Tag Archives: banking

How The Destructive Force Of Bank Credit Works

(Alasdair Macleod) Commentators routinely confuse the deflationary effects of a contraction of bank credit with the inflationary effects of central bank policies designed to offset it. Central banks always ensure their stimulus is greater, so inflation, not deflation, is always the outcome.

In order to understand bank credit, we must enter the mind of a banker and understand how it is created, why it is expanded and why expansion is always followed by a sharp contraction.

But we have now moved on from a simplistic credit cycle model, given the global economy was already facing a tendency for bank credit to contract before the coronavirus drove supply chains into the greatest global payment crisis in history. The problem is now so large that to maintain both economic stability and price levels for financial assets the central banks, led by the Fed, will have to issue so much base currency that fiat currencies will become almost worthless.

In these conditions the banks that survive the next several months will then begin to expand bank credit anew to buy up physical assets instead of their normal financial fare, sealing the fate of fiat currencies with a final expansion of bank credit as the banks themselves dump worthless currencies for real assets.

Introduction

Never has it been more important to understand the psychology and motivation behind changes in the level of bank credit at a time when governments and central banks are relying on commercial banks to transmit Keynesian stimuli to distressed borrowers. And never has it been more important for analysts to differentiate between deflationary forces that come entirely from the contraction of bank credit and inflationary forces that arise from central banks’ monetary policy.

Whether policies to rescue economies from the financial and economic effects of the coronavirus will actually get to the intended businesses depends largely on the transmission mechanisms for base money. While special powers for direct funding of large corporations may be implemented and the extension of public ownership to prevent bankruptcies of large players is very likely, commercial banks will be expected to play a central role in distributing monetary stimuli to businesses of all sizes. But since they regard small and medium size businesses as either too risky or not worth bothering with, it will be a struggle to get them to deliver the financial support intended.

In any advanced economy, a Pareto 80% of GDP is provided by small and medium-size enterprises. In a highly centralized banking system, for the banks that have access to the Fed through prime broker subsidiaries, SMEs are simply not worth bothering with. It leaves the majority of enterprises providing goods and services to the public out in the cold. Bankers looking through the dip will want to preserve more profitable relationships with large corporations and reduce their exposure to risky, expensive-to-administer smaller loans.

Investors who are used to getting positive returns solely on the back of expansionary monetary policies are now egging on the authorities to spend, spend and spend one more time. Pension funds and insurance companies in particular will now discover they are being lumbered with the cost of monetary expansion by an increasing depreciation of the currency, which escalates future liabilities. Ever since the investment industry pandered to the inflationary policies of central banks this outcome was inevitable, because both logic and sound economic theory tell us you cannot continually inflate your way out of trouble.

That end point is where we have now arrived. The state has come to rely completely on inflationary stimulation. The helicopters have warmed up and are ready to distribute monetary largess created by the magic of central banking, not just to individuals, but to their employers as well.

Mission impossible is to restore economic activity to where it was before the coronavirus shutdown. Politicians assume is can be achieved by deploying military precision. They have taken for themselves a mandate to sweep aside all bureaucracy and all objections to the role of the state. All it requires is for the banks as well as other critical actors to submit to their authority.

The Credit Cycle Was Turning Down Before The Chicom Virus Hit

It ignores the impact of the credit cycle, which was already turning down in the second half of last year. In response, the Fed first stalled its attempt to restore its balance sheet to normality and from September onward was forced to publicly intervene to inject massive amounts of liquidity into the banking system through the repo market.

All was not well in wholesale dollar markets at least five months before the virus hit, so the problem is more complex than a simple return to normality when the virus passes. Furthermore, the authorities trying to keep the economy from imploding are out of their depth, so much so that individuals in the private sector are gradually realizing it as well. Financial risk has escalated considerably, which has one effect: bankers will use every opportunity to reduce the size of their balance sheets. The authorities will struggle to get banks to hold fast, let alone distribute subsidies to producers and consumers alike.

Attempts at rescuing the global economy and supporting financial asset values upon which bank collateral is based will require massive inflation of base money, as outlined later in this article. But these attempts will have to fight bankers trying to control their lending risk in order to protect their shareholders’ capital from being wiped out. Their motivation to deflate bank credit will be greater than ever before.

An appreciation of the deflationary implications of the current phase of the credit cycle requires an understanding of how bank credit fluctuates and the predominantly psychological factors that drive it.

Origins Of Bank Credit

The general public is not aware that there are two separate sources of money. The central banks are empowered to issue money, but commercial banks do so as well. One way they do this is by taking in deposits and then lending them to borrowers for an interest rate turn. When the borrower draws down the loan to make payments, more deposits are created as the payments are made.

A second course of money creation is simply by lending money into existence. In this case, the loan is created first, and as it is drawn down, deposits are created. This is regarded as the more usual practice, hence the description of the process being the expansion of bank credit. Any imbalances that arise between banks are resolved through the interbank market.

