Of PIGS And Elephants

We all know the pitfalls of comparing apples to oranges. But what of pigs and elephants? (Note: PIGS = Portugal, Ireland, Greece, Spain).

Case in point, the sovereign debt crisis which started in Greece and spread to Portugal, Spain and other such debt-fed porcines. It wasn't long before Italy, France and other EU nations started feeling the ripples in their government bond prices. Even Germany, that beacon of uber-conservative government finances, saw its CDS prices climb higher.

Analysts, financial journalists and global pundits are now falling all over themselves to criticize the Greeks for the mess they made. Nouveau-popular Roubini and Taleb have gotten in on the act and a day does not go by without mention of Greece in the front pages of major financial networks (Bloomberg, Reuters, WSJ, FT..). They have even unearthed a funky $1 billion cross-currency swap from 2002 arranged by Goldman Sachs (who else?).

Ahhh.. as the ancient Greeks used to say: Δρυός πεσούσης πας ανήρ ξυλεύεται (once a tree is felled everyone can be a lumberjack). To use yet another allusion, the Greek pig is being sacrificed at the altar of "high" finance.

And who's the elephant? Why, the USA of course! Compare the size of projected budget deficits for 2010: Greece $27 billion, USA $1.6 trillion - and that's just the federal deficit, i.e. excluding state and local deficits. And everyone is hyperventilating about the Greeks' ability to borrow? Oh, puh-lease!

It is evident to even the least suspicious observer that what is going on is a concerted effort to besmirch the euro in order to drive the dollar higher. Why? Because the US needs to borrow on a gargantuan scale from foreign investors. Since the US cannot pay high interest rates (they would destroy the economy), it must make Treasury bonds attractive in other ways, i.e. through the dollar exchange rate in the FX market. What matters to a foreign bondholder is total return: interest plus FX gains.

Pretty simple to see the picture when the dots are connected..

Insurable Interest And CDS

The Greek debt crisis is a perfect example of what is wrong with the Credit Default Swaps market. As I have said many times previously, starting in 2007, CDS are not real swaps (as in forward FX swaps or interest rate swaps) but insurance contracts. (I am more than suspicious that Wall Street and The City came up with this obviously misleading name in order to avoid regulation from the staid and conservative insurance regulators.)

AND... as this very good article in the Financial Times makes clear, everyone in the CDS market plays with fire without having any insurable interest in the underlying credit risk (i.e. without owning the bonds). The FT writer says it succintly: "We have given Wall Street huge incentives to burn down your house".

The "arsonists" are to be found everywhere in our investment community (a better term would be juvenile delinquent gang) and they are profiting mightily: pension funds make hefty premiums from selling CDS, investment banks make fat profits by "making markets" ( e.g. Greek CDS commonly have 20 bp bid-offer spreads) and by attacking bonds directly, hedge funds make a quick buck by buying and selling CDS. Happy times everywhere, except for the poor people who have to foot the bill in the end, i.e. those who have to borrow.

This utter nonsense has got to stop NOW. Global regulators can do this with two strokes of a pen:

1. You want to sell CDS? Fine - you must become a regulated insurance company with adequate segragated reserves, actuarial departments, etc.
   
2. You want to buy CDS? Fine - show proof of insurable interest, i.e. you must own the underlying bonds.
   

Delenda Cartago (Wake Up America!)

This story made the "front" web-page of New York Times: China Leading Global Race to Make Clean Energy. According to the article, China is now the world's leading manufacturer of wind turbines, ahead of Denmark, Germany, Spain and the U.S. It is also the largest maker of solar panels and is leaping ahead in the construction of nuclear and "clean" coal-fired plants.

Surprised? I'm not, because as a trained engineer I know very well that manufacturing is at the core of technological advancement: start with making cheap textiles in Lowell, Massachusetts and you end up sending people to the Moon - particularly if your competitors are fat and lazy and you are hungry and motivated.

Does it sound familiar? Of course it does, because history does repeat - but we must know enough of it to recognize the pattern of the tune, not just the notes on the scale. And that's another reason why this blog makes so many references to the past, frequently from the Graeco-Roman era. As Ecclesiastes put it: There's nothing new under the Sun.

Before I am painted a hopeless past-gazing curmudgeon, here is a very young singer that gets it: Miley Cyrus is just 17.

..Wake up America. Tomorrow becomes a new day. And everything you do matters. Yeah, everything you do matters, In some way. Stand up, I'll try if you will. Wake up, It's not a fire-drill. All she needs is a little attention, Can you give her just a little attention? Oh, it's easy to look away, But it's getting harder day by day...

