Credit Agricole
Securities (USA)
Mike Mayo
(1) 212 261 4000
11 May 2010
United States
US banks
EU and the bailout
Industry updateToday we hosted a conference call with CLSA strategist/historian Russell Napier and two individualsanalysts from STRATFOR (geopolitical intelligence firm) to cover recent events in the EU. Per the CLSA strategist, countries, regulators, and central banks will do whatever it takes to reflate economies and the EU is a microcosm of this global theme. From an investment opportunity standpoint, he thinks US equities offer potential, whereas investors in European equities should wait until the ECB implements a much looser monetary policy. Per STRATFOR, the scope of ECB actions has not been made clear but the ECB stands ready to buy government debt and perhaps much more, even if individual countries have backlashes. All agreed that political and street unrest is a wildcard, and tensions tend to increase when roughly 30% youth unemployment (in much of Southern Europe) is combined with 30-degree temperatures (Celsius) and summer will be here soon.
All agree that the EU and ECB made big decisions
The short-term positive is that recent actions by the EU and IMF help to improve liquidity and reduce the systemic risk and contagion threat, though all agreed that these moves also only postpone the ultimate costs. One issue is that, after placing sovereign debt on the EU’s balance sheet, it gets tough to these reverse actions (member countries will have to increase their commitments rather than end them). Another issue is that governments are unlikely to take all the needed structural measures, implying that the ECB may eventually need to pursue reflationary policies as its only escape. To that end, Russell Napier indicated that it has been a long time since Germany’s hyper inflation in 1923, and eventual acceptance of some inflation is probable in order to help certain countries print their way out of their debts (in part at least).
Laddering of the layers of support
While the bailout package is large, there are differences among the levels of support. The top tier consists of EUR60bn of EU – this money is available today. A second tier reflects the IMF funds of EUR250bn that are ready. The lower tier is the EUR440bn of bilateral money that may never be needed, but, if it is, will need individual country governments to approve. This would likely be the most controversial step since one country would, in effect, be giving money to another. This is one of several examples of how political leaders can lose legitimacy by not fully reflecting the interests of those who they represent. In any case, the speakers felt that, the ECB would eventually provide the necessary support (from a monetary standpoint) over individual country interests, especially of smaller countries
Welcome to today's conference call. The topic is Greece and the EU and the bailout world that we live in. This is a follow on to our conference call from last week. I'm Mike Mayo, bank analyst with CLSA.
Before we get started a reminder we're hosting a New York City bank conference, financials conference. We have four panels in four hours for some leading speakers and thinkers. We have Larry Think, Jon Corzine, Greg Fleming, Rogin Cohen, David Rubenstein, top officials from FASB and the ISB all in a little more than four hours. It's May 25th in the morning in New York City. If you don’t have details please let us know and we can help you get signed up.
But let's get on with today's call with three guest speakers. One is CLSA strategist and historian Russell Napier. The way I see it what Russell has been saying is that governments and central bankers will beg, cheat, borrow and steal to make economies work and the EU is a microcosm of Russell's broader theme.
Russell has been dead right over the past year with this theme. So it will be great to get an update from Russell and how you can make money off of what's happening. Our second speaker is Marko Papic with Stratfor. Stratfor is a geopolitical intelligence company. They literally hire some people from the CIA. Shows you what degree they go to get good intelligence.
But they also have the context for history and the politics that go into what's happening in today's markets. Marko himself has done geopolitical research for a decade. Last Wednesday Marko said on our conference call and we have a transcript of this call that the EU would be popping champagne that coming weekend. And that they did and the market certainly did yesterday.
The third speaker is also with Stratfor, Robert Reinfrank. He is a senior economic analyst with Stratfor and he is on the call to talk about the mechanics of what the EU is doing. Each will speak for a few minutes. I'll ask a few questions and then we'll take general Q&A.
So let's go from the specific to the general. So Marko what's next for Europe? You had a great call last week. What have you done for us lately, right? What's your next call here?
All right well there is definitely trouble ahead and we can talk about the political hangover right from the start. The euro is still down and that is going to become a political problem because it suggests to the European public that the bailout/ECB intervention is not enough.
We know that that is not necessarily trueconsidering the fact that peripheral eurozone sovereign bond yieldshave fallen down and that the ECB has been intervening. So let's talk about political consequences really quickly here.
