Planning, Carry, and Intervention (Tchir)

Thursday, May 24th, 2012

by Peter Tchir, TF Market Advisors

The market continues to trade with extreme volatility. Yesterday’s decline was deep and painful, only to be followed by an equally vicious rally on rumors of a rumor. This morning has already seen Europe rally, fade, then rally again. The overall theme remains the same, with concerns about Europe being counterbalanced by hopes of central bank action and government policy. Maybe as a bank bull down here, I am reading too much into it, but the whale trade fiasco seems to finally be getting put into perspective. That is good for JPM and the financials and the market.

The fear that the EU is preparing a plan for Greece to exit seemed like the worst excuse to sell off that the market has used. There is a real chance Greece will exit. Without significant concessions from the ECB and Troika, it will be there only option. I would much rather that Greece planned for it rather than just gave it a shot. Any hope of a Grexit not being incredibly disruptive to itself and to the rest of Europe will depend on planning. Real planning, not the typical EU style that assumes the market will do what it would like, but one that puts some stresses on the potential outcomes and works hard to deal with them. Given how much money the ECB and Troika are on the hook for, the concerns of deposit flight in other countries if redenomination risk rises, the EU will have to be very careful what it does. I think that as the EU actually works on some plans (shocking that it hasn’t yet) their concern for their own safety and their ability to really manage the worst case scenario will come into doubt, and they will make some concessions with Greece to give everyone time.

And timing is everything. Lots of people are asking what changed from Friday, or from yesterday afternoon. The answer is very little. But what actually has occurred from 2 weeks ago when the S&P was 1,357. The answer there is also very little. Fears of an imminent Grexit have been overblown. That has been our message. Neither side will have the guts (nor stupidity) to rush this decision. It will take time. Time is key because it does give hope that enough can be done that the exit doesn’t turn into a full blown crisis in Europe and that risk of currency flight in Spain and Italy can be contained. Timing is key, because without imminent catalysts, the oversold conditions and “carry” can come into play. RSI, as simple as it is, remains one of my favorite indicators. So much bearishness has been stuffed into the market, that the ability to rally on next to nothing remains high. We even ignored some okay housing data, which only 2 months ago everyone agreed was the key to a successful recovery.

Shorting credit is expensive. Everyone seems to forget about that. Seeing IG18 blow out from 93 to 123 reminds everyone how cool it is when credit blows out. HYG down from 91 to 87.5 is another great example of how quickly credit moves. Spanish CDS at 540 and still near the record highs posted last week is another example where it blew out from a low of 355 in March, to 555 last week. The problem here with being short is how expensive it is. HYG is paying 7% per annum and the price is rising. The cost to sit short is high, and if you take away the noise around Greece (overdone) and JPM (overdone) the arguments for it to be higher than this are all still in place. Even with Spain, you pay 100 bps running and have a pull to par effect, so you slowly bleed money being short. Add to that, the fear that one of these mash it all together and throw government money (that the government doesn’t have) solutions is enough to get the markets excited and you have the making of a short squeeze. The true “trading float” of Spanish bonds in particular is very small. Most bonds are held in buy and hold accounts at banks and insurance companies. Neither of these groups, overexposed as it is, are buying, but they aren’t selling either, so any improvement in the situation can result in a move disproportionate to the improvement. This is also true, to a lesser extent, in the Italian bond market.

I remain constructive here under the assumption that

• Central banks continue to be extremely dovish and may even take some actions
• Grexit, while likely isn’t imminent and the EU will start trying to sound less arrogant and belligerent towards Greece
• The sell-off in financials, part in Greece, but at least in part due to the whale trade, is over and is reversing as people are able to understand that even at JPM the CIO’s entire book is okay, and that this was not a systematic trade affecting all banks
• Data will continue to be mediocre, but with enough bright spots that the bulls can latch on to something and try and push high
• Sell in May and go away may be a good investment strategy, but selling ahead of a long weekend typically isn’t

Copyright © TF Market Advisors

Tags: Amp, Concessions, Decline, ECB, Excuse, Extreme Volatility, Fears, Fiasco, Government Policy, Greece, Hook, Jpm, Nbsp, Rally, Stresses, Tf, Troika, Whale Trade, Worst Case Scenario, Yesterday Afternoon
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The Axis of Weeble is Definitely Wobbling

Monday, May 14th, 2012

Weebles wobbling, spinning tops running out of energy, running out of room to kick the can, whatever analogy you want to use, the world seems like an incredibly dangerous place.

Greece is going to leave the Euro. That is now pretty much everyone’s expectation. I continue to believe that although they are highly likely to leave, it isn’t for a few more months, and that there will be some real effort from the Troika, led by the ECB to resolve this situation. This isn’t about helping Greece. This is about saving what is left of Europe. What does a new currency really do for Greece? It sounds exciting and the conventional wisdom is that it lets them inflate their way out of their problem. I think all it will do is inflate them into a “Mad Max” world. How is Greece going to be able to afford gas and food if they revert to the Drachma on short notice? Greece doesn’t export enough to get a huge immediate benefit. Yes, it will be cheaper to produce in Greece, but very little is set up to take advantage of that right now.

But it is the ECB and the rest of Europe that need to worry. Greece needs further debt cuts even more than it needs a new currency. Not only would the ECB’s and IMF’s existing holdings be converted to the new currency, Greece may decide to default outright. The ECB and IMF are both staring at massive losses. If Greece goes to the Drachma and doesn’t change the debt to Drachma, then they will have killed themselves. That just isn’t possible. So switching to drachma, and then possibly even defaulting is what is necessary. How will the ECB and IMF deal with it? The ECB might have to make a capital call. That would send tremors through the system. The IMF will deal with it, but expect talk about countries pulling out of the firewall. There is talk about having the EFSF make the ECB whole. That’s not even taking money from one pocket and shifting it to another, it’s the same damn pocket. The market will not like that.