Going back to the NY Times article, here are some particularly interesting excerpts:

• These efforts to dominate renewable energy technologies raise the prospect that the West may someday trade its dependence on oil from the Mideast for a reliance on solar panels, wind turbines and other gear manufactured in China.

• Interest rates as low as 2 percent for bank loans — the result of a savings rate of 40 percent and a government policy of steering loans to renewable energy — have also made a big difference.

• With prices tumbling, China’s wind and solar industries are increasingly looking to sell equipment abroad — and facing complaints by Western companies that they have unfair advantages. When a Chinese company reached a deal in November to supply turbines for a big wind farm in Texas, there were calls in Congress to halt federal spending on imported equipment.

Our biggest obstacles in recognizing today's yesterday, so to speak, are those sclerotic high priests of political economy who daily genuflect to the crumbling altars of neoclassical deities. "Praise Adam, Glory be to Milton, Hallowed is thy Invisible Hand..". Meanwhile, the Chinese summarily dethroned Marx, Lenin and Mao when their teachings became obsolete.

I am not saying that we should today follow the Chinese model as is, any more than we should have followed the Japanese model a quarter century ago. Imitation may be flattering, indeed, but it never leads to true advancement.

Instead, we should renounce what cannot be modified, modify what can be improved and invent anew what cannot be improved.

Quantum Economics?

I was helping one of my daughters with her physics homework the other day (subject: pressure, she's in junior high) and my thoughts wandered to how little we really understand the economy. The immediate reason was that her teacher insisted on a verbatim definition of pressure, exactly as it appeared in her textbook, and loped off 50% of her grade in a a recent test because she answered in her own words.

I was mad as hell and even contemplated pulling rank on him (I had a couple of rather famous physics professors in college), but better sense prevailed. I am old enough to know that an old dog can't change his bark and all I could accomplish would be to put my kid on the spot. The guy probably thinks that Newtonian physics is current science, anyway...

Which brings me to the post's subject: given that quantum physics describes our world in terms of multiverses, probability functions and uncertainty, why do dismal economists still insist on "classical" theories from the time of Adam Smith, the near contemporary of said Sir Isaac Newton - who lost a fortune speculating in the South Seas Bubble and was then honest enough to admit that “I can calculate the motions of heavenly bodies, but not the madness of people”.

(Note: If you haven't already read it, I strongly recommend Extraordinary Popular Delusions and The Madness of Crowds, Charles Mackay's classic first published in 1841 and continuously re-printed ever since.)

The Law Of Gravity As Applied To Fools

Our "modern" economic theory even predates thermodynamics! How can we possibly still use Adam Smith as our economic foundation, without first integrating real science into markets and money so that they are at least compatible with the First and Second Laws of Thermodynamics? After all, isn't the real economy all about the transformation of matter and energy? Or have we focused so much on money, finance and intangible assets that we have come to think of them as the economy?

And when I say "real science" I certainly don't mean the thin veneer of financial engineering that was applied onto the rotten surface of structured finance (CDO-cubed?!), but something entirely different. For example, why don't we start by including into our econometric models those pesky "externalities" (pollution, environmental degradation, resource depletion...) that Adam Smith left out? Maybe he (and so many others after him) was right in ignoring them, living as he did in an 18th century world that seemed boundless. But can we ignore them today?

Isn't what we are going through today another manifestation of living under boundary conditions? Or, to use a parallel from physics: hasn't our world "shrunk" to the point where Newtonian physics no longer applies and we have to start using quantum economics?

Tempest In A Tzatziki Pot

Note: I was going to title today's post "Permission Denied", but then I decided to join the ranks of the Dumb Title Brigade (see further below). If you are not familiar with Greek cuisine, see here for the wiki on tzatziki (jeez, will this guy quit with the bad word puns, already?)
________________________________________________

Greece has been on the market's ropes for some time now, after it announced a whopping 12.7% budget deficit for 2009, the largest in the eurozone (a year ago the previous government was projecting it around 4%). If Disraeli was alive today, this massive departure from reality-based numbers would have doubtlessly caused him to cry "Lies, damned lies and Greek statistics".

Analysts and the financial press are having a field day with this, dusting off their schoolboy knowledge of all things Greek: "A Greek Tragedy", "Marathon Ahead For Greek Economy", "Greece Enters Plato's Cave"... I bet "Greek Bonds Skewered Into Souvlaki" is the next salvo from the Dumb Title Brigade.

