Issue 72- June 28, 2011


Sovereign, Central, Commercial

As we suggested in our year end newsletter, the Euro Zone and their most profligate members, Portugal, Ireland, Greece and Spain, known affectionately as the P.I.G.S., are now the front and center challenge facing the world’s financial markets. Greece is playing the staring role, but as in any well written suspense, it is the interplay of the supporting cast that makes this story riveting.

The Euro Zone and its governing body, the European Central Bank, were established in 1999 by 11 nations in an effort to provide a common currency and interest rate climate for member nations. The union has grown to 17 nations and includes some 300 million people. The premise behind the confederation was to promote economic activity among all members. Each was expected to abide by a series of strict financial requirements and as such the debt of the member sovereign nations could be held by banks as Tier 1 capital. What could go wrong? In a word – much.

Prior to the establishment of the ECB, the borrowing costs of the member nations were vastly different and reflected the inherit credit differentials between say Greece and Germany. Greece’s borrowing capacity was limited by market forces that recognized the limitations of Greece’s economy to repay debts beyond a modest amount. With the coming of the ECB however, Greece was no longer Greece per se, but rather a card carrying member of the Euro Zone. There would follow a near total collapse of credit spreads between the strongest members and the weakest.

The Euro Zone was structured much as the early United States under the Articles of Confederation; a union that presumed but could not enforce the cooperation of all of its members. Greece effectively armed with its ECB credit card and enabled by the European Banks who were more than happy to hold their sovereign debt as super cheap capital began what in hindsight was the predictable cycle of credit in the absence of market discipline. This same story was played out across the Euro Zone periphery in Portugal, Spain, and Ireland.

Historically many nations have gone into default and while it is certainly not an ideal situation, restructurings force a cathartic process which allows all the effected parties to move forward with some amount of shared pain. Unfortunately in the current situation, there are several factors which make a traditional restructuring either unpalatable or unfeasible depending on your position.

The common currency of the Euro Zone means that the tried and true method of inflating ones own currency as a means to diminish the total owed is unavailable to the P.I.G.S. Without currency devaluation as an option, write downs would typically be taken. However….. banks have lent so much money to the P.I.G.S. in the form of sovereign bond holdings that it is not entirely clear that they could withstand the true write downs to their capital. So here we have it. The P.I.G.S. can’t pay and the banks can’t “afford” to recognize their obvious losses.

Enter the International Monetary Fund which historically is chartered to help emerging countries who find themselves shut out of capital markets. The IMF in conjunction with the ECB have cobbled together loans to keep this accounting charade afloat. However, the only sensible point in buying time and thereby effectively making the problem far larger with the compounding effects of time is to hope that the future will be a more forgiving climate. However, as a condition of these bailout packages, each of the borrowers has been required to acquiesce to severe austerity measures. The notion that an insolvent nation suffering under the weight of massive debts and hugely unpopular austerity measures will prosper to the point of repayment is silly.

If the sovereign bonds of the P.I.G.S. are trading in the market at 50 cents on the dollar, then the bank’s capital composed of these bonds is also worth 50 cents on the dollar regardless of the fiction they might publish in their quarterly reports. Banks are defacto operating with impaired capital today. Period. This then begs the question of why the banks can’t take some modest haircut on their loans to settle the immediate matter and to allow the healing process to move forward.

Why we call them "Banksters"

Enter the third member of our cast, the commercial bankers who have written billions of credit default swaps on the P.I.G.S.

“The net increase in financial exposures due to the existence of the CDS market in sovereign credit risk has not made the real economy safer, but instead multiplies the dollar amount of the basis risk in all markets, real or imagined. You cannot get rid of systemic risk and "too big to fail" until you limit credit derivative products to holders of actual debt. Instead we have hedge funds and banks gambling on the end of the world.” - The Institutional Risk Analyst, June 21, 2011

Credit Default Swaps are simple wagers on the outcome of an event. Will Greece default on their debt – yes or no? Which side do you want? How big a bet? Repeat again and again. Since the Over The Counter Derivatives Market is not transparent in any way, there is no way to know exactly how large these bets are and unlike those contracts listed on the exchanges, there is also no mechanism to call for collateral as their implicit values move up and down. This is precisely the mechanism that brought AIG to bankruptcy. They wrote and wrote and wrote bets on mortgages with no accounting or governor on the process to the point at which even a small change in that market brought down the entire house. The Banks at this point have effectively threatened the global financial markets that any default – real, imagined, or technical, will trigger these billions of contractual explosions.

So the P.I.G.S. can’t pay, the European banks can not “afford” to account for their current reality, and the global commercial banks have so completely bet their franchises on the outcome of this drama that the world is effectively held hostage by the fear of triggering a cascading event such as we saw in the fall of 2008 with the fall of Lehman Brothers.

