Le radeau de la Méduse

This painting by Gericault, one of the most famous of the French Romantic School, depicts survivors of the shipwreck of the frigate La Méduse as they are to be rescued by the brick Argus.  The disaster was caused by incompetent leadership and resulted in over 150 deaths.  The survivors picked from the raft resorted to cannibalism to survive.

It is too soon to compare the current travails of the eurozone with those of the sailors of La Méduse, but surely it isn’t to say that a euro shipwreck looks increasingly possible.

The latest report by the IMF on Greece is sobering.  The Greek economy is weaker than anticipated, the pace of structural reforms is slower (partly as a result of bureaucratic resistance, partly as a result of poor implementation); bank deposits keep on shrinking, credit to enterprises is falling, competitiveness is marginally improving, mostly as a result of dismissals.

While large institutional bank creditors had “voluntarily” agreed to a “haircut” of 50% on their Greek public bonds, rumor has it that the government wants to apply it only to the nominal value of the debt; by offering very low interest rates and extending maturities it would increase the effective “haircut” to 75%.

Greece is in a bind as the IMF, ECB and other euro governmental credits are exempted from the “haircuts” so that private creditors bear the brunt of the restructuring.  As I wrote in a previous note, there is little difference between a 75% haircut and reneging on one’s debts.  Argentina is a good example of that, and it has been a decade since it hasn’t been able to tap international bond markets.

Furthermore, can Greece fail to pay 75% of its public debts and still belong to the eurozone?  Can Greece restructure its public debts, exchanging them for new bonds worth 25% of the originals, and still characterize the process as voluntary? The answer is no and no.

Initially, I thought that the insistence by several European heads of state that the exchange be voluntary was nothing more than pride.  Now, I wonder.  What if big European banks had been sellers of CDS (credit default swaps)[1]?  Why not?  After all, the underlying credit risk was supposed to be zero; what a better business than selling for thousands of euros protection (CDS) against a risk that was non-existent (sovereign default)? 

European banks may have sold relatively few Greek CDS, but they may have sold tons of French, Italian and Spanish CDS, and a formal default in Greece would, at the very least, force these banks to provision against the other countries’ CDS because the myth of zero-risk eurozone would disappear.  Provisioning is a euphemism for taking a (big) loss.  I did look into the exposure of BNP and other banks to European sovereign debt but these banks only disclosure their exposure in their banking books, not in their trading books, which is very unfortunate under the circumstances.

The only way for Greece not to, in effect, renege on its obligations is for the IMF, the ECB and other euro governmental creditors to share in the losses of restructuring.  If not, Greece is out of the eurozone, with all the implications it carries for the rest of the area.  Even then, it is difficult to see how Greece will improve its competitiveness and enable its economy to grow fast enough, particularly given the European austerity and deleveraging policies.  At the end of the day, I can’t see how Greece stays in the eurozone.

The other eurozone members face different but equally daunting problems.  One is the fragility of their banking system.  In the US, banks account for 1/3 of total credit and capital markets for 2/3.  In Europe, the proportions are reversed yet banks have less capital and less stable funding (their ratio of loans/deposits being well over 1.0).  In recent weeks, big European banks have announced extensive divestiture programs to strengthen their balance sheets.  This may be good at the micro level, but it is bad at the macro, leading straight to recession.  And then there is the CDS question raised above.

European governments could have forced their hands with their equivalent of a TARP program (by far the most successful US effort to stem the 2007-2008 financial crisis).  Yet they shied away, afraid of jeopardizing their credit ratings.  This was a terrible mistake.  The financial situation will not improve until banks get stronger, and sovereign ratings will drop unless forceful governmental action is taken.

The other problem is existential.  Member countries share a goal but not the means to reach it.  They want to be a powerful economic bloc but they do not want to pay the price for it but harmonizing their fiscal and social policies, and in the process relinquishing some degree of sovereignty.  They desire a common currency but refuse to let the ECB back member states private banks not to mention member state public debts.  Finally, member state populations, when asked, reject the idea of a Brussels command, yet they now have to accept one from Berlin and, yes, Brussels.

As the situation worsens and tensions rise, the survivors are warily eyeing each other; numerous meetings have shown that they are unable to reach big decisions (such as recapitalizing their banks, getting the ECB to step up to the plate) or to display real solidarity.  The sniping has started (witness the French/UK[2] war of words on credit ratings) and will get worse. 

For all of the demonstrations of coordination and harmony, it is clear that Germany is the leader of the eurozone and France is the more equal of the rest.  When de Gaulle envisioned l’Europe des Nations, he meant not to relinquish sovereignty to Brussels; today, it has been relinquished in part to Berlin.  President Sarkozy will no doubt continue to play the game until the elections; doing otherwise would mean acknowledging a reality which the French dislike. 

Afterwards, changes are inevitable.  Pulling up to Germany’s level would require huge changes in labor laws and a shrinking of the public sector which seem beyond Mssrs. Sarkozy or Hollande powers.  France can’t revert to the age-old French/English/Prussian triangulation because the UK are outside the eurozone.  Italy, under strong leadership, could offer France some of the balance it wants.  Still, Italy would not offer a real triangulation, and as a result, I think that France will wish for less European integration rather than more, for a gaullian Europe of Nations so to speak.  Ironically, in so doing it would get closer to the UK position.

