Everything that you wanted to know about "Why You Should Monitor Europe" but were afraid to ask.

A brief introduction - one of my favorite posters on this site is BOz who has demonstrated a knowledge and passion on financial topics.  I have enjoyed our exchanges both here and offline and I have learned quite a bit. I thought it would be informative and beneficial to get BOz to share his thoughts with all of us.  Thanks BOz!

I was honored when Cake or Democracy (CoD) asked if I would be a guest contributor on this blog.  In particular, CoD asked whether I would like to post some thoughts on Too Big To Fail (TBTF) banks along with the many regulators we have in the US.  Though I do monitor TBTF banks and regulators, I am not an expert.  Any knowledge I have in TBTF banks and regulators was obtained primarily through my interest in staying a step ahead of the next stock market bubble.  To do this, I read many reports, analyses, and blogs about the US and global economy.  Note I am not a day trader - I just try to heed Warren Buffet’s first rule of never lose money.  When asset bubbles pop, losses can add up more quickly than even the Buffalo Bills care to reflect on.

Within the same conversation with CoD, I was later asked whether I thought that “the greece default issue would cause another economic setback.”  I knew then I had my first guest topic though be forewarned that I’m barely scratching the surface.  An entire book can be written on this subject and I’m only attempting to explain this to someone who may have simply seen a headline about trouble in Greece.

Finally while CoD and I may not agree on a given topic, we both look at this as an opportunity to learn as differences contain far more lessons than agreements. I hope you find my musings informative, thought-provoking, and useful.  I look forward to your comments.

Why You Should Monitor Europe

Regardless of where you were in 2008, you knew about the financial crisis that hit the world when Lehman Brothers failed and Congress failed to pass the Troubled Asset Relief Program (TARP).  Retirement plans fell hard that October and people phoned their Congressional Representative telling them that they needed to fix this situation.

Without getting into details, banks were bailed out.  Several trillion dollars worth of stimulus and interest rate easing put a halt to the stock market rout.  New laws like Frank-Dodd were passed that would prevent banks from taking too many risks.  Indeed a year later, it seemed that government and central bank policy saved the day. 

Yet the main problem behind the crisis went unresolved - large amounts of debt.  

Now you may wonder why I am going to move the discussion over to Europe considering US debt obligations and the loss of AAA debt status.  Simply put, large amounts of debt are not solely a US-phenomenon.  With the US debt limit raised, global markets moved forward to find the next weak link that threatens to break the chain of the global financial markets.  Thus we turn to Greece, which has the very real potential to inflict far more damage to world financial markets right now than the 2008 crisis.  

Greece

The European Union (EU) has an annual GDP at just over $16 trillion. Delving into each individual country’s share, you find Greece’s annual GDP is approximately $300 billion, which accounts for about 2% of EU GDP. In thinking about Europe’s banking system, you would be correct to ask how can such a small country bring down a financial system. 

Similar to the US, the Greek government borrowed money for many years to make budgetary ends meet.  The loans paid for government services, worker salaries and benefits, and principal and interest on previous loans.  According to Eurostat (the EU’s statistical keeper), Greece owed debts of ~$329 billion at the end of 2010.  Recalling that the Greek economy creates ~$300 billion annually, you may begin to question whether Greece can service its debts. 

In a growing economy, there is a chance that a country can grow its way out a such a debt problem.  Economic growth means more tax revenues.  Governments can allocate these new revenues toward debt fulfillment.  

Greece, however, is not growing. Investors began to lose confidence in the Greek government repaying its debts and demanded more interest on new loans.  Eventually, investors deemed the risk high enough that interest rates rose to where the debtor (Greece) could not afford to borrow.  

Yet the debt hole was already dug.  Remember Greek debt finances payment of interest and principal on previously borrowed money.  As Greece cannot repay what it previously borrowed, it either needs to restructure, refinance, or default on this debt.  As private investors do not wish to perform these tasks, we look to Europe for a solution.

Why Greece Matters to Europe

Besides not wanting to admit failure, Greece matters to Europe because EU banks are Greece’s primary creditors. When Greece defaults, these banks will be forced to recognize losses on their balance sheet, losses which could make them insolvent.  Governments would have to nationalize these banks and repay depositors using taxpayer money.

