Saturday, June 30, 2012

What happened at the EU summit?

There’s an old saying that copper is the metal with a PhD in economics. Well, in my opinion, the stock market has a BA in Learning Disability. I need only remind readers of the fact that the S&P reached its all-time high in October 2007 after the credit markets froze and the CDO price index collapsed.

More recently, everytime there is an EU summit, the market erupts in euphoria: crisis over! The stock market is so bored with the euro crisis, and so totally uninterested in anything exogenous to its earnings models, that it will grasp at any straw that will allow it to go back to studying eps models and earnings “surprises”. I see no information value about the summit in the market’s reaction on Friday.

So what happened in Brussels? Not much, as far as I can make out:

1. An EUR 120 billion stimulus package using existing EU money. Yawn.
2. Direct EFSF/ESM bank recaps, once each eurozone member has surrendered its bank regulatory authority to an EU regulator yet-to-be-named. That will be a simple matter!
3. Something very convoluted about the ESM’s priority of claim at Spanish banks that is supposed to make bondholders feel better.
4. Allowing the EFSF/ESM to buy government bonds in the secondary market with an eye to reducing yields.

What didn’t happen?
1. No agreement about fiscal union, which is Germany’s precondition for eurobonds.
2. No mechanism to allow (or force) the ECB to buy government bonds in the primary market.
3. No (public) jawboning of the ECB for monetary stimulus.
3. No mention of Greece, which is still trying to renegotiate its bailout.

I have to assume that the market’s euphoric reaction reflects the view or the hope that Merkel and Schauble have had a meaningful change of heart about Germany’s role in saving the eurozone. I see no evidence of this. And there is still the small matter of the Bundestag (which has not yet passed the “fiscal pact”) and the Constitutional Court which looks fish-eyed at any loss of German sovereignty.

Once again, the EU has solved the immediate crisis (Spain’s insolvent banks) without providing a roadmap for any sort of final resolution. In my view there remain the following eurozone scenarios:
1. Breakup and chaos, as the PIIGS face daunting borrowing costs and default.
2. Fiscal union permitting the issuance of eurobonds.
3. The ECB provides inflationary stimulus and refinances the PIIGS.

Germany does not want #1 to happen, and is prepared to discuss #2, but no one is jumping at the chance to permanently surrender their sovereignty to Berlin, and anyway it requires a new treaty. #3 is the best solution, but it is not under consideration and it also requires a new treaty.

The spotlight now shifts to Athens, where the new government will have to choose between massive mandated budget cuts (and riots) or exit (and riots).

Thursday, June 28, 2012

The ECB can easily save the eurozone

As a thought-experiment, let’s imagine that Germany decides to permit (or is forced to permit) a monetary rescue of the eurozone, as opposed to a fiscal (eurobond) approach.

There is a rate of inflation (perhaps 8-10%?) that will allow the PIIGS’s to close their budget gaps, as nominal revenues race ahead of expense. So the PIIGS will be in surplus and their debt/GDP ratios will start to decline. Additionally, the euro will weaken in the foreign exchange markets, which will improve the current account positions of the PIIGS as well. That’s a pretty good start.

Let’s also say that the ECB stands ready to refinance the maturing debt of eurozone members based upon certain fiscal criteria and at various risk-adjusted interest rates (which are lower than current market rates). This will expand the ECB’s balance sheet, perhaps at the desired rate or perhaps above it. To the extent that the ECB’s asset growth exceeds the targeted rate of inflation, it can sterilize its purchases by selling “ECB bonds” to the public (just as the Fed can sterilize purchases of agency MBS by selling Treasuries). Investors replace their risky government bonds with “riskless” ECB bonds (riskless, because the ECB prints euros).

This would mean that not only would the PIIGS be in surplus with declining debt ratios, but also that they would no longer face refinancing risk. Crisis over. And not only would Germany not have to bail out anyone, it’s own creditworthiness would improve as well (at the expense of its credulous bondholders).

Frankly, I can’t imagine a better outcome for all. Europe would immediately enjoy nominal growth, followed by real growth as confidence and investment return. Just as inflation is always and everywhere a monetary phenomenon, so is nominal growth. If the Bank of Italy can manage it, so can the ECB.

