Risks of Market Contagion from a Greek Default

 

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

While U.S. markets closed slightly up on Monday September 12th, panic reigned in Europe. The risks of a hard default by Greece reached 98% according to one model. Interest rates in Greece were spiraling out of control (the two-year government yield hit almost 70%) and credit default swaps on European sovereign and bank debt reached record levels again.

While Greece is a small economy and there are only two major countries --- France and Germany -- that hold substantial amounts of Greek government and corporate debt, this is only the very tip of the financial iceberg that threatens a titanic like sinking of world markets similar to what occurred during the 2008 Credit Crisis when Lehman Brothers collapsed. Problems in Greece are shared by two other small national economies, Ireland and Portugal, and by two much large economies, Spain and Italy. The Italian economy is roughly the size of the UK economy. It is too big to bail out. Can you imagine the UK defaulting and there being enough money available for an international rescue? If not, don't assume that problems with Italy can be fixed either. Spain is also too large to rescue.

Country defaults have implications well beyond their borders because large international banks have exposure to loans in them. In the global financial system, all large international banks are interconnected. Big banks such as Deutsche Bank, Société Générale, and Bank Paribas have substantial relationships with U.S. banks. The large banks are still in a weakened state from the 2008 crisis. This is showing up in British banks, which like the U.S. banks have limited exposure to Greek debt, and in Bank of America. Credit default swaps have reached record levels for some British banks and Bank of America's stock price keeps dropping.

The Greek default, and this will happen one way or the other at this point, will be similar to the demise of Lehman  in 2008. Contagion spread throughout the world financial system. In the U.S. the close to trillion dollar TARP program had to be instituted to hold up the banking system. In total, as much as $11 trillion in programs (the Federal Reserve alone had half a dozen major ones) had to be implemented to patch things up. The will for such an effort no longer exists, which will mute whatever response the authorities come up with will be delayed and muted. After Greece, something will have to be done with Ireland, Portugal, Spain and Italy. Those who think that the U.S. markets will be isolated from these events are at best engaging in wishful thinking and at worst are purposely misinforming the public.

Disclosure: None

Daryl Montgomery
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

Greek Tragedy Moves Closer to Final Act

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Greece has finally requested an activation of a proposed EU-IMF $60 billion aid package. Negotiations on the terms will be taking place over the next several days. Currently it looks like Greece will be loaned the money at a five percent interest rate. This is more likely to delay default rather than prevent it.

Events on April 22nd finally forced Greece's hand. Moody's downgraded its sovereign debt to A3 from A2 and placed it on credit watch for a possible further downgrade. At almost the same time, the EU Statistical Agency revised Greece's 2009 budget deficit as a percentage of GDP to 13.6% from a previous estimate of 12.7%. The markets reacted negatively with yields on 10-year Greek government bonds rising to 8.7%. Spreads between Greek and German debt rose to 5.6%. Credit default swaps, which are bond insurance, rose to a very high 650 basis points. The euro (FXE) hit a fresh 11-month low of 132.55 against the U.S. dollar.

How much will loan support from the EU and IMF really help Greece though?  The aid package provides enough money to tide Greece over into some time in 2011. Greece has not been having trouble borrowing money, but the trouble is paying high interest rates on the money its borrows. Would 5% be low enough to not seriously threaten Greece's attempt to reduce its budget deficit?  The answer is probably not. Greece, like many countries before it, has entered a downward spiral where debt default becomes inevitable without massive ongoing bailouts. Attempts to balance its budget will severely damage its economy, which is heavily dependent on government spending (as is the case for many other countries including the United States). As it cuts spending and raises taxes to reduce its budget deficit, its GDP will also decrease. A lower nominal budget deficit with lower GDP, means the percentage of the budget deficit to GDP may not decline that much despite extensive efforts to make it happen.