The yields spread of Greek 10-year government bonds over German ones has risen as high as 310 b.p. (3.10%), the highest in nearly 10 years. The five year credit default swap has likewise jumped to 340 points (see chart below).

Five Year CDS On Greek Government Bonds

But...

The Greek Problem has now turned into a European Problem, as speculators the world over are turning this debacle into an opportunity to drive the euro lower in the foreign exchange market. The dollar has strengthened from 1.51 to 1.41 vs. the euro in just two months. Moreover, policy and geo-strategy wonks are salivating at the prospect of the eurozone (and then the entire EU) falling apart. All that for a country with a GDP amounting to less that 2% of the entire EU.

There is no question that Greece needs to overhaul its public sector - indeed, its entire economy. But that's a far cry from speculating that it will be the cause of the EU's demise. There's simply too much invested, over too many decades, by the other 98% to let the 2% drag it down. Greece is simply going to be denied permission to default and/or exit the euro zone. Therefore, the whole thing will end up amounting to no more than a tempest in a tzatziki pot.

And what will happen next? After the Greeks have made their grudging obeisance to the All-Mighty Market in the form of mandatory reforms, the EU will bail them out (probably in the form of ECB credit facilities). I expect this in the next few months, even weeks.

P.S. My buddies working at CDS desks are reporting something quite interesting: non-Greek institutions are not accepting Greek names (i.e. Greek banks) as counterparties when the latter are trying to sell CDSs. It does make logical sense (if Greece defaults would you want your Greek bond insurance to be issued by a Greek bank?), but it makes for a very thin and one-way market. My experience says that this is very dangerous ground for those going long Greek CDS, right now.

CDS Counterparty Politics

Long-time readers of Sudden Debt (it was started on Dec. 2, 2006 with this post) know of my insistence that credit default swaps (CDS) pushed the current financial crisis over the edge of the precipice. This relative newcomer to the roster of financial instruments acted as a catalyst, much as a slow chemical reaction proceeds at explosive levels with the addition of even a tiny amount of the appropriate substance.

I posted many times on CDS, from Phantom Menace to CDS Factors In Equity Valuation (a four-part series: Part A, Part B, Part C, Part D.) and frequently commented on one aspect that made them truly dangerous to the stability of our financial system, i.e. counter-party risk. It didn't matter, I claimed, that a dealer's CDS book was "square", i.e. that he slept comfortably thinking his market risk was zero because he/she had offsetting positions with other dealers.

When I said that huge notional CDS amounts really mattered (see chart below) I was pooh-poohed as a Cassandra, particularly by those professionals who only saw as far as their "blotter" and who never worried what would happen if a major participant went belly-up.

Until it did.

CDS Outstanding (Data: ISDA)

The AIG saga is now unfolding in ways that "professionals" would not even dream of and is snaring past and present Treasury Secretaries who rushed to bail out the failed insurer's counterparties at 100 cents on the dollar, to the tune of $62 billion.

I must admit I made a big mistake three years ago: I thought no American government would ever dare to use such an enormous amount of public money to cover the private losses of the nation's wealthiest institutions. And I am once again amazed at these same institutions' hubris of paying record-breaking bonuses for 2009 results. If this isn't the stuff that makes for public uproar and revolution, I don't know what is...

Debt On ICE(land)

I have a bunch of friends, both inside and outside the finance business, who vehemently claim that countries cannot and do not go bankrupt. Their position obviously flies in the face of history (Ottoman Empire, Czarist Russia, Argentina... and a whole bunch of others), but they keep on insisting. Unfortunately, they have been in good company (well.. bad company) at least since the 1970's when Walter Wriston, then CEO of Citibank infamously proclaimed that "countries don't go bust". A decade later the Latin Debt Crisis nearly sunk a number of major US banks, Citi included (they were ultimately bailed out by the Brady Plan).

I think what my friends really mean is that in today's financial world countries could (and do) go bust in essence, but then get bailed out by the likes of the IMF, other central banks or creditors' groups.

However, it looks like things are about to change; that a shift of tectonic proportions is taking place in - of all places - tiny Iceland.

Iceland: Unlikely Hotbed of A Debt Revolution?

I am not going to repeat what went on there during the credit boom and its aftermath - you can read about it here. What is more important, however, just took place a couple of days ago: the country's people have forced a referendum on the issue of their government borrowing $5 billion to repay foreign depositors (mostly Brits and Dutch) of three failed Icelandic banks. Simply put, The People of Iceland are angry at having to foot the bill for private transactions gone sour. (If you prefer Latin, Vox Populi Deus Irae.)

