What a novel thought

What a novel thought that George Papandreou, the Prime Minister of Greece would insist on a binding public referendum for the European Union Greek Bailout Proposal.

George Papandreou has a 2 Vote Majority at best in the Parliament, and many suspect that he does not have that, and he does not want to find out the hard way.  The easiest decision to make is to let someone else make that decision, the blame is theirs not yours.  Of course you can advise them on the decision that they are being asked to make, but the fallout is theirs alone to bear.

If the people of Greece pass the referendum Mr. Papandreou will be able to say “I did not force this upon you, a majority of your fellow citizens agreed to accept this burden”.  The main problem will be that however the outcome of the vote the effects will not only affect the current generation it will be on at least the next two generations.  If the citizens of Greece pass of the life line with anchor attached, and then decide that Greece needs to go in a different direction, well so be it, again the choice was theirs to make and theirs to bear.

Greece might have been the birthplace of democracy, but since the end of World War II it has not spent much of the time in a stable democracy.  Greece history since World War II has been anything but stable.  About the only thing stable was the name.

Since the end of World War II some 67 years there have been 48 different governments in Greece.  Just a crude back of the envelope calculation would indicate that the average Greek government has a half-life of 8.4 months.  Mr. Papandreou must be doing something right considering that he is currently at 2.85 half-lives.  It could also mean that the situation is so balled up that no one in his or her right mind would even consider taking the position. (My condolences, You have won the election and you are the new Prime Minister).

The European Proposal has nothing to do with Greece, but everything to do with its own major banks, and the really sloppy practices (Regulators and Banks) that they have been operating with for at least past 10 years.

The various powers that are in place with banking over sight functions failed, and they failed big.  The data was there, and it was available, either by sheer incompetent or criminal collusion it was not acted on.

It was not an either or situation I believe that it started out with incompetents, and then graduated to criminal collusion.  Some of this incompetent is a result of deliberate/legislative blurring of the lines between commercial and investment banking.  Some of this incompetent was due to lack of experience with investment banking, or the assumption that investment banking was just like commercial banking.

That said when the various individual operating the banks started to make large amounts of loans to the Greek Government, and the incompetent regulator did not call them on it, and for that fact neither did their Board of Directors nor the stockholders.  Who wants to stop the elevator on the way up (The ride is really great counting those unrealized gains)?  The management of the Banks recognized this fact and jumped in with both feet, and just compounded the problem. (our depositors are demanding their interest payments, and I need my bonus)

Greece was writing IOU (they were not the only ones), Backed by the Full Faith and Credit of the Greek Government in a currency that they did not control.  The Investment Bankers where getting fat commissions and fee helping them write and place the IOU.  The Basel Treaty inadvertently provided a ready market for all the paper that was being created (Tier I Assets Requirements, the mistaken assumption between Zero Risk and No Risk, and that Sovereign Debt is “Riskless”) Zero Risk is relative, and No Risk is Absolute, the former is real and it is continually changing to reflect the current conditions.  The later is a figment of the mind and a delusional mind at that.

The European Governments do not want the Greek government to default.  A Greek debt default would trigger the first way of various Credit Default Swap agreements.  Since the Credit Default Swaps are not regulated (they are not regulated anywhere) no one has any idea of the magnitude of the counterparty risk, but if the experience of the United States is an accurate example we will all find out in rather short order.

Europe stands at the edge of the abyss, and I am afraid that they will fail the test.  In 2008 when the United States stood at the edge of the abyss the decision was easier to make since the states are united by form and function (Constitution, laws, monetary, de facto common language, common national history), we fought a civil war to establish most of these facts.  Europe has not had this experience (most of their wars have been just the opposite).  Europe in practice is not united by form and in reality by function.  Europe carries a tremendous amount baggage from its past, that makes it easier to be separate rather than united.

The term “common good” does not ring true in Europe, for Europe.  Common good does have resonance for the people only as it applies to their nation.  The lack of trust between the various members of the European Union is palpable, and in many case lies just beneath surface.  Any significant economic distress will bring this to the surface with all of attendant ramifications.

Many of the older and middle-aged Germans are scarred by the experiences economic turmoil of the Weimar Republic, and the initial post war period, in particularly their treatment at the hands of inflation and hyperinflation.  Many Germans are myopic and rather emotional on this subject (So are the Italian, French, you name them).  In many cases these Germans will not admit, much less understand that they benefit from this expansion of debt in Europe.  Many will not recognize that the debt allowed German industries to sell goods and services abroad.

Many of these Germans enjoyed the trip going up, but they are not looking forward to the trip down.  Many of the German that I talk to express a strong belief that this situation is only isolation to Greece, or maybe to the Southern Europeans, and that the effects will somehow by magic be isolated to these areas.

The various European governments, and for that matter the United States, are not coming clean with the various electorates as to just how vulnerable their countries are visa vie the risk in their respective financial systems (The United States passed the Dodd-Frank Bill and now we can sleep safe at night (NOT)).

The world has had sixty some years of peace in Europe, but this could be coming to an end in the coming years.  I hope that I am really wrong on this point.

Germany is the only European country with the financial resources to address this debt issue, unfortunately it will not address it, the internal political costs are too great, and the political cost of not addressing it are a matter for another day, and possibly another German Chancellor to address.  Regardless of the decision the People of Greece make it, the out come will not be good for Greece and the European Union.

What does the Bond Rating Really indicate?

The rating of a Bond is only a rating agents measure (OPINION) of the issuer of that particular obligation likelihood to meet the terms and conditions of the obligation, i.e. make the right coupon payments on time and return the promised principal on time.  The rating says absolutely nothing else about other risks, much less what those risks might be.

