My Mortgage Blog

“Volatility” is Wall Street’s favorite term for losing your shirt. Volatility means down and up and down and up, a transient emotional upset.
     
That’s not what this is.
     
The Dow set one of its highs since the Great Recession began, on July 21 at 12,724. That was the same day that Europe announced its newest effort to save itself. On the next day the plan was exposed as a sham, and the Dow has since unraveled not quite 2,000 points. That is not “volatility.”
     
In the same span, the 10-year T-note has fallen almost one full percent, and almost broken 2.00% for the first time since 1950. That is not an investment. That is cash running to mattresses.
     
Only a minor portion of this trading traces to faltering recovery here. This is Europe.
     
The most immediate and fatal hazard in Europe, growing all week long: its banks and the European Central Bank itself are packed with sovereign bonds not worth face value. Exactly as the Great Freeze in July 2007, the financial system ceases to function when nobody knows what collateral is worth. We take collateral for loans in assurance that we can sell it if we have to, and make ourselves whole, or mostly so.
     
The sovereign debt problem inside European banks takes two forms. First is the mass of government bonds on their balance sheets as long-term holdings. In the mysterious world of bank capital, none is required to back up holdings of sovereign bonds because we all know that they will not default. (Not a joke.) Unlike any other loan on bank books, any loss on sovereign bonds is a hit to capital required to support other loans. The risk to these bonds today comes in either outright default (missed payment), or currency risk (payment in New Drachmas). Bank imploders.
     
The second risk is worse. Banks everywhere are linked by loans to each other, backed by collateral. The best collateral: government bonds. Today, every bank in Europe knows that every counter-party bank is impaired to one degree or another, and every one is studying the prospect of fire-selling semi-phony collateral into a market with only one buyer: the European Central Bank.
     
The ECB is exposed to nearly $500 billion of Greek debt alone, holdings of bonds bought to support a crashing market, and a great deal more held as collateral against cash hosed into banks, replenishing runs on each other. The ECB began two weeks ago to buy Spanish and Italian bonds when those markets began to crash, and to take French bonds with them. Jean Claude Trichet, a true believer in the European experiment, has executed these policies over the violent objections of Germany, the only country in the zone strong enough to back the ECB’s central bank fiction.
     
The inherent, structural weakness of the ECB is the source of this week’s panicked trading. Faith in all central banks rests on national capacity to pay taxes, and upon faith itself. The euro-currency zone has no taxpayers, just 17 parliaments with disparate and contradictory interests. The ECB rests on faith alone. If the zone is unable to find sound financial footing, and soon (as PIMCO’s El-Erian said, “Weeks and days, not years and months”), then the world will have to deal with the bankruptcy of the ECB.
     
Even if it comes to that, or any number of other European disaster permutations, in the US we are likely to be okay. We are less dependent on exports than anybody. As commodity prices collapse, inflation here will disappear. It will be easy to sell Treasurys for a long time, and we have a lot to sell.
     
Take all of that to the mortgage markets... at any authentic European salvation, the 10-year and mortgages will run up, and fast. Even the Fed’s two-year sorta-promise to stay at zero will not hold us here.
     
And as it is, our markets are frustrating borrowers. Only a handful of giant securitizer-wholesalers survive, and they are raising margins, not passing through all of the market gains. That situation will improve the longer we stay on Europe-watch, but see above: any European rescue, and this record-low episode will conclude.