A View from the Trenches, March 29th, 2010: "The Euro crisis, Stage 2: The infection of the banking system"
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The main factor driving last week’s action was the summit of the
European Union, and its declarations regarding Greece (We could also
include the US Healthcare bill as another factor, but its consequences
are still unclear). In particular, France agreed with Germany to allow
the IMF to be engaged in a potential aid package. The reaction from the
European Central Bank (ECB) on this resolution was mixed, with Mr.
Trichet first suggesting it was a “bad idea” and later supporting it….
The ECB has no alternative but to show support.
We bring Greece’s situation to your attention today for two reasons. The
first one is related to our comments back on February 10th (refer: www.sibileau.com/martin/2010/02/10 “An
Institutional perspective on the Euro”) when we had anticipated
this outcome. Back then we wrote:
“…If the IMF has to intervene, the European Union will definitely be
a Confederation. This is unfortunately the path of least
resistance. This is the easiest and less painful path. If the
IMF is engaged, the Euro will no longer be considered an alternative
global reserve currency and the bid that there was under such belief
will no longer be there. We shall be sellers of Euros under this
scenario. This is the worst-case scenario, for if the EU
citizens lose purchasing power, the global recovery will become a
long-term dream. Note that we don’t care about Debt/GDP ratios or other
metrics. The relevant issue here is that on the margin, the Euro would
no longer offer more safety than other strong, healthy currencies. In
fact, its complex institutional framework would be a burden, compared to
other ones, simpler to understand…”
The second reason is related to our comments back on January 7th and
22nd (refer: www.sibileau.com/martin/2010/01/07 “Don’t
forget Greece” and www.sibileau.com/martin/2010/01/22 “What are
they thinking?”). Last Thursday, the ECB decided to extend its
emergency collateral rules into 2011. The decision was naturally
welcome by Greece, with Prime Minister G. Papandreou explicitly saying
it will “greatly assist banks”. We had also anticipated this move, when
we wrote:
“…Whatever assistance Greece may get from Europe will not be
explicit. Nobody will face the scrutiny of public opinion or the moral
hazard of such a move. As I wrote earlier, I believe Greece still has a
lot of tricks at hand that can use to its benefit, to keep financing its
current deficit. One of them is with the private placement market. If
Greece continues to use it, selling its debt to local banks (which take
deposits in Euros), then Greece will have infected the Euro zone with
its disease, forcing the European Central Bank to provide
liquidity lines to its financial system. This would be a hidden way to
support the deficit and I would be surprised if it is not explored…”
We are not gurus. We do not have the crystal ball at “A View from
the Trenches”. If we were able to predict this, it is because we’ve
seen and lived through it before. Greece in 2010 is going through the
same dynamics Argentina went through in 2000. When we identified this
link between the ECB and Greece, we suggested to focus on the spread in
the credit default swaps market between the National Bank of Greece SA
(NBG) and Greece’s sovereign risk. We chose NBG only because its credit
default swap is the most liquid of the Greek banks’ financing the
government. As you can see in the chart below (source: Bloomberg), this
spread has widened since we first addressed it on January 7th.
It is clear that the “infection” of risk transferred from the
sovereign to the financial system is in full effect, with Greece’s
sovereign risk now tighter than that of its banks (We understand (but cannot confirm) that
Greek banks already have bought half of this year’s issuance by the
Greek government). If the ECB validates this transfer, something to
monitor as the collateralized BBB- liquidity lines are used, the spread
should narrow to lower absolute levels. What would have given in then?
What will have been the escape valve to address the imbalance? The value
of the Euro, which should fall (all other things equal), with this
quantitative easing measure. Therefore (as we warned on Dec.17th (www.sibileau.com/martin/2009/12/17 ), on occasion of
Greece’s initial EUR2BN private placement) , all those who invest their
savings into Euro-denominated assets will be subsidizing Greek
taxpayers. It is a hidden tax, and one that neither Merkel nor Sarkozy
need to explain to their constituents. For the rest of the world, in our
view, this loss in European purchasing power will be a drag on global
economic growth.
Another point we would like to make here is also related to the
summit of the European Union as well as to our comments on Canada, made
on March 4th (www.sibileau.com/2010/03/04 ). Essentially, we have
put forward the notion that Canada and the Canadian dollar are no longer
receiving just the “commodity bid” (i.e. “mercantilist bid”), but also
the “safe-haven bid”. We suggested that to visualize this, one could
follow the spread between the ETF “XIU.TO”, that tracks the S&P TSX
60 composite (orange) vs. the ETF “IGT.TO”, which tracks the price of
gold, in Canadian dollars. We updated the chart first shown on March
4th, below (source: Bloomberg):
This spread widened as the Greek situation worsened, as anticipated
back on March 4th, and it tightened last week (i.e. as gold increased in
Canadian dollar terms, the TSX fell), following the summit of the
European Union. We think this proves our point.
And lastly, a word on “method”, as followed at “A View from the
Trenches”. On Mach 22nd we said that “…What is about to happen
politically and in terms of monetary policy has never been seen before.
Therefore, any quantitative assessment done based on historical stats
will be pure misleading inference…”
Think about what we’ve done above: We proposed a theory (hypothesis),
suggested a proof (thesis, i.e. focus on the spreads described above),
and later tested the hypothesis (demonstration: sovereign vs. financials
spreads, and XIU vs. IGT). We like the deductive method because we
think that there is nothing more practical than a good theory. Other
analysts play a pure inference game. They take observations going back
to the ‘70s and give you, for instance, the inferred probability that a
certain event will trigger an expected result. We think this inductive
approach is misleading and totally clueless, although it always looks
more “scientific” because those suggesting such inferences are
statisticians providing trading ranges. However, we could provide
trading ranges in our deductive approach as well (We don’t provide
trading ideas in this letter for obvious compliance reasons though). The
trading range game and its cousin, the so-called “tail risk”, is what
gave birth to correlation books and to synthetic CDOs among other
things, and we all know how it all ended. They were the product of
inductive reasoning.
Martin Sibileau
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