Guest post - Europe's Third "Snake in the Tunnel"

"The world of men is dreaming, it has gone mad in its sleep, and a snake is strangling it, but it can't wake up." - David Herbert Lawrence, English writer.

Courtesy of our good friends from Rcube Global Macro Research, please find enclosed their recent note on the Euro and its "Third Snake in The Tunnel".

"During the past few weeks, the global markets’ spotlight has moved from Europe back to its usual US focus, concentrating on US companies’ results and on the effects of the coming “fiscal cliff”. In Europe, as cans were kicked and bazookas were loaded, the “muddle‐through” scenario that we referred to in our previous Eurozone papers1 is now back on track. That said, like most observers, we believe that the Euro crisis is far from over.

Let’s first look at the Euro from a historical perspective and reminisce about the system that led to its creation: the “snake in the tunnel”. 

The “snake in the tunnel” was the mechanism that European Economic Community (EEC) members used in an attempt to limit currency volatility after the collapse of the Bretton Woods system in 1971. The “tunnel” consisted of bands of 2.25% up and down, inside which currencies were allowed to trade (in other words, currencies were allowed to lose 4.5% against the Deutsche Mark, the strongest currency). The system started in April 1972 with 9 members (the six EEC founders and three soon to be members). The UK left the tunnel in June of the same year, Italy in January 1973 and France in 1974 (it later rejoined and left again in 1976). By 1977, only Benelux and Denmark were left in the tunnel with Germany. Even for those who remained, tunnel limits had to be adjusted a few times because of the strength of the DEM.

In 1979, the system was resurrected with a more appealing name: the “European Monetary System” (EMS). Tunnel limits were readjusted regularly during the early eighties. By the mid‐eighties, disinflationary policies throughout Europe finally brought semblance of stability to European currencies (see graph below):

However, by the early 1990s, the system had failed again: in 1992, after only two years of membership, the UK left (soon after “Black Wednesday”), and Italy followed in 1993. Although Germany’s insistence at keeping interest rates high following its reunification was blamed for the failure of the EMS (it was already Germany’s fault!), any other large asymmetric shock would have resulted in the same outcome. 

After two failed attempts in their battle against volatility, as “third time’s a charm”, European politicians decided to up the ante. In the Maastricht Treaty, they decided to eliminate currency volatility once and for all by simply eliminating individual currencies themselves. The Euro would be an irreversible solution, because no provision would be made to facilitate the return of national currencies. For the general public, the single currency would simplify their lives when travelling within Europe (and save them money in exchange fees). 

As we know in retrospect, the first ten years of the common currency (and common rates curve) led to huge bubbles and malinvestment in PIIGS countries – on government debt, private debt, wage inflation, and so on. 

Had the PIIGS countries kept control of their currencies, they would have been able to monetize part of their debt in the face of the crisis that ensued (like most central banks currently do not refrain from doing). Additionally, letting their currencies slide would have helped them regain competitiveness. 

Instead, market adjustments had to be made in other ways, and volatility, the politicians’ nemesis, reared its ugly head and found a new habitat: government debt yields.

With the Euro, we therefore now have a third “snake in the tunnel”. Instead of central banks trying to defend their currencies, various entities (ECB / IMF / ESM / EFSF and so on) intervene whenever a Eurozone member’s sovereign spread breaches an unofficial threshold of around 600 bps against Germany.

In exchange for being bailed out, PIIGS countries have to apply harsh austerity measures internally, under the authority of the “Troika”. In a way, they have been demoted to developing countries original sinners, indebted in a currency that is not theirs to print.

For both political and economic reasons, this system of conditional bailouts is not a viable solution in the long term. This is evidenced by the fact that countries that benefited from a bailout are still trading above the 600bp tunnel limit. 

For the Euro to survive in the long term, we believe that large explicit transfers of wealth between creditor and debtor nations will be necessary at some point. Regardless of the term used, the European Union will have to morph into a de‐facto “federation”. 

The feasibility of a federal Europe 

In his September 2012 State of the Union address, José Manuel Barroso, the European Commission President, proposed to transform the EU into a “federation of nation states”, with preliminary discussions starting before the 2014 European elections. 

In early October, EU’s President, Herman Van Rompuy made the case for a Eurozone central treasury, which would have its own budget and be able to raise funds. 

Although these proposals havenft sparked enthusiasm, we believe that moves towards a federal Europe will be the only way to avoid the next leg of Euro crisis to be fatal. 

In fact, some of the most ardent supporters of a federal Europe have always considered the Euro as a way to force deeper integration. The current debt crisis is the perfect setup to promote integration, because it forces countries to create a gcommon beasth to feed.

