Greece, China and the Animal House Senate Hearings

* Greece – by virtue of the rout in the market for Greek bonds this morning, the situation in Greece is nearing a head. Yields on some short dated paper has hit 25%, while 2 year Greek debt was trading at a 78.5, for an 18.5% yield, up 3.2% on the day. (Subsequently, the 2 year rate has dropped to 16%). Yesterday, S&P downgraded Greece’s sovereign debt to a junk rating. This will cause many investors to sell Greek debt, because many of them can only own investment grade rated debt, and most investment guidelines takes the lowest of the ratings as a guide to what a portfolio can own. Ratings on Greek debt are also critical to the ECB’s lending facility, which accepts investment grade rated debt for loans to financial institutions, including Greek banks. However, all the ECB requires is that one rating be investment grade, so while Fitch remains at BBB- and Moodys does not down-grade their A3 rating below junk, (Moodys has Greek debt on its downgrade watch-list), then the ECB will continue to lend against Greek government debt. Even if Greek debt gets downgraded to junk by all three ratings agencies, the ECB might still take their debt as collateral for loans.


The IMF is already starting to blink, with a story which started circulating yesterday afternoon, that they will double their contribution to the Greek lending line from 10 billion Euros to 20 billion Euros. My guess is that Greece will avoid a default on their May 19th debt maturity for 8 billion Euros. The entire Greek government debt market, on average, trades below an 80 dollar price, with some of the longer dated debt in the 60s. I like buying Greek debt here, only because I believe the EU and the IMF will actually fund Greece’s debt needs over the course of 2010, and the short dated paper will do much better.


This leads me to a more macro discussion of the proliferation of debt on a global context. They system has been built on a presumption that the debt will be re-paid, when in fact, a decent share of this debt was created and taken on by entities who do not have the financial wherewithal to service the debt. This has been the case for a good share of the US housing market debt, and hundreds of domestic banks. Greece represents another $300 billion of over-extended borrowers, which is far in excess of their GDP (130%). How does a country make itself whole, to the point where it has enough income to service and pay down the debt? Clearly, the plan for Greece is to solve its problems through austerity measures. This is the opposite to the plan which the countries which can print money or issue debt are doing. The US, in contrast, will have run a 3 year deficit of over $4 trillion, by the end of 2011. The bottom line is that even though Greece will institute austerity measures, they will not have enough growth in their economy to service and ultimately repay the debt. 


The Greek rescue plan is analogous to the many failed government programs to save the US housing market. The Greek plan is no different than a loan restructuring, in which the interest and principal which is owed is added back to the end of the payment waterfall. The debt is still there, and in fact is even greater, even if the borrower does not have to make good on its obligations over the short term. The three years of loans which Greece will get from the EU and the IMF will be at an interest rate which is below what the market will charge them. This is analogous to a mortgage loan rate modification. But what we are learning from the US mortgage experience is that the borrowers also need principal reduction in order to ever be able to pay off their debts. If Greece was not part of the EU, and with their own currency, at this point, Greece would just devalue their currency, and de-facto, would achieve principal reduction right away. Instead the charade of a cohesive EU will continue for some time to come. Nonetheless, what Greece will be going through will hurt their economy, and there is no way this plan will succeed. This is just another example how our governments are kicking the can down the road. This is deflationary.


* More on China: I went back to the PBC’s website, and have determined that the Central Bank has grown its balance sheet by a multiple of 6.3 times, over the last 10 years. This amounts to a 20% annualized growth rate.  How can that not result in inflation. In dollar terms, the PBC balance sheet has grown by a multiple of 7.75, for an annualized exchange rate of 23%. 


As a followup to yesterday’s piece, a reader writes in with the following question:


“Great color on China, Rick. Question: When China’s bubble bursts, what affect will that have on commodities? Wouldn’t that drive down commodity prices as their demand falls off cliff?”


Yes, anytime a bubble bursts, it takes spending power away from those who were borrowing too much money, and are defaulting on their debt, as well as away from those businesses who the defaulters patronize. In turn, that will reduce the demand for commodities and anything else which the economy consumes. However, the interesting thing to sort out is to figure out when the bubble will burst, and what will the Chinese government do to counteract the effects of a bursting bubble. For starters, if the bubble does not burst for a couple of years, then oil will have plenty of chances to take out its 2008 high of $147 a barrel, and might deflate from much higher levels, to a level still above today’s prices.  And when the bubble bursts, China, with $2.6 trillion of foreign currency reserves, will have lots of fire-power to keep the show rolling along. However, the casualty will be the US, since China will be selling US debt to keep their economy rolling. In turn, US rates will come under pressure, and that will hasten phase two of what will then be known as the Great Depression 2.


