Thursday, May 31, 2012

A New Government Created Debt Bomb

US and European regulators are essentially forcing banks to buy up their own government's debt—a move that could end up making the debt crisis even worse, a Citigroup analysis says, reports Jeff Cox at NetNet.

Cox goes on:
Regulators are allowing banks to escape counting their country's debt against capital requirements and loosening other rules to create a steady market for government bonds, the study says.

While that helps governments issue more and more debt, the strategy could ultimately explode if the governments are unable to make the bond payments, leaving the banks with billions of toxic debt, says Citigroup strategist Hans Lorenzen.

"Captive bank demand can buy time and can help keep domestic yields low," Lorenzen wrote in an analysis for clients. "However, the distortions that build up over time can sow the seeds of an even bigger crisis, if the time bought isn't used very prudently."

"Specifically," Lorenzen adds, "having banks loaded up with domestic sovereign debt will only increase the domestic fallout if the sovereign ultimately reneges on its obligations."

The banks, though, are caught in a "great repression" trap from which they cannot escape.

"When subjected to the mix of carrot and stick by policymakers...then everything else equal, we believe banks will keep buying," Lorenzen said.
This, btw, is one of the problems that I pointed out exists with the Volcker rule, when I wrote:
Bottom line, what the Volcker Rule does is drive banking from the private sector and toward the government sector. Thus, this rule, rather than limiting credit, simply pushes banks to use funds to invest in and provide more liquidity for the government sector.


  1. It should be a lesson to people who constantly parrot that government bond funds are "safe" asset classes. In the end, none of the banks own government bonds, they rent them. They hold them on their books for the sole purpose of using them as collateral to leverage off of. And banks do this because governments allow them to leverage as long as the banks in turn purchase new issues of debt.

    The banks, to the extent they can, will attempt to push these bonds onto others in the finance community: pension funds, hedge funds, corporations, and retail investors. When there's no a bigger sucker left, the banks are screwed.

    Allowing banks to not count government debt as part of their leverage ratios doesn't change the reality of the situation. If the leveraging instrument falls in value, "regulatory requirements" are not going to matter. But preserving the price of the government bonds was what QEII and Operation Twist were all about. QEIII is all but guaranteed at this point

  2. This is basically a financial modeller's worst nightmare. How do you represent a positive outcome for a financial move hinged on a plan that will ultimately turn out on the negative side of the equation?