This Is the News That Sent Stocks Higher?

No Deal on Greece Bailout

Germany rejected calls for boosting the size of the planned euro-zone bailout fund, even as talks on restructuring Greek debt stalled over the weekend and raised the specter of a possible Greek default.

Stocks modestly lower in early evening trading.

Bill Hester: Five Risks to the Global Economy in 2012

As we're all a bit forecast weary by this point in the year, here's a list - not of prognostications - but rather of potential risks that may come into even greater focus this year. These risks – whether they intensify or pass – will likely play an important role in driving the performance of global stock markets in 2012.

1) The Persistence of Wide Spreads Among European Debt – Even if Bond Holders are ‘Rescued'

There are two components of the European credit crisis - debt levels and economic growth prospects. While the conversations to this point have leaned mostly toward reducing debt levels, economic growth prospects and the overall viability of a common currency will likely get a closer look this year, especially as Europe heads for recession.

During this two-year crisis investors have continually called on the ECB and euro area leaders to ‘fix' the debt issue: by wiping out half of Greece's debt, by protecting Italy's access to debt markets through bond purchases, or by suggesting a levered EFSF, the euro area's rescue vehicle.

But even if the ECB does bend to the will of the bond markets this year, and begins to buy sovereign debt directly, the single currency is left with all of the same weaknesses that existed prior to the crisis: the inability to tailor interest rate policy for each individual economy, the lack of foreign currency adjustment needed to offset differences in competitiveness, and growth-limiting trade dynamics throughout the area.

Martin Feldstein, a long-time euro skeptic, in this month's Foreign Affairs magazine made the point this way: “During the past year, Germany had a trade surplus of nearly $200 billion, whereas the other members of the eurozone had trade deficits totaling $200 billion. A more comprehensive measure that factors in net investment income reveals that Germany has a current account surplus of nearly five percent of GDP, whereas Greece has a current account deficit of nearly ten percent of GDP. Put another way, Germany can invest in the rest of the world an amount equal to five percent of its GDP, whereas Greece must borrow an amount equal to nearly ten percent of its GDP to pay for its current level of imports”.

One of the strongest benefits at the introduction of the common currency was that investors priced government debt similarly across the euro area. During this period investors thought of the euro area as a group of countries that would not only share a currency, but also share economic performance and long-term outcomes. Smaller countries and those of southern Europe experienced the greatest amount of benefit from converging yields. Yield on Greek debt fell by more than half in less than 10 years. Even stock market valuation ratios converged. The spread between the countries with the highest and lowest PE ratios dropped by more than half during the period.

While this period could have been used to improve some of the issues surrounding productivity, competitiveness, and trade dynamics among countries, what occurred instead was that governments took on larger amounts of liabilities, and as interest rates fell, housing bubbles formed. With that period passed, it's difficult to imagine that investors will soon return to the mindset that Portugal, Ireland, or even Italy, will soon again converge materially – in either economic performance or level of credit risk - with Germany.

I highlighted this risk and the graph below early in the European credit crisis ( The Great Divergence ). At that point the sovereign debt of Portugal was priced at 200 basis points above German bunds, compared with 1100 basis points today. Here is an updated graph.

There is a long history prior to the period of the shared currency where spreads among countries and with Germany were dramatically and persistently wider than even today. This was because expected economic growth rates, inflation expectations, and the real rates required by investors differed. Now that investors have been reminded of the structural weaknesses of a common currency – even outside of the discussion of high debt loads - persistently high spreads may be here to stay. Those spreads will surely play a role in the potential long-term growth rates of economies and euro area stock market valuations.

2) Sovereign Debt Rollover Risks

When the history of the European Credit Crisis is written, it'll likely be in two parts. The first part will cover the debt crisis of the smaller European countries – mainly the woes of Greece, Portugal, and Ireland. It will cover Greece's admission that its accounting didn't add up. And how Ireland's bad bank debt was turned into sovereign debt – which tripled its debt to GDP ratio in just three years. It will also cover the trajectory of peripheral sovereign bond yields in the face of investor uncertainty, where yields were first pushed above seven percent, and then eventually to much higher levels, forcing a rescue program.

The second part of the story will be about Italy and Spain, and potentially France, and how they were either pulled into the fiscal debt maelstrom or whether the ECB and euro area leaders were able to ring-fence them from the more troubled smaller euro countries. It will cover whether investors pushed these core countries from liquidity concerns to solvency concerns. While these chapters are still being written, the outcome may very well be available to historians (and investors) much sooner than many are expecting. One reason is because of the vast amount of sovereign and bank debt that is due to mature this year, all of which will needed to be rolled over because of existing budget deficits. The two countries that pose the greatest risks for rolling over this debt are Italy and Spain.

The chart below gives some sense of the relative importance of Italy – and to a slightly lesser degree Spain – in meeting its rollover demands this year versus the smaller euro area countries. The graph shows the cumulative amount of debt that will mature this year in the countries listed. (These totals count all government debt coming due – including shorter term notes – and are therefore larger than estimates of only long-term debt.) The graph shows the limited bond market needs (and therefore rescue funds needed) of Greece, Portugal, and Ireland, relative to those of Italy. Also, notice how steep the line is for Italy's maturing debt during the first four months of the year – when almost half of this year's total debt will mature.

It will be important to watch bond auction demand in Italy and Spain in the beginning of the year. The recent bid to cover ratio – a measure of the eagerness of bond investor to participate in an auction – for Italy's 10-year notes has mostly been in line with results from early last year. Of course, the level of yield will also matter. The chart below shows the weighted coupon of the existing debt outstanding for each country (in blue) versus the current yield (using the weighted maturity of existing debt) of its bonds (in red). For many years during the Euro's first decade, borrowing costs continued to fall versus the average cost of the existing debt of these countries. This trend has now changed for most of Europe, except Germany and France. This will likely continue to further widen economic divergences among countries.

This is one more benefit Germany is deriving from the crisis. In addition to a weaker euro, which helps fuel its export-oriented economy, the cost of financing its sovereign debt relative to its existing debt continues to fall while the smaller countries struggle with rising financing costs.

3) The Depth of Italy's Recession

It would be difficult to overemphasize the importance of Italy retaining access to the bond markets, and mitigating further losses in its sovereign bonds. According to the Bank for International Settlements, foreign claims on Italian debt total $936 Billion – that's larger than the combined foreign claims on the debt of Portugal, Ireland, and Greece. And core Europe is long a mountain of Italian debt. French banks, for example, hold 45 percent of Italy's liabilities. Much more is at stake than France losing its Triple-A rating if Italy moves from a liquidity concern to a solvency concern.

What eventually would force that shift is if investors come to believe that the country's ability to handle its debt load over the long term is compromised. Those concerns can be partly alleviated if Italian Prime Minister Mario Monti delivers a balanced budget by 2013, which he promised this week. Unfortunately, near-term economic risks could make these goals difficult to meet in practice.

This year economists expect the Italian economy to contract only slightly – by 0.3%. The graph below shows the year-over-year change in the OECD composite leading indicator for Italy (lagged by six months) versus the year-over-year change in Italian GDP. The change in the leading indicator is currently -9.8 percent. That's suggesting a much deeper contraction in the Italian economy than current forecasts. Following any decline of greater than 5 percent in the year-over-year change of the leading indicator has led to an average contraction in the Italian economy of about 3 percent six months later.

Even assuming austerity measures might ease some of the country's debt load, it would be difficult to offset this steep of a decline in output. Hold debt levels static, and that rate of economic decline would force Italy's debt to GDP ratio to rise to 122% from 118% – clearly the wrong direction if the hope is to ease long-term solvency concerns.

Investors in Italian stocks may have moved some distance toward pricing in a deeper recession than what is currently expected by economists. The FTSE MIB Index declined 40 percent peak to trough last year (the index fell 25 percent on a calendar basis). But a deeper decline in Italy's economy this year that pushed debt to GDP ratios materially higher would likely catch bond investors' attention, and then ultimately the attention of global stock investors.

4) The ECB, LTROs and European Bank Funding

Will the ECB's three-year long-term refinancing operations (LTRO) work as a stealth quantitative easing program? Will banks borrow long-term funds from the ECB and turn around and buy sovereign debt? That's the hope. But there are strong tides of data pushing back against this idea.

While there was much fanfare last month after the ECB loaned 523 banks 489 billion euros, the actual amount of new funds was a more modest number. This is because two earlier loan programs expired on the same day as the three-year LTRO was held, and banks probably rolled these funds into the three-year operation. The earlier operations included a 3-month loan of 141 billion euros offered in September, and a net 112 billion euros of overnight loans. The ECB also allowed banks to shift 45 billion euros from an October operation into the 3-year LTRO. Of the 489 billion Euros operation, that left about 191 billion euros of fresh loans. (See this link for ECB euro operation results.)

