default

The European financial system, like the others, is efficient but is not robust. It makes the most of what it has and runs on a razor edge between efficiency gains for individual agents and horrendous systemic losses. It depends crucially on the performance of its sovereign assets. System survival depends on one hand whether or not counterparties can absorb the necessary haircuts and on the other, whether fundamentals of debtor nations are strong enough to stand on their own. Spain and Italy will have to stand on their own, because when Greece goes, Ireland will most likely go, which will in turn set off a critical mass such that the nation who dictates monetary policy (Germany) will be taking care of its own self.

Last Wednesday we cited from a Reuters report, according to which the last ditch Greek MLEC/CDO rescue operation, would be welcome to S&P and Moody's as "The whole charm of the French model is that it was worked out in a such way that it will be fine with the rating agencies." Because absent a decree of no EOD, the whole thing is pointless. Well, as often turns out, this was yet more wishful thinking on behalf of some bureaucrat, masked as fact. S&P has just come out with the following: "In recent weeks, a number of proposals relating to this  topic have surfaced, and the particulars in some cases are evidently still  in flux. This credit comment looks at the most prominent of the recent proposals, put forward by the Fédération Bancaire Française (FBF) on June 24, 2011, in the context of our criteria for evaluating distressed debt exchanges and similar debt restructurings (see Related Research below). In brief, it is our view that each of the two financing options described in the FBF proposal would likely amount to a default under our criteria" and specifically: "we believe that both options represent (i) a "similar restructuring"
(ii) are "distressed" and (iii) offer "less value than the promise of
the original securities" under our criteria. Consequently, if either
option were implemented in its current form, absent other mitigating
information, we would likely view it as constituting a default under our
criteria." Goodbye MLEC 2 - as expected you were just as useless as your first iteration back in 2007.

A few days ago, when we explained that the current iteration of the European bailout plan is nothing but a repeat of the failed MLEC off-balance sheet plan, which was supposed to prevent the subprime bubble from exploding, we wondered just why Europe has settled on this plan. Now we know: it appears that it was the rating agencies, arguably well-padded with $100 bills to compensate their collective conscience, who suggested that this is the only format of perpetuating the global ponzi without Greece being declared an Event of Dafault. Per Reuters: "The whole charm of the French model is that it was worked out in a such way that it will be fine with the rating agencies." There it is: expect headlines to slowly start leaking from S&P et al that the MLEC part deux will actually not be an Event of Default, and so Europe has the all clear to continue kicking the can down the road for several more years courtesy of money that is literally created out of thin air, and pledged by assets that no longer generate virtually any cash flows.

With mainstream acceptance of my presumptions of the potential of serial sovereign debt defaults, its time to take a more realistic look at how it may happen & the potential consequences.

On the day when the flawed euro experiment will get its first popular pseudo-referendum, it is only logical that prominent euroskeptic Nigel Farage would sound off on how he sees things for Greece, Europe and the currency union, and why he believes the current situation is nothing short of slavery: "Listen to Borges state: "We really believe that many of the current problems result from incomplete integration. In the process of developing monetary union like the United States, which is a fully integrated monetary union, you have obstacles that magnify the problem." What he seems to forget is that final fiscal and monetary union in the US only happened after the then bloodiest war in history, in a country that was already united by language law and customs. It is extraordinary that the IMF is suggesting that this economic crisis is in any way synonymous with what was happening in the US in the 1840s. The only slavery here is of the people to the Eurocrats dream. For without democratic control, we are left with something akin to slavery."

When we said over two weeks ago that the second Greek bailout is Dead On Arrival, we were, as sometimes happens, just a little ahead of the curve. S&P has just confirmed that a "voluntary debt restructuring" would be characterized as an event of default from the rating agency's point of view, which is the most disastrous outcome, as it would impair the collateral held by the ECB and be the true catalyst for a liquidity freeze, while anything ISDA decides on whether Greek CDS is triggered and if a rating agency default is an ISDA determination Event Of Default, is almost completely irrelevant, as discussed in our CDS myth debunking post over the weekend.

