Lighthouse Investment Management

In his book “More money than God”, Sebastian Mallaby describes how George Soros received a signal from Helmut Schlesinger (president of Bundesbank at that time), to go ahead and speculate on a devaluation of the Italian Lira and the British Pound.

Germany had enjoyed a boost from the integration of Eastern Germany, which, partially due to a generous 1:1 exchange offer for the Eastern German Mark, led to unacceptably high inflation. Despite numerous warnings from the Bundesbank, fiscal policies did nothing to reign into the growing threat to price stability. Seeing its advice ignored, the Bundesbank fought back and raised its discount rate all the way to 8.75%.

This caused problems for other European countries, who were forced to follow the Bundesbank unless they wanted to risk a weakening of their currencies. They had to apply a restrictive monetary policy despite their own economies just recovering from the recession of the early 90′s.

According to Mallaby, British finance minister Lamont had insulted Schlesinger at a meeting, trying to extract a promise to cut German interest rates. Despite Schlesinger’s refusal, Lamont led the press to believe Schlesinger had made concessions.

The “payback” didn’t wait for long; Schlesinger publicly denied any intention of cutting rates. He also expressed low confidence in the fixed relationships among European currencies, particularly the “unsoundness” of the Italian Lira.

This was the go-ahead for George Soros to attack the European Exchange Rate Mechanism. Mallaby:

“Schlesinger’s answer was as clear as Soros could have wished for. The Bundesbank was open to the idea of monetary union, but not at any price. It’s first priority was to preserve the proud tradition of the inflation-proof Deutsche Mark, and if other economies could not stomach the austerity this implied, well, then they should devalue.”

“Soros suspected that Schlesinger would be perfectly content to see his hard line on inflation sabotage the plans for European monetary union, since that union would involve the creation of a European central bank, which would supplant the Bundesbank.”

“All bureaucracies are motivated by self-preservation, Soros reflected, and Schlesinger, a career Bundesbank official, was surely the personification of this tendency.” 

Ironically, 20 years later, a similar setup emerges, albeit with (so far) fixed exchange rates. While Germany enjoys the lowest unemployment rate of the last two decades, its European trading partners are re-entering into recession.

In the run-up to the umpteenth Euro-summit last week, most market participants expected the ECB to “reward” politicians with the long-awaited “all-in” action of purchasing increasing amounts of PIIGS government debt.

If you haven’t done so, I recommend listening to the ECB press conference Q&A session (16 minutes into the webcast). Draghi expresses surprise about market expectations the ECB would step up bond purchases after the summit. Draghi subsequently repels any attempt at extracting any concessions whatsoever.

Minute 36: “Why is it so impossible for the ECB to act like the other central banks? –” We have a treaty: price stability and no monetary financing”

Minute 59: “Why wouldn’t it be okay for Euro-zone central banks to lend to the IMF?” – “I think each central bank has its institutional set-up. The primary mandate of the ECB is price stability. In the US the primary mandate of the Fed is completely different from us. Same is for the Bank of England”.

Draghi left no room for ambiguity or interpretation. Every single attempt to extract some hope of monetary creation was cut up, diced and discarded. It couldn’t have been clearer. Draghi mentioned the “principles of the Bundesbank”. The spirit clearly lives on. Those that claim the Bundesbank intentionally encouraged speculators to attack the British Pound in order to expel it from the European Exchange Rate Mechanism in 1992 might find another example of “creative destruction” in front of their disbelieving eyes.

How this could be good for equities (Friday’s rally) is a mystery to me. But then again, the S&P 500 celebrated a new all-time high in October 2007, mere four weeks before the official start of the “great recession”.

The answer to the question “why would the Bundesbank intentionally crash the Euro” lies in the TARGET2 system of intra-Euro central bank payments. Izabella Kaminska of FT Alphaville describes how the Bundesbank has run out of assets to sell in order to fund other Euro-zone central banks. This in itself is quite amazing. The Bundesbank and the Dutch Central Bank seem to be financing the entire Euro-zone central bank system. As the music stops, the Bundesbank is taking away all chairs at the same time.

Merkozy are still trying to save the Euro by severe austerity at the last minute, but it is too late. Financial markets have already revolted and put countries in various buckets via yield curve “triage”:

The ghost of the Bundesbank has reappeared, this time under the disguise of an Italian. Ignore its powers at your own peril.