By these means a bank’s own capital becomes a fraction of the bank’s expanded liabilities, hence the term fractional reserve banking. Figure 1 shows the bare bones of fractional reserve banking, with a bank’s balance sheet measured in monetary units (mu), early in a phase of credit expansion.

This balance sheet reflects a cautious approach to bank lending. Shareholders’ equity is valued at one third of customers’ deposits and is covered twice by government bonds, which will all be less than five years to maturity and is regarded in the banking system as the risk-free investment standard. At this stage of the credit cycle and with the banking community generally risk-averse, lending margins are profitable. The ratio of total assets to shareholders’ equity is five times. Put another way, profits and losses from changes in asset values are multiplied five times at the shareholder level.

Figure 2 shows the same bank’s balance sheet towards the end of the expansion phase of the credit cycle.

The economy has responded to both monetary stimulation from the government’s deficit spending and interest rate suppression by the central bank. The cohort of bankers has seen a lessening of lending risk and has responded by actively seeking lending opportunities among large corporations. Bankers are now lending increasingly to medium size corporations as well as investment grade rated borrowers where the margins are better. Falling unemployment and growing economic confidence decreases lending risk for credit card and other consumer debt, and the bank has extended additional credit for creditworthy customers. Liquidity from government bonds and bills has been drawn down in order to increase allocation to higher-yielding corporate debt. The balance sheet has expanded to give an overall gearing on shareholders’ equity of 12.5 to 1.

This means a two per cent margin averaged across total assets yields a 25% profit on share capital. But by the time this snapshot is taken, competition from other banks will have likely reduced lending margins generally, and the bank has responded by taking an even more aggressive lending stance, so lending margins overall are likely to be less generous than at the start of the credit cycle and loan quality will have deteriorated.

While shareholders are enjoying excellent returns, it has become a highly risky situation for the bank. The slightest pause in the economic outlook, whether it be from interest rates being raised by the central bank attempting to control the boom, or perhaps an exogenous factor, such as trade tariffs being raised between the bank’s jurisdiction and a major trading partner, will cause the directors of our bank to switch from greed to fear in a heartbeat. In our example, all it takes is losses of 12.5% of the bank’s assets to wipe out shareholders’ equity.

If one bank suspects there may be a deterioration in trade conditions, it is certain that others will as well, because they have similar business information. Due to the dangers of balance sheet gearing, bankers are exceedingly prone to group think.

When it happens, the switch from greed to fear travels like wildfire. But some banks are likely to be caught out, having been aggressive lenders trying to increase the size of their bank, often with a chief executive on an ego trip. Fred Goodwin at Royal Bank of Scotland was a recent example. Ignoring all signs of the ending of a cycle of credit expansion, Goodwin pushed through a consortium takeover of ABN-AMRO in October 2007, with RBS’s portion funded by debt. The bank’s balance sheet gearing became twenty-four to one.

With gearing of that sort very little needs to go wrong to wipe out shareholders equity, which is what happened. Failures of this type are an acute risk when the banking cohort has been lulled into a false sense of lending risk by a prolonged period of business stability combining with the siren’s beckoning of a financial bubble.

Reducing bank balance sheets without creating economic instability is virtually impossible. Driven by their group think, frightened bankers will seek to reverse credit expansion all at the same time. They sell corporate bonds in a market with no buyers. Spreads, the difference in yield between government bonds and riskier corporate debt, blow out, catastrophic for book values. Business and personal loan facilities are capped and withdrawn, driving many companies into the hands of insolvency practitioners. It can become a race between bankers to reduce the size of their balance sheets before their competitors, as the rapid withdrawal of bank credit triggers bankruptcies and unemployment. It has happened repeatedly for the last two hundred years.

The economic effect was summed up by economist Irving Fisher in the 1930s, who is forever associated with the theory of debt deflation. As the oxygen of credit is withdrawn, businesses get into trouble and banks begin to liquidate collateral. Liquidation of collateral drives their values even lower, exposing additional formally secured lending as no longer secured. Further collateral sales follow, driving collateral values down even further. And so on.

That was in the depression years, and Fisher’s point was to link the collapse of businesses, asset values and also the failure of banks themselves with the contraction of bank credit. Subsequently, central bank policy has focused on trying to anticipate and stop the deflation of bank credit in the first place, always ready to turn on the money spigot. The government then subsidized the economy by increasing its spending without raising taxes. By using the stimulus of unfunded government spending and central bank money creation, the government and its central bank are following the Keynesian economic playbook, which now sets the relationship between the state and private sectors.

Despite everything attempted by statist intervention, we still have periodic bouts of bank credit deflation. But matters have evolved from the simple model illustrated in Figures 1 and 2 above. Banking has become highly regulated, and banks now lend on a formulaic basis, set globally by the Basel Committee (we are on rules version 3) and by local regulators.

