Bob Carlson

European leaders finally accept that Greece is insolvent; it isn’t simply experiencing a liquidity crisis. Debts are reduced to make the payments something Greece can handle. Even better, policy is predictable. Markets don’t like uncertainty. They can handle bad news and adverse events when there is some predictability about the events or the policy response. John Taylor of Stanford makes these and other points in his column in The Wall Street Journal. He delivers the good news, the bad news, and warnings about what could go wrong.

Will the debt write-down, the diminished contagion, and the recognition of the policy problems be enough to make the second bailout work as agreed to, with Greece fulfilling the required conditions? Unfortunately, the answer is probably no.

The IMF forecasts for Greek economic growth are too optimistic, and some Greek politicians, including Antonis Samaras, leader of the major conservative party, have already said they will try to change the conditions of the agreement after the upcoming election. The bailout is front-end loaded, with about €90 billion of the €130 billion paid at the start to recapitalize Greek banks, sweeten the debt deal, and finance the budget.

Robert Rodriguez of FPA Capital retired from active portfolio management with an enviable record of mutual fund returns. He achieved superior returns with less volatility while holding high levels of cash from 1998 on. Recently, he gave a sort of valedictory speech and a warning to the Institute for Private Investors. Rodriguez was an early proponent of the idea that a debt and housing bubble was developing and invested accordingly.

His current view is that the problems aren’t over. The 2009-2011 period was an interlude. Because of high government debt levels in Europe, Jpaan and the U.S. and private debt in the U.S., it’s only a matter of time before there is another great crisis. All the liquidity pumped into the economies by central banks makes the situation very volatile and uncertain. He’s recommending that investors focus on the return of their capital first, maintaining high cash and short-term bond positions, and be ready to deploy the cash to capture opportunities that have a high  margin of safety.

Phase 2 is now beginning and I think we are on the cusp of a decade of extreme economic and financial market turbulence. Uncertainty as to the effects of high system wide financial leverage and the outcome of the battle to determine what the proper roll and magnitude of government should be within an economy are key elements in this future turmoil.

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On December 21, the ECB established its new Long-Term Repo Operation (LTRO) that provided €489 billion of three-year 1% loans to 523 banks. At almost twice the expected demand, it demonstrated the seriousness of the banking crisis. A second LTRO takes place on February 29. Shorter-term borrowing costs have declined but longer term sovereign debt yields for Italy, Spain and France, remain elevated indicating that serious reservations persist about the program’s potential long-term success. “Banks represent about 80 percent of the lending to the euro area,” according to ECB President Mario Dragi.9 The linkage between banks and their sovereign governments will likely increase since many expect these loans to be recycled into additional sovereign debt, hopefully into more periphery debt. Additionally, the ECB relaxed its lending standards so that, in some cases, single-A asset-backed securities may now be pledged as collateral. These initiatives are nothing more than rescues or backdoor bailouts that further reward unsound fiscal and financial behavior.
Will this ploy resolve the euro-zone crisis? I believe for only a short period, unless a fundamental restructuring of the EU occurs. Italian Prime Minister Mario Monti’s December budget plan introduced rules that allow banks to issue bonds, guaranteed by Italy, as collateral for loans from the ECB. Playing this game of recycling money to the banks, so they can buy sovereign debt, allowing sovereign countries to go on their merry way, resembles a shell game. It’s DELUSIONAL! I am skeptical there is the will or the ability to reform the EU because it will require ceding fiscal sovereignty to another. The combination of fiscal austerity and rising interest rates means Europe is either near, or already in, recession. The Euro’s structure will face additional tests until at least one or more members exit. Should the weaker countries exit, a stronger Euro is likely. If there are no exits, it means transfers of wealth from the northern to the southern euro-zone countries, which would result in a weaker Euro and a more unstable EU. On January 13, Standard & Poor’s downgraded France, Italy and seven other European countries while assigning France and 13 other euro-zone nations a negative outlook. Without any exits, the next round of downgrades will likely encompass Germany’s AAA status. EU structural uncertainty and high system-wide leverage should make for a difficult European investment environment.

Greece is going to have to default on its debt. No other conclusion is possible, because there’s no way it will have enough money over any reasonable time to pay the debt. Yet, European leaders seem determined to prevent a Greece default, short of actually giving it cash to pay its debts. While an actual default by Greece would cause problems for many European banks, the problems could be managed with some decent work by central banks and governments.

So, why is the thing being stretched out?

