Barbarians At The Gate

As an old hand in the sovereign bond market I can understand - though in no way do I condone - "the market's" attacks on Greece and Ireland, even Portugal.  They are small countries at Europe's economic periphery who borrowed more money from foreign lenders than was good for them and thus left themselves wide open to speculative attack.

 Pygmies And Giants

But now things are getting serious:  "the market" is attacking Spain, the world's eighth largest economy with a GDP of 1.1 trillion euro ($1.4 trillion). And "the virus" is spreading to Italy, Belgium and even to that paragon of financial probity, the most admired country in the world, Denmark.  Yes, Denmark.

Take a look at the Credit Default Swaps (CDS) charts below (all from CMA).

Italian Sovereign CDS

Belgium Sovereign CDS

Denmark Sovereign CDS

(To make things clear: Denmark isn't even a member of the Eurozone! It's a full member of the E.U. but it still uses its own currency, the krona.  It's debt/GDP ratio at 42% is tiny.)

So what is going on?  Not to mince words, a concerted attack on the viability of the euro and thus on the very foundation of the EU itself.  The existence of a common currency for the world's largest economic block is a threat to the US Dollar Hegemony, i.e. anathema for those who wish to prolong the world as we knew it, a modified construct from the Bretton Woods era.

The barbarians are at Europe's gate, threatening to tear down and pillage what took nearly three quarters of a century to construct.  But it's not going to happen.  Like Hannibal's elephants ante Rome's portas, the big financial institutions that are behind this ill-advised campaign are themselves vulnerable.  They need massive amounts of cheap liquidity as fodder (only the Fed is supplying it at the moment) and risk-taking leveraged customers to piggy-back their positions (essentially, hedge funds). 

They also rely on the complete absence  of meaningful oversight and regulation for credit derivatives, an inexcusable condition for which European politicians are entirely to blame.

What is the solution? Starve the beasts.

1. Immediately withdraw all public pension funds from ALL alternative investment managers.
2. Prohibit any financial institution that has ANY activity in the EU from having ANY position in EU sovereign CDS.  This includes banks, brokers, insurance companies, hedge funds, etc. that are either domiciled, have rep offices or raise funds in the EU.  And when I say ANY activity in the EU I mean it: not even advertising would be allowed, no articles written by its employees, no interviews, nothing. NO-THING.

Bottom line: you want to play?  OK let's play.  But the rules of the game are  going to be for the benefit of the people, not to attack the people.  Because moral hazard should be, above all, moral.

Let's Try Some Perspective

The drumbeat against the euro is increasing daily.  It will fall apart, it will be limited to a hard core of Northern countries, it was a bad idea to begin with, you can't have uniform monetary policy without uniform fiscal policy, etc etc. The cacophony is so loud it is making common sense impossible to break through, particularly since "the free market" is screaming at the top of its lungs.

Let's try some perspective on that "free market", eh?  

• Gross Folly #1: How come the eurozone's financial center is... London?!!  What this means in practical terms is that a scrum of bottom-line-is-everything bonus-hungry twenty-somethings hardly out of school are running the show.  And to top it off, they and their country (the U.K.) are not even members of the eurozone. They don't use it, they don't believe in it and, if anything, they hate its guts.  Literally.  This like trusting a bunch of juvenile delinquents who amuse themselves with setting cats on fire to run the pet shelter. 

• Gross Folly #2:  We let those same kids deal in sovereign bond CDS (credit default swaps) in an unlimited amount, without any regulation, in a completely opaque OTC market.  They don't have to hedge their positions with the underlying sovereign bonds, they don't have to account for their actions to anyone but their immediate boss - who is also in line to make a huge bonus from their profit - and they don't give a damn if they push some poor country into bankruptcy and its people into starvation.  Literally.  This is like giving the nuclear missile launch keys to a bunch of manic-depressives and telling them they have to compete amongst themselves for their meds.

•  Gross Folly #3: We have allowed huge amounts of public and private pension monies to be managed by "alternative-investment" firms, e.g. hedge funds who are compensated on the outrageous 2/20 schedule.  (The US Social Security is still OK, as it can only invest in Treasurys, but it came close to succumbing a few years ago.)  This is like giving a bunch of convicted arsonists a tank-farm full of gasoline, asking them to put it to profitable use.

