Wednesday, January 25, 2012

Disaster Myopia, Normal Accidents, and the Euro Policy Elite

2012 has taken on a decidedly optimistic tone after an  inauspicious start.  Some people seem to think that things in the Eurozone are largely settled and done with and that we can begin moving on with our lives.   I am not one of those people.

As we stand today there are two possible outcomes for the EU. In the first scenario, a critical mass of member states enacts a sweeping range of thoughtful and clever reforms that allow them to transform themselves into sustainable economic systems, capable of  creating livelihoods for the majority of the population without placing untenable costs on society.  This will require convincing or forcing a large number of entrenched insiders - politicians, pensioners, workers in closed trades, criminals, subsidized farmers, and so on- to relinquish some or all of the benefits they have come to enjoy over many years to outsiders.  By outsiders, I mean largely mean people under 30.  And they must do so while not incurring adjustment costs so high as to break the fragile banking system and, by extension, the EU.  This doesn't mean simply firing people and exposing uncompetitive enterprises, public or private, to economic realities, it means having a significant number of people consent to their lives being drastically changed so that others might have the opportunity to live productive, dignified lives.

It is that, or the EU continues to slowly deteriorate until it won't, at which point policy makers will find the decisions being made for them.  It didn't always have to be this way.  But this is what the EU's assembled political apparatus has left us with.  In zen bhuddism, this is called 'small mind'.  In markets, we call this disaster myopia, or perhaps simply collective incompetence.

By a critical mass, I really just mean Italy and Spain, although France and Germany aren't as far behind as they might like to think.  As the two most exposed of the big Eurozone economies, they are what matters now.  Greece, Portugal, Ireland, and all the rest, clever acronyms aside, are irrelevant sideshows.  For those out of the loop, I suggest you check out Edward Hugh's recent update on Spain.  

The Eurozone's core problems have not gone away.  LTRO may have alleviated the immediate short-term funding needs of European banks it has not, as some have suggested, taken the possibility of a systemic run on banks off the table.  Nor will any clever bit of financial engineering or macro-economic policy.  What is needed is enlightened leadership capable of guiding a disparate collection of peoples, each with their own idea of who and what is to blame for the problem they face, through a difficult and novel process of painful change.  That is, as soon as they agree on what the problem is, and how exactly it is that it came about in the first place.

As a recent report by the folks at the Peterson Institute has highlighted, Europe has some tough decisions to face:

So, enough sweeping generalities and on to the specifics of this week's post.

I’ve already briefly discussed LTRO and why I think it represents an incremental stop-gap and is not a substitute for effective, coordinated action from heads of state.  This is an ECB forced to do its best to atone for the sins of sovereigns while striking an increasingly uncomfortable balance between monetary and fiscal policy.  It is not a substitute for effective, coordinated action from heads of state.  While the expectations for February's second and final LTRO have swelled considerably, it is worth noting that markets have not been given any indication that LTRO will continue in the future, which limits the effectiveness of deploying such large sums of money (albeit on a secured basis).  As far as everyone knows, this is a one time thing and is not capable of holding things together indefinitely.  

 At the end of the day, its just another liquidity solution, and one with two important costs:

Firstly, bonds deposited with the ECB become locked out of the intermediation system.  To the extent these are high quality collateral that would have otherwise been repo’ed to broker-dealers, this is a problem. While cheapest to deliver incentives and an increasingly broader range of acceptable collateral (which may or may not include un-listed, un-traded bonds issuedby banks to themselves expressly for punting back to the ECBwill have limited the portion of high quality collateral accruing to the ECB, the poll of eligible collateral will continue to shrink.  

Repo financing plays a crucial role in modern banking by providing what is effectively a wholesale deposit base.  This deposit base gets levered as pledged collateral gets rehypothecated several times over in a chain of transactions, creating a velocity of collateral that keeps the system running smoothly, but at the cost of increasing the possibility of cascading margin calls between counterparties (as MF Global clients have unfortunately discovered).  This dynamic manifested itself in the early days of the US subprime crisis and required a Fed program explicitly designed to recycle collateral, which although somewhat successful was obviously unable to prevent the inevitable from happening.  Market participants and policy makers are gradually becoming more aware of the systemic importance of repo and the implications that it has for financial stability but I think the central role that it occupies remains understated, at least in the popular narrative.

