Is Greece No Longer a Risk?

In the last few days, the upstart government of Greece formed by Syriza Party leader Alexis Tsipras has completely reversed itself and signed up for a bailout from the EU that requires far more austerity than Greek voters rejected in a referendum just a week ago.  By all appearances, the EU rammed the ultra austere package down the throat of the Greek left-wing party, flattening Syriza's contentions like a tractor trailer rolling over a marshmallow.  We've had months of hand-wringing and teeth-gnashing over the dangers of a Grexit, and financial markets have shuddered every time Greece appeared to be heading out of the EU.  The EU's peremptory demands at the last minute might seem to have been a high-risk roll of the dice that somehow went in the EU's favor.  Or the EU knew that Greece had no leverage and made the Greeks take everything the EU wanted.

Considering how cautious the EU has been in the past, giving Greece two earlier bailouts totaling some $250 billion, it isn't probable the EU was bluffing in this round of talks.  That would likely mean it believes it has built a shield wall around its banking system that could withstand the consequences of a Grexit.  Stated otherwise, Grexit may no longer be thought to be a major risk to the European financial system. 

Even though the EU and Greece announced a "deal" today for a bailout, it's not at all a firm agreement, but rather a process for pursuing the possibility of more European assistance to Greece.  First, Greece has to adopt a number of austerity measures dictated by the EU.  Next, the parliaments of individual EU member nations have to approve further bailout talks.  Then, Greece will get interim financing that will keep it barely afloat while it and the EU yak for more months, maybe many more, to try to reach the final terms of a third bailout. 

There are many contingencies in this process, and it's quite possible the process won't lead to another bailout.  In that case, Grexit will follow.  But will it matter?  The EU seems to believe that Grexit wouldn't be a disaster, or it wouldn't have taken such a seemingly high risk negotiating position.  If it's right, then Greece will be mired for a long time in austerity and hard times one way or another.  And if the EU is wrong, then watch out, because a European financial crisis could lead to many, many bad consequences for a lot of people.

What's Wrong With The Cyprus Bailout

The draft proposal on the table to bail out Cyprus consists primarily of closing one bank--Popular Bank of Cyprus, also called Laiki Bank--transferring deposits of 100,000 Euros or less to another large bank called Bank of Cyprus, and freezing deposits exceeding 100,000 Euros.  The frozen assets, which evidently amount to somewhat over 30 billion Euros, will be used to fund Cyprus' share of the cost of the bailout (5.8 billion Euros).  How much frozen account holders will ultimately receive is unclear, since the funds for paying them out would have to come from bad assets of Laiki Bank--defaulted loans and the like.  The hit they will sustain apparently could be large.

At first glance, this revised bailout appears not unlike bank liquidations as seen in the U.S.  Account holders with insured deposits (i.e., at or below the $250,000 threshhold) are fully protected, and those holding excess balances are at risk, taking losses if the assets of the bank don't fully cover the nominal value of their accounts.  But the Cyprus bailout is different.

The process by which Cyprus and the EU got to where they are today was one of political fits, false starts, near collapses and last minute expediency.  The first proposed bailout included a levy on all deposits, a proposal which the Cypriot legislature roundly rejected.  After scrambling futilely for assistance from Russia, the Cypriot government bowed to the stern diktat of the European Union that depositors be tapped.  But both the EU and the Cypriot government wanted to protect insured deposits (those of 100,000 Euros or less), so the burden had to fall on deposits in excess of the insured amount.  And because Laiki Bank is suspected to be the bank of choice for a supposed den of money launderers, tax evaders and other scoundrels, the blade fell on its large depositors.  Large depositors at other banks were spared the guillotine.

 What's missing is the due process of law.  There isn't even a flimsy facade of legal due process.  This isn't an ordinary liquidation of a troubled bank.  Cyprus got into financial trouble, asked for a bailout, was told by the EU that a Cypriot contribution would be a prerequisite, and only then did Cyprus figure out who would pay the piper.  The ultimate resolution is politically driven, not the result of the application of established legal procedures. 

If the large depositors of Laiki Bank are iniquitous Russian oligarchs as some EU officials have hinted, one can't feel terribly sympathetic about their plight.  Legality doesn't seem to have played much of a role in the way many wealthy Russians acquired their riches.  But, ordinarily, modern nations seize property only in accordance with the rule of law.  If a bank depositor isn't proven to be liable, for one lawful reason or another, then he or she shouldn't be deprived of property. 

It wasn't Robin Hood, or even Jesse James, who absconded with the assets of large depositors of Laiki Bank.  It was the sovereign governments of the European Union.  When governments depart from the rule of law, capital will start exiting stage right.  Large depositors in any EU nation that's financially shaky will likely behoove themselves to move their capital to safer places.  The shaky countries may get shakier.  The EU tries to present the Cyprus situation as a unique, one-time problem.  But how many well-to-do depositors want to leave their money at risk, in case that's not true? 

The EU will enjoy a near-term rebound from the Cyprus bailout.  But longer term, it encounter trouble attracting the capital it badly needs to rebound from recession and fuel future growth.  And it may well find that dealings with one of its major energy suppliers--Russia-- will take sharper tone.  When the due process of law isn't applied, some people start thinking that might makes right.  And that would be unfortunate for Europe, given the history of the last century.

The Central Banks' Failure to Eliminate Risk

Now, it's Cyprus--tiny Cyprus, with 0.2% of the EU's GDP--that's shaking up the financial world.  The Asian stock markets are falling on Monday, March 18, 2013, and stock futures indicate that the European and U.S. stock markets are also headed downward.  Runs have already started at Cyprus' banks, and a bank holiday was declared for Monday, in order to stop the outflow of rats from the ship. 

The proximate cause of the panic is a proposed EU bailout for Cyprus that includes taking from depositors at its banks 6.7% of deposits under 100,000 Euros, and 9.9% of deposits exceeding 100,000 Euros.  Surprisingly, this tax (which is to help pay for the bailout) would hit small depositors that were supposed to be fully insured up to 100,000 Euros.  The bailout violates a sacrosanct principle of bank regulation--that deposit insurance cannot be impaired.  Deposit insurance is the key to depositor confidence, and the foundation of commercial banking.  America's banking system recovered from the Great Depression (which saw thousands--yes, thousands--of bank failures) only when deposit insurance was instituted.  If you scare depositors, an entire banking system can go belly up in less time than it takes to scramble a couple of eggs.

The powers that be which fashioned the Cyprus bailout--the EU, the European Central Bank and the IMF--imposed the depositor tax because of the somewhat shady doings of Cypriot banks.  They extended the scope of their businesses way beyond their home island, accumulating assets amounting to twice the size of Cyprus' GDP.  Reportedly, around half of their deposits are from Russians, and suspicions of money laundering, tax evasion, and other alleged shenanigans lurk.  The stolid burghers of northern Europe have been wrinkling their noses over the unsavory aromas rising from Cyprus' banks, and they evidently view a tax on depositors as fair compensation for the trouble the EU is now being put to.

Whether or not the deposit tax is fair is, from a commercial standpoint, pretty much irrelevant.  The financial markets thrive on confidence.  The EU's financial crisis eased last summer when the head of the European Central Bank said, in substance if not words, that he would authorize the printing of money to prop up failing EU member nations.  The bond vigilantes backed down.  But the Cyprus bailout's tax on deposits is the opposite of money printing, and implies that losses are possible for holders of deposits in banks at other weak EU nations.  There's nothing that shakes confidence like the prospect of losses, especially if one was supposed to be insured against them. 

