Depression in Europe?

There seems to be growing optimism in the United States that the economic recovery is picking up steam.  This is all fine and good, but I still believe that the major potential bump in the road for the United States is the economic and financial situation in Europe. (See my post of January 4, http://seekingalpha.com/article/317268-issue-number-1-for-2012-recession-in-europe.)

Now we have the new austerity program passed by the Greek parliament and the unrest in the streets of Greece protesting the austerity program.

But, the new austerity program, at this point, does not end the concern over whether or not this new plan will be sufficient to end the Greek insolvency.

Greece is insolvent.

With the government’s new austerity program, however, Greece will get a new financial bailout.  The question now becomes: will this new bailout program buy Greece enough time to get its ship in shape so that it can work its way out of its insolvency?

Some think not.  For example, Wolfgang Münchau writes in the Financial Times, “My central expectation is that the program will happen.  A period of calm will set in, but after a few months it will become clear the cuts in Greek wages and pensions have worsened the depression…. Before long, another round of haircuts will be beckoning.” (This from the article “Why Greece and Portugal ought to go bankrupt,” http://www.ft.com/intl/cms/s/0/57485f60-540a-11e1-8d12-00144feabdc0.html#axzz1mGnbTALH.) 

There is another problem on the horizon, however, and that is the fact that a new Greek government will be be elected in April.  The expected winner at this time is Antonis Samaras.  The question is, what will this new government do after it assumes power?

Münchau argues: “I cannot see how this (the bailout) is going to work politically.  For a new prime minister who contemplates a full term of four years, the temptation to pull the plug and blame the mess on his predecessors must be big. He will then have four years to rebuild the country from the rubble of a eurozone exit.  It would be politically much riskier for him to stick to a program that he himself says does not work, and which will keep his country in a depression for the length of his mandate—possibly beyond.” 

And this is exactly the dilemma a “turnaround” leader faces…do I struggle along with the things that were left me…or, do I clean house and start with as clean a slate as possible.

I have successfully completed three corporate turnarounds and to me there is no choice.  The nice thing about being brought in to turnaround an organization is that you have a certain time period to blame everything on the previous management and clean house.  If you don’t do the house cleaning right up front, however, you lose most of your leverage to change things.  The decision is not difficult: you start with as clean a slate as possible.  In the case of Greece, then, declare bankruptcy

Greece is insolvent.  “To rebuild itself, Greece needs a functioning economic infrastructure, a modern labor market, and a less tribal political system.”  It also needs less corruption throughout its culture. 

This is not the only set of problems that Greece…and Europe…faces.  New data on the economies of Europe coming out this week are expected to be rather dismal.  The forecasts for the fourth quarter GDP of the eurozone run from a 0.4 percent to a 0.6 percent contraction.  These figures include the fact that even Germany seems to be in a decline.  Industrial production figures for December are also to be released this week and some analysts see a decline in this measure of more than one percent. (http://www.ft.com/intl/cms/s/0/f9558702-53e1-11e1-bacb-00144feabdc0.html#axzz1mGnbTALH) 

There is some feeling that the first quarter of 2012 may find growth in positive numbers, but not by much.  Germany and others may experience some kind of recovery then, but the southern peripheral countries are not expected to start growing again for some time.  And, with unemployment in excess of twenty percent in some of these countries and continued government austerity, 2012 prospects remain quite gloomy. 

The next question, though, is where the pressure will be applied next.  Münchau contends that Portugal is also bankrupt and should follow Greece in declaring bankruptcy.  Will the international investors now turn their attention to Portugal?  I wouldn’t be surprised. 

Countries…businesses…individuals…do not resolve their financial difficulties until they resolve them.  Continued bailouts only tend to postpone a final solution.  They very seldom correct the insolvency that is causing the problem. 

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/).  

It Depends Upon Your Definition of "Is"--Greek Bailout 2 or GB2!

Is Greece declaring default on it sovereign bonds?

To some, it depends upon your definition of “is”. 

Is a “selected default” or a “restricted default” a default?

There is only one answer in my book.  Greece is declaring default.

The reason Greece is defaulting is because Greece is insolvent.   (See my post from Wednesday, http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership.)

At least some of Greece’s sovereign debt will be written down by around 20 percent in the new deal reached yesterday among European officials.  (I will not use the title “leaders” for this group of individuals.)  On Monday of this week, Greek bonds were selling at about a 50 percent discount.  As word that a possible agreement might be reached by European officials, the discount declined and the bonds were selling at 60 percent of par or 65 percent.

