Wednesday, December 7, 2011

The EU summit will fail

This week’s EU summit meeting will fail. The purpose of the meeting is to agree to a fiscal stability plan that will persuade the ECB to rescue Italy and Spain. This will fail for two reasons.

First, there is considerable daylight between what Germany wants and what the EU or the  eurozone can agree to. Germany wants a new treaty with binding constraints. A new treaty requires all 27 countries to sign on because every country has a veto. A number of EU countries that are not in the eurozone lack enthusiasm for this idea. It is unclear if European law contemplates a treaty that leaves out a number of members. There could be a eurozne-only agreement, but not a treaty. It is hard to see how the leaders can emerge on Saturday with anything like what Merkel wants.

Second, there is little reason to believe that there is anything that can persuade the Bundesbank to reverse its position on rescuing Italy and Spain. While Draghi has made hopeful noises, the president of the Bundesbank, Jens Weidmann, has not. His position is that this is a matter for the EU to solve via eurobonds, which Merkel has ruled out. Draghi cannot rescue Italy and Spain without the Bundesbank’s consent.

It will be interesting to see how the leaders, who are staring into the abyss, can construct a communique that will obscure the summit’s failure. 
Many European leaders have said that a failure to rescue Italy and Spain will lead to catastrophe. But standing in their way is Germany, which won’t agree to guarantee other countries’ debt, and the Bundesbank, which will not allow the Bundesbank to become the eurozone’s bond buyer of last resort. 
Without either eurobonds or an ECB rescue, Italy and Spain are doomed.

In the event of their default and/or redenomination, the rest of Europe will have to recapitalize their banks. This will place strains on everyone, especially France and Germany. In the end, I would expect the ECB to capitulate and embark upon an unprecedented campaign of quantitative easing.

Should it fail to capitulate (soon), the outlook for the eurozone is dire. Those of us outside the eurozone (UK, Canada, US, Australia, Japan) will be able to lean against the deflationary forces blowing over from Europe.

The major economy most at risk now, besides Italy and Spain, is France. France may lose its AAA, will have to bailout its banks, and will have to remain credible in the bond market. This will force a level of austerity that could lead to civil unrest.

Thursday, December 1, 2011

Draghi's speech to the European Parliament: a breakthrough?

Mario Draghi, head of the ECB, gave a somewhat dovish speech today to the European parliament. As the NYT reports:

He seemed to be saying that the bank would use its virtually unlimited resources to keep financial markets at bay, if government leaders in the euro region agreed to do their part by addressing the structural flaws that had allowed the debt problems of Greece to mutate into a threat to the global economy.

“What I believe our economic and monetary union needs is a new fiscal compact,” Mr. Draghi said. “It is time to adapt the euro area design with a set of institutions, rules and processes that is commensurate with the requirements of monetary union.” After government leaders take steps to improve the way the euro area is managed, “other elements might follow,” Mr. Draghi said.

I can’t imagine Draghi would make such a statement without the consent of the ECB’s governing board, including the Bundesbankers. He seemed to be saying that if the “Merkel Plan” is adopted, the ECB would intervene more forcefully in the government bond market.

The Merkel Plan would change the eurozone from a monetary union into a fiscal union, with Brussels in charge of national fiscal policy. It has not yet been fully embraced by Sarkozy, and it leaves unanswered what would happen to the 10 EU members who are not part of the eurozone.

I won’t say that the ECB’s independence has been compromised de jure, because it certainly hasn’t. But the ECB has found itself in the awkward position of either leaving its “price stability” comfort zone, or else standing by while the eurozone (its raisson d’etre) goes away. It would be understandable if certain board members did not wish to preside over the dissolution of the eurozone.

“Who will rescue the eurozone?” is a hot potato that has been tossed back and forth between the ECB and the eurozone governments for a number of weeks. It would seem that they have begun to inch toward a joint plan:
the eurozone will impose a fiscal strait-jacket upon itself, in return for which the ECB will intervene forcefully in the bond market, thus rescuing Italy and Spain.

There are two big ifs here: (1) Will all 17 members agree to the Merkel Plan; and (2) if they do, can Draghi really deliver the ECB in force? Previously, the ECB had demanded that the eurozone issue guaranteed eurobonds. Now it would appear that it is prepared to buy national bonds without any guarantees on the basis of the “fiscal pact”. As always, I am skeptical. But this latest news suggests that all is not yet lost, and there may indeed be light at the end of the tunnel.