The financial markets have been coasting on a mellow buzz from toking up on central bank monetary accommodation.  Ultra low interest rates and quantitative easing have taken the edge off volatility, and the markets seem to know no fear.  But there is no way to eliminate financial risk.  You can only transfer it somewhere.  The Cypriots apparently wanted to transfer the risks and costs of their bankruptcy as far north as they could.  But the folks up north didn't seem to cotton to that notion.  So the risks and costs blew back, and as we now see, blowback can be nasty. 

Who knows how this will all end.  No doubt high ranking officials on both sides of the Atlantic are engaged, even as we write, in frantic discussions to figure out how to prevent the spread of financial contagion.  The baseline problem is that the EU as a whole hasn't decided how to allocate the costs of resolving its financial crisis.  This is probably a harder problem than the resolution of the U.S. government's current dysfunction, since, in Europe, people from disparate countries and cultures must somehow find common ground.  Since these are the same people who fought two horrendous World Wars against each other in the 20th Century, it remains unclear if they will succeed.

In the meantime, remember that central bank monetary policy can provide a methadone high, at best.  It won't last forever, and the aftermath may be a real downer.  It's fine to feel good about the financial markets right now.  But keep in mind that the central banks cannot eliminate financial risk, and if you relax your vigilance, risk could bite your left ankle in a flash.

How the Financial Markets Enable the EU Sovereign Debt Crisis

Imagine Barack Obama or Mitt Romney saying, "If re-elected/elected President, I'm going to do everything I can to restore prosperity and full employment, and, believe me, it will be enough." The stock market's reaction would be neutral to negative, and a lot of people, perhaps most, would laugh and suggest the candidate try out as a joke writer for the Tonight Show.

Last week, the head of the European Central Bank, Mario Draghi, vowed to do everything he could to prevent the collapse of the Euro zone and added that "it will be enough." He offered no details on what he had in mind. The stock market rallied and Euro zone interest rates dipped. The next day, the leaders of Germany and France, Angela Merkel and Francois Hollande, rose from the chorus and shouted "Amen" (while also skimping on details). The stock market rose again, with the Dow Jones Industrial Average closing over 13,000, a threshold it hadn't crossed since May. In the last two trading days of the past week, the Dow rose almost 400 points (or 3.15%)--all because a few EU leaders swore on a stack of sovereign bonds that, by golly, they were going to something or other really good.

This follows a pattern that has persisted throughout the EU sovereign debt crisis. Storm clouds gather, interest rates rise, and stocks fall. European leaders, alarmed by the market action, issue rosy press releases, promising rose gardens while avoiding any detailed explanation of how salvation will be attained. Stocks rise while interest rates fall. Everyone is happy.

But, then, reality inserts itself. The baseline problem with the EU debt crisis is that the sovereign liabilities in questions are simply too great for the debtor nations to repay. The question is where the losses will fall--on creditors, citizens of debtor nations, taxpayers of wealthy EU nations, issuers of credit default swaps or other interested parties? The intractable tussling over this essential and, for some, existential, question forces examination of ugly details revealing that there are no easy answers. Bottom line: someone needs to give up a shipload of real wealth to pay off the debts. There are no volunteers. Stocks again fall and interest rates again rise.

But the EU's leadership has learned that the financial markets respond to talk therapy, and talk is cheap. If they talk interest rates down, even if only temporarily, they can stall on making the hard choices needed for true resolution. Politicians have never met a hard choice they wanted to make. So they yak their way to a brief respite, and fiddle until the markets waver again. Meanwhile, overall debt levels among EU nations keep rising while Europe slides into recession. There's something wrong with this picture. But, as long as the financial markets display an appetite for b.s., the EU's leaders will keep serving it up.

Target2: The EU's Little Surprise

Well, it seems that if the financially weaker members of the Euro zone were to go belly up, their Target2 liabilities alone might be enough to soak up the entire EU bailout bazooka. Isn't that something?

What are Target2 liabilities, you ask? The Euro zone operates a settlement and clearance system called Target2. Settlement and clearance systems have existed for centuries, serving to provide centralized places where checks and other funds transfers between banks can be netted out and paid. For example, most major European banks have claims on each other for payment of checks, wire transfers and numerous other types of funds transfers. These transactions can be done directly with each bank (highly inefficient), or presented to a centralized clearinghouse, which adds up all claims of and on each bank, nets them, and asks the bank at the end of each business day to make a single payment to (or receive a single payment from) the clearinghouse. The Federal Reserve System operates a humungous settlement and clearance system for American and foreign banks dealing in dollar denominated transactions. Without settlement and clearance systems, modern finance couldn't exist.

The prototypical settlement and clearance system doesn't extend overnight credit. Its job is to make sure there are no unpaid liabilities on the part of member banks and expects each member to completely pay all its obligations at the end of the business day.

But the EU's Target2 system evidently is different. It seems to have a little spigot for overnight credit. And, indeed a fount for some EU member nations. Greece reportedly has a 100 billion EU indebtedness at Target2 (see http://www.cnbc.com/id/48094098). The total unpaid Target2 liabilities of Greece, Spain, Italy and other troubled Euro zone member nations could be in the range of 700 billion plus Euros, equal to or greater than the 700 billion Euro bailout bazooka. And we haven't counted the formal sovereign debt of these nations, which totals in the trillions of Euros. Target2 requires collateral for intraday credit. But its collateral requirements, if any, for overnight credit are unclear. There may be none.

This is a funny way to run a settlement and clearance operation, with credit available on a continuing, overnight basis. It contravenes the basic purpose of settlement and clearance, which is to balance the books. By allowing member nations to participate on an unbalanced basis, Target2 seems to have bought itself a mission creep problem that it can't solve without blowing up the European Monetary Union. After all, how does Target2 collect from Greece or another nation with an unpaid overnight balance? If it boots that nation out of Target2, it effectively boots that nation out of the Euro zone. That, in turn, precipitates all the dire consequences that Europe's leaders profess to want to avoid.

If a Euro zone member nation--let's randomly pick Greece--is unable or refuses to pay its Target2 liabilities, the losses evidently would be allocated among the central banks in the Euro zone. Most likely, the central banks of the larger nations like Germany and France would bear more liability than, say, Finland's central bank. Hence, the incentive for the EU powerhouses to keep trying to muddle through the crisis even though Greece is trying mightily not to repay its debts and Germany is striving mightily not to pay Greece's debts, either.

How Target2 became a secret sugar daddy for the spendthrift Euro zone members remains unclear. Whatever the explanation, the sudden surfacing of these liabilities only darkens the clouds gathering over the European financial world. Target2 evidently has been quietly carrying these liabilities without forcing repayment. That doesn't promote confidence in its financial solidity. Wary member banks might be inclined to take defensive measures, and those, if extreme enough, could resemble a credit crunch. We just had a credit crunch in 2008 and it made for a lousy party. There's no easy way to reduce these Target2 liabilities since the debtor nations ain't got the moola to pay down the outstanding overnight balances. Which means they'll be barking up any nearby tree for yet another bailout.

But the EU's bailout bazooka appears overwhelmed once Target2 is added into the mix of indebtedness it's supposed to cover. High ranking EU officials will surely issue a comforting sounding press release or two to paper over the Target2 problem. But talk therapy, a favorite EU maneuver, hasn't done squat to resolve the crisis and it won't help much here, either.