Perhaps a slowly healing US and resilient BRICs will give Europe six months to a year to avoid disaster.  But the pressure will not abate, the price to pay will not drop.  In the end, a Europe of Nations is more representative of the continent’s two millennia of history than a contrived eurozone.

Germany could mitigate the strength of its new currency by preserving a mini eurozone with Austria and the Netherlands.

---

[1]  This is a question that hedge fund manager David Einhorn has also been asking.

[2]   I know, the UK is not part of the eurozone.

Market prices are what they are

Market prices are what they are, and it is an exercise in futility to argue with them; if you think they are too low, buy; if they seem too high, sell; or you can just stay away if they look too confusing.

As I am writing this note, consider this.  The French 10 year euro-bond yields 3.511% p.a. to maturity.  This bond is rated AAA.  The Brazilian 10 year dollar bond yields 3.486%, yet it is rated BBB.  Finally, the Colombian 10 year dollar bond yields 3.662% and is rated BBB-.

In other words, markets rank France just below Brazil whose credit rating is eight levels below, and only two levels above the investment grade floor.  Markets put France barely above Colombia which is rated nine levels below and barely investment grade.

Most musings by the press and economists point to France’s credit rating being lowered but remaining within the high investment grade zone (AAA to AA-).  But markets put France barely within the investment grade category; markets price in the possibility of a small loss or haircut. 

Actually, “small haircut” is an oxymoron: no country will be forced or willingly go into default simply to reduce its debts by 5% or 10%.  Rather, the small loss is actually an expected value: a given level of haircut or loss times a probability number.  So is it 30% x 2%? Or 20% x 10%?  Who knows. 

What markets are saying is that this probability number is no longer zero and that, barring strong European political will (which is so far conspicuously absent), it could be anything.

On the other hand, one could also question how strong the economies and financial systems of Brazil and Colombia would be if Europe were to spiral into chaos and the US would continue to twiddle its thumbs.  With all due respect to Brazil and Colombia, I have always thought that emerging market investment grade was another oxymoron.

So what will it be?  It is fair to say that France is no longer a AAA borrower, at least not until it makes some reforms that it has shied away from.  It is probably a AA- or an A+, three to four levels below AAA.  At the same time, I cannot rationalize buying Colombia or Brazil at current yield levels.  Would you buy buy Brazilian or Colombian bonds paying a nominal annual return of 3.5% to 3.7% if you had to hold them for 10 years, come what may?
.

Unless you are convince that a Japanese-like decade of deflation is coming, I find it very difficult to buy any sovereign bond at current yields. 

Proust’s financial madeleines

There are images that are forever associated with great crises, and every time we see them, we are reminded of their context, like Proust with his madeleine.  IMF chief Michel Camdessus watching over, as Indonesian President Suharto signed a financial assistance agreement, was the most vivid image of the 1997-1998 Asian Crisis; a generation of leaders across the emerging markets swore that never again would they be caught in such an embarrassing situation, which led to the massive foreign exchange reserves accumulation of the following decade.

The shared smirk between Chancellor Merkel and President Sarkozy, as they were asked about their faith in Prime Minister Berlusconi, has become the symbol of the current European crisis.  But what will it lead to?  PM Berlusconi has been replaced by PM Monti, and Italians are no fonder of public humiliations than Indonesians were back then.

Standard & Poor’s was criticized for having taken into account politics in its decision to downgrade the US.  They were just trying to look a few years ahead, and were right to introduce this qualitative factor.  If we want to look into the future of Europe, we should consider history and culture too.

Italy is the key to a successful European project.  It was a founding member of the European Coal and Steel Community in 1951, the first step toward the constitution of a European project, and of each of its subsequent iterations (the European Economic Community, the European Community and the European Union).  Its population and its economy have been of a size comparable to those of France and (West) Germany; leaving it out would have been like trying to build a stool with two legs.

The importance of Italy was and remains also rooted in history and culture.  Culturally, Italy is the gel that makes Europe click.  For all the outward demonstrations of affection, France and Germany are strong enough to head a balanced Europe, yet too different to make a harmonious one.  Imagine a symphonic orchestra with brass, percussion, woodwind but no string section.  It could play, but somehow it would not sound right and both players and the audience would soon tire of it. 

Finally, Italy is of strategic importance to a united Europe.  It represents its the Southern flank, bordering the Mediterranean basin, and offering the major entry point for people and goods from the former Yugoslavia, and beyond, through Turkey, from Central Asia.

So Italy, for all these reasons, is an essential part of Europe; should Italy fail, so would Europe.  And my judgment is that it won’t, and this for three reasons.

First, Italy’s current problem is one of economic and financial management, not one of solvency.  Unlike Greece, Italy can grow its economy to pay its debts.  Second, the rest of the euro zone has no choice but help Italy save itself, and themselves.  Third, Italy is on the edge of the precipice, and that is the only spot where people and countries will really accept to make changes; in this instance, this meant forcing out the prime minister, voting in a non-political cabinet led by the very able Mario Monti, and giving it two years to try and turn the country around.

