Fault Lines: Is the Banking Bulet Really Dodged?

Fault Lines is That Retired Guy's periodic run down of the Euro dangers on the horizon (next two weeks).

Meltdown in Spain has once again been averted with an agreement to provide direct banking support from the European bailout funds (EFSF and ESM).  As usual, the market has cheered, but are the fault lines really all closed?

Watch Out For That French Downgrade

That Retired Guy (TRG) has been very vocal about the risk of a French downgrade from Moodys or Fitch.  The direct risks have actually come down a bit because the ECB has been relaxing it's collateral rules so that the rating agencies opinions are less important.  However, they will still matter to the market, and also to the guarantees provided to the EFSF.   And a downgrade can only be more eminent now that Hollande has made it clear that austerity is not his plan.

TRG is sticking to his prediction that a French 10 Year Government Bond yield of 4% or more would predicate another serious turn in the crisis.

Did They Really Agree?  Really?

Today, the markets are very excited about the agreement to allow the bailout funds go directly to Spanish banks.  However, the real work is yet to come, and the likelihood that there will be some bickering over the details seems almost certain.  If the details have some holes, then the net effect will be disillusionment with Europe's ability to end the crisis, and that in itself may cause problems.

Where's Cyprus?

Cyprus has requested a bailout.  Any surprises will make for nasty headlines.  Cyprus is a small country, and the bailout funds available are certainly enough plug any Cypric hole, however there is still a change that Cyprus becomes a catalyst for bigger problems. 

Angela Against The World

Angela Merkel had a rough night.  First, her German boys got ejected from the Euro 2012 Tournament, and she found herself facing a united front of meek governments demanding easier crisis terms.  She buckled, and so this morning, the markets are once again inspired by hope that the latest measures will put an end to the crisis.

Angela must miss her old friend Nic.  Hollande has been boosted with a surprisingly strong mandate in France, and is now leading the revolutionary cry against austerity.  So far, Angela has maintained her support in Germany in spite of a number of political u-turns, but will the German public really tolerate France's insubordination?

That Retired Guy predicted a slightly different form of Merkeland when Hollande was elected.  It's still a little too early to say weather 'Angela Against The World' is the new normal, but even if it is, the big question today (considering the market's move up):

Is 'Angela Against The World' really such a good thing?

Spain's Problems Were Made by the ECB in Greece

Spain's banking bailout last week has been less then successful, but the blame has not managed to get to the responsible party.  There is little question that Spain's problems stem from the property bust, and resulting banking crisis.  Spain has not helped it's cause by acting as if the banking problem could be solved without state support.  However, considering that the problem is a banking crisis, and the 100 Billion Euro bailout should be sufficient to recapitalize the banks, it is curious that the bond market's judgement of Spain is so harsh.  The 10 year government bond for Spain crossed 7% on Thursday.  If Spain is forced to pay that rate for long, then a full bailout will be required.  So why does the Spanish banking bailout appear to be such a failure?  The answer lies with the ECB, and the way they handled the Greek debt restructuring.

Europe's handling of Greece has been a comedy of errors, but possibly the biggest error or all was the ECB's idiotic insistence that they be spared the effects of the debt restructuring.  When Greece restructured their private bonds on April 25th the ECB had held approximately 50 Billion of the bonds which they had bought in the open market in an earlier effort to support bond prices.  The bonds that the ECB owned were the same bonds that were being restructured, and the long standing legal principle of Pari Passu states that ALL bondholders (including the ECB) must be treated equally.  The ECB didn't like this idea, and pulled an audacious, illegal kludge to insure that their bonds would be treated differently.  The did this by exchanging their bonds for new ones, but since this treatment was not offered or granted to any other bondholders, it was an absolute travesty.  The outrage was muted because the other bondholders (mostly European banks) are so beholden to the ECB that they did not want to bite the hand that props them up.  However, just because no one complains does not make it right.

Additionally, just because they thought they got away with it in Greece does not mean that they actually did.  Today, we see the fallout of the ECB's behavior in Spain.  The banking bailout should have been enough to calm the market, but it only made things worse.  Bondholders of Spanish debt understand that they are implicitly subordinated whenever official support is provided.  The subordination can be legal (in the case of the ESM) but the real concern is the illegal kind.  The precedent has been set, and it states that  in a pinch the ECB will change the rules in their favor at the last minute.  How the rules get changed is unknown, all that can be certain is that it will be to the detriment of anyone holding Spanish debt.

The ECB is getting their comeuppance, and it's poetic justice in a way, only it's a shame that Spain and the Euro will suffer for the ECB's poor judgement.

Hempton is a Brave Man

Fellow finance blogger and surfer John Hempton has been investigating and exposing Chinese frauds for some time now, but his latest post raises the bar quite substantially:

The Macroeconomics of Chinese kleptocracy

Were it not for his impressive record of finding fraud, his recent post would be easily dismissed, but That Retired Guy (TRG) thinks he may actually be on to something.