Shorting Germany, preferably bunds, is my favorite way to play this (with French bonds a close second). I think the next leg if it occurs wipes out the myth of Germany as “safe haven”. If Greece goes, losses to the Troika will be real and any attempt to paint over them will be too obvious. The staggering size of the commitments that will ultimately flow onto the shoulders of Germany and France will end the idea that somehow their credit is somehow better. The guarantees matter, and these bonds will be affected.

I still expect some “surprise” headlines bringing all the people involved to some form of resolution, that won’t obviously fix everything, but will buy time. Notice Draghi has not once said anything about this, and really he seems far and away the most competent person at the ECB.

Then back here, we can focus more on JP Morgan. Since 2007, JPM had a loss in one quarter only. They lost 9 cents in Q4 2008. The just made 1.70 in Q1 of this year. Citi had 9 quarters of losses in that period. Their worst quarter was -23.80 per share compared to a tiny 1.11 per share in Q1. MS had 6 quarters of losses, with the biggest being 3.61 AND they lost money in 2 quarters last year. Yes, $2 billion is a big number. It may have grown, it may turn out smaller. In any case, it is unlikely JPM will have a loss this quarter. This group and the overall risk management of the firm is part of why they have done so well relative to their peers. If you want to focus on the fact that $2 billion is a huge number to a normal person, that is fine, but you may be getting more angry than you should. The reality is that JPM, with $2.3 trillion in assets is huge, and every business they are in is big, and P&L swings will be large in $ terms, but seem completely reasonable in percentage terms.

Yes, regulatory scrutiny will intensify, but this is a problem at all big banks. The specific risk of this trade has been overdone. Unfortunately it is hard to tell how much of the price move is specific to one aspect or the other, so I can’t quite get comfortable with the situation in terms of getting long JPM, but will be looking at outperformance trades.

Futures have already had a wild ride, and I would expect that to continue throughout the day. MAIN is out to 169 +12 bps on the day. XOVER is at 718 +36 bps on the day. It is ugly, with minimal liquidity – even the best market makers are back to making 1 bp markets in MAIN. IG18 is opening at 112, which is 3.5 bps wider, and HY18 is at 94 3/8, so down about 5/8. The moves in XOVER and HY relative to MAIN and IG seem more normal than Friday, when we saw almost amazing outperformance in the HY space (where JPM is allegedly short).

Spain and Italy are under attack again. Ten year yields have hit 6.26% and 5.70% respectively while CDS is at 640 and 480 respectively. Scary numbers, though Spanish 10 year may be getting to the point where we see some ECB intervention in the secondary markets.

So with problems across the globe and the mood so dim, I can’t help but think we are set up for a rally on the back of any scrap of good news. I don’t see Greece hitting the breaking point just yet, and the market will digest the JPM loss as it thinks more rationally, and Spain and Italy are not so heinous that they should respond well to any ECB intervention.

Tags: Analogy, Axis, Conventional Wisdom, Currency, Dangerous Place, Drachma, ECB, Efsf, Expectation, Firewall, Gas And Food, Greece, Imf Deal, Mad Max, Massive Losses, Max World, Spinning Tops, Tremors, Troika, Weeble, Weebles
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What Could Have Gone Wrong at JPM

Friday, May 11th, 2012

by Peter Tchir, TF Market Advisors

Well for once we don’t have to talk about Spain or Greece.

This is the end of synthetic CDO’s and may well be the end of CDS as an OTC product, but we have time to look at that later. There will be a lot of information and misinformation out there.

For now, the key is what is this going to do for the markets.

As best as I can tell, they were generally short High Yield risk. They were mostly short tranches, mostly in off the run, and had some curve trades on.

Against that, they were generally long IG, mostly tranches, mostly IG9, and had some curve trades on.

The positions, if we ever find out exactly what they were, are complex. At some level this disclosure has something to do with mark to model. Gp

So HY17 is lower on the quarter. If they were short, they should have made some money? Strange and in any case, a relatively small move.

IG9 10 year is wider. Was out 15 bps since the end of the quarter, from 112 to 127.

To lose 2 billion on a 15 bp move, that would be about 275 billion of notional equivalent.

Scary, but something very strange has gone on.

E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts

Copyright © TF Market Advisors

Tags: Bp, Bps, Curve, Disclosure, E Mail, Gp, Greece, Ig, Misinformation, Money, Nbsp, Otc Product, risk, Spain, Strange, Synthetic Cdo, Tf, Trades, Tranches
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Stratfor On Europe’s Growing Anti-Establishmentism

Tuesday, May 8th, 2012

 
“The traditional political elites are losing control of the system they once dominated.” 12 of the 17 member states of the EMU have seen their governments collapse or been voted out in the last two years. As Stratfor’s Kristen Cooper notes, this is testament to the near political impossibility of implementing austerity and maintaining popular support. The tough truth is that while voters initially turn to the mainstream opposition they soon realize that they have little to offer that is different and so radical, extreme, or previously marginalized political parties will, and have done in Germany (Pirates) and Greece (Golden Dawn) already, see an increasing share of the popular anti-establishment vote and implicitly hamper any political solutions to the crisis that Europe awakens to every morning.

