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.   

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!

The Health of the Banking Systems in Europe and the United States

What still bothers me is that governments in both the United States and Europe have not resolved their problems with the solvency of their banking systems.

The question remains about how long these problems are going to be carried along.

This morning we read, “Ireland’s Largest Banks Given Failing Grades.” It is assumed that the government is going to take over the banks and the price tag is going to be a minimum of about $35 billion. (http://professional.wsj.com/article/SB10001424052748703806304576234180828120692.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Following up on this there is the article about the bank problems in Spain, “Spain May Take Over CAM as Deal Talks Fail.” Here again we have the possibility of nationalizing another bank. Moody’s Investors Service estimates that the minimum needed to get the Spanish savings banks adequately capitalized at between €40 billion to €60 billion. (http://professional.wsj.com/article/SB10001424052748703806304576234912073054934.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

On a smaller scale, we have another fiscal crisis in Portugal as it became known that the government’s financial figures were incorrect and that budget matters are worse than was expected. This news came a few days after Portugal’s credit rating had been downgraded once again. This, and the concern that Portugal may not be able to meet bond repayments falling in April and June, has raised new issues about the solvency of the Portuguese banking system.

In addition, we are still awaiting the results of the recently administered “stress tests” of European banks. There is substantial concern about what these “tests” might show.

And, question marks still hang over the health of the smaller banks…that is smaller than the biggest 25 commercial banks…in the United States banking system. The number of commercial banks on the FDIC’s list of problem banks was just under 900 on December 31, 2010. In all of 2010, 157 commercial banks failed while mergers occurred for 197 other banking organizations, many of them not exactly healthy.

This means that almost 12 percent of the commercial banks of the United States are on the problem list of the FDIC. Some put the number of commercial banks that are facing severe operating difficulties at 40 percent of the banking system.

I have argued that a major reason for the quantitative easing on the part of the Federal Reserve is to provide sufficient liquidity for the “smaller”, “troubled” commercial banks so that the FDIC can close or arrange mergers for as many of these banks as possible in an orderly fashion.

The concern over the health of the commercial banks in American and Europe is real.

And, now we are seeing just how extensive the financial crisis was in both Europe and the United States in 2008/2009. These banking systems collapsed together. And, the banking systems have continued to fail to resolve their issues together.

The release of the Federal Reserve statistics on borrowings from the Fed’s discount window, “Fed Kept Taps Open for Banks in Crisis”, is amazing in many respects. Some of the biggest borrowers, it turns out were from Europe. The Fed certainly became the worldwide “lender of last resort.” And, the Fed added large amounts of “junk” in the process. (http://professional.wsj.com/article/SB10001424052748704530204576235213193119194.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

The problems arose from real estate lending and the problems that continue are related to real estate lending.

The question that remains concerns the depths of the problems that still exist in the European and United States banking systems.

People I know are still in shock over the sale of the Wilmington Trust Company in early November 2010, a bank that everyone thought was in pristine shape. (http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount)

This subject came up again in discussions I was a part of during the past weekend.

The concern? How many more situations like that of the Wilmington Trust Company are there “out there”?

This is the worry that we cannot seem to shake.

And, the debate always seems to come back to one thing: Why is the Federal Reserve acting in the way it is? Injecting $1.5 trillion of excess reserves into the banking system does not make a lot of sense…unless the banking system is less solvent than we are being told.

There is a lot of discomfort… in both Europe and the United States…when it comes to looking at the banking system. Unfortunately, we may never understand how bad off the banks have been until we get more and more information in bits and pieces as things work themselves out.

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.

How Long will the United States Dollar be a Safe Haven?

“The U. S. dollar is recapturing its role as the primary safe-haven currency, eclipsing the yen and the Swiss franc, as tensions in Korea and Europe escalate.

That re-emergence as the ultimate sanctuary for those fleeing risk will likely result in continued strength against major rivals in the next few weeks, analysts expect.

‘Recent events just reinforce the underlying message that during times of turmoil, almost no matter what the source, the U. S. dollar is seen as a safe harbor for investors,’ said Doug Porter, an economist at BMO Capital Markets in Toronto.” (http://professional.wsj.com/article/SB10001424052748704008704575639022158300444.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj)

The question is “how long will the U. S. dollar remain a safe haven?