The EU Fighting Market Forces

A fundamental reason why EU bailouts repeatedly belly flop is that the EU is trying to work against market forces, rather than harnessing them to its advantage. The most recent 100 billion Euro "bailout" of Spain consisted of a press release promising a large sounding amount of money, with no details about where the money would come from or on what terms. Evidently, the idea was to use a big number to impress the bond vigilantes into simmering down. But the BVs are much better poker players than the EU's top ministers, and sniffed out the bluff in one trading day.

The baseline reason why the EU is in debt hell is that it's growing too slowly to service the outstanding amounts of its sovereign and quasi-sovereign debt (the latter including bank liabilities which national governments are legally or de facto obligated to cover). The simple solution to this problem is to boost economic growth. The time-honored way of fostering growth is to increase the nation's international competitiveness and thereby rev up its domestic production. This would be done by devaluing the currency and lowering wages. Governments would cut back on deficit spending, so as to begin the process of deleveraging. These adjustments are economically painful and politically difficult. But they put debtor nations in the position of using market forces to their advantage. This generally leads toward the path to recovery.

The EU's policies to date have focused on fighting bond market forces with "bailouts" that consisting of c0mbatting debt with more debt. Profligate nations are told to adopt policies aimed at austerity. But the European Central Bank won't devalue the Euro, so part of the normal path to recovery isn't being taken. Profligate nations are told to attempt dramatically painful cuts in government benefits and pay, without the assistance of a devalued currency. But too much drama is offputting and we are seeing the consequences in anti-austerity movements across much of the EU. These protest movements, in Greece, France and elsewhere, could lead to the break-up of the EU, as German taxpayers are likely to balk at ponying up the hundreds of billions of Euros it would cost to preserve the EU. The bond markets aren't fooled, and private sector money is gradually staging a run on Euro-denominated debt owed by any nation whose creditworthiness is in question. Only massive purchases of sovereign debt by debtor nation banks (which in turn may need bailouts themselves if things get stinkier) are keeping the credit markets open for some of the bigger spenders in the EU.

By trying to flimflam the bond markets while not effectively making the underlying economic adjustments that would lead to renewed growth, the EU continues to run off the road into the ditch. As we learned in the 2007-08 collapse of the real estate and mortgage markets in America, when conditions become extreme enough, basic economic forces prevail over government band-aids. To preserve the EU, everyone has to make painful sacrifices. People in profligate nations must accept lower wages and government benefits, along with much greater control over their governments' spending by the bureaucrats in Brussels. People in wealthy nations like Germany must accept significantly increased tax burdens to help their struggling neighbors through the crisis. The entire EU must accept the notion that the Euro should be devalued, by a lot and quickly.

The EU can't declare de facto bankruptcy because so much of its sovereign debt is held by its own banks that defaults would send its banking system swirling down the porcelain goddess. Of course, that wouldn't actually happen because national governments in Europe would bail out their banks. But the bailouts would require a new round of sovereign debt, thus perpetuating the not at all virtuous cycle.

The citizenry of Europe were told that the European Union would bring prosperity. These political promises now hinder effective resolution of the problem. Once promised prosperity, the citizens won't allow the politicians to take it away. But economic cycles have not been (and cannot be) repealed. Every society built on promises of permanent prosperity will eventually be hoisted by its own petard (see Soviet Union, Communist China for further reading). China and its much lower wages represent a path that won't be acceptable to Europe's bourgeoisie. The United States, with its bona fide national identity, will be difficult for Europeans, who are provincial deep down, to emulate. Indeed, it took a bloody civil war for America to truly become one nation. Europe won't go that far, not after the two world wars in the 20th Century.

The breakup of the Soviet Union may well illustrate what will happen to the EU. The Soviet Union was a historical experiment in fighting market forces, and it failed spectacularly. The EU won't fair any better in the end.

Fools Among the Holders of Greek Debt

A couple of months ago, most holders of Greek government debt reluctantly agreed to a deal to take a loss (called a "haircut" by the financial cognoscenti) of about 75% of the nominal (i.e., face) value of the debt as part of the second bailout package offered to Greece by the EU. Another aspect of that deal was the Greek government would institute austerity measures in order to reduce its future need for debt. The coalition government then governing Greece, a pushmi-pullyu shotgun marriage of two opposing parties, solemnly agreed to the austerity measures.

Just a couple of days ago, Greek voters gave the coalition government something like a machine gun divorce, placing bootprints on the behinds of the coalition parties and effectively putting a Communist politician in the position of calling the shots. It's been decades since Communists in any democratic nation have had a scintilla of political power. But there's never a dull moment with the ongoing economic and financial crisis.

Needless to say, the Communist leader, Alexi Tsipras, isn't of a mind to embrace austerity. He does say he wants Greece to remain in the Euro zone. And why not? Since the beginning of the EU sovereign debt crisis, Greek governments have made promises about fiscal probity and austerity, gotten promises of bailouts, not quite fully lived up to their promises to throttle back spending, and gotten bailed out anyway because the wealthy EU nations always blinked first. The Greek Communists might as well play the same game, and take credit for any blinks they can induce.

Meanwhile, back at the ranch, those holders of Greek debt who agreed to the 75% haircut must be wondering how foolish they now look to the people on whose behalf they manage money. It's well understood that there is political risk associated with speculating in sovereign debt. Politicians will, when push comes to shove, favor their constituents over money managers in the top 1%. Nevertheless, professional financiers dabbling in sovereign debt are supposed to be able to assess political risk astutely. Just two months after the second bailout deal, they've lost the benefit of their bargain because of a political risk that was staring them in the face when they agreed to the haircut.

Private investors will be reluctant to play in the EU sovereign debt sandbox in the future. It's not a winning strategy to take a big haircut and then find out two months later that you have to deal with a newly risen Communist politician.

With the evaporation of private investment interest in the sovereign debt of weaker EU nations, the European Union will have a problem. A fairly large one, in fact. Its member nations can't function without debt. But, with natural investors unwilling to lend their savings, EU sovereign debt (at least for the weaker member nations) would have to be financed by the European Central Bank. The ECB would protest that this violates the letter and spirit of its charter. But what choice will it have? The EU doesn't have a mechanism for defenestrating a member nation, however badly it behaves. And its undercapitalized banking system is up to its ears in the sovereign debt of weak EU nations and can't afford to keep booking losses.

But if the ECB starts to monetize the debt of weaker EU nations (which it already is doing in shadow form with its three-year loans to large member banks), the debt of the wealthier EU nations will become less attractive to private investors. A big money print by the ECB will inflate the Euro in Germany just as it inflates it in Greece, and no creditor wants to hold debt denominated in a potentially inflationary currency. If private investors step back from German sovereign debt, the EU game will be up.

In the end, the wealthier nations will probably leave the EU, and possibly create a smaller currency union with each other. Or they may just go it alone. Either path will garner the interest of private holders of capital. And that would be the way to restore true financial stability.

A Farewell to European Union

The stock market's penchant for taking the short term view has never been so evident as tonight, with Japanese stocks down over 2% and U.S. stock futures down around 1% following anti-austerity elections in France and Greece. These election results are hardly a surprise; they've been predicted for weeks. Yet, the market is acting like it is shocked--shocked--that electorates would put their personal well-being ahead of the bond market's interests.

The market, as it so often does, allowed itself to be lulled into complacency by the EU's bailouts, which were just kicks of the can down the road with maximum PR effort. Press release politics, it was, and the market took the press releases at face value.

