Examiner finds Lehman Brothers' dirty little secret: Repo-105

An bombshell report on the Lehman Brothers fiasco released this week demonstrates the level of financial shenanigans--and perhaps fraudulent misrepresentations--taking place behind the doors of 745 Seventh Ave. The report is a court document, prepared by the court-appointed Lehman Brothers bankruptcy examiner, Anton Valukas, as the bankruptcy resolution still winds its way through New York Supreme Court today, some 18-months after bankers were last seen leaving the Lehman headquarters with boxes the day the firm went belly-up on September 15, 2008. Most of those Lehman employees clearing their offices had no clue that the firm was up to--and neither did shareholders until this week's report.

While the examiner does not have any prosecutorial authority, the report is apparently a blueprint for creditors still trying to get their pieces back, and an expose on what the executives at Lehman were up to--including signing off on materially misleading statements, which, the last time I checked, was in violation of Sarbanes-Oaxley. Here's an article from Bloomberg, which is worth reading in full: Fuld "Negligent" as Lehman Hid Levage, Report Says. If you'd like to read the examiner's entire 2,200 page report for yourself, you can do so here.

Central in the report is the discovery that Lehman Brothers was surreptitiously using a special type of repurchase agreement (repo) known as a "repo 105." Regular repo's are very commonly used by banks, and serve the purpose of allowing a bank to access cash as a low rate in return of exchanging collateral that it cannot sell or does not want to sell, usually yield-bearing collateral.

A crude repo example between two persons could be explained if I need $50,000 liquid cash, but didn't have the liquid cash. Let's say I have, however, $50,000 in a CD that is bearing 5% (back when CD's used to do that). I can't access the $50,000 because I don't want to incur the penalty, and the cheapest rate I can get for short loan is 6%. I devise a repo plan and approach you: I offer you the CD as collateral for an advance of $50,000, agree to let you collect the interest it bears while you own it for a month (about $208), and agree to repurchase the CD from you in one month for $50,010. This means that you'll make $218 virtually risk-free, because you have the CD as collateral if for some reason I don't buy it back. I, on the other hand, am actually saving $32 over what it would have otherwise cost me to borrow $50,000 at 6% for 30-days. That's the basic form of a repo, but for Lehman Brothers, we're not talking $50,000--we're talking $50 Billion. In such huge numbers, a hundredth of a percentage point (aka a "basis point") is a huge difference in financing cost.

Central banks use repo's, commercial banks use repo's, investment banks use repo's-- everybody's using repo's. Repo's have become ever more common and integral in the system, especially since the boom in securitization and other "asset-backed" paper, because this collateral, particularly during the RMBS boom, was both something that banks wanted to hold on to (they didn't want to sell it for cash because the value was increasing), and because the paper behind the collateral was also higher yield-bearing securities. Now, let's compare the basic repo, which is therefore a financing device, to what the examiner discovered in Lehman's hamper--the repo-105.

To put it bluntly, Lehman's repo-105 is a specialized device with a specifically different purpose from the regular repo which, at least in Lehman's case, is used primarily for deceiving regulators, investors, and shareholders by allowing for a $50 Billion quarterly window-dressing charade. The regulators were "lazy" because if the examiner could figure this out, they could have too; additionally, please note that missing from this list is "auditors," because the auditors were actually informed of this action by a whistle-blower, Matthew Lee, but they didn't want to hear it. Neither did Fuld and the other executives, as they fired Lee for questioning the practice.

You see, like a regular repo, a repo-105 has the repo-seller (Lehman) selling securities to a counterparty (repo-buyer) with the promise from Lehman to buy the same securities back at a set price and set date in the future. The "105" part, however, is the red light: "105" is referring to the fact that the counterparty (repo-buyer) demands not just 100% collateral (or "matching collateral") in return for agreeing to the deal and delivering the cash for the securities upfront, but the counterparty is actually demanding more collateral--ie, 105%--upfront before advancing the cash. Considering our above example of you and me as parties to the CD repo, this might smell a little fishy to you: if you would have demanded 105% collateral, I would have been better off getting the loan from the bank at 6%, right?

Right--so, if Lehman's repo-105 smells fishy to you, it should.

As you can probably see from the example, the only reason a bank would want to engage in a repo-105 is because:
A.) it had few other choices for getting cash, ie, other financing was too expensive; or
B.) it was trying to hide something.

The examiner's report reveals that both were true for Lehman:

1.) Banks were not willing to advance Lehman cash for the collateral it was offering because the collateral--largely backed by RMBS--was losing value by the minute. A 100% collateral match simply wasn't enough, as the counterparty was not only taking risk extending cash to Lehman, but was giving up an instrument--cash--that was actually bearing more yield than the collateral Lehman offered (which were disintegrating RMBS).

2.) Lehman was desperate to make the deals at whatever cost because they were not accounting for them as financing on the balance sheet, but as sales of toxic debt! The examiner's report reveals that the firm was financing up to $50 Billion of toxic debt in a single repo-105, while simultaneously shifting the bad debt "off" the balance sheet by listing it as a sale at quarter end--when it was actually financing that the bank had to cover days later. Lehman was using the repo-105's to hide its turn state of insolvency. If that also smells fishy, you're right again!

So, Lehman managed to "shift" billions off its balance sheet through the use of repo-105 accounting magic by simply writing the repo financing as an asset sale. If you did this--say, wrote off your monthly mortgage payment as a "sale" of the same amount to your checking account--well, then you'd be a multi-billion dollar investment bank, too! Of course, I don't suggest you try it, seeing as it is nonsensical and illegal, but if you'd like more details as to how Lehman did it, read Repo 101 on Repo-105's.

Lehman was using the repo-105 as a financing tool, meaning that they were pledging certain securities on the balance sheet as collateral for a cash advance from a counterparty, with the agreement that Lehman would re-purchase those same securities at a later day for a higher price. The counterparty advanced the cash, and in return made a profit off the repurchase from Lehman at that later date. Again, the reason Lehman had to front more than 100% collateral--105% or more--is because the "collateral" was comprised of increasingly compromised securities that the counterparty recognized as risky. The collateral was also illiquid, as evidenced by the fact that Lehman couldn't outright sell the securities for cash, and so the counterparty then appropriately demanded a risk premium. The next question you might be thinking is, "Okay, so even if the investors and shareholders didn't know that Lehman was engaging in repo-105, surely the counterparties who were demanding that 105% collateral knew--who were these counterparties, and what did they do with that information?"

Good question. Here's your answer: just seven non-US banks: Barclays, Mizuho, UBS, Mitsubishi, Deutsche Bank, KBC and ABN Amro. Why only non-US banks? Simple: Lehman could not get a single American law firm to sign off on the repo-105 "technique" it was utilizing, as they all recognized it as in violation of American reporting rules. Hell bent on using it, Lehman found London-based law firm Linklaters, who approved the deal according to British law. The first name on that list--UK-based Barclay's--is the very bank that made a killing buying up Lehman Brothers assets in "the deal of the century" after its bankruptcy. And now we learn of Barclay's role in the repo-105, which clearly indicates that the bank knew of Lehman's balance sheet gymnastics and pending insolvency. (But this is fodder for another post all together.)

Other US banks, including JP Morgan and Citigroup were engaged in regular repo's (not "repo-105's), but they also started demanding more collateral, according to the report. The examiner concludes that these increased collateral demands "had direct impact on Lehman’s liquidity," and that "Lehman’s available liquidity is central to the question of why Lehman failed," which is to be expected for an irresponsible and over-extended firm. Most essential in the report in regards to the repo's is that Valukas reveals Lehman had been using repo-105's for the purpose of window-dressing its balance sheet, and "removing" $50 Billion or more from its liabilities, for at least two quarters before the September 2008 collapse.

Most of the repo-105 business was through Barclays, Mizuho and UBS. Check this article out. Below is a quote from the examiner's report that is in the article (broken up for easier reading):

"In the 2007 to 2008 period, Lehman’s Repo 105 counterparties were primarily restricted to Mizuho, Barclays, UBS, Mitsubishi, and KBC, though some of these also tapered off their Repo 105 trading in 2008...

