European Defaults: Portugal is Next After Greece

It ain’t over until it’s over…

The yield on the 10-year Portuguese government bond closed above 14.80 percent yesterday, a new record for the euro-era. 

“The markets are pricing in a Portuguese default with 10-year bonds trading at about 50 percent of par, a deeply distressed level in the eyes of many investors.” (http://www.ft.com/intl/cms/s/0/49916f7a-468a-11e1-89a8-00144feabdc0.html#axzz1kTbnc8Yy)

“Friday the 13^th may be an unlucky omen for Portugal.  On that day, almost two weeks ago, Standard & Poor’s became the last rating agency to downgrade Lisbon to junk, marking the moment for many investors when default looked inevitable for Portugal as well as Greece.” 

For more on this see my post on blogspot “Credit Downgrades and Europe” for January 16, 2012. (http://maseportfolio.blogspot.com/).

The downward spiral in defaults will continue as long as Europe fails to honestly face its problems. (See my post on blogspot for January 25, 2012 titled “How Long Will Europe Continue to Lie to Itself”: http://maseportfolio.blogspot.com/.)  

In the past, analysts, including myself, tried to explain what officials in Europe were doing by casually remarking that their actions amounted to “kicking the can down the road.”  Basically, the actions of the European officials were an effort to postpone dealing with the real issues, hoping that by delaying what was needed to be done the situation would eventually correct itself.

Now, it seems that the days of “kicking the can down the road” are reaching a climax. 

European officials hope to reach a deal on the Greek debt situation by the end of this month.  The current write down seems to be somewhere around 50 percent of face value, but there still remain issues to be decided like whether or not the European Central Bank will have to write down the Greek debt it has on its books. 

Bond markets have responded to this reality by dumping Portuguese debt.  Note that the yield on the ten-year government bond was about 10.40 percent (compared with 14.80 percent yesterday) around the middle of November, a time when it still seemed that maybe the European Union might be able to pull things together and avoid a Greek default. 

As the officials of Europe finally seriously travelled down the path to restructure Greed debt, the price of Portuguese debt started to weaken.  The price declines accelerated, as the possibility of a Greek write-down became more of a reality.  Today, the yield on the 10-year bond was around 15.00 percent.

I know that governmental officials hate to give in on these write-downs because they hate to concede to the “bond markets” and “speculators”. 

It is hard for governmental officials to admit that maybe the “bond markets” and the “speculators” might be right. 

It is a very difficult lesson for governmental officials to accept the fact that they cannot continue to cater to their constituencies with jobs and other benefits ad infinitum.  Over the longer-run, either taxes have to be raised or money has to be printed because the bond markets will not continue to underwrite debt that will be repaid, both principal and interest, by the issuance of more debt.

The economist Hy Minsky referred to this kind of debt financing as a “Ponzi” scheme.

 “Ponzi” schemes come to an end and the end cannot just be blamed on the “bond markets’ and the “speculators”.  In fact, the governments just line the pockets of the “bond markets” and the “speculators” by extending their uncontrolled spending until the collapse of the market becomes a “sure thing.” 

So the charade continues and Portugal seems to be next. 

Who will follow Portugal?  Spain…or Italy…who knows?

Yet, this is not the only concern that many of these officials are facing.  The austerity programs enacted by governments throughout Europe are not setting well with the people.  There is “discontent” and “upheaval” arising in many countries.

“The only consistent messages seem to be that leaders around the world are failing to deliver on their citizens’ expectations and that Facebook, Twitter, and other social media tools allow crowds to coalesce at will to let them know it.  That is not a comforting picture for the 40 heads of state  or leaders of governments who are attending the World Economic Forum (in Davos, Switzerland)…”  (http://www.nytimes.com/2012/01/26/world/europe/across-the-world-leaders-brace-for-discontent-and-upheaval.html?_r=1&scp=1&sq=across%20the%20world,%20leaders%20brace%20for%20discontent%20and%20upheaval&st=cse)

The situation is quite uncomfortable.  But this is what happens when you fail to deal with a problem…when you continually try to “kick the can down the road.”  The situation does not go away and the delay in dealing with the situation often turns out messier than if the situation had been dealt with earlier. 

The only way for the officials to resolve a condition like this is to get in front of it.  I don’t see anyone around in a position to do this.  The only real possibility is Merkel but the resentment that already exists against Germany makes it that much more difficult for her to achieve what is needed. 

If no leader arises then the defaults will continue…and the austerity will grow…as will the “discontent” and the “upheaval.” 

“Europe risks being handicapped if it doesn’t deal decisively with this challenge to democracy.”  Thought provoking way to end the New York Times article.    

How Long Will Europe Continue to Lie to Itself?

“Bank Seeks To Avoid Taking Loss On Bonds.”

So reads the headline for the New York Times article on the dilemma of the European Central Bank. (http://www.nytimes.com/2012/01/25/business/global/eu-officials-continue-to-press-for-a-quick-deal-on-greek-debt.html?_r=1&ref=business)

“European leaders have begun discussions with the European Central Bank on several options that might keep it from having to take a loss on its 55 billion-euro portfolio of Greek bonds.”

“The deal could address what has long been one of the more vexing questions in reaching a broad agreement on reducing Greece’s mountain of debt: how to get the central bank, the largest holder of Greek bonds, to participate in a debt restructuring without having to take a large loss that would have to be covered by European taxpayers, German ones in particular.

Private sector investors, including large European banks and hedge funds, have complained bitterly—and in some cases threatened legal action—over the central bank’s insistence that its 55 billion euros in Greek bonds were exempt from the loss that the private sector is facing, which some have estimated at 60 cents on the euro.”

The European Central Bank cries, “You can’t hold me responsible for my actions!”

There are articles all over the place on this issue. 

For example, on the front page of the Financial Times: “IMF urges ECB to take a hit on 40 billion-euros in Greek bond holdings.” (http://www.ft.com/intl/cms/s/0/74d2b31a-46b2-11e1-bc5f-00144feabdc0.html#axzz1kTbnc8Yy)

Greek debt will be written down…finally.

But, will people still be avoiding reality in some affected areas?

And, remember, this is all voluntary to avoid kicking off the credit default swaps outstanding…what a crock!

Still on the list of lies…Portugal…Spain…Italy…

Lies have a long life and can come back to haunt you in many…often, unfortunate…ways.  Just ask people up at Penn State these days. 

The resolution of a situation in which people cover up and try to avoid the truth never ends well.  The leaders (and I use this term lightly) of Europe that are perpetuating this comedy continue to draw it out as long as possible. 

The problem is that the European dilemma will continue to exist until it is dealt with.  For more on this see my blogpost “Credit Downgrades and Europe” posted on January 16, 2012 on my blogspot site (http://maseportfolio.blogspot.com/).  

Super Mario and the European Central Bank

Tuesday, a new player moves into the top rung of European officials dealing with the European financial crisis. 

Mario Draghi is not “new” to the European scene, but on Tuesday he takes over as the president of the European Central Bank replacing Jean-Claude Trichet, and so is “new” in this important position.