But the problem with the EU sovereign debt crisis is that debt must ultimately be repaid. It can be repaid by debtor remittances to bond holders. Or it can be repaid by forcing bondholders to take partial losses, with debtors kicking in a few pennies for the sake of principle (or principal, if you will). And most typically for the EU, it can be repaid by rolling the debt over, with the help of bailouts from wealthier nations. The last was the EU's first choice, although Teutonic imposition of austerity policies was the EU's way of trying to make debtor nations share some of the burden.

Austerity by itself is likely to produce only economic deceleration. It reduces spending and therefore economic stimulus. The workable form of austerity--austerity along with currency devaluation--can work. It was a formula for recovery by various Asian nations following the 1997 financial crisis there, albeit with substantial short term pain. But Greece's and France's citizens aren't willing to bear the pain of austerity, and the ECB and Germany aren't willing to devalue the Euro. So the EU's brand of austerity isn't destined for success.

The absence of true political union within the EU made it too easy for member nations to ask, not what they could do for the EU, but what the EU could do for them. Europe's political leaders bear much responsibility, presenting the EU as an great opportunity, while downplaying the risks. If the EU were selling securities in the U.S., the SEC would have serious questions about the completeness of its disclosures.

A true currency union can't realistically be a goal by itself. It must be accompanied by true political union. Witness America's Civil War, which not only unified the United States. It also made the U.S. dollar America's sole currency, when federal legislation in 1863 taxing state issued currencies--and federal victory over the Confederacy two years later--effectively eliminated all competing legal tender.

But Europe is too diverse for true political union. Unity requires a willingness to share burdens, to pay an economic price so that political unity can be maintained. Europeans don't have enough in common to contemplate such generosity with any degree of equanimity. So the EU as it now exists cannot survive. Some nations will exit. Those sufficiently similar in outlook and economic strength may stay together in a smaller currency union. But the recent collapse of the Dutch government, due to the growing strength of the right in the Netherlands, raises doubts about the potential for even a smaller currency union.

In one sense, the Euro was part of Europe's effort to prevent another world war. Both world wars of the 20th Century imposed almost unimaginable costs on Europeans. Postwar leaders sought economic union in order to diminish national differences that had fostered the hostilities. But Europeans remain tribal, something that economic interests and market forces have not overcome. And European tribalism will take its toll on the financial markets.

The Greek Debt Crisis: Another Failure of Derivatives

Once again, derivatives have failed. This time, it's in the Greek sovereign debt crisis. Greece and many EU member nations are dead set on making private holders of Greek bonds take losses in the range of 70% of the face value of the bonds. Not only that, but the EU wants to structure the hit to private bondholders in such a way that it doesn't trigger the requirement for credit default swaps (which are insurance on the bonds) to pay injured bond holders. The legalities involved become rather labyrinthine at the margin. Suffice it to say that the entire bucket of yogurt may well end up in court, where attorneys charging very reasonable fees will secure the funds needed for their children's college tuition.

Court isn't where holders of credit default swaps want to be. Even if, after years of litigation, they receive substantial recompense, they are likely to view CDS's as a flop. A derivatives contract is meaningless if it doesn't transfer risk as advertised. And CDS's on Greek sovereign debt are starting to look pretty hinky.

An interesting question is why is the EU so intent on preventing payouts on the CDS's? Possibly, the EU is concerned that the counterparty risk is concentrated in one or a few institutions, where the losses from payouts might be destabilizing. We're also told that we are supposed to be comforted by the fact that the net exposure in the CDS market for Greek bonds is around 3 billion Euros and that CDS exposures are collateralized, so that counterparties shouldn't be caught in a "run" a la AIG 2008. Okay, 3 billion Euros isn't that much for the world financial system as a whole. But what if it's concentrated in one or two or three firms? As for collateral, what quality are we talking about? If the collateral is EU sovereign bonds (a likely possibility), then one would be forgiven for nervousness about undercollateralization.

In addition, the EU may wish to punish the speculators that bought up Greek sovereign debt at substantial discounts to face value and would profit handsomely if they received CDS payouts (which could be as much as 100 cents on the Euro, although technicalities of the calculation of payouts could result in smaller but potentially still profitable payouts). Ever since hedge funds walloped the British pound in 1992, Europeans have had a fear of financial speculators. Whether that's rightly or wrongly so, CDS holders may be suffering as a result.

Whatever the problem may be, the EU's fears of CDS payouts are evident. Surely, this sordid episode will shake up the market for EU sovereign bonds. Liquidity will fall as private investors realize they can't offload the risk of the political dysfunction that's at the heart of the crisis. EU members have criticized the Volcker rule, arguing that it will discourage big U.S. banks from making markets in EU sovereign bonds. These critics, however, should deal with their own botch-ups before foisting blame on American efforts to safeguard depositors' money. The heart of the EU sovereign debt crisis is that Europeans wanted the benefits of a currency union without having an effective mechanism for dealing with the risks. As bond investors come to realize it's difficult to offload political risk via the CDS market, liquidity in EU sovereign bonds will surely diminish. And the fault lies on the eastern side of the Pond.

Distribution of Income and Wealth is the Issue

As much as many politicians--mostly on the right--try to deny it, today's politics are all about the distribution of wealth and income. Democrats, with President Obama at the forefront, have made financial inequality a crucial element of their 2012 platform. Republicans argue against new taxes, and for the long term reduction of taxes and the shrinkage of the federal deficit. That, too, affects the distribution of financial resources, mostly in directions unfavorable to middle class and modest income households. Long term cuts, to be effective, would have to come to a large degree from Medicare and Medicaid, which verge on insolvency in the relatively near future. Social Security benefits may well shrink over time, although the cuts aren't likely to be apocalyptic. The 1% won't have to trim their sails much if the Republicans have their way. Most of the rest of us will notice the increased costs we would bear.

The Euro crisis is all about the distribution of economic resources. As a whole, Europe has more than enough money to resolve the sovereign debt crisis. But a lot of the money that would have to be paid out to bond vigilantes would come from the good burghers of northern Europe, and they have no appetite to cover chits signed by spendthrift members of the EU. Reality is the Europe isn't a whole, and its continental wealth isn't available to cover the debts of profligate nations. The thrifty don't want to distribute their wealth to the prodigal.

In China and India, even as substantial middle classes emerge with the turn toward capitalism, hundreds of millions remain mired in poverty. The governments of both nations, in different ways, grapple with difficult problems of distributing the fruits of growth. China also confronts a demographic problem far worse than America's; its principal solution to date has been to slash the safety net once provided by the iron rice bowl. Both nations equivocate when asked to commit large sums to bailing out Europe. How can they explain to their citizens why they should save much wealthier Europeans from themselves?

In times of brisk economic growth, the expanding size of the pie makes sharing easier. Stagnation, however, brings out harpies. Increasing growth is the obvious solution. But that, for sure, falls into the category of more easily said than done (for elaboration on this point, call Ben Bernanke, Fed Chairman and Tim Geithner, Treasury Secretary).

Since the times when humans clung together in small groups of hunter-gatherers, distributional questions have existed. Hunting is a hit or miss process (pun intended), and the lucky hunter bringing down a deer would expect to share it with the entire group, just as the next day, another lucky hunter would share.

In a modern free enterprise system, protection of private property rights is important to provide incentives to work, save and invest. But market forces, alone, do not always produce distributions of financial rewards that comport with societal needs and norms. The demands of market-based economies altered social structures. Extended families disappeared as children reaching adulthood move hundreds and even thousands of miles away to find suitable jobs. Family-based safety nets evaporated as families splintered. But market forces make no provision for those injured on the job, the sick, the disabled, the laid-off or other unfortunates; and most certainly not for the elderly who no longer wish to or can work. Government programs were necessary to fill the gap.

