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Europe In Debt (Part 1): Creating a Monster

This is the first of a comprehensive three-part in-depth analysis of the European economic havoc currently haunting the Union like a malicious worm, mutating itself again and again, threatening the very core of EU’s financial system. It’s a so-called “Must Read” for everyone trying to understand what’s going on – on stage and behind the scenes. These three articles has recently been published by the independent research center EVRO Intelligence ASBL at their website eurointelligence.com. Former derivative trader, Satyajit Das, provides exceptionally valuable insight and some harsh conclusions.

“In order to restore solvency, overburdened borrowers must stabilize debt and begin to reduce the level of borrowing. This requires GDP Growth exceeding interest rates, a budget surplus (through spending cuts and/or tax cuts) or a combination of these.”

Satyajit Das


“In early 2010, drawing on the military leadership of President George W. Bush, European leaders declared the economic equivalent of “mission accomplished”. A bailout – whoops support! – package of Euro 750 billion had shocked and awed speculators into submission. Like the Bush pronouncement, the European prognosis provided premature. The return of European sovereign debt problems in late 2010, culminating in the bailout of Ireland highlighted the deep seated and perhaps intractable problems of some over indebted European nations,.”

And here we go!

Mission Interrupted

In the first half 2010, the trigger was the large budget deficits and high debt levels of the “PIGS” (Portugal, Ireland, Greece and Spain) or “PIIGS” (including Italy). For Greece, a lethal cocktail of the need to finance maturing debt and deficits, use of derivatives to disguise debt levels and general lack of candor about its borrowing, exacerbated the problem.

The European Union (“EU”) responded ultimately with a variety of measures, including an Euro 110 billion bailout for Greece and the Euro 750 billion European Financial Stability Funds (“EFSF”) designed to underwrite the liquidity of the besieged Euro-zone members.

The European Central Bank (“ECB”) separately supported the EU measures. The ECB’s role, presumably with the tacit agreement of the EU and members, was crucial, avoiding the problems of lack of consensus and disagreements at the political level.

The ECB purchased bonds issued by Greece, Ireland and Portugal in the secondary market to support prices. By mid-December 2010, the ECB had purchased Euro 72 billion as part of these operations.

More importantly, the ECB supported banks in the troubled companies, providing funding when money markets would not finance these institutions.

The funding was at attractive rates (around 1%), against security of government bonds lodged as collateral for the loans. A delicious arbitrage and backdoor way of financing the troubled borrowers ensued.

“The illusion that the countries had access to commercial funding sources at reasonable rates was maintained. The banks also earned large returns, the difference between the yield on the bonds and the ECB funding rates.”

Domestic banks in Greece, Ireland, Portugal and Spain purchased their own government’s debt, ensuring crucial demand and “successful” auctions. The purchased bonds were used as collateral to secure funding from the ECB. The illusion that the countries had access to commercial funding sources at reasonable rates was maintained. The banks also earned large returns, the difference between the yield on the bonds and the ECB funding rates.

As of August 2010, the level of ECB funding was as follows:

Euro (billions) % of Deposits % of Gross Domestic Product
Greece 96.1 26 40
Ireland 95.1 14 60
Portugal 50.1 15 30
Spain 119.0 5 11

Following the Irish crisis in the second half of 2010, the funding demands on the ECB have increased. Ireland’s borrowing from the ECB has reached Euro 136 billion (86% of Gross Deposit Product (“GDP”)), around a quarter of Euro-zone member drawings on the facility.

The ECB has expressed concern about Europe’s “addicted financial groups“. But with banks affected by their sovereign’s debt problems and maturing debt not being rolled over, the ECB has little option but to continue the arrangement.

The approach of the EU/ ECB assumed that the problem was temporary liquidity not solvency. The solution was to ensure that the troubled countries could continue to finance. The restoration of confidence would enable a rapid return to market financing and the status quo.

“It was a pure confidence trick.”

Nothing exemplified this better than the ill-conceived and poorly designed EFSF.

Amongst the multiplicity of problems were the limited guarantees from Euro-zone countries and a reliance on CDO rating methodology.

The preliminary analysis of the EFSF by the credit rating agencies confirmed the view that the facility was not designed for use. Close inspection also revealed that the facility was only capable of being drawn for an amount as low as Euro 250 billion, well short of the advertised Euro 750 billion. It was a pure confidence trick.

As concerns about the underlying solvency of the countries continued, markets became increasingly nervous.

The uncertainty manifested itself in the increased interest rates on European sovereign borrowing, which rose to levels above those at the time of the Greece bailout.

Irish Futures

The tensions focused around Ireland. While the problems of Ireland are well documented, the sequence of events was curious.

