The importance of being earnest, about the Eurozone in general and the Euro in particular

The Unknown
As we know,
There are known knowns.
There are things we know we know.
We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.
But there are also unknown unknowns,
The ones we don't know
We don't know.

—Donald Rumsfeld, Feb. 12, 2002, Department of Defense news briefing

Another change in perception this week, to follow up on my article about the Dubai mirage. This time, Greece in particular and the Eurozone in general!

On Tuesday, Fitch Ratings Inc. cut Greece's rating to BBB+ with a negative outlook and it unnerved the markets.

Markets once again have a short memory. BBB+ was the rating for Greece before the introduction of the Euro in 1999.

http://www.fitchratings.com/shared/sovereign_ratings_history.pdf

Greece managed to fiddle with its stats to get in the Eurozone and benefited from the cheap funding available to all members of the coveted Euro currency. We all know what happened to Spain, cheap funding generated a massive real estate bubble and when it went tumbling down Spain's employment rates went through the roof (Spain unemployment level will rise to 22% in 2010 and some Spanish regional banks are still sitting on hefty losses). Eastern European citizens also played a dangerous game, borrowing in Euros or CHF. All these "cheap" loans went badly wrong when Eastern European currencies had to be devalued as the GDP in these countries dropped like a stone.

As any form of peg, the Euro, although a safe haven for many, has now become some countries worse nightmare. As Greece cheated it's way it, Greece is now facing great troubles as it cannot cheat its way out by massively devaluing its currency and reduce therefore the debt to GDP percentage which currently stands at 110%.

Greece 5 year CDS (232.19 Bps on the 5 year point, source CMA DataVision) is now trading above Turkey 5 year CDS and the spread of Greek debt versus 10 years German Government bonds (Bund) is trading at level not seen since 1999...

I remember a conversation I had with a trader back in 2005, about the spread between 10 years German Bund and 10 years Italian BTP. At some point the spread between both was around 22 bps. This was abnormally tight and at the time I thought it was a fantastic bet to put on and a very simple one: betting that the spread would go back to where it was before the introduction of the Euro, above 120 bps. It did happen. Now the spread has come back to the 60bps level. I don't think that in the near future it will stay there.

The virtues of joining a single currency doesn't coincide with the vices of some European governments, who issued more debt and ran larger and larger budget deficits. It is a game you cannot play forever unless you can devalue and make your own citizens poorer in the process, which used to be a regular tool used by Italy before joining the Euro.

When I hear Mrs Christine Lagarde saying the following: 'I don't think Greece could go bankrupt,' on RMC radio. I have to disagree.

David Einhorn, who is President of Greenlight Capital, was cited in a recent letter published by John Mauldin' in the excellent "Outside the box" on the 26th of October
Here is an excellent quote relating to Mrs Lagarde foolish statement: "To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable."

Even France is increasingly at risk. The last time France had a balanced budget was in 1980. Since then, the government has been spending more than it has been collecting and the service of the external debt (payments of the interest only), is not even covered by the receipts coming from the income tax.

As per a Reuter article published today:

http://in.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idINGEE5B80FO20091209

She also said that French debt was popular in financial markets but France would continue to take care to ensure that there was not threat to its credibility.

"By comparison to our partners we are very well rated," Lagarde said. "So France's signature is good. The market likes our paper and we are extremely determined to be very careful to the way we issue."

Asked about the potential size of a new loan that President Nicolas Sarkozy is planning to fund investment projects, Lagarde said: "It must be a figure which does not raise questions about the quality of France's debt signature."
It is once again all about maintaining at all cost perception that everything is fine.

Well, things are not fine.

Because of the euro, governments cannot cheat at the moment by devaluing their currency. France had three devaluations in 1983 as a reminder.

Italy used to regularly devalue the Lira before the introduction of the Euro.

Could Greece or Italy leave the Euro?

For those who would like to evaluate the probability of this event, please find enclosed the link to two very good articles:

One written by Nouriel Roubini on the subject in 2005.

http://www.rgemonitor.com/roubini-monitor/92824/what_happens_if_italy_dumps_emu_and_the_euro_devaluation_default_and_lira-lization_of_euro_debts

The other I recommend reading is the excellent article written by Macro Research House Gavekal on the subject written as well in 2005.

http://gavekal.com/dforum/attach.aspx/51/divorceitallianstyle.pdf

For those who would like to track sovereign risk in the CDS markets, please use the following useful link:

http://cmavision.com/market-data/#riskiest

The CDS market is a good indicator of the perception of risk for both corporate risk as well as sovereign risk.