The costs of this strategy are that price stability is sacrificed for growth, and holders of low-yielding euro-denominated bonds will suffer. The sacred “credibility of the euro”, so near and dear to the Germans, will be shattered forever. It might even become, temporarily, a “high yield currency”. A weak euro with volatile inflation will theoretically raise the risk-free real rate of interest in the eurozone.

But why do modern central banks exist? Don’t the reasons include (1) preventing financial collapse, and (2) preventing depressions? If so, Germany will have to discard the “hard euro” shibboleth, and accept what the US has already done, which is dual mandates of low inflation plus growth. Hyperinflation is an extremely destructive and inequitable event, but that is not what is recommended. What is recommended is inflation such as the world experienced in the 1970s, which did not end Western civilization.

Everything that I have written above is already in Mario Draghi’s mind. The problem is that it will take much more dislocation and distress to force Germany to permit the ECB to “go wild”. They are wedded to the hard euro and to the single mandate. So in the end they will have to choose between a Mediterranean monetary policy or a Mediterranean economic collapse. Please pick one.

Monday, June 25, 2012

Is a rift developing between the Bundesbank and the ECB?

I’m sure that there is some source for information about ECB politics, but I haven’t encountered it yet (maybe it’s in German). So I only know what I read in the papers about what’s going on there; I don’t have any backroom gossip. The latest ECB news is that it has once again lowered its collateral standards to allow PIIGS banks (i.e., Spain) to continue to have access to credit. It used to be that the ECB accepted only blue-chip assets; today there isn’t much that it won’t take.

The interesting development is that not only did the Bundesbank dissent from this decision, but that it did so publicly. What does this mean? It suggests that, to some degree, the Bundesbank may be losing influence at the ECB.

The ECB is controlled by a 23-member Governing Council which consists of the six members of the Executive Board, plus the 17 governors of the eurozone’s central banks. There are two Germans on the Governing Council, versus 21 others, including seven members from the PIIGS.  Voting on the Council does not reflect the financial resources or credit ratings of the member countries. The PIIGS plus France have nine votes (if you include Draghi) to Germany’s two.

I have to assume that Draghi, the ECB president, acts as the leader and consensus builder on the Council. Under pressure from France and the PIIGS, he evidently decided that maintaining the liquidity of the Spanish banks (downgraded today) was more important than collateral quality or keeping the Bundesbank happy. Presumably, the Bundesbank knew that it would be outvoted, so that it could take its principled stand without triggering the collapse of the Spanish banking system.

So far so good. But on the horizon is the possibility of a major break between the Bundesbank and the ECB.

The Bundesbank has emphasized its view that the ECB has no mandate beyond price stability. The Germans believe that there is no legal basis for the ECB to bail out banks or governments. And further, the president of the Bundesbank has said that the ECB has no mandate to purchase jointly-guaranteed eurobonds, since this would represent a backdoor government bailout.

This would seem to set up a conflict between the AAA-rated Northern Europeans (5 votes) and the PIIGS plus France (9 votes). In the deciding middle would be Belgium, Estonia, Malta, Austria, Slovenia and Slovakia.

Should Draghi decide to throw his hand in with the PIIGS and push the Council toward an ECB-funded bailout, this would put the North into quite a pickle. Would Germany allow the ECB to grab its credit card and use it to bail out the PIIGS? Not willingly. But what could they do? They are treaty-bound to uphold the decisions of the ECB; they have no veto.

I see such a conflict looming. I don’t know how it could be resolved, other than by German capitulation. Watch this space.

Europe faces its Minsky moment*

*A “Minsky moment” is the economic phenomenon that occurs when over-indebted borrowers are forced to sell good assets to pay back their loans, causing sharp declines in financial markets and jumps in demand for cash. In any credit cycle or business cycle it is the point when borrowers begin having cash flow problems due to spiraling debt. At this point no counterparty can be found to bid at the high asking prices previously quoted; consequently, a major sell-off begins leading to a sudden and precipitous collapse in market-clearing asset prices and a sharp drop in market liquidity.

Modern finance (1982-) is the story of testing the limits of leverage (global debt capacity). The consolidated ratio of domestic credit to GDP for the developed world has been steadily rising for thirty years. Levels of indebtedness have reached unprecedented levels not seen since WW2. And these levels of indebtedness have been achieved in a world without financial repression: there are no war-bond drives, no interest ceilings, no Treasury-Fed treaty. This has all been accomplished in the free market.