"..E-mail from Chaz Gothard, Lehman, to Mark Gavin, Lehman, et al. (Sept. 4, 2007) [LBEX-DOCID 4553246] (“KBC are no longer able to finance our 105 agency trades. . . . This effectively means we only have 3 counterparts with which to transact this business – Mizuho, Barclays & UBS. Whilst they have taken all the paper we’ve thrown at them to date this situation should not be relied upon.”);

"...e-mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 28, 2008) [LBEX-DOCID 3207903] (reporting Repo 105 trades with “Barclays – $ 3 billion, UBS – $ 6 billion, Mizuho – $ 2 billion”);

"...e-mail from Mark Gavin, Lehman, to Daniel Malone, Lehman, et al. (May 20, 2008) [LBEX-DOCID 736184] (noting in e-mail with subject line “RE: Repo 105 CPS” that “Mizuho - $5bln,” “[n]o longer at the table: Barclays up to $15 bln,” “UBS up to $10 bln,” “Mitsubishi up to $1 bln,” and “KBC up to $2 bln”)..." "

There are many more examples of this kind of funny business in the examiner's 2,200 page report. The fact is, we only know about this surreptitious "financing" because Lehman went bankrupt. We will likely never know which other banks were up to the same deciet and perhaps fraud, because the Federal Reserve has opened up the flood-gates of liquidity and lent taxpayer money to save the skins of dozens of others banks which otherwise deserve to be, and should be, in Lehman's bankrupt place as well.

By the way, the Federal Reserve still refuses to release any information of how much was given to how many banks: we will only know when we get the bill.

Gold Stalls in $ and Soars in €

Something's up with gold and the euro. We know EUR is under major pressure right now, and has been since November. But just to demonstrate what's happening currently, consider this: gold closed Friday at $1126...in USD. In EUR, on the other hand, gold closed at €826--an all-time record high!

This is a very interesting paradox, especially for people like myself who look at gold as much closer to a currency than a commodity. Remember, the all-time high for gold in USD was back on December 03, 2009 at $1226. Today's close in USD terms at $1126, we're a flat -$100 (-8.1%) off the USD high for gold--and yet we have a new high for gold in EUR. That obviously reflects EUR weakness, but I think it reflects more than that.

When gold was at that USD high $1226 in December, it was trading at about €808, which was also at that time an "all-time high" for gold in EUR. So, gold hit highs in both USD and EUR at the same time in December, and now EUR has been hit again. Since the first "high" in EUR, gold gained 2.25% against EUR and lost 8.1% against USD before hitting the second, new all-time high today at €826. But if you look at the USD v EUR, you'll see that USD has moved from 0.66 on Decemeber 3rd to 0.74 today--a 12.2% change. In other words, while USD gained 12.2% against EUR, it only gained 8.1% against gold. Do you see where I'm going with this?

What seems rather bizarre to me about this week's USD-EUR-gold drama is that gold is "supposed to" drop when USD gains strength against other currencies--especially EUR--not record gains against both USD and EUR. I just say "supposed to" because people who deny that gold is a currency are always using it's sensitivity to USD-EUR as "proof" that the market only views gold in terms of other currencies, and thus it is strictly a commodity. Well, their "proof" just vanished, because now we have gold doing things independent of USD or EUR, and the market indeed treating it more like a currency. This is demonstrated by the fact that USD gained 50% more relative to EUR than it did relative to gold (12.2% v EUR; 8.1% v gold). I think this is important because it appears that gold, as money, is in a unique situation. It is currently at a high against EUR and about 8% below the high in USD. If USD strengthens more against EUR, this will only increase the price of gold in EUR, leading to more EUR highs. Conversely, if EUR strengthens against USD, it will only come with a drop in USDX and thus the value of USD, which will likewise lead to an increase in the price of gold in USD. The US Dollar Index v Gold is clear, and can be seen on when you compare charts of USDX v gold (all data from Feb 19 2010):

Here's USDX:

Here's Gold:

And here's my cut-and-paste blend of the two (red is USDX, grey is Gold):

These charts say, "USDX down, gold up." So again, if EUR weakens, it will result in newer, higher highs against gold. If USD weakens, it will drive down the USDX and weaken also against gold. It seems that EUR will be under a lot of pressure at least until this Greece mess gets straightened out, which, of course, has been pushed out another month. And speaking of Greece, they are certainly wishing they had some gold right now--well, actually, they are more than wishing, they are blaming the Germans for the Nazis for having stolen it decades ago. The plot gets thicker.

(Sidenote: this Dubai thing is not over, either. Not by a long shot: its appears right now that the offer from Dubai World to its creditors will be $.60 on the dollar, and no interest payments--a 40% haricut, and no payments! Needless to say, this is a developing story. Time and secret bankster meetings will tell what the Greek mess sorts out to, as well.)

Euro in Crisis--Thanks to dopes who buy Greek debt

You might have been watching the euro (EUR) tumble over the last couple months, and especially over the last several weeks as this crisis with Greece's finances really heats up. EUR has moved from around $1.50 in November to as low as $1.35 by the end of last week (3 month chart in USD). EUR is under major pressure, and it appears to be a fundamental pressure that is being stoked by the realization of the euro's fragility, as demonstrated by what a little nation called Greece can do to an entire "economic community."

As you would guess, the weakness in EUR has been matched by a relative strengthening in USD, as people sell those sliding EUR and scoop up USD. Compare this 3 month USDX (USDX is the "US dollar index:" USD versus 6 major currencies, weighted most heavily for EUR), and you'll see that while EUR has been moving down from its recent $1.52 high since November, USD has been moving up since its recent 74 lows in Nov/Dec. Right now, as EUR sits at a 9-month low versus USD, the USD itself is at about an 8-month high (1 year USDX). Now, currencies battle each other all the time, of course--but the question with EUR right now is whether or not this is an external battle with other currencies--like USD--or an internal battle with itself.

As we know, using the USD as a unit of measure against the EUR can be deceiving, but in the case of the recent EUR slide, EUR has lost against all major currencies, not just USD. Check these out 3-month charts: EUR v Canadian Dollar (EURCAD); EUR v Australian Dollar (EURAUD); EUR v Pound (EURGBP); and most importantly EUR v Swiss Franc (EURCHF). All down, down, and down. USD and Swiss Franc (CHF) appear to have been the biggest beneficiaries of money taken out of EUR and placed in USD and CHF.

And its very difficult to gauge EUR because it so artificial and it covers such diverse economies, which is also exactly why its really coming under pressure right now. Of the 27 nations that make up the European Union, there are 16 nations which have adopted the euro as their currency, and these make up the euro zone. These 16 euro zone nations are: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, and Spain, which contain a total population of over 328 million (which is about 20 million more than the US). Some of these nations joined after the introduction of the euro. Over a quarter of these nations--specifically Greece, Spain, Portugal, Italy, and Ireland--are in serious economic and fiscal trouble, and face huge deficits and obligations. The population of these financially troubled nations is 182 million, or over 55% of the total euro zone population.

For a little historical perspective on EUR (and I mean "little" because there's not much history to work with!), EUR was trading at $0.90 back in 2002 when it was introduced as paper (it had be running for a couple years before that as an electronic inter-bank currency). Here's a fabulous chart from the ECB on the EUR v USD. You can move the time-frame back to Jan 1 1999, and you'll see that when EUR was introduced, it was about $1.18. EUR slid for nearly three years, reaching a low of $0.825, then generally rose for seven years to a 2008 high of $1.59, before crashing to $1.26 during the October 2008 fiasco. Since then, things have been mixed--which is to be expected in any currency during this mess, especially when that currency is measured against the wild n’ crazy USD. At any rate, I'm bringing all of this up because for the first time ever, major European bankers themselves are losing confidence in their own brainchild--the euro!

