Mr. Euro undergoes Psychoanalytic “Undervaluation”

Yesterday, we conducted an interview with Greek economist Yanis Varoufakis, on the 7 stages of Grief in Europe. It is the contention of many, Yanis included, that European leaders and policymakers are in denial about how large the size and scope of their banking problem. We decided to put Mr. Euro on the couch with Freud for some psychoanalysis. Click below for the full episode, an our apologies in advance for some of the Skype disruption half-way in. It comes and goes:
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Eurozone bail-out fund has to resort to buying its own debt

I like this article, because it points out just how absurd debt financing through the creation of more debt is. The EFSF is a great example of how financial alchemy works. First, you create an artificial entity, incorporated in Luxembourg of course, that can issue debt with the explicit guarantee of eurozone member states with a credit line of up to €780 billion and a lending capacity of €440 billion. Then, you go to the three major rating agencies, and ask them to slap an equally artificial AAA rating on the thing. Voila. Now you can take a largely insolvent continent, pool its insolvency together, and borrow at lower interest rates from banks who themselves, are largely insolvent due to the fact that they own public and private debt from the same countries that they didn’t want to lend to in the first place. Of course, the banks are willing to go on lending because it is the only way to keep the ponzi scheme going. Otherwise, they would have to go bankrupt now, as opposed to later.

But, apparently, this is no longer good enough. The EFSF has been forced to borrow at higher costs (breakdown of latest issue), not just in terms of nominal interest, but also relative to German bunds of similar duration, whose yields have dropped substantially year-to-date. Now, the Telegraph is reporting that the EFSF, during its latest issue this month, had to step in and buy up more than 100 million euros of its own bonds in order to achieve its funding target (basically, in order to keep it’s nominal borrowing costs down, or put another way, to keep up appearances that investors actually want to buy what it’s selling at a reasonable price). Representatives for the fund have since denied this, but whether it is true or not isn’t really the point. The point, dear reader, is that a fund that has no capital in it, and whose capacity to borrow is a derivative of the taxing authority of a very suspect and loosely organized continent of previously waring states, can technically buy, with money it doesn’t have, a stake in something that doesn’t even exist. And yet, this is where we find ourselves in today; in a derivative universe disconnected entirely from underlying values, and thus, from reality itself. 

I have pasted the relevant article from the London Telegraph below, for your amusement.

The European Financial Stability Facility (EFSF) last week announced it had successfully sold a €3bn 10-year bond in support of Ireland.

However, The Sunday Telegraph can reveal that target was only met after the EFSF resorted to buying up several hundred million euros worth of the bonds.

Sources said the EFSF had spent more than € 100m buying up its own bonds to help it achieve its funding target after the banks leading the deal were only able to find about €2.7bn of outside demand for the debt.

The revelation will be seen as a major failure and a worrying sign of future buyers strike after EFSF officials and their bankers had spent recent weeks travelling the world attempting to persuade key investors, including China’s national wealth fund and Japanese government funds, to buy its bonds.

Chinese and Japanese money was crucial to last year’s first bond sales by the EFSF, but they have since been dismayed by the eurozone’s failure to resolve the worsening debt crisis and alarmed at how fund has morphed from being a rescue facility for European banks into a potentially €1 trillion leveraged first-loss insurer for eurozone governments.

Other European Union funds are also understood to have supported the EFSF’s bond sale. The failure of the EFSF will increase pressure on the European Central Bank to effectively become the lender of last resort for the eurozone, a move it has strongly resisted.

At a private breakfast organised by PI Capital last week, Mark Hoban, the Treasury minister, said: “What it doesn’t do is provide the next stage of the solution, which is how do you stop this from happening again?” he said.

The move, by the European Investment Bank, will cause more disquiet among non-eurozone EU members who have become concerned about their growing exposure to the cost of rescuing the currency bloc.

Looking at Debt from a Wider Perspective

(Source: Bloomberg)

One of the things has has always ticked me off about the propaganda criticizing Greeks for their purported “laziness” and their satisfaction with living off of a highly indebted government sector is that it completely ignores the fact that when you factor in both public, as well as private sector debt, Greece falls right off the list of countries in the biggest amount of trouble.