Tags: Austerity, Collapse, Emu, Europe, Germany, Golden Dawn, Governments, Greece, Impossibility, Kristen, Losing Control, Member States, Opposition, Pirates, Political Elites, Political Parties, Political Solutions, Popular Vote, Stratfor, Truth
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Europe Wasn’t Destroyed in a Day

Monday, May 7th, 2012

by Peter Tchir, TF Market Advisors

Just like Rome wasn’t built in a day, the Eurozone won’t be destroyed in a day, but it is on a path that leads to eventual dismantling. What day will historians choose to pick as the day that the Euro died?

• The day Greece or someone else first leaves the Euro
• The elections of May 6^th
• The day Greece changed laws to retroactively add Collective Action Clauses and created a new class of bonds for the ECB
• The day that Greek Private Sector Involvement was finished and new bonds traded at 20% of par

Personally, I think the Greek PSI was what proved the Eurozone was doomed. Greece restructured debt, made different rules for different holders, and yet, the new bonds trade at 20% of par. It’s like drink non-alcoholic beer, why put up with the better taste with no useful result at the end. So these elections, while important are merely another step on the path the Eurozone has been headed for months, if not years.

The markets will digest the elections as we illustrate in the weekly report. We are already seeing it play out. After an initial swoon in markets, they have rebounded, and already threaten to take out some post election shorts. Germany has said they will play nice with France. Merkel seems to have the trickiest job as she and her supporters lost support for their bailouts, and yet in Greece, the people who took the bailouts also lost power. It is funny that both the giver and receiver are viewed as having done the wrong thing. This will be important over time, but not this week.

This week we will see everyone play nice. Conciliatory words will be spoken. Growth will become the topic de jour. The markets will fall all over themselves once again on news of bank bailouts. The headlines we get in the early part of this week will once again be overwhelmingly designed to encourage people and the markets. Europe will have a new spirit of co-operation and will welcome fresh insights into the process. Growth, growth pacts, plans to grow, infrastructure growth, etc., will be talked about. There will be talk, and maybe even action on the bank recapitalization efforts. Good banks and bad banks will abound. Governments will promise money to banks at rates so low no sane investor would even consider. So I look for a continued bounce and am a bit net long in the TFMkts Best Ideas™.

Ultimately these plans will fail, and we will see fresh lows on the year for stocks, with the U.S. and Germany hit hardest (having outperformed by far too much already), because:

• Germany in particular, but France and the Netherlands will have trouble justifying their contributions to the bail-out. They will be forced to turn to domestic issues to satisfy their electorate and this will become obvious to the market.
• Growth isn’t easy to achieve. Once “growth” moves from a vague concept stage into something resembled a plan, investors will likely laugh at the attempts. It will be clear that most of the plans are unlikely of achieving long term growth above and beyond the cost of achieving it. That will not help the bond markets, and in turn will spill over into equities as they realize they were fooled by headlines and hype over reality, once again.
• The good bank/bad bank concept is a loser to start with. The bank recapitalizations just enshrine zombie banks. By the time a bank is getting government gifts, the problems they have hidden are likely as large as the obvious ones. The managers don’t worry about lending, they worry about protecting their jobs and their income and hoping nothing else comes out. They hoard the new money in an effort to grow capital and in the hopes that the problems no one noticed go away before someone notices. Starting fresh banks would be ideal. Or letting some bad banks fail and then starting them fresh would be okay. Letting the existing banks get taxpayer money at uneconomic rates, does nothing for the citizens, or the country, and ultimately if there is any “winner” it will be the banks, but even that may take years to play out.

I remain slightly long having been significantly short at the start of last week. I will look to add to some areas that should benefit the most from another short squeeze – with Spanish stocks sticking out. I continue to avoid Spanish and Italian bonds as I think the fixed income markets will be less likely to be tricked by the headlines, and there really is no natural buyer. I am looking at adding Greek bonds now that the election is over and we have seen a bit of a sell-off. A treasury short looks appealing, and the economic data in the U.S. continues to support the idea that high yield bonds should perform decently (ie, paying the coupon without much price volatility in either direction).

E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts

Copyright © TF Market Advisors

Tags: Bonds, Collective Action Clauses, ECB, Elections, Euro, Eurozone, Greece, Headlines, Historians, Insights, Merkel, Nbsp, New Spirit, Non Alcoholic Beer, People, Private Sector Involvement, Psi, Rome, Swoon, Tf
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Country Default Risk (YTD April 2012)

Saturday, April 14th, 2012

In our prior post we highlighted year to date country stock market returns.  Below we highlight the change in sovereign debt default risk for 50 countries.  For each country, we show where its 5-year CDS (credit default swaps) currently stands and where it was at the start of the year.  Prices are in basis points.

As shown, just 3 of the 50 countries have seen default risk increase in 2012 — Portugal, Greece and Spain.  Spain is the main problem, with default risk now up 32.31% year to date.

Norway, Switzerland, the US and Sweden have seen huge drops in default risk so far this year.  Norway now has the lowest default risk of any country at 22.05 bps, followed by the US at 29.6 bps.  It’s been awhile since US CDS has been below 30.

Tags: April, Basis Points, Bps, CDS, Countries, Country Risk, Country Stock, Credit Default Swaps, Debt Default, Default Risk, Greece, Norway, Portugal, Sovereign Debt, Sovereign Risk, Spain, Stock Market Returns, Sweden, Switzerland
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60 Minutes Reviews the European Debt Crisis

Monday, April 9th, 2012

60 Minutes did a piece on the situation in Europe, and for a not financial oriented TV show, it did a pretty fine job of describing the situation for a mass audience.   They key line I wish they had expanded upon was along the lines of “in the past, if Greece found its accounts overdrawn the country simply printed more money, or devalued its currency…” – which are paths the U.S., U.K. and Japan now follow.   Further they should have explained how these financial injections are backdoor bailouts for the financial elite, namely German and French banks, among others.

