I'm back in New York after a week on the west coast speaking at events hosted by IBM Performance. Their analytics software helps CFO's manage risk trends globally with real time results. The timing couldn't have been better with the shock waves coming out of Europe.
I had to ask, is this 1931 all over again?
In the early 1930's, similar to the last several years, the US started a global financial crisis only to have it spill over to Europe and then smash back to American shores. Two years after the Crash of 1929, in May 1931, a colossal Austrian bank, the Creditanstalt, collapsed into a sea of insolvency.
A few months later disaster struck when Danat Bank of Germany, one of the largest banks in the world, crumbled under it's own weight of debt. As many of the great investing sages have opined, these events resulted in a global financial crisis and ultimately, the bank failures of the Great Depression. This shock represented the Lehman Moment of that era. By July 1931, 49% of German trade unioners were jobless. Politically, the door was wide open for Hitler to move in. Facists and communists around the world filled a capitalist void that today Fed Charmain Bernanke and a swarm of central bankers cringe a the very thought of repeating.
Kohl's Federalism vs. The Austrian School
Fast forward to June 2012. Germany faces the dilemma of going with Mr. Kohl's Federalism, translation, giving money to the Mediterranean forever. The other choice is breaking up the Euro, which would mean a trillion Euros of pain and Target 2 losses. With over 40% of Germany's exports to peripheral countries, GDP in Germany would take a sharp hit as exports plunge as well.
What Does Germany Stand to Lose?
Between 1999 and 1993, German exports rose by around 3%. But between 1999 and 2003, exports increased by 6.5%. Between 2003 and 2007, two years after the introduction of euro notes and coins, German exports rose a staggering 9%. The federal government-owned investment bank KfW researched the benefits of this boom and determined that membership in the currency union has created profits in Germany in the last two years alone of €50 billion to €60 billion, Spiegel online recently noted.
Historically Sovereign Default is Not Uncommon
Yesterday in Dublin, Carmen Reinhart, Senior Fellow at the Peterson Institute for International Economics, made some interesting comments which hit home with my thinking.
"In terms of debt resolution in advanced economies, the points of reference are WWI, the 1930's and WWII. In 1932, the only country to repay its debts to the US was Finland. The US then abrogated the gold clause." Reinhart said.
Default is not uncommon. "Between 1945-79, real interest rates for 22 leading economies were negative over 50% of the time." Her point is growing your way out of a debt overhang has almost never worked. There's almost always a deflationary debt restructuring and financial repression. This is one of the reasons why commodities are so weak and oil is 25% off this years highs. Even with all the obvious printing, deflation is the silent threat.
The Land of a 1000 Head Fakes
Enough of history, how do we trade this market today? A few weeks ago I said on CNBC, sell the rallies until you see the whites in the eyes of the bazooka. Well, this past weekend we saw one but it was a half a mile away. If we remember the lessons of 2008, the trading time between a Charlie Gasparino bazooka storybreak and the actual event was reasonable compared to today. What Hank Paulson, Harry Reid and Nancy Pelosi could put together in a week can take a months in Europe. It's the land of a 1000 head fakes, don't forget it.
The Glass Ceiling Over US Equities is the Yield on the Spanish 10 Year Bond
Take Spain, I've been saying for a month now, US Equities don't move higher with the unresolved systemic risk sitting in the banks in Spain. It's truly a Lehman like threat. There's a ceiling over US equities and it's getting the truth from Spain in a deep and detailed stress test with a right sized bank recapitalization plan. Without a plan markets trust, yields on Spain Government bonds head north.
Why is this important? According to Bloomberg, the 3 largest banks in Spain hold on with trembling hands to 20% of Spain's sovereign debt, or $172 billion worth. For the last 15 years, there was nothing at all wrong with banks owning this kind of colossal slugs of government bonds. For one, the price volatility of government bonds in Spain was about 75% lower than it is today and the banking regulators have been fine with government bond size positions on bank balance sheets. In fact, sovereign debt is not counted as "risk weighted assets" in all the leading banking capital framework, bestowed to the world from our regulatory lords.