Unwelcome crises are part of life. What's unnatural isn't crisis, it's pretending that life should be nothing but a smooth, uninterrupted rise in consumption. Yes, I'm talking about Greece and the EU. The situation is somewhat analogous to finding out your total cholesterol is over 300. Gee, I thought I was eating well, and was in pretty good shape... alas, that was all wishful thinking; normal is 180. At 300, you're at serious risk of long-term health problems
So the European Central Bank injects 120 billion euros of "medicine" to cure you, and a year later your cholesterol readings are 395. Hmm. The "medicine" didn't work; instead, it actively prolonged and deepened the crisis. Humans need time to accept new realities, and to make necessary adjustments. People lose their wealth, they adjust. They lose their successful careers, they adjust. They face health crises, they adjust. This kind of wrenching adjustment is not abnormal, it is utterly normal.

Stagflation Threatens Major Global Economies - Inflation in China at 5.5% and UK at 4.5%. Another fundamental factor supporting gold prices and likely to lead to further gains are the increasing signs of stagflation in major global economies. UK inflation data released this morning shows that inflation remains high at 4.5%. The Bank of England expects inflation to reach 5% later this year prior to falling but the Bank’s credibility is increasingly strained as inflation has now exceeded the BoE’s target of 2% for 34 of the last 40 months. British savers and pensioners are suffering from negative real interest rates and this continues to make gold an attractive diversification from a devaluing pound. There appears to be a gathering “perfect storm” of deepening inflation, slowing economic growth and double dip recessions, stagflation, sovereign debt crisis in many major western economies and the risk of sovereign and banking contagion.

"This Court is mindful of the impact that this decision may have on the mortgage industry in New York, and perhaps the nation... Nonetheless, the law must not yield to expediency and the convenience of lending institutions. Proper procedures must be followed to ensure the reliability of the chain of ownership, to secure the dependable transfer of property, and to assure the enforcement of the rules that govern real property."

In yet another bad omen for Greece, now that Bailout Plan #2 has been demonstrated to be impractical and every question related to it is met at best with silence, it is back to plan B: letting Greece default. And in what is very good news for longs in the Drachma black market (which is already offered on an "when issued" basis by several large financial institutions), the Bundesbank's president Jens Weidmann just announced that “If the [Greek] commitments are not met, that cancels the basis for further funds from the aid package,” Weidmann told the newspaper. “This would be Greece’s decision, and the country then would have to bear the surely dramatic economic consequences of a default. I don’t think this would be sensible, and it would surely put partner countries in a difficult situation. But the euro would even in this case remain stable.” Translation: we now believe our banks are well enough reserved for what comes next. It also means that the rift with the ECB, which will be exposed as near-insolvent courtesy of using Greek collateral for tens of billions of loans that will have to be impaired, is now terminal. As for the far trickier, and now answered, question where the money to withstand this upcoming systemic shock comes from, just read this expose on the Fed's use of QE2 reserves.

Yesterday Reuters reported that a troubling, yet potentially inevitable development may be imminent: the default of the US, granted, a short-lived one (though we are not sure just how the world's "reserve" currency will be backed by a national that is technically insolvent). Luckily for the US, everyone else (except China) is just as bankrupt. Yet if there is one thing pushing Lehman into competitive bankruptcy just so that Goldman would have a monopoly in the US fixed income sales and trading market, it is that any such action will have massive downstream consequences, and in the pyramid of "unpredictable downstream effects", the insolvency of the US is at the very top. And just to make it clear, now that a default is becoming a palpable option, China announced that the United States is "playing with fire" if it opts to briefly default on its debt, which could undermine the dollar, Li Daokui, an adviser to China's central bank said on Wednesday. Yet the statement could very well backfire after Li, speaking on the sidelines of a forum, said China needs to dissuade the United States from defaulting on its debt, but he believed China may hang on to its investment in U.S. Treasuries in any case. This is precisely the case made by Stanley Druckenmiller: in fact, should there be a technical default, US bonds will become a true safe haven investment as America will for the first time take a step to indicate that it believes the relentless abuse of its fiscal situation is coming to an end.