The question is, is this enough of a haircut?

There are other provisions: new longer-term bonds to replace shorter-term bonds, lower interest rates, and additional help for Portugal and Ireland.

However, it seems as if the most general comment on the new package is that the eurozone has bought itself some time.   

The first response of the financial markets has been positive reflecting that the Europeans have done something good.  However, as the news continued to sink in, markets backed off once again. (“Jitters over eurozone fringe snuff out rally”, http://www.ft.com/intl/cms/s/0/3de1daa0-b451-11e0-9eb8-00144feabdc0.html#axzz1SlzuB7bE.)

GB2 may not be enough.  And, then there is the fear of contagion: Is GB2 large enough to protect against the “Lehman Brothers” effect?  At first the failure of Lehman Brothers on September 15, 2008 seemed to be self-contained…but then problems occurred as financial concern spread to other areas and other firms. 

What about Portugal?  What about Ireland?  What about Spain…and Italy?

And, what about the United States?

There still are a lot of unanswered questions.

My response to this is two-fold.  First when you are in trouble, like Greece…and others within the eurozone…you need to act decisively and in a way that creates a belief that you mean to back up what you do. 

We work in a world of incomplete information.  We don’t know precisely what the correct amount of action is needed to solve a problem.  My view is that a leader needs to act decisively enough so that there is a good chance that the problem will actually be solved.  Also, the leader needs to act in a way that conveys to others that she or he is in charge of the effort and that whatever needs to be done will be done.

Second, the leader needs to create the belief that she or he will follow up on what has been done to close any gaps that might still be found to exist.  Financial markets must come to believe in that the leader will "stick at it" until the problem is corrected.

The officials in Europe have failed on both accounts.  First of all, they have denied and denied and denied that there was any problem they were accountable for.  It was always someone else’s fault. 

Second, the officials in Europe have never wanted to do more than the bare minimum in trying to correct the situation.  “How little can I get away with?” seems to be the question they ask. 

Third, no one seems to want to be in charge. 

Which leads me to my final point, the financial markets do not have much regard for anyone in the European hierarchy.  In this they seem to reflect the sentiment of the citizens of Europe. 

“Restricted default” or “Selected default”?  This seems to be like being partly pregnant: in my understanding you are either pregnant or you are not pregnant!

When will the European debt crisis be resolved?

It looks to me like the can has just been kicked a little further down the road.   

Greece: Please Take More of the Medicine That Has Already Failed to Treat the Disease

With respect to the Greek sovereign debt situation, two statements reported this morning stand out.  First, Simon Tilford, chief economist at the Center for European Reform in London is quoted as saying: “The Greeks have been told to accept more of the medicine that has already failed to treat the disease.”  The consequence of this is that Greece has already entered a “death trap.” (http://www.nytimes.com/2011/06/23/world/europe/23greece.html?_r=1&hp)

The other statement deals with how the European banks will deal with some of the cost of a second bailout of Greece: “The trick will be for the private sector to take losses on Greek bonds, without Greece being declared in default.” (http://professional.wsj.com/article/SB10001424052702304657804576401471860518598.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj)

The problem: “If the banks are forced to accept losses, ratings companies likely will declare a default.  Even if the banks act voluntarily, Greece could still be considered in default on some of its debts.” 

For more on this issue you might check the column by Satyajit Das in the Financial Times, “Final arbiter in Greek saga is an untested private body.”  Das is referring to something called the Determinations Committee, a group set up by the International Swaps and Derivatives Association.   This body may be the one that determines whether of not Greece goes into default or not.  (http://www.ft.com/intl/cms/s/0/95e3131a-9bf9-11e0-bef9-00144feabdc0.html#axzz1Q6N7EfJG)

Marty Feldstein, the Harvard economist, considers the dilemma facing European leaders: “If Greece were the only insolvent European country, it would be best if its default occurred now…But Greece is not alone in its insolvency and a default by Athens could trigger defaults by Portugal, Ireland and possibly Spain. (http://blogs.ft.com/the-a-list/2011/06/22/postponing-greeces-inevitable-default/)

Oh, oh!  The “I” word!

So, Greece is insolvent.  Portugal is insolvent.  Ireland is insolvent.  Possibly Spain is insolvent. 

And the European leaders are forcing Greece (and these other countries) to just continue taking more of the same medicine.

But, we can’t have insolvency squared or insolvency cubed?  Or, can we?

