Another Take on the European Situation and the Market "Melt-Up" on 10/28/2011

Excerpted from John Mauldin:

On Wednesday, October 28, 2011, the market reacted like the European banking problems were solved. But if you look deeply there is more to the market "melt-up" than simple euphoria and relief. There is an unintended consequence that will come back to bite us. And it may well involve derivatives and credit default swaps.

The ECB seemed to indicate that after the summit it would continue to buy Italian and Spanish debt. But that commitment was rather vague. Italian paper was just north of 4% in July. Today Italian interest rates rose to 5.88%, even with apparent ECB buying. More on the reason for the rise later.

They did agree at the summit that private bondholders should lose 50% on their Greek debt. This mostly means banks, pension funds, and insurance companies, along with the €35 billion owed to the Greek pension system.

The summit decided that the Greeks should also privatize another €15 billion in national assets, on top of the €50 billion they are already supposed to have done, but on which no progress has been made. All the while finding €17.5 billion to fix the hole in their pension funds, which was already so deep that no daylight could seep in.

When Leverage Is the Kind-of Answer

The Europeans also agreed to leverage the EFSF by some amount, but they were unclear on the details as to what that actually meant. The concept is that they will guarantee the first 20% of losses on any newly issued debt. It was left unstated whether that includes the loans committed to Ireland and Portugal but not yet issued, or just new commitments.

Somehow, by a mechanism not revealed, this is to be leveraged up to about €1 trillion, which is about half of the lowest estimate I have seen of what is needed. Thus the desperate hope that the ECB will step in, because that is the only real source for the money that will be needed.

Further, if you are a market participant thinking of investing in sovereign debt, when was the last time you saw a sovereign country write down less than 20% of its debt? Answer: Never. If a sovereign debt goes south, it's for a whole lot more than 20%. It seems that whatever the EFSF guarantees is almost certain to turn into a loss. What self-respecting country would write off less, if the hit is taken by entities that have no votes in the national parliament? 20% becomes the starting point. There will be lots of screaming when those losses come home.

Merkel and Co. are selling the whole proposition on the premise that the problem is simply one of confidence, and that if the EFSF restores confidence in the various nefarious government debt schemes, then all is saved. Well, except for Greece, which has already been flushed. The problem is that it is not a lack of confidence, it is a lack of solvency. There is too much debt in Greece and Ireland and Portugal and Spain and Italy. And ultimately France.

Meanwhile Back in Portugal

"Data released by the European Central Bank show that real M1 deposits in Portugal have fallen at an annualized rate of 21% over the past six months, buckling violently in September. Portugal is rapidly descending to Greek status. Yet another banking crisis looms.

There is a universal assumption in Ireland that the country will get debt relief. That is a €60-billion hole in the ECB balance sheet. From Businessweek.com:

"Why is it acceptable to write down Greek debt, when the Irish pay private bankers' debts?" Gerry Adams, leader of Sinn Fein, said in parliament on Oct. 25. Kenny told Adams he's seeking debt reduction on a ‘number of fronts.'

"The government has already signaled it may seek to shift some of the costs of bailing out the banking system to Europe, relieving the burden on the taxpayer. [And putting it squarely on European taxpayers as a whole!]

Think that will sell to Spain, when they have to figure out how to back their banks, which are for the most part basically insolvent? What about Italy?

Let's Just Change the Rules

Never assumes the rules are what you think they are just because they are written down, if someone else can change them. The final thing that happened at the summit is the rules got changed. The banks "voluntarily" took a 50% haircut. Voluntary in that Merkel, Sarkozy, et al. told them that the alternative was a 100% haircut. "That's the offer, guys. Take it or leave it." And because the write-off was voluntary, there would be no triggering of credit default swaps clauses. Because if it's voluntary it's not a default. Huh?

And that smooth move, triggered a rather significant unintended consequence, which resulted in the market "melt-up." Let’s walk through this rather bizarre world of derivative exposure without causing anyone’s head to explode:

Let's say you bought credit default swaps on a certain bank's debt (let's use JPMorgan, but it could be any bank) because you think that Morgan is exposed to too much credit default swap risk. Just in case. Now, if Goldman sold you the CDS, they could and would in turn hedge their risk by shorting some quantity of Morgan stock, or perhaps if the risk was sizeable enough, the S&P as a whole. It would depend on what their risk models suggested. But as of yesterday, the risk evaporated: there would be no CDS event. So why buy CDS?