A new head of a central bank is generally “known” but, not having ever been in the position before, he (when are we going to get a woman head of a central bank?) is untested and it is uncertain how he will really act under pressure. 

There is an interesting article in the Sunday New York Times about Mr. Draghi titled “Can Super Mario Save the Day for Europe?” that gives us some background on this “new” leader: (http://www.nytimes.com/2011/10/30/business/mario-draghi-into-the-eye-of-europes-financial-storm.html?_r=1&ref=business)

In this article Mr. Draghi is cited as vowing “that there would be no surprises on his watch.”

Vintage Draghi seems to provide a “performance so subtle and politic that it seem(s) to please everyone.  Which, it turns out, is the Draghi way: people often seem to see what they want to see in him.” 

Yet, Mr. Draghi seems to produce.  Although having sterling academic credentials, he in not some academic that gained his laurels by writing about historical events.  He has actually been in “real” administrative positions that have required tough decisions to be made and leadership to be shown.  In these positions he has shown well. 

He has been in the private sector and, although this is the place where people seem to question some of what he has done, he performed well in his role as a vice chairman of Goldman Sachs in Europe.  

He seems to be a person that let’s his actions define his positions and does not get all “hung up” about how best to communicate with investors and markets as does the current Federal Reserve System. 

I particularly like the description of Mr. Draghi given by Francesco Giavazzi, who worked for Mr. Draghi at the Italian treasury.  Mr. Giavazzi, a classmate of his at M. I. T., states that Draghi learned a very important lesson in his efforts to bring Italy’s fiscal problems under control so that Italy could join the new common monetary zone that was being created for Europe.  At that time Italy was dealing with “high levels of debt” and “runaway deficits” which led to Italy being expelled from the European Exchange Rate Mechanism, the European currency system that preceded the formation of the eurozone. 

The efforts of Mr. Draghi and his team brought things under control so that Italy avoided bankruptcy and could become a founding member of the new currency union.

Mr. Giavazzi states that the lesson that Mr. Draghi learned through this experience “is that rather than waiting for help, you need to regain the confidence of the markets through your own actions, and that if you do not do the right thing, no outside help is enough—you will have a solvency problem.” 

Encouraging.

Furthermore, people that have worked with Mr. Draghi claim that even though he is an economist he “put aside models and theories for what actually works.”  Mr. Draghi seems to be a pragmatist. 

So, Mr. Draghi appears to be an experienced, pragmatic leader who is confident enough in his abilities that he can let his actions speak for themselves.

Sounds too good to be true!

Best wishes, Mr. Draghi, we all wish you the greatest success!        

Second European Market Response: Italian Borrowing Costs Surge

The first response of world financial markets to the eurozone package produced early Thursday morning was positive. 

The second response…

“Italy issued 10-year debt on Friday but paid the highest price since joining the euro as investors demonstrated skepticism over the center-right government’s economic reform program in the first bond auction in the region since new steps were agreed to tackle the eurozone debt crisis.

The auction served to underline Italy’s current dependence on purchases of its bonds on the open market by the European Central Bank in a program that began on August 8 as yields rose above 6 per cent.” (http://www.ft.com/intl/cms/s/0/c7d47b22-0146-11e1-ae24-00144feabdc0.html#axzz1c10EG1Ea)

The underlying concern with the new eurozone package is that the officials in Europe still believe that the problem is one of liquidity, a crisis in confidence, which can be resolved by more bailout gimmicks.  As a consequence, these officials have, once again, avoided the fact that the problems they are facing are solvency problems and that eventually someone will have to bear losses.  The solvency issue has not been resolved since little or no new money is being put on the table.

Yes, there is an agreement for a 50 percent write down of “private” holdings of Greek debt.  But, note, that “public” holdings of Greek debt amount to about 40 percent of the total Greek debt outstanding.  These “public” holdings will not be subject to the haircut reducing the debt. 

The “public” holdings include the Greek securities held by the European Central Bank, the International Monetary Fund, and eurozone governments. 

Furthermore, the “haircut” is a “voluntary” write down in the hopes that a payout on Credit Default Swaps will not be triggered.  European leaders feared that if a “non-voluntary” event occurred, a CDS payment would be kicked off and this might cause a “Lehman Brothers affect” which would create more funding problems for banking institutions throughout the continent.

Also, this funding problem might expose other countries…like Italy, Spain, Portugal and France…in their efforts to place their sovereign debt.

The difficulty Italy had in placing its debt on Friday might be an indication that this effect is already at work.

 And what additional pressure does this put on the European Central Bank?

“
The ECB remained firmly in crisis management mode following the marathon Brussels summit to stem the sovereign debt crisis.

Within hours of the meeting, traders reported that the ECB was intervening again in the Italian government bond market – a clear sign that its controversial purchases were far from being wound down. “ (http://www.ft.com/intl/cms/s/0/7d4850e6-00a7-11e1-ba33-00144feabdc0.html#axzz1c10EG1Ea)

Included in the plan was a proposal for the recapitalization of European banks.  But, the question is, will these new requirements actually provide the protection needed.  In the recent failure of the Dexia bank, the bank met the initial requirements for capital.  It seems as if the regulators of the European financial system are still reluctant to admit the serious needs of the banking system to add capital…a shortcoming that is related to the “joke” these regulators perpetrated in the two applications of “stress tests” to the banks of Europe. 


But, the European officials also included in their bank recapitalization plan a proposal that the national governments in Europe would increase guarantees of their banks.  This just increases the specter that these national governments will have additional liabilities adding to their already heavy debt loads. 

Finally, there is the European Financial Stability Facility (EFSF).  This is the last resort lender in which everyone in Europe commits to bailing out everyone else in Europe.  That is, the EFSF is a scheme that says that “Europe is Solvent”…even though individual nations within the eurozone are not solvent.

Whether or not “Europe is Solvent” depends on the willingness of the solvent countries within the EU to continue to pay for the shortcomings of those countries that are not solvent.  The success of this depends upon whether or not the existing problems are “liquidity” problems or “solvency” problems.  “Liquidity” problems relate to a lack of confidence and a lack of confidence can only be a short-term phenomenon. 

Officials hope that by “re-arranging the chairs” once again that the crisis of confidence will come to an end.  The thing these European officials fail to understand that in the game of “musical chairs”, every time the music begins to play again another chair is taken from the game.  At some point, the fact that the eurozone does not have sufficient capital to cover its outstanding debt will become evident.

The efforts to bring money in from China, Japan, or elsewhere, seem like a desperate move.   

Again, it seems as if Europe has come up short again. 

Trichet Delivers: ECB Hikes Its Interest Rate!

The European Central Bank raised its policy interest rate by 25 basis points this morning and, I believe, changed the game.

Mr. Trichet, president of the ECB, delivered on his promise initiatlly given in March.

To me, this is a “tipping point”, even though the Bank of England kept its policy rate constant. Other central banks around the world have been raising their policy rates over the past year but no “Western” central bank had followed.

