Pandora’s Box

In a recent post titled Easy Money, we shared our concerns around capital flight in China.  The outflows appear to be accelerating and the risks are real, but dwarfed by bank runs in Europe today as Europe’s leaders have just opened up Pandora’s Box, openly acknowledging that a country could abandon the Euro.  Michael Pettis recently described how policymakers in Europe may have just set in motion a chain of events that will ultimately break up the EU.  His logic is paraphrased below.

  • As soon as any depositor realizes that bank deposits are likely to be redenominated into drachma, he will pull his deposits out of the banks so as to protect the value of his savings (this has been ongoing in Greece already). But obviously only a few depositors will be able to do this before forcing the bank into closing. In order to prevent the resulting collapse in the banking system, the only thing Athens can do is to freeze bank deposits long before most depositors have had a chance to cash out.
  • But depositors know this. As the probability of Greece’s leaving the euro rises – and clearly it rose dramatically this past week – anxious depositors eager to prevent their deposits from being frozen and redenominated in a weaker currency know that they will have to speed up their withdrawal of deposits from banks.  And of course as anxious depositors withdraw their deposits, the likelihood of a banking crisis rises, and with it the likelihood of Greece’s being forced to freeze deposits and leave the euro.?
  • We are caught, it seems, in one of those self-reinforcing loops that almost always presage a collapse. Rational behavior by individual agents leads towards a catastrophic event the threat of which reinforces the behavior.
  • Without a credible intervention this process almost always ends the same way. There is in my opinion a very high probability that within weeks, or months at most, Greece will be forced to freeze bank deposits as a prelude to leaving the euro. Mexico in 1994 and Argentina in 2001 chose the Christmas/New Year holiday season to announce their devaluations. Will Greece follow suit??

It is remarkable how closely Greece is following the Argentina experience.  The charts below are from JPM’s Sovereign Default Time Capsule.  Note that in each case, IMF and other bail-outs did not end the crisis.  Without a devaluation, short-term fixes and bridge loans do little do solve underlying structural issues.  Pettis asks the difficult question, “As households from Italy, Spain, Ireland, Portuguese, and other vulnerable countries read every day about hardships faced by Greek families, what will they do?”  And answers, “Once Greece goes, even the least sophisticated households in other countries will know what the consequences for depositors will be . . . This is simply part of the logic of sovereign financial distress – declining credibility causes stakeholders to act in ways that reduce credibility further.”

For those looking for a quick summary of the European Crisis, this short clip should do the job.  In short, bankrupt governments are doing everything in their power to keep bankrupt banks on life support, while bankrupt banks try to prop up bankrupt governments.

We provided investors with our interpretation of recent events in Europe last week.  While the news-flow out of the EU is coming at a rapid-fire pace, and rumor mill is spinning even faster, we thought it was worth sharing, so an excerpt from our letter is available below:

Last month, risk assets globally celebrated the “solution” to Europe’s debt crisis with one of the strongest one-month rallies in equity prices.  It is important to understand that rallies of this magnitude are hallmarks of “bear markets” and are prone to fantastic failure. Two particular developments sparked October’s short-covering rally. The first component was better US economic data that exceeded overly pessimistic expectations. “Hit your head with a hammer long enough and it just stopping feels great,” is the best analogy we’ve heard for the recent “improvement” in economic indicators. The second factor was the latest “Band-Aid” to patch Europe’s credit crisis. In this letter, we’ll provide additional color on both developments, in addition to our understanding of the implications.  In short, we think the coming hangover from last week’s risk party will be painful. 

The few investors that saw even a remote probability of recession a month ago have now vanished, along with any aversion for risk, after learning that GDP grew 2.5% last quarter. Put simply, the consensus is assuming that because the economy grew last quarter, it will not contract in future quarters.  We prefer to look ahead while managing the portfolio, rather than staring in the rear view mirror. The forward looking evidence still suggests that the US, as well as the EU, is in recession or at least staring over the edge. This is clearly a non-consensus view after October’s market rally, but it is important to recognize that the recovery of initial losses after early signs of economic weakness is not unusual, and is often followed by more abrupt and more severe losses. My friend Marcus Griffin, Chief Investment Officer of Glenmore Advisors in Atlanta, shared the chart below with us this week, which clearly illustrates this point.


Last week, European policymakers announced a new plan during the final hours of a self-imposed deadline.  While the plan may have reduced the short term risk of a disorderly default, upon closer inspection of the “new” plan, investors should recognize that there is really nothing “new” here at all – it is simply a leveraged version of the “old” plan. We discuss the three components of the announcement below:

  • European Financial Stability Fund (EFSF) – Leaders of the Eurozone countries agreed to more than double the size of their rescue fund to 1 trillion euros, but still failed to elaborate on who will foot the bill. It’s worth noting that the EFSF is not actually a “rescue fund” in its current structure.  It is simply a plan with no actual capital, but roughly 250 billion euros promised (net of the funds already committed to bail out Greece) from the same EU countries in need of assistance, seeking additional funding from private investors, not yet identified. Got that? Essentially European leaders have promised to borrow money that they do not have, in order to leverage these funds four or five times, to be able to buy enough debt that they will issue to pay back existing debt. No wonder markets are so excited. Unfortunately, stocks aren’t the only thing making new highs on this announcement. European debt spreads, a measure of the cost of borrowing, are rising across Europe as shown below. The basic idea of leveraging the EFSF is flawed. The “protection” offered does nothing but potentially delay default IF it entices outside investors to cover the 1.5 trillion euros of Italian and Spanish sovereign funding needs for the next few years (which completely ignores several trillions more in bank rollovers). IF investors are unwilling to buy bonds from these governments today, we wonder who will buy EFSF bonds backed by these same governments when the markets have decided that these countries are no longer credit worthy. Apparently, very few, as the EU just postponed a 3 billion euro bond issue due to “market conditions.”