In economic terms, the countries with the most to lose in a federal solution are the creditor countries, which are generally also the ones with the highest GDP per inhabitant (Ireland being the exception). What follows is a back-of-the-envelope calculation of what a federal Europe would imply in terms of permanent wealth transfer for these countries. 

Right now, the European gfederal budgeth represents a tiny percent of EU's GDP, with around half of that devoted to the Common Agricultural Policy.

In the US, Federal outlays represent around 22% of US GDP. 

As a thought experiment, we can imagine a Eurozone federal budget that represents 20% of the Eurozone's GDP in the long term (the federal budget would probably only concern Eurozone members, because applying it throughout the EU would require a preliminary "Brixit"). Like in the US, the federal budget for the Eurozone would cover military expenses, a large part of social expenses, infrastructure, and so on. Some of the funds would be spread according to each countryfs population (e.g. military expenses), while others would be more heavily skewed towards poorer countries (e.g. social expenses). 

Conservatively, we can estimate that richer EZ countries would have to give up around 30% of the difference between their own GDP per inhabitant and EZfs average. 

The current ranking of EZ countries by GNP per head of population is shown below:

Roughly speaking, countries in the richest group would have to reduce their living standards by between 5 and 7% if the EU was to transform into a European federation (we ignored Luxembourg, which is a clear outlier at 244% of the average GDP per head). 

At first glance, this does not look like a huge sacrifice to save Europe, especially if these adjustments are spread over the next 10-20 years. 

However, when we look at growing divides within countries such as Italy, Spain or Belgium, national solidarity (let alone European solidarity) does not seem to be the course of history. 

At the risk of sounding like parrots, we maintain that the Euro is a purely political construct, and therefore depends on politiciansf (and ultimately voters') views of their best interest. If growth rates remain anemic in Europe, it will be politically very difficult to add a new gbeasth to feed. 

Right now, PIIGS' sovereign spreads still indicate large implied breakup probabilities over the next 10 years. With a 10 year yield spread of around 350bp for Italy and assuming a potential 50% devaluation, the implied exit probability for Italy is around 50% over the next 10 years (for more on this subject, see Rcube Macro Analytics 18 01 2012 - The likelihood of a Euro Breakup). 

In our view, spreads should continue to tighten in the coming months, as politicians still show strong willingness to accept any compromise to maintain the system - even in the case of Greece, which should soon receive an extra . 30 Billion despite its lack of progress in putting its own house in order. 

At the same time, as long as Europe does not clear steps towards becoming a Mundellian "Optimum Currency Area", we do not consider that Italy's or Spain's bonds are suitable carry investments, especially for the longer part of their curve. To paraphrase JP Morgan when asked what the stock market would do, we believe that Eurozone spreads will continue to fluctuate."

We could not agree more with our friends from Rcube.

"And for love’s sake, each mistake, ah, you forgave 

And soon both of us learned to trust 

Not run away, it was no time to play

We build it up and build it up and build it up

And now it’s solid 

Solid as a rock " - Solid, Ashford and Simpson lyrics

 Stay tuned!

Macro and Markets update - Combat stress reaction (CSR), the Danish standoff and much more!

Combat stress reaction (CSR) or post-traumatic stress disorder. It is probably what most are feeling after an epic month of July.

From the dowgrades of Portugal, additional dowgrades on Greece and Ireland, contagion to Italy, ongoing debt ceiling debate in the US, European banking stress tests,new European plan for Greece, poor economic data, and now threat of downgrade on Spain from Moody's, I am glad it is the end of the month and the week-end.

On Friday we have had some poor data coming out of the US in relation to GDP. The stand off goes on for the US debt ceiling goes on and we had Moody's adding some extra spice whith a threat of downgrade on Spain. And of course in that relaxed and friendly environment, Gold is making new highs.

Can someone please press pause?

Markets update:
Sovereign 5 year CDS in core countries, Denmark starting to feel the heat...

Denmark's sovereign CDS is now at 86.83 bps, rising 18.29%, widening by 13.43 bps according to CDS data provider CMA.

Update on the Danish situation:
Denmark's risk perception has reflected by the CDS market, has been increasing after S&P said that as many as 15 Danish banks could default.
Denmark is at war with the rating agencies. Very recently Danske Mortgage Unit sacked Moody's and declared it might hired Fitch:

Danske Unit Sacks Moody’s, May Hire Fitch - Bloomberg
On the 23rd of June, another Danish banked at sacked Moody's:
"Realkredit Danmark sacked Moody’s on June 23 after being told to provide an extra $6.14 billion in collateral to keep its covered debt graded Aaa."