And the determination of whether or not a default takes place seems to depend upon a private organization that has never rated any debt before and must, it seems, determine what the definition of “is” is. 

This seems like a scene out of an old Peter Sellers movie!

This is nothing more than a Ponzi scheme being enacted by a bunch of comedic characters.  The Ponzi scheme: borrowing more and more money to pay the interest on the growing body of debt. 

This is the “death trap” mentioned above.

My belief is that the financial markets will be the final arbiter of this picture.  I believe that the “leaders” of Europe are creating a “risk-free” bet that many hedge funds and other investors with lots of money are waiting anxiously to exploit.  Governments seem to have a penchant for creating such “risk-free” bets.  Just ask George Soros.

Marty Feldstein has declared Greece insolvent.  So have a lot of other people. 

The financial markets will take care of this.

An aside about the situation in the United States: the Congressional Budget Office just released new projections for the federal budget.  In the new projections, the interest paid on United States debt will increase from around 2 percent of Gross Domestic Product in 2011 to over 9 percent in the year 2035. And, this is with relatively benign projections on interest rate movements. (http://professional.wsj.com/article/SB10001424052702304657804576401592689113956.html?mod=ITP_pageone_1&mg=reno-secaucus-wsj)

Is this just another rendition of the “death trap”?

What is Causing the Worldwide Government Debt Crisis?

Mohamed El-Erian, the Chief Executive Officer of PIMCO, writes this morning that “It is now commonly accepted that Greece’s predicament is due to two inter-related problems: the economy is unable to grow, and the debt burden is enormous. (http://blogs.ft.com/the-a-list/2011/06/17/only-a-totally-new-greek-approach-can-save-europe-now/)

Yet, El-Erian states, neither of these issues are being addressed in the discussions going on concerning the resolution of the debt crisis in Greece.

The reasons for this are complicated although they very often boil down to the priority to handle short-run problems immediately and postpone the long-run problems to another day.  Of course, the famous quote of John Maynard Keynes comes to mind: “In the long-run we are all dead!”

A good listing of the complicated entanglement of the politics of the Eurozone is present in the Wall Street Journal article “Europe’s Greek Stress Test” by John Cochrane and Anil Kashyap. (http://professional.wsj.com/article/SB10001424052702304186404576389542793496526.html?mod=ITP_opinion_0&mg=reno-wsj) The authors list four key facts:

“First, the Greek government has borrowed more than it can plausibly afford to pay and certainly more than it will choose to pay. It now owes more than one and a half years' economic output.”

“Second, European banks are holding the bag.”

“Third, the European Central Bank (ECB) is now involved as well.

“Fourth, in the end this is all about Ireland, Portugal, Spain and Italy.”

In other words, by ignoring the basic underlying causes of the problem, the sickness has spread and now envelopes nor only Europe…but the world.

In other words, the old economic paradigm is dead, and the political leaders of the western world have only made things worse by trying to keep the old paradigm alive. 

As a consequence, the options available to these leaders are shrinking and those options that are left are becoming less and less desirable.

And, even if the bailouts continue and postpone the resolution of the crisis until another day, the two basic issues mentioned by El-Erian are not being addressed.  These are the issues pertaining to the reasons for slow economic growth and the reduction of the massive debt levels that are outstanding. 

The solution…increase economic growth and lower debt levels.

The problem…over the past fifty years or so the political leaders of most western nations worked with an economic paradigm that resulted in an increase in debt levels to increase economic growth.  That is, credit inflation, whether in the economy as a whole, or in a particular sector like housing, would buy politicians additional votes by keeping economic growth high and unemployment low. 

“The solution” reverses almost 100 years of the economic and political thought of western intellectuals.  It also contradicts the perception of many voters in western countries. 

Keeping a lid on debt exposure is an old-fashioned idea and one that collides with the modern day concept of what governments should do and of the excesses of the consumer society. 

An emphasis on education and training also is an old-fashioned idea although it was the basis of economic productivity and inventions in the nineteenth and early twentieth centuries in the United States.  And, this particular emphasis is one that collides with the modern-day approach to “certification” and the building up of “self-esteem” where everyone passes or everyone gets A’s.

The current sovereign debt crisis is not going to go away with “doing more of the same.”   Yet, changing the economic paradigm is going to be difficult.  We see this on the streets of Greece…and Spain…and Vancouver…oops, sorry…

The focus is on Greece right now and rightfully so.  But, the lessons need to be learned by others…but this will not make it any easier.  Long-run solutions are never “easy”.