And this is an important point to note for two reasons. First, I find it even more egregious and morally wrong to criticize a society for the debt racked up by its government than I do for debt wracked up by households and individuals, because the latter reflects more accurately the decisions and behavior of the citizens themselves. Secondly, bank debt, as we saw in the case of the US and Ireland for example, can easily become public debt when the private sector starts to contract and banks are faced with the possibility of bankruptcy.

Just something to remember while everyone obsesses over the size of Greek and Italian national debt. A lot of the other countries with lower debt-to-GDP ratios have a lot of unrealized losses on the balance sheets of banks within their national jurisdictions that could easily go from private to public hands very soon.

ZeroHedge: Naked in Europe

This is a great article posted on ZeroHedge today (written by Peter Tchir) that explains why sovereign CDS do not correlate so well with the underlying bond yields. One of the things I find most interesting is the reference to the role that the EUR/USD exchange rate plays in all of this, since CDS are not written in the domestic currency (in the case of european bonds, they are written in dollars).

From ZeroHedge, via TF Market Advisors:

Naked in Europe

So Europe is getting closer to announcing some form of ban on naked CDS.  What they hope it will accomplish and what it will actually accomplish are two very different things.

First, let’s look at the mindset.  It about a ban targeted at entities that buy CDS (go short the credit).  It doesn’t target those who are selling protection.  Why is it fine for an institution to sell protection?  If the goal is to support the bond market, ban the sellers of protection.  Anyone who sells protection is doing that rather than buying bonds.  If an institution couldn’t sell CDS “naked”, and they wanted exposure to the sovereign risk, they would have to buy bonds.  Isn’t the contagion risk and counterparty risk all related to those who sold CDS?  Yes.  Wouldn’t an exchange or full clearing help this without hurting the market?  Yes, but somehow that is “off the table” as too complicated.

Anyways, so what do they hope to get by banning naked shorts?  They expect CDS to tighten.  That will likely be the initial reaction.  They expect a tightening in CDS to lead to improved purchases for bonds.  That is unlikely to occur.

Let’s take a close look at Italy to show why their expectations are likely to be disappointed.  First, it is important to remember that CDS on Italy trades in $’s and their bonds are denominated in Euros.  That is a key difference.  If you buy (or sell) CDS on Italy, the flows are in $’s.  So as Italy widens you make money on the CDS.  You would also make money being short Italy in the bond market.  If the correlation between Italy widening, and Euro weakening is high, the CDS is a better way to be short.  This creates a basis that is far more complex than a straightforward CDS where the CDS is denominated in the same currency as the underlying bonds.

Italian 5 Year Bond Yields, Spread to Bunds, and CDS

It is easy to see that there is relatively little correlation between Italian bond yields and CDS.  Spreads are in many ways more important, but at some level it is the yield a country is paying that matters.  It is also true that as a country becomes deemed to be a real credit risk it no trades on a spread basis, it trades on a yield basis, and ultimately moves to trading purely on price.  Investors in Ireland and Portugal are looking at yield now.  Those countries have moved past the point where anyone thinks of them in terms of spread to bunds.  Greece has moved purely to trading on price.  No one really cares what yield they are getting, it is all about price.  It is also useful to note that yield is not well correlated with CDS because much of what is being discussed as part of a European “Solution” would cause German yields to increase – partly as the flight to safety bid dissipates, and partly because they will be shouldering a larger debt burden to prop up the rest.  In any case, if any politician is expecting Italian yields to move with CDS, there is very little historical data to support that.

CDS and the spread to bunds are more correlated.

The spread to bunds and CDS are definitely more closely tied together.  This chart at least gives hope that if the EU can get Italian CDS to go a lot tighter, the bonds could trade tighter.  Working against that argument is the fact that the CDS is already trading at a wide basis, so some of the tightening in CDS would just normalize the basis, and as mentioned earlier, some of the spread tightening will be offset by rising German yields (absent a massive rate cut by the ECB).  So at least from this graph, there is some reason to believe that collapsing CDS levels would help the problem in the EU, but even here it is not horribly compelling as they seem to move inline more often than not (CDS isn’t a clear leading indicator) and the basis right now is quite high anyways (the correlation between Euro Credit Spreads and FX rates at very high right now).