One reason might be the credit default swaps (CDS), which is a form of insurance against bond defaults. When someone lends money or purchases a bond, the person can buy a CDS from a bank or other firm that’s willing to guarantee it will pay the debt if the debtor doesn’t. The reason AIG was bailed out is that it wrote an enormous number of CDS and couldn’t pay them after Lehman Brothers failed in 2008.

But, what happens if the CDS aren’t paid? Would that lead to a lock up of global bond and debt markets? Would people stop lending if they believe they couldn’t obtain insurance via CDS?

Here’s a good analysis of why CDS are the real problem and why we don’t know enough about them to make good decisions. It’s why we need to be cautious with our portfolios regardless of how good the economic data looks and how accommodating the central banks are.

Now traders fear the issue will come back again with a vengeance.  The [finance] ministers do not want to see a lot of CDS contracts triggered since they don’t know who owns them or, more importantly, who wrote them.  That could become a domino-like contagion ala 2008.

But, traders fear a worse outcome might occur if the CDS contracts do not kick in. What good is insurance that doesn’t pay off.  That could lead to the assumption that all CDS insurance was useless.  That would stratify debt around the globe.  Great credits could get all the money they wanted, but less than great credit would be shut out because it could not be insured.  That could make the future one in which “the haves” will have whatever they want and all others nothing.  Welcome back to the Middle Ages.

We know that the Federal Reserve’s QE and zero interest rate policies are hurting savers and conservative investors. But can the policies do long-term damage to the economy? The evidence from Japan is appearing to indicate that it does. Japan’s been following policies for over 20 years that are similar to those the U.S. has been following the last few years. Mired in a depression since 1989 or so, Japan’s economy is looking worse. The FT’s Alphaville has a pretty good summary of the problems facing Japan and how monetary policy hasn’t helped and might have made things worse. Fortune goes further and posits that Japan might soon be following Greece down the road to default. Japan certainly has joined the usual precursor to default, which is devaluation of the currency.

These aren’t academic or interesting musings. Japan is a significant part of the world’s economy, and its problems probably held back global growth the last couple of decades. Because of Japan’s importance to the global economy, a ratcheting down of its economy or a debt default likely would be damaging to everyone else’s economy.

Perhaps more importantly, since the U.S. is closely following Japan’s policies after the bursting of its bubble, whatever happens to Japan eventually is likely to happen to the U.S.

Wall Street is buying protection in the form of credit default swaps to prepare for that day Japan implodes. Trading of swaps on Japanese sovereigns has been highly volatile in the past year — they are currently being sold at around 135 basis points, 100 basis points above Japan’s debt yield, credit traders in New York and London tell Fortune. Credit default swaps provide a way for investors to make money in the event of a default.

While the Japanese debt bomb isn’t expected to go off tomorrow, Japanese CDS is now 50% higher than where it was a year ago. Wall Street involvement in the Japanese debt market has grown in the last few years, which could bring increased pressure on the government to try and solve its debt dilemma. Eventually, though, the Wall Street bond vigilantes could drag Japanese bond yields up to levels that could cripple the government’s ability to pay off its debts, setting the stage for one of the most prolific sovereign debt defaults in history.

Sure, the amount of debt Greece owes to European banks is large. The probability is will pay a significant portion of that debt is small. The damage the eventual default will do to the European banking system and the global economy could be substantial. It’s already disrupted markets and the economy for almost two years. But that’s not the worst of it. The austerity measures being imposed on Greece are damaging its society and probably leading to severe long-term consequences. The recent riots are but a small sample of the damage. There’s a good but disturbing review of the situation in the recent New York Times Magazine.

By many indicators, Greece is devolving into something unprecedented in modern Western experience. A quarter of all Greek companies have gone out of business since 2009, and half of all small businesses in the country say they are unable to meet payroll. The suicide rate increased by 40 percent in the first half of 2011. A barter economy has sprung up, as people try to work around a broken financial system. Nearly half the population under 25 is unemployed. Last September, organizers of a government-sponsored seminar on emigrating to Australia, an event that drew 42 people a year earlier, were overwhelmed when 12,000 people signed up. Greek bankers told me that people had taken about one-third of their money out of their accounts; many, it seems, were keeping what savings they had under their beds or buried in their backyards. One banker, part of whose job these days is persuading people to keep their money in the bank, said to me, “Who would trust a Greek bank?”

The extended period of unemployment by millions of Americans is having some unexpected long-term effects. Of course, the economy is producing less because of the overcapacity. The government budget also is in worse shape because all those people aren’t paying taxes, and they’re likely drawing some kinds of public assistance. Recent data indicates that many of the long-term unemployed are applying for Social Security disability benefits and being granted the benefits. This move has several effects. It takes them out of the work force permanently and reduces government tax revenues long-term. It also means Social Security is paying more in benefits than were assumed before the financial crisis, and it probably is accelerating the time when SS taxes received are less than the benefits paid.

