How Spanish Debt Default Would Trigger an Epic Financial Crash
Interest-Rates / Eurozone Debt Crisis Nov 22, 2012 - 08:59 AM GMTBy: Graham_Summers
Over the last week I’ve introduced the concept of collateral: the little known basis for the entire financial system. We’ve also addressed why any EU sovereign default would bring about an epic meltdown as EU bonds, particularly those of Spain and Italy are the collateral underlying hundreds of trillions of Euros worth of trades for EU banks.
Again, the most important issue for the financial system is the search for high quality collateral.
Indeed, it is the search for high grade collateral that has caused such periodic spikes in Treasuries, German Bunds, French sovereign bonds, and Japanese bonds (all of these have yielded 0% or even negative yields in the last five years). Big banks are moving away from PIIGS bonds into safer havens.
This is also why the Fed isn’t touching Treasuries with QE3 and why it won’t touch short-term Treasuries with Operation Twist 2 (this program sees the Fed selling short-term Treasuries to buy long-term Treasuries): the Fed wants to keep as much good quality collateral in the system as possible (long-term Treasuries are problematic because institutions know it’s highly likely the US will default within the next 30 years).
However, even this move is problematic because much of the Treasury market is locked up with governments both foreign and domestic.
| Total US Sovereign Debt | $16 trillion |
| Foreign Nation holdings | $5 trillion |
| Intergovernmental holdings | $4.8 trillion |
| US Federal Reserve | $1.5 trillion |
| Remaining | $4.7 trillion |
Again, this is why clearinghouses (which oversee the derivatives markets) are now allowing Gold as collateral: they know that eventually sovereign bonds will be worth less or even worthless. And they want access to their clients’ Gold for when this happens.
With that in mind, the countries that will ultimately be considered safe havens when the BIG collapse starts are those with the largest Gold reserves.
| Country | Gold Holdings | % of Foreign Reserves in Gold |
| The US | 8,133 tonnes | 75.1% |
| Germany | 3,395 tonnes | 71.9% |
| Italy | 2,451 tonnes | 71.3% |
| France | 2,435 tonnes | 71.6% |
| China | 1,054 tonnes | 1.6% |
| Switzerland | 1,040 tonnes | 14.2% |
| Russia | 918 tonnes | 9.2% |
| Japan | 765 tonnes | 3.1% |
| Netherlands | 612 tonnes | 60.2% |
| India | 557 tonnes | 9.8% |
I’m not going to get into the issue of whether this Gold exists still (many commentators claim that Central Banks have in fact sold much of this) as I have no way of proving it. The key issue is that the financial elite are now trying to get their hands on Gold as collateral because they realize that sovereign paper based collateral from the EU will soon be worth much less or even worthless.
It is no coincidence that Germany floated the idea of accepting other EU nation’s Gold in exchanged for bailouts back in May 2012 when Europe teetered on the brink of collapse:
Europe’s debtors must pawn their gold for Eurobond Redemption
Southern Europe’s debtor states must pledge their gold reserves and national treasure as collateral under a €2.3 trillion stabilisation plan gaining momentum in Germany.
The German scheme — known as the European Redemption Pact — offers a form of “Eurobonds Lite” that can be squared with the German constitution and breaks the political logjam. It is a highly creative way out of the debt crisis, but is not a soft option for Italy, Spain, Portugal, and other states in trouble.
http://www.telegraph.co.uk/finance/financialcrisis/9298180/Europes-debtors-must-pawn-their-gold-for-Eurobond-Redemption.html
It’s also not coincidental that Germany is performing an audit of its Gold holdings today, either.
Bundesbank Says NY Fed to Help Meet Gold Audit Request
The Bundesbank said the Federal Reserve Bank of New York will help it meet auditing requirements related to its gold reserves that were demanded by Germany’s Audit Court.
“We have been in discussions with the Federal Reserve Bank of New York about the Bundesbank’s holdings of gold,” the Bundesbank said yesterday in a letter to the German parliament’s budget committee. “The discussions have been fruitful and the Federal Reserve has expressed a commitment to work with the Bundesbank to explore ways to address the audit observations, consistent with its own security and control processes and logistical constraints.”
The agreement is part of a compromise between the German central bank and the Audit Court, which has called on the Bundesbank to take stock of its gold holdings outside Germany, saying it has never verified their existence.
The Bundesbank distributed the letter to reporters after board member Carl-Ludwig Thiele and the Audit Court’s head Dieter Engels testified to budget committee lawmakers in the lower house of parliament in Berlin.
http://www.bloomberg.com/news/2012-10-25/new-york-fed-to-help-bundesbank-meet-gold-audit-requirements.html
I realize that the last few essays have been pretty dense. So I’ll summate everything here:
1) The #1 issue for the financial world is too little quality collateral backing too many trades.
2) The search for good collateral has lead investors to seek high grade sovereign bonds (Treasuries, German bunds, French bonds, Japanese bonds) as a safe haven between 2008-the present.
3) The folks who monitor the derivatives market (the large clearing houses) realize that sovereign bonds are not going to be a safe haven for much longer and so are looking at Gold as a new form of collateral for trades (this has NEVER been the case before).
4) Germany and other nations will be increasingly looking to audit and accumulate their Gold holdings.
Keep all of this in mind at all times going forward. This is the BIG picture for the financial world.
This is why I’ve been warning that 2008 was just the warm-up. What is coming will be far far worse: the collateral crunch that will ensue when Spain or Italy defaults (they have €1.78 trillion and €1.87 trillion in external debt respectively) will be absolutely massive. At a minimum it will be multiples of times larger than what followed Lehman’s bankruptcy.
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Graham Sumers
Chief Market Strategist
Good Investing!
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Graham also writes Private Wealth Advisory, a monthly investment advisory focusing on the most lucrative investment opportunities the financial markets have to offer. Graham understands the big picture from both a macro-economic and capital in/outflow perspective. He translates his understanding into finding trends and undervalued investment opportunities months before the markets catch on: the Private Wealth Advisory portfolio has outperformed the S&P 500 three of the last five years, including a 7% return in 2008 vs. a 37% loss for the S&P 500.
Previously, Graham worked as a Senior Financial Analyst covering global markets for several investment firms in the Mid-Atlantic region. He’s lived and performed research in Europe, Asia, the Middle East, and the United States.
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