Thursday, 09 June 2011 00:19

Over A Year After Being Dismissed As Sensationalist For Questioning the ECB's Continued Solvency After Sovereign Debt Buying Binge, Guess What!

There has been a lot of noise in both the alternative and the mainstream financial press regarding potential risk to the ECB regarding its exposure at roughly 48 to 72 cents on the dollar to sovereign debt purchases through leverage, and at par at that. This concern is quite well founded, if not just over a year or so too late. In January, I penned The ECB Loads Up On Increasingly Devalued Portuguese Bonds, Ensuring That They Will Get Hit Hard When Portugal Defaults. The title is self explanatory, but expound I shall. Before we get to the big boy media's "year too late" take, let's do a deep dive into how thoroughly we at BoomBustBlog foretold and warned of the insolvency of both European private banks and central banks, including the big Kahuna itself, the ECB! The kicker is that this risk was quite apparent well over a year ago. On April 27th, 2010 I penned the piece "How Greece Killed Its Own Banks!". It went a little something like this:

Yes, you read that correctly! Greece killed its own banks. You see, many knew as far back as January (if not last year) that Greece would have a singificant problem floating its debt. As a safeguard, they had their banks purchase a large amount of their debt offerings which gave the perception of much stronger demand than what I believe was actually in the market. So, what happens when these relatively small banks gobble up all of this debt that is summarily downgraded 15 ways from Idaho.

Well, the answer is…. Insolvency! The gorging on quickly to be devalued debt was the absolutely last thing the Greek banks needed as they were suffering from a classic run on the bank due to deposits being pulled out at a record pace. So assuming the aforementioned drain on liquidity from a bank run (mitigated in part or in full by support from the ECB), imagine what happens when a very significant portion of your bond portfolio performs as follows (please note that these numbers were drawn before the bond market route of the 27th)…

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The same hypothetical leveraged positions expressed as a percentage gain or loss…

 

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Relevant subscription material for BoomBustBlog paying members:

  1. File IconGreece Public Finances Projections
  2. File IconBanks exposed to Central and Eastern Europe
  3. File IconGreek Banking Fundamental Tear Sheet

Online Spreadsheets (professional and institutional subscribers only)

Several months later I posted several followup pieces along the same vein:

To Cut or Not to Cut, The Irish Threaten To Play Rough With Those Clippers: Threats of Haircuts Rattle the ECB! Thursday, March 31st, 2011

I also made it very clear that haircuts and restructurings were on the table for Portugal.

The last bullet point is the kicker, but before I expand upon that, let's look at what loading up on Portuguese bonds felt like back then. These Bloomberg screen shots provided by Zerohedge tell the story in an instant:

Same thing for Ireland:

And below are the three horsemen of the Eurocalypse. Ironically the bond market is offering a far higher yield for ultra short-term Portuguese than Irish.

I pulled the covers off of the speculation over whether Portugal would default or not. Most of the “experts” declared that a default was not in the cards. I strongly recommended that the so -called “experts” pull out a calculator and run the math. Not only will there be defaults, but the haircuts will look particularly nasty. SeeThe Truth Behind Portugal’s Inevitable Default – Arithmetic Evidence Available Only Through BoomBustBlog followed by The Anatomy of a Portugal Default: A Graphical Step by Step Guide to the Beginning of the Largest String of Sovereign Defaults in Recent History (December 6th & 7th, 2010). We find the ECB Throws Portugal a Temporary Lifeline, but just as with Greece and Ireland, that faux lifeline will simply not be enough in the real world.

We consider serial defaults to be a foregone conclusion

The harder question is to determine which direction and it will originate from and when. I will mathematically determine if the European safety net that was formed is even physically possible of containing the threat. On that topic, and back to CNBC:

The toughest item on that agenda is the strengthening of the financial backstops because of German resistance to increasing the size of the 440 billion euro European Financial Stability Facility, EU sources say. Berlin has also opposed allowing it to be used more flexibly to provide standby credit lines or to buy government bonds or fund bank recapitalization before a country hits the buffers.

