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Eurozone Banks Dump Bad Paper on Taxpayers

by John Rubino on July 2, 2012 · 24 comments

Bloomberg is reporting on what looks like a brazen con being pulled on taxpayers by eurozone banks and governments. It goes like this: During the recent credit bubble the PIIGS country banks created and then sold a bunch of low-quality mortgage bonds. Now they’re buying them up at big discounts to the original price, booking a profit on the trade, and using those securities as collateral for low-interest-rate loans from the European Central Bank.

European Banks Bolster Capital With Shunned Bonds: Mortgages

Spanish and Portuguese banks are leading European lenders in buying back their own mortgage- backed securities at distressed prices to bolster capital and stockpile eligible collateral for European Central Bank loans.

Banco Bilbao Vizcaya Argentaria SA (BBVA), Banco Comercial Portugues SA (BCP) and other lenders this year repurchased 6.6 billion euros ($8.4 billion) of asset-backed bonds they issued, more than double the level for all of 2011, according to data compiled by Deutsche Bank AG. Banks buy the debt, packages of loans in which they kept subordinated portions, for less than face value, and book a capital gain similar to the discount.

The purchases follow European Banking Authority demands that banks raise 114.7 billion euros by last week after the sharp fall in the value of bonds issued by governments in the 17-member shared currency. The deals are poised to accelerate after the ECB last month reduced the minimum ratings it will accept for mortgage securities offered as collateral for cheap loans, adding incentive to lenders to buy back debt and pledge it with the Frankfurt-based institution.

“Compliance with the EBA rules has been the main reason of all buybacks we are seeing so far, but there will be more deals since the ECB will take more of that paper,” said Frank Erik Meijer, head of asset-backed securities at The Hague-based Aegon Asset Management, which oversees 220 billion euros of assets. “Lenders with little or no other sources to raise capital and funding can turn to this strategy.”

Northern Rock
The bigger the discount the mortgage debt is trading at the larger the incentive for banks to repurchase their own deals because that translates into greater capital gains.

U.K. lender Northern Rock Asset Management Plc last month offered to buy back bonds issued under its Granite program as some were trading at 58 percent of face value. They’ve risen to 69 percent of face value after the Newcastle-based lender bailed out by the U.K government said it would offer 64 percent to 77 percent of par.

Incentives are greatest for Spanish and Portuguese lenders, where yields over benchmark rates for mortgage-backed securities are as much as 17 times higher than comparable notes pooling home loans in the U.K. Eleven Spanish banks and four Portuguese lenders have put out tenders to repurchase some of their securitizations, according to Barclays Plc data.

Few Alternatives
European lenders have few alternatives to raise capital as demand for shares of financial companies has plummeted amid the crisis over the common currency.

Sales of stock from European financial institutions fell 71 percent to 2.7 billion euros, data compiled by Bloomberg show, as Europe’s sovereign debt crisis has spread from Greece to Spain, roiling credit and equity markets. The Bloomberg Europe Banks and Financial Services Index (BEBANKS) declined more than 28 percent in the last year.
Shares have fallen even as the European Central Bank pumped 1 trillion euros of three-year loans, known as the LTRO program, into the system since December, making it easier for them to fund such transactions. ECB provides the secured loans at a rate of 1 percent.

“LTRO money has made it easier for banks, especially from peripheral countries, to use funding to raise capital at a moment when other possibilities such as sale of stock or asset sales are virtually closed,” said Conor O’Toole, the London- based asset-backed securities analyst at Deutsche Bank. “Even as buybacks are at record levels so far this year, we expect a second round of tenders.”

Rating Changes
Last month, the ECB, which demands residential mortgage- backed securities to be graded by at least two credit rating companies, said it will allow a second ranking as low as the least investment grade, six steps below the prior requirement. The central bank also widened the range of asset-backed securities it accepts as collateral.

Banks can pledge between 40 and 50 billion euros of bonds, which were not eligible due to rating cuts, said Bank of America Merrill Lynch analysts including Alexander Batchvarov.

Securitizations pool assets ranging from corporate loans to mortgages and slice them into securities of varying risk. The transactions remain on the originator’s balance sheet when it retains the riskiest slices.