Earlier versions of these controls permitted Fred Goodwin to take the RBS balance sheet gearing to credit hyperspace. They say lessons were learned, but the only lessons learned by the regulators were new ways to keep their eyes shut and ears plugged. Stress testing of bank balance sheets assumes little more than a moderate recession and denies the likely consequences of anything worse. The economic crisis starts with a change in banking cohort group think, and not, as regulators with their useless stress tests assume, a decline in GDP, a rise in unemployment, a rise in price inflation, or Heaven forbid, an unexpected financial crisis. And if you think extreme bank leverage would have been controlled following the Fred Goodwin episode, think again. Figure 3 shows current balance sheet to equity ratios for a selection of major banks. Through the magic of modern accounting practice, they are almost certainly higher than reported.

From the few examples in Figure 3 we can anticipate bank failures to originate in Europe in the event of a general contraction of bank credit. Despite reducing its balance sheet significantly in recent years, Deutsche Bank is in Fred Goodwin territory, closely followed by BNP and Barclays. And the credit cycle has very obviously turned down again. The regulators persist in behaving like the three wise monkeys, wholly unaware there is a credit cycle and what these ratios indicate.

The large American banks are not so heavily geared, but that will not protect them from the global credit contraction that will now intensify.

Enter The ChiCom Virus

We have made the important point that before the coronavirus lock down, the credit cycle was already turning down. Liquidity strains had surfaced last September, with the Fed routinely supplying tens of billions of dollars of liquidity through the repo market.

The monetary base, which represents the quantity of money in public circulation created by the Fed, is now growing at the fastest pace on record. But since January, a new problem arose: the disruption to production supply chains from the virtual shutdown of Chinese production due to the coronavirus.

The manufacture of anything requires multiple inputs, commonly referred to as supply chains. The concept of a supply chain suggests they are one dimensional: a series of production steps that go towards a single product. This is not the case. Supply chains are multidimensional and involve supplies from many sources in many jurisdictions at every production stage. The sequential shutdown of China, South Korea and much of South East Asia was followed by Europe, Britain and America. During these shutdowns almost all production and sales of non-food goods and non-essentials ceased.

While the assembly of a product progresses in one direction, payments flow backwards down the chain as each production step is delivered. The sum of the payments involved is far greater than the value of the final product. The global payment disruption is therefore significantly greater than the GDP number, which only consists of the sum total of final products bought by consumers. In the case of the US, an approximation of domestic payment disruption is contained in the gross output statistic, which is $38 trillion compared with a GDP of $21 trillion.

The US economy is significantly services-driven, with shorter supply chains on average than an equivalent manufacturing-based economy, such as China or Germany. If you add together supply chain payments abroad that feed into final goods sold in America, total payments for intermediate production stages in dollar-driven production probably add up to more than $50 trillion, the majority of which are now frozen.

To understand the impact of this new factor on bank credit, we must divide business customers into two classes; those with cash and those that depend on bank loans for working capital.

Both categories have establishment and other costs that continue despite the collapse in production. Those with cash liquidity draw it down to make payments, reducing bank deposits, which are recycled into other deposits which may or may not be with the same bank. When those deposits reduce existing overdrafts, bank credit contracts reflecting a loan repayment. When they amount to a simple transfer of deposit ownership, they do not.

The greater problem is with businesses that need loan cover for missed payments. There are so many of them with payment failures, bankers are being overwhelmed. Whether they realize it or not, they cannot afford to say no to demands for credit because Irving Fisher’s debt deflation problem is so urgent that to deny loan requests would likely end up wiping out the banks’ own shareholders’ capital and then some.

Supply chain payment failures are becoming a banking problem many times larger than the banking cohort shareholders’ capital. The ratio of US gross output to total equity capital for commercial banks in the US is nineteen times. In other words, unless the Fed can increase base money by at least that and somewhat more to compensate for a degree of bank credit contraction, the economy and the banking system will almost certainly crash.

In Germany, where the two major private banks shown in Figure 3 have balance sheet to equity ratios of 15.1 and 22.6, supply chain disruptions seem certain to lumber them with a fatal combination of dramatically widening commercial bond spreads and payment failures from the mittelstand.

Everywhere else, the problem is the same. The Fed has responded by reducing the cost of drawing down established central bank liquidity swaps lines, but they were only available to the ECB, the Bank of Japan, The Bank of England, Bank of Canada and the Swiss National Bank. Recognizing the wider problem, on 19 March the Fed extended swap lines temporarily to the central banks of Korea, Australia, Brazil, Denmark, Mexico, New Zealand, Norway, Singapore and Sweden for six months. A notable absentee from the list is China, which one would have thought is the most important user of dollar liquidity based on trade.  Politics trumps the delivery of monetary policy in defiance of the scale and urgency of the crisis.

