Does This Remind You of Anything --- Like Our Do-Nothing Super Committee Members? Or Maybe Our Entire Do-Nothing Congress?

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.

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

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

PARIS (AP) — France reacted with outrage after the Standard & Poor's ratings agency accidentally sent out a message saying it was downgrading the country's prized "AAA" credit rating during a tumultuous week in Europe's protracted debt crisis.

The error stood for an hour and a half Thursday before it was retracted by the agency — spooking markets by foreshadowing the event that could sound the death knell for the 17-nation eurozone.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

By SARAH DiLORENZO, AP Business Writer

Copyright © 2011 The Associated Press. All rights reserved.

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?

The Greek Problem

So Much For Jobs Creation!

The European Mess: How We Got Here

November 2, 2011

By Peter Wallison

‹‹Previous Page |1 | 2 |

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.

Insanity or Convenient Illusion or Something Else?

Euro-Zone’s Leveraged Solution to Leverage

Posted At : October 24, 2011 5:10 AM | Posted By : Satyajit Das
 

If as Albert Einstein observed insanity is “doing the same thing over and over again and expecting different results”, then the latest proposals for resolving the Euro-zone debt crisis requires psychiatric rather than financial assessment.

The sketchy plan entails Greece restructuring its debt with writedowns around 50% and recapitalisation of the affected banks. The European Financial Stability Funds (“EFSF”) would increase its size to a proposed Euro 2-3 billion from its current Euro 440 billion. This would enable the fund to inject capital into banks and also support Spain and Italy’s financing needs to reduce further contagion risks.

One proposal under consideration entails the EFSF using leverage to increase its size and enhance its ability to intervene effectively. Attributed to US Treasury Secretary Tim Geithner, the proposal is similar to the 2007 Master Liquidity Enhancement Conduit (“MLEC”) super conduit which was ultimately abandoned.

The EFSF would apparently bear the first 20% of losses on sovereign bonds and perhaps its investment in banks. This resembles the equity tranche in a CDO (Collateralised Debt Obligations), which assumes the risk of the initial losses on loans or bond portfolios. Assuming the EFSF contributes Euro 400 billion, the total bailout resources would be around Euro 2,000 billion. Higher leverage, a lower first loss piece, say 10%, would increase available funds to Euro 4 trillion. The European Central Bank (“ECB”) would supply the “protected” debt component to leverage the EFSF’s contribution, bearing losses only above the first loss piece size.

The proposal has a number of problems.

The EFSF does not have Euro 440 billion. After existing commitments to Greece, Ireland and Portugal, its theoretical resources are at best around Euro 250 billion, assuming that the increase to Euro 440 billion is ratified by European parliaments.

The EFSF must borrow money from the markets, relying on its own CDO like structure, backed by a cash first loss cushion and guarantees from Euro-zone countries. In fact, some investors actually value and analyse EFSF bonds as a type of highly rated CDO security known as a super senior tranche. This means that the new arrangement has features of a CDO of a CDO (CDO2), a highly leveraged security which proved toxic in 2007/ 2008.

The ECB, the provider of protected debt, has capital of about Euro 5 billion (to be raised to Euro 10 billion), supporting around Euro 140 billion in bonds issued by beleaguered Euro-zone nations, purchased as part of market operations to reduce their borrowing cost. The ECB has also lent substantial sums (market estimates suggest more than Euro 400 billion) to European banks without access to money markets at acceptable cost, secured over similar bonds. While the Euro-zone central banking system has capital of around Euro 80 billion that could be available to support the ECB’s operations, this adds to the incremental leverage of the arrangements.

The 20% first loss position may be too low. Unlike typical diversified CDO portfolios, the highly concentrated nature of the underlying investments (distressed sovereign debt and equity in distressed banks exposed to the very same sovereigns) and the high default correlation (reflecting the interrelated nature of the exposures) means potential losses could be much higher. Actual losses in sovereign debt restructuring are also variable and could be as high as 75% of the face value of bonds. 

The circular nature of the scheme is surreal. Highly leveraged vehicles, in part backed by weakened nations like Spain and Italy, are to undertake the “rescue” of the same countries and their banks. Levering the EFSF merely highlights circularity in the entire European strategy of bailouts, drawing attention to the correlated default risks between the guarantor pool and the asset portfolio of the bailout fund. This is akin to an entity selling insurance against its own default. This only works if all commitments are fully backed by real cash and savings, which of course nobody actually has, requiring resort to familiar “confidence tricks”.