Bilbao, Spain-based BBVA bought back 638.2 million euros of bonds backed by mortgages, consumer and company loans in a deal allowing it to record a 250 million euro capital gain, according to a June 28 regulatory filing. Banco Comercial Portugues offered to buy back as much as 300 million euros of bonds it issued between 2003 and 2007 mostly under its Magellan program backed by residential mortgages.

Some thoughts
Stripped of all the terminology, this scam comes down to European governments investing taxpayer funds in risky mortgage bonds — in order to prop up banks that made a lot of ill-considered loans in order to generate big year-end bonuses. This may be legal, strictly speaking, but it’s definitely not moral, and to the extent that European taxpayers figure out what’s happening, the result should be, um, noisy.

It’s also interesting that the banks admit that they have no other source of cash. The markets at long last appear to have recognized that most big European (and American for that matter) banks are stuffed so full of bad paper and on the hook for so many billions in derivatives that they’re terrible bets. Now only governments with docile citizens are left to keep the zombie banks animated.

This game, like many others in today’s global financial system, can go on as long as the currencies the central banks are creating remain viable. Once euros and/or dollars lose their attractiveness as a store of value, the end will come quickly.

  • Ethan

    We need a visual to go with this one.

    • http://www.roycobden.com Roy Cobden

      Like something spinning around a toilet bowel?

  • Tom

    HI John,
    You wrote your book and used logic to deduce the outcome for the dollar. Where along the collapse continuum would you guess we are? What has surprised you about the collapse path?

    • John Rubino

      Hi Tom,

      The only surprise so far has been how long it has taken. We thought a financial collapse/currency crisis was just a few years away back in 2004, but the world’s governments have done a brilliant job of delaying the inevitable. At the risk of getting the timing wrong again, it sure seems like they’re running out of ammo now.


      • Bruce C.

        I know what you mean by “the world’s governments have done a brilliant job of delaying the inevitable” but I would credit – or blame, rather – taxpayers and investors more. They are the ones who have enabled this charade to continue. I think you would agree that if more people, and a surprisingly small fraction of them at that, would simply convert even just a portion of their savings and investments to physical gold and silver the fiat system would collapse.

        Maybe that is a scary prospect and maybe it actually would be to experience, but I don’t know of a more effective, practical, and democratic way to impose economic justice and to reset the entire financial system.

      • Agent P

        There is much sentiment – especially in ‘deflation’ circles, that a slow, measured grind of falling asset prices, credit scarcity and $USD purchasing power strength is what’s on the menu for the next however many years. Wisdom of history and a sense of global fragility speak otherwise. The scales show that one side is overweight real $Debt, and the other side is attempting to balance the scale with M.O.P.E. One side is real, the other is hot air – and more $Debt. So, when something happens that might fall outside of the probability scenarios of M.O.P.E., we have an immediate cascade of events that can only be short-circuited – or delayed, by immediate Federal Reserve $action. Jim Sinclair has been and will continue to be ‘right’. Define it any way you like, QE to infinity is The Only avenue left available to forestall global social chaos.

        • Bruce C.

          First of all what is “M.O.P.E.”? More Of Perception Economics? In any case I assume it applies “money printing”.

          You/Sinclair may be right; I honestly don’t know, in part because things may happen differently in different countries/economies.

          Consider this from Martin Armstrong:

          His basic point is that HISTORICALLY deflation occurs in the country/economy with the “reserve” currency, which I suppose is still considered the US. Other currencies usually do hyper inflate when the SHTF. What’s unique about today is that everything is so interconnected. We shall see what happens.

          • paper is poverty

            I think it’s Management of Perception Economics.

            An interesting thing about the German hyperinflation is that in terms of real money (gold, silver), they had a deflation going on. In gold equivalents, money supply was shrinking, prices and wages were falling, thus purchasing power was rising. But of course they weren’t using gold, they were using purely paper marks, and in terms of marks there was massive hyperinflation. If they had been using gold-backed marks instead, then we would all talk about the Great German Deflation of the early 1920s.

            Reserve currencies have never before been purely fiat the way the dollar is (at least, as far as I know). So when Armstrong says the country with the reserve currency experiences deflation, he’s only looking at currencies with tangible backing. I don’t think he has any examples in that data set that are comparable to the US today. Sure, empires debase currencies, in the Roman case (according to Armstrong) down to only 1/50 of the starting value, but they were still using a tangible currency with at least some precious metals content. US dollars have absolutely no tangible value (less even than the marks that were burned as fuel). Deflation in gold terms is already ongoing in the US today, but it hardly precludes a hyperinflation in dollars.

