November 30, 2011

Why Central Banks’ Action Could Make Matters Worse

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Europe, Finance, Foreign, government, investment advisor, investment banking, investments, sovereign debt, Stocks, taxes tagged , , , , , , , , , , , , , , , at 9:47 PM by Robert Barone

NEW YORK (TheStreet) — Over the past 18 months, we have witnessed the emergence of what has become known as the “European Debt Crisis.” Capital markets have become increasingly concerned over the sovereign debt of the European peripheral countries and the solvency of the financial institutions that hold much of that debt. You can tell from the 10-year borrowing rates shown in the table below exactly where the concerns reside.

Solvency issues manifest themselves in liquidity issues. Looking at the table, you can see that investors are hesitant to lend to the lower tier without significant compensation for the credit risk they know they are taking. The solvency issue also plays havoc with the ability of the banks to access the short-term capital markets for their everyday liquidity needs. And, in some cases, especially among the banks in the lower tier countries in the table, those liquidity strains are huge.

If you were a Greek citizen, for example, wouldn’t you go to your bank and withdraw all of the euros you could and put them in your mattress? That is, in order to protect yourself from the prospect of waking up one morning to find that your account was no longer denominated in euro, but in “new drachma” converted on a 1:1 basis, and the free market value of that “new drachma” was such that it took 4 to purchase 1 euro? So, the silent run currently occurring on Greek banks is not surprising.

>>The Real Reason Behind the Central Bank Scramble

A similar phenomenon is beginning to happen to the continent’s banks. This is showing itself in the form of an unwillingness of financial institutions to lend to each other and a severe tightening of the private sector money markets.

So, the coordinated move of the central banks announced today is a reaction to the near shut down of the money markets and it makes liquidity available to the continent’s banks. But, this is not the end of the story because this move only addresses the symptoms (the resulting liquidity issues), not the cause (the solvency issues). As we know in America, the Savings and Loan Industry in the 80s was able to access the money markets in $100,000 increments due to FDIC insurance. As a result, the solvency issues weren’t addressed early when they were relatively small. But, eventually, they had to be dealt with.

Thus, the move by the central banks, by printing money and making it readily available to the banks, only postpones the inevitability of having to solve the solvency issues. It buys time. The tradeoff is twofold:

1) it increases inflationary pressures;

2) it allows the solvency problem to continue to fester, and perhaps, become even worse.

The sovereign nations have two choices: inflation or austerity. They would choose the former except for Germany’s resistance. That story is still being played out. For the banks, significant recapitalizations must occur. We are likely to see a lot more drama played out on this issue, especially if one of the larger institutions has a misstep or is attacked by the marketplace as we saw in the U.S. in 2009.

Robert Barone  and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment  Advisor. Statistics and other information have been compiled from various sources. Universal   Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.  Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.   A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

 

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November 23, 2011

Super Committee Could Hurt Dollar’s Reserve Currency Status

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes tagged , , , , , , , , , , , , , , , , , , , at 4:30 PM by Robert Barone

NEW YORK (TheStreet) — The decisions of the Super Committee are likely to have more far-reaching implications than are currently envisioned, as the deliberations have been cast only in political terms by the media. There are, however, significant long-term economic implications.
As we have seen over the past couple of weeks in Europe, contagion can spread like wildfire. The bond yield spreads to U.S. Treasuries or German Bunds on all European peripheral country debt, and even on the debt of AAA rated (at this writing) France, have widened significantly and are displaying huge volatility depending on the day’s headlines.
>>Debt Super Committee Could Spoil the Holidays
Luckily for the U.S., the dollar is still the world’s reserve currency and, in a world of fiat currencies, shows up as the least risky because of its worldwide liquidity and its unabashed penchant to use its money printing press in a financial crisis. So, despite the imbalances clearly present in the U.S. today (see U.S. Debt Crisis: What’s the End Game? ), there still exists a “flight to the lowest perceived risk” (formerly known as “flight to quality”), when crisis and uncertainty rear their ugly heads.