And it is an impressive achievement: to be able to accumulate trillions upon trillions in debt in a free market without government compulsion. Although the phenomenon of the “debt supercycle” is not new, what we see today is the mother of all supercycles. Somehow, the developed nations have managed to build sufficient confidence in the stability of the financial system and the financial markets that investors willingly hold the debt of highly-leveraged borrowers whose only source of liquidity is more debt.

The principal drivers of this growth, both in the US and abroad, have been disintermediation and securitization. Prior to the modern era, the total amount of debt was limited by (1) the capital levels of financial institutions and (2) growth in pension assets.

Disintermediation has freed debt growth from these limiting factors, and securitization has made  possible endless permutations of asset repackaging. In housing finance, we have seen mortgages packaged as RMBS, repackaged as CDOs and then repackaged again into CDOs of CDOs which are in turn purchased by financial institutions which fund themselves in the debt markets. Whatever equity there ever was in housing finance resided pretty much with the original borrower, who frequently had no equity to start with. That, gentlemen, is truly a triumph of leverage (a $10 trillion triumph).

In the US, nonfinancial debt has grown by 8 times since 1982, while financial debt has grown by 18 times, clear evidence of using debt to buy debt to buy debt.

And how has this mountain of free-market debt been built? Confidence, unprecedented confidence (plus recklessness compounded by indexation). When an investors buys a Treasury bond, does he ever ask “How is the US going to pay me back”? Never. He purchases on the basis of the presumption of liquidity: that no matter what, there will be a liquid market in the long-term debt of the US government. And he will probably be right. The last time the Treasury bond market dried up was in the spring of 1933, when the banking system was being  liquidated, the Fed was defending the gold standard, and the government ran out of money.

Today, the global debt mountain rests on the confidence that the authorities will never allow another massive debt liquidation to occur. Such a liquidation was threatened in 1982, 1992, 1998, 2002 and 2007, and each time the authorities stepped up and provided the “bidder of last resort”. Other than the much analyzed Lehman failure, the authorities have not allowed panic to bring down the pillars of financial stability, and in the Lehman case they immediately drew a line between Lehman as the rest of the financial system. The question to be asked about 2008 is not who was allowed to fail, but rather who, besides Lehman, wasn't.

It is interesting to note that in the US, private market debt peaked in 2007 and has been slowly declining ever since (fully compensated for by the growth in federal debt). In other words, it can be argued that 2008 was the “Minsky moment” for dollar-based finance. Too soon to say; right now it could go either way.

The threat to global financial stability today is not the collapse in the market for American mortgage securities and their derivatives; that has occurred and been fully digested.

Today’s threat to global stability is the accelerating decline in the market for the debt of the peripheral eurozone governments and their banks. It is fair to say that not one of the PIIGS can readily refinance its government or bank debt in the private bond market today. Each of them is facing its own private financial catastrophe (delayed but not solved by EU bailout money).

Confidence has evaporated, liquidity has been withdrawn, and leverage has been deemed excessive for each of them: Portugal. Ireland, Italy, Greece, Spain and now Cyprus. The bond market is awarding no points for effort; they are all contaminated despite occasional virtue.)

Confidence is fragile: built up over decades, it can disappear overnight (e.g., September 15, 2008). Any shock can trigger the panic. What was an acceptable credit yesterday can become radioactive today. Confidence is precious; it makes the world go round. Once lost, only overwhelming firepower can bring it back. Firepower such a $1 trillion bank capital injection coupled with an overnight doubling of the Fed’s balance sheet. Under such circumstances, it was futile to “fight the Fed”.

The market expectation for a similar European demonstration of shock and awe is slowly fading (but not yet shattered). It seems that every day, Merkel has to reiterate that Germany will not participate in a massive government/bank bailout with no strings attached, and that Jens Weidmann has to reiterate that the Bundesbank/ECB will not provide the bidder of last resort for junk-rated PIIGS securities (although ECB collateral standards keep declining).

This week’s EU summit will demonstrate to the world, once again, that there will be no German capitulation.  Will that be the trigger for Europe’s Minsky moment, or will it be delayed? I don’t know. But what I expect is a continuing loss of confidence in the eurozone, a further decline in market liquidity, and the ultimate end of the European debt supercycle.