The next chart might be the most interesting.  The ECB entered into two big bond purchase programs, last fall and August of this year.  It is interesting to see how bond spreads tightened as they were the direct beneficiary of the ECB intervention, but the CDS market relatively ignored the intervention.  It is also worth noting that after the period of intervention the bonds drifted back to their fair market value rate.

I would expect a similar reaction to intervention in the CDS market.  The CDS market would react as it is the “beneficiary” of the government intervention, but the bonds would not blindly follow CDS tighter.  The bond market would realize that the CDS move was artificial.  You would likely see some initial move tighter as investors scramble out of bad hedges, but then what?  Expecting bonds to respond to a manipulative intervention is a bad idea.

Move and Countermove

Let’s assume the EU bans naked shorts in sovereign CDS AND lets the ECB or EFSF sell protection.  This is even more than is mentioned in the current rumor, so the market should respond amazingly well, right?  Not so fast.

CDS will tighten.  Potentially tighten dramatically.  I could easily see Italian CDS trading from 440 to 200 in the short run if naked shorts were banned and some EU entity started selling CDS.  The big question is how much of that spread tightening will transfer to Italian bonds?  My guess, and it is only a guess, is that bonds will tighten by less than 100 bps, and possibly less than 50 bps.  The CDS market largely ignored the intervention in the bond market the two times that was in full throttle.  Why would this be different?  Don’t forget, the CDS market is tiny in comparison to the bond market.  The net outstanding CDS on Italy is only about 2% of the bonds outstanding.  Talk about the tail wagging the dog.  Manipulating a small fraction of the market will do little to instill confidence and will only take away a source of pricing.

What will happen to German Bund yields?  It is hard to see them reacting well to this.  At the very least some of the premium built into German bunds as a flight to safety will disappear.  Depending on the rest of the “Grand Plan” Germany will become more risky and may need to borrow debt (or crowd out its own direct issuance with all the guarantees they are providing).  So for Italian bond yields to fall, the impact of the Grand Plan and CDS manipulation will need to impact spreads more than German bund yields rise.  That is possible, but I suspect the results will disappoint and Italian 5 year debt will struggle to get below 5%.

Well, the ECB could slash rates to zero.  That would lower the yield of bunds (the closest Europe will have to anything resembling a risk free borrower by that point).  That lowering of yield should translate to Italian bond yields, though as we are seeing in the US, it is hard to push certain assets below a threshold yield.  Investment grade bond spreads here have become more volatile recently in part because they cannot move in line with treasuries when treasuries do better.  Operation Twist caused IG spreads to widen, at least in part, because too many investors can’t afford to own corporate bonds with such a low yield.  A part of the recent move tighter was just this unwinding.  Look at how stable LQD has been relative to TLT.

So now the EU will have banned naked CDS, sold CDS, cut rates to zero, announced a Grand Plan and Italian 5 year bond yields could still easily be above 4.5%.  What have they accomplished?  They will have accomplished very little and certainly nothing that is sustainable.  What happens the next time the Italian government votes down an austerity package or the deficit comes out worse than expected?  I think just like when they ban anyone being short stocks, they will regret not having the short covering bid on the next down leg.

The New Short

Since nothing mentioned does anything to actually fix the economies or balance sheets that are in trouble, it is reasonable to assume that some investors will remain bearish or become bearish at these new levels.  They might buy some CDS depending on how tight it is, it may be worth doing it, although they will be concerned about not only price intervention but some form of legal intervention as the EU seems willing to at least consider bending the rules to avoid triggering Credit Events and the ECB seems willing to say and do anything to ignore their mark to market losses.  But at some level the basis will become worth at least putting some risk capital to work.  Some investors will want to short bonds, putting that pressure on the bond market.  That would clearly be banned quickly and borrowing sovereign debt to short would be scary as the rules could be changed.  Then what?  Short bank stocks?  No, you can’t do that.  So then what?  Shorting indices and playing the FX markets will be the only option.  Expressing a view on sovereign credit will have to be done through other markets.  That could cause pain for the shorts, but also could create a spiral in the stock market.  If the wealth effect is so big and the confidence from a rising stock market is so important, this could backfire.   Now policies could be made that make the market look cheap or to help earnings.  Money could be printed.  Lots could be done, but as you can see, all this does is shift the battleground and make it ever more complex.

