Issue 80- May 10, 2012



Voters across Europe voted this past weekend and clearly expressed their frustration with the current course of financial events. This brings the total number of Euro Zone administrations which have gone down to defeat in the past two years including France, Ireland, Portugal, Greece, Italy, Spain, and the Netherlands to 7. These election results along with previous restructuring plans have set the stage for the next chapter in the Euro Zone.

Texas Hedge

This past winter, the European Central Bank announced and implemented a far ranging liquidity program designed to alleviate immediate funding stresses across banking systems. The Long Term Repo Operation, or LTRO as it is known, lent over € 1 Trillion to over 800 banking institutions. With euro based deposits seeking safer havens and US Money Market funds shunning short term euro bank vehicles, these banks were in desperate need of a new source of funding. The LTRO attempted to address two birds with one stone. First, there was an immediate source of cheap liquidity for the banking system. Second, it effectively created a quid pro quo, whereby these banks became the buyers of last resort for their native sovereign bonds. Initial reports were enthusiastic. Yields in Spain for example fell below previous worrisome levels and the talking heads of finance declared an end to the European Debt Crisis. Or was it?

With the benefit of hind sight we now know that what the LTRO really accomplished was to implement a “Texas Hedge” where one inadvertently amplifies a risk that one is really trying to minimize.

Throughout 2011, banks across the Euro Zone were seeing their capital eaten away by the deterioration of the credit quality of their substantial sovereign bond holdings, specifically those issued by the P.I.G.S. This was going to reach a tipping point in March with a looming Greek Default. As we wrote in our March Newsletter;

“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.”

The LTRO program which came in advance of the Greek restructuring changed the nature of the holdings of the individual banks. Prior to the program, the problem had been Spanish banks holding Greek bonds, etc.. After the LTRO, Spanish banks held Spanish bonds. While the program bought time, it has also effectively tied at the hip the finances of the sovereign state to their native banking industry and vice versa. There is now no easy way for either party to diversify their holdings or their funding sources. This program has concentrated risk across the Euro zone.


With the French and Greek elections of May 6th, voters clearly stated that they don’t like the austerity path that had been presented to restore financial solvency while remaining within the Euro. The problem with this, to state the obvious, is that this does not leave the political leaders with many levers left to work with. Austerity is not something a nation would ever choose. Rather it is an unwelcome outcome. In regards to the markets, what comes next is going to be tricky with significant practical limitations.

Beginning with Greece, if it is unable to form a coalition government with as many as four minority parties represented, then they will be unable to meet the next milestone specified by their predecessors in March. If no cash is forthcoming, then something will have to give. We have long argued that national restructurings are not unknown events in the modern world. The impaired country devalues their native currency and repays its debts on a discounted basis to the best of their ability. The weaker currency allows the country to attract new working capital and may begin the process of growing once again. The inability for the weakest Euro members to move forward in their own currency has been the single biggest stumbling block to a resolution.

Spain is presenting other symptoms. Already we have seen one of Spain’s larger banks, Bankia, require an injection of national funds to compensate for further losses in its real estate portfolio. With youth unemployment north of 50%, it is again hard to imagine how Spanish leaders can conjure up the required growth while remaining within the Euro currency.

France represents a third challenge. With the election of Francois Hollande who has promised more growth oriented policies, markets may well begin to charge France a substantial premium to borrow more funds. The question becomes can the growth hare out pace the cost tortoise? If not, France too will be forced to confront the cost benefit analysis of remaining tied to a strong currency.

Finally, compliments of the LTRO, skittish markets may force an unthinkable margin call across the Euro Zone. Sovereign bonds are posted as collateral for the LTRO funds. If the market for these bonds drops substantially, native banks which borrowed the money in the first place to shore up liquidity would dump these bonds back onto the market in an effort to meet the margin calls. These banks have few other means of meeting the calls other than a sale.

There is however another intriguing angle to all of this native concentration; it certainly makes an exit from the Euro a far less complicated event. Perhaps this was the method in the madness of the LTRO all along. After all it bought a few months of valuable time and realigned the assets and liabilities into more orderly units.

Markets are quickly moving to recognize that we are in this next decisive chapter. Euro Zone leaders have spent the better part of 3 years now trying to find a way to sustain what Pimco’s Mohamed El-Erian has termed “the unsustainable”. They had been able to buy time, but the confluence of events may now be at hand which forces the necessary changes to allow all members – current and potentially former – to heal national finances. While potentially tumultuous, the process allows the possibility of better future finances. These outcomes will be significant headwinds within the southern euro region, but exactly how much growth does anyone currently see out of this area under these circumstances? A more compact euro entity would remain a formidable player on the world stage and those members who need to step away at this time may look to rejoin the union in the years ahead.

To be continued –

Patsy & Jen


In this Edition

  • Choices
  • Texas Hedge
  • Outcomes

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

79 - 04.09.12
13,000 x 1,400/ Lessons Learned/ It's Not Insider Trading When Congress Does It/ Crystal Ball

78 - 03.21.12
Goldman's Casablanca Moment/ Mr. Macy meet Mr. Gimbel/ The Fiduciary Standard - The Gold Standard

77 - 03.05.12
Punxsutawney Greece/ Foaming the Runway/ "The Euro Crisis is Behind Us/ Healing Hoopla/ What Price Income?

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



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Market Highlights



3/30/12 12/30/11 12/31/10 12/31/09 12/31/08 12/31/07
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