Will this smaller figure be used by banks to buy sovereign debt? Any purchases will probably not in be in large amounts. That's because, as Bloomberg Economist David Powell recently pointed out, the 191 billion euros of new loans are less than the value of bank debt scheduled to come due this quarter alone. And with the unsecured debt markets essentially closed to many of these banks, the ECB loans will be needed to fund existing assets.

Up to 700 billion euros of European bank debt comes due this year, with about 200 billion euros coming due the first quarter, according to Bloomberg data. The financing needs coming due in the first quarter “imply that euro area banks will not have extra money as a result of the three-year auction to purchase European sovereign bonds, using a carry-trade strategy, because the amount of fresh cash is less than the amount of bank debt that will mature during the quarter”, Powell wrote recently.

Meanwhile, the ECB's balance sheet continues to grow. At 2.7 trillion euros, it's now levered 33 times to its own capital, versus a leverage ratio of 25 back in September. For investors holding out hope that the ECB becomes more involved in the debt crisis, it's clear that the central bank is already deeply involved.

As the size of the ECB's balance sheet grows, the quality of its collateral is declining. Open Europe, a Brussels-based think tank, estimates that through government bond purchases and liquidity provisions to banks, the ECB's exposure to Greece, Portugal, Ireland, Italy, and Spain has reached 705 billion euros, up from 444 billion euros in early summer - a 50 percent increase in six months (their note was published prior to the December 21 three-year LTRO, which likely further boosted lower quality collateral). They also remarked, “the number of banks which are becoming reliant on the ECB is alarming and hopes that the functioning of the European financial markets will ever return to normal are diminishing – creating a long-term threat to Europe's economy.”

5) Widespread Global Slowdown

Risks exist outside of Europe, too. Leading indicators suggest that the risks of a synchronized global downturn are building. (See John Hussman's recent discussion on this topic: When "Positive Surprises" Are Surprisingly Meaningless . ) The year-over-year changes in the OECD's Composite Leading Indexes for the United States, the United Kingdom, Japan, and Europe have all turned negative to varying degrees. Of these, the OECD's index that tracks Europe's major economies is declining at the fastest pace (-6.5), with the 12-month change in the US index falling just below zero in the latest release of the data.

Now that negative leading indicator readings for these four major regions of the world are in place, stock market risks have climbed considerably. The graph below is one way to show the typical outcome when all of these leading indicators are negative. The red bars (right scale) represent drawdown – or the decline from each prior peak - in the MSCI World Index. The blue bars (left scale) are just a sum total of the number of regions where the year-over-year change in the OECD leading indicator is positive. The large blocks of blue areas reaching the top of the graph represent periods of widespread economic growth, such as the late-1980's and -1990's, when the leading indicators for all four regions were positive. The large blocks of white space represent those periods where economic contraction was widespread – such as in 1974, the early 1980's, in 2000, and in 2008. Importantly, the sum of positive leading indexes has dropped to zero once again.

Probably the best way to summarize this chart is that when the majority of developed economies have negative leading indicators on a year-over-year basis, investors should at least allow for large stock market declines. The declines beginning in 1974, 1990, 2000, and 2007 all began from periods when the leading indicators of all four regions had – or were about to - turn negative. The worst of those - 1974, 2000, and 2007 also began from very rich market valuations. The stock market collapse in 1987 is the only example of a large decline without at least some notification from the OECD's leading indicators of oncoming weakness. The 1980-1982 period, where global stocks fell more modestly, can be explained by the extremely low levels of valuation during that period, unlike today's higher levels.

The above global composite of OECD leading indicators also does a surprisingly good job of providing a coincident signal of US recession. Here are the dates where all four indicators first turned negative along with the actual month a US recession began in parenthesis: December 1973 (November 1973), February 1980 (January 1980), December 1990 (July 1990), December 2000 (March 2001), and November 2007 (December 2007). The indicator warned 5 months into the 1990 recession, and 3 months early in 2001, but within a month of each other recession (missing only the 1981 recession). This composite indicator turned negative with the October data.

Debt loads and economic growth vulnerability probably sum up this list of risks best. While these were topics investors focused on in 2011, this year will raise the stakes. Large quantities of debt will need to be rolled over and coincident indicators are likely to follow the currently downbeat leading ones. Both will need to be watched closely.

Mauldin: Europe and Sovereign Debt Economics; the Endgame Approaches -- Soon!

One of the interesting things about being in Hong Kong is that I get to see the weekend edition of the Financial Times 12 hours early. And the headlines were not all that pleasant. As I promised last week, we will cast our eyes to Europe and ponder what is in store for Europe for the year and the next five years. And what do we read on page 2? The "ECB raps revisions to draft a fiscal pact." Seems they feel there are too many loopholes, which will make the document meaningless … somewhat like the treaty they have now. And we further learn that "Greek default threat grows as talks falter." Seems there is a lack of agreement on how much of a haircut the investors ought to take, and the Greeks don't want to guarantee any future debt, just in case they need to default some more in the future. But they do want the €15 billion they need to keep the debt machine running for a few more months.
And on page 1, in big type, we are surprised (but not very) by the headline, "France and Austria face debt blow." Seems those sharp-eyed accountants over at S&P have decided to downgrade French debt from AAA. Which of course leads to another headline on page 2, suggesting "Firepower of bail-out fund cast into doubt." The currency markets were shocked – shocked I tell you – that S&P would do such a thing and promptly took back the euro rally and cast the euro down to recent cycle lows. Who knew, other than the entire free world not watching reality TV, that S&P was planning to do such a thing? And we read elsewhere that the European Commission is dismayed that S&P would do something so clearly not right, at least according to the way they keep their own books.
Even here in amazing Hong Kong, with the growth of China driving a wave of prosperity, eyes are fixed on Europe. How will they deal with the crisis? We read that US exports to Europe were down 7% last quarter, and Europe has not yet really entered into recession, which is almost guaranteed this year. And if US exports are down, then so are Asian and Latin American exports. Global growth appears to be threatened.

Solving the Mayan Code

There are so many pieces of data to go through in order to augur Europe's future – I want readers to know I have left no stone unturned! In fact, I went to some very old stones to get help with this week's letter. I began to scrutinize the Mayan Code from ancient Central America, which so many feel predicts the end of the world on December 21 of this year, bringing my fresh eyes to an old mystery.
After much deliberation, I have come to this astounding insight: The Mayan academics who created the code were not in fact astronomers or even astrologers. No, it is clear they were another breed of even more dubious forecasters, called economists. Once you approach the glyphs with that understanding, it becomes clear they are not predicting the end of the world, merely the end of Europe. One symbol clearly shows the Greek flag dipping to the ground. Another depicts the Italian flag with its wheels coming off. Oh, and you don't even want to know what they have prognosticated for the French. This is a family e-letter and I can't squeeze such language past the censors. But now that I have provided the basic insight, I leave it to you, fellow scholars, to decipher the rest of code.
And we will spend our time together here this week trying to discern what it means, in fact, for Europe to come to the place in its journey where it must make extremely difficult and often painful choices. As I wrote last week, as I started this voyage of discovery with you, the choices the various countries in the developed world are now making will put us on a path that does not allow us to turn back without severe consequences. (If you missed last week's letter, here it is.) We are left with debt that must be dealt with, with imbalances that must be balanced, and with deficits that must be brought under control. No matter what we choose, there will be pain for all of us. You cannot make debt go away without paying it back or defaulting, one way or the other, which means someone loses. And as we will see, paying it back can be very difficult, indeed, once it has grown this large.