Now, the “West” has followed and this alters, not the outlook for interest rates, but the timing of future increases.

There are three areas one needs to focus on within the current environment.

First, keep an eye on what goes on in the Eurozone in terms of country “bailouts” and the potential re-structuring of the sovereign debt within the nations of Europe.

It was not a coincidence that Portugal asked for help the day before the meeting of the ECB. Portugal has lots of debt coming due this year; its credit rating has gone through several reductions already this year; and the country is without a government and facing an election. Even Portuguese banks were saying that they would not buy anymore debt issued by the government of Portugal.

Facing a “new” attitude in the capital markets and rising interest rates, what is substituting for a government in Portugal had to act. In essence, the IOUs were coming due.

And this means, I believe, that the IOUs are going to be collected elsewhere within the Eurozone. The day of reckoning has been advanced. People are going to have to do something now.

Second, watch what European banks are doing and are going to do. On Wednesday, two European banks announced their plans to raise new capital. The total to be raised amounts to about $19 billion and brings the total capital raisings announced this year by European banks to almost $36 billion.

Again, I don’t think that the timing of the announcement, the day before the ECB raised its interest rate, was a coincidence.

Furthermore, the Spanish government this week stepped up efforts to get its “healthy” banks to buy up a good portion of its “savings” banks in an effort to shore up Spain’s threatened banking industry. With Portugal now seeking help, a greater focus is going to be placed upon the fiscal health of the Spanish government and its banking system. Spain is going to move because it appears as if it may be “next in line”.

In addition, there still are the results of the recently applied “stress” tests on the commercial banks of Europe. Two things here: there is the question about how valid the tests are; and there is the response of the banks, themselves, to the results of the tests.

The European “stress” tests are already being questioned relative to whether they are strong enough to really be anything but a subject of jokes. If the tests are too weak to prove anything, then the credibility of the European regulators will suffer a serve blow at a very crucial time. This will not raise the financial markets confidence in the European banks and the European banking system.

The European banks may have to “act on their own” to overcome this loss of regulatory credibility. The way to do that? The banks can raise a significant amount of capital on their own and take the whole question of capital adequacy out of the hands of the regulators. This may be a part of the strategy of the European banks that are now raising capital.

Third, continue to observe the behavior of the United States dollar in foreign exchange markets. My guess is that this move by the ECB to raise its interest rate will cause further erosion of the value of the United States dollar in foreign exchange markets. This move may not be immediate, but will persist over time.

By raising its policy rate, the ECB may be forcing Europe to get its act together and resolve some of its solvency and governance issues. The movement by the Portuguese is just a starting point. The movement of the banks adds momentum to the process. If this action truly brings events “to a head” then, I believe, everyone will be better off for it.

But, if Europe begins to move in the right direction, what is in store for the United States dollar?

Europe moving to resolve some of its issues will only result in more pressure for the value of the United States dollar to decline. And, this decline will only provide additional evidence that the international community has little confidence in the current leadership of the United States to really address its fiscal (and monetary) problems.

The question then becomes…will this change the nature of the discussion within the United States?

Will this twenty-five basis point change in the policy interest rate of the European Central Bank serve as anaction that creates the “tipping point” for the direction of economic and fiscal policy in Europe and the United States?

I’m sure that the wiley Mr. Trichet would like to see this happen.

I’m not sure that the former professor of law from the University of Chicago and the former chairman of the Princeton Economics Department would agree.

The Euro: Trichet versus Bernanke

How important is reputation in monetary circles?

I believe that the general movement in the value of the Euro relative to the United States dollar over the past seven months or so gives a picture of how the reputation of a central banker, when compared with his peers, can be reflected in financial markets.

The particular comparison here is between Jean-Claude Trichet, president of the European Central Bank (ECB), and Ben Bernanke, chairman of the Board of Governors of the Federal Reserve System. The winner has been Trichet; the loser Bernanke.

In general, the “bad” news has been coming out of Europe, the fiscal problems in Ireland, Greece, Portugal, Spain, and, if we want to get even more picky, Italy and France. The fiscal crisis really began to heat up at the beginning of 2010. The “crisis” caused another “flight to quality” in foreign exchange markets, that is a movement into the United States dollar and this is shown in the accompanying chart. The U.S./Euro Foreign Exchange Rate dropped early in 2010 and bottomed out in June as the European Union seemed to be getting its act in order.

Notice that the value of the Euro really begins to rise again in early September. This marks the time just after Chairman Bernanke announced to the world that the Federal Reserve was going to enter into another round of Quantitative Easing, now fondly referred to as QE2. (http://seekingalpha.com/article/222704-bernanke-in-the-hole)

The rise in the value of the Euro against the dollar was almost 12 percent throughout the fall.

Still the Europeans dawdled and the dollar strengthened again as money left Europe for “quality” assets.

Trichet took care of this after the March rate-setting meeting of the ECB. At that time he sent out strong signals that the ECB should raise its target interest rate at the April meeting.

So, after a decline of something less than 8 percent following the peak value reached in early December, the Euro has climbed another 9 percent or so, even in the face of continued concerns about the health of the banks in these countries and the revelations about the fiscal condition of some of the governments trying to get their budgets back in order. These concerns were accompanied by several downgrades of some sovereign European debt.

“As traders continued to bet the European Central Bank would pull the trigger on the first of several interest-rate increases on Thursday, the euro hit five-month highs against the dollar,” (http://professional.wsj.com/article/SB10001424052748703806304576242362812362214.html?mod=ITP_moneyandinvesting_3&mg=reno-wsj).

Thursday is the meeting of the ECB. The bets are obviously on the ECB raising its target interest rate.

Trichet has a credibility that Bernanke does not have. Trichet is standing up for some kind of monetary constraint. Bernanke keeps throwing spaghetti against the wall.

Trichet has moved ahead of events. Bernanke has always missed the turn of events and lagged sadly behind resulting in the need to over-react to situations.

But, this reflects the whole position in the United States. There is no one around that seems to have any credibility for establishing any financial or monetary discipline in the United States government. Why should anyone want to bet on the United States government establishing some kind of responsible budgeting when projections are for the government debt to increase by as much as $15 trillion over the next ten years? And, why should anyone want to bet on the Federal Reserve system controlling inflation during this time period when the leader of the central bank has injected $1.5 trillion dollars of excess reserves in the banking system and is always “late to the dance”?

The market is taking Trichet at his word. The market is also trusting his determination.

The United States? Maybe Paul Ryan, chairman of the budget committee of the United States House of Representatives, can build up some reputation in financial markets that someone in America is going to draw a “line in the sand.” Right now the financial markets are not betting on his success.

So for now, Trichet…and the Euro…seem to win.

Trichet: It's All About A Strong Euro

Jean-Claude Trichet, the President of the European Central Bank (ECB), made headlines toward the end of last week by suggesting that the ECB might have to raise its major interest rate in April.


