It’s now abundantly clear that austerity is failing.  And it will continue to fail until a true resolution is brought to the table.  That either involves a full dissolution of the Euro (resulting in full sovereignty with the former currencies) or a push towards fiscal union.  These half hearted moves that we keep seeing just aren’t going to fix the root cause of the currency crisis.  The single currency system is broken.  Just like the gold standard was broken.  There is no reviving it in its current form.  It either needs major changes like the USA did when it created a full fiscal union or it needs to be busted up so these nations can regain monetary sovereignty and floating FX.

The sad thing is, Germany likes the way things have been.  As long as they can avoid having their banks defaulted on then they continue to enjoy being the trade surplus nation within the single currency and the primary beneficiary of the EMU.  They have meager growth, but record low unemployment.  Things are pretty good on a relative basis!  So they’re holding on for dear life just hoping that something turns around and the music continues to play on.  But the music is coming to an end and Germany needs to start making decisions.  They either need to leave the Euro and stop holding everyone in the EMU hostage to their demands or they need to start making some concessions and moving towards fiscal union.  And since it’s becoming clear that they won’t make decisions then someone has to start making decisions for them.

There’s no provision in the EU for kicking a country out (as far as I know), but that doesn’t mean they can’t create one.  The peripheral nations could all unify and I am certain they’d find support from France at this point since Hollande is pushing for fiscal unity as well.  Together, these countries can all start pushing Germany around.  In fact, they could threaten to kick Germany out of the EMU (though they clearly don’t need to go that far!!).  It sounds crazy, but that’s the last thing Germany wants.  If they were kicked out of the EMU they’d not only default on trillions in Euros, but they’d have to bring back the D-mark which would be a total disaster for their economy as the D-mark would soar versus the Euro and crush their export driven economy.  Ironically, it would likely result in higher debt levels for Germany as automatic stabilizers would result in more government spending as recession occurred.  So they’d not only lose their trade position, but they’d end up printing more money anyhow!

Now, part of this is a bit facetious.  I really don’t think they should try to kick Germany out of the EMU.  But they should certainly unify more tightly and begin pushing back very aggressively. There’s much more to the EMU than Germany, but for some reason everyone is taking orders from Angela Merkel.  Europe needs leaders to start walking into meetings and making very serious threats.  There are millions of people held hostage in a depression due to this inaction.  Someone needs to start standing up for them and recognizing that the currency union needs very serious changes and it needs them YESTERDAY.

“Commenting on the Flash China Manufacturing PMI survey, Hongbin Qu, Chief Economist, China & CoHead of Asian Economic Research at HSBC said:

“Manufacturing activities softened again in May, reflecting the deteriorating export situation. This calls for
more aggressive policy easing, as inflation continues to slow. Beijing policy makers have been and will step up
easing efforts to stabilize growth, as indicated by a slew of measures to boost liquidity, public housing and
infrastructure investment and consumption. As long as the easing measures filter through, China will secure a soft landing in the coming quarters.’”

Personally, I am shocked that Obama even has a prayer in this election given the unemployment rate.  I said back in 2009 that the unemployment rate was likely to be over 8% when he was running for re-election and that that would bury his chances.  But boy was I wrong about that.  According to Intrade the President is still the odds on favorite to win the upcoming election at 58%.

But the stock market could change all of that in a heart beat.  I was struck by the chart below showing the Intrade odds of an Obama win versus the S&P 500.  In this “what have you done for me lately world” it seems that the latest stock quote is one of the primary drivers of the well-being of the country and a real-time reflection of the President’s efficacy.   Obviously, this isn’t an entirely rational view of the world and stock prices don’t always reflect our reality, but the data doesn’t lie….

Since the post on gold lease rates back in December, a number of Sober Look readers have asked whether there is a long-term relationship between gold lease rates and gold price. Based on the weekly data available, there is none. The scatter plot below shows weekly moves in gold futures price vs. weekly moves in 3-month gold lease rates since 6/29/2007.

Source: Bloomberg

The R-squared, which shows the proportion of variance in gold price explained by moves in lease rates is 0.008. Daily data shows no significant relationship between the two either.

One would think that higher lease rates should provide support to gold price because a commodity that could be leased at a higher rate should be worth more. But that assumption is not supported by the data. In fact the recent moves demonstrate somewhat of an inverse relationship.