Total success will be very difficult, but significant progress is likely.  In this case, France will find itself under tremendous pressure.  In the early 2000s, Chancellor G. Schröder substantially improved the German economic competitiveness through a broad mix of social, labor and tax reforms.    France did not, or could not, match this, and its labor productivity is generally estimated to have lagged Germany’s by at least 30% as a result.

If Mario Monti can convince his compatriots to make substantial reforms, France will be put in a very delicate position: not on the edge of the precipice to have to make big changes, but close enough to feel the intense pain.  Furthermore, with presidential elections coming up, it is out of the question to set up a “technocratic” government, and very unlikely to expect a coalition cabinet.  With profound political divisions and powerful trade unions accustomed to call strikes whenever they want to, the new president, Nicolas Sarkozy or François Hollande, may be in a position where the austerity measures that he can get approved in Congress are very unpopular yet insufficient to reverse mounting financial pressures.

Italy is not Greece, and I do expect that it will pull out, although I don’t expect this will be a linear process.  I do expect France to have a rough 2012 and possibly 2013.  Indeed, the image that will be most closely associated by this European crisis may not be the Franco-German “smirk”; it is yet to be seen and may be most Gallic in nature.

Confidence or else

In the final scene of Le Corniaud, a classic of French movie comedies, as they ride to the police station, a gangster (played by de Funès), is explaining to the naïf who helped in his capture (played by Bourvil) how to multiply his prize money.  The naïf is doubtful and de Funès can’t help but blurt out: “Don’t you trust me? But really, don’t you trust me?”

The US, Europe and China face their own economic problems, but the common obstacle towards their recovery is the lack of trust in which their citizens hold politicians.  And of course, the greater the needed sacrifices, the more people will insist that politicians be both competent and fair-minded.

Take the Greeks.  Here they were, spending their merry and voilà, they got into the EU, no questions asked.  And not only could they keep overspending, but now they could borrow all the money they wanted almost as cheaply as Germany. Was it their fault if they took free money, or was it the fault of the markets that threw the money their way?

The problem is that markets now want Greeks to become German-like overnight.  Other European countries would give Greece more time, if they trusted it.  And the Greeks themselves would likely bite the bullet, if they trusted that the pain would be shared among all parties, rich and poor, foreign creditors and fellow European nations.   

But whom to trust to lead them?  The Panhellenic Socialist Movement (PASOK) was in power when Greece joined the euro-zone; the New Democracy succeeded it and it was on its watch that serious deficiencies in public finance accounting were recorded; finally, PASOK came back in 2009 but its current leader, George Papandreou, has seen popular support evaporate.

With responsibilities for mistakes so evenly shared, it is understandable that no party is viewed as a savior and that the Greek population seems to prefer a coalition government.  Still, even if this is what happens, the task of the new government will be extremely difficult.  More austerity looks unlikely as not politically feasible.  Increasing the “haircut” on foreign creditors wouldn’t reduce public debt that much, and if it reached 75%, the whole exercise would look more like repudiation than restructuring.  A meaningful debt reduction would necessitate the ECB, the IMF and several governments accepting to take a loss on their loans, which is possible but, in some instances, would be a first.

Even if some combination of the above were achieved, Greece would still need to grow and become more competitive.  It is regrettable than privatizations, which could both help reduce the debt and form the basis of a more competitive economy, have been deemphasized lately.  This leaves only three possibilities: cutting salaries further, introducing permanent transfer payments within the EU or devaluing the currency. 

As I noted earlier, I think that further cuts in salaries are not in the cards.  Setting up permanent transfer payments is a possibility.  After all, exports account for 1/3 of Germany’s GDP, and of these, 63% go to the EU (35% or so go to the euro zone countries).  It is clear that countries like Germany (and the Netherlands) need a healthy Europe to which they can export in euro terms; their exports outside the euro zone benefit from being denominated in euro, rather than in a stronger deutsche mark.  For the richer members, it makes sense to permanently share some of these benefits with the poorer members of the euro zone.  But again, it is unlikely to occur in the near term.  Finally, there is devaluation, i.e. exiting the euro; this would offer immediate and sizeable financial benefits provided that such a move was accompanied by very tight management of public spending and inflationary expectations.

I think that the odds are 50/50 that Greece stays within the euro zone.  Staying, in my view, would necessitate the following: (1) the ECB, the IMF and European governments taking a “haircut” on their loans; if my memory is correct, some supranational institutions took a loss on their Argentine loans a decade ago; (2) the privatization program being expanded to up to $100 billion and implemented as soon as possible, with some features akin to the Chilean capitalismo popular in order to give the Greek population a share in its upside potential; (3) the coalition government implementing the adjustment program  more effectively than its predecessors, and (4) some sort of medium to long term transfer system at the euro zone level (there again, confidence will be key, confidence by the euro zone members that Greece will deliver on its promises, confidence by the Greeks that richer euro zone members will deliver on theirs).

Unless all sides can show results, confidence will collapse and we will be left with the exit scenario.  External financial assistance will be cut; this won’t be so difficult if European banks are recapitalized and Italy mends its ways.  The Greek population will refuse to sacrifice further, will reject traditional political parties and leaders; unrest and violence will grow; parties outside the mainstream will gain influence and by the end of 2012 the possibility of a military coup will have greatly risen.  Contrary to popular opinion, military coups usually occur because a sizeable portion (at least 1/3) of the population wants it, not because some general feels like grabbing power.  This would isolate Greece politically and economically and precipitate its exit from the euro zone.

