Vultures of Liquidity Descend On Cyprus

It’s always nice to be right!  Just about a month ago, after Cyprus froze bank accounts and announced its intent to seize deposits, I noted a great arbitrage opportunity:

If capital controls are likely to be temporary, you should see a flood of Europeans with suitcases of dollars landing at Nicosia.  They will be exchanging cash for checks written on (temporarily frozen) accounts in Cypriot banks at a large discount to par – Cypriots will give up anything for liquidity right now.  The entrepreneurs will just have to wait for capital controls to be lifted, and they’ll have made enormous profits.  If capital controls are likely to be permanent, then the discount to par will be much greater because of the perceived likelihood of confiscation, forced conversion to Cypriot drachmas/rubles/whatever, and being locked in Cyprus.

Well, that day has arrived.  Distressed-debt investors (the pirates of the financial world) have seized the opportunity.  According to one Cypriot quoted, currently the going rate for Cypriot cash is around 20% of face value.  It might be a fair price given liquidity constraints and policy uncertainty, it might be price-gouging on a vulnerable population, or it might well be both.  That’s the beauty of highly volatile and illiquid assets – there are huge returns to having even a slightly better idea of what’s going on than your counterparties.  I suspect that two “…former Lehman Brothers distressed-debt traders [who have] traded Icelandic bank claims and claims on the bankrupt Lehman…” are probably smarter, better-informed, and under less duress than their Cypriot counterparties.

The main issue for real traders is scalability – landing in Nicosia with ten thousand dollars cash in exchange for Cypriot checks can’t provide a channel for a hedge fund to invest large amounts of cash.  Actually making this a large enough investment opportunity for an institution, as opposed to an individual, requires channels for moving institutional amounts of money millions at a time. If those channels existed, then the arbitrage opportunity wouldn;t.

Separatismagical Thinking

Catalonia flag in Llivia (Photo credit: Xamonich)

The Catalan independence movement has taken off in recent months.  The elections are coming up on Sunday, and over the last year support for independence has risen dramatically.  The Times briefly touches on the pragmatic reasons not to – namely the advantages of EU membership and the greater clout that Catalonia derives from being part of Spain. It leaves out the likely crippling consequences of an immediate withdrawal or “Catalexit” – their equivalent of the Grexit.  This would have all the same consequences from suddenly leaving the Euro – bank runs, financial crisis, capital flight, and so on.  This is a very real potential consequence of independence – Catalonia wouldn’t be a Euro or EU member upon its separation from Spain.  These are not secrets.

The Catalan case, happening in the here and now, does a good job demonstrating the clear problems with a rationalist approach to politics.  People frequently act in rational ways – for example, as consumers deciding between competing products or as managers attempting to cut costs.  But when it comes to judging whether issues of principles such as “democracy” or independence, people frequently cease their ability to conduct cost-benefit analysis.  This isn’t a new notion – it is one the classical historians knew instinctively.  But sometimes whenever we get too caught up in sociology or political science or economics, it is good to remember that there are more important things to most people than dollars and cents.

Political Equilibria

I have severe doubts about the latest “solution” to the Eurozone crisis, which can be simply summed up as unlimited ECB secondary market purchases of troubled sovereign debt provided the sovereign in question meets certain fiscal demands.  I should begin by saying that it looks to be much better than anything I’ve yet seen come out of the Eurozone leadership in an attempt to solve the crisis – the ECB can’t run out of money, and is thus the only actor with the funding to actually resolve the crisis without a debt default.  However, technical financial aspects aside – it fails to establish a plausible political mechanism for fiscal and monetary management of the Eurozone as a whole and of member countries.

Bluntly put, this is a breathtaking power grab by Mario Draghi.  His plan would install a central bank veto over national tax-and-spending decisions, with the power to send them into bankruptcy if they don’t obey.  If I were a Spaniard or Italian, I would find this abrogation of my democratic rights to be sufficient reason to strongly oppose this plan on principle alone (and they agree).  As an American with no direct stake in their democratic rights…I care mainly that they will care.  Especially since in addition to the Draghi veto, the plan also maintains the key weakness of every plan up until now – all Euro member states get veto power over budgets as well, since the Eurozone must approve a fiscal bailout before the ECB will step in to buy bonds.

I should stress that this struggle for power between fiscal and monetary authorities is not an inherent feature of the Eurozone.  If Ben Bernanke announced tomorrow that he wouldn’t step in to resolve a financial crisis unless Congress passed a budget he personally approved of, the same dynamic would apply.  Even suggesting the possibility in an American context demonstrates what a poisonous political dynamic is being created here.  The fact that the ECB is dominated by Northern European interests and the “troubled members” are mainly Southern doesn’t help, but it doesn’t create the dysfunction.  I would instead point to an ideological belief – the technocratic faith in balanced budgets as a solution to all problems, and an obsessive desire to avoid inflation in the core at all costs.  This is bound to create a serious conflict with the democratic process in Southern Europe.