To Solve the Crisis You Must Solve Three Problems

There are three main problems in Europe. The first is that most of the banks are massively insolvent, because they have 30 times their capital invested in the second problem, which is the sovereign debt of countries that are going to have trouble paying that debt. If the banks have to mark down the debt to what its real value is – or to what it will soon be – they will be bankrupt on a scale that makes 2008 look like a waltz in the park.
Countries simply cannot function in a manner that can be called normal without viable banking systems, which is why the authorities spend so much time worrying about them. If banks can't make loans, then businesses must cut back, which means fewer jobs, products, and services, which quickly becomes an ugly spiral. Losses in the private sector mount up. This obliges the treasury secretary to get on one knee and beg some elected official who has no understanding of how business and economics work to save the world as he knows it.
But if countries must step in and save their banks, then they have to assume some of the losses. (I am assuming that this time shareholders get completely wiped out, as do most bondholders. Taxpayers – read voters –are actually paying attention this time. They are in no mood to bail out bankers.) But most of the countries in Europe with the worst banks simply do not have the money to invest. They already have too much debt. Where do they get the capital? (More on that later.)
For most of the past two years, European leaders have tried to deal with the problems as though they were short-term liquidity problems: "If we just find the money to buy some more Greek bonds, then Greece can figure out how to solve its problems and then pay us back. Given enough time, the problem can get solved."
They have now arrived at the understanding that it this not a short-term problem. Rather, it's a solvency problem of the various governments, which of course creates a solvency problem for their banks. They are now addressing the problem of solvency and providing capital until such time as certain countries can get their budgets under control and the bond market sees fit to provide the capital they need.
But they are completely ignoring the third and largest problem, and that is massive trade imbalances. Germany exports products to the peripheral European countries, which run trade deficits. As I have shown in several letters, a country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. That is simple, unavoidable math, based on 400 years of accounting understanding. Ultimately, there must be a trade surplus if leverage and debt are to be reduced.
Greece runs a trade deficit of about 10% of GDP. Until they can stop that bleeding, they cannot get their government and private budgets under control. It is not simply a matter of cutting budgets or raising taxes. Indeed, their economy will continue to shrink, making it more difficult buy foreign goods without increasing their own production of goods and services. It is a vicious spiral. And that same spiral will spin up to take in all of Europe. Again, more on that later, as we consider what their choices are.
But for now, let's start with my contention that if you do not solve all three problems you do not solve the real problem. Greece cannot "stand on its own" without a change in its cost of production relative to Northern Europe. Neither can Portugal, et al., unless Germany either changes how it exports and consumes more, or Germany is willing to fund Greek (and Portuguese and Italian and…) debt, so those countries can continue to run large deficits.
Let's resort to something I have done in the past, and that is to create a simple model to help us understand the issues involved. As always, when we make simple assumptions we are ignoring the real complexities. I know things are vastly more complicated than the following simple analogies, but the underlying truths are basically the same.

Getting Simple About Europe

Let's assume a country that has a gross domestic product (GDP) of $1,000. In the beginning it taxes its citizens about 25% of GDP and spends the money for the public's benefit. But alas, it spends about 30% of GDP, so it must borrow the overage (about $50) from its citizens or from the citizens of other countries. Because the country starts out with relatively little debt, interest rates on this loan are low, because those who buy the debt can easily see that the the country can pay them back. If the debt of the country is only 5% of GDP ($50) and the interest rate is 4%, then the amount that must be paid as interest is only about $2 per year. Not a whole lot, about 0.2% of GDP.
But this goes on year after year. Sometimes the deficits get smaller and sometimes they get larger, depending on the economy; but government expenditures grow at the same rate as the country grows, and the debt keeps growing at an average of 5% of GDP per year. Now, if the country is growing at 3% a year, after 24 years the economy will have doubled to $2,000 GDP. That means the debt has grown (roughly) to a total of $1,800, which is now a debt-to-GDP ratio of 90%. Debt has grown faster than the country's economy. Note that if the country had held its budget down to where it grew slower than GDP, thus reducing its need for debt, that ratio would be lower, even if the debt had grown. You can indeed grow your way out of a debt problem if the growth of government spending is less than the growth of the economy.
But what if the size of government grows to about 50% of GDP, rather than 25% or 30%, over the 24 years, as politicians decide to spend more money and voters decide they want more benefits? (Think France.) Then the private sector must pay about 50% of its production to the state – plus, the debt is now growing unwieldly. The private sector has less to invest in new businesses and tools, and the growth of the economy slows.
And then along comes a very nasty recession. The revenues of the government fall as the economy shrinks. If the economy shrinks by 3% and total taxes are 50%, then tax revenue falls to $970. But the government does not cut back; and indeed, because it must pay unemployment benefits and welfare (because unemployment rises in a recession), its expenses actually rise by 5%! So it now needs $1,050 to pay all its budgeted expenses. And it must now borrow $80 to pay everyone it has promised to pay, in addition to the $100 it was already borrowing every year to cover its deficit, or a total of $180 a year, which is 9% of GDP.
(Yes, I know that debt must change as a percentage over time and nothing is stagnant, but work with me here.)
Now debt-to-GDP is rising by about 5% a year. Not a large number in the grand scheme of things, and everyone knows that the recession will soon be over and the deficits will come down. Sovereign governments never default on their debts – our government leaders assure us of that. They can always raise taxes or cut spending, can't they?
And things rock along just fine, and the bond market continues to buy the debt, until one day you look up and the debt is 120% of GDP. Then the bond market gets nervous and says that instead of 4% it wants 7%. Now the interest payments are over 8% of GDP and 16% of government spending, which means the government must either cut back on services or salaries or benefits, or raise taxes, or borrow more money. But cutting spending and raising taxes have consequences. They reduce GDP growth over the following 4-5 quarters as the economy adjusts.
What if that interest rate cost rose to 10%? Then the interest cost to the government would become 20% of its expenses and be rising faster than the country could grow, even in the best of times. And if they continued to borrow at 7% and the country did not grow, those interest expenses would rise at least 7% a year – as long as interest rates didn't go up.
And what if the other countries who had been buying the government's debt looked at the basic math and realized that, another step or two down the current path of government spending, there was no way they would be able to get their money back?

How Much Risk Do You Want in a Government Bond?