Tuesday, June 19, 2012

Europe's latest panacea

Press reports out of the G-20 summit in Mexico say that Italy and France have suggested that the EFSF/ESM buy the bonds of PIIGS who are engaged in fiscal consolidation, but who have been priced out of the market. This would, it is thought, allow the funds to buy these country’s bonds at subsidized interest rates, and thus reward them for their virtuous behavior. It is felt that this would allow countries such as Spain and Italy to receive assistance without having to submit to IMF/EU conditionality.

Angela Merkel, under pressure from everyone, did not dismiss the suggestion out of hand. (However, her proposal is for an EU fiscal union, which has not been embraced by Hollande.)

I must be missing something, because the treaty establishing the ESM states that: The granting of any required financial assistance under the mechanism will be made subject to strict conditionality. Everybody in the room may have agreed to ignore this provision, but the Federal Constitutional Court in Karlsruhe is a stickler on things like laws and treaties.

But let us assume that the plan can be implemented and that the ESM will be established on schedule next month. The ESM will be have EUR 80 billion in paid-in capital which can be leveraged up to EUR 500 billion using contingent guarantees (EUR 700 billion including the EFSF). The ESM is expected to be rated AAA by the three agencies, but I don’t consider that a given. The rating hangs on the AAA ratings of Germany, France and the Netherlands. France has already lost one of its AAAs, and is at risk of losing the other two.

And Germany, how sturdy are its AAAs? Clearly, the larger the ESFSF/ESM exposure to the PIIGS, the greater is Germany’s contingent indebtedness. Assuming that France ends up at AA, can the ESM really work, and will it be credible in the market? I don’t know, but the EFSF’s bond yields have been volatile, and consistently in excess of AAA benchmarks.

So I see the following challenges to the Monti/Hollande plan:
1. The treaty language about conditionality.
2. The Constitutional Court’s interpretation of the treaty.
3. The Bundestag’s willingness to consent to the plan. (The Bundestag has not yet ratified the treaty.)
4. The ESM’s rating outlook, given the iffy outlook for France.
5. The longer-term implications of the ESM for Germany’s AAA rating.

If these hurdles can be jumped, the plan will provide breathing room for Spain and Italy, and would signal Germany’s willingness to take bold steps to save the eurozone. However, the fiscal outlook for the PIIGS remains frightening, especially now that we know that their banking systems are much worse than advertised. The stress tests performed last year, we now know, were an exercise in legerdemain. The Spanish and Italian banks will require many billions to remain solvent, and the ECB won’t lend to them unless they are solvent. That too could change, but you wouldn’t know it from what Draghi and Weidmann are saying.

If Merkel signals that she is willing to pursue this plan, there will be a big relief rally. However, the best that this plan can do is to keep Spain and Italy alive for another year. It isn’t big enough to refinance all of their maturing debt. And Greece is still out there, in extremis.

Monday, June 18, 2012

Are the US authorities prepared for eurozone collapse?

During the financial crisis, the US government rescued the financial system from full-blown liquidation following Lehman’s collapse. The government rescued banks, bank holding companies, mortgage banks, securities firms, nonbank financial institutions, insurance companies, GSEs, and money market funds. All of this was done more or less on the fly, some of it within existing law, some on the edges, and some with new legislation such as TARP.

It is worth noting two things: (1) the government prevented a financial collapse; and (2) the total cost of the “Wall Street bailout” was zero. All of the Fed’s loans and most of the Treasury’s capital investments were repaid with interest, plus gains on warrants.

Following the successful resolution of the crisis, there was bipartisan criticism of the fact that the government “bailed out the reckless bankers”. You can still read in responsible publications that the Fed, the Treasury and the taxpayers spent “trillions” bailing out the banks. (If I lend you one thousand dollars overnight for one thousand days, I have supposedly lent you one million dollars.)

The legislative result of this populist outcry was the Dodd-Frank “Wall Street Reform and Consumer Protection Act of 2010”. The big debate over the bill was whether to end Too Big To Fail or allow it under special circumstances. The result was a fudge that sort of allows limited TBTF under certain circumstances for instiutions deemed to be systemically important (Sifis). It reads to me as if creditors of failed institutions, such as bondholders of bank holding companies, are at risk.

I expect that the looming collapse of the European financial system will put this new machinery to the test. The principal vectors of European contagion will be (1) market and credit losses on government and bank bonds; (2) losses on European loans; (3) losses on credit protection written on European obligors; (4) capital impairment resulting from credit and market losses; and (5) loss of confidence-sensitive funding due to the unknown scale of the above losses in relation to banks’ capital resources.

