Monday, October 31, 2011

Risk is Not Out of the Picture

I wrote this article for and it was posted on Friday morning (last week). You can read it with community feedback here: (OptionsProifts)

The market is up, the CBOE Volatility Index (VIX) is down. This is the best October for US equities ever. Europe is settled... Wait... Is it?

So the European leaders got together this weekend and finally settled on what at times seemed a contentious negotiation. The net result is a ripping market, so clearly, we’re out of the woods... Right?...

Here are some bullet points to the newly agreed plan:

1. Greek debt holders will accept fifty percent write downs (sort of). Here’s a caveat: “The euro zone will offer "credit enhancements" or sweeteners to the private sector totaling 30 billion euros. The aim is to complete negotiations on the package by the end of the year, so Greece has a full, second financial aid program in place before 2012.”

Source: Reuters; Euro deal leaves much to do on rescue fund, Greek debt, by Luke Baker and Julien Toyer

2. The Eurozone banking sector needs recapitalization to the tune of 106 billion euros.

3. The “bail-out” fund for emergencies has been increased from 440 billion euros to 1 trillion euros. This is the fund that has already been used to prop up Greece, Ireland and Portugal.

Ok, here’s where I think there are some problems, I dunno, call me crazy.

First just a fact: Several of the countries in the Eurozone are in recession or nearing recession. With that in play, here are some problems I see:

1. 106 billion euro recapitalization fund considering Italian and Spanish banks alone likely need more than that seems awfully low. Keep in mind, a huge chunk is earmarked for Greece. I dunno, 106 billion euros…not enough, no?

2. Other banks in France and Germany have started agreeing to recapitalize by deleveraging. Here’s a quote from a phenomenal Reuters summary:

“German sources told Reuters that four German lenders -- NordLB, LBBW, Commerzbank and Deutsche Bank -- would be asked to shore up their capital. Three leading French banks ruled out the need for government help in meeting tougher capital requirements.”

Source: Reuters; Euro deal leaves much to do on rescue fund, Greek debt, by Luke Baker and Julien Toyer

That sounds really complicated, so here’s the English version. The banks agreed they carry too much risk and they will reduce that risk by reducing debt load. They will reduce that debt load by lending less. Just to be clear, lending less means slowing an economy that is already or near in recession. Very scary.

3. The “bail-out” fund was increased to 1 trillion euros, but, where does that money come from? Yeah, there were no details, no sentence fragments, nothing that I have found that tells us where the magical 600 billion euros come from except for this: “Around 250 billion euros remaining in the fund will be leveraged 4-5 times, producing a headline figure of around 1.0 trillion euros, which will be deployed in a variety of ways.”

An FT article writes:

The €1,000bn that has been touted for the fund’s size is, as a result, a guesstimate based on the still-untested ability to multiply a still-unknown asset base by four to five times. “This is an approximate value,” acknowledged Angela Merkel, the German chancellor. “We don’t know yet how this works.”

Source: Financial Times; The devil in the details and the data, by Peter Spiegel in Brussels

So just to be clear, how are they going to find the 1 trillion euros to protect banks from being over leveraged? They’re going to lever up 4x-5x on a quarter trillion euros. WTH?

4. Not that #3 isn’t bad enough, but there weren’t any details about how the money from the “bail-out” fund would be used. What if Spain, Portugal, Italy, Ireland and Greece all need it? What if Germany and France need it?

5. Just to be clear about Greece, AFTER the writedown of its debt, the country will face a debt load that is 120% of GDP by 2020. Whoa! It’ll be 120% in eight years and working down from ~160% until then. Problem solved…Really? Even further, the details of the writedown aren’t really even close to being done. Here’s another snippet from the DT article:

“Not only is the reduction in Greece’s debt dependent on almost all current bondholders participating in the plan, but the actual bond-swap which will produce the savings has not even begun to be negotiated.”

I thought Greece was in dire straits? Ya know, garbage building on the streets because of strikes, etc. Does this sound like a fast acting plan?

There are doubters out there, big ones. Here are some snippets from that same Reuters article:


Oil giant Royal Dutch Shell (RDS.A) said it planned to curb its investments in the European Union in future due to doubts about the bloc's chances of recovering from the crisis.

"Europe's macroeconomic position can only recover and the sovereign debt crisis can only be addressed through underlying economic growth," Simon Henry, chief financial officer, told reporters on a conference call on Thursday.

"We do not see the European Union creating the conditions for that, in fact quite the opposite," he said.


The FT article quotes a JPM analyst:


“More than we had expected … has been left to be finalised and detailed over the next month,” Malcolm Barr of JPMorgan wrote. “There is plenty of room to doubt whether each of the key aspects of the package will deliver.”


All in all, the agreements reached seem to be, and forgive the crassness, bs. They couldn’t walk away with nothing, so they walked away with something really bad? Leveraging up to get 1 trillion euros which may not be enough and has no direction anyway? Slowing the recessionary economies more by deleveraging (but they just levered up?). 106 billion euros for recap when the other “non-headline” countries likely need that much alone and that’s not to speak of Greece. A restructure for Greece that leaves them on the edge again. Wanna bet they need help in say... six months?

The market is up, fine. Vol is down, fine. In my opinion, the risk is not gone -- no matter how much the Dow soars. Keep your head up, punches will continue to fly. Having said all of that, the market wants to go up, so, it might go up a lot…like DOW 13,000 a lot...

This is trade analysis, not a recommendation.

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1 comment:

  1. nicely written article. is there anyway we can have an update on this on the consequences of the ECB monetizing this sovereign debt crisis?