Thursday, November 4, 2010

What Bernanke Doesn't Understand

The United States Constitution was designed to create a government of checks and balances. Even during the Civil War, Lincoln could not ignore the powers vested on Congress and the Supreme Court. Which is why it is at least curious that we have come to vest quasi-dictatorial powers in the office of the chairman of the Federal Reserve.

Like his predecessor, Bernanke seems to be able to ad-lib extreme and profound policy initiatives with the sole backing of his "I know better" reserved for the most powerful dictators in History. Dictators, by the way, the American system has worked hard to avoid. Even Roosevelt in the midst of the Great Depression, had to deliberate, negotiate and even back down before the Supreme Court. Since the Federal Reserve was not contemplated in the Constitution, there is no mechanism to keep them in check, force them to debate, and even reconsider their actions. The confirmation process, as we have seen, is opaque enough to be out of the reach of most Americans. Yet, this individual (the other members just seem to go along for the ride) wields more economic power than the President of the United States.

As the Greeks described long ago, efficiency is the main advantage of a good dictator. The main disadvantage is that is hard to tell the dictator when he is wrong. For all the trust we seem to place in his wisdom, Bernanke has shown in the past not only a dangerous lack of understanding of the complex global financial system (see "The sub-prime crisis is small and well contained," or "American financial institutions are strong and well capitalized," among others), but also a willful disregard for the consequences of his actions. After all, is there anyone on this planet who still disputes that the Greenspan policies created the housing bubble? The most dangerous leader is the one who does not seem to acknowledge the past and learn from his mistakes.

Unfortunately, for us, Bernanke is a prisoner of his academic record. As most know, the studied the Great Depression and the Japanese debacle long ago. Back then, he decided what the problem was and what the solution should have been. As far as he is concerned, Japan could have avoided the two lost decades after their real estate bubble burst by throwing money from a helicopter. Never mind what History says about the aftermath of bubbles, or how high the relative value of Japanese land was in 1990, or the effects of an older population in a country without immigration, or any of the dozens of factors that have influenced the Japanese economy. Bernanke wrote a paper saying the monetary-hammer was the tool and, to him, every crisis looks like a monetary-nail.

Today, our esteemed professor has and OpEd in the Washington Post explaining HIS decision from yesterday. If you want to save time allow me to paraphrase, "core-inflation is too low, unemployment is too high and I do not know what else to do." That's it.

Sure, there is some academic language about lower rates encouraging consumption and investment which is dutifully parroted by our media, but who are we kidding? Does anyone really think that driving the 10 year bond from 2.80% to 2.50% will spur even one project? Would you buy your neighbor's house as an investment just because mortgage rates go from 4% to 3.5%? Would you buy it if the rate was zero?

As anyone following our economy knows, companies and individuals have been borrowing money at record low rates for a while. Those who haven't probably cannot because of lack of income, collateral or future earning streams, not because rates are too high.

What Bernanke conveniently ignores are the risks of his policies. No, I am not talking about hyperinflation, the destruction of the US dollar or other medium to long term calamities that may indeed result from his actions. My contention is that we are creating obvious problems right here and now.

Like Greenspan, Bernanke has very particular views about inflation. Not only does he choose to ignore important service components like health care which are underrepresented in the indices, but he explicitly ignores food and energy, two of the three most important items in a poor family's budget (the third being housing). Not only is much of our oil imported, but all commodities, even if locally produced are priced in dollars in the global market. In addition, for the past 10 years or so, commodities have become an active asset class for global investors/speculators. If QE results in a lower dollar, we will in all likelihood see higher commodity prices. Yet Bernanke will insist that there is no inflation, which will encourage even more speculative flows into commodities creating vicious circle that will heavily impact on the American poor. Talk about helping the little guy.

A policy of lower rates in a deleveraging economy neither spurs growth nor encourages employment. Hard as it is for Bernanke to understand, context matters and influences the economy's sensitivity to interest rates. Lower rates, instead, are nothing but a subsidy to those willing to take on leverage (banks and speculators) from those owning the capital (savers and retirees). As we know, money is fungible. Thus, the is no reason why the banks and speculators will all of a sudden rediscover productive projects at home because rates are 0.50% lower. Instead, they will continue to pump money into commodities, projects abroad and maybe stocks. Unless you own some of these, I fail to see how that benefits the average American.