There are no easy answers to distributional questions. But it's important to debate and decide them, because they are among the most crucial issues of the day. Trying to silence President Obama by accusing him of class warfare is tantamount to avoiding the central point in today's political dialogue. Whichever side you take on the question of the size of federal deficits, or the allocation of tax burdens, you're talking about the distribution of financial resources. A nation that faces up to the responsibility of dealing with this problem has a chance to reach the accommodations that lead to social harmony. A nation that ducks the issue and indulges in political mudslinging will face a grim future.

The Sovereign Debt Crisis: Europeans To Live In Glass Houses

The latest EU proposal for resolving the sovereign debt crisis promises "automatic" consequences if member nations' annual budget deficits exceed 3% of their GDP. The European Commission, the executive arm of the European Union, can also impose additional requirements. All this is supposed to keep EU members on the straight and narrow, never spending excessively, texting while driving, or using any cuss words.

But there's a catch. EU members holding 74% or more of the union's voting power (votes are allocated among EU members by size, similar to the U.S. House of Representatives) can vote to lift the sanctions. Virtually all of EU members fail to comply with its requirement to keep total national sovereign debt at not more than 60% of GDP. Many have trouble meeting the 3% budget deficit requirement. In other words, the members of the EU are not without sin. If a fellow member nation needed dispensation from the "automatic" consequences and the EC's sanctions for going over the 3% limit, would the other EU nations be the first to cast a stone? When you live in a glass house, you will do unto others as you would have them do unto you. The 74% catch (we can call it "Catch-74") renders the "automatic" consequences semi-automatic and creates a go along, get along dynamic that is antithetical to the notion of fiscal discipline.

Only Britain dissented from the latest proposal, steering its own course in turbulent seas, Union Jack snapping briskly in the wind. It's unclear that Britain's tack makes economic sense. But if the EU fails to definitively resolve the crisis, there may be many on continental Europe who will think themselves accursed not to be among the happy few who chose to keep their monetary policy independent.

Will EU Members Learn to Share?

The latest leaks from high ranking EU officials concerning the sovereign debt crisis hint at the possibility of not one, but two bailout funds. Details are scarce; but maybe that's the idea. They can keep the palaver going as long as you don't ask what army of investors is supposed to step out front and center to fund this financial engineering. That's the key to making the bailout work--or not. Someone has to plop a lot of cold, hard cash money on the barrel head in order to truly end the crisis. S&P, however, is threatening to downgrade most of Europe. Whence will investors find the courage to buy the EU's financial engineering when they see the price of sovereign debt credit default swaps escalating?

This is something the leaders of Germany and other wealthy EU nations spend little time publicly admitting. Instead, they focus on how to impose discipline, austerity and clean living on the profligate. Greece, Ireland, Portugal, Italy, Spain and perhaps other nations would have to earn every Euro they spend, and would pay penalties for deficits, failing to wash behind their ears, and using cuss words. Somehow, enough righteousness is supposed to transport the EU to the utter bliss of true currency union.

But the EU is missing an important point. The world's most successful currency union, the United States, exists perennially in a state of financial imbalance. For over a century, the wealthy states on the East Coast, more recently with the wealthy states on the West Coast, have subsidized less wealthy states in between. These imbalances have existed in the form of federal subsidies to farmers, ranchers, the mining industry, the railroads, and more. The Interstate Highway System was another big subsidy, benefiting large, thinly populated rural states more per capita than it benefited densely populated states. But none of the United States tries to hold others of the United States to fiscal rectitude. Imbalance is implicit in the structure of the Constitution, apportioning as it does two Senators to each state no matter how large or small. And imbalance runs the other way. On a per capita basis, the less wealthy states probably provide more people to serve in the military than the wealthier states, resulting in steeper non-financial costs on the former when America goes to war. Americans tolerate imbalance because national unity is more important to them than any rigorous reconciliation of ledgers.

To make the EU really work, Europeans need more than just their economic welfare. Financial self-interest isn't the superglue required for political union. Neither is sheer power. Rome's legions, Napoleon's armies, and the Third Reich's panzers all failed to hold Europe together. Angela Merkel, Nicholas Sarkozy and other proponents of the EU have shrewdly played their cards to keep the crisis from tipping over into financial panic. But the EU needs greatness in its leadership, calls to electorates to seek a new destiny. That's missing, and given the historical divisions among Europeans, a most tribal collection of peoples, it's not surprising that issuers of EU sovereign debt credit default swaps are selling their contracts dearly.

The Federal Reserve and Its Petard

Even casual readers of today's financial news know interbank lending is drying up on an international scale, and that the world financial system is getting the shakes. That's why the Fed and other major central banks announced yesterday a currency swap program to ensure dollar liquidity in Europe and elsewhere. But even as the Fed mounts up and tries to lead the charge, we should remember that it is tripping over its own ultra low interest rate policy.

The Fed's principal monetary weapon is to control the fed funds rate. That's the rate banks charge each other for overnight loans. The Fed has targeted a rate of 0 % to 0.25%, and has promised to hold it there until Antarctica is covered by tropical rain forest. A bank with excess funds can't hardly make a plugged nickel when its lending rate is virtually indistinguishable from zero. And when you consider that many of the larger European banks that are now desperate for dollar funding are, by virtue of the EU sovereign debt crisis, not glowingly golden credit risks, it's no surprise that American and other banks with excess dollars are stuffing entire bulbs of garlic into their mouths any time an EU bank asks for a loan. In other words, the Fed's own zero interest rate policy is hampering interbank lending that could alleviate the very credit crunch it's now desperate to combat.

I leave it to you, dear reader, to decide what to say about the Fed and its petard.

Does the Federal Reserve Have a Secret Bailout Plan For Europe?

Today's announcement of a coordinated monetary easing program led by the U.S. Federal Reserve, providing currency swap lines to the central banks of other major nations, was the news the stock market wanted to here: a walloping big dose of moral hazard that infused dollar-denominated liquidity into an increasingly stressed European banking system. The Dow Jones Industrial Average blasted upward 490 points, the largest move in two and a half years. Markets always love it when a governmental body reduces their risks. Recall, however, that there is no such thing as the elimination of financial risk. It can only be transferred. If risk is transferred away from market participants by a government program, you know who just got the short end of the stick. (Hint: look in the mirror.)

The Fed's move came when the EU was wobbling precariously at the edge of the precipice. The recent spasms and convulsions of EU member governments has accomplished nothing except prove that the EU's governance process couldn't hold together a neighborhood book club. The absence of action by elected officials has led many to urge that the European Central Bank monetize the EU's sovereign debt by buying it up. But the ECB, hewing to its charter purpose of maintaining price stability, has only dipped a toe or two in the shark infested waters of the EU sovereign debt markets. Even as it buys a distressed nation's debt, it sells debt of stronger nations in order to keep the supply of Euros stable. This, however, doesn't monetize debt.

The Fed, by contrast, has promised with its currency swap program, to print dollars early, often and in bulk. The swap lines are priced to provide Black Friday discounts, except for the next 14 months. The Fed provides to other central banks dollars in exchange for Euros (or Canadian, British, Japanese or Swiss currency), with the other central bank obligated to return the dollars at the same exchange rate as existed when the swap was entered into. Thus, the Fed nominally has no risk.