The real surprise is that he is willing to come out with something so inflammatory in the first place.  China is a pretty nationalistic place, and if he is right in his post, it is also the largest, richest mafia organization in history.  He is hitting at the core of what is likely to be seen as THE most sensitive issue for the nation.  At very least, Hempton can probably expect his computers to be hacked, and at worst, you can't eliminate the possibility of becoming personally hacked-up or otherwise coming to a violent end!  So, TRG says 'hat's off'  for speaking truth to power, and if not actual truth, then 'hat's off' for having the guts to say it anyway.

His main premise is that China works because the captive population is forced to save an negative rates, and this gives the thieves in power room to steal and still look like a successful economy.  It's true enough, although TRG suspects that most Chinese bureaucrats and SOE employees (at least the low level ones) probably have a firm conviction that they are doing the right thing for their country.  Not that their conviction matters per-se, in fact, that may be the reason the the whole fraud works.

The problem with macroeconomics is that there is generally little, or no predictive value to it.  Knowing that China will blow up someday does not tell me what to do tomorrow.  Furthermore, when China does blow up, the macroeconomic story will still be a background issue, and the thing that really gets the ball rolling will be some sort of event.

Macroeconomics are a bit like the stage design in a theater production.  The theme of the stage certainly contributes to the feeling of the play, but it does not direct the plot in the way that the dialog, or action does.  Even if China is the biggest fraud ever, it can still get much bigger.  It could even grow to become the first world empire before things collapse.

TRG doubts Hempton would refute this, for example, it's unlikely that he has found a way to make a financial wager on the macroeconomic story.  Of course, that doesn't make the macroeconomic story any less interesting.

Fault Lines - Now it Gets Political

Fault Lines is That Retired Guy's weekly run down of the Euro dangers on the horizon (next two weeks).

What a difference a week makes.  Last week, the main concern was banking, and to a degree, it remains, but the Spanish move to ask for a bailout for it's banks is likely to reduce the chance of a run at least in that country, and there were no major issues coming out of the Greek banks last week, so for the next two weeks politics will play center stage.

Hollande is Likely to Cement His Position, Is That a Good Thing?
The issue with French elections is that they have been surprisingly good at ignoring the elephant in the room.  France does not see itself as an overburdened debt country with too generous of a state, and a aging, growth starved economy.  In fact, evidenced by their bond rate, the rest of the world doesn't see France that way either.  Unless of course you actually ASK someone.  In that case, you will here some version of French troubles that include too much debt, too little growth, an aging population, a overly generous state and (especially if you ask an American) a tendency of the population to not work very much.  This is a curious condition...  TRG is used to seeing cases where perception and reality have become disjointed, but in France, we have a case where perception has in fact become disjointed from perception!  Nowhere is this more apparent then on the French political stage where the issues are widely acknowledged, and yet somehow completely ignored in policy proposals.

Were Europe not in such a mess, France's identity crisis could probably continue for years, however...

So what are the risks for Europe coming from France.   It seems likely that Francois Hollande will take another victory for his party by packing the parliament with his party.  He has played his cards perfectly since the presidential election, and he is surprisingly popular going into the parliamentary election.  The problem for Hollande is that there are wolves stalking.  Moody's and Fitch seem very ready to downgrade France, and probably they are just waiting for the end of the election cycle so as not to give an appearance of taking a political angle.  Things are playing out almost exactly as TRG himself had predicted (and yes, he is very surprised whenever that happens).

The crack that will open to engulf France is not the election, it is the downgrade (see 'Merkelland' for a full description why).  The downgrade may not be in the next two weeks, but TRG sees the election as a significant step in the process.

Greek Politics
The upcoming Greek election is such an obvious fault line, that TRG isn't even going to delve into it deeply hear apart from saying that another Greek deadlock is almost certain.   With Greece running out of money, and the Troika looking for any excuse not to give more, things are bound to come to a head.

The Cyprus Bailout
TRG expects a bailout to be announced for Cyprus in the next few weeks, and this could unsettle markets.  Cyprus is small, so a bailout will be hay rather then a haystack, but there is a real risk that we are coming to the straw that breaks the camel's back.

A Banking Surprise is Still Ever Threatening
TRG is probably going to stop talking about this particular Fault Line, but not because it is going away.  Rather, it is so ever present that he is going to get tired of mentioning it.  See the last Fault Lines post for a description.  Needless to say, it could happen in the next two weeks.

The Market's Up, But Don't Let That Fool You

To the casual observer, the market performance over the last few days would suggest that things have changed dramatically.  That Retired Guy (TRG) is not so sure.  The Fault Lines in the Euro certainly have not become any less precarious.  Of course there has been market commentary linking the moves in the market to the prospect of direct capital injection into Spain's banks from the European Union.  TRG is not convinced about this either.

