European Central Bank Bets the Ranch

The European Central Bank has evidently been taking EU sovereign debt as collateral, even as it expands its balance sheet to a record size in order to finance the EU's banking system. Taking sovereign debt as collateral bets the solvency of the ECB on the solvency of the EU. In the event of a sovereign default, the banks borrowing from the ECB may well not be able to repay their debts to the central bank. The ECB might theoretically try to sell its collateral to recover its losses. But the very act of selling the sovereign debt would likely push down its value, impair European banks all the more, and further weaken the ECB. The ECB, for practical purposes, may be making uncollateralized loans when it takes EU sovereign debt as "collateral."

The ECB surely realizes this. But it may have little choice, since Europe's banks probably have limited amounts of other assets they could tender to the ECB as collateral. Without the ECB's loans, the European financial system would probably have to pull back on lending, forcing an economic contraction at a time when Europe desperately needs growth to escape the claws of the sovereign debt crisis. So the ECB probably has little choice but to bet the ranch. Its hopes of repayment rest primarily on whether or not Europe grows. Europe's prospects for growth depend heavily on whether or not its governments can institute effective fiscal policies. Given the EU's political dysfunction, one cannot help but wonder whether the ECB will lose the ranch.

The Sovereign Debt Crisis: Europeans To Live In Glass Houses

The latest EU proposal for resolving the sovereign debt crisis promises "automatic" consequences if member nations' annual budget deficits exceed 3% of their GDP. The European Commission, the executive arm of the European Union, can also impose additional requirements. All this is supposed to keep EU members on the straight and narrow, never spending excessively, texting while driving, or using any cuss words.

But there's a catch. EU members holding 74% or more of the union's voting power (votes are allocated among EU members by size, similar to the U.S. House of Representatives) can vote to lift the sanctions. Virtually all of EU members fail to comply with its requirement to keep total national sovereign debt at not more than 60% of GDP. Many have trouble meeting the 3% budget deficit requirement. In other words, the members of the EU are not without sin. If a fellow member nation needed dispensation from the "automatic" consequences and the EC's sanctions for going over the 3% limit, would the other EU nations be the first to cast a stone? When you live in a glass house, you will do unto others as you would have them do unto you. The 74% catch (we can call it "Catch-74") renders the "automatic" consequences semi-automatic and creates a go along, get along dynamic that is antithetical to the notion of fiscal discipline.

Only Britain dissented from the latest proposal, steering its own course in turbulent seas, Union Jack snapping briskly in the wind. It's unclear that Britain's tack makes economic sense. But if the EU fails to definitively resolve the crisis, there may be many on continental Europe who will think themselves accursed not to be among the happy few who chose to keep their monetary policy independent.

Will EU Members Learn to Share?

The latest leaks from high ranking EU officials concerning the sovereign debt crisis hint at the possibility of not one, but two bailout funds. Details are scarce; but maybe that's the idea. They can keep the palaver going as long as you don't ask what army of investors is supposed to step out front and center to fund this financial engineering. That's the key to making the bailout work--or not. Someone has to plop a lot of cold, hard cash money on the barrel head in order to truly end the crisis. S&P, however, is threatening to downgrade most of Europe. Whence will investors find the courage to buy the EU's financial engineering when they see the price of sovereign debt credit default swaps escalating?

This is something the leaders of Germany and other wealthy EU nations spend little time publicly admitting. Instead, they focus on how to impose discipline, austerity and clean living on the profligate. Greece, Ireland, Portugal, Italy, Spain and perhaps other nations would have to earn every Euro they spend, and would pay penalties for deficits, failing to wash behind their ears, and using cuss words. Somehow, enough righteousness is supposed to transport the EU to the utter bliss of true currency union.

But the EU is missing an important point. The world's most successful currency union, the United States, exists perennially in a state of financial imbalance. For over a century, the wealthy states on the East Coast, more recently with the wealthy states on the West Coast, have subsidized less wealthy states in between. These imbalances have existed in the form of federal subsidies to farmers, ranchers, the mining industry, the railroads, and more. The Interstate Highway System was another big subsidy, benefiting large, thinly populated rural states more per capita than it benefited densely populated states. But none of the United States tries to hold others of the United States to fiscal rectitude. Imbalance is implicit in the structure of the Constitution, apportioning as it does two Senators to each state no matter how large or small. And imbalance runs the other way. On a per capita basis, the less wealthy states probably provide more people to serve in the military than the wealthier states, resulting in steeper non-financial costs on the former when America goes to war. Americans tolerate imbalance because national unity is more important to them than any rigorous reconciliation of ledgers.

