Rosenberg Explains What (If Anything) Has Changed

Still confused by the 500 DJIA point rally in 48 hours? You are not alone. Here is David Rosenberg guaranteeing that your confusion will be even greater when you realize that nothing has really changed, suffice to say that the record confusion has provided the best smokescreen for nothing short of a collusive global window dressing session for massively underwater hedge and mutual funds.

So What Changed?

Well, yesterday afternoon there seemed to be a leak to CNBC's economics reporter that something bold was being cooked up to deal with the debt crisis in Euroland without having to resort to 17 different parliaments for approval, using the European Investment Bank (EIB) as the conduit — establishing a Pan-European TARP plan, if you will.


Nothing has been officially announced, but according to a news article published by CNBC here is what this new structure could look like (there are lots of moving parts):

  1. It would involve money from the European Financial Stability Facility (EFSF), a bailout vehicle created in 2010 to alleviate the sovereign debt crisis in Europe, to capitalize a special purpose vehicle that would be created by the EIB, a bank owned by the member states of the European Union.
  2. The special purpose vehicle would issue bonds to investors and use the proceeds to purchase sovereign debt of distressed European states.
  3. This could potentially alleviate the pressure on the distressed states and on the European banks that hold a lot of the distressed sovereign debt. The bonds issued by the special purpose vehicle could then be used as collateral for borrowing from the European Central Bank (ECB), allowing the central bank to make loans to banks faced with liquidity shortages.
  4. They would buy bonds of the special purpose vehicle, and those bonds could be used to access liquidity facilities from the ECB.

Although the structure is complex, the underlying result is relatively simple. Banks would essentially be allowed to exchange their sovereign debt for debt issued by a special purpose vehicle created by the EIB capitalized with funds from the EFSF.


In some ways, this resembles the original plan for the Troubled Asset Relief Program (TARP). As originally conceived, the TARP would have purchased "toxic securities" from banks. (This plan was abandoned when U.S. regulators concluded that it was too difficult to price the securities and that the plan would take too long to implement.) In this case, the "toxic securities" would be sovereign debt rather than mortgage bonds.


One question is whether this will require an expansion of the EFSF. The fund has already committed to providing emergency loans to Ireland, Portugal and Greece. It is expected to provide over 100 million euros ($134.9 million) in additional funding for a Greek bailout.


After those loans, the fund will be down to about 298 billion euros ($402 billion), according to some estimates. German Finance Minister Wolfgang Schaeuble on Monday said that there is no plan to expand the EFSF.


This is likely why the plan appears to make the new vehicle a levered fund, which borrows far more than it has in equity capital provided by European governments.


Now to reiterate — no official plans have been released. Details may change as European officials work on the structure. Based on the limited details available, George Young, who runs our global macro fund, and Michael Isenberg, our resident financials expert who works on our hedge funds, have boiled it down to the conclusion that the banks would get EIB bonds in exchange for PIIGS debt. That would remove the PIIGS debt from their balance sheets. The EIB SPV would be capitalized with the equity injected by EFSF, and debt issued in the market by EIB.


Germany and France are the main guarantors of both the EFSF and the EIB. Therefore, the SPV would be taking on PIIGS debt and the banks would get EIB paper (effectively German/French bonds) in exchange. The PIIGS debt purchased could be up to 1.8 trillion euros — if they take 200 billion in equity from the EFSF and lever it up 9:1 — and would then be owned by the EIB, whose entire capital structure is guaranteed/backstopped by France and Germany. In effect, this is a stealth Euro bond. The weaker European countries' liabilities are being put into a securitized structure, which has a credit guarantee wrap from the stronger European credits. So the new paper issued to the market is a combination of weak credits (via the assets backing the lending) and stronger credit (via the capital structure guarantee). Thereby creating a blending of credit — voila a Eurobond in sheep's clothing. One might think this could impact France and Germany's credit rating.


No doubt the market wants a solution. And it wants massive amounts of money thrown at the problem, regardless of who pays (so long as it's not the banks holding the debt!). But a proposal, as we have seen, is one thing — getting it in place and approved is another. How big is it? How flexible is it? What will it buy? What are the dilution risks for the recipient banks? Is it legal, specifically under the German Constitution? These are all important questions.