However, it was interesting to see the dynamic between Greece and Germany in far greater detail than the numbers we are numb to – the long and violent history of this continent makes for interesting relationships.

14 minute video, email readers will need to come to site to view

Tags: 60 Minutes, Backdoor, Continent, Currency, Debt Crisis, Europe, Financial Elite, French Banks, Germany, Greece, Japan, Job, Key Line, Mass Audience, Money, Relationships, Tv Show, Video Email, Violent History
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Chuck Royce: Why the Rally Can Last

Tuesday, April 3rd, 2012

by Chuck Royce, Royce Funds

Can the current rally last through the end of the year?

I think it can. What’s interesting to me is that we’re seeing one of those rare occasions when one of our predictions for the market as a whole worked out almost exactly the way we thought it would. For a while now, we have been noting the disjunct between the very negative and alarmist headlines and the more optimistic view our own analyses and contacts with managements were revealing. It seemed to us as early as last September that the economy was in better shape than the conventional wisdom was suggesting.

“I think we’re on our way to a positive and satisfactory year.
I also believe that we’re on our way to seeing three- and five-year
average annual total returns that will look better than what
most investors have seen recently.”

There were—and are—problems that need to be worked out, but we were hopeful that eventually the world’s bankers and politicians would formulate solutions, at least for the most immediately pressing issues, such as Greek default. The announcement of a bailout plan for Greece created a great sense of relief throughout the capital markets. Once it became clear that Europe would not go bust, investors felt better about the growing stability in the world economy. This positive development, along with the improving economy and the underperformance of the stock market over the last five years, leads me to think that the rally can last. The year’s remaining quarters may not be as robust as 2012′s first three months, but I remain cautiously optimistic and still think that this decade will be better for stocks than the previous one.

So you’re still a strong believer in equities?

Absolutely. I think we’re on our way to a positive and satisfactory year. I also believe that we’re on our way to seeing three- and five-year average annual total returns that will look better than what most investors have seen recently. To me, it all comes down to equities remaining the most effective choice for assets that carry risk. I agree strongly with the notion that a carefully constructed stock portfolio is the best way to build long-term returns that can outpace inflation and preserve purchasing power.

Returns for the major U.S. indexes—and many around the globe—were closely correlated in the first quarter. When do you expect this to change?

It’s certainly more pleasant to participate in a correlated rally than it was last year to be part of a widespread bear market. I expect correlation to remain fairly high through the intermediate term, though I don’t see that refuting the argument that we still need to shop the market for what we think are the highest quality small-cap companies trading at attractive valuations. So as much as correlation has been a fact of life for most of the current market cycle, we continue to invest with an eye toward non-correlated equity results, particularly when looking at companies outside the U.S. We build our portfolios anticipating that they will outperform and, more importantly, provide strong absolute returns over the long term. At some point, we expect correlation to abate and more differentiated returns to materialize.

Do you still see quality stocks, regardless of market cap, as potential market cycle leaders?

We do. Quality as we define it—companies with strong balance sheets, positive cash flow, and high returns on invested capital—has done well on an absolute basis both in the current rally and since the small-cap high in July 2007. However, during the rally off the October 3, 2011 small-cap low, quality small-cap stocks have lagged. This hasn’t been altogether surprising since most rallies, especially those in the aftermath of the financial crisis, have not favored quality. However, our thought is that quality will likely begin to lead when we start to see more differentiated returns. When those investors who have been avoiding stocks return to the market, we suspect that many will be looking for those attributes that we typically seek.

Should there be room in asset allocation plans for global or international small-caps?

We think that any diversified asset allocation plan should include some global or international stocks. The reality is that we are in an increasingly global economy. Equity portfolios that hold mostly or exclusively domestic companies are invested in stocks that derive a substantial amount of revenue from outside the U.S. More important from our perspective is the vast size and return potential of the universe. We see it as too important an area to ignore.

What do you see as Royce’s strengths culturally?

We also believe strongly in eating our own cooking. Each of our portfolio managers is a large shareholder in the funds that he or she manages, which is an absolute necessity. I don’t think you can manage effectively without some skin in the game.

First, company culture is an important and necessary topic. It’s especially important for financial services firms in light of the op-ed piece that Greg Smith wrote recently in The New York Times. We have always cherished certain values here at Royce, and those values inform everything that we do. For example, our long-term orientation doesn’t simply apply to our portfolios, it also applies to the holding periods we have for stocks, the tenure of portfolio managers on our funds, the length of time we want all of our employees to be with the company, and even the objectives and tenures of the management teams that we meet with. We look for companies capable of establishing long-term goals for their businesses because we typically plan on holding companies for at least a few years. There are several that we have owned for more than a decade.

We also believe strongly in eating our own cooking. Each of our portfolio managers is a large shareholder in the funds that he or she manages, which is an absolute necessity. I don’t think you can manage effectively without some skin in the game. Our employees who are not part of the investment staff are also shareholders, so it’s a company-wide practice that we encourage. Somewhat related to this is the fact that many managers serve on multiple portfolios, which had fostered a highly collaborative culture. There are no rewards for having the best idea and no penalties for coming up with ones that don’t work. We evaluate our people with the same long-term standard that we use for portfolios, so each manager will have his or her share of hits and misses. Making mistakes is part of learning how to be successful, so we allow for that and are never shy about admitting when we’ve screwed up. We can’t expect shareholders to make a long-term commitment to us without being transparent about our process and practices.

