Please, click here to read this article in pdf format: april-12-2010

This was a “busy” weekend, and we are left with no alternative but to write about it on a Sunday night…
First, we offer our deepest condolences to the people of Poland on the tragic deaths of their President, Mr. Kaczynski, First Lady Maria Kaczynski, and those who were traveling with them, on the 70th anniversary of the Katyn massacre.

Europe was also on the front pages, with the announcement of a EUR45BN rescue package, consisting of EUR30BN by European Union members and EUR15BN by the IMF. Of course, this money is at below-market interest rates. We suspect that Greece shorts will be squeezed this morning, although much of the rally we saw at the end of last week was on the speculation of this outcome. Personally, we believe this is only buying time for the European Union and we fail to understand the logic behind this package, if it is real. To us, it looks more like a threat, for it seems Greece’s Finance Minister, Mr. Papaconstantinou, said the government still plans to issue debt, without taking up the offer for aid. Another relevant point here is that from now on, we should expect the same kind of response to other worsening fiscal deficits, as in the case of Spain or Portugal. Will the Union be there for them? If so, what kind of exit policy can the European Central Bank (ECB) undertake?
On this note, in our last letter (Thursday, April 8th) we had assumed the graded haircut schedule announced by the ECB was going to include government debt. We were wrong. Details were subsequently released and the program will exclude government debt.

Thus, one more act has closed on the European theater and we have no choice but to think the world can only print its way out of this crisis. This is the reason why we turned bullish on gold last week, for as our market thesis states (refer: www.sibileau.com/martin/2009/04/21 ), every major central bank has now to face internal unique problems that prevents a global coordination in monetary policy. Gold therefore will increasingly play a role as the common denominator for all fiat currencies.

As central banks are (unsuccessfully) seeking to structure their respective exit strategies, governments are looking for a way to build the next line of defense against a future liquidity crisis. Sometimes, the line looks like the Maginot line…

On Saturday, Canada’s National Post reported that Ms. Julie Dickson, Canada’s chief bank regulator, prefers a scheme whereby banks could insure themselves against failure with debt that converts to equity (refer: “OSFI offers conversion as bank shield”, at : http://www.financialpost.com/story.html?id=2785584 ).  If correct, we think Ms. Dickson may be referring to contingent notes, similar to those recently issued by Rabobank. On March 12th, Rabobank issued a EUR 1.25 billion, benchmark 10-yr Senior Contingent Note, at an annual coupon of 6.875%. These notes are contingent on Rabobank’s capital, as a percentage of assets. If this ratio falls to less than 7%,  the notes will be written down to 25% of face value. Therefore, the bank will record a gain on the issue, which increases its capital.

We have no view on this particular debt issue. But we believe that encouraging this type of financing as a buffer against a liquidity crisis is absurd. We cannot mince words here. In fact, the widespread use of this type of debt will only help precipitate a crisis, in a self-fulfilling dynamic.

No investor in any part of the capital structure of a financial institution should feel any safer with this scheme. As soon as an event triggers only the mere likelihood of a liquidity squeeze, noteholders will dump the notes with the proverbial violence. The transfer of wealth from noteholders to shareholders will only be temporary, for immediately after this event, the capital gain will never, ever, offset the liquidity costs financial institutions will face to remain going concerns. Depositors will feel at risk and a serious run against those financial institutions will trigger a swift downward spiral.

Indeed, with senior contingent notes, financial institutions are buying a put from the note holders. However, believing that these notes constitute a solid cushion against systemic risk equals to ignoring the leveraged and correlated nature of financial institutions under a fiat currency system.

Martin Sibileau

Please, click here to read this article in pdf format: april-8-2010

We’re back from Chicago, where we spent the Easter weekend, a holiday in Canada. Since last week, we have the feeling that some changes of consequence have taken place at the macro level, globally. We will try to summarize what we believe is the most relevant:

-Sovereign risk: Europe/Greece
On Tuesday, we heard/read rumors that depositors in Greek banks are withdrawing/not renewing their deposits. Only rumors… What was not a rumor was the European Central Bank’s (ECB) decision to introduce a “graded haircut schedule” on government debt (i.e. Greek debt) in January 2011. The details of this decision will be released today, but we think this would be inconsistent with the role of a lender of last resort. Think about this for a moment…To accept junk collateral at a discount sends two signals: a) the recognition of a junk paper, with the establishment of a cap price for that paper, and b) the explicit monetization of a fiscal deficit, at a specific rate (the rate of issuance of the government that places the debt as collateral)! Besides, it will inevitably create frictions between the issuing governments and the ECB. The difference between inflation and hyperinflation is nothing else but the incorporation of inflation expectations to prices by investors. If a central bank facilitates the job, then we are entering dangerous waters. We, at “A View from the Trenches” had anticipated this back on December 17th (www.sibileau.com/martin/2009/12/17 ) and later laid out the scenario, on January 7th (www.sibileau.com/martin/2010/01/07 ). We were clear, we wrote we would be sellers of Euro. These events remind us of our years at the Univ. of Buenos Aires, when a professor that shall remain anonymous compared inflation with pregnancy: “Nobody can indefinitely be just a “little” pregnant”, which brings us to our next point:

-Gold:
Almost a year ago (refer: www.sibileau.com/martin/2009/04/21 , “Two main market theses”),  we put forward a simple thesis on gold: “…when there is global coordination of inflationary monetary policies, gold cannot be a safe and lucrative asset. When inflationary monetary policies are not globally coordinated, gold is a safe and lucrative asset…”. This thesis was very useful and has never proved us wrong so far… On Tuesday, we turned bullish on gold. With the ECB’ decision to monetize peripherals’ sovereign debt, China’s recent signal that the Yuan will gain flexibility while still manipulating interest rates (the government announced yesterday its intention to begin issuance of 3-yr debt), the upcoming election in the UK and fiscal crisis in the US (see further below), global monetary coordination is taking a pause (the Fed concluded last week its unprecedented purchase of mortgages). Since the Dubai event, we had been neutral-to-bearish of gold (refer: www.sibileau.com/martin/2009/11/30 ), preferring Canadian equities, to ride the safe-haven bid theme on the Canadian dollar. We had showed the spread between the ETFs XIU.TO (TSX 60) and IGT.TO (gold, in CAD), to make our case. As the chart below shows (source: Bloomberg), the spread tightened this week. We were waiting for IGT.TO to touch the C$112 level for confirmation of the trend and that happened yesterday. The trigger however was, in our view, the ratings downgrade of Greek banks (National Bank of Greece, EFG Eurobank Ergasias, Alpha Bank, Piraeus Bank, Emporiki Bank of Greece, Agricultural Bank of Greece and General Bank of Greece) on March 31, at 8:31am ET.

-Sovereign risk: US (the next big thing)
While we have seen an impressive increase in the volume of public issuance lately driving swaps into negative territory, since last week, a series of news has muddied the waters: Harrisburg, PA, announced it will miss a loan payment, Fitch cut Illinois’ rating on $23.4BN of municipal bonds one notch to A-, citing a rising budget deficit for 2011, and New York state announced a delay in $2.1BN of school aid, given its $9BN deficit for 2010. The news yesterday of an 11.5BN (vs. +5BN) fall in consumer credit and the Healthcare bill don’t help at all in the face of the massive state/municipal deficits. Yes, other central banks are reallocating what they can from what they had in the form of Euro to US Treasuries, but the yield curve is still steeper vs. last month (with yesterday’s news, the 2y10y spread flattened by -3.2 bps to 279.4 bps). How is this going to work out within an increasing interest rates environment? Exactly! There will be no increases in the near term, or at least, not as quickly as most expected, according to Tuesday’s Federal Open Markets Committee’s statement, which brings us back to our point on gold…

Martin Sibileau

Please, click here to read this article in pdf format: march-1-2010

Over the weekend, we came across an article from U.S. Congressman and former Presidential Candidate Ron Paul, with whom we sympathize (refer: www.ronpaul.com ). The article was titled “Are U.S. taxpayers bailing out Greece?” and published on February 16th (refer: http://www.ronpaul.com/2010-02-16/ron-paul-are-us-taxpayers-bailing-out-greece/ ).
Briefly, Mr. Paul wrote: “…Is it possible that our Federal Reserve has had some hand in bailing out Greece? The fact is, we don’t know(…)Unless laws are changed to allow a complete and meaningful audit of the Federal Reserve, including its agreements with foreign central banks, we might never know if this is occurring or not…”
Mr. Paul left us thinking, and after careful consideration, we realized that the implication of this exercise may (or not) be in contradiction with what we wrote on Friday. Let us explain:

To begin with, we believe that indeed, there would be a cost to U.S. taxpayers, if Greece defaulted. We don’t think Greece will default, at least not in the near term, but there would be a cost nevertheless. The cost is not explicit and it would show its ugly face if a credit event was triggered under a sovereign (i.e. Greece’s) credit default swap.

Why?

Any US financial institution with a net long exposure to Greece’s sovereign credit default swaps would face an immediate funding problem. Therefore, the Fed would be pressed to rescue such institutions, while at the same time, it would have to provide currency swap lines to the European Central Bank, to avoid a collapse of the Eurodollar market.

The cost regarding the financial rescue would be on US taxpayers. This would be an unnecessary and most disappointing cost. After so much “quatsch” on regulation, how would the current US Administration justify having missed a flag as big as that of sovereign credit default swaps. There is currently a lot of quatsch about sovereign credit default swaps, but all superficial. The economic ignorance of politicians prevents them from understanding what these derivatives really imply. As we wrote earlier, under a system of fiat currency, allowing banks to sell insurance on sovereign debt is no different than allowing children to sell insurance on the financial risk of their parents. But politicians focus on the greedy side of those who trade these swaps, which is really idiotic, because these derivatives represent a huge boost to systemic risk, even if they were traded for the most morally justifiable reasons. If somebody bought credit insurance on the parents of the seller of that insurance, be it the most educated, hardworking or honest kid, he or she would still be dreadfully misled by the formal aspects of the contract, which lacks any solid content. The solution does not reside in prohibiting them, but in requiring that collateral on such trades, at least on non-Emerging markets credit default swaps, be posted in gold. (Note: Why do you think I believe that a commodity collateral would not be required on credit default swaps on emerging market countries?)

On the other hand, the cost needed to save the Eurodollar market would be global. The global feature of this cost is driven by the violent foreign exchange volatility the world would have to bear, where the notion of a global reserve currency would be clearly challenged. This brings us back to the point made last Friday, when we wrote that a sovereign credit event would be deflationary, and that liquidity preference, in particular a strong demand for USD, would challenge the value of gold.

We kept and keep thinking about this one. Given the hypothetical nature of this event, we can only speculate as to what conditions would be necessary for gold to rally. The first one that comes to mind is a catastrophic situation, where the Fed actually bails both the financial institutions and the Euro market but the market no longer trusts monetary authorities and every USD facilitated by currency swap lines is swiftly bought with Euros and immediately exchanged for gold.

If you think this twice, you will acknowledge it would not be the first time a flight to safety of this nature takes place. In fact, it would make sense. But again, this should occur under a total lack of monetary policy coordination and something else: The firm conviction that stimuli programs are useless. This would be a true capitulation. What is the probability for this scenario? Not too high for now, but not too low either, in our view.

Martin Sibileau