Not only that, but it is surreal actually that the markets could rally on a leak to a CNBC economics reporter on a plan that is still bereft of details (classic shoot first, ask questions later ... like the ballyhooed rumour of China stepping into the fray with a bailout package for Europe). So if this leak is true, Europe is going all in with leveraged bets that will water down the credit quality of both France and Germany. So what this means is that there will be no strong fiscal credits left (the euro has to be a gigantic short here) in the region.


If my reading of history is accurate, the experience with SPVs hasn't been so successful. The blown opportunity to let Greece default, ring fence it, and have individual countries support their banks I think would yield much more desirable results, even if painful over the near-term. And there are more complications. So the EIB will take the beaten-up PIIGS bonds off the banks' balance sheets? But at what price? Par? Market? Somewhere in between? The banks don't take a haircut at all on this? And if this is all an attempt to prevent banks from taking a hit, I just can't see how German taxpayers are ever going to be willing to bailout Spanish banks. This all smacks of desperation to me and I think there would be a taxpayer revolt in both Germany and France over it.


Then again, there is always the risk of being too pessimistic. Let's hope this is a game changer for Europe. Then we can at least go back and concentrate on the data and recall that the peak in the S&P 500 took place right after the market digested that weak Q1 GDP report and all the revisions to the downside. The data yesterday were ignored but the trio of Chicago Fed index, new home sales and Dallas Fed index was very worrying. I sense that the downward revisions to EPS are going to accelerate. I also believe we are staring a recession in the face and one that will be very difficult to emerge from seeing as what little policy bullets are left in the chamber, both monetary and fiscal, after so much was expended to deliver the weakest recovery of all time. Just contemplate that 295k new home sales number for August — not that the latest data-point has sagged to a six-month low as much as it is 25% lower now than it was in June 2009, at the very lowest point of that massive recession. If that is not cause for pause, I'm not sure what is.


As for the whippy rally we saw yesterday (and the follow-through today), let's not forget other facts on the ground:

  • The Fed just told us that downside risks to the macro outlook are "significant". Since we are coming off roughly flat economic growth in the first half of the year, it would seem as though contraction at some point soon cannot be ruled out. Very few asset classes are priced for that prospect, though credit and raw materials stocks along with financials have come a very long way.
  • Volume actually dropped on the NYSE yesterday, despite the price gain.
  • New 52-week lows still outnumbered fresh highs.
  • The 50-day and 100-day trendlines are in confirmed correction patterns.
  • The market had a chance to break out through the upside of the recent range and failed; stocks that looked set to lead the advance have faltered badly. Only "policy pronouncements" as the S&P 500 trades down to the low end has prevented a more serious correction from taking hold, at least for now.
  • The number of leading stocks that saw higher volume in yesterday's action was few and far between.

From a macro standpoint, what is undermining the U.S. outlook much more than what is happening in Europe is the increasingly uncertain and complicated policy outlook, whether it pertains to health care, financial reform, and of course, fiscal policy. Nobody knows just how austerity in the near future is going to affect them in the pocketbook, and remember all of the Bush tax cuts also terminate in 2013. That alone will drain GDP by roughly two percentage points.


Basic economic theory posits that as households and businesses become more uncertain about the future, the more they save from their after-tax incomes — and a rising savings rate in the private sector at a time of belt-tightening in the public sector is not the prescription for growth, unless somehow exports emerge as a critical safety valve. For sure, if there is one development that does seem encouraging, it is that there is something of a manufacturing renaissance taking hold, but the effects on the overall economy are going to pale next to the round of consumer retrenchment we are likely to see in coming quarters and years.


Let's hope China's 5-year plan to swing its economy away from export dependency to consumerism happens quickly and orderly, because producers in the U.S. are going to need that impetus (and we would have to add that Beijing's strategy of allowing the yuan to strengthen even with all these global jitters is an encouraging sign in this regard).

Source: David Rosenberg of Gluskin Sheff