EU rescue: Fact or Fiction

With great drama, the EU announced a package of measures designed to end the current fiscal crisis sweeping Europe.  Most economists polled in the last 24 hours are cautious as to whether the plan will work.  As with everything with the EU, it is one step forward and......simply hard to say whether it is also a step back.

The package contains: (1) a "voluntary haircut" on Greek debt held by banks (but not the debt held by the ECB) of 50%.  This seems rational, but the irrational part is that it was accompanied by a statement that the Greek debt is to reach a level of 120% of GDP by 2020!!!.  Of course, 2020 is a long time, which implies that the Greek debt load is way out of balance today and benchmarks long in the future have a tendency to get diluted over time when the spotlight moves away.  This latter term is highly speculative for reasons I have discussed previously.  Simply restated: the cut in Greek spending is so large as to imply a massive cultural change, not just a tinkering with the Budget.  This cultural change  must be unprecedented in the annals of economic history; at least since the hyper-inflation of the 1930s.  Finally, there is no real discussion of how much money Greece, Italy, or Spain, will need in the short term or how it will be financed.  But see below.  Finally, this deal is "voluntary" only as it relates to large Euro banks (who will be forced to accept the deal) and will not be considered a default under the terms of standard CDS instruments.  What about the other holders: hedge funds and non-Euro investors?  They might not be so accommodating. 
(2) The EFSF fund is going to be leveraged "4 to 5x" and will reach $1.4T.  First, we don't actually know how big the Fund is today, but assuming the math is right, it implies that the fund is down to something around $300B from €440B .  Second, it is a bit of a mystery how  this leveraging is going to take place.  If outside lenders/investors don't join, isn't this just going to lead back to France and Germany who effectively guaranty the bonds of the EFSF today?   On what terms will outsiders lend or invest?  Will the Chinese or IMF make an investment with any risk of loss, or will they, particularly the Chinese, require concessions or other quid pro quo?  Doesn't this lead right back to France and Germany being the funders of last resort?  (Italy and Spain don't have the cash, and the others are too small to matter).  The EFSF will have two roles apparently: (a) to provide funds to bailout EU governments; and (b) to purchase Sovereign bonds in the market.  But even $1.4T doesn't go very far.  Apparently, the bond purchases are designed to hold bond rates down, and provide financing of a last resort to the beleaguered  sovereigns (e.g., Greece);  but this reminds me of currency intervention and we all know how well that has worked.  Also, is the ESEF willing to take a loss on the bonds that it purchases? Apparently not;  which makes it is a sort of Ponzi scheme in which the EFSF buys bonds and then lends money to the sovereigns to pay the interest on the bonds just purchased.  If outside investors in the EFSF are going to be guaranteed against loss to some extent, isn't this leveraging merely creating a contingent liability of France and Germany--as the largest countries in the Eurozone?  Whew. 
(3) Banks will be forced to raise capital by June 2012 to bring capital ratios to 9%.  Apparently, in addition to discounting Greek debt by 50%, the banks must discount Spanish Debt by 3%.  I haven't seen anything on Italian debt.  This equity will be raised through all sources including cuts in dividends and bonuses, sales of assets, contraction of assets and sales of equity with the sovereigns, not the ESEF, being the investors of last resort.  Since the French banks are rumored to have the largest problems, doesn't this lead back to France and their vulnerable AAA rating.  Or will this become basically the "mother of all sales" on French bank equity?  Economists have been critical of the capital requirement because they see it as highly contractionary--at a time of Euro recession. 

You have to ask the question: Why all the machinations?  Why not just the obvious simple solution?  Well, of course, the Germans are trying to limit their exposure and save Merkel's government, and the French are trying to save their AAA rating and Sarkozy's career.  At the same time, EU leaders know that they have to provide a "shock and awe" blast to the markets to cool the fear of contagion.  Again, we are short on the "details".  Probably, this plan will work, with periodic agony, over a period of time; but we have just lived through one Black Swan event, and now we remain vulnerable to another.   "Kicking the can down the road" has become the fiscal strategy of choice outside of the UK.

As the (Old) World Turns: Is the European fiscal crisis drawing to an endgame?