Portuguese Prime Minister Jose Socrates said last Friday his country had no need of outside assistance because it was ahead of schedule in reducing its budget deficit.

Socrates, who heads a minority socialist government, is stubbornly avoiding a bailout, mindful of the traumatic history of Portugal’s two International Monetary Fund rescues since its return to democracy in 1974.

The Mathematical Truth Concerning Portugal’s Debt Situation

Before I start, any individual or entity that disagrees with the information below is quite welcome to dispute it. I simply ask that you com with facts and analysis and have them grounded in reality so I cannot right another “Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!“. In other words, come with the truth, or at lease your closest simulacrum of it. In preparing Portugal’s sovereign debt restructuring model through maturity extension, we followed the same methodology as the Greece’s sovereign debt maturity extension model and we have built three scenarios in which the restructuring can be done without taking a haircut on the principal amount.

  • Restructuring by Maturity Extension – Under this scenario, we assumed that the creditors with debt maturing between 2010 and 2020 will exchange their existing debt securities with new debt securities having same coupon rate but double the maturity. Under this type of restructuring, the decline in present value of cash flows to creditors is 3.3% while the cumulated funding requirements and cumulated new debt between 2010 and 2025 are not reduced substantially. The cumulated funding requirement between 2010 and 2025 reduces to 120.0% of GDP against 135.4% of GDP if there is no restructuring. The cumulated new debt raised is reduced marginally to 70.6% of GDP from 72.2% of GDP if there is no restructuring. Debt at the end of 2025 will be 104.8% of GDP against 106.1% if there is no restructuring
  • Restructuring by Maturity Extension & Coupon Reduction – Under this scenario, we assumed that the creditors with debt maturing between 2010 and 2020 will exchange their existing debt securities with new debt securities having half the coupon rate but double the maturity. The decline in the present value of the cash flows is 18.6%. The cumulated funding requirement between 2010 and 2025 reduces to a potentially sustainable 99.5% of GDP and the cumulated new debt raised will decline to 50.1% of GDP. Debt at the end of 2025 will be 88.6% of GDP (a potentially sustainable).
  • Restructuring by Zero Coupon Rollup – Under this scenario, the debt maturing between 2010 and 2020 will be rolled up into one bundle and exchanged against a single, self-amortizing 20-year bond with coupon equal to 50% of the average coupon rate of the converted bonds. The decline in the present value of the cash flows is 17.6%. The cumulated funding requirement between 2010 and 2025 reduces to 100.1% of GDP and the cumulated new debt raised will decline to 52.8% of GDP. Debt at the end of 2025 will be 90.9% of GDP (a potentially sustainable).

We have also built in the impact of IMF/EU aid on the funding requirements and new debt raised from the market between 2010 and 2025 under all the scenarios.

A more realistic method of modeling for restructuring and haircuts

In the previously released Greece and Portugal models, we have built relatively moderate scenarios of maturity extension and coupon reduction which would be acceptable to a large proportion of creditors. However, these restructurings address the liquidity side of the problem rather than solvency issues which can be resolved only when the government debt ratios are restored to sustainable levels. The previous haircut estimation model was also based on the logic that the restructuring of debt should aim at bringing down the debt ratios and addition to debt ratios to more sustainable levels. In the earlier Greece maturity extension model, the government debt at the end of 2025 under restructuring 1, 2 and 3 is expected to stand at 154.4%, 123.7% and 147.0% of GDP which is unsustainably high.