And you remember the saying that “Opinion are like assholes, everyone has one”.  That especially applies to this article.

The rating of debt obligations was originally only applied to commercial debt not sovereign debt.  The application of rating to dedicated revenue backed governmental debt (Municipal Bond) may be appropriate.  The application of this type of rating to sovereign debt may be totally inappropriate.

The issuing agent pays for the rating (So who interest does the rating agent really represent?), which should be your first clue.  It was offered as service to the potential buyer (how to dress your pig), your second clue.  And off course it was offered as being unbiased (The rating agent get their money up front), your third clue.  Finally the rating agent does not participate in the debt market (The rating agent has no skin in the game), your forth and final clue.

Sovereign debt has some additional issues that currently is not or cannot be addressed by the rating agents.  The greatest and most pernicious is the risk associated with the likelihood of the issuing sovereigns to inflate their currency.  The commercial issuers bonds typically do not have any direct means to inflate their currency, unless they are state owned industries (AKA People Republic of China).

In many cases commercial issuers of debt typically are forced to issued assets back debt, where as sovereign debt is not back by any real assets, other than the words that the issuer of debt backs the debt with the following words “Full Faith and Credit of the “Fill in the Country Name”.  In other words sovereign debt should be viewed with some suspicion and possibly viewed as being subordinated debt.  If the country defaults, you as the bondholder have claim, a very tenuous claim.  If you hold the defaulted paper long enough, you might get a pittance back at some distance point in the future, but you are just a likely to get nothing.

If a commercial issuers of debt issues subordinated debt, there are currently 4 recognized levels of subordinated debt in the FpML (Sub Tier1, SubUpperTier2, SubLowerTier2, and SubTier3), it in some cases it could carry the same rating as senior debt issued by this entity, since the rating supposed to be only a measure of the issuer ability to meet the terms an conditions of the note.

If the company has issued already issued large amounts of senior and subordinated debt well in excess of the value of the company, the rating agency may determine that it is more likely or not that the issuer of the debt will not be able to meet the terms and conditions of this instrument, and hence provide a lower rating.

Typically subordinated debt already come with higher stated interest rate, this is done to entice potential buyers to overlook the possibility that the borrower may not be able to meet the terms and conditions of the instrument.  If the issuing agent does not like the rating that a particular rating agent assigns to an instrument, there is nothing that precludes the issuing agent from NOT passing this information on to any potential buyers (Since they are dressing a Pig), and seeking another review that is possibly more favorable (They like a Pig in a red dresses).  And as stated earlier, the rating is only an Opinion, and it is based on information provided to the rating agent by the issuing agent.  If the information is questionable or fraudulent, any recourse is not against the rating agent but against the issuing agent.

The Bond rating was was never designed to measure risk or safety of an instrument.  It’s uses as a measure of safety of one obligation versus other investments is a perverted misapplication of the rating and as such the buyer should beware.  It is not the first perverted misapplication of a measure in the world, nor will it be the last.

You can have two instruments issued by sovereigns both with Triple “A” rating, but the first issuing agent has a long and glorious history of currency manipulation.  The second issuing agent is not known for this type of behavior except in the most dire of circumstances.  Both instruments are issued with the same stated interest rate, but will the bonds have the same effective interest rate?  The short answer is an emphatic NO.

Both issuers of the debt have a long history of meeting the terms and conditions of the instruments, hence their instruments should carry the same Rating.

The issuer of the debt with the long and glorious history of currency manipulation will pay a higher effective rate, since knowledgeable purchasers of his debt will only offer an appropriately discounted bid for this debt.  This reduced purchase price should produce a yield that should account for the risk for the anticipated currency inflation that the issuing agent is likely to create in attempt to reduce the cost of this debt.

In the end there are two instruments with the same rating, but with different effective interest rates.  It is this effective interest rate that connotes a more accurate valuation of the risk associated with an instrument, not the rating.

It appears that sovereign debt regardless of it’s rating carries far more hidden risk than other forms of debt, particularly secured debt.  The thought that Treasury notes were or are riskless is a very quaint idea, you know like the Easter Bunny, but in fact it is nothing more than an illusion since they can inflate the currency; after all it was or is just a spot to put your money when you did or do not know what to do with it, another misapplication of a measure.

Using your own countries Sovereign Debt regardless of the instruments rating as core assets for the banks in your country can be done, and has been done, it creates a ready market for your countries debt.  You only owe your self; you have conjured wealth out of thin air.  Since the obligation is denominated in your currency, and if your government chooses to inflate their currency the market price floats, everything appears to be fine, you do not see the inflation.

Using Sovereign Debt of another country denominated in your currency as core assets for your banks is folly.  The debt that you hold may not “Change” in value in the normal course of actions, with the exception of if and when via force majeure that Sovereign defaults on the debt.  The have conjured wealth out of thin air, and you have no effective mechanism to keep them from conjuring more wealth.  On the surface your banks appear to be capitalized, but your banks in reality are under capitalized.  You have exposed your capital markets to outside forces, which you have very little if any control of.  (Can You Say EURO?)

Using Sovereign Debt of another country denominated in that countries currency as a core assets for banks in your country is sheer lunacy.  They have conjured wealth out of thin air, and for you the wealth should appear to be more of an illusion then a reality.  The value of the debt rises and falls with via the interplay of the two currencies, for which both governmental policies have direct effects.  The banks capitalization is constant shifting, one moment you are ok, the next moment you are not.  You can band aid some of the effect by reducing leverage applied to these assets.  If that were the case you would be better off using your own Sovereign Debt, more bang for your buck.

As Always “Caveat Emptor”, or for those who do not get Latin, “Check Your Six”.  Which are really nice ways of say that you should only risk funds that you can afford to lose.