Please, click here to read this article in pdf format:may-3-2010

Sometimes, the questions we ask are more important than the answers we may have. Post-announcement of the EUR110BN package for Greece by the IMF and the EU over the weekend, perhaps there is merit today in asking a few questions:

It has become clear and public that European sovereign debt is being and will continue to be bought by European banks backed by the ECB, making the sovereign risk contagion back to the financial system a done deal. Therefore, how safe are those who bought sovereign credit default swaps (“cds”) from banks that are now exposed by the sovereigns?…We have mentioned this ignored side of sovereign cds in previous letters (for instance, refer: www.sibileau.com/martin/2010/03/01 ). How this issue is not discussed while every regulator in the world is still looking for ways to reduce systemic risk is beyond our understanding.

If sovereign jump-to-default risk increased, the ECB would most likely monetize sovereign debt (actually, the ECB is already doing it), further devaluing the Euro. But as long as no sovereign defaults, things will be under control. However, if a Eurozone sovereign ended in a credit event triggering the cds contract…How bad would the run for liquidity to the USD be? CDS contracts on European sovereigns trade in USD.

How much would counterparty risk (=risk between the banks that traded the cds) jump? Is the size of outstanding sovereign debt and that of the cds net notial useful to assess the impact? We think not and we guess that anyone downplaying this issue based on the size of Greece’s cds net notional outstanding doesn’t understand the leveraged nature of capital markets. Are Greece’s funding needs in 2010 not minimal compared to the impact they are causing?

The next question is whether gold would rally or fall. To answer it, we have to speculate on whether the Fed would or not extend currency swaps to the ECB to avoid the collapse of the Euro. The Fed did so in Sep/Oct-08, upon the Lehman event, and we believe the Fed would so again, which brings us to the another point… What is riskier?:
a)    To have the Fed extend currency swaps to the ECB to provide liquidity to the financial system for clearing purposes (as in post-Lehman) or…..
b)    to have the Fed extend currency swaps to the ECB,  as a ultimate back-up on liquidity on sovereign debt?

In the first scenario, should gold not sell? (It did). In the second, should gold not rally, as a sovereign default causes the collapse of the Euro (our base case assumption here)? Would American taxpayers ever get their monies back if the Fed extended those swaps to the ECB under the second scenario?

However, we don’t want to sound too pessimistic this morning. The package announced yesterday will bring a short relief to the markets, hopefully pushing gold to lower levels. We were a bit scared when on Friday, while gold, oil and Canadian stocks rose, the value of the Canadian dollar fell. Was that end-of-the-month profit-taking?

If gold corrects today after the April rally, should it not make sense to buy the weakness? After all, should we not believe Greece’s Finance Minister Papaconstantinou when he commits to serious cost-cutting? Personally, we have never ever heard of a successful bailout package for a nation with high tax evasion. Greece’s problem is not about cutting costs. Greece’s problem is institutional in its underlying structure and bailout packages cannot address that. When the USD40BN IMF package for Argentina was announced, it bought the country approximately a year, before the final collapse, as it didn’t count with a central bank to monetize its debt (Argentina’s central bank worked as a convertibility agency). This makes us think Greece should be luckier this time.

Martin Sibileau