If so, this is very bullish news, the best news in months if not years.

France should ring-fence its banks now

There are two ways that Italy and Spain can be rescued from collapse: either the eurozone agrees to issue eurobonds which are guaranteed on a joint-and-several basis by all 17 members, which would be used to refinance maturing debt; or the ECB agrees to act as bond buyer of last resort and establishes a standing bid for Italian and Spanish bonds at an agreed yield.

If either of these events occur, Italy and Spain will be able to continue to repay maturing debt. If neither of these events occur, then at some point the bond market will close to Italy and Spain, as it did to Greece. (The bond market may have already closed, since the ECB does not disclose its purchases by individual country.)

Under the bad scenario, Italy and Spain will have to restructure their debt and/or leave the euro. Either way, banks will be faced with substantial writedowns.

Which brings us to France. France is a strong credit (somewhere in the AA category) despite its banking system’s exposures to Italy and Spain. Its banks, however, are not strong credits on a standalone basis, because of their eurozone exposures as well as general unprofitability.

The weakness of France’s banks (especially BNP) is contaminating France’s own credit, such that France is having to pay yields as much as 2% above Germany. It is time for France to bailout its banks, and thus demonstrate its ability to withstand defaults by Italy and Spain.

There are a number of ways for France to bailout its banks, but here is a pretty common method: Establish a state owned entity (or use an existing state institution such as CDC) to buy marketable assets (i.e., sovereign bonds) at current market prices (below their current accounting value) and make up the losses with new equity. That way, the banks would no longer be at risk of further writedowns on this paper, and should thus regain their credibility in the debt market. There is much less of a problem with exposures to Italian and Spanish banks; these are manageable and declining, with the ECB taking up the slack.

For reasons that I can’t fully understand, the rating agencies have said that if France incurs additional indebtedness in order to bailout its banks, it is likely to lose its AAA rating. Since these costs are known contingent liabilities, this threat suggests that the agencies are using mechanical debt ratios, as opposed to taking into account contingent liabilities. This is particularly peculiar for S&P, which has been saying for over a decade that it takes into account the contingent liability posed by the banking system when analyzing sovereigns.

In any case, France has already lost its AAA in the bond market, partly in anticipation of a downgrade, and partly due to the weakness of its banks. In my opinion, France should bite the bullet now, take the downgrade, and move on. This would give the bond market one less thing to worry about.

Wednesday, November 30, 2011

Today's announcements mean nothing

So, the Dow index is up by over 700 points this week. This is certainly a market that has been impatient for good news. What was the good news?
1. Reports of a Paris/Berlin plan to organize a fiscal stability pact for the eurozone without the need for a treaty.
2. Reports of an $800 billion IMF bailout plan for Italy, since denied.
3. Establishment of large dollar swap lines between the Fed and the ECB.
4. Lower collateral haircuts at the ECB.

The Paris/Berlin plan is intended to lure the ECB into bailing out Italy; that won’t happen. The IMF bailout of Italy was a false rumor. The Fed/ECB moves announced today are plumbing adjustments which mirror their actions after the Lehman bankruptcy. They are routine and easily predicted.

The dollar run on the eurozone has squeezed the banks; these steps should make it easier for eurozone banks to meet their creditors’ demands. It won’t stop the run. There is nothing in this package for Italy itself, only its banks. So, as the police like to say, nothing to see here folks.

I would venture to say that, later this week, the harsh reality will sink in, and the markets will lose their euphoria and give up their gains. At present, there is nothing standing in the way of a major Italian funding crisis.

Tuesday, November 29, 2011

Thoughts about Greek redenomination

Let’s assume that Greece manages to run out of money in the next few months (which is up to the EU/ECB/IMF troika). Assume that the troika says no to the next tranche or the one after that, and Greece can’t pay its bills. (Note that its bills don’t include maturing bonds because it is in the process of repudiating them). Then what?

Greece will have two choices: stay on the euro and default domestically (stop paying government wages), or redenominate into drachma. They will opt for the latter, redenomination.