I suppose it is what we can expect for forgetting the principles that made this country great and bestowing to much unchecked power in one individual, even one with a PhD.

Friday, July 30, 2010

European Stress Tests: The smoking gun

What is a (banking) stress test?

In theory, is an exercise where the bank revalues its assets under one or more adverse scenarios in order to find out whether or not it is adequately capitalized.

In simple words, "if things became worse than they are now, do we have enough money (capital) to absorb the losses?"

A prudent banker prepares for the actual stress (not the test) by either reducing the price of an asset (or creating a rainy day account) once collection becomes less than certain. Again, "I think US treasuries are 100% safe so I value their chance of default as zero (no rainy day account). Greece on the other hand, I am not so sure, so I either value the bonds below par or create a rainy day account." If someone doesn't pay, the bank doesn't take the full hit on the day of default since it has provisioned against the loss. Monitoring credits and saving for a rainy day is the very essence of banking.

In Europe, bankers were happily riding the gravy train of buying Greek, Spanish, or Portuguese debt and treating it like German debt (no chance of default). Since the Greek debt paid higher coupons but required no provisioning, this was great for returns as well as bonuses.

At some point early this year, someone realized that the Greek debt was not as safe as its German brethren. Even the rating agencies, never too aggressive to downgrade anything, currently rate Greek debt as junk.

Since most European banks are loaded with Greek debt, the policy makers faced a dilemma vis-à-vis the stress tests: If they used stress prices (current market prices minus a cushion) the banks would show the potential for steep losses. If they didn't perform the tests, the market would continue to distrust the European banks.

The solution? Allow the bankers to decide which portion of their balance sheets would be tested. How? By giving them the chance to book whatever they wanted in a so-called investment account. This would be akin to grade students on just the questions they are sure they know. They can still get a few wrong so, technically, it is still a test.

According to bloomberg :
"Lenders hold about 90 percent of their Greek government bonds in their banking book and 10 percent in their trading book, according to a survey by Morgan Stanley. They have to write down the value of bonds in their banking book only if there is serious doubt about a state’s ability to repay in full or make interest payments."
Yes, you read correctly. They booked 90 percent of the Greek debt in the banking book which means they can price everything at par. One can assume that the rest of the balance sheet was treated in the same way. This, of course, includes not only Spanish, Italian, Irish, and Portuguese debt, but, we may presume, Hungarian mortgages denominated in Euros as well as all sorts of loans to Eastern European companies.

Unfortunately, the first casualty of this blatant attempt to manipulate public perception of European banks will be confidence itself. Once lost, it will not be easily restored.

Spain "Austeridad (pero no mucha)" [Austerity (but not too much)]

I truly pity those who attempt to explain daily market moves. Last month, it was all about the PIIGS. This month, our manic-depressive portfolio managers, tired of waiting for another shoe to drop, have shifted their attention to the US economy.

Naturally, as they look at the US economy getting weaker, they had to do something, after all, what kind of a professional would you be if you didn't trade? So they sold the US dollar. Which of course means buying the Euro and the Yen.

So, for two weeks, we have heard that "the Euro is going up because Europe is stabilizing." Is it because of the stress tests? Well, not really, the tests had all the stress one can expect in the European continent in August. Not only did they ignore the true sovereign risk, but they made sure to render the results meaningless by allowing the banks to decide which risk would be tested while hiding the rest in investment accounts. I mean, would any buyer ignore any portion of a bank's assets on account that they promise to hold them to maturity?

In the meantime, the PIIGS are hard at work cutting their deficits for the benefit of the bondholders. Spain, for instance, has cancelled all sorts of public projects. Some of these, were only launched last year when the mantra was "Spend! Baby, spend!"