To make the EU really work, Europeans need more than just their economic welfare. Financial self-interest isn't the superglue required for political union. Neither is sheer power. Rome's legions, Napoleon's armies, and the Third Reich's panzers all failed to hold Europe together. Angela Merkel, Nicholas Sarkozy and other proponents of the EU have shrewdly played their cards to keep the crisis from tipping over into financial panic. But the EU needs greatness in its leadership, calls to electorates to seek a new destiny. That's missing, and given the historical divisions among Europeans, a most tribal collection of peoples, it's not surprising that issuers of EU sovereign debt credit default swaps are selling their contracts dearly.

Retire By Making Your Dollars Last

Managing your money in retirement is often depicted as a problem of how to allocate your portfolio, how quickly to draw down your net worth, when to begin taking Social Security and whether or not to buy long term care insurance. But managing one's financial assets is only part of the picture. Consider how you spend--the less your cash outflow, the easier it is to afford retirement. And you don't necessarily need to become a connoisseur of cat food or learn the dozens of ways to prepare rice and beans.

Pay off the mortgage. One of the most surefire ways to reduce month expenses is to pay off the mortgage. Since your retirement income will probably be less than your income while working, offloading the mortgage will improve the quality of your sleep.

Take the auto mechanic off your speed dial. Buy cars that are reliable and known for longevity. With the increased computerization of cars, the cost of repairs is skyrocketing. You don't have to buy a tinny econobox. If you can afford a luxury car, choose an Acura or Lexus, not some other brands that enrich repair shops.

When it comes to appliances, spare your back. High quality in home appliances isn't, to borrow a stock market phrase, closely correlated with price. The most reliable and long lasting washing machines and dryers tend to be the traditional, modestly priced top loaders. Currently fashionable side loaders have their attributes, but at the cost of higher purchase prices and less longevity. Plus you have to bend over or kneel down to get access to them. Your back and knees may have an opinion as to whether or not that's a good idea. Cheaper, more reliable, longer lasting, and easier on the back and knees is a pretty good bargain.

Use generics whenever possible. Generic drugs can be much cheaper than name brands. Why pay for a fancy name when the medication is the same at a lower price?

Avoid credit card debt. The most expensive loans most Americans take are credit card balances carried over from month to month. If you use credit cards, only charge what you can pay off at the end of the month. That way, you earn rewards, cashback bonuses, etc., without paying any interest. Why enrich banks in your golden years?

The Federal Reserve and Its Petard

Even casual readers of today's financial news know interbank lending is drying up on an international scale, and that the world financial system is getting the shakes. That's why the Fed and other major central banks announced yesterday a currency swap program to ensure dollar liquidity in Europe and elsewhere. But even as the Fed mounts up and tries to lead the charge, we should remember that it is tripping over its own ultra low interest rate policy.

The Fed's principal monetary weapon is to control the fed funds rate. That's the rate banks charge each other for overnight loans. The Fed has targeted a rate of 0 % to 0.25%, and has promised to hold it there until Antarctica is covered by tropical rain forest. A bank with excess funds can't hardly make a plugged nickel when its lending rate is virtually indistinguishable from zero. And when you consider that many of the larger European banks that are now desperate for dollar funding are, by virtue of the EU sovereign debt crisis, not glowingly golden credit risks, it's no surprise that American and other banks with excess dollars are stuffing entire bulbs of garlic into their mouths any time an EU bank asks for a loan. In other words, the Fed's own zero interest rate policy is hampering interbank lending that could alleviate the very credit crunch it's now desperate to combat.

I leave it to you, dear reader, to decide what to say about the Fed and its petard.

Does the Federal Reserve Have a Secret Bailout Plan For Europe?

Today's announcement of a coordinated monetary easing program led by the U.S. Federal Reserve, providing currency swap lines to the central banks of other major nations, was the news the stock market wanted to here: a walloping big dose of moral hazard that infused dollar-denominated liquidity into an increasingly stressed European banking system. The Dow Jones Industrial Average blasted upward 490 points, the largest move in two and a half years. Markets always love it when a governmental body reduces their risks. Recall, however, that there is no such thing as the elimination of financial risk. It can only be transferred. If risk is transferred away from market participants by a government program, you know who just got the short end of the stick. (Hint: look in the mirror.)

