Why These People Are Smiling: Is There No Atlantic Wall of Financial Protection for the U.S.?

We had some more fancy footwork and relieved smiles from Angela Merkel and Nicolas Sarkozy this past week. The reason for the smiles is not that the Euro debt crisis has been resolved, but they believe they have found a formula to deep-six the problem. It’s more of a containment plan than a solution. Their smiles are saying, “Phew! Not on my watch!” These days, the model of a successful politician is someone who can kick the can so far down the road that they could qualify for their respective national soccer team.

In this instance, the swift kick will come in the form of some serious arm twisting of banks and other financial institutions subject to arbitrary government power, in an effort to command a “voluntarily” swap. This would mean swapping perhaps 4 percent yielding Greek debt purchased years ago (when Greece was not an outlier) into 4 percent yielding Greek debt due in some future year, despite today’s 30 percent market yields given Greece’s junk bond status. Hence, the governments will need to use the regulatory whip to obtain private compliance of this swap for the same “notational” value debt (amount due) that has lesser market value (EU to Discuss Greek Plan that Skirts Default Risk).

As previously discussed (As Greece Goes So Goes Europe: How the Unthinkable Happens), the Greek problem for the other countries of the Euro zone goes well beyond supporting Greece’s current budgetary shortfall. If Greece is unable to fund its deficits today, it cannot pay interest on all outstanding debt — hence her cumulative outstanding debt defaults. Since the banks of the Rich Uncles of Europe have been induced to hold much of that debt, they would realize losses on the cumulative Greek debt (presumably since WWII) as well as losses associated with the rating downgrades of the cumulative debt of other weak Euro sovereigns held by their banks. The write-downs of these bank assets would dissolve bank capital Euro for Euro and represent a banking system insolvency that would force the other countries of Europe to borrow vast sums to replace their banks’ depleted capital. So the magnitude of the cost to the Rich Uncles would be based on the cumulative outstanding sovereign debt of the all the Poor Uncles of Europe rather than just meeting this year’s Greek budgetary shortfall. This is the mechanism for a very large Euro debt multiplier.

From the Rich Uncles’ point of view, it is cheaper to keep feeding Greece than to cover the losses on cumulative Greek and other downgraded sovereign debt, but the Rich Uncles’ body politic is outraged, so they had to seek a middle ground. So the not-so-voluntary swap would provide Greece with rollover funding at cheaper borrowing costs than what is available on the market, and it would also avoid a failed debt auction. If this were all to occur, the climatic default would then be postponed.

Now, if you think the U.S. sits safely on this side of the Atlantic, immune from Euro problems, and that we only need to address our own insolvency problems, guess again. There is no Atlantic Wall of Financial Protection. Part of the breaching of the Atlantic Wall comes via the International Monetary Fund, which has also been tapped to support Greece. The IMF can issue a capital call on its member nations, requiring the U.S. to step up for about 30 percent of the call. At present, bank regulators are scurrying to determine the extent of U.S. financial institutions’ losses from holding Euro sovereign debt as we back our banks with FDIC insurance, which is scraping along the bottom.

But there are other sources of U.S. exposure to Greece. Bernanke at his latest press conference indicated that U.S. money market funds had a substantial exposure to the Euro banks as they have loaned them funds. He suggested that “a disorderly Greek default [non-contained, as discussed above] would have significant effects on the U.S.”

But the more serious issue on this side of the Atlantic Wall is not so much depreciated assets of U.S. banks or money market funds from investments in Euro obligations but from the same roundabout, little recognized vulnerability as occurred in the Lehman Brothers episode of 2008. U.S institutions have exposure to the Euro debt problem not so much from their direct holdings of Euro debt but from financial insurance exposure via the CDS market. The same thing happened when AIG called the Fed on Thursday of the week Lehman Brothers collapsed; by the weekend the Fed owned AIG (or 80 percent of it) in return for meeting the firm’s CDS financial insurance obligations. It is reported that while Euro banks hold much of the lousy Euro sovereign debt, they have insured it by obtaining insurance mainly from U.S. institutions, so the losses will in turn be conveyed here. In an open global financial system, it is difficult to segment losses, so Europe’s problems will have become our problem.