Canceling projects is relatively easy. After all, the construction workers are not the direct responsibility of the government. Public employment is another matter. As Spain announced today new record unemployment (click here if you can read numbers in Spanish) the report shows that the public sector continues to hire (click here if you can read charts in Spanish). According to this report, the "Autonomias" (regional authorities independent of the central government) have hired over 73,000 new employees in the last 12 months.

The conclusion is quite obvious. The markets focus on the big announcements by names they know like Trichet and Zapatero. If your competitors do the same, you can always say that you had all information available at the time. The reality on the ground, however, is quite different. In Catalonia, like in California, everyone the government fires/not hires is a voter. In the end, these are the people the politicians have to answer to, whether the bondholders like it or not.

Nobody has ever grown out of austerity without a devaluation. Although every situation is different, I suspect the reason is that the people on the ground, in the end, prefer bankruptcy to starvation.

I'll leave the moral judgment to the reader.

Disclosure: no stocks mentioned

Tuesday, May 11, 2010

An American Package for Germany

In 2008 in the midst of the financial crisis. Hank Paulson gave the term bazooka financial significance. The idea was that if you announce a package large enough you will not have to deploy it because the market will step in front of you and finance whatever you want financed.

Back in those days China, the US, the UK, Brazil, among others, announced large fiscal packages to stimulate their economies. The Europeans, on the other hand, claimed they didn't need to because of the automatic stabilizing effects of their wide and generous social safety net.

Then, in the beginning of 2010, the world discovered that Greece had borrowed too much money and lied about it. Not only that, but Portugal, Ireland, Spain, Italy and others (nobody talks about Austrian banks and Eastern Europe anymore) had more or less done the same (ok, maybe except for lying).

So the Germans, stingy and hardworking as they are, complained that they shouldn't bailout the lying spendthrift Greeks who retire at 50 and do not work too hard. In addition, the law clearly states that bailouts are not allowed in Europe. True said the Greeks, but we owe 300 billion euros and, guess what, most of it to your banks and those of your new friends the French. So, you either bail us out or we blow up your financial system.

At that time, Merkel and Sarkozy went looking for the bazooka. Could it be a declaration of solidarity? the market said no and the Greek curve became inverted. Could it be 10 billion? same response. What if we call the (gulp) IMF? short lived rally. What if we promised over 100 billion which could finance Greece for several years? That should do it. Except nobody would buy the bonds from their banks and they already own a lot. What could we do?

Enter Tim Geithner, an experienced member of the Rubin/Greenspan/Bernanke team of anything for the banks. You have to make the package large enough to ignite short covering by the speculators in Chi...Frankfurt. If you set up a special purpose vehicle (we have AIG, Fannie, Freddie, etc) you do not have to show it as national debt. You can finance it over 30 years and kick the can down the road. Maybe in a couple of years they will discover spontaneous nuclear fusion in Thessaloniki and the market will rally saving the banks. In the meantime, they can put all the Greek, Spanish, Irish, AIG, Fannie, Italian, and Dubai bonds in the investment account and keep them at par.

In the Lexus and the Olive Tree, Thomas Friedman describes the world alternative models (circa 1999) as the five gas stations. In the 2010 version, everyone has become an American financial engineer. A financial alchemist can turn any solvency crisis into a liquidity crisis. Thus, no bank ever needs to write down any investment because they can always count on a government guarantee and a friendly regulator. In this context, why would Bank of America or Wells Fargo lend to anyone if they can buy Greek bonds yielding 8% with a German guarantee and finance them at 0%?

The fact is that no country has ever cut 10% of its GDP in spending without a devaluation and Greece cannot devalue without leaving the euro and, as a consequence, defaulting on its debt to the German and French banks. Nobody in their right mind would finance this with his/her own money even if it meant losing monies already sunk into such a project. Of course, other people's money gets a different treatment.

This situation is unsustainable and it may blow up with the next German election, IMF audit, or Greek strike, but it could work and, hopefully, by then I'll be gone and You'll be gone. So, party on Garth! Party on Tim, Angela, Nick, George...

Wednesday, May 5, 2010

Why Is The Greek Bailout Not Working?