The problems facing the whole banking system have never been greater. Individually, commercial banks are bound to take every opportunity to reduce their risk exposure before the market values of collateral, particularly equities, corporate debt and both residential and commercial property categories fall further in value. Banks will attempt to reduce their interbank exposure, particularly to European banks. Eurozone banks are likely to be the first to fail, needing state bail outs. Counter party risk in over-the-counter derivatives becomes a major concern for all. And central banks are on a wing and a prayer if they think commercial banks will simply ensure liquidity gets to the right places in time to prevent a financial crisis.

The Final Crack-Up, BOOM

The Fed and other central banks can only blag solutions to a rapidly debasing currency, but the commitment to maintain financial asset values by printing money in the manner of John Law three hundred years ago will require such enormous amounts of base money as to bring forward the destruction of the fiat dollar and all the other fiat currencies. Banks will have fought for survival in this changed world, with many of them succumbing to public ownership.

In this rapidly deteriorating environment, it won’t be long before the smarter bankers realize that they can deploy the expansion of bank credit to acquire not financial assets, which will become worthless being priced in worthless currency, but real assets. The model adopted is likely to be that of Hugo Stinnes, who in 1920-Germany was known as the inflation king. Stinnes borrowed rapidly depreciating marks to buy up factories and property, amassing an empire of 4,500 companies and 3,000 manufacturing plants. Stinnes died in 1924, the year after the great inflation, and his empire subsequently collapsed.

Banks emulating Stinnes have an additional advantage. They can make acquisitions as principals by expanding bank credit again when they are confident that repayments when falling due will be worth significantly less. Bankers under the cover of nationalized banks might even direct the expansion of bank credit into newly created vehicles in which they have personal interests. This behavior is atypical and might even have the support of a hapless state desperate for any form of financial stability.

This last act, the restoration of bank credit in its relationship with base money will add a rising multiple of the trillions of central bank base money scheduled to be issued in the coming months and will be a vital component of the crack-up boom with which all currency collapses end. The role of the banks as the medium with which the state seeks to tame free markets will ultimately hasten the end of the fiat currencies from which they have profited so much, and the end of central banking as well.

Source: by Alasdair Macleod | GoldMoney.com

U.S. National Trade Council Director Peter Navarro Warns Wall Street Globalists: “Stand Down” Or Else…

(TheLastRefuge) The words from Peter Navarro will come as no surprise to any CTH reader who is fully engaged and reviewing the multi-trillion stakes, within the Globalist (Wall St-vs- Nationalist (Main Street) confrontation.

For several decades Wall Street, through lobbying arms such as the U.S. Chamber of Commerce (Tom Donohue), has structurally opposed Main Street economic policy in order to inflate profits and hold power – “The Big Club”. This manipulative intent is really the epicenter of the corruption within the DC swamp.

U.S. National Trade Council Director Peter Navarro discusses how Wall Street bankers and hedge-fund managers are attempting to influence U.S.-China trade talks. He speaks at the Center for Strategic and International Studies in Washington, D.C.

This article was built around the following short news clip…

Originally outlined a year ago. At the heart of the professional/political opposition the issue is money; there are trillions at stake.

President Trump’s MAGAnomic trade and foreign policy agenda is jaw-dropping in scale, scope and consequence. There are multiple simultaneous aspects to each policy objective; however, many have been visible for a long time – some even before the election victory in November ’16.

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If we get too far in the weeds the larger picture is lost. CTH objective is to continue pointing focus toward the larger horizon, and then at specific inflection points to dive into the topic and explain how each moment is connected to the larger strategy.

If you understand the basic elements behind the new dimension in American economics, you already understand how three decades of DC legislative and regulatory policy was structured to benefit Wall Street and not Main Street. The intentional shift in fiscal policy is what created the distance between two entirely divergent economic engines.

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REMEMBER […] there had to be a point where the value of the second economy (Wall Street) surpassed the value of the first economy (Main Street).

Investments, and the bets therein, needed to expand outside of the USA. hence, globalist investing.

However, a second more consequential aspect happened simultaneously. The politicians became more valuable to the Wall Street team than the Main Street team; and Wall Street had deeper pockets because their economy was now larger.

As a consequence Wall Street started funding political candidates and asking for legislation that benefited their interests.

When Main Street was purchasing the legislative influence the outcomes were -generally speaking- beneficial to Main Street, and by direct attachment those outcomes also benefited the average American inside the real economy.

When Wall Street began purchasing the legislative influence, the outcomes therein became beneficial to Wall Street. Those benefits are detached from improving the livelihoods of main street Americans because the benefits are “global”. Global financial interests, multinational investment interests -and corporations therein- became the primary filter through which the DC legislative outcomes were considered.

There is a natural disconnect. (more)

As an outcome of national financial policy blending commercial banking with institutional investment banking something happened on Wall Street that few understand. If we take the time to understand what happened we can understand why the Stock Market grew and what risks exist today as the monetary policy is reversed to benefit Main Street.

