"Those whom the gods would destroy, they first encourage to borrow cheaply"

Today's must read on the next financial panic.

All About 'The Blob'

Read it and weep.

Who Wants to Break Up Too Big to Fail Banks?

Quite a few former Too Big to Fail bank CEOs, actually.

h/t Simon Johnson.

On The Problem With Postponing the Inevitable

Today's Eurogeddon must read.

Video: Debt and Redemption Documentary

At the risk of sounding trite it's often helpful to put a face and voice behind the news.

This short documentary by VPRO, which does excellent work overall btw, has some good coverage of the fallout from the dealings by both small and large Italian municipalities in derivatives like interest rate swaps. And if terms like 'derivative' turn you off but you're still interested in learning more and trying to understand the financial crisis, then video is particularly recommended.

Interviews include the Rolling Stone's Matt Tabibbi, Brooklyn based investor-blogger Reggie Middleton, and former IMF Chief Economist and Professor Simon Johnson.

The most interesting fact from the documentary for me was learning how the City of Milan agreed to be on the hook financially to a bank in the event of a debt default by Italy (the nation state).

Are there any other municipalities which have contractually guaranteed the debt of a sovereign state?

Video: Simon Johnson's White House Burning

Video: Lawrence Lessig's Republic, Lost - How Money Corrupts Congress—and a Plan to Stop It

Note to video departments everywhere that the below video is a fantastic way to show a presenter and his/her slides.

h/t Barry

Believe the Hype? Eurozone Collapse Fear-mongering Kicks Into Overdrive

Munchau gives the Eurozone at most 10 days to fix its problems before it implodes.

DeLong argues that "the Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash”.

But Johnson and Boone say such measures are basically pointless and have declared "The End of the Euro".

All of the above are respected thinkers with loads of experience and credibility, so clearly we are on the precipice of financial apocalypse.

But are we?

The Icy Silence

One country has taken a completely different path to the government and central bank financed bailouts urged by many of the Econoratti as the only way to save the Eurozone (and global economy) from economic catastrophe. That country is Iceland.

Iceland committed financial heresy when it decided to let its three formerly pygmy-sized banks, which rang up a remarkable $100 billion+ in losses, go bankrupt.

And how have things turned out for Iceland? So far, not too shabby.

Sound intergalactic advice

Iceland, an approximately $12 billion GDP economy, is small and none of its banks were Too Big to Fail. So it's an open question whether the example set by Iceland can be repeated by a larger country with a much more important banking system (i.e., Spain or Italy).

Having said that, one of the remarkable things about the current crisis debate is the near complete lack of contemplation of that very question. Instead an almost unanimous call is being made for the Germans to unleash the ECB money printing 'bazooka'. But that is just one of several different options.

As we contemplate Eurogeddon let's keep Iceland in mind. Contrary to what financial scaremongers would have us believe economic life does not come to an end when banks are allowed to fail and countries are allowed to go bust.

Recommended links & Photo of the Week

Coming soon to a Eurozone bank near you?

1. Beware of falling masonry (Economist) Good tactical overview of the eurozone crisis and some of the options being considered. See also 'Banks Build Contingency for Breakup of the Euro' (NYT)

2. Latvian bank Krajbanka set to be wound up (AFP) Above bank run image is of Krajbanka.

3. The Rise and Fall of Bitcoin (Wired) Contrary to the title I don't think this is the last we've heard of Bitcoin, or other virtual currencies, but an interesting and informative read nonetheless.

4. Prepare for riots in euro collapse, UK Foreign Office warns (Telegraph)

5. Why Not Break-Up Citigroup? (Simon Johnson) Citibank has blown-up and required a bailout three times in the last three decades, or once on average every ten years.

6. How could Reebok sell trainers for $1? (BBC) Contrary to popular believe it's not all glum news here at TPC. I was able to see the remarkable Nobel Peace Prize winner Professor Muhammad Yunus speak this week (video below). His bank, Grameen, is doing amazing things and gets a BHAG nod.

7. MF’s Missing Money Makes You Wonder About Goldman (Jonathan Weil)

World's Most Dangerous Banks and Their Host Countries

Below is the Financial Stability Board's list (by host country) of systemically important financial institutions (SIFIs), alternatively known as the 29 banks which are simply Too Big to Fail.

Twelve different countries are home to these 29 banks. Half of those countries host just one Too Big to Fail institution, and the other half host anywhere from two (Germany and Switzerland) to the U.S.'s eight.

