Who needs haircuts?

Those fretting over the the potential moral hazard of fiscal action over the last two years can now take a deep breath. It is here already, and so widely and deeply proliferated that the once onerous spectre of bad debt no longer seems that way. To creditors and bond investors, a haircut is no new thing - it has been happening for hundreds of years. People, institutions and, yes (!), even governments have recovered from defaults, whichever side of the ledger they happened to be on.

The NEW WAY of dealing with credit crises is based on a rather dangerous assumption; that default will lead to catastrophe, that 50 cents on the dollar will somehow lead to financial Armageddon. So taxpayers bail them out - banks, insurers, car companies, and now governments. Yet how can we bail out other governments? Well I ask you, who is the IMF but us? Taxpayers of member countries have a say in this matter. It is not just a far away problem for the citizens of Germany and France to moan about.

That governments are bailing out other governments through the IMF is not new, but it has been reserved almost exclusively for the third world. Now the IMF and the EU are jointly bailing out a country that lied through its teeth with the help of some venal investment bankers about the state of its finances. Greece has been in default for half its history. Fiscal mismanagement in Greece is as entrenched as tax dodging and violent political activism, all of which form a vicious circle.

Let Greece default again, give bondholders the haircuts they should have anticipated. Restructure the debt, move on. The path chosen delays the inevitable: a monumental day of sovereign debt reckoning. The path chosen doesn't end with Greece; it continues through Portugal, Ireland and Spain, it ends with a trillion euro hangover.

Welcome to the bailout economy, we're sweeping it free of consequences.

Sometimes it's best to let others speak for you.

An excerpt from David Rosenberg's daily missive:

The drama continues following S&P’s slice to Greece’s debt rating (to junk status of BB+, a three-notch decline, which prompted a surge in 2-year bond yields to a Zeus-like 15%) and the two-notch decline to Portugal’s rating, to A- from A+. The Euro has bounced back this morning and the flight to higher quality German and French bonds has partly reversed course as the markets are swirling with speculation that the IMF is about to announce a stepped-up aid package (yet again!) and the ECB’s Trichet (“Mr. Euro” himself) is set to make a trip to Berlin to meet with German parliamentarians today. (In the U.S., the huge rally in Treasuries has subsided too as the bond market braces for $42 billion of fresh 5-year T-notes today). JGBs have rallied all the way to four-month lows, in terms of yield, to 1.28% — talk about a switch to defense (not to mention a slap in the face to the conventional wisdom that JGBs are an accident waiting to happen — see Clock is Ticking on Japan’s Low Debt Yields on page 23 of the FT).

The problem of course is that if Greece is bailed out then surely Portugal, Ireland, Spain and perhaps even Italy may not be too far behind. The inability of Greece — and others within EMU — to enact an independent monetary policy at a time of crisis has exposed the flaws of the union. The lack of a cohesive national government is another flaw in times of turbulence, which is why the U.S.A. has longevity and the Eurozone likely does not. It may well be the time to assess why it was that past attempts at unionization in the region — the Latin Monetary Union and the Scandinavian Monetary Union in the late 19th century — ultimately fizzled out.

While the Euro has come back this morning (temporary) from its year-low abyss, global equities are still reeling from the contagion concerns (the MSCI Asia Pac index down 1.5% today) and a stock market priced for perfection is once again confronting a world with blemishes. (Add to that the U.S. government’s attacks on Goldman Sachs as another blemish, at least as far as the investment community is concerned — even John McCain got involved in yesterday’s populist lynching: “From the reading of these emails, there is no doubt their behavior was unethical and the American people will render a judgment.”)

Anyone notice the volume on the U.S. exchanges swell as the selling picked up steam yesterday in yet another in the long list of “distribution” sessions? (Volume on the exchanges surged to a combined 7.6 billion shares — the second highest level for the year.) Portugal’s stock market has traded down to a 12-month low and it’s so bad in Greece that the government has banned short selling for two months. (Hey, it worked in the once-capitalistic U.S.A. didn’t it?) We see in the NYT that Barclay’s analysts believe that Greece needs €90 billion to see them through, €40 billion for Portugal and €350 billion for Spain!

