Friday, October 28, 2011

Bunga Bunga! La Dolce Beta?

Debt relief celebrations have commenced in a spectacular fashion as a liquidity tsunami was unleashed on global capital markets on Thursday, driving up all risk assets. Stocks surged, extending the biggest monthly rally for the Standard & Poor’s 500 Index since 1974, and the euro strengthened as European leaders agreed to expand a bailout fund to stem the region’s debt crisis. Treasuries sank, while metals and oil led a rally in commodities. Emerging-market stocks which got clobbered in Q3 are now approaching a bull market, with the benchmark index up 20 percent from Oct. 4.

Thursday's price action might have caught some off-guard but it didn't surprise me one bit. I was well positioned to capitalize as I knew that European leaders would finally hammer out some deal or risk global depression or worse. There is only one trade you should all be positioned for in the next few months, the "RISK ON" trade.

Why am I so confident? You can keep reading the gloom & doom on blogs like Zero Hedge who are paid shills for hedge fund managers like Eric Sprott, Jim Chanos and Hugh Hendry, talking up their book and spewing hot air on solars and warning of China's imminent implosion or you can read my comment below and find out the real truth from the world's best and most underpaid independent pension & investment analyst -- someone who doesn't shill for any hedgie or pension fund, big or small. And unlike the clowns on Zero Hedge, I actually have to trade to survive and don't like to bullshit anyone, especially investors who have been frightened away by these volatile and crazy markets (on days like Thursday, I have to be ready for the big beta boost!).

And to all you stupid pension funds paying 2&20 to hedge funds that are selling beta as alpha, I want you to pay particularly close attention because you've all been hoodwinked, distracted and scared shitless while elite hedge funds, short sellers and high-frequency trading scam artists rob you blind.

What does a day like Thursday mean? Is it just another short-covering rally which will fade as the market resumes its downturn? Should you stay on the sidelines and wait for a better time to buy? You could do that but let me explain to you why you should be playing this rally and buying the dips hard. There are deep psychological forces playing on money managers who are seriously underperforming their benchmarks. They are all suffering from performance anxiety, just as they did back in June 2009, and need to make up for those savage Q3 losses and are looking for a mega beta boost from the markets.

And what about that $2.5 trillion or more in hedge fund assets? Hedgies are also looking for a big beta boost or risk seeing massive redemptions at year-end. Most of the money in hedge fund land is with L/S equity funds which are basically all long small cap stocks and short large cap, but the truth is they're mostly long all caps which is why the majority also underperform when markets head south. The same goes for the prop traders at big banks, they too need a beta boost.

So how do you position yourself for the massive counter trend rally that I believe lies straight ahead? As I stated in my last comment, you go long/overweight sectors that got clobbered in Q3 (like tech, financials, mining, metals, material and energy shares) and short/underweight sectors that did relatively well (ie. defensive sectors).

Below, I have put together a sample of stocks I track and trade in various sectors which outperformed the overall market during Thursday's powerful rally. Broke them down into financials, tech, coal, mining and metals, energy and solars (click on each image to enlarge):

As you can see from the images above, big money is hungry for big beta. Where are they looking for this big beta boost? From the stocks and sectors I posted above. These sectors will offer investors that extra beta juice they're desperately seeking to shore up their returns.

It will be volatile, there may be more unforeseen negative surprises like some stupid ratings agency downgrading the US once again, but I would seriously keep on buying the dips on risk assets and riding 'La Dolce Beta' wave higher. Summer is over and sectors that are most leveraged to the global economy are heating up again, so keep calm and get ready to party like it's 1999 again as I see another melt-up forming here. Below, some music to brighten up your mood after that euro debt fiasco (images have been approved by the Italian PM's office).

Thursday, October 27, 2011

Let the 'Debt Relief' Celebrations Begin?

James G. Neuger and Stephanie Bodoni of Bloomberg report, EU Sets 50% Greek Writedown, $1.4T in Rescue Fund:

European leaders cajoled bondholders into accepting 50 percent writedowns on Greek debt and boosted their rescue fund’s capacity to 1 trillion euros ($1.4 trillion) in a crisis-fighting package intended to shield the euro area.

The 17-nation euro and stocks climbed while bond spreads narrowed after leaders emerged early today from a 10-hour summit in Brussels armed with a plan they said points the way out of the quagmire, albeit with some details still to be ironed out.

“Overall the outcome is better than we anticipated one week ago,” Laurent Bilke, global head of inflation strategy at Nomura International Plc in London, said in an interview. “There are several issues left open, but I do believe that getting a more necessary debt relief for Greece is a pretty important step.”

Last-ditch talks with bank representatives led to the debt- relief accord, in an effort to quarantine Greece and prevent speculation against Italy and France from ravaging the euro zone and wreaking global economic havoc. Greek Prime Minister George Papandreou will address the nation at 8 p.m. in Athens to outline the summit’s ramifications for the country at the eye of the two-year sovereign debt crisis.

“The world’s attention was on these talks,” German Chancellor Angela Merkel told reporters in Brussels at about 4:15 a.m. “We Europeans showed tonight that we reached the right conclusions.”

ECB Role

Measures include recapitalization of European banks, a potentially bigger role for the International Monetary Fund, a commitment from Italy to do more to reduce its debt and a signal from leaders that the European Central Bank will maintain bond purchases in the secondary market.

The euro advanced to a seven-week high against the dollar, rising above $1.40 for the first time since September. It was at $1.4007 at 11:48 a.m. in Brussels. The Stoxx Europe 600 Index surged 2.6 percent.

“It’s long on words, short on detail,” said Peter Dixon, an economist at Commerzbank AG in London. “The solution that’s been put in place now gives us enough ammunition to stave off any immediate problems but we may well run into other problems down the track.”

The summit was the 14th in the 21 months since Europe pledged solidarity with Greece, and came amid mounting global pressure for the bloc to deliver a credible anti-crisis toolkit before a Group of 20 meeting Nov. 3-4 in Cannes, France.

Banks Summoned

Europe’s leaders took the unusual step of summoning the banks’ representative, Managing Director Charles Dallara of the Institute of International Finance, into the summit to break the deadlock over how to cut Greece’s debt to 120 percent of gross domestic product by 2020 from a forecast of about 170 percent next year.

Dallara squared off with a group led by Merkel and French President Nicolas Sarkozy around midnight after issuing an e- mailed statement that “there is no agreement on any element of a deal.”

Sarkozy said the bankers were escorted in “not to negotiate, but to inform them on decisions taken by the 17 and then they themselves went on to think and work on it.” Luxembourg Prime Minister Jean-Claude Juncker said the banks’ resistance was broken by a threat “to move toward a scenario of total insolvency of Greece, which would have cost states a lot of money and which would have ruined the banks.”

Insolvency Threat

The resulting “voluntary” losses by bondholders were the key plank in a second bailout for Greece, which was awarded 110 billion euros in May 2010 at the outbreak of the crisis. The new program includes 130 billion euros of official aid, up from 109 billion euros envisioned in July.

The Washington-based IMF, meanwhile, said it is ready to disburse its 2.2 billion-euro share of the next installment of Greece’s original bailout. The release of the euro zone’s 5.8 billion-euro share was approved last week.

Greek, Spanish, Italian and French bonds all rallied today, with the spreads over benchmark German bunds narrowing. The yield on German 10-year bonds jumped eight basis points, the most in more than 11 weeks, to 2.11 percent at 10:05 a.m. London.