On Oct 9,  Ch. Merkel and M. Sarkozy announced that they “will reach an agreement regarding the recapitalization of Europe’s banks”.  Since then news reports have indicated that the European Central Bank is considering a requirement that European banks increase Tier I common equity capital from a minimum of 7% to 9% within 9 months.  If they cannot raise private capital, they will be required to accept some form of government aid.  In the meantime, the “troika” of international auditors are supposed to approve Greece’s next distribution of funds from the EU.  There is great risk in both of these steps which are fundamental to solving the European fiscal crisis. 

The Merkel-Sarkozy agreement is only a statement of principle and not in any sense a real agreement.  It fudges the main issue dividing the two countries.  There are two schools of thought.  The Germans want to see recapitalizations handled on a country-by-country basis.  Lets call this the “Irish Solution”.  The French want to handle it on a consolidated European-wide basis.  Lets call this the “French Solution”.

The issue with the Irish Solution is that the sovereign debt of the home countries would escalate dramatically, which (1) could lead to a down grade by the rating agencies and certainly would lead to an increase in spreads in the financial markets; and (2) it would highlight the political fallout of a bailout for ‘bankers'.   The French solution would involve the use of the European Stability Fund but augmented in some way.  The French feel that they have already contributed to this fund by their guaranty of payment and it should be used first. 

The plan is supposed to be announced no later than early November at a meeting of the G-20 but the October 23 meeting of EU leaders will be an early test of the resolution. 

In the meantime, Greece has announced a new round of budget austerity measures designed to both cut expenses and raise revenues.  Again, there are many unanswered questions and the plan looks fudged.  The plan relies on property tax since Greeks are notorious cheaters on income tax.  But property tax is also problematic since there is no systematic record of property ownership in Greece.  Moreover, what is reported is often based on unrealistically low appraisals relating back many years.  So tax collection has an element of “volunteerism” that is likely to be ignored by  many Greeks.  There is also a plan to reduce government employment and a further reduction in government salaries (40% in total reductions).  The latter are good ideas in a country in which civil servants obtain salaries that are said to be 2-3x of the private sector with generous pensions and yet corruption is still rampant.  The only problem is that the real reductions in employment are still to come.  The Greek “austerity” plan is really a dramatic cultural change with a smaller and more efficient civil service that will be paid closer to levels of the private market.  This seems ambitious for a plan that is to be implemented in just 2-3 years.  There is plenty of room for disappointment—meaning default.  Assigning compliance to the “troika” seems to set the stage for a default at some point; if not in November, then early in 2012.  

The history of this saga has been filled with half-measures that are taken only when the EU has been forced to act by external factors.  The world’s equity markets seem now to believe that this cat is going to change its stripes and now act decisively and definitively.  There is plenty of room for disappointment.

Housing Crisis Continues

Almost all Americans recognize that one of the most serious obstacles to an economic recovery is the lingering after-effects of the housing crisis.  Apparently, the Federal Government hasn’t caught on yet.

Many Americans have differing opinions about the origin of the housing crisis.  Was it greedy bankers, or greedy thieving homeowners?  Or a little of both?  In any event, the housing bubble pushed up prices across the entire spectrum of US real estate fueled by easy money and a willing Federal government.  The consequences were widespread and nearly catastrophic. 

 American citizens have watched massive bailouts of the banking system due to reckless or incompetent investments in mortgage securities.  I have long supported TARP as the only pragmatic way to address a systemic problem that threatened all of us.  Thereafter, led by the left-leaning Obama administration, the Federal Government  attempted to implement mortgage modifications for defaulting homeowners in order to “keep them in their homes”.  Curiously, despite the “best” intentions, the re-default rate has been extraordinarily high which confirmed the view that many of these people should have never been lent money in the first place.  This latter program has been more controversial since it might in some, many or most instances, depending on your point of view, reward borrowers for misbehavior.  Again, it is simply a reasonable pragmatic response to an unprecedented problem.  It would be nice to say that misbehaving borrowers would not be assisted, but the Government does not exercise discretion very well.  In any event, the program has been far from successful. 