Thus, the following additional spreadsheet scenarios have been built for more severe maturity extension and coupon reduction, or which will have the maturity extension and coupon reduction combined with the haircut on the principal amount. The following is professional level subscscription content only, but I would like to share with all readers the facts, as they play out mathematically, for Portugal. In all of the scenarios below, Portugal will need both EU/IMF funding packages (yes, in addition to the $1 trillion package fantasized for Greece), and will still have funding deficits by 2014, save one scenario. That scenario will punish bondholders severely, for they will have to stand behind the IMF in terms of seniority and liquidation (see How the US Has Perfected the Use of Economic Imperialism Through the European Union!) as well as take in excess of a 20% haircut in principal while suffering the added risk/duration/illiquidity of a substantive and very material increase in maturity. Of course, we can model this without the IMF/EU package (which I am sure will be a political nightmare after Greece), but we will be recasting the “The Great Global Macro Experiment, Revisited” in and attempt to forge a New Argentina (see A Comparison of Our Greek Bond Restructuring Analysis to that of Argentina).

Here is  graphical representation of exactly how deep one must dig Portugal out of the Doo Doo in order to achieve a sustainable fiscal situation. The following chart is a depiction of Portugal’s funding requirements from the market before restructuring…

This is the same country’s funding requirements after a restructuring using the same scenario “4″ described above…

And this is the depiction of new debt to be raised from the market before restructuring…

And after using the scenario “4″ described above… For all of you Americans who remember that government sponsored TV commercial, “This is your brain on drugs. Any Questions?

The full spreadsheet behind all of the calculations, scenarios, bond holdings and calculations can be viewed online here by professional level subscribers. Click here to subscribe or upgrade.

... Now back to the present day...

So, More Than A Year After I Sounded the Alarm About Insolvent Central and Private European Banks, I See the Following Headlines in the Mainstream News

Look at what's been floating in the news yesterday...

Financial Times: ECB firefight leaves it exposed to Greek shock:

As eurozone politicians scramble to bring Greek public finances back under control, the question of how much the European Central Bank will lose if they fail to avert a default has taken on greater importance.

ECBIn the past year, the ECB has bought €75bn ($110bn) in government bonds from the eurozone’s weakest economies and provided unlimited liquidity to their banks against collateral of declining quality. The suspicion in eurozone capitals, especially Berlin, is that ECB opposition to a debt restructuring is so vehement because the financial consequences for the euro’s monetary guardian would be substantial.

“Hefty losses for the ECB are no longer a remote risk,” warned Open Europe, a London-based think-tank, in a report on Monday.

It estimates the ECB has €444bn in exposures to Spain, Italy, Portugal and Ireland, as well as Greece. “There is a hidden – and potentially huge – cost of the eurozone crisis to taxpayers buried in the ECB’s books.”

Here's another one - European Banks’ Capital Shortfall Means Greece Debt Default Not an Option, as excerpted:

A failure by European regulators to make banks raise enough capital to withstand a sovereign default is complicating efforts to resolve Greece’s debt crisis.

The “fragilities” of Europe’s banking industry mean a Greek default isn’t an option, European Union Economic and Monetary Affairs Commissioner Olli Rehn said in New York last week. By delaying a decision some investors consider inevitable, policy makers risk increasing the cost to European taxpayers and prolonging Greece’s economic pain.

“European officials are trying to buy time for the troubled economies to get their house in order and the banks to be strengthened,” said Guy de Blonay, who helps manage about $41 billion at Jupiter Asset Management Ltd. in London.

While estimates of the capital shortfall vary, the vulnerability of European banks to a sovereign shock isn’t disputed. Independent Credit View, a Swiss rating company that predicted Ireland’s banks would need another bailout last year, found in a study to be published tomorrow that 33 of Europe’s biggest banks would need $347 billion of additional capital by the end of 2012 to boost their tangible common equity to 10 percent, even before any sovereign default.