Continue reading the full article at SeekingAlpha here.

Recommended links

1. Why is Greece turning down the “bailout” (Tyler Cowen)

2. Circular commitments lead to a Ponzi economy (Letter to the FT). Here's the key quote:

If governments stand behind banks and banks stand behind governments and the central bank lends freely to both and also underwrites financial markets, then financial asset prices become completely detached from economic reality. In this “system”, the central bank implementing more quantitative easing is no different, in economic terms, from Bernie Madoff marking up his client accounts every month.

3. The Bailout That Busted China's Banks (WSJ)

4. Mr. Hoenig Goes to Washington (Simon Johnson)

5. Bond Dealers See Fed Holding Rate Near 0% at Least Through First Half of 2013 (WSJ)

6. Papandreou Is Right to Let the Greeks Decide (Spiegel)

7. Live European debt crisis coverage (BBC) and (Telegraph)

Default Myth Busting: Sorry Simon and James, the U.S. is not a Default Virgin

Professor Simon Johnson and James Kwak of The Baseline Scenario have an article at Vanity Fair about the geopolitical importance of credit in late-18th century France, Great Britain, and (especially) the United States. Their article, however, fails to mention an important detail which also happens to contradict their claim that "the (U.S.) federal government would always honor its debt".

The consolidation/conversion of U.S. revolutionary state debt into federal debt, which took place in the early 1790s, and which the authors refer to in the paragraph prior to the above quote, represented a U.S. sovereign default. (For more on this event see Reinhart and Rogoff (click on the U.S. tab) or Sylla, et al, which describes the 'haircut' bondholders received (6% to 4%).)

The notion that the U.S. has never defaulted has unfortunately been repeated often enough that, like the incorrect claim that TARP was "profitable", otherwise well-informed people have come to believe it.

In terms of other U.S. defaults, Reinhart and Rogoff also count Franklin Roosevelt's 1933 prohibition on owning gold and the subsequent devaluation of the U.S. dollar vs. gold as a default.

It's not very surprising to see Vice President Biden promoting the myth that the U.S. has never defaulted (in his case following a visit to the U.S.'s largest creditor, China). Professor Johnson, however, should know better.

Why the Vickers Report on Banking Reform Failed the UK and the World

Kotlikoff rips the Vickers commission's final recommendation:

The Independent Banking Commission’s final report is a grave disappointment. The ICB (chaired by Sir John Vickers) seeks to reinstate Glass-Steagall by ring-fencing good banks and letting bad banks do their thing and, if they get into trouble, suffer the consequences. This proposition was tested by the collapse of Lehman Brothers, whose failure nearly destroyed the global financial system. 

The commission retains the current system apart from some extra requirements primarily imposed on the good banks (the retail banks). The main impact of this is likely to be to foster more financial intermediation to run through the bad banks, i.e. if you impose more regulation on financial companies that call themselves X and less on companies that call themselves Y, companies that call themselves X will start to call themselves Y. In short, the commission has in effect taxed good banking while sanctifying shadow banking. The commission has also chosen to regulate based on what a bank calls itself, rather than on what it does.

A year back, Mervyn King, Bank of England governor, described the current banking system as the “worst possible.” In a speech, delivered at the Buttonwood Conference in New York, he called for the analysis of Limited Purpose Banking — a reform plan that I developed, which replaces traditional banking with mutual fund banking and makes no distinction between financial intermediaries.

At the end of last year, I travelled to London and met the commission staff to discuss Limited Purpose Banking. I had thought the commission would take the proposal and my discussion with them seriously. That was not to be. In fact, the commission spent very little space discussing the proposal, despite Mr King’s urging that it be carefully studied, and notwithstanding its remarkably strong endorsement by economics Nobel Laureates George Akerlof, Robert Lucas, Edmund Phelps, Edward Prescott, and Robert Fogel as well as by former US secretary of state and former US secretary of the treasury, George Shultz, by Jeff Sachs, Simon Johnson, Niall Ferguson, Ken Rogoff, Michael Boskin, Steve Ross, Jagdish Bhagwati, and many other prominent economists and policymakers.

Do the opinions of the governor of the Bank of England and all these prominent authorities on finance and economics deserve to be dismissed in seven sentences? For seven sentences is all the commission was able to spare when it came to discussing Limited Purpose Banking, notwithstanding the 358 page length of its report.