Greece may still choose to exit the euro zone in a democratic fashion if it decides that it cannot bridge the productivity gap with the core of the euro zone, or if it decides that the costs of such an effort outstrip its benefits.

What is clear is that Europe must be rethought as it is becoming fragmented.  At present, we have the 10 non-euro countries, some of which have sizeable and vibrant economies (Poland, Sweden and the UK), we have a strong core euro zone (with the likes of Germany, France, the Netherlands, Finland), we have a weak euro periphery (Portugal, Greece, Cyprus) and finally some countries which could move into any of the above categories (Italy, Spain and Ireland).

If a euro zone with 27 members is not feasible, at least for a long time, what should Europe stand for?  If its purpose is to strengthen the economies of its members, wouldn’t a free trade zone achieve that, without the need for a common currency?  If the purpose is enhanced security, what is the need for a common fiscal policy?  What is the sense of a common central bank if this bank is not the lender of last resort?  Harmonizing fiscal and monetary policies is much more demanding than it sounds when one realizes that this necessitates harmonizing social, labor and defense policies too.   

For a thousand years, France, England and Germany’s predecessors have followed a policy of triangulation to advance their interests and keep rivals in check.  In a sense, the European Union was a way to keep tabs on each other, to get not so close as to surrender sovereignty yet close enough to discourage confrontation.  It might have worked if the Union had been limited to its founding members.  It wasn’t.  The status quo will not work.  Each nation, the wiser for the experience, must now decide what it wants and what price it is willing to pay. 

I think that the current financial crisis can be contained in a relatively short period of time if confidence can be restored.  It will take years to solve it and longer still for a new Europe to emerge.

Are European banks undercapitalized?

This is the subject of fierce discussions nowadays.  My view is that they are, and by a significant margin.

Capital is the ultimate cushion to absorb unexpected losses and to inspire confidence from market counterparties and customers.  In other words, carrying sufficient capital is an essential element of risk management and a cost of doing business.  Banks and their critics have argued that other elements need be considered as well, such as funding, customer profiles and reserve policies.

All of this is true.  European banks, by and large, rely more on wholesale funding than their US counterparts; this is evident when one compares ratios of loans to core deposits.  On the other hand, European banks point out that they do not net out derivative positions as American banks are allowed to do, and this is also true.

Perhaps the most telling indicator that European banks are undercapitalized is the fact that their risk weighted assets, against which they need to carry capital, represent a much lower proportion of total assets than they do at American banks.

To illustrate this point, we have selected four of the largest and best European and American banks.  Both European and American exponents include one bank with strong exposure to investment banking and one with a greater exposure to traditional commercial banking.  They are JP Morgan (JPM) and Wells Fargo (WFC) on one side of the Atlantic and BNP Paribas (BNP) and Deutsche Bank (DB) on the other.  For the European banks, we have also used their adjusted total asset numbers, meaning as reduced by netting out derivatives positions.

The results are eye opening:

	JPM at 9/30	WFC at 9/30	BNP at 6/30	DB at 6/30
Total adjusted assets	$2,289	$1,305	$2,175	$1,750
Risk weighted assets per Basel I	$1,221	$982	$863	$464
Ratio of TA/RWA	53%	75%	40%	27%

Let me reiterate that all four banks are presenting their financial results in accordance with the rules and regulations applicable to them.  I would also note that Wells Fargo is the closest to traditional banking, so that it makes sense that it has the highest TA/RWA ratio.  But recent history has shown that there is no such thing as a riskless financial asset.  Based on this observation, BNP and DB carry much less capital in relation to their total assets than JPM and WFC, and they are more exposed to a riskless asset, like a sovereign bond, suddenly becoming "risky" and therefore deserving of a capital cushion. 

From a common sense point of view, I submit that it is less risky to make relatively small loans to millions of customers who have checking and savings accounts with you than to hold billions in sovereign bonds or to extend billions in credit lines to banks whose actual risk profile is known, if at all, only to their management.

This is not to say that European banks should be demonized or punished.  It is close to impossible for major banks not to hold bonds from their own governments, and the dicier public finances get, the greater the pressure heaped on them to increase these holdings.  It is also understandable that, as the European Union developed and matured, they would want to expand their operations in neighboring countries.  Italy, now in the gun-sight of everybody, was a founding member of the European Community for Coal and Steel, back in 1951, and of every subsequent iteration up to the present day EU.

In that sense, these banks were not guilty of gross misbehavior, like making loans to borrowers who could not afford to pay current interest.  I can sympathize with European CEOs who clamor for their countries to get their act together and shore up their budgets and public borrowing needs.

But at the end of the day, counterparties and customers will determine the profitability and even the fate of European banks, or at least of their management and shareholders.  In this regards, European banks have been too cute, relying on rules that were too good to be true.  Perhaps because they enjoy much closer rapport with their governments than American ones do, they have forgotten that markets can quickly get unforgiving and ignore the best Power Point presentations.

