Issue 75 - December 5, 2011


The Problem

Market participants would certainly be well within their rights to wonder what in the world had beset global capital markets in the 4th quarter. Low rates and modest economic data and earnings would not seem to be the recipe for hyper volatility. But the potential unraveling of the euro zone fabric has sent the markets scrambling. What was intended to be a lasting framework for geopolitical and economic prosperity across some 350 million people, the Euro Zone has turned into an unsustainable and unworkable ship of state. The limitations of the Maastricht Treaty, which laid out the terms and conditions for Euro Zone members, came to light some 18 months ago when Greece announced to the world that they owed more than they could pay. That this was a surprise to global markets was perhaps excusable as the requirements of membership explicitly prohibited running deficits in excess of 3% of GDP. That there was absolutely no provision incorporated into the treaty to address and correct violations has proven to be its Achilles Heel which has doomed the original design and allowed the profligate behavior of the P.I.G.S. to metastasize now throughout the entire Euro Zone financial core.

What Could Go Wrong

As we have noted in previous letters, the Euro Zone was constructed initially as a geopolitical confederation onto which a financial system was later bolted on top. Two horrific world wars and a highly corrosive cold war made for a strong argument of “Never Again” no matter what the cost. But just as our fore fathers had difficulty enforcing the rules of a confederation, 200 years of human progress did not make it any easier. It seems obvious now, but the Euro was only designed for calm and disciplined financial waters. The common currency provided the veneer of common credit conditions across the entire zone, but this was simply never the reality. The common credit façade led banks to purchase previously unthinkable amounts of bonds issues by the P.I.G.S. These were in turn allowed to count towards their mandatory capital requirements just as if they were AAA German Bunds, the gold standard of Euro Zone credits. Market pricing discipline disappeared along with drachmas, liras, and pesetas. The credit manufacturing machine steamed along for a decade before anyone seriously considered the implications of debt to GDP ratios in excess of 100%. An entire economic continent with no central command or control and no ability to devalue its currency in times of stress was simply defenseless against a rising tsunami of debt. The more the individual nations issued the more the banks had to purchase in order to protect the principal of their existing holdings. Professor Moriarty could not have envisioned a more effective and nefarious plot: to simultaneously bankrupt sovereign governments and the pan European financial system.

Compound Interest

Yes, problems do grow at compound interest. Look no further than the initial reports in the spring of 2010 on the insolvency of Greece. But by EU finance minister’s standards Greece was not technically insolvent because there was no provision in the treaty to allow for Greece to be insolvent. This was like saying I can’t be broke, I still have checks. The leaders of the ECB fought tooth and nail to ensure that the reality of Greece’s true financial condition was never reflected in the pricing of their debt. The ECB determined credit quality, not the market or god forbid the rating agencies.

Greece was not and is not a going concern. They do not have the economic production to pay their current employees, vendors, and pensioners let alone service or retire debts. As the pipeline of new credit was finally exhausted, the nation turned to their finance ministers as the next source of funds. There is an old adage that if you owe the bank $1000 the bank owns you, but if you owe the bank $1,000,000 then you own the bank. Such is the case here. The banks were desperate not to have their holdings written down. No one could conceive of any solution to make all of the parties’ whole. There was no silver bullet.

Clearly now the debts must be restructured for all the bondholders (not just the private creditors as suggested by the ECB in an apparent effort to drive the remaining private capital totally out of the market!). Typically this can be done through a combination of devaluing the currency, a certain amount of principal forgiveness, along with economic plans within the country to stimulate growth. But Greece went “0 for” as they say. They did not possess a currency to devalue. The ECB would not permit a principal markdown for fear of what these marks might say about the capital levels of many of the major Euro Zone banks, and Greece was never going to suddenly turn into a northern European economic workhorse. So the band played on and the problems got bigger.

Germany or Bust

For some time there has been an assumed “Plan B” that if the collective 17 member nations could not come to a satisfactory solution regarding the debts of the P.I.G.S then “Germany would pay for it”. After all, Germany it was said “had the most to benefit from maintaining the current construct”. In reality, this was more likely “Plan A”. But someone forgot to explain to the German people why they should pay for their southern neighbor’s profligacy. As the crisis has mounted, cries for Germany to get on with it and provide all needed funds for the bailout have been coming from all corners. Consider the plea from the Polish Prime Minister who said on November 30th,

"I will probably be the first Polish foreign minister in history to say so, but here it is," Sikorski said in Berlin on Monday at a meeting at the German Society for Foreign Affairs. "I fear German power less than I am beginning to fear German inactivity. . .”