            Events also happen faster today than in ancient empires, which is important if you give credence to Jim Sinclair’s “currency collapses are psychological events” idea. A slow collapse as in Roman times takes too long relative to a human lifespan to cause a panic out of the currency. The American or Western collapse will happen much more quickly.

          • Bruce C.

            First of all, I don’t necessarily agree with Armstrong’s analysis as it pertains to the US dollar in particular, I just wanted to point out to Agent P that his claim that the “wisdom of history and a sense of global fragility” is not necessarily why the US dollar would hyper inflate. I’m not saying it won’t or can’t, just that history and global fragility are not guides that would suggest that, just the opposite in fact.

            But that said, using Armstrong’s own facts and logic I can see how the US dollar could hyperinflate despite being the world’s reserve currency that he thinks is so important. In fact, I think his reserve currency idea is a red herring. Just as you said, I too don’t know of any example in which a reserve currency was purely fiat like the US dollar. But following Armstrong’s own examples and explanation, and your own concerning gold and the German mark in the 20’s, it’s clear to me that what really goes on during financial turmoil is the hoarding of “real” money, or that which has the most intrinsic value, NOT the reserve currency of the day per se.

            Roman coins were hoarded because they were the most valuable currency in the world at the time, containing real precious metals, and because as people sensed/experienced metal dilution of the coinage they were hoarded. Bad money drives out good money. It’s the same reason people started hoarding pre-’64 US silver coins after they were reformulated with less silver (same face value, less precious metal).

            In the case of German marks during the 20’s, it was gold that was hoarded (and thus became more valuable and increased in purchasing power) not the paper/fiat marks themselves. Instead they were literally churned before losing even more value.

            The analogy applies to Argentina, Zimbabwe, and all the other famous hyperinflations. In those cases it was primarily the US dollar that was hoarded (and gold/silver too but there was just much less of it), because the US dollar was considered the most valuable currency at the time. “As good as gold”.

            Therefore, if that is the primary directive during financial turmoil – the hoarding of that which is believed to be the most valuable – then in the case of the United States and its dollar I should think that gold/silver would be hoarded and not used as money to the extent that the dollar is perceived to lose value. If there happens to be another currency in the world – even if it is purely fiat – that is perceived to be as valuable as gold/silver, and more useful as money, then that currency would begin to be used. This is an expansion of Armstrong’s own example of “scrip”. People will use as money whatever they think is best at the time. Gold (and silver too to some extent) is an excellent form of currency in theory as long as not too much is need in circulation, so in the modern case – today – something else would probably be used as currency if the SHTF but gold/silver would still be valuable as STORE of wealth.

            Now, something more needs to said here. So much for my alternative analysis of Armstrong’s thesis. The practical question going forward is whether or not the US dollar will in fact begin – or continue – to lose its perceived value. Based upon current financial metrics, despite all the theoretical reasons why the US dollar should already be considered fairly worthless, including its loss of 96% of purchasing power since 1913, the US dollar is still considered to be the best and strongest currency in the world. So far, most people think that the US dollar is a better form of money – both as a currency and store of value – than gold or silver. That is literally an act of faith, and it is absolutely crucial in a credit-based fiat money system that we have. Lose that faith, and in my opinion dollars would NOT be hoarded, despite being the world’s reserve currency as Armstrong would contend. Precious metals would be, because I don’t think anything else in the world would be considered more valuable.

            I think “the financial authorities” such as the Fed knows this and for precisely that reason I don’t think they will be as willing or compelled to devalue the dollar as quickly or as much as many people expect, despite arguments that “it’s the only way to deal with the national debt”. It’s not. High inflation, possibly leading to hyper inflation, is not the only option, I don’t care what history suggests. High, and certainly hyper-, inflation would not be good for the wealthy, the banks, the politicians, or the financial system. It would be suicidal. Mike Shedlock has a good piece about this: http://globaleconomicanalysis.blogspot.com/2012/06/is-there-limit-on-central-banks-ability.html.