Ireland had sought “prime mover advantage” in austerity, reducing its budget deficits through severe cuts in government spending and tax increases. It established a state bank restructuring agency – National Asset Management Agency (“NAMA”) – to deal with bad loans made by banks. Ireland had completed its 2010 financing program, not expecting to come to market until early 2011.

It also had Euro 20 billion in surplus cash.

A series of related events focused attention on Ireland. Bank bad debt problems re-emerged, especially at Anglo-Irish Bank. Forecast loan losses were revised upwards significantly, in turn increasing the demand on the state to finance the bailout of the banks. The cost, still unclear, was estimated at around Euro 50 billion (30% of Ireland’s GDP).

This had the effect of pushing the 2010 Irish budget deficit to around 32% of GDP.

“They say if a politician denies that he is going to resign stridently often enough, he almost certainly will.”

German Chancellor Angela Merkel raised the prospect of bondholders being forced to “share” losses in any debt restructuring. After a sharp increase in rates for many European countries in response to the suggestion, at the G-20 summit in Korea, European leaders clarified the proposal. It would only apply after 2013, when the current bailout arrangements expired. This drew attention to the temporary and short term nature of the EFSF and related support mechanisms.

Independently, Anglo Irish Bank offered to repurchase its outstanding subordinated debt for 20% of face value, warning that the return to investors in bankruptcy or restructuring would be far worse. This highlighted the risk of loss on Irish State or bank debt.

At the same time, Austria withheld its share of the due installment of funds to Greece, arguing that key hurdles had not been met. While the Austrian posturing was mainly driven by domestic politics and funds were eventually released, the fragile nature of European support for the troubled borrowers was highlighted.

The parlous state of Ireland’s economy was unhelpful. The Irish economy shrank by 1.2% in the third quarter, a surprise to economic forecasters.

Markets pushed up yields on Irish debt inexorably. Higher rates caused losses on holdings of Irish bonds, triggering further selling.

As rubber-necked accident voyeurs joined the party, the costs for Ireland to borrow commercially reached economically unsustainable levels closing access to financial markets. Depositors started shifting their money abroad, threatening a fully-fledged bank run.

They say if a politician denies that he is going to resign stridently often enough, he almost certainly will. Strenuous denials of the need for a bailout ended inevitably in one. A grim Irish Prime Minister Brian Cowen announced that Ireland would be receiving aid from the EU subject to meeting EU/ International Monetary Fund (“IMF”) conditions. It would, the Taioseach insisted, “secure Ireland’s future.”

No one believed him.

Bailing Times

The Irish bailout facility totaled Euro 85 billion, made up of Euro 35 billion for the banking system (Euro 10 billion for immediate recapitalization and Euro 25 billion to be provided on a contingency basis) and Euro 50 billion to cover the financing of the State. The average interest rate would be of the order of 5.8% per annum, depending upon the timing of the draw-down and market conditions.

Euro 67.5 billion of the facility was to be provided by the EFSF (Euro 22.5 billion), the European Financial Stability Mechanism (“ESM”) (Euro 22.5 billion) and bilateral loans from the UK, Sweden and Denmark and the IMF Extended Fund Facility (EFF) (Euro 22.5 billion). The remaining Euro 17.5 billion was to come from Ireland’s National Pension Reserve Fund (NPRF) and other domestic cash resources.

The limited level of funding from the EFSF and the new ESM, a permanent successor to the EFSF, tacitly acknowledged the shortcomings of the funding mechanism proposed earlier. The raid on Irish pension fund reserves brought back memories of Argentina’s confiscation of Central Bank reserves and pension funds to finance the State.

After a brief rally, familiar concerns re-appeared. Estimates suggested that the Irish banks alone required around Euro 16 billion in capital and a further Euro 38 billion in financing. This totaled Euro 54 billion, 64% of the Euro 85 billion package. Given that Ireland required Euro 70 billion to meet maturing debt until 2013, the size of the bailout facility was arguably inadequate.

As in the case of Greece, the bailout package dealt only with short-term liquidity, failing to address Ireland’s longer term solvency.

The arrival of an IMF/ EU team to prescribe a “cure” did not inject the expected confidence in an imminent recovery. Ireland had been self administering the same medicine for some time, with indifferent results.

The Irish economy has not recovered from recession, with GDP only registering growth in one quarter since 2007.

Overall, the economy has shrunk by nearly 20% from its peak. Gross National Product (“GNP”), which is a better indicator of living standards, has fallen for nine successive quarters.

The official unemployment rate is around 14%, though the level of real unemployment and under employment is greater. House prices are 36% below their 2006 level.

Consumer spending has fallen sharply, the result of lower income and increased savings levels of around 12% of income (an increase from 3.9% two years ago).

