Thursday, May 20, 2010

"Lessons for Europe; Lessons from Europe"

Sydney M. Williams

Thought of the Day
“Lessons for Europe; Lessons from Europe”
May 20, 2010

Fear and greed drive markets on a daily basis. Like lemmings, market participants go rushing off, first in one direction then another. Emotions rule behavior, temporarily upsetting performance for investors, but, in reality, providing opportunity for those who utilize “Mr. Market”.

Europe has become the most recent source of concern. Greece has been in the news all year. But virtually coincident with the peak in our market – April 23rd – the Germans began demanding greater austerity on the part of the Greeks; the Greek Ten-Year Bonds spiked to 9.3%. The Euro, however, has been in decline since the beginning of last December.

The problems appear to have roots in a profligate, socialist culture in the “Club Med” nations, and in a currency that did not permit default on the part of states. The very existence of debt and deficit limits perversely suggested that politicians would have a hard time resisting bailout pressure. The Euro allowed Greece to borrow at much lower rates than was otherwise possible. German buyers of Greek bonds (and others) were willing to take a moderately higher return, but obviously never anticipated bankruptcy. If, as John Cochrane of the University of Chicago wrote recently in the Wall Street Journal, the founders of the Euro had said to the Greeks, the crisis might never have appeared: “Go ahead, use our currency if you like. Rack up any debts you want. We don’t care, because we are not going to bail you out – we’ve set it up so we can’t bail you out. Bond buyers beware.” The fear of principal loss is what keeps bonds fairly priced.

However, in my opinion, it is too early to count the Euro out. It has only been in existence since January 1, 1999. Europe is a collection of nations, each with a unique culture. Those cultural differences can be a source of discord, as we have seen in recent days, but they also can be a source of strength, as myriad opinions can lead to a broad consensus. While Europe has a history dating back thousands of years, states such as Germany and Italy are younger than the United States, though their city-state predecessors are far older. Our “single currency”, the Dollar, was conceived at the time of George Washington’s first term and whatever currencies existed prior was the province of individual banks or states. At the time, citizens considered their home to be the state in which they lived, which for many dated back 150 years. Virginians were Virginians first and Americans second. Those from Massachusetts considered their state their home. Fifty languages were spoken in Pennsylvania alone at the time of the Revolution; Noah Webster, with his school primers, ensured that English would be the language of the new United States.

Members of the first Congress had difficulty overcoming these regional preferences; and it took years to overcome regional and state biases. Eighty-seven years after the Revolution began, the Civil War was fought to preserve the Union, but regional differences persisted for years. In the scheme of things, twelve years is not a long time to prove the worthiness of a single currency. In 2005, Mark Leonard, Executive Director of the European Council on Foreign Relations and author of Why Europe Will Run the 21st Century, wrote that he sees Europe as a “community of regional entities”. Whether the Euro and/or the European Union survives I cannot predict, but I believe its obituary is premature.

On Tuesday, Angela Merkel, the German Chancellor, imposed bans on the naked short selling of euro-zone bonds, uncovered credit default swaps and 10 financial stocks listed in Germany. Naked short selling implies no need to borrow the assets, so the market can be of unlimited size. Any short, though, has to have someone on the other side of the transaction. Typically, short sellers of equities borrow the stock they intend to short, pay a fee for doing so, are responsible for any dividends and have to put up margin and add to it if the stock moves against them. In the U.S., corporate bonds can be shorted in similar fashion. The creation of synthetic credit default obligations (CDO) and credit default swaps (CDS) permitted markets to become of unlimited size. Again, there has to be an entity – a counter party – on the other side of the transaction. If the buyer of a CDS bets correctly and the underlying bond defaults someone has to pay, as AIG discovered. If the bond does not default, the underwriter collects the premium. In this manner, the CDS market has characteristics similar to the insurance industry, but is unregulated and is of a unknown size, far greater than the underlying issues. A real problem with naked short selling is that it has the ability to “wag the dog.”

Despite this ban, “bond vigilantes” can still do their work, in calling attention to bad credits and bad behavior, without doing damage by accentuating and aggravating the situation. With naked shorts permissible, the very size of these markets can overwhelm the underlying issues they reflect and are real-life manifestations of “reflexivity”, the term George Soros has used: those rare instances where cause and effect create a symbiotic relationship, where cause drives effect and the resulting effect fuels cause. Large deficits cause CDS prices to rise; higher CDS prices raise borrowing costs, which in turn cause deficits to further increase. In the U.S., the naked short selling of stocks is prohibited, though the ban was overlooked by the SEC in the years leading up to 2008. However, the effective naked shorting of debt via the derivatives markets is still permitted, unwisely in my opinion.

Simply banning short selling, as the U.S. did on September 19, 2008 for 799 stocks, was a serious error, as the market fell 25% over four week period until the ban was lifted. But Ms. Merkel’s decision appears to be one on naked shorts.

In the midst of vicious cycles there never seems to be an exit, but there always is – sometimes painful, sometimes not. As to how this particular cycle ends, I do not pretend to know. As investors, the best we can do is look for opportunities and wait for Mr. Market.

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