"Fu$k the Fundamentals!": Negative Rates In EU Will Absolutely Wreck the Very System the ECB Sought to Save

Reggie Middleton's picture

I have been warning Veritaseum users about the unbridled risks the ECB is taking with its banking system by slamming its yield curve - driving short and medium term rates negative. Despites the ECB's proclamations, its banking system is still quite fragilem, and it is putting pressure on the barely recovered fractures, causing additional stress fissures.

Before we go on, if you haven't read "It's All Out War, Pt 3: Is the Danish Krone Peg to Euro More Fragile Than Glass Beads? The Danish National Bank Infers So! and "How the Danish Central Bank is Destroying the Danish Citizens' Wealth Form Both Sides While Stressing It's Bank!", please do. My warnings in 2010 on the PAN-EUROPEAN SOVEREIGN DEBT CRISIS will do a lot to fill in the background as well.

Yesterday, the Wall Street Journal ran a story on the Spanich bank, Bankinter S.A., which was actually paying customers interest on thier mortgages, in a rather backwards twist that is the result of the perverse incentives (basically, the opposite of typical tenets that underly fundamental analysis) that come about when you turn the world of borrowing, literally, upside down. Here's an excerpt (and remember I warned about Spain 5 years ago in "The Spanish Inquisition is About to Begin..."):

At least one Spanish bank, Bankinter SA, the country’s seventh-largest lender by market value, has been paying some customers interest on mortgages by deducting that amount from the principal the borrower owes.

The problem is just one of many challenges caused by interest rates falling below zero, known as a negative interest rate. All over Europe, banks are being compelled to rebuild computer programs, update legal documents and redo spreadsheets to account for negative rates.

Interest rates have been falling sharply, in some cases into negative territory, since the European Central Bank last year introduced measures meant to spur the economy in the eurozone, including cutting its own deposit rate. The ECB in March also launched a bond-buying program, driving down yields on eurozone debt in hopes of fostering lending.

Of course you will foster lending if the borrowers actually get paid to borrow. Reference this quote from the article:

“I’m going to frame my bank statement, which shows that Bankinter is paying me interest on my mortgage,” said a customer who lives in Madrid. “That’s financial history.”

The client in 2006 took out a roughly €500,000 ($530,000) home mortgage loan based on Swiss franc Libor, plus 0.5 percentage point. Since then, Swiss franc Libor has fallen far enough into negative territory to make his mortgage rate negative.

I'd like to take a poll of everyone reading this to determine if anyone, and I mean "anyone", besides a European central banker, thinks this is sustainable! Why shouldn't all of us US speculators head over to Spain and take out mortgages on property so the Spanish mortgage banks can pay the property off for us. Hey, I'm sure that will work wonders for the fundamentals of the already superbly healthy (ahem!) Spanish property market - particularly along the not so speculative coasts.

 
Spain is not the only place this nonsense is happening. I warned about it in Denmark as well as the Danish Central Bank prints krone until the inkwell runs dry to purchase rapidly depreciating euros (very good for the fundamental health of the economy, I'm sure) while pushing its rates negative and wrecking its mortgage banks as well - reference  "How the Danish Central Bank is Destroying the Danish Citizens' Wealth Form Both Sides While Stressing It's Bank!".

 

Danish Central Bank prints risk into its economy

The last time I issued warnings on this scale for the continent, it's bankings system nearly collapsed (PAN-EUROPEAN SOVEREIGN DEBT CRISIS). I see no difference here except for the fact that the stakes may be a little higher. Here's an excerpt from today's WSJ piece on a similar topic that I will rename "Fu$# the Fundamentals!":

Switzerland became the first sovereign to issue a 10-year bond carrying a negative yield, raising 232.5 million Swiss francs ($237.2 million) with investors paying for the privilege of lending. Mexico followed with a 100-year €1.5 billion bond that was swiftly snapped up. By Friday the price of the bond had risen five points, and it was yielding less than 4%. In the eurozone, French five-year yields turned negative. And German yields continued to grind deeper into negative territory: yields on eight-year bonds briefly dipped below zero, while the two-year yield stands at minus 0.277%.

This all happened LAST WEEK! Yes, in one week. Now, let's parse this parargraph, sentences by sentence:

  1. Switzerland became the first sovereign to issue a 10-year bond carrying a negative yield, raising 232.5 million Swiss francs ($237.2 million) with investors paying for the privilege of lending - What makes this so amazing is the fact that it was actually purchased by someone, somebody, or something. Of course, if I was a betting man, I would wager that the ECB purchased a sizeable chunk through its QE program. If that is true, then the ECB is channeling welfare money directly into Swiss coffers in a most unusual, deceptive, and potentially destructive way. I don't know why so many market participants feel that negative interest rates are free. They actually abstract a signficant costs that most may not see upfront. We shall definitely find out forthwith, won't we?
  2. In the eurozone, French five-year yields turned negative. And German yields continued to grind deeper into negative territory: yields on eight-year bonds briefly dipped below zero, while the two-year yield stands at minus 0.277%. I literally, simply have nothing to say!
  3. Mexico followed with a 100-year €1.5 billion bond that was swiftly snapped up. By Friday the price of the bond had risen five points, and it was yielding less than 4%. Whaaatt???!!! Investors should be war of 10 and 20 year money, and here they are buying 100 year bonds and driving the price up from that point! Let's look at this from a historical perspective. Mexico has had 194 years of independence, and 44.6 of those years in default! That's 23% of all the time that it could have to pay its debts. What are the chances that Mexico will go another 100 years without a single default (hint: it's had 8 defaults in the last 194 years). Not think of the ample 4% compensation your getting for that 100 year money that has roughly a 1 in 4 chance of NOT defaulting! Yes, just think about it...

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This is what we at Veritaseum have called "Sophisticated Ignorance" Or Just A Very, Very Short Term Memory? Foolish Talk of German Bailouts Once Again...

Wait, It gets better. This, from the WSJ article:

A Madrid judge in November ruled against a client of Banco Santander SA who claimed that Spain’s largest bank inappropriately established a floor on his mortgage in 2013 and therefore owed him money. The plaintiff had taken out a mortgage in 2005 that offered a fixed rate of 2% in the first year and Euribor minus 1.1 percentage points thereafter. The plaintiff said he was now owed money from the bank.

To buttress his argument that a bank shouldn’t have to pay a borrower for a loan, the judge quoted from a June 2014 statement from the Bank of Spain that “a payment in favor of the client in these situations would never apply, but rather the application of an interest rate of zero by the entity.” The Bank of Spain spokesman said the statement cited in the case was issued by the central bank’s customer-complaints service, which typically responds to particular cases. The Bank of Spain hasn’t issued a systemwide decision on how banks should treat negative interest rates, he said.

Defining "borrower" can put the Spanish banking system in a lot of trouble. Is the counterparty in an interest rate swap that was used to hedge rate risk on it's loan a borrower? Is so (and although I'm not a lawyer, it does make sense), does this mean that Banco Santander's counterparties no longer have to honor their pledges to Santander past the (unstated, at least contractually) zero percent bound? Does Santander not have to honor its part of its counterparties' hedges? Do you see how quickly this can get ugly? It's not as if there's that much equity in the system. Once two or three counterparties "legally" default, the system comes tumbling down!

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