How would this work? I can't think of any exact precedents, but the closest I can come up with would be Argentina’s 2001 move from the dollar currency board into the New Peso or whatever they called it. Here is my scenario for Greece:

1. By presidential decree, freeze all deposits, debts and financial contracts, foreign and domestic.
2. Impose currency and capital controls prohibiting any movement of financial assets out of the country.
3. Temporarily close all land, sea and air borders to prevent the smuggling of euro notes.
4. Announce the redenomination of all deposits, debts, contracts, and currency notes into drachma on a one-to-one basis. This would include all foreign debts, claims and contracts with the possible exception of the ECB.
5. Require that all euronotes be exchanged for drachma.
5. Allow the drachma’s external value to float (since the Bank of Greece will have no international reserves and no international credit, assuming that the ECB does not make credit available).
6. Sell drachma bonds to the Bank of Greece in order to pay the state’s bills.
7. Nationalize and recapitalize the banking system with government bonds.
8. Impose permanent capital and exchange controls to prevent capital flight and speculative attacks on the drachma.

Debts incurred under foreign (i.e., English) law will have to be litigated. There is ample legal precedent for successful repudiation of such debts and contracts (Peru, Ecuador, Argentina, Russia, China, Cuba, etc.).

Once this exercise has been completed, Greece will be effectively debt free, will be able to pay its bills, will have a solvent and liquid banking system, and will have a very competitive currency. However, its international trade lines will be temporarily eliminated, until it is able to accumulate enough foreign currency to finance its imports on a cash basis.

The terms of trade will shift dramatically in favor of Greek exports and against imports. The importation of oil (which requires dollars) will be a particular problem, unless exporters are willing to extend credit. This could prove to be a big problem, although Greece would not be the first country in such a fix. Over time, as Greek exports grow, foreign currency receipts would be able to finance imports. (Currency controls will allow the Bank of Greece to prioritize imports.)

The standard of living in real terms would decline as inflation would exceed nominal wage growth. The real price of domestic tradeable goods will rise with the real cost of imports. The need for fiscal austerity will be a function of the regime’s willingness to tolerate inflation. Given the Greek social model, the government will choose inflation over the alternative, and there will be no external pressure to do otherwise. We have already seen this in Russia, Yugoslavia, Ukraine and elsewhere. While it is true that the middle class’s domestic savings will be wiped out, most Greeks have their savings elsewhere, so the social impact may be muted.

The foregoing is my best estimate of what we are likely to see next year. Because Greece is small, the international impact would be negligible, as would be the case with Portugal. The same would not be true for Spain or Italy.

Europe retries the "Mellon Experiment"

What happened to Italy and Spain in the past year? How did they go from being respectable AA sovereigns able to issue debt at low yields to international basket cases having to pay Latin American rates? Did their credit ratios change? Did they lurch to the left?

Well, no. Nothing happened. They have the same credit metrics today that they have had for years. But something happened. What was it?

What happened was PSI, German for “private sector involvement”.

Until last summer, it was eurozone doctrine that “default by a eurozone sovereign is unthinkable.” Which meant that the eurozone was a collective credit, in which the weak were supported by the strong to everyone’s mutual benefit. This was a great policy so long as it existed only in theory and not in practice. Then the high-living Greeks came along and demanded a bailout.

Faced with bailing out a hopeless quasi-marxist charity case, German voters balked. Germany decided that it wouldn’t support a bailout of Greece unless there was PSI, meaning that bondholders must “participate” in the “burden sharing”.

The theory was that by injecting risk into eurozone bonds, the market would encourage fiscal discipline in a way that the original eurozone treaty  had failed to do.

The German desire for market discipline in the eurozone worked as well as anyone could have hoped. The market realized that the bonds of eurozone sovereigns and banks were risky, and began to price in this risk.

The  credit risk premium demanded by the bond market is a function of expected loss. If default is impossible, expected loss is zero. If a default is a given, expected loss is the “loss given default”, the difference between the present value of the promised and expected cashflows.

Greece has announced that it will provide its bondholders with a deal worth 25% of the promised value. Therefore the “official” expected loss on Greece’s bonds is now roughly 75% (but actually more, since the deal involves new paper of questionable value). So, not only is there now risk in the eurozone bond market, there is a lot of risk.

Once the bond market understood that eurozone sovereigns were standalone credits, it began to look at them as such. Not only did investors have to analyze each of these credits (using, God forbid, financial ratios!), it had to anticipate how other creditors would act, since not only were these countries exposed to insolvency risk, they also faced liquidity risk.

Using the “liquidity risk screen”, out popped two names: Spain and Italy. They popped out because their market takings are so large and everyone’s exposures are so large. Reductions in investor and counterparty concentration limits would push these names out of the bond market (since everyone was at their limits already).