Double Edge Sword of Leverage
As a former Lehman bond trader, I must remind you of the double edge sword of leverage. If a bank is levered 20x, with $1 billion of net tangible equity vs. $20 billion of assets. Just a 10% drop in the value of your assets = turn out the lights, the party is over.
Equity investors worldwide, the first thing you should do every morning, before brushing your teeth, is find out where the yields are Spain's bonds. Spain's 10 year bond trades with a 94 handle, down from 107 in March of this year. Today, is not 1990's, the price of this bond is more important than the price to earnings ratio on your favorite stock. Never forget the lessons on Lehman Brothers, respect systemic risk.
Credit leads stock prices. Spain 5 Year CDS is a ceiling on US equities, must come down for stocks to move meaningfully higher.
Spain 5 Year CDS, 10 wider today at 607
Systemic risk must be reduced for US equities to move higher. When you have an economic shock like Lehman Brothers failure, it can take a decade or more to get back to completely normally functioning capital markets. Seventeen years, from 1990 to 2007 the volatility index, the VIX spent about 340 days above 30. Five years, from 2007 to 2012, the VIX spent about the same amount of time north of 30, and we came very close to crossing the threshold last week. Needless to say, we are living in a elevated period of earnings, GDP and stock market volatility. Why? Because we are surrounded with 1000x the systemic risk factors the global equity markets faced from 1980 to 2000.
In Spain over the weekend, European leaders attempted to preemptively trump the market with a $100 billion bank recapitalization plan which was heavy on presentation but light on details.
What is unquestionable is that the Spanish bank bailout will lead to a resurgence of populist anti-banker sentiments and the placing once again of the treatment of senior bank bondholders on the public agenda across the Eurozone. Stay tuned for Occupy Madrid coming to a TV near you.
Markets Thirst for Truth & Clarity
Bottom line, the market needs truth and clarity to move higher. Step number one, the market needs to know what the true losses are? We wont know this until the two "independent audits" of the Spanish financial sector currently underway have been completed most likely between the 18th - 21st June 2012 (and this is just a first look, deeper review still pending). Remember Lehman Brothers, went from a September 8th, 2008 conference call when investors were told the firm had plenty of liquidity, to September 13th, when a $32 billion hole in the balance sheet was found.
The Speed of Finding the Truth?
Thanks in large part to Hank Paulson and his team: what was accomplished in the USA between September of 2008 and March of 2009, just 6 months, Europe is taking two years, going on 3 to accomplish. Why was the Irish bank recapitalization in 2010 and Spain's in 2012 again? The US didn't do a bank recapitalization in Florida in 2008 and Nevada in 2010.
Deep down the markets know this and don't like it: the growing lack of trust is leading to higher bond yields in Spain and systemic risk. This can be seen rising correlation in the US equity markets. Elevated correlation was awful in 2008, bad in 2011 and unpleasant today. It's been said that in the height of a true panic, like 1907, 1929, 2008 correlation moves to 1 across all asset classes. Rising correlation is not good for stock prices, we want to see this turn south for US equities to head north.
One of the few pieces of good news is the Italian economy is nearly 50% larger than Spain, but Italy's mortgage debt outstanding is only half (56%) that of Spain. In other words, less potential for a large scale bank recap in Italy.
Identical Pattern 2008, 11 & 12
ICJ / CBOE S&P 500 Implied Correlation Index
The Clarity the Markets Need
Was this bank bailout to Spain a ready, fire, aim deal?
1. Spain has not yet submitted a formal application for financial assistance but will do so shortly.
2. European Stability Mechanism (ESM) or the European Financial Stability Facility (EFSF)?
Will the $100 bln loan to Spain be from the ESM or EFSF? The ESM will enjoy the same seniority as all other loans and obligations of the beneficiary ESM member, per the ESM treaty.
The ESM more likely to provide funds to Spain than EFSF , the German finance minister's spokesman said yesterday. The ESM is expected to start up in July. The ESM is explicitly senior to existing Spanish bondholders, uncertainty over this unknown is driving Spanish bond yields higher, 6.06% yesterday to 6.6% today. The Eurogroup statement says Spain's aid may come from EFSF OR ESM, leaving open the possibility that Spain formal application may wait until the ESM has formally been established in July 2012.