Full article here.

If Not Obama, Who Does Secretary Geithner Take Orders From?

Here's the story about how Treasury Secretary Tim Geithner, perhaps emboldened by his ability to get away with tax evasion, decided in March 2009 to ignore President Obama's directive to dissolve Citibank.

As MIT Professor Simon Johnson and others have pointed out, the most recent financial crisis marked the third time in the last three decades that Citibank has needed a taxpayer financed bailout. In other words, once every 10 years on average Citibank goes bust.

Obama, perhaps aware of this fact, maybe thought it was time to put an end to the joke that Citibank and its lackluster management can stand on its own two feet without government backing. Why didn't Geithner agree with his boss?

Friends of Bob: Summers, Orszag and Geithner

Yves Smith has a theory. Another possibility is that dismantling Citibank would have put an end to the #1 preferred post-government destination for officials looking to cash-in like Robert Rubin, who pocketed hundreds of millions of dollars in compensation as Chairman of Citibank following his position as Treasury Secretary, and Peter Orszag, who left the Obama administration for a similar lucrative position with the megabank.

And what consequences has Geithner suffered for his supposed insubordination? Apparently none based on the fact that Obama purportedly had to beg him to stay on through the 2012 election.

Why Greece Will Default Soon, and What Happens Next

As the haze and rhetoric surrounding the Greek debt crisis begins to lift we can now paint a pretty good picture of what's in store over the next few weeks for Europe's seemingly never-ending debt saga.

The June 29 Deadline

The FT describes the latest details and deadline in the Greek debt endgame:

...pressure is building to have a deal done within three weeks because of an IMF threat to withhold its portion of June’s €12bn bail-out payment unless Athens can show it can meet all its financing requirements for the next 12 months. 

Officials think Greece will be unable to return to the financial markets to raise money on its own in March – as originally planned in the current €110bn package – meaning that the IMF is now forbidden from distributing any additional cash. Without the IMF funds, eurozone governments would either be forced to fill the gap or Athens could default. 

To bring the IMF back in, the new deal must be reached by a scheduled meeting of EU finance ministers on June 20.

The hard deadline may in fact be June 29, when a 12 billion euro ($17bn; £10bn) payment is due to be made to Greece, of which 3.3 billion euros would come from the IMF.

Driving the IMF's credible tough stance are hard lessons learned (and apparently not forgotten) in Latin America a decade ago.


Remembering Argentina

Paul Blustein has written two very insightful and accessible books on recent sovereign defaults and IMF bailouts. His first, titled The Chastening, details the 1997-1998 Asian financial crisis. His follow-up focussed on the financial crisis which struck Argentina's shortly thereafter, and is titled And the Money Kept Rolling In (and Out): Wall Street, the IMF, and the Bankrupting of Argentina. Both books are available in in the Good Books and Films section on the right side of this blog.

Continue reading the full article at SeekingAlpha here.

Video: Simon Johnson Rips Too Big to Fail at Bretton Woods

The Biggest Loser (Besides the Irish) in Ireland's Ongoing Debt Crisis

Noted economic historian Barry Eichengreen has written perhaps the most scathing damnation of this week's Irish bailout. I strongly encourage reading the full piece.

Professor Eichengreen takes aim at Germany in particular. In the below passage he compares the Irish bailout to Germany's own hopelessly burdensome WWI war reparations, which played a key role in the rise of the Nazis and perhaps the Great Depression:

"Ireland will be transferring nearly 10 per cent of its national income as reparations to the bondholders, year after painful year.This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor. Do Mr. Trichet and Mrs. Merkel have a contingency plan for this?"

The short answer to Barry's question is, of course, no.

Irish Bailout Rejection Fallout

European sovereign bailouts may wind up becoming a lot like Department of Defense contracts in that the only thing contract signing signifies is the beginning (rather than the end) of negotiations. For example, if the new Irish government rejects its bailout as expected there may be an attempt to stem the ensuing crisis by negotiating down the hopelessly high bailout interest rate of 5.8% (or 7.25% depending on how it's calculated). And Ireland's controversial low corporate tax rate of 12.5%, rumored during the height of the drama  to be on the table for european 'harmonization', may also be revisited.

Any such renegotiations should be viewed as window dressing aimed at delaying the final reckoning. The fundamental problem is that Ireland is insolvent. No amount of additional liquidity or tax rate bargaining alters this inescapable fact. Faced with this prospect, Europe's current leaders are struggling to determine who will take the biggest hit from Ireland's inevitable default.