This suggestion raised quite a bit of controversy and also helped the Euro to rise, briefly, to more than $1.40 per Euro. It also, some said, set the stage for the weekend in Europe and the upcoming discussions about fiscal affairs in the eurozone countries. (http://seekingalpha.com/article/256255-meanwhile-back-in-europe-a-view-of-the-ecb-inflation-and-other-matters)


Trichet has been as hardnosed as anyone in recent years about keeping inflation in check. And, since 2003 when he became President of the ECB, he has been adamant about maintaining an inflation target as the primary objective of the central bank.


In doing so, he has been relatively successful in allowing eurozone economies to expand while keeping the Euro strong, especially against the United States dollar.







In this chart we see an almost steady climb in the dollar/euro exchange rate from about 2002 until late 2008 when the financial markets began to collapse and there was a “flight to quality” toward the United States dollar.

As market participants moved back into “risk” in 2009 the dollar/euro exchange rate began to rise again, roughly reaching $1.50 per Euro. The sovereign debt crisis in the eurozone resulted in another drop in the exchange rate but the Euro began to rise again once Fed chairman Bernanke started talking up his plans for Quantitative Easing, Part II, for the Federal Reserve in late August 2010.


The strength of the Euro, especially against the United States dollar, should be seen as a source of pride for the President of the ECB. Trichet, a Frenchman, saw how upsetting inflation or the threat of inflation could be in international financial markets when he served in the Treasury Department in France during the time that Francois Mitterrand was the President of the French Republic.

Mitterrand was a socialist and who came to power in 1981. Early in his first term, Mitterrand followed a radical economic program, including nationalization of key firms. The economy developed a serious inflationary problem and money fled France causing a substantial decline in the French Franc. After two years in office, Mitterrand made a substantial u-turn in economic policies. In March 1983 he presented the so-called “Liberal turn”, in which priority was given to the struggle against inflation so that France could remain competitive within the European Monetary System.


The young Treasury Department official took note of this and applied the lessons learned when he became a Governor of the Banque de France, a Governor of the World Bank, an Alternate Governor of the International Monetary Fund and the President of the ECB.

Leading the European Central Bank is one thing, but the ultimate success of Trichet’s efforts to keep European inflation under control is also dependent upon the European Union (EU) getting its fiscal act under control. The sovereign debt issue and its resolution amongst the eurozone countries is crucial to the EU in keeping inflation under control and even whether or not the Euro will continue to exist.


The problem in the eurozone is that the limits or restrictions on independent sovereign nations to conduct their own fiscal policies have not been very effective. The leaders of the EU are going to have to reach some satisfactory solution to this problem or there will be continued attacks on the sovereign debt of the less disciplined countries and this will tend to bring with it attacks on the Euro.

In my view, the EU has two choices. It either moves toward the German model of conservative fiscal control of governmental budgets or it fails to bring sufficient controls on less-disciplined governments which, to me, is basically saying that the EU will err on the side of not offending anybody.


To err on this latter side is to seal the fate of the Euro. If one takes the “weaker” side, if one allows the less-disciplined to get-away with their lack-of-will, then the financial problems of the eurozone will continue and there will be a movement away from the Euro. Over time, the value of the Euro will slowly deteriorate. The Germans will not remain in such a union and the Euro will become “legacy.”

Trichet hopes, I believe, that the Germans will prevail in determining the fiscal parameters of the European Union now being discussed. This, to me, is the only hope for the Euro surviving in the longer run. In this, the Germans win…which a lot of people in Europe…and elsewhere…don’t really want to see.

Ultimately, however, the more fiscally prudent nation will prevail whether or not the Euro does. I believe the Germans don’t want the Euro to become history, but they are not willing to sacrifice their economic strength and benefits to live with the excesses of other governments. It is good to be economically strong!


Thus, to Trichet, it’s all about a strong Euro. He has done his job in setting the stage for the continuing discussions within the EU over the future of eurozone cooperation, fiscal policies, and debt restructuring. For the eurozone to be a strong player in the global economy in the future, the EU must have a strong currency. Trichet has done his job in an effort to achieve this goal.

Meanwhile Back in Europe

Europe has been relatively quiet recently, except for occasional bursts of news coming from or about German Chancellor Angela Merkel. The euro has been relatively strong: it has risen a little over 7% against the U. S. Dollar since the beginning of the year. Relative interest rate spreads on sovereign debt in the eurozone have remained relatively steady.

However, there still remains a lot of work to do in Europe and with all the disagreements among the leaders as well as everything else happening in the world the bailouts and other financial relationships are just not getting done. Let’s just say one shouldn’t get too comfortable in this quiet.

Something concrete for the near term: the European banks are starting their second round of stress tests this weekend. This second round is supposed to be “sufficiently stringent” this time.
We’ll see! They sure weren’t very “stringent” the first time around.

The question is whether or not confidence in the European banking and financial system can be returned so that other matters can be dealt with.

Beyond that, meetings will continue among the leaders of the European nations. Whether or not they can craft a bailout plan is still up in the air. In addition, the process for how the nations are to conduct their fiscal affairs also needs to be decided upon. Problems will still linger until they achieve some more coordination in budget-setting…hard for sovereign nations to give up.

But, speaking of sovereign nations, the problem of sovereign debt still overhangs the financial
markets.

Kenneth Rogoff, who co-authored the book “This Time is Different”, stated in Berlin yesterday that Greece and Ireland will need to restructure their debts. (See http://www.bloomberg.com/news/2011-03-02/rogoff-says-debt-restructuring-inevitable-in-greece-ireland.html.)

Rogoff also added that Spain and Portugal may be forced to do the same thing.

Bondholders, he argued, may have to take losses as large as 40 percent of their holdings of this sovereign debt.

“If Spain were to have a restructuring of central government debt, I don’t think it would end there” said Rogoff, “Spain is just too big.” Other countries facing a restructuring might then include Belgium and more.

But, this is not all!

Europe is facing more inflation. For one, the United Nations announced that world food prices rose to a record level in February and may exceed this level over the next few months. Furthermore, the turmoil in the Middle East is not easing price pressures as the pressure on oil prices increases.

The new element in this latter situation is that Asian countries like China and India now have the wherewithal to hedge against the unrest in the Middle East by shoring up their oil reserves. Even as these oil importing countries add to world demand as their economies grow they also have the financial resources to stockpile reserves in a way that presents a new dynamic to global markets.

And, the money is there for this process to continue worldwide: “What can best be described as ‘the unintended consequences of quantitative easing’ (on the part of the Federal Reserve in the United States) have played a major role. With many emerging nations addicted to their dollar currency pegs, easy US monetary policy finds its way into every nook and cranny of the global economy.” This written by Stephen King, group chief economist at HSBC in “Central Banks Risk Wrecking Recovery” (http://www.ft.com/cms/s/0/cab418ce-44c3-11e0-a8c6-00144feab49a.html#axzz1FMM69iWr).

These “unintended consequences” will continue to plague commodity markets worldwide. Nations and investors have the dollars or the access to dollars to keep these prices rising and this access will not go away soon.