The yield on Greek bonds due in October 2022 fell 117 basis points to 24.15 percent, Spanish 10-year yields dropped 16 basis points to 5.32 percent and Italy’s 10-year bonds advanced for a second day, with yields falling 13 basis points to 5.81 percent.

ECB President Jean-Claude Trichet, who has warned against the spillover effects of bond writedowns on the banking system, didn’t take part in the confrontation with bankers on the debt relief. He later praised the leaders’ determination to get ahead of the crisis.

Trichet’s Call

The measures agreed “have to be fully implemented, as rapidly and effectively as possible,” Trichet, who leaves office Oct. 31, said afterwards.

Leaders tiptoed around the politically independent ECB’s broader role in keeping the euro sound, making no mention of its bond-purchase program in a 15-page statement. The Frankfurt- based central bank has bought 169.5 billion euros in bonds so far, starting with Greece, Ireland and Portugal last year, then extending the coverage to Italy and Spain in August.

While Trichet didn’t mention the controversial purchases either, his successor, Mario Draghi of Italy, indicated that the policy will continue. Speaking in Rome yesterday, Draghi said the ECB remains “determined to avoid a poor functioning of monetary and financial markets.”

Leaders backed two ways of leveraging up the 440 billion- euro rescue fund, which was designed last year to shield smaller countries such as Greece, Ireland and Portugal, and lacks the heft to protect Italy, the euro area’s third-largest economy.

Leverage Options

Under plans to be spelled out in November, the fund will be used to insure bond sales and to create a special investment vehicle that would court outside money, from public and private financial institutions and investors.

Canadian Prime Minister Stephen Harper, speaking at a conference in Perth, Australia, called the agreement “grounds for cautious optimism,” and urged European leaders to work out details of the plan and implement it.

Europe cast about for more international money to aid the rescue, with France’s Sarkozy set to call Chinese leader Hu Jintao tomorrow with the goal of tapping into the world’s largest foreign exchange reserves.

While the mechanics are a work in progress, European Union President Herman Van Rompuy said the leverage effect would multiply the power of the fund by a factor of four to five. He compared it to normal banking business that needn’t entail excessive risks.

‘Detail Further’

“It will be important to detail further the modalities of how this enhanced EFSF will operate and deliver the scale of support envisaged,” IMF Managing Director Christine Lagarde said.

Europe also struck a bank-recapitalization accord, setting a June 30, 2012, deadline for lenders to reach core capital reserves of 9 percent after writing down their sovereign-debt holdings. Banks below that target would face “constraints” on paying dividends and awarding bonuses, a statement said.

The European Banking Authority estimated banks’ capital needs at 106 billion euros, with Spanish banks requiring 26.2 billion euros and Italian banks 14.8 billion euros. It gave them until Dec. 25 to submit money-raising plans to national supervisors.

Banks that fail to raise enough capital on the markets will first tap national governments, falling back on the EFSF rescue fund only as a last resort.

So what does this deal mean for Greece and the global economy? When it comes to deals of this magnitude, the devil is in the details. Andreas Koutras sent me his preliminary thoughts on the EU statement on Greece:

Finally the European political leaders seem to have reached an agreement on how to deal with the debt of Greece and the one brewing in Italy, Spain and France.

Although the statement issued by Europe is at places vague, the main points that can be discerned with regards to Greece are as follows:
  • The haircut would be 50% and it would voluntary. The fact that they still insist on a voluntary agreement is significant and important. The CDS may or may not trigger, but this is the least of our concerns. This is purely an ISDA decision that would predominantly affect the CDS market. The main point is that any voluntary exchange would place Greece under Selective Default and not under default thus avoiding the nasty side effects of bankrupting the Greek banks and pushing the country into a limbo state needing drip-feeding for months.
  • The statement excludes ECB holding.
  • The programme would contribute 30bln towards the PSI. The statement refers to “a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors”. We take this to mean a reduction on the face value of the bonds, but we reserve full judgement until we have more information or clarification from the EU.
  • It further stipulates that the objective is to reduce the debt to GDP by 2020 to 120%. There is a clear reference to “a Greek” monitoring and implementation. This is to allay fears of loss of sovereignty. Given however, the hitherto inability and inadequacy of the Greek government to enforce and implement much of what has been agreed this may be altered on the ground. There would be yet again a new Memorandum of Understanding.
With regards to the 50% haircut and whether it is on the Notional amount or the NPV we have:

NPV haircut
The statement refers to the “notional held by private investors” and this may mean the amount rather than the face value. For this reason we examine the NPV case.
A haircut of 50% on the Net Present Value could be achieved if for example you reduce the average coupon on the PSI proposed options by 2% and lower the guarantee to 50% from 100%. In this case the 30bln that the statement refers to as a contribution to the PSI is roughly what is needed for the stock of Greek bonds. In other words, if all 177bln of outstanding Greek stock (excluding the ECB) is exchanged into a 30Y bond with only 50% AAA guarantee, Greece would need to purchase close to 29billion worth of a zero coupon (depending on where they mark the 30Y rate).

Accounting wise though the reduction in the debt to GDP from the matching of the Asset (zero coupon) and the liability (30Y bond) would only be around 56billion. Thus day one after the exchange Greece would owe around 136% and given time to 2020 this could fall to 120%. The problem however, is that Greece would also need to start servicing this debt, day one. At an average of 2.5% coupon this would mean 5billion on interest only a year. Greece unfortunately still runs a primary deficit of around 2.5billion and it would be very difficult to meet this without further external assistance or grace period.

Notional reduction
A 50% reduction on the face value of all outstanding stock would reduce the debt by 88.5 (50% of the 222 of stock-45 of ECB)billion would reduce the debt to GDP to around 124%, day one. As we have no details of how the new bonds would look like or what form the principal guarantee (if any) it is hard to evaluate it.

Combination (Face reduction, 15% cash, NPV loss)
A combination approach is the other possibility. Namely, a reduction in the face value of the bonds with a simultaneous NPV write down on the new bonds and possibly a cash payment of 15%. This was leaked a couple of days ago as an alternative. Again, the 15% cash payment or 26billion on the 177 billion (222-45) of outstanding Greek stock in Private hands ties nicely with the 30bllion that the statement says has been earmarked for the PSI. In this case a 50% face reduction (minus 88.5billion on debt) taken with the cash payment (plus 26billion) would take the debt to GDP to around 135%.

There is no mention in the statement under which jurisdiction the new Greek debt would be offered. We expect that since bondholders would suffer a substantial haircut now, they would demand future protection under English law. If that is the case, then under the scenarios examined above 100% of the outstanding Greek debt whether in the form of bonds or bilateral loans would be under English law. This would significantly reduce the ability of Greece to exercise any control over it and it would make harder any future default or restructuring for Greece.

Conclusion-Greek banks
The solution given to the Greek debt crisis does not seem to be comprehensive as it lacks important details on the sustainability of the Greek debt after the voluntary exchange. Greece would still need to have large primary surpluses day one in order to service the new debt. Also there ambiguity on the state of the Greek banks after the exchange. A 50% cut would leave them needing recapitalization. Is this going to happen through common equity and hence nationalization or through preferred? The common equity approach would overnight not only change the ownership but it would effectively place them under EU control (through the control of Greek finances). Thus the dynamics and the incentives are altered.
Let me give you my preliminary thoughts on this debt deal. First, let me just say that I'm glad EU leaders told the bankers to "go fuck themselves," which is what they should have done long ago. Second, as reported in ekathimerini, a 50% haircut means that Greek debt is sustainable but banks face temporary nationalization and pensions will get hit:

A deal that imposes 50 percent losses on private sector bondholders means Greece's debt burden will be sustainable, Greek Prime Minister George Papandreou said on Thursday.