  • Capitalisation of Banks: The European Council concluded that, “There is a broad agreement on requiring a significantly higher capital ratio of 9% of the highest quality capital . . . to be attained by 30 June 2012 . . . Banks should first use private sources of capital . . . If necessary, national governments should provide support, and if this support is not available, recapitalization should be funded via a loan from the EFSF in the case of Eurozone countries.” While well intended, European estimates of just 106 billion euros to recapitalize the banks, are simply inadequate. The IMF recently increased their estimate of bank capital needs to 300 billion euros a few weeks ago. At the same time, these capital estimates do not take into consideration the impact of the current economic contraction underway, resulting in an increased pace deleveraging, additional asset sales, and ultimately, capital requirements which could be multiples of current guestimates.

Furthermore, Tier 1 capital, or “the highest quality capital” required by Europe’s Heads of State, is an utterly useless measure of solvency during times of stress.  Dexia was supposedly at 12% right up to its ultimate bankruptcy. It is ridiculous to treat the same government bonds at risk of default as “riskless” assets when determining capital adequacy. Rather, investors should only consider the simplest form of capital that can absorb losses – tangible common equity. On this basis, we can easily identify the banks and banking sectors most at risk. In addition to Dexia, which had a tangible common equity to total assets ratio of 1%, French and German banks stand out as the ones most in need of capital injections. Seen in this light, the reluctance to accept additional “haircuts” from their southern neighbors is quite obvious.  Both the German and French governments have significantly less fiscal flexibility to bail out their reckless peers once you consider the cost of recapitalizing their banks at home. And per former Bundesbank President Axel Weber, as the sole guarantor to the EFSF, “Germany could end up with a debt of 314 percent of GDP in an extreme case.”

Source: BCA Research

  •  Beware Greeks Bearing Debt: Under the deal, private sector banks “voluntarily” agreed to a 50% haircut on Greece’s debt burden, which would potentially cut its debt to 120% of GDP by 2020 (in line with Italy’s massive debt burden today) from 160% currently. Once again, this is not enough as the ECB, one of the largest holders of Greek debt, does not appear to be subject to the haircut. This is not a sustainable debt level considering the lack of growth in the country and in the Eurozone. 

The flurry of news out of Athens over the past week has been nothing short of spectacular.  Rather than recap the Papandreou Circus Show, which might require an additional letter in itself, we thought this illustration below provided a good sense of the antics we have been watching and the market’s reaction to every word emanating from Europe. The bottom line is that the Greek Prime Minister’s ridiculous maneuverings forced policymakers to openly admit that a country could actually leave the Eurozone.  Europe is crumbling and the likelihood of a messy default is increasing by the day.

The current condition has all the elements of the classic “prisoner’s dilemma” where there is temptation for each party to deviate from agreement at every step of the way, even if it ends up being extremely counterproductive to everyone. The evidence speaks for itself – approaching two dozen “Summits” over the past two years and we are no closer to resolving the problem of too much debt, with more debt. Instead, we are a lot closer to the end of the European Union as we know it. European policymakers may still prevent a disorderly sovereign default with a “grand and comprehensive” solution, but they cannot prevent the recession which is already in progress. Consequently, we are sticking with our credit default swaps, which cost us during the recent rally, but should see much higher prices ahead.

We recently read a piece from a manager we respect who is now “fully invested” largely based on the following premise – “IF we are not in a recession, and IF we are not going to have one, and IF the European “can kick” means no repeat of the Lehman systemic meltdown – IF all these “IF’s” are likely to be realized – then the bear is going into hibernation for the winter and the surprise will be to the upside.” While we would love nothing to be so optimistic, we can’t help but notice that those are A LOT of IF’s!!  As prudent managers of your capital, we believe that having some insurance in case all those “IF’s” don’t line up perfectly, is a necessity in the world we live in today. 

Our goal is to try to generate attractive returns in any market environment, so we use a variety of strategies to protect capital during difficult periods.  Risk protection must be in place at all times since the timing and magnitude of market dislocations are unpredictable. As such, insurance creates a drag on our profits because timing inherently unpredictable events is impossible, but well worth the cost during periods like last quarter. The Wall of Worry is high enough that positive surprises could lead to higher stock prices near term.  In fact, the cycle work we follow points to another “high” in December. Our best guess for how far a rally could run is shown in the chart above, which does not leave a lot of upside potential from here. Given deteriorating fundamentals, slowing growth and increasing financial market stresses, we view the risk-reward profile today as less than compelling – a fact that becomes abundantly clear when viewing the risk levels shown above.  Of the 11 “waterfall declines” since 1929 identified by Ned Davis Research, we have not seen a single case historically where the market has exceeded pre-crash highs within eight months.  In the eight cases where the crash lows had been broken, the market went on to break to lower lows 75% of the time.