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President Trump and Treasury Secretary Mnuchin have already begun assembling and delivering a new banking system.

Instead of attempting to put Glass-Stegal regulations back into massive banking systems, the Trump administration is creating a parallel financial system of less-regulated small commercial banks, credit unions and traditional lenders who can operate to the benefit of Main Street without the burdensome regulation of the mega-banks and multinationals. This really is one of the more brilliant solutions to work around a uniquely American economic problem.

♦ When U.S. banks were allowed to merge their investment divisions with their commercial banking operations (the removal of Glass Stegal) something changed on Wall Street.

Companies who are evaluated based on their financial results, profits and losses, remained in their traditional role as traded stocks on the U.S. Stock Market and were evaluated accordingly. However, over time investment instruments -which are secondary to actual company results- created a sub-set within Wall Street that detached from actual bottom line company results.

The resulting secondary financial market system was essentially ‘investment markets’. Both ordinary company stocks and the investment market stocks operate on the same stock exchanges. But the underlying valuation is tied to entirely different metrics.

Financial products were developed (as investment instruments) that are essentially wagers or bets on the outcomes of actual companies traded on Wall Street. Those bets/wagers form the hedge markets and are [essentially] people trading on expectations of performance. The “derivatives market” is the ‘betting system’.

♦Ford Motor Company (only chosen as a commonly known entity) has a stock valuation based on their actual company performance in the market of manufacturing and consumer purchasing of their product. However, there can be thousands of financial instruments wagering on the actual outcome of their performance.

There are two initial bets on these outcomes that form the basis for Hedge-fund activity. Bet ‘A’ that Ford hits a profit number, or bet ‘B’ that they don’t. There are financial instruments created to place each wager. [The wagers form the derivatives] But it doesn’t stop there.

Additionally, more financial products are created that bet on the outcomes of the A/B bets. A secondary financial product might find two sides betting on both A outcome and B outcome.

Party C bets the “A” bet is accurate, and party D bets against the A bet. Party E bets the “B” bet is accurate, and party F bets against the B. If it stopped there we would only have six total participants. But it doesn’t stop there, it goes on and on and on…

The outcome of the bets forms the basis for the tenuous investment markets. The important part to understand is that the investment funds are not necessarily attached to the original company stock, they are now attached to the outcome of bet(s). Hence an inherent disconnect is created.

Subsequently, if the actual stock doesn’t meet it’s expected P-n-L outcome (if the company actually doesn’t do well), and if the financial investment was betting against the outcome, the value of the investment actually goes up. The company performance and the investment bets on the outcome of that performance are two entirely different aspects of the stock market. [Hence two metrics.]

♦Understanding the disconnect between an actual company on the stock market, and the bets for and against that company stock, helps to understand what can happen when fiscal policy is geared toward the underlying company (Main Street MAGAnomics), and not toward the bets therein (Investment Class).

The U.S. stock markets’ overall value can increase with Main Street policy, and yet the investment class can simultaneously decrease in value even though the company(ies) in the stock market is/are doing better. This detachment is critical to understand because the ‘real economy’ is based on the company, the ‘paper economy’ is based on the financial investment instruments betting on the company.

Trillions can be lost in investment instruments, and yet the overall stock market -as valued by company operations/profits- can increase.

Conversely, there are now classes of companies on the U.S. stock exchange that never make a dime in profit, yet the value of the company increases. This dynamic is possible because the financial investment bets are not connected to the bottom line profit. (Examples include Tesla Motors, Amazon and a host of internet stocks like Facebook and Twitter.) It is this investment group of companies that stands to lose the most if/when the underlying system of betting on them stops or slows.

Specifically due to most recent U.S. fiscal policy, modern multinational banks, including all of the investment products therein, are more closely attached to this investment system on Wall Street. It stands to reason they are at greater risk of financial losses overall with a shift in fiscal policy.

That financial and economic risk is the basic reason behind Trump and Mnuchin putting a protective, secondary and parallel, banking system in place for Main Street.

Big multinational banks can suffer big losses from their investments, and yet the Main Street economy can continue growing, and have access to capital, uninterrupted.

Bottom Line: U.S. companies who have actual connection to a growing U.S. economy can succeed; based on the advantages of the new economic environment and MAGA policy, specifically in the areas of manufacturing, trade and the ancillary benefactors.

Meanwhile U.S. investment assets (multinational investment portfolios) that are disconnected from the actual results of those benefiting U.S. companies, and as a consequence also disconnected from the U.S. economic expansion, can simultaneously drop in value even though the U.S. economy is thriving.