Until something is done to demonstrate that Europe is on a sustainable path to being able to pay back debt, or the ECB prints money and takes a chance on unleashing inflation, little manipulations will not help.  In fact they will likely hurt in the long run.

Unintended Consequences seems to have taken on a new meaning.  Unintended consequences means to me, that a lot of thought went into the consequences and the end result surprised.  I no longer believe that significant thought goes into the potential consequences.  The analysts see what they want and get tunnel vision on the series of consequences they want to see, rather than really trying to figure out what might happen.  Europe is not only behind the curve, they act like they are playing checkers with a 4 year old, when the markets are a game of chess, and they should be seriously analyzing the moves and countermoves that can occur before determining their next move.  They also have to remember the risk side.  So much focus is on the possible benefits of a “Grand Plan” that no resources are being devoted to what happens if that plan fails.  Maybe they should strive for less potential upside to the plan in order to sure that this isn’t the last plan they can try.

Slovakian MP and Party Head Standing Firm against more Bailouts

Malta and Slovakia are the two countries in the Eurozone yet to ratify the expansion of the EFSF.

Der Spiegel did a great interview of Robert Sulik, the head of a minor party in Slovakia, whose unwillingness to sign him and his party over to the latest bailout measures is raising some concern in Europe.

Notice how uncharacteristically sane his arguments against the fund are.

From Der Spiegel:

SPIEGEL ONLINE: Mr. Sulik, do you want to go down in European Union history as the man who destroyed the euro?

Richard Sulik : No. Where did you get that idea?

SPIEGEL ONLINE: Slovakia has yet to approve the expansion of the euro backstop fund, the European Financial Stability Facility (EFSF), because your Freedom and Solidarity (SaS) party is blocking the reform. If a majority of Slovak parliamentarians don’t support the EFSF expansion, it could ultimately mean the end of the common currency.

Sulik: The opposite is actually the case. The greatest threat to the euro is the bailout fund itself.


Sulik: It’s an attempt to use fresh debt to solve the debt crisis. That will never work. But, for me, the main issue is protecting the money of Slovak taxpayers. We’re supposed to contribute the largest share of the bailout fund measured in terms of economic strength. That’s unacceptable.

SPIEGEL ONLINE: That sounds almost nationalist. But, at the same time, you’ve had what might be considered an ideal European career. When you were 12, you came to Germany and attended school and university here. After the Cold War ended, you returned home to help build up your homeland. Do you care nothing about European solidarity?

Sulik: If we now choose to follow our own path, the solidarity of the others will also crumble. And that would be for the best. Once that happens, we would finally stop with all this debt nonsense. Continuously taking on more debts hurts the euro. Every country has to help itself. That’s very easy; one just has to make it happen.

SPIEGEL ONLINE: Slovakia’s parliament is scheduled to vote on the bailout fund expansion on Oct. 11. How do you predict the vote will turn out?

Sulik: It’s still open. The ruling coalition is composed of four parties. My party will vote “no”; the other three coalition parties intend to say “yes.” What the opposition says is decisive.

SPIEGEL ONLINE: The Social Democrats have offered your coalition partners to support the reform in return for new elections. Do you think the coalition is in danger of collapse?

Sulik: I don’t see any reason why it would.

SPIEGEL ONLINE: What will you do should the EFSF reform pass despite your opposition?

Sulik: For Slovakia, it would be best not to join the bailout fund. Our membership in the euro zone, after all, was not conditional on us becoming members of strange associations like the EFSF, which damage the currency.

SPIEGEL ONLINE: If the euro only causes problems, why doesn’t Slovakia’s government just pull the country out of the euro zone?

Sulik: I don’t see the euro as the problem. It’s a good project. Everyone involved can benefit from it — but only if they stick to the ground rules. And that’s exactly what we’re demanding.

SPIEGEL ONLINE: Which ground rules should we be following?

Sulik: We have to observe three points: First, we have to strictly adhere to the existing rules, such as not being liable for others’ debts, just as it’s spelled out in Article 125 of the Lisbon Treaty. Second, we have to let Greece go bankrupt and have the banks involved in the debt-restructuring. The creditors will have to relinquish 50 to perhaps 70 percent of their claims. So far, the agreements on that have been a joke. Third, we have to be adamant about cost-cutting and manage budgets in a responsible way.