Finally, I think that discipline and consistency are vital parts of our culture. Maintaining our discipline has been crucial to building long-term returns, whether we’re talking about the ’87 crash, the early ‘90s recession, the Internet Bubble or the 2008 crisis. Through all of those points and more, we stuck to what we think we do best. It wasn’t always easy, but our sense through each trying time was that eventually we and our shareholders would be rewarded for our patience.

Important Disclosure Information

The thoughts expressed in this piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Investments in securities of micro-cap, small-cap and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see “Primary Risks for Fund Investors” in the prospectus.) Securities of non-U.S. companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic or other developments that are unique to a particular country or region. (Please see “Investing in Foreign Securities” in the prospectus.) Therefore, the prices of securities of foreign companies, in particular countries or regions may, at times, move in a different direction than those of securities of U.S. companies. (Please see “Primary Risk of Fund Investors” in the prospectus.)

Copyright © Royce Funds

Tags: Bailout Plan, Believer, Bust, Capital Markets, Conventional Wisdom, Decade, Disjunct, First Three Months, Gold, Greece, Last September, Optimistic View, Politicians, Quarters, Rally, Royce Funds, Shape, Stock Market, Stocks, Those Rare Occasions, World Economy
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€300 Billion of “Firewall” Money up in Smoke (Tchir)

Monday, April 2nd, 2012

by Peter Tchir, TF Market Advisors

Last week’s firewall headlines devolved into a “mine is bigger than yours” argument, as official headlines touted the highest possible number, and any reasonable analysis showed that the available money had only increased from €300 billion to €500 billion.  Far less than the official headlines and any analysis of how the EU cobbles together €500 billion leaves serious doubts about it ever being achieved (Spain and Italy are expected to contribute 30% of that amount, which doesn’t make sense since they are potential users of the firewall).  See here for a more detailed analysis of the “unused” firewall money and where it comes from.

What hasn’t been discussed much, is how useful is the firewall?  What did the €300 billion already spent accomplish?

At best, the firewall helps the markets, but does little for the real economy, and at worst, it hurts the economy by avoiding hard decisions and shifts risks and costs from the private sector who made the original bad decisions, to the taxpayers.

Greece, Portugal, and Ireland received €300 billion of firewall money or commitments already.  What has that done?

Greece defaulted on its private sector debt.  The new Greek private sector debt trades at 20% of face value, a level that is lower than the old Greek bonds ever go to – think about that – the New “restructured” Greek debt, trades at lower prices than the old debt ever did – hardly the sign of a good restructuring.  The economy is in shambles and has done nothing but deteriorate while the “firewall” was put in place.  The firewall in Greece did nothing to help the Greek economy, delaying the inevitable default made the economy worse, and Greece still has the same amount of debt outstanding (in part because the taxpayers have recapitalized the banks), so now they just owe that money to different (more powerful) entities so their bargaining position is even weaker.  A sad state of affairs and not a ringing endorsement of why anyone would want “firewall” money.

Portugal has not yet defaulted on its debt, but while accepting firewall money, they have also been busy at work letting the governments guarantee bonds issued by banks, so the banks can stay alive.  Just like in Greece, the first restructuring will leave Portuguese debt burden unchanged, it will just replace who they owe it to, and force the taxpayers into capitalizing the banks that have now completely developed a parasitic relationship with the country.  While Portuguese bonds benefitted substantially from LTRO and more promises that no PSI in Portugal would occur, both the 5 year and 10 year bonds have been weak the past few days, and still trade at prices 70 and 60 respectively, that indicate that restructuring is still to come.  The main hope for those bond investors is that somehow, they get paid out and the public sector takes the risk – as sad as that seems for taxpayers, it doesn’t seem impossible that that is what the EU would decide to do.

Of all the countries that have received “firewall” or “bailout” money so far, Ireland seems the closest to turning the corner.  The 10 year bond yields less than 7% and there is real talk about improvement in the Irish economy.  Having said that, they are already re-negotiating their payment schedule for their bank recapitalizations.  Yes, Ireland had actually been relatively okay until they threw taxpayer money at the banks without realizing what a deep dark hole they had gotten themselves into.  In all 3 of these countries, it is the state support for banks that is making the crisis worse, or in the case of Ireland, sparked the crisis.  The other issue with Ireland is that it is the smallest of the 3 countries that have needed help.  With only €121 billion of “official” government debt (all the guaranteed debt, hidden derivative debt, commitments of support, etc., are not readily available), it is much smaller than even Portugal with €171 “official” government debt.  One of our themes has been that smaller markets are easier to manipulate and the central bankers and politicians can hide problems longer there since the capital they are willing to throw at covering up the problems is disproportionately large.  I’m not saying that is happening in Ireland, but I would also be careful about reading too much into their bond yields, as the size of the market makes it much easier to manipulate.

So of the €300 billion spent already to “firewall” or contain Europe, it is hard to see what has been achieved.  Greece’s default, and bank recapitalization caused Greece to demand more firewall money.  As Portugal seems destined to head down the same path, they too will need more money and will take a solid bit out of that remaining €500 billion, when they convert bank losses into taxpayer loans.  Ireland seems most likely to be able to avoid needing more money, yet, having said that, they are re-negotiating terms of their existing bailout.  Hardly a successful use of €300 billion (not including IMF money).

