Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again. - John Maynard Keynes, A Tract on Monetary Reform There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have insight to appreciate the incredible wonders of the present. - John Kenneth Galbraith Hitler must have been rather loosely educated, not having learned the lesson of Napoleon's autumn advance on Moscow. - Sir Winston Churchill

Charts are not predictive in nature, rather they are instructive on how to best prepare and get an edge when deciding to enter into a position, [or exit one]. It is of the utmost importance to have a game plan in place, beforehand, otherwise, one is relying upon factors more emotionally driven than fact driven. The function of reading a chart is to gain insight from the most reliable source available, the market itself. What a market does is generate information that reflects the outcome of all source decision-makers, from the most highly informed and experienced to the least informed and weakest, with varying degrees of skills in between.

A drop of the gold price to $ 500/ounce is highly unlikely in view of the sharply rising National Debt in the USA but also in Europe. To quote John Hathaway, manager of one of a most respected gold fund, a sharp rise of the gold price is more likely: "With gold and silver under continued attack from the mainstream media, John Hathaway warned King World News that we are at the point where global investors will be shocked as gold is quickly repriced a jaw-dropping $1,000 higher, taking gold to new all-time highs.

WASH, RINSE AND SPIN National weather forecasting organizations, most of which are members of the UN WMO (World Meteorological Organization) are obliged to toe the WMO party line – still rock solidly promoting “the new paradigm”. This dates from 25 years ago, and claims that human CO2 emissions are causing “dangerous global warming”. Not believing in this is not “new paradigm”.

This is a documentary about a girl who gets cured from cancer that was recorded by her boyfriend. Easy to watch during dinner or other household chore: http://www.youtube.com/watch?v=0U5XeSaO_QY

 

 

While millions of Americans fret over how it can be possible that their data and phone calls can be eavesdropped without a warrant by thousands of low level NSA analysts (some even without High School diplomas), the rest of the world can fret over who or what protects them from the prying eyes of the Netplex without the benefit of one of these.

Afterall, 99.99% of the world's internet traffic passes through the good old USA does it not?

And if Google and Facebook are selling your data to Coca Cola and JP Morgan, what makes anyone think they won't sell it to the snoops?

And what is this statutory carrier indemnification we keep hearing about?

And, BTW, how the fuck do they know who is "foreign" and who is not anywho?

Do you remember having to show your birth certificate, drivers license or passport when you opened your Google or Facebook account? 

Someone should ask the Vice Chairman of Booz Allen these questions since, evidently, he is the Former Director of the NSA.

 

To my Dad and all you fringe low brow Zero Hedge Dads...

 

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If Obamacare's stated goal was to broaden the health insurance market, give more options to consumers, and generally lower the cost of health insurance, courtesy of the IRS' flawless execution of yet another unprecedented government expansion, it may be in for a tough time. Because while on paper every statist plan of centrally-planned ambitions looks good, in reality things usually don't work out quite as expected. Case in point the news that Aetna will stop selling health insurance to individual consumers in California at the end of 2013, in advance of Obamacare's complete transformation of the insurance market: a transformation which just incidentally may see most private health insurance firms follow in Aetna's steps and the emergence of a single-payer system along the lines of the British National Health Service. A government-mandated and funded system which, needless to say, crushes private enterprise, and ends up costing far more for all involved than an efficient market based on individual wants, needs and capabilities constantly in flux.

But that's ok - there is an administration which is smarter than the entire market, and a Federal Reserve which will monetize any deficit funding, and the only trade off is making the already ridiculous US federal debt ridiculouser.

For more irony we go to the WSJ which informs us that that "pullout is likely to draw attention as California has become a focus of national debate over the law's impact. Supporters, including President Barack Obama, who highlighted the state in a recent speech, argue that it has shown the success of the health overhaul in encouraging competition and pushing down prices."

If in some parallel socialist universe, the exit of competitors ends up boosting competition, than yes, we agree. In this one, however, things are a little... different.

For now, Aetna is just the start. A relatively small start:

Aetna said it currently has about 49,000 individual policyholders in California. In 2011, when it had substantially bigger membership, it was the fourth-biggest player in the state's consumer market, with about 5.2% of the plans sold that year, according to a report from Citigroup Inc.

 

Aetna isn't one of the 13 insurers participating in the state's new consumer insurance marketplace set to launch this fall under the federal law. Like several other major national carriers, it has said it would join only a limited number of these exchanges. A carrier can still offer consumer plans without being in the exchange.

 

Aetna said it will continue selling health insurance in California to employers and Medicare beneficiaries, as well as dental and life-insurance products. The insurer said it is "fully committed to serving the needs of our 1.5 million members in the state." A company spokeswoman declined to comment about the reasons for Aetna's individual-business withdrawal.

As long as those members aren't on individual insurance: those members will have to find a different provider of insurance.

People who currently have Aetna individual health coverage will have to find plans with other carriers by year-end. That might be easier because of the federal health law's requirements that insurers no longer decline coverage or set premiums based on people's health history, but still, "it's going to be confusing" for Aetna policyholders, said Ken Fasola, chief executive of HealthMarkets Inc., parent of insurance agency Insphere Insurance Solutions. His firm plans to send written notice to affected clients, then follow up with calls and, if wanted, visits.

Aetna is just the first to crunch the numbers and realize that one indeed has to pass a law first to find out how much money will be lost - by private companies - as a result.

The health law is expected to expand the individual insurance business, but the new coverage rules will also mean major changes. Also, in the new exchanges, consumers are expected to focus closely on costs, particularly monthly premiums. Insurers may find it tough to compete if they don't have scale in a particular market, partly because they can't match the prices that competitors win from health-care providers.

As for the "model" assumptions behind Obamacare, it is likely too late to clarify that one does not get strong competition in an artificial marketplace in which the service providers are dropping out one by one.

The Obama administration has highlighted its expectation that the new health-insurance marketplaces will generally boast strong competition, with around 90% of consumers buying their own plans living in states where there would be products from at least five insurers.

 

But in at least some places, the offerings will be limited. In Washington state, for instance, nine insurers bid to sell plans in the individual market but only one carrier, Kaiser Permanente, bid to sell a small-business plan through the exchange in some counties, forcing Washington officials to cancel plans to run a full small-business exchange for the first year.

So instead of "strong competition" the end results was a government-enforced... monopoly. And guess who has all the pricing power in a monopoly.

Oh well, such is life under "central-planning" - the end result is always complete disaster, but at least the intentions to promote "fairness" were quite noble.

    

Whether as the basis for the monetary unit of a country, or in its role in comparison to the currency of other assets, the price of gold has long been a subject of great interest to both the scholar and the general public. MeasuringWorth has created a multi-century time series of the barbarous relic's USD price. From the penny, the crown, the rose ryal, the guinea and the sovereign coin, the question of "what was the price then" is answered combining a number of sources and Visualizing Economics compares the 'real' price of gold since 1791 to GDP, wars, US presidents, and inflation...

 

(click image for larger version)

    

Submitted by John Rubino via The Dollar Collapse blog,

Things have been a little erratic lately here in US, but not really headline-worthy. The economy continues to grow, sort of, houses continue to sell and stock and bond prices fluctuate but can’t seem to follow through in either direction. We are not, in short, engulfed in any kind of crisis.

