Bullish on Greece? David Einhorn vs. ViennaCapitalist

David Einhorn is bullish on Greece. ViennaCapitalist comments on that:

"I do not hope/assume Einhorn deliberately wanted to convey a wrong picture. It is more likely that one of his many analysts made a mistake. Nevertheless, he should have noticed that this doesn’t add-up. Worse, the mistake is not merely academic, but has real implications for Einhorn’s investment thesis as it means that the Greek sovereign still has a massive debt problem, something which has to be addressed when talking about bank investments. Unfortunately, it is something he doesn’t mention further in his presentation".

Now I know what David Einhorn thinks.

Beware of Repaying Sovereign Debt!

Here is a most interesting article about the repayment of sovereign debt, or rather: how sovereign debt often gets repaid only centuries after the fact, if ever. A couple of points:

* the UK government announced recently that it will repay £218 million from the £2 billion of debt that it incurred during WW1. Note that this is debt from roughly 100 years ago!
* incredibly, some of the debt which will now be repaid goes back as far as the 18th century! It includes "the capital stock of the South Sea Company originating in 1711, which had collapsed in the infamous South Sea Bubble financial crisis of 1720", according to the UK Treasury.
* Germany paid off the last portion of its debt stemming from WW1 in October 2010! Ponder this: a country which had experienced decades of "Wirtschaftswunder" and which had become extremely wealthy had still been owing debt from 100 years ago during all this time!
* and, of course, Greeks will argue that Germany still hasn't paid the forced loans from WW2 (and they have a point there, in my opinion!).

This reinforces a point which I have tried to make forever: the principal issue with debt, not only sovereign debt, is not that it gets repaid. The principal issue with all debt is that it gets 'regularized'. Sovereign debt in the Eurozone presently stands, I believe, around 90% of GDP and everyone is concerned that this indebtedness may even go up. Markets are nervous; many predict a collapse caused by this debt. But suppose, for a moment, this debt would be increased, in one stroke, to 120% of GDP with the only proviso that the entire debt would be structured in such a way that it doesn't have to be repaid for the next 100 years. Put differently, the debt would be totally 'regularized'; that is: no one would have to worry about pending defaults, etc. I would bet that everything would return to normal rather quickly.

Another point which comes across in the above article is that too early a debt forgiveness may not be smart. Suppose Germany, back in 1953, had not been forgiven its debt but, instead, repayment of that debt would have been extended to 50 years or so. There can be no doubt that the Germany of the 1990s or the 2000s could easily have handled what now seems to be a relatively small amount of WW2 debt. After all, this is a country which could afford to spend more than 2 trillion Euro, so far, in the aftermath of unification.

I have a vague memory of New York City's financial crisis back in 1975. The City was facing bankruptcy and the Federal Government under President Gerald Ford refused a bail-out (newspaper headline: "Ford to City: Drop dead!"). There was a financial alchimist, Felix Rohatyn from Lazard's, who advised NYC and managed to avert bankruptcy. One day, the 'rescue of NYC' was announced; everything was fine again. I was wondering at the time how NYC could find so much money so quickly to repay its debt. Well, the City hadn't repaid a single dime; it had simply restructured and 'regularized' its debt.

There are probably only few countries in the world whose sovereign debt today is lower than, say, 20 years ago. So, from the standpoint of cash flow, most countries have added to their debt and not repaid any of it (whenever they paid debt on maturity, they did so with new debt which they could raise). As a result, sovereign debt always has a sort of perpetual character. The real issue as regards debt sustainability is whether the payment of interest is within the borrower's capacity. But even if that were not the case, there are alchimistic solutions for it. For example: the interest rate can be set below market and a good portion of it can be capitalized, if not all. As long as the debt gets 'regularized'...

Perhaps the even greater problem than sovereign debt not getting repaid is when sovereign debt does get repaid. In the last years of the Clinton presidency, the US started to accumulate very large budget surpluses. In 1999, Clinton announced that the national debt would be totally repaid by 2015. There was great worry in financial markets: What should the world's liquidity do when there were no longer risk-free US Treasuries to invest in? What would that mean for the stability of financial markets? President Bush then solved that problem in a hurry by making tax cuts for the rich and by starting two wars. And the world seems very happy today that there are so many US Treasuries in the market, safe havens for flight capital in times of nervousness.

How SYRIZA Could Succeed

The prominent radical Slovenian philosopher Slavoj Zizek made the statement which I reproduce below. He made that statement in an interview with a Greek newspaper. I picked up a German translation in the blog NachDenkSeiten. I hope my re-translation into English is half-way correct.