Recent data (source: Bloomberg)

The rationale for this inverse relationship is fairly simple. As more investors put short positions on, there is higher demand to borrow the metal (one needs to borrow an asset in order to short it), driving up lease rates. Many gold investors have been shorting gold using forward or futures markets to hedge their holdings. But dealers who buy forwards from these investors end up shorting physical gold to become neutral. The end effect is the same – large volumes of gold shorting should translate into higher lease rates. The recent weekly data shows a correlation of -0.6 (R-squared of 0.4).

Recent data (source: Bloomberg)

Whether this recent relationship holds going forward remains unclear. But based on historical data, the correlation should revert back to zero over the long run.

Housing bear Gary Shilling and housing bull Mark Kiesel of PIMCO debated the state of the U.S. housing market on Bloomberg Television’s “Street Smart” with Trish Regan and Adam Johnson.

Shilling said that housing prices will decline 20% this year because “there are 2 million inventories, both visible and shadow inventories, over and above normal working levels”, which is “a tremendous overhang.”  He went on to say that “excess inventories are the mortal enemy of prices.”

Kiesel justified his bullish stance on the market, saying that, “all inventories you look at, whether new existing or shadow, they are coming down” and “there is only 144,000 new home sales for sale. That’s at a 49-year low.”

Kiesel on purchasing a home in California and whether he’s having buyer’s remorse:

“No.  I will say it is a little chaotic because there are a lot of boxes around. I think after renting for six years, my view is that housing prices have fallen about 35% and the inventories are coming down and banks are starting to lend again gradually. U.S. housing looks very cheap relative to international housing.  I feel good about putting some money into housing right now.”

Shilling on why housing prices will decline 20% this year:

“Because of excess inventories. We estimate that there are 2 million inventories, both visible and shadow inventories over and above normal working levels. That is a lot. Back in normal times, we built about a million and a half houses a year, so two and a half million is a tremendous overhang. Excess inventories are the mortal enemy of prices. What may happen here is that now that the robo signing flap is settled and the big banks settled for $25 billion with the various state attorneys general and the federal government, they have been holding off on foreclosures because they had enough bad PR. Now they have settled that, I think they will go back to foreclosures. The National Association of Realtors says that when foreclosed houses are sold, they sell at a discount of 19% to existing houses and that drags everything down when you get a big dumping of these houses on the market. I’m looking for another 20% decline and that is what it would take to bring them back to the long-term averages. They go back to 1890 in terms of median single-family house prices.”

Kiesel on how he factor in those inventory levels:

“Currently, we have 2.5 million homes in existing inventories which is down in the last seven years from 4 million. There is only 144,000 new home sales for sale. That’s at a 49-year low. The existing inventory is at a seven-year low. If you look at the shadow inventory, there were 3.6 million homes that were 90+ days delinquent two years ago. Today, there is only 2.9. All inventories you look at, whether new existing or shadow, they are coming down.”

Shilling’s response:

“They are coming down, but they are still huge…Yeah, they are down, but when you count in the shadow, and particularly this category that the Census Bureau has, which are houses held off the market for other reasons, very descriptive. This includes foreclosed houses that are vacant, but not yet sold. It includes houses that people have listed, but they couldn’t stomach the bids they got so pulled them off the market. You count all of that in and you are still over a working inventory of about 2.5 million.  You are still 2 million above that when you count everything in.”

Kiesel on what number he’s tracking: 

“What I was quoting was the 90+ day delinquencies. If you add that with the foreclosures, you do get to the 3.9 level. The thing about housing is that it’s very much a regional market. The homes that your viewers and people actually would want to buy, you need to look at the existing inventory that is quality. Go out and look for a house now. There is less quality inventory on the market today than a year ago. That shadow inventory will get absorbed quicker than you think because the implied rental yields is roughly 5%-12% in a lot of markets, so investors will line up. Gary, I respect your work and I read your books and if housing goes down 20%, I will back up the truck and likely PIMCO will, too.”

Shilling’s response:

“That’s right. At that point the percentage underwater of mortgages would go from now 23% to our estimate is 40%. The equity of people who have mortgages which has come from almost 50% in the early eighties to 17% would go down to about 7%. Virtually nobody with a mortgage would have any equity. What that would do to consumer spending to say nothing to mortgages and mortgage-backed securities derivatives, that is pretty heavy duty stuff. That is recessionary kinds of things. We think that will happen over the next three-four years, one way or the other.”

