American (or European) Py

This morning the European Central Bank made some very accommodative moves.  While the details are a little wonky, here is a rough summary (emphasis on “rough”):

  • Targeted Long-Term Refinancing Operations (TLRTO):  These operations are designed to “grease” the monetary policy transmission mechanism so accommodation becomes reflected in the “real” economy.  To make the operation more attractive to banks they may eliminate the premiums charged to banks and lower the benchmark rate.  Today’s announcement lowered the cost of funding to 0.10% above benchmark.
  • ECB to purchase ABS:  The idea here is for the banks to bundle various securitized loans and sell them to the ECB.  Today’s plan includes both new and existing Asset Based Securities and Residential Mortgage Backed Securities.
  • Lowered Rates:
    • Rates on main refinance operations were lowered to 0.05%
    • Rates on marginal lending were lowered to 0.30%
    • Rates on deposit facility were cut by 0.10% to -0.20%.  Yes.  Those little dashes in front of the percentages indicate that banks will be paying interest on the money they deposit at the ECB.

In the wake of this, rates on 2-year paper in eight European countries went negative; with the lowest negative rate being paid to Switzerland (-0.119%) and the highest negative going to Austria (-0.049%).  I think I’d balk at the privilege of paying the Swiss 0.119% to give them the use of my money.  But hey, that’s just me because apparently someone is willing or the rate wouldn’t be where it is!

As I write this, the EUR/USD has fallen 1.60% to 1.2939 – the ECB having (at least for now) the desired impact of hammering down the Euro.

In Europe, reactions in the equity markets were generally positive.  The DAX gained 1.02%, the FTSE gained 0.06%, and the CAC 40 gained 1.65%.

That’s a pretty healthy reaction.  It seems that draconian fixes are considered bullish while the underlying problems necessitating these fixes are ignored.  A money manager has to make his numbers each quarter, so I suppose that’s understandable on some level.

The US markets were generally positive early in the day, but the gains faded after the 159, 648th rumor came out of Ukraine.  This was the most recent of the 79, 824 bad news rumors, and it took the markets fractionally lower.

Early this week I linked an article about “liquidity traps.”  Roughly (again) defined, a liquidity trap is where injections of cash by a central bank into the private banking system fails to decrease interest rates because there is a prevailing belief that interest rates will soon rise.  Similarly, if the cash is not being deployed due to “hoarding” there is little impact on creating inflation (which a few countries could use right now…  Italy, I’m talking to you).  This is described as M * V = Py, where M is the money supply, V is the velocity of money, and Py is the product of price and units.  An increase in Py would be evidence of inflation.

Since there is no question that the Fed and the ECB are ramping up the “M”, and there is little evidence of an increase in “Py”, one could deduce that “V” is the lollygagger.  To wit, here is a quote from the St. Louis Fed’s website:

“During the first and second quarters of 2014, the velocity of the monetary base was at 4.4, its slowest pace on record. This means that every dollar in the monetary base was spent only 4.4 times in the economy during the past year, down from 17.2 just prior to the recession. This implies that the unprecedented monetary base increase driven by the Fed’s large money injections through its large-scale asset purchase programs has failed to cause at least a one-for-one proportional increase in nominal GDP. Thus, it is precisely the sharp decline in velocity that has offset the sharp increase in money supply, leading to the almost no change in nominal GDP.”  – Economist Yi Wen and Research Associate Maria Arias in a St. Louis Fed article:

Now, in full disclosure, the concept of the liquidity trap is a construct of Keynesian economics.  The Austrian School would argue that the lack of velocity during these periods of low interest rates is a result of previous mal-investment and the discounting of an assets value at an extremely low rate (time preference).

I wish I definitively knew the cause of the flaccid “V”, but after witnessing 5 years’ of ramping up “M”, I’m beginning to side with the Keynesians on this one.  It would seem that much mal-investment would have worked through the system at this point, resulting in some juicy Py.

Mmmmm.  Juicy Py.



The Spanish Bail-in. Huh?

Sometime between attending the high school graduation party for the son of one of my high school classmates, and waiting for the temperature to drop a little so I might mow the lawn in comfort, I spent an hour reading more about this weekend’s Spanish bank bailout.