But out in the world, especially in once-hot emerging markets like Brazil and China, the story is very different. As Prudent Bear’s Doug Noland explains in his most recent Credit Bubble Bulletin:

Meanwhile, the “developing” market Bubble continues to unwind. As leverage comes out of the commodities, currency “carry trades” and developing stocks and bonds. And as capital flight becomes a more serious issue, the marketplace must ponder the consequences not only of what a faltering Bubble means for scores of markets and economies, there is as well the issue of developing central banks having to sell from their trove of Treasuries and bunds and such to finance a surge in outflows (“hot” and otherwise). There’s even this new dynamic where Treasury yields rise on days of global currency and equity market tumult. It’s been awhile...

 

I suspect that the global jump in yields (and CDS and risk premiums) has more to do with de-leveraging than it does with tapering worries. This dynamic has caught many by surprise. The speculators anticipated cleverly exiting their leveraged MBS and other trades based on their expectations for Fed policy. Now, there’s a tremendous amount of unanticipated market uncertainty.

 

Japanese policymakers have really mucked things up. The Nikkei sank 6.5% Thursday and was down 1.5% for the week. Perhaps it’s a little early to pronounce the BOJ’s “shock and awe” monetary experiment a failure. The yen rallied 3.5% this week against the dollar. Against the Philippine peso it was up 4.5%, versus the South Korean won 4.1%, the Indian ruppee 4.3%, the Malaysian ringgit 4.0%, the Indonesian rupiah 3.2%, the Argentine peso 3.9% and the Brazilian real 4.2%. Indonesia raised rates to support its weak currency. The yen “carry trade” (sell yen and use proceeds to buy higher-yielding instruments globally) is doling out painful losses – forcing the unwind of leveraged trades across many markets. I wouldn’t be surprised if the yen short is the largest short position in modern history. The yen bears are now running for cover – causing all kinds of havoc in the currencies and securities markets.

 

“Emerging” Asian markets are in the middle of an unfolding financial storm. Friday’s 2.1% gain cut the Philippine equities loss for the week to 9.2%. Even with Friday’s 4.4% recovery, the Thailand stock exchange ended the week down 3.4%. South Korea’s Kospi dropped another 1.8%.

 

Latin America is as well caught in troubling dynamics. Brazil’s currency (real) traded to a four-year low against the dollar this week – despite currency interventions and the removal of taxes on financial flows and currency derivatives. Brazilian equities were hit for 4.4% this week, increasing y-t-d losses to 19.1%. Mexican stocks dropped 2.4%, boosting y-t-d losses to 10.2%.

 

The Shanghai composite dropped 2.2% in a holiday-shortened week. China pegs its currency to the U.S. dollar, so we can’t look to the performance of the renminbi for much of an indication of flows or mounting financial market stress.

 

I have posited that China is in the midst of an historic Credit Bubble. I have over the years tried to explain how interrelated their Bubble is to ours. Our mismanagement of the world’s reserve currency led to 20 years of huge Current Account Deficits. A significant portion of the Trillions of associated IOU’s have made it onto the balance sheet of the People’s Bank of China, especially over recent years. And no Credit system and economy has gone to greater excess during the post-2008 global reflation. It was the “fledgling” Credit Bubble spurred to “terminal phase” excess.

 

If the “developing” economy Bubble has passed an important inflection point, then China is vulnerable. If “hot money” is leaving EM [emerging markets] then China should be susceptible. And, let there be no doubt, when China finally succumbs global economic prospects really dim – and prospects for some fellow EM economies turn downright dismal. Recall how the tightening of subprime finance gravitated to “Alt-A” and then worked its way to the “conventional” core. And when housing in general began to falter the bottom fell out of subprime.

 

This week provided a bevy of notable China-related headlines: From the Financial Times: “China Debt Auction Failure Raises Liquidity Fears;” “Fresh Data Highlight China’s Sluggish Growth.” From Bloomberg: “China Debt Sale Fails for First Time in 23 Months on Cash Crunch;” “China Local Debt Audit ‘Credit Negative,’ Moody’s Says;” “China’s Leaders Face Test of Growth Resolve After May Slowdown;” “China Export Growth Plummets Amid Fake-Shipment Crackdown.” From Reuters: “Fitch Warns on Risks from Shadow Banking in China;” “China Estimates Fake Trade Invoicing at $75 billion in Jan-April;” “China State Auditor Warns Over Local Government Debt Levels.”

 

The price of Chinese sovereign Credit default swap (CDS) “insurance” jumped from 92 to 113 in three sessions, before dropping back down to 98 on Friday. Chinese interbank lending rates have recently spiked higher – and there were even reports of several borrowers forced to pay up for increasingly scarce liquidity. There were debt auctions that did not go smoothly. The currency forwards market is showing some atypical downward pressure on the renminbi.

 

Many believe this newfound tightness in Chinese money markets can be easily resolved by liquidity injections from the People’s Bank of China. And perhaps Chinese monetary and economic managers still have things under control. If so, the same clearly cannot be said for many of their fellow “developing” policymakers. Capital flight is always extremely difficult to manage.

 

I worry that the world has never faced the possibility for such destabilizing flows and speculative de-leveraging. To be sure, global markets have never been as dependent upon the power of central bankers. And in my mental tallies of risk and complacency, I never envisaged they could so elevate in tandem.

So can the US stay placid when the rest of the world turns chaotic? Highly doubtful. There’s a market phenomenon in which one investment play blows up and forces those on the wrong side of the trade to dump their liquid assets to raise cash. Which causes the high-quality assets to fall as much or more than the junk. As Noland notes, the world’s premier liquid asset is the Treasury bond.

If the developing world’s need to raise cash is a factor in the recent spike in US interest rates, this implies a feedback loop in which rising US rates further destabilize emerging markets, forcing the sale of more Treasuries, and so on. Can the Fed stop this? Not unless it wants to buy up not just the newly-issued Treasuries as it does now, but the trillions of dollars of bonds that might be dumped once things really get going.

It’s important to understand that we’re here because for years the developed world in general and the US in particular have been exporting their problems to the developing world via monetary policy. We fund our overspending by creating a bunch of new dollars,  many of which flow beyond our borders looking for higher yields. They land in, say, Brazil, pushing up both local asset prices and the exchange rate of the real. So individual Brazilians see their cost of living rise while Brazilian exporters are priced out of global markets. This is the currency war that Brazil’s government has been complaining about.

Then the hot money flows back out, causing a different set of problems for a country that has spent the past decade trying to adjust to excessive capital inflows.

 

The result: some seriously fragile banks and over-leveraged companies and investors, any of which could trigger a nationwide crisis.

The same general process is at work in other major emerging markets, with each in its own way now posing a threat to the global financial system — at the pinnacle of which sit the S&P 500 and the Treasury market, looking an awful lot like Southern California real estate circa 2007.