The fight is on.
"Moody’s argues that Denmark’s adjustable-rate mortgage bonds represent a bigger refinancing risk because they, unlike other Danish covered bonds, don’t match the maturities on the loans linked to them. The adjustable-rate bonds tend to have maturities of one to three years compared with an average loan maturity of 20 to 30 years."
Fact is Denmark has one of the best mortgage system in the world.

The issues relating Danish Mortages bonds are tied to BASEL III. Will the EU classify danish mortgage bonds as highly secure and liquid (level 1 securities) like government bonds?
Denmark has the third largest mortgage bond market after the United States and Germany. Excluding Danish Mortgage Bonds from "Level 1" securities would trigger a sell-off and put the entire Danish Banking system under pressure (the current liquidity pool of Danish banks is made of 85% of Danish Mortgage Bonds and only 15% of Government bonds).

So far the EU has postponed its decision until 2015:

EU postpones key decision for Danish mortgage bonds - Reuters

The rating agencies are taking a very agressive stance relating to the Danish Mortgage Bond markets which is not entirely justified given the ongoing discussions between the EU and Denmark about its very specific and unique banking system.
As a reminder, the Danish mortgage markets is based on the "Principle of Balance":
Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes. The Danish model, which has withstood many tests since it was brought into existence after the great fire of Copenhagen in 1795. For more on the subject of mortgage systems, and housing, you can check previous post "Are Fannie Mae and Freddie Mac on the path to a crash à la Thelma and Louise?"

Back to our market update!
The SOVx, which represents the index for Sovereign risk in Western Europe and comprising 15 countries including Greece, is drifting wider again:

Same story for the index representing corporate credit risk, Itraxx Main Europe 5 year index (containing 125 names rated at least investment grade):

But in relation to corporate leverage and debt, although companies are already facing margin compressions due to rising commodity prices, company debt in 2012 will slide to its lowest level since 1996 according to a study made by Societe Generale. Some are still deleveraging but most are sitting on a pile of cash and have managed to control and reduce costs (lean and mean?).

Source: Company Debt in Europe Will Slide to Lowest Since 1996: Chart of the Day - Bloomberg.

"Companies’ net debt as a proportion of earnings before interest, taxes, depreciation and amortization will fall its lowest level since 1996 next year, according to Societe Generale."

"The ratio of European companies’ debt to Ebitda will fall to 0.8 in 2012, according to Societe Generale. The last time that corporate debt dropped below Ebitda, European stocks rallied 154 percent over the following five years."

But at the same time, there is a lot of uncertainties due to sovereign issues, with the ongoing European debt issues and the current US debt ceiling debate.
The US 1 year CDS spread is now trading above the 5 year point, although the curve is inverted, there is no need to panic given the level of the spread indicates a very low probability of default (around 6% over 5 years):

But with the ongoing turmoils, "Risk off" is still the game "du jour".
Vix climbing up steadily, not yet reaching March levels but getting close:

Time for some Macro updates:
The great shock was the release of the US GDP figures for the second quarter as well as the revised figure for the first quarter. Truly appalling. GDP climbed 1.3% at annual space, from an median forecast of 1.8%, but following a 0.4% revised gain in the prior quarter! Revisions to GDP figures indicates that the 2007-2009 recession shrank 5.1% from the fourth quarter of 2007 to the second quarter of 2009, compared to a previously reported 4.1% drop. The second worst contraction in post WWII era was a 3.7% decline in 1957-1958 according to Bloomberg.

Household purchases, which represent 70% of the GDP rose at 0.1%. Slower job growth increases the risk for the second semester. Next week employment figures with the NFP (Nonfarm Payrolls) will be essential and so will be the ISM figures release. There is an increased risk of double dip for the US economy. Massive spending cuts would strike another blow to a faltering US economy.
I pointed out we had stagflation in the UK in my previous post, the US is as well stuck in a stagflationay environment.

The Chicago ISM's business barometer fell to 58.8 in July from 61.1 in June. Figures above 50 signal expansion. The median forecast was for a 60 print.

The US debt ceiling debate will certainly add on company's reluctance to hire in this environment.

So, yes it still "Risk Off" for the time being.

To be continued...

Are Fannie Mae and Freddie Mac on the path to a crash à la Thelma and Louise?

The tragic ending of Thelma and Louise could be similar to what awaits Fannie Mae and Freddie Mac.

http://www.thestreet.com/story/10965824/1/fannie-freddie-tough-sell-bailout-now-youre-talking.html

"Despite the fact that America's housing-finance system has cost taxpayers more money than any bank bailout and many consider its flawed structure to be the single biggest contributor to the financial crisis, it seems most people don't know how it works or care how the housing-finance problem is resolved."

