Hmmm december 18 2011

1. Hmmm… THINGS THAT MAKE YOU GO A walk around the fringes of finance To Subscribe to Things That Make You Go Hmmm..... click HERE “Given a choice between you and me…
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  • 1. Hmmm… THINGS THAT MAKE YOU GO A walk around the fringes of finance To Subscribe to Things That Make You Go Hmmm..... click HERE “Given a choice between you and me you pick you and I’ll pick me I’ll never forget what you said when you left Every man for himself – ARTICLES OF FAITH, EVERY MAN FOR HIMSELF 340 “Say the word and I’ll turn you loose 320 I got mine now you get yours 0 30 0 Just like you I’ve got my price N 20 Sure is nice that someone paid I’ve got my ticket out of here 0 But for you, I fear, it’s much too late 28 NW It’s nothing you can blame me for 40 W In love and war It’s every man for himself ” NE260 – Steppenwolf, Every Man For Himself 60 “Now it’s every man for himself tonight240 SW We’re lookin’ out for number one, tryin’ to get on with E 80 our lives And it’s heart-breakin’ SE it’s soulachin’ and 220 When you got nobody else S 10 So friends it’s good to have you here tonight 0 But it’s every man for himself 0 20 12 – Neal McCoy, Every Man For Himself 0 180 140 16 0 18December2011 1
  • 2. THINGS THAT MAKE YOU GO Hmmm... 2. O n Sunday, December 4th, 2011 on the Chugoku Expressway in Yamaguchi Pre- fecture, Japan, what Yamaguchi’s Express- way Traffic Police Unit’s executive of- ficer, Mitsuyoshi Isejima called “a gathering of narcissists” was making its way from Kyushu to Hiroshima in what were later described as ‘atro- cious driving conditions”. The gathering, a collection of super- car enthusiasts, were driving approxi- mately 300 million yen’s worth (or the equivalent of 2,500 ounces of gold) of precision engineering at what eye- witnesses estimated to be 85 – 100mph on rain-soaked roads. As the parade of supercharged vehicles approached a tight bend, one of the two Italian cars at the head of the pack suddenly swerved out of control and careened across several lanes of traffic and into the central reservation, leaving debris everywhere and damaging the other Italian beyond repair. Immediately behind the Italian vehicles was a big, sturdy German car which, upon reaching the same bend and seeing the Italian cars in trouble made the fatal mistake of slamming on its brakes which, on an extremely slippery surface is the very last thing you should do. All the advanced computer technol- ogy in the world couldn’t stop the German car from being dragged into the chaos as it too slammed headlong into the Italian pile-up in front of it. Several other extremely expensive German and Italian cars were sucked into the tangled wreckage of twisted metal (luckily, nobody was seriously injured). Driving along quietly behind the European supercars was a Toyota Prius. Sadly, even though it wasn’t part of the speeding cavalcade, the Japanese car too was damaged beyond repair when it found itself part of the pile-up... T he last thing I really wanted to write about AGAIN was Europe but those damn Eurocrats just won’t let it go so I find myself staring down the barrel of yet another EU summit that occurred this past weekend and trying to sift through the aftermath in search of any meaningful shift in either the speed or the trajectory of the descent into chaos. If you look closely enough, you can just about see some meaningful words amongst the usual spout- ing, but once again those words seem to be backed with either hot air, magical ‘money’ or promises of accords that will never stand a test of their strength – and believe me, those tests are coming. In our offices here in Singapore, we jotted a short checklist on the whiteboard going into the Summit last weekend that we felt laid out what was, at a minimum, required to ‘fix’ the problems facing the Eurozone (fully cognizant of the fact that any ‘fix’ would be short-term in nature until deficits were brought under control. The purchase of time seemed to be the best-case scenario).18December2011 2
  • 3. THINGS THAT MAKE YOU GO Hmmm... 3. That checklist looked like this: 1. International coordination 2. Actual cash backing 3. European lender of last resort 4. Fiscal changes/discipline mechanism 5. Bank recapitalization/EuroTarp The party had, interestingly enough, got started a week earlier as the con- certed Central Bank action to loosen up dollar funding lines along with a ‘co- incidental’ Chinese reserve requirement cut pretty much checked off num- ber one on our list well in advance of the summit proper – a little welcome gift, perhaps? The coordination is important – principally for Germany as they look for a valid reason to allow the printing presses to be activated in the basement of the Eurotower in Frankfurt (previously the Commerzbank Tower). Having set out its anti-printing stance long, long ago, back when a billion euro was a lot of money, Germany cannot now be seen to be weak to its electorate as the nightmare of Weimar-era hyperinflation lives on in