Repo Market

The Chairman is about to take the lectern to discuss bank structure and competition at the SIFI conference at the Chicago Fed. His prepared remarks are likely to be a little less exciting than the Q&A where the world will be watching for the words "buy, buy, buy", "mission accomplished", or "taper". Charles Evans will be his lead out man. Finally, since Bernanke will be discussing shadow banking, or the source of some $30 trillion in shadow money always ignored by Keynesians, Monetarists and Magic Money Tree (MMT) growers, a topic we have discussed over the past three years, here is the TBAC's own summary on how Modern Money really works.

This is the second of three articles on the suppression of gold. In the first article we showed that, under mainstream economic theory, the suppression of the gold market is not a conspiracy theory, but a logical necessity, a logical outcome. This second article will show how that suppression takes place, and potentially how to protect ourselves from that manipulation.

While the rest of the world was blissfully enjoying its latest reflation experiment, one country that has hardly been quite as ecstatic about all the blistering free money entering its real estate market (if not so much the Shanghai Composite) still warm off the presses of the G-7 central banks, has been China. Because China knows very well that while in the rest of the world, free money enters the stock market first and lingers there, in China the line between the reflating house market and the price of hogs - that all critical commodity needed to preserve social stability - is very thin. As a result, last week China withdrew a record CNY900 billion out of the repo market - the first such liquidity pull in eight months. This move had one purpose only - to telegraph to the rest of the world that the nation, whose central bank has patiently stayed quiet during the recent balance sheet expansion euphoria, will no longer sit idly by as hot money lift every real estate offer in China. Moments ago we got the second sign that China is less than happy with the reflating status quo, when the HSBC Flash PMI index for February missed expectations of a 52.2 print by a big margin, instead dropping from the final January print of 52.3 to just barely above contraction territory, or 50.4. This was the lowest print in the past four months, or just when the PMI data turned from contracting to expanding in November of last year.

Sometimes, it feels good to hope. But since last September, nothing has really changed. At least not fundamentally. The zero-interest rate policies were going to encourage share buybacks, dividend payments and any method to allow the extraction of whatever real value is still available to extract from corporations/businesses by their owners. This meant leverage was going to increase, unemployment would remain high, capital expenditures were going to decrease and the risk of defaults was to going to rise. A year later, all these symptoms are starting to surface. One more reason to avoid stocks and be long gold. But in my view, it will take longer than many believe, for these imbalances to burst "...As long as the people of the EU put up with this situation and the EU Council (…) effectively kills democracy at the national level AND as long as the Fed continues to extend US dollar swaps, this status quo will remain… Whenever the political sustainability of the EU is challenged, we will see a run for liquidity... The trend is for asset inflation, and will last as long as the people of the EU and the US do not challenge the political status quo..." Unemployment and the tolerance of those unemployed will tell us when the time has come.

From Fed's Stein: "The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade." Thanks to the magic of FAS 140 banks can literally transform worthless garbage into supersafe Treasurys, then use that newly transformed collateral via further repo as cash to fund simple stock purchases, and at the end of the day nobody knows where the exposure came from, who the counterparty is, and what the ultimate liability is!

Perhaps one of the most startling and telling charts of the New Normal, one which few talk about, is the soaring difference between bank loans - traditionally the source of growth for banks, at least in their Old Normal business model which did not envision all of them becoming glorified, Too Big To Fail hedge funds, ala the Goldman Sachs "Bank Holding Company" model; and deposits - traditionally the source of capital banks use to fund said loans. Historically, and logically, the relationship between the two time series has been virtually one to one. However, ever since the advent of actively managed Central Planning by the Fed, as a result of which Ben Bernanke dumped nearly $2 trillion in excess deposits on banks to facilitate their risk taking even more, the traditional correlation between loans and deposits has broken down. It is time to once again start talking about this chart as for the first time ever the difference between deposits and loans has hit a record $2 trillion! But that's just the beginning - the rabbit hole goes so much deeper...

The natural reaction from policy makers, so far, has not surprised us. 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... 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. 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…”. 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. 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.

About a month ago, in the third-quarter report of a Canadian global macro fund, its strategist made the interesting observation that “…Four ideas in particular have caught the fancy of economic policy makers and have been successfully sold to the public…” One of these ideas “…that has taken root, at least among the political and intellectual classes, is that one need not fear fiscal deficits and debt provided one has monetary sovereignty…”. This idea is currently growing, particularly after Obama’s re-election. But it was only after writing our last letter, on the revival of the Chicago Plan (as proposed in an IMF’ working paper), that we realized that the idea is morphing into another one among Keynesians: That because there cannot be a gold-to-US dollar arbitrage like in 1933, governments do indeed have the monetary sovereignty. It is not; and in the process of explaining why, we will also describe the endgame for the current crisis... "…We cannot arbitrage fiat money, but we can repudiate the sovereign debt that backs it! And that repudiation will be the defining moment of this crisis…"

To those familiar with Algebra, we suggest that the Ponzi scheme we live in is actually an overdetermined system, because there is no solution that will simultaneously cover all the financial and non-financial imbalances of practically any currency zone on the planet. Precisely this limitation is the driver of the many growing confrontations we see: In the Middle East, in the South China Sea, in Europe and soon too, in North America. That these tensions further develop into full-fledged war is not a tail risk. The tail risk is indeed the reverse: The tail risk is that these confrontations do not further develop into wars, given the overdetermination of the system! We have noticed of late that there’s a debate on whether or not the US dollar zone will end in hyperinflation and whether or not the world can again embrace the gold standard. The fact that we are still in the early chapters of this story does not allow us to state that hyperinflation is only a tail risk. The tail risk is (again) the reverse: That all the steps central banks took since 2008 won’t lead to spiraling quasi-fiscal deficits.

