July 27, 2012

New Soap Opera: The Comedy of Euros

Posted in Banking, Bankruptcy, Economy, Europe, Finance, greece, Spain tagged , , , , , , , , , , , at 8:49 PM by Robert Barone

The term “European Theater” was first coined during World War II. Today in the financial markets, the term has come to symbolize an ongoing soap opera, where the audience is continually held in suspense as the bad actors (the politicians) promise actions and solutions to current crises, which have been created by their prior actions. Each time solutions are proposed, the audience breathes a sigh of relief (i.e., relief rally in the equity markets) only to be disappointed when they find out that the solutions won’t work or can’t be implemented.
 
As a result, the crisis and suspense continues, keeping the audience’s total attention (even while dinner on the stove at home is burning). Meanwhile, a new issue or crisis appears, it seems, on a daily basis.
 

Likely New Episodes

Daily we watch yields on Spanish and Italian debt move ever higher, now in zones where other countries have cried “uncle” and asked for bailout help. At the same time, the credit default swaps on Spanish and Italian debt have risen to record levels.
 
New Episode: Will the capital markets force a Spanish bailout by locking Spain out of the debt markets?
 
  • Spanish bank recapitalization: We have recently learned that the European Central Bank is willing to impose losses on the shareholders and junior bondholders of some of the Spanish savings banks. (When they bailed out Ireland, all bondholders were saved.) The draft of the document meant to give Spain’s banks 100 billion euros has this provision, but the periphery’s finance ministers are opposing it.
 
  • New Episode: Is 100 billion euros enough for Spain’s banks? The general rule of thumb appears to be that the ultimate amount needed is usually higher by a factor of at least two.
 
  • Spain’s regional provinces are now coming hat in hand for bailouts of their own. And those regional governments must refinance more than 35 billion euros in the near future.
 
  • New Episode: Are there enough resources in the European Financial Stability Facility (EFSF), the temporary bailout fund, and the European Stability Mechanism (ESM), the proposed permanent bailout fund, to bail out Spain and its regions? What about Italy?
 
  • The problematic link between Spain’s sovereign and its bank’s balance sheets has not been severed, as the audience was led to believe during the “Summit” episode.
 
  • New Episode: Will the ESM require the Spanish government to guarantee the bank capital? If so, will market reaction drive borrowing rates for Spain even higher, or lock them out of the capital markets altogether?
 
  • Greece now appears unable to produce an austerity plan acceptable to the Troika (EU Commission, ECB and International Monetary Fund). Greece has a 3.8 billion euro bond payment due in August. And the ECB just announced that it will no longer accept Greek government bonds as collateral for loans, thus locking Greece out of ECB borrowing.
 
  • New Episode: Will the Troika impose its own plan, or will it withhold bailout funding? Without access to the ECB, will Greece default again? And, will this lead to Greece’s immediate and disorderly exit from the monetary union?
  • Each monetary union country is required to put capital into the ESM. Italy will be required to pony up 20% of the ESM capital.
 
  • New Episode: What sense does it make for Italy to borrow at 7% when the ESM would offer a rate of return that is closer to 3%?
 
  • The ECB holds tons of Greek debt on their balance sheet at par (i.e., 100% of face value) (Portuguese, Spanish and Italian debt, too). If (when) Greece leaves the monetary union, they will renounce this debt, causing the ECB to need more capital to cover this loss.
 
  • New Episode: Will the remaining members be able to contribute even more capital? That will put additional pressure on the weaklings — again, Portugal, Spain and Italy will have to go to the capital markets to borrow at extremely high rates to meet their capital contribution requirements.
 
  • Will the ESM be allowed to purchase sovereign debt in the secondary market as promised in the “Summit” episode? This is meant to support Spain and lower the interest rate it has to pay to borrow. The Dutch, Finns and probably the Germans may say ‘Nein.’

Politicians in a Box

The bad actors in this soap opera, the politicians, know that if they attempt to do the right thing, they will be voted out of office by populations who value their entitlements more than anything else. Look at Greece and the near victory by the Syriza party (anti-austerity) in the last set of elections. And now, we see riots in Spain.
 
These bad actors have proposed so-called “fixes” that merely kick the can down the road, from bailouts (Greece, Portugal, Spain, Ireland) to a banking union in order to avoid addressing the core issues. The fixes enacted calm the audience for shorter and shorter periods. For example, the deposit flight from Spain’s banks now continues unabated, despite the capital plan for Spanish banks announced during the recent “Summit”.
 
This soap opera will continue to play out because liquidity does not produce solvency. The ECB and politicians can throw all of the money they can create at the problem, but, until debt restructuring occurs (i.e., dealing with the debt), the soap opera will continue. Debt restructuring means that some lenders won’t get repaid at all and others will have to take a haircut. Inevitably, some financial institutions (i.e., lenders) will fail. The game to keep them alive cannot go on forever.
 
Eventually, the markets will tire of the soap opera, lose confidence (as they appear to be doing), and close the capital market to these players. It would be much better to have an orderly restructuring than a disorderly one imposed by a panicky market. But, so far, no European leader has stepped up with such a plan (i.e., a plan to exit the weaklings from the monetary union).
 