With some exceptions, European banks need to raise fresh capital, now.

Dr Strangelove: or how I stopped worrying and love the debt

Major T.J. “King” Kong: “The contents of your survival kit is... one pair of nylons, five condoms, one .45 caliber pistol with two magazines, $200 in gold coins, 2 packs of chewing gum, one miniature bible and combination Russian phrase book... OOOOOWEEE, a feller could have a pretty good time in Vegas with all that!

To many investors there is a new doomsday machine, the European sovereign debt crisis, and they can be forgiven if they are mistaking European politicians for the cast of Stanley Kubrick’s famous black comedy, President Merkin Muffley, Premier Dmitri Kissoff, Group Captain Lionel Mandrake and General “Buck” Turgidson among others.

Unlike the doomsday machine though, this crisis can be stopped if decisive action in taken.  The one lesson of past financial crises is that authorities must get ahead of events and stop them by applying massive force.  Mexico in 1994 is perhaps the best example of that.

Unfortunately, the EU has done the opposite, partly out of pride (no, this is not Latin America, and no, we don’t need the IMF) and partly out of inexperience.  While the initial tab was put at €30 billion, it is now in the trillions.

As I have argued in this blog, there is no way for Greece to pay off or even service its public debt, and as a result, there is little incentive for it to make drastic adjustments; the Greeks, and other countries in the same situation, have to understand that they need to sacrifice as much for their own benefit as for that of their creditors.  This presupposes that the debt be significantly reduced both via “haircuts” and large scale privatizations.

Whether Greece remains a full member of the EU or not is not easy to answer.  In either case, it would need to make profound structural changes, as did Chile in the 1980s, otherwise, it would continue to stagnate (if it stayed in the EU) or would expose itself to exploding inflation (if it exited).  My view is that if Greece exited the EU it would probably not come back; as much as sticking to the euro would represent a headwind, being a member of the EU would maintain pressure on Greece to practice good economic management.  All things considered, it is probably best for it to stay in the EU.

The heavy lifting is really about Italy, and to a much lesser degree, Spain.  Quite simply, there is no EU without Italy. Germany and the rest of Northern Europe should know it and act in consequence.  Likewise, Italy should realize that not making the kind of adjustments that are necessary will sink the euro, and they will sink with it.

So for all of you in Berlin, Paris, Rome, Brussels and elsewhere in Europe, here is, one more time, Major T.J. Kong:

“Well, boys, I reckon this is it - nuclear combat toe to toe with the Roosskies. Now look, boys, I ain't much of a hand at makin' speeches, but I got a pretty fair idea that something doggone important is goin' on back there. And I got a fair idea the kinda personal emotions that some of you fellas may be thinkin'. Heck, I reckon you wouldn't even be human bein's if you didn't have some pretty strong personal feelin's about nuclear combat. I want you to remember one thing, the folks back home is a-countin' on you and by golly, we ain't about to let 'em down. I tell you something else, if this thing turns out to be half as important as I figure it just might be, I'd say that you're all in line for some important promotions and personal citations when this thing's over with. That goes for ever' last one of you regardless of your race, color or your creed. Now let's get this thing on the hump - we got some flyin' to do.”

Michael Phelps and me

I am a masters swimmer who particularly enjoys the 200 and 400 medley events.  As the new season begins, each member on our team sets his goals for 2011-2012.  Suppose for a second that our captain should tell me that my goals are too modest, that instead they should be to beat Michael Phelps and train in consequence, that anything less would be viewed as failure and evidence that I was a slacker.  I love swimming, I love training, but I think beating Michael is not in my cards.

Today, the Greek public debt represents anywhere between 160% and 170% of GDP, and with GDP shrinking hard, that percentage is more likely to rise than to drop.  The Greeks know it, the EU knows it and creditors know it too.  In fact, Greece is as likely to pay its debt as I am to beat Michael.

Yet the fiction of quasi full debt service (quasi because of the 21% haircut proposed on 2011-2014 maturities) is maintained.  This is proving little incentive for the Greeks (why should we sacrifice for an unattainable goal?), the creditor banks (why should we recapitalize now if we might drag this for another year) and the rest of the EU (Germany will eventually have to step up to the plate).  Worse, the whole affair is shaping up as a dangerous game of musical chairs, where the actors keep a wary eye on each other, ready to jump at a second’s notice, and where markets are gradually seizing up.

A better strategy would be to accept reality and provide the basis for a successful workout.  Greece can only pay a fraction of its debts but that should not result in a regional or global market and economic catastrophe.  Indeed, I believe that such a strategy would result in a sharp recovery in confidence and thus stock and bond valuations. 

Such a strategy would rest on two pillars: the first would be to reinforce those European banks that need it, most likely via capital subscriptions from the European Financial Stabilization Fund.  Bank valuations are so depressed now that relying on private capital is not feasible, except perhaps for a fraction of the amounts needed.  In this regard, it is crucial that the terms of the EFSF capital injection not be punitive, and this for two reasons: banks can be castigated for making bad loans but not so much for buying their country’s sovereign debts, and it is important for the future that private investors want to buy bank stocks.  TARP is a good example to follow.

