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
Good post, especially in conjunction with COD’s last post. A few random thoughts: (1) there are probably a number of big financial organizations who are shorting this crisis in one way or another, and working very hard to make sure these shorts pay off, (2) I have no idea if Greece had a Glass-Steagall equivalent but this crisis is yet another example of the folly of combining commercial and investment banking in the same institution, (3) I’ve come to believe that some of the volatility we are seeing in the stock market is due to algorithmic trading (which is now over 70% of all activity) which is only aggravated by issues like this.
ReplyDeleteLastly, I think this should give us pause as we listen to Cowboy Rick talk about our entitlement society and getting rid of Social Security. The point of Social Security is to provide security to old people when they can no longer work. For today’s 40 year olds who knows what crisis will tank their portfolios 25 years from now. But it is clearly ridiculous to allow something like the Greek monetary crisis to consign old people to a marginal existence.
Medina, thanks for the comment. A few thoughts...
ReplyDeleteThe Greek debt crisis is actually more like the subprime housing crisis in that it's inception was due to the miss pricing of risk. Remember that house prices never go down thus there is little chance for massive numbers of homeowner defaults? Also remember that if we bundle enough mortgages together and securitize them, then overall it's less risky ergo let's rate it AAA? In this case, the bundling was done by the Euro project. All of the sudden, Greece which has been in default for 105 of the past 200 years was AAA like Germany and could borrow at rates similar to Germany. Massive homeowner default is similar to sovereign bonds never default. In short, the miss pricing of risk led to a huge asset bubble financed by debt. Unfortunately when the bubble pops, the debt remains (and again, Greece is not alone here).
While I don't know the percentage, I think you're right about algorithmic and high frequency trading exacerbating volatility. On the other hand if we take it away, there may be unintended consequences. Let's use the example of banning shorts in the market. I think shorting keeps the market in check. When someone shorts a stock, sooner or later they have to "cover" their short and buy the stock back. In a downward market, shorts covering create a natural break in the action because they want to lock in the profit. If you look a few years back when shorts on financial stocks were banned, that's when individual stock crashes got worse because no one wanted to be the first get their feet wet buying a stock. Shorts get their feet wet because they want their profit. Bringing this back to algorithmic trading trading, would banning it make for a bigger crash? I don't know, but it would be worth investigating.
Oh boy, a comment about Rick. I have parents and in-laws on SS, so naturally I want them protected. Yet the system is in dire need of reform. The biggest problem is we need to have a national conversation on what level of benefit and entitlement programs that we willing to pay taxes. Greece is not going to constrain old people in the US to a marginal existence. However Greece provides a real time movie of what can happen in the US if we do not get our debt under control. Greece started its downward spiral when its debt-to-GDP percentage hit 110% because investor lost confidence in its ability to repay. usdebtclock.org has our national debt currently at $14.882 trillion and our GDP at $14.991 trillion so roughly 99.3% debt-to-GDP. If you take total US debts, then US debt-to-GDP goes to 363%. When are US creditors going to lose confidence? It'd be nice to have a plan so that their confidence never comes into question.
I feel bad for the Greeks as I know there are people suffering through nothing they did directly. However someone has to be responsible too for the debts incurred by the profligate government.
Source for 105 years quote:
http://seekingalpha.com/article/188482-sovereign-default-stuck-between-dire-and-disastrous
Boz, good reply and I agree with a lot of what you say. There are a couple of things that I have been thing about lately that I vaguely alluded to in the first comment. One, I’m not convinced a lot of the bundling/CDOs/etc was a rational mispricing of risk. Dan Arielly, in his book Predictably Irrational (http://en.wikipedia.org/wiki/Predictably_Irrational), argues that a great deal of the economic decisions we make are not rational but are based on the way our brains work – which is often not rational. Add to this the clear drive of individuals in a lot of these organizations to maximize their wealth at any cost, and you have a mispricing of risk that was not even remotely rational. I kind of think that the role of regulators should be to try to “rationalize the markets”, whatever in the fuck that means, but at least they should put guard rails up so we don’t crash too badly. But, as COD discussed in Goldman etc, that was clearly killed by the organizations who were supposed to be regulated.
ReplyDeleteTwo, I agree with the shorting argument. And, while I think there is clear evidence that there is a lot of activity is done to enhance the value of those shorts we should not make them illegal. But, I think that algorithmic trading may be different. Over the years I worked building simulations of various things, sonar systems, submarines, oil well blowouts, etc. One thing that would often happen is we would have code that would simulate various parts of the whole system and they would occasionally have modes in which they would reinforce collective errors. That is what I worry about here. I think the flash crash of a few months ago may have occurred because of this and the increasing volatility that we see may be because of this. Banning it is probably not possible, but we need to sit down and figure out how it is affecting markets and how to mitigate some of that bad stuff – a lead in to the next paragraph.
Three, as far as Greece hurting retirees in this country, it may be a stretch but consider this. In April I was laid off from a place where I had worked for over 32 years. When the crash hit in 2008 said company used that as an excuse to kill the pension program. Now, when I was canned I was able to retire and collect a pension but it was about 80% of what it would have been if it had not been killed. (As a side note, when the market came back all rationale for their actions evaporated but they didn’t reinstate it for obvious reasons). Now, let’s look at workers in the future who go through this with no pensions. There is another crash, which is bound to happen (http://www.amazon.com/This-Time-Different-Centuries-Financial/dp/0691152640/ref=sr_1_1?ie=UTF8&qid=1319948711&sr=8-1) but now workers at this company don’t have pensions and they have to start taking money out of their 401k upon retiring. But, the Greek crisis of that time is happening and the value of their 401k is going up and down like a yo-yo, a la the last year or so. They very easily could end up in a spot where they liquidate their 401k many years before they die. WTF do we do then? In the 60’s my mom’s parents were living in a converted chicken coop on a small farm outside of Oakfield. No running water, just a pump in the kitchen and an outhouse – great place to take a dump in the winter. That is what bugs me about Cowboy Rick and his buddies. Fixing SS is relatively simple, Medicare is different. I’m starting to deal with that and with the fact that my wife is 7 years younger than I am. But I’ll save all that BS for another whine.
Anyway, good post and I’m glad to see someone else wastes a lot of time on Seeking Alpha.
Whats going on in europe is totally out of hand and then some. The euro crisis will get worse much worse before it gets better.
ReplyDelete