Markets Explode on Crazy Rube Goldberg Eurozone Deal

The Dow Industrials increased by 340 points on Thursday on the basis of a new Eurozone deal announced at 4 AM on Thursday morning. That would be beyond belief if it weren’t for the fact that nothing is beyond belief today. This Eurozone deal is the craziest Rube Goldberg thing imaginable. These European leaders got together in the middle of the night and strung together a bunch of proposals, most of which mirror the causes of the financial crisis in the first place.

Here are the major parts of the deal, according to Bloomberg, and according to numerous comments I heard and read on Thursday:

  1. Greece’s bondholders will “voluntarily” take a “haircut” of 50%, under threat of forcing Greece into total default, in which case bondholders will lose close to 100%. The bondholders will be able to exchange their old grungy bonds for sparkling new long-term bonds worth half as much, but which are insured by the EU. Because this scheme is “voluntary,” there will be no “credit event,” and so credit default swap (CDS) insurance payments will not be collectible. The objective is that Greece’s deficit-to-GDP ratio will be LOWERED to 120% by 2020, from its current 160%.
  2. Europe’s bailout fund, the European Financial Stability Facility (EFSF), which is supposed to prevent future crises, will be increased to €1 trillion from its current €440 billion (of which €250 billion is all that’s left – the rest has already been spent). The increase will be accomplished through financial engineering in two ways:
    • Instead of using the money to bail out countries (Spain and Italy), the money will be used to INSURE or GUARANTEE the countries’ bonds, so that ordinary investors will feel safe purchasing those bonds.
    • A separate Special Purpose Vehicle (SPV) will be created, which can receive money from countries like China and Brazil, so that the money can be used to bail out Spain and Italy. Those loans would also be INSURED by the EU.

  3. The major bondholders of Greek debt are banks, and since they’ll lose a great deal of money, they’ll have to be recapitalized. An unnamed mechanism will be used to lend them the money. The biggest banks requiring recapitalization are: 5 Spanish banks – €26 billion; 6 Greek banks, €30 billion; 4 French banks, €8.8 billion; 5 Italian banks, €14.7 billion; 13 German banks, €5.2 billion.

According to Christine LaGarde, head of the International Monetary Fund (IMF), “What we have today is a comprehensive plan that includes all the ingredients.” And according to German Chancellor Angela Merkel, “This now brings us to stability and to a stable currency union!”

Problems with Part 1 – 50% ‘haircut’ on Greece’s debt:

  • Lowering Greece’s deficit from 160% of GDP to 120% of GDP is hardly something to brag about. It means that Greece’s debt will continue rapidly increasing through 2020 and beyond.
  • No one would blame you, Dear Reader, for wondering why that ratio can’t be lowered to 120% right away. After all, once all those bond exchanges are done, Greece’s deficit should fall immediately, shouldn’t it? Well, no. The problem is that the fall to 120% depends on very aggressive economic growth assumptions that have no chance of occurring (see below).
  • Banks have agreed in principle to the 50% haircut, but no one has committed to it, and they don’t have to, since it’s “voluntary.” The scheme only works if EVERY bank signs up for it. But any individual bank would be better off not joining into the deal, since they’ll presumably take no haircut at all, since Greece supposedly won’t default.
  • What will be the interest rates and terms of the sparkling new bonds to be exchanged for the grungy old bonds? No one knows.
  • The haircut should have been larger than 50%, but banks would not agree to it.
  • The scheme assumes that Greece will implement all the austerity measures they’ve agreed to. But now that the bailout plan has been announced, there’ll no longer be any motivation to take the political heat to implement them, and Greece has never implemented its previous commitments.
  • The scheme is based on estimates of Greece’s economy that have been consistently wrong every time in the past. These guys don’t have the vaguest idea what’s going to happen to Greece’s economy next month, let alone by 2020.
  • The Greek people have no desire to make any further sacrifices for this plan. As one analyst put it, “When you go to Greece, it’s not that people are angry and protesting. It’s that they’re resigned, frustrated, and void of hope. That’s a much bigger drag on the economy than the fact that at the moment there might be less money going around.”
  • It’s not up to the Europeans whether or not the haircut causes a “credit event” that pushes Greece into default. It’s up to the ratings agencies — S&P, Moody’s, Fitch – much beloved in Europe. And that will depend on just how “voluntary” the haircut is. If there’s any whiff of force, then Greece could be declared to be in default.

Problems with Part 2 – EFSF expansion to €1 trillion:

The “Special Purpose Vehicle” (SPV) was one of the fraudulent abuses that led to the financial crisis (See “Questions and answers about the ‘credit crunch'” from 2007).