That is €480 billion of refinancing help, which dwarfs the latest €45 billion EU-IMF joint aid announcement by a factor of TEN (according to Ken Rogoff, the IMF is maxed out after €200 billion)! Do euros grow on trees as fast as Bernanke-bucks? Would the ECB, modeled after the Bundesbank, ever resort to the printing press for a fiscal bailout? Where exactly is this money going to come from? You can see why commodities are still under pressure as V-shaped recovery hopes are given a sober second thought. Even in countries like Canada, small and open as it is, has seen its currency lose some of its altitude despite the widespread perception that the local economic and financial backdrop is pristine as can be (Canada is in relatively good shape, indeed, but we challenge some of that conventional wisdom below). What a time for the Bank of Canada to have moved the domestic money market to price in a 275 basis point tightening cycle. (Remember how the Asian crisis, which started with tiny Thailand, stopped the Fed’s planned rate hikes in 1997 in its tracks and who knew that time that more rate cuts were coming down the pike? How many times has the front end of the Canada curve looked this attractive before?)

With that in mind, the Fed had better be very careful about changing any of its wordings in today’s post-meeting press release (especially the day after the VIX index soars 30%). Recall the Bank of Canada’s strident tone last week (watered down a tad by Governor Carney in yesterday’s statement to the House of Commons) which prompted the money market or immediately price-in a rate hike at the June 1 meeting.

Yesterday was really as much, if not more, about Portugal than it was about Greece. Contagion risks are spreading as they were amidst the turmoil around Bear Stearns in early 2008 and we know how that turned out. Bear was not too big to fail; neither was Lehman thought to be at the time. And then the Obama team decided to bail out the other large banks with fiscal costs in the future that will massively constrain domestic economic growth.

Let’s look ahead — beyond Greece and Portugal to Spain. Its combined fiscal and current deficits are the highest in the industrialized world, save for Iceland (and we know what shape it is in). The amount of debt it has to refinance in the coming year is as large as the entire Greek economy (though the latter is getting smaller by the day). So this is not even a case of being too big to fail as much as being too interconnected globally to default. Think of all the global banks, most of them in Europe, which hold onto all this spurious Club Med debt. Moreover, if the other two major rating agencies follow S&P’s lead and cuts Greece to “junk”, then the ECB would be in a real bind for it cannot hold below-investment-grade bonds on its balance sheet. If the ECB does accept junk-rated Greek debt as collateral, then the sanctity of its balance sheet will be seriously undermined; though this ostensibly didn’t matter too much to the Fed in the name of saving the system.

At the same time, refusing to accept Greek debt would exert tremendous strains on the European banking system (see Hobson’s Choice for Germany ECB on page C16 of the WSJ; and also have a look at Debt Crisis Poses Risks to ECB Balance Sheet on page A12 of the WSJ). Whether or not all these countries can be saved by the IMF, Germany or the ECB, the reality is that the downside to the Euro, even at 1.32, is huge. Think of a retest to the lifetime lows of 0.85 at some point down the line.

The Chinese stock market is down now for the fifth session in a row — the longest losing streak in 16 months and the lowest close since October 12, 2009 (dare we say when the S&P 500 was trading 100 points south of where it is today, and the Dow lower by a 1,000 points). And the index leads commodities by four months, so this is not exactly a constructive signpost as far as the near-term outlook for resource prices is concerned (see more below).

So, we have the problems in Euroland, signs of a property bubble in China, and the darling Brazilian economy now in overheating phase to such an extent that the central bank is about to hike rates 100bps in one fell swoop (did we mention the Henry Tax Review in Australia, which is due out on Sunday and set to propose tax changes for the resource and banking sectors?) — and yet all we hear from the rose-coloured bullish pundits is how we have to now measure the U.S. equity market based on “global considerations”, not merely the American economy. Yesterday, we heard a classic rear-view-mirror comment from UPS CEO Scott Davis that went: “Economies around the world are showing signs of recovery.” Every word in that comment was accurate except the tense — replace “are” with “were” (not to mention that this is classic top-of-the-market that defines the term “famous last words”).

There you have it.