Here's a newsflash for all of you who are still not grounded in reality. The loss to the banks have already occurred it just hasn't been officially recognized. You see, their bond and debt holdings are already devalued. The value is gone, vamoosed, disappeared. Waiting makes things worse because the excessive austerity measures imposed upon Greece (and every round of negotiations to appease the political gods makes things that much worse) are very recessionary and the debt noose is tightened with every proposed bailout. More debt is being added (problem) when the path to recovery is less debt (solution). It's really just that simple. The longer the asset holders wait under these recessionary austerity measures smothered by increasingly excessive debt, the less said assets will be worth. Those of you who regularly read me know this song, I've been singing it in American English to the stateside banks regarding real estate assets:

  1. Reggie Middleton’s Real Estate Recap: As I Have Clearly Illustrated, It’s a Real Estate Depression!!!
  2. There’s Stinky Gas Inside Of This Mini-Housing Bubble, You Don’t Want To Be Around When It Pops!
  3. The Residential Real Estate Week in Review, or I Told You We’re In A Real Estate Depression! The MSM is Just Catching Up
  4. Reggie Middleton’s Real Estate Recap: As I Have Clearly Illustrated, It’s a Real Estate Depression!!!
  5. Dexia Sets A $5.1bn Provision For Loss On Trying To Sell The Same Residential Real Estate Assets Upon Which JP Morgan Has Slashed Provisions 83% to $1.2bn from $7.0bn

[youtube MukxtjCVc5o]

So fail to recognize your losses if you wish, you will just have bigger losses to recognize when the European fat lady sings :

And from Professor Rogoff of "This Time Is Different: Eight Centuries of Financial Folly" fame, in the FT.com:

Yet if the euro is torn by centrifugal force, perhaps because European leaders are constitutionally incapable of making tough decisions on how to radically trim periphery debt burdens, it could take a great many decades before any other region attempts a similarly ambitious programme. The 1980s and 1990s taught us that for countries with open capital markets, fixed exchange rates are a mirage that cannot be indefinitely sustained. If the euro goes the way of the Argentine currency peg, the noughts and tens – the first decades of the 21st century – will be viewed as teaching the same lesson about more radical currency marriages. Sovereignty and currency co-habitation do not mix.

Oddly, the euro was not at the heart of the recent financial crisis. Only Spain can really be described as an epicentre country, and of course the US and the UK had far greater systemic importance. Rather, the sovereign debt crises that Europe is experiencing today are a typical aftershock of a deep financial crisis. Nevertheless, even if the euro system was not at the heart of the crisis, it needs to be able to withstand two standard deviation shocks.

From Open Europe via ZeroHedge: ECB Has €444 Billion PIIGS Exposure, A 4.25% Drop InAsset Values Would Bankrupt European Central Bank

"The ECB’s attempts to paper over the cracks in the eurozone may have temporarily softened the impact of the crisis, but have exacerbated the situation in the long-term. The ECB has dug itself into a hole and now we are seeing that there is no easy way out.”

“Huge risks have been transferred from struggling governments and banks onto the ECB’s books, with taxpayers as the ultimate guarantor. There’s a real risk that these assets will face radical write-downs in future with eurozone governments and banks teetering on the edge of bankruptcy. This amounts to a hidden – and potentially huge – bill to taxpayers to save the euro.”

“The ECB’s wobbly finances and operations to finance states have landed a serious blow to its credibility. It must now seek to become the strong, independent bank that electorates were promised when the Single Currency was forged.”

Requisite video viewing on this topic...

[youtube WsTdV86nAGw]

[youtube LdGdyEQYoe8]

[youtube D47MbNquwF0]

Last modified on Monday, 11 July 2011 07:35

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  • Comment Link Pieter Saturday, 11 June 2011 15:36 posted by Pieter

    Anton:

    Interesting views. But be careful what you wish for. Have you read Griftopia by Matt Taibbi? Chicago has sold the parking rights of its town center to an Arab trust for 75 years. The city cannot close its center for traffic because the Arabs are not interested in festivities but want their parking revenues. This creates an impregnable financial barrier for every celebration.

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  • Comment Link Anton Saturday, 11 June 2011 11:11 posted by Anton

    Pieter, yes, they are creating more money. The core problem are the banks. So, Germany is trying to save its banks by giving money to Greece.

