Credit Watch, November 15 – A General Bankruptcy


As we noted in 'The Merkel-Sarkozy Plan' – the fact that these two mentioned the possibility of future debt restructurings for insolvent euro area nations would provoke – as a presumably unintended consequence – a sizable market reaction. That has indeed happened – yields on the debt of the PIIGS soared for thirteen straight days, in what is probably best described as a 'no bid' market. We doubt Merkel and Sarkozy really considered the effect their public mutterings would have on the markets (they are famously insensitive to financial market psychology) – and not surprisingly, ECB chairman Trichet has voiced his displeasure over the debate. After all, the ECB will now feel compelled to monetize even more of this shaky debt – something it would rather avoid.


A good summary of the situation with excerpts from reports in the financial media on the latest rout in PIIGS debt can be found at Mish's site.

Don't get us wrong – we certainly agree with the idea of debt restructurings as such. Bailing out all and sundry with the lame argument that we'd be worse off if we didn't do it must come to an end – the buck must stop somewhere.

After all, the real economic losses brought about the bubble and its inevitable collapse can not be avoided by bailouts. All that happens is that people who had nothing to do with incurring these losses are forced to pay for them against their will – in short, it is a political decision that determines on whom the losses shall fall, in defiance of a market-based outcome.

That this is a bad idea should be obvious; and it is not, as some of the more rabid interventionists claim, merely an issue of 'morality'. It is also about letting market processes work the way they should. There can be no functioning market if the possibility of failure is suspended. Shareholders and bondholders of big banks – the institutions at the heart of the crisis that has now caught up with the sovereigns at the euro-area's periphery – willingly took a risk. No-one forced them to invest in these securities. They may well have done so with the expectation that in case anything went wrong, they would be bailed out, but we don't recall that any guarantees to this effect were ever in place.

Fostering such expectations, i.e. fostering what is known as 'moral hazard' , can only serve to severely distort economic decision making. In fact, this very moral hazard is one of the things at the root of the crisis. Banks would not have taken the risks they took had they not expected to be backed by central banks and governments in the event of their speculations going wrong. This in turn has no doubt influenced the decisions of the people investing in their capital structure.

Similar arguments can be considered in the context of sovereign debt as such (this is to say, without considering the connection to the banking crisis). Generally this type of debt is considered as the 'least risky' , based on the taxation monopoly of nation states. In addition, if a nation prints its own currency, it need in theory never default directly – it could also choose to default indirectly by inflating its currency into worthlessness (this seems to be the 'chartalist' solution propagated by people like Warren Mosler). Investors in US treasury bonds rely heavily on this fact; they expect to be able to sell in time should inflation expectations suddenly rise strongly. They certainly do not expect a direct default, given the Fed's unlimited power to create money from thin air.

In the euro-area's peripheral nations, the situation is slightly different. Let us first look at what is not different. Politicians everywhere in Western democracies – in all regions with the power of taxation (this includes states in federal unions, such as the states comprising the US that raise their own taxes) – have a tendency to use booms to vastly expand government spending. Anyone who cares to look at a few statistics can ascertain this. The political promises that buy votes are costly. As H.L. Mencken noted, 'every election is an advance auction of stolen goods'.

Some nations have created truly astonishing extremes in terms of accruing liabilities that they will never be able to pay (at least not in money that has the same value as today's). Ultimately even those that are still seen as paragons of fiscal virtue today will have to face the 'unfunded liabilities' demon. Including these liabilities in the debt calculation shows that the entire Western world is essentially bankrupt.



A chart by Dylan Grice of Societe Generale – if unfunded liabilities are included in the calculation of the debt of Western democracies, a picture of insolvency emerges.



The Boom, the Bust and the Bazooka

During the easy money boom, major asset bubbles developed in the euro area's periphery. This should not have surprised anyone. Back when the PIIGS still had their own national currencies, they were devalued regularly as a matter of course. Their sovereign debt always sported a large inflation premium as a result. No-one ever expected to see Greek bond yields approaching German ones. And yet, this is what happened when the euro was introduced. Yields converged, without a change in the underlying fundamental realities.