Cuts in government spending and higher taxes have mired the economy in recession. Falls in tax revenue necessitate increasingly deeper cuts in spending to try to stabilize public finances. In 2010, the budget deficit was forecast at 12% of GDP, even after spending cuts and tax rises worth Euro 14.5 billion

The problems of the banking sector are increasing due to the poor economic conditions. Hitherto largely confined to commercial property, problems are now spreading to the broader economy. Unemployment and lower incomes mean that householders are unable to meet payment obligations on mortgages and other loans.

Weak economic conditions have affected businesses, increasing default levels.

“The maturity of the bailout package is likely to be extended, acknowledging that it cannot be repaid.”

Following the bailout, the Irish government announced further cuts in the budget deficit of Euro 15 billion, with Euro 6 billion scheduled for 2011.

The package included Euro 10 billion of spending cuts covering social welfare, health care, education and the public sector.

There were Euro 5 billion of tax increases, including increases in value added tax (VAT), income taxes and property taxes. Controversially, the low 12.5% corporate tax rate, crucial to maintaining Ireland’s competitive position, remained unchanged, despite complaints and pressure from the EU.

The ability to meet the required targets is uncertain. Forecasts are predicated on “aspirational” growth of 2-3%. Moody’s Investor Services, the rating agency, cut Ireland’s debt rating by five notches Baa1, two notches above junk, with a negative outlook.

The experience of Greece under the IMF/ EU plan is instructive.

While there has been some progress, Greece is struggling to meet its budget targets due to a shortfall in tax revenues, forcing ever more aggressive spending cuts exacerbating Greece’s deep recession. Planned asset sales and structural reforms are unlikely to stabilise public finances. Faced with the unpalatable choice of withholding funding due to non-compliance with the plan or allowing default, the EU/ IMF have continued to disburse funds propping up the economy.

The maturity of the bailout package is likely to be extended, acknowledging that it cannot be repaid.

In the absence of strong economic growth, inflation and a massive devaluation, the peripheral economies, such as Ireland and Greece, may be unable to shrink themselves to solvency.

Changes In Government Debt = Budget Deficit + [(Interest Rate – GDP Growth) X Debt]

In order to restore solvency, overburdened borrowers must stabilize debt and begin to reduce the level of borrowing.

This requires GDP Growth exceeding interest rates, a budget surplus (through spending cuts and/or tax cuts) or a combination of these.

“There is little prospect of many European countries returning to balanced budgets any time soon.”

EU/ IMF assistance to Ireland was designed to address the high yields on Irish bonds, which curtailed the State’s ability to borrow. But the 5.80% cost of the bailout debt requires an equivalent growth rate and a balanced budget simply to stabilize debt at current very high levels.

Based on the IMF’s best estimates, there is little prospect of many European countries returning to balanced budgets any time soon. Given the toxic conjunction of high cost of funding, low growth and high starting level of debt, it is near impossible for these countries to contain the spiral to a restructuring of their debt or default.

The difficulty of managing outcomes is evident. ECB President Jean-Claude Trichet told the Financial Times on 23 July 2010:

Given the magnitude of annual budget deficits and the ballooning of outstanding public debt, the standard linear economic models used to project the impact of fiscal restraint or fiscal stimuli may no longer be reliable. In extraordinary times, the economy may be close to non-linear phenomena such as a rapid deterioration of confidence among broad constituencies of households, enterprises, savers and investors.

When asked for directions, the old joke is that some wise guy pipes up: “If you want to go there, then I wouldn’t start from here.”

The same could be said of rescuing overburdened European countries.

By Satyajit Das

eurointelligence.com

(Satyajit Das is the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.”)

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Investors Beware: Crucial Week Coming Up

The coming week will be a kind of make-or-break for the global financial markets. Not only do we have a Congressional election in the US, we’ve also got the FOMC‘s decision on further quantitative easing coming up. In addition, the European sovereign debt problem has taken a turn for the worst, with the difference in CDS spreads hitting a record high on Friday.

“The next few days will have a crucial importance on both politics and economics.”

Gavan Nolan


The revival of political risks in Greece, Portugal and Ireland, and the growing potential of an Anglo Irish Bank debt exchange, caused the sovereign CDS spreads to widen further. The basis between the Markit iTraxx SovX Western Europe Index and Markit iTraxx Europe Index reached 53bp on Friday – the widest on record.

However, according to Markit.com, the SovX is trading with a considerable skew; “i.e. the theoretical level of the index is trading tighter than the index itself,” credit analyst Gavan Nolan writes in Markit’s weekly credit wrap.

And when comparing the theoretical levels of the two indices the difference is 36bp.

“A high level but nothing exceptional and well below the 47bp reached on May 6,” Gavan Nolan points out.

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Formerly Known As “Political Risk”

Politicians have been derided many times for their often shaky knowledge of economics.

Ronald Reagan’s supply-side policies were dismissed as “voodoo economics” by none other than George Bush in the 1980 presidential race.

