Explaining the Euro Deal

The Euro Group delighted us all late last week with hints of progress. The plan expands the scope of the European Financial Stability Fund (EFSF), European Central Bank (ECB), and International Monetary Fund (IMF). It also includes strict measures to enforce fiscal stability, but is gridlocked at the will of member country politics. The proposal places more hope in the ECB and Central Banks to liquidate our way out of the mess, but does nothing to solve structural issues, and places a heavy burden on the IMF. It is essentially a transfer of responsibility (the bad bank(s) method). It could work, but it involves a lot of risk. Let's step back and understand how the system works.

The two videos  accurately explain the European capital markets. 

The ECB strategy is to become a lender of last resorts. There is clearly an imbalance between surplus central banks like Germany and deficit central banks like Ireland and Greece. Too many Euro-zone countries riddled in financial misery have a high dependency on stronger countries to provide liquidity. The strong national central banks loan money to the ECB, which in turn loans to the deficit central banks in greater amounts than received. The new strategy is to tap the inter-bank market and borrow just enough funds from private banks in strong countries like Germany. These borrowed funds are then loaned to the private banks in deficit countries. The hope is to sure up the private banks, while reducing exposure to the deficit national central bank.

Solving the Collateral Crunch comes in when surplus national central banks loan to the IMF. The IMF then buys sovereign debt from the private banks in deficit countries. Euro group system lending by the surplus national central banks is also acquired by the IMF. Again, the hope is that the private banks, with cleaner balance sheets, will sure up the system. The trash held in the IMF and ECB will then regain value, and the IMF will now be equipped with collateral that was purchased by the surplus national bank sellers.

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Now, structural issues still remain. Public trust is not evident in Europe as savers deposit less money into banks. These banks have less cash on hand to make loans; the hope is that the IMF and ECB can offset this. With new cash on hand, will private banks lend? Not quite. Just like int he US with QE, banks know that there is greater risk of default among borrowers. Austerity and further slowdown is a big factor, and growth is still nowhere in the agenda.

In the UK, Prime Minister Cameron chose to veto the decision to join in the Euro Group proposal. The plan calls for tougher fiscal surveillance and high standards; if the UK does not perform up to par it faces the risk of financial sanctions. London is all it's got at this point, with finance being its economic life-support.

Bottom line - we still have major work to do. But, the plan makes sense. It just lacks the structural gut to make sure that it is executed as planned, and that the private banks realize the economic uptick to actually perform. That economic uptick is unfortunately political.

The US markets turned soar on Monday as the Dow dropped 162 points. The Euro declined as well, as the dollar strengthened giving rise to Gold and Crude Oil. Gains from last week Friday were virtually lost. Moody's warned that the EU Summit does not decrease the chances of a downgrade - citing political and structural constraints as the big factor (the European culture). S&P raised a red flag again as it now looks to review Germany and France.

Central Banks Prepare for Greater Risk

A hell week full of European bond sales, bank downgrades, and government response indicates that greater risk is ahead. All participants in the global capital markets from governments to investors are taking necessary steps to protect themselves against further downturns.

The events of this week displayed the true colors of market participants. Finally, for better or worse, governments have come to the realization that fiscal policy will accomplish very little. Efforts to correct this fiscal grid-lock places pressure on central banks to perform. With monetary stimulus essentially exhausted (certainly in the US), central banks seized this opportunity to protect themselves against foreseeable risks.

This report is lengthy, but feel free to skip sections. If you care less about the reasoning behind the downgrades, you might want to just skim straight to the Central Bank response section.

Ratings Agencies Draw their Red Flags
S&P presented a string of bank downgrades which included Bank of America, Citigroup, Morgan Stanley, Wells Fargo, and other major players. At face value, people were quick to either panic or brush this off. The panic came from those who saw this as confirmation of a deepening crisis. Others viewed the downgrades as useless; the problems are obvious, and we saw this coming. However, both groups share the same belief that the global capital markets are entering further misery. We cannot be arrogant and place the downgrades aside without looking deeper into the reasoning behind it.

