The Swiss Release the Kraken!

By John Mauldin

Jan 20, 2015

“Below the thunders of the upper deep,
Far far beneath in the abysmal sea,
His ancient, dreamless, uninvaded sleep
The Kraken sleepeth: faintest sunlights flee….

“There hath he lain for ages, and will lie
Battening upon huge sea-worms in his sleep,
Until the latter fire shall heat the deep;
Then once by man and angels to be seen,
In roaring he shall rise and on the surface die.”

– Alfred, Lord Tennyson, “The Kraken

"The exact contrary of what is generally believed is often the truth."

– Jean De La Bruyère

“Cry ‘Havoc!’ And let slip the dogs of war!”

– William Shakespeare, Julius Caesar, Act III, Scene I

“No mas!”

 – Roberto Duran to the referee at the end of his fight with Sugar Ray Leonard, 1980

If you want evidence that central bankers play by their own rules, regardless of what they say or what conventional wisdom tells us, last week’s action by the Swiss National Bank should pretty much fill the bill. My friend Anatole Kaletsky, in a CNBC interview not long after the announcement, quipped (with a completely straight face) that just as James Bond has a license to kill, central bankers have a license to lie.

Swiss National Bank Chairman Thomas Jordan had assured us just the week before that the Swiss would continue to “hold the peg” whereby the SNB kept the value of the Swiss franc from rising higher than €1.22. “The cap is absolutely central,” he said. And SNB Vice Chairman Jean-Pierre Danthine said publicly only last Monday that the peg would remain a cornerstone of Swiss banking policy.

Early Thursday morning the Swiss abandoned that policy. Much of the press coverage in the (largish) wake of their surprise move has focused on the costs to banks and hedge funds around the world, but you have to realize that serious pain is being felt in Switzerland itself. Every bank and business that held non-Swiss-franc debt or investments took an immediate 15–20%+ haircut on its holdings. Swiss investors lost at least 10% on investments in their own stock market and more on shares they held in other stock markets. Forty percent of Swiss exports go to the Eurozone, and the Swiss franc is now over 30% higher than it was five years ago – with almost half that movement coming in one day. Those exporters just got hammered.

And this was not a painless policy decision for the SNB. Citibank estimates the SNB’s losses to be close to 60 billion Swiss francs. Let’s try to add a little perspective on that. The US is (very) roughly 40 times the size of Switzerland in both GDP and population. At today’s conversion rate, the Swiss lost something like $70 billion if Citibank is right. That’s like the US Federal Reserve’s losing $2.8 trillion. That, my friends, will leave a red mark on any central bank’s balance sheet. Not that the Swiss can’t afford it or that they’re going to be out on the corner with a tin cup, but they do have a considerable quantity of euros that are now much less valuable. And dollars and yen and pounds and renminbi. But then again, they are in the privileged position of having a currency that the rest of the world wants, so much that in order to hold it you will have to take a haircut on your deposits at the SNB, a haircut that is going to increase (more on that later).

There are also serious losses in the international banking community. We are just now beginning to learn how many funds and brokerages will have to close.

Do you think that SNB Chairman Thomas Jordan will be going into the local restaurants and getting high-fives and fist bumps? Exactly what do you think his reception will be in Davos (where he is scheduled to appear)? Christine Lagarde, the managing director of the IMF, gave a somewhat frosty reply to my friend Steve Liesman at CNBC when he asked her only a few hours after Jordan’s move (in what was clearly an already-scheduled interview) about her thoughts on the surprise announcement. She was not amused, but she kept her professional stage smile in place. (It was a very good interview.)

In Norse mythology, the Kraken was a sea monster that attacked ships unaware. In Greek mythology, it was a pet sea monster (of either Hades or Zeus) that would be released upon enemies that annoyed its master. It has been an iconic figure in comics and movies for the last 30 years. “Release the Kraken!” is the standard line prior all hell breaking loose.

In an era when central bankers are supposed to be more open, collaborative, and communicative, what would make the Swiss National Bank decide to turn on a dime and shock the markets – to release the Kraken, as it were? Note that in fact all hell did break loose. Rather than delivering hints accompanied by a few well-placed leaks, the Swiss decided it would be best to completely surprise the markets. It will be a long time before we get the full story on what must have been going through their heads as they reached the decision.

I have spent the last few days reading a great deal and talking with friends, trying to understand the “why” of the suddenness of the Swiss action. If we can get some insight into this question, perhaps it will give us a few clues as to upcoming global central bank policy changes in general and the problems facing Europe in particular.

While I do fully intend to try to reduce the length of my letters this year, this one is going to be longer because it will contain a significant number of charts. We’ll look at the data that made Thomas Jordan and his team at the SNB throw in the towel on their peg policy, and I think we should look at it in depth. Just as Roberto Duran walked away from Sugar Ray Leonard at the end of the eighth round of their famous fight in 1980, telling the referee “No mas,” the SNB signaled that it had had all the pain it could deal with.
The First Casualty of the Currency Wars

My last book, Code Red, was all about the currency wars that I expect to dominate the latter part of this decade, triggered by Japan’s massive quantitative easing. Jonathan Tepper and I pointed out that, going forward, it is every central banker for himself.
While the world’s central bankers typically matriculated at the same schools and espouse the same beliefs, and while they regularly meet each other at conferences and BIS meetings and freely employ words like cooperation and collaboration in their dealings with one another, the reality is that they are all politically captive to the countries they serve.

While central bankers may espouse independence from their governments, they do live and work in their particular countries and are largely responsible for those countries’ economic well-being. They are going to do whatever they feel is necessary to help their governments and domestic businesses perform as well as they can, while trying to maintain the stability of their local currencies.

Japan is not going to cater to Korea with its monetary policy; neither is Indonesia really interested in helping Singapore or Malaysia; and countries like Switzerland and Sweden carve out their own paths on the flanks of the Eurozone. The US Federal Reserve has made clear on many occasions that it is not responsible for the policy decisions and outcomes of any other country. If you were the Swiss National Bank and looked at the following data, what would you do? The simple fact is that Europe and the Eurozone just don’t make sense; nor, given the recent Swiss action, do they seem to be pursuing the sorts of policies that would improve their condition.