Kiesel on whether employment levels are at a stage at which consumers are feeling confident enough to make an investment in buying a home:

“If you look at it, we have added 2 million jobs in the private sector over the last year. Confidence is picking up. The U.S. economy is doing well in numerous states and sectors like energy pipelines, technology, autos, manufacturing. There are many areas in the country where there is a housing shortage. The shadow inventory and the amount of homes underwater, there are 11 million homes but it is concentrated really in three states:  Arizona, 61%, Florida, 45%. Yes, there are some weak areas, but the fact is that in certain areas, housing is picking up and prices are going up and so again, it’s very regional.”

Shilling’s response:

“You and I can remember almost a decade ago as this problem was developing and we were on top of it and you were too, that people initially said, the problem was only in subprime mortgages and those are loans that luckily people will never have to meet. Then, they said it is only in Arizona and Florida and Phoenix. Then as it expanded, they said it is bicoastal, don’t worry. Everyone else is safe. Tip O’Neill said that all politics is local and you can say the same thing about real estate. Somehow, the composite, the national numbers are made up of those local pieces. There are a lot of shortages here or the other place. That I think is begging the question, overall, there is still a tremendous excess inventory.”

Kiesel on whether he’ll lower his assumptions about the economy:

“We are looking at basically 1-1.5% real GDP, but you don’t necessarily need superfast GDP to get housing to recover.  Housing again is down 35%. The inventories are coming down. We are gradually employing more people. Housing relative to other asset classes—equities, bonds—looks attractive.”

Shilling on the New York-area housing market and whether Wall Street money not being what it used to be has affected real estate:

“I think it very much does. If you look at what is happening to the stock markets and related securities in the last month–if this continues, I think we will see a lot of softness in Manhattan and in the Hamptons and other places influenced by that. If you read off the employment verses GDP curve, if you’re looking at even 2% real GDP growth, that says that the unemployment rate would chronically rise about 1% point a year.”

Kiesel on the West Coast housing market:

“Housing is very much based on jobs, based on consumer confidence. We were in the subprime capital of the world in parts of Orange County and we can show you houses that are down 50-60%. In my neighborhood, housing prices fell 20-30% from the peak. The economy is not a recession, we are growing, and banks are flush with cash willing to lend gradually and the Fed is set to reflate. The key here is that you want to own a hard asset in a world of very low to negative real interest rates where the Fed is going to print money.  You have to own something tangible.”

Kiesel on the opportunity cost of buying a home:

“I think stocks are looking at basically nominal GDP, which is 4% plus dividends of maybe 2, so you are looking at 6. There are rental yields in housing out there above that. Plus, you get the benefit of actually living in the house. From my perspective, I still think that housing beats a lot of asset classes.”

Kiesel on whether PIMCO is looking at housing as an alternative to bonds:

“We own non agency mortgages and those securities benefit from a housing recovery. If Gary is right and we do see housing prices go down 20%, the U.S. will be one of the cheapest housing markets in the world. It is already near one of the cheapest.”

Shilling’s response:

“Actually, it would take a 22% decline in median single-family house prices to bring them back to the long-term trend that Bob Schiller has identified going back to 1890. That has been corrected for CPI, general inflation, and for the tendency for houses to get bigger over time. That would bring them back to the norm. They might seem cheap but there are only where they would have been for over a century.”

“Michael Covel talks to writer and trader Jack Schwager, author of the Market Wizards series. Schwager’s new book, Hedge Fund Market Wizards, is now out. Covel and Schwager discuss some of the commonalities between the many traders Schwager has interviewed, and the lessons that can be gleaned from their diverse approaches. Schwagger’s new book opens with a quote regarding the importance of even-mindedness from rock climber Alex Honnald, and Covel and Schwager discuss how topics seemingly unrelated to trading can contain relevant lessons. Many of the other traders profiled in Hedge Fund Market Wizards are discussed, including Ed Thorp, Steve Clark, Jaffray Woodriff, and Ray Dalio. Covel asks Schwager what his big takeaways from his interviews have been, and the lessons he’s learned from talking to some of the most successful traders in the game. Further topics include how markets behave differently in different environments; the importance of asymmetric positive skew trades; how diversification is the “only free lunch on wall street”; how Schwager defines risk; and the “gain to pain” ratio.”