There is an article linked up on infowars that is just remarkable. Here it is, from the Daily Mail, and it's worth reading in full: Collapse of the Euro is "Inevitable:" Bailing out the Greek economy futile, says French banking chief." The article clearly follows the headline: a top strategist from Societe Generale--the mega French bank (and FRS primary dealer, I might add),--Albert Edwards recently declared to Bloomberg and others that the euro is basically doomed, and that "the Greek budget crisis is a symptom of imbalances that will lead to the breakup of the euro region" (Bloomberg's paraphrasing of Edwards). This is remarkable statement to hear from a top strategist, particularly when he's from one of the very banks that helped create the euro in the first place. It is drawing attention to what's happening with the euro and the question of whether the shake-up is a reflection of outside pressure, or some internal, fundamental flaw of the multi-national currency.

Edwards is no lightweight: he was voted second-best European strategist in 2009, and has predicted currency meltdowns before. From the Daily Mail , Edwards says:

"My own view is that there is little "help" that can be offered by the other euro zone nations other than temporary, confidence-giving "sticking plasters" before the ultimate denouement: the break-up of the euro zone."

"Any "help" given to Greece merely delays the inevitable break-up of the euro zone."
Mr Edwards argued that Portugal, Ireland, Greece and Spain are too economically weak to withstand the rigours of eurozone membership. Countries that are highly uncompetitive are normally able to slash interest rates and devalue their currencies to prop up their economies. But this is not possible within the euro, given its one-size-fits-all economic governance. The implication is that weak, peripheral eurozone members will have to suffer years of painful deflation and tumbling living standards, as well as draconian budget cuts, in order to adjust."

And from Bloomberg:

"Southern European countries are trapped in an overvalued currency and suffocated by low competitiveness," top-ranked Edwards wrote in a report today. (Martin) Feldstein, speaking on Bloomberg Radio, said a one-size-fits-all monetary policy has fueled big deficits as countries’ fiscal records differ.
The problem for countries including Portugal, Spain and Greece “is that years of inappropriately low interest rates resulted in overheating and rapid inflation,” Edwards wrote. Even if governments “could slash their fiscal deficits, the lack of competitiveness within the euro zone needs years of relative (and probably given the outlook elsewhere, absolute) deflation. Any help given to Greece merely delays the inevitable breakup of the euro zone.”

As outlined in these two articles, Edwards is saying that the "overvalued currency" and "years of inappropriately low interest rates resulted in overheating and rapid inflation," which can only be remedied temporarily by "years of painful deflation and tumbling living standards, as well as draconian budget cuts, in order to adjust," but admits that even such measures would "merely delay the inevitable breakup of the euro zone." As Edwards sees it, the euro zone is doomed. But what does that mean for the euro itself?

Both articles above mention Martin Feldstein. Feldstein is a very well-known and well-regarded Harvard University economist. According to the articles, Feldstein said the euro zone simply "isn't working," and that this is due at least in part to the fact that while the ECB alone sets interests rates for the euro and thus the 16 nations that use it, the euro zone has "a single monetary policy and yet every country can set its own fiscal and tax policy." He continued that, “there’s too much incentive for countries to run up big deficits as there’s no feedback until a crisis.” A crisis--like Greece.

When Iceland went down (read: “when banksters took down Iceland”), it dragged its own currency (Krona) with it. Now in the euro zone, we have at least five nations--Greece, Spain, and Portugal, and Italy, and Ireland--which are in serious fiscal crisis, and which all share the same currency. It is unprecedented. Milton Friedman himself was not a fan of the euro, and he predicted over a decade ago that the euro currency itself would not survive its first crisis, never mind the euro zone. I remember people on Bloomberg radio in 2009 talking about the fact that apparently Freidman was wrong about the euro, because it has indeed survived, and it was actually stronger than the USD at the time. Well, well, well, now--not so fast. Now we have the #2 European strategist coming out in chorus with Freidman's decade-old prediction, at least in regards to the euro zone part. The next question would be to further consider what the breakup of the euro zone would do to the euro currency itself. The heat is yet to come, and the euro is already getting singed. Of course, like I said above, the major benefactor of this happens to be the USD. There is, of course, all kinds of conspiracy-theory putty there. So, let's just speculate for a second. We will get to what might happen to the euro if the euro zone goes down later, but first, lets consider this: what would the USD look like right now is the EUR wasn't such a mess?

Think about what Edwards and Feldstein said: an "overvalued currency" and "years of inappropriately low interest rates" running up "big deficits" and "no feedback until a crisis"--hum, what other national currency does that remind you of? Obviously, I have no way of determining what USD would like if EUR wasn't so ugly right now, but all things considered, and in my opinion, if USD had any strength, it should right now be shining. Instead, while USD looks "good" compared to the disastrous 10% EUR has lost relative to USD since November, USD itself had lost 15% from the beginning of 2009 to Dec 2009, and is still down 8% from a year ago. That's not exactly "shining." And this with the help of huge amounts of money leaving EUR and rushing to USD. We can only speculate, but image what that change would look like without EUR giving everyone such a reason to leave.

I mentioned above that Milton Freidman thought the euro would not survive its first encounter with serious crisis. I have been finding various euro-death stories, fantasies, and predictions quite often since I started researching it in 2008 (there is apparently an entire underground culture of euro-hating folks who write extensively on the internet, and I manage to find a lot of that stuff, along with the myriad dollar-haters, too!). In the process of researching the report I did on the Euro Currency Standing Committee at the BIS (you remember, the group that's name was changed three weeks after the introduction of the electronic euro to the "Committee on the Global Financial System" which is now trying to possibly centralize data for singular monetary control!), I encountered plenty of historical skepticism of the euro that goes back to well before the currency was even agreed to by treaty. Freidman wrote extensively about the euro, and the problems with it. Many others did too. But fast-forwarding to the current situation, one very interesting article I discovered in mid-2009 is this one here: Euro Doomed to Fail as Governments Pull in Opposite Directions. It was actually written over a year ago (Feb 3 2009), and is worth reading, especially considering what we now are seeing with Greece.

In the article, the author details the problems caused by the euro zone's structure itself, and goes even further than Edwards recently did by speculating about what this possible inadequacy means for the euro currency structure itself (emphasis mine):

"There is admittedly an embedded weakness in the way the European currency union is structured. In the United States, arguably that largest currency union in the world, fiscal transfers between member states allow for the federal government to adjust for variances in economic performances. There is no such mechanism within the euro zone, which explains why the member states are subjected to a number of rules. These rules require for everyone to exercise a high level of economic discipline. The problem is that there is little or no such discipline."

"EU countries outside the euro zone, such as the UK, have also lost out to Germany in recent years, but the UK has been able to play a card which is not at the disposal of the euro zone members. That card is called devaluation. Whether by design or otherwise, the UK has received a massive boost to its competitiveness in recent months as a result of the sharp fall in the value of the pound. Italy used to play this card repeatedly back in the days of the Lira. So did countries like Denmark in the dark days of the 1970s."

"Another issue, which is potentially even more destabilizing for the euro longer term, is the massive liabilities facing Europe as its population ages. We have borrowed table 2 below from Goldman Sachs which makes no secret of the challenges facing a number of European countries. Greece is clearly facing the biggest challenge. Public debt, which currently stands at about 95% of GDP, will grow to a whopping 555% of GDP by 2050 if the current pension and social security programme is left unchanged. The Greek government is painfully aware of this and have been working on several new initiatives. It was the passing of one of those new laws which caused the riots in Athens before Christmas."

This is a nice summary. In the first group, by "fiscal transfers between the member states" of the US, the author is referring to the redistribution of wealth done by the Federal government through our confiscatory federal taxes and Congressional re-allocations (aka, our despicable “American socialism”). For example, California contributes much more income absolutely and per capita to the Federal government than does West Virginia, but West Virginia gets more money per capita than California. Because of the uniform tax policy, the Federal government (again, despicably and unconstitutionally) effectively regulates the fiscal policy of the states, and can coordinate this with monetary policy to the degree that the Federal Reserve will independently "cooperate." In our union, there is a mechanism to centralized regulation, and its called the Creature from Jeckell Island. Likewise, the Federal Reserve can unilaterally utilize the mechanism of devaluation to control prices and exports (ie, Plaza Accord). These mechanisms allow the central bank control of the dollar in a fashion that affects all the states in our union.