When the hurricane of fear hits this side of the Atlantic, it will focus upon financial institutions with the most European exposure. In the maelstrom, we may find ourselves facing another Lehman moment. What will be crucial then will be coherent signalling from the authorities that there is no repeat no risk to creditors of large US financial institutions. Any ambiguity on this subject will fuel the tidal wave of contagion. Geithner knows this, but can persuade the rest of the administration?

The authorities will be handicapped during this crisis by politics. Since the Obama administration will be in power until at least next January, the crisis will most likely happen on their watch. While the Obama/Geithner/Bernanke team will want to do everything they can to stem the crisis, they may not have the full support of the Congress or the Romney campaign. Rescue efforts could (will) be demagogued, as they were in 2008. It is unlikely that Congress can derail the rescue, but it can certainly add confusion and uncertainty.

I reiterate that two things must occur to stem the contagion: (1) no Sifi can be allowed to default upon anything; and (2) this fact must be clearly understood and credible. In fact,  during a financial crisis, the list of Sifis can be very long, since one run will lead to another.

Sunday, June 17, 2012

Europe sounds the All-Clear

Boy, that’s a relief! Just a few days ago the eurozone was about to blow up, and now they’re sounding the All-Clear. I feel so much better now. Mario Draghi has a bank rescue plan, and Greece will accept the bailout and stay in the zone.

Tomorrow the stock market will rise, yet again. Watching the stock market during this crisis has been fascinating: stocks are so screamingly cheap that the market will grasp at any straw to rally. Any news is good news, even bad news.

Now let’s go back to reality. Actually, Europe hasn’t won the war.

First of all, the “Draghi Plan” as described in today’s NYTimes is a long-term solution to an immediate problem. Yes, of course it would be nice if the eurozone had a single bank regulator, and yes it would be nice if the eurozone were able to create a credible deposit insurance scheme. Someday, who knows, all of that may come to pass. But right now, there is no reason why a rational bank depositor in any PIIGS bank would not be in the process of moving his money not only out of the country, but out of the eurozone.

Draghi is seeking some basis to continue lending to the insolvent banks in the PIIGS. He needs a solvency fig-leaf to justify continued lending to bankrupt banks, and the dirty secret is that every PIIGS bank is insolvent if its government bond portfolio is marked to market.

Next, the Greek election. Let’s assume that New Democracy and PASOK form a coalition and agree to continue the austerity plan “with modifications”. This assumes three things: (1) Merkel will agree to renegotiate; (2) the IMF will agree to renegotiate; and (3) there is some possible deal that can stave off a Greek collapse.

It’s point #3 that worries me: it is not clear that there is any way to solve the Greek problem. Greece is not merely insolvent in the sense that she can’t repay all of her debts; she is insolvent in the sense that, even if she repudiates every penny of her debt, she still cannot pay for (or finance) her imports. Greek government revenues are collapsing, and the Greek current account deficit remains large. Greece is a basket case that needs foreign aid; her debts are worth nothing. Greek exposure should be marked to zero at every eurozone bank including the ECB (and the IMF).

Finally, in more good news, the Socialist Party is reported to have won a majority in the French Parliament. Hollande and his leftists appear to hold all the reins of government. We can expect to see the Socialist's "growth plan" soon. (Keep an eye on French bond yields.)

France is now off the austerity reservation, and is no longer Germany’s partner in resolving the eurozone. France and Germany are at odds on the central policy issues. France is seeking to isolate Germany in the hope that she can force her to capitulate to the have-nots. The idea is that France will win, Germany will lose and have to pay reparations to Europe again (for being successful). 

Sunday, June 10, 2012

Rescuing the eurozone: What would Isabel Peron do?

There appears to be a widespread assumption (see this week’s Economist) that all would be well in the eurozone if only Angela Merkel would just step up and do the right thing. The right thing is defined as agreeing to co-guarantee joint eurozone bonds and to allow the ECB to make unlimited credit available to eurozone governments and their banks. Her refusal to do so is attributed to German stubbornness and selfishness.

Frankly, it is pointless to attempt to discuss the eurozone crisis in moral terms. Morality is irrelevant under such circumstances. All is fair in financial crises.