The Fed's move came when the EU was wobbling precariously at the edge of the precipice. The recent spasms and convulsions of EU member governments has accomplished nothing except prove that the EU's governance process couldn't hold together a neighborhood book club. The absence of action by elected officials has led many to urge that the European Central Bank monetize the EU's sovereign debt by buying it up. But the ECB, hewing to its charter purpose of maintaining price stability, has only dipped a toe or two in the shark infested waters of the EU sovereign debt markets. Even as it buys a distressed nation's debt, it sells debt of stronger nations in order to keep the supply of Euros stable. This, however, doesn't monetize debt.

The Fed, by contrast, has promised with its currency swap program, to print dollars early, often and in bulk. The swap lines are priced to provide Black Friday discounts, except for the next 14 months. The Fed provides to other central banks dollars in exchange for Euros (or Canadian, British, Japanese or Swiss currency), with the other central bank obligated to return the dollars at the same exchange rate as existed when the swap was entered into. Thus, the Fed nominally has no risk.

Consider, however, what might happen when the Fed is dealing with the ECB. The latter won't print money; and consequently has available only so many Euros to swap with the Fed. If the ECB needs more dollars than it has Euros to offer in swap, it's out of luck under the currency swap program. But the Bernanke Fed is clearly hellbent on delivering liquidity, and the delivery process used would only be a technicality. If one process isn't enough, they'd use another. This is the approach the Fed took in the 2008-09 financial crisis, when it expanded the scope of its quantitative easing to buy mortgage-backed securities, commercial paper, business loans, car loans, and other consumer loans. Had the crisis worsened, the Fed probably would have bought the kitchen sink and Uncle Arnie's old lawnmower.

The Fed has its thumb in the European dike. Its currency swap program has bought a little time for Europe's politicians to get their act together. But let's be real. Even though the politicians fervently claim that they will now give the crisis their full attention, experience teaches that they will fail. The EU has a herd of cats dynamics, and true European fiscal discipline and reform is less likely than Bernie Madoff being paroled.

What if the ECB needs more dollars than the currency swap program could provide? This may be a possibility. European banks may experience yet more difficulty getting dollars to fund their dollar-denominated loans as the EU crisis metastasizes. To prevent a credit crunch, the Fed may decide that it would buy EU sovereign debt. The Fed has wide latitude to decide how to implement monetary policy. While buying sovereign debt denominated in a foreign currency would be a first, one suspects that the Fed would, as it has in the past, liberally interpret its mandate in order to do what it considers necessary.

Buying EU sovereign debt would set the Fed on the slippery slope. If there were losses, where would the losses land? (Hint: look in the mirror.) And what if the Fed's money printing were inflationary? Where would the burden of inflation land? (Hint: don't shift your gaze.)

Of course, high ranking government officials in the U.S. and Europe would decry such a scenario as preposterous. But consider that Europe is deadlocked in a death spiral. The politicians can't function and the ECB firmly believes it is legally precluded from monetizing the EU's sovereign debt. The one governmental body in the world that has the resources and willingness to step in is the Fed. Today's action takes the heat off Europe's politicians, if only momentarily. They will probably take it as an excuse to stall and delay instead of impose harsh conditions on all of their electorates (which would be austerity for the spendthrift nations and payment of the bailout costs by the wealthier nations). They'd probably figure they could get away with inaction because the Fed would surely step in with more moral hazard.

If the Fed monetized EU sovereign debt using dollars, that would likely signal the demise of the Euro, with the dollar substituting as Europe's common currency while European nations again issued local currencies. This was the way Europe worked in the 1940s, 50s and 60s. In such scenario now, the Euro bloc might be able to disentangle itself from the crisis, albeit painfully, without triggering a worldwide credit crunch. Maybe that's the Fed's secret plan.

The Fed's not above acting dramatically if quietly. We've recently discovered that it loaned over a trillion dollars to distressed banks during the 2008-09 financial crisis, far more than it had previously acknowledged. Ben Bernanke demonstrated that he would act when it looked like no one else could or would. The eyes of the world may again turn to him, and we shouldn't expect inaction.

Hidden Bargains

If you want a Black Friday bargain, you have to be ready to be pepper sprayed, horse collar tackled, and perhaps trampled a few times. There are easier ways to get bargains.

