Geithner and Zombie Banks
September 19, 2011
Good morning. The market was strong every day last week, closing up 4.8% on the week at 121.52. So far in September, historically the weakest month for the market, we have seen the market down strong 3 days, up big one, down 2, and now up 5, all for a net loss of 70 cents in the SPY. Last week’s strong market caused the VIX to drop 19.7% to 30.98, the lowest close since August 3, 2011. Why the sudden optimism, or at least the semi-disappearance of fear in the market (as defined by the VIX Index)? The economic numbers of the week were surely not all that bullish, in fact quite the opposite. Just last Thursday they showed economic activity in the east (Empire State Survey) down strong yet again, the CPI stronger than predicted (or wanted at .4%), and Jobless Claims higher again at 428 K. So why the optimism? For one, on a technical level, the market (as defined by the S&P Futures), failed to break down through the 1136-1140 level despite repeated attempts. There was also a change in tone in Europe (maybe temporary), as Germany and France declared again that Greece would remain a member of the European Union. In addition, there was to be a big meeting, attended by U.S. Treasury Secretary Tim Geithner, and the predicted result would be a coordinated injection of dollars to the European Banks (maybe along the lines of the huge injections of money here in the U.S.).
Is that a positive thing? The jury still appears to be out on that policy here, but it sure seems like Geithner is sold enough on its merits to export it. I, for one, have a real problem with it; the incredible bloating of the system with money to save the few, regardless of whatever unintended consequences might befall the many. I have even more of a problem with this strategy when the few are European Banks.
I know I covered some of this last week, but since we (the U.S.) are now sending our Treasury Secretary Tim Geithner to Europe to become part of (meaning invest our money in ) the solution I think it might be beneficial to go further. We need to understand from a base level what, in fact, is happening in a country like Greece, and who the potential players (winners and losers) might be. It is really not unlike what is happening monetarily in a lot of the states here, although the politics and historical ties are surely different. Greece has historically been a country that has not been as fiscally conscious (in terms of tax collection, rates, ongoing benefits, etc.) as maybe some of the countries in Europe. Anyone investing in Greek sovereign debt has traditionally received (premium varied) a better rate than investing in, say, Germany. Traditionally, in Europe, a lot of the purchasers of this debt were Banks, as European Banks have “owned” a lot more equities and private and sovereign debt on their balance sheets than American Banks (maybe less so in recent years). So as the economic growth around the world slowed to a stop, those affected the earliest were naturally those most fiscally challenged to begin with, like Greece. This does not happen in a day, however, and gradually the “price” of this Greek debt has eroded as people believe the chance of being paid the interest and/or principal going forward goes down.
So now, if the particular bond is selling for, say, 40 cents on the dollar, the effective “return” to someone buying it for that price might be two and a half times the original “rate” or more (if a 100 year bond has a coupon of 6%, and you can somehow buy it for 50% of value, the return to you is 12%, assuming they pay). By now it is almost impossible to figure out, since there is an active secondary market for these securities, whether somone is an original investor, a “recent” investor, a so-called “bottom feeder, or whoever. The only thing that is for sure is that now the issuer, in this case Greece, has probably reached the stage where paying all the interest and the principal (at least on time) is not going to happen. This happens all the time, businesses and people can’t pay (for legitimate and other reasons) and there are mechanisms in place to mitigate the situation (bankruptcy being one). Right now, if Greece were to say that “We can only pay 60 cents on the dollar, but we have raised taxes, cut costs, etc. and once we have done this we should be good going forward,” the world would adjust, in part because it already has adjusted. The original investors, banks and otherwise, may have already sold out and “taken” their losses, or in any case should be “valuing” these investments at the now market prices. It appears, however, that is some cases that has not happened, and the machinations of the rest of the ECB to “save” Greece is really an act to prevent these current holders from higher prices from “losing” what they already, in effect, have lost. Many people in the financial press have opined in the last few weeks that many European Banks cannot stand (equity wise) the “mark downs” that would occur if Greece defaulted (maybe combined with Spain or someone else). All that means is that they are still holding the value higher on their balance sheet and have just not marked them to market. If that is the case the capital problems are already there, it is just not being addressed as such in the hope of a last minute miracle.
As for those who are buyers of this debt at 40% of value, or 25% of value, any potential bailout from the outside means a huge windfall on the price they have paid. So, for instance, if Germany, or France, or now it might appear the U.S., were to get involved with this “save” they would be essentially using taxpayer money (yes, chumps like us again) to run funds through Greece back through to the “holders” of this debt, many of which would be locking in massive profits it the debt were even close to being paid in full. It is interesting that some of the European governments, notably Germany and France, have been “supporting” the Greek sovereign debt market by buying the debt on the open market at reduced prices. So they themselves are also in position (as policy makers) to benefit (show a profit) if a bailout were to happen, even with taxpayer money from another government “pot.” I know this is somewhat twisted, and maybe it is by design, but think of the U.S. government bailing out Citi two years ago. In that case the government bought stock in Citi, gave them incredible benefits (cheap borrowing and the ability to pay virtually zero on deposits) so they were able to save themselves and actually see appreciation on the stock the government bought. The government then sold the stock at a profit, and will say made money on the whole deal, but not count at all the value of the “cheap” money “we” gave them or the “cost” to the rest of us of zero interest on our deposits. Europe, with Geithner’s help, is trying to think up something similar. Think also, but I will not go into it here, the probable magnitude of Credit Default Swaps (essentially insurance sold on Greek debt) outstanding that also could also cause a problem if a default were to take place. Are we going to bail them as well, or some of them like in the AIG situation?