    

In UBS' view, 1994 is critical for guiding investing today. The key point about 1994 was not that US bond yields rose during a global recovery. But that the leverage and positioning built up in previous years, on the assumption that yields would remain low, then got stressed. The central issue, they note, is that a long period of lacklustre growth, low rates and easy money induces individual investors, funds, non-financial corporates and banks to reach for yield. In many cases, they gear up to do it. And as Hyman Minsky warned; in this way, stability breeds leverage, and leverage breeds instability.

 

 

Via UBS: 1994 Redux?

...

Sebastian Mallaby has written an excellent account of the 1994 bond market blowout in ‘Hurricane Greenspan’, chapter eight of his book ‘More money than God’ (Bloomsbury press, 2010). In his depiction of the legendary hedge fund trader Michael Steinhardt – he describes how hedge funds, and a range of other financial institutions, chased convergence trades from 1990-1993.

They played term carry (borrowing short term to buy long dated bonds within the US). They ran cross regional carry trades (borrowing in Germany or the US to buy Italian & Spanish bonds as these countries prepared for EU membership).

And they rushed to buy assets that were priced off convergence trades; emerging market property, peripheral banks. They even bought defensive growth stocks (with the idea that the PE on a defensive growth stock should converge to the inverse of the 10 year yield).

We argue below that the set-up today is very similar to that in early 1994.

The danger in these trades is that a cyclical recovery, especially a global cyclical recovery, will cause yields to rise and compel policy makers to withraw accommodation. And that this can induce an outsized reaction in all the convergence trades ultimately priced off treasuries, as leverage is removed.

This is why the central lesson from 1994 is that, after a long period of easy money, when a cyclical recovery kicks in and policymakers are setting to remove accommodation, at all costs avoid convergence trades and avoid assets that are priced off convergence trades.

And the popular convergence trades of the past months have been;

• Emerging market credit
• Emerging market property
• Southern European sovereign debt
• Peripheral European sovereign debt
• US mortgage backed securities
• US and global high yield debt
• Global defensive growth stocks.

So what brings us to think that we can use 1994 as a guide to investing for the rest of 2013?

In the section below we highlight several key developments from 1990-1995 and the comparison with the current situation;

1990-Feb 1994

The Fed ran a very easy monetary policy from 1990-early ’94 in an attempt to reflate the US economy in aftermath of the S&L crisis. We have seen lower rates & even easier monetary policy since 2009.

US growth remained lacklustre throughout 1990-1993, going through a series of moderate ‘mini-cycles’. We have seen even more lacklustre growth over the past four years.

US 10-year treasury yields fell from 9% to 5% from 1990-early 1994, as a recession and then disinflationary pressure pushed down inflation expectations. Treasury yields fell from 4.3% in 2007 to 1.4% in the summer of 2012.

US banks hoarded treasuries.

Lending remained lacklustre.

Corporates hoarded cash & paid back debt.

From 1990-1994 Capital flowed into emerging markets. Asia boomed. The former USSR saw large inflows also. Capital flowed heavily into emerging markets from 2009-11, although it then slowed in 2H11 & 2012 as the Fed ended QE2.

Credit spreads tightened from 90-94, and from 09-13.

Commodities remained in the doldrums from 1990-1994. This was unusual, given the strong capital flows into emerging markets. But the implosion of the military/industrial complex in Russia from 1989 saw domestic demand for commodities collapse. Russia then exported nickel, aluminium, palladium, platinum, copper and oil to get hold of hard currency. Commodity prices came under intense pressure. This contrast is with the 2009-13 period – where capital flows & restocking drove commodity prices higher from 2009-11, but where capital outflows, destocking and new supply drove prices lower in 2011/12.

Headline CPI trended down, persuading many that there was no cause for rate hikes. We have seen a similar trend from mid-2001.

The dollar trade weighted index range traded between 80 & 95 from 1990-1995. An interesting development was that the dollar weakened while the US economy recovered through 1994, and while the Fed raised rates 225bps. The DXY has been range trading in a similar manner, broadly between 75 and 90 since 2009.

The extended period of low rates and strong capital flows into emerging markets induced a huge build-up of leverage across financial & non-financial institutions on a global basis.

The strong flows of capital into emerging markets set off the procyclical growth dynamic we have described regularly.

Capital inflows induce central banks to print their own currency to buy the dollars coming in. Bank deposits rise, and banks lend to construction and engineering companies. Growth & inflation pick up. And with nominal rates sticky, real rates fall. That in turn incentivises procyclical gearing up to buy & build houses, inventory and general fixed capital formation.

The Asian tigers grew aggressively, and their stock markets boomed going into 1993. Emerging markets recovered in 2009/10, struggled into 2011/12 and then saw a patchy recovery until recently.

The problem with the reflationary process in emerging markets is that it sows the seeds for its own destruction. Because the low real rates in EM induce excessive gearing & fixed capital formation – compared to a more balanced allocation of capital, had real rates stayed steady above zero. This leaves misallocated capital, and the latent potential for bad loans to emerge when credit becomes scarce. It also causes a deterioration in the trade balance. Both make emerging markets increasingly dependent on capital flows to stay afloat.

In many cases, emerging market governments will react to rising inflation by attempting to restrict credit growth (rather than raising rates). The problem with this is that it incentivises US dollar borrowing.

Emerging market business finds it attractive to borrow in dollars when domestic inflation is rising, the domestic currency is appreciating, and domestic borrowing costs are higher than dollar funding. And it is even more attractive when the activity the loans are funding – from inventory building to FCF – sees price/cost rises.

But when the trends reverse – the domestic currency depreciates, the dollar funding becomes more dear, the inventory values fall – then emerging market corporates can find themselves squeezed. Very rapidly.

But it is not just EM. In the long history of financial crises, the ‘reach for yield’ during a slow growth and low yield environment has on multiple occasions set up the conditions for financial stress when yields eventually rose.

The book ‘More money than God’ by Sebastian Mallaby (Bloomsbury, 2010), gives an excellent description of the leverage and yield enhancing structures that built up in the 1990-1993 period, and the carnage inflicted upon that leverage in 1994. Some examples include:

• Bank & hedge fund carry trades – borrowing at the short end to purchase long dated bonds.
• Borrowing in USD and German marks to buy Italian and Greek long term debt
• Borrowing to buy high yield corporate debt.
• he use of interest rate swaps to generate yield enhancement.
• Leverage purchases of buy-to-let properties

We have also seen a significant build up in leverage over the past four years. Buy-to-let investment has risen strongly in the US/UK/Switzerland/Scandinavia. Retail investors have become heavily exposed to credit through mutual funds and credit ETFs.

Investors became very overweight long duration defensive growth and dividend yielding equities, at the expense of cyclical exposure.

Investors have left themselves highly exposed to any kind of cyclical rally outside the US, as well as within it. Valuations (as we noted here) are extremely varied.

1994

As macro activity in the US accelerated, corporates stopped hoarding cash and started to seek to borrow to expand their businesses.

US banks, which had been hoarding treasuries, sold them to make way for increased corporate loans. Treasuries started to sell off.

The Fed then responded to the steepening curve and the improving macro conditions by raising rates by 25bps in February 1994. This came as a surprise to the market, which was not aware of the Fed’s internal deliberations. The transcript of the February meeting indicates that Fed members were wary of a 1988/89 style spike in inflation if they did not start the process of tightening.