But before I comment on that…  I have to say that, in the event gray hair doesn’t make one conscious of his age, attending a graduation party for the offspring of a peer will remedy that in short order!   That, and finding out, at that same party, that Bruce Springsteen signed his initial recording contract 40 years ago this week.

I tried to rationalize my feelings by recalling a line from a song by Jethro Tull:  “You’re never too old to rock and roll.”  Then someone pointed out that the song was released 36 years ago.

Back to Spain.  In the hour I had allotted to reading, I read a piece by DeutcheBank detailing how the Spanish bailout would work within the framework of the existing Euro-zone treaties.  I also read an analysis of the weekend’s events written by Bruce Krasting.  Finally, I hopped over to Bloomberg to look at the equity market futures and the EUR/USD exchange rates.  What follows are my observations in no particular order:

  • As of this writing, the Euro has strengthened by 1.02% over the USD.  Forex seems to think the bailout has legs.
  • US stock futures (DJIA) were up 141 points.  The bulls are back.
  • The Nikkei Index is trading up 60 points while Singapore has thus far added 38 points to its index.
  • Other markets have yet to open.

All-in-all, the weekend’s developments have brought back evidence of the “animal spirits.”

I hope the rally truly has legs and the bailout is a meaningful step towards removing the Sword of Damocles that has hung over the market’s head for the past 5 years.  But here’s the problem.  It’s not a bailout.  Having read the documents (the DB doc in particular since it referenced this term twice), what is occurring is known as a bail-in.  A bail-in!  Sounds nice.

The thing about a bail-in, is that it really is (as is known in bankruptcy parlance) a cramdown.   I mean, if someone came up to me and asked if I’d rather be “bailed-in” or “crammed down, ” my gut would say “Bail me in!”

But they are one in the same.  And this is where the Krasting article makes its finest point.

In a bail-in (or cramdown), positions in the capital structure that had previously been senior get “crammed down” into subordinate positions.  Spanish bank loans that were subordinate only to the actual depositor’s money will likely be moved to the third position, as the bailout loans take the second spot – essentially cramming down the senior loan holders.  Sorry, I mean bailing them in.

On the surface, that sounds dandy.  The bondholders knew the risks when they bought the bonds, so knocking them down a notch in the capital structure is fair and just.

Kind of.

If you wanted to be fair and just, the entire capital structure all the way up to, but not including, depositor accounts should be wiped out until the bank has adequate capital.  That’s a different argument to be made another time.

But we live in a world of unintended consequences.  We presently have the luxury of witnessing these consequences much more frequently, since governments can’t seem to take their hands of the knobs for even a second.

My reticence about this bail-in, is that senior bank loan holders in other countries (like Italy, France, and maybe even Germany) might decide that it’s too risky to hold these loans.  Should things go poorly in those countries, might they be bailed-in too?  Could fear of this (unintended consequence) create mass liquidation of senior loans in Europe, akin to those we saw in the US in 1998 (you could buy $1 worth of senior floating bank debt for about $0.50 at the time)?

If I were long the senior loans of banks in the above-mentioned countries, it would certainly give me something to consider.

But…  I’m not long those loans, and it looks like it’s time to cut some grass.

This has been my 3rd blog in as many days, and I thank you for your indulgence.  I find living in this period of history to be fascinating.  And I enjoy sharing that enthusiasm via the blog.  What strikes me as funny, though, is through all the troubling big-picture discussions, there are still parties where we celebrate fine young men graduating from high school.  And weed-riddled grass that needs to be mowed.  It’s that small-picture stuff that makes life so enjoyable.

Whether or not some Spanish bank is getting bailed-in.

Keep the Bonds and Pass the Kefalograviera

Today, in a case of deja vu all over again, the equity markets were roiled by the news from Greece.  This time, the news revolved around a select group of private creditors banding together to reject the bond-swap offer that had recently been proposed.

Greek officials now estimate that between 75% and 80% of all bondholders have agreed to participate in the bond swap.  That number, while high, falls below the 90% threshold required to avoid something called the Collective-Action Clause (CAC).  The CAC is a rather interesting bit of retroactive “law” stuffed into already-existing bond contracts.  Basically, it states that, in the event a 90% participation rate is not achieved, the majority of the bondholders can get together and vote to have the agreement be binding on all bondholders.  Except the ECB.  They’re exempt, of course.