Further, the risk to financials was cut by a large, somewhat murky amount. But it was definitely cut, so risk assets (equities) were bought. Which puts any long/short hedge fund in a squeeze, especially those with an anti-financial-sector bias. But because of the nature of the hedge, the whole market moves. It involves rather arcane concepts that traders call delta and gamma. (Remember that the recent rogue traders, most recently at UBS, had been at delta trading desks?) Guys at those desks can calculate that risk in a nanosecond. You and I take a day just to wrap our head around the concepts.

And it just cascades. The high-frequency-trading algorithm computers notice the movement and jump in, followed quickly by momentum traders, and the market melts up. Because a significant risk was removed. But not without cost.

Let's go back to where it was noted that Italian interest rates are rising even as the ECB is supposedly buying. What gives (demand SHOULD drive rates down!)? It is clearly the lack of private buyers, and a lot of selling. Because now you can't hedge your sovereign debt. If you ever need that insurance, they will just change the rules on you, so why take the risk?

Destroying the credit default swap market will make it harder to sell sovereign debt, not easier. Those "shorts" were not the cause of Greek financial problems; the Greeks did it all to themselves. As did the Portuguese, and on and on. Now admittedly, rising CDS spreads called attention to the problem, much as rising rates did in eras long past. And that did annoy politicians. And clearly, banks that had exposure to that market got the "fix" in to make their problems go away.

John Mauldin’s conjecture is that a major writer of sovereign CDS were German Landesbanks. Think Merkel didn't have that report? As did Sarkozy, on French exposure? It was a very high-stakes poker game they were playing this week. But one side of the table could rewrite the rules. There is no way to prove or disprove these speculations, because there is no source that can really plumb the depths of the situation. And that is a problem.

An event like the Eurozone summit changes an obscure rule with some vague clauses about triggering a credit event – and the market reacts. This time it was a melt-up. Next time it could be a meltdown, as it was in 2008.

Examine Your Risk Profile

Sorry about all of the econo-speak lately, but I think it’s necessary to at least have the necessary background out there as I say that the problems that have concerned me have not gone away. There are several parties that want people to think that they have gone away, but they haven’t. I’m not even sure that I blame the people who are trying to publicly soft-sell the problems IF I thought they were diligently working to fix the problems outside of the glare of the limelight. But I don’t believe that is the case.

Technically speaking, the stock market is looking OK. I would not be surprised to see the current rally go on for a few more months even. Additionally, with U.S. elections only 12 months away, I would expect politicians to do everything that they can to bolster the stock market. But the issue is the magnitude of the economic problems today, most prevalent in the European banking situation, but which could quickly spread to the U.S. banks. I continue to tell people to examine their risk profile and to make sure that you are cognizant of the risks out there and that you have your investment and retirement portfolios structured accordingly.

The EuroZone Crisis and Wednesday's Summit Agreement

Taken primarily from The Daily Capitalist:

Some take-aways of the EuroZone crisis and Wednesday’s summit agreement:

1. It isn’t over.
2. The European Monetary Union’s (the “EMU”) is a failure.
3. They spent too much (and it still wasn’t near enough) and can’t possibly repay the debt.
4. Banks will need to be bailed out.
5. They will print money.

In order to understand the EU summit “breakthrough” we need to understand how the players in the EuroZone look at it. Last week a leaked confidential assessment of the problem that was prepared by the IMF was published by Linkiesta’s Fabrizio Goria. The document revealed the IMF’s private assessment of Greece and the requirements for a bailout.

Here is a summary of how the IMF sees the problem:

1. The Greek economy is increasingly adjusting through recession and related wage-price channels, rather than through structural reform-driven increases in productivity. This is due to “administrative capacity limitations in the Greek government” which is a diplomatic way of saying that the Greek government can’t pull off the reforms.
2. In keeping with experience to date under the program, it is assumed that Greece will take longer to implement structural reforms, and that a longer timeframe is necessary for them to yield “macroeconomic dividends” (i.e., economic growth). They paint a dismal picture as Greece falls into a severe recession.
3. Greece won’t raise as much money as projected through privatization of public assets. Through 2020, total privatization proceeds would amount to €46 billion, instead of the €66 billion assumed.
4. They assume that Greece will run fiscal surpluses starting in 2013 but note that it requires “sustained and unwavering commitment to fiscal prudence by the Greek authorities."
   
