WHAT I KNOW ABOUT THE EUR0
December 12, 2011
What do I know about the Euro that you might not and I can share with you? It is certainly not as much as many experts and others in the financial business, but a fair amount more than some. I can tell you that the Euro currency was created as a result of the Maastricht Treaty, which formed the European Union, and began its official life on January 1, 1999 as an accounting currency and came into daily use on January 1, 2002 with the introduction of coins and bills. The initial value of the euro in January 1999 was established based on agreement by the members, and exchange ratios agreed to for the respective currencies (franc, mark lira, peseta). During January 1999, 1€ was worth about $1.17. The euro traded below $1.00 at the end of 2001 and averaged in the $0.88 cent range in early 2002. Beginning in 2003, the value of the euro has traded comfortably over a dollar and trended upward during the decade. As a result of the present crisis of confidence, its value is presently about $1.34. Most of what I know I remember from our widespread travel to Europe, and in every year since, as it crept up in value, American travelers have faced rising prices and much more expensive tourism abroad as well as increasing prices for imports from Europe.
In pre-Euro days, Carol and I traveled to Greece when the drachma was Greece’s currency. I recall that we stayed in the Athens Hilton, perhaps the top 1st class hotel in Athens for something like the equivalent of $125 per night, and had a series of great meals on the Plaka with wonderful fresh grilled fish at around the equivalent of $10-15 per person. Today, the Greece that we read about daily is in crisis and in a state of economic collapse and uses the euro just as they do in Paris, Madrid, Rome and Berlin. The Hilton, still one of the top hotels, now starts at 350€ equivalent to $475 per night and the same grilled fish meal is apt to run at least $50 per person. Greeks now buy Mercedes Benz’s instead of old Datsun’s (pre-Nissan) like the one we rented on Crete and drink Champagne rather than the Retsina wine that we drank. The average Greek citizen can come to New York for shopping and stay first class and eat well using the euro as a strong currency as we did with dollar/drachma. One regret I have is that when I visited Delphi, I failed to ask the Oracle of Delphi about euro economics and made the mistake of relying on our Oracle of Omaha for his Americentric view.
When I made my first trip to London, Madrid and Paris as a college student in 1959, which was only 14 years after the end of WWII, I relied on the famous guidebook of the day, “Europe on $5 A Day.” It could be done. We had fewer dollars but they went a long way. Measuring purchasing power, roles have been reversed over the last 20 or so years, with Europeans (and Asians) now traveling to the US for budget vacations and cheap shopping while average Americans have pretty much had to retire their passports. I guess that’s why people enjoy the “Bellagio” in Las Vegas rather than the real one on Lake Como in Northern Italy. Turkey, a non-Euro country with its weaker currency and lower prices, now attracts American tourists much as Greece did years ago. I imagine that they are contemplating joining the EU as well.
The overall description of the European financial crisis includes weakening economic conditions and the inability of certain member states of the EU running large deficits to refinance their debts and borrow money at acceptable rates. Declining sovereign bond values have created losses for financial institutions and investors holding those bonds, and have damaged bank balance sheets. The crisis surfaced in the spring of 2010 in what are known as the PIIGS countries – Portugal, Ireland, Italy, Greece, and Spain. Now, the crisis has grown to include virtually all of the 27 EU members, and the future of the EU and the Eurocurrency is questioned. The European banking system is believed to be in great distress with a number of French and German banks rumored to be near insolvency. Lenders and investors are demanding that sovereign governments reduce their deficits and are pushing severe austerity measures, which are causing woes for citizen consumers.
The US stock market has been on a rocky road for the last year and spent November and early December in an extremely volatile trading pattern with days of huge gains and losses trading places as news and rumors about the Eurozone crisis were aired. The problem seemed to receive some good news and a victory on Friday the 9th as the European Summit reached an agreement to provide unified support to the EUR currency as well as a commitment to rework the EU treaty to correct some of the initial deficiencies in the structure. Unfortunately, both the perennial euro skeptics and deal-skeptics are equally disappointed in what is perceived as a deal which seems to be just another promise to do something while that something remains elusive.
