Issue 77 - March 5, 2012


Punxsutawney Greece

Investors around the globe have understandably grown weary after nearly two years of relentless “Greek Default Imminent” headlines. Complacency at this time may prove to be unfortunate as this particular chapter in the Euro story appears to be heading toward a tumultuous conclusion.

It is well understood now that Greece with its current labor laws, benefits, irregular tax collections, and resulting GDP is not a going concern. It will certainly not be able to make good or to roll over its upcoming March bond maturities. What is less well understood is that the latest “Greek Bailout” that has been put forth has very little to do with the Greece and everything to do with the Euro Zone banks, Greece’s largest creditors.

We have argued that the Euro Zone was at its heart a political construction rather than a financial one. The efforts of these past two years have focused on preventing a potential Greek default and subsequent rupture in the political fabric, not on how to get a wayward member back on track. This latest proposal is further evidence. Greece will not receive any of the €130BB directly. These funds will be used to pay back creditors; first the European Central Bank and the IMF, and then the banks and other private investors. However, in what may prove to be a fateful and far reaching decision; private investors will receive vastly inferior terms in the proposed restructuring relative to their governmental counterparts. Specifically, the ECB and IMF will receive par, while the banks and other private investors would likely recover only a quarter of that amount. From a private investor’s perspective, this retroactive subordination is particularly worrisome and begs the question of under what future circumstances would they ever buy more sovereign bonds of those impaired (or potentially impaired) nations?

The IMF which was established at the end of World War II does have historical precedent for such subordination. IMF credit was always put into a senior position whenever they would be brought into a region as a lender of last resort. However, their central role up until the Euro crisis was played in those lesser developed locales which had no other access to credit: not from within the borders of the developed Euro Zone! The ECB on the other hand has no such historical precedent. They intervened in this crisis by buying Greek bonds on the open market just like any other investor. Again, what must our beleaguered private investors be thinking as it relates to the bonds of Italy, Spain, and Portugal? All markets where the ECB has also made open market purchases.

As a practical matter, the ECB hopes to create this subordination by mandating that the Greek government invoke legislation known as a “Collective Action Clause”. The concept being, if Greece can round up 75% of the private bondholders who are willing to tender their bonds under these proposed terms, then they can then force the remaining private bond holders to go along. As Martin Blessing of Commerzbank chided, “The participation in the haircut was as voluntary as a confession during the Spanish inquisition”. S&P downgraded Greece on February 27th to “SD” known as a selective default in response to this proposal.

In our opinion, Greece's retroactive insertion of CACs materially changes the original terms of the affected debt and constitutes the launch of what we consider to be a distressed debt restructuring….As we have previously stated, we may view an issuer's unilateral change of the original terms and conditions of an obligation as a de facto restructuring and thus a default by Standard & Poor's published definition….

Despite the many talking heads who regularly dismiss the proceedings in Greece as “being behind us”; the proposed restructuring even under these terms is far from a foregone conclusion. The flow chart below shows that participation rate of fewer than 75% will likely lead to an old fashioned default and a triggering of the credit default swap insurance policies that remain yet another wildcard in this process.

Foaming the Runway

In our last newsletter, we referenced a program targeted at extending badly needed liquidity to Euro Zone banks known as the Long term Repo Operation or LTRO. 523 banks took down €489 Billion in December and an additional tranche of €529 Billion with 800 institutions took place on February 29th. This program is credited with bringing stability to the financing needs of the Euro Zone banks as both the interbank market (LIBOR) and the US Money Markey complex have been sharply reduced sources of funds. However, the vast majority of those funds remain on deposit at the ECB. In other words, the banks took out over €1 Trillion in three year money at 1% but have yet to make any meaningful loans either to other Euro Zone banks or companies. Why would they do that?

The ECB is certainly sponsoring this program to provide the necessary resources for the participating banks to either roll over or to purchase new/more sovereign bonds. Not coincidentally in 2012, we have seen the rates on both Spanish and Italian new issues come down dramatically. But there may be practical limits to what bankers are prepared to do. Again, Martin Blessing, “Taking the ECBs cheap loans to buy sovereign bonds, particularly those in southern Europe, doesn’t appeal. I think we have enough of the securities.”

So if there are practical limits of Sovereign bond purchases and the untapped funds are simply collecting dust on deposit at the ECB – why issue another tranche? Clearly, the ECB is using this successful program to create a monstrous liquidity reservoir for their entire banking system. They are in essence foaming the runway in advance of landing something large and unpleasant. In a time of such uncertainty, they clearly want to have a way to provide firebreaks to the salvageable parts of the confederation and the LTRO appears to be a mechanism that the market can currently live with.