Sabbatical

I've been meaning to write an entry for some time now. Every day the electronic reminder pops up and is summarily deleted. Yet every day was like the last and the next - a low volume melt-up on tepid news, no news, or spinning of the bad news. When I turned on CNBC and Jim Cramer was telling punters to buy Ambac (ABK) only because other insolvent insurance stocks like MBIA stocks were up hundreds of percent, I lost faith in the equity markets being anything else but a measure of foolishness. This was after a JP Morgan note that reminded investors that Ambac shares had "no value".

It was groundhog day, and this suits the high frequency trading desk very well. The appearance of the algos from the depths, pulling up corpses like AIG, MBIA and Ambac. All boats lifted with the rising tide of liquidity. Earnings season was again an exercise in institutionalised lying, and banks unsurprisingly made record profits from bond and proprietary trading. Aside from financials, the story was again one of increased margins rather than revenue with few positive surprises. Here's David Rosenberg's take:

Net, net, the situation is still the same for the most part. Earnings surprises are still being driven primarily, though not exclusively, by cost surprises (weren’t CAT revenues down 11% YoY?). The “surprise factor” (the gap between actual and what was estimated going in to the release) for total earnings is 21%, skewed by the 74% surprise factor in the Financials space, excluding Financials, the surprise factor would be around 10%.

The revenue surprise factor is running at a much more modest 3% and excluding Financials (which saw an 8% surprise factor), it would be flat. In other words, outside of financials, revenues are just meeting analyst expectations. In a nutshell, the impressive earnings surprises, thus far, is being driven by Financials cost surprises (including write offs).

The financial world is slowly waking up from its slumber and the GS litigation, Greek and Portugal downgrades, and pending US legislation are injecting some long overdue sense into the low-volatility, fairytale markets. Let's not forget the big bad gorillas sitting on the balance sheets of Chinese banks and the comatose nature of US job and property markets. Sabbatical over.

The New Myopia

Next week is the new long-term, tomorrow's headlines will claim that
we have solved the problems of today. Economic crises that appear
enduring, will be dismissed as speed bumps that are already priced
into markets. Immovable mountains such as sovereign debt, unfunded
pension and public health liabilities will be neatly wrapped in
unspecific political language and left for the next guy. The next guy;
for our children. Why do we so idly assume that future leaders with a
strong sense of political responsibility will make hard decisions when
they have so few examples of it in our political history? Is it in our
nature that decisive action and hard choices are only made on the very
brink of disaster?

Sunday marked they latest version in an innumerable parade of schemes
to save Greece from sovereign default. Bloomberg announced it as
solved: the EU had hatched a plan to solve the Greek crisis. Carry on
chaps, nothing to see here. Yet crises on of national debt, budget
deficits, and sovereign debt issuance, problems are never short-lived.
Nor are they solved by the end of the quarter. Argentina, along with
the ill-advised IMF assistance program was out in the woods for a
decade from 1991 to 2001. Bear in mind that, as a percentage of GDP,
Argentina had half of Greece's debt budget deficit. Furthermore, they
were not constricted by a monetary union. The EU and the IMF look set
to repeat the Argentina mistakes by choosing the bandaid option that
characterises our political landscape. No mention has been made of
stricter austerity measures, nor blocking access that Greek banks have
to the EU financing window. Here they borrow from the EU and lend to
the Greek government, pocketing the difference.

Sovereign debt crisis (absent a sudden default) are an erosion, not a
landslide. Credibility wanes in financial markets and this is
manifested in higher interest charges on bonds. A lack of structural
change does nothing to solve the long term credibility issue. Having
the EU guaranteeing your debt issuance is a stop-gap; it is a symptom
of our muddle-through global economic policy - more of the same and
hope for the best.

Unfunded liabilities

That large unfunded liabilities exist around the Western world is not news. The problem has been known for some time. Yet the wilful denial, creative accounting and fairy tales that surround the issue, have kept it in the background.

On Monday, Stanford University's public policy program released their report on California's unfunded pension liabilities. They cam in at $500 billion, nearly eight times greater than officially reported. This is almost seven times larger than the sum of outstanding voter-approved state general obligation bonds in California.

This growing problem is repeated in many other countries. It points to larger deficits and, where this isn't possible, severe budget cuts. Of course this will also be accompanied by tax hikes. All a poisonous cocktail for sustained recovery.