Additionally, credit default swaps (CDS) written to protect against a Greek default and subsequent bank failures would be paid out.  These “insurance-like” products have been called financial weapons of mass destruction for good reason.  If the insurer within a swap cannot fulfill its obligation, a potential cascade failure of the banking system may occur as the party that bought the insurance may not be able to pay its own claims.  It was CDS that brought down AIG in the US housing bust.  Much to my own dismay, the US government via the taxpayer paid out AIG’s obligations.  As CDS are not regulated or on an exchange, no one knows who will owe whom what until the event triggers the swap.  With the International Swaps and Derivatives Association (ISDA) estimating the CDS market to be $26 trillion in 2010, the potential risk here could be astronomical.

Furthermore in trying to bail out Greece, the European Central Bank (ECB) allowed banks (both Greek and EU banks) to exchange Greek government bonds for Euros - meaning the ECB loaned money using Greek bonds as collateral. When Greece defaults, the ECB will be forced to recognize this loss and will likely need to be recapitalized too from the EU taxpayers.

What is Europe Doing to Solve this Crisis

The EU, ECB, and IMF (International Monetary Fund) have tried solving the Greek crisis through bailout loans and austerity measures, such as fewer services, higher taxes, and government pay cuts.  They hoped this solution would make Greece a growing competitive economy again.  Unfortunately this plan failed because it caused the Greek economy to contract.  This led to Greece requiring more bailout loans and austerity measures, which have still failed to produce the desired result.

The EU, ECB, and IMF are currently trying to calculate another pain-free method to exit this situation.  However more bailout loans are unattractive politically, and debt write-offs are equally unattractive (though necessary) to bondholders.

Misery Enjoys Company

Remember when I said large amounts of debt are not solely a US-phenomenon. Even if a market-acceptable solution is found, Greece is not the only EU country with too much debt.  The EU, ECB, and IMF also bailed out and imposed austerity measures on Ireland and Portugal.  One of the many reasons why there is no easy Greek solution is whatever the EU resolves to do, it is quite likely trouble will simply migrate to Ireland or Portugal.  Hence the EU has to solve for these two countries as well increasing the overall cost.

Furthermore interest rates are rising on Italian and Spanish debt as financial markets begin to lose confidence that their debts will be repaid.  While Greece, Ireland, and Portugal are relatively small, Italy is the 3rd largest economy in the European Monetary Union and Spain is the 4th largest.  If these countries cannot finance/refinance their debt, the future of the euro is bleak as these countries are too big to bail out.

So How Does this Affect Me Here in the US

There are many avenues that these European troubles can affect you as an individual and as a taxpayer.

Stock market crash - the bank problem alone will cause markets to sell off as investors flee risky assets.  Additionally, Europe is one of the US’s largest trading partners. It is also China’s largest trading partner.  Hence, global trade will falter causing a US (and global) recession.  Furthermore if the euro dissolves, many contracts written with euros will need rewritten and who owes what to whom will have to be decided.  

Euro bond markets - you can lose money if you are in international bonds in any EU country.

Money market funds - take a look at where your money market funds (MMF) are invested and you will likely find short-term investments in European banks. These “safe” investments may lose money if that foreign bank fails.  

International Monetary Fund - the US contributes to the IMF which is currently providing bailout loans to Greece, Portugal, and Ireland.  More loans to Europe are feasible in which case the US taxpayer is at risk.

How Can I Protect My Assets

As I post this article without knowing you, your age, or your risk tolerance, I will refrain from making investment advice.  Its also important to realize that Europe and Greece are only one piece in the global financial market puzzle.  Trying to position your assets for this one piece without regard to the other puzzle pieces (that are beyond this article) could prove detrimental to your nest egg.

However, I will share a few words from the Wizards of Wisdom:

Don’t let your investments keep you up at night.  If they do keep you awake, you are taking more risks than you are comfortable with.  Talk to a professional about reallocating to less risky investments so that you can sleep.  During your conversation with said professional, ask why they believe that their recommendation is less risky.  If you are not convinced by their explanation, don’t invest.  Remember it’s your nest egg.