    Either way, I think that if the state helps because the banks are in trouble, then the banks should be taken over by the state. It makes no sense to have taxpayers pay in order to make whole the shareholders, bondholders and managers of banks that have made the wrong bets.

    Of all, I don´t see any reason the managers should keep whatever remuneration they received in the past. It is in nobody´s interest to keep the same people in charge.

    If the state takes over the banks, it receives assets in exchange for the money it has created. Once the emergency is past, the banks can be put on the market again and money recovered.

    Printing money out of thin air leads to a devalued currency, higher taxes and interest rates, as you said. This then has a detrimental effect on the rest of the economy, even those sectors which would otherwise be healthy. So, taking over the banks would seem to me to be the way to go. But it was not done here in Europe, nor in the US.

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  • Comment Link Pieter Saturday, 11 June 2011 08:46 posted by Pieter

    Anton, Frank,

    Obviously there are plenty of creative people who may find solutions for the structural problems we are facing. But apparently we do not yet realize what the root of the evil is. Let me give you an example. Reggie claims that there may be no money for free, so raise the interest rates. For there is no respect for free money and this corrupts trade. He is not alone in his views. Every main stream economist will confirm the policy of central banks to raise interest rates if you have to slow down the creation of new money.
    But what happens if you raise interest rates? Interest is not in the existing money supply. You will have to create more money, more debt to pay for this interest. If you cannot create more debt, than you have to steal money from people one way or another. So the creation of new debts is compulsory if interest rates are raised.

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  • Comment Link Anton Friday, 10 June 2011 20:56 posted by Anton

    New sources of revenue could easily be created by simply legalizing things that are uselessly outlawed now, such as drugs and prostitution.

    Whatever one thinks of them, both are available to everyone, but both are also forbidden in most countries. Fighting drugs costs a lot of money, which only drives the price up--thus increasing the incentive to make them readily available.

    If the state gave drugs away for free, it would not earn an income. But it would immediately achieve substantial savings on enforcement. If it charged a small fee, the state would earn some income--though that income would be too small to induce illegal sources.

    The point is that there are so many inefficiencies here in Europe, that it would be very easy to reduce governments´ costs and improve productivity.

    Politicians often do not even have the competence (let alone the incentives!) to tackle structure problems. And the system reacts to short term emergencies, rather than on long term planning. There would be much to learn from China on this. And there would be a dire need for competent people to devise a long term plan--not guided by obsolete ideology, as so often is the case.

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  • Comment Link Anton Friday, 10 June 2011 20:42 posted by Anton

    The problem is that austerity crushes the economy. Because of this, asset sales would occur at depressed prices.

    One solution would be to pool all the country´s assets into a company and using the company as collateral to renew the debt--with a long maturity, say 10 years.

    The country would then embark on a long term plan of reforms. If the reforms work, the debt will be paid back, as agreed. If the country´s reforms do not work, the creditors will take over the assets. (If the assets are not sufficient, power of taxation could also be foregone to the creditors.)

    This deal should increase the availability of credit because of the backing of real assets--and because a long term plan would reduce immediate uncertainty. As a result, the interest rate should be considerably reduced. It would also allow the country to avoid a fire sale now, which is the worst possible time.

    As immediate risk is reduced (shifted to the future, but with a long term plan), the situation would immediately improve also for banks).

    At the same time, measures could be taken to improve efficiency. For example: Greece has considerable military expenditures. Greece´s military personnel and equipment could be turned over to the EU, which could create an EU military force and border control force. There could be considerable budget savings for all by creating a single EU organization for diplomatic corps, such as embassies and consulates, even tax authorities and a legal/court system. This would cut costs for governments and citizens alike. It can´t be done overnight, but it could be planned over the next 10 years.

    Practically, countries pledging assets would be betting that either they succeed or they lose sovereignty. But that doesn´t mean they are risking much, since their management so far has been disastrous.