The U.S. tri-party repo market is one of the most important components of the financial system - that noone has ever heard of (though not ZH readers: Tri-party repo has been a core topic of several of our 2009 posts exploring the nuances of the Lehman collapse - initially here and here and then multiple times as we discuss the backbone of the shadow banking system). The 2007-09 financial crisis exposed weaknesses in the design of the U.S. tri-party repo market that could rapidly elevate and propagate systemic risk. We have long-discussed the importance of the collateral and hypothecation markets and a recent study of the market identifies the collateral allocation and unwind processes as two key mechanics contributing to the market’s fragility. While the topic is relatively specialized, it is critical to understanding the reality behind the curtain and the paper below provides clarification of the bilateral and tri-party repo markets (The Fed, Bank of NY, and JPM - who in effect have first refusal on any collateral in the system), dealers' intervention, and its potential as a source of financial systemic risk.

What might happen to your favorite ETF in a crisis?  As the the half life for the next Fed-induced bubble happily converges with the six month mark on Mr. Bernanke's QE3, these things never matter...until they do

One of the key stories of 2011 was the revelation, courtesy of MF Global, that no asset in the financial system is "as is", and instead is merely a copy of a copy of a copy- rehypothecated up to an infinite number of times (if domiciled in the UK) for one simple reason: there are not enough money-good, credible assets in existence, even if there are more than enough 'secured' liabilities that claim said assets as collateral. And while the status quo is marching on, the Ponzi is rising, and new liabilities are created, all is well; however, the second the system experiences a violent deleveraging and the liabilities have to be matched to their respective assets as they are unwound, all hell breaks loose once the reality sets in that each asset has been diluted exponentially. Naturally, among such assets are not only paper representations of securities, mostly stock and bond certificates held by the DTC's Cede & Co., but physical assets, such as bars of gold held by paper ETFs such as GLD and SLV. In fact, the speculation that the physical precious metals in circulation have been massively diluted has been a major topic of debate among the precious metal communities, and is the reason for the success of such physical-based gold and silver investment vehicles as those of Eric Sprott. Of course, the "other side" has been quite adamant that this is in no way realistic and every ounce of precious metals is accounted for. While that remains to be disproven in the next, and final, central-planner driven market crash, we now know that it is not only precious metals that are on the vaporization chopping block: when it comes to China, such simple assets as simple steel held in inventories, apparently do not exist.

September has arrived which means for Europe reality can, mercifully, return. First on the agenda: moments ago the French government suddenly announced the nationalization of troubled mortgage lender Credit Immobilier de France, which is also the country's second lagrest mortgage specialist after an attempt to find a buyer for the company failed. "To allow the CIF group to respect its overall commitments, the state decided to respond favourably to its request to grant it a guarantee," Finance Minister Pierre Moscovici said according to Reuters. What he really meant was that in order to avoid a bank run following the realization that the housing crisis has finally come home, his boss, socialist Hollande, has decided to renege on his core campaign promise, and bail out an "evil, evil" bank. Sadly, while the nationalization was predicted by us long ago, the reality is that the French government waited too long with the sale, which prompted the Moody's downgrade of CIF by 3 notches earlier this week, which in turn was the catalyst that made any delay in the nationalization inevitable. The alternative: fears that one of the key players in the French mortgage house of cards was effectively insolvent would spread like wildfire, leading to disastrous consequences for the banking system. End result: congratulations France: your Fannie/Freddie-Dexia moment has finally arrived, and the score, naturally: bankers 1 - taxpayers 0.

Moments ago the US Treasury auctioned off the latest monthly batch of 2 Year bonds, this time $35 billion, or toward the higher end of the issuance range, which was a bit of a dud. Pricing at 0.273%, this was a brisk move from July's record low 0.22%, a weakness which was substantiated by the expected pricing of 0.266% even though the When Issued traded at 0.275% coming into the auction, so technically there was no tail. That said, a very modest 9.01% was allotted at the high yield, implying the bulk of the action in the Dutch Auction was below the closing yield. Beneath the headline, the internals were not pretty either, with just 22.3% of the total bond taken down by Indirect bidders, well below the 32.78% TTM average, demanding an increase in both the Direct and Primary take downs, the former taking down 16.08% while the Dealers having to push 54.66% of the entire auction promptly into the tri-party repo market in exchange for cash to be used for much wiser purposes, such as buying Las Vegas REO real estate and converting it into rentals. Was the weakness of the auction a harbinger of disappointment from Jackson Hole - stay tuned for an opinion from Credit Suisse which says precisely this. And while the auction itself may have been unspectacular, there is a very historic aspect to this particular $35 billion bond issue, which we will reveal after market close.

What do USD money markets have to do with gold? Money market funds invest in short-term highly rated securities, like US Treasury bills (sovereign risk) and commercial paper (corporate credit). But who supplies such securities to these funds? For the purpose of our discussion, participants in the futures markets, who look for secured funding. They sell their US Treasury bills, under repurchase agreements, to money market funds. These repurchase transactions, of course, take place in the so-called repo market. The repo market supplies money market funds with the securities they invest in. Now… what do participants in the futures markets do, with the cash obtained against T-bills? They, for instance, fund the margins to obtain leverage and invest in the commodity futures markets.  In summary: There are people (and companies) who exchange their cash for units in money market funds. These funds use that cash to buy – under repurchase agreements - US Treasury bills from players in the futures markets. And the players in the futures markets use that cash to fund the margins, obtain leverage, and buy positions. What if these positions (financed with the cash provided by the money market funds) are short positions in gold (or other commodities)? Now, we can see what USD money markets have to do with gold!  Let’s propose a few potential scenarios, to understand how USD money markets and gold are connected...