Tipping Point -Germany

Headlines out of Europe continue to dominate market trends in the US, and what is historically a strong week for equities turned in to a continuation of the downward trend that started in April. This past week has been the worst Thanksgiving week for stocks since 1942, the year the US officially set the holiday at its current date. The Dow Jones Industrial Average down roughly 12% from its highs in April and many investors are thinking the infamous "Santa Clause Rally" will not appear this year. Equity markets in Europe have fared even worse. While the volatility in our equity markets is frustrating, there have been certain events this past week that have signaled the crisis overseas is coming to a tipping point.

Last Wednesday, Germany, the pillar of strength and leadership during this crisis , suffered a blow to confidence after investors’ appetite for the country’s debt waned. The country was planning to raise 6 billion euros ($8 billion) from the sale of ten-year bonds and fell dramatically short of that goal by 40% or 2.3 billion euros ($3 billion). The yield on the ten year jumped 25% to 2.263% from 1.823 earlier this month. Credit default swap costs for Germany as well as France jumped to new records this week.

The aforementioned suggests that investors might be concluding that the previous rock­bottom yield that these bonds have offered in the past do not justify the increased risk of Germany coming under enormous financial strain in meeting the demands of an Italian or Spanish bail­out. Another explanation may be that market participants are coming to realize that a “euro­bond” solution, (discussed later) may be the only solution to the crisis that is spreading throughout the continent, in which case borrowing costs for Germany will rise in the future.

This failed auction is clearly a test of confidence and a blow to the German economy that has been largely sheltered from the crisis to date. Stephen Castle of The New York Times writes, “Since 2009, Germany and a handful of other countries, like the Netherlands, have benefited significantly from cheaper borrowing costs as investors diverted cash from riskier assets and the bonds of southern European countries to debt issued by the Continent’s fiscal hawks.

According to an estimate by Re­Define, an economic research institute in Brussels, Germany saved around 20 billion euros ($26.7 billion) in borrowing costs from 2009 to 2011, with an additional 20 billion euros in estimated savings locked in for the future”.

The strength of Germany has allowed it the bully pulpit to reprimand and demand from those countries greater austerity measures and gives it the top spot in negotiations for a solution. One can’t help but speculate that some in Germany are looking at this crisis as a much needed wake-­up call sending a message to southern

Europe to get their act together and tackle much needed reforms.

While lower borrowing costs for Germany may be a beneficial side-effect, there is no mistaking that a rise in these costs will prove a turning point during these negotiations. With annual government spending on close to 300 billion euros, this is one turn of events that can have a dramatic impact on the Euro­zone crisis.

“A month ago, as far as the eye could see, Germany was to be the last good credit in Europe, able to bail out all the others. Well, that illusion has liquidated itself in a hurry. Investors sent a message at Berlin’s Wednesday bond sale, sitting on their hands for $3 billion being offered. The message: markets are getting ready to punish Germany for the sin of its neighbors’ over-borrowing, unless Germany allows the sin of money-­printing to paper over those sins in the short term.” Memo to Europe: Forget the War, Holman W. Jenkins, Jr. ­ Wall Street Journal Opinion – 11/26/11.

Many leaders and economists have challenged Germany’s visions of austerity in the face of a continental recession. The weakened German bond offering may also provide a shift from pro-austerity measures to talks of pro­growth measures. They argue that the fundamental support for any loan is the ability to generate and collect

taxes. That is highly dependent on a growing economy producing profits. Whatever the cause, the massive failure of Germany to meet its funding goals last week is sending a clear message to Angela Merkel and company…get something done and fast!

Tipping Point – Italy

Italy is one of the largest economies in Europe and one of the largest borrowers of debt in the world. It has beensaid that Italy is the central battleground in the euro-crisis. Its 1.9 trillion euros of debt make the country too

big to fail but also too big to bail out. Indeed a collapse of the Italian economy would inevitably destroy the

euro and set forth a negative chain reaction that would spread globally. A global recession and a complete

lock down on the global credit market would occur. Therefore when borrowing costs for Italy soared last week,we should look closely at future attempts to raise capital. The latest weekly reading for the Italian ten-year bond is yielding 7.261%. This figure is above the critical 7% reading that many think of as the crisis level andthe nations borrowing costs have increased an astonishing 49% since March. Prime Minister Mario Monti said

European leaders understood an Italian collapse would mean “the end of the euro”.

This increased pressure in the Italian bond market will likely raise the alert levels in Europe and we would

expect a redoubling of efforts towards the solution.

Casualties of Crisis Increased evidence of panic exists in the euro­zone. The debt crisis has toppled seven European governments, including Italy and Greece, by raising those countries borrowing costs to dangerously high levels over the past year.