Let us accept the promise that it is in Germany’s interest to rescue Europe. Let’s not debate that, we’ll just take it as a premise. Germany agrees to sign up to lend its credit to the entire eurozone, and the Bundesbank allows the ECB to buy the bonds of troubled governments.

First, let’s look at the eurobond piece. While it is possible that an announcement such as this would reopen the debt markets to allow the PIIGS to to issue their own debt, that is quite doubtful. The bond market is not charitable. Therefore, the future source of credit for troubled eurozone governments will be eurobonds, co-signed by Germany, forever.

The outstanding government debt of the eurozone is ~$14 trillion. The debt of the PIIGS is ~$4.0 trillion. Germany’s GDP is ~$3.0 trillion, and its debt is ~$1.5 trillion. Germany’s credit is not strong enough to shoulder the burden of the PIIGS debt, let alone the rest of the zone.

Were eurobonds to become a German contingent liability, Germany would no longer be AAA. Would there be a ready market for trillions in such bonds? Perhaps, but not at AA yields. That would be real “story paper”.

Ok, let’s stipulate that it would be difficult to get fiduciaries to buy trillions of eurobonds at risk-free yields. What about the ECB? Certainly the ECB could be the buyer of last resort for eurobonds, the European equivalent of Treasuries. At present, the ECB’s balance sheet is EUR 2.7 trillion. Can it sterilize a few trillion of new eurobond purchases? No, it can’t, because it is already stuffed to the gills with unsellable peripheral bonds and TARGET2 exposures to peripheral banks. The ECB has only a limited ability to buy eurobonds unless it permits the monetary aggregates to increase in a manner unrelated to the conduct of monetary policy. (There is a strong case to be made that the ECB has been too tight and that a dose of inflation would be very helpful. An involuntary growth of the ECB’s balance sheet would be a good thing, but we are getting into a rather fanciful realm. The Bundesbank is still in charge.)

So we appear to be at an impasse: eurobonds will be a hard sell in the debt markets, and the ECB can’t buy them all. Does that mean that Europe is out of tools to rescue the euro? We need to take off our OECD hats, and put  on our faded old Latin American hats (remember the LDC crisis of thirty years ago?).  Instead of asking “What would Angela Merkel do?”, we need to ask instead “What would Isabel Peron do?”

The eurozone will be facing a Latin American crisis. No one wants its currency, and no one wants its bonds. Every Latin American country has been in this position many times. How do you finance yourself when your obligations are distrusted?

The answer is simple, but a bit drastic: impose capital controls. There is plenty of money within the eurozone to allow it to finance itself, so long as banks and investors have no other options. If zonians are prohibited from buying “foreign” bonds and other instruments, the zone’s savings can be mobilized to invest in eurobonds.

I might add that this would not be a completely novel experience for Europe. During the postwar era, most zonal countries had capital and exchange controls. Free capital movement is a relatively recent phenomenon. Even today, China maintains both exchange and capital controls, and it certainly hasn’t hurt them.

My argument here is that the euro can be saved, but only by taking very drastic action. European exchange controls would represent a major shock to global markets; exchange controls would violate WTO and the implicit architecture of the eurozone. (Remember that the euro was supposed to supplant the dollar as the world’s reserve currency?)

The foregoing is intended to throw cold water on the rescue of the euro. We are talking about uncharted territory and the land of unintended consequences. Europe is not Latin America, and this is not 1954. My point is that the steps required to save the euro are extreme and unfamiliar (as well as illegal).

My expectation is that, in the end, the euro will fail and Europe will enter a deep depression.

Thursday, June 7, 2012

Brussel's latest mistake

Right now, the debate raging in Europe is how to rescue the insolvent Spanish banking system, which is being bled dry by depositor outflows. Spain has asked the EU to recapitalize its banks (to enable the ECB to keep lending against the run). There is debate concerning the need for a eurozone deposit guarantee to restore confidence and end the runs on the peripheral banks. Depositors in the peripheral countries face the risk of bank failure as well as the risk of a forced redenomination into domestic currency.

Because banks are highly levered, inherently illiquid, and analytically opaque, depositor confidence is maintained by the expectation of both a lender of last resort as well as a state rescue authority. Such mechanisms are the reason why banks never default on their deposits and are instead rescued (bailed out). Throughout the entire financial crisis of 2007-12, no eurozone bank, no matter how tiny, has defaulted upon its deposits.

