Click here to read this article in pdf format: october-27-2011

As we write these comments, no concrete proposal for the European Financial Stability Facility (EFSF) has been presented after the summit that took place yesterday, among leaders of the European Union (EU). However, markets seem to consider as highly likely that three fundamental decisions will be made:

1.-The EFSF will be leveraged, under a first-loss insurance scheme, to cover the initial losses on newly issued debt of EU sovereigns.

2.-Greece’s sovereign debt will be restructured without triggering a credit event.

3.-The eventual haircut (i.e. discount) on Greek debt will be significant (approximately 50%) , higher than 20% for the purpose of our discussion below.

Together, these three measures, if implemented, would generate an inconsistent system, leaving the European Monetary Union in worse shape.

The current limit on the European Financial Stability Facility is EUR440BN. If we subtract the existing commitments to fund the Irish, Portuguese and Greek programmes, we are left with approximately EUR200BN. If these were pledged to cover, say the first 20% of newly issued sovereign debt of EU members, we would have about a trillion Euros, 20% insured (i.e. Eur200BN/0.2 = Eur1 trillion). This would mean that investors of the first trillion Euros in sovereign debt would only suffer losses, if these surpass 20% of their investments.

How can we tell investors they will be safe enough with a 20% cushion, if they simultaneously see a haircut on the Greek debt in the order of 50%? To make matters worse, if existing hedged (with credit default swaps) investors of other EU peripherals sovereign debt see that no credit event is triggered (i.e. default is not acknowledged) in the Greek case, why would they keep paying to insure their bond holdings with credit default swaps? After all, those who thought were properly hedged on their Greek debt holdings would now see that the insurance premiums they bought are useless.

The consequence of these last two measures would generate a sell off in sovereign credit default swaps, eventually taking liquidity from this market, and in the process, likely increasing the cost of owning the newly issued debt that the leverage EFSF initially sought to cheapen, by providing a 20% first-loss insurance.

Lastly, as a structured credit product, the senior tranche owned by investors (the EFSF would have a subordinated tranche of 0-20% in losses, investors would be senior, with exposure to losses above 20%) will be negatively impacted if the contagion (i.e. correlation of defaults) spreads (i.e. increases) within the European Monetary Union. Think of this example: suppose that a veterinarian sold a farmer an insurance contract where the first 20% of the cattle covered by the contract would be refunded, if it catches a certain disease. As long as that disease is contained, the insurance contract provides the farmer with peace of mind. It is clear then that if the disease becomes epidemic, the farmer will find himself in a more compromised position.

Investors of EU sovereign debt are actually in a position weaker than that of our hypothetical farmer. The same sellers of the insurance, by forcing haircuts bigger than the loss they insure and without triggering a credit event would actually be increasing the likelihood that the default contagion within the region spreads. Bondholders without a proper hedge may fire sell their investments, raising the cost of the newly issued debt, further threatening the position of the EU banks, which are currently asked to increase their capital.

This could indeed end in a vicious circle that would dangerously spiral, for if we are correct…the next logical step would be to ask who would reinsure the insurers, as a region-wide collapse is on the horizon. As we saw in the US with mortgage insurers, that person was the Fed. Will that be the fate of the European Central Bank as well? The recent rally in gold seems to tell us the answer.

Martin Sibileau

Click here to read this article in pdf format: october-17-2011

We apologize for not having written sooner. We usually do if we find new, market moving information. Unfortunately we have not in the past three weeks, which is also evident in the range trading all asset classes have witnessed.

As we write, the G-20 is meeting and the EU will have its own discussions, later in the week. One of the main topics markets have been paying attention to is that of EU banks recapitalization. This is not news. We have been discussing the futility of this issue since 2010. It is nothing short of circular reasoning. On June 4th, 2010, we warned that:

“…there continues to be confusion in the analysis of the EUR problem. The latest one consists in criticizing the ECB for lack of clarity in its bond purchases (…) While the Fed gave details about its unsterilized asset purchases, the ECB will not. But we explained why this is so:

“…The Fed was financing what we call in Economics a “stock”, i.e.( mortgages) “…a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past…” (http://en.wikipedia.org/wiki/Stock_and_flow ). The ECB is financing “flows”, deficits, or “…a variable that is measured over an interval of time…” Therefore, by definition, we cannot know that variable until the interval of time ends…When will deficits end? Exactly!! Nobody knows! Thus, it is naïve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seen…”

Again on June 29th, 2010, we added that: “…Finally, we want to discuss an idea suggested yesterday by Morgan Stanley’s Global Economics Team (ref.: “The Lure of Liquidity”, The Global Monetary Analyst, Morgan Stanley, June 16th, 2010). The authors (i.e. J. Fels and E. Bartsch) propose that “…the Euro has been caught in a vicious circle, where the sovereign debt crisis and the bank funding crisis are mutually reinforcing each other…”. Essentially, monetary policy, which this report calls “Passive quantitative easing” is to blame for this spiraling circle. It is also proposed that had the ECB activated “Active quantitative easing”, where the central banks buy public or private (i.e. mortgages) bonds in size, the result would have been different…the crisis would have been contained.

We could not disagree more with this flawed and misleading notion. It is flawed because it doesn’t acknowledge the structural difference in what the ECB is financing, vs. what the Fed was financing. We brought up this issue weeks ago, when we said the Fed had been financing “stocks” (a magnitude in Economics), assets, which are finite and certain, like mortgages, while the ECB is financing “flows”, which are only determined at the end of a period (i.e. Q4 2010) and are therefore uncertain. Thus, the ECB cannot commit to buy a certain size of debt and run the risk of failing to meet expectations. The ECB, as well, cannot have an exit strategy, as we discussed in our letters at the beginning of May.

This interpretation is also misleading, because it suggests that the solution to this problem would have been increasing the capitalization of the European financial system. This system is not active, but passive in this story….”

The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital:

However, as we write, policymakers are considering the recapitalization of EU banks again. Not only does it not make sense, but also, should this exercise be coercive in nature to the private sector, forcing bondholders to become equity investors in a mandated conversion, unspeakable damage will have been done globally to any prospects of growth. This is the path that may be taken after all and we are accordingly ready to see higher correlations, volatility and the run for USD liquidity make a comeback. Gold could be seriously affected in the process.

What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility. On January 28th, 2011, we described in detail what we think is still a viable alternative: The swap of EFSF bonds for sovereign bonds, in the secondary market.

We want to end our comments today with two observations, back on this side of the pond:

1.- Since the announcement of Operation Twist, unlike what was expected, the US yield curve has steepened, rather than flattened. Is this the result of a reallocation from US bonds to stocks, or a vote of non confidence on the Fed? For now, we are inclined to believe in the former, but only because we find stocks had been oversold too fast. Longer term, we have our doubts and we find that this steepening of the yield curve and gold stronger in USD terms rather than in Euros, is not a coincidence.

2.- Last week, the Fed created ex-nihilo approx. $1.3 billion to lend for 3 months US dollars to EU banking institutions. These are US dollars nobody in the US has saved for, and these are US dollars indirectly financing, many times via the credit multiplier, the fiscal deficits of the EU. A forced recapitalization of EU banks would eventually increase the size of these operations, because private investors would dump their holdings running for liquidity. We hope this will not occur because the only possible unwind in that case would be through global USD inflation. Again, gold stronger in USD rather than in Euros, we think, is not a coincidence.

Martin Sibileau