Twice in the past three years, the United States dollar has served as a “safe haven” for the world. Once, following the financial collapse in the fall of 2008, the value of the United States dollar against the currencies of major currencies rose from a trough in March 2008 of 70.3 to a peak of 84.0 in March 2009.

The next trough came in November 2009 at 72.2, but the sovereign debt crisis in the Euro-Zone in early 2010 caused the value of the dollar to rise again as a “safe haven”, peaking at 79.0 in June of that year.

After June the dollar, once again, continued to decline, falling to 71.0 in the first full week of November 2010. As mentioned above, the value of the United States dollar is now climbing.

Most analysts, including myself, believe that the long term trend in the value of the dollar is down. The United States government is basically un-disciplined with little or no self-control. This is not a slam against the Democratic Party because I believe that the Republicans have acted in a similar way. Fiscal deficits have led to mountains of federal debt, and the example set by the federal government has been emulated by the public at large over the past fifty years building up more-and-more debt over time. The Federal Reserve has supported this credit inflation and has even underwritten a large portion of it…and promises to underwrite a whole lot more.

The consequence of this lack of discipline and self-control has been reflected in the decline in the value of the dollar over the past forty years, since President Nixon floated the dollar. The chart below just shows us what has happened over the past ten years where the primary culprit has been the Republican Party.

From the peak value reached in February 2002 the dollar reached a trough in March 2008, 37.3 percent below the earlier peak. The dollar became a “safe haven” in the fall of 2008 and moved from its March trough to a short-term peak in March 2009, rising by 19.4 percent. Once this move was over, the value of the dollar dropped once again, this time by 15.5 percent.

The point is, the long-term pressure on the value of the United States dollar is to decline. This can be observed very clearly in the accompanying chart.

Since the value of the dollar was floated and the current data series began, January 1973, the dollar has declined by about 34.4 percent. So, the general trend of the value of the dollar since it was set free has been downward. Over the longer haul, nothing has really changed much in the way of American economic policy.

The bottom line to all of this is that nothing has changed in the past fifty years as far as the fundamental philosophy behind the economic policy of the federal government. The long run prospect for the value of the dollar is down!

There will be upswings, flights to the “safe haven”, but the basic trend will be downwards.
But note, the 2008 recovery in value of the dollar went on for about one year before the decline set in again. Therecovery in value associated with the euro-zone sovereign debt crisis lasted only seven months before the movement down began once more. The short-term peak reached in 2010 was 6.0 below the previous peak in 2009.

How long will this move into the dollar “safe haven” last and how high will the value of the dollar reach?

My guess is that the value of the dollar will move upwards for several months. The peak will be somewhere in the neighborhood of the March 2009 peak and the June 2010 peak. But, the decline will begin once again.

And, the longer run? As the periphial countries in the euro-zone get their acts together and become stronger over time, attention will look for other countries that need to be chastized. After Greece, Ireland, Portugal, Spain, Italy, and possibly France…will the focus of the financial markets turn to the Unitred States…and not as a “safe haven”?

The European Situation and the Financial Markets

Are the financial markets the WikiLeaks of economics?

Politicians and economists and business people ignore what financial markets are saying at their peril.

The financial markets have not responded well to the “rescue” package for Ireland put together by the European Union. The news out of London: “The euro continued to slide Tuesday, falling to a 10-week low under $1.30 as Italian, Spanish, Portuguese and Irish bond-yield spreads all continued to widen relative to Germany.” (http://professional.wsj.com/article/SB10001424052748704679204575646211228101600.html?mod=WSJ_Currencies_LEFTTopNews&mg=reno-wsj)

“The euro had started the European day with a rally, helped by regular month-end flows in its favor. However, things turned sour again as it became apparent that the risks of contagion remained as strong as ever and that Italy is now being affected by the lack of investor confidence in the euro zone.

Like the debtor countries on the periphery, Italy watched the yield on its bonds rise relative to those of Germany as investors demanded greater returns for holding Italian debt.”

The Financial Times writes: “it is still hard to see how Ireland can repay all the debt it has now taken on. So it is unsurprising that the market sensed a fatal combination: governments lacked the means either to nix moral hazard or end the crisis by writing an enormous check.” (http://www.ft.com/cms/s/3/8540ea0a-fb9f-11df-b79a-00144feab49a.html#axzz16locxnQW)

The European banks still remain a problem. Not only do the banks have serious solvency issues facing them, the eurozone’s banking system is a much bigger proportion of the economy than the proportion found in other countries, especially the United States.