The data suggests that LTRO has done little to change the underlying contraction of shadow bank financing.  ICAP, who operate the largest repo platform in Europe, sees repo volumes down 30% from mid-Q4 levels in their latest survey.  While its possible that LTRO is in part responsible for this –the  approx. €50-60 drop off in repo volume could correspond to the new financing extended by the ECB if you figure in the re-hypo leverage – the underlying trend suggest that the private repo market is becoming increasingly dysfunctional.  This matches the data from ICMA, which suggests that repo financing contracted 3.3% in Q4 (despite modestly climbing year on year).  More relevant to the discussion at hand is the contraction of EUR denomed repo, falling to 59.8% from 63.5% during the quarter, which is also reflected in the geographic composition of collateral:

As a reminder, to lose money on a repo transaction, you need to have the counterparty walk away and the collateral end up being worth less than you thought.  With the fates of European sovereigns and financial institutions moving in lock-step, its not very surprising that markets have scaled back repo.  With European financials still overly reliant on short-term financing, this deleveraging has and will continue to be painful, which is likely why the ECB embraced LTRO in the first place.   

Also, lets not forget that assets deposited with the ECB are still marked to market and subject to margin requirements, so that even though LTRO may replace evaporating private repo financing, it does nothing to block a potentially Euro-shattering spiral of climbing haircuts.  In fact, by shortening the collateral chain, it couples the various linkages in the system even tighter.  

The second, unstated cost of the ECB's expanding backstop, LTRO or otherwise, becomes clear in the context of the ongoing Greek ‘private sector involvement’ negotiations.  The Troika plan for Greece has failed and the domestic economy continues to deteriorate with little sign of stabilizing.  Lets for the moment set aside the not all that unlikely possibility of negotiations breaking down amidst a ruinous disorderly default and assume we get a deal.

The ECB’s holdings of Greek debt are substantial and likely stand somewhere around 20% of the total outstanding issue.  Due to the political need to protect the ECB from embarrassing losses, the ECB will almost certainly be carved out of any deal that gets negotiated, despite recent rumblings from mean girl Christine Lagarde (rival clique leader Frau Merkel disagrees and her opinion seems to be the one that matters lately).  This is all good and well except that this implicitly makes private creditors junior creditors.   Not only junior creditors, but as PSI has demonstrated, juniors whose rights are subject to an incoherent, unpredictable restructuring process dictated by political whim (although in fairness this is largely true of all sovereign restructurings).  In the context of PSI, this means that the private sector would have to foot a significantly larger bill than it would otherwise in order to bring the overall debt levels down to more reasonable levels.  So, the most realistic outcome will be a default-worth write-off that actually gives Greece some hope of reviving itself, which will almost certainly be larger than the 50-55% figure initially floated.  Anything less and, barring a sudden and dramatic change for the better in Greek policymaking, we will be back in the same place before too long.

While the CDS impact has been greatly exaggerated and Greece’s fiscal weakness is well known, a default-sized write down further dents the EU’s credibility and will result in unforeseeable consequences for the European banking system.  Greece was always going to default and the longer the EU refuses to admit this, the deeper the hole will get.  The repricing of other sovereign credits to reflect the subordination of the EU’s creditors and the realization that Ireland and Portugal aren’t far behind Greece could provide a sufficient shock to set off a fatal haircut bank run.  LTRO may shield banks, but it does not shield a number of their counterparties, and at the end of the day the contagion effect is impossible to eliminate with the Euro banking system standing as it does on explicitly ‘risk-free’ sovereign debt.  It is sadly ironic- although typical of economic policymaking that attempts to legislate such unacheivable outcomes- that the Basel regulations intended to create financial stability will have end up providing the incentive for the EU to Texas hedge its banking system.   

More worrying than any direct catalyst, however, is the fact that markets will only go through these exercises so many times before they lose patience with policymakers and this has been lingering for far too long already.  Perhaps economic historians will one day wonder how it was that the stubborn denial of a problem <3% of EU GDP ended up killing the whole project.  

What we have today is an extremely complex, fragile system in which the key constituents' fates are tightly coupled through a wide range of potential mechanisms, many of which directly feed into each other .  When you overlay this with the multitude of political constraints that have almost unilaterally eliminated the best possible solutions, timely and coordinated policy responses become a near impossibility. Charles Perrow would say that such a complex and dynamic system inevitably leads to unexpected and deadly outcomes when the various components become tightly intertwined- this is what he calls a 'normal' accident.  The European financial system, resting as it does on insolvent sovereign credits that underpin an over-levered banking system largely cut off from private market funding, and held together by repo financing prone to bank-run like evaporation, certainly fits this description.   

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