  • Insuring other companies’ bonds was another fraudulent abuse that led to financial crisis. Companies like AMBAC, which had AAA ratings, would INSURE or GUARANTEE Citibank’s fraudulent bonds, thus giving them AAA ratings as well. When AMBAC started collapsing, the insured bonds became toxic.
  • China has already expressed coolness to investing in the SPV. Why would anyone in their right mind invest in the SPV? Chinese fund managers have drawn a lot of criticism for losing so much money on American stocks, so they won’t be willing to invest anything shaky again. Furthermore, China has 200 million people in poverty, so China’s leaders won’t want to be seen giving charity to countries richer than their own.
  • There are hopes that the IMF will contribute to the EFSF, but that’s not certain either.
  • There are no details on how the EFSF will supply money, whether by payouts or insurance. The statement said that a decision would be made on a case by case basis.
  • There may be enough money in the EFSF to bail out Spain, but there’s not nearly enough for Italy, and Italy’s situation is deteriorating quickly.
  • Germany is going to have a huge exposure to the bailout fund. If Italy’s bonds are insured, and Italy defaults, then the German taxpayer will have to pay out the insurance. Will Germany’s parliament agree to that clause?

Problems with Part 3 – Bank recapitalization:

The bank recapitalization is the least controversial of the proposals, but since banks will be recapitalized with new debt, they will be even more reluctant than they already are to lend money, leading to a new credit crunch.

General problems:

  • This entire plan is so much hot air. No one has committed to it and all details are unknown. The details have been promised for November, but let’s remember that the details were previously promised for today, and that was after multiple postponements.
  • Germany has the biggest exposure to this plan, some €200 billion. And Germany’s Constitutional Court has already ruled that these plans need more than Merkel’s approval — they need the approval of the Bundestag (Germany’s parliament).
  • The plan is based on aggressive assumptions of economic growth in Europe, assumptions that cannot possibly be fulfilled. As I’ve said many times, Generational Dynamics predicts that no growth will occur again until the mid 2020s, when the current generation of very young children become teenagers and start to demand that their parents spend more money.
  • In fact, manufacturing (PMI) data from Europe indicates that Europe is headed for a major recession in the next couple of quarters.

On CNBC on Thursday morning, Hank Smith, the Chief Investment Officer of Equity for Haverford Quality Investing, was asked whether stocks were cheap, and he said the following:

“Absolutely they’re cheap on a P/E basis. They’re selling below the historical average at about 13 times next year’s earnings.”

This is an absolute lie, and he knows it.

The historical average, based on trailing earnings, is 14. I have not seen any historical analysis of the P/E ratio based on forward earnings, but I have seen figures that indicate that forward earnings (based on analyst estimates) have averaged something like twice as high as the earnings turn out to be. This implies that the historical average for P/E ratios based on forward earnings is 7, which means that a P/E ratio of 13 is extremely expensive, even if Smith himself, who undoubtedly earnings a multi-million dollar salary, is too dumb to understand this. There’s no doubt that his technical staff understands it, so this is a purposeful lie.

As I’ve said before, analysts and journalists on CNBC and Bloomberg TV ALWAYS lie when they talk about price/earnings ratios (also called valuations). I’ve discussed this in “5-Oct-10 News — Goldman Sachs’s Cohen gives price/earnings fantasy” and “24-Aug-10 News — Ariel’s Bobrinskoy gives price/earnings fantasy.” So, in case I’ve been too subtle, let me state it clearly: Hank Smith of Haverford Quality Investing was on CNBC on Thursday morning and he purposely lied about P/E ratios.

The Dow Industrials average increased by 340 points on Thursday, and the Dow is now on pace for the biggest monthly point gain in history, according to the pundits. Back in 2004, someone online asked me, “How can you ever be proven wrong? You’re predicting a financial crisis, and if it doesn’t happen, then you just say it hasn’t happened yet.” My response at that time was, “Public debt has been increasing exponentially. If it ever starts leveling off and falling, then you can tell me I’m wrong.” I was predicting that the financial crisis would occur in 2007, and that turned out to be right in the sense that the credit crunch began at that time. Still, the major crisis hasn’t yet occurred, because governments around the world have been increasing public debt to astronomical levels.

Every action taken by America, Europe, China and other countries since 2007 has been to stave off disaster by enormously increasing public debt. I can’t tell the exact date when this is all going to come crashing down, but Thursday’s parabolic stock market surge may indicate that it may not be far off.


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