Although Greek debt problems did not appear overnight it is obvious that something has radically changed in the last 30 days. In a world used to thinking that policy makers can fix markets at will just by deploying their balance sheets it is disconcerting to see the lack of market reaction to the ongoing efforts by the IMF and the EU to avoid a Greek default. The question is why isn't anything working? Is it because the money won't come, because the Greeks won't deliver on the conditions, or are there other factors?

Although the Greek debt/deficit problems have been known for some time they did not seem to have any market impact until late last year. In fact, as late as October 2009, the Greek government didn't seem to have any trouble getting financing as Greek bond yields were around 2.3% for 2 years. During the first quarter of 2010, in the midst of shocking discoveries about off-balance sheet debt and accounting irregularities the yield on 2-year paper soared to 6.6%. By then, conversations about a European bailout began to appear on a daily basis in the financial press. After much dithering by the German government, European commitment to Greece was firmly declared and the IMF was enlisted in the rescue. The process should have climaxed last Sunday with the announcement of a gigantic package of more than 100 million euros which should be sufficient to keep Greece out of the public markets for, at least 18 months.

Under the Hank Paulson description of TARP ("If you have a bazooka in your pocket you won't need to use it") large amounts of public money commitments do their work without ever being deployed as private financing usually steps in to capture, in this case, the Greek spread for the German guarantee. After markets sold off yesterday, the consensus (if after the fact) opinion was that the markets either did not believe the monies will be forthcoming or that they process will fail over Greek intransigence. Although Ms. Merkel's speeches do not betray any conspiracy, the 48-hour Greek strike does give this theory some credence. In my opinion, however, there is something completely different and perhaps unavoidable at play.

Last Sunday, the NY Times published a useful diagram to show why Europe is so concerned about Greece ("Europe's Web of Debt"). In simple terms, the German and French banks have too much Greek debt much in the SAME way many banks own too much real estate and/or toxic assets (they still do, by the way).

Consider the case of a risk manager at a large German bank. You have been told, very recently, that owning so much Greek debt is bad banking and that you should have never accumulated so much. As luck will have it, you, your boss, and the regulator, agree that you will get a chance to get out either through bond maturities or by selling your risk as Germany will not allow Greece to go bankrupt. You are just waiting for the bonds to rally from the low 80's to something closer to par, where you have them marked as investments held to maturity often are, to cut your exposure.

Under the scenario above, every announcement meets the aggregate of all banks who have been natural buyers of Greek debt over the past n-years as better sellers and NOT as buyers as the bazooka deployers would want. In other words, the EU tried to bluff the market into financing Greece for a while longer and the market, unbeknown to its individual components, is calling the bluff.

Markets are about mass psychology. What policy makers fail to understand, is that the same participants who had no trouble accumulating Greek bonds at 150bps over German credit are unlikely to be enticed to resume financing at 14.5% over 2 years because they already own too much Greek debt. This, in my opinion, is why the Greek curve has stayed inverted in the face of positive announcements and why it is likely to stay that way. In other words, even if Germany would somehow agree to underwrite Greek risk no matter what for 3 years, which is very unlikely, the curve will stay inverted from 4 years forward (i.e. beyond the German guarantee) until all the excess Greek debt (that over what banks really think is too much) matures.

Like our sub prime borrowers, Greece borrowed too much over many years. The banks who bought this debt are now chocking on the risk and there aren't any new risk takers to take the balance. No amount of austerity from the Greeks will change the fact that 120% debt to GDP is now perceived as too high. Debt binges usually work themselves out over time or through defaults and this time is...the same.

Tuesday, May 4, 2010

Is TARP Greek for "Save the Bank(er)s?

There was a time when we thought that the biggest problem with bailouts was moral hazard. Like with so many things in life, the only loss is to one's innocence and only the first time.

As it is well known, the Greek government is on the receiving end of an ever increasing bailout package. In exchange, for such a ridiculous amount of money and the invaluable tutelage of the IMF, which by the way will become a super-senior creditor ahead of ALL bondholders, the Greek government promises to produce what amounts to a balanced budget.