It’s not just about deflation. Switzerland is experiencing deflation and yet has full employment, a balanced budget, and a positive trade balance. Germany, France, Austria, Belgium, the Netherlands, Finland, Sweden, and Denmark are all either in deflation or close to it.

Recent central bank policy has led to the anomaly of negative interest rates. Negative rates began to show up a few years ago and are now pervasive. I’m going to post close to a dozen charts from Bloomberg. You might want to save this letter so you can show it to your grandkids in 30 years when they complain about aberrant economic conditions and volatility. “Kids, you have no idea what we went through back in the mid-teens! It was way wacko back then.”

Each chart for a European country compares the yield curve from a month ago to today’s. As you can see, rates have moved strongly downward.

Note in the first chart that Switzerland’s 10-year yield is NEGATIVE (-0.08%).

Germany’s yield curve is negative through six years! Which almost forces you out the yield curve, bringing 10-year rates down to below 50 basis points!

Seriously, can you understand a world where French four-year bonds have a negative yield? Or where their 10-year bonds yield about a third of the US rate?

Netherlands rates turn positive four years out – whoopee.

Belgium, with debt-to-GDP of 101%, has negative rates. Go figure.

Meanwhile, Italy has debt-to-GDP of 133% and growing by 4-5% a year and a 10-year bond yielding less than that of the US 10-year.

Spain – all positive, but with a 10-year that pays less than Italy’s.

Gotta love the Portuguese 10-year at 2.97.

Ireland has debt-to-GDP close to 125% and lower rates throughout the yield curve than the US rates.

Rates are even falling in Greece … if you want to go out 17 years.

And here are the US and Japan, for reference.

Japan’s 7-year is almost negative (+0.1%).

Not only are the Swiss not holding the peg, they have put out the “Not Welcome” mat, lowering their negative interest rates to -0.75%, with the implication that if that isn’t enough, they will drop them to -1.5%. You want a Swiss safe haven? It will cost you.
And the irony is that many will pay it. Losing only 0.75% a year sounds really good if you are Russian. (The Danes moved their negative rates to -0.2% this morning just to make sure no one starts to see them as a rent-free safe haven.)

Then you look around at the rest of Europe, and what you see, mostly, are problems. Where is the growth going to come from? Russian corporations and oligarchs have taken out massive Swiss-denominated loans, as has much of Eastern Europe. More than one million Hungarians are in dire straits. Nearly 65% of the country's household mortgages are denominated in foreign currencies – mostly Swiss francs, according to the National Bank of Hungary. And according to Bloomberg News, more than 40% of mortgages on the books of Poland’s banks are denominated in Swiss francs. When the borrowed currency surges against the borrower’s home currency, the effective cost of that debt balloons.

Pity the Poor Swiss

To help us understand the mindset of the Swiss central banker, let’s turn to a tongue-in-cheek analysis of the problems of the SNB by my friend Charles Gave. (Charles has a wicked-sharp sense of humor at all times, but he’s at his best when skewering economists.)

They [the SNB] didn’t mind pegging the Swiss franc to the Deutsche mark, but it is becoming more and more obvious that the euro is more a lira than a mark. A clear sign is the decline of the euro against the US dollar.

Mr. Draghi has been trying to talk the euro down for at least a year. This should not come as a surprise. After all, in the old pre-euro days, every time Italy had a problem, the solution was always to devalue.

But the Swiss, not being as smart as the Italians, do not believe in devaluations. You see, in Switzerland they have never believed in the ‘euthanasia of the rentier’, nor have they believed in the Keynesian multiplier of government spending, nor have they accepted that the permanent growth of government spending as a proportion of gross domestic product is a social necessity. The benighted Swiss, just down from their mountains where it was difficult to survive the winters, have a strong Neanderthal bias and have never paid any attention to the luminaries teaching economics in Princeton or Cambridge. Strange as it may seem, they still believe in such queer, outdated notions as sound money, balanced budgets, local democracy, and the need for savings to finance investments. How quaint!

Of course, the Swiss are paying a huge price for their lack of enlightenment. For  example, since the move to floating exchange rates in 1971, the Swiss franc has risen from CHF4.3 to the US dollar to CHF0.85 and appreciated from CHF10.5 to the British pound to CHF1.5. Naturally, such a protracted revaluation has destroyed the Swiss industrial base and greatly benefited British producers [not!]. Since 1971, the bilateral ratio of industrial production has gone from 100 to 175... in favor of Switzerland.

And for most of that time Switzerland ran a current account surplus, a balanced budget, and suffered almost no unemployment, all despite the fact that nobody knows the name of a single Swiss politician or central banker (or perhaps because nobody knows a single Swiss politician or central banker, since they have such limited power? And that all these marvelous results come from that one simple fact: their lack of power.)

The last time I looked, the Swiss population had the highest standard of living in the world – another disastrous long-term consequence of not having properly trained economists of the true faith.

Draghi: Quantitative Teasing

“Whatever it takes!” was Draghi’s mantra just a few years ago. He has been promising action for all that time and has basically delivered nothing. As I noted a few weeks ago, he has pushed his “street cred” to the limit. He really has to deliver something at the January 22 ECB meeting, or the markets will simply no longer believe him. If he doesn’t do something significant, I think the euro could rip higher, applying even more deflationary pressure throughout Europe.

(Note that there is really nothing all that bad about deflation unless you have a high level of debt and your budget isn’t balanced. Then you get caught in a debt spiral, which forces you into something that has come to be universally abhorred, called austerity, which in other days and times was simply called living within your means.)

Draghi is not lacking in the desire to be more like Bernanke and Yellen. The problem is that he must win consensus among the board of governors of the ECB. To do any serious quantitative easing without the approval of Germany and its Bundesbankers would create very serious problems for him in Europe.

It now appears that what the ECB will do is compromise. They will go ahead to do QE, but each country will assume responsibility for its own bonds. Under that plan, Germany will not be responsible for French or Italian or Spanish bonds bought by the ECB. The ultimate responsibility will be with the national central banks of the individual countries.

This would create a “silo effect” and have long-term implications. To take one example, as noted above, Italy has 133% debt-to-GDP, and its debt is growing at 3 to 4% a year. Now, if the ECB began to purchase Italian debt, the cost of that debt would fall. Since Italy has to refinance (and purchase new) at least 10% of its debt this year with an average cost of well over 3.5%, it could lower its overall interest cost. But given that the country is in deflation and will likely be in its third straight year of recession, deficits will be higher than forecast, and debt-to-GDP will increase.

