Issue 60- May 04, 2010

Intensity

Greece picked a bad week to finally come clean with the potential size of its liabilities. As a result, the rating agencies responded with a downgrade to junk status and additional downgrades to two other P.I.G.S. members, Portugal and Spain. What was a need of $60 billion on April 11th is now a need of $160 billion just two weeks later. It certainly makes one wonder what the week of May 10th might bring! Germany, never keen on helping the most profligate member of the EU with a short term loan, is understandably that much further opposed now that the reality has come to light. Further complicating matters is a looming German election. Problems have truly grown at compound interest. The Euro, since its inception in 1998, has always been a common currency operating within a sphere of no common fiscal policy and no single monetary voice. The problem which transcends Greece is that any significant challenge requires the coordination of 16 central bankers. The Euro has been a hugely successful confederation, but it has never been a true union.

Greece does not have the ability to roll over its debt coming due this month and the majority of the paper is held by banks across Europe. The Bank Credit Analyst estimates that collectively they hold $2.3 billion of P.I.G.S. debt. If there was a rolling default averaging a discount of 40% for example, 21% of tangible capital would be wiped out of the banking system. The Euro system will not contend with a calamity of that magnitude and as such other unpalatable options are being considered.

It does take two to tango, however. Even if a suitable package can be designed, the question remains as to whether it could be practically implemented. To be charitable, the Greeks have not historically been known for economic transparency. Any package constructed by the IMF with the substantial assistance of an unwilling Germany is going to contain provisions that will be a hard pill for Greece to swallow. The mere suggestion of what might be coming has already resulted in statewide riots.

What we are left with is a situation where the necessary tools to effectively address this crisis simply do not exist. If the Euro is going to be a viable global currency, the European Central Bank is going to have to create the necessary infrastructure to support their monetary confederation. In the short term, they will act in their collective best interest in order to buy time. Depending on collective political will, they will either build out their financial tool set or they won’t. The status quo however cannot adequately serve the long term interests of members and the market seems willing to apply substantial discipline in order to encourage that transformation.

Principles versus Rules

There is simply no substitute for strong principles. Rules can never be a substitute for principles and we could never invent enough rules to anticipate every possible situation. The recent excoriation of Goldman Sachs is a quintessential example of this.

Goldman Sachs, as a major Wall Street broker dealer, was highly involved in all aspects of the mortgage market. Broker dealers, as the name implies, are both underwriters of new issues and then market makers in their secondary trading. As technology has made the costs and associated profits of securities transactions minimal, Wall Street responded with an emphasis on underwriting. The more the merrier.

The vast majority of Goldman’s clients are institutional investors who by their implicit status are not protected to the same standard as individuals. It is a Caveat Emptor marketplace. It is also a marketplace with a virtually insatiable appetite for high grade fixed income securities. The Basel II Accords which determine bank equity capital, attempted to preclude future systemic global problems by putting a heavy emphasis on having the members hold AAA rated assets.

The stage was set – low interest rates in the US spurred a home ownership bonanza where the only rate limiter was the availability of credit. That was neatly solved by Wall Street alchemy which managed to take all manner of loans – the good the bad and the ugly - and spin them into AAA rated silk that the sophisticated institutional investors around the world bought with zeal. That is until the music stopped and those ultra low interest rates were normalized.

There were those who recognized that tipping point and they wanted to invest accordingly. The problem was that there was no standard market in which to affect a short position in those vulnerable, low quality mortgages. Enter Wall Street alchemy again. Goldman Sachs underwrote a security known as a Collateralized Debt Obligation. This is synthetically created position meaning that it is an amalgamation of other loans. It is not the direct liability of any issuer, government, corporate, or municipal. But it was AAA rated.

The complaint leveled against Goldman was not that they should not have sold such a sow’s ear. Nor was it that they should not have been shorting the mortgage market at the same time that they were peddling rotten mortgages. This was well known as demonstrated on the front page of the Wall Street Journal on December 14th, 2007 (http://www.gata.org/node/5840). The complaint brought by the SEC was that they did not disclose that they had been approached to create this particular package of hand picked loans by this particular gentleman who wanted to short the market – big time. Now this is a principle problem writ large and it was endemic on Wall Street.

A number of other firms have proudly announced that they too were approached to underwrite this very package and that they had declined. But we all know – you can’t be just a little bit pregnant. Every major firm underwrote these horrendous securities. A number of them even retained for their own accounts the most hideous tranches and were subsequently bankrupted.

There were no rules prohibiting the underwriting of junk mortgages. Once upon a time there had been strict standards but congress, in a well intentioned effort to promote even more home ownership, allowed Freddie Mac and Fannie Mae to apply their good housekeeping AAA rating on pools that historically would have never been acceptable.

Rules can always be bent where principles cannot. The collective mortgage establishment wrapped itself in the knowledge that nothing they were doing was technically illegal, but that was certainly not a principled position.

Congress is currently trying to inject into the system a sort of synthetic set of principles through a combination of new capital requirements and old structural restrictions. We have commented that privately held Investment Banks were more cautious with their partner’s capital than their public versions have shown themselves to be with shareholder money. Whatever regulations do come down, all investors will be better off by voting with their feet and conducting business with those firms who practice strong client centric principles.

Best Wishes,

Patsy and Jen

• Intensity
• Principles versus Rules