The proposal assumes that it will not need to be used, avoiding exposing its technical shortcomings. The EFSF too was never meant to be used, relying on the “shock and awe” of the proposal, especially its size and government backing, to resolve the crisis.

The proposal is driven, in reality, by political imperatives - avoiding seeking national parliamentary approval at a time when sentiment is against further bailouts and lack of support for an increase in the size and scope of the EFSF.

It is also designed to reduce the increasing risk to the credit ratings of France and Germany. This last factor is increasingly important given concerns raised by rating agencies about the quantum of contingent liabilities being assumed by these countries. For example, after the increase in the size of the EFSF to Euro 440 billion, Germany’s commitment to the EFSF is over Euro 200 billion.

The scheme may also facilitate the ECB covertly monetising debt, “printing money”; to generate the protected debt to leverage the structure and also to cover the losses on its own exposures to distressed sovereign debt. It is simply another means of allowing the imply another way of requesting that the ECB to expands its balance sheet to absorb increased credit risk.

It now looks like the proposal to leverage the EFSF via the ECB are unlikely to be pursued - but as this is Europe nothing should be discounted. Instead, different forms of leverage are under consideration - EFSF to enter into credit default swaps to protect holders of bonds issued by weak European sovereign borrowers; EFSF to guarantee the first 10% or 20% or 40% of losses to bondholders; EFSF to act as bond re-insurer.

Unfortunately, all these new schemes like previous proposals are unlikely to succeed. The unpalatable fact remains that Europe may not have the capacity to rescue everybody that now seems to need rescuing without imperilling the financial health and ratings of stronger countries such as France and Germany.

As Sigmund Freud’s observed: “Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.”

We Can Hope, Can't We?

No Encouragement on the Horizon --- Stocks Get Hammered

On September 2nd I posted some thoughts about areas of concern for the US and global economies (see "Some Random Thoughts About Who We Can Trust and Other Stuff").  It's time to update some of those observations given what has transpired over the past three weeks, namely:  President Obama's address to the joint session of Congress on September 8th re: jobs creation ("the American Jobs Act"); the President's announcement several days later as to how to pay for the jobs legislation he proposed; the President's deficit-reduction proposal that he put on the table a couple of days ago; the Republicans' reactions to those proposals; the Federal Reserve's actions of yesterday ("Operation Twist"); the continuing drama with respect to the Eurozone debt crisis; and various economic numbers re: the US and global economies.

The American Jobs Act, Deficit Reduction and Republicans' Reactions - The cost of the proposed jobs legislation would be about $447 billion.  Perhaps 1/2 of this (maybe more) would not create new jobs --- rather, it would effectively provide cash flows to various groups that would maintain current spending levels and, thereby, not cause economic deterioration and further job losses.  (This is certainly important to assure that the economic softness that we are already experiencing is not exacerbated.)  The other half would be split between creating new jobs (e.g., infrastructure spending) and providing businesses with greater cash flow (e.g., lower payroll taxes).  The problem with this latter issue is whether businesses will spend the increased cash flow in creating new jobs or let it accumulate along with the trillions of cash that already resides on corporate balance sheets.  Overall, I'm not convinced that the American Jobs Act is a bold and imaginative enough program to stimulate the US economy to growth.  Moreover, I don't believe businesses will create new jobs before there is increased demand for their products --- and I don't think the American Jobs Act (even if enacted in its entirely) will stimulate very much increased product demand.

With respect to the President's deficit reduction proposal, the concepts are fine: entitlement reform, tax reform, reduced spending --- but the devil will be in the details and the whole proposal has been effectively kicked over to the Congressional Deficit-Reduction Super Committee.  I still lack confidence that the Super Commitee can reach bi-partisan compromise on the details of any deficit-reduction program.

And then we have the Republicans' (and some Democrats') reactions to the Jobs Act and Deficit-Reduction proposals.  The Rs don't want any tax revenue increases and the Ds don't want any significant entitlement reform.  This is an equation for continuing partisan gridlock, with no end in sight.

   

Finally, my overall reaction to the Obama job and deficit-reduction proposals and the Rs' responses is this --- it's all about campaign politics and not about advancing meaningful policy proposals designed to effect bi-partisan solutions in the next few months to enhance the lackluster US economic recovery.

Eurozone and China - The problems in the Eurozone continue and no resolution is on the horizon.  Further, recent economic data for the Eurozone economy have provided evidence of further slow-down or contraction.  Moreover, it appears China's economy is also slowing more than anticipated.  Bottom line --- the global recovery is in trouble.

