The Biggest Scandal to Hit In Years...

School for Scandal:

Why Even a Scandal Can Help Certain Currencies

Good Day Currency Traders!

It seems no person, company, city - or even entire country - can protect themselves from investment bankers' creative investment solutions.

Yesterday morning, Telegraph broke the story that Italian authorities are now on the hook for an astonishing €35 billion (US$48.1 billion), thanks to some bad bond loans that took out with investment heavyweights like Deutsche Bank, JP Morgan Chase, and UBS, among others.

Italian authorities had no idea what hit them (or so they claim). They took out the bonds in the ‘90s to pay for some public spending. They never expected to lose so significantly on the derivatives contracts with these major investment banks.

Now Italian police are investigating the banks. They're throwing around words like "possible legal action." They're saying this could be the biggest scandal to hit Italy in years.

But as usual, this scandal is just another bit of relative news in the currency markets. In other words, this scandal is hurting several currencies and boosting another currency by comparison.

Front and center this morning, the dollar has stolen back gains from both the Swiss franc and the euro. The euro was sitting at 1.34 this morning, and the Swiss franc has taken a tumble too...

So, what's the reason behind this move? Two words: bond scandal.

This bond scandal will cause Italy to lose large sums of money. Some major banks like Deutsche Bank and UBS are right smack-dab in the middle of the investigations.

Deutsche Bank is located in the Eurozone, while UBS is in Switzerland, so you can imagine why the Swiss franc and euro are dropping. There are other banks like JP Morgan Chase reportedly involved, but the majority of the problems reside in Europe.
Investment Houses Gambled and Italy Lost

The crux of the scandal goes back to the investment houses.

Investment bankers, many based in London, spotted a major opportunity in the 1990s. Italian cities and regions wanted to borrow money.

To avoid ballooning debt, the central government required local authorities to put away a percentage of the loan every year in a "sinking fund" so they would be able to repay the full sum when the debt was due.

Investment banks offered to manage the sinking funds. While the funds initially had to be invested in Italian government bonds, the criteria were widened to include other government debt within the European Union.

This could include debt from countries seen as more likely to default, such as Greece, as long as it was triple-A rated.

The banks took a fee to manage the sinking funds. They argued to the Italian authorities that as well as saving the money to repay their initial loan, they might also make some money from the investments. Many did when the global economy was booming.
Authorities Didn't Know What Was Coming?

All of the contracts were different. But critics have said some contained a "sting" which the Italian authorities did not properly understand.

The local authorities only earned a return on the money they put aside, but, in reality, their total loan was at risk; the banks could invest all of the money the authority had borrowed through bonds.

If everything went well, the bank would pay a return based on the incremental amounts the local authority was putting into the sinking fund, and keep the rest as profit.

If things went badly, it was the local authority, which would have to pay for the loss, and then also have to pay off the bond when it became due.

And that, my friends, is what the issue is now. As you can imagine, things have not gone well, and the local Italian authorities (like cities) are left holding the bag, and they have no way of paying this debt! It's a remake of The Italian Job.

Also, a Japanese Bank (Nomura) was involved in this mess. This is the first time any Japanese Bank has been involved in the mortgage bond meltdown. This could be why the Japanese yen has seen a removal from terra firma the past couple of days.
Greenback is Loving This Scandal

The dollar is loving this scandal.

Of course, there's still a bit of euphoria surrounding the dollar from the Obama-bounce that I told you about yesterday. It seems every time the President-elect goes on TV to discuss his "stimulus plan," the "bounce" just becomes more pronounced in the markets.

There's a lot of euphoria being built up for this plan. I'm still concerned about exactly how large this stimulus plan will be once lawmakers get their hands on it. Any further spending just adds to our National Debt, folks. And that, in a nutshell, is a BIG problem for me.

The euphoria is spilling over to the risk takers, as I explained yesterday. The Big Winner yesterday was the Brazilian real, which made a full six-figure move higher, followed by a full eight figure move higher.

The real still has a long way to go, to climb to last summer's levels. But, Shoot Rudy! Why throw cold water on this move? A 14-move higher is better than 14 figures lower.

Speaking of Scandals - Madoff Is Still in the Hot Seat

Have you been following this Madoff stuff? I hear lawmakers are going to grill the SEC next. Ridiculous! As if the lawmakers could have figured out what Madoff was up to if they were the SEC! But, it's interesting anyway.

The thing that ticks me off about the Madoff meltdown is that his people pulled the wool over the SEC's eyes, even though the SEC made eight probes in the past
16 years.

Other lawmakers expressed concern about the SEC itself and whether it should even exist. Rep. Ron Paul, R-Texas, said he believes Congress should eliminate the agency, which he argued gave investors a false sense of security about Madoff and other problematic investment vehicles. "Investors should be self-reliant," Paul said.

Individual investors...companies...authorities that have control of government money - perhaps that "self-reliant" adage applies to everyone. Just ask the authorities in Milan.

That's it for today!