The math explains the underlying worries about further risk. Once we understand this, everything else begins to fall in place.

The ratings result from a calculation comprised of a weighted average of significant variables. These variables measure the strength/weakness of a banks' financial structure.

The Stand Alone Credit Profile (SACP) is comprised of preferred stock evaluations, combined debt ratings, and basic levels of government support. This portion of the formula is all about the bank's ability to pay back debt to stock and bond holders based on its balance sheet of deposits, returns on lending, government guarantees, etc. Bottom line - this is the overall health of the bank.

Extraordinary Support is the next variable. Simply put, this measures the bank's access to government support on extraordinary levels such as capital injections and other sorts of "bailout-style" measures. This also includes support by a group - if a bank is part of a major bank, it will receive support from greater levels.

SACP + Extraordinary Support = ICR 

Issuer Credit Rating (ICR) is the result of this calculation. This is what we see as investors; the combined rating of the bank. It is important to note that the ICR takes into consideration of potential for additional direct support from the parent bank or sovereign government. 

All math aside, this all shows that government support is a major component in the model used to rate banks. With the current turmoil, there is intense pressure on governments to perform. If there is uncertainty, it is reflected in the rating. 

Patterns of boom/bust indicate likely government support. However, history shows that government support never solves the underlying problems. Banking crises will happen again, and these rating will continue to take this fact into account. 

The recent S&P report is revised for modern times. The truth is that government support is uncertain. Governments are less able to support a range of banks because of its own balance sheet constraints. However, we are given more certainty for groups of banks with shared problems, as systemic risk on the entire system is more important for Central Banks to perform their role of  ensuring price stability in the economy. 

Supporting the system is one thing, but direct support will make less impact. Liquidity and capital injections are unlikely to raise SACP because of the underlying internal cash difficulties of that specific bank. There is execution risk of utilizing government funds effectively, and managing the flight back to independence is very difficult.

History shows that banks almost never reach back to a level of independence. Government support is a drug that never leaves the system. It causes market distortions that raises false expectations, creating an environment in which a completely independent bank will not be equipped to operate in (hence the fall of regional banks in the US). Depositors are propped up with artificial fiscal and monetary measures such as stimulus and low interest rates. The most striking part of government support is that banks are pressured into providing loans to industries and companies that support the growth mission of that nation. These are usually high risk loans (a repeat of the housing crisis), but the certainty of government support is priced in to these models, so it does not look as bad. 

We are operating in a world of powerful zombie banks (a fancy way of saying Government Related Enterprises - GRE) that are in desperate need to become independent and correct these market distortions - thereby saving the public from underlying misery.  

Central Banks to the Rescue

Market distortions aside, the Central Banks (well, the US only) seem to be saving themselves as they work to calm the financial crisis. 

Eurogroup ministers held a press conference to discuss their progress in expanding the capacity of the European Financial Stability Fund (EFSF). The ministers appeared exhausted and less hopeful; but there might be good reason behind this attitude. The thought is that even if the member countries do not cooperate in getting its fiscal house in order to pay back debt, the ECB and partners would have hedged against this. 

The frustration is certainly directed towards the politicians in the member countries. As Megan Greene (Economist Meg) strongly advocates in her blog, Central Banks need to protect themselves against losses on these relief funds. The use of Special Drawing Rights (SDR's - a combination of currencies), or implementing  her 'Big Bazooka' plan is a way for these Central Banks to play defense amidst the political bickering. This is business!

Notice the large amounts of swaps used during the '08 crisis

Fortunately, the US Federal Reserve understands this. Calling for global cooperation to increase access to US Dollars through currency swaps will strengthen the safety net of global banks in seek of liquidity. The idea is that a foreign bank or firm will pay their currency in exchange for borrowed dollars from the US Federal Reserve. At the end of the contract, the foreign firm or bank is obligated to repurchase their currency from the Fed at the same exchange rate. The foreign firm also pays a market based interest rate to the Federal Reserve for the liquidity swap protection. The US stands to gain from this move.