5. They won’t be able to return to private markets to finance their debt until after 2020. This will require “official financing” (i.e., a bailout from the solvent eurozone members) of €252 billion through 2020.
6. They are very concerned that Greece will not meet these targets because their economy and government is not robust enough to withstand economic shocks (low growth, high interest rates), thus throwing off the entire projection on which the bailout is based. If this occurs, then Greece may not be able to go back to the markets to refinance its debt until 2027.
7. In order for Greece to have “sustainable” debt levels, the following needs to happen:
1. Generous official support (up to €440 billion under the worst case scenario), and
2. At least a 50% haircut to their debt, which requires cooperation from its private bank creditors. This would get Greece down to a debt level of 120% of GDP by 2020. Under the worst case scenarios, they see the debt level rising to 208% of GDP.
8. Another requirement is €30 billion of support for creditor banks to recapitalize.

As you can see, these policy conclusions are based on assumptions that someone in the IMF just made up. Anyone that’s seen the riots going on in Greece or who’s read anything about the situation there knows that the Greek people have no intention of making any concessions with regard to their “promised” standard of living (the problem with socialism is that you eventually run out of other people’s money). Like all projections, especially ones going out more than a few years, they are fictions and are impossible to verify or have any confidence in. Yet, if you look at these assumptions, this is what the summit participants are basing their agreement on.

Here is what happened Wednesday at the summit:

The European Financial Stabilization Facility (the “EFSF “) will issue bonds over-guaranteed by EMU members. These bonds will be issued in exchange for the Greek bonds (which are, in effect, in default). They will also be used to back the bonds of Spain, Italy, Portugal and most probably others – it just depends upon what timetable one is talking about operating under.

In order to get all member guarantors in line, the deal had to include bond creditors taking a 50% hit.

The private bank creditors were never really happy about this. It does several things to them (not the least of which is an earnings hit), but mainly it also reduces their Tier 1 capital - any EMU sovereign bond may be counted as Tier 1 capital at face value no matter what the market value is. And now, by taking a 50% haircut, the banks need to boost their core capital.

Late Wednesday night in direct talks with Angela Merkel, Nicolas Sarkozy, and the IMF’s Christine LaGarde, the chief negotiator for the Institute for International Finance, the bankers’ lobbying entity, reached an agreement with the group. In exchange they got several assurances. One of them is that they would get €30 billion of “official funding” to help stabilize their Tier 1 capital. One estimate says they need €106 billion of additional capital (two-thirds of which is related to Greece, Spain and Italy). They will be required to have a 9% Tier 1 capital ratio by July, 2012. They also got assurances from their respective governments that they would not be allowed to fail. Remember that they have also financed other sovereigns on the brink. It was literally a game of chicken and they blinked when threatened with Greek default, which could spread to other sovereigns whose debt they hold.

For the Greeks, they get a temporary reprieve and a total of €130 billion of additional funds (up from €109 billion). They are supposed to reduce debt to 120% of GDP by 2020 (per the IMF assessment) and carry out structural reforms. 120%! It will soon be apparent that this target will never be achieved.

All of the parties know that the €440 billion won’t be enough. So the French are out raising money from non-EMU members with the hope they can increase the fund from €780 to €1 trillion. Thus their trip to China to beg Hu Jintao for money. The Chinese are experiencing a kind of schadenfreude over this whole thing, secretly enjoying their new power role in international finance as the Europeans go hat in hand to them for contributions for the EFSF. And it’s just mind-boggling that China is now perceived as a rescuer after they have very willfully and meticulously destroyed the manufacturing economies of the U.S. and Europe. China has said they will contribute, but they have also said they want something in return: Stop complaining about the Chinese currency exchange rates. The Chinese fear that their “contribution” will be perceived as a bailout of the West and that won’t be popular with Chinese citizens. They are entirely correct in that assessment.

The bottom line is that the Europeans are piling debt on top of debt, except that the new bonds will be paid on demand with the sovereign guarantees of EFSF. This is not popular with German and French taxpayers since they will account for almost 50% (48.51%) of the Facility. Add in Italy’s 18% and these three countries are on the hook for a potential €530 billion. Don’t think for a moment that this won’t have repercussions for every politician come election time.