As we have noted on numerous occasions, Japan no longer has a functioning bond market without the Bank of Japan. What happens when Italian debt rises in cost to the point that individuals no longer want to buy that debt and the market essentially becomes the European Central Bank? Crazy? I think not. It won’t happen this year or the next or even for a few years after that; but unless Italy gets its budgetary house in order – something that will be difficult given its huge pension and healthcare obligations and poor demographics, debt-to-GDP of 150% or 160% is possible by the end of the decade. That is the level at which Greece became a problem a few years ago.

Now, I understand that all my Italian readers will point out that Italy is not Greece, but they both have to coddle the bond market with a reassurance that those who bought will get paid. And given the track record of Italy over the last century, it is not altogether clear to me that you can approach Italian debt with 100% confidence. I know, it’s different this time; but bond buyers are a fickle lot. You buy government bonds because you want to avoid risk.

Draghi is going to have to fight the perception that he is enabling countries to avoid dealing with their imbalances, even as he tries to improve the terms of trade by forcing the euro down.

The common wisdom is that now the Germans are fighting against assuming Italian debt by putting it on the books of the ECB. But Will Denyer points out this morning that there is reason to think that the various countries might actually want that debt for a time, until it can indeed be mutualized in some distant future. Writing for GaveKal, he says:

The US has just provided a remarkable example of the third option at work. Last year, the US Treasury paid a record amount of interest, roughly US$430bn. But over the same period the Fed remitted almost US$100bn to the Treasury, thanks to a balance sheet bloated by QE operations. If we net out remittances from the Fed, the Treasury’s interest payments fall by almost a quarter. Or, to put it another way, with US$17.6trn in debt outstanding in 2014, this effectively lowered the Treasury’s interest cost by around 50bp. And that is before we factor in any effect on market rates.

But what about the eurozone, where many governments are involved?
Normally, any profits made by the ECB are pooled and distributed to member countries in proportion to the central bank’s capital subscription weightings, which are based on population and gross domestic product. That means Germany gets the most, then France, and so on... These outflows pay no attention to where the profits came from. In a QE program today, most of the profits are not going to come from German or French bonds, which yield next to nothing. Most are going to come from the smaller peripheral governments that are currently paying more interest on their debt. We don’t need to do any math to figure out that QE done by the ECB would result in a massive transfer of wealth from the periphery to Germany and France. This is true almost regardless of how purchases are apportioned.

What would make a big difference is if the ECB made an exception to its normal profit-sharing practices, and said that all profits on Portuguese bonds will go back to the Portuguese government, all profits on Italian bonds go back to the Italian government, and so on…. In this structure, all eurozone governments would benefit from QE, at the expense of anyone holding the currency (just as happened in the US, UK, Japan…). The German government would also benefit from any central bank purchases of its debt, but it will no longer also receive a massive transfer of wealth from the periphery.

While everyone is talking about how Germany may demand that credit risk be isolated within each country, that may be a mirage. It may well be the peripheral governments that want the profits from QE to stay within each country – so they can reap all of the regular benefits of currency debasement.

What does this mean for markets? However it is structured, QE is likely to weigh on the euro (that is, if the ECB actually debases its currency on a scale that lives up to lofty expectations). A big QE announcement would also probably lift equity prices, at least initially.

So what caused the Swiss to act? I think it was in part that they looked at the general weakness of Europe and its seeming inability to pursue reforms or to address its imbalances in any realistic manner. Many Eurozone leaders seem to think the European Central Bank has magic in its vaults and simply hope that the Germans can be persuaded to release some of that growth pixie dust. The Swiss look at their own experience and see the continued growth of debt and unfunded obligations in Europe as a real problem.

On top of all the other developments, the European Court of Justice issued a preliminary ruling on Wednesday that allows the ECB to employ quantitative easing. There are rumors that the ECB is going to propose a package that may run as high as €2 trillion – countered by “leaks” that suggest the total will be a fraction of that amount. Frankly, the market has priced in €500 billion already. If Draghi doesn’t deliver a multiple of that, I think we will see a disappointed market.

Was the Swiss banking and business community given a heads-up? Were there phone calls from one desk to another? Clearly, there are communication channels. And the timing of the ECJ ruling and the announcement by the SNB the next day is more than suspicious. (Yes, I know it’s a preliminary ruling, but do you really think it will get changed?)

I think the SNB looked down the road and saw the euro at parity to the dollar (which is where Draghi and the rest of Europe would like to have it), realized how much they would have to spend and ultimately lose to maintain the euro peg, and decided it simply wasn’t worth the cost. That $70 billion loss could turn into a $150 billion loss before you knew it.

Simply removing the peg and taking that much buying off the table will in itself begin to reduce the value of the euro. Will the Swiss begin to move some of their rather large euro holdings to US dollars and other currencies? That move would seem the logical follow-on, and it would push the euro down even farther.

In 2002 I said the euro would rise to $1.50 and then fall back to parity. We do seem to be on that journey. This is not, of course, a one-way trip; and I would expect the euro to correct upwards at some point before resuming its downward journey.

The interesting question will be, if the ECB starts down the path of QE, at what point will it feel it can stop? Will it depend on an inflation-target number? It doesn’t seem likely that QE can actually deliver inflation in a deleveraging world – and Europe must at some point deleverage. Thus, we could see QE in the Europe for a rather long time.

The Eurozone is simply unbalanced, and a monetary policy appropriate for Italy or Spain is not appropriate for Finland or Germany.

Unless and until its members create a fiscal union and come up with some formula to mutualize their debt, the Eurozone will remain imbalanced and will become increasingly likely to break up. Ironically, if they fail to pursue QE, there will be a crisis sooner rather than later; but a crisis is precisely what they need in order to address the present imbalances. They are not going to substantially reform their labor and budgetary processes except in the act of crisis resolution.

A significant QE package (on the order of €1 trillion or more per year) may be enough to postpone the crisis for at least several years. And perhaps that is all they intend to do, thinking that somehow they can all get a handle on their budgets and that growth will magically ensue in a world where debt has already overwhelmed the markets and governments have grown too large relative to the private sector that is necessary to support those governments. Stir into that mix healthcare and pension obligations that are even larger than those in the United States, and you have a surefire formula for a major crisis at some point in the future.