So now Italy and Spain no longer trade as double-A western Europeans; instead they trade as BB “special situations”. Investment grade portfolio managers are selling them in anticipation of the inevitable downgrades into junkland.

So, thanks to the miracle of market discipline, we are now looking at defaults by Greece, Italy, Spain and Portugal. Isn’t market discipline a wonderful thing?

During the the Depression, the secretary of the Treasury, Andrew Mellon,  advised the president, Herbert Hoover:
Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people. (Herbert Hoover, Memoirs)

The Mellon Experiment lasted four long years (1930-33), and was an economic disaster on a scale that beggars the imagination. We are about to watch as Mr. Mellon’s experiment is tested once again, this time in Europe. Will it be more successful there? Will it help people to work harder and live more moral lives? Will the fragile political institutions of southern survive what they were unable to survive the last time?

The deus ex machina for the US in the Depression was the replacement in 1933 of the deflationist Hoover team with the inflationist Roosevelt team, which took the US off gold and flooded the economy with dollars. Europe has no Roosevelt in the wings, only Mario Draghi.

Sunday, November 27, 2011

$800 billion IMF bailout for Italy?

The financial media are moving a story out of Italy (La Stampa) that the IMF will launch an $800 billion rescue of Italy and Spain:

The International Monetary Fund is being lined up potentially to help Italy and Spain amid growing fears that a European rescue scheme will not be able to prop up the countries, it emerged last night. Reports in Italy suggested that the IMF is drawing up plans for a €600 billion (£517 billion) assistance package for the country. Spain may be offered access to IMF credit, rather than a rescue package, to avoid it being “picked off” by the markets in the coming weeks. (Telegraph)

What is even more incredible is that Bloomberg reports that this story is moving markets.

Now for a dose of reality. The IMF has never and will never engage in a major operation without the active consent of the US for obvious reasons. Therefore, a rescue of the eurozone on any scale (let alone $800 billion!) requires US consent which, in practice, includes the House of Representatives, which holds the purse-strings. This would require Treasury (Geithner) to consult with the House (Boehner). Boehner would have to consult with his caucus, who would be outraged at being even asked. (Some perspective: Two presidential candidates are members of the IMF subcommittee: Ron Paul and Michelle Bachmann.)

Secondly, the IMF’s balance sheet is currently around $360 billion. It would be a bit of a stretch for a $360 billion institution to launch an $800 billion rescue of a single member, even if the US was on board.

So this market-moving story is untrue. Once the market figures that out, it will begin to sink in that there is no deus ex machina in the wings for the Italians and the Spanish. And once the market has finished grasping at straws, it will have to begin to process what is really going to happen: the unthinkable.

Dateline: Athens. This is not a joke.

Hot off the wire from Athens:
The head of Elstat, Greece’s new independent statistics agency, faces an official criminal investigation for allegedly inflating the scale of the country’s fiscal crisis and acting against the Greek national interest.

Andreas Georgiou, who worked at the International Monetary Fund for 20 years, was appointed in 2010 by agreement with the fund and the European Commission to clean up Greek statistics after years of official fudging by the finance ministry.

“I am being prosecuted for not cooking the books,” Mr Georgiou told the Financial Times. “We would like to be a good, boring institution doing its job. Unfortunately, in Greece statistics is a combat sport.”

The accusations against him, which are likely to shock European Union officials, come as eurozone finance ministers prepare to decide on Tuesday whether to release a delayed €8bn ($10.6bn) loan tranche to Athens, needed to pay public sector salaries and pensions next month. Over the past 18 months rows about the size of the Greek deficit have strained relations between Greece’s finance ministry and its international creditors.

Mr Georgiou is due to appear before Greece’s prosecutor for financial crime on December 12 to answer the charges. If convicted of “betraying the country’s interests”, he could face life imprisonment.