Now you ask, “Doesn’t an insurance company that received handsome insurance premiums (greater than 15 percent for Greek debt) have the income and assets to pay the insurance claims?” Well, the insurance companies typically hold the same assets as the banks, so their own balance sheets will be in trouble even before facing their insurance liabilities.

So now the crux of financial containment comes down to having some debt relief for Greece that is not legally characterized as a default that would trigger a capital loss for Euro banks and a financial insurance event for U. S. banks that have insured the same. It all depends on whether the legal system will consider the swap outlined above as a de jure as well as a de facto default, whether the rating agencies lower ratings, and whether the swap becomes a triggering event for a CDS payout. A written contractual obligation is subject to legal interpretation, and if it is unfavorable to a government, well, governments make the laws, and they can change the laws to protect themselves.

That, I presume, is the reason for the smiling heads of state on both sides of the Atlantic. Barrack Obama has in effect sent a message that we are “behind” Europe, which has multiple interpretations (Merkel and Obama Talk Debt Crisis). Does that translate to, “A U.S. default is behind yours, as we will be affected by contagion”; or, “We will finance you somehow because of that”; or, “We are hiding behind you and hope you can contain the problem yourself”? In any event, Merkel was awarded the Presidential Medal of Freedom as a down payment of our gratitude if she can preserve the Atlantic Wall. I listened to the lengthy, strained accolades they bestowed upon each other in hopes of shifting the burden of responsibility to the other; there was some serous nervousness on both parts.

However, despite governments pulling out all the containment stops, market discipline must still be faced. That is, even if governments declare a bank’s capital to be sufficient by their stress tests (which did not include government debt!), and the accountants are muzzled by eliminating market-based accounting, and the rating agencies are held hostage since they are now regulated by the SEC, and legal definitions of defaults are changed, and the triggering events in CDS contracts are altered, the market still determines whether to hold their own deposits in the affected banks. Yes, it is somewhat difficult to determine the stability of the banks, given the level and complexity of the financial cover-ups, but the market is taking names and making estimates of risk exposure to various financial institutions. In fact, it is worse to have a mere suspicion about the risk for each institution than it is to know the exact amount, because when the risk is uncertain, the market goes conservative and projects the largest imaginable losses for each institution.

Even if the rule of law is thrown out and the containment capsule holds for now, the banks will be bled as depositors seek safety and move deposits to banks that do not have pretend assets. It is no surprise that Euro banks are losing bank deposits, and the movement of capital away from Europe is reflected in higher overnight borrowing costs (measured in LIBOR rates) as these banks must pay up for replacement funding. This movement away from the distressed assets and the banks that hold them dissolves the profitability of the “protected banks.” At this time, the ECB is providing replacement funding for Euro banks whose depositors are fleeing, and in turn, investors who hold the Euro currency would be expected to convert to another currency.

Now that we have interpreted the above photos, we as investors need to determine how to protect our capital, which comes down to finding a country whose currency is appreciating for a good reason and whose banking system is not caught in the vortex of a cyclone. Such a country would need to have an independent source of economic thrust from the developed world, and its financial institutions would not hold the same assets as the developed world’s banks nor insure Euro sovereign debt. This criteria eliminates the Swiss franc and Swiss banks (though they have been recapitalized), the Nordic countries, Canada, and other dollar countries. Financial contagion on a global scale narrows investor choices substantially.

The safer choice seems to be pointed in the direction of the Renminbi, which can be purchased as an ETF and is moving upward. Banks in China, which are preparing to step up to international currency status, were recapitalized last week as China implemented a program similar to (but larger than) TARP in the U.S. There is, of course, the other king of the market that relies on no government, and that is gold, which is also moving upward for those who wish to avoid the pitfalls and intrigues of the distressed developed financial world. With no Atlantic Wall of Financial Protection, the flight to quality asset this time is not likely to be the dollar to the same extent it was in 2008.

As Greece Goes, So Goes Europe: How the Unthinkable Happens

The Maastricht Treaty of 1992, which created the Eurozone and the European Central Bank (ECB), requires fiscal responsibility of its members. Annual fiscal deficits relative to GDP were not to exceed 3 percent, and cumulative debt was supposed to be limited to 60 percent of GDP. Efforts to police members to these standards were ignored or dropped in the last decade, with only moral suasion left as a regulator.