The financial markets are flashing a warning signal that the cost of insuring a bank default has risen severely in Europe and in Spain. Plus, given how large the banks are relative to the size of the economy, questions have arisen about the ability of these countries to continue to provide bailouts. The situation in the banking sector of Greece looks positively “great” relative to Ireland, France, Spain, and Portugal.

Yet people continue to ignore what the financial markets seem to be telling them. It is very easy to claim that the markets don’t really understand a situation or that the blame for a situation rests elsewhere. See, for example, the op-ed piece in the Financial Times, “Spain is threatened by a crisis made in Germany”: (http://www.ft.com/cms/s/0/bb515190-fbf2-11df-b7e9-00144feab49a.html#axzz16lsMDit2). Every time the author makes an argument that Spain stood up for Germany in earlier times, he only talks about individuals, not what was happening in the market place. He now makes the argument that Germany, out of short sightedness, is hurting Spain. There is nothing about markets or what markets are doing. It’s all personal, not business!

Spain has problems and the problems are of their own doing. Now they need to get their books in order. (See my post “Is the Euro Bad News for Spain,” http://seekingalpha.com/article/239065-is-the-euro-bad-news-for-spain.)

In the vast majority of cases I am familiar with, the people who ignore the information being generated by the financial markets end up losing. One needs to have an overwhelmingly strong case that the market is wrong before one places a bet. In fact, betting against the market is like setting up one-way bets for traders. (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.)

Furthermore, when talking about the banks, we still find a lot of people not really understanding the difference between a liquidity problem and a solvency problem. A liquidity problem is a short-run problem pertaining to “asymmetric information.” Something happens, a bankruptcy in the case of the Penn Central situation, and the “buy-side” of the market begins to question the situation of other high-grade customers that have issued commercial paper. In cases like this a central bank provides liquidity to the market so that the buyers will return as prices begin to stabilize. But, this is a short-run event.

A solvency problem is much longer-term and the state of the organizations, banks in this case, is known in the marketplace. And, that is a problem as far as raising funds is concerned. Firms in this situation cannot raise funds because no one wants to lend to them due to their extremely weak financial condition. But, this is not a liquidity crisis, it is a solvency crisis. People would lend to the organization if they were not financially challenged.

Yet, this is what we read in the New York Times with respect to the European financial crisis: “Ireland’s banking problems are only the latest example of how seemingly solvent institutions can be brought to the brink because they cannot in the short term raise the cash needed to finance themselves. Only four months ago, Allied Irish Banks and Bank of Ireland were given a clean bill of health in the European Union’s official stress tests. One weakness of these tests was that they stressed solvency, not liquidity, although that may be remedied next year.

The two biggest Irish banks did not have a large enough base of stable retail deposits. The loan-to-deposit ratios at Allied Irish and Bank of Ireland stand at just above 160 percent, which made them excessively dependent on wholesale money from other banks and big investors. When that dried up, they had to turn to the European Central Bank. When deposits from corporate customers also started to flee, emergency action was required.” (http://www.nytimes.com/2010/11/30/business/global/30views.html?ref=todayspaper&pagewanted=print)

Maybe, just maybe, the stress tests were not strong enough, as many have claimed. Certainly “the markets” did not think that the banks were healthy. This is even admitted in the article: the banks were “excessively dependent on wholesale money” and “when that dried up” real problems ensued.

Come on…wholesale money is very sensitive to the financial condition of the banks. The banks may have passed the stress tests but they failed the market test. Who is kidding who? You believe the stress tests? I’ve got a bridge to sell you!

This is why many politicians and certain economists don’t like the market system. Market performance often contradicts the world views held by these politicians and economists. And, that makes them angry!

One-Way Bets for Traders

Government interventions are taking place all over the world from the Federal Reserve’s quantitative easing program to the efforts to prevent debt write-downs in Europe to South Korea’s currency intervention.

Will governments ever learn?

Wise advice: “Today’s eager interventionists should take note. Far more than they realize, they are setting up one-way bets for traders.”

The reason: sooner or later, markets “revert to the mean”: markets ultimately adjust to their underlying economic value.

“Hedge funds know that South Korea’s won is being artificially held down by the government and is therefore more likely to rise than to depreciate, so they are hosing Seoul with capital and compounding the problem of hot inflows that Korea is desperate to alleviate.”