If the $100 billion loan is through the EFSF, it in effect subordinates the outstanding $700 billion of Spanish bonds in the market. This begs the question, after Greece are capital markets getting cram down fatigue? How will this impact future issuance of bonds?
3. Spanish bank bailout will push government debt ratio above 100% of GDP in 2015?
4. Spain will pay around 3 to 4% interest on the new bank bailout loan, depending on market conditions, EU spokesman Amadeu Altafaj says on TVE
5. How much equity will the government of Spain get for cash to banks? A combination of measures will be used to determine how much equity will be injected by state and how much banks can independent squeeze both sub note holders and equity holders through further rights offerings.
6. The Finnish government has confirmed that it will seek collateral from Spain should the funding come from the EFSF. How will this be presented?
Keep in mind, the Portuguese bank recap was near $8 billion, it was already negotiated 1 year ago with Troika and already done.
Portuguese PM Coelho said there's no reason to ask for new conditions for Portugal's program following the rescue request for Spanish banks. A story from Agence France-Presse reported on Sunday that Ireland, which has done better under its bailout program than fellow delinquents Greece and Portugal, is set to ask for a renegotiation to match Spain's deal.
Financial Backbone of the Eurozone is Bending
German 10 year bunds have moved from 1.14% to 1.36% over the last 10 days. Today Bill Gross noted, "German Bunds join the maelstrom. Very few scenarios in which they do well. Only German exit favors Bunds." Last June they yielded 3%, I don't think the market is respecting the $700 billion of Target 2 liabilities facing Germany. Behind the scenes what I'm seeing is the financial pluming of the Eurozone is in full retreat back home. Increasingly, Spanish and Italian banks own more of their own assets while countries to the north want to own less of them.
The FT reported today, citing Economist Karl Whelan, noted a decomposition of Spain's Target 2 balance showing mainly foreign capital that is substaintially flowing out.
The wake up call that Greece just might leave the Euro, is creating pause as other countries in the Eurozone are now thinking twice when choosing to do business and banking with one another.
Bazookas? ECB Ready to Fire a Barrel?
Last week at the ECB press conference, the Governing Council announce an expansion of the full allotment policy through at least year-end.There were a few of shifts in their language which should be noticed. A clearly more dovish tone:
- They referenced, "increased downside risks to the economic outlook."
- The outlook for the economy was termed "weak." This is a very aggressive word for the ECB to use.
- They downplayed inflation risks and called them "broadly balanced" risks.
- A few members supported a rate cut during the council
These Tricks are Still in the ECB's Bag
- ESM lending directly to banks
- ESM banking license
- Eurobonds (2014/15)
- EU deposit guarantee scheme
- ECB direct bond purchaces in open market
- Ask Fed to Expand Swap Lines
- ECB TARP or TALF or ETALP
Buy stocks when you see the whites of the eye of the Bazooka.
Mutually Assured Destruction
According to a leaked message carried on the front page of Spain's El Mundo newspaper Monday, Prime Minister Mariano Rajoy ordered his finance minister to reject conditions that would have led to Spain surrendering control over its economy. Like Dick Fuld, he's confident Germany will cave under the sytemic risk threat Spain presents to Germany and the rest of the global financial system.
"Resist, we are the fourth largest power in Europe. Spain is not Uganda," Rajoy reportedly texted minister Luis de Guindos who was negotiating the bailout terms in a teleconference with other euro zone ministers.
Stay tuned, if Germany did cave, will Spain push harder next time?
Speed Up the Banking Union Please
As most people know, in 1999 the Euro was launched, Europe's Federalists chose to pick the low hanging fruit first and leave the difficult work of forming a true banking union for later. Now is sure later: Lehman Brothers sped up the clock, but that was almost 4 years ago. We are very close to a breaking point.
Political leaders of Europe, take a page out of the Hank Paulson playbook and accelerate your fiscal and banking union. Mr. Market is carrying a deadly sword; don't force him to use it. He will, as a former Lehman loyalist, I painfully know this all to well.