In the euro zone, there is no such mechanism available to an individual nation that allows an individual nation to devalue its currency as a strategic advantage, because, of course, no nation has its “own” currency. Any euro-zone nation likewise shares the same currency with its major trading partners—the other euro zone nations--and cannot single-handedly control the value of the currency. Conversely, there is also no mechanism for the ECB that allows for centralized regulation of the member states' fiscal and tax policies--not yet, anyway. At least for a little while still, the member nations have some limited "sovereignty," which is, of course, compromised by their commitment to the European Union and its various treaties. As of right now, they are still permitted by their bankster rulers in Frankfurt and Strasbourgh to have different tax and fiscal plans. The current European Union's tax policy is complex and not currently "harmonised," which creates exactly the reason why the other frugal nations (like Germany) are so mad at Greece, because they and their taxpayers might have to bail those irresponsibly Greeks out!

Of course, the Treaty of Lisbon, which was just ratified fully in December 2009, will vastly change this--it is "harmonisation" on steroids, and authorizes an amazing and insane amount of authority in the new, soon-to-be super strong and utterly supranational EU President and Parliament, which will be able to take whatever it wants from whoever it wants and redistribute as it’s almightiness sees fit. There will soon be a uniform EU tax code (or at least euro zone EU), you can bet on that. But right now under the current Greek situation, the centralized scheme is not yet created or operational. I'm sure that when it is, they will use Greece as an example of their authority--and in fact, they might be doing it to some degree right now.

I say this specifically because it looks like the citizens of other nations in the euro zone may actually have pay up and bail out Greece, and have their money stolen from them and given to the bankster debt-owners holding paper from a country that isn't even their own! As you can imagine, the people are already very mad about this: the idea of bailing out Greece is utterly rejected by the people of Germany and other nations who don't want to pay for Greece's irresponsibility (and more importantly, pay for the banksters' stupidity/arrogance in buying the bad debt in the first place!). This article from Der Spegiel discusses the different scenarios for handling the Greece problem, and it identifies bailing out Greece as a "Worst Case Scenario:"

"One scenario is that it [the ECB] could declare Greece to be an exceptional case and provide bridge loans in order to prevent the bankruptcy. But it would have disastrous consequences. After all, why would weak countries make any effort to balance their budgets if they knew the EU would bail them out in the worst-case scenario.

"If the EU remained firm against Greece, that would certainly be fair to the member states who have practiced balanced budget discipline in the past. But that would also be politically untenable because it would drive investors away from any country that showed even the slightest signs of not being able to service its debt. They would have to continue raising the interest rates on bonds, and eventually the Greek virus would spread further, driving other countries into bankruptcy.

"In this highly theoretical scenario, the euro would, indeed, collapse. The currency could survive the bankruptcy of one member state, but it couldn't sustain a series of them.

"Euro-skeptics have long warned that tension inside the euro zone could destroy the currency one day. They now feel their convictions have been affirmed -- even if the aforementioned scenarios remain far from reality."

That's an interesting analysis--but it was written over a year ago, and the "Greek virus" is still thriving and multiplying. The "highly theoretical scenario" of a Greek default is no longer "far from reality." According to this analysis, the choices are either the "disasterous consequences" of providing a bridge loan to prevent bankruptcy, or the "politically untenable" denial of funds that would lead Greece to an "inability to service its debt" and spark a viral spread across the euro zone which would "drive other countries into bankruptcy" and surely "collapse" the euro. So, apparently, these are the choices: bad or worse.

Greece's spending, lack of tax collection, corruption, and various other irresponsible behaviors have been subsidized and enabled by the euro for a decade. The EU, the ECB, and Greece have all known this for years. Greece was not an original member of the euro zone: it was barred from joining in 1999 because it didn't meet the fiscal requirements. After "promising" reform and changes and whatnot, Greece was allowed in by the ECB two years after the launch, in 2001. And guess what--the "promises" to be good are still pending actualization. Even before it was admitted, people had been worried about what Greece would do to the infant euro. In fact, here's a BBC article from the very day, Jan 1 2001, that Greece adopted the euro—over ten years ago--and it mentions the same concern over Greece's public debt, public spending, and generally whack finances that we are hearing about today. However, the article ends with the statement that Greece's involvement in with the euro will have "little impact" on the currency. How things change in ten years: Greece's impact is hardly so insignificant. And now people from other nations might have to foot the bill to the banksters!

It would be an unprecedented insult of a caliber never before seen if euro-zone taxpayers are forced to bail out the stupid, irresponsible, and reckless banksters who lapped up the obviously toxic Greek paper when it was so blatantly obvious to even the Daily Mail over a decade ago that Greece had no possible way of paying it back! It seems clear that this was the assumption (the plan?) all along: by golly, the banks will not lose one single euro of their numbskull paper investment in the impossibly upside-down Greece, not even if we have to steal money from Germans to settle it! Europeans—wake up! Letting a group of criminal banksters destroy your currencies and feed you back a single, bankster-controlled piece of paper will only continue to lead you to the utter dismantlement of your entire economic and social structure--just ask us, we know!

It is not clear yet what the EU's plan is on Greece. Last week, the EU finance ministers "pledged" to "help" Greece, but gave no specifics on what that meant. A recent poll of Germans showed that people think Greece should be expelled from the euro zone rather than bailed out. Of course, if the EU bails out Greece, who's next? Spain? Portugal? Italy? Ireland? Where does it stop? The EU leaders are meeting again today in Brussels to perhaps hammer something out. It is likely it will be yet another transfer of wealth from the people to the debt-holding banks, probably under the guise that some impending economic collapse would occur if they didn't do "something." But we shall see.

We shall also see what happens with the deteriorating euro zone. If Edwards and others are right, there is no saving it. The next question, then, would necessarily be the euro itself. In the article quoted above (this one), here some of the author's observations:

"..I may disappoint one or two readers..but I firmly believe that the euro will almost certainly survive the current crisis. I am much more worried about some of the member countries."

"There is nothing in the Maastricht treaty [Treaty on European Union, 1992] which prevents a member country from leaving the euro, yet the decision to join is effectively irreversible. There are a number of reasons for this, the most important being economic costs. Take Italy which has a history of compensating for lost competitiveness through regular devaluations. If Berlusconi did the unthinkable tomorrow (sorry – nothing is unthinkable in Berlusconi's world), Italy's borrowing costs would explode. My guess is that bond investors would demand double digit returns on a Lira denominated bond to compensate for the dramatically increased devaluation risk. Already in a precarious fiscal position, Italy could quite simply not afford that."

"So, if any country were to leave the euro, it would more likely be from a position of strength, and only one country possesses enough strength to pull that off in the current environment. That country is Germany. And, although the euro is not particularly popular in Germany, I believe it is extremely unlikely for Germany to make such a move unilaterally. There are several reasons for that – Germany's history in Europe being the most important."

"At the same time, the fact that the euro has saved the bacon of more than one country in recent months - Ireland being the most obvious example - should not be ignored. For this very reason, the euro membership is actually far more likely to grow than to shrink as a result of the financial and economic crisis engulfing the world. The issue the EU has to deal with is whether the new applicants should actually be welcomed. Most of those who would want to join will bring plenty of baggage."

"Another possible outcome, which you hear almost no mention of, is the possibility of a new Transatlantic currency. When I mention this possibility, everyone laughs, but think about it for a second. The economic crisis on both sides of the Atlantic is enormous. Both are resorting to the same formulas – large fiscal stimulus and quantitative easing (a word invented by central bankers because 'printing money' smacks too much of Zimbabwe). There is a real risk that the entire financial and monetary system on either side of the pond needs to be re-designed. If that were to happen, I am pretty confident that the Fed and the ECB would at least sit down and discuss the possibility of a joint currency. That would also allow the UK to join a currency union without too much egg on its battered face."