Here is some background on this story from September:

Greece revamps statistics service board after row

Fri, Sep 16 2011
ATHENS, Sept 16 (Reuters) - Greece said on Friday it would replace the board of its independent statistics service (ELSTAT) after two members resigned and another was quoted as alleging that 2009 deficit data had been artificially inflated.
It said ELSTAT chief Andreas Georgiou would keep his post.
The upward revision of Greece's budget deficit in 2009 to 15.4 percent of gross domestic product exposed the scale of the country's fiscal derailment and sped up the debt crisis which is still rocking the euro zone.
"The 2009 deficit was artificially inflated to show that the country had the biggest fiscal shortfall in all of Europe, even higher than Ireland's which was 14 percent," ELSTAT board member Zoe Georganta was quoted as saying by the Eleftherotypia newspaper.
Georganta said the inclusion of a number of utilities under the general government inflated the deficit. She said this had not been handled according to Eurostat guidelines and that the chairman rejected the board's objections.
"We have a new kind of occupation in Europe by the Germans," Georganta told Real FM radio, adding that German officials at Eurostat put pressure on the government to inflate the 2009 deficit to justify harsh austerity measures.
Greece in 2010 unveiled legislation to make its discredited statistics service fully independent after the European Union demanded that it puts an end to the release of flawed economic data.
Frequent revisions of national account data since the country joined the euro zone in 2001 had infuriated its partners in the bloc who demanded an overhaul of the service.
The overhaul took place under former finance minister George Papaconstantinou. It included regulations to stop political meddling by giving parliament, rather than the government, the task of appointing its chief.
Papaconstantinou was quick to dismiss the allegations on Friday, saying the deficit revision was fully in line with Eurostat's methodological guidelines.
He said the revision of Greek fiscal data in 2010 was the result of close cooperation with Eurostat and the same methodology as the rest of Europe was applied.
"Unfortunately for all of us, Greece's deficit in 2009 was 15.4 percent of GDP as was officially announced by Eurostat and ELSTAT," Papaconstantinou said in a statement.
"Let's understand the dire situation the country faced instead of fabricating cheap and easy conspiracy-type excuses for the absolute fiscal derailment we experienced," Papaconstantinou added.
Finance Minister Evangelos Venizelos on Friday introduced an amendment to a draft bill on bank supervision which stipulates that ELSTAT's current board will be replaced, with the exception of its chief.
Parliament has to approve the new board at ELSTAT.
Venizelos told lawmakers on Thursday that the resignations did not affect data collection and processing and put his support behind ELSTAT chief Andrea Georgiou.
"Unfortunately, at a level of interpersonal relations and functions, a problem has emerged," Venizelos said without elaborating.
"The president of ELSTAT is considered by all our institutional partners, and mainly by Eurostat, a person of experience and someone who can guarantee that the sad chapter of 'Greek statistics' is closed," Venizelos said.
ELSTAT President Andreas Georgiou said in a statement: "The compilation of these statistics was done in full compliance with the rules and standards of the European System of Accounts and European Union Regulations."

Paris and Berlin try again

The latest front in the European civil war over the fate of the eurozone is no longer Athens or Rome or even Berlin. It is Frankfurt, headquarters of both the Deutsche Bundesbank and its “subsidiary”, the ECB.

To the west is Paris, which is desperately seeking to find a way to make the ECB rescue Italy before it's too late. To the east is Berlin, which is desperately seeking to find a way to make Italy creditworthy enough for the ECB to rescue. In the middle is the Bundesbank, which is the ultimate arbiter in this matter.

Last week, Paris, Berlin and Rome agreed to stop hectoring the ECB to act as Italy's lender of last resort. Next week, they plan to move to Phase II, in which they will replace demands with inducements. The plan, as reported, is for the eurozone to announce a new “stability pact” to enforce budget discipline, but without the insuperable hurdle of another EU treaty.

Reuters reports:
"Based upon these measures, there should be a majority within the ECB for a stronger intervention in capital markets," Welt am Sonntag said. It quotes a central banker as saying: "If the politicians can agree to a comprehensive step, the ECB will jump in and help."

There is no mention of the Bundesbank, but presumably it is included in this optimistic prediction.

I am skeptical. Rome can sign a hundred new stability pacts (Rome will sign anything), but pacts do not bind the Italian political process. Italian politics is about only one thing: how to slice the pie. There is no room in such a system for a smaller pie, only a larger one.

Italian politics developed over half a century of inflation and devaluation. When the pie got too big, the currency did the adjustment. Under the euro, it’s the pie itself which must do the adjusting: mission impossible.

Foreign observers labor under the illusion that replacing Berlusconi with Monti makes the slightest difference. It doesn’t. Monti and his technocratic cabinet are irrelevant in Italian party politics: they have no party. Their “base” is foreign: Brussels, Paris, Berlin. Only Italians get to vote in Italian elections.

