Merkozy's Frankenstein

Via Peter Tchir of TF Market Advisors

Whatever the European experiment once was, it has morphed almost beyond recognition.  The policy responses have made the problem worse, not better, and it is becoming more complex.  The contagion is spreading because every policy is linking the countries more closely, but not in a controlled and thoughtful way but in a haphazard poorly thought out way.

Many banks in Europe would fail without ECB funding, so the ECB funds those banks.  Even more banks would fail if sovereigns fail, so the ECB funds the sovereigns so the banks don't fail.  A Greek default, which may not actually be bad for Greece, was deemed as bad for Europe so they get money from the IMF to pay back the ECB directly and to the banks so that the ECB doesn't have to offer as much direct support.  It is all so circular.  It probably was also unnecessary.  Anyone notice some big write-downs banks are taking on Greek bonds?  The world isn't ending.  The world wouldn't have ended in 2010 either had Greece defaulted or banks negotiated restructurings with Greece with similar haircuts.  The fear of that led to the creation of programs that have spread the contagion and taken the attention of the EU and IMF away from other, even bigger problems.  In hindsight, it is hard to argue that Europe wouldn't have been better off with a Greek default over a year ago.  Bank stocks wouldn't have gotten as low as they are now, and the system would be easier and simpler.

EFSF has gone through forms faster than Lady Gaga goes through costumes at a concert.  At every step, the EFSF has been poorly thought out, and has been an attempt to create a number or vehicle that the street can be happy with. It is clear, without a doubt, that no serious credit structurers or traders were involved in the process.  Not a single iteration has been met with anything more than disdain by people who create these sorts of vehicles for a living.  Why Europe couldn't pause and try and figure out something real, I don't know, but they got hooked on the idea of all members participating (at least on paper headlines), that guarantees weren't real money but were effective, and that the market (China) would beg for a chance to invest in their latest scheme.  These schemes never involved more than a page of ideas when at least a ten page term sheet would be necessary.  Had they ever tried to create an actual term sheet they would have seen the flaws and been able to start from scratch on something that could work.  Instead they plug along, and Regling, goes and asks China for money, in spite of not having a product to offer.

How many EU leaders are necessary?  Can there be a gag order on some of them?  How many are over their heads?  Regling may have been good for the original EFSF, but he seems incredibly out of his element on this.  When did the IIF guys ever speak, and who ever listened?  Not Ackerman, but Dallara? Then there is Juncker and Rehn.  Both clearly benefit from a bigger Euro, but what is their role?  Then you have 17 ministers of finance, and some similar number of ECB board members.  It is a shambles, and way too many people are involved and spread their often poorly formed opinions freely. Not that I'm a fan of task forces or anything, but this haphazard approach of giving everyone a voice and then reacting to how markets react to their comments is ridiculous and is a part of the problem.

In the meantime we are happy that "Unity" governments are being imposed on a couple of countries.  The "technocrats" will save the day.  Unity government sounds like a cult.  How long will the people accept being governed by these "unity" governments that seem to be Merkozy's puppets?  Probably until the next economic downturn or the first austerity measure they don't like is actually enforced.  Berlusconi may have been pushed out, but I think Papandreou left in order to try and avoid being tainted but the outcome of agreeing to taking money to pay back the ECB and EU banks.  The unity governments will agree to anything right now to get money, but the next step in the process is far from clear.

The bull case for the Euro is that the ECB will lower rates to zero and buy all the debt of all the countries.  Yes, zero rates and unlimited printing are the bull case for the Euro.  As far as I can tell, zero rates and unlimited printing are the bear case for the dollar.  I am not saying that the Euro bulls aren't correct, it just seems strange that the same policies would have the opposite impact over the pond.

French bond yields are now the widest relative to Germany ever.  There is outrage that there is an "attack" on French bonds.  Seriously, you don't think Sarkozy's willingness to backstop anything and everything (including Dexia) has had an impact on French bond yields.  The bonds are weak because the economy is getting worse, and the French have shown no willingness to do what it takes to remain a safe haven.  Trying to turn this on speculators is just silly, the French bond problems are a direct result of the French governments actions.  What constitutes an attack must also have changed, since a 2.4% yield for 5 years is not exactly disastrous.  Who knows what 5 year rates will be once the ECB is done printing money to buy all the sovereign debt and then all the debt of banks.  If the inflationists are correct, 2.4%  might be quarterly inflation, not a 5 year bond yield, but I shouldn't say anything negative since "clearly" the policy makers know what they are doing - at least to prop up stocks for a few days, weeks, or maybe even months.  The S&P report that allegedly downgraded France from AAA is interesting.  The French are angry about it, but what no one is saying, is that when the US got downgraded, treasury prices went higher.  French bond prices went lower because the market doesn't believe they are AAA.  The French can complain all they want, but the market doesn't believe in their credit or their ability to support prices; whereas, for US bonds, no one really cares what the rating agencies have to say.  This is a big distinction, and rather than maybe some angry phone calls between cigarette breaks, the French should figure out how much European risk they can really sustain.

Greece should have been allowed to default or restructure over a year ago. They didn't because of fear, and now they are in worse shape, and the various programs dragged down other countries.  While the focus is on Italy right now, Spain is a mess.  Unemployment is high at 21.5%, and McDonald's received 310,000 applications for 2,700 positions (from  The Spanish banks are fighting for deposits.  In spite of government laws trying to prohibit banks from paying high interest to depositors (yes, another example of how convoluted it has become), the banks now offer IOU's rather than deposits. They also offer gifts such a crystal with deposits rather than the toaster (the gift is now a meaningful part of the interest being paid).

I don't know what Europe can do right now, but maybe 2 weeks in seclusion, with gag orders is what is required.  Step back and try and figure out real solutions.  No rhetoric, just real work.  They need to get some people who can focus on details and understand credit markets involved.  They need to focus less on advice from FX and Interest Rate specialists and get some real credit experts involved since it is a credit problem.  The EU should be stopped out.  They should be put in a time out, and not come out until real solutions are decided (and that solution may have some real negative consequences for some institutions).  It won't happen, they will keep trying to deal with this piecemeal and make the problem bigger and more complex.

It reminds me of a time being long a HY homebuilder bond.  That bond was going down in price as the housing market was getting crushed.  I bought some CDS on the name to "cover the position".  But the CDS was already trading extremely wide of the bonds and had support from the "index arb" community, and the biggest holder of the bond was still selling.  The position was losing money, but the idea was to short some forest product bonds.  I mean, if housing is selling off, the lumber companies would have to be in trouble.  Between a weakening dollar and strong EM demand, those bonds kept rising too.  So I decided I should get long some energy names since they should benefit from the same influences as the timber companies. I decided to sell CDS rather than buy bonds, because that seemed prudent against the short CDS in homebuilders.  Of course, a big oil discovery was made, and the bonds dropped, but worse than that, this company had a short term maturity that was now at risk making the CDS particularly weak.

Nothing worked, and the reality is the only smart decision, obvious to most from the start, was to sell the stupid homebuilder bond.  Making things more complex primarily in reaction to previous moves with limited understanding of what you are getting into is a recipe for disaster, and Europe has followed this policy for years now, it is a shame they don't see it before it is too late to fix.


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