Almost 20 years later we now know the value of moral suasion, as first Greece then Ireland and now Portugal, among other members, are not only well beyond those pledged debt ceilings but also to the point where the government bond market is no longer willing to hold their debt securities without support from other governments or government entities. Hence the Eurozone has split into what I have previously called Poor Uncles and Rich Uncles. The Poor Uncles are trying to corral Rich Uncles to either guarantee their debt or out-and-out purchase their debt (On the Ratio of Rich to Poor Uncles).

The situation has now become dire for Greece, and both the Poor and Rich Uncles of Europe once again must face the issue that will not go away. It was only a year ago that a bailout fund was put in place to purchase Euro government debt, if the market would no longer have any part of it. Since then, the number of governments that are stepping up to the trough for assistance has increased. There are clearly too many Poor Uncles for the few remaining Rich Uncles to assist without themselves being put into the poorhouse. Nonetheless, the Rich Uncles are at least making noise that they could once again provide assistance. Given the uncertainty of the Rich Uncles’ pledges, just two months ago, the original three-year bailout fund had to be made permanent to placate the bond market with a new, higher amount being pledged to fund the Poor Uncles.

While a permanent fund sounds reassuring — and did reassure a naïve bond market for a few months —trouble arose when the Rich Uncles decided they would only provide funding for the permanent fund over a five-year period. Then when it became time to put their money where their mouth was and the first Rich Uncle installment came due, Germany indicated it would only put up half of its first installment and that it would take six years to complete its share of the funding. Understandably, the market’s confidence in the willingness of the Rich Uncles to step up to the plate plunged, along with the market value of Greek bonds. The market yield on two-year Greek bonds rose from 16 percent to beyond a respectable junk bond rate of 24.5 percent.

Just to do the back-of-the-envelope math, Greek government debt is currently equal to 143 percent of Greece’s GDP —and rising by another 10.5 percent relative to GDP this year, with no end in sight. Also, much of the Greek debt is short term, under four years. If the debt is refinanced over the next four years, when due at the present market cost of funds, a tax bite of more than one-third of ALL Greek income would be required just to pay interest on its government’s debt.

If that doesn’t bring the county to its knees, 61 percent of Greek debt is owned by foreigners, so a majority of the interest payments is then shipped abroad, widening the country’s current account deficit (see the April 2011 IMF Global Financial Stability Report for more details). The interest payments alone would reduce the annual GDP flow rate by about 20 percent. This means Greek debt service on current market terms unravels the economy and hemorrhages the fiscal imbalance. Denial might be an option when debt is accumulating, but is no longer an option when income systemically deteriorates.

The Rich Uncles of Europe are quickly running out of time and options to further paper over the fiscal sinkhole. With the unthinkable happening, their minds are frozen by the totality of the issues at hand with various parties walking out of meetings if the subject comes up. Government dysfunction is not merely a U.S. problem. The issues and decisions are so far-reaching that consensus among the Rich and Poor Uncles and the ECB and the IMF doesn’t seem possible. The options include changing the charter of the ECB to allow it to monetize distressed sovereign debt to provide an inflation deterioration in the real value of all Euro debt at the cost of a capital flight from the Euro; saving the Euro and expelling Greece from the currency union, (leaving the wealthier countries to wonder whether the currency union will still have viability as a reserve currency if more of the Poor Uncles are expelled); and offering further aid to Greece on the condition that the Rich Uncles take control of the taxing and spending of the Poor Uncles, meaning the Poor Uncles give up their sovereignty on fiscal matters.

Given the stakes in these decisions and the difficulty of reaching a consensus, there is no doubt that there will be one last attempt to save Greece by doing what governments do best: postponing the inevitable. In one effort to buy time, French Finance Minister Christine Lagarde is aggressively marketing her bid to become president of the IMF to further tap IMF bailout funds. Another option to buy time (but not settle the problem) would be to sell off Greece’s national assets in order to balance budgets and retire debt. Someone call Donald Trump and let him know that the Parthenon and some beautiful Mediterranean coastline are available for a fabulous golf resort. Or call China to offer up an island in the Mediterranean as a wonderful site for a naval base. Or call the investment bankers, as Greek nationalized companies are for sale to anyone at distressed prices.