Ger- many’s collective psyche (the country goes to the polls in 2013 – assuming all goes to plan) and so being part of a new ‘Committee To Save The World” would play well on the domestic stage and, perhaps, give Frau Merkel the breathing space she so clearly needs if she’s to show any flexibility whatso- ever. The coordination angle received another timely boost the day before the Summit convened as Mario Draghi cemented his role as the anti-Trichet by cutting rates for the second time in as many meetings. More importantly, however, he made a few careful adjustments that were designed to help alleviate clear pressures building up amongst the Eu- ropean banking sector as rumours of an imminent collapse by a major European financial institution swirled around, and it was those adjustments that brought the festive season to the banking sector a little early this year. It is very much in the language emanating from Draghi’s ECB that the real moving parts were to be found - the Summit would turn out to be, like all the others before it, a totally ineffective package disguised as a damp squib dressed as a solution. We shall discuss the Summit briefly later, but for the time being, let’s focus our attention on the ECB’s chicanery - the magnitude of which was largely either unnoticed or misunderstood. In his press conference Draghi made some major announcements that WEREN’T outright, unlimited moneyprinting and so were consequently ignored by the markets, but which, when examined, turned out to not only be moneyprinting in all but name, but also have the potential to make the actions of the Fed, the BoE and the SNB look positively Austrian. F irstly, the ECB agreed to adjust the threshold for collateral it would accept from AAA to A and extend their largesse to include bank loans. Now, whilst this doesn’t sound like much of a move, it basically makes just about everything the banks own eligible as collateral – a handy handout for the18December2011 3
  • 4. THINGS THAT MAKE YOU GO Hmmm... 4. struggling European financials to be sure. This move alone mobilizes a huge amount of constrained collateral that ailing banks will be able to pledge to the ECB (thus deteriorating the quality of ITS bal- ance sheet further still, but that’s a matter for another day) and, with the National Central Banks of the EU also being given the green light to accept the same loans as collateral, the chances of a major funding crisis striking the banks was lowered significantly. The other big move the ECB made was to extend loan duration to banks to three years - at a stroke removing immediate fears of insolvencies due to the ongoing crunch in term-funding markets across the continent. In essence, the ECB told banks to bring them any old crap they had knocking around and they would exchange it for nice, clean, fresh euros for a minimum of three years (a time period you can guarantee will be extended should we get anywhere near it without an improvement in conditions). Hey Presto! Magic Money. Not only that, but, by supplying these extended credit lines to banks, they implicitly nudged them to- wards using their newly-loaned cash to buy...guess what? Yup, that’s right, European sovereign debt! You have to hand it to them once again, a very clever solution - even though the markets didn’t re- joice. As I was pondering this last week, an excellent ‘Outside The Box’ from my friend John Mauldin landed in my inbox. It included the thoughts of GaveKal on the subject and their explanation of the ECB’s move was far better than anything I could come up with so I’ll leave it to them to explain it: The three--year unlimited liquidity operations announced last Thursday could provide infinite mon- etary support for European banks and through them, their sovereign debt markets. Once these three--year repos get started, banks in the Club Med countries will be able to borrow as much as they want from the ECB at 1% and use this money to buy government bonds now yielding 6% or more. Because of the unprecedented maturity of these repo--operations, banks will now be able to theoretically acquire unlimited government bond portfolios without exposing themselves to rollover or maturity risks. Banks will therefore be able to pick up 500bp of carry, with zero risk-- weightings, by hoovering up all the debt their governments can throw at the markets. Of course there would be risks—we cannot say banks will want to jump on this deal, but in theory they can. This Ponzi scheme could potentially result in an even bigger money--printing operation than any- thing the US, British and Swiss central banks have done on their own accounts. It would allow the banks to rebuild their equity with no dilution to shareholders. And if the banks in Italy or Greece became too “profitable” by using cheap ECB funding to buy up their entire sovereign debt markets, then the Italian or Greek governments could always recover the “excess” profits with special taxes. The governments could thus effectively reduce their own cost of funds to the 1% rate offered to banks by the ECB. Of course if the Italian government defaulted on its debts, Italian banks would go spectacularly bust. But these banks would go bust anyway if the Italian government ever de- faulted. All the incentives for Italian bank management will therefore be to go for broke in their sovereign debt markets, making maximum use of the new ECB credit lines. You see? Genius. Oh, one other thing to mention before we move on (GaveKal again): And it is crucial to remember that banks are likely to use the ECB credit lines only to buy the bonds of their own national governments, partly in response to political pressures but also for prudential18December2011 4