So what about an increase in interest rates?

Well, for the twenty-second month the European Central Bank (ECB) held its main interest rate steady at 1%. Jean-Claude Trichet, ECB president, stated that inflation was a worry and although the rate was held at the current level for the time being, it certainly could rise in April.

Inflation in the eurozone was 2.4% in February, above the target limit of the ECB which is 2.0%.

Rising interest rates can only put more pressure on the governments in Europe, just as rising inflation rates can increase calls from Germany for greater government discipline in fiscal affairs.

“Back in Europe” things are still unsettled. As to the undercurrents going on above look out for the following:

First, the bank stress tests will show little or nothing and will give financial markets very little additional confidence in the European banking system;

Second, no agreements will be reached within the European Union until some of the nations within the EU restructure their debt and the pain of the fiscal situation will then become very obvious;

Third, this restructuring of debt and the continued increase in inflation will put Merkel and Germany in an even stronger position to get a more conservative process of fiscal oversight included in any package that the EU agrees upon;

Fourth, the ECB will hold off an increase in its main interest rate for as long as it can so that a rise in the rate will not serve as a cause of the debt restructuring and will allow the leaders in the EU to craft a new relationship in as orderly fashion as possible.

Inflation will continue to rise in Europe and in the rest of the world and this will put central banks under greater and greater pressure to begin to combat the inflation. Politically, this is still going to be very hard because of the mediocre economic recovery now taking place and the political unrest being caused by governmental restructurings. But, that is another story.

No Peace on European Sovereign Debt

When I read the news coming out of the Eurozone these days I get a very strong sense of déjà vu, all over again.

This feeling comes from hearing over and over again, leaders, whether of nations or of corporations, complaining that “the markets just don’t understand us!”

My response in cases like this is that the markets understand you…too well!

We have been going on and on about the fiscal crisis in Europe for at least a year now. And, things still are unsettled. (See my post “Four Uncomfortable situations to watch in early 2011”, http://seekingalpha.com/article/244531-four-uncomfortable-situations-to-watch-in-early-2011.)

And, the resulting financial crisis is not because there is not enough liquidity circulating around in world markets. The European Central Bank and the Federal Reserve System have seen to that. (See my post “Is QE2 a Bubble Machine?”, http://seekingalpha.com/article/245255-is-qe2-a-bubble-machine.)

As evidence of this I point to the fact that Brazil has launched a fresh attempt to limit the appreciation of its currency, “Brazil in Push to Curb Rising Currency”, http://www.ft.com/cms/s/0/7becb4e4-19c6-11e0-b921-00144feab49a.html#axzz1AMDfgcKJ.
And, it is not that Europe is not getting a sympathetic response from other countries. China, especially, has moved to provide funds to purchase sovereign debt. However, China is not that excited about further bailouts.

Still, Greece is continually fighting off concerns about how it is handling its fiscal affairs. (See http://professional.wsj.com/article/SB10001424052748704415104576065250841058220.html?mod=ITP_pageone_2&mg=reno-wsj.)

And, “Portuguese yields near euro-era high” (http://www.ft.com/cms/s/0/d2b3d95e-19c3-11e0-b921-00144feab49a.html#axzz1AMDfgcKJ). “If Portugal’s borrowing costs keep rising, then the government will reach a point where it will have to seek financial assistance from the international community.”

The major rating companies continue to put out downgrades of government debt and voice their concerns that further downgrades will be necessary. Investors also continue to translate this viewpoint into market prices: “The costs of insuring against a default by Western European sovereign borrowers in the credit default swap market surged, briefly touching a record on Thursday, according to data provider Markit. Swaps prices for Spain, Belgium, and Ireland closed at records, according to Market. The gap between yields on most European sovereign bonds and relatively safe German debt also widened.” (http://professional.wsj.com/article/SB10001424052748703730704576066243894186226.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

The fact that this situation still exists after a year of massive efforts by the nations in the European Union and the International Monetary Fund and that lots and lots of money has been spent to resolve the underlying problems indicates to me that somebody is on the wrong page.

Furthermore, given that the situation has not gone away during this twelve month period indicates that the problems have not just been created by the “greedy bastards” known as speculators that have turned against a weakened opponent. If anything the leaders of the European Union have created “one-way bets” that have drawn speculators to feast on their difficulties. (See my post “Interventionists are Setting Up One-Way Bets for Traders”, http://seekingalpha.com/article/237076-interventionists-are-setting-up-one-way-bets-for-traders.)

My final comment on the behavior of the leaders of the European Union with respect to their sovereign debt crisis goes back to one of my favorite Stephen Covey quotes: “If you think the problem is out there, that is the problem!” It is very easy to pick out people in the investment community as a scapegoat for the problems you experience, especially if you can brand them as “greedy bastards.” Yet, pointing fingers at others and calling others names seldom, if ever, solve problems.

The leaders of the European Union need to face reality. Somewhere, sometime, the value of the debt that is being questioned is going to have to be written down. These leaders are going to have to accept the reality that they did a bad job in managing the responsibilities that they were given.

The process that these leaders are going through now is taking up too much time, is costing too much money, and is drawing the focus of these leaders away from things they really should be dealing with.

My experience is that when things like this are drawn out for such a long time and do not seem to be resolving themselves, it is time to “bite-the-bullet”, admit your mistakes, and move on.

This is a difficult thing to do but it is time to start attacking other problems that need to be dealt with.

Europe and the Solvency Issue

More and more people are becoming aware of the fact that the problem in Europe is one of solvency and not liquidity! Yesterday, the European Central Bank warned “that euro-zone banks face a €195 billion in write-downs this year and next due to an economic outlook that remained ’clouded by uncertainty.’” (See http://online.wsj.com/article/SB20001424052748703406604575278620471963334.html#mod=todays_us_money_and_investing.) This is equivalent to slightly more than $239 billion.

Not only that but it is estimated that these banks will need to refinance roughly €800 by the end of 2010. (See http://www.nytimes.com/2010/06/01/business/global/01ecb.html?ref=business.) This is equivalent to about $984 billion or roughly $1.0 trillion.

More and more people are beginning to realize that countries within the European Union are going to have to restructure loans and this will mean that many euro-zone banks are going to have to write down many of the assets they have on their balance sheets. Hence, we face the problem of the solvency of the banking system.

Why has it taken so long for these people to realize that the problem is a solvency problem?

The reason, I believe, is that the mainstream economic models we have been working with over the past 50 years have focused upon “liquidity” issues. Debt has played very little role in these models.

Yes, I know that some ‘fringe’ economists like Hyman Minsky wrote about these issues, but try and find any kind of a discussion of debt and solvency in major macroeconomic textbooks.

Many post-World War II discussions of money and the demand for money are “framed” within the terminology developed by John Maynard Keynes in the 1930s, around the term liquidity preference, “The term introduced by Keynes to denote the demand for money.” (This is from the Glossary of the macroeconomic textbook by the Keynesian economist Olivier Blanchard.)

