SwapClear profits go. Some [profits] go to the OTC derivatives dealer-banks that form a curious governance mechanism for SwapClear, known as OTCDerivNet. The amount of profit that goes to these banks is dictated by a sliding scale of thresholds set out in an arrangement between LCH.Clearnet and the banks, revised last year.

It is a glass bead game that few even in the industry understand, but the bottom line is that any LSE deal with LCH.Clearnet would probably have to allow SwapClear to be ring-fenced somehow to allow the banks to carry on. I can’t see the SwapClear banks represented on the LCH.Clearnet board being enthusiastic, either, about exchange control of LCH.Clearnet (which is what you’d get if the LSE wants 51 per cent).

This is one hurdle that Markit, the LSE’s rival bidder, does not face. Perhaps that is why the LSE has offered a knock-out €21 a share price for LCH.Clearnet, above Markit’s €15 offered for 100 per cent of LCH.Clearnet.

So, the big London banks on the LCH board capitulated. But why? Perhaps they read the proverbial handwriting on the wall, as power centers on the Continent were jostling for a carrot-and-stick-induced LCH crossing of the channel. If London were to lose LCH, the Deutsche Borse/NYSE Euronext faction might shift the occidental financial axis firmly along a New York/Frankfurt line.

The carrot was that the EU is currently considering giving clearing houses access to central bank liquidity in a crisis (i.e., ECB bailout funds), similar to the arrangement between the Federal Reserve and the DTCC and CLS Bank. The stick was that the ECB would require clearing activities to be conducted within the EU (sic Germany) as a precondition to access, which would require a re-domicile of LCH on the Continent. On September 15, the UK threatened to sue the ECB over the issue, but only yesterday, the tide turned, as Poland intervened (emphasis ours):

Derivatives clearinghouses such as LCH.Clearnet Group Ltd. may face less pressure to move parts of their business from the U.K. to the euro area as European Union negotiators seek to resolve a clash between Britain and the European Central Bank.

Poland, which holds the EU’s rotating presidency, proposed changing a draft law on over-the-counter derivatives so that “no member state or a group of member states should be discriminated, directly or indirectly, as a venue for clearing services,” according to the document posted on an EU website. The U.K. said “there are a number of issues” requiring discussion before Britain can sign off on the law.

The new wording was added to negotiating texts after the U.K. said on Sept. 15 that it would sue the ECB over its plans to prevent some euro-denominated securities from being cleared outside the 17 countries that share the currency. The text was added to ease U.K concerns that the ECB may push for clearinghouses to relocate, according to an EU official familiar with the talks who couldn’t be identified because negotiations on the measures are private.

Bloomberg continues:

‘Highly Unclear’

“It is highly unclear whether the ECB has the power to make policy like it did in the July paper,” Damian Carolan, a lawyer at Allen & Overy LLP, said in a phone interview from London. “People were quite surprised how far it felt its jurisdiction to extend.”

The Polish proposal would put the U.K. “in a far stronger position in saying that the ECB has gone outside its remit,” Carolan said. “I don’t think it brings you legal certainty but it brings this policy decision clearly into the legal framework.”

The U.K. lawsuit hasn’t been officially registered with the EU Court of Justice in Luxembourg.

Clearinghouses such as LCH.Clearnet and Deutsche Boerse AG’s Eurex Clearing operate as central counterparties for every buy and sell order executed by their members, who post collateral, reducing the threat from a trader’s default.

The derivatives rules are scheduled to be discussed at a meeting of EU diplomats on Sept. 29, according to the EU official. Draft EU laws need approval from the European Parliament and national governments before they can take effect.

The seemingly unlikely bridge between the UK and Poland is made by Poland's finance minister, Jacek Rostowski, a "British-born economist and academic...[who]...will now chair meetings of EU finance ministers and hopes to take part in critical talks among euro-zone finance ministers." A hardliner for EU solidarity (though Poland has itself yet to join the euro), he has pushed strongly for the Greecian bailout and an IMF-style approach that, at least initially, favors growth over austerity. What concessions or favors he might have wrung from the UK are unknown, but we would not be surprised to see a British role in the EFSF cum pan-European bond, once the twin Hungarian calls for a crisis come to fruition.

Regardless, the LSE's vert just improved by a few inches. Not enough for a slam dunk, but enough to maneuver in the paint.

John Tsang Does Chicago

Hong Kong FinSec, John Tsang wrapped up his world tour this week in Chicago, meeting with some movers and shakers in both the political and financial realms (emphasis ours):

: FS promotes HK in Chicago

Sep 27, 2011 (M2 PRESSWIRE via COMTEX) --

Financial Secretary John Tsang continued the final leg of his US visit by meeting President and Chief Executive Officer of the Federal Reserve Bank of Chicago Charles Evans in Chicago yesterday.

They discussed Hong Kong's unique role as an offshore centre for renminbi banking, renminbi trade settlement and the issuance of renminbi bonds.