Greece will produce no more primary budget deficits from next year, but some of the country's banks may face temporary nationalisation as a result of the debt relief, he warned.

"The debt is absolutely sustainable now,» Papandreou told a news conference after a meeting of euro zone leaders, which reached agreement with private investors on a 50 percent write-down.

"Let's hope a new and better day dawns, both for Greece and for Europe... Greece can settle its accounts from the past now, once and for all».

Debt-laden Greece needed the drastic measure to avoid a sovereign bankruptcy that was threatening to engulf other weak members of the eurozone periphery such as Ireland, Portugal and Italy.

Under the 130-billion euro deal, Greece will obtain 30 billion euros upfront from other governments, as a guarantee for banks that will take part in the voluntary reduction of 100 billion euros of the debt they hold.

Papandreou said he expected the deal, which will be implemented through a bond exchange, to be wrapped up by the end of the year.

The deal cuts Greece's debt by 50 percentage points of GDP, compared with just 12 percent under a previous EU deal struck in July, Papandreou said.

If Greece pushes reforms fast enough, it may even manage to return to markets much faster than 2021, as currently predicted by the International Monetary Fund (IMF), he added.

"Enough with primary budget deficits, from next year on there won't be any, we'll be passing to primary surpluses,» Papandreou said.

The haircut is expected to impose big losses on the country's banks and state-run pension funds, which are up their necks in toxic Greek government bonds of about 100 billion euros.

The government will replenish pension funds' capital, but banks may face temporary nationalisation, Papandreou said.

"It is very likely that a large part of the banks' shares will pass into state ownership,» Papandreou said. He pledged, however, that these stakes will be sold back to private investors after the banks' restructuring.

"After restructuring we will then take it (the shares) out to the market, as other countries have done... it is a very standard procedure and nothing to be afraid of,» he said.
Of course, the deal was met with skepticism from the country's conservative opposition, stating that the haircut cannot make the Greek debt sustainable, as this would require a primary surplus and economic growth. But the deal will give Greece the breathing room required to focus on structural changes and economic growth. Interestingly, ekathimerini reports that Greece will use future revenue from the country’s ‘Helios’ solar energy project to cut debt by as much as 15 billion euros ($21 billion).

Are sunny days ahead for Greece and the global economy? I think so and remain overweight/long tech, commodities, cyclicals and energy, especially Chinese solars and underweight/short defensives (basically go long anything that got slaughtered in Q3 and underweight/short anything that rallied in Q3). I would, however, sell the news on the euro and would be very careful here as this is only a temporary reprieve; there remains a long, tough slug ahead (see interview below with Mark Dow, a hedge fund manager at Pharo Management).

The Irish are already crying foul on the Greek debt deal and surely Spain, Portugal and Italy will want to cut their own deals. In fact, that's what Berlusconi is probably thinking in that picture above. Or maybe he's thinking of more "bunga bunga" parties with women dressed as nuns performing stripteases. Whatever the case, let the 'debt relief' celebrations begin and let's move past this endless debt crisis which has wreaked havoc on global capital markets.

Wednesday, October 26, 2011

Violent 'Blow-Up' in the Periphery?

Euro 'drama' continues. Ekathimerini reports that German Chancellor Angela Merkel said on Wednesday she was committed to achieving sustainable decisions at a summit of European leaders later to tackle the eurozone debt crisis but that no one should expect solutions that work overnight:

"I will work toward reaching sustainable decisions this evening,» Merkel told parliament shortly before a vote by German lawmakers on plans to leverage the euro zone bailout fund.

Merkel also said that she wanted to get Greece back on its feet as quickly as possible but that it would be a long path and a debt write-down alone would not solve Greece's problems.

"We must certainly accompany Greece for quite some time to come,» she said.

If, as expected, German lawmakers pass the motion, Merkel's negotiating hand will be strengthened in the Brussels talks.

Greek television stated that in a speech Merkel referred to 2020 and didn't give specific details on the haircut but the few numbers she cited were in line with a 50% haircut.

Bloomberg reports that banks are pushing back against European leaders on the size of losses they are ready to accept on Greek bonds as officials struggle to rescue the debt-laden country while avoiding a default:

There are limits “to what could be considered as voluntary to the investor base and to broader market participants,” Charles Dallara, managing director of the Institute of International Finance, an industry group that’s participating in the talks on Greek debt, said in an e-mailed statement yesterday. “Any approach that is not based on cooperative discussions and involves unilateral actions would be tantamount to default.”

The discussions are part of an attempt to solve the two- year-old sovereign-debt crisis that has pushed Greece toward default and roiled global markets. European Union leaders, who hold a second summit in four days tomorrow, are seeking an agreement on bolstering the region’s rescue fund, recapitalizing banks and providing debt relief to Greece to avoid contagion spreading to Italy and Spain.

Meanwhile in Greece, Government spokesman Ilias Mossialos said on Wednesday that PASOK will continue to rule with its 153 deputies in a bid to curb speculation that the Socialists will seek opposition support for a vote on an EU rescue deal. I can assure you that the main opposition leader, Antonis Samaras, will not support the Government as all he's doing is looking to score political points and opportunistically capitalize on the crisis.

And in an attempt to calm fears of a run on banks, ekathimerini reports that the head of Greece's bank stability fund said on Wednesday that deposits held at Greek banks were not at risk because his fund stood ready to recapitalize lenders hit by a restructuring of the country's sovereign debt:

"The capital that will be provided to banks through us means that depositors should feel safe. This should lift the fear that exists today about deposits,» Panagiotis Thomopoulos told reporters as he welcomed Horst Reichenbach, head of the EU task force in Greece.

Greek business and household bank deposits have shrunk by 20.9 billion euros or 10.2 percent since the beginning of the year. They are down by 48.8 billion euros or 20.5 percent since January 2010 when Greece's debt crisis began.

"Mr Reichenbach's presence here proves the interest of the EU for the good functioning of Greece's banking system, irrespective of what the solution will be for Greece's public debt,» Thomopoulos said.

Mr. Reichenbach's presence will do little to calm Greek citizens who are now suffering from an economic collapse, all thanks to the IMF's myopic austerity measures. What is the endgame of all this political posturing and dithering in Europe? Listen below to two excellent Yahoo Daily Ticker interviews with James Galbraith, professor of economics at the University of Texas.

Professor Galbraith still has concerns about the state of the US economy and thinks it's time for the US to spend its way to recovery. "I think the previous talk of a double recession was largely a red herring — through this entire period we have been on a track of very weak performance after an extraordinarily large downturn," he says. "From the stand point of the unemployed in the population there is practically no recovery at all and I think that is still the present situation."

As far as Europe is concerned, however, he has a much more dire prediction. "The peripheral countries of Europe are in deep difficulty [and] Greece in particular is being destroyed," says Galbraith, referring to forced cuts in healthcare, education and public services that have led to many violent protests. "I think [Europe's sovereign debt crisis] ends when there is a really violent blow-up on the periphery, probably originating in Greece or possibly in some other place ... . At some point the destruction of the society becomes intolerable, and that's where you'll see the flash point, it seems to me."