Benefits of Reserve Currency Status

The rapid spread of the contagion in Europe should be a wake-up call to U.S. policy makers, especially the Super Committee. Any stumble or failure to propose something significant in the form of deficit reduction could further jeopardize the dollar’s reserve currency status and bring the day of reckoning perilously closer. The Nov. 14 edition of Barron’s (Enter the Yuan) set forth five benefits of reserve currency status:
  • Investor willingness to hold your currency and paper;
  • The ability to print money to purchase foreign assets — without paying any interest;
  • Easy issuance of debt and worldwide acceptance;
  • Deeper financial markets ultimately benefiting your financial institutions;
  • Conducting trade in your currency which avoids exchange rate risk and benefits your exporters.
Think of what could happen to the U.S. without reserve currency status. Like what has already happened in the European periphery countries, interest rates would rise. This will occur even if the U.S. shares reserve currency status, which is the most likely initial scenario. I (see Wow-II! That’s A Lot of Interest!) and other prominent economists have estimated the cost of debt in the U.S. if rates rise. Some possible scenarios are truly frightening in that the cost of the debt relative to the federal budget and GDP could put the U.S.’s debt burden on par with or higher than that of Greece, Italy and the other countries involved in Europe’s debt crisis. 
For sure, as I opined in the above referenced blog on Dec. 1, 2010, “[g]iven the structural nature of the deficit and the difficulty of slowing or reversing defense costs or the costs of ‘social’ categories, even small upward changes in interest rates … will exacerbate the deficit and economic growth issues.” Thus, preserving reserve currency status, just for the lower interest rates that accompany it, is critical.

Recession Implications, QEs and the Financial System

While recent data suggest that a U.S. recession is not imminent, some leading edge economists and even the San Francisco Fed believe that the inevitable recession in Europe in 2012, a slowing growth rate in Asia and China, and fiscal austerity at the state and local levels could tip the U.S. into recession. The San Francisco Fed says this probability is above 50%. A renewed recession will certainly cause the Fed to embark upon additional QEs, and the Administration and Congress will react by increasing the deficit (after all, it is an election year!). This will further erode the world’s confidence in the dollar as the world’s reserve currency.
The U.S. financial system was not “fixed” by TARP or Dodd-Frank. MF Global has shown that some of these institutions still have insanely high levels of leverage and are more than willing to make “all in” bets. An implosion in European financial institutions may negatively impact both the mid-sized and the Too Big to Fail institutions and cause further credit tightening. Under such circumstances, I can envision another TARP-like response from the Treasury and Fed with more money printing and secret lending further eroding the dollar’s status as the world’s reserve currency.
One has to wonder why China hasn’t come to Europe’s aid given that China exports as much or more to Europe as it does to the U.S. The answer could be that China has a long-term plan to vault the Renminbi (RMB or Yuan) toward reserve currency status. The benefits are numerous as outlined above. Already McDonalds, Caterpillar, Unilever, UBS, Volkswagen and the World Bank have issued bonds denominated in RMB in the Hong Kong market. It is no secret that China wants its emerging market trading partners to settle merchandise trades in RMB and wants a financial center on par with New York and London on its mainland. So, a flailing Euro and QEs in the U.S. advance the RMB as a potential reserve currency.
The importance of the Super Committee recommendations for the dollar’s status in the world and the special privileges, liquidity, and low borrowing rates that accompany that status cannot be overemphasized. Failure to make significant progress will only hasten the day when there won’t be a “King Dollar.” The end result will be higher borrowing rates, lower economic growth, a continuation of depressed economic conditions, and a further lowering of the U.S.’s standard of living.
TheStreet
Robert Barone  and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment  Advisor. Statistics and other information have been compiled from various sources. Universal   Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.  Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.   A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

November 18, 2011

U.S. Debt Crisis: What’s the End Game?

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes tagged , at 11:52 PM by Robert Barone

NEW YORK (TheStreet) — It is pretty much settled that the European Monetary Union, as it is now constituted, cannot survive. It is just a matter of whether the course of events will be disruptive, or will be coordinated by the European leaders. Given what we have observed over the past year-and-a-half regarding their unfolding debt crisis, I suspect the former. We may even see bank runs, frozen credit markets, plunging equity values and other ugly stuff if the political forces there don’t get their acts together real soon.

