How and Why a Spanish Default Would Trigger an Epic Financial Meltdown
November 21st, 2012
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.