Moving from liquidity preference we get the concept of “liquidity trap” from the Keynesian dogma: “The case where nominal interest rates are equal to zero and monetary policy cannot, therefore, decrease them further.” (This, too, comes from Blanchard.) That is, people want to hold money and don’t want to loan money to invest in plant or equipment or inventories and so forth.

Obviously, this latter possibility resonates with Keynesian fundamentalists in terms of the situation that has existed over the past year or so.

The problem with this is that the idea of liquidity preference and the liquidity trap apply to the future. People don’t want to invest privately and just want to hold money because the expectations of future investment performance are so low and so risky that money is the safer way to hold their wealth. This is why, in the Keynesian paradigm, government deficit spending works because people will buy the government debt and the government can then “invest” and put people back to work whereas the private sector cannot.

But, what if the problem is that people and businesses (including banks) are so in debt that they cannot spend and that the cash they are holding is to provide them with funds to exist on in the future? That is, what if people and businesses are bankrupt or are facing bankruptcy because of the debt they have accumulated and are hoarding their wealth in very liquid assets so that they can buy what they need out of what remains of their wealth?

Maybe economic cycles are connected with credit inflations or debt deflations, cumulative buildups of debt followed by the need to unwind the excessive use of leverage built up in the earlier period. This cyclical behavior contains the problem of solvency, not liquidity. (Keynes, interested in the short run, focused on liquidity. Irving Fisher, the prominent American economist from the 1920s, focused on the longer run and wrote about debt deflations.)

It seems that economic policymakers in Europe (and in the United States) have been interpreting the problems of the last two years or so as a liquidity problem. Hence the responses of the leaders of the European Union have been couched in terms of solving their economic and fiscal issues by making sure that there is sufficient liquidity in financial markets for them to continue to function. Yet, the problems have not gone away because the issues of restructuring the debt and asset write-downs have either been ignored or pushed under the covers so that they don’t have to be discussed.

This has been true in the United States as well. The United States Treasury Department responded with the TARP program that was, at least initially, aimed at providing liquidity for ill-liquid assets on the books of banks and other institutions. (See my post of November 16, 2008,”The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.) Furthermore, much of the effort of the Federal Reserve in 2008 and 2009 was aimed at providing liquidity to the banking system and the financial markets and not to problems of solvency.

In fact, I have been arguing over the last six months or so that the real reason why the Federal Reserve is keeping its target Federal Funds rate so low is that there are real asset problems in many of the small- to medium sized commercial banks. The Fed is keeping the rates low so as to help the banking system escape the “solvency” problem of the smaller banks from getting worse while the FDIC works through the liquidation process. Note, again, that the FDIC is closing more than 3.5 banks per week through May 28, 2010 and has 775 banks (There are about one out of every eight commercial banks on the problem list!) on its watch list, a number that is still increasing every quarter.

“The challenges for banks in the 16-nation euro-zone include exposure to a weakening commercial real estate market, hundreds of billions of euros in bad debts, economic problems in East European countries, and a potential collision between the banks’ own substantial refinancing needs and government demand for additional loans.” This quote is taken from the New York Times article referenced above.

The source of this concern? The European Central Bank!

The problem with a solvency crisis is that ultimately assets must be written down to more realistic values. In the cumulative process that occurs in the euphoric credit inflation that precedes a debt problem, asset values attain unrealistic levels. That is why people and businesses (including banks) continue to leverage up their balance sheets.

Valuations eventually must be put on a more realistic basis. This is where the European Union is at the present time. The unanswered question is, how far must valuations be reduced to achieve this realistic basis. And, of course, the bigger concern is whether or not these reductions can be achieved without inducing a cumulative debt deflation. No one really has the answer to either of these questions before the fact.

However, the excesses of the past must be paid for!

The Focus is on Europe

The recent events in Europe have captured the attention of the world and taken the heat off of China and the value of its currency, the United States and the value of its currency, and financial reform in its various forms.

The focus, in my mind, is going to stay on Europe for a while because that is where the greatest amount of disruption to world financial markets and damage to world economic recovery can take place.

How long will this disruption and damage last?

I continue to recall a piece of advice given several years ago that has never let me down. The advice is this: If you say the problem is ‘out there’, that is the problem! That is, if you blame your problems on everyone else or everything else, your outward facing focus is the problem. Maybe you had better look at what you are doing before you start blaming someone else.

I have found this true in individuals, families, organizations, communities, businesses, and governments.

Right now, Europe is over-run with self-pity blaming speculators and the ‘irrationality’ of markets.

As a consequence, Europe has responded to the difficulties it faces with a grudging move to maintain the liquidity of its financial markets while preserving as much as it can the ‘integrity’ of its economic model. Its leaders are still trying to hold onto their model of the world.

Hence, the blame must be aimed at someone else!

And, that is precisely the problem.

The fundamental problem is that the economic model used by most of Europe is faulty and the current financial problem is one of solvency and not liquidity.

The three primary perpetrators of these fallacies are President Nicolas Sarkozy of France, Jean-Claude Trichet the head of the European Central Bank (French), and Dominique Strauss-Kahn the Managing Director of the International Monetary Fund (also French).

So far, these French leaders have been the winners of the political battles for the heart of the
European Union. So far, international financial markets have given these leaders at least a D- in terms of the plan they have devised to save union.

Where can we find this grade?

The value of the Euro has declined 18% from the middle of December 2009 to this morning.

The German Parliament has voted to support the current ‘bailout’ but throughout Germany discontent is rising concerning the leadership shown by the German Chancellor Angela Merkel. She, more than any other leader within the European Union, seems to be losing her clout.

Chancellor Merkel cannot afford to follow the French leadership.

Germany has established its position within the European Union through its strong economic growth fueled by a very robust export sector. It has also been fiscally prudent and plans to reduce its budget deficit to zero by 2016. The yield on German bonds attests to the belief the international investment community has in the intent and discipline inherent in Germany to sustain these outcomes.

It is these factors, carried over to the whole EU, that have benefitted other nations within the community to the extent that they could live beyond their means and feast off of their association with the Germans.

This, as we have seen, is an unsustainable relationship. Either Germany has to give in and accept fundamental reforms to the European Union that would seriously damage German competitiveness. Or, it has to maintain its discipline and continue to adhere to its fundamental world view.

There is no question as to what I think Germany should do!

Yet, if Germany continues to encourage its competitiveness in European and world markets and maintains its fiscal discipline, others within the European community will either have to emulate them or will have to remove themselves from this union. It seems as if we are at the juncture where there are no other choices. A wishy-washy response at this time will just postpone the outcome.

Of course, the critics of Germany see such a German policy as disastrous. Following the German model of reigning in wages and social benefits and achieving real control over fiscal budgets would result in further dislocation of economic resources in Europe accompanied by social and political upheaval.

The problem is that these other European nations have put themselves into a position where there are no ‘good’ solutions! Years-and-years of profligate living eventually lead to a situation where nothing they can do provides happy answers.