I certainly hope professor Galbraith is wrong about this but watching the political dithering going on in Europe makes me extremely nervous and it agitates me. Perhaps it's time to remind Germans of their past, as Albrecht Ritschl, professor of economic history at the London School of Economics, did in an op-ed article to the Guardian in late June, Germany owes Greece a debt:

The Germans are not amused these days. Look everywhere from tabloids to the blogosphere, and it seems that the public mood has reached boiling point. Loth to shoulder another national debt increase and finance another bailout, the Germans have started questioning everything from the wisdom of supporting Greece to the common euro currency, or indeed the merits of the European integration project altogether. This might be strange for a country that is nudging ever closer to full employment, and which is about to recapture its position as the world's leading exporter of manufactured goods from the Chinese. But the Germans say they've had enough: no more underwriting of European integration, no more paying for this and that, and certainly no more bailing out the Greeks.

What is truly strange, however, is the brevity of Germany's collective memory. For during much of the 20th century, the situation was radically different: after the first world war and again after the second world war, Germany was the world's largest debtor, and in both cases owed its economic recovery to large-scale debt relief.

Germany's interwar debt crisis started almost exactly 80 years ago, in the last days of June 1931. What had triggered it was Germany's aggressive borrowing in the late 1920s to pay reparations out of credit. A credit bubble resulted, and when it burst in 1931, it brought down reparations, the gold standard and, not least, Weimar democracy.

Having footed the resulting massive bill, after the second world war the Americans imposed the London debt agreement of 1953 on their allies, an exercise in debt forgiveness to Germany on the most generous terms. West Germany's economic miracle, the stability of the deutschmark and the favourable state of its public finances were all owed to this massive haircut. But it put Germany's creditors at a disadvantage, leaving it to them to cope with the financial aftermath of the German occupation.

Indeed, the London debt agreement deferred settlement of the reparations question – including the repayment of war debts and contributions imposed by Germany during the war – to a conference to be held after unification. This conference never took place: since 1990, the Germans have steadfastly refused to reopen this can of worms. Such compensation as has been paid, mostly to forced workers, was channelled through NGOs to avoid creating precedents. Only one country has challenged this openly and tried to obtain compensation in court: Greece.

It may or may not have been wise to put the issue of reparations and other unsettled claims on Germany to rest after 1990. Back then, the Germans argued that any plausible bill would exceed the country's resources, and that continued financial co-operation in Europe instead would be infinitely more preferable. They may have had a point. But now is the time for Germany to deliver on the promise, act wisely and keep the bull away from the china shop.

Now is still the time for Germany to deliver on the promise or risk throwing the entire world into another Great Depression and who knows, another world war. And someone should remind those 'brilliant economists' at the IMF/ Troika that the standard remedies are doomed to fail as austerity measures are only exacerbating economic hardship and won't help peripheral economies fix their debt profile. Perhaps it's time for China, Russia and even Israel and Turkey to come in and help stabilize the Greek economy. Once again, European leaders are proving to be completely incompetent.

Tuesday, October 25, 2011

State of Injustice?

Ekathimerini reports, EU deal will need a big majority:

A new bailout for Greece, currently being hammered out by European Union leaders as part of a broader rescue package for the bloc, will need a qualified majority of at least 180 in Greece’s 300-seat Parliament, Finance Minister Evangelos Venizelos suggested on Monday after telephoning opposition party leaders from Brussels to brief them on the progress of talks at an EU summit.

Asked by reporters late on Monday whether the government would seek a qualified majority when the rescue package reached in Brussels is put to a vote in Greece’s Parliament, Venizelos said that “such matters must be addressed with a heightened sense of responsibility and if possible voted through Parliament with a broad majority, not because this is a legal requirement but because it is a national imperative and political responsibility.”

The minister added that he had briefed party leaders on “the framework of negotiations, the basic figures, the crucial issues, the priorities and the risks.”

Earlier in the day, the leader of the rightwing Popular Orthodox Rally (LAOS), Giorgos Karatzaferis had indicated, in an interview on Mega television channel, that the government was planning to seek 180 votes for any deal reached in Brussels, instead of a simple majority of 151.

Prime Minister George Papandreou made no statements on Monday on his return to Athens from Brussels where he had stressed on Sunday that the debt problem was not Greek but European. On Tuesday Papandreou is to brief President Karolos Papoulias on progress in the debt talks before returning to Brussels for an emergency EU summit tomorrow which is expected to produce some sort of solution to Greece’s debt problem and set up a firewall against the crisis for the bloc as a whole.

According to sources, EU leaders have agreed on two things -- a haircut for holders of Greek sovereign debt to the tune of at least 50 percent and the recapitalization of the European banking system.

Sources told Kathimerini that Venizelos had referred to a “radical haircut” that would not be big enough, however, to threaten the stability of the Greek economy.

The FT reports that European negotiators have asked Greek debt holders to accept a 60 per cent cut in the face value of their bonds, a hardline stance that far exceeds losses agreed in a deal between private investors and eurozone authorities three months ago. If this happens, it could trigger CDS contracts.

This morning I watched a Greek morning talk show, Kalimera Ellada (Good Morning Greece), where they were talking about what this "radical haircut" (in Greek: kourema) means for the Greeks. Basically, Greece will be effectively shut out of international capital markets till 2020. As they said on the show: "They are saving the banks and asking citizens to slice our throats. Troika will give us 5 euros and expect 10 back but we can't access international capital markets. Instead, we will pay it back by cutting wages, pensions, and through zero growth."

Commenting on the state of affairs, Alexis Papachelas of ekathimerini reports, State of injustice:

I could see them walking along Vassilissis Sofias Avenue, a central Athens thoroughfare. They looked angry and tired, but also quite militant. They were nurses and doctors employed at state hospitals and still in their work clothes. I was thinking that none of the politicians who belong to Greece’s main political parties would have anything convincing to tell these people.

These people are not the big-name doctors who have grown used to receiving under-the-table payments or bonuses from pharmaceutical companies to prescribe their medicines rather than cheaper alternatives. These people never accepted bribes from the drug firms that leeched off the state coffers for so many years. They have read dozens of reports about corruption but are yet to see anybody ending up behind bars for it.

It is extremely unfair that people such as these, who have worked hard all their lives, are now being forced to take a drastic reduction in their salaries. I am not just talking about doctors and nurses, but also police officers, military men and other responsible employees who serve in crucial positions around the country. It’s extremely unfair that a military officer doing his service on a faraway island has to see his salary plummet while some of his more privileged colleagues are fighting to perpetuate their outrageous perks.

Since the early days of the crisis, the government of Prime Minister George Papandreou has opted for the easy option of imposing across-the-board cuts or its labor reserve scheme which would affect specific categories of employees.

If the government does not change its tune, the state apparatus will fall apart. It will lose staff that would have a lot to offer simply because they happen to be near the retirement age.

The riot squad officer guarding the Parliament will one day drop his shield and walk away because he is no longer able to stand the pressure of poverty and endless tension.

Great though the panic created by the pressure coming from the country’s international creditors may be, Papandreou and his administration must do everything they can to find ways to protect the heart of the state apparatus, and take action against idleness and waste.