Now, government bond investors are a curious breed. They invest in government bonds because they actually think there is not supposed to be any risk. They want their money to be safe. If they wanted risk, there are lots of opportunities to invest with the potential for more reward.
The moment that government bond investors begin to think they might be at risk, they leave. And history suggests they tend to leave seemingly all at once. It is the Bang! moment. Someone fires the starting gun, and they all head for the exits. They start selling their bonds to speculators at discounts, which makes the effective interest rates in the market rise, sometimes by a lot. That means that if a country wants to borrow more money, it will have to pay the effective price in the market, or maybe as much as 15-20% IF – a big IF – it can even get someone to buy the bonds, which of course makes it even more difficult to pay their debt as interest costs rise.
Now, let's add a twist. The other countries that have bought those bonds are not actually countries, but banks in other countries. And because the regulators of those banks knew it was impossible – inconceivable – that a sovereign country might default, they allowed their banks to buy 30 times as much sovereign debt as they had capital in their banks. They did not have to reserve against any losses, so these were "free" profits for the banks. You pay 2% on deposits or short term commercial paper and buy bonds paying at 4%. You make a 2% spread, which you then do 30 times. Now you are making 60% profits on your capital and deposits. It is a very nice business – as long as everyone pays the interest. And because it is such a good business, you just roll over the debt every time the bond comes due, because you want more easy profits.
Let's say that banks bought up to 10% of their total government sovereign-debt holdings in our problem country. If the country gets into trouble and says, we will only pay 50% of our debt (we will discuss why below), then that means the banks lose 5% of their total assets. But they only have about 3% capital, because they were allowed to leverage. That means they are functionally bankrupt.
Without a functioning banking system, other countries now have to step in and take the losses (and perhaps wipe out the shareholders and owners of their banks). That would be bad for the other countries, as that much spare cash is not just lying around in government coffers. They are ALL borrowing money already and have their own deficits to worry about.
So everyone gets together and they tell the bankrupt country (because that is what it really is), we will lend you more money to keep you alive, but you must agree to balance your budget. And since that is the only way the problem country can get more money, they initially say, "Sure. We can do that. Just give us some money now so we can get it figured out and get everything under control."
In the world of government, living within your means is called austerity. And it's an uphill slog. Let's say your deficit started out at 15% of GDP (somewhat like Greece's). If you agree to cut that deficit by 4% a year for four years running, if everything stays the same, you could be back in balance. But the other counties would have to agree to lend you the difference between what you budgeted to spend and what you took in as tax revenues. Just to keep things going. Otherwise you'd have to default on your debt. If the countries simply have to guarantee the loans and not actually spend the money, it is a lot easier than having to find real money to save their banks, so they agree.
But the cuts you have to make are not as easy as everyone hoped. It seems that employees don't like having their pay cut, and unions don't want pensions cut, and retirees certainly expect the government to fulfill its promises; and don't even get started on cutting healthcare, which is a God-given right.
So you raise taxes and cut spending by about 4% the first year. But a funny thing happens. That reduces the private economy by about 4%, so the base on which taxes are collected is reduced, which means less revenue is raised, which means that the deficit is much worse than projected. And then the following year you have to make another 4% in cuts, plus the last shortfall, just to make your plan and get to the agreed-upon deficit, in order to get more loan money. It becomes a very vicious circle.
And let's look at the endgame. That debt-to-GDP ratio will rise to at least 150%, while the economy is actually shrinking. If interest rates settle to a mere 7% (hardly likely), it means the people of the country are going to have to pay over 10% of their total production to foreign banks each and every year for decades, never mind paying down the principle.
Let's throw in one more twist. The country has been buying about 10% of GDP more from other countries than it sells to them. That is because the relative wages in the problem country are about 30% higher than in the "good" countries. The good countries get the money from what they sell and have a nice surplus. The problem country soon runs through its savings, trying to buy the goods and service it wants; and the private sector, as well as the government, must cut back.
What happens is that you are locking in what feels like a depression initially, and then you have a slow- or no-growth economy for many years, as so much of your work goes just to pay back that debt to the banks of other countries.
Understand, your government has freely obligated itself to pay that debt. But it means that its citizens in effect become debt slaves for a generation or two to foreign banks. Not a very popular platform for a politician to run on for re-election.
Long-time readers know I think the neo-Keynesians do not have a proper view of the world. They live in a theoretical world divorced from what really happens. But in this respect they are deadly right. Austerity on the scale needed by many countries will only reduce potential GDP. The Keynesian prescription is to therefore run deficits and borrow money until you get growth again; but when you have already exhausted your ability to borrow money, it just doesn't work.
More debt makes if far more difficult to grow your way out of the problem. If you are already drunk, you can't get sober by drinking more whiskey. If Greece cuts its deficit by 15% of GDP, the reality is that GDP over time will be reduced by about 20%, and the debt will grow, both in real terms and as a percentage of GDP. A 20% decline in GDP is by any standard a depression and makes it even harder to grow, as so much of what you do make has to go to basic expenses and not productive capital. And if you have the burden of massive debt it becomes damn near impossible.
That is why individuals can file for personal bankruptcy. We no longer force people into slavery or debtor's prison to pay their debts, at least in most places.
So our problem country goes to its lenders and says, "We think you should share our pain. We are only going to pay you back 50% of what we owe you, and you must let us pay a 4% interest rate and pay you over a longer period. We think we can do that. Oh, and give us some more money in the meantime. And if you refuse, we won't pay you anything and you will all have a banking crisis. Thanks for everything."
The difficult is that if our problem country A gets to cut its debt by 50%, what about problem countries B, C, and D? Do they get the same deal? Why would voters in one country expect any less, if you agree to such terms for the first country?
So now let's return to the real world of Europe. Greece cannot pay its debt without a major depression. So its wants to pay only 50%, but it doesn't even want to guarantee that in any meaningful way; so bondholders scream, "We get nothing in return for agreeing to take a 50% haircut?!" Which is today's headline.
Greece cannot print its own money, so unless it leaves the Eurozone, it's stuck. They can default on their debt, but that means they are shut out of the bond market for some period of time. That would force them to make the spending cuts they are now resisting, as they would simply not have enough money to pay their bills. Even with a 100% haircut they're looking at a shorter but very real depression. And because no one will sell them products they need, like energy and food and medicine, unless they can sell or trade something in return (that trade-deficit problem), they will be forced to change their lifestyles. Wages must drop or productivity rise to be competitive with northern Europe. And that differential is about 30%. I am not certain, as I have not been to Greece in a long time, but my bet is, you won't find many Greeks who think they are overpaid by 30%.
But that is what the market is going to say. And that is the third problem, which Europe is not addressing. Germany and the northern tier are simply more productive than the Southern periphery. (With the possible exception of Northern Italy, but Italy all gets lumped together, which is why many Northern Italians want to be their own country and not have to pay taxes that go to Southern Italy. I am not taking sides, just observing what we read in the papers.) Until Germany consumes more from the peripheral countries or the peripheral countries become more productive, the imbalance will not allow a positive solution.
Prior to the euro, the imbalances would be handled by currency exchange rates. The value of the drachma would go down relative to the value of the deutschmark. Things would balance over time. Now, all of the eurozone countries are effectively on a gold standard, with the euro standing in for gold this time. Britain, the US, and Japan print their own currencies. Their currencies can rise or fall over long periods of time, based on national accounts and the desires of foreigners to buy goods or invest in their countries.
Greece and the other peripheral countries face a difficult choice. Do we stay in the euro and pay as much as we can, and watch our economy drop; pay nothing and watch our economy drop (as we get shut out of the bond market); or leave the euro and go back to our own currency and watch our economy drop?
They have no choices that allow them to grow and prosper without first suffering (for perhaps a long time) some very real economic pain. As I have written in previous letters, leaving the eurozone has severe consequences; but the economic pain of leaving would go away sooner and allow for quicker adjustments, than if they stayed. However, the initial pain would be worse than the slow pain they'd suffer by staying in the euro. Their choice is, simply, which pain do they want – or maybe, which pain do they think they want? Because whatever they choose, they are not going to like it.
And just as I was finishing this section, this note came from Naked Capitalism:
"The three Troika inspectors—Poul Thomsen from the IMF, Mathias Morse from the EU, and Klaus Mazouch from the ECB—are supposed to head to Greece next week to inspect its books; the budget deficit is once again higher than the revised limit that Greece had vowed to abide by. And they're supposed to negotiate additional 'structural reforms.' But there probably won't be three inspectors, according to senior IMF sources. Missing: Poul Thomsen. The IMF has had enough.
"Already, according to more leaks, IMF Managing Director Christine Lagarde had warned German Chancellor Angela Merkel and French President Nicolas Sarkozy that the fiscal and economic situation in Greece had deteriorated. Hence, the 'voluntary' haircut on Greek bonds held by private sector investors should be increased to more than 50% to maintain the goal of bringing Greece's debt load down to 120% of GDP. And the second €130 billion bailout package, agreed upon on October 26, should be enlarged by 'tens of billions of euros.'
"The German reaction was immediate. 'There has to be a line somewhere,' said Michael Fuchs, deputy leader of Merkel's party, the CDU. 'This cannot be a bottomless barrel.' Even if Merkel were amenable to committing more taxpayer money to bail out Greece, she'd face a wall of opposition in her own party. And he wasn't brimming with optimism: 'I don't think that Greece, in its current condition, can be saved,' he said."
The article goes on with a description of the chaos in Greece. It is worse than I have described. Really. And so terribly sad.

Do You Have a Spare €1.5 Trillion?

Before I hit the send button this week, let's look at a few charts that can help us judge the current scope of the problem. These are from the very astute Bill Hester of the Hussman Funds. He wrote a very solid piece entitled "Five Global Risks to Monitor," at http://hussmanfunds.com/rsi/fiveglobalrisks2012.htm. It is very good, if sobering, reading.
This first chart shows how much bank debt is maturing in Europe over time. You have to add in how much new debt must be sold, as they will need to raise capital to balance the sovereign debt losses. Do you have a spare €1.5 trillion? Yes, some of that is rollover debt, but banks are trying to reduce their exposure to each other and may not want to roll over that debt, unless they can turn around and get capital from the European Central Bank to buy it, which is a back door to debt monetization.

The next chart shows how much debt must be rolled over by governments in the coming year. Notice how much Italy must raise in the first three months!

And one last chart from Hester. This is the rise in the cost of new debt as older, cheaper debt comes due. My simple example is not at all extreme.

Next week we will look further into Europe. As a preview, I do think this is the year they will be forced to the very hard decisions. We will examine what a fiscal union would look like and how likely it is to happen, and what the prospects are for a break-up of the eurozone, and compare several scenarios for what Europe may look like in five years.

It's a Downgrade Parade

But Wall St is still in denial. Downgrade disaster, but Wall St ignores it and buys the market right back up in anticipation of more Fed money-printing.

Europe Could Go From Bad in 2011 to Even Worse in 2012

by Charles Forelle at WSJ:

Bouts of panic. Moments of elation. Vertiginous plunges. Markets lurching on the scantiest fragment of news from a Parliamentary committee in a minor-league country.
That was investing in Europe in 2011. Be prepared in 2012 for at least more of the same.
The rocky road was thanks to weakening economic performance across the continent and, most of all, to the euro-zone debt crisis.
The economic story is almost certain to be worse. Europe saw modest growth in the first quarter of 2011, and then the slowdown began. Most economists now project recession in 2012.
As for the debt crisis, it is far from over. At the end of 2011, European leaders all but gave up their bid to build a giant bailout fund—they just don't have enough cash—and instead scrambled to assemble the underpinnings of a tighter fiscal union, in the hope of giving a reluctant European Central Bank confidence to step in and offer support for government-bond markets.
But Europe has only touched its toe on the fiscal-union path, the faraway end of which is common debt issuance for the 17-nation bloc. A lot could go wrong before it gets there.
The peril starts in January, when euro-zone governments plan to issue a wall of debt. "It's going to be hard to take it all down," says Nick Firoozye, senior European rates strategist at Nomura Holdings Inc. in London.
Then come the fraught negotiations over Greece's debt restructuring. Euro-zone leaders and big creditors agreed in October that bondholders would take a 50% haircut, but the mechanics of the complex restructuring aren't finished. Greece may try to push for a better deal. "It's in Greece's interest not to reach an agreement," Mr. Firoozye says.
But there is pressure to complete a deal before mid-March, when Greece is scheduled to repay a €14.4 billion ($18.7 billion) bond. Any hiccups could unnerve markets.
Across asset classes, investors should expect volatility and uncertainty. Here's a guide:

Bonds

European government bonds have been the asset class most affected by the crisis so far. It has been "an environment punctuated by bit of optimism and bits of pessimism," says Nicholas Gartside, international chief investment officer for fixed income at J.P. Morgan Chase & Co.'s asset-management arm. "You've had both extremes, and our view is you are likely to see those extremes continue into the next year."