Consider, however, what might happen when the Fed is dealing with the ECB. The latter won't print money; and consequently has available only so many Euros to swap with the Fed. If the ECB needs more dollars than it has Euros to offer in swap, it's out of luck under the currency swap program. But the Bernanke Fed is clearly hellbent on delivering liquidity, and the delivery process used would only be a technicality. If one process isn't enough, they'd use another. This is the approach the Fed took in the 2008-09 financial crisis, when it expanded the scope of its quantitative easing to buy mortgage-backed securities, commercial paper, business loans, car loans, and other consumer loans. Had the crisis worsened, the Fed probably would have bought the kitchen sink and Uncle Arnie's old lawnmower.

The Fed has its thumb in the European dike. Its currency swap program has bought a little time for Europe's politicians to get their act together. But let's be real. Even though the politicians fervently claim that they will now give the crisis their full attention, experience teaches that they will fail. The EU has a herd of cats dynamics, and true European fiscal discipline and reform is less likely than Bernie Madoff being paroled.

What if the ECB needs more dollars than the currency swap program could provide? This may be a possibility. European banks may experience yet more difficulty getting dollars to fund their dollar-denominated loans as the EU crisis metastasizes. To prevent a credit crunch, the Fed may decide that it would buy EU sovereign debt. The Fed has wide latitude to decide how to implement monetary policy. While buying sovereign debt denominated in a foreign currency would be a first, one suspects that the Fed would, as it has in the past, liberally interpret its mandate in order to do what it considers necessary.

Buying EU sovereign debt would set the Fed on the slippery slope. If there were losses, where would the losses land? (Hint: look in the mirror.) And what if the Fed's money printing were inflationary? Where would the burden of inflation land? (Hint: don't shift your gaze.)

Of course, high ranking government officials in the U.S. and Europe would decry such a scenario as preposterous. But consider that Europe is deadlocked in a death spiral. The politicians can't function and the ECB firmly believes it is legally precluded from monetizing the EU's sovereign debt. The one governmental body in the world that has the resources and willingness to step in is the Fed. Today's action takes the heat off Europe's politicians, if only momentarily. They will probably take it as an excuse to stall and delay instead of impose harsh conditions on all of their electorates (which would be austerity for the spendthrift nations and payment of the bailout costs by the wealthier nations). They'd probably figure they could get away with inaction because the Fed would surely step in with more moral hazard.

If the Fed monetized EU sovereign debt using dollars, that would likely signal the demise of the Euro, with the dollar substituting as Europe's common currency while European nations again issued local currencies. This was the way Europe worked in the 1940s, 50s and 60s. In such scenario now, the Euro bloc might be able to disentangle itself from the crisis, albeit painfully, without triggering a worldwide credit crunch. Maybe that's the Fed's secret plan.

The Fed's not above acting dramatically if quietly. We've recently discovered that it loaned over a trillion dollars to distressed banks during the 2008-09 financial crisis, far more than it had previously acknowledged. Ben Bernanke demonstrated that he would act when it looked like no one else could or would. The eyes of the world may again turn to him, and we shouldn't expect inaction.

The EU Sovereign Debt Crisis: Skipping a Few Dominos

A hooded figure of Death appeared at the Euro's door today, scythe in hand, beckoning insistently. Germany held an auction of 6 billion Euros worth of 10-year bonds (called "bunds") and sold only 60% of it. The German central bank, the Bundesbank, bought the rest. But that's like your right hand buying from your left hand. The German auction was catastrophically bad. And, who knows, the Federal Reserve may have contributed to the shortfall, by subtly putting pressure on U.S. banks to trim their Euro-denominated exposure (see http://blogger.uncleleosden.com/2011/11/sovereign-debt-crisis-skipping-few.html).

By contrast, the U.S. Treasury Department today sold $29 billion of 7-year Treasury notes, receiving three times as much in bids as it was offering (or close to $100 billion in bids). Even though the U.S. may be approaching another credit rating downgrade, the greenback remains a sturdy oak in a forest of blighted trees.

That the German bund auction went so badly means the European sovereign debt crisis is fastfowarding more rapidly than anyone anticipated. Next to topple were supposed to be Italy, Spain, France, Belgium, and Austria. Then, the Netherlands, Finland and Luxembourg would be at risk. But Germany was seen as the last bastion of stability, the wealthy uncle who could save the family if disaster struck. Indeed, the latest concept being proposed for salvation, the Eurobond that was to be backed on the entire EU, would be feasible only if Germany's creditworthiness was beyond question. That's no longer true. If Germany can sell only 60% of a bund auction, how could the EU as a whole sell a Eurobond auction?

The sovereign debt crisis has skipped the intermediate dominos and smashed directly into Germany. The German government continues its opposition to Eurobonds. At this point, that may be irrelevant because the viability of the Eurobond has been called into question. One naturally asks what else might be on the table. That's the really scary part. There is no Plan B. Germany has always been the fallback, the backup, and the backup to the backup. After Germany there's no one, not the IMF, not America, not China, not Russia and not Brazil.

The EU sovereign debt crisis is now proceeding at warp speed. That doesn't mean collapse is imminent. Experience teaches that the financial markets hear what they want to hear and need only one or two rosy press releases from prominent government officials to stage a relief rally. Time and time again, that's the way the EU has kicked the can down the road and avoided the moment of truth. But the EU's principal tactic has been to substitute new debt for old debt, offering promises to replace the promises that this member nation or that couldn't keep. Actual transfers of wealth to reduce debt doesn't seem to be on the agenda. But this paper-for-paper game keeps expanding the amounts of debt outstanding, and investors will eventually tire of playing (as they did with the German bund auction today). When that happens, the Grim Reaper will be waiting to collect his due.

The EU Sovereign Debt Crisis: There Are No Safe Havens

The EU sovereign debt crisis has metastasized in two weeks from being a problem with Greece, to being a problem with Italy, Spain and France. Bond yield spreads for the debt of these much larger countries are widening away from German bunds. The dollar is once again dearly loved in the capital markets in spite of the Federal Reserve's persecution of positive returns on dollar denominated loans. The EU's much touted expansion of its bailout fund to over one trillion Euros is d.o.a. With the large Romance language speaking nations on the cart approaching the guillotine, a trillion or two just doesn't amount to jack, especially since this proposal was simply another paper shuffling shell game to flim flam creditors into believing that swapping new EU debt for old debt was somehow in their interest. The EU's overall ability to repay has been deteriorating. Why would new debt be attractive?

With all the turmoil, one would think that gold would be skyrocketing in value. But it hasn't. Since reaching its peak of $1923 per ounce this past summer, gold dropped below $1600 and has recently meandered around in the $1700s. As we discussed in September (see http://blogger.uncleleosden.com/2011/09/why-gold-isnt-safe-haven.html), gold is intimately linked to financial assets, and derives its value from financial market interactions. It's no safe haven.

Nor is anything else. Countries that are viewed as having sound currencies, like Switzerland, have been intervening in the currency markets to keep their exchange ratios down. Otherwise, capital will flood in, drive up the value of their currencies, and wreck their export businesses.

Weirdly, the U.S. dollar has by default remained the world's safe haven. If nothing else, investors know that, in the worst case, the U.S. Treasury will conspire with the Fed to print however much money it takes to pay America's debts. The Congressional Supercommittee tasked with reducing the federal deficit is on the verge of belly flopping. But the financial markets remain sanguine, evidently believing that capital has nowhere else to go.