So therefore, the key question is not whether a new stability pact will make Italy creditworthy; it can’t. The question, instead, is whether such a scheme could be used to induce the ECB to pretend that Italy is creditworthy. Or in even more crucial terms, whether Berlin has any leverage over the Bundesbank.

I don’t know the answer to this. I have no idea what levers Berlin might have to get the Bundesbank on board. Going by history, however, it does not have sufficient leverage. We should find out pretty quickly, because time is of the essence.

For argument’s sake, let’s assume that the Bundesbank and the ECB relent, and announce that the ECB will begin to bid directly at Italian bond auctions, with the goal of keeping yields below X%.

What would be the consequence? Clearly, there would be a major global rally across all asset classes, even euphoria. But we’ve been to euphoria before.

Once the shouting died down, would anyone trust the ECB enough to buy Italian bonds at the targetted yield, or would investors take advantage of the subsidized bid to unload? They would unload! Italy’s government debt exceeds EUR 1.5 trillion, which is a pill that the ECB would find hard to swallow, since its total assets are EUR 2.5 trillion.

So, over time, the ECB would be confronted with the choice of having to to sell every other asset it owned, giving up on Italy, or losing control of the monetary base. These are the considerations that have led the ECB to take the hard line that it has so far.

Political Addendum
It should go without saying that this latest scheme was cooked up by Sarkozy. It represents his latest effort to find a way out of the fix that the eurozone is in. Merkel has gone along because (a) she doesn't want to seem indifferent to the Italian crisis; and (b) it takes the ball out of her hands and drops it into the ECB's court. The Bundesbank has been saying that this is a problem for the eurozone governments to solve, while the eurozone governments have been saying that it is the ECB's problem.

Thursday, November 24, 2011

Here comes the run

That sucking sound you hear is the Big European Bank Run.

Right now there are four bank runs occurring in the eurozone: (1) the bond market has closed to many eurozone banks, and their maturing bonds cannot be refinanced; (2) as bank risk committees lower their eurozone concentration limits, interbank and counterparty exposures are being cut or eliminated; (3) wholesale depositors (money funds, investors and corporations) are prudentially reducing their  eurozone limits; and (4) retail depositors in Greece, Italy, Portugal and Spain are either cashing out their deposits into euro notes, or transferring them outside of the eurozone, to Switzerland or beyond.

At the acute level, all (retail and wholesale) depositors fear a deposit freeze in the critical countries, which is by now inevitable for Greece, and very likely for Italy, Spain and Portugal. Greece will need to freeze deposits soon, because Greek depositors aren’t stupid. They know that, once your euro deposit has been frozen, it will emerge on the other side as drachma-denominated wallpaper. Once Greece announces its freeze, the heat will be on for the rest. Those who freeze will, of course, have to leave the zone. You can’t unfreeze back into a currency that you don't print.
At the subacute level, creditors are wary of all European banks with exposure to the critical countries. Despite the fact that most such banks are too big to fail, credit committees are loathe to rely exclusively upon such contingent promises.

Although so far all of my forecasts have been directionally correct, my accuracy as to timing has been poor; I expect things to happen faster than they do. This has been because I overestimate the market’s speed of reaction, and I underestimate Europe’s ability to come up with endless fudges (such as eliminating collateral standards at the ECB). Nonetheless, I predict that Greece will have to freeze by year end, which should prompt the cascade of events resulting in the breakup of the eurozone.

As we know from similar such situations in the past, the authorities in the frozen countries may seek to force the repatriation of offshore deposits. For this reason, prudent eurozoners will follow long-established tradition by moving their funds far away, using dummy corporations as well as cash in numbered boxes. And the truly prudent will want these caches denominated in anything but euros, which may explain why 10-year Treasuries now yield a whopping 1.9%.

Wednesday, November 23, 2011

Are German bunds now a risk asset?

This morning, the German finance ministry’s auction of 10-year notes was substantially undersubscribed, forcing the Bundesbank to buy 35% of the sale, and resulting in a 15 bp rise in yield to 2.06% (compared with 1.90% for comparable-maturity Treasuries).

Until now, German bunds have been the risk-free benchmark for the eurozone, against which other issuers’ credit spreads are calculated. It would now appear that if the Treasury were to offer benchmark maturities in euros, they would trade through bunds. In other words, there now appears to be some sort of risk premium being added to bund yields.

