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