The politicians will argue that they bought time.  That they have “saved” the banking sector.  That is the best they can come up with, that by delaying they made the default in Greece less problematic, and that by saving the banks, they make the future better.  I have argued all along that a default would not be catastrophic – the politicians didn’t do it when I first suggested – May 2010, but once they did allow the default to occur, it was far less painful than they would have led you to expect.  I have argued that keeping dead banks alive does little for future growth, while making the problems bigger.  I’m not the only one to say that, but I think Yalman Onaran’s “Zombie Banks” does a great job showing that time and again, the desire of politicians to delay the recognition of problems, particularly for banks, means the final tab for society will be much higher. The examples of this happening time and again are frightening (and recent), yet here we are trying to implement the same flawed policies.

How would the firewall work if Spain needed money?

It is great to talk about the “firewall” and just how big it is, but what happens if Spain starts to deteriorate.  The likely scenario would be that Spanish bond yields start climbing.  Let’s say that the 5 year bond gets to 5.0% and the 10 year gets to 5.75%.  They are currently at 4.1% and 5.33% so this move would represent a serious shift in concern, but still be nowhere close to the worst levels seen in November (or pre LTRO – maybe Europe should switch from calling this 2012 AD, to 1 ALTRO?).

The first line of defense would be some ECB Secondary Market Programme (SMP) purchases.  The ECB would go into the market to buy bonds.  Given the problems the ECB’s holdings of Greek bonds caused (full payment and separate laws), the EU may choose to use EFSF or ESM money to buy the bonds.  These entities are set up to work with the ECB, to buy bonds in the secondary market.  With all that has gone on, I believe that the ECB will direct the purchases, but won’t use their own balance sheet.  So any purchases will subtract from the remaining firewall.  It also means that Spain will be guaranteeing some portion of the money being spent to buy Spanish bonds.  For small size, say €20 billion or less, Spain will probably not opt to “step out”.  With all the overcollateralization built into the guarantees, versus funded amount, there will be political pressure for Spain to remain part of the bailout team, in spite of the ludicrously circular nature of that.  The argument will be that “secondary market purchases” are temporary, etc.   The market will buy into that at first.

So the Doika (EFSF & ESM) will buy bonds.  Initially this will scare the “speculators” who are short, and encourage the “investors” who will buy some bonds to participate in the potential short squeeze rally.  The fact that many of the “speculators” are the same hedge funds that become “investors” will be ignored.  We will see a rapid improvement in yields as dealers won’t fight the Doika, and fast money may even try to jump on the band wagon.  The rally will likely be short lived, and not too dramatic, as LTRO has already been priced in, and shorts aren’t as prevalent in the past, and this round of weakness has been caused by fast money being caught long and overestimating the longevity of LTRO, rather than a “bear raid” on the country.

So let’s say after the SMP, Spanish yields drift back to 4.50% for the 5 year, and 5.25% for the 10 year.  What has been accomplished?  What was actually done for Spain?

Did Spanish borrowing costs decline?  No.  The price of secondary market debt doesn’t affect Spain’s current budget.  Spain is obligated to pay the coupons agreed to when bonds are issued, the secondary market does not affect existing interest payments that Spain is due to make.  It might help control the cost of Spain’s new issues, but the country is already issuing almost 70% of their debt with maturities of 2015 or less, so keeping long term yields artificially low doesn’t have much of an impact there either.  Then why do it?

In theory, all borrowing in Spain will be benchmarked against sovereign debt.  So banks who borrow money for 5 years will pay a spread to 5 year Spanish yields.  Companies that borrow will also pay a spread over the 5 year sovereign rate.  So in theory controlling the 5 year sovereign rate affects all Spanish companies that borrow money for 5 years.  The same thing goes for the 10 year yields.  That is great in theory because typically banks and countries are creating new debt every day at a faster pace than the country is creating debt, so you effectively “leverage” the SMP money, because keeping the sovereign debt yields low, means all the companies in the country can borrow at a lower yield.  That might work in a “normal” environment, but we have moved so far past “normal” that it is laughable to believe this transmission works.  It obviously didn’t work in Greece, and hasn’t worked in Portugal, so why ignore that?  In Spain (and Italy) banks have become addicted to ECB funding.  They have grown addicted to issuing bonds to themselves, getting a guarantee from the country, and then taking those bonds to the central bank to get money.  They aren’t consistently issuing bonds to the public where the benchmark sovereign yield matters.  More than that, they have shifted their borrowing to ever shorter maturities.  The banks are borrowing more and more short term and they are definitely NOT lending money long term.  They are lending to companies long term, if at all.  The whole lending dynamic in the countries has broken down, so assuming traditional monetary policies work in this environment is just flawed.

So, other than calming the markets, at least temporarily, barely anything is done for the country, the banks, or the companies in Spain.

It might keep the cost of “hispabonds” down.  These are bonds that would be issued by regions, but come with a government guarantee.  On the other hand, these bonds might be the worst idea yet to come out of Spain.  All the existing ways of hiding debt – off-market derivatives, verbal guarantees, private side-letter guarantees, commitments to EFSF/ESM where not all commitments are used, have the benefit of being difficult to find, or to convince people that they have a real impact on the creditworthiness of the nation itself.  Hispabonds will attract attention to the fact that Spain is really issuing these bonds because the regions are in worse shape than the country.  It will be hard to convince people otherwise, as these bonds will be right out there in the open where anyone can see them.  Once the “guarantees don’t count” mantra has been breached, the potential floodgates of concern open up.  How big is Spain debt, really?  Not the “official” number, which is attractive, but the real debtload?  It is high, and growing quickly, and likely unsustainable.

