A waste of a perfectly good betrayal

November 8, 2011 | Capital markets, Credit event, Eurozone, Global news, Greece, Law, Markets, Regulation, Speculation

By:David A. Smith


Tell me honestly: if you intended to betray everything you had espoused for decades for the sake of selfish expedience, you’d want to get something really valuable for it, wouldn’t you?


But your immortal soul’s not worth very much, Herr Faust


You wouldn’t trade it for a few days’ grace before a catastrophe made worse by your actions – would you?


Yet that’s what Europe’s leaders did last Friday, as reported by economist Carl Weinberg in the surgically acidic High Frequency Economics (which I have permission to quote):


Smiling into the abyss: the perspicacious and peppery Carl Weinberg


We have all suffered a breach of faith in the conduct of economic policy in Greece. 


When Mr. Weinberg says ‘we’, he means the capital markets, whose vengeance is swift, as well as voters in both Greece and the Eurozone, whose vengeance opportunities are being methodically denied them by anti-democratic processes as bald as any I can remember. 


Calling a referendum earlier this week, Prime Minister Papandreou used the threat of unthinkably bad consequences for the nation to bully opposition leaders into supporting the austerity plan imposed by the IMF.  Yes, the threat of a referendum was a bluff.  So as of yesterday afternoon, the referendum was called off. 


As to the pressure being brought to bear, consider this little diktat from Germany, referenced in the Daily Telegraph’s panic-by-kaleidoscope report, Debt crisis live (7 Nov):


14.21 [GMT – Ed.] Greece must stick to its bailout plan obligations regardless of its domestic turmoil, German Finance Minister Wolfgang Schaeuble insisted today. He said:


Whatever will happen, Greece has to stick to what has been agreed. With a new government, with an old government, with new elections or a referendum or not …


You will do what we tell you, national sovereignty and democracy be damned?


And this is how we paradrop onto Crete


We can bide time for them but to regain their sustainability, to regain their competitiveness, that has to be delivered by Greece in one way or another.


Am I the only one who shudders when I hear a German saying, ‘You vill obey’?


He stressed though that eurozone leaders needed to “pay respect to the burden the Greek people have to take. It is not fair what is going on in the Greek society … but we can’t avoid it.”


Yet this is not the breach of faith that Mr. Weinberg referenced.  That’s more complicated but no less brutal, and it was inflicted on the capital markets.  Let Mr. Weinberg explain:


Also, we have all suffered a breach of faith in credit default swaps this week, as the ISDA agreed with the EU governments that the 50% haircut demanded of Greek bond holders will not be deemed a default or a credit event. 


“Safe, efficient markets”

We’ve just renounced our motto


As Mr. Weinberg speaks to a knowledgeable audience fluent in this lingo, he uses the crispest phrases.  Allow me to translate.


I’m here to tell you what you have to do to protect me


We know that the European lenders have been strong-armed and coerced (“Bribed?  Did I say bribed?”) into taking half what they are owed. 



“What is a credit event?”

“That means Europe exploding.”


But that’s not the breach.  The breach is what follows immediately thereafter.


If you have property and casualty insurance on your house, and your house is damaged by weather (say a freak snowstorm that downs trees), your insurance company pays you for your loss.




This is not a power outage


That’s why you bought insurance in the first place – to lay off the risk of a freak snowstorm.  In capital markets-speak, you’ve hedged your homeownership position by buying a snowstorm default swap. 


Nor is this


If there’s a freak accident, you suffer the inconvenience but your insurer pays you.



Now suppose that the state government – not your town government – decides you’ve been living too high on the hog and your house is unstable.  It arrives, bulldozers in hand, and demolishes that rickety extension you built out back.  You’ve now lost half of your house.  Terrified, you call up the insurance company and say, “Okay, pay me half the value of my house.”


“Sorry,” comes the voice on the telephone, “but the state has declared that its destruction is not a casualty and we are legally not obligated to pay you.”




“In fact, we are prohibited from paying you.  Because if we paid you and everyone like you, we’d been bankrupt.  Goodbye.”


In other words, you bought Monty Python’s famous never-pay insurance policy.


Vicar: It’s about this letter you sent me regarding my insurance claim.  It says something about filling my mouth in with cement.

Devious: Oh well, that’s just insurance jargon, you know.


That’s just insurance jargon, you know


Vicar: But my car was hit by a lorry while standing in the garage and you refuse to pay my claim.

Devious: (rising and crossing to a filing cabinet) Oh well, reverend Morrison … in your policy … it states quite clearly that no claim you make will be paid.

Vicar: Oh dear.

Devious: You see, you unfortunately plumped for our ‘Neverpay’ policy, which, you know, if you never claim is very worthwhile … but you had to claim, and, well, there it is.

Vicar: Oh dear, oh dear.


That’s the breach.  And its consequences are swift and terrible:


This undermines and destabilizes all investment positions in bonds, as no one who owns a bond hedged by CDS can be comfortable at present yields given the risk involved. 


Again translated from capital markets and economics, if all casualty insurance is invalid, then no one is safe, and anyone who had planned his or her finances based on the availability of insurance to deal with catastrophic loss had better start hoarding cash immediately – or uninvesting in any rickety structures.


Volatility signals risk, and banks facing risks clam up: with their balance sheets threatened by extreme and unpredictable swings, banks will retract loans from the market and add to their capital bases. 


I don’t like what I’m seeing!


That is guaranteed to drive up the price of what little credit is left.


Yields on Italian tens jumped 30 basis points after the ISDA’s ruling. 


With reliable insurance no longer obtainable, the full risk of default now has to be borne by the underlying security.  This passes the cost of the risk back onto the borrower.


Like every southern-Europe nation, or the famous PIIGS: Portugal, Italy, Ireland, Greece and Spain.