As we know, balanced budgets are as rare as honest politicians as nobody likes to pay taxes and everyone is rather attached to their salaries and/or entitlements. In my opinion, the Greeks are as likely to deliver a balanced budget in 2013 as anyone else in Europe and beyond, which means not at all. How does anyone think that raising taxes and cutting salaries will deliver short term growth in the presence of higher rates is a mystery to me. More importantly, the market for Greek bonds seems to agree with my assessment as the curve is still inverted from 2 years onward signaling concern about default.

Yet, we still get comments from various analysts and politicians to the effect that the situation is under control and it has a fair chance of getting better (if only the market would finance Greek debt at "reasonable" prices).

In this context, it is interesting to find out that the money from the package seems to be following a familiar script. In other words, just like our TARP, the Greek package is already mutating from "fund the government" (or pay the debt, which is equivalent) to "stabilize the banking system" which means the banks will get the money and decide what to do. Maybe even pay bonuses.

The problem with this (global) crisis is that it is destroying whatever credibility we may still have on the financial/political system. Enormous amounts of public money are being doled out on an attempt to keep the party going. The tragedy is not that, if History is any guide, it will not work, but that people will feel cheated out of their hard earned taxes. Money comes and goes, however, credibility is easy to lose and hard to get back.

Friday, April 30, 2010

Greece: Setting Up for the Final Act?

According to our esteemed financial press it is almost a done deal. Greece has agreed to austerity measures designed to cut their deficit by 10% of GDP in three years and with this they will get an infinite amount of money from the IMF (20% courtesy of American taxpayers). With this financing, they will not have to come to market anymore (why are 2 year bonds still trading over 12%?).

"There was not much room for us to negotiate," the Greek official said. "This is the way the IMF works—if you want the money, you go by their terms. "
Makes sense. In the old days, before too big to fail, lenders used to dictate covenants for emergency financing. The IMF, as we know, thinks all the Greeks have to do is cut spending and raise taxes. Apparently, the Greeks needed the IMF to show them they didn't need to run deficits all those years because their economy would have worked the same with much less spending.

Interestingly enough, this flies in the face of the Trillions in stimuli that have been showered in the US, China, Brazil, the UK, and others, based on the theory that the worst thing you can do to a slumping economy is cut spending. I suppose Keynesianism only works in countries of certain size? I guess I missed that lecture in my macro 101.

In any case, it is clear that the overpaid geniuses at the IMF are back to their old methods. The debt must be paid at all costs because it was issued. Whether there is any chance of the Greek economy ever generating enough surpluses to pay the IMF, now first in line ahead of the bondholders, it is apparently of no interest to the politicians who just want this unforeseen crisis to away fast.

Meanwhile, in Athens, the unions are certainly going to think about what it is best for them. Can you blame them? At some point, they may realize that the problem is as much Germany's (or France's) as much as it is theirs. Why? because if Greece cannot deliver the austerity measures and the IMF does not provide the money to cover the deficit the German banks will lose (again) several billion euros. In this context, it is perfectly reasonable for the Greeks to claim shared responsibility and reject the austerity terms while accepting the money. At that point, the Greek politicians will prefer the voters to their friends in high places.

Therefore, if you think this crisis is over I suggest you consider you consider what would you do if they cut your salary because the government has issued too much debt. If you think this is a ridiculous proposition because Greek public employees are, in your view, overpaid, consider how much success you think you could have convincing them (hint: Greek unions do not like to be pushed around).

The bottom line is that, no matter what the Greek government says, a 10% deficit cut will be difficult to implement. The guys at the IMF have plenty of experience in the matter. If I have to bet, I'd guess the first audit will result in a disagreement of some kind over lack of progress. At that time, the IMF, after consultation with the G7, will issue a waiver. By then, the markets may be ready to reconsider the viability of the Greek debt (by then) junior to the IMF loans

Of course, it is possible that this time will be different and Greece will be the first country ever to emerge from a situation like this without a devaluation.

Meanwhile, the Greek bond curve is still inverted.