"There is no way to succeed in Greece if one has no other idea than to try out a leftist government which then fails, only to have afterwards nice historical memories in the sense of ‘gee, how nice it was then!’ No. In Greece we have a corrupt and clientelistic state. I am aware that what I say now may sound crazy and that certain Marxists will crucify me for it. However, I think that SYRIZA must strike alliances with some truly productive capitalists who are also tired of this situation. We must be pragmatic. Perhaps SYRIZA should form a credible middle-class party which will finally turn Greece into a totally normal state, a state which has some similarities with a normal liberal democratic state. The absence of such a state is a hurdle for SYRIZA but it is at the same time a unique chance. To put in into Marxist language: the middle-class parties are dumb not to occupy this territory and the voters know that. Of course, not all SYRIZA voters are leftists, I know that, but they are sick and tired of the existing middle-class parties. And they hope that someone will finally govern”.

I can't think of a better advice for Alexis Tsipras than the above.

The Ease of Doing Business in Greece

Much ado has been made about the fact that the recent Doing Business Report of the World Bank/IFC showed Greece at the bottom of Europe. Only few commentaries have noted the fact that Greece actually improved its ranking from #65 to #61 over the previous year (out of a world-wide total of 189). Not even that is the key point, however, because such a minor improvement may be due to statistical errors.

The major point, though, is that Greece now ranks in 61st place in a ranking where Greece ranked in position #108 at the beginning of the crisis. That is an improvement which cannot be attributed to statistical errors!

Yes, Greece still ranks at the bottom of Europe. The only countries of significance ranking below Greece which I could find are Croatia and Cyprus. On the other hand, Italy is only marginally better than Greece. Whether that is a compliment to Greece or a criticism of Italy is a moot point; it is a fact.

If Greece jumped 47 positions since the beginning of the crisis but did not overtake any European peers, that can only mean that those European peers also improved their positions. Again, that's not bad for Greece but good for Europe, instead.

The two categories which prevented Greece for attaining an even higher position were 'registering property' and 'enforcing contracts'. The good news is that this cannot be a surprise to anyone and that, according to what I have read, much focus is being put on these two areas (i. e. EU Task Force). The not-so-good news is that it takes a very long time to register improvement in such areas.

Below are links to articles which I have written on the subject since the beginning of the crisis.

Greece vs. the Former Yugoslav Republic of Macedonia
Which way to the future, please?
The ease of doing business in the EU
Doing business with corruption
Doing Business Report 2014

A Rather Unsophisticated Analysis of the ECB Stress Tests

The results of the stress test have been released and we now know that all but 25 of the 130 or so largest banks have passed it. Certainly all the really 'big players' have passed it. Everything fine?

Yes and not really. Clearly, any detailed examination/audit of the largest banks is always a good thing. However, the markets will never trust a bank only because the ECB says that it can be trusted. There is much more to the secret of what makes up confidence.

How safe, to take just one example, is Deutsche Bank? Safe enough to pass the ECB stress test, for sure. But safe enough to withstand a major confidence crisis?

At the last reporting date, 30 Jun 14, Deutsche reported total assets on balance sheet of 1.665 BEUR (that is one-thousand-six-hundred-sixty-five billion). A bank is as good as the loans which it has on its books? Once upon a time, perhaps, but no longer today. Deutsche's loans amounted to 388 BEUR; that's only 23% of total assets.

Quite strikingly, Deutsche reported 'total financial assets at fair value' of 927 BEUR. Those were composed of 'trading assets' (211 BEUR), 'positive market values from derivatives' (485 BEUR), 'designated financial assets' (176 BEUR) and 'financial assets available for sale' (55 BEUR). Altogether, these financial assets represented more than half, 56% to be exact, of total assets of Deutsche.

What are those financial assets? Well, typically there is not a customer on the other side but a 'counterparty' instead. Typically, those counterparties are publicly rated, publicly rated by the same rating agencies which gave sub-prime paper a triple-A. And, typically, many of these assets are not traded in a public market where one could derive market prices. Instead, their value is often derived from a formula, be it Black-Scholes or whoever else. The reported value of those assets is as good as the formulae applied. When the formulae no longer work, the value of those assets can no longer be determined (as LTCM found out in 1998).

The equity ratios calculated by the ECB are not based on notional amounts but rather on imputed amounts. The equity requirement is a function of the risk-weighting of the assets (more risk requires more equity and vice versa). The point is that the risk-weighting is done by the banks themselves using very, very complex formulae. Any such system is always prone to manipulation. As a result, one must also look at the equity ratios based on the notional amounts in the financial statements.

Deutsche financed its total assets of 1.665 BEUR with equity of 68 BEUR, i. e. equity accounted for 4% of total financing. That is about twice the equity ratio which Deutsche reported only a couple of years ago; truly a significant improvement. It translates into a leverage of 24:1. Compared to the roughly 50:1 leverage which Deutsche had had, this looks very good. However, such leverage levels are still in the category of hedge funds. One can still argue that Deutsche is a hedge fund with an associated commercial bank.