The second pillar of the strategy would be to provide an incentive for Greece to make tough decisions.  This means that creditors should share in the pain and that Greece should share in the rewards of making sacrifices and revamping its economy.  The idea is not new and there are many ways to do so.  Obviously, refusal by Greece to try hard should be sanctioned severely by the rest of the EU.

It is the ancient Greek mathematician, Archimedes, who said “give me a fixed point and I will raise the world with a lever”.  What modern Greeks need is a lever to raise their energies, i.e. a reasonable baseline with a clear upside and downside.  And what I need is for Michael to give me a one minute head start, on the 200 that is.

Mrs. Merkel makes a good move

The widely leaked existence of a Plan B whereby Germany would support its banks and insurance companies should Greece default on its debt is a constructive move forward:

1. It attempts to delink Greece from the European and world financial markets.  As Mrs. Lagarde noted last month, banks are unfortunately very efficient instruments of contagion, so that strengthening them is the best way to contain the Greek crisis;

2. It sends a very clear message to Greece that Germany is not obliged to bail it out, particularly if it doesn’t fulfill its commitments.  By announcing Plan B, Mrs. Merkel defuses any possible blackmail from Athens;

3. Finally, it forces France, Italy and others to provide similar protection to their own banks, which in turns should stabilize the financial markets and set the stage for a realistic Greek debt workout.

Bond and stock markets have lost a multiple of Greece’s public debt in value.  It shouldn’t be, and this move by Mrs. Merkel is welcome.

Longer term, it is getting ever clearer that the Greek debt will be restructured along realistic lines.  While I originally thought that a wider privatization program could keep the total “haircut” at or below 20%, I no longer feel that confident.  Even if Greece embraced a €100 billion program, I don’t see how the haircut could be less that 40%.

Finally, the Merkel move is also a warning to Portugal and Ireland, although their prospects are not as dim.  As for Spain and Italy, there is no European plan yet.  Spain seems to be taking measures to reduce its deficit, but Italy is further behind, appears less committed and represents a much bigger challenge.  No doubt Mrs. Merkel will need to keep working hard.

The US Presidential Election: A Democratic alternative?

By all accounts, President Obama has had a difficult summer 2011.  His approval ratings are close to their all times low.  More worrisome than the overall score are the underlying dynamics. 

The Rasmussen Presidential Tracking Poll is calculated by substracting the percentage of voters who Strongly Disagree with Mr. Obama’s conduct of affairs from those who Strongly Agree.  While the Strongly Disagree rating has fluctuated around the low 40s mark since the spring of 2010, the Strongly Agree rating had fallen from the high 20s to the high teens.  In other words, the President is not gaining core supporters, and he is crystallizing opposition against him.  According to IBOPE Zogby, the President’s approval rating now stands at 40%; Gallup gives him 42%.

But it is the economy that is Mr. Obama’s biggest challenge, as only 26% of voters approve of his management according to Gallup.  Given the depth and range of the problems and the inability so far of the President to reach a consensus with the Republicans, it seems unlikely that he will be able to turn the situation around quickly.

This week, he is to present his plan to create more jobs.  Some of the leaks point toward money for infrastructure, unemployment benefits and reduction in payroll taxes.  Will this package be big enough to change sentiment and to make a difference? Are there enough “shovel ready” infrastructure projects? Will the bidding terms be designed to stimulate rapid mobilization or to secure high union participation?  The President suffers from a credibility gap both with his left and the opposition.  It is therefore difficult to expect a miracle from this forthcoming announcement.

So far, no Republican candidate has succeeded in rallying both Republicans and Independents; moderates such as Romney and Huntsman are viewed with suspicion by party members, while more conservatives candidates like Perry seem unlikely to win over many Independents if they win the primaries.

But the President remains vulnerable as the Democratic Party may not want to go with a candidate who has low ratings and is unlikely to win votes across party lines.  Democrats will also worry that of the 33 seats in the Senate that will be contested, they currently hold 21 vs. 10 for the Republicans.  Incumbents are very unpopular, so that Democratic seats are proportionately more exposed, and with that, the control Democrats have of the Senate.

Thus, the main danger for Mr. Obama, in my view, is the rise of a moderate Democratic candidate for the presidency who could appeal to Independents and some Republicans, and also who could protect Senate seats.  If she were to run for president, Secretary Clinton would keep most of the Democratic votes (losing some on the left to abstention) and she could win over many Independents.  By winning 20% of the Republicans she should secure victory.

Clearly, it would be very awkward for her to campaign, even if she left the cabinet.  Even then, I suspect that she would not want to run against the man who offered her the second most powerful position in government.  There are only two ways for her to secure the nomination: for President Obama to announce that he is not running, or for the Democratic Convention to make the decision for both of them.

This is not an issue that is receiving much attention for the moment.  It may never materialize if the President succeeds in turning sentiment and the economy around, although this would likely require him to make some very important changes in his goals and modus operandi.

If he does, the prospects of the US economy look brighter.  If he doesn’t, they also look brighter because markets will start factoring the possible entry of a moderate Democratic challenger.

So far however, markets extrapolate current trends in a straight line; they do not consider the possibility of an inflection point.  In the real word, there is no such thing as a straight line for ever.