  • 5. THINGS THAT MAKE YOU GO Hmmm... 5. reasons. If the Euro were ever to break up, Unicredit would not want to own any Greek or Spanish debt, since this would entail unpredictable currency risks. An Italian bond, by contrast, would be redenominated into the new Lira and would be matched perfectly against Unicredit’s borrowings from the Bank of Italy, which would also be redenominated into Lira. Thus, the result of the ECB’s covert QE via the banks will be gradually to re--nationalise the bank- ing systems and the sovereign debt structures in Europe. This process will help Club Med countries avoid sovereign debt defaults, but it will make eventual breakup of the euro much less painful – and therefore more likely. Every man for himself. N aturally, myopic markets focused on some other Draghi soundbites that dashed hopes they had for more upfront monetization. In particular, his hardline stance against bending the rules of the Maastricht Treaty were seen as borderline betrayal by an audience clearly embracing pantomime season and casting poor Mario as the villain: Draghi: “It’s legally complex. The spirit of the treaty is that one cannot channel money in a way to circumvent the treaty provisions... The key thing is that we should not try to circumvent the spirit of the treaty no matter what the legal trick is. What matters for the people and what matters for the confidence and the credibility of the institution is this spirit... If the national central banks want to lend to the IMF and the IMF wants to lend to Indonesia or China, that is fine; if they wanted to lend exclusively to Europe, we think it would be incompatible with the treaty... Let’s not forget that the ECB is not an IMF member … more generally, the mechanism by which money is being channeled to the European countries should not obscure the fact that we have a treaty that says no monetary financing to governments...” Markets: “Booooooo!” Draghi: I was surprised by the implicit meaning that was given to the ‘other elements will follow.’ … A new fiscal compact, comprising a fundamental restatement of the fiscal rules together with the fiscal commitments that euro area governments have made is the most important precondition for restoring the normal functioning of financial markets... The ECB has an important role, as the guardian of stability … what is happening is a redesign of the fiscal agreement in a way that would enhance, rebuild confidence in the euro area. We have our own ideas, views, and we have collaborated but the ultimate decisions are in the hands of the leaders... We shouldn’t refrain from wishing for great progress toward common fiscal rules, controlling, ex ante, budgetary legislation. I wish all our leaders the best, and the ECB is here … But that doesn’t mean the ECB will respond, by the way.” Markets: “Hissssssssssss!” Draghi: “[The ECB] foresees annual real GDP growth between -0.4% and 1.0% in 2012 … These [significant downward] revisions mainly reflect the impact on domestic demand of weaker confi-18December2011 5
  • 6. THINGS THAT MAKE YOU GO Hmmm... 6. dence and worsening financing conditions, stemming from the heightened uncertainty related to the sovereign debt crisis” Markets: “Be-HIND youuuuuuuuuuu!” Given the mood of the ratings agencies in the aftermath of the previous week’s concerted action, lowering the minimum acceptable credit rating for collateral was a smart preemptive move to get ahead of what is likely to be a raft of downgrades that would bring a LOT of AAA and AA paper down to A in very short order: (Axcess News): Standard & Poor’s placed the long-term sovereign debt of 15 Eurozone member countries on Creditwatch … while Greece was spared Creditwatch status by the rating agency. The news came after ...the second day of rising stock indexes after last week’s news from Central Bankers worldwide of their intervention, though the Rating Agency was indifferent to the move citing concerns over those Eurozone countries placed onto Creditwatch status with negative long- term outlook. The countries cited by Standard & Poor’s were: Italy, France, Spain, Portugal, Luxembourg, Ireland, Austria, Belgium, Finland, Netherlands, Estonia, Malta, Slovenia, Slovak Republic and Germany. “We expect to conclude our review of eurozone sovereign ratings as soon as possible following the EU summit scheduled for Dec. 8 and 9, 