Reuters

After a year of stops and starts in trying to resolve the debt crisis, France's Nicolas Sarkozy and Germany's Angela Merkel, shown at a June meeting, face another year of without resolution.

The extremes in 2011 were dizzying. Like U.S. Treasurys, German government bonds rallied strongly as a safe-haven bet. But Italian yields spiraled into junk-bond territory.
Performance of "peripheral" euro-zone bonds—a category that probably now includes Italy, the third-largest economy in the bloc—is likely to be hugely volatile. The yields are enticing, but the investment isn't for the faint of heart.
The giant risk is a sudden stop in financing to Italy. The ECB has tried to prevent that with a modest program of bond buying and big injections of liquidity into the banking system. But many analysts are skeptical that banks will take that cash and finance Italy. Regulators are pressuring them to reduce their exposure to the wobbly periphery, not increase it.
At the same time, Mr. Gartside says the outlook remains bright for Germany. There is little visible threat from bond investors' two chief villains—inflation and higher interest rates—and Germany should continue to be a haven.

The Euro

One of the head-scratchers of the debt crisis so far has been how well the euro has held up amid all the frantic fretting about the dissolution of the currency zone. The euro started 2011 at $1.34 and ended it at $1.30 (with rounding). Yes, there have been ups and downs in between, but the common currency never broke $1.50 and only barely sank below $1.30.

There are a few explanations. First, the fear of a schism in the euro zone is probably overblown. Second, currency rates are influenced by banal factors such as interest-rate differentials, crisis or no crisis. And even after a round of rate-cutting, the European Central Bank has a higher target rate than the Federal Reserve.
There are more-subtle factors. Stephen L. Jen, managing partner of London hedge fund SLJ Macro Partners and a currency watcher, says European banks and corporations have been repatriating overseas assets—helping to offset flight out of the euro zone. And much movement has been "south-to-north" migration, he says—investors pulling out of Greece, but piling into Germany and the Netherlands. That is neutral for the currency.
What to expect in 2012? A crucial dynamic will be the recession everyone expects is coming. If it is nasty, the ECB may cut rates and, some analysts believe, even hold its nose and adopt a quantitative-easing policy where it buys bonds to provide monetary stimulus to the economy. That would erode the interest-rate advantage the euro has over the dollar and implies a weaker euro.
Of course, the ECB isn't the only one with these concerns: If the U.S. Federal Reserve embarks on a third round of quantitative easing, or QE3, the pressures are potentially reversed.
And there is always the threat of policy stumbles by European leaders jolting the markets.
All in all, "trading euro-dollar will require a lot of care," Mr. Jen says.

Stocks

European equity investors probably wish 2011 were just a bad dream. The U.K.'s FTSE 100 was off 5.6%, Germany's DAX fell 15% and France's CAC-40 lost 17%.
Can investors hope to wake up in 2012? Maybe.
Domestic economic performance will likely be bad, but the big companies in Europe's major indexes are world-wide players, and they can benefit from a brighter picture in Asia and even the U.S.
"The rest of the world is in a much better place," says Nick Nelson, UBS AG's European equities strategist. "It's a European recession, not a global recession."
A somewhat weaker euro, he expects, will also aid the region's exporters.
The downside? The debt crisis has been an albatross for equities. Mr. Nelson notes that the price-to-earningsmultiple investors have been willing to pay for European stocks correlates inversely with an index of European sovereign credit-default swaps—a measure of the risk of government debt default. In other words, when the debt crisis rears up, investors are less likely to take a gamble on stocks.
That was on full display in August, when Italy tumbled into the maw of the crisis. The Milan exchange was pummeled, but so too were bourses in Paris and Frankfurt and London. The DAX had three days in August on which it fell by more than 5%; before August, the last such single day was in March 2009.
Mr. Nelson predicts a small rise in European indexes in 2012—but it is an outlook dimmed by uncertainty. "Volatility," he says, "is massive."

And Thus the Year Ends

Gaping Hole In Europe's Deficit Expectations

The Eurozone's Constitution requires countries to keep their deficits below 3% of GDP. Nearly all of them have deficits higher than this amount. Spain's is more than 2 1/2 times that amount!

The Challenges for LTRO to Be Effective

From Peter Tchir of TF Market Advisors
Carry, LTRO, Data, and VIX
Once again we seem to have a discrepancy between what “credit” people think and what “equity” and “FX” people think.  The broad market rallied strongly today, at least in part because of the LTRO.
On one thing, everyone agrees, the take up rate will be high.  There will be strong demand for the LTRO.  What differs is the impact that will have on the market.
At one end is a belief that banks will be borrowing this money so they can purchase new assets.  The allure of carry will be too much to pass up, and with government encouragement, they will rush to purchase new sovereign debt and maybe even lend more.  That will turn the tide in the European debt crisis since there will be buyers for every new issue, and the market can move on to “strong” economic data in the US.
The other end of the spectrum is that the banks will use this facility to plug up existing holes in their borrowing.  They won’t have to rely on the wholesale market or repo market as much as they can tap this facility.  It will take some pressure off of the “money market” as banks won’t be scrambling for as much money every day, or over year end, but it won’t lead to new asset purchases by the banks.  Banks need to deleverage and that hasn’t changed.  The bonds can have a 0% risk weighting, but that doesn’t mean anyone, including the banks, believe it.  The road to hell is paved with carry.  That is an old adage and likely applies here. 
High Yield did well today (with HY17 outperforming HYG and JNK).  Investment Grade did okay as well (LQD tightened on a spread basis, though it shows up as a loss for most retail investors).  IG17 also was tighter as no one wanted to be hedged.  Away from that, more exotic trades, like curve trades didn’t show a similar strength.  These are the sorts of trades that would do well if everyone was looking for carry and thought the problems were solved.  Little things like that further underscore how likely it is that banks will participate.
Most banks are overexposed to these risks in the minds of investors anyways.  Will buying more of something that is risky really help?  Will loading up on a single position to the point that it can wipe you out be deemed as prudent?  I think banks that have managed themselves well to this point will be very reluctant to add significantly to their exposure.  You may get some token purchases so they can tell their regulators that they are playing nice, but beyond that, they will wait and see if the situation is really fixed.
The reason banks are not buying more of these bonds has little to do with funding costs being too high.  Risk and leverage are too high.  That hasn’t changed here, and most credit people believe that this new funding will encourage new asset purchases.  Without that, it helps the banks by reducing some uncertainty on their existing debt rollover needs (let’s not forget the hundreds of billions of bank issued debt that needs to be rolled this year), but doesn’t encourage asset purchases or balance sheet expansion.
Earlier today I had a bullish tone and did see 1300 and 1100 as being equally possible.  With a 40 point move from overnight lows it seems like a lot, especially since to the extent I was right, it was for all the wrong reasons.  I continue to believe that there may be an agenda behind the truth that is emanating out of Europe recently, but this LTRO plan doesn’t do it for me.  With our models showing seasonality being strongest from close of business tomorrow until the 27th, it is hard to be short, but without real news, we will be fading this.
On the data front, I am a bit confused why housing starts going up is a good thing.  The only industry that may be worse at predicting future demand than the airline industry, is the homebuilder industry.  They build homes, it’s what they do.  Carefully managing inventory to demand is not their strong suit.  A story about great demand and shortages of homes for sale would be much bigger news and may warrant a rally, I put this in a neutral category, at best.
On the earnings front, it seems like as many companies are missing as beating.  Oracle missed after the bell and is being punished.  It is far from clear to me that the earnings story is that compelling, and the strength in the dollar is the last thing the nascent surge in manufacturing needs.
We have a political system that couldn’t agree that the sun comes up in the morning without holding special sessions.  Their ability to provide any help to the economy is zilch and no matter how many times people say it, there is no strong evidence that “gridlock” and “a government that does nothing” is actually a good thing for stocks over the short term (even though it may be by far the best thing for the economy in the long run).
VIX is back to levels last seen in August.  The fact that those levels preceded a sell-off is largely being ignored on a day the DOW moved up 337 points, but as far as I can tell, VIX is as much a “risk on” / “risk off” asset as anything else and has limited predictive value (as in none).  Somewhere out there, the quants are analyzing the skew of longer dated options as a better tool that may retain predictive value, but that is complex, and requires effort, but is probably the work that is required to make some sense of what the “vol” market is telling us.  It is definitely the sort of work that serious tail risk hedge funds and quant funds are looking at and analyzing. 
Here is the “vol skew” graph function on the SPX on Bloomberg.  As far as I can tell you would need to be either a rocket scientist or a Deadhead to understand it.  I am neither, but am convinced that to the extent the vol market contains useful information, it is far more complex to figure out, than pulling up a VIX closing level. 