If only Europe could make progress on its debt problems!  But there too, although it is probably too early, trends do not follow straight lines and they will inevitably encounter an inflection point.

Madame Lagarde goes to Jackson Hole

Madame Lagarde should be pleased with her participation at the Jackson Hole conference this year.  With her speech last Sunday, she achieved two important goals.

First, by calling European politicians to task, she established her independence and silenced those who thought that she might find it difficult to represent all member countries of the International Monetary Fund or to deal objectively with Europe’s financial problems. 

No doubt the US, which would end up being the lender of last resort if the EU were to collapse, were pleased with her call for action.  So were many emerging countries which, some years ago, were subjected to tough medicine when their economies and public finances spun out of control.

Second, she said aloud what some would only murmur in private, and she went to the heart of the current malaise in European financial markets.  Already, several European governments and even the ECB are pooh-poohing her recommendations.  That may be an understandable emotional reaction, but the fact is that pressure for action has been raised a few notches and markets will not fail to “misbehave” if nothing is done.

What Madame Lagarde said was that weakly capitalized banks contributed to the financial problems of Europe because they were viewed as carrying too little capital and therefore vulnerable to country restructurings.  The resulting lack of confidence in bank counterparty risks reduced market liquidity and thus propagated sovereign crises well beyond their borders.  Therefore, said Mme Lagarde, European banks needed to raise capital, preferably from private sources, but also from public sources if need be.

Comparing European banks with US banks, it is obvious that the latter are less well capitalized than the former.  US banks went through a tough stress test back in 2009 after which most of the biggest ones raised fresh capital.  Additionally, US banks set ample loan loss reserves and dialed back lending so as to essentially rely on their deposits for funding.

By contrast, the last two European stress tests have failed to inspire investor confidence, and rightly so.  European banks, by and large, carry less capital, have less generous loan loss provisions and enjoy lower levels of deposit funding.  Most crucially, these stress tests didn’t really show what happens if some countries restructured; it may be understandable that Europeans did not want to trigger self-fulfilling prophecies, but markets had no such compunctions, and they didn’t like what they saw.

It is therefore evident that many European banks must be strengthened.  The ECB and others say that they stand ready to provide liquidity, but they do that in a highly inefficient way, and, depending on the scenarios, they may not have enough money.  Mme Lagarde’s prescription, which is along the lines of the US TARP, is better.

If a large deposit bank carries a conservative debt leverage of 10:1, it is very obvious that providing it with €1 of equity will allow it to raise €10 of debt in the interbank or other debt market.  This is a lot more efficient than lending it €10.  If its leverage is higher, the gains in efficiency are even greater. 

The problem is that banks have been demonized, and capital has been presented by governments and some regulators as shackles to prevent another meltdown rather than a base from which to make good, profitable, loans.  This is hardly the kind of “atmosphere” that will entice investors to pay a fair price to subscribe fresh bank capital.  In truth, US banks had it easier in 2009 because the anti-bank movement and Dodd-Frank had yet to gather full momentum.

Be it as it may, many European banks need more capital, and if European governments do not want to become big bank shareholders, they need to tone down the rhetoric and be more realistic about bank regulations.  Should public capital be needed, using the European Financial Stability Facility (also called the €440 billion bail out fund) would indeed be a good idea.  It would introduce an element of objectivity, providing a regional pwespective and improving the chances that all banks would be treated equally.

Mme Lagarde’s first act was a success.  More will be expected from her as the European problems are difficult and of a size that will pull the whole world into their solutions.

Hannibal meets the hobbits

In 216 BC, the Carthaginian General Hannibal won a crushing victory over the Roman armies at Cannae.  For reasons that remain unclear, Hannibal hesitated and decided not to march towards Rome, prompting Maharbal, his famed cavalry chief, to tell him that he knew how to win, but not how to capitalize on victory.

In 1863, President Lincoln removed General Ambrose Burnside from command after his loss at the battle of Fredricksburg, and characterized his action as having snatched defeat from the jaws of victory.

Coming into being in 2009, the Tea Party crystallized popular rejection of Washington insiders, of politics as usual and of reckless taxing and spending.  Although it represents a minority of American voters and Congressmen, the Tea Party has gained strong political influence as it can call on 80 or so votes, thereby denying the Republican party of its majority in the Lower Chamber.

The Tea Party could justly take credit for sensitizing Americans to the need to rein in spending, for spurring the Republican Party to present a deficit and debt reduction plan and for trying to block Democrats from ever expanding the reach of government.  However, their insistence that there be no increase in the debt limit or that any legislation include provisions that the Democrats or the President couldn’t accept risks snatching defeat from the jaws of victory.

I believe that the Republicans could have successfully pushed for a package that would have been heavily geared towards spending cuts; such a package would have been credible and therefore more difficult for Democrats to reject outright.   Instead, Washington continues to show a sorry spectacle and sows doubt in our ability to govern ourselves. 

It is the very nature of democracy that victories are the result of negotiations, with one side rarely achieving 80% of his goals.  As Senator McCain observed, only in Middle Earth can the hobbits totally vanquish Mordor.  And as strange as Washington appears at times, it is not Middle Earth yet.

So the spectacle goes on.  We may yet stumble further as we did with the first vote on TARP.  Luckily (?) for the US, the eurozone is not looking too good, and there are not enough yens or Swiss francs to go around.