It’s worth a listen if you decide not to purchase the book….

My old firm, Morgan Stanley, has done something that is extremely surprising. They have been bearish, something large Wall Street firms rarely are. The last really bearish major strategist who was outright and long time bearish that I remember was also at Morgan Stanley, Barton Biggs in the late 1990′s through the Summer of 2002.

The brokers there hated him (and Steven Roach) for being so obstinately gloomy. It isn’t great for business generally. I had a different mindset. I went to Morgan Stanley because someone at the top was bearish and it was obvious at the time (at least to me) that it was the right thing to be.

They are sticking to it:

On Oct. 6, 2011, the MSSB Global Investment Committee recommended (and still does) that investors overweight select safe-haven assets and underweight select risk assets, reflecting global concerns about policy efficacy, ongoing household and sovereign balance sheet deleveraging, recession in Europe and slowing growth in many developed economies. Thus, risk assets may continue in their multiyear sideways, range-bound secular market, given: (i) the magnitude and duration of the previous secular uptrend (i.e., a 1,300% increase from 1982 to 2000 for US equities); (ii) significant continuing imbalances for several major economies relating to central governments’ budget deficits, indebtedness, savings, consumption, trade, currency relationships, global competitiveness, sovereign-debt quality and foreign exchange reserves; (iii) the lingering aftereffects of the severe financial and systemic recession of 2007-2009; and (iv) doubts about the timing and effectiveness of the authorities’ policy measures and voters’ response thereto.

I am sympathetic, though neither that nor their bravery in being so makes them right. That being said here are the list of bullish and bearish factors they see warring to determine the ultimate outcome:

Equities Bullish Factors

• Factors arguing in favor of equities include: (i) negative real interest rates, six central banks’ coordinated liquidity provision to funding markets, the Long-Term Refinancing Operation by the European Central Bank, and possible further monetary stimulus in the US; (ii) continued GDP growth in emerging Asia and Latin America; and (iii) policy easing and a likely soft landing in China (Morgan Stanley continues to estimate real GDP growth of 9.2% in 2011, 8.5% in 2012, and 9.0% in 2013).
• As of May 18, the consensus of analysts’ forecasts for S&P 500 calendar-year earnings per share growth is 14.7% for 2011, 8.5% for 2012, and 11.9% for 2013, according to Thomson Reuters.
• Recent consumer credit, motor vehicle sales, housing starts,and ISM manufacturing and non-manufacturing data still reflect continued expansion.
• Producer and consumer price inflation rates remain at low levels and deflation risks, while not eliminated, have faded.
• Equity 12-month forward price/earnings ratios are not excessive and the earnings yield (the inverse of the P/E ratio) is at very high levels relative to Baa corporate bond yields.
• High US corporate cash levels, which enable increased dividend payouts, stock buybacks, and mergers and acquisitions activity.

Equities Bearish Factors

• As of the end of April, US unemployment was 8.1%; the broader measure of unemployment, U-6, was 14.5%.
• Medium-term GDP growth may be held back by: (i) continuing foreclosures, home price weakness and a significant shadow inventory overhang; (ii) bank, government, and household deleveraging; (iii) state, local, and federal government fiscal austerity measures; (iv) recessionary trends in Europe; (v) decelerating growth in China, India and Brazil; and (vi) lackluster jobs growth, regional industrial production, retail sales, durable goods orders, and real personal income trends.
• Global investors and officials have continuing concerns about the quality, maturity structure, and magnitude of several countries’ sovereign debt burdens and their ability to service such obligations.
• Germany, France, several other Euro Zone countries, the UK and the US have been implementing fiscal austerity measures; absent political change, US fiscal drag will likely be significant in 2013.
• US stocks are not undervalued using long-term earnings metrics; the Shiller P/E—that is, price divided by 10-year average earnings—for the S&P 500 is 20.8, 27% above its long-term average.
• Real median household income has fallen 10% since 2007.
• Analysts’ consensus earnings estimates for 2012 have fallen 6% versus their peak and appear likely to decline further.
• In 2013, maximum tax rates on dividend income are set to almost triple, to 43.4% from 15.0% currently; on capital gains, to 23.8% from 15.0% currently; and on interest income, to 43.4% from 35.0% currently.