He called on Chinese Consul-General Yang Guoqiang, before visiting the Chicago Mercantile Exchange to meet its Executive Chairman Terrence Duffy.

He also called on Chicago Mayor Rahm Emanuel before attending an event to celebrate Cathay Pacific's launch of daily non-stop passenger flights between Hong Kong and Chicago.

Mr Tsang will visit Caterpillar Inc today before returning to Hong Kong.

Press Love Fest for NY Attorney General Schneiderman Ignites; Will He Be the One to Lock Up Goldman's Blankfein?

We mentioned the rising star of Eric Schneiderman the other day, wondering who was pulling his strings in the fight against the big banks. The next day, Ben Smith, of Politico asked, "Is Eric Schneiderman America's most powerful liberal?"

New York Attorney General Eric Schneiderman was too busy running for office during the first two years of the Obama presidency to really pay much attention.

“Obama ran on this visionary platform, and then something happened, between the time I started campaigning and the time I finished campaigning,” he recalled in an interview in the spacious, sparsely furnished office he won last year, around the corner from the New York Stock Exchange. “But it certainly looked different in December of last year than in June of ‘09.”

By that time, Schneiderman, a trim, impatient liberal, was preparing to be sworn in to a jobEliot Spitzer turned into the terror of Wall Street. And he was almost perfectly placed - and almost perfectly suited by temperament and ideology - to be one of the ringleaders of a nascent, post-Obama left, a kind of liberal tea party.

A New Yorker who represented the Manhattan’s Upper West Side, writes for The Nation, and has spent a decade fighting his party’s moderates, Schneiderman found himself in the position of being one of the few public officials who could try to erase an act that was the key root cause of early progressive disappointment with Obama: his relatively gentle handling of Wall Street in the wake of the 2008 economic crisis.

Just months after he took office, Schneiderman reversed the position of his predecessor - current Gov. Andrew Cuomo - and rang the alarm on a settlement being negotiated by 50 state attorneys-general he saw as too lenient toward the big banks.

Reading on, we learn the big banks might be in for a good old fashioned fishing expedition (emphasis ours):

There are sharp disputes over theory and facts in the bank settlement talks, and the reality can be hard to tease out from unreleased letters between the banks and the states and off-the-record, talks. As Schneiderman tells it, he became alarmed soon after taking office at what he saw as a failure do demand more internal bank documents, and at suggestions that the banks would be able to settle not just narrow issues around the handling of foreclosures, but broad questions about the securitization of sub-prime loans that underlay the 2008 crisis.

“I was concerned about the scope of the investigation that had been conducted, and I was concerned about what kind of release the banks wanted,” he said. “I wasn’t going to release claims that hadn’t been investigated.”

Miller says the AGs and federal agencies have copious files on the housing crisis, and bridled in particular at Schneiderman’s claim that the settlement could ever have included a release from claims involving securitization or other broad issues.

“He’s essentially made that up,” he said of Schneiderman. “The release will center on robosigning and servicing and issues that are closely related to servicing. It’s not going to be a broad release.”

...

Schneiderman argues that a deeper investigation would give the AGs more leverage for a more sweeping settlement, and that this is the last, best chance to get at issues at the heart of the troubled American economy.

“I think a more creative, robust settlement would be a good thing for this economy, and I think a thorough investigation that airs this out is critical for restoring public confidence,” he said.

Schneiderman doesn’t appear likely to back down, and he has deeply unsettled the fragile coalition of attorneys general, with several others joining him to press – demagogically, in Miller’s view – for a narrow release. Spitzer – who regularly calls to advise Schneiderman to follow an activist path – praised him to POLITICO for “continuing the notion that the New York Attorney General is the most effective outspoken voice in an environment where the federal regulatory agencies still haven’t flexed their muscles in a meaningful way.”

The love fest didn't stop there, because one day later, Nina Burleigh at Salon sycophantically asks a similar question, "Is New York Attorney General Eric Schneiderman the One to Finally Fight Big Money's Power in Politics?"

Schneiderman, like Obama, comes from the low-drama school of political presentation. He doesn't get red-in-the-face mad. He doesn't seduce. He's earnest and self-effacing and pedagogical. But unlike the president, he has a steady refusal to back down and a ready willingness to fight. He is the antihero that boiling mad progressives hope can manacle and perp-walk those responsible for the financial crisis.

...

As if responding on cue to that taunt, the New York Post reported two days later that one of Schneiderman's staff attorneys had been moonlighting as a dominatrix for hire under the name Alisha Sparks. In her day job, she had negotiated deals with errant bankers, by night she was allegedly taking money to whip submissive men into states of bliss. Schneiderman promptly put her on unpaid leave on the basis of the charge that she had broken the rule against outside employment. His press secretary assured me that Sparks hadn't come anywhere near the current ongoing investigation. But financial bloggers immediately smelled a rat and suggested the outing was just the beginning of a coordinated dirty war on Schneiderman's office as he turns up the heat with bank subpoenas.