First,Spain and Portugal immediately announced further austerity measures and this is not a coincidence, of course, it wasmost likely a requirement for the actual bailout. Second, markets are still very skeptical of the ability of the EU to implement the enormous bailout package.
This is a very well placed skepticism. However,The loans of the 440 billion euro portion of the bailout are bi-lateral and/or are guarantees. So they actually don't have to go through the same approval procedure as the Greek bailout.
You will not have to go around 16 you know member parliaments and all that. Nonetheless the fact still remains that somebody will be paying for somebody else if push comes to shove. And this almost makes it more improbable that the funds will be used because it would mean let's stay a government in the Netherlands is forwarding funds to individual member state and once you are put out there on the spot by yourself that is really a political kiss of death.
It's going out on a limb like that for another member state. And we haven't seen Europeans really ever do that. Third, you still have the issue of austerity measures. The bailout and the ECB intervention came with "strings attached," of course. So everybody now has to implementausterity measures and everybody is asking especially in the Club Med what this will look like?
This means a very hot summer in Southern Europe. And the first country to quit on austerity measures could launch the entire crisis back on the brink of you know Armageddon. And remember Greece has a very violent history, a very pronounced left/right split. We talked about this in last week's conference call.
And Portugal meanwhile is being ruled by you know a minority socialist government that until now has been able to get the opposition to agree to everything. But as stakes are rising it's not clear that they will for the future so neither is very stable.
The key dates to watch, liquidity swap with the U.S. resumes today and then you've got six months long term refinancing beginning tomorrow and also three month long term refinancing beginning on 26th of May and 30th of June. We want to see how much more liquiditybanks take on because the ECB has essentially been acting as Europe’s interbank market, so this is an important (inaudible) number to watching.
The second thing to watch to for and this more on the political side, is a slew of elections coming up.
We can talk about the U.K. in terms of the coalition forming, but you have also have the Netherlands, Slovakia and Belgium, all three eurozone members statesthat have elections in June. The Netherlands is one to watch because they usually fund EU efforts at a greater per capital terms than anyone else and the bailout could become an electoral issue, spiraling everything out of control again. If one of the EMU-5 leave the bailout effort, it would become unsupportable. greater in terms of per capita, efforts than anyone else really and if they balk and they very well may, and if this becomes an electoral issue, it could really spiral everything out of control again just because the bailout would then a force unsupportable if one the EMU-5 leave it.
So this definitely adds instability to the mix as well. In the long term we also have you know three major European Countries, Germany, France and Italy and they all have political repercussions from this. Germany immediately we saw that on Sunday, with the loss in the North-Rhine Westphalia elections. Italyhas prime minister Silvio Berlusconi holdingholding a very desperate coalition that really under any rational circumstance should not be together but they're basically held by his patronage. He is going up there in age and down there in popularity so that’s a very unstable situation as well, especially if they begin implementing austerity measures. Because they may be forced to do (ulsterial) measures as well.
At the end of the day the question, the over arching question is where to from here? With the Euro zone and the European Union, the role of Germany as a leader and we can talk about that further if there's interest in that in the Q&A. I turn now to Robert Reinfrank, who can speak to the specifics of the actual plan and the mechanics of it would be Rob Reinfrank.
Good morning, so the 750 billion euro bailout package is going to be comprised of 60 billion eurosfrom the European Commission, 440 billion euros will be EU-backed loan guarantees and the IMF is going to pick up 250 billion euros in loans and guarantees. The ECB is also going to provideadditionalliquidity support by reactivating the USD swap facilities with the Fed and reintroducing its exceptional liquidity measures. Tomorrow the ECB will offer a 6-month long-term refinancing operation with full allotment, and therate will be the average minimum bid on the main refinancing operations.On the 26th of May and on the 30th of June the ECB will also conduct 3-month long-term refinancing operations with full allotment at the fixed rate of 1 percent.
Additionally, the ECB has also said that they're conducting intervention the secondary markets to provide liquidity, although the ECB has yet to disclose the extent of itsintervention, and I don’t think it’sgoing too soon. Be that as it may, the charts show that peripheral eurozone sovereign bond yields werecrushed yesterday, most likely reflecting both short-covering and the ECB’s intervention.