There was an interesting article in the Saturday Wall Street Journal titled, “What Kind of Game is China Playing?” (http://professional.wsj.com/article/SB10001424052702304259304576374013537436924.html?mod=ITP_review_0&mg=reno-wsj) The answer is that American leaders need to learn how to play the game of “Go”, an ancient Chinese board game.  The game of “Go”, “emphasizes long-term planning over quick tactical advantage, and games can take hours. In Chinese, its name, wei qi (roughly pronounced "way-chee"), means the "encirclement game."

The economic paradigm of the past fifty years emphasizes “tactical advantage”, the short-run.  Why this approach became so popular was that the political leaders of the western world saw it as the means of gaining their goals…getting elected and then getting re-elected.

What El-Erian and others are arguing for is more emphasis by these political leaders on the “strategic” and not the “tactical.”  The “strategic” aims to achieve “sustainable” results.  The “tactical” way of dealing with a problem always contains the caveat that the other problems will be dealt with when they become the major issue.

Well, the other problems have now become the major issue.

And, this is the lesson for the countries included within the definition of the western world. 

Politicians are going to have to learn how to think “strategically.”  The question is, “Can politicians be allowed to think strategically in a democracy in which winning the next election is the most important thing on their agenda?”

Greece, in my mind, is going to have to restructure its debt in one way or another.  So is Ireland…and so is Portugal…and so in Spain…and so on and so on.  How many more countries will find themselves facing a restructuring of their debt is, of course, unknown. 

It is painful when you find out you have been working with a model that is not correct.  Creating more spending and more debt is not the solution to every problem.  Yet, we have lived by this model for a long time.  And, now the bill seems to be coming due.

To me, this is what is causing the worldwide government debt crisis. 

Time For Policymakers To Change Economic Models--Got That Portugal?

 Government policymakers just don’t seem to get it!

The economic philosophy governments have been using as the foundation of their budget and monetary policy since World War II isn’t working.  Governments need to change direction.

Most governments in the developed world need to do a “turnaround.”  But, turnarounds are only successful when the organizational model is changed.  Often this change requires a new management team.

For the past fifty or so years, the governmental leadership in most countries in the developed world have assumed, basically, the same economic philosophy.  And, as in the American case, both political parties have assumed the same fundamental economic model. 

This economic model got us to where we are, and, as in the case of most turnaround situations, the old model must be re-placed before the turnaround can be achieved. 

The financial markets understand this!

The governments involved don’t seem to get it…yet!

We have several “case studies” going at this time.  These “case studies” are called Ireland; Greece: and Portugal. 

Of course, the initial response of these governments when financial markets began to become skeptical of their performance was…the market behavior was driven by speculators…it is not our fault.

The next response was the attempt to bail out these countries.  And, what does a bailout achieve?  A bailout “buys” time with the assumption that given time these governments will be able to get through this period of turmoil. 

Not once do we hear of the possibility that these governments might be operating with a philosophy of government that doesn’t work!

And, the financial markets don’t respond positively to these efforts.  The leaders of these governments shrug their shoulders, get a puzzled look on their faces, and ask why the financial markets continue to punish them and their people.

Portugal cuts a deal with the European Union and…”Portugal was forced to pay a higher interest rate to raise  1.12bn in short-term debt on Wednesday, shortly after announcing a  78bn bail-out agreement.” (http://www.ft.com/cms/s/0/1cb74060-7642-11e0-b4f7-00144feabdc0.html#axzz1LTb4L5XR)

The financial markets seem to be saying…”Nothing has changed!”

Portugal, you still are living off the same model.  You have not really altered anything!

And, this dance has been going on since the beginning of 2010.  Yet, no one seems to think that they need to do anything differently.

Is Spain next?

That, of course, is the question that everyone is asking.  And, some analysts are saying that Spain has gotten the message.

The question is…has Spain really gotten the message?

If not, then, who is next?

As I wrote yesterday and the day before…some things have changed.  The world is in a period of transition.  The next fifty years is going to be remarkably unlike the past fifty years. 

Assumptions are going to have to change.  Leaders are going to have to adopt new models and new philosophies.  And, as we are seeing, the transition is not going to be easy.

The ultimate question relates to the United States…when, along the chain of dominoes, is its turn?

A major problem of the transition will be the speed at which it can occur. 