I actually think the inclusion of Tim Geithner in the decision process for the European Leaders adds a sinister connotation. I think they, and to some extent we, will end up with some huge mess of a policy like we have here. They will inject huge amounts of cash into the Banking system, so they can “weather the storm capital-wise,” they will “restructure” the Greek debt in what will be called a technical default, but not enough to trip the caveats of most of the Credit Default Swaps. That leaves the Banks in a position, like here, of paying virtually no cost of deposits so the current income should skyrocket. The attempt to inflate the system will be an obvious attempt, like here, to eventually repay all those shaky loans with lessened dollars or euros. I think Tim Geithner thinks this type of solution is brilliant, and worth whatever price others may have to pay.
What do we think? Well, the last time excessive monetary stimulus caused high inflation, roughly the late 70’s to early 80’s, large sections of the population were largely unaffected and did not lose economic ground. Most can remember that when the inflation rate reached 11% or so, you as a depositor or investor in risk free paper (like U.S. Treasuries) were compensated by interest rates over that amount. Banks and Treasury rates were higher than the inflation rate, so those with cash balances at least kept pace. CD rates for the average investor reached the 16% number. Workers had cost of living adjustments written into contracts, so wages (for many but not all) kept pace as well. Now, however, that is not he case. Deposit rates (zero to 2%) are not close to keeping pace with increasing inflation (even the lame numbers the government gives us), as last weeks CPI represented a 3.8% increase year over year. There is also no way the average worker saw an average 3.8% raise last year, and the Census Bureau last week reported the average worker last year again lost ground to inflation.
So what do we do? Mr. Geithner, just let Greeks default. Let them pay out whatever they can, get their act together going forward, and go forward. The Banks that are in trouble, they already are in trouble, tell them to get some more chumps to give their lousy leadership (the people you protect at all costs) more money to lose or go out of business. Someone will take their place, and it is about time. Put the zombie Bank in government receivership, fire all the idiots that were supposed to be watching, cancel whatever pension they think they have coming, sell off the pieces, and start over. We can handle it. The sellers of Credit Default Swaps, if they can’t pay those who they sold them to, get yourself to Bankruptcy Court where you can pay out what you do have, and you get fired as well. Those that bought Credit Default Swaps from institutions now broke; next time know better who you bet with and don’t expect the rest of us to cover their shortfall. I might feel bad for you, but I can’t help you. What I think our illustrious leaders need to understand is that it is not just the money; it is the lack of morality in both the mess and the solutions that is tearing this society apart. It is not an option for the person without a raise (or job), who is losing his or her house, to come up with one dime to save some ass that sold a Credit Default Swap on Greek debt and now can’t pay. I don’t care about saving the “system,” morally it can’t happen, and if this administration does not see that they should leave before they are thrown out. At some point someone needs to have a moral compass other than the one pointing towards the next (or last) contribution.
So how do we trade it? Again, given the risks of this sovereign debt mess spreading and some sort of domino effect brought on by Banks in trouble possibly happening I think everyone needs to have some protection in place that keeps every portfolio’s total risk within the proper range. In fact, the situation could present itself that the wild volatility within a defined range causes profits to be made on just the regular adjustments of a hedged position. For instance, if a client were to buy a stock at $100 and buy the 100 put for, say, $10, he would have bought the right to sell the stock until expiration for $100. In this case his total risk (ignoring commission) would be $10 (sell the stock at $100, but paid $10 for that right). If the stock were to plummet down to, say, $90, the person might want to “adjust” that protection. Maybe he can buy the $90 put for $9 and sell the $100 put for $15. He now has a possible loss of $14, but if the stock were to go back to $100 he may again be able to buy the $100 put for $10 ($5 gain on the adjustment) and sell the $90 put for $6 (losing $3 on that adjustment). In this case the stock is now unchanged but he has made $2 on the adjustment. In some stocks or indices this has happened several times in the last few months, and some money has been made on these routine adjustments. Again, we are staying protected and trading within the protection. As for the discretionary trades, looking to take advantage of volatility differences, it has been a difficult time. Execution in some stocks has been uneven, and it is difficult to find a predicted volatility that we might trust. I think we need to be aware that a big influx of dollars in Europe might cause the market to go up like the initial stages of QEII, even if the effect might only be temporary.