Anatomy Of The End Game, Part 2: Variations On The Problem

Tyler Durden's picture

Authored by Martin Sibileau of A View From The Trenches blog,

“…Just like since the beginning of the 17th century almost every serious intellectual advance had to begin with an attack on some Aristotelian doctrine, I fear that in the 21st century, we too will have to begin attacking anything supporting the belief that the issuer of the world’s reserve currency cannot default, if we are ever to free ourselves from this sad state of affairs…”

The intention today was to do a revision of what I had expected in 2012, what happened and what I think will happen. However, we may have to put this aside one more time, given the feedback received on the last post, titled “Anatomy of the End Game”. I seem to have been misinterpreted and to clarify this very important topic, I present a second part to make absolutely clear that:

  1. It is misguided to believe that the end game should be blamed on the shadow banking system. Should regulators succeed in leaving regulated banks the role of funding the commodities and futures markets, the end game would not be avoided and its violence would be even greater,
  2. Fiscal austerity in the US, if my assumptions (clearly laid out in the previous post) apply, would be irrelevant unless it produces a sizable fiscal surplus,
  3. The approach taken by policy makers addressing this logical outcome (which they mistakenly call tail risk –the tail risk is the reverse: That the game does not end-) is wrong.

The End Game in a world without shadow banking

There are continuous attempts at further regulating money market funds and central counterparties (i.e. clearinghouses), based on the belief that their operations entail risk of a systemic nature. But the systemic nature of the risk is simply due to the leverage built upon the collateral that these players use to provide funding. There is nothing particularly intrinsic to either the players, the markets that use that collateral or the collateral (i.e. sovereign debt, mortgages, etc.) itself, to make them “systemic”. To coerce these players to increase their capitalization or to prevent them from freely disposing of their liquidity as risk varies only increases costs and volatility.

Let’s assume the extreme case where the “shadow banking” sector disappears and banks become the sole providers of funding in the repo market. The figure below describes the situation.

In stage 1, we can see the consolidated balance sheets of the financial institutions, traders, and non-financial institutions (private sector). Traders have US Treasuries as assets, which in stage 2, they sell to source cash. This cash is expressed as deposits (in stage 2), which are liability of the financial institutions. Deposits then, are backed by US Treasuries. When these are repudiated (our main assumption) the sustainability of the financial institutions is challenged, precisely at the same time that traders may be suffering a short squeeze on short commodities positions and margins are called. This short squeeze would also affect the commodities and futures markets’ clearinghouses (not shown in the figure). From stage 3, it is easy to see that depositors (non-financial institutions) who are not part of the aggregate “traders” class are the ones who are most at risk. The faith in the US dollar system is lost and a run on the banks is triggered.

We must clarify that the US dollar zone/system is not bound by geographical or jurisdictional borders. A Hong Kong or Brazil based bank that relied on US dollar funding to generate relevant net interest income would be equally affected by the liquidity squeeze, as so many European banks learned in 2008 and 2011.

 

Under this scenario, and unlike the case where the shadow banking system funds the repo market, the Fed would not have the luxury of choosing whether or not to intervene. It would simply be their duty to do so, and they may believe that they have the option to purchase the US Treasuries from the banks with or without sterilization. But in the end, it would not matter…sadly. Let’s go through the process:

a)      The Fed purchases US treasuries without sterilization

This is the easiest option to understand. As the figure shows below, the Fed purchases US Treasuries from the financial institutions and their reserves grow. As the whole context in which this would occur is not positive for economic growth, to say the least, and the private sector delevers: Loans outstanding, on a net basis, decrease. Deposits decrease and the non-financial private sector increases cash on hand. The equity of the financial sector, naturally, suffers. This cash on hand will keep rising as long as the US debt remains repudiated and US Treasuries need to be monetized by the Fed. Eventually, in the absence of alternative investments (as in the current context, with zero to negative interest rates), the cash is simply spent on consumption. In an environment of financial repression, where companies use whatever liquidity preferably to distribute back to owners via share buybacks or dividends (as we expected back in March), the higher consumption facing lower production ends up driving prices higher.