All the new entrants needed to do was pretend for a little while that their fiscal situation had improved – against all odds – to fulfill the criteria of the 'Stability Pact'. Once the boom began, they were able to continue this pretense, while ramping up their spending to fresh heights.

An inflationary boom allows a lot of mistakes to be covered up by creating unsustainable (if not to say fictional) accounting profits – these in turn lead to unsustainable tax revenue increases for governments, which then form the basis of enormous new spending.

Investors in the bonds of small nations at the euro-area's periphery should have been aware what kind of risk the boom created for their debt. While it could be argued that Greece actually deceived bondholders by falsifying its accounts, it should nonetheless have been clear that once the asset bubble reversed, all euro area governments would find themselves in the soup deficit-wise.

Since the biggest booms occurred in those nations for which the ECB's administered interest rates were especially low, it was foreseeable that they would suffer the greatest relative damage. Apparently bond investors nonchalantly overlooked that given a supranational, nominally independent central bank, these governments were deprived of the usual 'standard solution' to escape the ravages of the bust, namely currency devaluation and 'inflating away' the debt.

However, bondholders once again correctly perceived that once push came to shove, the rule book would simply be thrown out of the window and be replaced by ad hoc bailouts. And so it was, as the institution of the EU/IMF bailout fund proved. As readers may recall, the EU commission simply made use of a paragraph in the treaty that was supposed to regulate emergency aid in the case of natural disasters like earthquakes, volcano eruptions and asteroid strikes; in keeping with the Keynesian view, economic busts are now seemingly regarded as 'accidents of nature'.

Alas, some politicians can apparently count beyond three (or in this particular case, beyond € 750 billion). Among those we find the newly austere Mrs. Merkel, chancellor of Germany, a.k.a. the 'EU's paymaster'. The EU/IMF bailout fund represents an arrangement resembling John Paulson's infamous 'bazooka'. Once it is brandished, markets will do whatever it takes to get it fired.

Conceivably, the fund could arrest the deterioration in the situation of the smallest nations (i.e., aside from Greece, Portugal and Ireland). The problem is that contagion is already infecting Spain and that the markets will no doubt begin to focus on it should Ireland and Portugal accept help from the bailout fund.

As we have noted in previous missives, a default/bailout of Spain would come perilously close to the fat lady singing. The real danger though is presented by the second 'I' in the 'PIIGS' acronym – Italy. Now, Italy has a considerable advantage in the form of large private sector savings. Nonetheless the government is drowning in debt (not a new situation, to be sure), and it is likewise deprived of the 'devaluation option', which it used to pursue with great zest in the decades prior to adopting the common currency.

We are not predicting a widening of the crisis to this extent – we are merely saying it appears possible. What is already clear is that no easy solution is in sight for either Greece, Portugal or Ireland. Ireland has no further rollover risk prior to the spring, but as we mentioned previously, it would already make commercial sense for it to apply for a bailout, based on putative interest cost savings alone.

As for Portugal and Greece, their respective situations seem to be getting worse by the day. In this context note that Portugal's foreign minister Louis Amado muses about a possible 'exit from the euro', while Greece, after admitting that its budget deficit estimates were still too low (we have by now lost count of the revisions), is talking about 'extending its loan repayment schedule'.

Note also that in a case of 'Friday panic' , EU leaders attempted to reassure Irish bondholders once again. As a result, PIIGS bonds rebounded on Friday after 13 days of losses, but the fact remains that the fundamental problems continue to fester. It will become increasingly difficult to keep markets in check with mere statements – especially when the statements are often contradictory.