Opportunities are easier to make up than losses.  I’ve been conservatively invested since 2007 when I felt that I stood to lose more of my nest egg than gain by being invested in the stock market.  While I missed much of the rebound in the stock markets from March 2009 to present, my portfolio also did not take any large losses.  Furthermore a new bull market will present itself someday.  When it does, I’ll be ready.

Looking forward to progressing through towards better times...

BOz

Goldman S*chs

I am feeling a little cranky today –

So what has my dander up?
That people don’t realize, that at a minimum during the recent Wall Street Crash beginning September 16, 2008 there was plenty of criminal intent.  Not criminal intent like I accidentally didn't fill out the right form but rather I can make a boat load of money while defrauding you. We were cheated in the worst financial crisis since the Great Depression of the 1930s.

According to Matt Taibbi (who in my opinion is a great reporter)
Nobody goes to jail. This is the mantra of the financial-crisis era, one that saw virtually every major bank and financial company on Wall Street embroiled in obscene criminal scandals that impoverished millions and collectively destroyed hundreds of billions, in fact, trillions of dollars of the world’s wealth — and nobody went to jail. Nobody, that is, except Bernie Madoff, a flamboyant and pathological celebrity con artist, whose victims happened to be other rich and famous people. The rest of them, all of them, got off. Not a single executive who ran the companies that cooked up and cashed in on the phony financial boom — an industry-wide scam that involved the mass sale of mismarked, fraudulent mortgage-backed securities — has ever been convicted

So why no criminal charges?? - the NY Times ran an article asking that very question.
As the crisis was starting to deepen in the spring of 2008, the Federal Bureau of Investigation scaled back a plan to assign more field agents to investigate mortgage fraud. That summer, the Justice Department also rejected calls to create a task force devoted to mortgage-related investigations, leaving these complex cases understaffed and poorly funded, and only much later established a more general financial crimes task force.
Leading up to the financial crisis, many officials said in interviews, regulators failed in their crucial duty to compile the information that traditionally has helped build criminal cases. In effect, the same dynamic that helped enable the crisis — weak regulation — also made it harder to pursue fraud in its aftermath.
A more aggressive mind-set could have spurred far more prosecutions this time, officials involved in the S.&L. cleanup said.
http://www.nytimes.com/2011/04/14/business/14prosecute.html?pagewanted=all

I thought I would go to the source. 

A Senate Subcommittee on Investigations, chaired by Democrat Carl Levin of Michigan, alongside Republican Tom Coburn of Oklahoma released a 650-page report
“Wall Street and the Financial Crisis: Anatomy of a Financial Collapse,”

It has been described as an unusually scathing bipartisan report also includes case studies of Washington Mutual and Deutsche Bank, providing a panoramic portrait of a bubble era that produced the most destructive crime spree in our history — "a million fraud cases a year" is how one former regulator puts it. But the mountain of evidence collected against Goldman by Levin's small, 15-desk office of investigators — details of gross, baldfaced fraud delivered up in such quantities as to almost serve as a kind of sarcastic challenge to the curiously impassive Justice Department —

I searched for and downloaded the report. I searched the report for the word “Goldman” and then excerpted the majority of the hits.  The report speaks for itself.   We all should be pretty pissed about this.
So without further ado – the rest of the blog is directly excerpted from the senate report.  It's a little long but so worth it.
Enjoy it, you paid for it it spades.

The Goldman Sachs case study focuses on how it used net short positions to benefit from the downturn in the mortgage market, and designed, marketed, and sold CDOs in ways that created conflicts of interest with the firm’s clients and at times led to the banks profiting from the same products that caused substantial losses for its clients.

Two case studies, involving Goldman Sachs and Deutsche Bank, illustrate a variety troubling practices that raise conflicts of interest and other concerns involving RMBS, CDS, and ABX related financial instruments that contributed to the financial crisis.

Throughout 2007, Goldman sold RMBS and CDO securities to its clients without disclosing its own net short position against the subprime market or its purchase of CDS contracts to gain from the loss in value of some of the very securities it was selling to its clients.

From 2004 to 2008, Goldman was a major player in the U.S. mortgage market. In 2006 and 2007 alone, it designed and underwrote 93 RMBS and 27 mortgage related CDO securitizations totaling about $100 billion, bought and sold RMBS and CDO securities on behalf of its clients, and amassed its own multi-billion-dollar proprietary mortgage related holdings. In December 2006, however, when it saw evidence that the high risk mortgages underlying many RMBS and CDO securities were incurring accelerated rates of delinquency and default, Goldman quietly and abruptly reversed course.