When all these options are exhausted, the final nail in the coffin will be a default on Greek debt that will be spun as an adjustment rather than a default. When you hear talk of restructuring (paying 30 cents on the Euro) or rescheduling (pushing the maturity of the existing bonds out to infinity), these are defaults by another name. For example, debt due on June 30, 2011, could arbitrarily be rescheduled to be due on June 30, 3011, to give all politicians involved adequate time to expire and adequate time for history books to be lost, so as not to be able to pin the responsibility on anyone in particular.  That will not work, since Greece can’t cover the interest, let alone the principal; but interest can also be adjusted downward arbitrarily. All those things can happen, but the bond market will go on furlough, and that will be the end of deficit spending for Greece for the foreseeable future. In the end, the bond market rules, as James Carville famously exclaimed: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody”.

One might wonder what’s in it for the Rich Uncles to anguish at the thought of a Poor Uncle default. That is, why are Germany and France so stressed with a Greek problem? The reason is that there are linkages between a Greek default and potential Rich Uncle defaults, triggered by banking system guarantees made by governments. Here is how it works:

In order to sell government debt at a low interest cost to Greece, other Euro governments have enticed banks and other financial institutions to purchase government bonds by waiving the need for banks to be fully capitalized to be in business.  That is, with the housing/mortgage meltdown putting such a large dent into the market value of bank assets and hence to their capital (net worth), banks can prevent a government seizure or nationalization if they hold what the government has defined as low-risk assets. Yes, you’ve guessed it: According to bank regulations, government bonds of the Eurozone are considered low-risk as per their ratings; so by stocking up on those toxic assets, banks can operate with little capital. This pattern is illustrated clearly in IMF data, which shows that the Eurozone members’ banks hold between 16 and 27 percent of their assets in bank claims on the public sector (as compared to 10 percent for U.S. banks). At the same time, their banks are short of capital as the inducement to hold “high-quality” government debt.

Take the Rich Uncle Germany for example, where 25 percent of banks’ assets are claims on the public sector (government bonds of unspecified governments) and their banks are leveraged 32 times their own equity capital. The inverse of 32 is an equity capital ratio of about 3 percent, so if Greek bonds are defaulted and contagion occurs — Moody’s recently indicated a Euro sovereign default would lead to all Euro sovereign rating downgrades — the market value of other Euro Sovereigns would be hit and the banks’ capital requirements would increase. It would take only a 12 percent decline in the market value of the banks’ government bond portfolio to drive German banks to zero equity capital. GaveKal estimates the market value of the Greek and other Olive Belt sovereign debt to be already 45 percent below face value, before any default or further credit rating downgrade has occurred. This means many banks will require additional equity capital, as banks will not pass future stress tests requiring government recapitalizations of the banks in very large amounts. This is not uniquely a German problem but a problem for all the Rich Uncles.

Seeing this possibility, in the last year many banks have sold their Greek debt to the ECB, which was willing to pay the full face amount as part of their Rich Uncle support role. To the extent the ECB cleared the Greek debt from commercial bank balance sheets, it now holds the most toxic of the toxics — but the commercial banks still have a diversified portfolio of the less-toxic assets that will still be subject to contagion meltdown and require government assistance. For that matter, a Greek default would require the ECB to be recapitalized.

To give you some idea of the implications, Switzerland, as an extreme example, recently recapitalized two of its very large banks to the tune of $1 trillion, while the Swiss GDP is only $500 billion! The figures are almost as dire in Ireland, where the combination of the recession and bank undercapitalization pushed the government debt load to 98 percent of GDP from 22 percent in the last three years. Hence, Germany must care if the Poor Uncle’s government debt is marked down, as that would cause it to ramp up its own public sector debt to make its banks whole. This is the government insolvency multiplier, in which one government’s insolvency triggers contingent financial obligations on other governments. Hence the meltdown dynamic runs from the Poor Uncles to the Rich Uncles via the Rich Uncles’ financial guarantees. In the end, the meltdown in Greece is also a high powered Rich Uncle problem.

Given government commitments for bank survivability, when government bonds go down, banks go down, and governments that in turn honor their financial guarantees to banks also go down. Those are the links in the chain that leads to the unthinkable. No wonder gold and silver and Swiss Francs are bouncing upward, and even the U.S. dollar looks good in comparison to the Euro.

