Libor, ECB, Maine
David R. Kotok
July 30, 2012
Revelations continue regarding the Libor rate-rigging scandal. Investigations into documents are underway in several countries. News releases reveal the names of banking institutions that may have been involved. Individual’s names are starting to surface.
We expect this news flow to continue for many weeks. Prosecutions may follow, along with the certainty of civil liability claims. Our estimate is that every single basis point of alleged Libor rate-rigging results in a possible claim of, at least, $35 billion for each year it occurred. The estimates of total Libor-related instruments range from $350 trillion low to as much as $800 trillion high.
A guest commentary on Libor written by Joel Naroff now appears in the “Special Reports” section of Cumberland’s website (http://www.cumber.com/content/special/Libor%20a%20guest%20commentary%20by%20Joel%20Naroff.pdf). Joel has developed strong views, and articulates them well.
Meanwhile –and segue – at the end of last week, Libor moved off the front page, replaced by Mario Draghi and his colleagues at the European Central Bank (ECB). Draghi was very clear in making a prefatory comment before he resorted to the words “whatever it takes.” He articulated his statement on the condition that all actions undertaken would have to be within the mandate and authorization of the ECB.
Markets ignored the prefatory comment. Celebrations in stock prices worldwide and a rally in sovereign debt markets ensued robustly. Many shorts were squeezed.
In the wake of the rally, the yield on Spanish sovereign debt is still at an unsustainably high level. The same is true for the debt yields of others, such as Italy and Portugal.
Cumberland Advisors continues to update eurozone credit spreads and yields weekly. They are on the website, www.cumber.com. Readers can find the slides in the contagion series at the bottom of the home page, or simply click here: http://www.cumber.com/content/misc/EU_Contagion.pdf.
The question for investors is tied to the capability of central banks to unilaterally solve the sovereign debt-related problems of these eurozone countries. We are skeptical. We think there is a difference between liquidity and solvency. Liquidity is already available globally in ample amounts.
The central banks of the world have driven the major interest rates to near zero. In the case of Europe, they could drive them a little lower, but not very much is left. They could provide additional excess reserves, which would quickly flow back into the central banks. They would do that by either buying or financing Europe’s junk sovereign debt.
In the US, the excess reserves already exceed a trillion dollars. If the Fed were to buy additional securities in the form of a QE3, the activity would result in higher excess reserves. If the Fed were to reduce the interest rate on excess reserves, it would not accomplish much. It would force behaviors that might be counterproductive; we don’t know.
What we do know is that worldwide experiences with the zero bound in interest rates are not universally positive. In fact, we can argue that they are decisively negative. For example, Japan has acquired massive sovereign debt and maintained near-zero interest rates for two decades. Have we seen any results in economic growth? The answer is no.
In the US, low interest rates are resulting in “financial repression.” While this has reduced borrowing costs for wannabe borrowers, it has also reduced interest earnings for savers. In our population, a very large cohort has now experienced a reduction in income due to the low interest rates obtainable on their savings. Is this a wise strategy? Only time will tell. Unintended consequences always reveal themselves on their own timetable.
Is it a sound strategy to force the elderly and the working savers to take on additional risk? How long do we sustain this position? Is the Federal Reserve policy of the zero short-term interest rate and a very low long-term interest rate (10-year treasury yield at 1.5%) the wisest of policies?
What if the Fed engaged in an additional Operation Twist? Would an extra quarter-point lowering of the home mortgage interest rate result in more housing activity? Is the mortgage interest rate preventing the purchase of a home by a wannabe buyer? Or is it the credit system that has tightened, so buyers cannot achieve creditworthiness in the eyes of lenders?
Some are not sure that the central bank policy of expanding balance sheets will do much good. Certainly, it hasn’t in Japan. It does not appear to have worked in the past and there is no reason to believe it will work in the future.
These policies seem to be very slow starters in the US. Perhaps more time is necessary to evaluate them. That may be. Or, perhaps, these policies are wrong?
Perhaps, in Europe, more expansion will give relief to profligate sovereign debtors whose unbalanced budgets and debt issuance continue to fund promises to pay social benefits. Or, perhaps, Europe is also headed in the wrong direction.
The solvency question suggests that those social benefits cannot be funded by the various countries’ economies, which are the presumed beneficiaries of ECB policy. When an economy is contracting, imposing more taxes and costs only exacerbates decline.
At the same time, if a country continues borrowing to fund social-payment promises it cannot afford, it only increases the debt-GDP ratio. Then, the ability to maintain the long-term payment streams that are promised to constituents is additionally impaired. I have just described half the members of the euro zone.
In Europe, the fundamental question remains, why should a German, Finnish, Dutch or Austrian worker take on credit risk to fund the retirement of a Greek who is able to retire 10 years earlier than the German?
Until the politicians level with their constituencies, the economies of Europe cannot grow. The situation, which is spiraling downward, will continue to do so, regardless of the sequential liquidity infusions of the ECB.
Cumberland Advisors is continuing to maintain a cash reserve. We do not think that the recent actions of the ECB are a permanent fix. We think it is a temporary measure, like other temporary measures. It was celebrated, by markets, as a relief rally. Note each sequential relief rally during this crisis has been smaller and shorter than the previous one.
In the coming few days, the annual gathering of finance and economic professionals will take place at Leen’s Lodge in Grand Lake Stream, ME. We are delighted to have Bloomberg TV’s Mike McKee in attendance on Friday. Other media representatives include Dow Jones News Service, the Wall Street Journal, and National Public Radio.
We look forward to some robust, vigorous discussion, debate, and dissection of US and worldwide economics and finances. We again look forward to the camaraderie among guests at this annual gathering. Reports from Leen’s Lodge will be plentiful, from journalists, TV personalities and yours truly.
This has been a fascinating week, with Libor and the ECB. The Fed is next. This incredible unfolding of financial history is taking place in the full media spotlight. In our view, we are rewriting the economics textbooks with an entirely new structure and learning along the way.
I’m looking forward to the debates and discussions in Maine this Friday.
David R. Kotok, Chairman and Chief Investment Officer