SPIEGEL ONLINE: Many experts fear that a conflagration would break out across Europe should Greece go bankrupt and that the crisis will spill over into other countries, including Portugal, Spain and Italy.

Sulik: Politicians can’t allow themselves to be pressured by the financial markets. Just because equity prices fall and the euro loses value against the dollar is no reason for giving in to panic.

SPIEGEL ONLINE: But do you really believe that politicians can calm the financial markets by stubbornly sticking to their principles?

Sulik: Let’s just ignore the markets. It’s ridiculous how politicians orient themselves based on whether stock prices rise or fall a few percentage points.

SPIEGEL ONLINE: You’re not afraid that a Greek insolvency could mark the beginning of the crisis instead of the end?

Sulik: No. There’s not going to be a domino effect along the lines of “first Greece, then Portugal and finally Italy.” Just because one country goes broke doesn’t mean the other ones automatically will.

SPIEGEL ONLINE: Nevertheless, banks could run into significant problems should they be forced to write down billions in sovereign bond holdings.

Sulik: So what? They took on too much risk. That one might go broke as a consequence of bad decisions is just part of the market economy. Of course, states have to protect the savings of their populations. But that’s much cheaper than bailing banks out. And that, in turn, is much cheaper than bailing entire states out.

SPIEGEL ONLINE: Does one of your reasons for not wanting to help Greece have to do with the fact that Slovakia itself is one of the poorest countries in the EU?

Sulík: A few years back, we survived an economic crisis. With great effort and tough reforms, we put it behind us. Today, Slovakia has the lowest average salaries in the euro zone. How am I supposed to explain to people that they are going to have to pay a higher value-added tax (VAT) so that Greeks can get pensions three times as high as the ones in Slovakia?

SPIEGEL ONLINE: What can the Greeks learn from the reforms carried out in Slovakia?

Sulik: They have to make cuts in the state apparatus. The Slovaks could also give them a few good ideas about the tax system. We have a flat tax when it comes to income taxes. Our tax system is simple and clear.

SPIEGEL ONLINE: One last time: Do you honestly believe the euro has any future at all?

Sulík: I believe the euro has a future. But only if the rules are followed.

Interview conducted by Maria Marquart

Greece misses its deficit targets once again…when will the default come?

Considering all the negative talk on Greece coming out of official circles in Europe over the past month, the fact that Greece has ended up missing its deficit targets for yet one more time comes as no surprise. In fact, there is nothing about this global debt crisis – yes, it’s global and it’s a debt crisis, not a sovereign crisis, or an economic crisis, or a this crisis, or a that crisis…it’s a crisis caused by too much debt and the inescapable cure of too much debt is default – that should surprise anyone anymore. Greece is unable to pay this debt, and the current path is only going to make the final default all that more painful.

As I said in a post here last month, I do expect Greece to receive this 6th tranche from the Troika in October, but I expect it to be “the sixth and final tranche.” In the best case scenario, members of the Troika are working alongside the Greek, Irish, Portuguese (and possibly the Spanish) governments, in conjunction with senior bank executives in Europe and the US, to restructure their debt in conjunction with some sort of “recapitalization” for the European banking system through the EFSF (or an expedited ESM). In such a scenario, recapitalized banks should have their equity wiped out accordingly and, where appropriate, be fully nationalized. If taxpayers need to backstop the losses on bad bets made by banks in order to prevent a total meltdown of money and credit, then the banks should themselves be treated as bankrupt entities.

Of course, if you go by what news outlets have been reporting, as well as the track record of bank executives overall in terms of their willingness to compromise on writedowns, I would give the above a slim chance of actually happening. What is more likely is that Greece will be dealt with in isolation as a “special case,” which will only lead to more dumping of Spanish and Italian debt (and consequently higher borrowing costs for these governments that could finally push them out of the bond markets entirely), and further decapitalization of the banking sector. Another possibility is that rioting in Greece gets so out of control that the government finally collapses, and a new government is elected that unilaterally defaults on the debt. I should remind readers that just because this last scenario seems “illogical” to the naked eye does not make it any less probable. The size of the debt problem is so large, and the interests of the parties needed to solve it so disparate, that coming to some sort of structured resolution isn’t simply a matter of exercising “good judgement.” Sometimes the scope of a problem overwhelms even the most qualified and well-intentioned people’s abilities to solve it. The global debt crisis may very-well be just such a problem.