 Over the next two months, it rapidly sold off or wrote down the bulk of its existing subprime RMBS and CDO inventory, and began building a short position that would allow it to profit from the decline of the mortgage market. Throughout 2007, Goldman twice built up and cashed in sizeable mortgage related short positions. At its peak, Goldman’s net short position totaled $13.9 billion. Overall in 2007, its net short position produced record profits totaling $3.7 billion for Goldman’s Structured Products Group, which when combined with other mortgage losses, produced record net revenues of $1.1 billion for the Mortgage Department as a whole.

Throughout 2007, Goldman sold RMBS and CDO securities to its clients without disclosing its own net short position against the subprime market or its purchase of CDS contracts to gain from the loss in value of some of the very securities it was selling to its clients.

The case study examines in detail four CDOs that Goldman constructed and sold called Hudson 1, Anderson, Timberwolf, and Abacus 2007-AC1. In some cases, Goldman transferred risky assets from its own inventory into these CDOs; in others, it included poor quality assets that were likely to lose value or not perform. In three of the CDOs, Hudson, Anderson and Timberwolf, Goldman took a substantial portion of the short side of the CDO, essentially betting that the assets within the CDO would fall in value or not perform. Goldman’s short position was in direct opposition to the clients to whom it was selling the CDO securities, yet it failed to disclose the size and nature of its short position while marketing the securities.

While Goldman sometimes included obscure language in its marketing materials about the possibility of its taking a short position on the CDO securities it was selling, Goldman did not disclose to potential investors when it had already determined to take or had already taken short investments that would pay off if the particular security it was selling, or RMBS and CDO securities in general, performed poorly. In the case of Hudson 1, for example, Goldman took 100% of the short side of the $2 billion CDO, betting against the assets referenced in the CDO, and sold the Hudson securities to investors without disclosing its short position. When the securities lost value, Goldman made a $1.7 billion gain at the direct expense of the clients to whom it had sold the securities.

In the case of Anderson, Goldman selected a large number of poorly performing assets for the CDO, took 40% of the short position, and then marketed Anderson securities to its clients. When a client asked how Goldman “got comfortable” with the New Century loans in the CDO, Goldman personnel tried to dispel concerns about the loans, and did not disclose the firm’s own negative view of them or its short position in the CDO.

In the case of Timberwolf, Goldman sold the securities to its clients even as it knew the securities were falling in value. In some cases, Goldman knowingly sold Timberwolf securities Throughout 2007, Goldman sold RMBS and CDO securities to its clients without disclosing its own net short position against the subprime market or its purchase of CDS contracts to gain from the loss in value of some of the very securities it was selling to its clients.

Goldman took a substantial portion of the short side of the CDO, essentially betting that the assets within the CDO would fall in value or not perform. Goldman’s short position was in direct opposition to the clients to whom it was selling the CDO securities, yet it failed to disclose the size and nature of its short position while marketing the securities. While Goldman sometimes included obscure language in its marketing materials about the possibility of its taking a short position on the CDO securities it was selling, Goldman did not disclose to potential investors when it had already determined to take or had already taken short investments that would pay off if the particular security it was selling, or RMBS and CDO securities in general, performed poorly.

While Goldman sometimes included obscure language in its marketing materials about the possibility of its taking a short position on the CDO securities it was selling, Goldman took 100% of the short side of the $2 billion CDO, betting against the assets referenced in the CDO, and sold the Hudson securities to investors without disclosing its short position. When the securities lost value, Goldman made a $1.7 billion gain at the direct expense of the clients to whom it had sold the securities.