And of course, that is a possibility--and a dream for globalists. It would also suit the general bankster-government feedback loop: if a program doesn't work, make it bigger, more extensive, and mandatory until it does! Or, Problem-Action-Solution. If the euro zone does not work in 16 nations, make it a transatlantic version that covers 20 nations, and if that doesn't work, make a global version that covers everywhere! It's very interesting that we have the chance to see what is happening right in Greece with euro. This is potentially something that will have long-lasting ramifications, especially if the ECB does not bust a bail out. I think that because of the Lisbon Treaty, it is only a matter of time before the EU is subject to a uniform, totally supranational tax code that will be imposed upon the citizens of the member nations through the unelected Parliamentary officials and unelected President. So if they steal some money from the people now and give it to Greece's creditors, that is just Lisbon-lite. But we shall see what happens, indeed.

Penny Arbitrage, the US Dollar, and the Commodities Market

Question: When is a penny worth more than a penny?

Answer: When there’s the chance for penny arbitrage.

Arbitrage is any investor’s dream come true! It is an opportunity to make money through a trade with zero risk of a loss. Literally: in an arbitrage situation, you cannot lose. If you can, then its not true arbitrage. While this may sound too good to be true, arbitrage is quite possible, and there is an entire niche of specialized investors who are constantly hunting down the latest chance to taken advantage of it. Arbitrage is an idiosyncrasy of the free market: as much as it might burn some people who don’t take advantage of it—including “people” of the international finance realm like those are the BIS, IMF, etc—arbitrage reveals locality in pricing over global uniformity. Therefore, of course, globalists hate arbitrage, because that locality threatens the centralized world they seek to unilaterally control. Here’s the IMF’s explanation of arbitrage, from Demystifing Hedge Funds, an external document on the IMF's website:

"The technique of arbitrage tries to profit from the fact that sometimes an asset trades at a different price in different markets at the same time. Because an asset should have the same price in all markets at the same time, a way to capture a low-risk profit is to sell the higher-priced asset in one market (sell it short) and buy the lower-priced asset (buy it long) in the other market. When the prices converge, an arbitrage profit can be captured by selling the formerly low-priced asset and buying back the formerly high-priced asset. A typical example of potential arbitrage opportunities is company bonds that are convertible into equity shares of the company.”

Please note, by “asset,” the authors are talking about financial assets—market-traded securities, stocks, debt, derivatives, etc—and not off-exchange commodities. Commodities often have different prices in different geographic areas: bananas are cheaper in Guatemala than in Russia, right? The availability of a commodity is often geographically limited or specific, thus the above-mentioned “assets” are those electronically exchanged paper assets which are equally accessible in all corners of the planet. Indeed, commodities can be lsited on exchanges, and when they are, they also be subject to price uniformity, and possibily arbitrage when locality breaks that uniformity. Just recently, a major arbitrage oppurtunity occured for Chinese copper traders who spotted a price difference between the London Metals Exchange (LME) price and the Shanghai price on futures contracts for copper: within hours, these savvy traders rallied the price up and pocketed a risk-free return. And of course, they never even touched the metal. It is pure arbitrage.

Arbitrage is not Chiquita buying bananas in Guatemala for $0.02/lbs, bringing them to the US, and selling them for $0.69/lbs. Chiquita is not conducting arbitrage because, while if everything goes well, they’ll make a nice profit, it is also possible that they could lose money. True arbitrage is totally protected from loss. Chiquita is trading: they are moving the cheap-to-produce, widely available, local commodity of bananas from a place like Guatemala to a higher-priced market where the bananas are otherwise unavailable, like Minnesota. Chiquita takes a risk and could lose: after all, the banana ship could get raided by gorilla pirates (not guerillas, but actual gorillas!), who eat all the bananas, kill the crew, and sink the ship. Its not likely, but its possible, and now Chiquita is out a load of bananas, a crew, and a ship. Therefore, there is risk to Chiquita’s venture, and so it is not arbitrage. Remember: arbitrage carries zero risk­—it must be impossible to lose. Also, true arbitrage happens nearly instantly: the trade is executed and the profit is collected. So, then, what is an example of arbitrage, and how to pennies relate to this?

Think about pennies while this example of arbitrage unfolds. Probably the simplest, easiest, and most common form of arbitrage happens when a trader realizes that the convertible bonds (bonds of a company that can be converted to stock in that same company) have a premium (or discount) to the current price of the equity (stock). This is called convertible arbitrage. Demystifing Hedge Funds explains it as:

“Convertible arbitrage. A strategy in which managers purchase a portfolio of securities that are convertible into other kinds of securities. For example, corporate bonds are often convertible into equity shares of the issuing companies. Normally, the prices of the bonds and shares trade in a close relationship. Sometimes bond and stock market conditions cause the prices to get out of line. Hedge funds buy and sell the bonds and stocks simultaneously, pushing the prices back into line and profiting from market mispricing."

Let’s say you are a trader. You are looking through convertible bonds, and notice that Company Z’s stock is trading at $10 a share. You also notice, however, that for some reason, Company Z’s convertible bonds are trading at 99% of face value, and are convertible to 11 shares. You do the math: you can buy $100 face value of Company Z’s bonds for $99, and it convert to 11 shares at $10 a share. In other words, you can buy spend $99 and get $110, instantly. You don’t know anything about Company Z, nor do you particularly care, because you will execute the buy and sell of the bonds and converted stocks instantly and simultaneously. Others, of course, will quickly notice this, and soon those with the bonds which you seek to purchase will demand a higher price (or convert the bonds to stocks themselves), and/or those with the stock you wish to buy will sell and buys bonds, thus driving down the price of the stock. Either way, the arbitrage will quickly evaporate, as the bond price will go lower or the stock price will go higher to equalize, or the stock will go higher and the bonds lower. Either way, those others in the market with Company Z bonds/stocks will have the market power to demand a higher price which will correct the arbitrage situations.

So, in convertible arbitrage the trader exercises the right to convert one to the other, or use one to purchase the other at a zero risk of loss. It must be instantaneously, electronically accomplished so that the arbitrager never “holds” the bonds/stocks, which will soon be subject to correction. The other huge example (though much less common) version is regulatory arbitrage. In regulatory arbitrage, traders can take advantage of some legal constraint that varies in different markets. Regulatory arbitrage plays one government’s policies against another, or with Basel II, one securitization framework against the other. There are financial geniuses in the regulatory arbitrage market, who have, as mere individuals, actually greatly hampered the Bank for International Settlements’ push for “standardisation” by revealing that the BIS’ Basel II framework itself is wrought with contradictions and arbitrage opportunities—and they are using it against the banks with great success. And banks themselves use regulatory arbitrage. Regulatory arbitrage along these lines, according to many analysts and the disgruntled finance ministers of the top twenty economies (aka the G20), had a significant role in sparking the current meltdown, particularly and specifically with the Basel II minimum capital requirement’s various ridiculous “capital calculation” schemes. (But I’m getting sidetracked: there will be a complete post on the role of regulatory arbitrage in Basel II soon.) So, that’s basic financial asset arbitrage. It’s a simple concept, even though the execution can be a little complex, and arbitrage helps keep prices of financial assets in line throughout the global paper investment market.

Thus is one example of paper asset arbitrage. Now for commodities arbitrage—penny arbitrage. I acknowledge outright that my penny arbitrage example is in no way a true arbitrage, because you cannot instantly make profits nor can you execute it while sitting behind a trader screen. To be totally technical, penny “arbitrage” is more like a hedge, as one “asset” (the penny) exposes the holder to two different markets simultaneously—the copper market (as a copper penny) and the currency market (as a unit of the US dollar). But unlike hedging, it actually carries zero risk--you'll always have whatever you started with. Therefore, I’m going to call it penny arbitrage, and maybe you’ll see why and agree.