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Source: by Sundance | The Conservative Tree House

Top Restructuring Banker: “We’re All Feeling Like It’s 2007 Again”

There is a group of bankers for whom “better” means “worse” for everyone else: we are talking, of course, about restructuring bankers who advising companies with massive debt veering toward bankruptcy, or once in it, how to exit from the clutches of Chapter 11, and who – like the IMF, whose chief Christine Lagarde recently saidWhen The World Goes Downhill, We Thrive– flourish during financial chaos and mass defaults.

Which is to say that the past decade has not been exactly friendly to the world’s restructuring bankers, who with the exception of two bursts of activity, the oil collapse-driven E&P bust in 2015 and the bursting of the retail “bricks and mortar” bubble in 2017, have been generally far less busy than usual, largely as a result of abnormally low rates which have allowed most companies to survive as “zombies”, thriving on the ultra low interest expense.

However, as Moody’s warned yesterday, and as the IMF cautioned a year ago, this period of artificial peace and stability is ending, as rates rise and as a avalanche of junk bond debt defaults. And judging by their recent public comments, restructuring bankers have rarely been more exited about the future.

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Ken Moelis

Take Ken Moelis, who last month was pressed about his rosy outlook for his firm’s restructuring business, describing “meaningful activity” for the bank’s restructuring group.

“Your comments were surprisingly positive,” said JPMorgan’s Ken Worthington, quoted by Business Insider. “Is this sort of steady state for you in a lousy environment? Can things only get better from here?”

Moelis’ response: “Look, it could get worse. I guess nobody could default. But I think between 1% and 0% defaults and 1% and 5% defaults, I would bet we hit 5% before we hit 0%.”

He is right, because as we showed yesterday in this chart from Credit Suisse, after languishing around 1%-2% for years, default rates have jumped the most in 5 years, and are now “ticking higher”

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Moelis wasn’t alone in his pessimism: in March, JPMorgan investment-banking head Daniel Pinto said that a 40% correction, triggered by inflation and rising interest rates, could be looming on the horizon.

These are not isolated cases where a gloomy Cassandra has escaped from the asylum: already the biggest money managers are positioning for a major economic downturn according to recent research from Bank of America. And while nobody can predict the timing of the next collapse, Wall Street’s top restructuring bankers have one message: it’s coming, and it’s not too far off.

However, the most dire warning to date came from Bill Derrough, the former head of restructuring at Jefferies and the current co-head of recap and restructuring at Moelis: “I do think we’re all feeling like where we were back in 2007,” he told Business Insider: There was sort of a smell in the air; there were some crazy deals getting done. You just knew it was a matter of time.”

What he is referring to is not just the overall level of exuberance, but the lunacy taking place in the bond market, where CLOs are being created at a record pace, where CCC-rated junk bonds can’t be sold fast enough, and where the a yield-starved generation of investors who have never seen a fair and efficient market without Fed backstops, means that the coming bond-driven crash will be spectacular.

“Even if there is not a recession or credit correction, with the sheer volume of issuance there are going to be defaults that take place,” said Neil Augustine, co-head of the restructuring practice at Greenhill & Co.

The dynamic is familiar: since 2009, the level of global non-financial junk-rated companies has soared by 58% representing $3.7 trillion in outstanding debt, the highest ever, with 40%, or $2 trillion, rated B1 or lower. Putting this in contest, since 2009, US corporate debt has increased by 49%, hitting a record total of $8.8 trillion, much of that debt used to fund stock repurchases.  As a percentage of GDP, corporate debt is at a level which on ever prior occasion, a financial crisis has followed.

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The recent glut of debt is almost entirely attributable to the artificially low interest-rate environment imposed by the Federal Reserve and its central bank peers following the crisis. Many companies took advantage and refinanced their debt before 2015 when a large swath was set to mature, kicking the can several years down the road. 

But going forward “there’s going to be refinancing at significantly higher rates,” said Steve Zelin, head of the restructuring in the Americas at PJT Partners.

And as the IMF first warned last April, refinancing at higher rates will further shrink the margin of error for troubled companies, as they’ll have to dedicate additional cash flow to cover more expensive interest payments.

“When you have highly leveraged companies and even a modest rise in interest rates, that can result in an increase in restructuring activity,” said Irwin Gold, executive chairman at Houlihan Lokey and co-founder of the firm’s restructuring group.

So with a perfect debt storm coming our way, many restructuring firms have been quietly hiring new employees to be ready when, not if, the economy takes a turn for the worse.

“The restructuring business is a good business during normal times and an excellent business during a recessionary environment,” Augustine said. “Ultimately, when a recession or credit correction does happen, there will be a massive amount of work to do on the restructuring side.” Here are some additional details on recent banker moves from Business Insider:

Greenhill hired Augustine from Rothschild in March to co-head its restructuring practice. The firm also hired George Mack from Barclays last summer to cohead restructuring. The duo, along with Greenhill vet and fellow co-head Eric Mendelsohn, are building out the firm’s team from a six-person operation to 25 bankers.

