Wednesday, August 14, 2013

The FED's Backdoor Bailout of Munis

Euro banks are pretty stupid. The latest example is that it has come out that EU banks were gorging on US muni debt. The reason for it is the search for yield in our ZIRP world. The cover for it is an EU loophole that allows the banks to invest in high yield risky muni debt as long as the muni is in a high rated sovereign. These investments do not require high capital ratios per the rules. Commerzbank supposedly has huge losses on Detroit. Who is the enabler of this? The FED. The FED and the USG have a motive: keep the muni and state governments rolling to delay the budget doomsday. Let's review this sewer system.

1. The FED prints money and pushes reserves into banks. The banks that have received this big push of QE 2 + QE 3 cash have been foreign banks operating in the US.
2. These euro-banks that should be insolvent due to their low capital ratios and bad PIIGS, US subprime, Euro subprime and subprime consumer loans are salvaged by the cash as reserves, then lever up through higher risk assets to attempt to earn their way out of their problem.
3. US Municipal debt in 2010 would have faced a day of reckoning in the next 12 months, per Meredith Whitney's calculations, due to budget problems and debt servicing issues in the area of "hundreds of billions".
4. The foreign banks have been buying US muni debt, especially high yielding risky muni debt, to earn more of a spread over ZIRP.

FED gives cash to foreign banks. Foreign banks use cash to then buy US Muni debt. Backdoor state and municipal interest rate subsidization and bailout. Lowest yields in '12 in nearly 50 years. Check the charts. As foreign cash rose starting at the beginning of 2011 (QE 2), muni bond yields dropped after a spike near the end of 2010. The FED rolled MBS to take care of mortgages, used QE to buy what they legally could of US Treasuries to bend the long end, and subsidized US municipal debt with the foreign bank shenanigans because the FED is explicitly prevented from doing it directly by law. State and muni goverments win by pushing off their problems, the euro banks win by collecting fat premiums from "safe" high yield fixed income assets, and the FED wins by maintaining the status quo.

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