Penny arbitrage demonstrates what fiat money does: it disintegrates value. Reach into your pocket, and pull out all of the change. Of course, we already know that any pre-1965 quarters or dimes that you might have in that mix are 90% silver, and therefore, currently, those silver coins are worth more than ten times the face value (in fact, with silver at about $17/oz today, they’re worth over twelve times face value). But, in all honesty, it is not very likely that you’ll have a pre-1965 quarter or dime. Most of the silver coins have been pulled from circulation by investors and collectors who know what they are worth, and so you’ll have to pay the about $12.29 for 4 silver quarters (in other words, $12.29 for $1 face value). That said, however, it is very likely that you’ll have some pennies. And it is also very likely that you’ll have some copper pennies.

So, do it now, check your pennies: any one with a date of 1981 or older is a 95% copper coin. During 1982, the penny’s composition was changed from 95% copper, 5% zinc to 95% zinc, and only 5% copper (coating), due to the increasing price of copper, which had peaked to over $1/lb in 1980, and was holding steady above $0.70/lb. (Do you see where this is going yet?) Some 1982 pennies are 95% copper, and some are 95% zinc, but you cannot easily tell unless you weigh them: the copper pennies weigh about 3.1 gm, and the zinc pennies weigh about 2.5 gm. Of course, the price of copper wasn’t simply increasing on its own in a vacuum as industrial commodity: the price of copper was increasing relative to the value of the dollar (or, in this case, the penny), which, because of its inflationary fiat nature, is constantly deteriorating. Congress changed the composition of pennies in 1982 because the cost of making the physical coins was increasing, while the purchasing power value of each $0.01 was decreasing.

Now for the arbitrage: those easy-to-find copper pennies have a declared face value of $0.01. Therefore, for monetary exchange, a penny (whether copper or not) is worth only $0.01. But, as copper, your little penny exposes you to the commodities market, and as metal, the little thing is worth more that double the face value—its actually worth a whopping $0.02 (or 0.0217498, to be more precise, today, Dec 30 2009, with copper at $3.35/lb). That is penny arbitrage.

As stated above, the mass of a copper penny is 3.1 grams, but as it is 95% copper, the actual copper content is 95% x 3.1 = 2.945 grams. There are 28.35 grams to an ounce (metric converter), and 16 ounces to a pound, therefore 453.6 gm/lb. So, to calculate the price per gram of copper, simply convert the price/lb to price/gm by following this equation:

Price/lb ÷ 453.6 = Price/gm

At $3.35/lb, copper is currently $0.0073853 a gram. At 95% copper, each copper penny contains 2.945 gm copper. Therefore, multiply the price by the content weight, and you’ll see that each copper penny contains $0.0217498 worth of copper, or more than twice the face value.

An easier way to do this is to calculate the number of copper pennies needed to make a pound of copper. Copper pennies are 95% copper and lose very little of their composition through circulation.

Number of 95% copper pennies needed to make 1 lb copper:

453.6 (gm in 1lb of copper) ÷ 2.945 (gm of copper in 1 penny) = 154.023 pennies.

So, you need 155 pennies (or $1.55) to have one pound worth of copper. Of course, as they are 5% zinc, these 155 pennies will actually weigh slightly more than one pound if placed on a scale (they'll weigh 3.1 gm x 155 = 480.5 gm / 453.6 gm (per pound) = 1.059 lbs).

Now, consider that the current price per lb of copper is $3.35 (Dec 30 2009). Do you get it now?

As the table above demonstrates, the price of copper overwhelms the one-cent face value of the penny when the metal hit $1.55/lb. A copper penny will be worth a dime ($0.10) when copper hits $15.41/lb.

For historical comparison, the Treasury could no longer afford to maintain the 90% silver content of halves, quarters, and dimes by 1962. The value of the paper dollar had decreased (read: "had been debased by the Federal Reserve System") to the level that silver was nearing a 1:1 ratio. The year 1964 was the last for 90% silver coins (40% silver halves through 1968, and then all circulating coins were silver-free). Since 1965, when silver traded at roughly $1.10 - 1.29/oz, the price of silver has increased by approximately $16.90, or 1536% (based on recent $18/oz silver; silver is today at about $17, and reached over $20 in early 2008).

Likewise, since gold was removed from the $35/oz peg in 1971, the metal has moved $1065, or 3043% (based on recent approximate $1,100/oz gold).

Therefore, as a monetary unit, a copper penny (and its zinc version) is pegged at $0.01, which sets both the floor value and the investment price for it as an “arbitrage” opportunity. However, as a piece of metal, the old copper penny’s value is over 2 cents. Over the long term, the copper price will likely rise in step with general prices, especially as the industrial demand for copper increases and more nations become industrialized, but an even greater factor in the “price” of copper will be the long-term loss of value of the US dollar unit.

I’ll be the first to declare that copper prices are very volatile: after a 60-year low of $0.60/lb in the 1990’s, copper has spent much of the last 15 years under $1.50/lb, which made the price nearly the same as the $1.55/lb copper-penny price. In 2006, the price of copper and nickel surged, making the coins more valuable as metal than as US currency, and forcing high replacement costs on the US Mint. Until 2006, it was not illegal to melt coins, but facing these high replacement costs, the Treasury prompted the US government to illegalize the melting of pennies and nickels (which are 75% copper, 25% nickel), and impose restrictions on the export of the coins to $100 face value. The copper price moved down in 2007 before again surging during the summer 2008 commodities bubble that pushed oil to $148/barrel. The melt/export ban remains in place for nickels and pennies. (A similar ban was placed on the melting of silver coins as part of the Coinage Act in 1967, and this ban was eventually lifted once the Mint could meet the US coin demand with the “clad” silver-free coins.)

At the 2006 and 2008 $4/lb level, $1.00 in copper pennies was actually worth $2.60 in copper. For the record: I am absolutely NOT suggesting to anyone to melt pennies or nickels—as detailed above, it is a federal crime punishable by a $10,000 fine and five years in prison, or both. I am simply using the difference in the “currency value” of copper pennies versus the “commodities value” of the copper in them to demonstrate what fiat money does to the value of our currency and the spending power of our savings.

So think about what the Federal Reserve’s fiat printing machine is doing to your savings next time you have a little copper penny in your hand. It is not rocket science, and it is not some crazy derivative: a dollar in paper, or as an electronic entry at your bank, is worth $1.00, period. Yet, a dollar in little copper pennies is currently worth $2.17. This is why we call the central bankers by their proper name: central banksters.

Perhaps anyone with electronic “cash” sitting in an account, or paper bills stuffed under a mattress, collecting zero or near zero percent interest should, maybe, think about turning all that savings into pennies, sorting through them, and filling up Arrowhead water jugs with the coppers! Hey--it can be a new home decorating item: a few thousand pounds of copper pennies in whatever will hold them! After all, it really doesn’t take up that much space: according to a very unscientific Google search, a 5-gallon Arrowhead jug filled with copper pennies would weigh about 245 lbs, and contain 35,000 pennies, or about $350 face value in pennies, with a copper content of 95%. Put it in the closet, and when copper is at $10/lb in 15 years, it will be worth $2275, or $1,925 more than the face value. Worst case scenario, the police-state raids your house, takes your pennies, and gives you Federal Reserve notes!

Left as electronic money in a savings account at 5% compounding interest (which you’d be lucky to find these days), that $350 will have grown to just $570 in 10 years (calculator). Left as cash in an envelope, it will remain at $350, and simply further lose purchasing power as the dollar devalues. Considering this, pennies are looking better by the minute! Plus, there’s the added benefit of denying a banking institution from taking your $350 and leveraging it out at 10:1, "buying" up the economy, further contributing to inflation, strengthening the Federal Reserve System, and continuing the devaluation of the dollar and atrophy of spending power! Why not pennies?

In 1924, in the Weimar Republic, paper money was worth more as fuel for the fire than currency; in 2009, in Mugabe’s Zimbabwe, a $1,000,000,000,000 (that's one TRILLION) in bank notes was used as wall paper. And today, a little old US penny is worth more as metal than as currency. We’re lucky..,but for how long?

Record Yield Curve: 230% above-average spread makes Mr. Bernanke 2009 "Person of the Year!"