Greenspan believed that the curve would flatten, as markets anticipated tighter policy moderated inflation expectations in the future.

But that’s not what happened.

The rise in rates instead dented the derivative trades predicated on no rise in yields, and it squeezed carry traders. That induced a more aggressive unwinding of treasury holdings, as leveraged carry trades unwound. And the Banks accelerated the sell off as they sold treasuries to make space for increased corporate lending. So the yield curve steepened over the year, with 10-year yields rising 306bps vs the 225bp rise in Fed funds.

An array of casualties ensued, from Orange county, California, that went bankrupt due to its exposure to a series of exotic interest rate swaps. To a number of prominent hedge funds – which saw extreme losses in February 1994.

Then there was the international fallout. The sharp increase in domestic demand for credit, combined with the increase in real rates induced powerful capital flows back to the US. This sucked liquidity out of several emerging markets, whose central banks had to retire domestic currency to repay the dollars exiting their countries. Soon, countries that had seen the most aggressive investment booms, which had done the most aggressive US dollar borrowing, and which suffered the largest current account deficits, came under intense duress. The Mexican peso crisis erupted, and the seeds were sown for a sustained deterioration in Asia, before the full collapse of the Asian crisis in 1997.

One of the conundrums of 1994 was the US dollar. It would be logical to think that, with a sharp rise in US growth, in rates & yields that the US dollar would have rallied. But it didn’t. It fell.

An important reason was that the US recovery, while stronger than expected, was not a big surprise. But what was a surprise was the European recovery – after the sustained post-unification funk in Germany, and the Scandinavian banking crisis in 1992. In our view in commodity strategy – it was the relative surprises – which made Europe’s recovery much more unexpected, that triggered the currency move.

This is particularly interesting today – with the broad consensus that the US dollar is going to rally, due to the more robust recovery in the US and the potential for tapering.

But it is always worth keeping an eye on relative macro surprises.

We see the potential for a counter trend fall in the US dollar.

Now there are clearly some stark differences between today and 1994. Back then interest rates were much higher. So 300bps on treasuries increased rates by three fifths. The same rise from the July low would treble rates. And certainly, the authorities are first talking about an extended period of QE tapering. We are still a distance away from actual rate hikes.

The Fed is also much more transparent than it was under Greenspan in the early 1990s.

Where conditions are similar is that a very large structure of leverage has built up on the back of low rates, from leveraged property & credit buying, large retail exposure to yield enhancement products (high yield ETFs etc), earlier dollar leverage driven investment booms in emerging markets.

So where are we now. It looks to us very similar to February 1994.

The Fed’s continued insistence on talking tapering despite the recent rollover in US macro surprises has started to unsettle leveraged yield enhanced positioning.

The US high yield ETF has come under severe pressure. The US mortgage spread has blown out relative to the US 30-year treasury yield. South African and Indian currencies are under pressure. India has responded by raising taxes on gold imports.

In 1994, Mexico was the first to feel the brunt. Followed by South Korea in 1997. In 2013, South Africa is feeling the pressure. Although other emerging markets, notably China, continue to benefit.

The next big question is; can the US withstand a higher cost of capital, like it did from 1994-98.

In short, no!

In the mid-late ‘90s, the US coped with a higher cost of capital in several ways. It enhanced productivity through a rapid adoption of tech. Corporates geared up, which ensured strong liquidity growth and ‘efficient’ balance sheets. Corporates went through a second round of ‘just in time’ inventory management and outsourcing. Consumers benefited from the strong dollar and falling commodity prices – seeing their disposable incomes improve. And the disinflation in EM translated to a downtrend in yields from 1994, which allowed for an acceleration in the housing market and an expansion of household debt.

But we have a number of concerns that hint at vulnerability.

The first is that the potential for sustained disinflation over multiple years is less, because yields are already low. Consequently, there is less scope for a sustained recovery in housing – beyond the initial flurry of demand from rising household formation. The sharp rise in mortgage spreads is one hint that this transition may be more difficult. The spread on mortgages may be particularly important for the leveraged buy-to-let investors, who have been heavily involved in the recent surge in housing sales.

Because we understand that a large part of the buying is from investors then seeking to rent out the properties, we suspect that the follow-through consumer demand may not be as aggressive as previously imagined. If a household buys a house, taking on debt, it opens the floodgates to increasing debt fuelled buying of cars, household furnishings and white goods. A very different psychology comes from paying a month up-front on a rental. You are much more likely to cut back, to be more frugal.

Government debt levels are clearly extended, and the deficit needs to be cut to prevent further deterioration

A more subtle point is that the extended expansion of government spending as a share of GDP in response to the financial crisis is crowding out the private sector, and reducing the productive potential of the US economy. This stands in stark contrast with the tight control of government debt in the early 1990s under the Clinton administration.

These suggest that it is much less likely that we see the US enter a ‘high plateau’ of growth as we saw from 1995-98, where the US saw a powerful productivity & credit fuelled boom while the emerging markets deflated. And it makes it more likely that the US stays on a lower trajectory, interspersed with periodic recessionary slowdowns in the years ahead.

The point at which the market realises this would likely herald a significant risk-off event.

    

Americans who disapprove of the government reading their emails have more to worry about from a different and larger NSA effort. As the AP reports, the program, that snatches data as it passes through the fiber optic cables that make up the Internet's backbone, which has apparently been known for years, copies Internet traffic as it enters and leaves the United States, then routes it to the NSA for analysis. As the name suggests, Prism is merely the intelligent filter, finding discrete, manageable strands of information within this much more massive data stream that is being collected and stored. Prism makes sense of the cacophony of the Internet's raw feed. What is unclear, as more details, interviews and documents become available, is how Prism fits into a larger U.S. wiretapping program in place for years (know as 'Hoovering' at one major internet company).

The government are in active denial, "the perspective is that we’re trying to hide something because we did something wrong. We’re not," but some senators note, "secret programs approved by a secret court, issuing secret court orders, based on secret interpretations of the law," hardly fit the 'transparency' ethic this administration has promoted.

In the meantime, as one former NSA official noted, "You have to assume everything is being collected."

Via AP,

Public statements and the few public documents available, show there are two vital components to Prism's success.

The first is how the government works closely with the companies that keep people perpetually connected to each other and the world. That story line has attracted the most attention so far.

 

The second and far murkier one is how Prism fits into a larger U.S. wiretapping program in place for years.

But, it is clearly an escalation...

The NSA is prohibited from spying on Americans or anyone inside the United States. That's the FBI's job and it requires a warrant.

 

Despite that prohibition, shortly after the Sept. 11 terrorist attacks, President George W. Bush secretly authorized the NSA to plug into the fiber optic cables that enter and leave the United States, knowing it would give the government unprecedented, warrantless access to Americans' private conversations.

 

Tapping into those cables allows the NSA access to monitor emails, telephone calls, video chats, websites, bank transactions and more. It takes powerful computers to decrypt, store and analyze all this information, but the information is all there, zipping by at the speed of light.