In the case of Anderson, Goldman selected a large number of poorly performing assets for the CDO, took 40% of the short position, and then marketed Anderson securities to its clients. When a client asked how Goldman “got comfortable” with the New Century loans in the CDO, Goldman personnel tried to dispel concerns about the loans, and did not disclose the firm’s own negative view of them or its short position in the CDO. In the case of Timberwolf, Goldman sold the securities to its clients even as it knew the securities were falling in value. In some cases, Goldman knowingly sold Timberwolf securities to clients at prices above its own book values and, within days or weeks of the sale, marked down the value of the sold securities, causing its clients to incur quick losses and requiring some to post higher margin or cash collateral. Timberwolf securities lost 80% of their value within five months of being issued and today are worthless. Goldman took 36% of the short position in the CDO and made money from that investment, but ultimately lost money when it could not sell all of the Timberwolf securities

.  In the case of Abacus, Goldman did not take the short position, but allowed a hedge fund,  Paulson & Co. Inc., that planned on shorting the CDO to play a major but hidden role in  selecting its assets. Goldman marketed Abacus securities to its clients, knowing the CDO was  designed to lose value and without disclosing the hedge fund’s asset selection role or investment  objective to potential investors. Three long investors together lost about $1 billion from their  Abacus investments, while the Paulson hedge fund profited by about the same amount. Today,  the Abacus securities are worthless. 

 In the Hudson and Timberwolf CDOs, Goldman also used its role as the collateral put  provider or liquidation agent to advance its financial interest to the detriment of the clients to  whom it sold the CDO securities.  Both Goldman Sachs and Deutsche Bank underwrote securities using loans from subprime lenders known for issuing high risk, poor quality mortgages, and sold risky securities  to investors across the United States and around the world. They also enabled the lenders to  acquire new funds to originate still more high risk, poor quality loans. Both sold CDO securities  without full disclosure of the negative views of some of their employees regarding the  underlying assets and, in the case of Goldman, without full disclosure that it was shorting the  very CDO securities it was marketing, raising questions about whether Goldman complied with  its obligations to issue suitable investment recommendations and disclose material adverse  interests.  

Goldman Sachs had helped to build an active mortgage market in the United States and had accumulated a huge portfolio of mortgage related products. In late 2006, Goldman Sachs decided to reverse course, using a variety of means to bet against the mortgage market. In some cases, Goldman Sachs took proprietary positions that paid off only when some of its clients lost money on the very securities that Goldman Sachs had sold to them and then shorted. Altogether in 2007, Goldman’s mortgage department made $1.1 billion in net revenues from shorting the mortgage market. Despite those gains, Goldman Sachs was given a $10 billion taxpayer bailout under the Troubled Asset Relief Program,70 tens of billions of dollars in support through accessing the Federal Reserve’s Primary Dealer Credit Facility,71 and billions more in indirect government support. 

So there you go. Pissed? You should be and this is only the tip of the iceberg.

If you enjoyed that, you read the whole report.  mmmmmmmmmmm

Get off my lawn!

When I first heard of the “Wall Street” protests my reaction was one of support. The initial government knee-jerk reaction of gloom and doom if we don’t bail out the “too big to fail” financial institutions and some of the subsequent reactions i.e. the post-crash overly restrictive loan policies the same bailed out with our money financial institutions instituted which caused an unnecessary crunch on small businesses that contributed to the ongoing recession were at the root of our current economic situation.

And this was all done while Wall Street payed out even higher bonuses to their employees then before they had wiped out half of my 401K savings. (I have the receipts to prove it). Then I saw the news – interviews with the protesters - I didn’t hear anyone clearly articulate what the protest was about – certainly not the things I believed in. In some cases I thought “they are half-wits – we are doomed” (of course trusting the media to fairly interview representative members of the protesting parties really wasn’t a good idea). Then I heard U.S. Representative Peter DeFazio’s speech on the Wall Street Protest– he so clearly spoke to the very heart of what the protests are all about and why they happened.

http://www.youtube.com/watch?v=hNNYWAZlCow

If the link doesn’t work than you can just cut and paste – it is well worth it. There is also a good article online at Slate.com posted by Annie Lowrey (link below)

It is not easy to say just what Occupy Wall Street wants; there is no concise list of specific demands. But the gist of the quickly snowballing movement is clear. Wall Street has not accepted responsibility for its role in the financial crisis and ensuing recession. It has done more harm than good for average citizens and businesses.  

http://www.slate.com/articles/business/moneybox/2011/10/occupy_wall_street_says_the_top_one_1_percent_of_americans_have_.html

and as Annie Lowery stated at the end of her article

 Whether Occupy Wall Street can help to rectify that imbalance—who knows. But there is certainly value in at least making sure Americans know just how unequal the country is.