Business Laptops. If you're in the market for a laptop, look at less expensive business models. Unlike laptops specifically aimed at consumers, business laptops are designed for heavy duty use, careless handling (it's the company's property, after all), and enough longevity that sales reps can convince corporate buyers the equipment is cost effective. Many business laptops are shock and spill resistant. They are often preloaded with good quality software. This, all for a price in the $500 to $700 range. Business laptops don't come in pastel colors, and are heavier than personal laptops (the additional ruggedness adds weight). But a well-made one delivers good value for the dollar.

Prepaid Cell Phone Plans. Prepaid plans give you direct feedback about your usage, by forcing you to buy more time when you're running low. These periodic demands for money teach you how much your yacking actually costs. You learn to reduce this negative feedback by controlling phone usage. You save by not paying for time you don't use.

Balanced Investing. A portfolio that's about 50% stocks and 50% bonds offers comparative stability in returns (see http://www.cnbc.com/id/45454073). Investors who enjoy stable returns are less tempted to trade, incur lower transactions costs, and face less of the volatility that tempts one to buy high and sell low. By reducing these negative factors, balanced portfolios can deliver good long term returns.

Renovated Homes. It's axiomatic among real estate professionals that home renovations, with rare exceptions, boost the value of a house less than 100 cents on the dollar cost of the renovations. This necessarily means a recently renovated home is a comparative bargain for the buyer who carefully researches prices and figures out where the actual market price is. A home that was renovated in the past year or two has a good chance of being a bargain. One that was renovated five or ten years ago may have appreciated enough that buyers don't really get a discount from the renovations (depending on the market). A beat up, water damaged foreclosure sale may a good deal. But so may be a sparkling recently renovated home. Do your research.

Year Old New Cars. Cars on a dealer's lot that are brand new, but one model year old can be an excellent bargain. The dealer will seriously discount them (sometimes with a quiet subsidy from the manufacturer) in order to make room for current year models. Year old new cars can be a better bargain than year old used cars, because they have no mileage but sometimes sell for not much more than a used car with 10,000 miles. Buying what the seller doesn't want is a good way to get a bargain.

The EU Sovereign Debt Crisis: Skipping a Few Dominos

A hooded figure of Death appeared at the Euro's door today, scythe in hand, beckoning insistently. Germany held an auction of 6 billion Euros worth of 10-year bonds (called "bunds") and sold only 60% of it. The German central bank, the Bundesbank, bought the rest. But that's like your right hand buying from your left hand. The German auction was catastrophically bad. And, who knows, the Federal Reserve may have contributed to the shortfall, by subtly putting pressure on U.S. banks to trim their Euro-denominated exposure (see http://blogger.uncleleosden.com/2011/11/sovereign-debt-crisis-skipping-few.html).

By contrast, the U.S. Treasury Department today sold $29 billion of 7-year Treasury notes, receiving three times as much in bids as it was offering (or close to $100 billion in bids). Even though the U.S. may be approaching another credit rating downgrade, the greenback remains a sturdy oak in a forest of blighted trees.

That the German bund auction went so badly means the European sovereign debt crisis is fastfowarding more rapidly than anyone anticipated. Next to topple were supposed to be Italy, Spain, France, Belgium, and Austria. Then, the Netherlands, Finland and Luxembourg would be at risk. But Germany was seen as the last bastion of stability, the wealthy uncle who could save the family if disaster struck. Indeed, the latest concept being proposed for salvation, the Eurobond that was to be backed on the entire EU, would be feasible only if Germany's creditworthiness was beyond question. That's no longer true. If Germany can sell only 60% of a bund auction, how could the EU as a whole sell a Eurobond auction?

The sovereign debt crisis has skipped the intermediate dominos and smashed directly into Germany. The German government continues its opposition to Eurobonds. At this point, that may be irrelevant because the viability of the Eurobond has been called into question. One naturally asks what else might be on the table. That's the really scary part. There is no Plan B. Germany has always been the fallback, the backup, and the backup to the backup. After Germany there's no one, not the IMF, not America, not China, not Russia and not Brazil.