For the record, we're against the settlements as well, but just don't believe the Wall St. hero cop story. As always, we simply follow the money.

Salon continues with a few more details on what Schneiderman wants to get his hands on.

Schneiderman said his office is "digging into" earlier phases of the mortgage-backed securities era. "Origination, the pooling of loans by the banks, the securitization, sale," he said, and activities after 2004, when the housing bubble started filling with air, and the numbers of mortgages dropped. "That's when things started to shift and you can see this whole process of -- making money of these securitizations was so profitable, that it didn't stop when it should have stopped."

Around the same time, he noted, investors began scrutinizing MBS more carefully, and diverting money into the more complex but also troubled collateralized debt obligations. As everyone knows in hindsight, the quality of mortgages deteriorated, the quality of securities deteriorated, and it all collapsed. "We are looking at what caused that to happen and what people were doing and what people knew," he said.

If anyone has data on mortgage-related securitization volumes going back to 2004, we'd love to see 'em. But, off the top of our head, we can think of one investment bank cum Federal Reserve member bank that was a leader in securitization "innovation" around that time, and which would be a coup for a rising AG to take down. Yes, the world's most fashionable bank to hate, Goldman Sachs, and its God's-work-doing CEO, Lloyd Blankfein (who, buy the way, recently hired a criminal defense attorney).

Another Soros-funded Attorney General, Former Rand Paul Opponent Jack Conway, Threatens the Big Bank Settlement

George Soros is just itching for a crisis. A few weeks ago, the NYT reported:

“This crisis has the potential to be a lot worse than Lehman Brothers,” said George Soros, the hedge fund investor, citing the lack of an authoritative pan-European body to handle a banking crisis of this severity. “That is why the problem is so serious. You need a crisis to create the political will for Europe to create such an authority, but there is still no understanding as to what the authority will do.”

The other day, we wondered aloud why the New York Attorney General, Eric Schneiderman, was aggressively blocking the Bank of American and Bank of New York Mellon settlement regarding Countrywide RMBS. Maybe he's just an uncorrupted politician looking out for the best interests of the good investors of New York. Or maybe, he's being pressured by one of his largest campaign contributors, George Soros.

In a separate matter, Schneiderman has also been an active critic of the settlement among the big banks and state attorneys general. Add to that list another recipient of Soros' largess, the AG of Kentucky and none other than Rand Paul's former opponent for US Senate, Jack Conway.

Will Soros get the US leg of his crisis? With all eyes on BAC, focus might soon shift to BNY Mellon. As RC Whalen wrote the other day at the IRA Analyst (behind pay wall now):

We cannot help but wonder if that August 30, 2011 lawsuit by US Bank did not have something to do with the unexplained volatility in the BK CSUITE. "Bank of New York Mellon raised eyebrows after the closing bell Wednesday by announcing the departure of Chairman and Chief ExecutiveRobert Kelly, but analysts say the bank won't miss a beat under new leadership, and the stock didn't either," writes Steve Schafer of Forbes.

Skip a beat or skip away is the question we have in mind. Under Sarbanes-Oxley, the general counsel of BK has an affirmative duty to make members of the board of directors aware of any failure in terms of internal systems and controls or future risks. Looking at the public record, it does not appear that BK has yet acknowledged the problems regarding trustee activities that have been made public by the State of New York.

The auditor of BK as well as the outside counsel to the bank also have affirmative duties to report to the SEC any failure to disclose such risks to investors in the event that the board fails to make such disclosure. Again, we see nothing in the public record indicating any disclosure by BK regarding these allegations by the State of New York. And is it not interesting that the New York AG was not represented at last Friday's meeting of parties in the Countrywide put-back litigation? While the penalties for failure to disclose in the Sarbanes-Oxley law are bad enough, a litigation by the NY AG using the Martin Act is the big shoe waiting to drop on both BAC and BK. What will the NY AG do? Stay tuned.

Stay tuned, indeed. As the only competitor to JP Morgan in the US custodial securities business, BNY Mellon is more of a systemic risk than BAC, and adds an interesting dimension to the current financial crisis.

John Tsang Does New York

After visiting the City of London (and threatening to repatriate HSBC and Standard Chartered, no less), and a pit stop in Edinburgh, Hong Kong Financial Secretary John Tsang landed in the US this week. Tuesday, he met with Blackstone co-founder Stephen Schwarzman, and Wednesday with FRBNY president William Dudley. According to a prior press release, he was to have met with officials at NYSE Euronext. Next up: Chicago, where he will visit the CME, among other places.

http://7thspace.com/headlines/394794/fs_visits_new_york.html

Hong Kong (HKSAR) - The Financial Secretary, Mr John C Tsang, had a busy schedule lined up for the first leg of his visit to the United States in New York today (September 21, New York time).