The Federal Reserve – Yesterday's actions to implement Operation Twist suggest the Fed is limited in helping the economy by the tools remaining in its monetary toolbox.  Further, the Fed commented "there are significant downside risks to the economic outlook, including strains in global financial markets."  Not very encouraging.

Republicans in Congress - In my post of September 2nd I raised the question of whether we can trust the House and Senate to agree to anything that looks like it will give Obama new life for the 2012 election process.  How can we trust the Republican caucus to agree to meaningful fiscal stimulus to salvage the US recovery and lower unemployment levels before the election?  Based on recent rhetoric, the answer is "we can't" --- and the subtext is "and let the American people be damned" for another 13 months until the 2012 election.

And, in large measure, because of all these issues - Today US and global stocks get hammered. 

No Jobs for Labor Day

Some Random Thoughts About Who We Can Trust and Other Stuff

A week ago I got out of the market as I closed all my volatility/momentum trades when the S&P 500 was @ 1175 --- it’s now @ 1205 (but this morning’s futures are looking as though the index will head considerably lower today because of the terrible August payrolls/earnings/unemployment report).  I don’t mind losing those 30 points (probably less than that when the post-payrolls-report market opens this morning) because I didn’t have to worry about any potential damages from either the Bernanke Jackson Hole speech last Friday (even though it didn’t result in a downdraft for the market) or Hurricane Irene (even though the damage was less than most weather experts anticipated).  Sleeping better at night was worth the trade-off between a somewhat higher market and a potentially significantly lower trading level.

This leads me to consider where we now find ourselves and who can (and, more importantly, who will have the courage to) lead the US and global economies toward recovery and away from a double-dip recession.  To that end, the following are some random thoughts on various issues.

Eurozone and European Central Bank – New sovereign debt problems (or the same old problems) in Italy and Greece are again negatively impacting the Eurozone and the European markets.  Can we trust the Eurozone countries and the ECB to work together to bolster the sagging Eurozone economy?  In the short-run, austerity by the offending countries without some stimulative actions by the ECB doesn’t seem to be the immediate answer.

US Exports to the Eurozone – According to a Brookings Institution research report¹, we export over $300 billion a year to Eurozone countries and virtually all of the rest of our exports go to nations that also export to the Eurozone.  If the European economy continues its sag, this would have a measurable effect on the US recovery.  We can’t afford inaction or ineffective action by the ECB and the Eurozone countries.

¹ source: http://www.brookings.edu/papers/2011/0822_euro_crisis_elliott.aspx#note1, Why Can’t Europe Get it Right the First Time… or the Second… or the Third?

The Federal Reserve – Chairman Bernanke’s speech in Jackson Hole last Friday didn’t lay out any new actions it might take with respect to stimulating economic growth.  Was that just a kick of the can down the road to motivate the Congress and the WH to engage in meaningful fiscal policy before the Fed committed to any additional actions --- or is the Fed limited by the remaining tools in its monetary toolbox --- or both?  In spite of the no-news Jackson Hole speech, the market moved higher.  I think prematurely.

President Obama – Can we trust Obama to have the imagination and courage to put a big jobs package on the table in his Joint Session of Congress Address next week and really fight for it?  And, more importantly, even if the answers are affirmative, does he have the political skill and capital to effect a bipartisan result?

Congress - Can we trust the House and Senate to agree to anything that looks like it will give Obama new life for the 2012 election process?  Speaker of the House Boehner won’t even agree to the date and time of a speech by Obama --- how can we trust him to get his Republican caucus to agree to meaningful fiscal stimulus to salvage the US recovery and lower unemployment levels before the election?

Congress’ Super Committee - Lots of questions and little optimism on my part at the moment.

Infrastructure Investment – This is something that needs to be put in place now to effect long-term economic growth.  Will the WH and Congress have the courage to do something big now when borrowing costs are so low?

Big U.S. Banks - These banks and smaller banks need to make loans available to small/mid-sized businesses (the real job creators).  Can we trust the banks to do this or will the big banks, subsidized by the Fed over the past three years with near-zero interest rates, just keep on arbitraging the effectively-free funds with low-risk investments (i.e., US Treasury securities and the like)?

Consumers – We had one decent consumer spending number this past Monday.  This gave some encouragement to the markets that the consumer isn’t totally sitting on the sidelines --- but we need consumers to keep spending.