A good list. I will throw in that I don’t believe China will do anywhere close to as well as Morgan Stanley estimates. In fact I think the other giant BRIC, India, will do poorly as well. You can find the full report here.

“The meaning of the phrase is that individuals may do bad things even though they intend the results to be good. An example is the economic policies of the 1920s and 1930s. These were intended to be a prudent response to the economic turmoil following World War I and the Wall Street Crash respectively, but they were one of the causes of the Great Depression and World War II in which millions of people suffered and died.” - source Wikipedia

The Credit Indices Itraxx overview – Source Bloomberg:

The Itraxx Crossover 5 year CDS index (50 European High Yield companies – High Yield credit risk gauge) was tighter by 33 bps, moving back towards the 700 bps level. It touched 790 bps on Friday. While most indices were overall tighter including Itraxx Financial Senior 5 year CDS index (cost of insuring the senior debt of 25 European banks against default) and Itraxx Financial Subordinated 5 year CDS index, the price action is akin to short covering.

Itraxx Financial Senior index fell to a low of 181 bps in March and has been widening since, reaching 309 bps on the 18th of May, the highest level since the 19th of December – The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level – source Bloomberg:

“Mind the Gap” we indicated on the 8th of May - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. – source Bloomberg:

While volatility has somewhat receded slightly in relation to the V2X Eurostoxx, the German 10 year Bund remains tightly below the 1.50% level indicating the “flight to quality” mode experienced so far.

The current European bond picture, a story of ongoing volatility for Italy and Spain, with Spain 10 year yields receding towards the 6% level - source Bloomberg:

Truth is, the rising exposure of peripheral banks to government bonds has indeed boosted Sovereign Risk – source Bloomberg:

“While ECB cash injections significantly improved bank liquidity conditions, more than 300 billion euros of announced austerity measures have pressured the budgets of central and local governments. Total euro-zone bank lending to governments has grown 135 billion euros since 2009, tying banks’ fates increasingly closely with their sovereigns.” - source Bloomberg.

No wonder both the SOVx index (representing the sovereign risk of 15 Western European countries with Cyprus replacing Greece in the index) and the Itraxx Financial Senior 5 year index have moved in synch – source Bloomberg:

“If a third Longer Term Refinancing Operation is needed, we believe it will be provided,” James Longsdon, a managing director at Fitch’s financial institutions group in London, wrote in a report today. The timing is “unlikely to be imminent without a further significant shock, such as a Greek exit from the euro.”

It could be a possibility given that for weaker peripheral financial institutions, the ECB remains the ONLY source of funding for ailing institutions. The recent downgrades of both Spanish and Italian banks undertaken by rating agency Moody’s means that many banks still face funding issues due to the over reliance of many European banks to wholesale funding.  According to Credit Suisse “Q2 issuance has been remarkably light so far, initially driven by earnings blackout periods, but since hampered by volatile market conditions. This lack of supply has been particularly acute for financials.”:

“For senior unsecured benchmark deals, we have experienced negative net issuance of approximately EUR94bn since April 2011.” – source Credit Suisse

Moody’s downgrades of Italian banks were centered on the unsecured Italian Bank Maturities that needs to be replaced:

“Moody’s Italian bank downgrade focused on poor wholesale funding access. In 2012 it suggests that only 20% of unsecured maturities will be replaced by new unsecured issues. A structural reliance on market funds poses “one of the biggest challenges for many banks,” as Unicredit’s 22.5 billion euros of 2012 maturities highlights.” - source Bloomberg.

“Moody’s cited deteriorating conditions and risk of increasing bad debt in its downgrades of the Spanish and Italian banks. Italy’s bad debt has risen 65 billion euros since the start of 2009, close behind Spain’s 75 billion increase. Corporate bad debt now represents two-thirds of Italy’s total and will likely rise should sovereign yields remain elevated.” - source Bloomberg.

In relation to Spain, rising unemployment, rising Non-performing loans and increasing fears of deposit flights (in relation to deposits flight, Greece’s banking system lost 9 billion euros of deposits this year and has seen outflows of 73 billion euros since the 2009 peak according to Bloomberg), reducing therefore the ability for banks in providing credit to support economic growth to the Spanish real economy, doesn’t bode well for the its recovery prospects and overly ambitious budget deficits targets. As shown by Bloomberg chart below, Spain’s 148 billion euros worth of NPLs dwarf austerity cuts:

“While Spain’s bad debt ratio of 8.37% remains below its February 1994 high of 9.15%, its current bad debt outstanding is more than 6x the 1994 equivalent. With provision requirements increasing and a fourth bank clean up underway, further real estate deterioration will materially offset 37 billion of announced austerity cuts”. - source Bloomberg.

