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.