Looking further down the road, this debacle will have legs and will impact the presidential election of 2012.  Candidates viewed as close to the Tea Party ethos, such as Ron Paul, Michelle Bachmann or even Tim Pawlenty could suffer if voters decide that their planks are unrealistically rigid.  Mssrs Huntsman and Romney have studiously stayed away from the debt limit debate.  That was probably wise, but once the storm passes, they will need to show that, if elected, they would handle the budget and debt debate better than the President did.  Voters may yet decide that they want the next president to combine strong convictions with a successful track record as a reformer and governor.  This might open the way to Governor Perry from Texas.  Finally, the current crisis reinforces the image of a Congress far more polarized than the general population.  Either one of the traditional parties will move to the center or a new Independent Party is bound to arise.

Crunch time for Greece

Today, Prime Minister George Papandreou sent a letter to Jean-Claude Juncker, President of the Eurogroup.  The letter is interesting for several reasons: it tries to force the eurozone governments into concerted action, it stresses that “Crunch time” has arrived, and finally it seems to invite bold and drastic action so long as the results are worthwhile.

More precisely, PM Papandreou seeks a sustainable debt level (read a lower debt level), the means to restart economic growth and access to the markets (liquidity).  Sensing that contagion to Italy and Spain would doom the eurozone and the EU, he demands an end to the “cacophony of voices and views”, reminds his peers that they face equally dire straits should their banks need to take big hits, and finally suggests that Greece will not make further sacrifices for the good of other nations unless other nations decisively step up to the plate.

What next?  The PM may be bluffing, but then he must have Plan B too.  I may be wrong, but I think that he wants a substantial debt reduction, and if this reduction is big enough, he doesn’t care whether private creditors are participating or not, or whether the debt restructuring constitutes an event of default or not.  As he sees it, that is the problem of the rest of the eurozone.  What is interesting in the PM’s letter is that he seems to lament more the “meager results” of the (French banks) plan than the fact it may trigger a selective default.
  

Some commentators have written that Argentina might be a model for Greece, i.e. a unilateral default.  I doubt it, as the 2002 default and subsequent 75% “haircut” proved very costly to Argentina.  I do think however that the 2009 prepackaged bankruptcyof General Motors could, and probably should, be.

For one, I don’t see the ECB and the creditors accepting a significant debt reduction voluntarily.  For another, the current handwringing reminds me of the months that preceded the GM bankruptcy and the dire warnings that the company could never recover from it.  Then as now, markets wanted two things: (1) avoiding chaos and (2) being presented with a realistic plan that would enable them to recover a reasonable share of their claims.  That is why they responded positively to the GM plan, even if it contained objectionable features.

So the pressure is on the eurozone to help Greece devise a pre-packaged default and restructuring.  PM Papandreou is calling on finance specialists to come up with a plan that “will work” and that politicians will then have to implement.  The trade-off proposed by Papandreou is pain for gain.

A restructuring would make the lower debt load sustainable, and would be a necessary condition for an economic restart.  But it would not be sufficient.  Having reduced debt by 20% to 25% via an exchange of old obligations for new ones sporting longer maturities and lower interest rates, Greece will need to do much more to improve productivity and encourage investments.

As I have written in this blog, I think that Greece will need to privatize at least €100 billions worth of state assets, bringing its ratio of public debt to GDP down to 70% to 80%.  It will also need to enact far-reaching reforms, many of which will be unpopular and difficult to implement.  In other words, privatization and reforms will take TIME and a mechanism will have to be devised to provide the liquidity that Greece needs by reassuring those that will supply it.  One possibility could be the creation of a privatization trust fund where the assets to be sold would be held for the benefit of the European supranational institutions that would provide liquidity to Greece.

The Chilean privatization program in the 1980s is, in my view, the best example to follow, and this for two basic reasons: it reestablished confidence and (2) it secured popular and political support; by selling financially healthy companies, the government could devise programs to empower many Chileans to share in the privatization promises.  As was the case in Chile, it will take time for Greece to clean up the finances of big companies and to negotiate, vote and implement new and improved labor, financing and economic frameworks.
 
Selling healthy companies makes it possible to empower citizens of modest means to buy into privatizations; if free markets and capitalism are so good, they should be tangibly so to millions of people.  In Chile, a significant share of key privatizations was ear-marked for mass participation (capitalismo popular); because the firms being sold were financially healthy, they could guarantee set minimum dividends for five years or so; these annual dividends were greater than the annual interest payments charged by banks on loans made to people for the express purpose of participating in specific privatizations.  The combination of financing, positive carry and stock appreciation proved very successful and should prove equally so in Greece.

We seem to be approaching the beginning of the end game in Greece.  The stakes have been raised high and restructuring is increasingly viewed as inevitable by all parties.  Rather than avoiding the inevitable, the eurozone needs to agree on a prepackaged exit where the immediate pain will be accepted in order to permit a recovery.  Euro governments and agencies also need to learn FAST that the only way to stop a crisis is to overtake it and apply overwhelming force. Sadly, what Mexico learned and did in the 1990s  has yet to register in European capitals.  It is a pity, a very expensive one.