Traders tend to act as if the current trend will never end. For some odd reason, they trust central bankers, when the truth is that central bankers will lie when they feel it is necessary. As Anatole said, they believe they have a license to lie. But one way and another, the current relative quiet in Europe will not hold indefinitely.

My friend Mohamed El-Erian has this to say about the Swiss National Bank decision:

Following the abrupt removal of the currency peg, Switzerland is now looking at a period of bumpy economic and financial adjustment. Being a relatively “open economy”, in which trade and tourism play an important role, Swiss companies face a considerable competitiveness challenge ahead. The country will also have to deal with issues of currency mismatches, as well as having to battle larger, externally induced deflationary forces.

But the implications extend far beyond Switzerland. Countries with Swiss franc denominated liabilities, such as Hungary, now have to deal with a major adverse valuation shock.

More importantly in terms of global systemic effects, politicians in the core economies within the eurozone – including Germany, Austria, Finland and the Netherlands – will see the SNB’s move as a reaffirmation of the dangers of substituting financial engineering for real economic reform. As such, they will be less willing to accommodate the hyperactivism of the ECB. And while this is unlikely to stop the ECB from doing more, it may increase the legal, reputational and unity risks it takes in doing so.

Then there are the consequences for a global economy which, in the absence of a comprehensive policy response in the advanced world, has ended up overly reliant on central bank interventions. Given that their tools cannot reach directly and sufficiently at what holds back growth and jobs, these central banks have been forced to use the partial channel of financial asset prices to influence real economic outcomes.

To this end, central banks have sought to repress market volatility as a means of encouraging risk taking that would then boost asset prices and thus encourage greater household consumption (via the wealth effect) and corporate investment (via animal spirits).

We are already in a currency war, where Japan and China feel the need to protect their competitiveness. Europe now feels compelled to follow. The furthering of various country’s campaigns in this war is creating massive divergence among the major central banks and an environment in which the dollar is likely to become much stronger than it otherwise would.

If the ECB does deliver massive QE, that course has the potential to set off an even uglier set of events than followed on Japan’s Halloween surprise. We could see a series of emerging-market crises, a rush to global risk aversion on top of divergence, and the USD carry trade might unwind quite forcefully, creating a very ugly feedback loop. The risk of financial shocks to the rest of the world – particularly to Europe’s thinly capitalized banking system and China’s questionably solvent financials – is enormous.

Trouble is, the “appropriate” measures needed to keep Eurozone risks at bay may be toxic for the rest of the world, and the “appropriate” policy for the rest of the world may be toxic for the Eurozone. Europe’s grinding further into deflation until the EMU collapses – by the ballot or by the bullet – is an ugly scenario for the world, but a far less immediate risk than that of a violent unwind in the USD carry trade.

It’s every central bank for itself, and I imagine Draghi, too, intends to surprise. Stay tuned.

The Cayman Islands, Zurich, Florida, and New York

I see Grand Cayman, Zurich, and Florida on my schedule, and New York is also looking likely in March. I am “entertaining” the Mauldin Economics writing and management team starting this weekend here in Dallas. Then in February it’s on to the Caymans. It has been awhile since I was in the Cayman Islands, and this time I’ll take a short hop over to Little Cayman to visit my friend Raoul Pal for a few days. A brilliant macroeconomist and trader, Raoul has now based himself in Little Cayman, although he frequently flies to visit clients. In March I’ll be in Zurich (and maybe some other parts of Europe) and then hop back over the pond to Orlando. I will be in NYC later that month, and DC is calling. Not to mention La Jolla. The present wonderful period of reduced travel is coming to an end.

The quote at the beginning of the letter from Jean de la Bruyère, the 17th century French philosopher, is one of my favorites and got me to wondering what else he might have written. Since research no longer requires a trip to the library but merely a few clicks, I was able to spend a good bit of time with the gentleman, even though he shuffled off this mortal coil some 320 years ago. Besides the usual French Enlightenment thoughts, he had a great deal to say about friendship and other personal relationships. Here’s a nice one: “Two persons cannot long be friends if they cannot forgive each other's little failings.”

But my favorite is: “To be among people one loves, that's sufficient; to dream, to speak to them, to be silent among them, to think of indifferent things; but among them, everything is equal.”

My own happiest times are when I am with family and friends. And I am particularly lucky in the number of friends I have. Old friends are the best, but new friends are wonderful, too, as there is so much to learn and share.

This weekend my fellow writers at Mauldin Economics begin to show up from around the world. Jawad Mian, whom you will get to know more about, comes Saturday evening, then Jared Dillian on Sunday, along with Olivier Garret and Ed D’Agostino.
Tony Sagami shows up Monday from Bangkok via Montana. I think Worth Wray will be here Sunday as well. Later in the week I’ll be joined by my new partners (yet to be announced) in what will become Mauldin Portfolios, a portfolio design and management firm geared to helping you create portfolios for your clients that work in the present challenging environment. We’ll do our best to understand the opportunities and risks in front of us, both those the market presents and the more direct business challenges. Long days, but the cameraderie will be sufficient, as de la Bruyère might say.

He also gave us a thought on book writing: “Making a book is a craft, like making a clock; it needs more than native wit to be an author.” And while that is a feel-good line for those who are published, the truth is closer to this pithy observation from Winston Churchill:

Writing is an adventure. To begin with, it is a toy and an amusement. Then it becomes a mistress, then it becomes a master, then it becomes a tyrant. The last phase is that just as you are about to be reconciled to your servitude, you kill the monster and fling him to the public.

Your hoping to slay a few monsters and fling a few books at you this year analyst,
John Mauldin
John Mauldin

01/17/2015 05:07 PM

The Digital Arms Race

NSA Preps America for Future Battle

By Jacob Appelbaum, Aaron Gibson, Claudio Guarnieri, Andy Müller-Maguhn, Laura Poitras, Marcel Rosenbach, Leif Ryge, Hilmar Schmundt and Michael Sontheimer


The NSA's mass surveillance is just the beginning. Documents from Edward Snowden show that the intelligence agency is arming America for future digital wars -- a struggle for control of the Internet that is already well underway.