The European Union's Only Option

The downfall of George Papandreou, prime minister of Greece, illustrates the European Union's only option for survival. Germany and France dictated the terms of the latest iteration of the bailout for Greece, which included tough austerity requirements and a 50% haircut for creditors. Both Greeks and creditors squawked, but ultimately knuckled under. Then, Papandreou threw a wrench in the works by calling for an ad hoc national referendum on the deal. Why he latched onto this misguided notion remains unclear. Whatever the reason, it threw the financial markets into a tizzy.

The prime ministers of Germany and France summoned Papandreou to be chewed out in Cannes. Most likely, George didn't get much time to work on his tan. Back in Athens, he called off the referendum. His next move was to maneuver for a coalition government, while his opposition called for snap elections. Germany and France stepped in again and made it clear that they wanted Greece to have a unity government that would implement the terms of the revised bailout.

Next thing you know, Greece is announcing that it has reached a tentative deal for a unity government. Tomorrow, Greek politicians will spar over who their next national leader will be. It won't be Papandreou.

What's happened in Greece was dictated by Germany and France. The Greeks weren't given a choice. They were told what bailout they would get and what governmental process they would use to implement it. In essence, Germany and France have assumed supervisory political control over Greece. This--the political unification of the EU--is the union's only chance for survival. Economically speaking, the EU's continuation depends on a transfer of wealth from the well-off nations of northern Europe to creditors of the more profligate EU members. The price of this transfer is political domination by the north.

Germany's been through this once before. When the Berlin Wall fell, prosperous West Germany unified with moribund East Germany. West Germany paid a very high price in bringing its formerly Communist sibling into the world of free enterprise. But the West Germans wanted unity and they were willing to pay for it. Now, Germans depend on the Euro Zone to sustain their prosperity, and they are gradually coming to realize their reluctant willingness to pay for the survival of the EU. The continued fecklessness of Greece and its government in dealing with the crisis has forced Germany and France to take charge. By the most contorted of processes, the EU is evolving toward political unity.

It's not inevitable the process will continue. Other nations are in trouble. Italy is the next target of the sovereign bond vigilantes. Interest rates on its bonds are rising sharply vis-a-vis German bonds, and it has recently agreed to be monitored by the IMF. Many Italians are irked by this infringement on their sovereignty. If Greeks and Italians feel put upon enough, they can simply leave the EU. That might seem highly irrational, since it could lead to the collapse of their financial systems and steep recessions. But let's not forget that twice in the last century Europe descended into horrific world wars that killed tens of millions of people. Europeans are eminently capable of highly irrational and self-destructive behavior.

No one knows all this better than the Germans, who were the most irrational and paid an enormous price for their self-destructiveness. That's why they're willing to pick up the tab now for the profligacy of their neighbors, but only if they can exercise political control over the spendthrifts. The question is whether Europeans, with their vast cultural differences--far greater than those between folks north of the Mason-Dixon Line and those to the south--can achieve the compromises and concessions needed for lasting political unity. The post-Communism breakups of Yugoslavia and Czechoslovakia tell us that Europeans don't always have a preference for political unification. Expect a bumpy ride in the financial markets while the EU works things out.

The Greek Referendum: What European Union?

Is there even such a thing as the European Union? The Greek prime minister, George Papandreou, has just announced an impromptu referendum to be held toward the end of this year, in which the Greek people will decide if they will accept the austerity and other measures required by the EU's bailout of Greece. The referendum was not previously mentioned by Greek leaders to the EU, and the EU is displeased, to put it mildly. It's holding back a bailout payment of 8 billion Euros that was to have been given to Greece in mid-November. Greece hasn't back down, and EU leaders are suggesting that Greek voters be asked to decide whether or not Greece should remain in the EU. Who knows? The Greek electorate may respond with a digital salute.

The Greek prime minister also faces a no confidence vote this Friday, Nov. 4, 2011. His legislative majority has been shrinking, and he officially has just barely enough votes to survive. If the no confidence vote fails, Greece will hold early elections. Those could further delay implementation of the EU's bailout plan.

The referendum and no confidence vote throw a massive wrench into the EU's governance "process." As it is, the EU has no established way to deal with a problem like the ongoing sovereign debt crisis, in which its very existence could be threatened. Europe's leaders have been winging it, meeting every week, and issuing innumerable upbeat press releases to manipulate the financial markets upward. Somehow, this ad hoc process produced a back of the envelope bailout that might at least delay the day of reckoning. But all the EU's efforts have now been suspended by the unexpected announcement of the Greek referendum and no confidence vote.

The referendum and no confidence vote demonstrate that there simply is no European Union. At its moment of greatest crisis, the fate of the EU rests on a snap decision by a Greek politician to hold a plebiscite and a no confidence vote. No one else in the EU signed off on this sui generis procedure. Yet, the EU, its currency, its financial system and its economic fortunes rest on the political vagaries of a country whose GDP is maybe 2% of the EU's GDP. There isn't a European Union. The EU has no rules, no governance process, no decision makers and no efficacy. It's like a group of people who have jammed themselves onto a very small life raft and are working against each others' efforts to keep the thing from tipping over.

If the EU blows up, the rest of the world will be dragged down as well. All this because of the political dysfunction of a nation with 0.5% of the world's GDP. That the fate of the European Union, and the world's financial system and economy, should rest on the electoral process of a small nation like Greece suggests that the interconnectedness of the world's financial system and economy has gone too far. Technology, derivatives and other linkages allow capital--and more importantly, financial risk--to flash around the globe almost instantaneously. While that's good when life is copacetic, reality is that some days are rainy. Today's hyperquick, hyperactive, and opaque financial system guarantees not only that capital flows immediately to the most attractive profit opportunity, but also that risk and financial contagion move equally fast in unpredictable, and therefore unhedged, ways. It may be time to establish significant limits on the extent to which financial risk can be palmed off. When faced with risk, people have a tendency to become responsible. But when you can pass the hot tamale to someone else, expediency trumps maturity. What we desperately need today is responsible behavior.

The only firewall left for the financial system is the taxpayer. Because taxpayers are becoming increasingly stressed, central banks have printed or will resort to printing money. This isn't a solution, just a kick of the can down the road. The Greek prime minister's decision to hold a referendum and no confidence vote serves as a reminder of a truth that is rarely acknowledged: there is no way of the current financial crisis without serious pain for everyone. The Greek prime minister is asking Greeks to grow up, face the fact that they will have to endure tough times, and agree to take their castor oil. Sooner or later, the rest of the world will have to do the same. But their politicians and other leaders continue to spin tales of Lake Wobegon, where everyone is in the top 1% and occupies only executive suites.

Dexia and MF Global Holdings: Canaries in the Financial Markets?

Financial market volatility as we've had in recent months inevitably takes a toll if it continues long enough. A few weeks ago, a large Belgian-French bank, Dexia, was bailed out and partially nationalized after sustaining heavy losses from the European sovereign debt crisis. This weekend, news services report that MF Global Holdings, a financial services firm, is on the ropes because of sizeable losses in proprietary holdings of European sovereign debt. MF Global and its advisers have reportedly been seeking to sell part or all of the firm, but no transaction appears imminent. This evening (Sunday, Oct. 30, 2011), we now learn that the firm has hired bankruptcy lawyers. http://www.marketwatch.com/story/mf-global-hires-bankruptcy-lawyers-wsj-2011-10-30?link=MW_home_latest_news, and http://www.reuters.com/article/2011/10/30/us-mfglobal-idUSTRE79R4YY20111030?feedType=RSS&feedName=topNews&rpc=71.

Because Dexia is a bank, its bailout was not a particular surprise. The EU could hardly allow a major bank to collapse at this moment of crisis, lest its entire financial system nosedive.