You can be assured that ultimately some part of this will be monetized by the ECB. Presently they have bought €169.5 billion euros in bonds so far, starting with Greece, Ireland and Portugal last year, then extending the coverage to Italy and Spain in August. This little detail wasn’t mentioned in the summit statement. Yesterday, Jean-Claude Trichet’s ECB successor, Italy’s Mario Draghi said the ECB remains “determined to avoid a poor functioning of monetary and financial markets.” Which means they will print if needed.

Don’t expect George Papandreou’s socialist PASOK government to adhere to the agreement. It’s farcical to think that they will come close to meeting their economic targets, even in a best case scenario because they wil not institute the necessary free market reforms that will spur future growth. It will also not be easy to dismantle the elaborate social welfare system there without more political unrest.

And Greece is not the only problem. Spain and Italy are large economies and face similar problems, just not quite on the scale of Greece’s. It all comes down to their ability to fund their excessive debt. Even France is being warned about its credit rating.

The EMU is built on a weak foundation. They allowed in countries that according to the Maastricht Treaty were not supposed to run deficits of more than 3% of GDP, yet they all did, even Germany. They allowed their members to spend and borrow without regard to economic reality and now the money has run out. I think that it’s a foregone conclusion that the EU is going to bail out their debt through inflation by printing money. That’s what countries do, unlike people and companies which default and go through bankruptcy.

It’s a mess. And it’s not over.

Why the US Should Care About Europe

The majority of this article comes from Chris Martenson is an economic researcher and futurist specializing in energy and resource depletion:

It is often the initial movements at the periphery tend to give us an early warning of when things might go wrong at the center - the marginal country, the weakest stock in a sector, or some fringe population that gives us the early warning that trouble is afoot. For example, rising food stamp utilization and poverty levels in the US indicate that economic hardship is progressing from the lower socioeconomic levels up toward the center (47 million U.S. citizens are now on food stamps!)

This pattern is now playing out in Europe, although arguably the earliest trouble was detected with the severe weakness seen in the eastern European countries nearly two years ago.

Because of this tendency for trouble to begin at the periphery before spreading to the center, it is worthwhile to spend some time watching junk bonds instead of Treasuries, looking at weak sectors instead of strong ones, and generally trying to scout out where there are early signs of trouble that can give us a sense of what's coming next. So let’s take this a step further and posit the idea that Europe is the canary in the coal mine that tells us it is time to begin preparing for how the world might change if the Euro-contagion spreads all the way to US Treasuries.

Why the US Should Care About Europe

At the very core of the global nuclear money reactor are US Treasuries and the dollar. If the dollar's role as the world's reserve currency collapses or even wanes, then the scope and pace of the likely disruptions will be enormous. Of course, it will be great to have as much forewarning as possible.

If (and I think the more likely word is "When") the contagion spreads from Greece to Portugal (or Italy or Spain), and then to the big banks of France and Germany in such a way that they fail, then rather than strengthening the dollar's role (as nearly everyone expects), we should reserve some concern for the idea that the contagion may jump the pond and chew its way through the US financial superstructure.

We may be well advised that the predicament is that the fiscal condition of the US is just as bad as anywhere, and we'd do well to ignore the idea, widely promulgated in the popular press, that the US is in relatively better shape than some other countries. 'Relatively' is a funny word. In this case, it's kind of meaningless, as all the contestants in this horse race are likely destined for the glue factory, no matter how well they place.

While there are certain to be a lot of false starts and unpredictable twists and turns along the way, eventually the precarious fiscal situation of the US will reach a critical mass of recognition. Before that date, the US will be perceived as a bastion of financial safety, and afterward everyone will wonder how anyone could have really held that view.

A good recent example of how swiftly sovereign fortunes can change: One day, everything was fine in Greece, which enjoyed paying interest rates on its national debt that were a few skinny basis points (hundredths of a percent) above Germany’s. A few short months later, Greece was paying over 150% interest on its one-year paper.

What happens when the same sweep of recognition visits the US Treasury markets? Is such a turn of events even possible or thinkable? Here's one scenario.