Without such a plan, the stronger European nations (like Germany, Finland and The Netherlands) will soon have had enough and will leave the monetary union on their own, most likely, to go back to their old currencies.
 

The Final Episode?

It appears that many of the New Episodes described above will soon play out as the situation appears to be in endgame mode. Some sort of resolution acceptable to the capital markets is being demanded by those very markets. The roller coaster is at full speed and it appears the tracks are about to end.
 
What new games can the European politicians play to buy more time? Is there anything they can do, short of having a plan to exit the southern weaklings that can now save the euro? What can they do now to even buy more time?
 
Unfortunately, it appears that a market-imposed resolution, which means market panic and financial chaos for Europe with grave worldwide implications, is rapidly approaching.
 
 
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.
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June 18, 2012

Why Greece is a big deal

Posted in Banking, Big Banks, Economy, Europe, Finance, greece, sovereign debt, Uncategorized tagged , , , , , , , , , , at 4:55 PM by Robert Barone

I’ve read in several different places that a Greek exit from the European Monetary union is not a big deal because Greece’s economy is small and represents only a small fraction of the economic output of the eurozone. Besides, it is already discounted in the markets. I disagree.Remember in the ’90s, when the Thai baht crashed, people said that Thailand was such a small part of Asia that there would be no fallout. But the fallout was huge because every country in the region had the same issues. This is clearly the case in the EMU. In reality, the issues in Portugal, Spain and Italy are the same as those in Greece. While I believe that there could come a time when Greece could exit gracefully, that time is not now because there is no process or set of rules governing such an exit.

Besides, if a sovereign country wants to exit, what, short of war, could prevent it? If Greece decided to exit now, it would repudiate its external debts and, as a result, banks and important European institutions could face insolvency. Greek society could deteriorate into chaos, including rioting, civil unrest and economic dislocation of many Greek citizens. Such contagion could well spread to Spain, Portugal, and even Italy.

Here’s some of the challenges Greece is facing:

• A return to the drachma means radical devaluation of the liquid assets held by Greek citizens;

• Greece imports all of its energy and most of its raw materials. Already, Greek utilities are in arrears to their Russian power suppliers because citizens are not making utility payments. And the Russians are threatening to cut off the power supplies;

• Money is already fleeing the country, so Greece would have to impose capital controls to further prevent money, capital and assets from fleeing, including restricting free access to and from the country via military operations;

• There would be significant impacts on Cyprus, or even on Turkey;

• The European Central Bank holds a huge volume of Greek bonds; in a chaotic exit, with Greek debt repudiation, the solvency of the ECB could be called into question (imagine, one of the world’s premier money printers having to deal with insolvency). Worse, the central banks of Germany and other stronger EMU countries will have to write off significant Greek assets, which have resulted from Greek citizens making euro deposits in the banks of these stronger countries.;

• There are implications, too, for the other external lenders like the International Monetary Funds and the European Financial Stability Facility;

• Bank runs, considered silent until now, would erupt in the other suspect countries (Portugal, Spain and Italy).

If Greece leaves the EMU under these conditions, what is to prevent Portugal and/or Ireland from doing the same? A Greek chaotic exit would make the capital markets skeptical as to whether the aforementioned countries plus Spain, and even Italy, could remain in the EMU. And the capital markets will test their resolve by raising rates in these countries to unacceptable levels until action is taken.

Portugal, Spain and Italy are repeats of Greece on a much larger scale. While aid from the other EMU countries for Spain’s insolvent banking system appears to have been forthcoming, at this writing, the terms of such aid have not been clearly established. Furthermore, the Spanish citizens are up in arms (literally) that the banks are being saved with nothing for the common citizen. And, if Spain’s banking Portugal’s, Italy’s or Ireland’s? Unfortunately, after Spain, the funding source, the EFSF, is essentially out of cash.

The Greeks go to the polls today and may elect leaders who will repudiate the austerity deals that the former government made in return for bailout funds. Or, as happened in the May elections, no one party may end up having enough influence to form a government. Furthermore, the Greek government is set to run out of money by June’s end. Let’s hope that Syriza’s party leader, Alexis Tspiris, if he heads the government, is just posturing about debt repudiation to get a better deal from the other EMU countries.

There are grave implications for the capital markets. The chaos and contagion in Europe could well spread to the U.S. financial system because, as we recently saw at J.P. Morgan, no one, including Jamie Dimon, knows what is on the balance sheets of the large U.S. banks. Any crack in the financial system foundation could well cause chaos even in the U.S. In addition, financial chaos always causes large equity market downdrafts.

Today’s elections in Greece are key, and the results of those elections will determine if Greece will even cooperate. If it doesn’t, sometime in late June or early July, it will run out of money. Given the track record of the European politicians, the probability appears low that Europe can avoid the chaotic Greek exit. Greece isa big deal, and I believe that we will find out just how big very soon.

 
 
 
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.
 
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.