Penny Wise and Euro Foolish

As one would expect John Hussman is especially cogent on the subject of what will happen in Europe

The Troika report released over the weekend notes that “the situation in Greece has taken a turn for the worse … Deeper PSI [private sector involvement – i.e. loss-taking], which is now being contemplated, also has a vital role in establishing the sustainability of Greece’s debt*. To assess the potential magnitude of improvements in the debt trajectory, and potential implications for official financing, illustrative scenarios can be considered using discount bonds with an assumed yield of 6 per cent and no collateral. The results show that debt can be brought to just above 120 per cent of GDP by end-2020 if 50 per cent discounts are applied… *Footnote: The ECB does not agree with the inclusion of the illustrative scenarios concerning a deeper PSI in this report.”

That footnote is interesting – it’s not that the ECB disputed the deeper loss-taking scenarios – it just didn’t want to include them in the report.

My guess is that European leaders will force a bank recapitalization within days – probably 100 billion euros, preferably 200 billion, but the larger number is doubtful because at present market values, European banks would have to sell new shares in nearly the same quantity as their current outstanding float in order to acquire the new capital. Yet Stratfor correctly notes that even in the event of a 200 billion recapitalization, a 50% haircut on Greek debt “would absorb more than half of that 200 billion euros. A mere 8 per cent haircut on Italian debt would absorb the remainder.” So a good chunk of the present EFSF could end up recapitalizing banks, especially if too little is raised from private investors. This would leave little ammunition against any further strains, should they develop.

Of course, Europe wouldn’t need to blow all of these public resources or impose depression on Greek citizens if bank stockholders and bondholders were required to absorb the losses that result from the mind-boggling leverage taken by European banks. It’s that leverage (born of inadequate capital requirements and regulation), not simply bad investments or even Greek default per se, that is at the core of the crisis.

The bottom line is a) European leaders will likely initiate a forced bank recapitalization within days; b) Greece will default, but the new hold-over funding may give the country a few more months; c) the EFSF will not be “leveraged” by the European Central Bank; d) banks are likely to take haircuts of not 21%, but closer to 50% or more on Greek debt; e) much of the EFSF will go toward covering post-default capital shortfalls in the European banking system following writedowns of Greek debt; f) the rest will most probably be used to provide “first loss” coverage of perhaps 10% on other European debt, which may be sufficient to limit contagion provided that implied default probabilities on Italian and Spanish debt don’t breach that level and the global economy stabilizes; g) uncertainty following a Greek default is likely to create significant financial strains, even in the absence of a recession; h) all bets for stability are off if the global economy deteriorates markedly from here, which is unfortunately what we continue to expect.


While there is a lot of talk about leveraging the EFSF to make it bigger, John points out how huge the amount is relative to the economies of Europe. We would point out the illegality of the proposal even if adopted, though maybe Germany will just ignore its own Supreme Court. As for herding the other 16 cats we are sceptical but not completely dismissive. Doing so in a timely manner is a whole other issue. This will be messy no matter how much everybody wants a magic solution to make the issue go away soon.

Other topics in John’s latest letter of interest is his note on the way we are once again twisting our regulatory system to once again allow banks to avoid holding adequate capital by transferring their massive derivatives risk under the FDIC umbrella. Meanwhile accounting gimmicks continue to allow banks to pretend they are making money:

If you look at those results for any of the major banks, it is immediately clear that the bulk of the earnings were of two sources: further reductions in reserves against potential loan losses, and an accounting gain known as a “Credit Valuation Adjustment.” Those two items, for example, were responsible for nearly 90% of Citigroup’s reported “earnings.” The Credit Valuation Adjustment (CVA) works like this: as the bond market has become more concerned about new financial strains, the bonds of U.S. banks have sold off significantly in order to reflect higher default probabilities. Under U.S. accounting rules, bank assets are no longer marked to market, but happily for the banks, the decline in the market value of their bond liabilities means that the banks could technically “buy their bonds back cheaper.” So the decline in the bonds, despite being due to an increase in investor concerns about bank default, actually gets reported as an addition to earnings! Surprise, surprise.

So, because your liabilities are marked down because it is increasingly likely you can’t pay them you are claimed to have made money! However, since your assets are not marked down (and their declining value is why it is feared you can’t pay your liabilities) you show no losses. Presto change-o profitability! Don’t you wish you could become a bank?

Read the whole thing.

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