There is still room to redefine laws, bank regulations (such as capital requirements), accounting rules, rating criteria, or the ECB’s rules for bailouts. It’s still possible to walk away from previously made government commitments to banks. However, this is just containing the government insolvency multiplier of past debt, and it doesn’t provide private funding for future baby-boomer entitlements. We are nearing the endgame when the bond market shuts down governments’ ability to spend beyond their individual means, as well as their collective means.


On the Ratio of Rich to Poor Uncles

Once again the fragility of the European PIIGS sovereign risk is findings its way back into the news which is another problem the global economic and financial community would like to be without. The pricing of Greece’s sovereign debt has slipped again to yields of 13% so that it hardly qualifies as investment grade either by the market or by the rating agencies. This slippage in pricing although not back to the panicky levels of last April and May strongly suggests the market is once again giving up on Greek debt despite the bailout underway. On top of that Ireland this past week has decided to bite the bullet and complete a banking sector bailout that runs its current year fiscal deficit to 32% of GDP further straining the credibility of Euro sovereign debt.

So we now need a bailout fund to fund the individual country bailouts. The bailout vehicle put together to purchase the weak Euro sovereign debt is a Special Investment Vehicle (SIV) as explained last May in The Smoke and Mirrors of the Greek Bailout Package has consisted of rounding up other willing and perhaps some unwilling Euro sovereigns and their institutions to fund the SIV to allow it to purchase shaky sovereign debt. How the bailout entity is being funded is by soliciting Rich Uncles to fund the purchase of irresponsible Poor Uncle’s debt within the Euro family of governments. The Rich Uncles thought it only fair that the Poor Uncles also partake in the bailout so the bailout entity is funded by all including the Poor Uncles. But it is the ratio of Rich to Poor uncles that provides the financial insurance to the Poor Uncles. Since there are few genuine Rich Uncles in the Euro zone, the EU with limited taxing capability, the IMF and the European Central Bank despite a charter commitment to not engage in country bailouts have been recruited to be Rich Uncles.

As one would expect given the general shakiness of the income behind the Poor Uncles and the Rich Uncles for that matter, portfolio managers have used the opportunity since the bailout fund was established to unload their sovereign debt position with most being purchased by the ECB. Additionally, the body politic of at least one Rich Uncle, Germany, as one would imagine is now questioning its participation when the agreement expires in two short years.

One hailing from the US might find this arrangement of “support” difficult to understand but it is analogous to the FDIC which guarantees losses from broke bank’s deposits being funded through deposit insurance premiums paid by the same broke banks and a handful of banks that would become broke if they tried to support the deposit obligations of the entire system. That is, the Euro bailout is not without precedent and to some extent is modeled after US deposit insurance guarantees. The chilling fact is there are too few Rich Uncle banks to support all the Poor Uncle banks so the FDIC fund is also transparently broke but the FDIC sticker displayed by all banks still gives US depositors a sense of comfort and they line up to deposit at exceedingly low compensation perhaps because the US taxpayers will be the Rich Uncle. More smoke and mirrors as the US government with its sizable deficit and explosive entitlements and a weak growth economy hardly qualifies as a genuine Rich Uncle any longer.

The Euro bailout package is explained in the smoke and mirrors referenced above and the absurdity of the package is perhaps best explained by the penetrating dry British wit contained in the following video clip. Yes, it’s almost that bad except perhaps it s worse in that the Rich Uncle of last resort has been the European Central Bank which has given up on its charter of being the stalwart Rock of Gibraltar of monetary conservatism of not being forced to print and purchase the sovereign debt the market will not. The larger stakes in the game are not saving PIIGS debt and their ability to continue to fund debt that cannot be serviced, but whether the monetary union will not in turn crumble if investors abandon the currency and hence eliminate the primary benefit of the monetary union’s reserve currency status that provided its businesses greater access to private global capital on favorable terms.

Once again, the short run beneficiary of PIIGS distress are Dollar fixed income holders as the 2009 US capital outflows has turned back into a US capital inflows that has put the US fixed income market in somewhat of a bubble since by comparison only, US sovereign debt is relatively safer….at least for now. Enjoy the video clip if you can laugh through the tears.

This all leads to the notion that it is time to give up on the “responsible” developed world financial claims including US fix income claims that are in a bubble and find an investment manager skilled in the art of finding and dealing with islands in the sun, perhaps called, Australia, New Zealand, Norway, Denmark, Canada, Brazil, etc. where the Rich Uncles are truly rich.