The last and biggest problem is that Draghi’s leverage is not credible.  This is a really big deal – in order for the ECB to blackmail Spain and Italy’s governments, it must be universally believed that Spain and Italy are not too big to fail.  If either Spain or Italy’s populace decided to call his bluff in the interest of avoiding further contractionary spending cuts, would Draghi shoot the hostage?  I think not, especially given the immense economic harm it would inflict on Germany.  Furthermore, I think it is universally realized that Draghi would not shoot the hostage.

This is not the normal credibility problem that central banks struggle with, but it does come down to credibility here.

On the Reliability of Price Signals

So over this past weekend, while blissfully out of touch and enjoying the sun and the Pacific, apparently Spain got bailed out.  Or at least, its banks were bailed out.  Spain “paid” for the bailout through a loan extended to it by “Europe” – in this case the European Stability Mechanism (ESM).  All agree it was a wonderful thing, handled totally smoothly.    The ESM had previously allocated a hundred billion or so for Spain, so the optimistic case is that that they were correct in forecasting the weak spots in the European financial system and have the cash ready on hand.  Movements in the bond markets agitate against the optimistic case, but who knows.

Dealbreaker argues that the movement actually reflects the fact that the ESM “bailout” was in fact below-market senior debt, demoting regular ol’ bondholders to junior status.  If you had anything less than 100% rock-solid confidence in Spanish debt, which is scarce at the moment, the subordination of the bonds you own should materially decrease its value.  In fact, it goes further into the minutiae of whether or not the deal should count as a debt restructuring and thus trigger credit default swaps (CDS) on Spanish debt.

Regardless of whether or not the CDS are triggered in this case, this just goes to show that a lot of the risk-management tactics applied to the sovereign debt market are fundamentally broken.  CDS allows debt-holders to “hedge” against debt by promising a payout for a credit event.  Bank collapses in 2008 showed counterparty risk – what happens if the CDS issuer (AIG) goes bankrupt?  The current issue with Greece and Spain is that the people that are judging for “credit events”, the ISDA, is manned by people who are up to their balls. Turns out the risk mitigation which was supposed to make everything happy and wonderful was just papering over the very real downside risks involved with sovereign debt – if the people who write the laws don’t feel like paying their debts, good luck suing for recovery.

Since all debt risk is generally keyed to the baseline of “the government is the least risky entity in a given polity to lend to”, this suggests that debt across the world has been generally, let’s say, optimistically priced.  Perhaps the developed world as a whole may be overleveraged?

J.P. Morgan’s Piddling $2B loss

Having spent a little while thinking and talking about J.P. Morgan’s $2 billion loss announced recently, I went from thinking it didn’t matter all to thinking it indeed has some larger significance for the post-financial crisis world.  At first, my stance was simply that it was a prop trading loss that while quite large in nominal dollar terms, is more or less immaterial to the health and profitability of one of America’s largest banks.  Some heads roll, some rich douchebags get golden parachutes, some hedge funds get to make some money off of J.P. Morgan’s getting-rolled-ness, and life goes on.

However, what it says about the post-crisis financial system does have some relevance and is not particularly reassuring.  To wit:

• JPM doesn’t understand its value at risk, and potentially no other bank does either.  Apparently they have, in response to this, scrapped their VaR model and gone back to an old one. That is the opposite of reassuring for a taxpayer-backed institution.
• JPM doesn’t understand or control its prop trading. Again, very distressing for a taxpayer-backed institution.
• JPM has almost certainly lost substantially more than $2B, since they have fairly wide latitude to lie in their financial disclosure thanks to post-2008 changes in accounting rules.  This is more a concern for JPM shareholders than taxpayers.

Even if everything goes as well as could be expected and worldwide depression does not result, a potential Greek default or Eurozone exit would probably cause massive chaos in all sorts of asset classes.  The fact that small movements in a spread of corporate credits vs. CDS could hammer JPM for $2B is not, again, reassuring.  Nor is the fact that they didn’t recognize that exposure.  All in all, it bodes poorly for the health of the American financial system should the shit completely hit the fan in Europe.

Europe & Serious-Minded Centrism

So, apparently we’re descending into crisis mode again – the austerity consensus in France has clearly fallen with the election of the Socialist President Hollande, and in Greece anti-bailout parties took two-thirds of the vote.  Some of these, like the seemingly fascist “Golden Dawn” are quite scary.

I just want to note, somewhat orthogonally to the actual situation, that the election results in Greece put an odd spin on the centrism and bipartisanship that Washington types always seem to extoll.  Much as those Washington types always extol, Greece’s Pasok and New Democracy joined hands and leapt into a better tomorrow, passing bold policy initiatives that were abhorred by the voters but that all the Serious People knew simply had to be done.  In other words, they acted as the very model of the national-unity-caucus that will One Glorious Day Save Our Nation From Fiscal Crisis.