            Defaults and deflation is another option. That may seem politically less popular but I don’t think that matters any more. There definitely seems to be a strong push and acceleration to a one-world government and financial system and it is definitely not democratic. The latest EU summit boondoggle is an effort by Monti and others (Bilderbergs and Trilateral Commission members) to set up something like that with the ESM. I’m just saying that governments this time may choose to impose austerity on the world despite the poliitcal pain because the alternative would be worse, at least for them.

          • Bruce C.

            Here’s an article about who’s behind the efforts in Europe, in case your interested: http://www.huffingtonpost.com/ellen-brown/european-stabilization-mechanism_b_1641552.html

          • paper is poverty

            Yeah, I think that’s a good approach: there’s the question of what will be hoarded as a store of value, but there’s also the question of what form of currency will be utilitarian and convenient. Cigarettes are a favorite currency, and I hear airplane-sized bottles of liquor work well too.

            I can see that gold and silver might become so valuable, and there might be so little in circulation, that they don’t operate well as currency. That’s the case, incidentally, in Jim Kunstler’s post-apocalyptic novels (World Made By Hand and its sequel). In his future, silver is used for large transactions only (say, the purchase of land or a few cows) and gold almost never changes hands. People would rather get along by bartering, inconvenient as that might be, than part with precious metals.

            Someone had a theory that during a dollar crisis, physical cash would disconnect from all those theoretical, 0’s-and-1’s dollars in the financial system, and this physical cash could still be used as a currency. At most 6% (my own guesstimate) of dollars actually exist in physical form, and virtual dollar creation will surely outpace physical dollar creation going forward. This is to say nothing of the theoretical value of stocks, bonds, derivatives, etc. And a large proportion of these linen dollars (at least half, I’d think) are not in the United States because they are out there acting as the world’s black market currency (drugs, arms, etc). So there might only be (say) $300 billion in physical notes and coins within the US, or a little under $1000 per person. If M0 stays at this level while the imaginary dollar supply in financial la-la land explodes, actual cash may disconnect and be used as a more stable form of currency.

            It wouldn’t be hard to implement. Gas stations already give better prices for cash than for credit (though for different reasons). And the under-the-table market has accelerated since 2008, and it mostly uses cash. I can imagine the government outlawing preferential treatment of cash, but then, those laws only encourage the very same black market in which cash flourishes.

            I’d be curious what you think of this possibility?

          • Bruce C.

            I think whatever unfolds will depend upon whether or not governments can maintain control, and on the level of independence the populace wants to have, so there are too many scenarios to speculate.

            However, your statement, “If M0 stays at this level while the imaginary dollar supply in financial la-la land explodes, actual cash may disconnect and be used as a more stable form of currency”, reminds me of what is going on in the gold market right now, so maybe what happens there will be a guide to what happens to physical dollars.

            “Paper” gold (i.e., shares of ETFs like GLD) is based on a fractional reserve system, as is the bullion banking system, and even the number of outstanding shares in gold mining companies can be multiplied by whim. There are those who have said something very analogous, namely, ‘Since the amount of above-ground gold bullion is relatively fixed while the imaginary gold supply in financial la-la land explodes, actual (physical) gold may disconnect and be used as a more stable form of wealth.’ There may come a time when you can buy as many shares of GLD that you want but not one ounce of physical gold will be available at any price close to the share price.

            Another thought has to do with capital controls. It occurred to me that one of the most effective ways of stopping black- and grey- market activities would be for governments (the US in particular) to simply
            issue new physical currencies, not necessarily in face value but appearance, and then declare the old currencies illegal to use. That would send the current US dollar even further “under ground” and out of circulation for all practical purposes, even though something like 95% of all monetary transactions are electronic any way. If that happens it will be very interesting to see what happens to the “old” US currency overseas. I’m not sure about this but I think there is about 900 B within the States and about the same around the rest of the world.

  • John

    The taxpayers getting the shaft? I thought that was a given.

  • Bruce C.

    Articles like this one gives me a headache. It’s typically European, which is to say complicated and convoluted, and – if one bothers to wade through the details – outrageous and absurd. For example, if a bank has cash to buy a crappy bond to use as ECB loan collateral then why not just put up the cash itself? Answer: Because in the on-going spirit of “extend and pretend” (remember that strategic slogan?) those discounted bonds can be valued at par, effectively providing leverage that cash couldn’t! After all, the circular reasoning goes, the only reason those bonds are crappy is because of depressed real estate prices, foreclosures, fraud, and overall economic recession, so if the banks can be recapitalized using those bonds as collateral then the banks can do their part in resurrecting the economy so all those crappy bonds won’t actually go in the crapper, and everything will be okay. You see?

