Sunday, September 11, 2011

To Be or Not To Be.

The markets are betting that Greece will default anytime now. The one year Greek bond yield is at 91%!

 If anyone is expecting a different outcome, then s/he is living in denial.  The debt to GDP ratio is well over 140% now and Greece is well behind all projections of deficit reduction. What else would you expect? Even in the best of times, the tax collection system in Greece was a joke. Now, with austerity, the GDP has gone down further and the tax collection along with it.

There is a general air of acceptance of the inevitable about the Greek default and with that, the non-PIIGS countries are trying to shore up their banks and insurance companies, which will have severe haircut, from 50% to 90% on their sovereign bond holdings and contagion effect. So now Germany is putting money in its financial institutions instead of putting in more money in the black hole that is Greece.

Last week, UBS published a research report on how solving the Euro problem will be expensive but not solving it will be even more expensive. For whatever it is worth, such a report should be taken with a large pinch of salt because if the Euro goes, UBS also goes under. Their conclusion, save Euro whatever the cost otherwise there will be war. It seems Paulson has found his match in Europe.

The European Union has only two choices:
1. Either save the Euro at the cost of the Sovereigns
2. Or, Save the Sovereigns and destroy the Euro in its present form.
But sometimes things do not go as planned and so it might be that both the Euro and the Sovereigns are destroyed.

Let us analyze the options.

The Euro at its current form can be saved only if Germany and other rich North European countries continue to provide unlimited funding and guarantees for the debts of the PIIGS countries. The public opinion and the political maneuver room is becoming narrower for this option.  They cannot force Greece out of the union. Only way possible is for Greece to leave voluntarily.  But Greece will not leave voluntarily because going forward; nobody will touch their new "Drachma". Apart from showing their ruins to the tourists, Greece does not have much to sell to earn money.  They import 70% of their energy, so energy cost will be prohibitive. Food will be so expensive that it will cause street riots. Banking will be dead. Business will suffer and unemployment will be sky high.  So Greece will continue to drain the Euro and suck Germany dry.

But how long before Germany says enough? If Germany is to leave Euro, its new "Mark" will be expensive like Swiss Franc. That will surely hurt the export driven economy of Germany. In addition, they will lose market access to the rest of the Europe. German banks that have lent money to other European countries, will be massive losers and will need Government bailouts.

In the first scenario, ECB will have to print money like the FED to continue to buy bonds of the PIIGS countries and that is not acceptable to Germany. In the second scenario, there will be huge disruption of trade and commerce and a depression is sure to follow.

In fact a depression is sure to follow in either way. The G7 countries are trying to solve the problem by injecting more liquidity. That serves to prop up the sick banks and financial institutions at the cost of the ordinary voters. And sooner or later, voters will respond with their boot. In worst case, with blood on the road. How far the political class will go to save the oligarchy is the moot question.

From John Hussman of Hussman Fund: “The global economy is at a crossroad that demands a decision - whom will our leaders defend? One choice is to defend bondholders - existing owners of mismanaged banks, unserviceable peripheral European debt, and lenders who misallocated capital by reaching for yield and fees by making mortgage loans to anyone with a pulse. Defending bondholders will require forced austerity in government spending of already depressed economies, continued monetary distortions, and the use of public funds to recapitalize poor stewards of capital. It will do nothing for job creation, foreclosure reduction, or economic recovery.
The alternative is to defend the public by focusing on the reduction of unserviceable debt burdens by restructuring mortgages and peripheral sovereign debt, recognizing that most financial institutions have more than enough shareholder capital and debt to their own bondholders to absorb losses without hurting customers or counterparties - but also recognizing that properly restructuring debt will wipe out many existing holders of mismanaged financials and will require a transfer of ownership and recapitalization by better stewards. That alternative also requires fiscal policy that couples the willingness to accept larger deficits in the near term with significant changes in the trajectory of long-term spending.”
More from Mr. Hussman: ” Presently, the global economy is in a low-level Nash equilibrium where consumers are reluctant to spend because corporations are reluctant to hire; while corporations are reluctant to hire because consumers are reluctant to spend. Unfortunately, simply offering consumers some tax relief, or trying to create hiring incentives in a vacuum, will not change this equilibrium because it does not address the underlying problem. Consumers are reluctant to spend because they continue to be overburdened by debt, with a significant proportion of mortgages underwater, fiscal policy that leans toward austerity, and monetary policy that distorts financial markets in a way that encourages further misallocation of capital while at the same time starving savers of any interest earnings at all.
We cannot simply shift to a high-level equilibrium (consumers spend because employers hire, employers hire because consumers spend) until the balance sheet problem is addressed. This requires debt restructuring and mortgage restructuring (see Recession Warning and the Proper Policy Response ). While there are certainly strategies (such as property appreciation rights) that can coordinate restructuring without public subsidies, large-scale restructuring will not be painless, and may result in market turbulence and self-serving cries from the financial sector about "global financial meltdown." But keep in mind that the global equity markets can lose $4-8 trillion of market value during a normal bear market. To believe that bondholders simply cannot be allowed to sustain losses is an absurdity. Debt restructuring is the best remaining option to treat a spreading cancer. Other choices are fatal.”
You can read the entire article here:

The smart money of Europe know that the situation is dire and money is leaving the shores of Europe like never before. In fact the Banks in the USA are now charging interest to accept short term deposit. That is why yield of 10 year US Notes are falling to ridiculous level. What do they know that we are missing?

Even if the USA  can manage to muddle through, events in Europe will surely push US and global economy in recession or worst still, in depression.  In short term, we can expect the weakness in the US markets to continue till October.  May be a tradable bottom will be available around Sept. 21st when the FED is expected to come out with QE3. As I continue to say, the world governments are better prepared than they were in 2008, but even then their hands are tied behind their back with the massive debt level.  There will be one last push up before the melt down. I do not believe that we shall see the S&P 500 below 1000 in 2011 but the fair value of SPX is around  400 to 600. That will be reached during the coming balance sheet contraction. May be it is time to listen to Napier again.