Gold and Swiss Franc Investors – As global uncertainly has been the watchword of late, investors have sought the “safe-haven” of gold and strong currencies.  However, if we are to see the equity markets move to the upside, a prerequisite will be that these investors see less risk in the global economy and redeploy funds into other than these “safe-haven” investments.

Corporations – Can we trust them to hire without legislated fiscal incentives or without an increase in demand for their products?  In a word, no.  And, as a free-market capitalist, I wouldn't expect or advocate corporations to do anything that isn't in their own long-term self interest (to be read as including all their constituencies --- shareholders, employees, customers, communities, etc.).

Having said all that, there may be some hope that September will be better for the equity markets than was August.  (In August the S&P 500 opened the month @ 1292 and closed it @ 1219, a decline of 5.6%.)  Some of what normally happens in September happened in August, such as economic forecast revisions.  Also, some of the shocks from the Eurozone and the US debt ceiling debate/S&P credit downgrade were put behind us in some fashion or other.  However, can we trust that there won’t be new or renewed shocks in September to create more volatility in the equity markets?

As a final comment, I noted within the past couple of days (after we regained communication with the world following Hurricane Irene’s pass through our area) that earlier this week CNBC conducted an interview with Abbey Joseph Cohen of Goldman Sachs (an equity market guru who merits considerable respect).  It was reported on CNBC’s website that Cohen “reiterated her forecast for the Standard & Poor’s 500 reaching 1450.”  At first read, this really surprised me and with good reason.  This is terrible reporting --- and I have commented to that effect on the CNBC website.

Cohen’s 1450 forecast was made in June 2011 --- this when the S&P 500 was trading near the 1300 level.  Specifically, the Cohen/GS prediction, based upon all the information available in June, was that the S&P 500 would close out 2011 in the 1450 range.  However, if you view the tape of the recent interview², what Cohen actually says is this, “the US portfolio strategy team believes that over the next 12 months we can see the S&P 500 reach about 1450.”  1450 by year-end 2011 vs. 1450 by the end of August 2012 are two entirely different animals.  This is clearly not a "reiteration" of Cohen's forecast.  Shame on CNBC.

² source: http://www.cnbc.com/id/15840232?play=1&video=3000042486

To end on a positive note, the Yankees beat the Red Sox last night and are tied in the loss column for first place in the AL East.  The Yankees have one more three-game series with the Red Sox this year --- on September 23^rd, 24^th and 25^th at Yankee Stadium.  If both teams take care of business between now and then, it will make for an exciting close to the regular season.

The Need for Additional Fiscal Stimulus

As Fed Chairman Ben Bernanke made clear today in his Jackson Hole speech, policy makers beyond the Fed need to actively participate in stimulating aggregate demand in the economy (i.e., Congress and the White House need to do their fair share with respect to fiscal policy stimulus.)  Nobel Prize-winning economist Peter Diamond comments on the need for additional fiscal stimulus, especially in the form of infrastructure investment, to help grow the US economy and reduce unemployment. 

Ben Bernanake and Hurricane Irene

Between Fed Chairman Bernanke's upcoming comments this morning and the approach of Hurricane Irene this weekend, I think I'll just stay hundered down for the next few days.  I liquidated all equity positions yesterday and find little reason to take any new investment risk until the BB speech and Irene damage can be assessed.

Approaching Bernanke’s Jackson Hole Speech – 2011 Version

For the past couple of weeks I’ve been engaged in short-term momentum/volatility equity trading (including leveraged ETFs) on a limited basis.  This has worked very well as I’ve bought when I thought the market has over-reacted on the downside and sold when the market has recouped the over-reaction on the upside.

However, as we approach Fed Chairman Ben Bernanke’s speech tomorrow in Jackson Hole, I’m preparing to liquidate at the open of the market today my current equity positions.  I’m concerned that the equity markets are expecting BB to say something to further buoy stock prices --- and I’m not sure what he can say to meet those expectations.

It seems to me there is more downside risk than upside potential attaching to the BB speech.  There are many who believe the Fed has exhausted the tools in its toolbox and won’t be able to do much more to promote more employment in the economy.  It appears fiscal policy will be the best way to create jobs --- and we all know how dysfunctional Congress is at the moment for this to be a realistic short-term result.  (For an example of this monetary- vs. fiscal-policy discussion, see http://economix.blogs.nytimes.com/2011/08/24/how-much-more-can-the-fed-help-the-economy/.)

If this is a correct assessment, the markets could again fall to their lows of the past month --- and if not correct, what’s the loss of a few upside points by comparison?

Getting ready to fasten my seatbelt for the bumpy ride ahead.