Those in power in 1939 must be absolutely spinning in their graves. But this perhaps more than other single comment reflects the level of frustration at the current situation.

It is not absolutely clear that the Germans are not willing to do more or in fact much more. Germany does have plenty to gain by being the defacto head of a prosperous Euro Zone. They are however demanding that prior to passing out blank checks, there needs to be structure, order, and rules. These types of mechanics would certainly take months if not years to work out. Those who want the check book approach are emphatically pointing out that time is not on their side. However, the markets have shown forbearance previously when it looked like there were solutions coming together and there is every reason to believe that they would do this again if a plausible pathway was rolled out in the near term. The biggest hurdle is not solving a long term solvency problem but surviving a short term liquidity crisis, particularly one that was clearly engulfing the euro banks.

The Cavalry

On November 30th, The Federal Reserve announced a massive coordinated action in conjunction with the Bank of Canada, the Bank of England, the Bank of Japan, the Swiss National Bank, and the European Central Bank to provide liquidity to the global financial system. Translation, all of these parties made funds available to the ECB to lend to the European banks that were having trouble getting funded. Make no mistake; one or more banks were in trouble.

Unlike US banks who are funded with a variety of sources such as deposits, CDs and longer term debt, their euro cousins have for years funded primarily in the US Money Markets or depended on the Interbank market for liquidity.

US money market assets have been contracting over the past few years. An ultra low rate environment coupled with a growing reluctance to purchase European bank paper means European institutions have lost a major source of reliable funding.

The Interbank market has not been much friendlier – where costs have risen steadily.

Taken together, these two charts represent the underpinnings of a 21st century bank run. The coordinated action may not be enough to save every bank in the zone, but it will hopefully provide the needed liquidity and market confidence to allow a more orderly process should a major institution need to be unwound or absorbed by another. Liquidity is the lifeblood of the credit markets and Europe absolutely needs to have access to credit and lots of it in order to maintain economic growth as it wrestles with the enormous task of revising the Maastricht Treaty of 1992.

Stress Tests

On November 22nd, the Federal Reserve announced that it would conduct another round of “stress tests” on the 31 largest banks (those with assets in excess of $50bb). This would be the first such exercise sine the spring of 2009. In addition to checking their viability for more extreme domestic economic conditions, the Fed clearly wants to get a handle on the “gross” exposure to sovereign credit among the 6 largest US institutions. Under current policy, these banks are only required to disclose their “net” exposure to sovereign credits. This presumes that the hedges that have been put in place would work seamlessly in times of hyper global financial stress: a fair bit of faith to be sure. But to make matters worse, one of the proposed solutions to the Greek drama was to essentially invalidate the credit default swaps used by many of the holders (and non holders as well – see our June 28th note) of sovereign paper as hedges. Again, in an effort to do anything other than take the write downs on Greece, the European finance ministers managed to impugn an entire derivative market. Essentially, if someone has the power to say that a default for one entity does qualify as a default for another, insurance ceases to be insurance. The Federal Reserve recognized this and is demanding to know how just how fully exposed, JP Morgan, Goldman Sachs, Bank of America, Morgan Stanley, Citigroup, and Wells Fargo are to the sovereign debt of the P.I.G.S. on a gross basis. These results will be made know after the first of the year.

Next Chapters

“Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth.” Sir Arthur Canon Doyle

We are almost certainly entering the next – not necessarily the final chapter, of the current global debt crisis. European ministers have set December 9th as the date of their next summit in Brussels. Many are calling this a “must win” situation for the euro. But there are so many practical details to consider, even if there were an agreement already in place, it is unrealistic to place that level of expectation on this next gathering. How exactly do you “unjoin” a currency – it takes years of preparation to roll out (or in); just ask Estonia. From 1928 -1940, they operated using their own Kroon. This was then replaced with Rubles which lasted throughout the period of Soviet occupation. 1992 ushered in the second era of the Kroon which lasted until January of this year when Estonia officially converted to the Euro. Currency, however complicated, is just a mechanical consideration. How will the 6 most impaired current euro zone members (Portugal, Ireland, Italy, Greece, Spain, and Belgium) sell the concept of their “fiscal integration” whereby they cede fiscal control to the other members? It is unlikely that this historic revelation would be put to a vote within the borders of these countries. So is this going to be enacted by fiat by unelected foreign ministers? How is that supposed to work? Our point is simply that solving this crisis will take years. It is a classic example of “the Boeing problem”. An airplane takes thousands of parts and they are all necessary. An agreement on a direction forward would be a herculean accomplishment for this organization. The task of implementation, which is what the market seems to be demanding, is a much longer term job. The liquidity bridge that was established this week was specifically stated to be in place at least through January of 2013. Markets will have to respond to this reality even if it continues to hold its breath and stomp its feet in the short term.