Evercore Partners in May hired Gregory Berube, formerly the head of Americas restructuring at Goldman Sachs, as a senior managing director. The firm also poached Roopesh Shah, formerly the chief of Goldman Sachs’ restructuring business, to join its restructuring business in early 2017.

“It feels awfully toppy, so people are looking around and saying, ‘If I need to build a business, we need to go out and hire some talent,'” one headhunter with restructuring expertise told Business Insider.

“In our world, people are just anticipating that it’s coming. People are trying to position their teams to be ready for it,” Derrough said. “That was the lesson from last cycle: Better to invest early and have a cohesive team that can do the work right away and maybe be a little bit overstaffed early, so that you can execute for your clients when the music ultimately stops.”

Of course, if the IMF is right (for once), Derrough and his peers will soon see a windfall unlike anything before: last April, the International Monetary Fund predicted that some 20%, or $3.9 trillion, of the total global corporate debt is in danger of defaulting once rates rise.

https://www.zerohedge.com/sites/default/files/images/user5/imageroot/2017/04/19/IMF%20debt%20warning%201.jpg

Although if and when that day comes, perhaps a better question is whether companies will be doing debt-for-equity swaps, or fast forward straight to debt-for-lead-gold-and canned food…

Source: ZeroHedge

***

Fortunately, the Dying Do Die

July 6, 2016 marks the point when the US government’s condition became irretrievably terminal. On that date the US Treasury’s 10-year note yield hit its low, 1.34 percent, and has been trending irregularly higher ever since. Historically, debt has been the life support for regimes in extremis. No regime has ever been more in debt than the US government. Its annual deficit and debt service expense are growing, old-age pension and medical programs face a demographic crunch, and now interest rates are rising. One way or the other, the government walking away from some or all of its promises is as set in stone as anything in this life can be.

HSBC Curbs Mortgage Options to Chinese Nationals Buying U.S. Real Estate

https://i0.wp.com/libertyblitzkrieg.com/wp-content/uploads/2016/01/Screen-Shot-2016-01-28-at-9.08.53-AM-768x770.jpgTwo days ago, I published a post explaining how the super high end real estate bubble had popped, and how signs of this reality have emerged across America. Here’s an excerpt from that post, The Luxury Housing Bubble Pops – Overseas Investors Struggle to Sell Overpriced Mansions:

The six-bedroom mansion in the shadow of Southern California’s Sierra Madre Mountains has lime trees and a swimming pool, tennis courts and a sauna — the kind of place that would have sold quickly just a year ago, according to real estate agent Kanney Zhang.

Not now.

Zhang is shopping it for a discounted $3.68 million, but nobody’s biting. Her clients, a couple from China, are getting anxious. They’re the kind of well-heeled international investors who fueled a four-year luxury real estate boom that helped pull America out of its worst housing slump since the 1930s. Now the couple is reeling from the selloff in the Chinese stock market and looking to raise cash to shore up finances.

In the Los Angeles suburb of Arcadia, where Zhang is struggling to sell the six-bedroom home, dozens of aging ranch houses were demolished to make way for 38 mansions built with Chinese buyers in mind. They have manicured lawns and wok kitchens and are priced as high as $12 million. Many of them sit empty because the prices are out of the range of most domestic buyers, said Re/Max broker Rudy Kusuma, who blames a crackdown by the Chinese on large sums leaving the country.

Well, I have some more bad news for mansion-flipping Chinese nationals.

From Reuters:

Europe’s biggest lender HSBC will no longer provide mortgages to some Chinese nationals who buy real estate in the United States, a policy change that comes as Beijing is battling to stem a swelling crowd of citizens trying to get money out of China.

An HSBC spokesman in New York told Reuters on Wednesday that the new policy went into effect last week, roughly a month after China suspended Standard Chartered and DBS Group Holdings Ltd from conducting some foreign exchange business and as authorities try to limit capital outflows.

Realtors of luxury property in cities like New York, Los Angeles, and Vancouver, said more than 80 percent of wealthy Chinese buyers have ties to China.

Luxury homes news website Mansion Global, which first reported the HSBC policy change, said it would affect Chinese nationals holding temporary visitor ‘B’ visas if the majority of their income and assets are maintained in China.

Meanwhile…

HSBC’s pivot away from lending to some Chinese nationals abroad comes as other international banks clamor to lend more to wealthy Chinese.

The Royal Bank of Canada scrapped its C$1.25 million cap on mortgages to borrowers with no local credit history last year in a bid to tap into surging demand for financing from wealthy immigrant buyers.

The New European Bank Bail-in System Goes Into Effect January 1st, 2016

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If you have a bank account anywhere in Europe, you need to read this article.  On January 1st, 2016, a new bail-in system will go into effect for all European banks.  This new system is based on the Cyprus bank bail-ins that we witnessed a few years ago.  If you will remember, money was grabbed from anyone that had more than 100,000 euros in their bank accounts in order to bail out the banks.  Now the exact same principles that were used in Cyprus are going to apply to all of Europe.  And with the entire global financial system teetering on the brink of chaos, that is not good news for those that have large amounts of money stashed in shaky European banks.