    I sympathize with the European taxpayers on this one because it is all so frustratingly crazy that just about all your mild-mannered protester can do is get “noisy”. And this is just one of many affronts. Imagine trying to organize a rally in front of the ECB about this. What kind of as sign could you make? “STOP ACCEPTING CRAP AS COLLATERAL!” Or, how about, “PAR MY ASS!!” Okay… maybe chants would be better…”NO MORE JUNK! … NO MORE JUNK!”.

    Hopefully for them it would sound more impressive in german.

    • paper is poverty

      Thanks for the laugh re: the protest signs. “Par My Ass!” gets my vote.

  • Carole Foryst

    Thank you for the insight. Questions.
    Who is/has tendered the debt to the originators? They must be booking losses, yet such occurrences are masked or not made public.
    Is the ECB purchase of low rated debt different from what the FED did/does? Is the bundling, securitizing, and trading all these toxic bonds imitating the US model involving Fannie/freddie , banks and FED that burdens the US?

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  • http://www.sh1ny.com Paul Blumenthal

    Current system is fascism. That’s true. But true free market economy always finishes as fascism (corporationism). That’s something that you guys don’t see. Let me give you an example:

    It is 1998. Nobody heard of web search, right? I don’t think that the term was even defined. So, obviously as nobody knew what it was, there was no Government regulation or intervention in the web search market, right? So, we have 1998 and we have 2 guys in a Garage creating Google. And thanks to the lack of regulation and lack of the Government intervention Google works out beautifully. So far so good. We have 100% pure beautiful capitalism for Google. Everybody happy. Capitalism at its finest. Now comes the part that is explained by Marx and you guys simply don’t grasp: In the year of 2010 Google sponsors a bill to regulate the market economy so its position as a monopoly for web search is secured by the law. That’s the fact bill like this has been developed by Google. Now Google bribes (aka ‘lobbies’) the House/Senate/etc and gets what it wants: if you use Google connections goes through fat and fast Internet connection. If you use something else, no matter how many times better, the law says that slower connections must be used. That’s exactly right. That’s fascism: laws created by corporations to secure their monopolistic positions at the same time empowering Government more as now it needs to eavesdrop only Google’s traffic. Everybody wins. Except for constituency that is. Fascism. In other words once those corporations grow big enough thanks to the lack of regulation and free markets THEY will regulate instead of the Government (democratically elected Government I should add).

    And I know what will you say: “Ahh.. it’s still because of the GOvernment because the Government enables this. Because the GOvernment allows bribing and lobbying to happen”.
    Well, this argument is aking to communists argumentation that communism would work great if just people could understand that they ought to be equal and not want more than their neighbor. It is the same stupid logic: oh capitalism would work great only if these stupid people would understand not to take bribes, lobby and have no special interests. It is utopia my friends. Politicians will always accept fact checks from corporations. This way corporations ultimately destroy capitalism that created them and replace it with corporationism known also as fascism. That’s the path that not only Google took, but also banks in the past – hence FED was created to secure their interests in 1917. Big Pharma, hence MedicAid and Medicare were created. And military complex hence all the wars.

    You see capitalism is self-destructing. So go there and read Marx before dismissing him as an idiot.

    Paul Blumenthal,
    http://www.sh1ny.com Founder.

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  • Brendan

    They should call this website dollarstrengthen.com

  • http://www.sh1ny.com Paul Blumenthal

    There WILL BE great America again! The reason is YOU People! People who have aweken to the dire reality of debt. Ron Paul supporters! Freedom true believers! That’s the last stand on Earth where people DO understand Freedom and DO understand capitalism. Look, I’m an US citizen, who was born in Europe. Who also lived in Asia. You can trust me on one thing: nobody really gets it except for the Americans. We will get through. There is hope. Because of the People. Just don’t give up and FIGHT!

    My little piece of fight is this little gold chart for free for everyone to use: http://www.sh1ny.com

    I hope you will find it useful.

    Paul Blumenthal,
    http://www.sh1ny.com Founder.

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