Europe's Sovereign Debt Crisis "Is Here to Stay"

by Felix Salmon at Reuters:

“By this time next week,” says Simone Foxman, “the euro crisis could be over”; she obviously doesn’t think much of Fitch’s analysis, which concludes that “a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach”.
I’m with Fitch on this one. But it’s worth looking at the bull case for the eurozone, as spelled out by the likes of Foxman and Tyler Cowen. At heart, it’s pretty simple:

1. The way to solve the euro crisis, at least for the next couple of years, is for the ECB to act as a lender of last resort.
2. The ECB is, quietly, doing just that — specifically by lending money for as long as three years against a much wider range of collateral than it accepted in the past.
3. Even though that money is going to banks rather than sovereigns, the banks will borrow as much as they can, at interest rates of about 1%, and invest the proceeds in Spanish and Italian debt yielding more like 6%, in a massive carry trade.
4. Which means that the ECB is, effectively, printing hundreds of billions of euros and lending it to distressed European sovereigns after all.

This, at least, is how Nicolas Sarkozy has been spinning things:

“Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6-7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.”

But look at the headline of the article that quote appears in: “EU banks slash sovereign holdings”. Here’s a taster:

Europe’s banks have slashed their holdings of sovereign debt issued by the peripheral nations of the eurozone, selling €65bn of it in just nine months…
BNP Paribas cut its holdings by the most, shedding nearly €7bn of the sovereign debt of Greece, Italy, Ireland, Portugal and Spain and leaving it with €28.7bn as at end-September. Deutsche Bank’s €6bn reduction was by far the biggest in percentage terms (66 per cent) and left the bank with just €3.2bn of GIIPS exposure.

My feeling is that, at the margin, banks are going to continue to reduce their holdings of PIIGS debt, rather than decide to follow in the footsteps of MF Global. But don’t take my word for it:

Senior bankers say they will cut further, despite pressure to use newly available, longer-term ECB loans to buy government debt as part of an officially-sanctioned carry trade.
“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”
That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.

Cowen says that “public choice mechanisms will operate so that desperate governments commandeer their banks to make this move, whether the banks ideally would wish to or not” — and normally I’d be inclined to agree with him. Sovereign borrowing always crowds out other forms of bank lending, when a national government decides it really needs the money.
But in this case, it’s not going to happen. Why? For one thing, the main tool that governments can use has already been deployed: if banks load up on sovereign debt, it carries a lower risk weighting under Basel rules and therefore makes their risk-adjusted capital ratios look more attractive. But that’s been the case for decades now, and it can’t be beefed up at all. Meanwhile, bank regulators and investors are looking at a lot of other ratios too, like total leverage. And as we saw with MF Global, they’re hyper-aware of European sovereign exposures these days. Any bank wanting to be considered healthy will stay well away from Spanish and Italian debt.
On top of that, the financing needs of Spain and Italy are much bigger than their respective national banks can fill — especially in the context of those banks trying to deleverage, and seeing their deposit bases move steadily to safer European countries. While national governments are reasonably good at twisting the arms of their own domestic banks and forcing those banks to lend to their sovereigns, they’re much less good at twisting the arms of foreign banks and getting them to do the same thing. Is there any way at all for the Italian government to persuade French banks to lend to it? No.
And more generally, the national debt of big European sovereigns like Italy and Spain is so enormous that it has to be held broadly, in bonded form, by individuals and institutions. Banks alone won’t suffice. Greece is small enough that most of its debt can be held by banks. Italy, not so much.
There’s an argument that it doesn’t really matter whether the banks buy Italian and Spanish debt or not: the main thing that matters is that the ECB is printing money, which is entering the system via the banking system, and which will ultimately find its way into sovereign coffers one way or another, especially since there’s precious little demand for commercial bank loans these days. But I don’t buy it: there’s a virtually infinite number of potential investment opportunities around the world, and there’s no good reason to believe that the ECB’s cash is going to wind up funding Italy’s deficit rather than, say, getting invested in Facebook stock.
If Europe’s banks use ECB cash to deleverage and buy back their own high-yielding debt securities, the investors getting that money are not going to automatically buy sovereign bonds with the proceeds. Especially since those investors don’t care at all about Basel risk weightings.
So much as I’d love Sarko’s dream to come true, I don’t think it’s going to happen. The eurozone’s sovereign crisis is here to stay.

A Risk Assessment on ECB's LTRO

Posted by Lisa Pollack on Dec 19 17:10.
The FT has already reported on how hesitant banks are about buying ever more sovereign debt. In fact they outright dumped  €65bn of bonds in just nine months. Hopes that banks would hold the hand of the sovereigns that back them continue to dim, as the Sarko carry-trade looks increasingly less likely in advance of this Wednesday’s offer of cheap 3-year ECB financing.
The presumption that banks are going to use the 3-year Long Term Refinancing Operation (LTRO) to buy sovereign bonds comes not just from the dreams of certain politicians, but also from the observation that yields at the short end of peripheral curves have come in dramatically.
Spanish bonds provide an example (chart courtesy of SocGen):

From the above, European financials have deteriorated over the last week while the yields on Spain’s government bonds have been coming in. Is this the result of banks buying up the high yielding bonds that they will soon be able to fund exceptionally cheaply?
Not so much, say the analysts at SocGen in their Rates Strategy daily this Monday. There are many factors at play, and true, one of them may be the anticipation of banks putting on carry trades, but the expectations may not transform into reality.
For one thing, banks are going to have to find a way to fund their existing asset holdings — to the extent that they don’t deleverage themselves into nothingness, that is — and a good portion of the current funding for them will roll off in 2012. SocGen points out that for eurozone banks in 2012, €250bn of senior unsecured bank bonds will mature, along with €83bn of government guaranteed debt, plus €19bn of subordinated debt.
Seeing as the unsecured market is somewhere between frozen and inaccessibly expensive, the most relevant candidate for the replacement of that debt is reckoned to be around €185bn of covered bond issuance, a figure which the analysts acknowledge may well be a bit on the high side (though at least it will be supported by another ECB programme to specifically prop up that market).
The rest of the funding needs to come from somewhere. And, well, the ECB is offering…
True, the ECB ties up collateral as equally as covered bonds do, but there is an extra attraction to the LTRO: the banks that take the 3-year funding will in fact have the option to repay any part of it after just a year, hence freeing up the collateral held against the borrowing at the ECB. Nice option… that isn’t too consistent with the whole “carry trade” concept where the maturity of the asset is matched to the term of the funding for it, the rates team at SocGen points out.
Oh, and the collateral posted to the ECB can be relatively low quality. Not like the stuff required for private markets, or for covered bond pools.
One thing that actually joins the LTRO on the supply-side for liquidity, according to SocGen, is the lower reserve requirements that will kick in for the maintenance period starting on January 18th. Falling from two per cent to one per cent will free up some €100bn that was on deposit with the ECB — something that will happen in advance of the second 3-year LTRO at the end of February. However, the SocGen analysts expect that this move will more likely lead to a decrease in weekly main-refinancing operations (MROs), than a decrease in LTRO demand. One to be aware of, anyhow.
But back to how unlikely carry trades are:

There are several obstacles to carry operations, namely the stricter capital requirements, the pressure on banks to deleverage; and the stigma attached to such trades if ever revealed.

Put even more simply, do you think a bank that shows an increase in sovereign bond holdings in their quarterly reports will find it easier or harder to fund itself in private markets?
And what if there is yet another EBA stress test that whacks sovereign holdings and then demands additional capital for potential losses? How clever will a sovereign carry-trading bank look then?
In addition to that, if the bonds were to reverse course and start tanking again, the banks would have to post additional margin on them.
All of that said, could the banks make a dent if they wanted to? Out of some sense of patriotism perhaps? Emphasis ours:

Euro area banks have some 6% of total assets in government bonds (with ratios slightly higher at 7% to 9% in Spain and Italy as per the most recent EBA data). If half of all Spanish and Italian banks (it is unlikely to be the larger names) were to raise the ratio by 1% next year, that would lead them to buy some €8bn-€10bn in each country. Most likely the impact would be far less, and graduated over time. Buying though on such a scale is modest as a percentage of total issuance (some 9% in Spain, 4% in Italy).