"The federal government now stands behind the vast majority of mortgages in the United States, and upwards of 90% of those originated since the financial crisis took hold. The Federal Reserve still holds over $1 trillion worth of residential mortgage-backed securities (RMBS) on its balance sheet, having purchased them to increase liquidity and spur additional lending."

"Yet the very system that has kept the U.S. housing market on life support has also drained federal coffers. Fannie and Freddie have so far cost the U.S Treasury Department $150 billion, a number that may rise to $363 billion, according to the FHFA."


http://www.bloomberg.com/news/2011-01-14/how-to-fix-mortgage-mess-in-three-steps-commentary-by-laurence-kotlikoff.html

How to Fix Mortgage Mess in Three Steps: Laurence Kotlikoff:

"Fannie Mae and Freddie Mac. What cute-sounding names. They suggest adorable siblings, not twin financial disasters that may cost $1 trillion when we get the final bill.

According to Edward Pinto, Fannie Mae’s former chief credit officer, in 2008 the two government-supported mortgage finance companies, along with the Federal Housing Administration and other U.S. agencies, were holding or guaranteeing some 19 million subprime home loans, or about 70 percent of all such debt.

Much of these toxic assets, as well as many of Fannie and Freddie’s prime mortgages, aren’t performing or will likely default. Nationwide, 8 million mortgages -- or one in 10 -- are under water, with the property’s value at least 25 percent below what’s owed.

The Federal Housing Financing Agency puts Fannie and Freddie’s losses at about $300 billion. But industry experts, like Janet Tavakoli, suggest the real number is closer to $700 billion. And if home prices fall another 20 percent to return to their long-term trend, the tab might climb to $1 trillion."

I agree with Laurence's statement in relation to the sick Fannie Mae and Freddie Mac. It is time to end this very expensive joke, once and for all.

The US government has no place in the mortgage business. Look at how the mortgage business has been managed in Denmark for a clue on how a sound mortgage system work.

The first Danish Mortgage Act was passed in 1850. Issued mortgage loans have a maximum loan to value (LTV) of 80% for residential properties.

http://www.globalpropertyguide.com/Europe/Denmark/Price-History

"To fund the loan, banks issue mortgage bonds. The strict legal framework of the “balance principle” requires mortgage bonds to match the value and terms of the corresponding mortgage loan the bank is funding. The framework has provisions limiting the currency, interest, and liquidity risks of bonds. The strict regulations of the mortgage market limit the risks shared between bond-holders and mortgage institutions, create transparency, and offer investors security. This helps the continued growth of the mortgage market despite tough macroeconomic conditions."

"A due on sale clause in a loan contract means that borrowers have to pay their loans in the event the property has to be sold. This clause isn’t attached in Danish mortgage loan contracts, as borrowers can transfer the remaining loan to the new owner, or can buy back the bonds. This is especially beneficial to borrowers who experience situations where house sales are involved.

This payment system discourages borrowers from defaulting their loans, as they remain liable for the payment of their loan if they default."

For more on the subject relating to the Danish system:

http://www.economist.com/node/12855447

http://www.bloomberg.com/news/2010-12-12/danish-top-rated-mortgage-debt-draws-investors-fleeing-crisis.html

Fact:
"Denmark’s mortgage bonds haven’t suffered a default since they were introduced after the great Copenhagen fire of 1795."

Fannie and Freddie were set up in 1968 and 1970. The question that need to be adressed by January 31st is the following: "What is the appropriate role of the government in the housing market?" The Dodd-Frank reform bill required the Treasury Department to issue a comprehensive proposal to Congress.

Tim Rood, a former Fannie Mae official, compares the idea of relinquishing federal support to going cold turkey off of a powerful drug:

http://www.thestreet.com/story/10965824/5/fannie-freddie-tough-sell-bailout-now-youre-talking.html
"You see some folks trying to draw the analogy between markets like Canada which have never had any government support or backing for the mortgage market and which seems to have achieved - on a much smaller scale - the nirvana of housing in homeownership rates, perfect matching of interest rate risks and all that," says Rood, who's now a managing director at D.C. consulting firm The Collingwood Group. "But it's like trying to compare an Amish baker to Keith Richards. There's no policy equivalent to methadone. We've been on it forever - you can't just say 'Look how easy it is to live without government involvement or backing of the mortgage market.' It's just not an easy thing to undo."

The answer is to privatize the system, following a Danish approach to mortgage financing:

"Affordable housing doesn't have to mean that everyone has to own a home. It's still a great dream and everyone should still aspire, if they choose to, to own a home. But when it comes to the government fostering 'affordable housing,' that might be rental housing."
says Edward Kramer, a former banker and regulator who is now a consultant at Wolters Kluwer.