The state mechanisms that backstop depositor confidence depend upon the willingness and the ability of the state to rescue banks. This has now been called into question in the eurozone because a number of states lack the resources required to maintain systemic solvency, which the ECB requires as a precondition for lending. That problem is most acute in Spain at the moment. Something will have to be worked out quickly to recapitalize the Spanish system, which requires at least EUR 40-50 billion.

Governments rarely publish blanket deposit guarantees, but they are understood to exist implicitly. Because regulators want investors to provide a degree of market discipline, such as credit ratings and other measures of solvency, they create sufficient constructive ambiguity around bailouts for markets to punish weaker banks. This requires a dance between depositor discipline, on the one hand, and market confidence on the other. No regulator can realistically expect Mrs. Gonzalez (or Papadakis) to add bank analysis to her other daily responsibilities.

Because governments stand behind their banks, when banks fail they are rescued at government expense. Generally (always) all bank senior creditors are protected with only holders of subordinated debt and other capital instruments at risk. Because banks are never “wound up” the way that failed grocery stores are, there is no way to impose losses on senior creditors such as bondholders; there is no liquidation. Therefore, the government must bail out the bank’s bondholders, who are generally large institutional investors. Taxpayer money is being spent so that these investors can walk away whole. This is politically unpopular.

Because Mom and Pop do not want to pay for bank bailouts, there is a frequent call for resolutions to impose costs on bondholders. Somewhere deep in the thousands of pages of Dodd-Frank there is language intended to allow the FDIC to allow bank and BHC bondholders to lose money.

And now, in its inimitable and blundering way, the European Commission has just published its long-awaited bank resolution plan. Lo and behold, it calls for bondholders to lose money under certain circumstances. This is excellent timing, coming as it does in the middle of the greatest banking crisis in modern European history. At the very moment when Europe is moving heaven and earth to restore market confidence in its banks, the commission comes out with a plan to allow banks to default upon their bonds. This means that now potential buyers of bank obligations face the risk that, even in the event of a rescue, they will lose their investment.

Therefore, an analyst of European bank bonds (let’s say Spanish bank bonds), must analyze (1) the bank’s solvency; (2) the government’s solvency; (3) the likelihood that the government and/or its banks will be recapitalized by the EU in the event that the government is insolvent; and (4) the risk that in the event of a recapitalization, losses are imposed upon bondholders. (I might add that it has already been established that bank bondholders are subordinated to credits extended by the ECB and the IMF.) One must ask: would any thinking fiduciary consider adding such a security to his clients’ portfolios except as a pure speculation with commensurate yield?

How are such Spanish bank bonds trading today? Weaker names, such as Bankia, are trading as deep junk. Bankia is in the process of receiving EUR 19 billion in recapitalization funds from the state. Despite that, its bonds are trading at an implied Caa1, or at risk of default.

It appears that Europe has two desires: (1) to restore confidence in the eurozone banking systems; and (2) to ensure that weak banks in weak eurozone countries will never regain market access, and will thus become permanent wards of Europe. I am beginning to understand Mario Draghi’s frustration with his European “partners”.

Wednesday, June 6, 2012

How the world will end

Originally posted May 28.

Losing a long war is not easy to accept. We are familiar with accounts of the final days in Berlin and Tokyo. Hemmed in by the Americans and the Russians, Hitler convinced himself that he had two armies in reserve to mount the counterstroke that would win the war. Having lost the entire Pacific as well as Okinawa, the Imperial Cabinet believed that no enemy could successfully set foot upon the sacred soil of Japan. In other words, when the truth is unimaginable, human psychology finds an alternative, more comfortable, reality in which to dwell.

This describes the current European financial situation. It would appear that the entire planet is in denial about what is about to occur in the eurozone. The commentariat keeps expecting Germany to pull a rabbit out of the hat and flood the continent with German-guaranteed eurobonds, or that Mario Draghi will mount a coup at the ECB and buy up every deadbeat country’s bonds.

Both could happen, but both are extremely unlikely. Current policy is the best estimate of future policy. Germany cannot guarantee the eurozone’s debt without control over the eurozone, which no one has offered her. Northern Europe will not permit the ECB to be hijacked by Club Med and turned into Catholic Charities. It is not just a matter of politics, it is also--as the Germans keep pointing out--a matter of law. There are no provisions for eurobonds, nor for the ECB to buy the bonds of the impecunious.