It’s all quite complicated to explain and understand, but a major criticism about the creation of the European Union has always been that it was: a treaty of economic union only, without the binding political structure to insure unified action; a club relatively easy to get into but impossible to get out of, voluntarily or involuntarily; an organization inconsistent in its composition where some member countries such as England, Sweden, Norway for example, kept their own currencies and therefore had independent economic and monetary mobility, with currency actions open to themselves, while most of the others, such as Greece and Spain as prime examples, were tied to the Euro currency and realistically, tied to the German economy. In my view, the current economic crisis demonstrates unequivocally that Germany has accomplished the domination of Europe in peace, what Hitler failed to do in a terrible war, and is now facing what I believe could be viewed as a paraphrase of Secretary of State Colin Powell’s Pottery Barn rule. They (Germany) broke it, they own it, and they are responsible for fixing it.
George Soros wrote a piece in the October 13, 2011 New York Review of Books entitled “Does the Euro Have A Future” in which he presented his primarily negative views of the difficult crisis that was then still playing out and obviously before the action undertaken just a few days ago. Basically, his conclusion shares the general pessimism of many, and states that “without a common European treasury, there is no clearly visible solution to the Euro crisis.” There is nothing that I have read of the summit accord that establishes that common treasury. Moreover, Soros wrote, “Even if a catastrophe can be avoided, one thing is certain: the pressure to reduce deficits will push the Eurozone into prolonged recession. This will have incalculable political consequences. The euro crisis could endanger the political cohesion of the European Union.” It is fairly obvious that the ball is solely in Germany’s court and in my opinion, the euro is really the Deutsche Mark under another name,
As a result of a recent German Constitutional Court Decision prohibiting certain actions including infusions of new money and new arrangements without the authorization of the Bundestag, Soros writes that “there is no alternative but to give birth to the missing ingredient: a European Treasury with the power to tax and therefore to borrow. This would require a new treaty…” which he admits “presupposes a radical change of heart” and is unlikely. He goes on to say “The German public still thinks that it has a choice about whether to support the euro or abandon it. That is a mistake. The euro exists and the assets of the financial system are so intermingled on the basis of a common currency that a breakdown of the euro would cause a meltdown beyond the capacity of the authorities to maintain.”
What did come out of the meeting on the 9th was an agreement by 26 of the 27 members of the EU signaling a strong commitment to the currency and to the continuance of the organization by effecting a major change in the treaty to strengthen supervision and control by the majority over the individual members’ economic and fiscal controls and programs. This agreement falls short of Soros’ view of a new taxing authority and amended treaty. England was the lone dissenter and did not agree to the final agreement. Since the inception of the EU, England has always held itself aloof as an island nation, preserving its independent currency and sovereignty and generally afraid of diluting English culture.
I am certainly not expert enough to know if this agreement to agree, or commitment to commit, or however one might describe it has sufficient hard cash behind it to do what it takes to avert the collapse of the EU, and assuage the fears of the bond vigilantes. Nonetheless, people in good faith have, in fact, committed to a course of action to preserve the union. That has to be taken seriously. On the other hand, this agreement will have to be approved by the member governments through changes to their constitutions or through new laws. This issue and the question of the survival of the euro is not yet solved, as evinced by today’s (Monday, 12/12) market action. But what I think and even what the respected George Soros writes in NYROB are unimportant in the investment world compared to the action of the markets. And when Soros puts his words into actions such as what he is alleged to have done in shorting the British pound a number of years ago, the markets move. And when markets move, big things happen. In fact, one of Soros’ maxims in his theory of reflexivity that I adhere to and respect is that markets drive fundamentals, rather than the conventionally believed opposite, that fundamentals drive markets.
Through the action of the bond markets, the European crisis has most recently driven two established elected leaders from office in both Greece and Italy with possibly more to come elsewhere until a plan is established and implemented to restore confidence. These leaders have been driven from office by market movements without elections, carried out by bond traders in bond trading pits using the Credit Default Swap (CDS), rather than being forced to go on the streets such as was done in Cairo or Benghazi.