Forced to deleverage, European banks are proving loans to entities that are willing to buy toxic loans and assets from the banks. This is one that needs to be reiterated. Banks are LENDING money to institutions so these very same institutions buy toxic assets from the banks that provided them the loan. It doesn’t take a financial wizard to understand that cannot work.

Banks such as Merrill Lynch, Barclays Capital and Nomura have issued statements that they are building contingency plans for the breakup of the Euro.

On Greece hiring BNP Paribas to assist in cramming down existing bond holders: “BNP and its client, Greece, want to corral as many investors as they can. The more bond holders they persuade, the more the bank would collect in fees.

So it is perhaps unsurprising that some recent meetings have taken on a forceful tone, according to three portfolio managers who attended three different sessions with BNP Paribas. The investors spoke on condition of anonymity because they feared retaliation by the bank. Contrary to what the I.S.D.A says, the BNP bankers have been telling bond holders that their credit insurance may not pay off down the road, because after the restructuring is completed, the terms of the old debt might be changed, these money managers said.

Normally, investors would shrug off such an argument.

But the warnings from BNP Paribas carried weight, the money manager said, because one of the officials who was making them. She is Belle Yang, a BNP specialist who also happens to serve on a powerful I.S.D.A. committee. The panel, the “determinations committee” for Europe, decides what constitutes a “credit default” in Greece or elsewhere on the Continent.” Gretchen Morgenson, Scare Tactics In Greece – New York Times, 11/20/11.

Adding fuel to the fire, it appears that the credit agencies have gone on a downgrade binge recently. On Thursday, while most in this country were enjoying the company of their family and feasting on a wonderful meal, folks in Portugal took to the streets in protest of new austerity measures imposed upon them.

Fitch also took the opportunity to downgrade Portuguese debt to junk status. Fitch forecasts the Portuguese economy will contract by 3 percent in 2012. Given the zero growth environment along with the tightening of the governmental purse strings, it seems unlikely that Portugal will able to pull itself out of this economic death spiral anytime soon.

Belgium became another casualty of the credit rating onslaught when S&P cut its long-­term sovereign credit rating for the European nation by one notch to AA from AA+. S&P cited a slowing economy and protracted political uncertainty. Moody’s downgraded Hungary’s debt to junk status. It is expected that the country will go to the IMF as well as the EU for assistance at this point.

Clearly investors and regulators are frustrated with the actions of credit agencies. According to an article by Roben Farzad in the 11/28/11 issue of Bloomberg Business Week, “Rating firms helped precipitate the financial crisis. So how did they get off scot­-free?” With all the calls for reform and regulation, he states that not much has changed in the way the credit agencies are conducting themselves. ”Where is the outrage?” asks James H. Gellert, Chief Executive Officer of Rapid Ratings, which had rated MF Global at junk for two years. “Things have gotten absurd.”

This Week’s Debt Deals

Italy, Belgium, Spain and France are all on the docket to raise money in the sovereign bond market this week, and the results could have a telling effect on the confidence the market is placing on Europe’s leaders to offer a logical solution to the debt problem. These debt offerings, if unsuccessful, can have additional negative consequences in the US equity market. All told, the euro area will be looking to raise about 19 billion euros ($25.36 billion) next week.

Greater Unification

Chancellor Angela Merkel has stated that the long­-term solution to this crisis relies on closer integration between European governments and an increased effort on the part of those economies that are fiscally challenged. She has openly rejected the idea as the ECB in the role of lender of last resort as well as a unified euro bond to finance the regions budget shortfalls. Merkel has stated that these options are not viable without true fiscal reform. Without reform, it will give those countries that have abused their fiscal authority a “free pass”, shifting liability of their debts to those countries that have shown restraint while driving up borrowing costs for the entire region.

On Thursday, leaders of Germany, Spain and Italy pledged to propose modifications to European Union treaties that would aim to further integrate economic policy. Angela Merkel said the treaty changes were crucial steps toward building a fiscal union and restoring investor confidence.

“Implicit in the German prescription is the message that the sinners who spent and borrowed too much deserve to be punished. They can regain competitiveness with structural reforms –which Germany will happily help to devise –over a sustained period.” It Shouldn’t Take a Panic To Spur Responsibility – Floyd Norris, New York Times, 11/25/11.

In Ms. Markel’s own words, “It would be a completely wrong signal to ignore these divergent interest rates, because they are an indication of where more work is needed…If we all work responsibly, convergence will take place all on its own. But to impose convergence on everyone would weaken us all.”