Greeks know they're getting screwed on this deal which is why they're prepared to fight till the death. The message on the Greek flag says it all, Molon Labe, which means "Come and take them". It is a classical expression of defiance reportedly spoken by King Leonidas in response to the Persian army's demand that the Spartans surrender their weapons at the Battle of Thermopylae.

There is a new battle being waged all around the world, not just Greece, which will have far reaching implications. Italy is next. The crisis in Greece is just the beginning as states scramble to cut across the board or face the wrath of international bond markets and speculators, impoverishing many of their citizens. This is part of the deleveraging/ deflation era that lies straight ahead.

But there is a backlash happening right now among frustrated citizens. Even in the US, people are finally waking up. That nine-year old boy in the video below got it right, it's "the reverse of Robin Hood," stealing from the poor to bail out the rich. All those who dismiss or criticize the Occupy Wall Street (OWS) movement, including powerful hedge fund titans like Ray Dalio (see clip below and watch full Charlie Rose interview by clicking here), are in for the shock of their lives as these 'Occupy movements' morph into a global revolution.

That's what happens when impoverished masses wake up and demand justice. That's why the financial elite are scrambling to come up with something in the final stretch of eurozone crisis talks, clashing with lawmakers on the size of losses they are ready to accept on Greek bonds. The "gods of high finance" fear two things: nationalization of banks and even more ominously, social revolution and the wrath of hungry masses.

Monday, October 24, 2011

PSP Investment's Annual Public Meeting 2011

On Thursday October 20th, PSP Investments (PSP) held its Annual Public Meeting 2011. You can download the Annual Public Meeting presentation for FY2011 and listen to the audio in English or if you prefer, the bilingual version.

Paul Cantor, the Chair of the Board spoke first. He discussed the shift into private markets and the Auditor General of Canada Special Examination Report. Paul was satisfied with the report and said that PSP has the "best nomination process among public and private funds." He commended PSP's past and present board of directors, making a special mention of Bob Baldwin who recently retired from the Board. He also praised PSP's senior management and PSP's 350 employees and PSP's "risk management." Finally, he announced he will be stepping down as Chair of the Board at the end of the current fiscal year (March 31st, 2012).

PSP's President and CEO, Gordon Fyfe, then spoke and went over PSP's Policy Portfolio. The strategy is similar to other large Canadian public funds, ie. shift assets out of public markets and into private markets, as well as focus on managing assets internally as opposed to external funds. PSP introduced a new asset class called "Renewable Resources," where it invests in properties that harvest timber like the Timberwest deal which was done with bcIMC, as well as properties that harvest agricultural products (probably farmland).

In private equity, Gordon spoke of direct investments, noting the investment in Telesat and stating that PSP recorded its best ever one-year return (21%) in private equity during FY 2011. He also stated that PSP sold a portion of the private equity fund portfolio (mega buyout), but provided few details to who and at what price. My sources tell me it was to CPPIB, which they co-invested along with Apax partners to acquire Kinetics Concepts, at a significant discount. No details were provided on how much of the stellar results in private equity during FY 2011 were attributable to direct deals and how much was due to the sale of their fund stakes.

In real estate, Gordon noted direct investments in Revera, distressed debt strategies, and investments in emerging markets like Brazil. He also noted several co-investments in multi-family and industrial properties were made in the US, in properties in New York City and Washington D.C., but provided few details. As I stated in my previous comment, real estate isn't a 'sacred chalice'.

In infrastructure, Gordon noted that investments were made in five terminal ports in Australia, in a Norwegian pipeline system, and Hydro-electric assets in Canada, but again few details were provided on these investments.

Noting the Auditor General's special sham report, Gordon stated he was pleased with the conclusions, namely that PSP's assets are safeguarded and controlled, resources are managed economically and effectively and efficiently, and operations carried out effectively. He also cited the report's key observations: key elements of a strong governance framework, PSP continues to develop risk measurement and management capabilities in line with industry, and compensation practices align behaviors while maintaining competitiveness.

Gordon ended by stating that in the first six months of FY2012, the Fund is down 5% mainly due to weakness in global equity markets but this doesn't take into consideration private market investments which are valued at the end of the fiscal year. Given the lags in private market valuations, there should be some positive contributions to the Fund's overall performance. Moreover, if some resolution comes out of Europe, global equity markets should perform well in the next few months, benefiting PSP's FY 2012 results.

Once again, the media did not cover PSP's Annual Public Meeting, which goes to show you how much interest mainstream media has in properly covering all large Canadian public pension funds, not just the Caisse and Ontario Teachers. On a personal level, would like to wish Paul Cantor and Bob Baldwin all the best. Have openly criticized many of PSP's decisions, but have also praised others and know that it isn't easy governing a large fund during these turbulent times. Paul and Bob should be commended for navigating through some volatile times at PSP, addressing thorny internal issues while dealing with difficult external market conditions.

Saturday, October 22, 2011

Real Estate Isn't a `Sacred Chalice'?

Going to watch the Habs vs. Leafs tonight but wanted to post a couple of excellent Bloomberg interviews with Tom Barrack, Chairman of Colony Capital, who discusses the European debt crisis and warns investors that real estate isn't a 'sacred chalice'.

I first discovered Barrack exactly six years ago when I circulated an article among PSP Investment's senior managers, The king of real estate's cashing out:
Tom Barrack, arguably the world's greatest real estate investor, is methodically selling off his U.S. real estate holdings as prices drive the market to nosebleed levels.

He likens the current real estate market to a game of polo.

"I feel totally safe playing polo on a field full of pros," says the bronzed 58-year old. "But when amateurs are all over the field, someone can get killed. They have more guts than brains. They charge after every ball and don't know when to hold back."

It's the same with U.S. real estate right now. "There's too much money chasing too few good deals, with too much debt and too few brains." The amateurs are going to get trampled, he explains, taking seasoned horsemen, who should get off the turf, down with them.

Says Barrack: "That's why I'm getting out."

Investors take heed. Barrack may be an amateur at polo, but when it comes to judging markets, he's the ultimate pro.

Arguably the best real estate investor on the planet, he runs a $25 billion portfolio of trophy assets, from the Raffles hotel chain in Asia to the Aga Khan's former resort in Sardinia to Resorts International, the largest private gaming company in the U.S.

Barrack's Colony Capital, one of the largest private equity firms devoted solely to real estate, has racked up returns of 21 percent annually since 1990, handing investors, chiefly pension funds and college endowments, 17 percent after all fees.

Barrack bought the Fukuoka Dome, Japan's Yankee Stadium, in part because he calculated that the titanium in the retractable roof was worth as much as the purchase price.

His strategy is to buy classy but neglected properties anywhere in the world where prices are low. Then, he'll pour in capital to fix them up, and resell in them in five years of so with their pedigrees fully restored. Says his friend Donald Trump: "Tom has an amazing vision of the future, an ability to see what's going to happen that no one else can match."

Right now, Barrack's view of the U.S. market couldn't be clearer: It's a great time to sell, and a terrible time to buy.

In fact, he sees signs of the tech bubble mentality in real estate. Too much capital is chasing real estate, he explains, with hedge funds, private equity groups, and rich investors all bidding on the same properties. "They've driven prices to the point where the yields on high-quality properties are like the returns on bonds, around 5 percent or 6 percent," says Barrack. "That's too low."

