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/).  

Wanna Chance to Double Your Money in 30 Days?

Why do large investors…hedge funds and others…like governments to get involved in financial affairs?

Because these investors can make lots of money from the actions of these governments. 

Ask George Soros about the behavior of the British government in the 1990s.

Now we have another possible piggy-bank on the horizon…thanks to the Greek government and the Eurozone.

“Under the deal Greece struck in July with its banks as part of Europe’s rescue plan, a substantial portion of its existing bonds are scheduled to be swapped into new longer-term securities that could be valued at more than 70 cents on the euro.” (http://www.nytimes.com/2011/09/29/business/global/hedge-funds-betting-on-lowly-greek-bonds.html?_r=1&scp=1&sq=greek%20bonds%20lure%20some,%20despite%20risk&st=Search)

Why is this “deal” important?

Many Greek government bonds “are changing hands for as little as 36 cents for each euro of face value.” 

Making money on this deal requires that the latest Greek bailout system is ratified by the parliaments of the 17 European Union countries that use the euro by late October. 

If the EU deal closes, “those who bought the bonds recently at distressed prices might in some cases come close to doubling their money.”  And, in only one or two months time!

Again, investors benefit…taxpayers suck it in…

“According to a person with direct knowledge of the debt swap, about 30 percent of the investors who are expected to participate in the (deal) bought their bonds after July 21.  They are not the original debt holders…”

What governmental “leaders” don’t seem to understand is that once they take a position, many other people in the world will change their positions to take advantage of the new position of the government.  Things just don’t stay the same.  And, if these “leaders” follow the same strategy over and over again…others will take advantage of the repeat strategy and use it against the “leaders”.

In the case of the European Union, the “leaders” of the EU have tried repeatedly to “kick the can” down the road.  By failing to take action in the past, these “leaders” have postponed the actions that must take place.  But, by postponing and postponing the day when the actions will take place, the “leaders” have just limited their options and created situations in which large investors can take advantage of the dislocations that have developed in financial markets. 

If the “leaders” had been leaders and had moved earlier when the dislocations in the financial markets were smaller, such possible large returns would not have been available.  By postponing action, these “leaders” allowed the situation to get further “out-of-line” and this results in the possibility of well-placed investors making lots and lots of money. 

Of course, the bailout must go through…and this is the risk that these investors face. 

And, the fate of the taxpayers?

“Defenders of the (deal) say that while it may not be ideal, it was the best deal that could be reached at the time.  If hedge funds make some money along the way, they say, that is a small price to pay for securing a contribution from the private sector.” 

An investment tip…look for dislocations created by government actions. 

Another place where lots of money was made recently was on French banks.  Why?  Well, because French banks…and other European banks…have been given special treatment in the past and the problems relating to European sovereign debt have been handled, well, inconsistently…at best.  And, then there were the “stress tests” given the European banks which proved to be a joke. 

The stock prices of French banks had to decline and with this decline the rating agencies lowered the ratings that were given to the banks exacerbating the decline in their stock prices.  The article cited above begins its discussion of hedge fund purchases of Greek bonds by stating, “After a number of investors struck gold by betting against French banks…”

Lots of money will be made from the European financial crisis.  Lots of money will also be lost.  The money made will tend to go to the better off who can “bet” against the governments.  Postponing actions to protect the “less well off” only seems to lead to situations where the benefactors of the ultimate actions of the government are not the ones the “leaders” of the government are trying to help.

As I have stated many times, Europe has gotten into the current situation by assuming that its sovereign debt problems were problems of liquidity and not solvency.  People tend to avoid as much as possible questions relating to solvency.  This is especially true of bankers and the assets that reside on their balance sheets. 

Solvency problems, however, cannot be postponed forever…they must eventually be dealt with.  But, this is where real leaders must step up.  Identifying solvency problems earlier rather than later is always a benefit.  Identifying solvency problems earlier let you deal with the issues surrounding the asset sooner when the problems are not so severe.  Dealing with solvency problems earlier rather than later allow one to make smaller, incremental adjustments that the institution…or country…can more easily absorb. 

People…especially politicians…don’t like to admit mistakes and so we declare that the problems we face are liquidity problems and not solvency problems and we postpone the day of dealing with them. 