Both of these quotes come from “Currency Warriors Should Consider India” by Sebastian Mallaby in the Financial Times. (See http://www.ft.com/cms/s/0/0f26703c-f105-11df-bb17-00144feab49a.html#axzz15Rw49cE9)

In other words, international investors, like hedge funds, are pouncing on the opportunities governments set up for them.

The won situation is just the reverse side of the classic George Soros “bet” against the British Pound in 1992. The British government tried to keep the value of the pound above an agreed lower limit in agreement with the policies of the European Exchange Rate Mechanism. “Black Wednesday” refers to the events of September 16, 1992 when the value of the pound was allowed to drop toward its underlying economic value. Soros, who had been selling the pound short is reported to have made over one billion dollars on this effort of the government to intervene in the market. The government set up a “one-way bet” for traders.

But, this is happening all over. Karim Abdel-Motaal and Bart Turtelboom, portfolio managers at GLG Partners, write this morning: “…emerging markets are being flooded with freshly minted dollars. No matter how much sand is thrown in the wheel in the form of intervention, transaction taxes or capital controls, these capital inflows will get through.” (See http://www.ft.com/cms/s/0/81dd24ea-f0c9-11df-8cc5-00144feab49a.html#axzz15S17R06s)

Preparations to take advantage of these “one-way bets” are not limited to one part of the world. “Asia’s financial firms are on the prowl—for deals as well as for new investors. Even as they continue to strengthen their capital base through stock offerings, Asian banks, insurers and other financial firms are converting the floods of capital in the region into firepower for acquisitions.” (See http://professional.wsj.com/article/SB10001424052748703670004575616162768312620.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

Financial capital is being built up around the world to take advantage of the incentives that exist within the current environment. And, governments are creating some of the most attractive incentives going!

With these huge amounts of capital available, governments can only maintain their interventions for a limited amount of time. Eventually, the markets win!

In trying to overcome the market, the “one-way bets” are created that make certain traders enormously wealthy, as in the case of George Soros. That is, these governments are underwriting Wall Street and not Main Street, just what they say they don’t want to do!

This seems to be what is happening to the debt markets in Europe. Earlier this year the European Union pulled together to avoid a collapse of the debt markets and save the Euro. It has become apparent that these efforts just provided a temporary escape from the underlying economic realities alive in Europe.

Europe, once again, seems to be approaching the edge of the abyss. Now, participants in the financial markets are calling for a debt re-structuring in many nations and not just a financial “safety net” to help support existing debt levels. Investors seem to be insisting that Ireland, Portugal, Spain, Greece, Italy, and even, possibly France, write down their debt and begin anew.

The earlier efforts did not produce the result desired. The earlier efforts did not achieve the path to the real underlying economic realities that exist.

Speaking of debt, let’s shift to the debt situation in the United States. I was taught that the Federal Reserve could only really control short-term interest rates because they had short-term maturities. The Fed could impact longer-term interest rates but only for a limited amount of time because these investments provided cash flows for a longer period of time than the Fed could dominate the markets. Thus, longer-term interest rates could be held below real economic values for the short-run, but the “bets” of the financial markets would come to dominate over time and the longer-term interest rates would either rise back to the levels market conditions warranted or could even rise above levels the market was once happy with because inflationary expectations would overcome and offset the efforts of the central bank to hold down long-term interest rates.

In other words, in attempting to artificially keep long-term interest rates low, the Fed will be creating a “one-way bet” that market participants can take advantage of and make lots and lots of money.

This is a “reversion to the mean” argument and is the basis for “Value Investing.” Over the longer run, markets adjust to economic realities. The risk associated with this conclusion is connected to the length of time it takes for the market adjustment to take place. This is the problem that Long Term Capital Management ran into. The “reversion to the mean” did not occur soon enough.

Eventually, the long-run is achieved and many investors make a lot of money!

Large amounts of cash have been accumulated to take advantage of these “one-way bets.” If it is observed that governments have set up “one-way bets” and will set up even more “one-way bets” in the future, capital will rush to take advantage of the free gift of the governments. The more the government’s attempt to maintain this intervention, the more money there is to make.

The underlying question concerns how much the government is willing to pay to maintain its intervention. In the Soros case described above, it has been revealed that the British government expended £3.3 billion in its attempt to keep the value of the pound above the lower limits. These are 1992 values and not 2010 values.

Who knows how much governments in Europe and the United States have spent in order to try and maintain their interventionists policies. The basic guess is in the trillions.