But, let’s not be so naïve as to think that we, in America, are immune from a similar scenario. No, the dollar isn’t going to break down into a set of regional currencies, although I do suspect that the coming QEs (3, 4, 5…) will significantly lower its value. What I am talking about is the inability of the U.S. political system to effectively deal with the economic imbalances that have developed in America, mostly in this century. By always kicking the can down the road, as only the skilled politicians in Europe and America can do, they assume the risk that the inevitable changes that must come to restore balance will be disruptive, even violent, rather than controlled and coordinated.

Nov. 23, 2001 — that is the next critical date for the financialmarkets, as they hang on the pronouncements of politicians, in this case, a subset of the U.S. Congress dubbed the deficit super committee. We have recently witnessed the skill with which Europe’s political leaders manipulated market sentiment each week as they continually showed their mastery of the art of can kicking.

>>Super Committee: Failure Isn’t an Option

In the U.S., progress on its own debt crisis should be much easier to achieve than in Europe, as only two sides have to agree, as opposed to 17 disparate and culturally diverse entities that form the European Monetary Union. But, because we are only 12 months from major U.S. elections, real progress on deficit reduction is unlikely. The U.S. debt crisis will surely be kicked further down the road.

Even in the unlikely event that the deficit super committee finds the $1.2 trillion to $1.5 trillion that they are looking for (there appears to be a bipartisan subgroup within the super committee pushing for such a result), such cuts will be placed in the out years, only to be recast, manipulated, or simply forgotten or ignored by the next generation of the political elite occupying the halls of Congress in 2021. Further, in reality, $1.2 trillion to $1.5 trillion is only a drop in the bucket of the spending problem in Washington, D.C., and, even if agreed to, won’t make much of a difference except to instill some hope in the equity markets, perhaps enough for 300 or 400 Dow points on or before Nov. 23.

In reality, the underlying social and economic issues in the U.S. are not really different from those of Greece, Italy, Portugal, Spain or Ireland. They revolve around overpromised entitlements and a rapidly developing entitlement mentality, overpaid government workers, an elite class of wealthy, a broken financial system, a business climate stifled by government regulations, a dwindling middle class, and an over-indebted consumer with a shrinking real income. We all recognize these as underlying causes for Europe’s sovereign debt crisis, but each and every one of these is a huge issue in America, none of which are likely to be addressed by the super committee, or, for that matter, by any committee until at least 2013.

Ultimately, failure to address these issues will cause a social backlash. It may well be through the regular political process, but the more the can is kicked down the road, the more likely it is that the social unrest will demonstrate itself through another process altogether. The Occupy Wall Street movement is but a canary in the coal mine.

The following imbalances are well documented:

  • Overpromised entitlements — these include more than $100 trillion of Social Security and Medicare benefits, food stamps for 45 million Americans, 99 weeks of unemployment benefits (while you are only counted as unemployed for 52 of those 99 weeks), underfunded state and local government pension plans, and overpaid government workers relative to the private sector;
  • A corrupt financial system in cahoots with whichever political party is in power that is encouraged to take excessive risks, reap outsized rewards, and is protected from their blunders by a powerful central bank with access to the only money printing press. Interestingly, the investing public has not made a significant return on their investible assets in this century while Wall Street bankers have become uber-wealthy;
  • The middle class in America is rapidly disappearing and the disparity between rich and poor widens every day:

– The cost of a college education (or even sometimes a decent high school one) is out of reach for huge segments of the population. A student loan bubble has developed. Guaranteed student loans are the only loan segment in U.S. banks that have grown since ’07, but given job prospects in a slow growth economy and liberalized rules for repayment, much of the $1 trillion of such outstanding loans are unlikely to be repaid, once again placing the burden of the financing on an unsuspecting taxpayer; – A housing crisis that has significantly impaired the savings and equity of most of America’s middle class, a crisis caused by the easy money policies of the central bank, the ill conceived ideas of a few in Congress regarding housing, and a quasi-government agency with a lust for power and greed on the part of its management;

  • An interventionist government that picks the winners and the losers (Too Big To Fail banks, GM, Solyndra, wind and solar energy) with its army of rule makers, attorneys, and income redistributionists rather than allowing the free market, which gave America its greatness, to choose.