The only thing these loose-living nations can hope for is for time, cause “things will get better in the future!” Yeh, sure!

I don’t know how many times I have heard this response in business and elsewhere. “The market doesn’t understand us!” “All we need is some time and things will work themselves out!” “It’s just that there are some ‘greedy bastards’ out there that want to make money off of our misfortune!”

Europe, your economic model of the world doesn’t work! The only way you are going to really get out of this mess is to change your economic model. Deficits and a lack of social discipline don’t contribute to economic health. But, it is so much easier to blame someone else and following Germany would be a disaster.

There remains a lot to work out in Europe. These issues are not going to go away overnight. How long things remain unsettled there depends upon how quickly people realize that the problems are internal and not a result of “irrational markets” and the greed of speculators. It is very difficult, however, to realize that your model of the world requires modification. Perhaps such change is generational…but, can we wait that long?

The European Union: It's a Question of Leadership

The dust is clearing around the recent negotiations in Europe concerning the “bailout” bill and what we are seeing, at least to me, is unnerving.

“France has won!” (“Paris seen as trumping Berlin at EU table” at http://www.ft.com/cms/s/0/4fbef0b4-5d5e-11df-8373-00144feab49a.html)

“The French government yesterday vowed to ‘reinvent the European model.” (“Sarkozy triumphs in his bid to rewrite the rules” at http://www.ft.com/cms/s/0/f2666c76-5d5d-11df-8373-00144feab49a.html)

The press has predominantly been following German Chancellor Angela Merkel over the past month or so as she struggled to achieve a “German” twist to the negotiations concerning the fate of Greece and the bailout package that was needed to keep the EU together.

Many in Germany did not like what her leadership has achieved as people voted against her party last Sunday making it ever so much more difficult for her to lead her nation.

Sarkozy, the president of France, kept a very low profile…for him.

And, who seems to have come out on top? France!

France’s intent? To build a new structure with greater budgetary policy co-ordination and more effective fiscal rules. In essence, to follow the French model, allowing the spenders to spend and the savers to pay for what the spenders are spending on.

The start is a vast loan facility to distribute cash quickly to “a stricken member” without prior approval from other national governments…especially Berlin! (However, the current effort is to last only three years, but once begun…)

Also, Sarkozy is said to be very happy with the decision of the European Central Bank to start buying euro-zone government debt. This is a massive step toward “Quantitative Easing” something the ECB had been constantly resisting.

The ECB has been “Bernankied”!

This shift in policy direction is seen by Sarkozy as “irreversible” and puts France in the driver’s seat.

In my mind, this “victory” just exacerbates the “race to the bottom” (See “How the euro-zone set off a race to the bottom” at http://www.ft.com/cms/s/0/5d666d5a-5c69-11df-93f6-00144feab49a.html.)

The feeling in Germany? The newspaper Bild Zeitung puts is very simply: "The 'safety parachute' for the euro is the ultimate crime for Europe. We Germans have made sacrifices for a stable euro for the last 10 years, with wage restraint and sacrificing pension rises. We have paid the price while others have been partying at our expense . . . Europe's path to a transfer union is simply a road to its ruin."

And, what direction are you betting the euro will go?

This whole muddle returns to the question of leadership and in Europe.

Unfortunately, I don’t see anyone there that I would call a real leader.

In terms of the leadership at central banks, the head of a central bank can only go so far in achieving a monetary policy independent of the party that rules a nation.

NOTE: Check out what recently happened to the head of the central bank in Argentina!

Ben Bernanke and the Federal Reserve System have never acted independently of the presidential administration in Washington, D. C. whether it was the Bush 43 administration or the Obama administration.

The only show of independence that Bernanke and the Fed has made is to keep the Congress from conducting an audit of them.

Alan Greenspan was the lackey of whoever was in the White House.

This is why the financial markets expect that sooner or later massive governmental deficits will be monetized. Central banks cannot forever “hold out” against a government that wants to continue to live way beyond its means.

And, because of this Jean-Claude Trichet should not be judged too harshly. The “profligates” are in charge and a central banker can only fight back so hard. At least if they want to keep their high profile position.

So, we go back to the victory that France has achieved. If people were uncertain over the future of the European Union and the future of the euro, in my mind a lot of that uncertainty has been removed.

The major uncertainties now relate to when the periodic financial upheavals are going to take place, how severe they will be, and how long it will take for a European leadership to arise that will have had enough of the “race to the bottom”?

Weak leadership always caves in to the popular short run viewpoint!

Goldman Had A Perfect Quarter

This may sound like a ridiculous headline, but it appeared in the Wall Street Journal today. (See http://online.wsj.com/article/SB20001424052748703880304575236132462861088.html#mod=todays_us_money_and_investing.)
The reason for the headline is that the Goldman Sachs traders made money every day the firm traded in the first quarter of 2010!

The article states: “Traders raked in more than $100 million daily for 35 days and made no less than $25 million daily during the rest of the three-month period, according to the regulatory filing on Monday. The streak was a first for the Wall Street firm, which typically loses funds on at least a handful of days in a given period.”

On that basis Morgan Stanley had a more typical quarter. Morgan Stanley lost as much as $30 million daily on four days during the quarter. The other days, well, they made money far in excess of the losses.

What the government takes away with one hand the government gives back with another.

While the government chastises Goldman and its management and sues it for securities-fraud, the Federal Reserve subsidizes Goldman with super-low interest rates.

During the first quarter of 2010, Goldman could borrow money for up to six months for 20 to 50 basis points. They could lend these funds out for almost 400 basis points, RISK FREE. And the Federal Reserve promised them that these spreads would continue to exist for an “extended period” of time!

Goldman Sachs should send Mr. Bernanke a big basket of fruit accompanying a big “THANK YOU, MR. BERNANKE” card.

Wish I could play this game!

And, now the European Central Bank seems to be getting wise to the game. And, our Federal Reserve system is going to support the ECB through currency swaps!

And, then the figures come in on Fannie and Freddie! And, with all the new spending programs coming from the Obama administration it is hard to take seriously the feeble coins that are tossed to the study of how to get the federal deficit under control. Official forecasts place the federal deficit under $10 trillion for the next ten years. I still believe that deficits will accumulate more toward the $15 trillion to $18trillion range.

The Fed is going to “tighten up” in the face of all this junk? Or, will they pull a “Trichet”. Or, has Jean-Claude Trichet, the Chairman of the ECB, pulled a “Bernanke”?

The problem, as I have written many times before, is that when a nation puts itself into a position like the United States (and many of the European nations and England) finds itself, there are really no good choices to left for it. However, the tendency is that once a nation finds itself in such a hole, they continue to dig deeper as the United States (and the European community) is now doing.

Peter Boone and Simon Johnson write in the Financial Times this morning about “How the euro-zone set off a race to the bottom.” (See http://www.ft.com/cms/s/0/5d666d5a-5c69-11df-93f6-00144feab49a.html.) The EU dug its own hole and now they continue to dig the hole deeper and deeper.

