Monday, November 14, 2011

Even Greece and Italy Have Been Able to Reach Some Compromise

Here we are 10 days from the deadline for the Congressional Super Committee to reach some compromise with respect to a budget deficit/debt reduction package --- and it looks very much at the moment as though the Super Committee Stupor Committee will fail miserably at its assigned task.

Fortunately, I think the equity and debt markets have already priced in failure.  Therefore, when November 23rd comes and goes without a wimper from the Super Committee, I'm not looking for any significant downturn in the markets.  (This, even if there is another downgrade of US sovereign debt -- after all, where are investors going to find a safer haven than the US at the moment?)  On the other hand, if the Committee actually put a meaningful proposal on the table for the entire Congress to vote on (up or down) by December 23rd, the markets could move higher.

In the meantime, I'm maintaining investment positions pretty much where they are today --- 70% debt/equity investments and 30% cash.

Friday, November 11, 2011

Are You Kidding Me? - Why Do We Pay Any Attention to Standard & Poors?

France lashes out at S&P's 'shocking' error

The error stood for an hour and a half Thursday before it was retracted by the agency — spooking markets by foreshadowing the event that could sound the death knell for the 17-nation eurozone.

The accident came just as Greece and Italy both were in the process of getting new interim governments led by financial experts to guide them out of the continent's debt crisis. Most European markets were still open at the time, and U.S. financial markets were in full swing.

Despite Standard & Poor's statement saying the original message had gone out to some subscribers because of a technical error and its reaffirmation that France's credit rating remained "AAA" — the highest level — and stable, some damage could not be undone.

The yield, or interest rate that France pays to borrow money for 10 years, has risen 0.32 percentage points since Thursday morning, hitting 3.48 percent Friday afternoon, the highest rate since May.

In the midst of a crisis where fear drives the markets as much as fact, the error has at the very least reminded investors of France's difficulties. And often the suggestion of something amiss is nearly as bad as having something amiss.

French Finance Minister Francois Baroin did his best to quell fears, calling the error a "rather shocking rumor of information that has no foundation."

"We won't let any negative message go," he said in Lyon in comments published Friday on the La Tribune newspaper website.

The French market regulator immediately opened an investigation into the mistake at Baroin's behest, and the minister also called for a European probe.

While the error may have increased the pressure on French bond yields, they were already rising — because, like many countries, France is struggling with slow growth and high debt piled up during the boom years.

The rise of such yields is at the heart of Europe's debt crisis: The increase of those interest rates in Ireland, Portugal and Greece — because investors considered them increasingly bad risks — eventually forced each of those countries to seek massive international bailouts.

Now Italy is coming under the same pressure. That poses a bigger problem because its economy and debts dwarf the others — Italy's economic output is 17 percent of the eurozone's compared to a combined 6 percent for the other three nations. Europe doesn't have enough money to fully bail Italy out.

But a French debt downgrade would be a problem on another order of magnitude. France and Germany's "AAA" credit ratings are the bedrock of Europe's bailout fund. Because the debt of those two countries is considered so safe, the fund pays very favorable interest rates on the bonds it issues.

Some analysts said the accident may have tipped the actual thinking at the ratings agency.

"I can't remember a situation where an agency released a rating movement in error and no doubt there will be many people who believe that there is no smoke without fire and that this cannot have happened unless S&P were preparing the ground for a downgrade," Gary Jenkins, an analyst with Evolution Securities, said Friday.

He hastened to add: "I have no idea if this is the case or if it was just a genuine error."

S&P, however, does not even have France on surveillance — the step that typically comes before a rating is downgraded. Moody's, on the other hand, says it is studying whether to put France's rating on notice.

A downgrade of French debt would also pose a domestic problem: President Nicolas Sarkozy, who is expected to face a re-election battle next spring, has staked his credibility on balancing France's budget by 2016.

Along the way, Sarkozy has laid out yearly targets for reducing France's deficit — each one tied to a growth projection. But those forecasts have repeatedly proved too rosy and his conservative government has already twice this year been forced to introduce extra cuts to stay on target.

It's clear the last thing Sarkozy wants to see is for French borrowing costs to rise as his government fights to clean up its deficits and keep the eurozone united.

On Thursday, the European Commission said it considered France's growth forecast for 2013 too high — and Baroin shot back that Paris has already set aside a reserve fund for that eventuality.

Copyright © 2011 The Associated Press. All rights reserved.

Thursday, November 10, 2011

This Roller Coaster - Made in Italy

Now that the Greek problem is moving to the back burner (for the moment), we have the Italians trying to sink the global economy. Will the US Congressional Super Committee be next?

Saturday, November 5, 2011

The European Mess: How We Got Here

By Peter Wallison

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The financial crisis in Europe seems very complex, but we understand that how it comes out will have important and perhaps painful consequences for Americans as well as Europeans. At its center is the fear that if Greece defaults on its debts that could endanger the health of European banks, and that in turn may cause a financial crisis not unlike what followed the collapse of Lehman Brothers in 2008. How did we get into this fix, so soon after 2008?

Last week, EU leaders agreed on a rescue plan for Greece that involves investors (primarily banks) writing off 50% of the value of their loans. Is this another case of the banks doing something dumb, or is there more to the story of these investments in Greece?

As a guide for the perplexed, here are some Qs and As that might shed some light on why we are where we are:

What's the underlying cause of this crisis? High debt-to-GDP ratios among the Europe's southern tier countries, resulting in an increase in the risk - and a decline in the value - of their outstanding debt.

What's the effect? The banks - primarily European - that hold this debt have been seriously weakened by the reduced value of these assets. If Greece actually defaults, the debt could become almost worthless.

Why did the banks buy this debt? Bank regulators from around the world encouraged it.
What? How did they do that? The current bank capital rules (known as the Basel rules after the Swiss city in which the regulators meet) give banks a strong incentive to hold sovereign debt.

What kind of incentive? The Basel capital rules make sovereign debt cheaper for banks to hold than other kinds of debt.

Can you give me an example? Sure. Bank capital is basically equity, common shares or their equivalent. It's the first to suffer losses so it's very risky and thus very expensive.

So? Under the Basel rules, banks must allocate at least 8% of their capital to support their loans to corporations, and less than half that for the mortgages they hold. It's called risk-weighting of assets.

OK. How much capital must they hold against sovereign debt? None

You mean the debt of all European countries has a risk weighting of zero? Yes
Even Greece? Yes

Why would the Basel rules treat the debt of all governments the same? Because the rules are made by bank regulators from around the world, all of which are agencies of governments. Governments like banks to buy their debt.

Could it be that the Basel rules would not have been adopted if the debt of all the participating governments had not been given the same zero risk-weighting? Yes

Does this mean that the Basel rules may have caused the financial crisis in Europe? Yes

Isn't this a severe indictment of the Basel rules? Of course.

What would we do without these rules? The market would decide which government's debt represents zero risk.

What's wrong with that? Nothing

Then why were the Basel rules developed in the first place? Regulators were worried that governments might decide to lower the capital standards of the banks chartered in their countries, giving them advantages against banks in other countries and making them riskier.

What were they afraid of? A race to the bottom. Basel is an attempt to assure standardized capital requirements for all internationally active banks.

But didn't governments, through zero risk-weighting of sovereign debt, just give themselves the advantages they were afraid might be given to the banks? Yes

And isn't that the cause of this impending crisis? Yes

So how do we get out of this? Ask your favorite bank regulator.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. He was general counsel of the Treasury and White House counsel in the Reagan administration and a member of the Financial Crisis Inquiry Commission.