And it is all being stored...

The government has said it minimizes all conversations and emails involving Americans. Exactly what that means remains classified.

 

That means Americans' personal emails can live in government computers, but analysts can't access, read or listen to them unless the emails become relevant to a national security investigation.

 

The government doesn't automatically delete the data, officials said, because an email or phone conversation that seems innocuous today might be significant a year from now.

 

What's unclear to the public is how long the government keeps the data.

But Obama voted against this during his campaign in 2007...

Congress approved it, with Sen. Barack Obama, D-Ill., in the midst of a campaign for president, voting against it.

 

"This administration also puts forward a false choice between the liberties we cherish and the security we provide," Obama said in a speech two days before that vote.

 

"I will provide our intelligence and law enforcement agencies with the tools they need to track and take out the terrorists without undermining our Constitution and our freedom."

The corporations knew what was coming...

When the Protect America Act made warrantless wiretapping legal, lawyers and executives at major technology companies knew what was about to happen.

 

One expert in national security law, who is directly familiar with how Internet companies dealt with the government during that period, recalls conversations in which technology officials worried aloud that the government would trample on Americans' constitutional right against unlawful searches, and that the companies would be called on to help.

 

The logistics were about to get daunting, too.

 

For years, the companies had been handling requests from the FBI. Now Congress had given the NSA the authority to take information without warrants.

But the workload was becoming onerous so it was centralized

What the NSA called Prism, the companies knew as a streamlined system that automated and simplified the "Hoovering" from years earlier, the former assistant general counsel said.

 

The companies, he said, wanted to reduce their workload. The government wanted the data in a structured, consistent format that was easy to search.

But denials were carefully worded

Every company involved denied the most sensational assertion in the Prism documents: that the NSA pulled data "directly from the servers" of Microsoft, Yahoo, Google, Facebook, AOL and more.

But PRISM is a filter on what the government is really storing

Prism, as its name suggests, helps narrow and focus the stream.

 

In that way, Prism helps justify specific, potentially personal searches.

But it's the broader operation on the Internet fiber optics cables that actually captures the data.

"I'm much more frightened and concerned about real-time monitoring on the Internet backbone," said Wolf Ruzicka, CEO of EastBanc Technologies, a Washington software company.

 

"I cannot think of anything, outside of a face-to-face conversation, that they could not have access to."

 

Whether the government has that power and whether it uses Prism this way remains a closely guarded secret.

Obama defends the 'intrusion' the only way we would expect:

"You can't have 100 percent security and also then have 100 percent privacy and zero inconvenience,"

And it's no surprise the President continued the eavesdropping

"You can't expect a president to not use a legal tool that Congress has given him to protect the country.

 

So, Congress has given him the tool. The president's using it.

 

And the courts are saying 'The way you're using it is OK.' That's checks and balances at work."

But in conclusion:

Schneier, the author and security expert, said it doesn't really matter how Prism works, technically. Just assume the government collects everything, he said.

 

He said it doesn't matter what the government and the companies say, either. It's spycraft, after all.

 

"Everyone is playing word games," he said. "No one is telling the truth."

    

• (FT) Markets often put a different slant on central bankers’ words than was intended, thus when Mr. Bernanke said ‘tapering’ the markets heard ‘tightening’

• The IMF on Friday urged the US to repeal sweeping federal budget cuts that will be a severe drag on economic growth this year. (Teabags not listening)

• U.S. producer prices up 0.5% in May and 1.7% YoY

• U.S. Industrial production was unchanged in May. The sector has seen little growth since the turn of the year, the Fed said

• The troubled city of Detroit will stop making payments on a portion of its unsecured municipal bond debt Friday, according to a report in the WSJ.

• China worried that tightening could trigger capital flight and set off debt crisis, says Ambrose Evans-Pritchard.

• The World Bank cut its global growth forecast for this year after emerging markets from China to Brazil slowed more than projected, while U.S budget cuts and slumping investor confidence in Europe’s are not helpful.

• Emerging markets risk an interest rate shock once the US Federal Reserve and other Western authorities start to withdraw global liquidity, the World Bank has warned.

• U.S. Banks repossessed 38,946 homes, an increase of 11% MoM. The number of homes hit with default notices for the first time grew by 4% (US housing might not be as strong as advertised)

• Fed's Beige Book business survey shows "modest to moderate growth" across U.S

• The Dow Transports, adjusted by the CPI, are in new high ground. Industrials, S&P etc are still lagging.

•  (FT) Gabon is planning to take assets back from three international oil companies including a subsidiary of China’s Sinopec in a sign of Africa’s growing assertiveness as competition intensifies for its natural resources.

• (Spiegel) There are more journalists in prison in Turkey than in any other country.

• Germany's high court made clear that it was skeptical of the ECB's program to buy unlimited quantities of sovereign bonds from struggling euro-zone member states. It could strike down the most successful tool in combating the crisis.

• The USDA trimmed corn production just 1%, to 14.005 billion bushels, well ahead of the market consensus. Traders had expected a drop of 2.2%. Ending stocks also surpassed market expectations. The USDA pegged 2013/14 corn ending stocks at 1.95 billion bushels, down from May but still the largest in eight years, and more than 8 % larger than the 1.8 billion traders expected.

• This year the world will eat 112m tonnes of pork. Around half will be munched in Chinese mouths, according to the Agricultural Outlook report from the FAO and the OECD, a rich country club. The Chinese have been the world's biggest meat-eaters for over two decades. Pork is their favourite: each person scoffs about 38kg a year, compared with 28kg swallowed by Americans.

• (FT) Sharp drop in availability of scrap copper has caught the attention of some hedge funds and traders, making them bullish about the red metal

Of the six candidates who ran in Iran’s presidential election, the most moderate and the only cleric – Hassan Rowhani – has been declared the winner by Iranian state television. His victory was a startling triumph. He won more than 50 percent of the vote in the first round and avoided a runoff. His victory [...]

With the world seemingly of the belief that the US is the cleanest dirty (it is not), we thought it might be useful - should you have money burning a hole in your sidelines pocket that 'needs' to be invested in stocks - to at least comprehend how rich or cheap the rest of the world is. UBS global equity strategy heat-map below identifies the most expensive (red) and cheapest (blue) sectors across 20 regions (and the aggregate) in one easy pocket-size cocktail-party-usable cheat-sheet. The US currently is most expensive and intriguingly Australia the cheapest relative to their own historical valuations.

(click image for large legible version)

 

 

Notes;

Dark blue (very cheap) = current relative valuation < -1.5 standard deviations from historical average.

Light blue (cheap) = current relative valuation between < -1.5 and <-0.75 standard deviations from historical average.

No colour (neutral or N/A) = current relative valuation between > -0.75 and <+0.75 standard deviations from historical average.

Peach (expensive) = current relative valuation between > +0.75 and <+1.5 standard deviations from historical average

Red (very expensive) = current relative valuation between > +1.5 standard deviations from historical average

Source: UBS research.

    

Things have been a little erratic lately here in US, but not really headline-worthy. The economy continues to grow, sort of, houses continue to sell and stock and bond prices fluctuate but can’t seem to follow through in either direction. We are not, in short, engulfed in any kind of crisis.

