Brexit and the Derivatives Time Bomb

This piece first appeared at Web of Debt. Sovereign debt – the debt of national governments – has ballooned from $80 trillion to $100 trillion just since 2008. Squeezed governments have been driven to radical austerity measures, privatizing public assets, slashing public services, and downsizing work forces in a futile attempt to balance national budgets. But the debt overhang just continues to grow. Austerity has been pushed to the limit and hasn’t worked. But default or renegotiating the debt seems to be off the table. Why? According to a June 25^th article by Graham Summers on ZeroHedge:

. . . EVERY move the Central Banks have made post-2009 has been aimed at avoiding debt restructuring or defaults in the bond markets. Why does Greece, a country that represents less than 2% of EU GDP, continue to receive bailouts instead of just defaulting?

Summers’ answer – derivatives:

[G]lobal leverage has exploded to record highs, with the sovereign bond bubble now a staggering $100 trillion in size. To top it off, over $10 trillion of this is sporting negative yields in nominal terms. . . . Globally, over $500 trillion in derivatives trade [is] based on bond yields.

But Brexit changes everything, says Summers. Until now, the EU has been able to reject debt forgiveness as an alternative, using the threat of financial Armageddon if the debtor country left the EU. But Britain has left, and Armageddon hasn’t hit. Other Eurozone nations can now threaten to do the same if they don’t get debt forgiveness or a restructuring.

The First Domino – Italy

That has evidently started happening, with Italy as the first challenger of EU rules. On June 27^th, Ambrose Evans-Pritchard reported in the UK Telegraph that the first serious casualty of the Brexit contagion had struck. The Italian government is preparing a €40 billion rescue of its financial system, as Italian bank shares collapse. The government is now studying a direct state recapitalization of Italian banks, to be funded by a special bond issue. They also want a moratorium of the bail-in rules and bondholder write-downs, although those steps are prohibited under EU laws. According to a June 28^th editorial on ZeroHedge titled “The First Casualty of Brexit”:

The likely outcome is that Italy’s [prime minister] Renzi will be “forced” to take matters into his own hands and enact a unilateral sovereign rescue of the Italian banking system in defiance of the EU, unless he wins concessions soon from Brussels. Those who know him say he will not go down in flames for the sake of European ideological purity. As a result, Brexit will be just the scapegoat used by Renzi and Italy to circumvent any specific eurozone prohibitions. And if it fails, all Renzi has to do is hint at a referendum of his own. Then watch as Merkel scrambles to allow Italy to do whatever it wants, just to avoid the humiliation of a potential “Italeave.”

Behind the Italian Collapse: Brexit or Bail-ins?

The ZeroHedge editorial questions whether Brexit was actually the cause of the Italian collapse. The banks were already in serious trouble. A good crisis was just needed so that EU rules could be suspended without admitting they were unworkable all along; and Brexit fit the bill. But the real trigger of the collapse seems to have been the bail-in scheme implemented in January 2016. According to ZeroHedge:

The new bail-in reform this year has brought matters to a head, catching EU authorities off guard. It was intended to protect taxpayers by ensuring that creditors suffered major losses first if the bank gets into trouble, but was badly designed and has led to a flight from bank shares. The Bank of Italy has called for a complete overhaul of the bail-in rules. . . . The banking squeeze has become politically explosive in Italy after thousands of small depositors were wiped out at four regional banks late last year. They were classified as junior bondholders even though most of them were just ordinary savers who did not realize what was being done with their money.

The bail-in scheme was supposed to shift losses from governments to bank creditors and depositors, but it has served instead to scare off depositors and investors, making shaky banks even shakier. On top of that, heightened capital requirements have made it practically impossible for Italian banks to raise capital. According to Lorenzo Cordogno, former director general of the Italian Treasury, the result has been that the ECB is “unwittingly destabilizing the banks in an overzealous attempt to make Europe’s banks safer.” But EU rules have been flexible in “emergencies.” Before the Eurozone debt crisis of 2011-12, the European Central Bank was forbidden to buy sovereign debt. Then Greece and other southern European countries got into serious trouble, sending bond yields (interest rates) through the roof. But default or debt restructuring was not considered an option. The ECB finally got on the quantitative easing bandwagon and is now buying government debt along with other financial assets at the rate of €80 billion per month. According to Evans-Pritchard, Brexit has not yet caused serious trouble in the debt markets, because this new QE policy has allowed the ECB to cap bond yields. Rather than deal with a very awkward Italeave, the EU could cave on its bail-in and bailout rules as well.

Time for a Reset

That may get Italy out of the woods, but the system is clearly broken. A $500 trillion derivatives time bomb poised atop a $100 trillion mountain of debt is not a stable situation. It’s time to push the reset button, but how? Bailouts and bail-ins have been tried and proved wanting. But a debt “jubilee” – simply canceling the debt – would devastate creditors and collapse the massive derivatives bubble. All else having failed, it may be time to do what should have been done all along: convert “sovereign debt” into “sovereign money.” The “event of default” triggering a derivatives meltdown can be avoided by simply paying the debts with money issued by the government. Your support matters…

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