This is not an exact science. It is impossible to know how the situation in Greece, or the Eurozone for that matter, will play out. The only thing that can be said for certain is that a country with officially over 150% debt-to-GDP, a budget deficit at or above 8.5% of GDP, an economy contracting at 5.5% of GDP, and prohibitively high borrowing costs (the yield on 1-year Greek government bonds has reached as high as 130%) is bankrupt. The more the government enacts draconian austerity measures in the face of a depressionary economic environment, the more its economy will contract. I have no problem with public sector cuts, but they need to be done efficiently (not based on artificial measures like who is closest to retirement for example, but based on the actual productivity and output of the person/department) and in conjunction with regulatory overhaul that eliminates some, if not all, of the economic hurdles that have grown by leaps and bounds over the decades. And of course, none of these measures can be taken with out at least a partial default, because the Greek economy simply cannot afford to service a debt this high and remain competitive. That’s a fact.

So, my prediction is that Greece and the Eurozone will muddle along until the end of December or early next year at the latest before some type of decision is made by the Troika that acknowledges just how much worse the problem is than has been admitted to up until now. In the unlikely scenario that the political will emerges to approach the problem with a comprehensive restructuring of peripheral debt in conjunction with bank recapitlization and regulatory overhaul, then we can begin to entertain visions of hope. If, however, Greece continues to be dealt with in isolation then yields on Spanish and Italian debt will continue to rise, European bank decapitalization will escalate, and the risk that more social unrest in Greece or some other peripheral European country will lead to political collapse and unilateral default/withdrawal from the Eurozone of one or more member states will grow.

More Austerity, More Taxes, More Strikes…

It’s the same old story in Greece this September, and it does not come as a surprise to anyone living in the country. Speaking with Greeks all throughout the summer, I arrived early on to the conclusion that the country was resigned to whatever fate awaited it, and optimism was not the predominant emotion driving expectations, this much I can tell you.

The “second Greek bailout” agreed to on July 21st, was conditional upon more austerity and higher taxes, but it appears that even these measures will not work to satisfy the Troika’s bloodlust. No matter how much the country cuts spending and increases taxes, the economy will continue to contract because the debt burden is inherently deflationary and the political and economic conditions such that further private investment is discouraged. Who wants to invest in a country that is perpetually on the brink of bankruptcy and civil unrest?

What upsets me the most as a citizen of Greece, and as someone who loves my country and my people very much, is that our government is totally broken, and there is no hope for leadership on the horizon. With Venizelos now poised to overtake Papandreou as the next leader of PASOK, the prime minister can spend more time abroad, where he feels most comfortable anyway, negotiating more bailouts, privatizations and debt deals with countries that actually have functional governments. Neither he nor Venizelos want to prepare the country for the possibility that they may have to “go it alone,” and this lack of preparation only weakens our negotiating position.

Greece needs leadership more now than at any time in living memory. We are desperate for it, and it is the only thing that can save our country. Rollovers, haircuts, and debt buy-backs are the tools of creditors. If the debtor doesn’t have anyone negotiating on his behalf, then all these “solutions” are rather meaningless. Greece will continue to decay, its economy will continue to collapse, and eventually, it will have to default in a completely disorganized and pernicious way.

The Effect of ECB Bond Buying on Sovereign Funding Costs

ECB Bond Buying and Sovereign Yields

I found this nice chart on Barry Ritholtz’s blog (the source is Der Spiegel). There isn’t anything here that we haven’t seen before, but the visual display of information shows two interesting things.

The first is just how hopeless the case for Greece’s borrowing prospects are. The country is completely priced out of the marketplace. The yields that the market is pricing in for long-term sovereign debt funding are way beyond anything that the Greek government could service were it not for the ECB and the various loan programs put together that have kept Greece temporarily out of the credit markets. It is just a matter of time before Greece defaults, and prolonging the agony benefits no one in the long-run, including the people of Greece.