Who Will Be the Biggest Loser?

Arguably the key issue to keep an eye on is whether senior Irish bank debt holders will be forced to take losses. If in fact Eichengreen's suggestion of 100% haircuts on insolvent Irish bank debt is adopted the ramifications for Europe's banking system would be difficult to overstate.

The below chart is helpful to understanding the implications of an Irish bailout rejection/and or default.

(click to enlarge)

The U.K. is Ireland's largest creditor with approximately $220 billion in exposure, so any Irish bailout rejection and/or default will weigh heaviest on Britain. Royal Bank of Scotland (RBS) and Lloyds TSB, which were previously placed on government life support, are particularly threatened.

An Irish rejection of the bailout will put substantial pressure on the still fragile British banking system, which post-bailout consolidation is now home to three of the world's five largest banks (including #1 RBS).

(click to enlarge)

In spite of the current austerity push in the U.K., the government participated in the Irish bailout and pledged approximately $10M to "a friend in need". An Irish Times editorial, reflecting the long and conflicted relationship between these two nations, greeted British 'kindness' with a degree of skepticism.

It's would appear that the U.K. (an EU member which never adopted the euro currency) helped bailout Ireland because rescuing a neighbor is politically more palatable than what would have been necessary if Ireland's debt situation had further deteriorated: recapitalizing the British banking sector (again).

A Lonely Lady

But if at some point an Irish default is inevitable, and the Eurozone nations align to protect their euro based banking system, Britain may well find itself the odd man out. And since further bank bailouts by parliament are politically DOA, Mervyn King and the Old Lady of Threadneedle Street may be left to step into the breach to recapitalize British banks. Any such Bank of England support would be coming on top of calls from the Cameron government for further quantitative easing to reduce the effects of government budget cuts and nagging inflation. In other words, sterling would be forced to do even more at a time when the currency is already stretched thin.

It is worth briefly reviewing the history of pound sterling in the 20th century. In the 1920s one pound fetched almost $5. The country was forced off the gold standard during the September 1931 Sterling Crisis, resulting in a sharp devaluation. Following the massive accumulation of debt during WWII, the pound was devalued again in 1948. This was followed by a further 15% devaluation in 1967. Following a severe recession in the early 1980s, the pound has traded as low as $1.03 in March 1985. Overall, there is well established history of devaluation when the going gets tricky.

While the recent plunge in the euro has provided a relative respite in what had been a steady weakening trend in the pound, Britain will bear the foreign brunt of any Irish bailout rejection and/or default. Further compounding this problem is China's curious financial support to Europe's 'Club Med' nations, but not Ireland, and Britain's total debt position which stands at a whopping 5x GDP (the world's largest total debt/GDP ratio). Based on these and other factors one can make a very good argument that over the medium-to-longer term the pound will continue its long drift downwards. Several ETFs are available to hedge against this risk.

“We’re not Greece!” “We’re not Ireland!” “We’re not Portugal!”

While the name of the country changes, the "We're not _____!" plea from a revolving panoply of European officials has become all too familiar.

Can any of Europe's politicians -- or anyone at all -- definitively state at which country's doorstep the rolling European debt crisis will ultimately stop? The short answer is no.

Europe's Two Big Challenges

The Economist has a comprehensive summary of the latest developments in this sad saga; the violence, which first turned deadly in Greece this spring, unfortunately shows no sign of abating in Ireland. From the article:

"[Germany's] Mrs Merkel and Mr Schäuble are continuing to insist on two proposals.

One is that the EU treaties must be amended to give permanent status to the European Financial Stability Facility. Without this, they say, the rescue fund will expire in 2013. But investors know from experience that treaty amendment is neither simple nor quick (it took years to push through the Lisbon treaty). Insistence on treaty change makes them nervous.

So, even more, does the second German demand: that future bail-outs must include debt-restructuring provisions to impose some losses (“haircuts”) on investors."

With respect to challenge #1, it is quite clear that Eurozone popularity is waning in certain quarters. Any treaty change could prove problematic, particularly in Ireland where such changes must be put to a referendum vote.

Europe's Web of Debt

On #2, haircuts to bondholders, it is worth taking another look at the complex edifice of european debt. The interlocking nature and size of cross-border debt holdings explains why European leaders fear allowing any one domino (Greece in May, Ireland this week) to fall.