And he sees the bubble deflating soon. Barrack thinks the catalyst will be a trend few others are talking about, a steep rise in the price of building materials and labor. "Construction costs have spiked 20 percent in the past nine months," he says. The reasons: Shortages of labor and materials like lumber because of the building boom, and increases in the price of oil, needed to produce everything from plastic piping to insulation to shingles.

The slump will show up first in speculative hot spots like Miami and Las Vegas, he says, where condo developers are preselling their projects for what looks like big profits. When they actually build the units over the next year or two, he predicts, they will end up spending more then the units are now selling for.

At that point, says Barrack, the developers will try to raise prices. "But most of these buyers are speculators," he says. "They will either sue the developers to get the original price or take their deposits back and walk away." The developers will then put the units back on the market, and the glut of vacant condos will drive prices down. "It's the busted deals caused by construction costs that will cause the turn in the market," he says.

So Barrack is buying just one type of property in the U.S.: Casinos. And in contrast to most gaming titans, he's doing it on the cheap.

Colony paid just $280 million for the 3000 room Las Vegas Hilton in 2003, one-tenth of what Steve Wynn paid to build his new casino, which has roughly the same number of rooms.

The reason Barrack likes casinos is that he's licensed to operate casinos in all the major markets, while most other private equity firms and other financial players don't have licenses. Hence, they're locked out of the market, and can't bid against Barrack. For Barrack, casinos are a safe, exclusive preserve, far from the frenzied melee that's makes every other part of U.S. real estate such a dangerous place to play.

For now, Barrack is getting off the field. But when the din subsides, and the amateurs depart, look for Barrack to ride back in, mallet cocked, ready to play again.

Barrack was right to note "there's too much money chasing too few good deals, with too much debt and too few brains." For me, this is the quote of the century when it comes to understanding pension Ponzi 101! And the same thing is happening all over again as pension funds shift assets out of public markets into private markets and hedge funds in search of "alpha" (more like leveraged beta).

Unfortunately, some of Barrack's casino investments have not fared too well. One pension fund manager told me "he's up to his eyeballs and forced to give up the keys" on investments like the Las Vegas Hilton hotel-casino. Nonetheless, I find it interesting that Barrack is still extremely bearish on residential real estate at a time when U.S. homebuilders rose the most in two years after an index of developer sentiment unexpectedly increased to its highest level since May 2010, spurring optimism that demand for new houses may be improving.

Will the king of real estate be proven right once again? I think so but the problem is that there's still "too much money chasing too few good deals, with too much debt and too few brains." Next up, Euro celebrations or more of the same? Who cares! Go Habs Go!

Friday, October 21, 2011

SEC Clamping Down on Large Hedge Funds?

Jesse Hamilton of Bloomberg Businessweek reports, SEC to Weigh Hedge Fund Rule on Systemic Risk Data Analysis:
Hedge funds and private-equity funds will be asked to deliver “extraordinary amounts” of new data to the U.S. Securities and Exchange Commission under a rule set for a vote next week, said SEC Chairman Mary Schapiro.

Under the version of the rule proposed by the SEC on Jan. 26, firms managing more than $1 billion would have to file quarterly information on fund assets, leverage, investment positions, valuation and trading practices on a new Form PF. That added oversight would also come with routine inspections.

“We have high hopes for the Form PF data,” Schapiro said today at a Managed Funds Association meeting in New York. The form was a requirement in last year’s Dodd-Frank Act, and Schapiro said the information will help her agency and the Financial Stability Oversight Council “understand where the risks are in the financial system.”

The January proposal described how the regulators will use the new data to assess whether a firm threatens to destabilize the financial system, as in the 1998 collapse of Long Term Capital Management LP. The SEC is set to vote on the final version of the Form PF rule Oct. 26.

Separately, Dodd-Frank requires the SEC to set up registration rules for private fund advisers. The registration, adopted in June, requires the reporting of “census-like data” on employees, investors and assets they manage. Unlike the registration data, the Form PF information wouldn’t be public.


Also today, Schapiro said the SEC wouldn’t consider short- selling bans such as those being weighed in Europe. So-called naked short selling, in which traders bet on an investment’s decline but don’t borrow shares as in regular shorting, was temporarily limited by the SEC in the 2008 credit crisis.

“I can’t envision the SEC doing another short-selling ban,” she said.

Schapiro also cautioned hedge funds to make sure they have “robust compliance policies” in light of recent insider- trading cases involving funds’ dealings with expert networks, such as in the conviction and July sentencing of former SAC Capital Advisors LP portfolio manager Donald Longueuil to a 30- month prison sentence.

“We’re right in the middle of so many cases and investigations,” Schapiro said, adding that funds should be “extraordinarily careful.”

She said there is a “pretty bright line” between legitimate research and insider information and crossing it “absolutely undermines confidence in the integrity of our marketplace.”

In another article, Katya Wachtel of Reuters reports that Schapiro doubts SEC will ban short-selling:

The Securities and Exchange Commission is unlikely to join the European Union in imposing another ban on short-selling, SEC Chairman Mary Schapiro said on Thursday.

"Never say never, but it is hard for me to imagine the SEC ever doing a ban on short-selling again," Schapiro said at a hedge fund industry conference. During the financial crisis in 2008, the SEC limited traders' abilities to bet that certain stocks would fall.

Earlier this week, the European Union said it would regulate short-selling of stocks and bonds more strictly and ban "naked" credit default swaps on government bonds to help ensure more stability in financial markets. In a naked swap, the holder has no risk of financial loss if the underlying security falls.

Schapiro was the keynote speaker at a conference sponsored by the Managed Fund Association, one of the most prominent lobbying groups in the nearly $2 trillion hedge fund industry.

The SEC chief also discussed insider trading in the hedge fund industry, and the controversial use of so-called expert networks by traders and portfolio managers. Expert networks match industry experts with fund managers to help them understand companies better.

The SEC and other government agencies have investigated abuses in the use of expert networks -- including the sharing of non-public information -- and several arrests and convictions have resulted in the past year.

"There is nothing wrong with doing tremendous due diligence and research to understand a stock," Schapiro said. "But there is a line, and I think it is a pretty bright line."

She said the SEC is currently involved in several cases.

"Insider trading is absolutely not a victimless crime," she said.

Schapiro said the SEC would vote next week on a proposal for SEC-registered investment advisers to work with funds and report information -- including assets under management, use of leverage and trading positions -- to the commission periodically.

While the data would be kept confidential, hedge fund managers are nervous that the information would reveal their highly classified and often profitable trading strategies.

In February. the Managed Fund Association sent a letter to regulators saying that "it is highly unlikely that any hedge fund is systemically significant at this time." Therefore, the industry should not be the target of increased scrutiny and reporting obligations, it said.

The SEC already started investigating one powerful hedge fund, Steve Cohen's SAC Capital, to examine whether the fund used insider information to profit from Johnson & Johnson's takeover of Cougar Biotechnology Inc in 2009. The civil inquiry is also looking at whether an "expert network" business that is part of an investment bank leaked nonpublic information to traders.

I won't comment on the specific case except to say this: in the financial services industry, hedge funds have first dibs on any information that gives them an advantage over other investors. Why? Because they generate the most fees for investment banks and thus are at the top of the client food chain when it comes to sharing material information. This is why I urge all pension funds to reevaluate their relationships with hedge funds. Most of these funds are charging 2 & 20 in management and performance fees, selling beta as alpha, and they're not sharing important information with their clients. And I'm not talking about "insider trading" information, just normal information like which sectors and stocks they're overweighting and why. Too many pension funds are way too timid when dealing with hedge funds.