First, at a breakfast roundtable with American Chinese business leaders and professionals, Mr Tsang gave an update on the latest developments in Hong Kong and enjoyed an open discussion on Hong Kong's unique role as the premier gateway to Mainland China.He called on the business community to grasp the opportunities in Hong Kong.

This was followed by an courtesy call on Consul General of the People's Republic of China in New York, Mr Sun Guoxiang.

He then attended a lunch hosted by the Federal Reserve Bank of New York (New York Fed), Mr William C Dudley.Mr Tsang shared with the bankers Hong Kong's development as China's global financial centre and as the offshore centre for Renminbi business, which is supported by the Central Government's national development blueprint, the 12th Five Year Plan.

In the afternoon Mr Tsang visited the Metropolitan Museum of Art, where he was given a guided tour of an exhibition titled "The Art of Dissent in 17th Century China: Masterpieces of Ming Loyalist Art from the Chih Lo Lou Collection", which is being held in collaboration with the Hong Kong Museum of Art.

Yesterday (September 20, New York time), Mr Tsang held a meeting with the Chairman, Chief Executive Officer and Co-founder of Blackstone, Mr Stephen A Schwarzman.

The New York visit runs from September 19 to 22.Mr Tsang, who is also visiting Washington and Chicago from September 22 to 27, seeks to forge stronger trade ties between Hong Kong and the United States.During the visit he will meet prominent figures from the political, financial and business sectors to discuss the global economy, provide an update on the latest situation in Hong Kong and promote the many unique advantages Hong Kong offers to entrepreneurs.

He will return to Hong Kong on September 28.

Source: HKSAR Government

Latest Fed Rat to Jump Ship Joins [Recently Downgraded] Citi; Cited as Expert in "Europe" and "Emergency Lending Programs"

Bernanke's learning the hard way how the pimpin game is played.

"You know the rules, your economist chose me."

After losing Brian Madigan and David Stockton to retirement, the latest of Bernanke's top three economic advisors to announce departure, Nathan Sheets, has just joined Citi as the firm's Global Head of International Economics. From BusinessWire:

NEW YORK, Sep 22, 2011 (BUSINESS WIRE) -- Citi today announced that Nathan Sheets has joined the Firm as Global Head of International Economics within Citi's Investment Research & Analysis division. Mr. Sheets will be based in New York. He will report jointly to Citi's Chief Economist, Willem Buiter, and to Citi's Global Head of Investment Research, Andrew Pitt. Mr. Sheets will work with Willem Buiter to lead the Firm's team of international economists, with a special focus on the position of the US in the global economy.

Mr. Sheets joins from the Federal Reserve Board in Washington D.C. where he served as Director of the Division of International Finance and as an Economist to the FOMC. Among his most notable accomplishments, Mr. Sheets acted as the Fed Chairman's international adviser at the onset of the European fiscal crisis in the spring of 2010. He was also a driving force behind the Federal Reserve Board's global emergency lending program.

Mr. Sheets acted as senior advisor to the U.S. Executive Director at the International Monetary Fund (IMF) while on leave from the Federal Reserve. In this capacity, he served as a liaison between the IMF and various U.S. government agencies.

Mr. Sheets received his Bachelors of Economics from Brigham Young University and his PhD from the Massachusetts Institute of Technology.

"We are excited to welcome Nathan to the firm. He brings with him an innate understanding of global macroeconomic issues and he will provide incredible guidance to our clients," said Andrew Pitt, Global Head of Citi Investment Research & Analysis.

Hamid Biglari, Citicorp Vice Chairman and Head of Emerging Markets and Content, added, "With over 18 years of experience with the Federal Reserve, Nathan's appointment underscores Citi's commitment to bring the highest quality insights to our clients."

Bernanke Bids for Soros' Danish Covered Bonds; Obama to Make Toast

The big news today was not of the twist type, but of another dance number (or slumber) between Bernanke and Obama. As expected, the Fed will be swapping some of its shorter maturity Treasury securities for longer ones into mid-2012, but it will also start purchasing mortgage backed securities again after an eighteen month hiatus.

Since the announcement of so-called QE-Lite (which preceded QE2), the Fed has kept its balance sheet from shrinking by buying Treasury securities with the proceeds from the maturing Agency and Agency MBS bonds it bought during QE1. No longer. The Fed will now purchase more MBS with this money. The question is: why?

With 30 year rates hovering around 4%, hasn't everyone who qualifies for a refinance already done so? And, that's the point. There are millions of homeowners who don't qualify for a refi because of a low credit score, lost job or simply being underwater on their home. To be useful, low mortgage rates need a fiscal side program to get around these hurdles. As Bruce Krasting pointed out several weeks ago, the FHFA, which regulates Fannie and Freddie, is already moving in this direction:

The second thing of note is that late Friday afternoon a was letter released by the FHFA. There was a very significant softening of the language regarding the terms for refinancing:

FHFA is also considering the barriers to refinancing mortgages that would otherwise be HARP eligible but for having a current LTV above 125 percent.