Both parties have failed to recognize the political and moral consequences that have flowed from these decisions.  Homeowners who are still paying their inflated mortgages aren’t receiving any government assistance.  This is a huge class of people in all walks of life  and it is difficult to generalize.  But clearly the decline in house prices (the largest financial asset of most people) has created a reverse “wealth effect” which is constraining the economic recovery.  One category that calls for some special attention are borrowers who now have mortgages that exceed the value of their house, in some cases by substantial margins.  (I am excluding any home equity loans from this discussion).  This phenomenon also calls for a pragmatic solution in the form of mortgage modification simply for the purpose of stabilizing the economy. This is not limited to subprime loans.  Among all homeowners, 20% are “underwater” and there is little difference between subprime and prime borrowers. The New York Times estimated the size of negative equity as $700-800 Billion.  

Many banks are willing to make some accommodation to “underwater” borrowers, and the Federal government appropriated funds to share a portion of the modification.  A frequent formula is that a modification (i.e., a reduction) of up to $100,000 would be shared equally between the Feds and the Bank. But guess what the principal roadblock is????

Fannie, Freddie, the VA, and the FHA do not allow reductions of mortgages which they hold or which they have securitized.  The result is that few mortgages have actually been modified.  Their rationale is that such a loan modification would create a “moral” hazard by encouraging subsequent borrowers to over-extend themselves in the future.  Again, this is not a case of subprime loans; virtually all of the Freddie and Fannie loans are prime. You might ask why NOW is the Federal Government getting morality? Apparently, the White House is unable to order a change in the practices at Freddie and Fannie despite the fact that they are now owned by the Feds.  This seems an odd place to suddenly become moralistic for a nation that pays people more not to work than can be earned by working and pays unwed mothers more for each subsequent child.   Most evidently, the bailout of the banking industry has created a widespread sense of unfairness (thanks, Tea Party).  At this point, we (the Government) need to do everything possible to restore equilibrium in the housing market.  The President strongly suggested that banks assist borrowers in refinancing at lower rates.  That is a good idea in that it provides a benefit, albeit limited, to many homeowners who are paying their mortgages.  But mortgage modification for “underwater” mortgages is also a useful and necessary step.

As I said in the beginning, we are simply in the business of pragmatism at this point.  We are all going to benefit from an improving economy.

(Source: The New York Times, October 6, 2011)

Europe redux (again)

The EU governments continue to walk a tightrope with respect to the fiscal crisis that they are facing. Ch Merkel said yesterday that Greece will NOT default but that there will be no “big bang” solution to end the debt crisis. 

She correctly, in my opinion, said that a Greek default would have unpredictable consequences, and could lead to speculative attacks on other vulnerable countries.  This would in turn risk a negative impact on the German economy. (source: Bloomberg).  But Merkel admitted that her “entire council” of economic advisers said that Greek debt should be restructured—advice that she is not prepared to accept for political reasons.  She questioned that if a “haircut” were to be imposed on Greek debt, where would it end?  Would there be a line of countries asking for similar relief.  This would of course disadvantage German taxpayers who had lived in a more prudent fashion.

She concluded that the only way forward was collectively; that there was no prospect of Germany going it alone—like Switzerland.  Earlier today, Ms. Merkel said she would support bank recapitalization if there was a "joint assessment" that it was needed and the rules were "uniform".

While this is a dynamic situation that is shifting rapidly, Ch Merkel’s remarks lead to a conclusion that the Euro leaders are likely to continue on the current course:  put pressure on the heavily indebted countries to heal themselves while providing a modicum of expensive Euro level financial aid to assist in the task.  This would create a continuing period of uncertainty, and a restraint on global growth as the major European countries adopt austerity measures from a budget standpoint. 

Many have predicted the death of the Euro (e.g., Pimco), but the reality may be worse—it will survive but go through a very long slow rough patch.  Ms. Merkel has clearly tied the existence of the Euro, and the EU, to German foreign policy (sic) noting that this is one of the fundamental pillars of peace in Europe. 

I would still advocate a TARP-like recapitalization of the major European banks, with a further facility available for additional problems.  This could be financed on a state-by-state basis.  Of course, this only increases the pressure on sovereign debt (see Ireland), but it creates a firewall against contagion.  Hopefully, the affected banks can find private capital in due course, but the sovereigns would be the investors of last resort.  Politically, this is not going to be too popular; but it is simply a reality that no European government (aside from Greece) is going to allow their banks to go bankrupt.  