We have now long argued that the economic episode we are in was going to last years not months as was hoped by many. The news out of Europe is not so much new information but rather further conformation of the enormity of the task left to be accomplished. Resilient, income producing portfolios will be well suited to contend with the ebbs and flows of the 24/7 news cycle which is currently driving markets.

We wanted to conclude this newsletter with a reminder of the importance of custody.

MF Global – Another Painful Lesson in Custody

Regulators are taking "all appropriate action" to figure out why there is a shortfall in customer funds at failed broker-dealer MF Global Holdings Ltd., Commodity Futures Trading Commission Chairman Gary Gensler said Thursday.

Mr. Gensler said the CFTC is working with other regulators "to ensure that customers maximize their recovery of funds and to discover the reason for the shortfall in segregated customer money," in remarks prepared for a congressional hearing on another subject.

By law, clearing firms like MF Global are required to "segregate" the funds of their customers from the firm's own assets and from one another. If a broker fails, separate accounts make it easier to transfer customers' futures positions and funds to another broker……..

"The most troubling aspect about the MF Global situation is the shortfall of customer money at the firm," Mr. Gensler said. "Segregation of customer funds is the core foundation of customer protection in the commodity futures and swaps markets." The CFTC is the primary regulator of MF Global's main futures-trading business.

MF Global – the successor firm to Man Financial Group which purchased the residual assets of the failed and fraudulent futures firm Refco whose head Phil Bennett went to prison for 12 years – is now scrambling to explain why several hundred million dollars of their client’s money is missing.
MF Global filed for Bankruptcy protection this past October 31st and while this is economically terrible news for their stock and bond holders, this should have been nothing more than a significant housekeeping nuisance for their customers. Broker Dealers and Clearing firms are required to segregate client funds from the assets belonging to the firm. Let us repeat, this is a “Requirement”, this is not a best practice option. In this case, and the final story is far from written, MF Global used either intentionally or accidentally, funds belonging to their customers to post as margin in the last throes of their financial viability. Time will tell how much money MF Global may have misappropriated, the important lesson in each of these episodes to understand how they are to be avoided.

The only way a broker dealer or a clearing firm can control your assets is to have them registered in what is known as “Street Name”. This is a wide spread practice in the broker dealer community to allow for ease of settlement among firms. The signing over to “Street Name” is what takes place at the opening of every brokerage account in what is known as the “Client Agreement”. It is not optional. What is optional is not using a broker dealer. If instead of using a broker dealer, clients were to use a Master Custodian (Northern Trust for example) the commingling of customer securities could never take place. The assets remain in the client’s name; not in street name and therefore can not be pledged or delivered to a non named account. The service of master custodian is not “free” as custody is perceived to be at broker dealers and this explains the relative rarity of their use among RIAs. However, how many of MF client’s today would have gladly paid a nominal number of basis points to avoid what not appears to be the beginning of a long process of “maximizing the recovery of their funds.”

Best Wishes –

Jen & Patsy


In this Edition

  • The Problem
  • What Could Go Wrong
  • Compound Interest
  • Germany or Bust
  • The Cavalry
  • Stress Tests
  • Next Chapters
  • MF Global - Another Painful Lesson in Custody

Huntington Steele

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Suite 3700
Seattle, WA 98104



Past Issues

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

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
can be found in our

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Market Highlights

  12/2/11 09/28/11


12/31/10 12/31/09 12/31/08 12/31/07 12/29/06 12/30/05 12/31/04
DJIA US 12,019 11,011
11,578 10,428
S&P 500 US 1,244 1,151


1,258 1,115


Nasdaq US 2,627 2,492
2,653 2,269
EAFE Int'l Equity 1,441 1,395
1,658 1,581


5 Yr Treasury .92 .98 1.75 2.02 2.71
5 Yr AAA Muni 1.17 1.04 1.27 1.75


10 Yr Treasury 2.14 2.09
3.38 3.92
10 Yr AAA Muni 2.45 2.15
3.44 3.26
30 Yr Treasury 3.04 3.14 4.39 4.325
30 Yr AAA Muni 3.99 3.87 4.38 4.9
EUR Currency 1.35 1.37 1.45 1.34
JPY Currency 77.88 76.38 80.44 81.32


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