Our objective is to provide borrowers in high-LTV loans who have a history of making on-time mortgage payments with an opportunity to refinance, resulting in reduced credit risk to the Enterprises and added stability to housing.

Bingo! The current ReFi restrictions that require a borrower be no more than 25% underwater and have a 780 FICO are about to be waived.

Krasting continues with more evidence:

The final bit of data comes from the CBO. They did an analysis of what the implications are of big refinancing might be. I contacted the CBO on this and they were very clear that the work they did on this topic was not a report on a specific proposal, but rather a generic review.

It is probably correct that any plan that the administration comes up with will vary in scope from the review by CBO. It is also correct that this review has been done in anticipation of a specific proposal. Therefore the review and the conclusions are worth noting. The key assumptions used in the analysis:

(1) Eligibility includes existing loans guaranteed by Fannie Mae, Freddie Mac, or FHA.

(2) A borrower must be current on an existing mortgage and must not have been more than 30 days late on any mortgage payments during the prior year, but there are no limits on the borrower’s current income or on the loan-to-value ratio of the new loan.

(3) The new loan has a fixed rate of interest, at the prevailing market rate, and a term of 30 years.

The CBO has concluded that there are $4.3 trillion of mortgages that broadly meet the above requirements. These mortgages have been converted to Agency MBS. The report looks at what were to happen if 10% in that universe were restructured. The following chart looks at the results.

We can only speculate about the exact details of the program, but conveniently, George Soros has one out of the can. From the Absalon Project website:

Absalon Project (Absalon) will market the Danish Mortgage Solution on a worldwide basis. Absalon is an extension of a partnership between affiliates of VP SECURITIES A/S and Soros Fund Management that was established back in 2005 with the purpose to implement the Danish Mortgage Model in Mexico. This project was successfully carried through with the creation of a mortgage servicing company in Mexico named HiTo that issued the first loans based on the Danish Mortgage Model just before Christmas 2007. Since then HiTo has introduced more loan types to the Mexican market and is issuing loans on a weekly basis, using the solution provided by Absalon.

The Danish way of financing housing through mortgage loans has proven its efficiency and reliability for more than 200 years. It has survived a few crises in its lifetime and also during the current crisis starting in 2008 the Danish Mortgage Model has proven its robustness to the benefit of the borrowers, the investors and the Danish Mortgage Credit Institutions themselves. The project in Mexico has attracted a world wide attention. Combined with the problems that have occurred since the subprime crisis started in the US the Danish Model has gained a lot of interest from all around the world.

Absalon Project was created to capitalize on the experiences from the project in Mexico to offer a solution based on the Danish Mortgage Model to customers on a worldwide basis. The offerings range from initial financial analysis of the possible benefits of introducing the model, over the creation of a Business Plan and Marketing Plan to the delivery of software, services and assistance in setting up the business procedures and the integration of the IT systems.

The US-tailored proposal was released September 1, 2011 and got a nod from RC Whalen, who wrote at ZeroHedge (emphasis ours):

Below is the intro for an important paper by Alan Boyce, Glenn Hubbard, and Chris Mayer, which lays out the finances of the mortgage market in great detail and argues for refinancing of all GSE-covered loans. For home owners, this proposal offers hope to obtain the refinance which is their lawful option but is being denied by the large bank/GSE mortgage cartel.

For investors in RMBS, this proposal is a disaster, a massive pre-payment on vintage RMBS and the loss of tens of billions in net interest margin for the financial system. This paper hopes to shift $70 billion per year from bond investors to consumers and thereby help the economy. The US banking system made $28 billion last quarter. Got your attention now?

-- Chris

Streamlined Refinancings for up to 30 Million Borrowers

By Alan Boyce, Glenn Hubbard, and Chris Mayer

Executive Summary

Frictions in the mortgage market have restricted the ability of tens of millions of borrowers from refinancing their mortgages, hampering monetary policy, slowing the economic recovery, and leading to excessive numbers of foreclosures. We propose a streamlined refinancing program that may benefit up to 30 million borrowers with government-backed mortgages, leading to possible savings of $70 billion per year in lower mortgage payments. Below we describe the current barriers to refinancings, how our plan would overcome these barriers, and why this plan is in the interest of taxpayers, the GSEs, and other mortgage service providers. We also discuss possible critiques and implementation issues and how such issues can be addressed.