But anyways, what is that would cause SMP to fail to hold.  Bad economic data?  Ever increasing unemployemt?  Failure to implement austerity?  Civil unrest?  Failure of a caja? Hispabonds?  Revelations of secret debt?  The list of potential catalysts is large.  All it takes is for one thing, and the market that is still positioned long can resume its sell-off quickly.  Remember, post LTRO, the banks are about as long as they can get and have to post collateral on mark to market losses on bonds they posted as LTRO collateral.  Foreign banks will remain reluctant to extend capital, since Greece showed that restructurings are based on what is politically expedient, and not what the rule of law was at the time you bought your bonds.

This weakness causes bonds to spike higher again, this time reaching 5.5% for the 5 year and 6% for the 10 year.  We see higher yields and a flatter curve as the market, caught long, realizes the last effort by the fire brigade failed to be sustainable.  Nervousness is creeping into the market.

This is likely where the politicians make things worse rather than better.  Some will start trotting out the “leveraged” EFSF/ESM concept.  A non-starter, that may spark a brief rally by the naïve who think it can work, only to be followed by more selling pressure as markets get nervous that Europe is heading back to the clueless stage.  The ECB will confirm that  no new LTRO is planned – since yields aren’t really that bad, and they too can see that LTRO is a double edged sword.  Renewed calls for austerity and dissention in Germany will add further concern.  People like myself, will legitimately show just how much debt Spain is obligated to pay, and now more investors will start to pay attention.  They will see that the guarantees are real.  By this time another €50 billion in firewall money will likely have been spent (€20-30 billion on Spanish SMP and some to Portugal and Italy as Spain isn’t deteriorating in a vacuum).  Rumors of law changes will abound.  Rumors that Spain is preparing to default on non-Spanish held Spanish bonds will occur.  There will be denials, but prudent foreign investors will be very fearful of getting involved in a deteriorating situation.

Long before the firewall money is spent, the outcome will come down to the ECB, France, and Germany.

What does the fire brigade do here?  It really is tricky.  At this stage, how do you stop the decline?  Buying more Spanish bonds and Italian bonds?  That will help, but not like the prior round, because now “speculators” who have been eyeing the horrific balance sheets of the caja’s, the regions, and the countries, will find ways to be short.  Spanish sovereign bonds may respond to more Troika purchases, but CDS will remain well bid.  Spanish bank and corporate debt that is beyond the maturity of LTRO will be attacked, not so much as a spread to sovereign bet, but one that sovereign yields will eventually spike.  The regions will become desperate for Hispabonds at exactly the time the market won’t buy them.  Although I believe Spanish yields will be worse than Italian yields at this stage, the Italian bond market will also be under pressure.  Guilt by association if nothing else, but sadly it is more than just guilt by association, in spite of recent progress, Italy has a lot of problems of its own, none of which is helped by increasing problems in Spain – the correlation is real.

What happens if Spain “steps out”?  If Spain decides it needs significant money to bail-out its cajas, regions, banks, and itself, then they will have to step-out.  That greatly increases the burden on Germany, France, and Italy.  Will they have the political will to take over Spain’s commitments?  Remember, even ESM is only partially paid in capital, so ESM and EFSF will be issuing guaranteed bonds into a market, that is experiencing growing concern with Spain and Italy.  Asides from the political will, does Italy have the economic capacity to step up its commitments if Spain “steps out”?  Does Spain “stepping out” create real risk that Italy too has to “step out”, leaving virtually the entire firewall up to Germany and France?  I think it does.  It is hard to see plausible scenarios where Italy can honor its commitments without getting dragged down.  They might not need to tap the firewall, but they may no longer be able to support it.

At this stage, all eyes will turn to the IMF and the ECB.  I continue to believe that the IMF is the most constrained.  Partly, their money is coming from reluctant donors, and partly because they do seem to do the most unbiased critical analysis of the situation (I’m sure what they discuss internally is far more morbid, than the already dire predictions they occasionally leak for public consumption).  So it comes down to the ECB.  The ECB will likely treat ESM as a bank or find some other way to fund programs so that these bizarre entities don’t have to rely on real markets for money.  Why ever rely on real markets for risk assessment and pricing when you have the power to print and sustain economically unviable positions far longer than anyone ever thought?

This will be the key.  It will once again fall to the ECB to come up with programs that “fix” things.  Or at least give the can another good kick.  Can they?  The ECB will have to print.  For the first time, it will become clear to everyone that if Germany and France can’t sustain the EFSF/ESM, then they can’t contain the ECB’s potential risk either.  The commitment of France and Germany to the ECB is joint and several, as opposed to the EFSF/ESM where each has exposure that is capped.  That risk will start to scare some sensible people.  Politicians will likely bring out the “if we don’t help them, we all die, scenario” but the reality, as throughout the entire crisis, will be that “helping” them ensure you all die down the road, rather than having just some serious injuries now.  Also, there will be a growing number of people, who may finally be listened to, that effectively argue that restructuring now, taking the losses and restarting with a sustainable system is the way to go.  They will only have to point to Greece and Portugal to make their point, and they will be able to clearly demonstrate that Spain’s roll in the bailout of those countries, only hurt Spain.  Too much of the bailout money goes to banks and insurance companies and not enough goes to fixing sovereign debt problems, or killing the banks that need to be killed so that others can survive.  Yes, we hear the trickle down argument, that hurting bank share prices, or the portfolios of insurance companies hurts the little guy, but after 5 years of trying that in the U.S. and Europe, maybe it is time to test the theory.  Most banks will not default if they have to take big hits on sovereign debt.

