Peak What? Christmastime In Hell? Part 3

by: The Nattering Naybob


A multi part examination of the interrelationship of Oil, Energy, Commodities, BRIC's, Emerging Markets.

Bonds, Dollar Denominated Debt, Forex Reserves, Reverse Repo, Dollar Swaps, HQLA, Monetary Aggregates, Market Liquidity.

Syndicated Lending, CDO's, CLO's, Carry Trades, Leveraged Loans, Offshore Dollar Banking and Off Balance Sheet Obligations.

In Part 3, we examine:

  • A portion of the BRIC dollar carry trade
  • A very brief revisit to the 1997 and 2008 bubbles
  • Currency and investment term mismatches
  • The MBS AAA ABS bubble and resulting scarcity of HQLA (high quality liquid assets)

The BRIC Carry Trade

From part 1: "an increase in foreign currency borrowing has preceded and been at the front and center of several global financial crisis." In the eight years of weak dollar policy leading up to the 2008 crisis: "The pace of [eurodollar] growth was due to cheap (debauched) dollars being utilized for carry trades and off balance sheet obligations."

Pricing oil in dollars means that (unless you are substituting) dollars must be available for exchange against local currencies. As long as petro dollars (Russia) and export dollars (China) are abundant, those possessing eurodollars (foreign dollars) can lend to emerging markets. This creates dollar denominated demand from the EM's (low interest debt) for purchasing (Chinese) exports and (Russian) resources. In good times, with a weak dollar, the lent eurodollars flow back to the sources at a higher yield, while servicing low interest dollar debt at both EM and producer levels. Carry trades are nice work, if you can get it.

With a rising dollar, the shoe is on the other foot, and you're doing the Ginger Roger's, every one of Fred Astaire's steps, in reverse. (Who was better?) The EMs get pinched as local currency must be debased to: service the dollar debt and swap for dollars to maintain consumption levels of dollar based imports and goods. For the producers to maintain export levels, oil/goods prices must adjust in dollar terms to accommodate the customer base or allow customers to purchase in their own currency. The EMs must debauch to cover their dollar debt. If they could pay in their own currency, the additional debauch would seriously debase any debt held in their local currency. Can you say downgrade? So if they can't come up with local scratch, their paying in dollars, and if they can't come up with those little pictures of our dead presidents, there's a phrase for that, can you say eurodollar debt default?

Blowing bubbles

The first bubble in 1997 was driven by European banks, financing East Asian capex with LTCM and Russian debt coming to a head. The second bubble in 2008 started with global banks and equity foreign direct investment supporting capex in the BRICs and wound up "justifying" $500K crap shacks across the US with the securitized "safe" AAA-MBS-ABS behind them going viral in a global fashion. Below note the effect of 98 and 08 on EM currencies.

Below a chart of the US dollar vs. yen exchange rate, note the RISE in dollar vs. yen. In the past, this is when the yen carry accelerated leading to a bubble build up. Note the recent upswing.

Below a chart courtesy of Martin at Macronomy which displays the inverse relationship of Fed custody holdings to EM markets. As money flows out, the red line (tracking deviation of reserves from the two year trend) declines during the buildup in each of the last two bubbles. Note the recent decline.

From part 2:

"A significant increase in [repo] fails while overall transaction volume has decreased 30 - 40% is an indication that something is bound up due to something being in very short supply. What could it be? And how did it get in such short supply?


Stephen Cecchetti BIS:

"The US financial sector created a wide range of securities and sold them to banks and investors around the world. In some cases, the underwriting was bad and risks were improperly appraised. But even when this was not the case, currency mismatches were created on the balance sheets of non-US holders of the dollar denominated assets. These assets were financed by a combination of wholesale borrowing, where a non-US bank would simply borrow dollars from a bank that had them, and foreign exchange swap arrangements, where the bank would swap its domestic currency liabilities into dollars. Importantly, both of these funding mechanisms - borrowing and swaps - are short term whereas the dollar assets held by the banks are long term." - Remarks prepared for Janet Yellen, the Federal Reserve Bank of San Francisco, Asia Banking and Finance Conference, 7-8 June, 2010

Note below the red line displays banks with more dollar assets than liabilities -long vs. less dollar assets than liabilities -short. The left panel indicates that dollar "long" banks required an estimated aggregate of $1.2 trillion (net) in US dollars, which they had difficulty obtaining access to when the dollar appreciated.

During the crisis in 2008, because of disruptions to these markets caused by collateral shortages, the obligations could only be met through international FX swap arrangements (which are now permanent) among central banks. What caused the disruptions? Read on.