And then of course they're also reactivating these USD swap runs with the Fed to provide USD equitity.
Right so in terms of the scope of the ECB's actions can you size it somehow?
Well, it's really difficult to say, principally because the extent of its intervention is contingent on future developments. However, the ECB haven’t told us and it doesn’t really want us to know. The thing about the ECB's not disclosing the extent or scope of its intervention is that it makes it all the more threatening for investors who are thinking about shorting the Euro or eurozone sovereign bonds because it maintains the threat that the ECB could squeeze you.
For very much the same reason that -- however“good” a trade it may be -- you don't want to short U.K. Gilt just becausethe Bank of England’s 200 billion pound Asset Purchase facility isostensibly on hold. It's that same sort of threat.
But I imagine that if the situation continues to deteriorate and the Club Med's (Greece, Portugal, Spain, Ireland, Italy)bondscontinue to come under pressure, I would imagine that the ECB could find itself on the hook for more purchases than it had originally intended.
So by not telling us they can do what they want.
Yes, that gives them the scope to act discreetly. And that makes the threat of their presence in the market all the more powerful.
And also another aspect of this scope the “political scope” if you will, is that what the European Union has really done here and what Euro zone has done is really unprecedented. And then the question for investors is where do they stop?
You know if you broke so manyTreaty rules of their treaties already, where does one stop? Could the worst case scenario be capitol controls at some point in the future if things get really bad? You know these are scenarios that investors now have to start thinking about just because of the scope in terms of the political is unprecedented. unprecedented nature of it.
And do you stand by your somewhat radical prediction Marko that the chance that the Euro fails in the next three years is half a percent? I say radicals based on some of the feedback I got.
Well you know we should qualify that by the fact that a lot of things could happen in the markets especially with the financial system. And yes there are threats there. Nonetheless in the short term they have shown that they can do whatever they want on a political level which is very important.
The bailout basically this past weekend was implemented and put together, was put together faster than you know most Europeans order a Macchiato. And that's very important because they've shown the ability to really walk over any of their own legal impediments to move.
So would you agree that the EU will beg, borrow, cheat and steal?
Yes, yes definitely. We are agreed there you know 100 percent. And …
Well that might be a good segue to Russell Napier and we can come back.
One thing I would just add really quickly is that there are exogenous threats to the Euro zone from outside the Euro zone that one should keep in mind. And those cannot be forecast within the mechanic of what we're talking about here.
Right. Well as far as a segue to Russell Napier, so you're seeing a microcosm of your theme Russell. I'm not sure if this was more dramatic than even you had expected. But, so what do we do with all this information? How do we make money?
OK, just a recap for anybody who's interested. I wrote a report last year called Supply, Demand, and Government which said that if you went to business school and learned to buy at supply and demand that it's not going to be very useful going forward.
So I think Europe is the classic example of that. And anybody who is unfortunate enough to be whip sawed in the last week by that, has been whip sawed by politics and not by markets. And there's plenty more of that to come.
Unfortunately I think it's going to come for a few decades. So what does the package of the weekend achieve and what doesn't it achieve? Well I think it brings in the spreads on the government debt on a prolonged basis, perhaps permanently, probably on a prolonged basis.
But it does not achieve this. Key places in Europe still have to deflate and I remember being an American December 2008 saying that the crisis had begun in America but would end in Europe. And it may only end after we destroy the democracy.
And I think still that's the course we're on for. We're on course to destroy a European democracy. And the fault of that lies squarely with the monetary authorities and not the government.
So the important thing to remember is that most of the events of the weekend involved the governments and a very limited contribution from the monetary authorities. And why I said it's limited even though they haven't given us a number is it does say in the ECBs press release that they will be sterilizing.
By bringing in this spread it's obviously extremely positive and extremely important, and helps a lot. But at the end of the day they're not going to be creating more money. So it helps from a monetary perspective and that it might persuade the private sector borrowing if obviously lending rates can be kept lower.
But it doesn't help create any more money within the banking system and it certainly is not going to be (inaudible) creating any more money outside the banking system. So in some parts of the world we've had central bankers doing extreme things and as yet European Central Bank has not done extreme things.
But I think picking up on what the gentleman said earlier I think it's really important. They are on a path. The path is leading in only one direction. They are accepting Greek government debt at full face value for discounting.