Europe has a Plan A, whereby each country would reform its economy, recapitalize its banks, and balance its budget. But Plan A is not working: it is being rejected by its intended participants, most notably France. There is an emerging southern European consensus that austerity is not the solution. Greece is in the vanguard of rejectionism, having defeated the austerity coalition in the recent election. Spain does not have enough money to bail out its banking system. Greece, Italy, Spain, Portugal and Ireland have lost access to the bond market. Greece, Italy and Spain have called for an end to austerity, and Ireland will be voting on it soon. Portugal is so far beyond hope that its bonds are trading for cents on the euro.

There is no Plan B. There is no well-thought-out plan for the orderly exit of the insolvent from the eurozone. There are no safeguards, no plans, no roadmap, nothing. The eurozone is unprepared for its own collapse. The Maastricht Treaty, like the US Constitution, did not provide for an exit mechanism. Instead of realism and emergency planning, we get denial and more happy talk. Just because something is “unthinkable” doesn’t mean it can’t happen (see: 1945).

Greece is rapidly running out of money. Greeks are withdrawing their deposits and have stopped paying their taxes and utility bills. She may not be able to stay afloat until the June 17 election. After the election, all hell will break loose.

We are facing Greece’s disorderly exit, default, and redenomination. Greece will be dependent upon foreign aid for essential imports such as petroleum and food. Civil order will be difficult to maintain and the army may be forced to step in (yet again).

Europe does not have the fiscal resources (absent eurobonds) to rescue Spain and Italy. Both countries have lost the ability to borrow in the bond market, and neither country is anywhere near balancing its budget. Both countries need more fiscal subsidy and funding for the banks.

Once Greece goes, a bank run in both countries is likely. There is nothing to stop a Spanish or Italian depositor from wiring his euros from his local bank to one in Switzerland, Norway or New York. There is no reason for him not to; it’s costless and protects him from redenomination/confiscation. The Italians are past masters at hiding money, and the Spanish are pretty clever as well.

What will happen when Spain or Italy hits the wall? The only thing still standing between the eurozone and financial chaos is the ECB. The ECB could buy government bonds and fund the bank runs. The scale of such an operation would be enormous, and would expose the ECB to huge credit risk. But it could step in, if Northern Europe permitted.

If the ECB does not step in, then ultimately Italy and Spain will be forced to exit the eurozone, default on their euro-denominated sovereign and bank obligations, and redenominate into national currency.

Should Spain and/or Italy default on their euro-denominated sovereign and bank obligations, massive losses would be imposed on the global financial system.  Because of the opacity of banks’ exposures, creditors would be unable to discriminate between the solvent and the insolvent (as was the case in September, 2008). The credit calculus would be not only the assessment of bank losses against capital, but also the assessment of a nation’s aggregate capital deficiency against its fiscal resources. The UK and Switzerland come to mind as countries that might not have the fiscal capacity to fully recapitalize their banks (although they could guarantee them).

The U.S. banks most likely to be affected by such a scenario would be the globalists: Citigroup, Bank of America, JPMorgan, Goldman Sachs and Morgan Stanley. I don’t have any numbers in front of me, but I can only imagine that they would require a TARP II. The US can afford a second TARP, but it would require Congressional legislation, which is not a slam dunk. The Fed can, of course, keep the system funded no matter what. Congress can’t stop that.

Massive wealth destruction combined with global financial chaos would be a challenge to the conduct of monetary policy by the world’s central banks. They would be tasked with preventing deflation, which would require a major round of QE. However, since banks are the transmission mechanism for monetary stimulus, this would require functioning banking systems. Each country would be faced with the need to restore the solvency of, and confidence in, its banks. In the past, this has been handled with the combination of a blanket bank guarantee and a recapitalization scheme (such as TARP).

The US financial system can withstand any shock because the US is a fiat money state. The Fed can maintain nominal prices, nominal wages and growth, if it acts heroically, as it did in 2008. The stock market will react negatively to the level of uncertainty caused by the collapse of the European financial system (as it did in 1931). The dollar should benefit, as should gold and yen. Unclear to me what would happen to sterling and Swiss; the benefit as havens, but their banks are highly exposed.

The worst thing about the coming crisis will be  its unforeseen consequences: financial, economic and political. While a European collapse would hit the US hard, we can be thankful that we are an ocean away, and have our own currency and financial system.