And how much have investors made taking advantage of these interventions? The Fed has kept its Federal Funds target close to zero for two years. This policy has put trillions of dollars into the hands of the already wealthy. So much for a more equal distribution of wealth in the world!

Governments never seem to learn.

The "Next Greece" Again

The New York Times business section carries the headline, “Traders Turn Attention to the Next Greece”: http://www.nytimes.com/2010/03/04/business/global/04bets.html?ref=business.

“Is Spain the next Greece? Or Italy? Or Portugal?”

Sounds vaguely similar to another article on the topic, my post of March 1, “Where is the Next Greece?”: http://seekingalpha.com/article/191242-where-is-the-next-greece. But, the subject is in the air these days.

The New York Times article wades into the issue of whether or not the “banks and hedge funds” should be doing what they are doing.

“Indeed, some banks and hedge funds have already begun to turn their attention to other indebted nations, particularly Portugal, Spain, Italy and, to a lesser degree, Ireland.” Aha, the PIIGS, of course without the G.

“The role of such traders has become increasingly controversial in Europe and the United States. The Justice Department’s antitrust division is now examining whether at least four hedge funds colluded on a bet against the euro last month.”

The same concern has been expressed over short sales.

Little concern was expressed about the debt policy of nations, states, municipalities, businesses and consumers when they were piling on massive amounts of debt to their balance sheets.

Of course, nations, and others, have good reasons for loading up with debt. It stimulates the economy and everyone wants prosperity and full employment. Well, don’t they?

Everyone wants businesses to prosper. Everyone wants everyone else to own their own home.

All good reasons for piling on debt.

But, when do “good intentions” spill over into “foolish behavior”?

And, in an environment where excessive amounts of credit are being pumped into the economy (thank you again Federal Reserve)n to spur on housing or some other “good”, shouldn’t it be expected that “extra-legal” means will be used to “get the credit out”.

But, when does serving “societal goals” become fraudulent and hurtful?

The problem in both cases is that there is a very blurry line between the “good” and the “bad”. On the upside, of course, emphasis is placed on the “good” being done, and the “bad” is alluded to but quickly dismissed. A common theme in such periods is that “Things are different now!”

On the other side, however, great pain takes place. One can certainly sympathize with those who live in Ireland, and Spain, and these other countries.

This, however, is just where “moral hazard” raises its ugly head. There is a downside to the excessive behavior of nations, states, and so on! There is pain on the other side of the pinnacle.
And, eventually the pain must be paid for. Bailing out those that used excessive amounts of debt just postpones the situation and usually leads people to behave just the way they did before the crisis. That is, the lesson learned is the one can behave badly and, if there is the threat of sufficient societal pain, little or no cost will be carried forward because of the previous un-disciplined behavior.

The problem is that those in power get mad at the bankers and the hedge funds and try to prohibit them in some way from moving against those private or public organizations that are financially weak. But, in doing so they are taking away a tool that can be used to enforce discipline on those who have lived excessively. The same applies to short selling.

We have seen behavior like that exhibited by the “banks and hedge funds” in the past. The last time these predators were called “shadowy international bankers”, many of whom were pictured as living in Switzerland. In that time the “ bankers” attacked the currencies of profligate nations. France, under the leadership of François Mitterrand, is perhaps the best known example of such a situation. Mitterrand, the socialist, had to pull back from his grand plans and became a believer in fiscal discipline and an independent central bank. Similar cases are on record.

It is disconcerting to see the increased efforts to reduce or eliminate financial tools that help to bring discipline to the market place. If these investment vehicles get punished or face harsh controls and regulations then the world is so much the worse for it.

Yes, I agree, at this stage it looks like the strong are kicking the weak member of the party. But, in these cases we forget that many benefitted greatly on the upside, particularly the politicians that promoted goals and objectives that were underwritten by the undisciplined use of debt. And, the central banks were prodigal in underwriting this credit inflation.

And, now the piper is calling in the debt.

It is a rule of life: those in power that create a given situation are often the most vocal opponents of those that respond to the consequences of what the powerful have created. If you create an inflationary environment fueled by excessive credit expansion then, sooner or later, the price must be paid.
Greece, Spain, Italy, Ireland, Portugal, England, and others are now facing the downside of so many years of “good intentions.” Let’s not just blame, or punish, the “bankers and hedge funds” for creating the situation we now face