Normally, internship applicants need to have polished resumes, with volunteer work on social projects considered a plus. But at Politerain, the job posting calls for candidates with significantly different skill sets. We are, the ad says, "looking for interns who want to break things."

Politerain is not a project associated with a conventional company. It is run by a US government intelligence organization, the National Security Agency (NSA). More precisely, it's operated by the NSA's digital snipers with Tailored Access Operations (TAO), the department responsible for breaking into computers.

Potential interns are also told that research into third party computers might include plans to "remotely degrade or destroy opponent computers, routers, servers and network enabled devices by attacking the hardware." Using a program called Passionatepolka, for example, they may be asked to "remotely brick network cards." With programs like Berserkr they would implant "persistent backdoors" and "parasitic drivers". Using another piece of software called Barnfire, they would "erase the BIOS on a brand of servers that act as a backbone to many rival governments."

An intern's tasks might also include remotely destroying the functionality of hard drives. Ultimately, the goal of the internship program was "developing an attacker's mindset."

The internship listing is eight years old, but the attacker's mindset has since become a kind of doctrine for the NSA's data spies. And the intelligence service isn't just trying to achieve mass surveillance of Internet communication, either. The digital spies of the Five Eyes alliance -- comprised of the United States, Britain, Canada, Australia and New Zealand -- want more.

The Birth of D Weapons

According to top secret documents from the archive of NSA whistleblower Edward Snowden seen exclusively by SPIEGEL, they are planning for wars of the future in which the Internet will play a critical role, with the aim of being able to use the net to paralyze computer networks and, by doing so, potentially all the infrastructure they control, including power and water supplies, factories, airports or the flow of money.

During the 20th century, scientists developed so-called ABC weapons -- atomic, biological and chemical. It took decades before their deployment could be regulated and, at least partly, outlawed. New digital weapons have now been developed for the war on the Internet. But there are almost no international conventions or supervisory authorities for these D weapons, and the only law that applies is the survival of the fittest.

Canadian media theorist Marshall McLuhan foresaw these developments decades ago. In 1970, he wrote, "World War III is a guerrilla information war with no division between military and civilian participation." That's precisely the reality that spies are preparing for today.

The US Army, Navy, Marines and Air Force have already established their own cyber forces, but it is the NSA, also officially a military agency, that is taking the lead. It's no coincidence that the director of the NSA also serves as the head of the US Cyber Command. The country's leading data spy, Admiral Michael Rogers, is also its chief cyber warrior and his close to 40,000 employees are responsible for both digital spying and destructive network attacks.

Surveillance only 'Phase 0'

From a military perspective, surveillance of the Internet is merely "Phase 0" in the US digital war strategy. Internal NSA documents indicate that it is the prerequisite for everything that follows. They show that the aim of the surveillance is to detect vulnerabilities in enemy systems.

Once "stealthy implants" have been placed to infiltrate enemy systems, thus allowing "permanent accesses," then Phase Three has been achieved -- a phase headed by the word "dominate" in the documents. This enables them to "control/destroy critical systems & networks at will through pre-positioned accesses (laid in Phase 0)." Critical infrastructure is considered by the agency to be anything that is important in keeping a society running: energy, communications and transportation. The internal documents state that the ultimate goal is "real time controlled escalation".

One NSA presentation proclaims that "the next major conflict will start in cyberspace." To that end, the US government is currently undertaking a massive effort to digitally arm itself for network warfare. For the 2013 secret intelligence budget, the NSA projected it would need around $1 billion in order to increase the strength of its computer network attack operations.

The budget included an increase of some $32 million for "unconventional solutions" alone.

In recent years, malware has emerged that experts have attributed to the NSA and its Five Eyes alliance based on a number of indicators. They include programs like Stuxnet, used to attack the Iranian nuclear program. Or Regin, a powerful spyware trojan that created a furor in Germany after it infected the USB stick of a high-ranking staffer to Chancellor Angela Merkel.

Agents also used Regin in attacks against the European Commission, the EU's executive, and Belgian telecoms company Belgacom in 2011.

Given that spies can routinely break through just about any security software, virtually all Internet users are at risk of a data attack.

The new documents shed some new light on other revelations as well. Although an attack called Quantuminsert has been widely reported by SPIEGEL and others, documentation shows that in reality it has a low success rate and it has likely been replaced by more reliable attacks such as Quantumdirk, which injects malicious content into chat services provided by websites such as Facebook and Yahoo. And computers infected with Straitbizarre can be turned into disposable and non-attributable "shooter" nodes. These nodes can then receive messages from the NSA's Quantum network, which is used for "command and control for very large scale active exploitation and attack."

The secret agents were also able to breach mobile phones by exploiting a vulnerability in the Safari browser in order to obtain sensitive data and remotely implant malicious code.

In this guerilla war over data, little differentiation is made between soldiers and civilians, the Snowden documents show. Any Internet user could suffer damage to his or her data or computer. It also has the potential to create perils in the offline world as well. If, for example, a D weapon like Barnfire were to destroy or "brick" the control center of a hospital as a result of a programming error, people who don't even own a mobile phone could be affected.

Intelligence agencies have adopted "plausible deniability" as their guiding principle for Internet operations. To ensure their ability to do so, they seek to make it impossible to trace the author of the attack.

It's a stunning approach with which the digital spies deliberately undermine the very foundations of the rule of law around the globe. This approach threatens to transform the Internet into a lawless zone in which superpowers and their secret services operate according to their own whims with very few ways to hold them accountable for their actions.

Attribution is difficult and requires considerable forensic effort. But in the new documents there are at least a few pointers. Querty, for example, is a keylogger that was part of the Snowden archive. It's a piece of software designed to surreptitiously intercept all keyboard keys pressed by the victim and record them for later inspection. It is an ordinary, indeed rather dated, keylogger. Similar software can already be found in numerous applications, so it doesn't seem to pose any acute danger -- but the sourcecode contained in it does reveal some interesting details. They suggest that this keylogger might be part of the large arsenal of modules that that belong to the Warriorpride program, a kind of universal Esperanto software used by all the Five Eyes partner agencies that at times was even able to break into iPhones, among other capabilities. The documents published by SPIEGEL include sample code from the keylogger to foster further research and enable the creation of appropriate defenses.