But out in the world, especially in once-hot emerging markets like Brazil and China, the story is very different. As Prudent Bear’s Doug Noland explains in his most recent Credit Bubble Bulletin:

Meanwhile, the “developing” market Bubble continues to unwind. As leverage comes out of the commodities, currency “carry trades” and developing stocks and bonds. And as capital flight becomes a more serious issue, the marketplace must ponder the consequences not only of what a faltering Bubble means for scores of markets and economies, there is as well the issue of developing central banks having to sell from their trove of Treasuries and bunds and such to finance a surge in outflows (“hot” and otherwise). There’s even this new dynamic where Treasury yields rise on days of global currency and equity market tumult. It’s been awhile…

I suspect that the global jump in yields (and CDS and risk premiums) has more to do with de-leveraging than it does with tapering worries. This dynamic has caught many by surprise. The speculators anticipated cleverly exiting their leveraged MBS and other trades based on their expectations for Fed policy. Now, there’s a tremendous amount of unanticipated market uncertainty.

Japanese policymakers have really mucked things up. The Nikkei sank 6.5% Thursday and was down 1.5% for the week. Perhaps it’s a little early to pronounce the BOJ’s “shock and awe” monetary experiment a failure. The yen rallied 3.5% this week against the dollar. Against the Philippine peso it was up 4.5%, versus the South Korean won 4.1%, the Indian ruppee 4.3%, the Malaysian ringgit 4.0%, the Indonesian rupiah 3.2%, the Argentine peso 3.9% and the Brazilian real 4.2%. Indonesia raised rates to support its weak currency. The yen “carry trade” (sell yen and use proceeds to buy higher-yielding instruments globally) is doling out painful losses – forcing the unwind of leveraged trades across many markets. I wouldn’t be surprised if the yen short is the largest short position in modern history. The yen bears are now running for cover – causing all kinds of havoc in the currencies and securities markets.

“Emerging” Asian markets are in the middle of an unfolding financial storm. Friday’s 2.1% gain cut the Philippine equities loss for the week to 9.2%. Even with Friday’s 4.4% recovery, the Thailand stock exchange ended the week down 3.4%. South Korea’s Kospi dropped another 1.8%.

Latin America is as well caught in troubling dynamics. Brazil’s currency (real) traded to a four-year low against the dollar this week – despite currency interventions and the removal of taxes on financial flows and currency derivatives. Brazilian equities were hit for 4.4% this week, increasing y-t-d losses to 19.1%. Mexican stocks dropped 2.4%, boosting y-t-d losses to 10.2%.

The Shanghai composite dropped 2.2% in a holiday-shortened week. China pegs its currency to the U.S. dollar, so we can’t look to the performance of the renminbi for much of an indication of flows or mounting financial market stress.

I have posited that China is in the midst of an historic Credit Bubble. I have over the years tried to explain how interrelated their Bubble is to ours. Our mismanagement of the world’s reserve currency led to 20 years of huge Current Account Deficits. A significant portion of the Trillions of associated IOU’s have made it onto the balance sheet of the People’s Bank of China, especially over recent years. And no Credit system and economy has gone to greater excess during the post-2008 global reflation. It was the “fledgling” Credit Bubble spurred to “terminal phase” excess.

If the “developing” economy Bubble has passed an important inflection point, then China is vulnerable. If “hot money” is leaving EM [emerging markets] then China should be susceptible. And, let there be no doubt, when China finally succumbs global economic prospects really dim – and prospects for some fellow EM economies turn downright dismal. Recall how the tightening of subprime finance gravitated to “Alt-A” and then worked its way to the “conventional” core. And when housing in general began to falter the bottom fell out of subprime.

This week provided a bevy of notable China-related headlines: From the Financial Times: “China Debt Auction Failure Raises Liquidity Fears;” “Fresh Data Highlight China’s Sluggish Growth.” From Bloomberg: “China Debt Sale Fails for First Time in 23 Months on Cash Crunch;” “China Local Debt Audit ‘Credit Negative,’ Moody’s Says;” “China’s Leaders Face Test of Growth Resolve After May Slowdown;” “China Export Growth Plummets Amid Fake-Shipment Crackdown.” From Reuters: “Fitch Warns on Risks from Shadow Banking in China;” “China Estimates Fake Trade Invoicing at $75 billion in Jan-April;” “China State Auditor Warns Over Local Government Debt Levels.”

The price of Chinese sovereign Credit default swap (CDS) “insurance” jumped from 92 to 113 in three sessions, before dropping back down to 98 on Friday. Chinese interbank lending rates have recently spiked higher – and there were even reports of several borrowers forced to pay up for increasingly scarce liquidity. There were debt auctions that did not go smoothly. The currency forwards market is showing some atypical downward pressure on the renminbi.

Many believe this newfound tightness in Chinese money markets can be easily resolved by liquidity injections from the People’s Bank of China. And perhaps Chinese monetary and economic managers still have things under control. If so, the same clearly cannot be said for many of their fellow “developing” policymakers. Capital flight is always extremely difficult to manage. I worry that the world has never faced the possibility for such destabilizing flows and speculative de-leveraging. To be sure, global markets have never been as dependent upon the power of central bankers. And in my mental tallies of risk and complacency, I never envisaged they could so elevate in tandem.

So can the US stay placid when the rest of the world turns chaotic? Highly doubtful. There’s a market phenomenon in which one investment play blows up and forces those on the wrong side of the trade to dump their liquid assets to raise cash — which causes the high-quality assets to fall as much or more than the junk. As Noland notes, the world’s premier liquid asset is the Treasury bond.

If the developing world’s need to raise cash is a factor in the recent spike in US interest rates, this implies a feedback loop in which rising US rates further destabilize emerging markets, forcing the sale of more Treasuries, and so on. Can the Fed stop this? Not unless it wants to buy up not just all the newly-issued Treasuries as it does now, but the trillions of dollars of bonds that might be dumped once things really get going.

It’s important to understand that we’re here because for years the developed world in general and the US in particular have been exporting their problems to the developing world via monetary policy. We fund our overspending by creating a bunch of new dollars,  many of which flow beyond our borders looking for higher yields. They land in, say, Brazil, pushing up both local asset prices and the exchange rate of the real. So individual Brazilians see their cost of living rise while Brazilian exporters are priced out of global markets. This is the currency war that Brazil’s government has been complaining about.

Then the hot money flows back out, causing a different set of problems for a country that has spent the past decade trying to adjust to excessive capital inflows. The result: some seriously fragile banks and over-leveraged companies and investors, any of which could trigger a nationwide crisis.

The same general process is at work in other major emerging markets, with each in its own way now posing a threat to the global financial system — at the pinnacle of which sit the S&P 500 and the Treasury market, looking an awful lot like Southern California real estate circa 2007.