The International Monetary Fund

The International Monetary Fund has pledged additional funds for cash strapped Euro­zone nations, but analysts fear the cost will be way too much the organization to bear. The IMF is offering six month credit to ease short­term credit needs as well as longer one and two year lines to provide wiggle room for a long awaited plan out of lawmakers. Experts say without the help of the ECB, the IMF will only have limited impact in stemming off the crisis. Case in point, the IMF has $400 billion available now. Italy has needs to refinance $350 billion over the next six months. Analysts put a $2 trillion price tag on the crisis.

The IMF may potentially play a key role in the crisis. “The IMF has already committed 78.5 billion euro to the Greek, Irish and Portuguese bailouts, or roughly a third of the total. (The EU put in the rest.) An Italian or Spanish collapse would need a bigger backstop, though, and the ECB is the only institution in Europe with the power to print the money that an Italy or Spain would need.

The central bank and its printing press might already be doing more in this crisis but for that pesky thing called EU law, which forbids the ECB from directly financing euro­zone governments. That’s where the IMF steps in to play the bag man. Since its perfectly lawful for the central bank to transact with the IMF, that loophole has some officials in Brussels and at the Fund salivating. The word is that the EU policy makers are looking to have a lending agreement ready in time for their next summit, on Dec.9.” Europe’s IMF End­Run, Wall Street Journal opinion, 11/26/11.

While this may be an easy fix around an EU law, it does have negative consequences to the US. Currently the US is responsible for contributing roughly 17% to the fund based on the size of our economy. Therefore we will be taking on addition risk tied to the euro crisis. On the other hand, Europe contributes roughly 23% to the fund thereby distributing more than three quarters of its risk globally.

The European Central Bank

Meanwhile the European Central Bank continues to buy Italian and Spanish debt in the hopes of depressing borrowing costs as temporary relief while a solution is formulated.

The ECB is looking at extending the terms of loans it offers banks to two or three years to try to prevent the crisis from precipitating a credit crunch that chokes the region’s economy.

While the ECB has reluctantly taken these actions, it has stated that its appetite for these transactions is diminishing. Unlike our Federal Reserve in the US that acts as the lender of last resort, the ECB has only one legal mandate and that is stable prices. The ECB has in this case has passed the buck to the European politicians by stating that’s not their job. They have stated publicly that the ECB is already “overstretching its mandate”.

From our perspective, the ECB conveys the wrong message when backing away from supporting the Euro­zone countries. By buying a small amount of bonds then saying publicly that it will soon stop doing it will spook investors away from the instruments. It also sends a message that it has little confidence of a near term solution to the crisis.

The central bank has joined in the German chorus that ailing nations need to cut government spending and seek to boost their economies’ competitiveness. The problem lays in that a ten or fifteen year workout cannot be crammed in to a one year time frame.

The debate drives on as to whether the ECB should step in and provide further assistance in stemming the financial crisis. “The right thing to do right now is for the Federal Reserve and the European Central bank to engage in further monetary stimulus. Having lowered short-­term interest rates, they should buy (or in the case of the Fed, resume buying) significant quantities of government securities to help push down long-­term interest rates and encourage investment…Central bank officials have wasted too much time over the last year worrying about how their institutions would appear to markets, to politicians and to the public, were they to undertake more stimulus.

Sometimes you have to do the right thing even if the benefits take time to become evident. If we do not undertake the monetary stimulus that the grim outlook calls for, then our economy will suffer avoidable and potentially lasting damage.” Adam S. Posen, Central Bankers: Stop Dithering. Do Something. – New York Times opinion, 11/21/11.

Not all are in agreement as to the role of the ECB. “And what if even that doesn’t work? The ECB would have squandered its monetary credibility, and shattered its charter, to buy the worst debt in the euro zone at the expense of the countries with the best fiscal policies and the lowest interest rates. It will have abandoned any semblance of market discipline in favor of a panicky rush to defend the ability of spendthrift governments to borrow. Price stability will move from the ECB’s sole mandate to its third or fourth priority…All of the fixes in the current crisis lack credibility with markets because they lack discipline that would show creditors that Europe’s problems of overspending, cradle-­to­-grave middle­-class entitlements and slow growth are being fixed.

The voices now pleading for greater “fiscal union” are really pleading for the Germans and the ECB to write their governments blank checks. But if they want them to pay this bill, then the French, Italians and others should be prepared to let the Germans and the central bank approve their budgets, their pension systems and other fiscal policies.” Bailout of First Resort – Wall Street Journal opinion, 11/21/11.

Euro-­Bonds

Several options have been floated about creating a centralized euro-­bond that will encompass the currency’s seventeen members. The first option calls for substituting all individual national bonds with one euro bond with a joint and several guarantee from all participants. Therefore the credit risk will be distributed throughout the euro­zone members and offer lower borrowing costs for those nations that are in trouble financially. All outstanding nation bonds would be converted in to euro-bonds under this scenario.