'Just a Bunch of Hackers'

The men and women working for the Remote Operations Center (ROC), which uses the codename S321, at the agency's headquarters in Fort Meade, Maryland, work on one of the NSA's most crucial teams, the unit responsible for covert operations. S321 employees are located on the third floor of one of the main buildings on the NSA's campus. In one report from the Snowden archive, an NSA man reminisces about how, when they got started, the ROC people were "just a bunch of hackers."

Initially, people worked "in a more ad hoc manner," the report states. Nowadays, however, procedures are "more systematic". Even before NSA management massively expanded the ROC group during the summer of 2005, the department's motto was, "Your data is our data, your equipment is our equipment."

The agents sit in front of their monitors, working in shifts around the clock. Just how close the NSA has already gotten to its aim of "global network dominance" is illustrated particularly well by the work of department S31177, codenamed Transgression.

The department's task is to trace foreign cyber attacks, observe and analyze them and, in the best case scenario, to siphon off the insights of competing intelligence agencies. This form of "Cyber Counter Intelligence" counts among the most delicate forms of modern spying.

How the NSA Reads Over Shoulders of Other Spies

In addition to providing a view of the US's own ability to conduct digital attacks, Snowden's archive also reveals the capabilities of other countries. The Transgression team has access to years of preliminary field work and experience at its disposal, including databases in which malware and network attacks from other countries are cataloged.

The Snowden documents show that the NSA and its Five Eyes partners have put numerous network attacks waged by other countries to their own use in recent years. One 2009 document states that the department's remit is to "discover, understand (and) evaluate" foreign attacks.

Another document reads: "Steal their tools, tradecraft, targets and take."

In 2009, an NSA unit took notice of a data breach affecting workers at the US Department of Defense. The department traced an IP address in Asia that functioned as the command center for the attack. By the end of their detective work, the Americans succeeded not only in tracing the attack's point of origin to China, but also in tapping intelligence information from other Chinese attacks -- including data that had been stolen from the United Nations. Afterwards, NSA workers in Fort Meade continued to read over their shoulders as the Chinese secretly collected further internal UN data. "NSA is able to tap into Chinese SIGINT collection," a report on the success in 2011 stated. SIGINT is short for signals intelligence.

The practice of letting other intelligence services do the dirty work and then tapping their results is so successful that the NSA even has a name for it: "Fourth Party Collection." And all countries that aren't part of the Five Eye alliance are considered potential targets for use of this "non-traditional" technique -- even Germany.

'Difficult To Track, Difficult To Target'

The Snowden documents show that, thanks to fourth party collection, the NSA succeeded in detecting numerous incidents of data spying over the past 10 years, with many attacks originating from China and Russia. It also enabled the Tailored Access Operations (TAO) to track down the IP address of the control server used by China and, from there, to detect the people responsible inside the Peoples' Liberation Army. It wasn't easy, the NSA spies noted.

The Chinese had apparently used changing IP addresses, making them "difficult to track; difficult to target." In the end, though, the document states, they succeeded in exploiting a central router.

The document suggests that things got more challenging when the NSA sought to turn the tables and go after the attacker. Only after extensive "wading through uninteresting data" did they finally succeed in infiltrating the computer of a high-ranking Chinese military official and accessing information regarding targets in the US government and in other governments around the world. They also were able to access sourcecode for Chinese malware.

But there have also been successful Chinese operations. The Snowden documents include an internal NSA assessment from a few years ago of the damage caused. The report indicates that the US Defense Department alone registered more than 30,000 known incidents; more than 1,600 computers connected to its network had been hacked. Surprisingly high costs are listed for damage assessment and network repair: more than $100 million.

Among the data on "sensitive military technologies" hit in the attack were air refueling schedules, the military logistics planning system, missile navigation systems belonging to the Navy, information about nuclear submarines, missile defense and other top secret defense projects.

The desire to know everything isn't, of course, an affliction only suffered by the Chinese, Americans, Russians and British. Years ago, US agents discovered a hacking operation originating in Iran in a monitoring operation that was codenamed Voyeur. A different wave of attacks, known as Snowglobe, appears to have originated in France.

Transforming Defenses into Attacks

The search for foreign cyber attacks has long since been largely automated by the NSA and its Five Eyes partners. The Tutelage system can identify incursions and ensure that they do not reach their targets.

The examples given in the Snowden documents are not limited to attacks originating in China. The relatively primitive Low Orbit Ion Cannon (LOIC) is also mentioned. The name refers to malware used by the protest movement Anonymous to disable target websites. In that instance, one document notes, Tutelage was able to recognize and block the IP addresses being used to conduct the denial of service attack.

The NSA is also able to transform its defenses into an attack of its own. The method is described as "reverse engineer, repurpose software" and involves botnets, sometimes comprising millions of computers belonging to normal users onto which software has been covertly installed. They can thus be controlled remotely as part of a "zombie army" to paralyze companies or to extort them. If the infected hosts appear to be within the United States, the relevant information will be forwarded to the FBI Office of Victim Assistance. However, a host infected with an exploitable bot could be hijacked through a Quantumbot attack and redirected to the NSA. This program is identified in NSA documents as Defiantwarrior and it is said to provide advantages such as "pervasive network analysis vantage points" and "throw-away non-attributable CNA (eds: computer network attack) nodes". This system leaves people's computers vulnerable and covertly uses them for network operations that might be traced back to an innocent victim. Instead of providing protection to private Internet users, Quantumbot uses them as human shields in order to disguise its own attacks.

NSA specialists at the Remote Operations Center (ROC) have an entire palette of digital skeleton keys and crowbars enabling access to even the best protected computer networks.

They give their tools aggressive-sounding names, as though they were operating an app-store for cyber criminals:

The implant tool "Hammerchant" allows the recording of Internet-based phone calls (VoIP).

Foxacid allows agents to continually add functions to small malware programs even after they have been installed in target computers. The project's logo is a fox that screams as it is dissolved in acid. The NSA has declined to comment on operational details but insists that it has not violated the law.

But as well developed as the weapons of digital war may be, there is a paradox lurking when it comes to breaking into and spying on third party networks: How can intelligence services be sure that they won't become victims of their own methods and be infiltrated by private hackers, criminals or other intelligence services, for example?