As we rapidly approach the 100 year anniversary of the Federal Reserve (signed into law on December 23, 1913) and the 16th amendment (ushering in that IRS favorite - the income tax) a question arises: what was life like a century ago? Conveniently, the following infographic breaks down some of the main ways in which life has changed in the past 100 years: from life expectancy, to marriage, education, employment, wages, entertainment, sport, and shopping (we finally find a time when JCPenney was actually popular), all the key ways in which the world and life in the US has changed in the past century are mapped out.

h/t @GreekFire23

    

While it’s obvious to everyone that the government is spying on virtually all of the digital communications of Americans – phone, email, Internet, credit card, etc. – the government is pretending that it only spies on foreigners and collecting our  metadata (which can actually tell a lot about us).

Indeed, the government is instructing Senate staffers to stick cover their eyes and pretend that the spying documents found all over the Internet don’t exist.

One free and easy way to protest mass surveillance, educate others, and yank Big Brother’s chain is simply to add a sentence to the end of your emails and web posts.

To give you the idea: you’ve seen the disclaimers at the end of emails from lawyers, investment advisers, and similar professionals.  You know, the ones that say stuff like “This is a confidential communication and can’t be used by anyone but the intended recipient”.  They put the same disclaimer at the end of every single email.

Why don’t we put our own disclaimer at the end of our emails and web comments, saying:

WARNING: The National Security Agency is likely recording and storing this communication as part of its unlawful spying programs on all Americans ... and people worldwide. The people who created the NSA spying program say that this communication - and any responses - can and will be used against the American people at any time in the future should folks in government decide to go after us for political reasons. And private information in digital communications may be given to big companies by the government.

 

Mass surveillance doesn't keep us safe, and even the top national security experts say that we don't need it. (They also say we should get a grip.)

This may help keep the issue alive even as the government desperately tries to sweep it under the rug.

Note: All modern browsers allow you to highlight, copy and then paste text with links in it into your email or web comment.  If you prefer, you can copy just the text and delete the links.

    

Back in May 2012, when we were making fun at the latest iteration of the now fatally discredited European stress tests, we took the first of many jabs at the what may currently be the world's most systematically important, and undercapitalized, bank in the world:

Finally, if anyone is still confused where the pain is headed next, here is a list from Morgan Stanley of all Euro banks with a Core Tier 1 ratio that is so low, that the banks will soon regret not raising more capital in the period of calm that the ECB's LTRO bought them.

 

 

Also, one bank is missing from the list above: Deutsche Bank. CT1/TA: 1.68%. Oops.

That's right - Deutsche Bank was so bad that it wasn't even allowed to appear on a screen of Europe's most undercapitalized banks - and we helpfully pointed out its true capital ratio of just under 2%, and an implied leverage of 60x!

Fast forward 13 months to a Reuters interview with former Kansas City Fed president and FOMC dissenter and sole voice of reason at the Federal Reserve, and current FDIC Vice Chairman Tom Hoenig, who confirmed that once again Zero Hedge was just a year ahead of the curve.

A top U.S. banking regulator called Deutsche Bank's capital levels "horrible" and said it is the worst on a list of global banks based on one measurement of leverage ratios. "It's horrible, I mean they're horribly undercapitalized," said Federal Deposit Insurance Corp Vice Chairman Thomas Hoenig in an interview. "They have no margin of error."  Deutsche's leverage ratio stood at 1.63 percent, according to Hoenig's numbers, which are based on European IFRS accounting rules as of the end of 2012.

In other words, the slighest systemic shock in Europe and Deustche Bank gets it. And as Deutsche Bank goes, so does Germany, so does Europe, so does the world.

Immediately confirming Hoenig's (and Zero Hedge's) observations, was Deutsche's prompt repeat that "all is well" and that "these numbers" are not like "those numbers."

"To say that we are undercapitalized is inaccurate because if you look at the Basel framework, we're now one of the best capitalized banks in the world after our capital raise," Deutsche Bank's Chief Financial Officer Stefan Krause told Reuters in an interview, when asked about Hoenig's comments. "To suggest that leverage puts us in a position to be a risk to the system is incorrect," Krause said, calling the gauge a "misleading measure" when used on its own.

Of course, DB's lies are perfectly expected - after all it is a question of fiath. So let's go back to Hoenig who continues to be one of the few voices of reason among the "very serious people":

Hoenig pointed to the gain in Deutsche Bank shares in January on the same day it posted a big quarterly loss, because it had improved its Basel III capital ratios by cutting risk-weighted assets.

 

"My other example with poor Deutsche Bank is that they lose $2 billion and raise their capital ratio. It's - I don't want to say insane, but it's ridiculous," Hoenig said.

 

A leverage ratio is a better method to show a firm's ability to absorb sudden losses, Hoenig says, and he has floated a plan to raise the ratio to 10 percent. He said the 3 percent leverage hurdle under Basel was a "pretend number."

 

Opponents of using such a ratio say that it ignores the risk in a bank's loan books, and can make a bank with only healthy borrowers look equally risky as a bank whose clients are less likely to pay back their loans. It also fails to take into account how easily a bank can sell its assets - so-called liquidity - or whether it is hedged against risk.

 

Still, equity analysts said that while Deutsche Bank likely will meet regulatory capital requirements, its ratios look weak.

Ugh: terminology, ratios, numbers. It's gives a chap the belly-ache.

But just as we were about a year ahead with our warning of DB's "off the charts" leverage, so we wish to remind readers that some time around June 2014, the topic of Deutsche Bank's $72.8 trillion in derivatives, or about 21 times more than the GDP of Germany, will be the recurring news headline du jour.

Recall from April: "At $72.8 Trillion, Presenting The Bank With The Biggest Derivative Exposure In The World (Hint: Not JPMorgan)" which for those who missed it, we urge rereading:

    

 

Bernanke claims the Fed can successfully exit its current strategy. He’s lying. Or he’s adhering too strongly to economics and ignoring human nature.

 

One of the easiest trades for financial institutions over the last four years has been to simply front-run the Fed during its QE programs.

 

After all, the Fed was literally broadcasting its intentions to the markets. So traders did what they do best and took advantage of this.

 

In this context, the second rumors begin that the Fed would taper its bond buying you should see bonds collapse as traders realize the game is up.

 

And if the Fed actually did taper or begin to implement a strategy that even resembled taking its foot off the gas… or God forbid exit, then we’d see a very rapid adjustment to reveal the “real” risk in the system and the “real” level at which rates should be.

 

Take a look at what happened to the 10-Year Treasury when rumors of “tapering” appeared:

 

 

 

The Fed cannot exit. It will claim that it can, but market reactions to any real exit will be disastrous. We’ve passed the point of no return. Bernanke’s best home is to retire before the music stops.

 

For more marketing insights, visit us at:

 

www.gainspainscapital.com

 

Best Regards

Graham Summers

 

    

A month ago we quantified that just the overt European bank undercapitalization (excluding spillover effects from counterparty liability and derivative exposure) resulting from non-performing loans, is a staggering €500 billion. These NPLs "reduce the capacity of banks to lend, hindering the monetary policy transmission mechanism. Bad debts consume capital and make banks more risk averse, especially with respect to lending to higher risk borrowers such as SMEs. With Italy (NPLs 13.4%) now following the same dismal trajectory of Spain's bad debts, the situation is rapidly escalating (at an average of around 2.5% increase per year)." The implied conclusion is that Europe has kicked the can far longer than it should, and as a result its banks have become zombie shell with unprecedented accrued losses, supported explicitly by their various governments, and thus, by the ECB, which is now in the business of preventing sovereign failure (despite its repeated promises otherwise).