The second option that has been discussed is to partially substitute national issuance up to a certain percentage of borrowing by an individual country. These bonds would also bear the full guarantee of the euro members but would keep the individual nations on the hook partially for the remainder of their financing. These first two options would require treaty changes since EU laws state that one government cannot bailout another government.

While these first two approaches seem the strongest in corralling the crisis, a third option with less teeth has also been floated. This option would have euro bonds replace some national issues, but the euro bonds would receive guarantees from each government only up to specific limits. Collateral such as cash, gold reserves or future tax revenues will be offered. This sounds like a national receivables financing deal that would not provide much relief to the current situation, in our opinion.

During a budget debate last Thursday, Angela Merkel reiterated her opposition to the creation of the euro-­bond, although some are speculating that the recent market actions may sway her at some point in the future. If Europe produced a centralized instrument in which to lend money to all euro­zone governments at low interest rates, the easy credit would reduce near­term funding pressures while allowing the proper runway to enact the kinds of reforms Germany says are needed.

Solutions

“Despite the overheated reaction, a six page German memo that surfaced last week is a most promising document. It describes, if you look between the lines, a Europe that becomes safe from sovereign default. No bank runs. No precipitous withdrawals from the euro. Instead a generous, pro-­reform receivership for bankrupt governments at the hands of fellow European governments.

The deadbeats would get debt relief at the expense of Europe’s banks, which hold much of their debt. The deadbeat governments would get new funding from somebody (likely the European Central bank), in return for welfare and labor-market reforms that would be democratically practical because they would be coupled with debt relief.

Herein resides the best possible solution to the European impasse: an outcome that restores growth, avoids self-defeating austerity, and allows the best possible recovery for bondholders, who collect more pennies on the dollar than they would if debtor countries were pushed into depression in a futile effort to pay every centime. The only downside would be a modest appearance of subservience to Berlin.” Memo to Europe: Forget the War, Holman W. Jenkins, Jr. ­ Wall Street Journal Opinion – 11/26/11.

“In contrast, ECB money-­printing accompanied with debt relief would let politicians in debtor countries allocate their scarce political capital to growth rather than austerity. It would let them focus on freeing up markets and flattening their tax codes rather than clawing income away from recalcitrant and powerful voting blocs.” Memo to Europe: Forget the War, Holman W. Jenkins, Jr. ­ Wall Street Journal Opinion – 11/26/11.

“Such a prescription can work, if the patients will follow orders. Eventually, their export industries could compete with Germany’s as they used to do. The excess growth in labor costs over the past decade would be reversed. There is, in fact, evidence that the medicine is having the desired effect in Ireland.” It Shouldn’t Take a Panic To Spur Responsibility – Floyd Norris, New York Times, 11/25/11.

“Policy makers keep offering short-­term solutions and advertising them as panaceas. But none of this will work for long until Europe starts to distinguish between good national policies and bad, supporting the good while letting the bad suffer the consequences.” Europe’s IMF End-­Run, Wall Street Journal opinion, 11/26/11.

Our hopes are for a clear and uncompromising solution that will not only curtail the panic stricken volatility that the markets of all instruments have had to suffer, but offer long-term stability that can be a model for other nations that may face similar circumstances. We are in agreement that there needs to be concrete and serious preconditions before the real work starts. Countries that have become addicted to overspending need to first admit there is a problem and commit to serious reform, even if it means taking a subservient role to a larger fiscal authority. In lock step with this commitment on the part of European leaders, the ECB must take a more active role immediately without violating their charter to support those European nations that face budget shortfalls. This can be done by working directly with the IMF. The global economy will be willing to bear some of the liability if it is shown that those countries with fiscal problems have taken serious steps towards fiscal reform.

Once this phase is complete and the markets are stabilized, then there needs to be serious conversation about centralized fiscal policy. This may take changes in EU and ECB law, but in the end it will be necessary to avoid another crisis. While we are not on the centralized regulation camp, if the intention is to continue to entertain a single currency and centralized monetary policy, then centralized fiscal policy is in order. Creating a mechanism whereby a central fiscal entity can approve and support an individual nation’s budgetary needs and growth initiatives will restore confidence in the European economic model.

Having a complete handle on the budgetary needs of member nations, a single euro­-bond can be issued at attractive rates. With reduced cost of capital to support fiscal reform, this will give Europe the time it needs to restructure and regroup while putting pro-­growth initiates in place.

We believe that these measures are being taken seriously and the markets are pressing the euro­zone for results. Given the yields for various European countries, credit default spreads and the brutal beating the equity markets are taking, leaders in Europe are under extreme pressure to get something done immediately.

Markets will rally off that news and the coming year will offer enormous returns for those investors that have the courage to start building their positions now.

Joseph S. Kalinowski, CFA