To control their malware, the Remote Operation Center operatives remain connected to them via their own shadow network, through which highly sensitive telephone recordings, malware programs and passwords travel.

The incentive to break into this network is enormous. Any collection of VPN keys, passwords and backdoors is obviously of very high value. Those who possess such passwords and keys could theoretically pillage bank accounts, thwart military deployments, clone fighter jets and shut down power plants. It means nothing less than "global network dominance".

But the intelligence world is a schizophrenic one. The NSA's job is to defend the Internet while at the same time exploiting its security holes. It is both cop and robber, consistent with the motto adhered to by spies everywhere: "Reveal their secrets, protect our own."

As a result, some hacked servers are like a bus during rush hour, with people constantly coming and going. The difference, though, is that the server's owner has no idea anyone is there. And the presumed authorities stand aside and do nothing.

'Unwitting Data Mules'

It's absurd: As they are busy spying, the spies are spied on by other spies. In response, they routinely seek to cover their tracks or to lay fake ones instead. In technical terms, the ROC lays false tracks as follows: After third-party computers are infiltrated, the process of exfiltration can begin -- the act of exporting the data that has been gleaned. But the loot isn't delivered directly to ROC's IP address.

 Rather, it is routed to a so-called Scapegoat Target. That means that stolen information could end up on someone else's servers, making it look as though they were the perpetrators.

Before the data ends up at the Scapegoat Target, of course, the NSA intercepts and copies it using its mass surveillance infrastructure and sends it on to the ROC. But such cover-up tactics increase the risk of a controlled or uncontrolled escalation between the agencies involved.

It's not just computers, of course, that can be systematically broken into, spied on or misused as part of a botnet. Mobile phones can also be used to steal information from the owner's employer. The unwitting victim, whose phone has been infected with a spy program, smuggles the information out of the office. The information is then retrieved remotely as the victim heads home after work. Digital spies have even adopted drug-dealer slang in referring to these unsuspecting accomplices. They are called "unwitting data mules."

NSA agents aren't concerned about being caught. That's partly because they work for such a powerful agency, but also because they don't leave behind any evidence that would hold up in court. And if there is no evidence of wrongdoing, there can be no legal penalty, no parliamentary control of intelligence agencies and no international agreement. Thus far, very little is known about the risks and side-effects inherent in these new D weapons and there is almost no government regulation.

Edward Snowden has revealed how intelligence agencies around the world, led by the NSA, are doing their best to ensure a legal vacuum in the Internet. In a recent interview with the US public broadcaster PBS, the whistleblower voiced his concerns that "defense is becoming less of a priority than offense."

Snowden finds that concerning. "What we need to do," he said, "is we need to create new international standards of behavior."

By Jacob Appelbaum, Aaron Gibson, Claudio Guarnieri, Andy Müller-Maguhn, Laura Poitras, Marcel Rosenbach, Leif Ryge, Hilmar Schmundt and Michael Sontheimer

January 18, 2015 5:32 pm
It can be morning again for the world’s middle class

There is little hope for integration and co-operation if it is seen as benefiting a global elite
The most challenging economic issue ahead of us involves a group that will barely be represented at this week’s annual Davos summit — the middle classes of the world’s industrial countries.
Nothing is more important to the success of industrial democracies than sustained increases in wages and living standards for working families, as the Inclusive Prosperity Commission, which Ed Balls and I co-chaired, concludes in a report .

Amid the focus on global finance, on geopolitics and on the moral imperative of helping the world’s poor, no one should lose sight of the fact that without substantial changes in policy the prospects for the middle class globally are at best highly problematic.

First, the economic growth that is a necessary condition for rising incomes is threatened by the spectre of secular stagnation and deflation. In the US, last year was to be one of rising interest rates with acceleration of growth, the end of quantitative easing, and the approach of tightened monetary policy. In Japan, prices were to start rising again. In Europe, it was to bring continued reform and normalisation.

In fact, 10-year rates have fallen by well over 100 basis points in the US and are only half as high in Germany and Japan as they were a year ago. In a number of major countries short-term interest rates are negative with lenders to governments forced to pay for the privilege.

Such low interest rates suggest a chronic excess of saving over investment, and the likely persistence of conditions that make monetary policy ineffective in Europe and Japan, along with their possible re-emergence in the US.

Market measures almost everywhere suggest inflation is expected to be well below target for a decade.

The world has largely exhausted the scope for central bank improvisation as a growth strategy. Excess demand, inflation, excessive credit and the need for monetary tightening should be the least of our policy concerns. Central banks will still have to do their part but it is time now for concerted and substantial measures to raise both public and private investment.

Second, the capacity of our economies to sustain increasing growth and provide for rising living standards is not assured on the current policy path. America is often held out as a model and indeed its performance has been strong by global standards. The US has enjoyed growth of about 11 per cent over the past five years. Of this, standard economic calculations suggest that about 8 per cent can be regarded as cyclical, resulting from the decline in the unemployment rate. That leaves just 3 per cent over five years as attributable to growth in the economy’s capacity. Even after our recovery, the share of US men aged 25-54 who are out of work exceeds that in Japan, France, Germany and the UK.

Demand factors apart, growth prospects are worse in Europe and Japan where adult populations are shrinking and ageing, and economic dynamism is subsiding. A significant part of the sharp downward revisions in the estimated potential of industrial economies over the past seven years is the consequence of the recession conditions of recent years. In many ways strong growth is the best structural policy for promoting future growth as investment rises, workers gain experience and so forth. But more must be done.

Third, if it is to benefit the middle class, prosperity must be inclusive and in the current environment this is far from assured. If the US had the same income distribution it had in 1979, the bottom 80 per cent of the population would have $1tn — or $11,000 per family — more.

The top 1 per cent $1tn — or $750,000 — less. There is little prospect for maintaining international integration and co-operation if it continues to be seen as leading to local disintegration while benefiting a mobile global elite.

The focus of international co-operative efforts in the economic sphere must shift. Considerable progress has been made in trade and investment. Less progress has been made in preventing races to the bottom, in areas such as taxation and regulation. Only with enhanced international co-operation will the maintenance of progressive taxation and adequate regulatory protection be possible. And only if ordinary citizens see benefit in an ever more open global economy will it come about.