“The first error was the diagnosis in 2010, namely that the crisis of the euro had its main source, if not unique, inloose fiscal policies. If this point is not debatable in the case of Greece, it is not true for Ireland and Spain.Before 2008, both countries had scrupulously respected the public deficit criteria. Their current difficulties were not caused by an excessive public debt; they appeared when foreign capital financing their housing bubbleended abruptly. In fact, current problems in the euro area therefore reflect as much a fiscal crisis than a balance of payments crisis. However, the policy prescriptions are not necessarily the same in one case or another.Faced with a budget crisis, as in Greece, it is essential to run a thorough reform of the state, forcing us to rethink the tax system to make it more efficient and reduce public funds waste. Faced with a crisis of balanceof payments, jeopardizing the banking system, the priority is different. There is  an urgent need to recapitalizeinstitutions in big trouble, if any, by nationalizing them, it should be the priority in Spain. In this country,controlling public deficits cannot  obviously be ignored, but it is secondary to the need of cleaning up the banking system.
The second mistake was to try to subordinate private sector creditors in the context of public assistance programs  for peripheral countries in trouble. This is the famous ”Deauville agreement” announced in October2010 at the end of a Franco-German summit. The ECB, under Jean-Claude Trichet as president at the time, saw its decision immediately criticized. In fact, it resulted in government securities issued by euro area countriesceasing to be considered as “risk-free assets”, they were previously even considered “risk-free” when they were not AAA. Risk premiums increased and the appetite for these securities declined, making it more difficult to control debt dynamics.”

“Recent developments in the Spanish banking sector have led investors to draw comparisons between the Spanish and Irish banking systems and analogies between the two are evident, in our view. Most notably, both countries are experiencing severe real estate market adjustments, as large imbalances accumulated over the decade prior to 2008 correct.
Loan losses soared in Ireland: It has been four years since the Irish lending boom came to an end, and the implied loss rate on all Irish bank loans based on the most recent provisioning data is 24%.
Eventually leading to realised losses for subordinated bondholders: The real estate related loan problems at Irish banks eventually caused subordinated bondholders to accept substantial realised losses. On average, subordinated bondholders recovered approximately 20% of par value.
Spanish banks have subordinated debt that could be used for burden sharing: In light of the similarities with Irish banks and the expected need for government capital injections into the Spanish banking system, the question of whether Spanish subordinated bondholders will eventually meet the same fate as their Irish counterparts becomes a legitimate one.”

Of course we agree. It has long been warning that, there would be more pain to come for both subordinated bond holders and shareholders alike (see our recent post “Peripheral Banks, Kneecap Recap“).

Barclays in their note added:

“Although bank bondholder involvement could help reduce Spain’s debt burden, authorities may avoid coercive burden-sharing because of elevated retail ownership of subordinated bank debt. Nonetheless, we acknowledge that there is downside risk to our base case loss estimates and that the risk of burden-sharing for subordinated bondholders of Spanish banks is material.”

The Irish example on a subordinated bond LT2 demise – source Barclays:

“The process was incremental, beginning with the nationalisation of Anglo Irish, advancing with the creation of NAMA, and culminating with the passage of the Subordinated Liabilities Order. Ultimately, subordinated bondholders recovered approximately 20% of par value on average”. - source Barclays.

Oh dear…

Ireland also took coercive actions in relation to subordinated bondholders:

“The Credit Institutions (Stabilisation) Act led to the Subordinated Liabilities Order (SLO), which was published on 14 April 2011 and was a key factor in the unfortunate fate of subordinated bondholders. The SLO enabled the State to exercise a wide range of powers over banking institutions, including modifying the terms of subordinated liabilities.
Specifically, the terms of lower-tier 2s were amended such that interest payments became optional and maturities were extended to 2035. The terms of upper-tier 2s were amended to remove all requirements to pay missed coupons. In addition, dividend stoppers were removed from both upper-tier 2 and tier 1s, eliminating the last of the structural leverage previously included in these securities.” - source Barclays

In relation to Spain, Barclays indicated:

“Spanish banks have €65bn of subordinated debt outstanding, or €47bn excluding Banco Santander and BBVA. Under our base case scenario, where lifetime loan losses reach €198bn, which would exceed the current stock of provisions by €88bn, the government could be required to contribute €45-50bn to the recapitalisation of the banking sector. The need for public sector support could be reduced substantially through coercive bondholder involvement.”