Germany is the biggest checkbook in the EU and, quite understandably, is insisting that the private sector share in the cost of any future sovereign debt defaults. Otherwise what is the point of distinguishing between the debt of different countries?

But can Europe's delicately interwoven debt and banking market cope with haircuts, particularly to senior debt? The current Irish crisis was sparked by discussion of losses on subordinated debt (80% in the case of Allied Irish Bank). Tellingly, Irish debt costs have continued rising even after its bailout was confirmed. This is in part due to rumors that senior debt holders may also be forced to take losses.

As former chief IMF economist Simon Johnson and LSE's Peter Boone recently wrote "market participants are good at thinking backwards: if they can see where a Ponzi-type scheme ends, everything unravels". In other words, the market for troubled sovereign debt depends on the ability of countries like Ireland and Spain to 'roll over' their borrowings until their economies begin growing again. (Ireland's economy began shrinking again earlier this year, and Spain's is projected to shrink for 2010.) Without economic growth the odds that troubled sovereign debts will ever be repaid in full (without outside help) is almost certainly nil.

In the months since the spring Greek crisis, the quasi-explicit bailout guarantee by the "troika" (EU, IMF, and ECB) has been the Eurozone debt market's linchpin. Now the bond market is calculating that Germany's insistence on private sector loss sharing by 2013 means than holders of certainly Greek, Irish, Portuguese debt, and perhaps the debt of other nations, will be forced to incur losses. Instead of waiting  around to find out the precise haircut percentage, investors are exiting risky pan-european sovereign debt positions post-haste.

China to the Rescue?

Ultimately, the answer to the question of where the Euro-debt unmerry-go-round stops depends on how far the ECB, IMF and German taxpayers are willing to go.

Simon Johnson thinks the ECB and Germans neither can or will, respectively, step up to the plate. He also questions whether the IMF has enough resources to bailout a country the size of Spain, let alone Italy or France. He goes on to speculate that if one of the large Eurozone nations needs a bailout that China, with its $2.6 trillion in reserves, may be asked to recapitalize the IMF. The attraction for China: increased global standing and leverage on contentious issues, such as its policy of maintaining an artificially low currency.

I believe that China may expand its existing role in Europe's debt crisis. However, European and U.S. officials will be reluctant to surrender center stage to China and will minimize Beijing's participation. While the exact form of the ultimate resolution is unclear, it will be a European-U.S. led solution.

Looking Ahead

The question of whether membership in the euro currency union is a good idea has taken root. Iceland's President has recently been talking up his country's relatively quick bounce back from bankruptcy abyss. Part of Iceland's rebound can be explained by the fact that it was able to devalue its own currency, which helped its export sector. In contrast to Ireland, Iceland also chose not to bail out its insolvent banks. The Czech Republic, slated to become part of the currency bloc, recently demurred on whether it would follow Sweden's path of never adopting the euro.

On the subject of whether any countries will abandon the euro currency all together, the consensus view popularized by Professor Barry Eichengreen was that joining the euro was irreversible due to the risk of sparking a bank run. But as NY Times columnist Paul Krugman states, this incentive to keep the euro vanishes when a bank run (like the one currently underway in Ireland) has already taken place.

Many questions remain, but one thing is certain: even with Ireland's bailout (the specifics are expected to be announced on Sunday before Asian markets open) the Eurzone crisis is far from over. Investors looking to insulate themselves from events may want to consider hedging currency risk through various inverse Euro ETFs, or by investing in precious metals.

Too Big to Save: Is Ireland the 'Lehman' of Europe's Sovereign Debt Crisis?

One of the most articulate and knowledgeable authorities on the financial system and crisis is MIT Professor and former IMF Chief Economist, Simon Johnson.

In two must watch videos Professor Johnson clearly explains why another financial crisis is inevitable unless specific steps are taken to prevent one.

Charles Ferguson on "Obama's Depressingly Rational Decision to Give In to Wall Street"

Academy Award nominated film director Charles Ferguson, who's documentary Inside Job about the financial crisis is currently playing in theaters, has penned an article on President Obama and Wall Street.

When will we stop indulging the fantasy that 'Too Big to Fail' banks are private enterprises?

And if you haven't already seen Ferguson's interview of former Fed Governor Fred Mishkin on his infamous "Financial Stability in Iceland" report, you can check it out here.