The US equity markets seem poised to move higher today bolstered by a potential rate cut in Europe on the retirement of Trichet, the Euro bank recap plan, and slightly positive US employment data.  Of course at this point, the life of a rally is measured in days or less. 

Tidbits from Oct 5

The US stock market rallied hard at the end of the session.  Is this real?  I don't think we will see a "real" bull market rally until there is better evidence that the US will avoid a recession.  Otherwise, it has the feel of short covering at the bottom end of the trading range (around 1100 on the S&P), and now a rise up towards the top of the trading range.  BUT,  the ADP report today, and the DOL jobs report on Friday,  could be market moving.  I think the recession talk has been overdone, so I expect a bounce off this data.  Starting next week, we will begin to see earnings reports for Q3 and, more important management guidance for Q4.  Again, my expectation is that these will be mildly positive and will spur a short term rally.  One key to watch is whether there is a breakout above 11,500 on the Dow (1200 on the S&P), and a breakdown in correlation of stocks.

There has been unusual correlation of individual stocks to the movement in the market averages.  Normally, it is a market of stocks not a stock market, but since August, most stocks seem to rise and fall based on the movement of the indices rather than fundamentals affecting the particular stock.  This seemed to break down a little in the last 10 days, which is a positive sign for bullish investors.

Update on Europe--The equity markets have been spooked for months on the prospects that there could be another "Lehman" with a large financial institution going bankrupt.  As I pointed out previously, this is just not going to be allowed to happen in Europe for many reasons.  Yesterday, this view was confirmed as the French and Belgian governments announced a plan to rescue Dexia, guaranty its deposits, and its funding.  (sound familiar?)  Furthermore, there is discussion in Europe today of a "recapitalization" plan for European banks.  I have advocated for some time that the first step ought to be a serious stress test followed promptly by a TARP like capitalization plan.  This would quiet the speculation about the future of Euro banks, and put them in a stronger position to deal with troubled sovereign debt write-downs.  But instead of acting definitively early on, the Euro governments have vacillated and taken half measures hoping to avoid a more far-reaching restructuring.  Ultimately, they will be dragged to the logical conclusion.  But this will put more pressure on sovereign debt across Europe (like in Ireland) and force the ECB into a more accommodating stance  which will reduce the value of the Euro v. the US$

  Its a case of pay now or pay later.  usually pay now is cheaper. 

China syndrome

The Chinese authorities have been taking actions for some time to cool the Chinese economy to allay fears of over-heating.  Inflation is high (6.2% in August) forcing the Financial Ministry into a tight money policy.   In addition, the Chinese are tightening requirements for home ownership to slow the red-hot property market.  It is always difficult to gauge what is going on in China and the economic reports are not consistently credible.  Nevertheless, the government's actions seem to be taking effect.  The question is whether this will be a hard or soft landing.  In Western experience, "soft" landings are rare.  Will the Chinese experience be different? 

Chinese GDP growth has been slowing for the last several quarters to 9.7% in Q1 to 9.5% in Q3, to an estimated 9% in Q3, and forecasted 8.4% in Q4.  Currently, the soft landing view is prevailing, especially after the release over the weekend of Chinese PMI (Purchasing Manager's Index) at 49.9.  The index has been stable for 3 months at approximately the same level even though a reading under 50 is thought to show contraction.

You also get different answers to the question of how dependent the Chinese economy is on exports v. local consumption.  I have heard various answers from credible economists.  the range is from 75/25 in favor of domestic consumption to 25/75.  It is a wide range.  I tend to favor the former from my readings.  Nevertheless 25% is still a major commitment to exports, and a slowdown in the Western economies would hurt.  Moreover, there are many Western companies manufacturing products in China for export to their home markets, including IBM, Dell, EMC, and CISCO.  I mention these because they were clients of my old company.  In 2008, these companies slashed manufacturing in China during the Great Recession. 

We are living in a funny world.  The world is becoming more dependent on one of the most opaque economies in the world; an economy whose currency is still not freely traded or floating.  to compound concerns, Chinese companies do not have the same credibility (as bad as it is) as Western companies in terms  of corporate disclosure policies.  Chinese economic growth has been impressive; and the rural to urban migration underpins continuing growth forecasts.  Nevertheless, I would still retain a dose of caution.