As far as the SEC is concerned, I think these new proposals are a bunch of smoke & mirrors. I've already covered Wall Street's "expert networks" and think they're full of it. Insider trading goes on all the time, and it's not just hedge funds engaging in this illegal activity. Sure, they threw the book at Raj Rajaratnam, but that won't deter other idiots from engaging in insider trading. All they'll do is sharpen their skills to go undetected, which is very easy to do.

But what about this ambitious project to inspect the quarterly filings of firms managing over $1 billion? While that seems intelligent, the reality is that it's fraught with potential pitfalls. Even I have been hoodwinked looking into quarterly filings of elite funds. For example, look at the top holders of Trina Solar (TSL) as of June 30th, and you will see Maverick Capital, one of the elite hedge funds I track (click on image to enlarge):

Had you bought shares of Trina Solar (TSL) blindly six weeks after the end of the quarter, when top holders were disclosed, you would have gotten your ass handed to you. Elite hedge funds and other elite funds know people look into their quarterly filings and often use that to their advantage, either shorting the stock or going long a stock. The point is analyzing data from large hedge funds is not as easy as it seems and unless the SEC has extremely competent people doing this, and pays them competitive wages, they won't be able to decipher all the data.

[Disclosure: I trade solars and am currently long Trina Solar and believe investors should take a hard look at all solar shares after the Q3 solar slaughter. Chinese solars and Chinese shares have been clobbered with the Euro crisis and rumors of an impending Chinese economic slowdown. Moreover, US solar firms have filed anti-dumping complaints against Chinese solar firms, but China slammed these complaints.]

And L/S Equity funds are easy; wait till you see the volume of data coming from global macro funds engaging in all sorts of complex trades using OTC derivatives. The SEC and other global regulators should seriously consider forcing all hedge funds to use managed account platforms that are supervised by central agencies (central banks?) and staffed with extremely competent people that know what they're doing. Only then will they be able to aggregate all the data of complex trades and see patterns of systemic risk. And even that isn't a given but this proposal should be given some serious thought. The cost will be low (pooling assets to lower cost) and all hedge funds should be part of it, not just those managing over $1 billion.

As far as the ban on short-selling, I agree, it will have the opposite effect, but I am still perplexed as to why the SEC allows naked short-selling to take place. If a fund doesn't own the shares or bonds, they shouldn't be allowed to speculate. Some of the wild gyrations I've seen in the stock and bond market are directly related to naked short-selling and high frequency trading. The SEC has a history of covering up Wall Street crimes and I'm afraid that they are just blowing smoke in our face with all these new proposals. On that note, I leave you with a couple of excellent Morningstar interviews with Vanguard founder, Jack Bogle, who says that speculation is dwarfing investing. Listen to what he says and think about how it will impact pension funds and other long-term investors (click on refresh if videos do not load).

Thursday, October 20, 2011

Options for the Upcoming EU Council?

Andreas Koutras was kind enough to send me his latest InTouch Capital Markets' report, Options for the upcoming EU council:
Another Eurogroup- another opportunity for rumours scaremongering and good volatility. Merkozy initially said that by the 23rd of October a comprehensive solution would be presented that includes Greece and the rest of Europe. Later the Germans dampened the optimism and suggested a more sober approach. Lets see then what is on the table and what solutions the market participants are discussing.
  1. Bazooka option for Europe
  2. The agreement signed on the 21st July with Greece. PSI, etc.
  3. Recapitalization of European Banks
  4. EFSF leverage
  5. Faster implementation of ESM
  6. Eurobonds or measures towards fiscal Union.
The ECB Bazooka Option

The original idea of the Bazooka option was for the ECB to start buying bonds of the European periphery once they hit a certain yield (say 5%). There are many reasons why the ECB refused to go down such a road and here at ITC we have written on it before (see Attachment). Currently, this option is out of favour both by bankers and many influential politicians (mostly German). Needless to say that there are numerous proposals, which in essence all come down one way or another into the ECB printing money or taking the risk on its balance sheet. Some, are structured so that the legal hurdles are overcome (Maastricht treaty) others are more cunning in disguising the ultimate risk taker in a complicated structure.

We therefore do not see a high probability of this option being exercised.

Greece and Restructuring the Restructuring

It is no longer a secret that Greece is insolvent whichever way you cut its debt. The truth is that the agreement of the 21st of July addressed more the concerns of the European banks rather than the solvency and sustainability of the Greek debt. Now the market is trying to restructure this agreement by demanding a full solution for the Greek Gordian knot. Hardly a day passes without someone proclaiming a figure for the haircut (21%, 35%, 50%, 60%, 100% have been mentioned).

Lets recap the deal currently on the table and see what is feasible rather than talk a number out of our head.

The deal was based on the assumptions of avoiding a credit event (proper default), saving the European banks (including the ECB) from writing big losses and easing the cash-flow burden for Greece for few years. The hidden assumption was that given all these, Greece would be able to grow out of recession and ultimately be able to sustain the debt payments.

The IIF presented four bond exchange options to the bondholders. Three involved a 30Y bond with capital guaranteed by a AAA security and one 15Y with partial capital guarantee at maturity. If one discounted these new bonds with a 9% yield then a price of 79% came out. Why 9%? Why not 10% or more, after all, the Greek yield curve is far above the 9% figure. The 9% is arbitrary but this is where the IIF thought the Greek bonds would be trading after the exchange. It couldn’t possibly be in double figure (more than 10%) as it looks ugly in the eye and very emerging market, not at all European.

How can we alter this 21% haircut without triggering a credit event. i.e. without a proper default.

Well, it can be done by a combination of things:
  • Altering the coupon. By reducing the average coupon by 1% we can go to 31% (in option 1)
  • If we reduce the capital guarantee to 80% instead of 100% to all options we gain another 5%.
  • Extending the maturity to 40Y could possibly bring some more, depending on the coupon.
  • One could assume 10% yield (say) instead of 9% yield. That would add another 3% of haircut.
In other words, without triggering too much objection from the bond holders we could have voluntary haircut of around 36%. Anything more than that would risk the participation in the PSI,which currently stands close to 90% (according to press reports).

Any talk of 50% or more then carries the big risk of a coercive offer, namely a default that Europe is trying to avoid all this time.

There are however, other aspects of the deal struck on the 21st of July that can be improved. For example,
  • They can allocate more money in buying back some of the bonds now trading close to 50% (or less).
  • They could extend the eligible bonds to 2030. Currently, only bonds maturing up to and including 2020 are eligible.
  • They may also find a way to include the ECB holdings (around 45bil), which are currently immune from the restructuring.
  • A more detailed Marshall plan could be structured
Even after the PSI exchange, Greece would be liable to pay for the interest in the new bonds. According to our calculations this is around 6bil (assuming original PSI deal), which presupposes a 3% primary surplus for Greece. As this is hard to achieve in the current recessionary environment then further bailout funds or grace period may be negotiated given that Greece comes clean in their commitments.