It seems the lost souls over at Time Magazine (who, of course, named the CCX's Dr. Richard Sandor "Hero of the Planet" in 2002) have now again added to their menagerie of confused choices for the latest "Person of the Year:" the honors for 2009 go to Chairman of the Federal Reserve Board in Washington, Mr. Ben Bernanke.

The Bankster Report has not analyzed what Time's parameters are for selecting these various annual "Persons," but one thing we can declare is that for the banks, Ben Bernanke might be the "Person" of their lifetimes! A dream come true! Today, as Mr Bernanke's mug is staring through the gloss on Time's cover, the banks ought to be hoisting the Chairman up on their shoulders, and marching around in celebration of their luck to have such a wonderful advocate. Mr. Bernanke & Company over at the Fed are making banks a lot of money, and they're making it very easy.

Nevermind the $700 Billion in TARP infusions from Treasury; forget about the $307 Billion in outstanding corporate bank/non-bank bonds that the FDIC is guaranteeing through the Temporary Liquidity Guarantee Program; exclude the Fed's purchase of $1.01 Trillion in agency/GSE paper from the banks and sovereigns; and just ignore the $1 Trillion Troubled Asset Relief Program--no, for this report, the Person of the Year, Mr. Bernanke's latest accomplishment is the Fed-induced yield curve spectacular!

The yield curve is the difference between interest rates on short-term debt and the long-term debt, and it is how banks make money off loans. They simply borrow short, and lend long. For banks in the US, this is usually done through US Treasuries, as part of the of fiat bankster masterplan. The banks can borrow short-term from the Fed (at the current near-zero Fed funds rate), take the "money" as an advance, and use it to buy short-term interest-bearing Treasuries, which have a higher yield than the "cost" of the Fed-"borrowed" money in the first place, and then with the borrowed/created money, simply use the short-term, low-cost (free!) money to front long-term, higher-interest yielding loans (like mortgages, etc). That's how to make a nice banker's profit. Or, of course, a banks can use a simple fixed-income strategy and simply borrow money to buy short-term paper, and then use the short-term paper's yield to purchase/finance loans to themselves for the long-term (10-year, 30-year) Treasury paper with the nice 3.5-4.5% yield, which they buy today and "pay themselves back" for in 10 to 30 years. Beautiful. A revolving fiat door of money creation.

And this money creation is a dream come true right now, because it is cheaper than ever. The practically free money which banks can borrow from the Fed right now at 0% cost needs only to yield them 0.1% for them to make a profit, and yet with the record yield curve, they are making much, much more than a measly 0.1%. In fact, in March 2009, the yield curve between the 2-year and 10-year note (the 2-10 spread) snuck over 275 basis points (bps, 100 bps is 1%), which broke the previous record by one bps. Its at 273 bps today--today, which is day-two of the Federal Open Market Committee meeting. At 2:15pm today, we will get the Fed's latest dictatorial decision on what this small group of men at the FOMC who are running the nation's monetary system will do with the low-as-possible interest rate level for the Fed funds rate. Of course, its at 0 to .25% right now, where its been for a year, and most people aren't expecting a change. Which is why Mr. Bernanke is "Person of the Year!"

When the Fed did the unprecedented last year and sunk the Fed funds rate to 0%, it did so to obviously encourage banks to borrow so it could flood the system with "liquidity" and save the world. Additionally with the TARP infusions, the Fed could bankroll the troubled banks by making it nearly impossible for them to lose money: even with the two times last December when the Treasury sold 3-month t-bills at a negative interest rate, banks could still make money off them if they purchased them, because they could hold them on reserve at their District Reserve Bank, and they would earn interest from the Fed. [Of course, that is hypothetical, because that would really only be temporary for a bank in so much trouble that it was buying 3-month bills to place them on reserve with the Fed, because the Fed needs (is supposed to, anyway) collateral for the original borrowing.] But it is an instructive example. All that said, the ideal place to make money for banks is still where it has always been--borrowing short and lending long, and thus the Fed's second strategy in steepening the yield curve steep is a dream come true.

The Fed, and specifically the FOMC, is the major mover of the yield curve. It is the only body that can, with the stroke of a pen, increase or decrease interest rates through its monopoly control over the Fed funds rate. The markets can influence the Fed, obviously, and the Fed vastly influences the markets, but control of the yield curve is really in the hands of the Fed. What we are experiencing right now is a positive, steep yield curve--a record positive, steep yield curve.. A positive curve is considered normal, of course, because that means that shorter-term debt is less risky than longer-term debt, and thus the yield for shorter-term debt is lower. In a stable economy with a solid future, that is the normal trend.

Conversely, a negative (or inverted) yield curve occurs when shorter-term debt is more expensive than longer-term debt, thus yielding a higher return than longer-term debt--and this is obviously not normal. It should not normally be more risky to hold shorter debt than longer debt, and in fact, the inversion usually is not outright do to risk. Instead, it is often due to concerns over liquidity and concerns over a change in profitability, and even more so, concerns over the central bank's moves. In an inverted yield curve, economists (and the Fed) use the 3-month/10-yr spread, because the 3-month is effectively priced at the Fed funds rate (for example, right now its at 0.03%, the Fed funds is at 0-.25% target range). Because of the fact that central banks control interest rates, an inversion can technically happen at any time: if a central bank feels like it, the central bank is the only body in control of the base rate, and it move it up higher than the 10-yr (or anything else!). For example, if the Fed came out at 2:15 today and said they felt like moving the rate to 4%, we would instantly have an inverted yield curve, as the 10-yr is yielding only 3.56%, so the short-term money would be more expensive than the long term debt. There's no way they will actually do that--but they can.

Thus, an inverted yield curve generally results from either a central bank's choice to increase the short-term borrowing rate (the Fed funds) in such a sharp jolt that it moves the yield higher than the long-term debt already issued and on the market, or a choice to decrease (or standstill) the short-term borrowing rate in an unexpected way, because the market may sense that as uncertainty and start itself driving down the long-term price by dumping long-term in favor of short-term. Also, the central bank's choice not to move increase rates signals that rates may have reached a high, a bubble may have peaked, and therefore a recession is coming which is force the central bank to cut rates. There are also other market-driven reasons this inversion can occur, but they are all related to the central bank: the market anticipates the central bank will do something contrary to the trend and therefore attempts to lock in higher rates; market anticipates a rapidly nearing shortage in liquidity or credit and therefore moves from long-term to short-term to increase access to cash; or the market anticipates serious tumult (recession) that prompts a rush to the safety of cash and the more liquid, shorter-term debt. Any way, its a bad sign! Since 1969, every inverted yield curve has forecasted a recession by 5 to 18 months (called the "lead time"). The last inverted yield curve we saw in Treasuries was in July 2006--15 months before the December 2007, the month that the National Bureau of Economic Research determined the official start of the current recession. Also worth noting is that the inversion itself occurred one month after the FOMC decided not to raise the Fed funds rate which it had been steadily pumping up since 2003. The market noted the same trend that the Fed did--something was coming, and the Fed was going to start cutting rates to prevent it, and further the bubble with cheaper money. This table demonstrates the peak of the Fed funds rate. From 2003 through June 2006, the FOMC increased the Fed funds rate from 1% to 5.25%. Since July 2006, when the yield curve inverted, the Fed has sunk the rate from 5.25% to 0%.

From this current zero-level, it is impossible to see an inverted yield curve, because rates can only go up. Therefore, what we are seeing today with Mr-Person-of-the-Year-Bernanke's Fed is the polar opposite--a record steep positive curve. As I mentioned above, the 2-10 spread is at 273 bps today. The 3-month/10-yr is at 353 bps. But even more impressive, however, is what is happening right now with the yield difference between the 2-year and 30-year Treasuries. The 2-30 spread was at 373 bps less than a week ago, which is a nearly 30 year record. I just checked it today, and its at 368 bps as I write this. Anyone can check the spreads on 2's, 10's, and 30's on this Bloomberg Government Bonds page. To determine the yield spread, simply subtract the short-term yield from the long-term. [For example, when I checked it today (December 16 2009) the 30-year was at 4.51% (or 451 bps), and the 2-yr was at .83% (83 bps), thus 451 - 83 = 368 bps spread].