And when Bill Clinton ran against George W. Bush in 1992, one of his most famous slogans was; “It’s the economy, stupid!

Probably one of the best indications of how deep the knowledge of economic and financial issues  are (in general) amongst our political leaders, sadly.

More recently, the newly appointed UK shadow Chancellor of the Exchequer Alan Johnson has faced opprobrium for his supposed ignorance, even half-joking that his first action would be to “pick up a primer of economics for beginners”.

But whatever their levels of competence – and many of them are more than competent – the actions and utterances of
politicians have a direct influence on the economy and asset valuations.

“Events in the euro zone’s periphery over the past few days have made this evident. Political instability in two of the most troubled countries in the currency club has caused a mini-revival of the volatility seen earlier this year,” Gavan Nolan writes in this weeks market wrap.

Greece’s spreads widened sharply this week, reversing some of the strong rally seen over the last two months.

The Prime Minister George Papandreou warned that “we have not yet escaped the danger. I am sounding the alarm”.

As if this wasn’t enough to deter investors, Papandreou threatened to call a general election if his party fail to win decisively in the upcoming local elections.

Then the finance minister George Papaconstantinou weighed in, revealing that the country has “serious tax compliance issues”.

“Those familiar with Greece will regard this as a truism, but if the sovereign is to get its fiscal house in order then it needs to fix this issue quickly,” Nolan points out.

The country’s budget deficit is expected to be upgraded by Eurostat to over 15%, and the sovereign’s spreads are still indicating that a debt restructuring might be the most likely – and least painful – way forward.

“On the other side of the periphery, Portugal – hardly a paragon of fiscal prudence – has its own political problems.” Nolan comments.

Budget talks between the minority Socialist government and the main opposition party, the Social Democrats (PSD), broke down on Wednesday. The latter party is insisting that spending cuts should make a larger contribution to the austerity package.

It is likely that a compromise will be reached before the final vote on the budget next month.

“Nonetheless, the uncertainty created by the deadlock caused spreads to widen and they are set to remain volatile until an agreement is reached,” Nolan notes.

“Political friction in the euro zone will no doubt be relevant to risky asset valuations next week,” the analyst writes.

The Risks of the Week

But any fresh developments are likely to be overshadowed by events across the Atlantic, as Tuesday brings the US mid-term elections.

The polls are predicting that the Democrats will lose control of the House and maybe the Senate.

“As investors digest the implications of possible political gridlock they will be hit by the FOMC decision the following day,” Gavan Nolan adds.

The markets have been pricing in additional QE for some time now, and are expecting a confirmation on Wednesday.

The big question is how big – and how gradual – the liquidity injection will be.

“Prior to both events are the ISM and Markit Manufacturing PMIs on Monday (services on Wednesday) and then the week ends with non-farm payrolls on Friday,” markit.com informs.

“The next few days will have a crucial importance on both politics and economics,” Gavan Nolan concludes.

Related by The Swapper:

Credits: PIGs Gone Wild

Marc Faber Expects Market Sell Off On QE2 Announcement

Chart Of The Day: Europe’s Web Of Debt

The Fight Against Currency War

Fitch Place Most US Banks On Negative Rating Watch

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Israel, USA Plans To Attack Within Next 3 Months, Iranian President Says

Iranian President Mahmoud Ahmadinejad says the United States and Israel plan to attack two countries in the Middle East as part of a conspiracy to apply pressure on Iran. This exclusive interview with Mr. Ahmadinejad, done by Press TV, is an absolute “Must See.”

“They plan to attack at least two countries in the region within the next three months.”

Mahmoud Ahmadinejad


“We have precise information that the Americans have devised a plot, according to which they seek to launch a psychological war on Iran,” Ahmadinejad stated in an exclusive interview with Press TV, Monday. “They plan to attack at least two countries in the region within the next three months,” he added.

He said the US seeks to achieve two main objectives with the scheme.

“First of all, they want to hamper Iran’s progress and development since they are opposed to our growth, and secondly they want to save the Zionist regime because it has reached a dead-end and the Zionists believe they can be saved through a military confrontation,” Ahmadinejad explained.

He also advised US President Barack Obama not to follow the policies of George W. Bush.

In addition, he warned Russian officials to avoid playing into the hands of Washington because that would go against their national interests.

US Expansion Of War In Middle East Imminent

Commenting on the nuclear issue, Ahmadinejad said Iran will resume nuclear talks with the West in September, adding that Iran wants Turkey and Brazil to participate in the negotiation.

Related by the Econotwist:

Is World War III Approaching?

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EU Officials Fears Second Depression And War

“We Stand At The Brink Of The Next Great Crisis”

“The Economics Of War Unfolding Now”

Germany In Favour Of Creating European Army

Wars Filling Norwegian Order Books

EU: Trading Bailouts For Weapons

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