“In the most recent case, the major dealer banks in the EU end US have created mountains of new credit risk with respect to Greece and Ireland by selling insurance to their clients, both commercial hedgers and speculators. The latter group is far larger than the true commercial hedging needs for risk management, a side benefit of the expansionary policies of the Fed under Alan Greenspan and now Ben Bernanke. Thus the original sin of monetary accommodation by the Fed comes back to haunt us all in the form of an uncontrolled market panic fueled by cash settlement credit derivatives….

The CDS market specifically has become so large and threatening that the politicians are even forced to renege on bets against Greece by the largest and most important bank clients.” - The Institutional Risk Analyst, June 21, 2011

"Extended Period" just got a lot longer

This current situation of mutually assured destruction can not prevail if for no other reason than the good people of the P.I.G.S. are not at all likely to cooperate particularly if they perceive that the are the only ones suffering. If the financial players are seen as getting through this not only without losses but with their gains intact we will have set the stage for a rerun of the post WWI period and the seeds of disaster that were sown at the Paris Peace Conference.

In “Lords of Finance” by Liaquat Ahamed, he argues very persuasively that the depression was not some random act of god or a failing of capitalism but was the result of economic policy misjudgments.

“Who then was to blame? The first culprits were the politicians who presided over the Paris Peace Conference. They burdened a world economy still trying to recover from the effects of war with a gigantic overhang of international debts. Germany began the 1920s owing some $12 billion in reparations to France and Britain. France owed the US and Britain $7 billion in war debts, while Britain in turn owed $4 billion to the US. This would be equivalent today of Germany owing $2.4 trillion, France owing $1.4 trillion, and Britain owing $800 billion. Dealing with these massive claims consumed the energies of financial statesmen for much of the decade and poisoned international relations.”

An interesting chapter in global financial history surely lies ahead.

Despite all of the uncertainty, what we should all know by now is that contrary to the daily drum beat of “rates have nowhere to go but up”, interest rates in the developed world will necessarily stay low for years. The unwinding of massive global debts whether by design or other less tidy means will put great periodic stress on markets. Low rates will provide a needed therapeutic backdrop for this deflationary episode.


On Monday, June 27th, the US One Month Treasury Bill was trading at negative 1 basis point: -0.01%. (This is practically accomplished by paying over par for a security which is redeemed at par with no coupon). The return of capital rather then on capital and an overriding demand for liquidity will be symptoms of a summer with this level of uncertainty. Here at home, the political theatre surrounding the US Debt ceiling will only add to the global drama. The US, unlike those Euro members currently in distress, has no reason to default on debts and we should all remember that our debt ceiling is 100% arbitrary.

Needless to say, income will be paramount at this time, providing investors with the needed resources to soberly assess market volatility. Interest rates have come down sharply since the beginning of the year. Two year notes now yield 0.35% versus 0.68% in early January. Five year notes are now 1.38% versus 2.11% and ten year notes are 2.87% versus 3.41%. Even the long bond has come down to 4.23% versus 4.47%. Municipal bonds have rallied from their massively oversold levels of January. A slowing of new supply as states and local governments addressed their budgetary gaps has allowed the market time to absorb excess supply.

Equity markets have persevered and are showing some forward progress for the first half of the year. While there were many who thought that the economy was off to the races at year end, businesses continue to operate in a far more prudent fashion and as such represent good value in many cases. As per our usual comments, high quality should be rewarded.

This summer is shaping up to feature a number of high profile economic acts, whether it be the actions in the Euro Zone or here at home in the halls of congress. We would be delighted to speak with you all at any time.

Best Wishes –

Jen & Patsy


In this Edition

  • Sovereign, Central, Commercial
  • Why we call them "Banksters"
  • "Extended Period" just got a lot longer
  • Forward

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

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
can be found in our

Newsletter Archive


Market Highlights



12/31/10 12/31/09 12/31/08 12/31/07 12/29/06 12/30/05 12/31/04
DJIA US 12,044
11,578 10,428
S&P 500 US 1,280


1,258 1,115


Nasdaq US 2,688
2,653 2,269
EAFE Int'l Equity 1,635
1,658 1,581


5 Yr Treasury 1.476 2.30 2.02 2.71
5 Yr AAA Muni 1.3 1.77 1.75


10 Yr Treasury 3.07
3.38 3.92
10 Yr AAA Muni 2.63
3.44 3.26
30 Yr Treasury 4.32 4.50 4.325
30 Yr AAA Muni 4.36 4.82 4.9
EUR Currency 1.42 1.41 1.34
JPY Currency 80.73 82.87 81.32


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