PIIGS about to get slaughtered?


Again the Telegraph:


14.05 It’s not just Italy which is getting a hard time today – Bruno Waterfield reports that Portugal, another bail-out recipient, has had a visit from the troika heavy mob, aka the IMF, the ECB and the EU. He tweets:


@BrunoBrusselsTroika officials arrived in Portugal today after govt called for ‘understanding’ on its plea for austerity terms to be relaxed.


The PIIGS’ governments have an impossible situations.  Their deficits, grown by decades of free spending from too-cheap Euro loans driven by Germany’s need to revive its economy, cannot be pruned fast enough to cover the debt service obligations.  Attempts to slam on the brakes plunge their economics into deep recession.  Failure to do so risks running out of cash (like Prichard, Alabama or the other municipal bankruptcies I’ve profiled).


This, by itself, could open the door to unsustainable bond yields on PIIGS debt in very short order. 


As the price of rolling over those loans spikes, the borrower nations will be unable to make the new payments from the moment they are made. 


We are enduring a much more volatile market environment today than a week ago.  Domestic credit to the non-bank private sector will be diminished.  A credit crunch is one of the fastest ways known to kill an economy.  So even the mere fear that a default by Greece is imminent kills the economy, with lasting damage even if an actual default never occurs. 


Te only thing we have to fear … is the Euro itself


Want evidence of the fear?  Try this, again from the Telegraph’s daily breathless updates:


13.20 Two remarkable stats from the New York Times‘ report on the rage and paralysis stalking Athens.


Greek banks have lost $63.5bn in deposits – 20% of GNP – with up to $20.7bn gone in the last two months alone. Greek families are sending their life savings abroad amid fears their banks could collapse.


Twenty percent of gross national product, fled overseas in a few months!  Can there be any greater evidence that Greeks with money (meaning choice, and probably meaning intelligence) have given up on the Euro as their currency?


This was in August


As the Greeks abandon the Euro, money abandons Europe, and that makes America look good – for the moment.


12.39 Yields on ten-year US Treasury notes declined to 2.03% this morning as concerns over the safety of Italian debt made American bonds a relative safe heaven [sic!].


I love that ‘safe heaven.’  If only heaven were available.


Gigapennies might help


“Attention is turning from Greece to Italy,” said Eric Wand, a fixed-income strategist at Lloyds Bank Corporate Marketsin London. “That’s driving safe-haven flows into Treasuries and bonds.”


So the European leaders and the ISDA, having betrayed the core principles of financial contracts and demonstrated they are utterly unreliable, instead of propping up the markets, have ensured that any capital with even a peanut-sized brain will run and hide.


Greece could – indeed, all but surely will – run out of cash before this domestic political squabble is resolved.  This is how close we are to a hard, chaotic default by Greece, and possibly its exit from EMU.  Everything depends upon decisions by Greek politicians, over whom no one has any sway. [Emphasis in original – Ed.]


When cash stops, people panic – and they can panic violently.


As families cut back, the number of uninsured drivers has risen by 500,000 in a quarter to 1.5 million.


Financial crashes presage physical crashes.


Of course, we are convinced, and have been for some time, that default is inevitable.  We now believe it is imminent. 


The banks of EMU nations remain undercapitalized.  The crisis persists, with the baseline path still pointing at a default and restructuring as the only plausible outcome for Greece.  This will generate numerous bank failures.  


I have a feeling that November 4, 2011 will be seen by history as Europe’s Black Tuesday – the day panic destroyed their markets.


Irrational and therefore both understandable and scary


No pile of hard cash exists to stave off cascading institutional failures in the wake of a breakdown of sovereign debt service commitments. 


Our base case still includes multiple sovereign defaults, institutional failures, a credit crunch and prolonged economic downtown cum depression in the Euro Zone.  The timing of that scenario is accelerated.


Years ago, when dealing with a slippery and pugnacious general partner, I asked an old general counsel at my company what to do.  “If I came home,” he intoned in lordly fashion, “and found him in my house, attacking my wife with an ax, I might call the police or I might try to stop him, but I wouldn’t be surprised.”



Well, we did see this coming


“I am impressed that the people have not yet stormed into Parliament and burned the politicians alive — like a souvlaki,” said one interviewee.


To paraphrase my old general counsel, if I woke up one morning and read that tanks had rolled through the streets of Athens and some doughy-faced tough generals with overlarge caps and too much gold braid were talking onto microphones about Greek’s unilateral return to the drachma and immediate nullification of all Euro-denominated Greek bonds, I might try to figure out what it meant, or reduce my exposure to the European markets, but I wouldn’t be surprised.


We did it before, we can do it again




UPDATE (Friday, 25 November):


Everything predicted above has played out, largely on schedule, as reported pithily by the Telegraph, which after chronicling the missteps concludes with this:


Suddenly, no-one wants to hold euro denominated assets of any variety, and that includes what had previously been thought the eurozone safe haven of German bunds.


Investors have gone on strike. The Americans are getting their money out as fast as they decently can. British banks have stopped lending to all but their safest eurozone counterparts, and even those have been denied access to dollar funding.


Once the investors gone on strike, it will take more than brave words to get them back into the markets.


Nobody wants Greek debt at any price


Especially when the Eurozone’s leaders have made clear that they have no principles but expediency:


But perhaps the biggest sin of the lot was effectively to render all credit default swaps (a form of insurance against default) on sovereign debt essentially worthless, or void, by making the Greek default ‘voluntary.’


This has made it impossible to hedge against eurozone sovereign debt purchases, and thereby destroyed the market. Worse, it’s made investors believe that the euro cannot be trusted, that it’ll repeatedly find ways of reneging on contract. That’s the point of no return. This is no longer a serious currency.


Needed in vast quantities in Europe right now