The MBS - ABS - AAA Bubble

Before the collapse of 2007 and 2008, asset backed securities (ABS) and covered bonds provided between 20 and 60% of the funding for new residential mortgage loans originated in the US, Western Europe, and Australia. As of the end of June 2009,in the US, nearly 19% of the $18 trillion worth of real estate related loans and consumer credit was funded by private label securitization. Of the estimated $4.5 trillion worth of securitized assets globally as of the end of June 2009, more than 85% were linked to American retail finance. Chart below from this BIS Report.

In Figure 3 above: Between 1990 and the 2006 ABS peak, assets with the highest credit rating rose from 20% of total rated fixed income issues to almost 55%. In other words, over half the AAA global debt of $5 trillion, was considered "risk free" due to private label securitization rendering ABS "safe". At the same time, the average percentage of issues with AAA rating: corporate issues 9%, sovereign issues 48% and private securitizations 75%. In other words, the majority of AAA securities were created by private securitization. Note, from 2008 and 2009 the AAA bubble reflates and sovereign debt had become the major force driving global AAA supply. When privately securitzed ABS vaporized, sovereign debt stepped in an attempt to fill the sudden HQLA (high quality liquid asset) gap.

The HQLA Shortage

AAA assets and CASH are HQLA which get posted as collateral in repo. HQLA is the medium of exchange for the banking system and shadow banking. What happened in 2008? A coupling of reduced supply of HQLA collateral due to counterparty risk and increased demand for HQLA collateral vis a vis off balance sheet obligations getting called. Note, a shortage of HQLA has a negative effect on lending similar to the effect a reduction in the monetary base has on the money supply.

A minor detail, we mentioned here, the Basel III LCR (liquidity coverage ratio) requirement going into effect for all banks on Jan 1st, 2015. Please be aware that State and Municipal Bonds are NOT considered HQLA under the new requirements. Investment grade corporate bonds have a default rate that is 37X higher than the default rate on investment grade municipal bonds. This exclusion from HQLA's definition will decrease the demand for munis, and the increased financing costs will hurt local government's abilities to finance infrastructure projects. So the Fed excluded a "safer" $3.7 trillion market (competitor) in favor of their bonds; along with the inferior corporate bonds and worthless MBS that the Fed is holding. Pure genius? A ruthless pimp or dealer always protects their turf.

Chart below from page 143 of the Credit Suisse 2012 Global Outlook:

the supply of "safe" assets has declined even as demand for them has increased. Exhibit 174 shows the outstanding stock of USD- and EUR-denominated bonds with perceived very low risk. From 2005 to 2007, the stock of these safe assets increased about as fast, and for a time faster, than the FX reserves being accumulated in EM countries. Starting in 2008, this changed dramatically.

The chart above is simple to analyze, from 2008 on previously "safe" AAA; US securitized (red); Agency MBS (light blue) and Euro Sovereigns (grey) totaling $12 trillion or 50% of the market are suddenly off the table. Note the market percentage of US Treasuries (blue and white stripe) in 2007, just below 20%, compared to 2011, voila 66%!!!

Ambrose Evans-Pritchard:

"The world's financial system is on a dollar standard, not a euro standard. Global loans are in dollars. The US Treasury bond is the benchmarks for global credit markets, not the German Bund. Contracts and derivatives are priced off dollar instruments. They now face the margin call from Hell as the global monetary hegemon pivots."

Who is the Man?

Just the US dollar EM corporate debt: $5.7 trillion, split between $3.1 trillion in bank loans and $2.6 trillion in bonds. As stated at the conclusion of our trip through Oz... Who are the masters? Who has been printing debauched dollars since 2000 and handing them out like crack to monetary meth heads in an effort to expand forex reserve and shadow banking share while funding global carry trades? Who floated and sold $10 trillion of tranched privately securtized debt that turned out to be worthless? Who preserved market and collateral conversion for those worthless debentures by excluding their major competitor from the Basel HQLA requirements?

Who encourages need by bailing out their junkies with additional product in the form of CB FX dollar swaps? When the new HQLA is auctioned, the house buy's half of the issuance. So who rolls over old debt with near zero rate debt, performs collateral transformation and increases the market price of the new debt by limiting the market supply? As a result of all the above, as of 2011 whose bonds accounted for two thirds (66%) of the total global collateral acceptable for HQLA banking purposes? Who is giving everybody the shaft? Can you dig it?

What would you do if you were Ben Bernanke or Janet Yellen? I too would be pimping Treasuries at the corner of the Eccles building while pulling double shifts at the QE bond printing press. Does it get any better? The Man, er, I mean the Fed wishes all those foreign and shadow banking institutions that need HQLA in the form of US Treasuries a Merry Christmas and Happy Holiday season.

In Part 4, our journey continues:

  • Oil production exposure
  • The potential effect on oil producing sovereign budgets
  • BRIC dollar debt exposure
  • More BRIC dollar carry trade

Market Plays

These global economic policy developments could affect numerous markets, sectors, indexes, commodities, Forex, bonds, mutual funds, ETF's and stocks.


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