Half of the benefit recipients suffer from “mental disorders” and “musculoskeletal disorders” (such as back pain). “Mood disorders” alone account for over 10% of this group. And once someone starts receiving these benefits, it’s almost impossible to take the off the program. In 2011 only 1% of the recipients lost their benefits because they were no longer deemed disabled. So how much is this program costing the US taxpayer? Apparently quite a bit.

JPMorgan: The cost to the federal budget of these programs has escalated along with the number of claimants, and now runs around $200 billion per year—more than the budgets of the Departments of Commerce, Energy, Homeland Security, Interior, Justice, and State combined.

There’s been a lively debate in some sectors of the financial media over the relative merits of stocks and gold. Warren Buffett, Jeremy Siegel and Larry Fink not surprisingly came down on the side of stocks. Others point out the dreary returns from stocks over the last 10 or 12 years, the significant increases in global monetary supplies, and conclude that gold has been the winning investment for over a decade and is likely to continue.

This article does a good job of laying out both sides of the argument while coming down on the side of those favoring gold.

Fink’s and Buffett’s preference for equity investment may have nothing to do with expectations regarding things like economic growth or profits, just money printing. This is not founded on sound economic reasoning, rather simply shifting capital into an ever-rising bath.

What happens when central banks stop filling the bath? Or worse, take the plug out?  Or worse yet, find that they are no longer in control of the water?

The investment world does not come down to an all-or-nothing decision between debt (mostly rubbish, now, admittedly) and equity. While the bigger picture is fraught with monetary mismanagement in response to a grave crisis, there are plenty of other investment choices out there, and a growing argument underpinning the ownership of real assets.

It seems the bankruptcy trustee for MF Global has tracked down the “missing” $1 billion or so dollars. Apparently the transactions and margin calls during the firm’s last five days were so numerous and frequent that neither the employees nor the computer system could keep up with them. The firm routinely used customer account money to fund its own operations and lost track of it. In normal times, the fund would use the cash during the day and it would be returned before the end of the day and be back in the accounts. But the whole process broke down as the margin calls and cash needs escalated. You can see some interesting flow charts and other information from the trustee here. You can find other interesting details here and here.

But that doesn’t mean the trustee has recovered all the missing assets or that customers are ready to be made whole. The securities that were moved around as collateral haven’t been fully accounted for.

The SEC has been trying to “fix” money market funds since the crisis of 2008. Then, one major MMF was liquidated and returned less than full value to its shareholders. (A fund sponsored by The Reserve Funds.) Others were supported by their parent companies, and ultimately the federal government guaranteed the funds for a period of time. The SEC apparently is ready to come out with several proposals that will increase the security of shareholders but also will reduce the already puny yields and limit the liquidity of the funds. The changes mean a money market fund will no longer be the checking account substitute that money investors have come to expect.

The SEC’s first proposal would call for money funds to abandon their traditional $1 share price, adopting a so-called floating net-asset value. Industry executives have fought the idea since it was floated in January 2009 by a think tank headed by former Federal Reserve Chairman Paul Volcker.

The second plan would require funds to build a capital cushion designed to absorb potential losses and hold back at least 3 percent of client redemptions for 30 days.

I’ve been saying the housing market is scraping along the bottom. Recently the web site Calculated Risk projected that the bottom of the housing market would occur in March 2012. The web site was an early forecaster of the housing bubble and the extent of the housing crisis. It said there already was a bottom in housing starts, sales, and other factors. It expects the bottom in prices to occur next month.Of course, a bottom isn’t necessarily followed by an upward spike upward. The web site seems to agree with my conclusion that we’re bouncing along a bottom and will bounce at a flat level for a while.

I think a March 2012 bottom in prices might be a little premature, but we’re getting near the bottom in prices. I think what would be most likely to trigger the bottom in prices is a belief that the Fed is getting ready to end its zero interest rate policy. Then, the people who’ve been waiting to buy will accelerate their plans.

And it now appears we can look for the bottom in prices. My guess is that nominal house prices, using the national repeat sales indexes and not seasonally adjusted, will bottom in March 2012.

The problem with using the house price indexes to look for a bottom is that they are reported with a significant lag. As an example, the recently released Case-Shiller index was for November and the index is an average of September, October and November – so it is a report for several months ago. The CoreLogic index is a little more current – the recent release was for December, and CoreLogic uses a weighted average for prices (December weighted the most) – but that is still quite a lag.

Both of those indexes will bottom seasonally around March, and then start increasing again.