Such postponements can only result in opportunities for others.  Wanna chance to double your money?        

Greece and Dimon and Bernanke

Standard & Poor’s rating services have just given Greece sovereign debt the lowest rating it has.  The Greek leadership is upset.  “We have a very tight fiscal package coming” the leaders say.  Yet the downgrades continue. 

The timing of the reduction in the debt rating, according to some pundits, is not coming at a very good time.

But, these things never happen “at a very good time”.  Building up excessive amounts of debt reduce options (http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options) and they leave you in a state where there is no “good time” to deal with the debt. 

Yet, people and governments, over the past fifty years, acted as if the amount of debt outstanding did not matter to their economy and that any fiscal difficulty a country might find itself in could be overcome by increasing the spending of the government and increasing the amount of government debt.

The amount of debt a government issued did not matter because the economic models the governments used did not include government debt.  Thus, a government could increase debt as much as it wanted and their economic models would be unaffected.

One of the primary reasons that debt, both public and private, was not included in the models was because there was not sufficient historical evidence on the levels of debt outstanding before, during, and after a financial crisis to justify inclusion in the models.  Kenneth Rogoff and Carmen Reinhart have attempted to eliminate this reason with their study of eight centuries of financial data presented in their book, “This Time is Different.”

Another reason why it is hard to study the burden of debt on a country is that the analysis of the risk associated with any given amount of debt is to a large extent psychological.  There seems to be little if any “tight” relationship between when the market determines that the amount of debt being carried by a country is excessive.  There seems to be no unique “trigger” to determine a sovereign debt crisis.

The bottom line is that the role of debt in the precipitation of a debt crisis is very, very complicated and the quantitative tools that exist are just not sufficient to fully capture any one specific situation.

As a consequence, the amount of debt a country carries is a judgment call, but the more debt a country accumulates the more it limits its future options and the more it loses control over the timing of any “crisis” that might occur.    

There seems to be other cases currently in the news pertaining to governmental decisions in areas that are very complicated and cannot be modeled in any satisfactory way. 

This is brought out very clearly is the column by Andrew Ross Sorkin in the New York Times this morning, “Two Views on Bank Rules: Salvation and Job Killers.” (http://dealbook.nytimes.com/2011/06/13/two-views-on-the-value-of-tough-bank-rules/?ref=business)

In this article, Mr. Sorkin re-plays the recent verbal exchange between Jamie Dimon of JPMorgan, Chase, and Ben Bernanke of the Board of Governors of the Federal Reserve System.  Mr. Dimon, among other things, questioned the ability of the Federal Reserve (of regulators) to understand the consequences of their regulatory actions.

Sorkin remarks, “it’s an uncomfortable truth that Mr. Dimon should be taken seriously, at least his suggestion that policy makers can’t predict the full impact of the coming regulation.”

Sorkin reports that when Mr. Bernanke answered Mr. Dimon’s question, he said, “Has anybody done a comprehensive analysis of the impact on credit? I can’t pretend that anybody really has. You know, it’s just too complicated. We don’t really have the quantitative tools to do that.”

Mr. Bernanke’s answer captures something that the economist Friedrich Hayek stated many years ago, that a central organization or one individual body can never possess sufficient information to make decisions that are dependent upon information that is dispersed widely throughout the economy and is relevant for “local” decision making.

With this statement, Mr. Bernanke loses more of the credibility that he had been trying to hang onto over the past eighteen months. 

The economic models that people and governments have been using over the past fifty years are inadequate, at best, and misleading in practice.  They work best when the economy is smoothly growing.  They just do not have sufficient data to handle the very complex situations that happen when things are not going smoothly.

As Hayek taught us, there is just too much relevant information for us to collect, store, and process and even if we could store it all, most of the information pertains to “local” situations that are way beyond our ability to model. 

Hayek also taught us that one of the major roles of the economist is to demonstrate to decision makers how little they really know about what they imagine they can design. 

In this respect, governments need to create the processes though which decisions are made and should not focus on the outcomes.  Outcomes are a result of those things a decision maker thinks he/she can “design” and this applies to bank regulation, unemployment targets, and so forth. 