• Gross Folly #4:   The people of Europe have entrusted management of the whole shebang to politicians, their appointees and committees of clueless bureaucratic mandarins who wouldn't know the difference between a CDS and a CDO if it sat up and hit them in the face. (Again, the US is somewhat better at this since key government positions are frequently filled by experienced financiers.)  This is like staffing Bedlam with a bunch of  South Italian city managers, soviet-era Russian chefs from Vladivostock and over-sized German nurses named Helga.  All overseen by the ghost of Joe McCarthy come back to life.  No doctors.  Oh, and only Wagner allowed in the rec room.

Have a nice weekend...

PS  A friend in the business sent me this picture today.  While I may not exactly agree with it, it is definitely indicative of sentiment towards Germany these days...

European Family Photo

How To Restructure PIGS Debt - A Modest Proposal

With Ireland in political turmoil over its application to receive bailout funds, it is becoming obvious that we are getting caught between a rock and a hard place: on one side, markets (a euphemism for the unholy alliance of public pension money and the private money of the ultra-rich) are no longer willing to roll over the existing debt of the over-indebted, never mind increasing their exposure, at anything approaching reasonable interest rates.  On the other, austerity programs attached to bailouts are causing  high unemployment, pay and benefit cuts, tax increases and service cuts.  

How long can this go on before things get seriously crushed, resulting in one or more massive unplanned defaults by sovereign borrowers, or massive social upheavals? Or both?  It is my opinion that time is running out.

A solution must be found, and the sooner the better.

Let's lay some ground rules:

          1.  A solution should include structural reforms, where appropriate.  For example, Greece must radically reform its public governance which is shot through with graft, corruption and ridiculous inefficiencies and raise the competitiveness of its economy so that it can produce goods and services attractive and attractively priced to the global marketplace.  Ireland should re-think its corporate tax policy and start generating significant domestic savings to fund itself locally, instead of relying on foreign portfolio investors who can - and do - disappear at the first hint of trouble (Ireland sports an external debt of 1,000% of GDP).

          2.  A solution should not trigger a credit event for credit default swaps (CDS).  Apart from not rewarding vulture speculators who bear significant onus for the current mess in sovereign bond markets, there is a systemic reason for avoiding a credit event.  Before the explosion of the CDS market a default would result in well-defined losses: debt outstanding minus recoveries.  For example, a "haircut" of 50% meant that lenders lost half  their capital.

Today, however, there is at least $2.4 trillion outstanding in sovereign CDS,  $2.2 trillion of which  is sold by dealers, i.e. big global banks.  If a credit event is triggered no one knows who will be pushed over the cliff by the tumbling dominoes, all happening in a matter of days (remember AIG?).  Most positions are "offset" in dealers' books, of course, but no one gives a damn about offsetting  when counterparty risk enters the equation in times of crisis (remember Lehman? or Bear? or Merrill? or Citi?).  Here's what it is: under no circumstances is Goldman going to offset positions with Deutsche today if it thinks there's a risk of the latter filing for bankruptcy tomorrow, and vice versa.

CDS Prices For PIIGS 

By allowing unrestricted CDS activity on sovereign debt we have increased credit exposure (more "debt" outstanding) and we also included more participants on the possible default list (the issuers of CDS).  Oh, and if sovereign CDS comes second in amounts outstanding with $2.4 trillion, guess who is first?  Oh yes, financial institutions, with $3.3 trillion.  The systemic collapse that will follow a large sovereign default is too scary to contemplate.

          3.  A solution should provide for meaningful debt relief, i.e. result in the cancellation of 30% to 50% of debt outstanding and, soon thereafter, resumption of borrowing from free markets at reasonable rates.

How is this to be accomplished?

Step One: The European Central Bank (ECB) purchases in the open market sovereign bonds of the countries most at risk.  Right now, this means Greece and probably Ireland.  Depending on maturity, Greek Government Bonds (GGBs) are trading around 55 to 75 cents on the euro.

Step Two: ECB returns the bonds to the issuing country at cost and accepts as replacement new bonds of face amount equal to the ECB's cost.  Maturity and interest rates remain the same.

Example: ECB buys 10 billion face amount of 30 year GGBs with a coupon of 4.60% at the current market price of 53, for a cost of 5.3 billion euro.  It returns them to the Greek state and gets 5.3 billion face of new 30 year bonds bearing a coupon of 4.6%.  Resulting debt reduction: 4.7 billion euro.

The operation is entirely voluntary for original bond holders, who don't have to sell.  However, given that the ECB is going to be in the market all the time, bond dealers will have to sell, or raise their offers in order not to be lifted.  Either way, the market will achieve a balance consisting of part debt reduction, part higher bond prices.


