Click here to read this article in pdf format: June 25 2012
We are as deceived as you are with the policy decisions undertaken by the European Union (EU) and the US. As we muddle through their consequences, today we take a moment to offer a few thoughts…
-On the EU: Banking Union, bailout funds and other tricks
After the second LTRO (i.e. long-term refinancing operation) and the Greek debt swap exchange (in March), the likelihood of the break-up of the European Monetary Union has risen exponentially, and continues to rise. Along with this trend, cross border lending by banks continues to fall and flight of capital from the periphery remains in place. The fear of a final collapse is there and rumours of a pending banking union were thrown at the markets.
A banking union, if true and under whatever form it takes, requires a final omni guarantor, backed by an omni pool of resources, funded by an omni tax. This means that the required step of a EU fiscal union is still the only solution to the (only) problem. As we repeated since 2010: This is an institutional crisis! The same analogy is applicable to any bailout fund that “they” may want to throw at us. EFSF? ESM? You name it, they are all useless. They all need an omni guarantee. To think otherwise is simply delusional and a waste of time. Fiscal union, on the other hand, is not possible overnight. It demands constitutional changes. Any strength in the Euro upon these rumors should be faded.
-The European Central Bank (ECB), its collateral and Argentina:
On Friday, the ECB announced that it will reduce the rating threshold and amend the eligibility requirements for certain collateral. In other words, the ECB is accepting lower rated assets to back its liabilities, i.e. the Euro. This brings the European Monetary Union closer to an “Argentina 2001” moment. Why? Argentina suffered from a fast deterioration because its banks, after years of hyperinflation and the confiscation of the 1989 Bonex Plan could only fund themselves via deposits. The European Union banks are getting dangerously close to that stage: Raising equity is no longer an option, unsecured funding has been subordinated by past bailouts, available assets to encumber are almost non-existent at this point (which is precisely why the ECB had to accept lower rated assets on Friday). Therefore, the only fools still funding the banks, at least the banks in core Europe (because banks in the periphery live on liquidity lines from the ECB) are the depositors. We want to believe that majority of these deposits come from corporations, whose treasurers deposit other peoples’ (i.e. the corporations’ shareholders’) monies. Otherwise, we would be underestimating the intelligence of the people of the European Union, and we don’t.
Given the circularity in the solution proposed by the leaders of the EU (i.e. banks buy debt from bankrupt nations; the banks go insolvent and are “saved” by the bankrupt nations, which in turn, are now even more insolvent), it is only a matter of time until the very deposits of EU banks are challenged, after every last asset owned by the banks is downgraded to junk and pledged to the central bank. This brings us to the next point…
-Who leaves first?
With the outlook of former austerity programs (which never got to be implemented, by the way) being relaxed, to “promote growth”, we now believe that it is likely that Germany be the first to leave the European Monetary. The latest action in bunds (i.e. Germany’s sovereign debt) seems to indicate that we are not alone with this thought. Here is why: If a peripheral country is seen as likely to leave the monetary union, the flight of deposits from that country to Germany’s banks appreciates Germany’s sovereign debt and its yields drop, as it has, to negative territory. But if those countries are perceived to stay, as it was after the Greek’s election during the past weekend, then Germany will have to foot the bill. Therefore, the value of its sovereign debt will fall and its yield rise. This is precisely what occurred in the past days. The question is: When will Germany leave? To which we answer in these simple terms: Germany will leave only when the cost of staying surpasses that of leaving. Under both scenarios (staying or leaving) there is a cost. The cost of staying, is a higher yield on Germany’s debt. How high? Potentially, to the magical 7% that Spain has touched and Italy is on its way to touch. Germany would leave before then, as the unthinkable (i.e.Germanyout of the capital markets) takes place. The cost of leaving would be represented by the defaults of the countries that stay, on their obligations to the Bundesbank (for the liquidity lines they enjoyed under Target 2). We think (and explained in our last letter) that this cost can be mitigated, if no capital controls are imposed and bi-monetarism is embraced. This would allow banks –both in Germany and the periphery- to take deposits in Euros and in the new local currencies. Under this scenario, the European Central Bank would not be dissolved. However, if Germany left first, we doubt there would be any incentive from the rest of the countries to allow the existence of Euro-denominated deposits.