b)      The Fed purchases US treasuries with sterilization

If the Fed decided to sterilize the purchase of US Treasuries being repudiated, the market would immediately begin to discriminate between those banks who get the benefit of carrying Fed debt and those who don’t. This is similar to what we see in the Eurozone: Deposits flee banks which are seen at risk of being caught on the wrong side of the tracks, should a break up of the Euro zone occur, to banks in the core of the Euro zone (i.e. banks with continuous access to liquidity lines of the European Central Bank). This arbitrage (why carry cash, which pays no interest, rather than Fed debt?) would drive all banks to buy distressed US Treasuries to make a difference exchanging them for Fed debt. This would be a very perverse process, because banks would drive deposit rates higher to maximize the sourcing of US Treasuries.

At this point, I am aware you may be confused: It doesn’t seem to make sense to first assume that Treasuries are being repudiated and later say that banks seek to raise deposits to purchase them. But this makes perfect sense, when we realize that in this context, the market for US Treasuries would be simply broken, segmented. Only banks with the privilege of access to the Fed’s window would be interested in US Treasuries, because only they would have access to the interest-paying debt of the Fed. The US Treasuries, effectively, would be marked to model by the Fed and as the private sector gets crowded out and deposits drop, the need for liquidity and profitability of the financial institutions would demand that higher interest be paid by the Fed on its debt.

You may ask why should the Fed be forced to pay higher rates, when the private sector would seem to be out of investment alternatives. First, we must remember that in this context, commodity prices would be rising and the nominal rate of return in gold would be a benchmark, just like simply holding US dollars in the ‘80s was a benchmark shaping inflation expectations in Latin America. Secondly, the Fed would be forced to pay higher rates to keep deposits from dropping in a context of decreasing trust in the solvency of the banking system. Those living today in the periphery of the Euro zone understand this. Why should deposits not drop? Because if they do, more currency will be circulating and available to buy real assets (i.e. gold) and the outstanding stocks of US Treasuries being repudiated would not be cleared from the market into the balance sheet of the Fed. Their increasing yield (as the price drops) would be a price signal to the market that the Fed would have every reason to kill.

 

However, if the value of the US Treasuries falls and the interest the Fed has to pay to sterilize their purchase rises, the Fed will face a net interest loss. The Fed may chose to keep accumulating these losses or may also decide to simply convert its debt in legal tender, to end the arbitrage between currency (not paying interest) and its interest-paying debt. In the first case, we end up with a plain monetization of US Treasuries, which we just analyzed above. The second case (enforcing Fed debt as legal tender) would truly mark the end of the game in terms that would make historians of the 21st century would devote entire volumes…

Why fiscal austerity would be irrelevant without a surplus

A logical outcome, which I think is clear from the two scenarios above, is that no matter how far the spending cuts go, the only way to compensate for the monetization of EXISTING INVENTORY of US Treasuries, is to reach a fiscal SURPLUS. Being only frugal won’t cut it!

In order to avoid being dragged to double digit inflation, there will have to be a fiscal surplus to offset the quasi fiscal deficit of the Fed. However, the implementation of austerity measures (i.e. spending cuts), will necessarily lead to a decrease in activity which would only be temporary if the same are accompanied by a widespread liberalization of markets. It is possible but unlikely, for reasons beyond the scope of this post. All sorts of negative feedback mechanisms could be triggered in this situation, only enhancing the repudiation of the US sovereign debt and the resolve of the Fed to monetize it (For instance, the so called Olivera-Tanzi effect postulates that as inflation rises, access to working capital is restricted and firms delay their tax payments, to get them devalued by inflation. The government therefore receives depreciated tax revenue while its operating costs increase, facing deficits that need to be further monetized, thereby fueling even higher inflation).