The charts below show the situation in CDS and euro basis swaps as of Thursday, the high point of the recent panic move. We will post new updates as soon as practicable and depending on whether any noteworthy new moves happen. As we have been expecting for many months (not that that was a really difficult forecast to make), the Markit SovX has broken decisively into new high ground after consolidating in a wide sideways move since the initial crisis high in euro area sovereign CDS spreads. From a technical perspective we have clearly entered a new phase of the simmering crisis – it has become acute once again.



1.   CDS



5 yr. CDS spreads on Ireland's sovereign debt, and the senior debt of Anglo Irish Bank and Bank of Ireland – sprinting to new highs. Below, CDS on Japan's sovereign debt, which continue to drift lower. Prices in basis points, color-coded.



5-year CDS spreads on the debt of the remaining PIGS (Portugal, Italy, Greece, Spain). Portugal and Spain are both in traders' cross-hairs, with the former sprinting to new crisis wides.



5 year CDS on Romania, Hungary, Austria and Belgium. This has hardly been remarked upon in the financial press, but the biggest contagion effect outside of the PIIGS themselves is now visible in CDS spreads on Belgium's debt. Belgium is in a difficult fiscal and political situation (its debt is huge and a split of the country into its Flamish and French-speaking halves is always in the air), and should be watched closely.


The Markit SovX generic index of CDS spreads on the debt of 19 Western European sovereigns – the breakout is in.


2. Euro Basis Swaps


3 month euro basis swap – after ignoring the deterioration in sovereign debt on the periphery for a while, these are widening again. Generally when these swaps turn more negative, it is a sign of stresses in the euro-area banking system rising, specifically w.r.t. the funding of dollar liabilities.



1 year euro basis swap – a similar picture. Widening again in a hurry.



The 5 year shows the least movement, but is also deteriorating again.



3.   Australian bank CDS

Lastly, given the increasing evidence of Australia's property bubble experiencing difficulties, we are taking a look at CDS spreads on the 'Big Four' (i.e. the four big, systemically important Australian banks) again. So far these spreads are tame compared to their previous highs, but clearly they have begun to rise. Given the dependence of the Australian banks on offshore funding, any grave troubles in the mortgage credit and housing bubble there is likely to quickly deteriorate into a banking crisis. We will continue to keep an eye on developments in this space.



5 year CDS spreads on Australian banks – still tame, alas, that could change in a hurry. The recent renewed tightening of Chinese monetary policy and the continued tightening in Australia's own administered interest rates bodes ill for the country's enormous housing and mortgage credit bubble. A crisis seems unavoidable at some point.



Charts by: Bloomberg



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2 Responses to “The Dominoes Are Toppling”

  • I have been wondering who is going to bail out the bail out. The TARP and the stimulus put the United States on the road to hell. The US can no longer inflate consumer debt through higher home prices and expanding consumer credit, which was financed out of home equity. The US has been inflating the world for 65 years, since Breton Woods was formed. Jacques Rueff warned repeatedly that the United State was creating another depression with the free accumulation of dollar debt around the world. Viet Nam and the Great Society made a solution a hopeless case.

    A short of Japanese bonds would be a home run trade, as there is almost no upside price possibilities from the current low rates, but I would venture hedging yen would be a real headache.

    • This is probably the central problem – at some point, the whole thing will become ‘too big to bail’. Once the market’s concerns move from the periphery to the center, it is all over but the shouting.
      As to JGB’s, I agree that one of these days this should be an excellent market to short. At present it is still easy to hedge the yen. Apart from yen futures and options, there are even exchange traded funds available for yen hedging purposes, so even individual traders can fairly easily take a position in yen. The advantage of all these listed products is that counterparty risk is really very small, so one can safely ignore that particular issue. Should we ever suffer a financial crisis big enough that even the clearing houses go under, then there probably wouldn’t be much of a financial system left anyway.
      Note however in the JGB/yen context that up until recently, the BoJ has had the least inflationary policy of the major central banks, which explains the yen’s strength. So one needs to keep an eye on whether that appears to be changing (as it one day no doubt will, given Japan’s huge deficit and mounting fiscal pressures).

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