Given the recent outrage by individuals investors relating to the performance of Bankia’s share price following its IPO in 2011, it will be interesting to watch the subordinated bond space given the difference in ownership between Ireland and Spain:

One has to wonder if Spanish retail investors will be inflicted additional pain…

On a final note a chart from Bloomberg indicates US Banks CDS track Europe’s higher as Spanish yields rise:

“In mid- to late-2007 European bank CDS were driven by liquidity fears and did not track yields particularly closely. As Spanish spreads rose again recently, sovereign fears have this time chased EU bank CDS levels higher. Even with limited sovereign exposure, U.S. banks’ spreads are tracking Europe’s closely, as fears regarding global growth heighten.” - source Bloomberg.

“The safest road to hell is the gradual one – the gentle slope, soft underfoot, without sudden turnings, without milestones, without signposts.”

C. S. Lewis -

Stay tuned!

How Substantial is the Fiscal Restraint in 2013?

CBO estimates that the combination of policies under current law will reduce the federal budget deficit by $607 billion, or 4.0 percent of gross domestic product (GDP), between fiscal years 2012 and 2013. The resulting weakening of the economy will lower taxable incomes and raise unemployment, generating a reduction in tax revenues and an increase in spending on such items as unemployment insurance. With that economic feedback incorporated, the deficit will drop by $560 billion between fiscal years 2012 and 2013, CBO projects.

If measured for calendar years 2012 and 2013, the amount of fiscal restraint is even larger. Most of the policy changes that reduce the deficit are scheduled to take effect at the beginning of calendar year 2013, so budget figures for fiscal year 2013—which begins in October 2012—reflect only about three-quarters of the effects of those policies on an annual basis. According to CBO’s estimates, the tax and spending policies that will be in effect under current law will reduce the federal budget deficit by 5.1 percent of GDP between calendar years 2012 and 2013 (with the resulting economic feedback included, the reduction will be smaller).

With that Fiscal Restraint, What Will Economic Growth Be in 2013?

Under those fiscal conditions, which will occur under current law, growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent, CBO expects—with the economy projected to contract at an annual rate of 1.3 percent in the first half of the year and expand at an annual rate of 2.3 percent in the second half. Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession.”

“A lack of new fiscal policy measures aimed at stabilising public finances amid continued rises in government debt ratios could lead to a further downgrade. A shock to Japan’s sovereign funding conditions such as a steep and sustained rise in yields would be strongly negative for the ratings, although Fitch does not consider this likely.”

I would say that I do not consider this “likely” either.  Now, I don’t know if I’d go as far as Joe goes in saying that Japan won’t ever default.  They could very well choose to default much like Russia did in the 90′s.  And I certainly wouldn’t make big bets on the political intelligence of Japanese officials (in either direction).  After all, there are a lot of politicians in this world who simply don’t know how the monetary system works and they might even conclude that a default would be good.  Who knows?  The Euro crisis that never ends hasn’t yet convinced some people that austerity is crushing these economies, but sometimes evidence in front of your face just isn’t enough.

But the more important point is that Japan is like the USA in being an autonomous currency issuer.  In essence, the US Treasury would never run into trouble procuring funds to pay bondholders because of its unique relationship with the Federal Reserve.  Bondholders know this so US bonds are seen as a save haven.  As an act of Congress and the lender of last resort the Fed can always be counted on to supply fund to the US government so bond holders can be paid and remain whole.  In this regard, the US government is a currency issuer because of its explicit political unity between its central bank and treasury (the exact thing missing in Europe).  The same relationship exists in Japan.  So, unless you think central bankers are bad at “printing money” for their governments then it’s rather silly to assume that Japan or the USA can’t obtain the funds to remain “solvent”.   Of course, Japan could suffer hyperinflation at some point, but as I’ve previously explained, this is quite a different phenomenon than “running out of money”.