How Contagion Might Spread to the US

Someday, perhaps within a matter of months but more likely in a year or two, the US Treasury market may fall apart as certainly and as magnificently as did Greece’s. Here’s how that might happen:

Step 1: As the global growth story frays, global trade decelerates, and the sovereign and total debt burdens of various countries drag at economic growth, fewer and fewer dollars will be accumulated and stored by various foreign central banks. The typical way dollars are stored is in the form of Treasury holdings. Because of this, several years of record-breaking Treasury accumulation by these foreign banks will grind to a halt and foreign Treasury holdings will begin to decline. Let me take this idea one step further – what if an elimination of Treasury holdings is actually planned by China with the express intent of causing economic catastrophe to us? China has had no qualms about taking the manufacturing base from the U.S. and Europe, so why should this be out of the range of possibilities?

Step 2: The US government, thinking that foreign lending had somehow become a permanent feature of life and having consequently ramped up spending and borrowing to record levels, will find itself unable to adjust quickly. Federal borrowing continues amidst a sea of squabbling over meaningless, barely symbolic cuts to spending, even as official foreign demand for Treasuries wanes.

Step 3: After it is recognized that the central banks are taking a breather from more Treasury accumulation, private participation in Treasury auctions begin to wane, with the bid-to-cover declining and eventually approaching dangerously thin levels. In parallel, Treasuries traded on the open market begin to creep up in yield, indicating that more sellers than buyers exist.

Step 4: The Federal Reserve, having publicly committed itself to maintaining a zero Fed Funds interest rate through 2013 and therefore finding itself in the awkward position of having to save face, will be forced to funnel more money into the Treasury market. But because it is already committed to selling short-maturity paper in favor of long-dated paper, it does this by announcing another round of quantitative easing (QE) in some other asset class held by the sorts of financial institutions that will have no choice but to immediately park that thin-air money into Treasuries. The holdings of money market funds come to mind.

Step 5: The rest of the developing world, especially China, takes an increasingly dim view of the US reserving for itself the right to print money to buy government debt while admonishing other countries for doing the same. First, there are just verbal protests, but then more and more Treasury selling begins to hit the market. Wall Street, happy enough to make a few bucks by flipping Treasuries at the Fed’s bequest, now sees that there’s a lot more money to be made by selling Treasuries and even more to be lost by holding them. Selling of Treasuries, pushed by a shift in foreign perception of safety (and utility), begins to pick up.

Step 6: As the selling picks up, the rate of interest that the US government has to offer in order to attract sufficient buyers to new Treasury auctions continues to increase. Forced by this circumstance, the Fed has to raise rates in order to appear as if they are in control of the process, when, in fact, they are (once again) merely following the markets.

Step 7: As interest rates spiral higher, the amount of money that the US government (as well as state and local governments) must borrow in order to service rising interest costs creeps higher and higher. In other words, the more money the US government has to borrow, the higher the rate of interest they have to pay, which serves to force more borrowing, which makes the rate of interest go higher...and higher...and higher...each feeding the other in a classic debt spiral. This is the same dynamic that Greece is currently suffering through.

Step 8: The interest rate spiral creates a fiscal emergency for the US government, where the only choices are between slashing spending enormously (which would serve to crush the economy, perhaps by 10%-20%, and driving tax receipts down, sharply creating its own dynamic of pain), or running out of money and defaulting on its bills, or printing money and accepting a steep fall in the international value of the dollar. Because slashing spending is a delicate and politically painful process, by default it almost certainly will not happen in time to prevent the interest rate spiral from occurring. As to the idea of running out of money, that is deemed an unthinkable option, which leaves money printing as the most likely option.

Step 9: While it is the politically easier solution, money printing leads to the abandonment of the US dollar as the main reserve currency of the world. This does not necessarily have to happen very quickly. It proceeds in fits and starts, but the end result is that the US can no longer export dollars in exchange for things, and this alone changes everything. Long accustomed to being able to export dollars and import things, the US grew to view this historical oddity as an entitlement. But instead, it was a relic of circumstances, first of the relative position of the US after World War II, and second due to the temporary requirement that all oil purchases must be made in dollars. This ‘petro-dollar’ feature meant that any country wishing to buy oil first had to accumulate a dollar surplus. In short, this meant having to run a trade surplus, if not with the US, then with a country that had one itself. This allowed the US to export dollars while other countries had to export real things.

The Importance of Exercising Vigilance

Keeping a close eye on the data is the key to determining whether or not this projected progression is underway or even likely. Of growing interest (and concern) is that we are indeed beginning to see several of the earlier indicators predicted above – notably, a decline in US Treasuries held by foreigners and growing signals that more government borrowing/money printing is on the way soon.