    But there would be other opportunities to capitalize on underused assets. China might not wish to make Italian ports and railway system as the backbone of its exports to Europe. But it could decide to do so, if it were given independent control in exchange for a fixed fee. Since competition is global anyway, creating extra-territorial areas and leasing them out would be beneficial for everyone in the same way as Hong Kong has. There would be spill-over effects if the area is chosen well--both in terms of occupation and cultural influence.

    Spain has an excess inventory of houses. But Japan has lots of homeless people. Why not create a Japanese city for the elderly?

    And so on.

    The point is that a long term plan of reform and efficiency improving measures would make the debt credible again. And that´s all that is needed: credibility. If there is credibility, there is time. If the time is used to create real value, then disaster coud be avoided. If not, in any case, the creditors would be holding real assets and control or sovereignty. If the system collapses, real assets will afford the best protection possible.

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  • Comment Link Frank Friday, 10 June 2011 16:21 posted by Frank

    Pieter:

    What we need to do is to have a growing economy and deflation. It is a neat trick if you can pull it off.

    We have way too much debt. “By the development of the computer it has rapidly grown and nowadays is 25 times as big, Yes, we only use 4% of the supply of money for all our transactions, the rest is sitting somewhere collecting interest and revenue very efficiently.” People confuse the unit of exchange of wealth for the real thing. $1 billion worth of cash has no intrinsic value. $1 billion worth of stuff has intrinsic value. The cost of making money by trading money is far lower than the cost of making money by making something of value, (As long as the debt bubble expands) when the debt bubble contracts then you lose money just as fast as you made it before.

    What we need to do now is to make it cheaper to make money by making something of value than to make money by trading money. We need to tax the payment of interest on debt, personal, business and bank to bank debt.
    interest and revenue very efficiently."

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  • Comment Link Pieter Friday, 10 June 2011 08:01 posted by Pieter

    Frank:

    Do you think that controlled inflation will solve the real problems?
    Keynes wrote in 1936: "Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation." It levelled to way for Professor Joseph Stiglitz and many others after him, who have established that the money system has mathematical flaws (idications of a Pyramid-game ) leading to abuse. In 1970 the financial economy was about as big as the “real” economy (you, me,governmentactions, trade, transport, factories, services). By the development of the computer it has rapidly grown and nowadays is 25 times as big, Yes, we only use 4% of the supply of money for all our transactions, the rest is sitting somewhere collecting interest and revenue very efficiently. Don’t believe me, check it. You’ll learn a lot if you know how to get out of the straitjacket of economic dogmas. That is why the banks are buckets with big holes. And this situation is not reversible. I strongly believe we have to question the structure of our money.

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  • Comment Link Frank Thursday, 09 June 2011 18:41 posted by Frank

    What would happen if you doubled the average wage in Europe? Would this tend to devalue the debt? Would this make the banks solvent? What would happen if you printed a bunch of money and gave it to everyone? Would this push towards full employment? And higher prices? Would this reduce the value of the debts held?

    Would printing money and using that money to replace the value of the savings that people have be fare to everyone? If we have an intentional 200% inflation then inflating savings by the same amount would that be good for everyone?

    Countries need to have a high enough domestic savings rate to meet the demand for domestic debt. Is this how you balance trade. Is this also the road to solvency for countries like Greece?

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  • Comment Link Binh Thursday, 09 June 2011 16:29 posted by Binh

    You and Whitney should appear on T.V. together:
    http://www.huffingtonpost.com/2011/06/08/meredith-whitney-more-validation_n_873341.html

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  • Comment Link Pieter Thursday, 09 June 2011 16:09 posted by Pieter

    Reggie,

    The Dutch economy showed a faint recovery; less than 2%. Politicians here in the Netherlands cling to this straw and CANNOT face the reality, nor left-, nor right-wing. They refuse to accept the truth that is staring them in the face, calling people like you and professor Rogoff defeatists.
    Dreamers? Cowards? Corrupt?

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