The fact is that on any given day, it's damn hard to explain what the market is doing with the actual facts of world events.  In the latest news, there are two New York Times articles that demonstrate that things are still pretty bad in Spain and Greece:

Greece Going Broke
The title say's it all.  Greece is running out of money, and the EU is not going to be happy about providing more.

Spain Holds Trump Card
This article puts a positive spin on the idea that Spain will enter bailout negotiations with a strong bargaining position.  It's true enough, but TRG fails to see how difficult negotiations are somehow a good thing, as if the situation in Greece, Ireland, and Portugal would have somehow been better if the bail out countries had gotten a better deal for themselves.  The fact is that German voters will NEVER think that the PIIGS are doing enough, and the PIIGS will ALWAYS think the austerity is too extreme.

So the market's up, but the storm clouds are as dark as ever.

Fault Lines - Watchout for the Banks

Europe is in a mess at the moment.  The once sturdy Euro has suffered some substantial blows, and a lattice of cracks have appeared in the foundation.  TRG has (belatedly) come around to the idea that Greece will leave the Euro, which immediately raises the question 'what will happen to the Euro then?'  Exit for Greece is bound to be messy, and the politicians have shown over and over again that they are incapable of getting in front of this crisis.  If Greece leaves, then that is likely to trigger more events that will spread pain through Europe, and the world.  However, Greece leaving the Euro may not even be the first event.  Clearly, we are no longer talking exclusively about Greece when we discuss threats to the Euro, and TRG believes that limiting the discussion to even Portugal, Italy, Ireland, Greece and Spain (PIIGS) is too narrow.  The cracks in the Euro spread far wider, for example, a credit rating downgrade in France could easily spark another moment of deep crisis.

'Fault Lines' will be a regular feature on the That Retired Guy blog, hopefully once every week or so.  The idea is to look at the coming two weeks and suggest what seem to present the Euro threats.  These threats are sure to change overtime, and TRG is hoping to chronicle where we are in each step.

Running (on) the Banks
The most likely catalyst for the next crisis would be if the current slow motion 'Bank jog' turned in to a full scale 'Bank Run' in Spain or Greece.  The smart money (corporate deposits of international companies) has likely already left these countries, and individual deposits are slowly leaking out too. 

All banks have an implicit risk of becoming insolvent if depositors all ask for their money at once.  Typically, this happens when a roomer circulates that the bank is going to fail and anyone who does not get their money out fast will loose it.  If this were to happen to any significantly sized bank in Greece or Spain, it would create an instant Euro crisis, that could easily result in a breakup of the currency.

The sad fact is that some people are being awfully foolish.   TRG has read stories of people pulling money out of the banks to keep it in cash at home.  Aside from the obvious security risk this creates, it is also completely ineffective as insurance in the event of Euro exit.  In an exit scenario, ALL money inside the borders of the country will be re-denominated INCLUDING NOTES AND COINS, the military will secure the border to prevent cash from leaving.  So keeping money as cash at home will not protect it.  Better to open a bank account in Switzerland, or use the money to buy an asset (such as Bunds) that will continue to be denominated in a currency worth having if the Euro splits.  TRG is not a big fan of gold, but it would also work as a short term store of value if the Euro breaks apart.

A Large European Bank (Anywhere) Has A Big Unexpected Loss
JP Morgan recently demonstrated that big banks have not learned any lessons from the past crisis.  TRG believes this is no accented, but rather a result of the broken banking culture that continues to fester, and is decaying the banking system from the inside out.  If a large European bank (Deutsche Bank is TRG's favorite candidate) suddenly announced that a few billion Euro's had gone missing due to some sloppy risk control, and/or 'rouge' trader then it would set of a shit storm in the market.  Deutsche Bank is TRG's favorite candidate for such a misfortune because like JP Morgan in the US they have been a big proponent of the "But our shit doesn't stink!" line of reasoning.  The reasoning is that because they survived the last crisis without any major scars, they should be seen as special.  Deutsche Bank has a ridiculous leverage ratio, and a weak capital position, one reasonably sized loss is all it will take before they are suddenly looking very shaky, and the fact that the German government would inherit the problem could leave the rest of Europe in a poetically ironic state of schadenfreude.  Deutshe Bank is not the only bank that could set off trouble, Societe Generale, Barclays, Unicredit, and Santander have all drunken deeply from the "But our shit doesn't stink!" trough, and any of them would suffer double if an unexpected loss were to come to light now.

The Ever-Present Political Risk
When times are rough, the simplest political mis-step can set off a major problem.  We came close last week when Spain's Rajoy suggested Europe help with the Bankia bailout without getting Angela Merkel's take on the idea first.  It looks like Europe will be coming to the rescue of Spain's banks regardless but the bullet seems to have been only narrowly dodged (and the Bankia story is not over yet).  Political risk could also come on the campaign trail in Greece, although the real political story will be latter in June with the election itself happens.