Below is what George Soros has to say about the Danish system and reforming the US mortgage market in 2008. The problems of the US mortgage market are yet to be addressed.

Soros: Denmark Offers a Model Mortgage Market
There is a safe way to securitize home loans.

By George Soros

"The American system of mortgage financing is broken and needs a total overhaul. Until there is a raealistic prospect of stabilizing housing prices, the value of mortgage-related securities will erode and Treasury Secretary Henry Paulson's efforts will come to naught. There are four fundamental problems with our current system of mortgage financing.

First, the business model of Government Sponsored Entities (GSEs) in which profits accrue to the private sector but risks are underwritten by the public has proven unworkable. It would be a grave mistake to preserve the GSEs in anything resembling their current form.

Second, the American style of mortgage securitization is rife with conflicts where entities that originate, securitize and service mortgages are generally not the same as those that invest in mortgage securities. As a result, the incentives to originate sound mortgages and to service them well are inadequate. No wonder that the quality of mortgages degenerated so rapidly.

Third, mortgage-backed securitizations, which were meant to reduce risk by creating geographically diversified pools of mortgages, actually increased risk by creating complex capital structures that impede the modification of mortgages in the case of default.

Finally, and most fundamentally, the American mortgages market is asymmetric. When interest rates fall and house prices rise, mortgages can be refinanced at par value, generating the mortgage equity withdrawals that fueled the housing bubble. However, when interest rates rise and house prices fall, mortgages can only be refinanced at par value even though the market price of the securitized mortgage has fallen.

To reconstruct our mortgage system on a sounder basis, we ought to look to the Danish model, which has withstood many tests since it was brought into existence after the great fire of Copenhagen in 1795. It remains the best performing in Europe during the current crisis. First, it is an open system in which all mortgage originators can participate on equal terms as long as they meet the rigorous regulatory requirements.
There are no GSEs enjoying a quasimonopolistic position.

Second, mortgage originators are required to retain credit risk and to perform the servicing functions, thereby properly aligning the incentives. Third, the mortgage is funded by the issuance of standardized bonds, creating a large and liquid market. Indeed, the spread on Danish mortgage bonds is similar to the option-adjusted spread on bonds issued by the GSEs, although they carry no implicit government guarantees.

Finally, the asymmetric nature of American mortgages is replaced by what the Danes call the Principle of Balance. Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes.

To state it more clearly, as home prices decline, the amount that a homeowner must spend to retire his mortgage decreases because he can buy the bonds at lower prices. The U.S. can emulate the Danish system with surprisingly few modifications from our current practices. What is required is transparent, standardized securities which create large and fungible pools. Today in the U.S., over half of all mortgages are securitized by Ginnie Mae, which issues standardized securities. All that is missing is allowing the borrowers to redeem their mortgages at the lower of par or market.

Because of the current havoc in the mortgage market, there is no confidence in the origination and securitization process. As a result, a government guarantee is indispensable at this time, and may be needed for the next few years. As the private sector regains its strength, the government guarantees could, and should, be gradually phased out.

How to get there from here? It will involve modifying the existing stock of mortgages, so that the principal does not exceed the current market value of the houses, and refinancing them with Danish-style loans. The modification will have to be done by servicing companies that need to be properly incentivized. Modifying mortgages that have been sliced and diced into securitizations may require legislative authorization. The virtual monopoly of the GSEs would be terminated and they would be liquidated over time.

A plan to reorganize the mortgage industry along these lines would inspire the confidence that would allow a successful recapitalization of the banking system with the help of the $700 billion package approved last week."

Mr. Soros is chairman of Soros Fund Management and the author of The New Paradigm for Financial Markets (Public Affairs, 2008).

For an additional essay from George Soros on the subject please see below:

http://www.georgesoros.com/articles-essays/entry/reforming_a_broken_mortgage_system1/

Both GSEs Fannie and Freddie have been held in federal conservatorship since September 2008 and have received roughly 134 billion USD in taxpayer money to stay afloat so far...

US Home Ownership from 1980 until 2010:

The End of the American Dream:

The current S&P Case Schiller index 20-City Home Price Index:

Ben Bernanke is well aware of the issue with both GSEs. There cannot be a sutained recovery in the housing market before the Obama administration releases its recommendations for the future of Fannie Mae and Freddie Mac.
The dominance of the GSEs in mortgage finance needs to be reduced.

It is up to the US Congress to work on a solution. Let's hope the the Treasury Department issue a comprehensive and intelligent proposal to Congress before the 31st of January.