The EU sovereign debt crisis is now proceeding at warp speed. That doesn't mean collapse is imminent. Experience teaches that the financial markets hear what they want to hear and need only one or two rosy press releases from prominent government officials to stage a relief rally. Time and time again, that's the way the EU has kicked the can down the road and avoided the moment of truth. But the EU's principal tactic has been to substitute new debt for old debt, offering promises to replace the promises that this member nation or that couldn't keep. Actual transfers of wealth to reduce debt doesn't seem to be on the agenda. But this paper-for-paper game keeps expanding the amounts of debt outstanding, and investors will eventually tire of playing (as they did with the German bund auction today). When that happens, the Grim Reaper will be waiting to collect his due.

The EU Sovereign Debt Crisis: A Farewell to Globalization?

Today, the Federal Reserve announced a new round of stress tests for the six largest American banks to find out how well they would withstand a market discombobulation emanating from the EU sovereign debt crisis. Translated from regulatory speak to plain English, this is a strong hint to the big banks that they straightaway ditch as much of their EU exposure as they possibly can, devil take the hindmost. Those banks that don't move with alacrity will be required to boost capital levels, an exercise detested by bonus loving bank executives (which would be about all of them).

It is ironic that the Fed would try to quietly build a firewall around the U.S. banking system. It has preached internationalism throughout the past four years as the financial markets belly flopped, and maintains generous dollar-denominated lines of credit to foreign central banks. The latter measure helps the dollar fulfill its role as the world's reserve currency, ensuring that there are enough dollars for the wheels of commerce. But encouraging major U.S. banks to offload Euro-denominated obligations de-globalizes. In effect, the Fed is saying, "Lafayette, nous allons partir."

Euro-denominated investments will face downward price pressure if U.S. banks begin casting them away. The Fed surely knows this would be bad for the EU's banking system, which is desperately reaching for any lifeline in turbulent seas. One can't help but wonder whether the Fed has concluded that the EU may not be able to pull itself out of its nosedive.

Why the Congressional Supercommittee Can't Reach a Budget Deal

Today, news services report that the Congressional supercommittee tasked with the responsibility for reaching a $1.2 trillion budget deficit reduction deal has a snowball's chance in a convection oven of success. That's really not surprising. Even though last summer's debt ceiling debacle taught every member of Congress that fooling around with the federal government's financial standing is reckless, the problem is that the American electorate doesn't want a deal. We have a Democratic President and Senate, and a Republican House. We want fiscal stimulus to combat with the nation's economic woes, but we also want fiscal conservatism to constrain long term debt growth. In other words, we want to have it both ways. That's not how to reach the compromises needed for a deficit deal. That's a formula for failure.

Look at California. The Golden State is the home of the no new taxes movement. In 1978, an amendment to the California Constitution severely limiting real estate taxes was approved by the state's voters in a referendum called Proposition 13. The antitax sentiment that propelled Proposition 13 to success set down deep roots in the state, and today California is a fiscal mess. Voters want good public services and schools. But they don't want to pay for them. To accommodate voters that want to have it both ways, California's state and local governments made fools of themselves with budgetary and borrowing shenanigans that accomplished little except kick the can down the road while schools and other public services deteriorated. Everyone--voters, politicians, public sector unions, and government employees--are to blame. There's no meaningful solution in sight. California has governmental gridlock that makes the federal government look somewhat functional even on bad days.

California, first in so many trends, will be America's fiscal future, unless we make up our minds to grow up. We have to pay for what we want, which could mean raising taxes. We also have to live within our means, which could mean cutting back on federal expenditures. We have to elect a government that can and will make decisions. But today, in Washington and across the nation, we are a house divided. That does not portend well for the future.

Of course, if there is no debt deal and the financial markets panic, all eyes will turn toward the Federal Reserve. This moment, if it occurs, will reveal the fallacy in the Federal Reserve's policy of endless accommodation. Because the Fed has been there when everything else failed, everyone now assumes that the Fed will always be there for us. Neither Congress nor the President have the incentive to actually do anything. Doing things in Washington necessarily means you will make enemies. And elected politicians always prefer to avoid making enemies. So it's better to do nothing and wait for the appointed officials and career civil servants at the Fed bail us out, because we know they will try. Of course, a few disheveled Cassandras foam at the mouth about moral hazard and the limitations of monetary policy. But ebullient pronouncements by inflation doves on the Federal Reserve Board allow the rest of the government to hear what it wants to hear and rationalize inaction. So Washington bubbles along, believing six impossible things before breakfast, and peering through the looking glass for the imminent arrival of prosperity that won't cost us anything.