The nightmare scenario for Europe is the proper credit event. Let me explain why I call it a nightmare:
  • Banks including the ECB would have to write down their losses immediately. No longer the option to have them in the banking book marked to fiction. Some banks have taken that road already but many have not.
  • ECB would not only write losses on their 45bil portfolio but would no longer accept Greek bonds as collateral. They could alter that internal rule but it is highly unlikely, as it would damage the reputation of the ECB even further.
  • European banks (non Greek) would have to replace this with other acceptable collateral. Given the recent funding stress, it would only add to the problem.
  • Greek banks would need to find alternative sources of funding or go bust causing further social unrest in Greece. One possibility is for the Bank of Greece to use the full ELA tool with the approval of the ECB. However, even in this case, the run on deposits may stress the physical currency reserves (need to issue paper money to satisfy withdrawals). Accessing the ELA that is a liability of the state (in default in this case) may cause some philosophical concern.
  • As there are no Collective Action Clauses (CAC’s) in the bonds under Greek law, it may take 6months or more to reach an agreement that satisfies the creditors. All this time Greece would need to finance pensions and salaries.
  • The risk of other countries, in particular Ireland asking for a proper haircut is great.Peripheral debt would suffer. This would probably force more losses on the European banks who hold Peripheral debt. EU must have a recapitalisation plan in place and not expect the market to come up with the equity.
  • If Europe decides a Credit event, then the Greeks might feel emancipated to deal with their debt themselves, rather than leaving it to Europeans. For example, they could pass a law transforming all GGB’s into 40Y zero coupons. Bondholders would then need to go to Greek courts to argue their case. This is not something that they would want to do. As Greece does not deny payment but only moves the repayment date it is not an appropriation of funds.
  • CDS contracts would have to be paid out. Although the net volume is small we do not know were the losses would hit adding to the unpredictability factor.
Thus unless the European leaders have concrete answers to the above risks, a credit event seems highly improbable. In conclusion, we believe that the deal struck on the 21st July would be altered but not as some suggest drastically.

Recapitalization of European Banks

There are various estimates on how much capital the European banks are short. The summer EBA stress tests suggested 3.5bil. The IMF calculated that 200bil are needed, whereas others have placed the figure in between. Nationalising Banks is actually more expensive than saving the country so it is not an option that one can seriously consider, unless of course, you bite all senior bondholders (on top of the subordinate ones) before the nationalisation.

The options that seem to be considered are a version of the American TARP. The original thought was for the respective countries to foot the bill (Germany suggested) but this looks hard from the perspective of the less well of countries that want Germany to take the bill. Another suggestion was to use the EFSF funds. However, Germany opposes the cash increase of the available EFSF, which now stands at 440bil. They instead seem to be accepting a more “efficient” use of this money.

EFSF Leverage

Various forms have been suggested in order to increase the “efficiency” of the 440bil that are currently available to the EFSF (actually less, around 250billion, as money are already committed to Ireland and Portugal and possibly Greece). The idea of transforming the EFSF into a bank and using the ECB funding was dropped very fast.

The current flavour involves the usage of the EFSF as almost a monoline insurance. Under this insurance scheme, the EFSF would insure the first 20% of losses given default of the new bonds issued in the Euro area. This, proponents say could increase the effectiveness of the EFSF to 1.25trilliion (250bil times 5). Although details of this proposal are not known with accuracy or certainty there are some concerns:
  • One of the fundamental principles of insurance is diversification of risk. You simply do not insure all the flats in the same building against fire risk. In the case of Europe, Italy and Spain represent a huge chunk of EU debt (more than 2.5trillion).
  • The EFSF insurance is like a father selling protection against death for his own his family including himself. There is very high correlation as 130billion out of the 440billion in the EFSF come from Italy and Spain (Greece, Portugal and Ireland account for 30billion). This effectively means that Germany and France would foot again the bill. This may cause further downgrades from the rating agencies.
  • The PSI idea was to share the burden with the private sector. The current insurance scheme moves this back to the official sector.
Article 125
(ex Article 103 TEC)
1.The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.
  • For the past 2 years, the EU is trying hard to avoid default and credit event. They did not allow Irish banks to default neither Greece to haircut their debt back in may 2010. Now they would be insuring bonds against default that they vowed to prevent?
  • This 20% insurance would be given to all regardless their solvency position? That is certainly not a prudent insurance policy from the point of view of the insurer
  • Markets may take the opposite view and start their pricing with a 20% portion as a AAA and the rest much lower. This would force the bonds of unsuspecting countries much lower than they are trading now
  • Under which credit events, would the 20% be triggered? Lets assume that “Failure to pay” is acceptable, would restructuring be an event that would trigger the insurance? Given that Greece is restructuring “voluntarily” would it be insured?
  • Some say that this insurance policy may contravene article 125 of the TFEU (see box)
At the moment we have no details of how this insurance can be implemented, however, my guess is that it is not something that can be implemented efficiently and fast enough to address the current crisis.

ESM brought forward

Another idea that is being put forward is to bring forward the implementation of the ESM. The ESM would certainly have more money to deal with the current crisis (lending of 500billion) but it also means testing for solvency all the countries at an earlier stage. In other words before the austerity plans had any time to work properly. It may then cause more volatility than ever before. Eurobonds and Fiscal Union.

Given the reluctance of policy makers to leak anything on Eurobonds and Fiscal Union we should expect very little progress on that front. However, back in august the EU charged the president Mr Van Rompuy to come up with suggestions.

We have not heard much since then and in his speech at the LSE he refused to release any details. It seems however, that Germany would come up with some sort of sanctions and measure against fiscal profligacy and much closer monitoring of budgets than ever before. This direction is potentially the only viable long-term solution to Europe’s problems. However, it depends how it is implemented. If for example is just an imposition of a Franco/German fiscal will, then it would cause far more problems than it would solve.
As I stated in my last comment, time is running out on EU leaders, especially now that Moody's downgraded Spain. In Greece, Greek Prime Minister George Papandreou is set to risk further social unrest as he pushes a new round of austerity measures needed to convince euro-area leaders that Greece will hold to its bailout program.

A friend of mine called me last night to tell me that markets move at "Mach Speed," but politicians don't care and he also reminded me of the story of Louis the XIV cutting off bankers' heads. "I wouldn't be surprised if we get a series of bank nationalizations in Europe and the US in the future as politicians and the public are fed up with all the shenanigans. As for ratings agencies, they're a joke and have to be done away with."

I'm not one who believes in nationalizing banks or any private entity but he's right, people are fed up of bailing out incompetence and negligent risk taking. I thank Andreas Koutras for sharing this important report with my readers and leave you with a recent interview he did on Greece's MEGA channel. The interview is in Greek and covers the points he raises above.

I also embedded an interview with Jim Swanson, chief market strategist at MFS Investment Mgmt., who says it is wise to be patient when it comes to foreign influences on our markets."People should be cautious because Europe could detonate through policy error," Swanson says in the attached video clip. He believes Europe is the "number one obstacle" blocking markets right now. "Foreign events are intruding on the business cycle and on valuation.''

Taking a longer term view, Swanson says his job --managing over $200 billion in assets-- is to stay fully invested and not to chase or time market bottoms. That said, he thinks investors will look back longingly six months from now. I tend to agree, if EU leaders get their act together and come up with a robust solution to this debt crisis, this will have been another excellent opportunity to buy stocks at depressed levels for a nice countertrend rally (do not believe in buy and hold as markets will be trading sideways for the next ten years).