Back from Paris
March 29, 2012
David R. Kotok
We are back from Paris. The head is filled with new info. For the publicly available portion of the conference, see the GIC website, www.interdependence.org.
The remaining comments will be my personal “takeaways” from both public and private conversations. By Chatham House Rule and Jackson Hole Rule, these words are attributable only to me. All errors are mine.
We will use some longer bullets for a format.
1. In my view, the situation in Portugal is unraveling. This may be the second shoe to drop in the European sovereign debt saga. Now that Greece has paved the way, the speed of unwind with Portugal may be much faster. I do not believe the markets are prepared for that. Runs are affecting Portuguese banks. Euro deposits are shifting to other, safer countries and the banks that are in those countries. Germany (German banks) is the largest recipient. Remember, deposits in European banks are guaranteed by the national central banks and the national governments, not the ECB. There is no FDIC to insure deposits in the Eurozone.
2. The issue is that Greece was supposed to be “ring-fenced.” Notice how European leaders have stopped using that word. Their new word is firewall. If a second country (Portugal) restructures, the sovereign debt issues become systemic rather than idiosyncratic. That becomes the second game-changer. Systemic risk needs big firewalls. We learned that the hard way with Lehman and AIG, which were systemic, vs. Countrywide and Bear Stearns, which were “ring-fenced” – or thought to be ring-fenced at the time.
3. A game-changer was the use (not threat) of the collective action clause by Greece. CAC altered the positions of the private sector. It rewrote a contract after the fact. That is why Portugal’s credit spreads are wide: the private-sector holders of Portuguese debt know that a CAC can be used on them, too. The same is true for all European sovereign debt. A re-pricing of this CAC risk is underway.
4. Private holders of Greek debt had several years to get out before the eventual failure. Those that did not get out were crushed in the settlement. Greece is now a ward of governmental and global institutions like the ECB, IMF, and others. It is unlikely to have market access for years. This is another game-changer. In the old crisis days, the strategy was to regain market access quickly and restore private-sector involvement. In the new Eurozone-CAC crisis days, the concept is to crush the private-sector holders, and that means no market access for a long time. Instead, we will have ongoing and increasing sunk costs by governmental institutions. Caveat: government does not know how to cut losses and run. Government only knows how to run up small losses until they are huge. Witness Fannie Mae in the US. Witness the sequence that allowed Greece to fester for years. Government does not know how to take the “first loss,” which is usually the smallest lost. Government does know how to run up moral hazard.
5. The term moral hazard means the action is done today and the price is determined later, after the chickens come home to roost and crap all over the coop. That is the nature of government everywhere. By the time the chickens return, the political leaders have changed. Those who took the moral hazard risk are gone. Those who inherited their mess are blamed during the cleanup. That is where we are today in Europe. Hence, the political risk is rising daily. Elections could change these governments, and the new governments may repudiate the actions of the old ones. We expect more strikes and unrest. That is how elections can be influenced.
6. European debt-crisis issues are lessons for the US. They belong in the political debate. Both political parties are responsible for our growing debt issues. Bush ran up huge deficits. Obama continued them. Each party blames the other. Neither takes on the responsibility of their actions. We shall see how this evolves between now and November.
Strategy issues for portfolio management
I am more pessimistic about peripheral Europe than I have been. All that my co-author Vincenzo Sciarretta and I wrote in our book several years ago is now being reversed by policies. In the beginning, the Eurozone benefited immensely from economic integration and interest-rate convergence. Now it faces disintegration and divergence. Reverse the chapters in the book and play the film backwards.
Can Europe find a stabilizing level and resume growth? Time will tell. Meanwhile, political leaders and central bankers are going to be tested again.
This ain’t over. Yogi is correct.
Alex Pollock of the American Enterprise Institute has a good essay on the history of sovereign default. There has been a lot of it. Here is the link: http://www.aei.org/outlook/economics/financial-services/banking/yet-another-sovereign-debt-crisis .
It is always good to be home.
David R. Kotok, Chairman and Chief Investment Officer