And since the topic of quantifying how big the sovereign assistance to assorted banks - both in Europe and the US (which Bloomberg calculated at $83 billion per year) - has become a daily talking point, we are happy to read that Harald Benink and Harry Huizinga have reached the same conclusion as us in their VOX analysis, and further have shown that in Europe the implicit banking sector guarantee by the state is a whopping €650 billion.

Until now, Europe’s banking sector has been kept afloat by implicit state guarantees of virtually all liabilities. Michiel Bijlsma and Remco Mocking (2013) of the CPB Netherlands Bureau for Economic Policy Analysis find that in 2012 these guarantees provided banks in Europe with an annual average funding advantage amounting to 0.3% of total assets. They base this estimate on a comparison of banks’ diverging credit ratings in scenarios with and without government bailout support. An annual funding advantage of 0.3% of assets can be capitalised to be equivalent to 2% of total assets, on the assumption of a discount rate of 15% commensurate with banks’ uncertain earnings prospects. Given total banking assets of €33 trillion in the Eurozone, we are talking about an implicit guarantee of about €650 billion.

Benink and Huizinga go so far as making the call for an urgent recapitalization of Europe's ban:

Europe has postponed the recapitalisation of its banking sector for far too long. And, without such a recapitalisation, the danger is that economic stagnation will continue for a long period, thereby putting Europe on a course towards Japanese-style inertia and the proliferation of zombie banks.

So while the recent advent of the Japanese Carry Trade has been a useful distraction to the insolvency of Europe's banking sector, the underlying reality, as confirmed by the build up of massive unrecognized losses, is only getting worse, and the market is well aware of this:

Banks are already saddled with ample unrecognised losses on their assets, estimated by many observers to be at least several hundreds of billions of euros and mirrored by low share price valuations, and an additional loss of their present funding advantage will be crippling.

...

On average, the market-to-book value of European banks now is about 0.50 (see Figure 1). This indicates that accountants’ estimates of bank capital are far too rosy, and that banks have substantial hidden losses on their books. In a recent speech Klaas Knot (2013), Dutch central bank president and European Central Bank governing council member, noted that restoration of banks’ balance sheets is a crucial requirement for economic recovery. To facilitate this process, Mr Knot states, it is essential to create transparency about losses in the banking sector and to have an orderly resolution of lossmaking assets. Without this, banks will remain restrictive in making new loans. Mr Knot adds that the planned European banking union offers an appropriate opportunity for speeding up the resolution process.

 

Furthermore, since European banks are unable to grow into their balance sheets using profits (for the simple reason that stripping away accounting gimmicks the vast majority of European banks are hardly profitable, if outright unprofitable), it will mean that the Cyprus bank resolution scheme will soon be coming to a seemingly healthy European bank near you.

The plight of Europe’s banks worsened considerably when Jeroen Dijsselbloem (2013), Dutch finance minister and Eurogroup president, stated that the approach taken in Cyprus of resolving failed institutions without using taxpayer money would in future preferably apply throughout the Eurozone. Consistent with this, Wolfgang Schäuble (2013), German finance minister, recently stated his desire ‘to ensure that enrolling taxpayers to rescue banks becomes the exception rather than the rule’, and that to achieve this ‘we need credible EU bail-in rules as soon as possible’.

 

Financial markets understood Mr Dijsselbloem’s message, as shown by a subsequent decline in the share prices of many institutions. Very low bank valuations imply that they will find it very difficult to recapitalise themselves by issuing equity or debt that is convertible into shares – in part because share issuance would further dilute the value of implicit state guarantees. Low share prices, in effect, imply that banks can raise only limited capital by issuing new shares, and that they may need to accept reduced issuance prices. Very few large European banks are raising capital by issuing new shares, no doubt as they realise that this is not in the interest of current shareholders. As exceptions, Deutsche Bank raised almost €3bn in April, while Commerzbank announced plans to raise €2.5bn through a heavily discounted rights issue in May.

The VOX authors' conclusion - the time to stop kicking the can has arrived:

Time to recognise losses

 

It is now urgent to start recognising losses on balance sheets to avoid a proliferation of Japanese-style zombie banks in Europe. To facilitate this, we advocate conducting a new and thorough stress test soon, similar to the one administered by US supervisory authorities in 2009. Of course, the financial position of most governments in Europe is much worse than that of the US in 2009. So Europe needs to take a path towards recapitalisation that in some respects differs from the earlier US approach.

• First, a credible stress test should assess the losses hidden on the balance sheet for each bank, as well as the likely cost of the removal of implicit guarantees of all liabilities.

This will result in an estimated capital shortage, taking into account capital levels as required by international bank supervisors. Recently, the Financial Services Authority (2013) conducted a stress test of UK banks, resulting in a necessary downward adjustment of reported regulatory capital of about £50 billion, and a resulting regulatory capital shortfall of £25 billion. The estimated capital shortfall of £25 billion is likely to be a low estimate, as it is by and large predicated on the continuation of implicit state guarantees in the UK. At any rate, thorough stress tests in other European countries are likely to reveal sizeable capital shortfalls as well.

• Second, supervisors need to assess whether the capital shortfall can be financed by international capital markets and/or national governments.

In case the required amounts are too high, the bank immediately must be entered into a resolution and restructuring process imposing some losses on unsecured creditors (the Cyprus model).

 

The legal basis for this resolution and restructuring would be an intervention law, which some European countries may need to enact through emergency legislation. Most banks in Europe, in contrast with their Cyprus counterparts, have significant financing by bond holders and can be recapitalised by imposing losses on holders of subordinated and common debt without infringing on savings deposits.

• Third, in the event that capital shortfalls are relatively small, supervisors could instead implement the US model.

This would mean that banks are given a limited period of time to issue equity on international capital markets, after which national governments step in to provide the remainder of the equity shortfall.

What is coming next is the New Normal's new favorite phrase: share sacrifice. Supposedly by unsecured creditors at first:

The way in which Europe recapitalises its problem banks now has a direct impact on the design of the future European banking union. If many banks are recapitalised by imposing losses on unsecured creditors, such as holders of subordinated and common debt, this is likely to be reflected in the design of the single resolution mechanism that will determine the extent to which bail-ins are mainstreamed in future bank resolutions in the EU.

Although coupled with the recent push to sequester large bank deposits, in part or in whole, and amounting to as much as $32 trillion globally under the guise of punishing tax evasion, one can be certain that secured debt holders, not to mention bank deposits, will also be impaired. It also means that when the most recent coming of the Japanese carry trade finally unwinds, and judging by the recent plunge in the Nikkei and surge in the JPY, its days may be numbered, look for the knock off effects in the European financial and sovereign bond market to usher in what may be the perfect storm of both Japan and Europe suddenly going from stable to highly combustible at the same time. Which will once again leave Ben Bernanke as the only central bank with any gunpowder left to preserve and restore stability in the "developed" world.