Politicians and non-elected maquinistas are still trying to figure out how to make the still-borne EFSF (European Financial Stability Facility) walk, or better, fly. A month after the “miracle of Cannes”, the trumpets of victory over the debt crisis have fallen silent. Instead, the first EFSF bond issue after the G20 summit ended up in disaster (reduced, postponed, not fully placed).

If you thought this experience was a lesson on how not to fight a debt crisis you were wrong: more debt, leveraged via a complicated structure, insured by itself, completely unfunded. Peter Tchir made the effort to go through the “EFSF guidelines”; his verdict: “beyond comical”. I am getting tired of hearing about new “miracle cures” every other day. It is such a waste of time. Like a pal, who, every other weekend, wants to introduce his “new” girlfriend and you wonder if it is worth to be nice and strike up a conversation.

The house is on fire, but politicians are discussing if buying a second dog would make the property safer, and what kind of collar it could possibly wear.

Should we believe ECB’s Noyer when he says (11/28) “The economic situation in Italy is not that bad”? Why then, may one ask, did Italy prefer not to release its Q3 GDP data (was scheduled for 11/16)? Is the third-largest government bond market on earth wrong in yielding 7-8% across the curve?

No, it is “not that bad”. It is horrible.

Take the rumor about EUR 400-600bn IMF help for Italy (strategically leaked on a Sunday). What does it say about Europe if the IMF has to bend over backwards to bail out one country for 12-18 months?

It says: “Europe is bankrupt and cannot save itself”.

Remember the latest product innovation from the IMF, announced not even a week ago? “Credit lines” of 500% of a country’s quota. Spain and Italy would be able to receive $30-60bn – a joke in the big scheme of things.

The program was already obsolete a few days after its inception. This is how fast the fire is burning through the attic – and the owners are still sleeping.

If the EUR 600bn for Italy materialized, Spain would feel entitled to some help, too. But Italy has first-mover advantage. Hence the ominous warning from the incoming Spanish government to “mull financial options without ruling out an application for international aid” (11/22).

Once Italy and Spain fed at the trough, it will be empty. The poor Portuguese will be left behind, as it will be every man for himself.

Greece has been reduced to a mere side-show. The only question being if the next tranche (EUR 8bn) will be paid out before Greece declares a “temporarily suspended debt service” on December 16 as EUR 12bn of debt matures. Even assuming the EU/IMF help flows, the cash drain, together with a monthly fiscal deficit of 1bn+, would be 5bn.

As usual, the bond market has already an idea on how this will pan out. Looking at various yield curves we get the following picture:

• Greece is “off the chart” (in the “toast” zone)
• Portugal will not make it as debt and interest is not sustainable and the EFSF struggles to raise bailout funds.
• The “soft Euro-zone” could survive by aggressive monetization of debt by the ECB – once the German hardliners quit. Inflation would probably follow in a few years, but that is another question.
• The “hard Euro-zone” would consist of Germany and the Netherlands. They unilaterally quit the Euro-zone and introduce a pegged currency pair.
• France is really the only unsolved question in this puzzle. Bond yields have peeled away from Germany a bit too far. Historically, France was a “soft” currency country with frequent realignments of exchange rate under the European ERM (Exchange Rate Mechanism). Given the strong political ties France will probably be forced to stay married to Germany, but it will be an unhappy marriage, with an eventual break-up at a later date.
• I have included Hungary just out of curiosity, since their love-hate relationship with the IMF is slightly entertaining.

Sometimes I get the impression Germany’s insistence on austerity is in fact an attempt to escalate the crisis. The Euro-summit on December 9 will bring treaty changes that allow countries to exit the Euro. Everybody assumes this is to “punish” deficit offenders, when, in fact, it is Germany’s carefully crafted exit from the Euro-zone.

The remaining countries will be free to print their way out of looming insolvency, albeit at the price of having to figure out who will pay for the substantial losses on PIIGS bonds parked at the ECB.

Germany will see its currency gradually strengthen, and temporarily suffer from declining exports, but Germany has lived well with a strong currency before. The alternative, a complete melt-down of the Euro-zone, is definitely less appealing.