MF Global, however, isn't a bank and doesn't have a hovering government Sugar Daddy waiting to hand over a blank check. It brokers derivatives transactions, and its operations include the clearance and settlement of derivatives trades. It also trades for its own account. The firm reportedly held about $6.3 billion in hinky European sovereign debt, and disclosed a quarterly loss of $191.6 million on Oct. 25, 2011. Moody's and Fitch have lowered MF Global's credit rating to junk, which could disrupt its normal access to credit. Some brokerage customers have apparently been exiting, stage right. Press reports indicate that, to maintain liquidity, MF Global has drawn down two bank lines of credit. Its banks include Citigroup, Bank of America and J.P. Morgan Chase. That these big boys would allow MF Global to tap out its lines of credit indicates a difficult situation. One surmises that MF Global may be facing a potentially major run by customers and, with its banks' assistance, is doing whatever it can to buy time to find an acquirer.

MF Global hired three of the largest law firms in New York to assist in a possible bankruptcy: Skadden Arps Slate Meagher & Flom, Weil Gotshal & Manges, and Sullivan & Cromwell. Chances are it wouldn't hire firms of this size and stature unless something very big might happen very soon. These firms can, on a moment's notice, throw legions of lawyers onto a matter such as a bankruptcy of MF Global. The retention of such massive potential legal resources doesn't signal a bright near term future for MF Global.

What's unclear from news stories is the condition of MF Global's derivatives clearance and settlement operation. Such operations typically are protected by the capital of the settlement and clearance firm, which may also hold collateral from counterparties. A crucial question is whether losses from the proprietary trading could spill over into the brokerage operation and impair its ability to honor its brokerage and clearance and settlement obligations. If so, the value of an unknown quantity of derivatives transactions could be thrown into doubt. Were that to happen, a pathway for financial contagion could open up and spread outward into the larger financial system. If there is a potential for financial contagion to spread, expect the Federal Reserve to open the monetary floodgates.

The MF Global situation provides yet even one more reminder that we really need to implement a new regulatory regime for derivatives. The possibility that a derivatives broker, that provides clearance and settlement services, might put customers at risk from its proprietary transactions is simply unacceptable today. For many decades now, clearance and settlement in the stock markets have been legally insulated from proprietary trading, and separately capitalized. Mistakes and misjudgments at proprietary trading desks shouldn't be able to blindside clearance and settlement customers. The Dodd-Frank legislation provides a framework for making clearance and settlement in the derivatives market much more rigorous and secure. With all the volatility we've had, it's entirely possible that more financial firms beyond Dexia and MF Global are headed for the shoals. How many more canaries in the financial markets need to stop tweeting and fall over before we have reform?

The EU's New Bailout: Who's the Sugar Daddy?

The EU's new bailout plan may be a somewhat clever bit of financial engineering. But one wonders if it isn't too clever by half.

For political purposes, holders of Greek debt "voluntarily" agreed to 50% haircuts, giving Greece about 100 billion Euros (or $140 billion) of debt relief. It's important that the haircut be deemed voluntary, or credit default swap counterparties (i.e., insurers against a Greek default) would have to make payments to holders of Greek debt. Such payments could make the contagion spread farther out into the financial system and financing costs for other weak EU member nations could rise. Plagues are harder to contain the wider they extend, so preventing this deal from triggering a requirement for CDS payments was deemed essential.

How voluntary the haircut is depends on how much you avert your eyes. With the heads of the German and French governments directly "discussing" the issue with them, Greek debt holders may have received considerable official guidance as to where their hearts and minds lay. Since most Greek bonds are held by banks that are "volunteering," those banks won't seek payment under their CDS contracts. The nonbank holders of Greek debt could do so, but they don't hold so much that they couldn't be paid off in full if necessary without disturbing the waters tumultuously.

Of course, CDS dealers may be alarmed tonight. If CDS holders can't recover in a scenario such as today's, there would be little incentive for them to continue buying CDS's, and the CDS market could collapse. Some might think that would be a good thing. While most financial industry bigwigs, economists and politicians would say that the connectedness of the world's economy and financial system is good, there can be too much of a good thing. With so much of the international financial services industry devoted to shifting risk around, instead of helping real businesses raise capital, it's reasonable to ask whether financial interconnection has been taken too far.

But we digress. The haircut banks will take on Greek debt will be softened. Greece will issue 100 billion Euros of new debt for the remaining 50% of the old debt that isn't being written off. This new debt will be supported by 30 billion Euros (or some $42 billion) provided by the EU as collateral. In other words, the EU is absorbing 30% of any losses on the new debt. But where will the EU get this 30 billion Euros? The EU's rules preclude central bank printing of money.

That leaves you-know-who to foot the bill.

The big banks in the EU will be required to boost their capital by a combined 100 billion Euros (or $140 billion) over the next eight months. This should help create a firewall around the EU sovereign debt crisis, and hopefully prevent it from spreading beyond the weak nations that are already on the ropes. One minor detail, though: where will the 100 billion Euros come from? Although EU banks might be required to refrain from paying dividends, and try to issue new stock to raise capital, it's doubtful they can put together 100 billion Euros in the next eight months. With the tens of billions of losses these banks are facing from Greek and other debt, they may not have that much in the way of profits to add to capital. And what legion of private investors would want stock of the pigs in a poke that the EU's banks have become?

That leaves you-know-who to recapitalize the EU's sick banks.

The third component of the new EU bailout is the leveraging of the remaining uncommitted 250 billion Euros in the EU's bailout facility created last year, the EFSF. Apparently, this money will be used to guarantee 20% to 25% of the value of new bonds to be issued to replace dodgy debt of shaky EU members. Because of the guarantee, it is hoped that bond vigilantes will accept lower interest rates on the new debt that will alleviate the financing costs of the spendthrift nations that are dragging down the EU. In theory, this isn't a bad idea. All we need now is a trillion or so Euros (or about $1.4 trillion) to invest in the new leveraged bonds.

Rumor has it that China and Brazil might help to bail out the EU. China has a $6 trillion GDP and Brazil's is $2 trillion. It's hard to envision these two developing nations trying to explain to their own less well-off citizens why anything approaching $1.4 trillion of their wealth should go to bail out the much wealthier citizens of the EU. China may kick in a few tens of billions, Brazil somewhat less. But that would leave well over a $1 trillion to go.

Politics prevent the U.S. from directly providing any assistance. The IMF, with a balance sheet in the range of $400 billion, couldn't bite off a real big chaw of the needed $1 trillion plus. And with the effectiveness of CDS's to offset default risk now in question, what army of private investors would touch these puppies with a ten-foot pole? Perhaps the EU's banks could be persuaded to "voluntarily" buy some of this sh . . . stuff. But at this point, the EU's banks aren't much more than conduits for losses to fall on you-know-who.

That leaves you-know-who to pick up the tab.

Taxpayers of the wealthy EU nations may be approaching a state of bailout fatigue. Add up the $42 billion in collateral for new Greek bonds, $140 billion for bank recapitalization, and $1 trillion or more for leveraged bonds, and you get $1.2 trillion plus. The good burghers of Germany, the Netherlands, Austria and the other wealthy EU nations will, at a minimum, scowl deeply when they realize what the new EU's new bailout means. Perhaps they'll cough up the money. Then again, when this much is involved, they may balk.

Without solid sources of funding, the EU's new bailout is the same as the emperor's new clothes. Clever financial engineering doesn't amount to jack if there isn't enough funding to make it work. And even if you look high and low, it's hard to find the EU's sugar daddy.