 

To me the process of openness and disclosure is still the most important thing that a government can require…of itself…or of the organizations it is regulating.  When the government begins to determine what decisions should be made and what outcomes are to be attained, it begins to exceed its ability to succeed. 

And, as the government fails to attain the outcomes it wants, it asks for more control to gain those outcomes…and then more control…and then more control…

Bank Honesty is the Best Policy: the European Case

If the history of banking tells me anything, it tells me that banks are only fooling themselves if they think that they can hide bad assets and then outlast the drag these bad assets put on their performance.

Headlines read,” Europe's Banks Stressed By Sovereign Debts Regulators Ducked” (http://www.bloomberg.com/news/2010-09-06/europe-s-banks-stressed-by-sovereign-debts-eu-regulators-failed-to-examine.html) and “Europe’s Bank Stress Tests Minimized Debt Risk” (http://professional.wsj.com/article/SB10001424052748704392104575475520949440394.html?mod=wsjproe_hps_LEFTWhatsNews).

What do these people think they are doing? Who do these people think they are fooling?

Covering up a bank’s position always comes back to haunt the bank.

Now, we hear that not only have the bank’s covered up their positions, but regulators and government officials have covered up the real position of the European banks.

“Europe’s governments can’t afford to question the quality of bonds they’ve sold to banks, says Chris Skinner, chief executive officer of Balatro Ltd., a financial industry advisory firm in London. “Bankers have got Europe’s governments in their pockets, primarily because politicians cannot change the way lenders do business without undermining confidence in sovereign debt,” he says.

The secret of getting out of a financial quagmire is to identify everything, recognize and accept your problems, and then do something about them.

To me, this is one of the reasons why the restructuring of the American banking system is proceeding as well as it is. I believe that the FDIC (and others) has identified most of the problems in the commercial banking industry, and they are substantial. But, they are generally known. The FDIC, along with the Federal Reserve, is working to resolve these banking problems in an orderly fashion. The FDIC is arranging mergers and is closing banks on a regular basis and the Federal Reserve is subsidizing the banking industry by keeping its target interest rate close to zero and by maintaining massive amounts of excess reserves in the banking system.

One does not see this happening in Europe. As a consequence, clouds still hang over the financial markets as, for example, yields on 10-year Greek bonds are around 11.25 percent relative to yield of about 2.25 percent on similar German bonds. This is true on other debt issued by Eurozone countries and this risk issue also shows up in the spreads on bank bonds.

There are more questions about “when” Greece is going to default on its bonds rather than “whether” it will default on its bonds.

Economic recoveries cannot really take place until the banking system of a country is sufficiently healthy. (See my post, “No Banking, No Recovery” on the situation in the United States: http://seekingalpha.com/article/218027-no-banks-no-recovery.)

But this problem seems to go deeper. This is from the Bloomberg article.

“While they’re stuck with their government bond holdings, Europe’s banks are also still carrying much of the troubled assets they had during the 2008 meltdown. Euro-zone lenders will have written down about 3 percent of their assets from the peak of the credit crisis by the end of 2010, compared with 7 percent for U.S. banks, the IMF estimated in April. The steeper writedowns by U.S. banks are partly because they held a higher proportion of securities, the IMF said.

That doesn’t excuse the lack of candor shown by many European lenders about the unsellable assets on their books, says Raghuram Rajan, a finance professor at the University of Chicago. “European banks haven’t owned up to the large amounts of toxic debt that they hold,” says Rajan, who was chief economist at the IMF from 2003 to 2007.

“The stress tests weren’t severe enough,” says Julian Chillingworth, who helps manage $21 billion at Rathbone Brothers Plc, an investment firm in London. “Many bond investors aren’t convinced the Greeks are out of the woods.” And if the Greeks haven’t emerged from their crisis yet, then neither have the European banks that hold their debt”.

If we are going to have banking systems that are stronger and less subject to systemic risk, bankers, regulators, and public officials must realize that good risk management includes openness and transparency. Bankers, historically, have been among the leaders in securing the “cover up” of bank positions and the quality of bank assets. They do not need the help of regulators and politicians to reinforce this tendency.