1) The problem

a) As of June 2011, more than 75% of GSE3 borrowers with a 30-year fixed-rate mortgage (FRM) have a rate of 5% or more, despite the fact that market-determined mortgage rates have been at or below 5.0% for nearly every month in the past two years and are currently around 4.25%.4 Under normal credit conditions we might have expected three times this many eligible mortgages to have been prepaid, as happened during the last refinancing wave from 2002 to 2003.5 This suggests tens of millions of borrowers have not taken advantage of a seemingly attractive refinancing proposition.

b) We believe that inefficiencies in the origination and servicing process, combined with GSE surcharges (so-called loan level pricing adjustments and adverse market delivery charges), falling home values, and conservative appraisals have made refinancing nearly impossible for most Americans.

c) In addition to blunting refinancing, these mortgage-market frictions are slowing the economic recovery by limiting the benefits of low interest rates for household spending. Unable to refinance their mortgages the way corporations have been able to refinance their debt, consumers are left with weak balance sheets and mortgage payments often above of the cost of renting, contributing to excessive delinquencies and foreclosures. These constraints on refinancing have a disproportionate impact on middle-class borrowers with origination balances under $200,000 and poorer credit and whose employment opportunities have been hit especially hard by the recession.

2) The Offer

a) Every homeowner with a GSE mortgage can refinance his or her mortgage with a new mortgage at a current fixed rate of 4% or less, with the rate subject to change up or down with the price of Agency pass-through Mortgage-Backed Securities (MBS). For borrowers with an FHA or VA mortgage, rates would be higher, but these borrowers should be included in any large-scale refinancing program.

b) The homeowner must be current on his or her mortgage or become so for at least three months.

c) NO other qualification or application is required, other than intention to accept the new rate (that is, no appraisal, no income verification, no tax returns, etc.).

Read the rest of the paper at link below:

http://absalonproject.com/wp-content/uploads/2011/09/BHM-V11-final.pdf

After the jump, the proposal continues (emphasis ours):

d) Minimal paperwork, other than what is needed legally to refinance in homeowner’s jurisdiction. The Bureau of Consumer Financial Protection may provide a one-page substitute for TILA, RESPA, and HMDA filings to further reduce paperwork and costs.

e) Homeowners can choose between a 15- or 30-year amortization schedules for newly issued mortgages.

f) Homeowners may only refinance existing first-lien mortgage debt and cannot cash out or roll multiple mortgages into the new mortgages.

g) GSEs would be required to issue new MBS in large, highly standardized, transparent, and homogeneous pools, as current Ginnie Mae II Jumbo securities are now issued.

h) Existing servicers would be relieved of their liability for past “Reps and Warranties” violations as long as the mortgage is current today and is at least a year old.

i) Existing second-lien holders would be asked to resubordinate to the newly refinanced first mortgage.8

j) Existing mortgage insurance contracts should be rolled to the new first mortgage.9

k) New title insurance policies must be done in a streamlined process and at low cost, likely a few hundred dollars at most.10

The whole paper is worth a read, and did anyone catch (h) above? That would tidy up some lingering problems, wouldn't it. [In fact, we might be tempted to wonder why New York Attorney General Eric Schneiderman, who's not nearly as anti-Wall Street as his "E.S." predecessor, is so aggressively blocking the BAC and Bank of NY Mellon settlement. We're sure it has nothing to do with campaign contributions from the amateur tennis circuit...but that's a thought for another day).]

In contrast to the CBO plan, Absalon envisions re-papering the entire MBS-eligible US mortgage universe--not just those that cannot refinance now. But, there's another striking feature that contradicts the CBO analysis. Remember part (a) of the deal:

a) Every homeowner with a GSE mortgage can refinance his or her mortgage with anew mortgage at a current fixed rate of 4% or less, with the rate subject to change up or down with the price of Agency pass-through Mortgage-Backed Securities (MBS). For borrowers with an FHA or VA mortgage, rates would be higher, but these borrowers should be included in any large-scale refinancing program.

These are not 15 or 30 year fixed rates envisioned by the CBO, but the equivalent of adjustable rate mortgages. Though not as common as fixed-rate in the Danish system, these floating-rate bonds are prevalent and are fixed to CIBOR two or four times annually.

If you think interest rates are going to stay low forever, great. If you think they might be materially higher sometime in the next three decades, then it might not be so wise to trade in your 5.5% 30 year fixed. Regardless, today Bernanke has pledged to keep mortgage rates low long enough to jump start whatever Obama's new mortgage program is, Absalon or not, and to buy the new MBS bonds with the lower coupon.

The Fed's Next Step: Thoughts on Operation Twist 2 and the Fed's Third Mandate (yes, there are really 3)

Now that Chairman Bernanke has inasmuch admitted he has no clue what's going on, but is ready to pull yet another rabbit out of his beard at the next FOMC meeting, it's time to address his monetary manipulation options and just why the most likely one might be illegal. While some might doubt the imminence of the next round of easing, according to the minutes of the last FOMC meeting, released only yesterday, there was a secret meeting by videoconference on August 1 to discuss the debt ceiling and the "possibility" of a ratings downgrade of US debt (which would occur just four days later). The last (and only, according to our search) videoconference was conducted October 15, 2010, just prior to the FOMC meeting that would announce QE2.

Curiously, Bernanke made scant mention of his "tools" Friday at Jackson Hole, perhaps not wanting to tip off the broader bond market on which Treasurys to load-up (though we're sure Larry Meyer is advising his clients). However, his options are basically twofold and come down to targeting either interest rates or the Fed's own balance sheet size.