These three concerns — secular stagnation and deflation, slow underlying economic growth and rising inequality — are real. But they are no grounds for fatalism.

The experience of many countries and many eras shows that sustained growth in middle class living standards is attainable. But it requires elites to recognise its importance and commit themselves to its achievement. That must be the focus of this year’s Davos.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary


Surge of Swiss Franc Triggers Hundreds of Millions in Losses

By Ira Iosebashvili, Andrew Ackerman and Alexandra Wexler

Banks, brokers and individual investors were left with hundreds of millions of dollars in losses a day after an unexpected surge in the Swiss franc sent shock waves through markets.

FXCM Inc., a major U.S. retail foreign-exchange broker, emerged as the biggest victim so far and had to be rescued by an emergency $300 million lifeline from investment firm Leucadia National Corp.

Shares of FXCM, one of the largest retail currency brokers in the world, were suspended on the New York Stock Exchange on Friday after the company said client losses on Swiss franc trades threatened to put it in violation of regulatory capital rules.

The two-year loan, with an initial interest rate of 10%, is “designed to maintain FXCM’s financial strength and allow it to prosper going forward,” said Leucadia Chief Executive Richard Handler.

FXCM didn’t respond to a request for comment.

Other firms were hit when the Swiss currency jumped by nearly 30% against the euro and 18% against the dollar in the minutes following the Swiss National Bank’s decision to stop reining in the value of the franc against the euro.

Citigroup Inc. and Deutsche Bank AG will each lose about $150 million on the franc’s appreciation, said people familiar with the firms. Goldman Sachs Group Inc. said Friday that the franc’s move will be immaterial to its earnings. Losses at Barclays PLC will be in the tens of millions of dollars, people familiar with the bank said.

Among hedge funds suffering losses: Discovery Capital Management LLC, a South Norwalk, Conn., firm that manages $14.7 billion, and Comac Capital LLP, which oversees $1.2 billion in London. Comac was down roughly 8%, according to a person familiar with the firm.
Losses could be reversed, but the setbacks are the latest for Discovery and Comac. Comac has been roughly flat the past two years, while Discovery ended last year down more than 3% in its flagship fund, after largely recovering from a double-digit-percentage loss early in 2014, according to people familiar with the firms. Bloomberg News earlier reported Comac’s loss.

Meanwhile, staff for members of the Financial Stability Oversight Council, a group of senior U.S. regulators, spoke by phone Friday to discuss the market’s reaction and the impact on specific financial institutions, according to a person familiar with the call. The discussion didn’t suggest there was an immediate threat to the financial system, this person said.

FXCM was founded in 1999 as one of the first currency brokerage firms to serve retail customers. In recent years, the company has expanded by acquiring weaker rivals, as a yearslong period of modest swings in foreign-exchange markets led to reduced trading and industry consolidation.
At the center of this week’s turmoil, analysts said, was the use by FXCM clients of borrowed money, or leverage. FXCM kept lower margin requirements, or the amount held as collateral for a loan, than its competitors, analysts said, a practice that enabled traders to boost returns by using borrowed money.

For years, foreign-exchange brokerages that catered to mom-and-pop investors operated outside significant oversight and were magnets for potential fraud. That all changed with the 2010 Dodd-Frank financial-overhaul law, which for the first time gave the Commodity Futures Trading Commission regulatory authority over the brokerages.

FXCM was among several firms that fought CFTC efforts to limit leverage at 10 to 1, saying in a March 2010 letter the proposal would have a “devastating impact on the retail [foreign-exchange] industry” and “drive it largely overseas.” The letter was signed by FXCM Chief Executive Drew Niv and eight other brokerage CEOs. The limit eventually was set at 50 to 1, meaning an investor could borrow $50 for every dollar put in.
On Thursday, a unit of Chicago-based exchange and clearinghouse operator CME Group Inc. tripled margin requirements for traders using futures tied to the Swiss franc, according to an advisory notice it sent to clearing members and risk managers.

Rick Smallwood, 43 years old, a technology consultant living in Belize, began trading in Swiss francs last summer at FXCM. He said he held a stop-loss order that aimed to benefit from the franc’s depreciation but would cap his losses if the franc appreciated beyond 0.97 francs per dollar. A stop-loss order is placed with a broker to sell a security when it reaches a certain price. The franc traded Wednesday at 1.02 per dollar.

News of the Swiss National Bank’s decision broke early Thursday morning in Belize. By the time Mr. Smallwood had finished his morning coffee, the franc had soared past his stop-loss order, exposing him to losses. FXCM sold off his position, a dollar amount he puts in the five figures, at 0.88 francs on the dollar.

Mr. Smallwood, who doesn’t use any leverage on his account, typically limits his positions to 1% of his total assets. He said he lost close to 5% of his account on the franc trade.

Mr. Smallwood, who said he is shifting his assets around to other brokers and other markets, blamed the problems at FXCM in part on other traders who use borrowed money in a bid to bolster returns.
“A lot of currency brokers are becoming insolvent because they’re letting people lever up so much,” he said. “There are people who trade responsibly that are exposed to more risk.”

On Friday, both the dollar and euro gained about 2% against the franc, after ending Thursday down 21% and 23%, respectively.

FXCM went public on Dec. 3, 2010, raising $211 million at $14 a share. But FXCM’s shares performed poorly. The stock fetched $12.63 at Thursday’s close and was down about 70% in after-hours trading Friday, at $3.75.

Matthew Wilhelm, principal at Lucid Markets Trading Ltd., an electronic-trading firm, sold 481,228 shares of FXCM in November, according to SEC filings. In June 2012, FXCM purchased a 50% controlling stake in Lucid Markets for $176 million, and Mr. Wilhelm received 5,284,045 shares as part of that deal, according to SEC filings. He didn’t return calls seeking comment.

Another big stockholder of FXCM has also sold large amounts of shares in recent months. Michael Romersa, one of the firm’s founding partners and a former executive, sold 236,193 shares from Dec. 19 to Jan. 9, according to SEC filings.

“I wanted the cash, so I sold some,” Mr. Romersa said. “I’m 68 years old. What am I going to wait for, until I’m 78?”

—Juliet Chung, Daniel Huang and Ryan Tracy contributed to this article.