When a company gets into serious problems, a turnaround specialist can be brought in to change the operating model of the company, enforce discipline, and execute the new plan.  The new leader has substantial authority to make these changes.   

The owners, the shareholders, give the turnaround specialist the authority to make the changes needed.  And, the changes are imposed, not on the owners, but on the employees of the company.  

In democratic governments, executing such a turnaround is not as feasible because the people that do the voting are the people that will bear the brunt of the changes.   It is hard for people to vote in favor of their own pain. 

So, the transition will not be over until it is over.  The future of the governments in the developed world will probably be very much like the last sixteen months have been.  Band aids in order to keep things afloat…but a failure to really get to the heart of the problem.  We will continue to try and “muddle through.”  

Sovereign Recovery Swaps? What Are They?

 Sovereign recovery swaps are “bets on how much money will be retrieved in a default.”  The first trades took place last year.  (See “Default risks spark interest in recovery swaps trading,” http://www.ft.com/cms/s/0/0ab272c8-702e-11e0-bea7-00144feabdc0.html#axzz1KivknddC.)

Why did sovereign recovery swaps arise?

They arose as “European policymakers have moved to curb trading of credit default swaps, the established way to hedge against the risk of a debt restructuring.” 

These new tools are gaining more publicity as the eurozone moves back into a crisis mode concerning the sovereign debt of their troubled constituents.  This is especially coming to the fore as Greece struggles over its failure to achieve fiscal targets set to combat earlier financial market unease. 

Greek debt reached euro-era high interest rates yesterday…as did the interest cost of Ireland and Portugal debt. 

Calls are increasing for a restructure of the debt of Greece.

So, financial market participants want a way to protect themselves against unfavorable movements in debt prices…given the wisdom of “policymakers” to curb trading in other instruments that might do the same thing.

With recovery swaps, an investor can bet on the level of “haircut” that might take place on any restructuring. 

A credit default swap might have a fixed recovery rate in the case of a restructuring.  If the recovery rate is lower than this fixed rate, the investor makes up the shortfall through the purchase of the recovery swap. 

Of course, there are risks associated with these tools: the “credit event” that triggers the contract must be due to a failure of the nation to meet obligations…it must be an “official” default.

The point I want to emphasize, however, is how quickly financial markets respond to fill a need when restrictions or potential restrictions are devised to restrict or constrain other means of achieving the same objective. 

Policymakers just don’t get it! 

In their efforts to fight “past wars”, policymakers invent new rules or regulations to combat behavior the policymakers deem to be inappropriate or unacceptable.  In doing so, these policymakers just chase the participants in financial markets to move elsewhere or to create new financial innovations.

Two points here:

First, in this electronic age, there is little that regulators can do to establish the “control” that they want because it is so easy for one form of “information” to be transformed into another form;

And, second, once financial innovation is in place, there is no going back to an earlier time.

Policymakers just don’t seem to understand these two points.

Furthermore, another fear that the policymakers have is that these financial innovations can be used for “speculation”. 

For example, when the government of Greece announced its latest budget results, the cost of borrowing immediately went up and the price of credit default swaps and sovereign recovery swaps rose.  Some government officials claimed that unconscionable speculators betting against the government caused these movements. 

This, of course, is the basic visceral response of leaders faced by market movements unfavorable to the direction they are leading their organization.  I don’t know how many chairman I have known or worked for that have claimed that ‘the market just doesn’t understand us” and “speculators are hitting us just when we are down.”

I was less worried the other day when Standard & Poor’s said that the outlook for the debt of the United States was negative than I was about the response of President Obama saying that the bond markets were being impacted by speculators.  Oh, my!

Policymakers must eventually deal with the problems they have created.  Many governments in Europe have been dealing with the problems they have created for many months now, yet have not faced their real issues head-on. 

Policymakers must eventually realize that they cannot resolve these problems by changing the rules and regulations or by trying to buy time with “quick-fix” bandages.  The eurozone has been attempting to “get around” the solution to the problems of its members with short-term “fixes” and have not dealt with the fundamentals of the situation.

Policymakers must eventually understand that in the modern world information spreads and that governments cannot respond to crisis by pointing the finger in another direction, blaming “speculators” or “terrorists” or some other agent that is questioning their leadership.  The governments of the eurozone must ultimately take responsibility for their actions and do something about it.

Keep your eye on markets and market innovations.  Don’t impose your own view on these market changes but dig as deeply as you need to in order to determine what the market is trying to tell you.  The markets may not always be right, but they do contain information we need to consider in making our own decisions.