Really, the Fed has been doing both, as it has continuously targeted the shortest end of the curve in the overnight Federal Funds market at 0-0.25% since late 2008, while its QE1 and QE2 operations aimed at increasing its balance sheet by a total of $2.35 trillion. Arguably, the latter helped facilitate the former. And, in the last FOMC statement, the Fed committed to keeping an exceptionally low Federal Funds rate into mid-2013. This means that even if the market starts demanding higher short term interest rates in the next two years, the Fed has pledged it will step in and flood the markets with liquidity via open market operations (likely temporary repos) to keep rates low. Think about that.

Correct or not, many perceive this massive digital money printing as causing the recent and growing price inflation at the pump and Piggly Wiggly. Recent civil unrest in MENA and (gasp) Londontown are serving as wake up calls. The public, when it perceives itself sufficiently aggrieved, will turn on its government on a shiny, FDR dime. Bernanke knows he needs something different to give himself plausible cover. See here for a variety of possibilities set forth by Goldman.

Today, we'll focus on interest rate targeting further out on the yield curve (so-called Operation Twist 2, or OT2), and why it looks increasingly likely. First hypothesized by David Rosenberg and discussed in detail at ZeroHedge, OT2 would be a quasi repeat of the Kennedy-era Fed operation, whereby it committed to purchasing enough Treasurys at the longer term yields to effectively cap them, in order to strengthen the US Dollar and prevent gold outflows, while simultaneously not putting pressure on short term rates. It was initially judged a moderate success, as indeed the yield curve flattened. While gold convertibility itself is now itself a barbarous relic, the concept of long term interest rate targeting has been revived as an alternative to balance sheet targeting.

The question is what maturity the Fed would target. If, as Rosenberg originally suggested, it is in the longest maturities (10 to 30 years), then we could indeed see higher stock market prices. As TradeWithDave reasoned (prior to Jackson Hole and the last FOMC meeting):

Here’s Dave’s gut instinct. This is a temporary attempt to strengthen the dollar artificially cooling inflation while attempting to coax cash off of corporate balance sheets into mid-term investments by inverting the yield curve and motivating banks to lend to businesses again due to attractive low, long-term rates. What will it actually do? Dave thinks it’s like “cash for clunkers”, but it’s really more just “cash for candy.” It will create the need for increased liquidity and more paper money and it will increase the near-term velocity of cash actually creating a currency shortage.

It will be like a sugar high. Like dropping a Mentos into a bottle of Coke. Wow! Then you’re left with a flat soda and sticky mess. Is anyone foolish enough to sink long-term or even mid-term (say a 7 year term loan for a business) investments when you have such an unstable environment? No. So, what will happen is an increase in liquidations (further drop in real estate prices) in an effort to lock-in short term returns.

In other words, companies will sell the ranch and use the money to chase the higher near-term returns which will allow them to pay stellar dividends which will rocket their stock price all while they destroy their (and our) long-term prospects… but who cares because they’ll make their numbers for the quarter while no one else is, which means they will not only survive, but prosper and further consolidate their leadership positions in the UPS/Fedex, Verizon/AT&T, Apple/Android, Coke/Pepsi duopolistic fantasy of a free market. If the sugar fix was legitimate investment and the dollar was fundamentally strong, then it would destroy the stock prices, spoiling our dinner and the intended wealth effect and we can’t have that now can we.

Since then, we have learned the Fed will target short term rates for two more years (which presumably could include a couple of modest Fed Funds rate hikes up to 0.75%). Accordingly, this might ultimately weigh on the US Dollar. If indeed the Fed ends up targeting longer term yields as well, we might end up with a yield curve that looks something akin to a handlebar mustache. In this scenario, the chase for yield would indeed be in the belly of the curve.

What the Fed might have all along planned is for a two prong interest rate targeting of both ends of the yield curve spectrum, with each leg to be implemented at successive FOMC meetings, sandwiching Jackson Hole for maximal PR value.

Another possibility, raised by Bill Gross of Pimco, is that the Fed will target the 2 to 3 yr maturities. Other than restarting the mortgage option-arm market, we're curious to know what this might accomplish, as the Fed would cede control of the long end. However, we do present it below as a possibility, which is a very rough sketch (we're not bond market wizards):

Why OT2 will not come from QE-Lite

The Fed continues to maintain its balance sheet size by buying Treasury securities as the Agency and Agency MBS securities it also owns mature or are paid off (so-called QE Lite). People pay down mortgages, the servicers pay Fannie and Freddie, who in turn pay the MBS holders, which includes the Fed (holding just under $1 trillion in MBS now). Accordingly, the Fed is still buying Treasurys at about $15 billion per month (down from over $100 billion per month during QE2).