The interest rate paid to the Fed after the swap agreement (usually ranging from overnight to 3 months at most) is determined by the market, on average. The US Fed sets the Federal Funds Rate, but swap rates are left for the market to decide upon agreement between banks and firms. To influence a lower rate with the liquidity swap program, all the US Federal Reserve has to do is simply announce that their swap window is open for more business. Banks run back to price in a lower interest rate in their models, and by doing so, future liquidity increases in the entire market. Rates are expected to decrease to 0.645% from 0.805% as of Tuesday. Now, rates are hovering around 0.523%.  

The Federal Reserve is artificially increasing the demand for dollars at its swap window, which will eventually send the dollar exchange rate higher. As foreign firms and banks extract greater value from our dollar, the Fed moves closer to inflating our way out of debt (paying back interest to our debt holders with a higher valued dollar is more affordable). The inflation is seen in the value of commodities such as corn, with future prices rising consistently. 

Preserving Wealth Against Higher Volatility

Too many times, the imagination of constant behavior has led us down a path of financial ruin. The thought that housing prices will always rise or the belief that dot com companies will continue a path of infinite valuation growth, propped up bubbles that left everyone involved (directly and indirectly) in a world of hurt.

The focus of this post is on those that are indirectly involved - the pension holders, mutual fund investors,  hard working individuals wanting to secure their wealth. Often times, these people just go with the flow and fail to take full control over their investments. For example, pension schemes are designed to make gains during bull markets, and remain steady during down-times largely through the hope that people will continue paying into the system. Volatile times call for greater optimization of portfolio returns to get out of the rat race of traditional investing.

Stop being a blind investor. It's time to take charge.

Buy and Hold is a common term in portfolio management. An investor picks an asset or a basket of assets with the intention of holding on to it for a long period of time. This is a gamble. You hope that your due diligence conducted now will grant you time without worry in the future. Sometimes this works. Investors stick with major companies like WalMart and even Apple for long periods of time and make significant gains in their portfolio. However, those that actively re-balance their portfolio are one step ahead, and are more secure than the buy and hold investor.

A portfolio should be diversified by industry (or asset type) and time of investment. Investors should have a mix of assets that have various time frames associate with the trade. One might invest in Apple for two years (with periodic check-ins and adjustments), but also invest in Oil and Gas only during specific conditions such as storage reports. The former involves less transactions with a clear eye on maintaining value, whereas the latter calls for a trading approach to handle long term uncertainty with short term gains.

This is an ongoing balancing act. Simple diversity in asset classes will only go so far. Investors need to look at the snapshot scenario. If an investor is focusing on a particular market condition - say the European debt crisis, correlation between assets must be managed properly. A naive investment -- placing large bets in the US equities markets hoping that this will protect your portfolio from European exposure.The problem here is that US companies have great exposure to Europe as it is a major trading partner; better hope you're not holding financial stocks that have a balance sheet full of Greek debt.

Investors need to understand that investing in Mexico is parallel to investing in the US. Placing money in Asia does not guarantee safety from the economic woes of the West as trade and financial dependence is evident. Investing in Australia without understanding Asia can be fatal (when China demands less, Australia suffers). The bottom line is that your portfolio needs to take a constant pulse of various conditions inside and out of your asset classes.

Another naive approach is to give up and avoid the global recession by investing in Gold for the long haul and be completely blindsided to scenarios that may play out. Investors can only prop up Gold prices for so long as the demand for liquidity to cover risky positions in equities will cause periodic moments of declining Gold prices. In the long run, gradual price rises may correct this, but based on your financial position, a margin call might drain your portfolio in its entirety. Short term speculation in smaller amounts will allow investors to cash in where they see opportunity. It requires more time and awareness, but your money deserves some attention. A lazy investor receives lousy returns.

The video above is from the video bar provided by Merrill Lynch Wealth Management. The panel of experts speak to this point very well.