So far, the Washington, D.C. elites have relied on traditional Keynesian means of deficit spending or interest rate manipulation to address some of these issues. But those measures simply do not work. Total debt is already too large, and creating more of it doesn’t help. And, the Fed is now impotent. As Bill Gross recently observed, lowering interest rates will not make U.S. manufacturing more competitive, doesn’t change the dynamics of a retail trade industry impacted by internet shopping, and actually hurts seniors and retirees trying to live off of investment income.

Like in Europe, the ultimate end game in the U.S. will be rebalance. The resolution of the above-mentioned issues can still be addressed within the existing political framework in a peaceful, well thought out, and coordinated way. But, if the can kickers in Washington, D.C. refuse to tackle those issues, they will be taking the risk that the inevitable rebalancing will occur through a disruptive and/or violent process.

Robert Barone  and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment  Advisor. Statistics and other information have been compiled from various sources. Universal   Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.  Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.   A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

 

November 9, 2011

Euro End Game: All Roads Lead to Monetary Breakup

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 6:39 PM by Robert Barone

— Three major issues must be resolved to save the European Monetary Union (EMU): The value of sovereign debt; the European bank capital issues; and the fiscal capacity or will to provide the needed financing. Unfortunately, no feasible solutions exist. The politicians have done everything they could to keep the market on the edge while, at the same time, continuing to kick the can down the road. The farther the can is kicked, the more painful and costly the ultimate resolution — the breakup of the EMU.

The Value of Sovereign Debt

As of this writing, the haircut on Greek sovereign debt currently on the table is 50%. The French want as small a discount as possible (it was originally set to 21% in the July agreement which was just ratified by the EMU countries a couple of weeks ago) because French banks hold volumes of Greek sovereign debt.

Germany, the other major player in the drama, wants a larger discount to force the private sector to contribute to the resolution, and because they know that they, and they alone, are the ultimate guarantor. The 50% haircut, however, is really not 50% because the EFSF and ECB, which hold 55% of all Greek debt, are exempt from the
haircut. So, at the max, Greece will be relieved of 22.5% of its debt.

However, in order to give Greece a half a chance to survive within the euro circle, the discount should be 80%, not 22.5%%. Even at an 80% discount, Greece’s Debt/GDP ratio will still be greater than 90%. At a 22.5% haircut, their Debt/GDP ratio will be so high, and interest payments to outside debt holders so onerous that it will require too much austerity. As we have just witnessed, Greece cannot meet the current required austerity measures imposed by outsiders. If the haircut on the Greek debt is too small and austerity is too severe, which it will be under the current set of principles being discussed, social unrest will continue. 

Ultimately, the Greek people will elect politicians who vow to remove the imposed austerity. The rise of Hitler was partly the result of imposed “reparations” from the previous war and the hyperinflation that resulted. If still inside the EMU, the problem of the value of the Greek sovereign debt re-emerges under the scenario now on the table. So, it is vital that the Greek debt haircut be large enough to give Greece at least a chance to succeed within the EMU. Of course, that assumes that there is a shift within Greece away from the entitlement mentality
that pervades the culture and that, given a second chance, they will adhere to a fiscal discipline. History indicates low odds of this.

But there are more issues that arise in the scenario in which Greece is given a second chance and kept inside the EMU. The slippery slope is that if the bond haircut is high, then Portugal, Ireland, Spain and Italy see that Greece has been given a second chance with much of its debt forgiven, they will want the same treatment. After
all, why should these countries institute austerity to pay the private sector and often foreign debt holders when Greece doesn’t have to.