Can you blame them? Or, to use a more visual approach to the matter, just look at the wonderful sculpture below.

Survival of The Fattest

Happy Holidays

May I offer my sincerest wishes for Christmas and the Holiday Season. I will take a break from posting for a week or so - unless there are serious developments, of course.

All The Best.

A Christmas Tree For Troubled Times

The Euro's Trojan Horse

'Tis the season of giving, so it should come as no surprise that at this time Sudden Debt invokes Troy's Laocoon in Virgil's Aeneid: "Timeo Danaos et dona ferentes" (beware of Greeks bearing gifts).

Why? Because as crafty inventors of the Trojan Horse Greeks may once again become infamous for yet another inside job: the euro's downfall - or, at least, its fall from grace.

Beware of Greeks Bearing Euros

If you have been following European financial matters at all, you know by now that Greece is in dire straits. It is beset by that trio of trouble that gives finance ministers white hairs by the hundreds: huge public debt (~120% of GDP), huge budget deficit (~13% of GDP for 2009), huge current account deficit (~10% of GDP for 2009). Oh, and its private sector debt went from 38% of GDP to 100% in less than a decade, mostly because households jumped on the debt wagon: their debt went from 15% to 50% of GDP in the same period, mostly on mortgage borrowing and higher housing prices.

Does the pattern sound familiar? Of course it does... this model of "economic growth", which substituted increased borrowing for earned income, was repeated all over the western world.

The immediate result is that rating agencies have now cut their marks for Greek government debt to BBB+, the lowest in the eurozone (S&P and Fitch. Moody's is still A1 but will soon downgrade) and borrowing costs have soared. Greek government 10-year bonds are currently yielding 5.74%, 271 basis points (2.71%) over the equivalent German bunds. In the years of the credit boom, of easy money and bubbly assets, this spread was a mere 20-30 b.p.

Likewise, credit default swaps (CDS) for Greek sovereign debt have now soared to 275-285 points (late Fri. updt.), up from 10-15 (see chart below, click to enlarge). This means that the mathematically calculated Cumulative Probability of Default (CPD) comes in at 21.5%, the 8th highest amongst sovereign risks (for comparison, Dubai is 6th on the list with 26.2%). To give you an idea of other eurozone members' CPDs, France is at 2.6% and Spain at 9.1%.

Greek CDS: Nosebleed on Mt. Olympus

All this trouble brewing in eurozone's weakest link is causing reasonable questions for the euro's viability as a global reserve currency. After all, claim the euro-naysayers, what is the EU if not a mere free trade zone with a common currency attached? In other words, Greece may be the euro's Trojan Horse... or at least, a damn good excuse for selling euros (see chart below, click to enlarge).

US Dollars Per Euro

Just one month ago I sounded the bell of euro's overvaluation vs. the dollar, having just seen the movie 2012. To use another Trojan allusion, there were simply too many Dollar Cassandras around, and they had even made guest appearances in popular movies. A sure omen of reversal, if ever there was one...

Throwing Good Oil After Bad Debts

Abu Dhabi decided to bail out Dubai (once again) by providing $10 billion in order to prevent a bond coming due today from defaulting. As the post's title says, that's precisely like throwing (more of) Abu Dhabi's perfectly good oil after Dubai's stinking bad debt. At today's prices, $10 billion is equivalent to nearly two months of Abu Dhabi's full-out oil production. And there's more bad debt where that came from, of course.

Ahhh, you will quickly say: it's only fiat money - book entries upon book entries. And Abu Dhabi still gets to physically keep its oil and can always hike the price it charges and get its money back from all the rest of us - including Dubai's lenders who are currently being bailed out (again).

Oh yeah? Not so fast..

In today's push-button interconnected global economy a bailed-out lender can immediately convert Abu Dhabi's pennies from heaven into a tangible commodity (say, crude oil), hire a VLCC and anchor the whole thing off the coast of Singapore. By bailing out Dubai and its lenders, Abu Dhabians are making a fool's bargain. They would have been much better off had they told everyone to take a hike, including those who kept building castles in the sand.

Ahhh, but what about the oil producers' ability to raise prices almost at will? Hah! And why do you think the US is sitting on Iraq, to mention just one geo-political petroleum pressure-point? Please note that Iraq has just announced plans to raise production to 12 mbpd in the future (it currently produces about 2.5 mbpd). If it succeeds (admittedly a huge if), it will surpass Russia and become the world's second largest producer of crude after Saudi Arabia. Kiss pricing power good-bye..