While it looks like Greece's problems happened overnight, they did not. Greece made efforts to hide its fiscal problems for at least a decade. Its most recent endeavors included simply lying about its budget numbers. The fibs it told were so outrageous that if Greece had been Pinocchio, its nose would have stretched across the Mediterranean. Nevertheless, the EU Statistical Agency accepted them without question. It was Greece itself that revealed the scam as it was falling apart. Pervasive lying with statistics is a common last phase before a fiscal collapse. Americans may want to take a close look at the GDP, inflation, and employment numbers produced by the U.S. government as they ponder this thought.

Disclosure: None relevant.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Surgery Done by a Bull in the China Shop

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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Today is the beginning of the spring quarter and the new fiscal year in Japan. Last night, most of Asia rallied and the Nikkei was up smartly (the Nikkei never hit a new low in the market sell off this spring by the way). A bailout plan in Taiwan for semiconductor manufacturers was bullish for tech stocks throughout the region. A Chinese manufacturing report was dismal, although off the low established last November (when the prices of many commodities also bottomed). European bourses are down this morning and the U.S. market indices gapped down after gapping up yesterday. The market is worried about the G20 Meeting tomorrow and the Jobs Report on Friday. The U.S. government possibly forcing GM into bankruptcy has also reared its ugly head again as well.

The government's current handling of GM is incredibly destructive economically. News has been leaked that Obama thinks a 'surgical bankruptcy' is the best option. If so, that surgery is being conducted by a bull in a China shop. A recapitulation of what is going on:

1. The U.S. Economy has been losing its manufacturing base for the last 30 years and has moved increasingly to a FIRE (Finance, Insurance, Real Estate) economy and this has led to the current implosion of our financial system.
2. Instead of trying to revive manufacturing, the government is trying to drive a top manufacturer into bankruptcy - and somehow this is going to improve things.
3. Sales for automakers are down as much as 50% year over year because of the economy. The U.S. government then tells reluctant car purchasers that we are trying to drive GM out of business and make them worry that if they buy a GM car they will ever be able to get it fixed (this may not be realistic, but it is something that will give the consumer pause and hurt GM sales even more).
4. No one knows how many credit default swaps there are on GM bonds, but the number is probably substantial. A bankruptcy would put them in the money and require that they be paid off. Most of them would have been sold by insurance companies and brokers that are already getting government bailouts and this will require more bailout money (probably many times what it would cost to bailout GM) to make up for the losses.
5. The U.S government just spent $5 billion bailing out auto part suppliers and is undermining that bailout if it forces GM into bankruptcy.
6. There are a large number of current and former employees of the auto industry, its suppliers, its shippers, etc that will be negatively affected by this action.
7. The GM announcement stopped a nascent stock market recovery in its tracks, wiping out billions more from retirement portfolios. The Dow was up over 20% (technically a new bull market) and the government apparently couldn't wait to drive it right back into bear market territory. Treasury Secretary Geithner already caused a major market sell off previously with his handling of Citigroup. If the Obama administration's goal is to keep stock prices down, they are achieving outstanding success.

While I am not a fan of bailouts, I am even more opposed to incompetent business practices combined with unlimited government stupidity. As we have said in this blog before you can bailout no one or you can bail out everyone, but doing some bailouts and not others produces the worst results. What the Obama administration is doing with GM makes no sense on any level - and it does not bode well for the handling of economic matters going forward.

NEXT: The Bull Heard Around the World

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

The Peoples Republic of the U.S. - the AIG Bailout

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

In a socialist state, the government decides what a company is worth, not the market. The Federal Reserve clearly demonstrated this concept by purchasing almost 80% of the insurance giant AIG on Tuesday night, September 16th. The Fed paid over 10 times what the market said its stake in AIG was worth. It is not clear what U.S. laws allow for the nationalization of part of the insurance industry, nor what companies will be bought next now that this precedent has been set.

The final phase of AIG's death spiral began on Monday evening when the major credit agencies downgraded it. This credit downgrade required AIG to post billions of dollars of additional collateral for its mortgage derivative contracts - capital that AIG simple didn't have. The implications were far more serous than the public realized, since AIG is a central player in the CDS (credit default swaps) market and does business with almost every financial institution in the world. If AIG went under it would have been unable to pay off its CDS obligations and its counter parties would have unable to collect on its trades. It was estimated that a large number of hedge funds, and possibly some banks, would have gone under along with AIG.