In Argentina, this negative feedback was always resolved with the plain confiscation of citizens’ assets: Savings accounts in 1989, chequing accounts in 2001, pension funds in 2008, etc. (I can’t stress enough how important it is for anyone in the financial markets today to study the monetary developments in Argentina between 1972 and 1991)

Policy makers look the wrong way

The natural reaction from policy makers, so far, has not surprised me. Rather than addressing the source of the problem, they have and continue to attack the symptoms. The problem, simply, is that governments have coerced financial institutions and pension plans to hold sovereign debt at a zero risk-weight, assuming it is risk-free.

This problem truly brings western civilization back to the time of Plato, when there was nothing “…worthy to be called knowledge that could be derived from the senses…” and when “…the only real knowledge had to do with concepts…”In the view of policy makers,  the statement “the probability of US sovereign default is zero” is genuine knowledge, but a statement such as “The US government needs to issue about $100 billion per month to finance its fiscal deficit” is so full of ambiguity and uncertainty that it cannot find a place in their universe of truths…(Note: I am paraphrasing Bertrand Russell here. I am certainly not erudite)…and just like since the beginning of the 17th century almost every serious intellectual advance had to begin with an attack on some Aristotelian doctrine, I fear that in the 21st century, we too will have to begin attacking anything supporting the belief that the issuer of the world’s reserve currency cannot default, if we are ever to free ourselves from this sad state of affairs. The following paragraph, from a speech by Paul Tucker (currently Deputy Governor at the Bank of England) says it all:

“…Two strategies come to mind which I am airing for debate. The first would be ‘recapitalizing’ the CCP (i.e. central clearing counterparty) so that it can carry on.  The second would be to aim to bring off a more or less smooth unwinding of the CCP’s book of transactions…”  P. Tucker, Bank of England, “Clearing houses as system risk managers”, June 2011

Policy makers then believe in recapitalization and coercive smooth unwinds. With regards to recapitalization, I will just say that we are not facing a “stock”, but a “flow” problem. US Treasuries would be repudiated because of fiscal deficits, which are flows. No matter how capitalized a clearinghouse is, once the repudiation starts, the break-up of the repo market and the short squeeze would unfold and develop. Whether there is or not a capital buffer is irrelevant to the problem. In fact, in my view, it would be better that there wasn’t: Why would you want to add more resources to a lost cause?

With regards to smooth unwinds, I think it is obvious by now that the unwind of a levered position cannot be anything but violent, like any other lie that is exposed by truth. Establishing restrictions to delay the unmasking would only make the unwinds even more violent and self-fulfilling. But these considerations, again, are foreign the metaphysics of policy making in the 21st century.

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Seasmoke's picture

Why is anyone waiting on "policy makers" to figure out a solution and do the moral and correct. Instead they should be sweating bullets when in public.

Silver Bug's picture

The end game is rapidly approaching. The FED has RUN out of bullets. They are shooting blanks.

 

http://dr-marc-faber.blogspot.ca/

El Oregonian's picture

More like: "They are shooting BlankS."= B/S

... Sadly, That is all that they have left...

FreedomGuy's picture

Every time I think they have run out of bullets, they find another. It is amazing what you can do with entries on a spread sheet.

imbrbing's picture

YEA, they just enter into the cell 1TTT of more bullets

Carp Flounderson's picture

Yep, and fools who write articles like this still think the fed operates like a hedge fund or something.  SOOO close to understanding how the system works, but you guys just can't seem to get these retarded 'end times' out of your heads.  

kralizec's picture

The End is Near!

Don't forget to decorate your favorite street light!

macholatte's picture

 

 

 

The can shall be kicked!

"So let it be written. So let it be done."

 

These are not the droids you're looking for. Nothing happening here.  Move on.

CH1's picture

Why is anyone waiting on "policy makers" to figure out a solution and do the moral and correct?

Exactly. They will keep their game going till the last possible moment. They have to, really. After all, how would they ever gain the same advantages without a structure that maintains them as rulers over everyone else? Each of them would be just another guy, and not a terribly good one.