In order to avoid the contagion that the others will want the same deal as Greece, there will have to be a consequence that dissuades them. The only consequence I can think of that is serious enough to dissuade them is expulsion from the EMU. Therefore, in order to avoid contagion under a scenario of an 80% bond haircut, it is
essential that Greece leave the monetary union, and that the EU set up and strictly enforce expulsion criteria.

Ultimately, though, because the four problem countries all have the same entitlement mentality, they will never be able to maintain the required fiscal discipline, and will ultimately be expelled. Apparently, the European politicians recognize this.  So, the 22.5% haircut deal currently on the table simply kicks the can further
down the road. The deal on the table cannot ultimately work.

European Bank Capital Issues

No matter how it is sliced or diced, Europe’s major banks are undercapitalized, and that is being kind. If
the sovereign debt they hold is marked to market, they are all insolvent. As we know from America’s S&L crisis in the ’80s and from the recent ’09 meltdown experience, a financial institution can operate in an insolvent condition for years, as long as it can get liquidity. In fact, there may still be such zombies in the U.S.

Enter the European Financial Stability Facility (EFSF). It’s function will be to support (i.e., buy) the underwater sovereign debt held on the books of Europe’s financial institutions at prices significantly above market, thus transferring the ultimate losses from the private sector to the taxpayer. The Fed did this in ’09, purchasing billions of mortgage-backed securities at above market prices from U.S. financial institutions. In effect, this is equivalent to the taxpayer making a capital contribution to the banks without receiving any ownership
interest. This is just a gift from taxpayers to stock and bond holders.

The ultimate capital contribution to the European banks will be in the trillion euro range, and it is likely that the EFSF will attempt to use leverage. But, because the capital contributions to the EFSF already being discussed (and I expect they aren’t as large as they need to be) are large relative to Europe’s GDP, there are likely to be ratings downgrades, causing interest costs to rise and making austerity in the EU even harder to bear. Under existing discussions, France, one of the two major characters in the whole crisis, is expected to make a contribution to the EFSF that is equal to 8% of its GDP. This alone will surely result in a ratings downgrade, as its Debt/GDP ratio has risen nearly 20 percentage points this year alone.

How long will the public endure the resulting austerity? Only long enough for the political process to elect leaders who promise to get rid of it. And, how do they do that? Exit the EMU.

Fiscal Capacity

It is clear that Germany and France are the key players (who are expected to be saviors) in this European drama. As explained above, as the drama unfolds, it is likely to put a tremendous strain on France’s fiscal capacity making it impossible for France to contribute further resources to the crisis (they are already on the hook for a significant contribution to resolve the Dexia issues). That leaves Germany as the last bastion of the euro. Think of the irony. The German people, by a large majority, never wanted to join the EMU. Their politicians brought them in kicking and screaming. Now, they are going to be asked to pay for all the entitlement and profligacy of their European neighbors. This just isn’t going to fly. When it gets to this point, and it will, Germany will simply say no, and that will be the end of the EMU.

Conclusion

It is already too late. The euro cannot be saved without the adoption of the U.S. federal model where the countries become the equivalent of U.S. states with one monetary and fiscal policy, ultimately run by Germany. Because of culture and history, the odds of this happening are about 0%.

The financial ministers can meet. There can be weekly, or even daily summits between the prime ministers. They can dream up debt Ponzi schemes with the EFSF, and can transfer losses from the private sector to the taxpayer. And, they are likely to do all of the above. But, ultimately, it is too late.

The EMU did not enforce its original rules, and now there is way too much debt. Like the S&Ls in the U.S. in the ’80s, it can be propped up for awhile. But, all of the actions that add debt or transfer it from the private sector to the taxpayer only make the final resolution more gut wrenching, difficult, and expensive. All roads lead to the breakup of the EMU. Better to do it now, in a controlled and orderly way, rather than let the happenstance of random events cause it to happen in the midst of a market crash.

Robert Barone, Ph.D.

Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.

Statistics and other information have been compiled from various sources. Universal Value  Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States. A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive,  Reno, NV 89521, Phone (775) 284-7778.