We Face Derivative Collateral Deflation And ECB Banks Could Be The Losers

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Low interest rates are the key to bank survival. We understand what happened in the S & L crisis, when banks made loans and Volcker raised interest rates to 20 percent. This destroyed the thrifts that loaned at 7 percent and had to borrow at rates far higher.

Alan Greenspan was a consultant to Lincoln Savings and Loan. A disturbing NY Times article tries to preserve Greenspan's credibility but can be seen as a bit of propaganda, as Greenspan was pretty tolerant of reckless behavior. However, another article gives credibility to the likelihood that much that happened with the failed savings and loans was as a result of high interest rates rather than criminal behavior, or at least bad behavior was forced upon the savings and loans.

It is perhaps true that the S & Ls needed to grow out of the high interest rate trap that was not their fault. They needed high end wealthy people to buy their products. Keating built the fanciest of places, and they couldn't save Lincoln Savings. Keating was eventually exhonerated of his crimes on appeal.

I am sure none of this that transpired was lost on Alan Greenspan. His quest for a return to the prosperity of the middle class in the low interest rate environment of the 60s and 70s, where the S & L's thrived, surely influenced his term as chairman of the Fed.

The regime of low interest rates that we have today is a direct result, in my view, of Greenspan's quest to make sure the big banks of today do not suffer the fate of the S & Ls. The low interest rate regime is almost foolproof, in that it is based upon the massive demand for treasury bonds in the interest rate swap market.

Unfortunately, built upon this seemingly noble Greenspan quest for low rates is the derivatives' new reality. Tools to keep interest rates low appear to be dishonest. We had CDO risk management scams, off balance sheet hiding of bad loans, and we had the LIBOR scam and the dishonest drive to keep interest rates low as seen in the interest rate swap scam.

The interest rate swap scam is the biggest of the scams and is very ongoing. The banks constantly say that companies must protect themselves from high interest rates. The companies have variable rate loans. They swap these to the banks in exchange for fixed loans. The banks demand collateral for these deals in the form of pristine collateral, namely treasury bonds.

That is why treasury bonds are so oversubscribed. There is a shortage of pristine collateral. I have written how Bernanke wants MBS to serve as pristine collateral. That didn't work out so well in the money markets when Henry Paulson told us that there was a run on the money markets in the fall of 2008.

But the bogus AAA rated CDOs were not, in fact, pristine. The only way to make future CDOs pristine is for Bernanke to force the US government to guarantee the bonds.

With the shortage of good treasury bonds in the world, something has to give to establish more sound collateral, or the interest rate swap market transactions will slow. This could be very deflationary.

As I said before, the Fed is in a box, creating sound collateral at the expense of Main Street prosperity. Derivatives are traded in clearinghouses, which need a lot of good collateral to protect them as middlemen.

So then, even though it is a scam, the interest rate swap market creates massive demand for treasury bonds. Interest rates stay low, and Main Street is hollowed out as the Fed no longer can do a Volcker and raise interest rates to stop inflation. Real wage price spirals cannot even be allowed to start in this economic reality.

But the risk of deflation is real. Negative interest rates would be a way to boost spending in a deflationary environment. But we know negative interest rates do not exist in the real world.

That brings us to the ECB. The Eurozone is probably more in danger of deflation than even the US. The Eurozone does not have much good collateral at all. The ECB is only giving out $47 in cash to the $100 of collateral it receives. Lending slowed because of this according to the FT article.

So, worldwide, as the cost of living increases, with speculation in housing, futures markets of all kinds, etc., the fortunes of Main Street waning. Jobs are slowly created but pay is limited and decreasing.

And in the ECB, the banks cannot be bailed out by government because of austerity fatigue and more importantly because governments are seeing their bond ratings decline. Unlike in the US, the governments need better bonds for the derivatives markets. Here we have quality treasuries, but not enough of them. There they have a need for more of their own good bonds.

That is why the ECB has gone down a different path than the Fed, seeking out bank bondholders and depositors to help make the banks solvent. The ECB is protecting the governments, at least for now. Risk for banks increases, however.

Bankers are not liked, no matter who they rely on for their bailouts. The question is, how much damage can they do to Main Street in the Eurozone and in the USA before it starts to affect their profits? Our savers are subject to massive austerity here, and the returns are small and hurtful to retirees, pension funds and insurance funds.

The interest rate swaps market is a 700 trillion dollar market. The banks who are protecting your business by taking your floating interest rate absolutely cannot be permitted to lose on that bet.

And yet, you continue to buy protection!

Perhaps you are in on the scam. Why else would you seek out a fixed rate that is still too high of a rate? Well, the truth is, most of you have been forced into accepting the interest rate swap in order to secure the loan.

As we see from the new FRED money multiplier chart, there is simply not much happening down on Main Street, and it doesn't look like there will be for some time. The chart leaves us on the precipice of deflation. While the deflationary spiral has been stopped, what happens when people and business start to put their cash in the safe instead of in the bank?

And folks, that would not be a bad idea anyway, since you are getting no real return at the bank. Is it worth the risk to keep all your money in the banks? No. Interest rates will not be going up, so your wait is in vain.

Max Keiser, who is a well known hater of banks, advocates that you only keep what you need in a bank that you can afford to lose. That won't work for everyone, and may not be rational. But then again, he is based in London now and that is in the European Union, where haircuts of savings is now the new normal.

Perhaps it is better to hedge your bank accounts with a short ETF. You can use the Proshares UltraShort MSCI Europe. (NYSEARCA:EPV) ETF.

Fred Shows Little Growth in Money Multiplier

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.