Benefits: debt reduction, bond market stabilization, CDS market coming back to earth, lower borrowing costs (eventually) for troubled countries, minimum political wrangling amongst EU nations, fast action.

Downsides: 

• Troubled countries may rely on ECB interventions and not implement needed structural reforms.  That's why the ECB should act only in conjunction with requirements already in place, moving deliberately and stepwise as reforms are enacted. 
• Bond prices may jump inordinately under ECB's buying program.  If this happens then ECB just doesn't buy, leaving the market to function on its own. Some patience and lots of market savvy are definite requirements for this plan (but not much money!).
• The ECB's balance sheet will expand, at least initially.  But it already boasts 1.9 trillion euro in assets, so even if it bought half of all GGBs and Irish Government bonds outstanding at a discount, it would only have to spend some 100 billion euro.  With markets being what they are, I doubt it would even have to be that much.

Objections:

• It's not ECB's business to bail out nations.  Oh really? Is it its business to bail out only financial institutions, then?  Let's keep in mind that central banks are, above all else, public institutions working for the benefit of the people.  And in such a plan the ECB is not really performing a bailout but a financial intermediation.
• ECB may be stuck with too many sovereign bonds for too long.  This will happen only if nations themselves don't quickly put their finances in order.  Reforms being a necessary condition for participation in the solution, this should not be a serious problem.  Once primary budgets are balanced and markets work smoothly, ECB will be able to sell the bonds - perhaps even at a profit.

One final point from the market-participants' point of view: CDSs are wasting assets, i.e. if a credit event doesn't happen within the period specified in the contract (typically 5 years) holders will lose their entire investment.  By today's prices of Greek sovereign CDSs, that's $5,000,000 (five annual $1 million payments), paid for covering $10 million face amount of bonds.  If ECB adopts this plan it is certain that CDS prices will collapse as dealers try to get out of positions as quickly as possible, further normalizing bond markets.

Ireland (Plus Mrs. Merkel)

Ireland is about to become the second country in the EU to get a bailout (Greece was first). News and analysis  on the subject can be found everywhere, so I'll just throw in a few charts.

Until recently Irish public debt was quite low, around 30% of GDP.  But when the property and banking bubble burst things changed very fast.  Government liabilities exploded from 60 to 140 billion euro in less than three years (see chart below).

 Chart: Central Bank of Ireland

Irish Government Liabilities

The main culprit of Ireland's demotion from prince to pauper is its failed banking system. Ireland boasts  a GDP per person that is second highest in the EU (in purchasing power parity terms) and yet... why did they go so massively in debt?  The private sector is in debt to the tune of some 350 billion euro (~175% of GDP), with home mortgages alone accounting for 110 billion (see table below - click to enlarge).

Chart: Central Bank of Ireland

Home prices are now slumping across Ireland, but as the chart below shows the bubble was a long time forming.

 Chart: ESRI

TSB/ESRI House Price Index

So, what happened in Ireland?  In a word, hubris.  When it entered the European Union in 1973, Ireland was a poor agricultural society - indeed, the poorest country in western Europe.  In a determined effort to bootstrap itself, Ireland focused on education and started attracting foreign (mostly American) manufacturers of high tech equipment and services, offering ultra-low corporate tax rates as an inducement.  It worked marvelously well, turning the country from pauper to prince.

And it all went to their head in the end,  as it always does in the human race.  Dublin became a must-got-to place, a sort of Rome-in-the-Guinness-belt.  Home prices soared and kept on soaring, despite the fact that incomes could not possibly keep up with spiking prices.  Irish home buyers borrowed heavily and in turn their banks borrowed from abroad, particularly from Germany (note the imbalance between debt and domestic deposits in the table above). 

It is estimated that German lenders currently hold about 150-180 billion euro worth of Irish liabilities, making the Irish Problem a very serious one indeed for the German financial system.   And it serves as a poignant counterpoint for Mrs. Merkel, the German Chancellor who has made so much political hay at home at the expense Greece, even though German banks hold only some 30-40 billion of Greek bonds.

P.S. A final prediction, for what predictions are worth: Europe is going to go the way of the US in bailing out its economy (-ies) and Mrs. Merkel is not going to make it past April 1, 2011 as Germany's Chancellor.

The Tri-Polar Era

The Bretton Woods agreement of 1944 established the preeminence of the U.S. dollar as the world's sole reserve currency.  The six decades that followed were the Unipolar Era for matters monetary, even after  Richard Nixon in 1971 unilaterally canceled the dollar's convertibility into gold.