Second, the light blue backdrop that represents sovereign debt purchases by the ECB (labeled state bonds) is visually misleading, because it appears overwhelming as it towers over the various yield curves displayed in the graph. The fact of the matter is that the roughly 150 billion euros worth of sovereign debt that the ECB has purchased through its Security Markets Programme (SMP) is peanuts next to the trillions of euros worth of support that the sovereign debt market in Europe will need before this entire fiasco is over and done with (assuming that Eurozone member countries, along with the ECB, will do whatever it takes to keep the nation states in EMU from leaving the single currency).

Unfortunately for the ECB, the central bank is ultimately going to have to eat huge losses as a result of its bond buying program, as well as its role as a backstop for eurozone banks. The last thing that you want to see as an investor (which the ECB becomes when it buys Greek, Spanish, Italian, etc. debt) is yields on the fixed income assets that you are buying rise after you sink your money in, because it means that the price of whatever it is that you bought is dropping in value. This nasty reality is what is giving the Bundesbank and other more hawkish players in Europe an ulcer.

The 6th and Final Tranche

Part of me feels angst over the inevitability of a Greek default, and how it will play out, but another part of me grows in excitement at the prospect that something good could come out of this entire mess.

For a very long time now, I have been saying that a Greek default is inevitable, and that eventually the country would have to exit the euro. This does not mean that euros cannot circulate in Greece, but it does mean that the government would have to return to the drachma for its public expenditures (sort of like in Argentina where pesos circulate next to dollars). This is optimal in my view.

It looks like we are coming closer and closer to that moment, though I still believe that Europe has one more can-kicking exercise in futility left in its playbook. I believe that Europe’s leaders have already decided that they cannot save the eurozone-17, and that their only hope to preserve the euro as a currency is to downsize the EMU membership so as to prevent disorderly exits and market forces from dictating who gets kicked out and how. To do this, they still need more time, and the 6th tranche may give them just enough of it to solidify their preparations.

The markets have already broken past the tipping point, and the momentum for default cannot be prevented for countries like Greece and Ireland. The run on Greek banks will continue until a default occurs, at which point capital controls will have to be implemented, or a massive liquidity intervention will have to be initiated by the ECB. I imagine that both will occur in tandem, which is why rich Greeks already moved as much money as they could outside the country in 2009 and 2010.

The most likely scenario is that the eurozone’s leaders will try and package together a Greek default with that of other eurozone countries like Ireland and Portugal. The defaults don’t have to be on 100% of the outstanding debt, but they would have to be on enough of it that markets would stop attacking those countries from a credit standpoint, as well as an investment standpoint (i.e. investors would no longer fear putting money to work in Greece because of uncertainty about its future). I don’t know what this number is, but the markets sure do, and right now they are pricing in at least 50% for Greece (though I suspect when it is all said and done, that we are looking at closer to 80% or more).

In such a scenario, the Germans will have to come to the rude realization that their enemy is not Greece, but their own financial system, and that of the world as a whole, that allowed for a model of export led growth that was simply unsustainable. Not only will they have to socialize bank losses, but they will start to lose markets for their products, because they built their factories and their capacity based on the assumption that the demand for their goods was sustainable. Too bad it was based on debt that now needs to be desperately liquidated.

Debts that cannot be repaid, will not be repaid, and it is high time that the folks over in Brussels figured this out. The first two bailouts of Greece, the bailout of Ireland, then Portugal and the ongoing bond buying of the ECB through the SMP, not to mention the loan support programs for banks soaked with peripheral sovereign debt has done nothing to address the core of the crisis, which is ultimately that certain governments in Europe are insolvent, and need to default. That means that people are going to have to take losses, and some banks are going to have to go broke and be nationalized if that’s what it takes to prevent a total meltdown.

My guess is that Papandreou’s decision to return to Greece is part of a larger realization by Europe’s leadership that they must move past the rosy scenarios and unrealistic hopes that over indebted countries could magicallly grow and cut their way out of this credit crisis, and come to the conclusion that an orderly default must now be constructed. This cannot happen in the span of the next month, which is why I think that the 6th tranche is on its way regardless, but I do believe that unlike previous loans, this one will be the last for Greece.

Only time will tell, but the clock is certainly ticking.