It has been suggested that the Fed could simply target longer maturities with this $15 billion fire power, or actually reshuffle its portfolio to extend its duration. Our view is this puts the Fed in a very precarious position, because once it guides expectations that it will extend duration, the bond market might awaken and demand a full commitment for yield targeting. As many have noted, the Fed cannot target long term rates and its balance sheet size simultaneously. It must be willing to purchase every single bond at a given maturity range.

The legal problem

The oft-cited "dual mandate" of the Federal Reserve for maximum employment and stable prices was enacted in 1977 when Congress modified the Fed's mandate. Curiously, stable prices is always interpreted by the Fed to mean 2% annual inflation dollar devaluation. However, there is actually a third mandate for "moderate long-term interest rates". It's right there in the Federal Reserve Act:

Section 2A. Monetary Policy Objectives

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

Exactly why the third mandate fell down the memory hole is revealed in the footnote of a speech given by none other than Bernanke himself (emphasis ours):

The Employment Act of 1946 established the objectives of "maximum employment, production, and purchasing power" for all federal agencies, whereas the 1977 amendment to the Federal Reserve Act gave the Federal Reserve the specific mandate of promoting "maximum employment, stable prices, and moderate long-term interest rates." Price stability requires that the central bank not attempt to drive employment above its sustainable level, and so in practice the Federal Reserve has interpreted its mandate to include maximum sustainable employment. The goal of moderate long-term interest rates is frequently dropped from statements of the Federal Reserve's mandate not because the goal is unimportant, but because moderate long-term interest rates are generally the byproduct of price stability.

Yet, what if exceptionally low long-term interest rates are the by-product of intentional distortions created by Federal Reserve interest rate targeting? Wouldn't this be an intentional and explicit violation of the Fed's statutory mandate of "moderate" long term interest rates?

What constitutes "moderate" is not explicitly defined, but long term rates are already at historically low levels, and it would be difficult to characterize any further targeted lowering as "moderate". While the 2-3 year range might be considered "middle term", the Fed's most likely option, the 10-30 year, is definitely long term.

All it would take is one Federal lawsuit and a sympathetic judge to serve a temporary restraining order on Brian Sack at the New York Fed to bring the digital money printing wheels to a grinding halt.

Now think about that.

End of Intermediate Term MIDAS TopFinder in Gold Suggests Moody's Downgrade Now Priced In

Today, we're taking a break from rummaging through the Fed's website to present a bit of voodoo technical analysis, which we usually reserve for our daytrading forum, but will post here, as it might be of some interest to those keeping track of the barbarous relic's recent surge.

For background* on the MIDAS TopFinder(TF)/BottomFinder (BF) tool, see our post at ZeroHedge from October 15, 2010, and the follow up by Andrew Coles here (coincidentally posted on July 5, the low from which the current TF was launched, and when he noted a rally was indeed possible as TF support from the weekly time frame had held).

The termination of the current TopFinder concurrent with the ominous bearish engulfing candlestick today likely signals an end to the current epoch of panic-to-quality induced by the Moody's downgrade of US debt. This would mean long term Treasury yields have likely troughed as well, at least for the short term [and, yes, they indeed plunged much lower than we had anticipated just prior to the Moody's news].

As Paul Levine wrote in 1997:

What I’ve just described here may be confusing to those who are new to using TopFinders, since people are usually expecting one indicator that will clearly identify the top. It’s important to understand what a TopFinder does and does not do. It does identify an accelerated uptrend that is all “of a kind”, with price behaving in the same way all the way to its end. The end of a TopFinder does identify the end of this kind of price behavior and the beginning of a consolidation even if it’s only a brief consolidation. And the end of the TopFinder does identify the place beyond which price behavior will be distinctly different. However, in spite of the catchy phrase “Top Finder”, it does not necessarily “find the top”. After the consolidation, price may resume going up, albeit with a different pattern than before the end.

So, the end of the TopFinder on the daily chart does not preclude yet another disaster from setting the markets ablaze, but it does suggest the Moody's downgrade is now priced in. Indeed, on the weekly time frame (reproduced to conform to Coles' July presentation), we might see a retracement to its rising TF (currently $1686), with a subsequent price rally to new highs above $2000. At 95% completion and incrementing 1% per week, that would coincide with mid-September.

Finally, on the secular/decadal time frame, as Coles wrote in July:

It may not have escaped the noticed of some readers that the secular degree trend (10 to 25 years) in gold from the 2001 bottom also appears to be accelerating. Indeed, as in Chart 7, we have the same setup for a TF (red), since S1 (green) displaced immediately from the trend when it was launched from the March 2001 bottom. This enormous secular-degree TF is 56.9% done, suggesting – on an extrapolation of a price/time reading from the cumulative volume prediction – that we could see another decade of rising gold prices.

Conclusion: sell your bullion? No! But, be wary of leveraged long gold exposure here.

*The recent Bloomberg Press publication by Coles and Hawkins, MIDAS Technical Analysis, has become the definitive reference book on Paul Levine's work, incorporating a number of innovations, including some of our work.