Over the weekend AIG attempted to borrow $40 billion form the Federal Reserve. The Fed, originally set up to lend just to commercial banks, had no legal authority to lend to insurance companies. And even though it had extended its lending to broker-dealers in March and to mortgage giants Fannie Mae and Freddie Mac in July, it was reluctant to add insurance companies to the list. Then on Tuesday evening, the Fed (with support from the Treasury and President Bush) decided to extend its legal authority way beyond anything ever intended by agreeing to pump $85 billion into AIG. The media described this $85 billion as a 'loan' even though a 79.9% equity stake in AIG was being given in exchange (note to media: this is a stock purchase, not a loan). This is not for already existing AIG stock, but for newly issued AIG stock, so AIG will have to increase its outstanding amount of stock to five times its current level. This is a better deal for stockholders than usual, since they will be left with something, instead of being completely wiped out.

Based on Tuesday's closing price, AIG had a market cap of just over $10 billion dollars. In order to buy 80% of the company (which was worth $8 billion according to the market), the U.S. paid $85 billion or over 10 times the market price. Socialism leads to just such economic absurdities. Unless this is stopped, expect more of this in the future - and the permanently ruined economy that always follows.

NEXT: The Mega Move Up in Gold and Silver

Daryl Montgomery
Organizer, New York Investing
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Mortgage Insurer Meltdown

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Bond insurers (Ambac, MBIA, FGIC, XL Capital, ACA, Security Capital) were only one of the many sectors of the financial industry that had gotten themselves into serious trouble by the fall of 2007. While these companies were not large compared to the banks or broker-dealers, they had an out sized impact because they guaranteed most municipal bonds in the United States and the ratings of those bonds couldn't be any higher than the bond insurance companies own ratings. Lowered ratings on bonds would mean higher interest costs, higher insurance costs, and even the possibility of not being able to borrow money for municipalities throughout the country. As with most of the problems created by the credit bubble, the bill would eventually wind up at the doorstep of the American taxpayer. As bad as this was, it was by no means the full extent of the damage that would be caused if bond insurers lost their financial viability.

Bond insurers are also known as monolines because for most of their existence they only operated in one line of business, the low-risk insurance of municipal bonds. That changed however in 1998 when they persuaded New York State regulators to allow them to underwrite high-risk Credit Default Swaps (a type of derivative that is insurance on a bond) on mortgage securities. Other states promptly followed New York's lead. The bond insurers set up shell companies called 'transformers' because they transformed a traditional bond insurance contract into a Credit Default Swap. These swaps in turn allowed investment banks to move commitments off their balance sheets and book profits up front - an accounting illusion that began to implode when the housing market went into decline.

On December 19, 2007, S&P finally downgraded bond insurer ACA from A to a junk rating of CCC. S&P was apparently one of the last to realize that that the company was no longer creditworthy. The company's stock had already fallen to less than a dollar (the price the market sets when a bankruptcy is expected) and had been delisted from the New York Stock Exchange in November, but apparently even that wasn't enough for S&P to give up the fiction of its A rating on ACA. Nor did S&P explain why ACA suddenly went from a creditworthy rating to junk status overnight when it belatedly downgraded ACA in December. S&P and the other rating agencies were quite aware of what would happen if they gave the bond insurers realistic credit ratings. Shortly after their downgrade of ACA, CIBC World Markets announced that insurance for $3.5 billion in securities it held backed by subprime mortgages was possibly no longer viable. In other words, the big banks and brokerage houses would be on the hook for all the subprime garbage on (and off) their books and would have to acknowledge it if the bond insurers were downgraded. One could safely presume that there was a lot of political pressure from many quarters to prevent this from happening.

Next: Sovereign Wealth Funds Bail Out the Banks

Daryl Montgomery
Organizer, New York Investing meetup

For more about us, please see our web site: http://investing.meetup.com/21