You might be thinking: 30-year record--that would put it back to Volker days, right? Right! Besides the one in 2006, there was another major inverted yield curve in April 1980, when the 3-month T-bill actually was actually yielding 240 bps more than the 10-yr note! Major volatility in interest rates controlled by the Fed was the cause of this. It was an incredible year: in December 1979, the Fed funds rate was at 13.78%. Three months later, by March 1980, the rate was 17.19%. And by December 1980, the rate was 18.9%. However, between March and December, the rate dipped to barely over 9% in July. As a result, the Fed single-handedly produced a yield curve, which likewise signaled to the market that a recession was near, and further put the pressure on bonds, and everything else. Its demonstrates the FOMC's iron grip on yields, and their prerogative to whipsaw when they feel like it. Or, as Mr. Bernanke is now doing, to lay it on thick.

Mr. Bernanke has created the opposite of the Fed-induced inversion today, because he has made the Fed-induced record steep yield curve! In fact, there's a 230% above-average return for banks on long term loans, as measured by the yield spread, which the banks are enjoying right now*. Of course, the Fed's argument is that without such a huge and unprecedented profit margin, the whole system would come crashing down because the banks would fail! They are half right--the banks would fail. But this system is already in shambles. This is clear: even as the banks are making record profits off spread lending with very limited risk exposure (or none at all if they are earning interest on reserves at the Reserve Banks), they are still fearing for their existence, and they are doing so for at least three reasons. Firstly, banks simply don't know how many of the new loans, and especially the older loans, one their balance sheets will fail. Even a record yield curve, when the spread is funding commercial, consumer, or mortgage loans, is only profitable when the loans are performing. Second, the banks don't know if the Fed will change its currently practically non-existent collateral requirements for all the heavy borrowing they are doing. If the Fed changes its currently liberal collateral terms, banks could find themselves without enough deposits or securities to offer as collateral for the advances, which would force them into the more expensive Fed Discount Window for emergency money. Thirdly, and most critically, the banks know that rates cannot stay at zero forever. If they make too many fixed-rate long-term loans at the current rate, they could find themselves paying more to fund the loans short-term than they are actually making long-term.

Banks, despite this currently easy money, are now actually anticipating a decrease in the real value of the money they make from cheap loans, and the steep yield curve which would normally be indicating profitability and confidence is being tempered by a realistic acknowledgement that the short-term Treasuries--at their record low yield supported by the near-zero Fed funds rate--must, must, must go up, its just a matter of when. There's the problem. The banks don't know what that 2-yr note will cost them in two-years, they just know it will be more. So in response, they are building in inflation. And we know this because they are saying it with their purchases and their actual statements.

As for their statement through purchases, short-term paper is looking ever more appealing. The Treasury is not having any problem selling the short-term debt (3-month, 6-month, 12-month, and 2-year). Its the longer-term 10-year and especially the 30-year that isn't so red-hot right now. In fact, yesterday's (Decemeber 15, 2009) auction was characterized by some "sluggish bidding" which pushed the 10-year note on the secondary market to 3.6%, the highest level since August. Interestingly, just last week, and in anticipation of the auctions, the 10-year moved up slightly, sending the yield down a tad from 3.48% to 3.43%. Conversely, by the time of the actual auctions, buyers had a change of heart--perhaps because by this week, they'd seen better estimates on the latest inflation numbers, the Consumer Price Index (CPI), and seen the actual numbers on the Producer Price Index (PPI). Yesterday's auction came after the release of the PPI numbers--which were much higher than economists' estimates and which indicated an inflation blip: producer prices soared by over 1.8% in November alone. Long-term Treasuries already offering only record low-yields look even less attractive after a number like that.

Today, the Consumer Price Index numbers were released. Last weeks' estimates on what to expect were hoovering around December 16 CPI numbers indicate a 0.4% rise in prices in November, 1.8% adjusted over the year. The Bloomberg economists' survey was expecting 0.1%. Both numbers are unexpectedly high.

Looking at November's PPI and CPI, anyone with realistic inflation expectations knows that a measly 4.51% on a 30-yr bond when a single month increase in consumer prices of 0.4% and producer prices of 1.8% is not going to help you one little bit. In order for interest (pun intended) to return to the long-term side, the yields will have to move up. Either the market will do this, or the Fed, or both. Meanwhile, as the interest in long-term debt dries up, the price will necessarily do down, and the yield curve could widen even more. Banks are holding short-term and cash. Why would any investor--unless it was a bank with access to the cheap Fed money-- be buying up long-term Treasuries at this near-zero Fed funds rate, when he knows that he will necessarily be hit when the Fed eventually increases rates? Why would he lock himself into the record low yielding return of the current long-term Treasuries, instead of waiting for the rates to increase and them buying the higher yield? And likewise, why would the banks, who do have access to the cheap money, use it to purchase long-term debt and thus contribute to a decrease in the yield spread buy increasing the price (decreasing the yield) of the long-term Treasury?

It is a standoff of sorts. The bond vigilantes cannot access cheap borrowed money from the Fed funds, and so they are not making a record spread--they are getting killed! While the banks this year have been profiting with a 2.75% average spread yield on their borrowed-money Treasuries, the people who actually held the Treasuries have been hit by over negative 2% . Investors are not stupid--the are going to shy away from the long-term debt until it starts rewarding them for holding it. And the banks are not stupid either--they are not going to contribute to a decrease in the yield spread that is making them money. The demand for long-term Treasuries is softening, which, of course, means that the Treasury is having to sell them at slightly higher yields to the reluctant purchases, which is, of course, further increasing the difference in yield between the short-term and long-term, thus steepening the curve. Simple, right?

Right. By November 30, the gap in the 2-year/10-year Treasuries was at 265 bps. So how does that stack up the normal 2/10 spread? Amazingly, it is DOUBLE the 20-year average of 115! Its actually well over double--its some 230% over the 20-year average! Indeed, if I was a banker, Mr. Bernanke would be my "Person of the Year!"

But maybe only for this year, as that inflation monster looms. When banks start anticipating inflation--which are themselves experts on the topic through their happy contribution with fractional reserve lending and leverage--and when banks start getting perhaps a little scared about it, you know we're in trouble. From the November 30 Reuters article:

"This would normally be viewed in a positive light as a "steep" yield curve -- higher yields on longer maturity Treasuries than their shorter-dated issues -- usually signals market expectations of steady economic growth and an environment where banks can lend profitably. Under the current near-zero rate regime, however, this unusually steep yield curve undercuts those expectations. It instead reflects anxiety over the timing of a Fed rate increase and an uneasiness that it will keep rates too low for too long and cause a resurgence in inflation.

Concerns of rising interest rates have persisted despite the Fed's pledge it will keep borrowing costs at record lows for an "extended period" until a recovery is sustainable.

These nagging worries have fueled demand for Treasury bills even though they are yielding close to nothing, while bidding for longer-dated Treasuries has been uneven at auctions.

"There are longer-term concerns about fiscal and monetary inflation," said Jim DeMasi, chief fixed-income strategist with Stifel Nicolaus & Co. in Baltimore."

Yeah, you think?

Better snatch up whatever you can with that free money before it runs out, and hold on, banks. The latest report (November 30) by Bloomberg on the subject determined that US banks increased their purchasing of US Treasuries with Fed-borrowed money by 26%. US banks, according to the latest December 2009 Federal Reserve Report (pg 27, or pdf pg 34) hold $165 Billion in new Treasuries. The same page also indicates that the same banks dumped about $380 Billion in agency/GSE paper, much of which was sold to the Federal Reserve (and this agency/GSE paper outrage is another report entirely, which will be forthcoming). But now you can be happy that the banks are raking in 230% above average returns on loans, all thanks to the Federal Reserve Chairman and "Person of the Year," Mr. Ben Bernanke.