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.