There is one simple rule for investors: avoid all things beginning with “Euro-”. Eurotunnel ended in bankruptcy. Eurodisney was a disaster for public shareholders. And so the Euro itself is following the same path.

“Euro” birds

European politicians are faced with one problem: none of their plans to end Europe’s debt crisis has worked. Absolutely nothing. Which is not that surprising – since when does adding debt solve a debt problem?

Fishing in Lake Acronym yielded only meager catches like SGP (“Stability and Growth Programme”, a paradox), SMP (“Securities Market Programme”, which has less to do with market than with manipulation), and, finally, the bazooka: the EFSF (European Financial Stability Facility).

“Stability” sounds good, and “Facility” leaves the uninitiated in the dark as to whether this is another debt pyramid and who will ultimately foot the bill.

The idea behind the EFSF must be so good the agency wants to keep it to itself and prefers not to shed light on the mechanism behind it. Based on leaked drafts and comments in the press it could look like this:

Observations:

1. Since Germany successfully repelled French demands for an EFSF banking license creative minds found ways of leveraging the (non-existent) funds.
2. The original EFSF capacity was EUR 440bn; 150bn already went to Greece, Ireland and Portugal. After 40bn inexplicably vanished, 250bn are left.
3. EUR 250bn is nothing compared to the funding requirements of Italy and Spain; hence it needs to be “leveraged”.
4. The EFSF would invest those 250bn in the “equity” (or high risk) tranche of a “Special Purpose Vehicle”. Governments, the IMF and Sovereign Wealth Funds (SWF) are supposed to gobble up the 500bn “mezzanine” (or medium risk) tranche. Together with a 250bn “low risk” tranche the SPV would have EUR 1 trillion in firepower.
5. This firepower is then used for purchasing “PIIGS” government bonds in primary and secondary markets. Some small change (EUR 106bn) would even be left over to recapitalize the entire European banking system.
6. To entice investors formerly burnt in PIIGS bonds to repeat their mistake, the SPV would issue “partial protection certificates” (PPC). Those PPC’s are in fact credit default swaps, but since politicians have blamed the latter for the consequences of their own actions they had to come up with a different name.
7. Credit default swaps (unless the gods at ISDA decide otherwise) at least pay out the difference between par (100%) and the recovery value. PPC’s would cover only a limited amount (20%, for example). Because, you know, a sovereign default wouldn’t be that bad. Greece, of course, is unique and an exception. Right; so unique that RBS wrote down its Greek holdings to 37 cents on the Euro.
8. For the “unlikely” event of a default (a 1 in 3 chance for Italy and Spain over the next five years according to implied default probabilities) the PPC will pay out a small token (in appreciation of your stupidity) of consolation. Not in cash, however, but in EFSF bonds. This is usually referred to as “captive insurance”. It is akin to the agent selling life insurance policies on the already listing Titanic.
9. Not only is the insurance circular, but so are the guarantees. Keep in mind that all the EFSF has raised to far is EUR 14bn (and that money is already spoken for). Initial “guarantees” of EUr 780bn have melted down to 726bn as Greece, Ireland and Portugal have “stepped out” (they can’t participate in their own rescue). In case of “step-outs”, the maximum guarantee is reduced and remaining countries have their share of guarantees increased. It’s a game of inverse musical chairs where the last one standing loses, not wins.
10. The only AAA-rated countries left are Germany, France, the Netherlands, Austria, Finland and Luxembourg. The last three do not matter due to size. With the German-French 10-year government bond spread at 1.5% the market believes France is about to lose its AAA. That leaves Germany and the Netherlands, or 33% of the original guarantors. In case Italy and Spain need money, 30% of the guarantors would “step out”, at which point the self-insurance scheme collapses:
11. Condolences go out to the poor souls who bought the first three issues of EFSF debt at minuscule spreads to swap rates. Official lenders like the IMF (and, until the “comprehensive plan to save the Euro-zone”, the EFSF) are not supposed to take haircuts as this could cause abdominal pains with innocent taxpayers in other regions of the world. Hence the “AAA” rating for the EFSF. But during the night of October 26/27, the beautiful EFSF butterfly went into reverse metamorphosis and emerged as an ugly larvae. “Last loss” became “first loss” participation. The risk profile had been changed by the stroke of genius. And it showed in the yield spreads to German government bonds:
12. It therefore does not come as a surprise the EFSF had to first scale down, then postpone, then buy part of their own bonds during the recently failed auction. According to an investor presentation in August, the plan was to have 7 bond issues by the end of 2011 (3 for Ireland, 4 for Portugal). It looks like the recent (4th) might have been the final one.
13. In a desperate move, Klaus Regling (CEO of EFSF) announced plans to raise money via short-term bills with maturities of less than a year instead. Lend long, borrow short – even bankers understand this is a recipe for disaster.
14. There was an odd statement by Chancellor Merkel at the recent G20 meeting in Cannes: “Hardly any countries in the G20 have said to participate in the EFSF”. This struck me as odd, since it was the truth, and politicians are not known to tell the truth. Did Merkel suffer from the effects of an extended stay at the bar with Putin? Unlikely. This just does not fit the usual “we will do everything to save the Euro”-line. She could have said something like “I am convinced the EFSF bond issue will be fully subscribed; the demand is so high we decided keep the books open for a little bit longer”. But no, she chose to tell the truth. Maybe it had dawned on her that the EFSF was actually a formula for mass (financial) suicide and that Germany would be the one footing the bill in the end? The only way to “escape” being burdened with other countries’ debt is to “step out” of the circle of guarantors. This could actually hasten the financial crisis.