Markets don’t give reasons for their decisions, and therefore there is no way of knowing why this happened. It certainly hadn’t been predicted. I can come up with a few possible reasons:
1. Bond investors performing top-down sector analysis have decided to reduce their exposure to Europe in general and the eurozone in particular*.
2. Investors recognize that there is a risk that the ECB will start printing money (for various reasons) producing a change in inflationary expectations.
3. There is a risk that Germany will be forced to backstop other eurozone sovereign credits, thus threatening Germany’s AAA rating.
4. A collapse of the eurozone could plunge Germany into a recession which would create fiscal pressures.
5. Speculators who have been long bunds and short peripherals may have decided to close out, thus increasing the supply of bunds on offer (although this seems pretty far fetched).

Whatever the reasons, the signal that it sends is a very bearish one. If the markets start demanding a risk premium for bunds, then premia across the board must rise further. Also, this event may strengthen the hand of those arguing against Germany risking its AAA to help the eurozone.

My conclusion would be that the eurozone is now in extremis barring something major coming out of the ECB or Berlin.
*In this evening's FT: A senior trader at a US bank said: “We are now seeing funds and clients wanting to get out of anything that is denominated in euros and that includes Bunds because they don’t know what will happen to monetary union." 

Tuesday, November 22, 2011

How much time does Europe have left?

Let us begin by taking the following as given: there will be no deus ex machina for the eurozone. Neither Germany nor the ECB will have a change of heart about bailing out the eurozone. The EFSF will remain the chimera that it has been since its inception.

Given the foregoing, how much time does Europe have left?

Right now, all that stands between the eurozone and Armageddon is the ECB. The ECB has been buying peripheral sovereign bonds, and it has been providing eurozone banks with unlimited liquidity (EUR 247 billion at today’s auction). Buying peripheral bonds has blunted spread-widening, and the liquidity spigot has prevented a liquidity crisis.

In theory, the ECB may provide unlimited liquidity to solvent member banks. Eurozone banks are technically solvent because they have not marked their sovereign bonds to market, nor are they likely to do so anytime soon. However, the ECB cannot refinance the entire eurozone banking system; it is too big. To do so would expand the euro's monetary base and severely complicate the conduct of monetary policy. (Wise observers would be happy to see the ECB forced to create a little inflation, but that is not in the cards.)

The Bundesbank has made clear that the ECB cannot, under its governing statutes,  provide “monetary financing” to eurozone member states. The ECB is by no means independent of the Bundesbank. Therefore, unless the Bundesbank relents (which we have already ruled out), the ECB cannot buy the bonds of the peripheral sovereigns in the quantities they will require if the debt markets remain closed.

So how much time is there left before this crisis comes to a head? My guess is that the ECB will have exhausted its appetite for peripheral debt by the end of January. If, as and when the ECB stops buying, the prices of Italian and Spanish bonds will plummet, which will place great pressures on the “economic solvency” of the eurozone banks. 

I cannot predict whether at some point these pressures force revaluations and consequent recapitalization, but this will occur next year.

Wednesday, November 16, 2011

It wasn't supposed to be this way: Socialism without money

A lot has been written about the pitfalls of allowing people to govern themselves. One of the best such analyses, if not the most recent, was written by Plato 2,500 years ago, in the parable of the “ship of state”. His criticism was that the skills of the politician are not the same as those of the statesman. The statesman (philosopher/king) must understand not only how to get power, but how to exercise it, and that those who rise to command are more likely to be skilled in the former than in the latter:

The sailors are quarrelling with one another about the steering. Every one is of opinion that he has a right to steer, though he has never learned the art of navigation and cannot tell who taught him or when he learned, and will further assert that it cannot be taught, and they are ready to cut in pieces any one who says the contrary.
They throng about the captain, begging him to commit the helm to them; and if at any time they do not prevail, but others are preferred to them, they kill them or throw them overboard.
Having first chained up the captain's senses with drink, they mutiny and take possession of the ship and make free with the stores. Thus, eating and drinking, they proceed on their voyage in such a manner as might be expected of them.
The man who leads the crew in their plot for getting the ship out of the captain's hands and into their own they compliment with the name of sailor, pilot, able seaman. But that the true pilot must pay attention to the year, seasons, sky, stars, winds, and whatever else belongs to his art, if he intends to be really qualified for the command of a ship, has never seriously entered into their thoughts or been made part of their calling. (Republic, Book VI)

This is precisely where we stand today (or at least, stood last week) with respect to the governance of the postwar Western democracies. The crew has been in command of the ship for some time (about forty years), and has been making free with the stores, eating and drinking in such a manner as might be expected of them.