The Maastricht Treaty of 1992 set forth the requirements for the creation of the euro, the European Union's common currency, which started circulating officially in 2002.  Thus began the Bipolar Era, a time of increasing concern for the United States since the euro challenged its monetary preeminence and threatened the very foundation of The Dollar Empire.  

America's serial troubles with the stock market crash of 2000, the 9/11 terrorist attacks, the Iraq and Afghanistan wars and the housing and debt implosion which started in 2007 and is still ongoing, have  only added to the dollar's woes, since Americans have chosen to combat their intractable socio-economic problems with a mere placebo, an anodyne as it were.  To wit, the loosest possible monetary policy and increasingly massive quantitative easing, i.e. the printing press.  

Naturally the dollar is losing value against the euro, prompting virulent  and under-handed attacks against the latter's credibility by American and allied economists, bankers analysts and associated flotsam and jetsam.  For example, the hugely disproportionate negative publicity surrounding Greece's public budget deficit - a laughable 0.25% of the EU's combined GDP.
 
Much more dangerous for American living standards, however, is the loss of the dollar's value against wheat, corn, copper, gold, oil and all other commodities.  The CRB index has zoomed back to its all-time highs not because of strong current or incipient demand from industrial users - the global economy  being still quite weak - but because the dollar is increasingly viewed with well-founded suspicion (see chart below).

CRB Commodity Price Index

And that's where the third pole comes in: China has become the world's second largest economy, but when it comes to its currency it is still acting like a poor, underdeveloped country.  The yuan's hard peg against the dollar is not exactly a sign of national economic confidence, never mind pride.  It's like a 6 ft. tall teenager feeling so unsure about riding a bike that he keeps the side-wheels on. 

An economy of such magnitude and global importance as China's cannot and should not use another country's currency, as it is effectively doing now through the yuan's peg to the dollar.  "It just ain't natural"- and what's more, it's clearly no longer in  China's best interest.  To use but one adverse example, what are the likely consequences of QE2 on the roaring Chinese property bubble?

It is time for China to completely un-peg its currency from the dollar and allow it to float freely, thus causing the world to enter the Tri-Polar Era.  From the perspective of balancing trade and geopolitical power, the existence of three major globally and freely traded currencies is more desirable than only one, and even better than two (the third will act as a buffer).

Furthermore, a tri-polar exchange regime is far superior to antiquated gold benchmark notions currently being thrown about (hopefully containing no serious intent).

Bernake As Greenspan

What is Mr. Bernanke doing with QE2 (quantitative easing part two)?  By his own admission, he is unleashing a flood of money into the system in order to forestall deflation.  And how is more (fiat) money going to help the so-called "real economy"?  Again by his own admission, by pumping up asset prices (i.e. stocks),  creating a wealth effect and thus giving birth to a virtuous cycle of confidence, consumption and investment.  

Here's an excerpt from  the link above, an op-ed Mr. Bernanke wrote for the Washington Post a few days ago.

"And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion." 

That's an astonishing statement of intent, coming as it does from the Federal Reserve, but let's accept it at face value (but, really, could you ever imagine that a head of the nation's central bank would act as a stock jobber for the S&P 500?).

Still, is Mr. Bernanke's asset-bubble strategy any different from what Mr. Greenspan did following the dotcom whump-and-dump of 2000-02?  Oh, not really - except that Uncle Alan chose housing and crappy mortgages, while Brother Ben's choices are shares and Treasurys.  I guess the former was burned by his correct but ill-timed Irrational Exuberance comment (and in markets timing is, after all, everything), whilst the latter has no such inhibitions.  Yet.

What can I say...? Does it matter what you drink, if you end up face down in the gutter in an incoherent alcoholic stupor?

One more time: what we need, and what needs to be seriously targeted by all concerned, is higher earned income (wages and salaries), not more debt-inflated asset prices.  

Period.

Common Sense

For today's elections I have only one thing to say.. OK, two:

1. Smart people don't cut off their nose to spite their face.
2. Remember the Alamo (you know... Bush?).

Enjoy the balloting.

P.S.  Here are some rather shocking data on wage distribution in the U.S.A. from the Social Security Administration. (Data refer to 2009 during which there were a total of 150 million wage earners.)

• The largest group of wage earners - a massive 24 million or 16% of the total - made between 1 red cent and $4,999.99.  On average they earned $2,016.
• The average wage for everyone was $39,054, but the median was a mere $26,261.  Two thirds of all workers made less than $40,000.

  Middle class? What middle class?  Look at the data...