Except that instead of the public admiring their civic spirit and bold leadership, they regarded both mainstream parties as discredited and turned to alternatives that were less boldly proposing much more popular fiscal policy alternatives.  Since those parties were emphatically notmainstream, they also happened to have some rather unsavory policy platforms such as nationalizing the financial system or driving immigrants en masse into the sea.  I would suggest to David Brooks that he seriously ask himself if that would be a possibility here.

Where does Greece go from here?

I see that the Greek government has approved the new austerity package, naturally greeted by Greece taking one more step to the total breakdown of social order.  This does solve the near-term problem of Greece potentially defaulting in March, but I don’t really see what medium-term and long-term problem it solves.  Greece’s deficit is not going anywhere soon, obviously.

More importantly, it seems like the institutions of democracy there are in genuine peril over the next few years.  The current government was more or less installed by bankers, of course, and whenever elections happen the opposition will take over.  With the bankers calling the shots, I have a hard time seeing how the (incredibly unpopular) austerity policies will change under a new government.  And in turn, how does that government survive?

The Greek polity does not want the policies that are being forced on it by its creditors, and there’s only so long this basic fact can be deferred.  The relevant consideration for Greece and the Eurozone is whether it can be held off long enough to bring its fiscal situation into balance.  I doubt it, personally.

Ship’s Going Down – Creditors First Into the Boats!

I realize this is not incredibly timely, but I just wanted to dwell on a feature of the Eurozone negotiations last week.  Felix Salmon covered this well – the agreement specified that all money, no matter what, would be delivered to private-sector bondholders.  This is a terrible idea!  Part of it is simply the aspect that it’s usually not a good idea to unilaterally and unconditionally guarantee anything, which is the main reason that Ireland is in the trouble it’s in right now.

More generally, this attitude towards bondholders seems unhealthy.  Unfortunately, sovereign defaults are a fact of life and ought to be considered by bond buyers when they buy the products.  Ultimately, this looks like governments making decisions for the benefits of their bondholders and each other rather than their citizens.  The nature of transnational governance does require that governments look out for each other’s interests and generally put the interests of the Eurozone ahead of the parochial interests of (let’s say) Greece or Germany or anyone else in between.  But there has to be a point where even a totally non-cynical observer has to wonder what set of interests are really coming first here.

The ECB’s Putsch?

Quite aside from the compelling view of the Italian money supply that led me to this article, I was actually fascinated by this article in the Telegraph.  It points out that the prevailing view in the media is that pressure from bond yields was what forced out Papandreau in Greece and Berlusconi in Italy.  However, the market for Italian and Greek bonds have basically locked up, with nobody other than the ECB willing to buy.  Therefore, the spike in Italian bond yields that drove out Berlusconi was something that happened with at least the passive consent of the ECB.  They could have prevented it through more aggressive buying.

In other words, the ECB may or may not be deliberately manipulating the bond market in order to (peacefully) depose the democratically elected leadership of Southern Europe, but it certainly looks like that’s happening.  The ECB is playing with fire here.

Europe and Failures of Imagination

One thing that I have noticed in all the commentary in the ongoing discussion and coverage of the Euromess is a lack of real creative juice applied to just how bad things could get.  Yes, there’s chaos and default and whatever.  But what about real gory scenarios?  I’m thinking a genuine old-timey, 25% unemployement, Depression with total bank failure and wholesale nationalization of the financial system across Europe.

That’s not even close to the worst scenario you can imagine…when economies turn that bad, I think it’s pretty clear that it doesn’t exactly tend to produce a healthy politics.  The process of such a collapse would, I think its fair to say, draw some real lines of divisions between blocs of European nations with differing interests.  Creditors v. debtors is the obvious one, but not the only possible one.  Most likely total economic collapse will lead to the fall of many political regimes and the replacement of  Center Left w/ Far Right, and Center Right w/ Far Left.  In such a world, some good-old-fashioned ideological conflict isn’t so hard to imagine, most likely within but perhaps between states.

What this all goes to show is that to some extent, the European Project has basically worked.  People have an extremely hard time imagining things getting real.  Perhaps that means that leaders will be sufficiently devoted to “Europe” as to have the courage to make the hard choices required to preserve it (namely, who foots the bill).  On the other hand, “Europe” is a new experiment in human history, and perhaps people just have a hard time getting creative about how south it could really go.

Side note: At a time when Big Important Things are happening, horse race journalism annoys me to no end.   This Time piece about “5 Things to Watch for at Tonight’s Republican Debate” neglects to mention the only thing that matters: Do any of the candidates exhibit a basic understanding of what will drive the US economy over the next week/month/year?  I think Mitt has it, but I doubt we’ll get to see it.