The sticky wicket here is that the CAC triggers Credit Default Swaps, since it is (by definition) a case of the debtor telling the creditor the terms in which payment will be made (or not made in this instance).  These aren’t Greek rules, rather they come from the International Swaps And Derivatives Association.

The other sticky wicket is that, if the bond swap is not successfully executed, the second Greek bailout from the ECB will not be forthcoming.  Should that be the case, Greece would likely experience a dis-orderly default.  That is contrasted with how spectacularly orderly things have gone up to this point in time.

It is also now rumored by Reuters that four Greek pension funds have decided to opt out of the bond swap.

On the bright side, this whole thing needs to be sorted out by Thursday evening.

While laying odds on the success or failure of this bond swap is not a game for the faint-of-heart, believing anything that comes from the Greek media is done at one’s own peril.  One piece of history we can rely on, however, is that when these macro issues dominate the news, correlations among asset classes tend to lock up…  and not in a good way.


Pip, Pip, Cheerio! We’re Out!

With the European economic summit now ended, I thought it might be useful to bullet-point the outcomes; to the extent they are understandable.

  • There will be a new agreement for better economic integration in the euro zone.
  • The new treaty could take up to three months to negotiate, and may require referendums in certain countries.
  • The new treaty would include automatic sanctions for countries exceeding stated deficit restrictions.
  • The European Central Bank (ECB) will cap the amount of its euro zone government bond purchases at 20 billion euro per week.
  • The ECB will provide unlimited 3-year funds to European banks, reducing the odds of liquidity induced bank failures and providing funds for those banks to buy government bonds.
  • Surprisingly, the European Stability Mechanism was held at 500 billion euro, much less than the expectations leading into the summit.
  • 9 of 10 countries that do not use the euro agreed to negotiate a new agreement alongside the new EU treaty, subject to parliamentary approval.
  • Britain refused to agree to the new treaty idea, since it did not include guarantees to protect its financial services industry.
  • Finland calls this agreement “The beginning of the beginning of the end of the crisis.”

Our takeaway from the summit…

  • The biggest positive for the near-term is the 3-year bank funding provided by the ECB.  Preventing a major bank failure is Job One in avoiding a contagious financial crisis.
  • The overall plan seems nebulous and subject to referendums and parliamentary approvals in countries where that may not be possible (ie. Ireland).
  • The treaty, should it come to pass, represents an historical surrender of sovereignty on the part of the 17 member countries, and could lead to increased social unrest in those countries that are sanctioned in the future.
  • Britain has taken a huge risk by isolating itself against the other 26 countries involved in this agreement.  50% of its economy is transacted with the EU, and the decision to vote “no” removes Britain from having any formal say in the details of the treaty.
  • We remain skeptical that this will end up being a significant event in terms of ending the crisis.  The bond market seems to agree, with Italian 10-year bonds still trading above 6.5%.

Acronym Deja Vu

I just want to make sure I understand today’s European bailout rumor/plan correctly…

First, the European Financial Stability Fund (EFSF) will construct a Special Purpose Vehicle (SPV)

Next, all the European sovereigns with pre-default debt will place their toxic paper into the SPV.

Then, the SPV will issue bonds back to the same pre-default sovereign nations.  These bonds will be rated as investment grade.

Finally, the pre-default sovereigns (PIIGS) will use their freshly minted investment grade bonds to borrow at favorable rates from the European Central Bank (ECB), to recapitalize their banks.

Maybe I’m having deja vu all over again (with all appropriate props to Yogi Berra).

Only the last time, instead of EFSF, SPV, PIGGS, and ECB the acronyms were MBS, CDO, CMO, and TARP.  The track record of blending together massive volumes of toxic debt, slicing and dicing it, and having investment grade debt come out the other side is a little less than stellar.

But, hey.  The rumor/plan was worth a couple percentage points on the major stock market averages.  A few more acronyms and we’re likely to have a bull market on our hands!