Below, I have shared part of an announcement about this new bail-in system that comes directly from the official website of the European Parliament.  I want you to notice that they explicitly say that “unsecured depositors would be affected last”.  What they really mean is that any time a bank in Europe fails, they are going to come after private bank accounts once the shareholders and bond holders have been wiped out.  So if you have more than 100,000 euros in a European bank right now, you are potentially on the hook when that bank goes under…

The directive establishes a bail-in system which will ensure that taxpayers will be last in the line to the pay the bills of a struggling bank. In a bail-in, creditors, according to a pre-defined hierarchy, forfeit some or all of their holdings to keep the bank alive. The bail-in system will apply from 1 January 2016.

The bail-in tool set out in the directive would require shareholders and bond holders to take the first big hits. Unsecured depositors (over €100,000) would be affected last, in many cases even after the bank-financed resolution fund and the national deposit guarantee fund in the country where it is located have stepped in to help stabilize the bank. Smaller depositors would in any case be explicitly excluded from any bail-in.

And as we have seen in the past, these rules can change overnight in the midst of a major crisis.

So they may be promising that those with under 100,000 euros will be safe right now, but that doesn’t necessarily mean that it will be true.

It is also important to note that there has been a really big hurry to get all of this in place by January 1.  In fact, at the end of October the European Commission actually sued six nations that had not yet passed legislation adopting the new bail-in rules…

The European Commission is taking legal action against member states including the Netherlands and Luxembourg, after they failed to implement rules protecting European taxpayers from funding billions in bank rescues.

Six countries will be referred to the European Court of Justice (ECJ) for their continued failure to transpose the EU’s “bail-in” laws into national legislation, the European Commission said on Thursday.

So why was the European Commission in such a rush?

Is there some particular reason why January 1 is so important?

This is something that I will be watching.

Meanwhile, there have been major changes in the U.S. as well.  The Federal Reserve recently adopted a new rule that limits what it can do to bail out the “too big to fail” banks.  The following comes from CNN

The Federal Reserve is cutting its lifeline to big banks in financial trouble.

The Fed officially adopted a new rule Monday that limits its ability to lend emergency money to banks.

In theory, the new rule should quash the notion that Wall Street banks are “too big to fail.”

If this new rule had been in effect during the last financial crisis, the Federal Reserve would not have been able to bail out AIG or Bear Stearns.  As a result, the final outcome of the last crisis may have been far different.  Here is more from CNN

Under the new rule, banks that are going bankrupt — or appear to be going bankrupt — can no longer receive emergency funds from the Fed under any circumstances.

If the rule had been in place during the financial crisis, it would have prevented the Fed from lending to insurance giant AIG (AIG) and Bear Stearns, Fed chair Janet Yellen points out.

So if the Federal Reserve does not bail out these big financial institutions during the next crisis, what is going to happen?

Will we see European-style “bail-ins” when large banks start failing?

And exactly what would such a “bail-in” look like?

Earlier this year, I discussed the concept of a “bail-in”…

Essentially, what happens is that wealth is transferred from the “stakeholders” in the bank to the bank itself in order to keep it solvent.  That means that creditors and shareholders could potentially lose everything if a major bank in Europe fails.  And if their “contributions” are not enough to save the bank, those holding private bank accounts will have to take “haircuts” just like we saw in Cyprus.  In fact, the travesty that we witnessed in Cyprus is being used as a “template” for much of the new legislation that is being enacted all over Europe.

Many Americans assume that when they put money in the bank that they have a right to go back and get “their money” whenever they want.  But if we all went to the bank at the same time, there wouldn’t be nearly enough money for all of us.  The reason for this is that the banks only keep a small fraction of our money on hand to satisfy the demands of those that conduct withdrawals on a day to day basis.  The banks take the rest of the money that we have deposited and use it however they think is best.

If you have money at a bank that goes under, that bank will still be obligated to pay you back, but it may not be able to do so.  This is where the FDIC comes in.  The FDIC supposedly guarantees the safety of deposits in member banks, but at any given time it only has a very, very small amount of money on hand.

If some major crisis comes along that causes banks all over the United States to start falling like dominoes, the FDIC will be in panic mode.  During such a scenario, the FDIC would be forced to ask Congress for a massive amount of money, and since we already run a giant deficit every year the government would have to borrow whatever funds would be required.

Personally, I find it very interesting that we have seen major rule changes in Europe and at the Federal Reserve just as we are entering a new global financial crisis.

Do they know something that the rest of us do not?

Be very careful with your money, because I am convinced that “bank bail-ins” will soon be making front page headlines all over the world.

by Michael Snyder in The Economic Collapse