I for one, would like to see a much different approach to dealing with the crisis then has occurred so far, but in any case, this is where we likely get.  It will all come down to the ECB, with the backing of France and Germany deciding to go all in, or PSI (default) on a large scale.  But in either case, the €500 billion of unallocated money is just a myth and this problem will hit a critical point long before much more money is drawn down.

Copyright © TF Market Advisors

Tags: Bad Decisions, Banks, Commitments, Doubts, Entities, Face Value, Greece, Greek Bonds, Greek Economy, Hard Decisions, Headlines, Leaves, Nbsp, Portugal, Private Sector, Restructuring, Shambles, Taxpayers, Tf, Trades
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Austerity – Mais, non. Spending – Nein. PSI – Tal Vez?

Thursday, March 29th, 2012

by Peter Tchir, TF Market Advisors

Austerity hasn’t worked for countries. So far the austerity path has made situations worse, rather than better.  Without stimulus, economies have seen their problems compound.  So now virtually everyone is against the idea that austerity is helpful.

That takes us back to spending.   Maybe it’s just me, but spending is what got us into this mess in the first place. If spending worked so well and was so easy we wouldn’t have a sovereign debt crisis in the first place.  Virtually every country was spending, yet deficits grew and economies shrank.  Why is there any faith that spending now will work?  Are we so good at targeting specific things that will really, truly, work?  Not a chance.  Spending will ensure debt grows just as fast, make the problem even bigger in the end, but will make people slightly happier in the near term.

So if austerity doesn’t work, and spending hasn’t worked, what will?

PSI, or Default, or Restructuring.

Debts have grown so big, that the only way to bring them under control is to default on them in one form or another and wipe some out permanently.  Doing it sooner than later is key.

Now is the time.  Portugal 75% haircut.  Ireland 50%.  Spain 40% haircut (once they put all the Spanish guaranteed debt on balance sheet, they will need 40%).  Italy 25%.  Greece – just make EU and ECB eat the same dish they served to public sector.  Only IMF money is sacrosanct.  The ECB, EFSF, and EU can take losses like the rest of us.  The EU talks about “firewalls”, well, put up or shut up.  The ECB can print away the losses.

Using current data, here is the amount of debt at the sovereign level for each country (I think if they are going to do the restructuring, they should put on balance sheet a lot of the guaranteed debt, so they only have to do this once).

Portugal:  €171 billion * 75% = €128 billion

Ireland:    €122 billion * 50% = €61 billion

Spain:       €712 billion * 40% = €285 billion

Italy:      €1,631 billion * 25% = €408 billion

Total write-downs would be €882 billion.

A lot of banks have written down holdings in Portugal already and taken reserves on other countries.  Greece shows that banks had done a semi decent job reserving against it.  Let’s assume €100 billion of losses have been reserved against or already marked.

That leaves €772 billion of losses.

The ECB has about €175 billion of non Greek bonds on its SMP balance sheet (or a number close to that)?  Assume an average loss of 40% on that (it is a mix of debt from the various countries).  That is €70 billion accounted for.  The ECB should just print that money. Call it a one-time exercise. With all the default/restructuring, inflation isn’t likely to be a concern.

So that leaves €702 billion still that needs to be taken out of the system.

Unicredit has an equity market cap of €23 billion.  Intesa is about the same.  Assgen (an insurance company, where the bond ticker is so much more fun than actual equity ticker) has a market cap of €19 billion.  BBVA is €30 billion.  DB is €35 billion.

The losses will be a massive hit to the banking and insurance industry.  But to some extent, so what?  The big “money center” banks will all survive it.  The DB’s, SocGen’s, BNP’s, HSBC’s of the world will take some serious hits.  US banks will take some hits.  But they have plenty of equity capital to support it, and they made bad lending decisions.

The BBVA’s of the world will get hit extremely hard, but they should be able to survive it.  I’m less sure about some of the Italian banks as they seem to have bigger concentrations, but in the end, there are a lot of banks.

So let the restructurings begin and figure out what to do with the banks after.

Many will survive without assistance.

Some banks may fail.  If the ECB and EU and EFSF protect senior unsecured creditors from losses at the expense of equity and sub debt holders, then the risk of a banking death spiral goes away. How much needs to be protected and at what level is unclear.  Some banks that were truly over exposed should see losses to  bondholders too.  Less losses for the public to bear and more losses for the bad decision makers to bear.

Provide “Warren Buffet” style equity capital to banks that want it or need it.  Why shouldn’t the taxpayers make money like Warren does?  Stop with the easy money for banks, make them pay the country like they would a private investor.

There has been ZERO evidence that bank share prices influence lending. It doesn’t seem to matter what we currently do to banks, they aren’t lending much.  So let’s not worry about their share price.  So long as they have access to money, they will or won’t lend regardless of whether their share prices are low.

Banks that are prepared and prudent will thrive in this environment.

Rather than making it hard to start new banks, the ECB and Fed should encourage new banks. There has to be 10’s of billions of Private Equity money that would start good mid-size banks.  Heck, maybe we could get an i-Bank.  But seriously, new money has been crowded out of the space by zombie banks and kick the can policies.

Take the hit.  Figure out who excels, who fails, and for those in between, what is the cost of surviving.   Open the markets to new equity capital and new participants.

Maybe this is too harsh and will never work, but it is a better path than pursuing the same policies that have failed year after year.

Tags: Austerity, Balance Sheet, Debt Crisis, Debts, Dish, ECB, Efsf, Faith, Greece, Haircut, Hasn, Losses, Nbsp, Psi, Public Sector, Restructuring, Sovereign Debt, Stimulus, Tf, Time Portugal
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