It's up to each of us to decide how long we want to continue supporting these clowns. How many beatings before we realize we can just walk away?

EuroInhabitant's picture

The world economy is recovering. Please read AEP:
ttp://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/

What end game? A new round of the old game has just started!

Surrealist's picture

What is it with AEP? He use to have so many good articles. Seem to be a pollyanna orgy of late.  

Yen Cross's picture

Good God/ More charts from vindictive sodomite squids... Not you Tyler, I'm just tired of reading the past!

  People don't lose hope, they just get old and fed up with the B/S...

Debt-Is-Not-Money's picture

"People don't lose hope, they just get old and fed up with the B/S..."

Don't fuck with the oldsters, they'd just as soon kill you than put up with your shit!

AmCockerSpaniel's picture

It's; " Don't f&%$# with old men. They have lived their lives, and have nothing left to loss."

lynnybee's picture

"People don't lose hope, they just get old and fed up .    Don't fuck with the oldsters, they'd just as soon kill you than put up with your shit!      how true, how true.   

disabledvet's picture

easy to get lost in the weeds in this stuff...so let me sum it up for ya'. In 2008 we actually DID default...at a minimum by not understanding the depth and breadth of the problem ("housing is not in a bubble")and at a maximum by just "flinging money around" in the hopes that it would "recreate the old order" (very different from "staunching the bleeding" as is being done in Europe i might add.) interest rates were surging, the deficit was soaring...the Endgame appeared nigh....and then. .... Like CPR the patient got a load of fresh air and "came to." Interest rates plunged, the market bottomed, an economic "recovery" of sorts took hold (i was out in Los Angeles in both 2008 and 2010 and the improvement was OBVIOUS.) Nothing but blue skies and sunshine? HARDLY. But the true "end of the world scenario" (collapsed dollar, mass social unrest, hyperinflation) did pass the USA by. So far. Now we have to deal with the REALITY of what happened...and indeed "there's a lot of B/S out there" not the least being "prices move in one direction" (higher) and "bubble re-inflation is a good...let alone do-able thing." Here's an interesting comparison for you: http://seekingalpha.com/article/99979-gold-s-relationship-with-real-estate this is an article JUST BEFORE THE COLLAPSE advocating buying gold just before the price of IT collapsed as well. CLASSIC bubble re-inflation propaganda. but look how closely real estate tracks the price of gold. THIS IS AN AXIOM OF FINANCE since both gold and real estate are ultimately "financial goods"...goods whose price is driven higher by LENDING ACTIVITY. And how is our lending activity today? ABYSMAL. Remember this: this chart works in reverse. When gold collapsed so did real estate. Gold recovered...real estate never has. This is why the ability of a bank to create "carry" is so important ("borrow short at low interest rates...lend long and high interest rates.") this "reinflates the bubble" and allows the "natural rate of inflation" to be born out. But this is in fact not happening. Long rates...in fact ALL rates!.. are being driven DOWN by the Fed out of FEAR that the deficit could "go Supernova" and blow up the economy in a whole new way. Unfounded or not this policy has consequences...not the least of which "financial assets" (gold, silver...now coal, now steel, now copper) are DEFLATING in price. This ALSO is a danger...one that poses a significant DEFAULT RISK on large chunks of our economy. Think of it as "jingle mail for the State" (jingle mail being what all those homeowners did when they stopped paying their mortgages--they mailed the keys of the house to the bank.) my contention is that JPMorgan/Chase does not have a massive short interest in gold but in fact a massive LONG interest in it...and if the price of gold collapses THAT will be what collapses "The Morgue" not as is presented here and elsewhere "their need to drive down gold prices at all costs." (which of course is primae facie ridiculous. Why would a bank want lower prices for anything? The BANKER might....but certainly not the bank.) In other words STAY TUNED...this thing is far from over.