The Euro-zone system “encourages “a race to the bottom”—led by governments in smaller countries, which relax fiscal and credit standards to win re-election.”

I would add that this claim could be leveled against the United States and Great Britain just as well as they raced to provide more and more social services and housing to the electorate in order to get re-elected and justified borrowing massive amounts of money, both domestically and internationally, through Keynesian arguments that there was an infinite supply of funds available to governments.

The governmental emphasis on generating huge deficits, on financial innovation and creating massive incentives to inflate the amount of credit outstanding, changed the whole environment of finance. And, of course, the very people that created this environment, the various presidential administrations of the past fifty years and their co-conspirators in Congress, now condemn what they have created and sue it. Yet, they also continue to underwrite it through bailouts and subsidies like the monetary policy of the Federal Reserve called “Quantitative Easing.”

All I can say about the quantitative easing is that there must be a very large number of the remaining 8,000 “small” banks in the banking system that are in very serious financial difficulty for the Fed to continue to maintain this policy and subsidize the further growth of the “big” banks!

There are no good decisions left. And, I fear, that the ultimate resolution of this situation, as Boone and Johnson argue, is for these profligate nations to default, “either through repudiations or inflation.”

However, things don’t stop here. What this situation points to is the weakening of the influence of the Western nations, especially that of the United States. Given the current situation, why should China bow to any wishes made to it by the United States government except to those that are particularly in their interest? (See my post, “Why Should China Change?”: http://seekingalpha.com/article/193689-why-should-china-change.) The same applies to India (see a very interesting article in the Financial Times this morning, “India: The Loom of Youth”: http://www.ft.com/cms/s/0/8aefdf1e-5c68-11df-93f6-00144feab49a.html) and Brazil. The United States (and Western Europe) have made these countries relatively more powerful and independent. And, given the current position of the United States (and Western Europe) why should the countries be generous to the dominant power in the world?

The world has changed over the past fifty years and the United States has contributed significantly to its own relative decline. (Watch this played out in future meetings, like that of the G-20.)

And, it has contributed to Goldman being perfect!

Greece and Insolvency

A financial crisis that is a result of the potential insolvency of a borrower is connected with the “true” value of the underlying assets held by the lender. In the case of the Greece bailout, the European Union (EU) and the International Monetary Fund (IMF) are working to keep the value of Greek bonds at 100% of face value.

Thus, the €110 billion (or $145 billion) package put together over the weekend is an effort to save the Euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so. Hopefully, at the end of this time Greece will be welcomed back into the capital markets so that it can raise its own cash, something it needs lots of.

Then, as is usually the assumption in insolvency situations like this, the debtor will grow out of its difficulties so that its debt will return to 100% of face value in the financial markets. The problem with this is that Greece is expected, at best, to return to the level of real GDP it achieved in 2009 in or around 2017. The austerity moves required by the IMF of the Greek government is not expected to contribute to a strong rebound in its economy.

Many analysts are contending that the bailout is really to protect the banks in Germany and France. The commercial banks in these two countries hold a massive amount of Greek debt. If one gives the Greek debt a haircut of 40% to 50%, several banks in these two countries will fail and require government support to keep the banking systems functioning. If this were to happen both nations would find themselves in deep economic trouble, threatening the recovery of all Europe.

But, note…”The European Central Bank (ECB) agreed to continue accepting as collateral any current or future Greek government bonds, no matter how much debt-rating companies downgraded them.” (See http://online.wsj.com/article/SB20001424052748703612804575222331434882588.html#mod=todays_us_page_one.)

By doing this, the ECB is attempting to prevent a liquidity crisis at Greek banks, because these banks can use the new collateral rule to get cash from the ECB by pledging their Greek bonds as collateral. Also, this rule will benefit euro-zone banks because it will mean that these banks can also get money from the ECB by pledging their Greek bonds as collateral.

There seems to be a special effort on the part of EU and IMF officials to take all discussions of losses on Greek debt “off-the-table.” The emphasis is upon ensuring that the banks that hold Greek debt and the financial markets that everyone will be “paid-in-full” over the next year or two. Anyone that talks differently will have his or her hand slapped!

The ultimate mechanism for insuring that debt is covered over the longer run is to produce an inflationary environment. And, in a severe financial crisis, the concern of the policy makers is to err on the side of providing too much liquidity. The policy makers do not want people, at some time in the future, to accuse them of not providing enough liquidity to the system which resulted in an even greater financial crisis.

Jean-Claude Trichet, the President of the European Central Bank certainly is adhering to this principle in the current situation. Trichet, the stern defender of central bank fight against inflation in 2007 and 2008, now seems to be putty in the hands of current circumstances.

Trichet, however, still seems to be a amateur when compared with his counterpart Ben Bernanke at the Board of Governors of the United States’ Federal Reserve System. When it comes to “throwing stuff against the wall to see if it sticks” Bernanke is the poster-child.

Inflation may be the ultimate tool that Europe uses to save the Euro and the European Union. The reason for this is the other nations that are on the brink of financial disaster: Spain, Portugal, Italy, and Ireland. Also, there is the U. K. sitting across the channel showing us the very real possibility of having a “hung” Parliament which would find it very difficult to do what it needs to do to get its own act in order. There may just be too much to do in the current state of affairs to overcome the lack of national discipline that has been exhibited in this the European region in the recent past.

The factor that might set this all off is the reaction of the government employees and the working classes in these nations to the austerity programs that are being forced down the throats of the governments in question. Europe has a long and proud history of labor movements and working class unrest. These movements have been relatively quiet in recent years. In Greece we are seeing a resurgence of protest that could fuel further unrest in other countries, especially in Italy.

It was fear of such unrest in Europe in the 1920s and 1930s that led to a philosophy of government policies that supported the creation of an inflationary environment to keep people employed with ever increasing wages. These policies were implemented in many countries once the disruptions created by World War II subsided. The history of labor movements in Europe in the twentieth century is long and rich. It is unlikely that the austerity programs will be easily accepted by the people being impacted by them.

Again, the problem we are seeing is that there are no attractive options to governments or governmental bodies after a long period in which financial discipline has been absent. As Carmen Reinhart and Ken Rogoff have shown in their book “This Time is Different”, every time that governments (or people, or, businesses) lose their fiscal discipline the time is never different.

The Piper eventually has to be paid.

The effort to prevent too much pain, however, is to bail out governments (and people, and, businesses) and then stimulate the economy to put businesses, and, people, and, governments, back where they were before the crisis began. This is done by inflating the economy through extensions of liquidity and programs to maintain asset prices. The goal: to get the economy back to where it was before the crisis began.

This is what the European Union, with the help of the International Monetary Fund, is attempting to do. Unfortunately, the underlying problem has not been solved. There are major amounts of assets on the books of financial institutions and other organizations that are substantially over valued. The question that lingers in an insolvency crisis relates to how long these financial institutions and other organizations can continue to hold onto the assets without marking them to a more realistic value or working the losses off through charges against other earnings?