That’s a “no” with words. Here’s the same with a graph, courtesy of Deutsche Bank with a couple of FT Alphaville modifications:

In the end, SocGen predicts a demand for €200bn on Wednesday.
RBC is in a similar ballpark, but warns that there’s a risk that the uptake could be lower than expected. There are currently already €350bn in excess reserves parked at the ECB which is much higher than they were prior to previous LTROs:

Furthermore, banks can fund the €432bn of tenders that mature this week with the weekly MRO and 3-month LTRO, so they don’t necessarily need to go to the 3-year tender just to keep things constant.
In addition to this, the RBC team notes that the exact details on the expanded range of eligible collateral hasn’t actually been decided yet, so it may not be clear to banks whether they have newly-eligible assets lying around that they may otherwise be willing to post.
In conclusion (emphasis ours):

A not too small outcome should suggest that banks use the new facility and get longer dated funding on board. This should sooth some anxiety about their funding risks going into 2012. A not too large outcome should also suggest that no unreasonable risks have been taken.

It’s the goldilocks of refinancing operations.

Pushing on a String: ECB's LTRO Doesn't Help Private Markets

The markets have been anticipating the onset of QE3 by the Federal Reserve. Indeed, Deutsche Bank believes that the market has already discounted $800 billion in QE3 purchases, which is anticipated to be concentrated in Mortgage Backed Securities (MBS).
Recall how the focus on MBS came about. QE2 involved $600 billion in the purchase of Treasuries, which pushed down the Treasury yield curve, flooded the system with liquidity and prompted investors to take more risk. The net effect of QE2 was to push up stock and commodity prices, but didn't do very much for the real economy. In effect, it found that it was pushing on a string. In response, the Fed wanted to concentrated on risk premiums where it mattered, such as mortgage rates, in order to stimulate the housing market. Thus the impetus for QE3 was born. Target MBS, it was said, and you will push down the cost of home ownership and stimulate housing.
Watch out for unintended consequences
The European Central Bank is currently conducting a Great Experiment with its LTRO (Long Term Repo Operation), /correct term is Long Term Refinancing Operations/ where it is offering unlimited amounts of three year liquidity to banks, collateralized by paper with credit ratings as low as Single-A.
There was some hope that LTRO would prompt banks to put on the carry trade. Borrow from the ECB at 1%, buy PIIGS debt at 5% or more and earn the carry (see my discussion of LTRO here). The banks repair their balance sheets. The sovereigns get access to loans. Everybody wins!
The program has resulted in some unintended side-effects. Izabella Kaminska at FT Alphaville wrote that LTRO has created a two-tiered market for collateral and the two markets are diverging:

Simply put, back in the pre-crisis days the two markets worked in tandem. Participants engaging with the ECB did not differentiate on the type of collateral they delivered to the ECB versus the type of collateral they held back for use in private funding markets.
The crisis changed all of that.Suddenly the cheapest collateral to deliver became the collateral of choice for ECB use. The most expensive or ‘quality’ collateral was held back for use in private markets.
A tale of two collateral markets
This is how central bank transmission mechanisms began to be compromised.
The private funding markets, dictated by interbank participants, could from now on only be influenced by large quality collateral holdings — which the central banks increasingly lacked. The public funding market, dictated by central banks, became the domain of trash collateral — which no one really cared about.
The central bank monopoly on the ultimate cost of money thus became based around access to trashy collateral, not quality collateral — which remained the preferred funding option for private markets.
Unfortunately, it’s private liquidity which ultimately determines the scale and depth of the eurozone crisis — and it’s in this market where ECB influence is waning.

Lead a bank to liquidity, but you can't make it lend
In other words, you take your junk lower quality paper to the ECB and you reserve your high quality collateral (e.g. bunds) for the private repo market. The problem is that the private repo market continues to seize up because of a lack of high quality collateral and a rising sense of risk aversion over counterparty risk, i.e. you don't trust that you are going to get paid back so you demand really, really good collateral.
No matter how the ECB steps in to inject liquidity into *ahem* second-tier debt market, Kaminska wrote that the market has lost confidence and there is little the ECB can do [emphasis added]:

Private markets must be convinced to lend unsecured or invest money in more than just the last few remaining AAA bond markets.
But as they say, you can lead a horse to liquidity but you can’t make it drink. Which is a shame, because that’s the main problem the ECB and other central banks are now facing: they are leading banks to liquidity but they can’t make them lend in private markets.

The ECB's experience with LTRO should be a cautionary tale for the Fed as it considers a QE3 program of purchasing MBS. You can lead a market to liquidity, but you can't make lenders lend and borrowers borrow.
Beware of unintended effects, Mr. Bernanke.
Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

Leverage Unlimited; Re-Hypothecation

By Christopher Elias (UK)
(Business Law Currents) A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back. Although details of the drama are still unfolding, it appears that MF Global and some of its Wall Street counterparts have been actively and aggressively circumventing U.S. securities rules at the expense (quite literally) of their clients.
MF Global's bankruptcy revelations concerning missing client money suggest that funds were not inadvertently misplaced or gobbled up in MF’s dying hours, but were instead appropriated as part of a mass Wall St manipulation of brokerage rules that allowed for the wholesale acquisition and sale of client funds through re-hypothecation. A loophole appears to have allowed MF Global, and many others, to use its own clients’ funds to finance an enormous $6.2 billion Eurozone repo bet.
If anyone thought that you couldn’t have your cake and eat it too in the world of finance, MF Global shows how you can have your cake, eat it, eat someone else’s cake and then let your clients pick up the bill. Hard cheese for many as their dough goes missing.
FINDING FUNDS
Current estimates for the shortfall in MF Global customer funds have now reached $1.2 billion as revelations break that the use of client money appears widespread. Up until now the assumption has been that the funds missing had been misappropriated by MF Global as it desperately sought to avoid bankruptcy.
Sadly, the truth is likely to be that MF Global took advantage of an asymmetry in brokerage borrowing rules that allow firms to legally use client money to buy assets in their own name - a legal loophole that may mean that MF Global clients never get their money back.
REPO RECAP
First a quick recap. By now the story of MF Global’s demise is strikingly familiar. MF plowed money into an off-balance-sheet maneuver known as a repo, or sale and repurchase agreement. A repo involves a firm borrowing money and putting up assets as collateral, assets it promises to repurchase later. Repos are a common way for firms to generate money but are not normally off-balance sheet and are instead treated as “financing” under accountancy rules.
MF Global used a version of an off-balance-sheet repo called a "repo-to-maturity." The repo-to-maturity involved borrowing billions of dollars backed by huge sums of sovereign debt, all of which was due to expire at the same time as the loan itself. With the collateral and the loans becoming due simultaneously, MF Global was entitled to treat the transaction as a “sale” under U.S. GAAP. This allowed the firm to move $16.5 billion off its balance sheet, most of it debt from Italy, Spain, Belgium, Portugal and Ireland.
Backed by the European Financial Stability Facility (EFSF), it was a clever bet (at least in theory) that certain Eurozone bonds would remain default free whilst yields would continue to grow. Ultimately, however, it proved to be MF Global’s downfall as margin calls and its high level of leverage sucked out capital from the firm. For more information on the repo used by MF Global please see Business Law Currents MF Global – Slayed by the Grim Repo?
Puzzling many, though, were the huge sums involved. How was MF Global able to “lose” $1.2 billion of its clients’ money and acquire a sovereign debt position of $6.3 billion – a position more than five times the firm’s book value, or net worth? The answer it seems lies in its exploitation of a loophole between UK and U.S. brokerage rules on the use of clients funds known as “re-hypothecation”.
RE-HYPOTHECATION
By way of background, hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is “hypothetically” controlled by the creditor, who has a right to seize possession if the borrower defaults.
In the U.S., this legal right takes the form of a lien and in the UK generally in the form of a legal charge. A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default.
In investment banking, assets deposited with a broker will be hypothecated such that a broker may sell securities if an investor fails to keep up credit payments or if the securities drop in value and the investor fails to respond to a margin call (a request for more capital).
Re-hypothecation occurs when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations much to the chagrin of hedge funds.
U.S. RULES
Under the U.S. Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime broker may re-hypothecate assets to the value of 140% of the client's liability to the prime broker. For example, assume a customer has deposited $500 in securities and has a debt deficit of $200, resulting in net equity of $300. The broker-dealer can re-hypothecate up to $280 (140 per cent. x $200) of these assets.
But in the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. In fact, brokers are free to re-hypothecate all and even more than the assets deposited by clients. Instead it is up to clients to negotiate a limit or prohibition on re-hypothecation. On the above example a UK broker could, and frequently would, re-hypothecate 100% of the pledged securities ($500).
This asymmetry of rules makes exploiting the more lax UK regime incredibly attractive to international brokerage firms such as MF Global or Lehman Brothers which can use European subsidiaries to create pools of funding for their U.S. operations, without the bother of complying with U.S. restrictions.
In fact, by 2007, re-hypothecation had grown so large that it accounted for half of the activity of the shadow banking system. Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as “churn”), the original collateral being used may have been as little as $1 trillion – a quarter of the financial footprint created through re-hypothecation.
BEWARE THE BRITS: CIRCUMVENTING U.S. RULES
Keen to get in on the action, U.S. prime brokers have been making judicious use of European subsidiaries. Because re-hypothecation is so profitable for prime brokers, many prime brokerage agreements provide for a U.S. client’s assets to be transferred to the prime broker’s UK subsidiary to circumvent U.S. rehypothecation rules.
Under subtle brokerage contractual provisions, U.S. investors can find that their assets vanish from the U.S. and appear instead in the UK, despite contact with an ostensibly American organisation.
Potentially as simple as having MF Global UK Limited, an English subsidiary, enter into a prime brokerage agreement with a customer, a U.S. based prime broker can immediately take advantage of the UK’s unrestricted re-hypothecation rules.
LEHMAN LESSONS
In fact this is exactly what Lehman Brothers did through Lehman Brothers International (Europe) (LBIE), an English subsidiary to which most U.S. hedge fund assets were transferred. Once transferred to the UK based company, assets were re-hypothecated many times over, meaning that when the debt carousel stopped, and Lehman Brothers collapsed, many U.S. funds found that their assets had simply vanished.
A prime broker need not even require that an investor (eg hedge fund) sign all agreements with a European subsidiary to take advantage of the loophole. In fact, in Lehman’s case many funds signed a prime brokerage agreement with Lehman Brothers Inc (a U.S. company) but margin-lending agreements and securities-lending agreements with LBIE in the UK (normally conducted under a Global Master Securities Lending Agreement).
These agreements permitted Lehman to transfer client assets between various affiliates without the fund’s express consent, despite the fact that the main agreement had been under U.S. law. As a result of these peripheral agreements, all or most of its clients’ assets found their way down to LBIE.
MF RE-HYPOTHECATION PROVISION
A similar re-hypothecation provision can be seen in MF Global’s U.S. client agreements. MF Global’s Customer Agreement for trading in cash commodities, commodity futures, security futures, options, and forward contracts, securities, foreign futures and options and currencies includes the following clause:

 “7. Consent To Loan Or PledgeYou hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate,loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.” 

In its quarterly report, MF Global disclosed that by June 2011 it had repledged (re-hypothecated) $70 million, including securities received under resale agreements. With these transactions taking place off-balance sheet it is difficult to pin down the exact entity which was used to re-hypothecate such large sums of money but regulatory filings and letters from MF Global’s administrators contain some clues.
According to a letter from KPMG to MF Global clients, when MF Global collapsed, its UK subsidiary MF Global UK Limited had over 10,000 accounts. MF Global disclosed in March 2011 that it had significant credit risk from its European subsidiary from “counterparties with whom we place both our own funds or securities and those of our clients”.
CAUSTIC COLLATERAL
Matters get even worse when we consider what has for the last 6 years counted as collateral under re-hypothecation rules.
Despite the fact that there may only be a quarter of the collateral in the world to back these transactions, successive U.S. governments have softened the requirements for what can back a re-hypothecation transaction.
Beginning with Clinton-era liberalisation, rules were eased that had until 2000 limited the use of re-hypothecated funds to U.S. Treasury, state and municipal obligations. These rules were slowly cut away (from 2000-2005) so that customer money could be used to enter into repurchase agreements (repos), buy foreign bonds, money market funds and other assorted securities.
Hence, when MF Global conceived of its Eurozone repo ruse, client funds were waiting to be plundered for investment in AA rated European sovereign debt, despite the fact that many of its hedge fund clients may have been betting against the performance of those very same bonds.
OFF BALANCE SHEET
As well as collateral risk, re-hypothecation creates significant counterparty risk and its off-balance sheet treatment contains many hidden nasties. Even without circumventing U.S. limits on re-hypothecation, the off-balance sheet treatment means that the amount of leverage (gearing) and systemic risk created in the system by re-hypothecation is staggering.
Re-hypothecation transactions are off-balance sheet and are therefore unrestricted by balance sheet controls. Whereas on balance sheet transactions necessitate only appearing as an asset/liability on one bank’s balance sheet and not another, off-balance sheet transactions can, and frequently do, appear on multiple banks’ financial statements. What this creates is chains of counterparty risk, where multiple re-hypothecation borrowers use the same collateral over and over again. Essentially, it is a chain of debt obligations that is only as strong as its weakest link.
With collateral being re-hypothecated to a factor of four (according to IMF estimates), the actual capital backing banks re-hypothecation transactions may be as little as 25%. This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing.
The lack of balance sheet recognition of re-hypothecation was noted in Jefferies’ recent 10Q (emphasis added):

 “Note 7. Collateralized Transactions
We pledge securities in connection with repurchase agreements, securities lending agreements and other secured arrangements, including clearing arrangements. The pledge of our securities is in connection with our mortgage−backed securities, corporate bond, government and agency securities and equities businesses. Counterparties generally have the right to sell or repledge the collateral.Pledged securities that can be sold or repledged by the counterparty are included within Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. We receive securities as collateral in connection with resale agreements, securities borrowings and customer margin loans. In many instances, we are permitted by contract or custom to rehypothecate securities received as collateral. These securities maybe used to secure repurchase agreements, enter into security lending or derivative transactions or cover short positions. At August 31, 2011 and November 30, 2010, the approximate fair value of securities received as collateral by us that may be sold or repledged was approximately $25.9 billion and $22.3 billion, respectively. At August 31, 2011 and November 30, 2010, a substantial portion of the securities received by us had been sold or repledged.
We engage in securities for securities transactions in which we are the borrower of securities and provide other securities as collateral rather than cash. As no cash is provided under these types of transactions, we, as borrower, treat these as noncash transactions and do not recognize assets or liabilities on the Consolidated Statements of Financial Condition. The securities pledged as collateral under these transactions are included within the total amount of Financial instruments owned and noted as Securities pledged on our Consolidated Statements of Financial Condition. 

According to Jefferies’ most recent Annual Report it had re-hypothecated $22.3 billion (in fair value) of assets in 2011 including government debt, asset backed securities, derivatives and corporate equity- that’s just $15 billion shy of Jefferies total on balance sheet assets of $37 billion.
HYPER-HYPOTHECATION
With weak collateral rules and a level of leverage that would make Archimedes tremble, firms have been piling into re-hypothecation activity with startling abandon. A review of filings reveals a staggering level of activity in what may be the world’s largest ever credit bubble.
Engaging in hyper-hypothecation have been Goldman Sachs ($28.17 billion re-hypothecated in 2011), Canadian Imperial Bank of Commerce (re-pledged $72 billion in client assets), Royal Bank of Canada (re-pledged $53.8 billion of $126.7 billion available for re-pledging), Oppenheimer Holdings ($15.3 million), Credit Suisse (CHF 332 billion), Knight Capital Group ($1.17 billion),Interactive Brokers ($14.5 billion), Wells Fargo ($19.6 billion), JP Morgan($546.2 billion) and Morgan Stanley ($410 billion).
Nor is lending confined to between banks. Intra-bank re-hypothecation is also possible as evidenced by filings from Wells Fargo. According to disclosures from Wachovia Preferred Funding Corp, its parent, Wells Fargo, acts as collateral custodian and has the right to re-hypothecate and use around $170 million of assets posted as collateral.
LIQUIDITY CRISIS
The volume and level of re-hypothecation suggests a frightening alternative hypothesis for the current liquidity crisis being experienced by banks and for why regulators around the world decided to step in to prop up the markets recently. To date, reports have been focused on how Eurozone default concerns were provoking fear in the markets and causing liquidity to dry up.
Most have been focused on how a Eurozone default would result in huge losses in Eurozone bonds being felt across the world’s banks. However, re-hypothecation suggests an even greater fear. Considering that re-hypothecation may have increased the financial footprint of Eurozone bonds by at least four fold then a Eurozone sovereign default could be apocalyptic.
U.S. banks direct holding of sovereign debt is hardly negligible. According to the Bank for International Settlements (BIS), U.S. banks hold $181 billion in the sovereign debt of Greece, Ireland, Italy, Portugal and Spain. If we factor in off-balance sheet transactions such as re-hypothecations and repos, then the picture becomes frightening.
As for MF Global’s clients, the recent adoption of an “MF Global rule” by the Commodity Futures Trading Commission to ban using client funds to purchase foreign sovereign debt, would seem to suggest that it was indeed client money behind its leveraged repo-to-maturity deal - a fact that will likely mean that very few MF Global clients few get their money back.
Written with contributions from Jack Bunker and Nanette Byrnes.