LawsofPhysics's picture

The U.S. defaulted over 100 years ago.  You are, in fact, already a tenant of the Corporation of the United States.  The real owners are those major shareholders of that private bank called The Federal Reserve.  Please wake the fuck up.  I wonder what those owners plan on doing with their properties and assets?  To know that is to know the future, but yes, JPM is always long gold and holding physical because they know gold is the only safe store of value when it comes to settling trade accounts.  Has been for 6000+ years.

 

stormsailor's picture

when he speaks his tongue moves purtier than a 20 dollar whore

Landotfree's picture

"The problem, simply, is that governments have coerced financial institutions and pension plans to hold sovereign debt at a zero risk-weight, assuming it is risk-free."

Sorry buddy that is not the problem.  That is only one of the last symptoms of the problem you see or you want to identify prior to the collapse.   

"With regards to smooth unwinds, I think it is obvious by now that the unwind of a levered position cannot be anything but violent, like any other lie that is exposed by truth."

You are actually running from the Truth in your whole article, the Truth ie Math always wins the War although it loses countless battles.   Blaming a symptom or an event at the end of the cylce is neither identifying the problem nor is it exposing the Truth, what the writer is doing is telling additional lies to cover up the problem, unfortunately or fortunately the writer does not have the unlimited power needed to cover up the problem forever.

ebworthen's picture

So you're saying the real problem is the FED expecting normal people to work for money and not create it out of thin air like they do, right?

Landotfree's picture

The Fed is only a symptom of the problem.   It has nothing to do with the Fed and what they expect or even if they exist or don't.   The problem is simple.... people are extracting from the system greater than they put into the system... ie interest.   You attach interest to your medium of exchange and I care not what policies or organization structure you have... it's a ticking time bomb... usually 6-8 decades or a generation.

Using the same equation expecting a different result is not going to work.   What happens now is irrelevant it was decisions made before you were born that lead this to this point and time.... all you see today is noise to distract from the real problem.  

ebworthen's picture

And the system is extracting from the citizen greater than they give.

This is why creating money from nothing is immoral.

They give to banks and charge citizens.

Immoral.

No reason for anyone to work or pay taxes when it is clear that the Government and the Financial Industry are intent on parasitizing labor and private assets, and returning less than .50 cents for every dollar they take.

Landrew's picture

Sadly, your critique has no meaning. So what is the problem other than the obvious, SYSTEM failure? Simply saying the FED is the problem isn't an answer. Your response was well written and I would genuinely like to hear your thoughts.

Lewshine's picture

I get it. I understand the "catch 22" scenerio coming at us at 225 mph. Nevertheless, the Fed has created an enviroment where the LIE controls the facts, however desperate the situation becomes. And until the mushroom cloud is in the rear view mirror, the Fed owns the action, the direction, the conversation and today and yesterday's results...Which will always be BETTER THAN EXPECTED.

The sheep will drink this cup, Zero Hedger's will look more and more foolish - And in a blink of an eye when most have copitulated comes the nuclear event that changes our lives forever. We wait on it as if it will be foreseeable...It won't be -At all!

 

WmMcK's picture

copitulated = capitulated + copulated?

Yen Cross's picture

Juxtapost/ (Juxtaposed) for hard core "Grammatical Scholars"...

reader2010's picture

Socrates was right when he famously said The unexamined life is not worth living for a human being.

francis_sawyer's picture

I [most excellently] learned that from Bill & Ted...

Yen Cross's picture

 I'm looking at a bit of a outside weekly close on risk F/X and HYG)  The shorts might have some strength next week/ The Middle East is blowing up again, and that Fiscal something is a lose/lose Greek scenario...

  Watch out for tape bombs  at market closes/ The heck with New York trading until 3:00 p.m.

ebworthen's picture

What is money?

If the FED can "buy" Treasuries and MBS's with "printed" money from nothing (Ctrl+P) then why mark the other end of the ledger?

Why not send every taxpayer $50K for Christmas and $100K for New Years?

Why even mark the debt column? 

If they were doing this with conviction and the whole idea were not a lie they would.