2011,” the Rating Agency noted. “Depending on the score changes, if any, that our rating committees agree are appropriate for each sovereign, we believe that ratings could be lowered by up to one notch for Austria, Belgium, Finland, Germany, Nether- lands, and Luxembourg, and by up to two notches for the other governments.” Those ‘other governments’ it turned out, included France – something that seemed to catch a few people off- guard despite the likelihood of some form of downgrade being common discussion for quite some time. French CDS (chart, right) soared again on the news (despite the fact that the debacle in Greece demon- strated just how ineffective a hedge these instruments could well turn out to be in the event of a sovereign default - assuming it was allowed to be SOURCE: BLOOMBERG called such). But a potential downgrade for France (amongst ‘the others’) was not, in and of itself, the big problem, as the FT pointed out a few days later: (FT Alphaville): In the event of a downgrade, S&P’s rating on EFSF will be downgraded to the low- est rating of the previously triple-As countries backing the structure (except Luxembourg). Since France could potentially be downgraded by two notches, EFSF could potentially be downgraded to AA. If France is ultimately only downgraded by one notch, then EFSF will also only be downgraded18December2011 6
  • 7. THINGS THAT MAKE YOU GO Hmmm... 7. one notch since the downgrade of the five triple-As backing the struc- ture will be limited to one notch according to S&P. Currently, the ESM would have 58.1% share of AAA shareholders. If the six AAA euro area countries are downgraded, then this will drop to zero and it seems highly unlikely that the ESM would be able to achieve an AAA. If France is downgraded to AA flat then we see a significant risk that the ESM will not be able to be rated above that level, particularly if the lending volume significantly exceeds the paid- in capital. Uh-Oh! The EFSF - saviour of the European sovereign debt markets - could become just another AA-rated piece of paper - or worse - because France (for example) loses its AAA-rating. Of course, one of the main REASONS for France losing it is the size of its contribution TO the EFSF. Circularity breeds contempt. A look at the potential downgrades in S&P’s ratings of EFSF contribu- tors (table, left) shows just how tenuous the entire house of cards has become. L o and behold, last night, the fun and games began in earnest as Moody’s jumped the gun and downgraded Belgium two notch- es whilst Fitch (never ones to see a train leaving the station that they SOURCE: RBS/BLOOMBERG didn’t want to jump on) warned Spain and G7 member, Italy, that, to use the words of the great Irving Berlin, ‘there may be trouble ahead’: (UK Daily Telegraph): Spain and Italy were both told to brace for a debt downgrade after a leading rating agency concluded that a “comprehensive solution to the eurozone crisis is technically and politically beyond reach”. The eurozone’s third- and fourth-biggest economies were warned by Fitch of a “near-term” down- grade, alongside Ireland, Belgium, Slovenia and Cyprus. In a further blow, Belgium separately saw its credit rating downgraded two notches, to Aa3, by another leading agency, Moody’s. It cited the “sustained deterioration” in funding conditions for eurozone countries with relatively high levels of public debt, like Belgium, and new risks stemming from the country’s troubled bank- ing sector. The downgrade and warnings, delivered after the markets closed last night, came as Spain said its debts had soared; talks with Greece’s private bondholders stalled; and Hungary broke off talks with the International Monetary Fund (IMF). Pitching itself firmly against Germany, the rating agency warned that the European Central Bank (ECB) needed to give a “more active and explicit commitment” to prevent “self-fulfilling liquidity crises” ripping through the eurozone. The ECB’s support for eurozone banks was praised but Fitch said the central bank’s “continued reluctance to countenance a similar degree of support to its sovereign shareholders” was undermining the efforts to create a firewall to stem the crisis.18December2011 7
  • 8. THINGS THAT MAKE YOU GO Hmmm... 8. Even Fitch are calling for QEU now! To increase the pressure, they upped the ante just a little more: *FITCH SAYS `COMPREHENSIVE’ FIX TO EURO CRISIS IS BEYOND REACH And, finally, they lowered the boom: *FITCH AFFIRMS FRANCE AT ‘AAA’; OUTLOOK REVISED TO NEGATIVE No matter if it’s a few years too late, religion is always a powerful thing to find. A fter the announcement by the ECB, all eyes turned to the following day’s summit and we didn’t have to wait long for the party to get started as it was announced that Herman van Rom- puy (the man Nigel Farage once so beautifully described as having “...the charisma of a damp rag, and the appearance of a low-grade bank clerk”) would be holding a press conference at 2am CET after the welcome di
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