I think this reader is hitting on a key point, and that is that there will be deflationary pressures in the economy on the back end of the cycle of bursting bubbles, whether it is the US housing market, Greece or the upcoming Chinese Real Estate bubble. The real question is how much will our governments debase our currency in the process, with the counter-vailing influence of inflation. This is where gold, an alternative currency will gain in value and prominance. You have heard it here many times, just thought I’d drop that in right here. 


* A skewering on Capitol Hill – Did you catch the grilling of Goldman Sach’s executives by the Senate committee yesterday? I did not catch all of it, but I did catch quite a few hours, and it was quite a show. For those who missed it, it was quite a spectacle. (see link below). The array of Senators pounded the Goldman executives on their role in the creation of a synthetic CDO, and their role in the trading of such. The Senators pounded Goldman with ambiguous questions which displayed the Senator’s ignorance as to the workings of a Wall Street Investment Bank. At the heart of the Senator’s ignorance was their contention that in order for Goldman to take a short position in a security or derivative, it meant that they were betting against the success of the security or derivative. For those of us in the business, we understand that these markets are akin to one big card game, with traders passing securities/derivatives around at a furious clip, setting prices for these securities/derivatives along the way. The presumption of players in the CDO business, which represents the most sophisticated types of instruments ever created, is that you really need to know what is going on in order to enter the casino. The Senators were treating Goldman as if they were selling toxic assets to Joe the Plumber from Iowa. To this end, my question is who was watching the brokers when they sold FNMA and FHLMC stock three months before they collapsed in May of 2008. 


The Senators had no appreciation that when a firm is running a trading book, that they are constantly taking long and short positions, and that the traders do not advertise what their net position is. And even if they did, whatever they reveal about their current position could change by the hour, day or week. And for those who missed it, the Senators tried to skewer Goldman Sachs for making trades which stood to gain from the failure of a security. The reality is that this is how the market operates. Not only did Goldman Sachs engage in this type of trading activity, but every broker dealer, or investment bank which runs a derivative or synthetic book will by definition, make transactions which bet against the success of a particular security. It is no different than making a sports bet in Las Vegas. In so doing, the casino is betting against the success of your team, by definition. 


Yet the Senators kept trying to condemn Goldman for the “short” trades which they made and for betting against their clients. Perhaps the Senators do not like this aspect of the business, and if that is the case, they would have served their own purposes by constructively trying to understand the nature of the business, and to then decide whether these businesses should be allowed to exist. Instead they came off as ignorant and adversarial. Through the process, I came to empathize with the Goldman crew, and the Kangaroo Court like atmosphere which they were confronted with. Clearly this is not the last we will hear of these types of discussions. In future endeavors, let me say that the Senators will be better served if they do make system wide issues come off as a vendetta against a specific firm. 


If you carry the argument forward, there is no way a derivative market can work unless someone is betting against the success of a stock, corporate bond, or whatever is being traded. And this is where this might be headed: a ban on derivatives altogether. This will also mean that the small percentage of derivative trades which are used for constructive hedging purposes, the original reason for them coming into being, might also be wiped away if reform means the trading houses cannot take the short side of a customer trade.


For those who missed yesterday’s hearing, I have attached a clip from the movie Animal House, which summarizes the jist of yesterday’s hearing:


LINK`http`www.youtube.com/watchv=A1Y80ue92Ao&feature=PlayList&p=8D8A0C11EEAB8439&playnext_from=PL&playnext=1&index=1`margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; padding-top: 0px; padding-right: 0px; padding-bottom: 0px; padding-left: 0px; line-height: 1.2em; text-decoration: underline; color: rgb(0, 51, 153); outline-style: none; outline-width: initial; outline-color: initial; `LINK


It will only take 4 minutes to watch, and will save you the 11 hours which is how long it will take to watch a replay of yesterday’s hearing. If the Goldman crew had chutzpah, they would have walked out of the hearing in the middle of it, like the Delta House did in the above clip. Instead, they let the Senators flail around for 11 hours.