Yen Cross's picture

People need to eat, and commodities fluctuate in price/The real currency is food.

Big Slick's picture

If it were possible to just print and distribute money, we would all still be Romans.

LawsofPhysics's picture

It takes energy to actually do anything, including grow plants (food).  The availability of energy always trumps all.  In fact if you unleash enough energy at once, you just have to come back later and pick up want you want.  Think about it.

disabledvet's picture

that's what caused Germany's hyperinflation..."giving money" directly to people. The question you need to be asking is "is this variant of money giving working as intended"...and of course the answer is "no." Sure...it drives down interest rates...but the INTENT is to "create jobs" via "growing the economy." For that to happen to Fed needs to STOP what it's doing..."do nothing" in effect.

ebworthen's picture

Yen Cross and disabledvet,

That is what I'm getting at.

If you distill this down it is a simple matter of morality.

The FED and the U.S. Government want me to work for money yet they create money from nothing and place the debt on my progeny and I.

Therefore, if I work for money I am working for my own enslavement to them.

It is immoral for the FED to create money from nothing.

nmewn's picture

It is also immoral for government to treat us as its property to be milked like cows.

WASHINGTON — The Obama administration said Friday that it would charge insurance companies for the privilege of selling health insurance to millions of Americans in new online markets run by the federal government.

The cost of these “user fees” can be passed on to consumers. The proposed fees could add 3.5 percent to premiums for private health plans sold in insurance exchanges operated by the federal government. "

http://www.nytimes.com/2012/12/01/health/health-insurers-will-be-charged-to-use-new-exchanges.html?ref=politics

Bear's picture

I think you miss the point ... they print money not to accomplish their Congressional approved dual mandate ... but to refinance and refund the previous grievous abuses of the American Bankstering System. If you want to know what's going on in the world get  a copy of Geroge Soros's daily calendar.  

 

Debt-Is-Not-Money's picture

"What is money?"

Money is purchasing media/medium-of-exchange placed into circulation wthout interest owed, if interest is owed then it is debt!

ALL of our currency is encumbered by interest and is therefore debt.

We have NO money (except for our valueless counterfeit coin).

Peter Pan's picture

The world is full of too many accounting entries based on conjured up money. This system has played havoc with the free market, which in turn the FED and others seek to manipulate in order to justify the accounting entries and conjured up money which in turn allows the owners of this fake wealth to continue stripping people of all remaining real wealth.

Poor Grogman's picture

The thing that has changed is that people can now see, examine, and discuss this modern financial paradigm that has become our prison.

When the "whole idea" of something no longer makes any sense to a majority of people then that idea will be cast aside, as is already happening with the " competing currencies" of PMs, bit coin,etc.

I still think there is plenty of inertia and a certain amount of resilience left in the current system though. Consequently I think we are in for a drawn out reset, perhaps over many decades...

grid-b-gone's picture

True. We are past the point at which an unwind was possible.

Only Iceland got it right.

Now that the structured deleveraging opportunity has passed, having been papered over, the market will provide the fix.

The market solution possibilities are growth with fiscal restraint, or default. Even if we got growth right now the lack of fiscal restraint would probably still mean default would be the eventual, final solution. This is because every day that is not FAIL day, is used as evidence that the correct policy direction has been chosen.

As long as fiat money is accepted, we can muddle along on this path for some time. Maybe a year, maybe ten years - nobody knows.

At some point the music stops. One needs to own a chair outright, or be able to buy one with a medium of exchange that will still be accepted, or be willing to start again from scratch post-reset.

I own a chair and it's not for sale.    

Yen Cross's picture

 China has 1.3 BILLION patrons/ I'm sure they are well - nourished<

woggie's picture

the beast is on the gobble
and all that matters is we're all headed for it's belly
http://youtu.be/ntmthFyaYzY

A Middle Child of History's picture

Woggie would oft post to this site,
A link that was nothing but shite,
What a fool and a bore;
One couldn't possibly do more,
to waste so many a byte.