The ECB examined each bank on its own merits. What was not examined, as far as I know, was the interdependency among the banks. Deutsche probably has its risk financial assets hedged with corresponding financial liabilities but on both sides they have counterparties. If a counterparty fails, Deutsche loses its risk protection.

Looking at the results overall, one gets the impression that the ECB examination had one very positive impact: it made the bankers nervous. Bankers should always be a bit nervous. Nervous about making bad loans; nervous about buying the wrong securities; nervous about getting caught at doing untoward things if they were to do untoward things. Most of the banks had taken some rather significant measures in the last year to improve their reported financial strength. Some banks have even announced to change and improve conduct and culture. Whether those are only temporary phenomena owing the the ECB examination or whether longer-term change will indeed result remains to be seen.

Beware of Cross-Border Capital Flows!

I very much enjoy reading John Mauldin's weekly Thoughts from the Frontline. The latest piece is titled A scary story for emerging markets. Mauldin predicts a rather gloomy future for the emerging markets because he fears a soon-to-happen turn-around of the massive capital flows which had gone into these markets since 2008. The possible outcome for emering markets he describes as something which could rival Greece's economic disaster over the last 5 years.

I comment on this article here because, in my opinion, it has a direct bearing on what happened in Greece (and in the Eurozone overall) since the arrival of the Euro. Of all the many reasons which are cited as causes for Greece's problems, if I had to pick one as the most important one, I would pick cross-border capital flows.

No Greek government can misspend foreign capital if there is no foreign capital in the first place. The same goes for the Spanish banking sector and construction industry. Cross-border capital flows can cause a boom as well as a bust. When cross-border capital flows are distorted by a fixed exchange rate (or a common currency) and, additionally, by a misperception of risk resulting from the implied support of a common currency zone, then all hell can brake loose. To me, the story of Greece and the story of the EZ-periphery is a story of cross-border capital flows!

Let me cite this key paragraph from Mauldin's newsletter: 

"Broad-based, debt-fueled overinvestment may appear to kick economic growth into overdrive for a while; but eventually, disappointing returns and consequent selling lead to investment losses, defaults, and banking panics. And in cases where foreign capital seeking strong growth in already highly valued assets drives the investment boom, the miracle often ends with capital flight and currency collapse. Economists call that dynamic – an inflow-induced boom followed by an outflow-induced currency crisis – a “balance of payments cycle,” and it tends to occur in three distinct phases. 

In the first phase an economic boom attracts foreign capital, which generally flows toward productive uses and reaps attractive returns from an appreciating currency and rising asset prices. In turn, those profits fuel a self-reinforcing cycle of foreign capital inflows, rising asset prices, and a strengthening currency. 

In the second phase, the allure of continuing high returns morphs into a growth story and attracts ever-stronger capital inflows – even as the boom begins to fade and the strong currency starts to drag on competitiveness. Capital piles into unproductive uses and fuels overinvestment, overconsumption, or both, so that ever more inefficient economic growth depends increasingly on foreign capital inflows. Eventually, the system becomes so unstable that anything from signs of weak earnings growth to an unanticipated rate hike somewhere else in the world can trigger a shift in sentiment and precipitate capital flight. 

In the third and final phase, capital flight drives a self-reinforcing cycle of falling asset prices, deteriorating fundamentals, and currency depreciation… which in turn invites more even more capital flight. If this stage of the balance of payments cycle is allowed to play out naturally, the currency can fall well below the level required for the economy to regain competitiveness, sparking runaway inflation and wrecking the economy as asset prices crash".

I am not sure that Greece ever had  a first phase but it certainly had a second phase and it is still living through the third phase, intensified by the fact that Greece could not play out a natural balance of payments cycle with declining exchange rates.

I have argued early on that even the economically most solid country can get into trouble through cross-border capital flows if it has a freely convertible currency and free movement of capital. If foreigners dump irresponsibly high volumes of capital on the economy and if they withdraw that capital at a point where the economy has become used to having it (perhaps even addicted to it), a foreign payments crisis is around the corner.

How the Oligarchs Ruined Greece

"By bailing out Greece without demanding fundamental reforms, the European Central Bank, the European Commission, and the International Monetary Fund have only strengthened the status quo. Even worse, the troika has lined the pockets of the very forces that brought about the economic collapse in the first place".

Prof. Pavlos Eleftheriadis, Oxford University, in Foreign Affairs.



ADDENDUM October 27, 2014
Below is an article by Nikos Kostandaras, Managing Editor of the Ekathimerini, published in the New York Times.

Greece's economic and political traps