The news today…there is going to have to be a debt restructuring within the eurozone.  Financial “band-aids”, government bailouts, and new rules and restrictions are not going to do the job.  Will it be Greece…or will it include Ireland?  Will it extend to Portugal…and then to Spain?  And, maybe others will be impacted as well?

The betting is getting hotter!

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.

Is This Europe's Month of Reckoning?

Interest rate spreads on European sovereign debt jumped to new levels yesterday. On 10-year bonds, Greek debt rose to 942 basis points over German bonds of the same maturity. Portugal rose to 436 basis points over the German yields and Spain jumped back up to over 200 basis points.

Is something on the horizon?

A lot it seems. See my earlier post, “Meanwhile Back In Europe” (http://seekingalpha.com/article/256255-meanwhile-back-in-europe-a-view-of-the-ecb-inflation-and-other-matters).

The new round of stress tests began on European banks last weekend. And,ever since they started the tests the bank regulators have had to defend themselves, to defend that the tests WERE NOT too soft!

Not a very good beginning to the upcoming events, is it?

How much confidence are we going to have in the results if the regulators are not even “out of the gate” and their methodology is being questioned? It’s just like the United States government saying it believes in a “strong dollar”.

Then again, how good can the tests be if the banks are changing how they do business right in front of the efforts of the regulators to re-regulate them? All sorts of things are going on, in Europe (http://www.ft.com/cms/s/0/da2622e4-4a8a-11e0-82ab-00144feab49a.html#axzz1GCsIX7ra and http://professional.wsj.com/article/SB10001424052748704629104576190732643514492.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj) as well as in the United States, and the regulators still seem to be creating an environment to avoid another 2008 crisis.

Oh, well, what else do regulators have to do to keep themselves busy?

And, the politicians still are on the lookout for “speculators”, those dastardly villains that create havoc for nations that don’t seem to have sufficient discipline to manage their fiscal affairs prudently. There are still a substantial number of member states in the European Union that want to ban the use of “uncovered” credit default swaps on sovereign debt. (See http://www.ft.com/cms/s/0/15e871a0-4aaf-11e0-82ab-00144feab49a.html#axzz1GCsIX7ra.)
This will stop the speculators!

Most of the distressed European nations that have experienced problems in the bond markets continue to deny responsibility for creating these sovereign debt problems. And, with unrest continuing or even increasing in these countries, governments face substantial internal pressure to place the blame for their problems “out there”, out where the shady “speculators” gather.

These “shady” speculators have taken the place of those “shadowy” international banks that inhabited the 1980s and caused sovereign nations, like France and Mitterrand for example, such incredible trouble.

Readers of my posts know what I feel about people who claim that their problems are “out there”!

One example of such unrest is that which is taking place in Greece. Adding to this is the fact that the unemployment rate in Greece recently hit a historic high.

In the face of all that is going on Portugal was able to issue new two-year debt on Wednesday, albeit at very expensive rates. Wednesday’s offering was for €1, which means that Portugal has raised almost €7 this year; approximately 35% of the year’s total funding need.

But, even this successful offering does not seem to ease the general concern in international financial markets that the overall political solutions to the problems being faced in the Eurozone are going to be resolved. In addition to the increased spreads in the bond markets, the Euro has fallen off in the last couple of days as the traders have worried that the leaders of the European Union will “pass” on reaching strong enough solutions to stem the lingering crisis.

There are still a lot of “unresolved” issues in the world and the existence of these issues points up the difficulties that people, states, and nations have created for themselves.

In my estimation it has taken Europe (and the United States) fifty years to get into the position it now finds itself. Europe (and the United States) has dug a big hole for itself. In many cases, people, states, and nations have not stopped digging the hole deeper!

In some cases, efforts have been made to stop the digging…and in one, possibly two, cases there have even been efforts to start filling the hole up.

No one seems to be really stepping up to really address the bigger problems…the leaders are nowhere in sight.

The international financial markets are indicating a lack of confidence in what is going on. The “stress” tests are too soft. Nations are still looking backwards to develop regulations. And, the leaders of the European Union are not going to come up with anything effective in their deliberations that begin again this Friday.

Kenneth Rogoff, who co-authored the book “This Time is Different," has recently stated that Greece and Ireland will need to restructure their debts. He also suggested that Spain and Portugal may be forced to do the same thing.

A debt restructure may be the only way to really make something happen. Historically, this is often the only way to get things changed when there is a total void of leadership!

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.