Friday, July 6, 2012

Bad Debt is the result of Prior Bad Underwriting

In the run up to the GFC Spain and Ireland were paragons of "sound banking" running surpluses, they imagined I suppose as a sort of rainy day fund for when the markets clouded over. As the booms boomed this seemed a prudent "leakage" from the pro cyclicality of demand in overstimulated financial markets. This "rainy day fund", however, conceptually failed to account for the consequences of a private debt bubble beyond the carrying capacity of Spanish or Irish central-ish banks. Lacking the monetary sovereignty to actually salvage the solvent, these semi-central banks let themselves be swamped with rancid private bank obligations.

Almost universally suppressed in the dominant mythology of the GFC is that for bad debts to first perk their putrid buds through the dung spread topsoil of finance there was by definition a prior failure of underwriting. Bad debts come from underwriters ignoring risk, thinking to cover themselves by tuning up returns, jacking up rates. Such underwriters, inured to what Minsky called "hedge phase finance" have no understanding of the inherent in-stability of the following "speculative" phase, nor the joys of "Ponzi" behavior where Chuck Prince's "musical chairs"establish the final resting place of what little underlying real wealth there actually is in a bubble. And the ECB is constitutionally blind to Minsky dynamics, committed to a doctrinaire Mellonist liquidation to cure all ills in the name of "sound money", so the sole institution that could manage the mess refuses.

Spain and Ireland ran up their rainy day funds when the sun was shining like the "sound bankers" they aspired to be. However, cash in the last decade has been given a freedom of movement unprecedented in history, and exponentially beyond any such liberty for actual goods making businesses or the humans they employ. This cross border harvest of cash allowed private banks in Ireland and Spain to stuff their respective economies with putrefying buds of debt in a process shorn of anything remotely resembling underwriting. When the "hedge" phase "Ponzi'd" the scale of the debacle was vastly beyond state balance sheets elasticity to cope. As if tazed, first Irish and more recently Spanish politicians and regulators have stumbled unthinking into the wholesale bailout of their fraudulent financial sectors nationalizing the dung bombs engineered by larcenous financiers. 

It was in that glazed eyed moment when the monstrosity of private debt began collapsing around these governments that a devastating apoplexy set in amongst representatives of the common weal. Here was the moment for galvanizing energy: to analyze debt and check it against its underwriting, where such habit persisted, to separate the good from the bad. Those who funded the dung bombs collapsing in on the state should at that moment have been forced to choke on their losses. What rainy day funds had accrued should have been deployed with Bagehot rules: at stiff rates against good collateral. Ensuring solvency of those who could show plausible underwriting and realistic potential for solvency. Sweden was able to separate its good from its bad when its banks collapsed in 93, likewise a US administration once in the misty past was able to unwind the S&L debacle with suitable claw backs and convictions. Iceland tried something like this and seems to be the better for it.

What has made this impossible in the GFC is the comprehensive capture of European, indeed Western administrations by powerful private bankers who would rather liquidate the balance of Europe or the West itself than face losses on the catastrophically fraudulent "marked to model" debts that justified their bonus pay. The only dim glimmer of hope I see in Europe is where some clever gnome at the ECB has created a debt repatriation incentive where Spanish banks can borrow at 1% from the ECB if they will loan it on to Spain at around 6% so Spain can continue to make payments on the private debt that it idiotically assumed rather than disciplining its banks. As the Monetarist Malaria begins to give core countries the fevers, more and more local bank debt will become more and more associated with its local State National Bank, even the Bundesbank, if they push it far enough will be reduced to borrowing at 6% from its subject banks who get 1% money from the ECB. In theory, this makes a wind down of the Euro fairly painless as National Central Banks will owe their debts to banks of their own nationality.

What I can't quite get to grips with is Target 2. As I understand it, if I'm a Spaniard I want to put my money in Germany in the hopes that when the system blows it'll retain some purchasing power there.  I move my funds. To keep things clearing across the increasingly stressed Euro system, the ECB shoves some reserves back to the Spanish bank who lost my deposit to ensure its continued solvency even in the increasing absence of deposits. This slow motion bank run has been in effect for about two years now. 

So it looks to me like if the system blows the local new Central Banks of newly fiscally sovereign nations will be sitting on massive Euro reserves of dubious value extended by an obsolete ECB, with virtually no deposits. On the other hand these new and true Central Banks will be well capitalized with reserves and a local fiscal sovereign who may actually give a shit about what happens to the local population it will now be administering in receivership, which may in turn attract back deposits after the initial depreciation shock to the new local currency. Local banks with local debts and local assets may all be put to use for some more popular purpose than extorted foreign debt service in the event of such a European Disunion. When you print your Lira or Peseta or whatever, you convert your reserves at par and see where they float and hope exchange rate gains and good policy attract back expatriated cash.

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