“The Euro Crisis is Behind Us?”

The “Greek Bailout” is not simply a financial proposal. There is also a 90 page memoranda outlining 38 specific changes to Greek tax, spending, and wage policies and a 10 page list of prior actions to be completed by March 1. Right.

Greece is entering its 5th year of recession and has unemployment in excess of 25%. The need to avoid default has been the driving force these past two years for both the ECB and the Greek politicians. However, what is left of the Greek economy now has to be asking itself if the price of remaining in the Euro is worth it. The current set of politicians in Greece is not likely to survive the April elections. The two parties which represented the people of Greece with 77% of the vote now find themselves down to something like 32% according to Stratfor. The next potential government has already declared their opposition to the current deal. Furthermore, Ken Rogoff of Harvard and co-author of “This Time is Different” estimates that Greek wages would need to be halved in order for the country to regain growth. Staying within the strong currency of the Euro makes wage adjustments that much more painful. It would not be hard to imagine a scenario in the very near future where the collective demands are simply beyond the means of Greece and the lesser of evils is deemed to be a default.

If Greece goes, can Portugal and their 30% plus unemployment be far behind? Yields on Portuguese debt have not fallen in line with those of Italy and Spain despite the LTRO’s. Ireland has just announced a nationwide vote on the European Fiscal pact that was introduced in December. The Irish leadership had hoped to avoid such a referendum while they are trying to implement €30 Billion of their own austerity treatment. Nicolas Sarkozy of France has stated that if he is re-elected, he will not hold a referendum; however he trails in the polls to the leader Francois Hollande. All of this is simply to point out that the Euro Crisis is far from behind us and will act as a governor on global growth for some time to come.

Healing Hoopla

The US Economy demonstrated continued signs of healing in the first two months of 2012 and the equity market found reason to rejoice in all manner of releases. S&P 500 earnings grew at a rate of 5.5% for the 4th Quarter which while positive still marks the end to 8 consecutive quarters of double digit growth. In addition, if we were to strip out the accounting driven gains of AIG and the turbo growth of Apple that rate drops to 0.8%. Jim Bianco of Bianco Research graded the quality of the earnings as a “Gentleman’s C”.

The unemployment rate dropped to a better than expected 8.3% however the participation rate, defined as those who are actively seeking employment, also fell to an unwelcome 63.7%

This number typifies what we have been seeing throughout this recovery: the US economy continues to heal slowly and unevenly and with the benefit of all the Federal Reserve’s spigots wide open. We can certainly celebrate the forward progress but we must not confuse a subsidized rebuilding process with long term robust growth.

What Price Income?

Pundits throughout the post 2008 period have looked reluctantly towards fixed income markets. The refrain of “rates have nowhere to go but up”, can be heard on any program or at any conference at any time. Jim Bianco documents their bearishness using Bloomberg’s Monthly Economist Survey for the 10 Year US Treasury. For 2011 over 88% expected to see higher rates in the next 6 months and their recent February reading has risen to 92%. Meanwhile, demographics and the extraordinary recent equity price volatility have continued to drive more and more investors toward income generating assets either out of need for tangible spending money or the desire for safer harbors. These factors have powered strong rallies in both the higher dividend paying sectors of the equity market as well as many fixed income markets. Several questions come to mind as a result. First, are rates likely to stay low and for what time frame and second, what price is fair to pay for what type of income? Furthermore, if rates were to stay subdued for an extended period of time, what will the pension plans and other liability managers do with their asset allocations in order to have a chance to meet their actuarial obligations?

Will rates stay low and for how long? It would be nice to have a proper crystal ball for this part of the exercise. The Federal Reserve has stated that they expect to keep rates low through 2014. Their balance sheet has exploded much has the ECBs which we showed earlier in this missive.

As a practical matter, rates are likely to stay low until such time as the Fed can begin to drain off some of these huge balances. There has been no path articulated as to how this will be done either in the US or the Euro Zone. Further, economic activity will need to improve to such a point that these support mechanisms can be removed.

“Reaching for yield” is an old maxim that refers to the unsound practice of chasing income beyond levels or credits that would be deemed prudent. Investing in those markets which are either binary or impossible to model would be good examples. Portuguese yields might be tempting, but they may or may not make timely payments of interest or principal. REIT’s have been popular vehicles but many are impossible to effectively model as the sponsors of these structures may be forced to give back a building at any time therefore reducing the cash flow stream materially. High current yields can be tempting on certain energy related trusts but depending on those structures, the depletion of the underlying assets will require a termination to the cash flows at a given date; a reality that current yield enthusiasts dismiss at their own peril. Finally tax policy for 2013 and beyond remains unknown and as of these writing, dividends will return to ordinary tax treatment with the expiration of the current tax law at year end. A doubling or more of the tax rate of ordinary dividends could significantly diminish their current favorability.

