A bankers dream: Subsidies and bailouts

During the recent bubble in real estate in Spain, banks amassed a nice gargantuan sum of loans (created more or less ex nihilo through the fractional banking process) which are now not worth their carrying value.
To match their balance sheets with reality, they are forced to write these assets at market value. This will mean a massive balance sheet contraction and a subsequent unwillingness of banks to further expand credit due to losses, and a weak economic outlook forces them to retrench without additional credit demand.
According to business.hr, Spanish banks need 65 billion euros of fresh capital.:

“Eurozone finance ministers agreed on Saturday that the Spanish government needs to borrow up to 100 billion euros to help banks after the bursting bubble in real estate markets and banks have problems with uncollectible loans.”

Well, this is what happens when you try to short circuit the wealth generation problem through credit expansion. Interest rates shoot up to signal a shortage of available savings to complete the initiated projects and the asset side of the balance sheet contracts. Gee, I wonder where the money is going to come from? Savings? Future taxes? Credit expansion?
Its really unbelievable that even after the crash, politicians are still fixated on generating overall aggregate demand to offset the credit collapse. They are fixing a debt issue with more debt. Brilliant. And after the banks receive this cash, just as they did with LTRO and LTRO II, where are they going to use thus liquidity? To increase loaning out to business ventures. I doubt it. They will use these funds to offset their loan losses and add to their loss provisions.
Certainly, they will pay no taxes in the immediate future, thanks to the tax carry forward loss.  Lavish bonuses will be paid and everything will look fine until the bill is due once more and the loan has to be rolled over at an even higher yield.
The ring-around-the rosy continues.

Common economic sense

 

I’ve decided to post an interesting cartoon that may escape the most literate mainstream economist of our day – the simple truths are the ones that evade us the most.

Straight from the Circle Bastiat, a glimpse into the puzzling world of “why does GM manufacture cars that nobody wants”. Enjoy.

Hedging vs. asymmetric hedging

 

Due to the large viewership of the blog post titled A short explanation on J.P. Morgan’s Derivatives Loss, I have decided to delve a little deeper and explain the difference between hedging and a strange phrase dubbed asymmetric hedging.

Jamie Dimon, CEO of J.P. Morgan Chase Corp., has attributed the recent massive losses due to asymmetric hedges the firm took. These losses were revealed in advance and ahead of the Q1 earnings report. What is interesting is the manner that the CEO described the loss, calling it a hedge gone wrong.

Now, to reiterate, to hedge means, to offset. An example would be to go long in an interest rate swap contract, in which J.P. Morgan pays a fixed rate of 500 basis points + spread between a AAA corporate bond and the 10 year Treasury security and receives 500 basis points + LIBOR. The transaction is settled quarterly and netted. This means that if at the settlement date, LIBOR is higher than the 10-year spread, J.P. Morgan, receives the interest difference between the two. This discrepancy is usually based on historical returns and current market fluctuations. In this case, the cash flows usually cancel each other out.

Now, in an asymmetric hedge, an example would be as follows: J.P Morgan would agree on a swap that includes paying 500 basis points + LIBOR and receives 500 basis points + the return on a thinly traded security or index. Now, in this case, the probability of small netted returns and cash flow netting is smaller, than in the previous example.

If for example, the thinly traded index fell 40% at the settlement date, J.P. Morgan would not only pay its cash flow, but the difference in the index between the two dates as well. It would have to book a massive loss for doing so.

That is an “asymmetric” hedge. Using leverage compounds the loss, and offsetting the position can also be very costly if the ongoing fundamentals for the swap is negative for J.P. Morgan.

The example doesn’t even resemble a classic hedge, but rather a speculative position. Even if J.P. claims that is making a market and offsets the position with its client through the hedge, seeking asymmetry is more something a hedge funds would do.