As we speculated yesterday...

• If in Fitch's opinion, an announced exchange offer constitutes a DDE,
  the sovereign issuer rating will be lowered to 'C', indicating that
  default is highly likely in the near term
• Fitch will place the issuer rating of the sovereign into default, specifically 'Restricted Default' (RD) upon closing of a distrssed debt exchange.
• Fitch says a potential Greek debt exchange if voluntary, could still be considered a default event
• Fitch says Greek debt exchange would be a default if bondholders terms were worse than original terms
• Fitch says stressed sovereign debt exchange with worse terms is a technical default even if deemed voluntary

The gist is clear: the great unknown of how the rating agencies will treat even a "voluntary" restructuring is still in the closet.

Is it ethical for the American homeowner whose mortgage has been securitized to default, even If they are not financially distressed? First, consider it is unlikely that marketable, fee simple, insurable title can be obtained as a result of fulfilling the obligations of the related promissory note. On the contrary the titles to some 60 million homes in America are badly clouded. Secondly, encouraging investment in an asset class that has been artificially inflated, then deliberately destroying the price of the asset, as part of a separate profit making scheme is unethical, and any agreement based on this type of fraud is grounds to consider the original debt instrument used in the agreement null and void. Fortunately these grounds are unnecessary, as increasingly US courts are ruling that these mortgages are already invalid for numerous other reasons.

Spot gold and silver prices rose slightly again this morning after hitting a one-month high yesterday as equity markets internationally came under selling pressure. The Moody's downgrade of Greece and worryingly poor US economic data again pushed investors to seek the safe haven of bullion. Gold reached new record nominal highs in sterling yesterday (£945.62/oz) as the pound fell on concerns about the UK economy. The supply situation in the silver market gets more interesting by the day. Registered COMEX silver inventories have fallen to multiyear lows at 29,631,268 ounces. In the last 5 days they fell from 32,132,903 ounces to Tuesday’s holdings of 29,631,268 ounces. As can be seen in the table below registered silver inventories fell every single day last week leading to a sharp fall of 8.4% in 5 days. Registered silver inventories are down a sharp 38.5% in just two weeks – from 41,044,280 to 29,631,268. The possibility of an attempted cornering of the silver market through buying and taking delivery of physical bullion remains real. However it would be very difficult to corner the silver market due to the very small nature of the silver bullion market. A COMEX default remains a risk as does a massive short squeeze which could see silver surge as it did in the 1970s and again recently leading to silver targeting the inflation adjusted record high of $140/oz.

And to think they cut it from 3% to 2.5% just a week ago. Michael Feroli, take it away: "When we revised down our estimate of Q2 GDP growth last week to 2.5% we noted that the risks to this quarter were still to the downside. Given the hard activity data we've received since then -- particularly the auto sales and construction report -- it looks like those downside risks are being realized, and we are lowering our Q2 projection to 2.0%. Even with this revision we'd assess the risks as still a little to the downside. Most of our downward revision in Q2 is located in consumer spending, where we think growth this quarter is tracking close to 1.5%. If our new estimate for Q2 is realized, GDP growth relative to a year-ago would be only 2.4%, implying almost no closing of the output gap over the past year -- an abysmal performance given that the output gap is arguably greater than 5% of potential GDP, or less arguably, that there are still almost 14 million unemployed workers. Our forecast implicitly assumes the debt ceiling issue is resolved in a manner which does not see a technical default of the US Treasury. Of course if that assumption were not to hold all cards would be off the table and we almost certainly have to pencil in a much more severe downgrade to our growth forecast. Our Fed call is unchanged and continues to look for a first hike in 1Q13."