Please, click here to read this article in pdf format: november-29-2010

We start the week with three main themes, plus the absence of one. Indeed, yesterday the EU/IMF disclosed the “85 Milliarden Euro Rettungspaket für Irland”. So far, this is to the best of our understanding, what has been agreed to:

-In terms of sources, das Paket will consist of EUR17.5BN contributed by Ireland + EUR22.5BN contributed by the IMF + EUR22.5BN contributed by the European Financial Stabilisation Mechanism + EUR17.7BN by the European Financial Stability Facility  + EUR3.8BN in bilateral loans from the UK + EUR1BN in bilateral loans fra Sverige og Danmark.

We note that the sources of the EUR17.5BN Irish support will be Irish Treasury (yes, I know…) and the National Pension Reserve Fund (no different than what Kirchner did in Argentina a few years ago, when the private pension funds were nationalized and put to good use financing the federal fiscal deficit).

-In terms of uses, das Paket will assign EUR10BN to capitalize Irish banks, EU50BN to cover budget financing needs and EUR25BN as contingent banking support. And here is where things get rather interesting…After Kanzler Merkel would threaten with haircuts on senior bank debt holders, European finance leaders yesterday had to commit to a plan, post-2013 (i.e. when temporary crisis facilities expire) that would treat writeoffs only on a “case-by-case” basis (as reported by Bloomberg), addressing “collective action clauses”. In our view, although this offers a bit of calm to investors, the “technical” damage has been done and it will be difficult to repair, unless there is now an explicit rejection by the EU finance ministers on the issue. They don’t want that? Fine, Mr. Market will eventually force their hands. Just sit tight and watch… What’s next now? Portugal?

The second theme that will impact this week’s action, and perhaps more to come, is the situation in the Yellow Sea, between the Koreas. The recent mediation by China to hold discussions among the Koreas, Russia, the US and Japan smells to a set-up to us, to buy more time for North Korea. It raises the question too, of whether this would have all not been planned before hand. Now, if South Korea rejects the invitation, it will look bad on them. If they don’t, nothing will come out of it, except that the dictatorship to the north will have won time. This could have been a great opportunity for China to demonstrate they are politically up to their pretension to be a global superpower. Because nothing will be solved, in our view, Asian stocks will be capped on their potential to the upside and the price of gold will keep a premium.

The third theme in our view is the expectation, after Black Friday, that consumer spending is slowly recovering and that this will be a force behind a “trend to rally”. Certainly, the recently announced $600BN monetization of federal debt by the Fed (also known as Quantitative Easing II) will also keep a bid on asset prices.

Lastly, another theme is actually the lack thereof, that we may see more clear if and once the public becomes comfortable with the situation in the EU: Namely, the lack of an exit strategy in the US. See, since the beginning of this year, the EU has been working towards gaining trust. Let’s recap:

 First, nobody thought they would pull out a spending cuts program. But so they did! We now have spending cuts from Ireland, UK to Greece. Yes, citizens protested big time, but the cuts are here to stay. Yes, they are not enough, but there is always more to cut and privatizations have not even been discussed yet. What about spending cuts in the US? 

Later, nobody believed the EU would really pull out a package for Greece. Yet, they rescued Greece and now Ireland. They even worked out a mechanism to address future crisis and most importantly they put deadlines to them: 2013. What did the US do on its municipal and state debt problem? So far, the municipal bond market suffered a huge outflow of money two weeks ago and Wall Street is making every effort to downplay the issue, as we expect of course, from those who make money distributing this debt.

Finally, the European Central Bank stated that their government purchase bonds would be sterilized. Nobody believed them (we included) and nevertheless, they did so issuing their own debt (EUR65.8BN at Nov 24th) and without driving rates to expensive levels. What has the Fed done? This is all brewing USD weakness in our opinion and it won’t be long till we see it bursting.

 
Martin Sibileau

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: february-11-2010

The world is speculating on the outcome of the meeting of European leaders later today, in Brussels. In the meantime, yesterday Mr. Bernanke made clear his intention to raise the discount rate, sooner than later. Furthermore, yesterday also, the 10-yr $25BN US Treasuries auction was weak. It’s true, there were a lot of other problems markets were focused on, including the weather on the east coast, but then again, are Treasuries not supposed to act as a safe haven in times of chaos? We took note of this and of the fact that yields rose in parallel (shift upwards), with the 2y10y curve ending at 281.1bps, flat. We will be watching this market closer as well as its impact on swaps and Agencies, for we feel this may be signaling an upcoming tectonic shift. It’s pure intuition for now, we acknowledge, but sometimes intuition has merits too…

On another note, we continue to insist with the view that Europe is facing an institutional crisis, rather than the short-term liquidity crisis seen by so many mainstream analysts. What is the difference? Here is a defining point:

If the crisis was indeed about short-term liquidity (with long term solvency concerns), then it should not matter whether it is the IMF or the European Union that bails out stressed peripherals. If the problem was only short-term liquidity, form should be subordinated to facts. Yet facts are subordinated to form. It is precisely because nobody seems to be able to come up with a sustainable and acceptable “form”, that we see no facts! (Facts = Risk mitigating actions, like loan guarantees)

If the crisis was only about short-term liquidity also, the Euro should have not been impacted as it has. How measurable is the impact of the liquidity situation in California on the USD? How can therefore Greece have such an impact on the Euro? It is the very sustainability of the European Union that is at the core of this crisis.

Why is this relevant? Because it tells us something: Today, it is likely that no long-term credible path will be announced.

Lastly and related to this crisis too, we want to draw collective attention to an issue that in our view has not received enough consideration. Much has been made and written on financial regulation necessary to prevent financial crisis. We, at “A View from the Trenches” have also written many times that regulation is useless and counterproductive, for the root of the problem is the monetary system that the world is embracing. A central banking system is intrinsically weak, arbitrary and leveraged, and attacking the distributors of a currency (i.e. financial institutions) will not make the system any stronger. However, there are other issues regulators can positively address, which we think have not been addressed yet. One of those is the potentially destructive nature of sovereign credit default swap contracts, which are currently booming.

In our opinion, these swaps are true weapons of mass destruction. Essentially, if a sovereign defaults, the party that bought protection should be compensated for the loss on the corresponding reference securities. But who thinks any counterparty would have enough liquidity to honor these contracts, if say, we see a default in the US or the UK, for instance? What would be the value of billions of credit protection on US sovereign risk sold by Citi or Goldman, if the US defaulted on its debt? What would be the value of credit protection on German sovereign risk sold by Deutsche Bank, if Germany or France actually defaulted? Zero! Given the fiat monetary system we live in, no financial institution would be able to have enough liquidity to fund the increasing margins, even before such defaults are declared, because the value of the collateral denominated in USD or Euros would drop materially, as jump-to-default risk rises. Under such scenario, things would spiral out of control and it would be evident that either central banks end up bailing out both the financial system and the sovereign, triggering a massive hyperinflation in the process, or the biggest of all depressions would be upon us.

Restrictions on this market would be useless, because they would not acknowledge the intrinsically leveraged nature of the contracts. The solution, in our opinion, is that counterparty risk be collateralized with gold, instead of fiat currency, for those sovereigns with the strongest currencies (=the most leverage!).

Martin Sibileau