It is also a very good indicator of possible movements in the equity markets. The equity market took many months to react to the widening of the CDS markets which started in August 2007, following the blow out of the two Bear Stearns Structured Credit Funds, which marked the beginning of the subprime crisis.

We have moved from a financial crisis to an economic crisis and now a sovereign crisis.

To conclude:

Yes, countries can go bankrupt and can go from being very rich to very serious distress. Markets have short memory, and so do Finance ministers...and particularly French ones as well.

Maybe Mrs Lagarde should study the history of Argentina which increased in prosperity and prominence between 1880 and 1929, and emerged as one of the 10 richest countries in the world at the time before completely crumbling down.

In our next episode we will revisit my central theme about perception and facts about the current economic situation.

I will leave you with a final quote from the movie The Matrix from 1999, year of the Euro as an appetizer for my following post

Morpheus: This is your last chance. After this, there is no turning back. You take the blue pill - the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland and I show you how deep the rabbit-hole goes.

Dubious Dubai and the issue of perception...

From Wikipedia definition of a "mirage"

"A mirage is a naturally occurring optical phenomenon in which light rays are bent to produce a displaced image of distant objects or the sky. The word comes to English via the French mirage, from the Latin mirare, meaning "to look at, to wonder at". This is the same root as for "mirror" and "to admire"."

Suddenly last week, Markets reacted strongly on news relating to the difficulties arising in Dubai. Sovereign CDS protection on Dubai significantly widen on the news and Credit indices such as Itraxx Main and Banks CDS also took a hit. It took them a while to realised how inflated their perception of Dubai real estate companies creditworthiness was.

It was all about false perception. Similarities can be made on this story that made headlines recently. Perception of the credit worthiness on Dubai World was all about implicit guarantees from the Dubai Government. Investors invested believing in implicit support. Probably the same investors who believed in the sacro-saint AAA rating issued on dodgy CDOs and CLOs as a gauge of credit quality of the underlying pool of assets in the structure. Probably the same investors who believed that a callable LT2 bond will be called on the call date by the issuer, because it has been market practice in the past. How suprised they were when Deutsche Bank, nearly a year ago in December 2008, decided not to redeem some sub debt on the date of the call! Investors trade sub debt based on the date of the call to calculate the price of the bond.

This shows you how short memory is on the market and how perception can affect sound judgement.

I travelled to Dubai in October 2008 and I went to Cityscape 2008 (as per the picture above, all rights reserved). For me it was an eye opener on the real estate bubble in Dubai. As equities market were getting crushed following Hank Paulson's fateful decision of letting Lehman go under with catastrophic consequences (when an orderly wind down could have been managed under FDIC's supervision), 60,000 "Real" Estate professionals were meeting in Dubai to have a look at the pharaonic new projects which were presented in this event. It was history in the making, the top of the bubble.

What's next for Dubai?

From the 1973 movie My Name is Nobody, here is a reminder of a little story told in the movie...
In “My Name is Nobody,” the protagonist, Nobody (played by Terence Hill), tells a famous fable:
"There was this little baby bird that fell from it’s tree in the cold of snow. It starts peeping, “Pa peep! Pa peep!” as it was damn near freezing.
Along comes this cow. She looks down at the little bird and feels sorry for it. She raises her tail and… “splah!”
…She drops a steaming hot cow pie right on top of it.
The little bird starts again… “Pa peep! Pa peep!” Because it’s hungry.
Along comes a mean ole Coyote… It reachs down easy into the cow pie and picks the little bird up. He raises the little bird higher and brushes the dirt off him real nice.
And then… “Gulp!” Swallows the little bird down all in one bite!
My grandfather says there is a moral to the story, but you have to figure it out for yourself…
At the movie’s end, the aging gunfighter, legend Jack Beauregard (played by Henry Fonda) figures out the moral to the story:
Folks that throw dirt on you aren’t always trying to hurt you, and folks that pull you out of a jam aren’t always trying to help you. But the main point is: when you’re up to your nose in shit, keep your mouth shut."

Although Sheikh Mohammed bin Rashid al-Maktoum tried to reassure the market, there was a continued sell-off in the Gulf stock markets today.

It looks like perception has changed, like perception changed for AAA ratings for structured CDOs/CLOs notes previously, and for callable LT2 bonds.

The price for the bail out of Dubai will be costly and prized assets such as Emirates airlines could possibly change ownership and end up in the hands of their powerful saviours Abu Dhabi.