They have been enabled in this debauchery because they inherited a ship of state with stored wealth in the form of unused debt capacity. They have been using this debt capacity to bribe each other for the temporary right to steer the ship. The four decades of eating and drinking the ship’s stores have been pleasant.

But now there is a problem on the horizon, to which Plato only alluded: what happens when the ship’s stores run out or, in the modern case, when the ship reaches its debt capacity?

We have the great (but temporary) luxury in the US of being able to watch as other counties around us run out of stores. In the past we have seen this happen to countries run by “other kinds of people”, such as communists and banana republicans. But now we are seeing it happen to countries not too different from our own: countries crewed by western Europeans, until recently regarded as “well run”. Indeed, the lifestyles on board some of these countries have been even more civilized than our own.

The people running these countries have never known any statescraft besides mortgaging the future in order to live beyond their means. This is all they know how to do: how to slice up this year’s piece of their children’s inheritance.

They don’t know it, but these politicians have left this world and have entered a completely new one: a world of not only finite financial resources, but a world in which the supply of resources is completely exogenous. They are learning that their long-honed skills of compromise, negotiation, bribery and flattery have no more value than necromancy, alchemy or phrenology. In a world of finite financial resources, the only valuable skills are economy and decisiveness, skills that not only do they not possess, but which they deride as inappropriate (see: all the printer's ink now being spilled about the “fetish of austerity”).

As Myron Minsky pointed out, the inflection point in the debt supercycle does not manifest itself gradually, such that it can be planned for and ameliorated. It happens when it happens (a black swan), and then it follows its course as the cycle changes decisively from leveraging to deleveraging, as lenders go on strike. (N.B.: Once the cycle turns, it is not merely a matter of not being able to borrow more, but rather the much more serious matter of having to repay what you have already borrowed.)

In the case of the current crisis, the black swan was the Greek government’s announcement in the fall of 2009 that Greece had been cooking its books for at least a decade. This caused a loss of confidence in Greece and unleashed the bond market jackals to begin to hunt down other other weak members of the herd.

This problem could have been contained if such a thing as “Europe” had existed in a corporate, as opposed to geographical, sense. But Greece soon revealed that Europe is not a country but rather a club, with no governance other than the membership committee.

The Eurocrats first said that the Greek problem was transitory and irrelevant because default by a eurozone sovereign was unthinkable and, in Trichet’s words, “not under discussion”. This was a somewhat persuasive argument until, last summer, Germany insisted that a precondition of any sovereign bailout would be a bond default. In other words, bond default went from being unthinkable to being a precondition of a bailout. That was the moment when the gas began leaking badly from the eurozone bubble. Things got dramaticaaly worse this week when the president of the Bundesbank stated decisively that the ECB would not act as a lender of last resort to eurozone sovereigns.

With this statement putting the nail in Italy’s coffin, the markets began to attack not only the non-AAA weakings but also the  “strong”, AAA sovereigns such as France and Austria. Insted of trusting and waiting for long-promised  “fiscal and structural adjustment”, the eurozone bond market is saying: “Show me, show me now, not tomorrow.” Overnight, the bar for market credibility has been raised ten notches higher.

As I said earlier, the political leadership of Europe is skilled at compromise and negotiation, skills which are completely lost on the capital market. You can’t negotiate with Bill Gross, or take Barclay's country risk committee out to dinner. These people owe you nothing, and they have nothing to gain by “working with you” or “being reasonable”.

I can see this epiphany already dawning on the Continent's leadership. You can hear it in the recent public statements of Papademos, Monti, Zapatero and Sarkozy. Their mouths are all saying the same thing: “We have no alternative to austerity. This is no longer a policy debate. There is no other path. It’s getting late.”

They are saying this because overnight they have become statesmen instead of politicians (and Monti never was a politician).

Unlike everyone else in their political systems, they have responsibility for financing the state. That responsibility concentrates the mind when the first thing you do each morning is to check Bloomberg to see how your bonds are doing. Each of these guys is doing that now, and what they are seeing is reflected in the frightened things they are saying.

Right now, diminishing credit market access is happening to Greece, Italy, Spain, Portugal, Ireland, France and Austria. Of these, France, Spain and Italy fall into the category of “too big to wargame”. Which means that they need to be wargamed now.