Where does this leave liability mangers looking to meet their targets? Low rates and uncertain tax policy are hardly a welcoming backdrop for further fixed income allocations. But income is a vital component in long term investing success. 2008 taught us that in spades. If you could withstand the initial assault and stomach the turbulence, you were rewarded and income was the secret sauce that made that possible. Rather than avoid fixed income markets, a broader approach to credits and structures would be more appropriate than simply increasing equity risk or illiquidity.

It has been a strong start to 2012 for markets on the merits of improving data and the Euro Zone has taken dramatic steps to improve the position of their banking system in the near term. The road ahead will continue to be challenging and no doubt disappointing from time to time. We will retain our allocation discipline and look to be opportunistic investors throughout the balance of the year.

Best Wishes –

Jen & Patsy


In this Edition

  • Punxsutawney Greece
  • Foaming the Runway
  • "The Euro Crisis is Behind Us?"
  • Healing Hoopla
  • What Price Income?

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

76 - 01.09.12
2012 - The Continuum/ Europe - Working in the Injury Time/ "Risk On - Risk Off"/ The Road Ahead

75 - 12.05.11
The Problem/ What Could Go Wrong/ Compound Interest/ Germany or Bust/ The Cavalry/ Stress Tests/ Next Chapters/ MF Global

74 - 09.29.11
Broken Transmission/ Chickens and Eggs/ Where to?

73 - 08.29.11
The Confluence/ The ECB/ US Economy - Distinction without a Difference/ A Different Kind of Exit/ Gold as a Thermos/ Where to Now?

72 - 06.28.11
Sovereign, Central, Commercial/ Why we call them "Banksters"/ "Extended Period" just got a lot longer/ Forward.

71 - 05.24.11
The Question is... How Many Years?/ "Unexpected" Housing Weakness/ P.I.G.S. Can't Fly/ Stages.

70 - 04.11.11
Inflation for thee, but not for me/ On the Other Hand .

69 - 04.05.11
Implications - A Bevy & A Wedge/ Implications - Quantitative Easing 2.0/ Implications - Rules Rules Rules/ Catching Up with the Can.

68 - 03.03.11
What Ever Happened to Housing?/ Where Do Loans Come From?/
Where Do Loans Go?/ The Last Straw/ The Path Forward/ Equity/ Clearing Mechanism/ Restart Your Securitization Engines.

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward

58 - 12.29.09
2009-The Year in Review/ 2010 - The Year of "The Exit"/ Deflation or Inflation?/ 4 Cylinder Economy/ Rates and Returns

57 - 11.04.09
Banks-Back to the Future/ Navigating the Tsunami/ TARP 3.0/ Implications

56 - 09.15.09
Are We There Yet?/ The Beginning? The Present/ The Journey is the Destination

55 - 08.04.09
A Transformation is not a Recovery/Not All Economic Data is Created Equal/
Smallest, Lowest, "Shortest"

54 - 06.24.09
Aftershocks/ Fragility/
Inflation and the Fed

53 - 05.29.09
A Brave New Road to Recovery/ Vehicle Choice/ Speed Limits

52 - 04.07.09
The Things We Know/The Things We Don't Know/Savings and Sensibility

51 - 03.25.09
The Correct Problem/ The Need for Speed/ No Good Deed Goes Unpunished

50 - 03.05.09
Rebuilding Credit/ Under Repair/Problems Persist/Big Chore

49 - 01.12.09
The Year in Review/ The Path Forward/ 2009


More Past Issues
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Market Highlights



12/30/11 12/31/10 12/31/09 12/31/08 12/31/07 12/29/06 12/30/05 12/31/04
12,218 11,578 10,428
S&P 500 US


1,258 1,258 1,115


Nasdaq US
2,605 2,653 2,269
EAFE Int'l Equity
1,413 1,658 1,581


5 Yr Treasury .87 .85 2.02 2.71
5 Yr AAA Muni .72 .94 1.75


10 Yr Treasury
1.96 3.38 3.92
10 Yr AAA Muni
2.08 3.44 3.26
30 Yr Treasury 3.10 2.914 4.325
30 Yr AAA Muni 3.58 3.82 4.9
EUR Currency 1.32 1.29 1.34
JPY Currency 81.51 77.36 81.32


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