-Operation Twist, Part Two
We are not going to add noise to the decision by the Federal Open Market Committee (FOMC) to extend its purchases of long-term US Treasuries and selling, in equal amount, short-term US Treasuries. We are only surprised (very much) by the fact that every analyst, fund manager or media anchor judges the decisions of the FOMC –past, present and future ones- by their impact on the private sector: On activity, on the labour market, on asset prices, etc. Why is nobody openly saying that in a country where fiscal deficits are higher than $100BN per month, the central bank has no alternative but to buy and monetize fiscal debt? Why is nobody linking the deficit and the purchases? Who can really believe that the US are not kicking the can? Who can really think that there will not be, eventually, straight debt purchases?
-The unintended consequences of zero-rate policies, from a micro perspective.
From our lessons in corporate finance, as students, we remember that equity is the riskiest part of a company’s capital structure. Equity is a call option on the assets of the company, with the value of its debt being the strike price. If the value of the assets increases over that of the debt, the spread goes to the shareholders. Hence, for that to occur, the company must “grow”. Companies that have a high likelihood of growing can be financed via equity. Companies that are not likely to grow, that are established in a mature industry and generate steady cash flows, are better candidates to be financed with debt.
With this in mind, we now turn to the fact that zero rate policies sought after globally by central banks have destroyed any possibility of obtaining a decent yield in corporate debt. This forces those who cannot afford to eat off their savings, to “gamble” them in the stock markets, with the hope that the same central banks will boost equity valuations. However, the zero-rate policies kill growth and those poor peoples who were forced to leave the comfort of corporate debt and transfer their savings to stocks will find themselves invested, contrary to common sense, in the riskiest part of the capital structure, in a call option, exactly at the time when no growth will come. How unfair is this?
-Why this agony can last longer than you or we can think
Unlike financial crises in underdeveloped countries, the one affecting the developed world takes place in sophisticated capital markets. There are futures/derivatives markets, forced savings via pension plans, and legalized Ponzi schemes whereby collateral can be pledged multiple times to support liquidity. These factors can cause a significant delay in reaching the “final outcome” and are subject to manipulation:
To break the futures markets, one needs to see a failed delivery by one of the players. But politicians can always capitalize or inject liquidity to that counterpart and avoid the break-up of that market.
A significant portion of the workforce is coerced to save through collective pension plans. The coerced savings act as a cushion between reality and illusion. Those forced to save believe in the illusion that somehow, their pension plans will provide them with an income in the future. If reality set in and the magic was lost, politicians could (and have done so) simply postpone the retirement age or even hike the savings rates enforced upon them. Even in the case where people realized that the cost of staying in the pension plans was higher than leaving them under penalties, politicians can simply “temporarily” prohibit withdrawals and effectively confiscate the monies.
It will take dramatic events to be confronted with these situations, but we think that this crisis will last long enough to face them.
-Murray Rothbard and his book “America’s Great Depression”
The question is therefore: When is this crisis going to crystallize and what will it take for it to do so? Don’t ask us why but we re-read Murray Rothbard’s “America’s Great Depression”. In its Chapter 12, under the section titled: “The attack on property rights: The final currency failure”, Rothbard tells us that: “…despite the gigantic efforts of the Fed, during early 1933, to inflate the money supply, the people took matters into their own hands, and insisted upon a rigorous deflation (gauged by the increase of money in circulation)— and a rigorous testing of the country’s banking system in which they had placed their trust…”
From this, we take two conclusions: (a) The crisis ends with a rigorous deflation or liquidation of liabilities, (b) That deflation has to be expressed in terms of a new standard (gold?).
In the ‘30s, the US dollar was still backed by gold. Gold was the Fed’s asset, the US dollar its liability. Today, the US dollar is backed by US Treasuries. Therefore, “to insist upon a rigorous deflation” is to repudiate the US Treasury notes. We can now see the implications of such repudiation, but we have written enough for today. We will elaborate more on this topic, in our next letter.
Martin Sibileau