Our Omahan Oracle, Warren Buffett, has characterized the CDS, as a WMD, i.e. a financial instrument of mass destruction. The powerful, market moving CDS is a derivative financial product which enables big money positions to create a highly visible expression of fear or panic, of disgust and disapproval, just as a child might wail when troubled, or an unruly mob might set fire to a car on the street. In fact, the CDS is the instrument that converts the financial markets into a casino much larger than Las Vegas. More than that, the CDS is the perfect instrument not only to place a bet, but to almost guarantee the outcome of that bet. Neither financial market nor insurance regulators are currently empowered to regulate the CDS and it remains under no regulatory jurisdiction despite the advice and recommendation of experts and efforts by Democrats.
The CDS is essentially an insurance policy covering bonds and debt obligations. In theory and practice, a large investor owning a bond and seeking to manage risk, could insure that holding against default by buying a CDS from an opposite counter-party willing to take the other side of the risk in exchange for a financial premium. At this point, it all sounds pretty legitimate, much in the same way that Chubb or Allstate would offer a homeowner a $1 million fire insurance policy on the home he/she owns. “Insurable interest” is the terminology used in the insurance business that defines the homeowner’s right to purchase insurance on the owned home against loss. Generally, insurable interest is established by ownership, possession or direct relationship.
But suppose, hypothetically, that thirty strangers came along who each wanted to buy a $1 million fire policy on that same house, that they didn’t own, but to collect the same payoff if the house went up in flames. Under existing law, insurance companies would not sell the policies to those strangers because they had no insurable interest in the property – the house belongs to someone else - and if they did, they would be exposed to $31 million in losses on a $1 million dollar house. Under those circumstances, leveraged 30 to 1, it would represent more of a wildly speculative bet than actuarially-based insurance, and it seems pretty likely that, in an unregulated market-driven situation, that house would somehow soon mysteriously go up in flames.
Using Greece as an example, in the case of CDS’s on any specific debt instrument, it is permissible and standard practice today that anyone can buy a CDS in any amount that selling counter-parties are willing to sell without owning the underlying debt security, even in amounts far greater than the entirety of the particular issue of debt outstanding. The buyers of specific CDSs need not own underlying bonds of the issuer, i.e., have no insurable interest, but instead be using the CDS as a method of creating a short position in the specific instrument or class. Thus, the CDS could be considered to be a security rather than an insurance product. As buyers buy the CDS, the price action will rise reflecting demand, and as the market price of these signal instruments rise, implying an increase in the perceived risk of credit default, all hell will break out. Feed the fire with rumor, and you could easily see companies like Bear Stearns, Washington Mutual, AIG, Merrill Lynch or Lehman Brothers bite the dust whether through shotgun marriage or bankruptcy, which was exactly what, happened during the fateful week of panic in September 2008. All those companies were victims of the same fate as sharp increases in the prices of their CDSs set in motion a self-fulfilling downward spiral. It appears that the similar CDS trading pattern is in play today. I can remember that in 1981, the US Treasury issued 15 year bonds due in 1996, carrying a 16.125% coupon. I shudder to think what would have happened to the United States if the CDS product was then available to bond traders in 1981.
The failure of the markets to respond favorably to the EU agreement reached last week is an ominous sign and is likely to usher in a new period of market turmoil. Bond traders are not likely to sit back and do nothing for six months or a year or more awaiting concrete action promised under the agreement. CDS spread prices could rise sharply and be heralded by cable financial media as implying further weakness in vulnerable countries and suspect banks. Rumors may fly, unnamed sources may issue provocative headlines and the emotions of crisis may continue to roil markets. In the meantime, austerity measures and spending cuts are sapping the vitality of European economies, damaging consumer confidence and affecting world trade. All eyes will be and should be on Angela Merkel and Germany and everyone should raise their voices in unison like Tom Cruise in the 1996 film “Jerry Maguire” and shout: Hey Angela, “SHOW US THE MONEY!”
Peter R. Mack
December 12, 2011