Whenever you come across a mystery in finance there always is an explanation. Like the question why the ECB would so ferociously resist any “haircuts” on Greek debt. Despite all the evidence that current debt, now expected to peak at levels exceeding most calculators’ capacity, is unsustainable.

Why would the ECB, the largest single holder of Greek debt, not set an example by accepting the 21% haircut orchestrated by the banking lobby in July? (In order to still reach the 90% acceptance rate, the ECB was simply to be excluded from the calculation). Instead, the ECB promised Sodom and Gomorrah in case of a haircut (“Greek restructuring would be a disaster” – ECB’s Bini Smaghi, July 20th).

According to this chart, the ECB holds (nominal) EUR 55bn out of a total of roughly EUR 350bn of Greek debt:

Now they didn’t buy it at par (100%), but, let’s say, at 70% or EUR 38.5bn. A 50% haircut would reduce the value to 50%, at a cost of EUR 7.7bn. And this is only Greece (the ECB has other fine bonds on its books; EUR 165bn in total). Marked-to-market, losses would be much higher.

Problem is, the ECB has only EUR 5.3bn in equity. Here’s the balance sheet at the end of 2010:

Source: ECB 2010 annual report

(By the way, 5.3bn equity supporting 163bn in assets makes for 30x leverage).

By the end of 2010, the situation (due to unrealized losses on PIIGS bonds) was so dire the ECB had to ask national central banks (NCBs) to double its equity to 10.7bn effective 12/29/2010. However, not all NCBs could or would afford their share, and so the payment was stretched over three years (as seen in those “three easy low payments” commercials). Only 1.1bn was paid in a first installment, the remainder due at the end of 2011 and 2012 respectively.

To make matters worse, the non-Euro NCB’s (among them the Bank of England) are not liable for any losses the ECB incurs (since they are not entitled to share any profits, for example from seigniorage, either). That would explain why some NCB’s were not too keen on coughing up the big dough at once.

The ECB is basically bankrupt and would need to ask NCB’s (and those in turn their governments) again for more capital. This would create lots of cheer as governments are already struggling to protect their ratings from falling.

Governments could try to extract concessions from the ECB in return for recapitalizing, endangering the little independence and credibility that is left at this stage.

Hence the ostrich strategy: pretend the Greek bonds are worth what they were purchased for (and the ECB’s equity is still there). And this explains the ridiculous fight against allowing Greece a fresh start.

Maybe it’s time to pull a “Jordan” and claim that negative equity doesn’t really matter for a central bank (“Does the Swiss National Bank need equity” – Thomas Jordan, Vice Chairman of the Governing Board of the Swiss National Bank, speech in Basel 9/28/2011: http://www.snb.ch/en/mmr/speeches/id/ref_20110928_tjn/source/ref_20110928_tjn.en.pdf).

Somehow, accounting tricks are not explained in the ECB’s educational material for students: