Thursday, February 25, 2010

Telling the future by reading Ben Bernanke's mind.

Ben Bernanke is the Chairman of the Federal Reserve Board and so is the first among equals in setting the monetary policy of the United States. He is also the Shadow Governor of the Peoples Bank of China, the Saudi Arabian Monetary Authority, The Emirati Central Bank, The Hong Kong Monetary Authority, and the Banque du Liban. That is because any country with currency pegged to the US dollar imports US monetary policy. The purists among you will point out that the Renminbi is actually a managed float but if you punch up a graph of it vs. the dollar you will not that it is very managed and not very floating.

So if you live in the United States or any of these other countries or have a relationship with the dollar, (and if you consume petroleum, wear gold, or eat an internationally traded grain, you do) then you have to care about what Ben Bernanke is thinking. He controls the supply of dollars in the world and has a strong influence over the rates at which they are borrowed and lent. So what is he thinking? To answer that we have to take into consideration: first, what is his mandate; second, what kind of guy is he; and third, what makes him get out of bed every day.

Ben Bernanke’s Mandate is to maintain price stability while promoting the maximum sustainable employment in the US.

Bernanke is required to keep inflation low while at the same time promoting substantial economic growth in the US. Note that I say the US. The Chairman has no responsibility to the economies of the nations which peg their currencies to the dollar. This has caused some issues for the Gulf states in the past and is currently exacerbating the concerns of the Chinese government about their economy potentially overheating. Bernanke does not care. He cares about the US and only the US.

Ben Bernanke is a very smart economist, a very creative central banker and has a generally Monetarist outlook.

Ben Bernanke is a Harvard and MIT trained economist who had a successful academic career ultimately chairing the Princeton Economics Department before joining the Federal Reserve. His tenure at the Federal Reserve has been marked by furious activity. The Fed used all of its usual powers such as the discount rate to their maximum extent, then used some that people never thought it would use like quantitative easing and finally Chairman Bernanke invented others like the alphabet soup of liquidity facilities when he felt the need arose. I consider him, and I think he would consider himself, a Monetarist. By a monetarist I mean that he believes that the money supply is one of the most important factors in determining macro-economic performance both in terms of growth rates and inflation. This view has informed his reactions to the crisis thus far.

Ben Bernanke makes more money from royalties on textbooks than he does for being Chairman of the Fed. He gets out of bed every day because he has a real chance of becoming the greatest Central Banker in the history of the world.

This may sound odd because Bernanke has been at the center of the storm over the financial crisis and its aftermath. He is a target for blame because he does bear some responsibility for the origin of the crisis and many of his decisions in its resolution have been controversial. His actions to preserve the financial system have distributed aid unevenly and enriched some who the public believes should be punished. He has been attacked from every point of the political compass indeed the high priestess of Monetarism has practically excommunicated him in an editorial in, of all places, the New York Times.

But to focus on the current press is to miss the larger picture. Bernanke was not the only guy responsible for the financial crisis but he is one of the few who does not have to run for election so a lot of people have sought to shift blame to him. The crisis has had a thousand authors but its resolution was written with a single hand: Bernanke’s. The world financial system was on the edge of collapse and Ben Bernanke brought it back by releasing as much liquidity into the world financial system as if he had broken open a Hoover Dam holding back an ocean of money. When that liquidity hit the markets maybe the wrong people got soaked with cash but the drought was over. This is why he is half way home to being the most successful central banker in the history of the world: people won't remember how he saved the financial system, they'll remember that he saved it.

The other half of it has to with how he soaks up that liquidity. The current holder of the title for best Central Banker in US history now that the Greenspan legacy seems to be as a bubble blower is Paul Volcker. Volcker is famous for killing the great inflation that plagued the US for most of the 1970s by jacking interest rates to the moon in 1980-81. This caused what at the time was the deepest recession since the Depression and put Volcker under massive political pressure but he stood tall, the country took the pain, the inflation subsided and set the stage for a high growth low inflation regime that has lasted almost to this very day. Given the amount of liquidity that Bernanke has poured into the system it is likely he will get the chance to pull a Volcker in addition to is rescue of the financial system.

What does this all mean for what’s ahead?

There has been a ton of speculation in the press and the markets about when the Fed is going to start tightening. There is a lot of concern that Fed tightening is imminent and that if the Fed jumps in too early it will kill the recovery in the crib. If it jumps in too late there will be inflation which, once it gets started is really hard to kill off without a massive recession. Personally I think you can take the three points above to predict what the future holds. Here’s what we know:

1.) Ben Bernanke can go down in history as the greatest central banker ever if and only if he can prevent his massive injection of liquidity from generating significant inflation. To do that he has to begin tightening before the CPI is actually registering inflation. Also as a monetarist, if forced to choose between price stability and employment Bernanke will choose price stability meaning he will risk a deeper recession if necessary to forestall inflation.

2.) Thankfully there is no sign that inflation is even on the horizon so Bernanke is likely to stand pat for a while and let the economy recover. As a monetarist Ben Bernanke believes that inflation is fundamentally a monetary phenomenon. Therefore his signal that inflation is on the horizon is going to be the monetary aggregates, such as M2, which have been stagnant or declining despite the massive amount of liquidity with which he has flooded the system.

3.) So now you know the future because you know what Bernanke is going to do. He is going to sit on his hands and let the loose monetary policy inflate asset prices, repair bank balance sheets, and hopefully stimulate the economy back to recovery before the monetary aggregates turn up. Once M2 starts creeping up, look out because Bernanke will act aggressively to head inflation before it gets going. Once there is more clarity on the Greek situation asset prices in the US dollar bloc have nowhere to go but up until the monetary aggregates turn upwards and Ben Bernanke responds to the bat signal. You heard it here first.

Thursday, February 18, 2010

Dubai announces that an announcement about the Dubai World restructuring plan is imminent. And they mean it this time, not like those other times...

When is suspense not suspense? Dubai World has announced that they will have a restructuring plan to present to creditors sometime in March. I have already written on delays in the negotiations and I don’t really want to focus on them too much. This is a lot of smoke and mirrors and the passage of time will bring it all to light because the debts must be paid and the next repayments are only weeks away.

The delays of the restructuring plan have been blamed by the Dubai World on its complex legal structure. Apparently there are over 1,000 legal entities inside Dubai World and the relationship between them and what they are worth it seems is quite a mystery. So much so that the DMCC, was able to walk out of the group altogether apparently with no compensation to the parent for any funds invested or services rendered, at least none that has been disclosed. Personally if I were in the process of walking my company out from its parent company which was at the edge of default I would probably not write a letter to a US judge urging leniency for my mentor who has been convicted of running a ponzi scheme, but then I’m not the CEO of the DMCC. I suppose it helps that the Chairman of the DMCC is the son of the Chairman of Dubai World. Thanks Dad. Creditors? Drop dead.

Dubai is no longer asking for a standstill agreement because they have been able to make interest payments so far. Whether this would be possible without the $800 million or so left over from the last infusion from Abu Dhabi after the Nakheel Sukuk was paid off is left to the imagination of the creditors. So, for that matter, have the eventual terms of the restructuring. There seem to be a lot of options on the table from haircuts to sliding scales of principal payment depending on term structure. Perhaps a debt for equity swap for the Nakheel Sukuk holders, or maybe a general conversion to zero coupon debt at a haircut but with a sovereign guarantee. Interestingly Dubai World says there will be no asset sales until a restructuring has been agreed. The asset sales by Istithmar and DPW don’t count because they’re not part of the restructuring. I don’t know how that can be true, if the creditors of the parent are going to be asked to participate in a restructuring then all the subsidiaries are part of it. Except the ones chaired by the son of the Chairman.

There seems to me to be only one sure thing among all of the various options on the table: losses. Big ones.

My guess is that a big factor in the delay has been the very disturbing realization within Dubai World that the assets that are inside the company are vastly less than the amount of money that is owed. More disturbing still is that it is probably not at all clear where the money went. I can’t really print all the theories about this that people are sending in to my blog email address but it seems that a truly colossal amount of money went into decorating offices and into marketing. Those things do not have great resale value. I’m sure some of it was taken fraudulently but my guess is that the vast majority of it was just spent on the things that gave the illusion of prosperity at the subsidiary companies. Now the investors will have to take the hit.

I realize that I have largely been critical of the powers that be in Dubai but only half the blame for this is theirs. As far as I am concerned there are no innocents in this tale. The creditors bear just as much responsibility. Not for the frauds and the losses but for a lack of diligence. How is it possible that you lend $6 billion to an organization that has over 1000 subsidiaries and when the music stops takes three months just to count them let alone value them. How do you lend money do a company whose structure is so complex that a major subsidiary walks away from the group altogether and you are unsure of your legal right to challenge it? How do you buy the bonds of a company that is carrying a non-existent crescent shaped island on its balance sheet at a valuation of $3.5 billion?

Easy, because it’s only money and its not yours. It belongs to the shareholders and the depositors and for some of the banks, to the taxpayers. But you, the guy making the loan, you get business class trips to Dubai. You get to stay in five star hotels, maybe you get a helicopter tour of the Jebel Ali Port. You get a big orgination fee and you can pay yourself out of that. The last thing you want is real scrutiny of how this all works, the first thing you want is to do it again.

And if you are the end investor why did you invest your money here in the first place? Because you wanted higher returns. How do you get higher returns? You take more risks by lending to organizations where you don’t fully understand what precisely the risks are. What are the risks? The risks are that if the Chairman takes your money and sets his son up in business with it or that your money is spent on office decorations and London billboards praising the company or is spent buying trophy assets at the top of the credit cycle, you’re probably not going to get all your money back. How much will you lose? That’s what we’re going to find out.

The short answer is “A lot.”

A Chicago-Style solution to the Bond Vigilantes: He pulls a knife, you pull a gun, He pays the offer on $1bln of CDS, you hit the bid for $10bln.

In my previous entry I wrote about how CDS have been a useful tool for the Bond Vigilantes who have launched a speculative attack on Greece and through Greece the very concept of the Euro. After a brief relief rally based on the EU meetings last week the Euro is falling off again and the Greco-German bond spread has yet to tighten. It looks as though the Bond Vigilantes may make another run at the beleaguered Greeks in an attempt to push them out of the Euro or to force the hand of the EU.

I would like to make a modest proposal to the Finance Ministers of the EU countries for how to deal with this problem: sell the hell out of Greek sovereign Credit Default Swaps.

Of all the measures that the EU and its member governments have been considering I think this would be the most effective. The first question to ask is what are the things standing in the way of EU action today. I think there are two issues. The first is moral hazard and the second is political will. The moral hazard issue is primarily one of signalling. A direct rescue of Greece sends a message to both the sparring parties within Greece itself as well as to those next in line for speculative attack they don’t really need to come to terms with their fiscal and economic policies because they can rely on a bailout. Interestingly the existence of the possibility of a bailout has the effect of entrenching the parties that need to cooperate in order to prevent one. The other issue is political will. The French and German voters would rather throw Greece out of the Euro System than have to pay for their costs.

So what are the tools that the EU is considering to use to assist Greece? The governments of Germany and France, the only ones really capable of providing aid are quiet on this point. Poland however said that the kinds of assistance that are being considered are loan guarantees and straight cash transfers. These are very blunt instruments. Cash transfers are probably only politically possible in an extreme emergency and perhaps only one for which the Greeks are not demonstrably culpable. The problem with loan guarantees is that they are a blunt instrument. For sure they would lower the borrowing costs to Greece on which the bonds which were guaranteed but they are kind of an all or nothing solution. As such, they would have the effect of delaying the necessity of the Greeks themselves reaching a compromise and might make default more likely. Markets beyond Greece would probably also assume they would be rescued and thus would have similar problems addressing their issues. Thus the EU is damned if it does and damned if it doesn’t.

EU government intervention in the CDS markets I think would be an excellent way to square these circles. CDS purchases require no transfer of principal except in event of default. That is to say the governments involved would not have to write checks to Greece. Rather they would simply be lowering the risk to others of writing those check and they would get paid for the serivce. This would be easier to accomplish politically than straight cash transfers as there would be no outflow from the treasury and no need to use taxpayer funds. Indeed if there were no Greek default this would be a net win for the taxpayers.

The economic effect would be very similar to establishing loan guarantees an intervention in the CDS markets would be much more flexible. The similarity would come from the fact that anyone who bought a Greek CDS would then be able to buy Greek bonds with no risk. This would have the effect of increasing demand for Greek paper and thereby lowering the funding costs for the Greeks and narrowing their deficit. Instead of being on a single issue however the Greek CDS could be used to protect any Greek paper and so might prevent some potential sellers from panicking and would calm the markets more generally. This is one source of flexibility, the other is that once the crisis had passed the governments could simply go out and buy the CDS back with minimal market impact. Withdrawing a loan guarantee would be much more problematic.

Intervention in the CDS markets would also have excellent signalling characteristics. For the parties within Greece the EU governments would maintain their studied ambiguity. CDS intervention is a partial and reversible loan guarantee. The parties within Greece would have some confidence that they were not alone but would not be able to completely rely on the assumption of a bailout. On the other hand for speculators to know that they were being sold insurance against an event that the seller could himself singlehandedly prevent. It would be like God selling you hurricane insurance. This would make the trade of gunning against Greece a massively more risky undertaking. If the intervention were sudden and massive it might have the effect of creating a short squeeze against the speculators and forcing them out of the trade altogether. I'm pretty sure the German government and the ECB are better capitalized than the top fifty hedge funds put together. I think this would have the effect of quelling the speculative attack on Greek debt and would give the Greeks some time for their reforms to work.

Just a modest proposal from

Monday, February 15, 2010

So Mr. Finance Minister, I'm here for the bond auction but first, say hello to my little friend, I call him the Credit Default Swap

I am inclined to favour financial innovation. Since the financial crisis began an innovation that has come under attack is the credit default swap (CDS.) Usually I rise to the defence of the CDS and attack its detractors as people who do not understand how valuable the product is. Recently however, in the hands of the “Bond Vigilantes,” the traders in government securities who decide at what rates governments can borrow, the CDS is an extremely powerful weapon.

First of all what is a CDS? It is a side bet between two parties on the creditworthiness of a third party. Imagine that you think the markets are underestimating the chances of a Nakheel default, you and I could trade a CDS on Nakheel. Here’s how it would work. First we have to agree on how much we’ll bet and for how long. Let’s call it $1 million and let’s say we bet for five years. This means that if Nakheel defaults at any time in the next five years I have to pay you the amount of money that someone who lent $1 million to Nakheel would lose. Let’s say for example that Nakheel went bankrupt and then the bondholders sold off the Nakheel assets and had enough to pay the bondholders $0.03 on the dollar or $30,000 for every million lent. If that happened then I would owe you .97 times our million or $970,000.

Sadly there’s no such thing as a free lunch so I have to charge you for this. Let’s say I decide you have to pay me 5%. What this means is that every year for the next five years you have to pay me 5% of the million dollars we agreed or $50,000, but if Nakheel does indeed default you can stop making the payments. So, you have to pay me $50,000 a year for five years or until Nakheel defaults and if it does I have you pay you something around $900,000 depending on how much the creditors can get for the balance sheet. Sound like a good deal? It sure as hell is. Nakheel CDS would be a lot more than 5%, the Dubai government is trading at 6.5% now.

For the past 20 years the CDS market has been the fastest growing derivative product in the world. There are literally trillions dollars of these things outstanding. Why CDS are so popular? CDS’s are a useful tool for banks to manage their risks. Have you noticed how the bet is kind of like a loan? The person buying the credit protection is paying out coupons every year in return for his insurance. Let’s imagine that you are a Nakheel creditor and you lent Nakheel $1 million at 5% interest. If you traded this same credit default swap with me you now have no risk and all. Every year Nakheel pays you your $50,000 and you pay it to me. If Nakheel defaults, you recover what you can from Nakheel and I pay you the rest. Notice also that while you had to actually come up with the $1 million that you lent to Nakheel, in our CDS transaction there is no exchange of principal, there’s only a payout in event of default. This makes it a lot easier to trade CDS than to actually make loans, especially if the capital treatment of CDS is different from that of loans.

As a result, CDS have helped make credit much more accessible across the world for two reasons. First, a bank has made a loan and then hedged it with a CDS it frees up the balance sheet and then it make new loans. Second, they made it possible for a lot of people to provide credit who did not have the infrastructure of banks. As you can see from the example above if you sell a Credit Default Swap you have the same risk profile as if you had actually lent the money except that you don’t have to actually put up the money or go through the hassle of becoming a bank. If you buy a CDS you have the same risk profile as if you were the borrower. Thus people who are not in the banking business can use CDS to produce the same risks and returns as if they were.

Sadly it’s not all sweetness and light. There have been two big issues with the CDS market. The first issue was systemic. Because the entire financial system was using CDS to cross-insure its risks it became very difficult to understand what would happen in the event of the collapse of a major CDS issuer. They had the effect of blurring the balance sheets of all the financial institutions together. For example AIG insured a truly epic number of loans. So many that had it collapsed it would have constricted the balance sheets of almost all the banks in the world and caused another wave of Lehman style collapses. As a result the government was forced to rescue AIG.

The other criticism of CDS trades is that they are used as a weapon by speculators seeking to attack otherwise solvent companies. The theory is that buying insurance against default on loans you haven’t made is like buying insurance on a house you don’t own and then lighting it on fire to collect the insurance money. This argument was made with regard to Lehman Brothers. I disagreed with that line of argument for the same reason that the truth is a valid defence in a libel case. The truth is that the Lehman bondholders got $.06 on the dollar meaning there was a hole in the balance sheet in the hundreds of billions. People buying Lehman CDS did not cause the balance sheet hole, Lehman’s management did. So this is where the fire insurance analogy breaks down, it wasn’t possible for the CDS buyers to create the carnage at Lehman, only Lehman’s management could do that. I’d say the analogy is hurricane insurance. Even if you buy hurricane insurance on someone else’s house, you can’t then cause a hurricane unless you’re God.

Recently however events in Dubai and to a much greater extent in Greece have been making me question the CDS as a product. As mentioned, Greece has to roll $75 billion of debt in 2010. This will be done in a series of auctions of new bonds the proceeds of which will go to repay old bonds and to finance the large deficit that Greece is currently running. What usually happens is the world’s bond investors decide what interest rate they need to be paid in order to justify the risk of default and then vote with their dollars. If they stand back from the auction or demand higher rates the government has to pay higher rates. If they stand back altogether the country is forced into default. You could think of it as there is a certain amount of demand in the world for Greek debt at each level of interest rates and at every auction the Greeks and the bond holders find out what level of interest rates match the demand of investors with the amount of debt the Greeks need to issue.

Now enter the CDS. Remember as we said above that a CDS enables anyone to replicate the returns of a loan. This is true for sovereign loans as well. So not only can people who are bearish on Greece refuse to participate in the auction they can front run the Greeks themselves and soak up the demand for the Greek bonds by buying CDS protection. If you sell me a CDS I pay you the coupons that you would receive from Greece and you only lose money if Greece defaults. This is exactly the same position you would be in if you actually lent the money to Greece. Except in our trade the Greeks don’t get any money at all! In essence I have disguised myself as Greece and absorbed some of the markets’ willingness to lend to Greece.

How important is this? To be sure the real issues are the fundamentals of Greece, can they fix their deficit problem? Will the EU bail them out? But the CDS can become a significant factor in its own right. It really depends on how many people in the world are bearish Greece. Imagine that there are people willing to bet $75 billion that Greece will default. That would have the effect on the market of creating another Greece or effectively doubling the supply of Greek debt and thereby pushing up the price at which the Greeks borrow. By buying CDS on Greece the bond vigilantes absorb some of the interest in lending to Greece and thereby actually push up the cost borrowing for Greece. If the Greeks have to pay more to borrow, it actually widens the Greek deficit and helps to bring about the outcome on which they are betting. So they can cause the hurricane by buying hurricane insurance, or as they see it, they can play God.

Sunday, February 14, 2010

Dubai World Creditors: batten down the hatches, the storm approaches.

Zawya Dow Jones, the extremely capable MENA news bureau reported today on some rumoured details of the package that might be offered to the Dubai World creditors. The proposal, if true, would be an utter fiasco for the Dubai World creditors.

The details, unconfirmed, were that creditors would have their interest payments eliminated, the maturity extended by seven years and receive a 40% haircut meaning that they would recover only 60 cents for every dollar lent. This plan may come with an explicit Dubai government guarantee though I’m not sure what that is worth considering the credibility of the Dubai government. There was also a vague description of full recovery over a shorter time horizon though 40% of the recovery would be taken in equity in Nakheel. Given that the balance sheet of Nakheel includes undeveloped desert and non-existent islands in various shapes valued at billions of dollars this may well be economically the same thing as the $.60 on the dollar seven years out.

I think this will come as quite a shock to the markets. The Nakheel Sukuk that matures in May is currently trading at $0.65 on the dollar. If the creditors of the parent company, which owns desirable businesses and is thought to be in better shape in aggregate than Nakheel, are being offered $.60 on the dollar with zero interest the debts of Nakheel are trading much to richly. Dubai CDS have been bid up in recent days and from this it looks like they are set to go higher.

The most important reason however that this will shock the markets is what it says about the level of support that Dubai is getting from Abu Dhabi. After the full repayment of the ’09 Nahkheel Sukuk with the cash infusion from Abu Dhabi creditors felt as though they would all be rescued by intervention from the richer Emirate. Being asked to forgo all interest payments and take a 40% loss plus an extension out to 2017 is basically another repudiation of support for Dubai by Abu Dhabi. As a result the damage won’t stop at Dubai World but will be transmitted to Dubai Holding, ICD and DIFCI as investors gather that the support from Abu Dhabi is indeed limited.

So what happens next?

First there are the creditors of the parent company which are based in the UAE: the Abu Dhabi and Dubai based banks. I don’t think a lot needs to be said about this because they will accept whatever deal is on offer because they are effectively controlled by the governments which are making the offer. The central figures in the next act of this drama are the international banks who are creditors of Dubai World at the holding company level.

The international creditors are led by HSBC and RBS. The decision they have to make is whether the deal they are being offered is better or worse than declaring Dubai World in default. It’s hard to know what would happen in event of default. Ordinarily the equity holders would be wiped out and the debt holders would then own all the assets. In this case, given that the equity holder is the government of Dubai, that may not be possible. If Dubai denied their rights to the underlying assets of Dubai World then they would have to pursue their claims against the international assets of Dubai World. I’ve given a list of these assets in a previous entry.

There are also the actions of Dubai World and Abu Dhabi since the rescue in late December to consider. At the time Abu Dhabi announced a $10 billion contribution to the DFSF, which it later scaled back to $5 billion, or just a little more than was necessary to pay off the Sukuk holders. Dubai World has also put Istithmar holdings into slow motion liquidation, selling its stake in an Indian airline, putting Inchcape Holdings a shipping company up for sale and liquidating a private aviation company. DPW has solicited interest in someone buying some of their assets in Australia. Notice what these businesses have in common, they are assets located outside Dubai or are attachable physical assets which cannot generate revenue unless outside the UAE (ships and planes.) That is to say they are slowly off loading the assets the creditors would be able to pursue in the event of default.

More disturbingly a company formerly considered part of the Dubai World group, the Dubai Multi Commodities Center has declared its independence from the group on the basis that it was originally founded by an Emiri decree. It may well be that the company was founded by decree but it seems to have been largely funded and incubated by Dubai World with the funds of the creditors. For it to leave the group with no compensation being offered to the parent company is asset stripping so thinly veiled as to be haram.

The Dubai official quoted by Zawya said that the reason that no deal has yet been offered is that they wanted the international creditors to have enough time to properly analyse the business plan of Dubai World. It seems to me that the business plan is offloading the attachable international assets and stripping the productive domestic ones without compensation to the parent. Given that there has been no response from the creditors to the defection of DMCC it seems that there are no loan covenants barring divestiture. Thus this is a brilliant strategy on the part of Dubai World. The creditors at the parent company cannot put Dubai World into default until the loans come due in 2011. By that time Dubai World may have been able to sell all of its international assets and remove all the valuable UAE ones meaning that by the time the creditors began to sue Dubai World all the recoverable assets would be gone. That makes $0.60 on the dollar with a sovereign guarantee look pretty good.

Thursday, February 11, 2010

Ever notice how the stars around the Euro sculpture in front of the ECB make it look like a cartoon that has been hit in the head?

So the EU summit today seemed to successfully navigate today between the Scylla of the Greek Unions and the Charybdis of the Bond Vigilantes. They basically made a non-announcement whereby they pledged aid to Greece in the event that Greece needed aid which they declared that it did not currently need. Their view was that the reforms currently proposed, perhaps with some additions, would be more than enough to combat the deficit issues and they called on Greece to take firm action to rein in it’s spending. What precisely the aid might be was left out of the communiqué.

This is where it gets interesting. So the communiqué was issued during the meeting and once it came out the Euro dropped like a stone. European equities also dropped like a rock. Spain, considered to be next on the list from Greece dropped 3% at one point. The US markets were off as well though good news on the employment front and a major buyback announcement. Markets generally headed lower until the press conference. At the press conference Merkel and Sarkozy repeated the mantra of the communiqué. A variety of other officials talked about how this was meant to send a strong signal to the markets of the confidence of the EU in Greece. The Prime Minister of Spain was at pains to point out that the Greek crisis has nothing to do with Spain. As to specifics the communiqué was a study in ambiguity. It took nothing off the table and it put nothing on the table.

Only one person was off message. The Prime Minister of Poland, Donald Tusk, was asked what form aid to Greece might take. “Cash and Guarantees,” said Mr. Tusk and at that moment the Euro began to rally. Now this is interesting. Was Tusk off message or was that the message? If either Germany or France said that they would provide cash and guarantees to Greece then it’s pretty much a bailout and the unions would dig in their heels. Poland? Who knows. The EU can have Poland say something explicitly like that and yet remain ambiguous because Poland itself is in no way capable of rescuing Greece. The other EU members have plausible deniability but they raise the risks of betting too hard against Greece.

All very interesting but the story is not over. All eyes are on the Euro, indeed the S&P 500 traded with the Euro all day today. The Euro is a massively liquid 24 hour barometer of what the markets think of Greece. If they think Greece is going under the Euro drops, if they think Greece will make it the Euro rallies. After the press conference the Euro rallied back from its lows but still closed the day lower. The European markets were closed by the time the press conference was over so the Euro is the only tool the Bond Vigilantes have against Greece overnight. We’ll see what Greek credit spreads do tomorrow. If they tighten and the Euro rallies, get ready for a massive jump in equity markets. On the other hand the markets might try to test the mettle of the EU Ministers. If so then we’re in for some fireworks.

Wednesday, February 10, 2010

The Greek Treasury will give away one giant wooden horse or every $1 billion of bailout money. Inside are public sector unionists waiting to spring!

Tomorrow at 4:45 Brussels time the EU will issue a press statement summarizing their deliberations on the pending Greek fiscal crisis. The markets have scraped themselves off the bottom the past few days on the hope that the EU will announce a support package for Greece. The foundational documents of the EU charter and the various legal agreements that created the Euro-zone tie the hands of the ECB and the EU to some extent though it seems as though the various European governments have spent some time looking for loopholes which would allow them to come to the rescue for Greece. There is nothing official as of yet but the market rumour seems to be that some of the stronger EU member states will announce guarantees of Greek debt conditional on the Greeks achieving certain fiscal targets.

This is setting the stage for a great drama. The main issue here is that over the next 12 months Greece has to sell about $75 billion worth of debt or about 20% of GDP. It sounds like a lot but under normal circumstances it wouldn’t be totally outrageous. These, however, are not normal circumstance. Partially on account of the financial crisis and partially on account of the fact that historically the Greeks have been living beyond their means, the fiscal deficit of Greece has grown quite large. One of the reasons that it has grown so large is that it has been relatively easy for various interest groups within Greece to hold the government hostage through strikes for large payouts from the government. So not only does the government have to roll a lot of old debt, it has to issue a lot of new debt as well.

The people who have to buy this debt, the worlds fixed income investors, have recently grown very sceptical about the ability of the Greeks to pay this money back. The Greek debt to GDP ratio is already very high, the budget deficits have been getting worse and the efforts of previous governments to close them. Over the last several weeks the interest rates that investors have demanded from the Greeks to roll their debt have spiked. Having to pay higher interest rates can by itself widen the governments’ fiscal deficit and this can then become a vicious cycle which ends in default. Given that the Greeks are in the Euro-Zone and therefore their money supply is controlled by the ECB rather than their own government they have only one thing they can do and that is to close the fiscal deficit.

And this has set up a three way game of chicken. The Greek government has two objectives, keep Greece afloat and stay in power. To keep Greece afloat they have to cut the fiscal deficit. To stay in power they have to do that without making too many people angry. So far their strategy has been to announce massive increases in taxes and massive cuts in benefits in an attempt to close the deficit. They are counting on fear of the majority of the population of an economic collapse in event of default to outweigh the anger of the people who will be harmed by the cuts.

The public sector unions have it a little easier. Their objective is to maintain their salaries and benefits. Their strategy is to make the government have to choose between remaining solvent and staying in power. To try to undermine the government the public sector unions have called a strike and some of the private sector unions have joined them. In previous attempts to implement austerity measures these strikes have degenerated into riots and brought down the government. This may or may not be a realistic possibility but until today these strikes have been scaring the hell out of investors.

The people with the most difficult hand to play are the other EU governments. Their objective is to maintain the integrity of the Euro system. Ideally Greece would enact the tough reforms necessary and all would be well. As per the above, however, there seems to be anything but consensus within Greece as to what should be done. The first problem they have is that all of them are also elected politicians and taxing your own people in order to help fund the lifestyle of the Greeks is going to go over like a lead balloon. The second problem is that the options you have are somewhat limited on account of the various treaties that govern the EU and the Euro. The kinds of things that the Fed and the Treasury department in the US did last year to save the banking system such as outright purchases of securities by the Central Bank cannot be done.

The most important problem facing the EU however is a game theory problem. If they signal that they are willing to help Greece they will embolden the public sector unions to continue to resist the governments’ austerity measures and in so doing to convince the Greek government that it will be easier to negotiate terms with the EU than with the unions. The follow on would likely be a speculative attack on Spain and Portugal in an attempt to force the EU to come to their rescue as well.

If on the other hand the EU signals a willingness to let Greece default this would certainly encourage those betting against Greece and frighten potential investors who are necessary for Greece to be able to issue the debt to meet its requirements in 2010. This would also likely provoke a speculative attack on Portugal and Spain. In strategic terms it would weaken the Euro Area and the confidence in the weaker member states and potential entrants. This is because if Greece still had its original currency it could just print the money and take the pain in the form of increased inflation. Inflation is just as or more destructive than fiscal austerity but it can be done without leaving too many political fingerprints and is therefore easier to achieve.

As you can see, its quite a narrow needle that the EU needs to thread tomorrow. Here’s what I think will happen. I think that the EU will announce tomorrow a series of steps to support Greece such as loan guarantees or other aid. This assistance will be conditional on Greece enacting reforms so draconian that the aid would in fact not be needed. On hearing this the markets will attack Greek debt in an attempt to force the hand of the EU. My guess is that the EU will stand pat either through will or indecision and eventually the majority of Greeks who support the reforms will prevail over the minority who oppose them and Greece will not default. I predict that after a sharp sell off markets will stabilize as it becomes clear that Greece will enact the necessary reforms. Then they’ll turn higher floating on the global sea of liquidity being produced by our man Bernanke. You heard it here first.

Sunday, February 7, 2010

It may be time for the Dubai World creditors to get on the hotline with their lawyers and go to Defcon 1.

If I were a creditor of Dubai World at the holding company level I would be getting very very concerned right now. The remaining Nakheel Sukuk holders I think are pretty much done for considering that they have no recourse to the parent and their bonds are collateralized with undeveloped desert land or non-existent islands. The Dubai World creditors though had a fighting chance because there remain some productive assets in the Dubai World group and not least of which are Dubai Ports World and the Jebel Ali Free Zone. DPW in addition to being a going concern is a publicly traded company with attachable international assets which should east the minds of creditors.

I had thought that not too much would happen with the Dubai World saga until we got close to the expiration date for the Limitless debt (no pun intended) at the end of March at which time it is likely that another cash infusion will be necessary in the likely event that not all the creditors will agree to roll over the syndicated loan. The National, an excellent newspaper in Abu Dhabi has two articles in it this weekend that bring the Dubai World saga back to the forefront.

The first thing they report is that the Dubai Financial Support Fund (DFSF) intends to take security against the assets of DW in exchange for contributions it will make toward interest payments. It’s not clear to me what form of security this would take but The National reports that it would jump ahead of the other creditors in event of default.

This is a highly perplexing move by the DFSF. In the first instance I imagine that the understanding of the Dubai World creditors would be that the purpose of the DFSF support would be to make the chances of a subsequent default near zero. What does it say about the conviction of the DFSF that its support will be effective in preventing default that it is demanding that it go to the head of the queue for recovery in event of default? It doesn’t exactly inspire confidence. If you were a creditor of Dubai World why would you agree to step back in line for recovery of your principal to only get some of your interest payments? No you wouldn’t. You would put Dubai World into default and in the event that you were blocked from recovering the Emirati assets you would pursue them in international courts. Why this would not be obvious to the people at DFSF who are negotiating this I also don’t know.

An even harder to understand story and potentially more damaging is the request by the Dubai Multi Commodity Center to have its logo removed from the Dubai World website. Removing the logo is not a big deal, what is more disconcerting is that DMCC now claims that it is not actually part of Dubai World. This must come as quite a surprise to the creditors of both Dubai World and DMCC as every press release I have ever seen by either group describes DMCC as a member of the Dubai World group and they have reported themselves as such to the financial media for quite some time.

I suppose what really matters is what the prospectuses for the loans at the Dubai World holding company level say. If they say that DMCC is part of Dubai World and the DMCC is now withdrawing itself from the balance sheet of the parent company this is almost certainly a breach of a loan covenant by Dubai World. If not then I would be demanding a strict accounting of everything that flowed into DMCC from Dubai World and what compensation Dubai World got in return.

An even stranger aspect of this is that the Chairman of the DMCC and the Chairman of Dubai World are father and son. Surely this need never have made the papers at all.

You would think that given that the eyes of the world are so focused on the handling of the Dubai World restructuring that this sort of thing would not be possible. You’d be wrong. Just ask the Damas shareholders.

What better way to compliment the Burj Khalifa than naming this the Parthe-Nahyan?

Dubai has had its mantle of most interesting sovereign debtor taken from it this week by countries in Southern Europe. There are some interesting similarities and differences between these two regions and I think it makes sense to discuss them comparatively. It also gives me a chance to branch out from talking about Dubai so exclusively.

Greece and Dubai have come to their problems differently. Dubai borrowed a massive amount of money to finance the construction of major infrastructure projects inside the Emirate as well as to buy international trophy assets. The implementation of the construction projects probably involved a lot of siphoning off of funds by Emirate merchant families thus the actual value that went into them was less than was borrowed. With the onset of the international financial crisis the earning power of those assets is now substantially less, and in the case of real estate spectacularly less, than when the money was lent leading to the threat of default. Additionally the prices of the international trophy assets have all declined.

The Greeks have run into problems because even before the crisis began they were running a fairly substantial budget deficit and as a result piling up substantial debts. The structural issues with the Greek deficit can be found in many EU countries but they are a worse in Greece. There is a substantial welfare state as elsewhere in the EU but the rule of law is also weaker and there is widespread tax evasion or avoidance. There are also strong unions in the public sector which make it difficult for the government to rein in spending. These issues were exacerbated by the financial crisis. Government outlays for unemployment and stimulus increased but also tax revenues declined. International maritime shipping isa major industry in Greece and has been particularly hard hit by the declines in international trade.

I think there are two interesting similarities between the Greek and Dubai situations both of which actually favour Dubai on a relative basis.

The first is that neither Dubai nor Greece are in charge of their monetary policy. Greece is a member of the Euro-zone and Dubai uses the Emirati Dirham which is controlled by the Central Bank and thus effectively by Abu Dhabi. This is a serious problem for Greece, the European Central Bank has a single mandate and that is price stability, as opposed to the Federal Reserve which has twin (and some would say opposing) goals of price stability and maximum employment. As a result the ECB tends to be more conservative with regard to its rate setting policy keeping rates relatively high and the Euro relatively strong. This is a tough position for a debtor because it both constricts growth and it maintains the value of the debt relative to real assets.

Dubai on the other hand uses the Dirham which is pegged to the dollar. Thus while it cannot control its monetary policy it effectively imports the monetary policy of the United States. This is helpful because the US is also a massive debtor trying to climb its way out of recession. This is not so good for Abu Dhabi which may suffer from asset bubbles as a result but it is great for Dubai. Dubai’s problems are just so large that it is hard to see this positive effect at work. If Dubai had the same monetary policy as Greece it would be in far worse shape.

The other similarity between Dubai and Greece is the role of outside agents. As both countries have struggled with their debts investors have been looking for possible saviours, in the case of Dubai they have looked to Abu Dhabi and in the case of Greece they have looked to the EU, the IMF and to Germany.

The financial world had been very focused on an EU investigation of the steps that Greece was taking to tighten its fiscal deficit. There was a lot of scepticism in the markets about whether Greece would be able to enact a tough enough reform package. In the end the EU gave its blessing to the package which instead of calming the markets had the effect of causing speculative attack on Portugal and Spain the two next countries in line behind Greece with troubled debt issues. Despite this weeks news Greece is nowhere near out of the woods as it has to roll over billions in debt over the next few months, a similar position to Dubai. Personally I think the Greeks will make it but if not then what?

If Greece requires external support it is not clear from where it would come. The European Central Bank has neither the mandate nor the resources to execute a US or UK style “quantitative easing” whereby it would just print Euros to buy Greek debt. The EU itself has no taxing power and its budget is far too small to help. It might be possible to create some special EU legislation to enable a financial rescue but this would be a highly complex process and would still have to be funded somehow. It is possible that EU member states may step in to preserve the stability of the Euro and the concept of European integration.

The trouble is that it is very hard to predict the actions of European voters. What would the fiscally conservative Germans say about paying higher taxes to finance profligate public spending in Greece? Who would think that Greek workers would go on strike to protest the very reforms that are meant to keep the government which pays them afloat yet that is what they are doing. It is possible that the IMF could be called in but if the Greek voters are unwilling to enact the relatively mild reforms being proposed what are the chances that they would impose the sort of draconian reforms the IMF is likely to require short of a default?

From this perspective the opaque relationship between Abu Dhabi and Dubai regarding the Dubai Financial Support Fund seems very simple and predictable. It may only be a matter of time before the bondholders are asking the Greeks "Who's your Abu Dhaddy?"

Never a dull moment in international finance.

Monday, February 1, 2010

Darn it, these binoculars aren't any better than the ones they have over at S&P

Last week S&P dropped its rating of Commercial Operations Group of Dubai Holding. Dubai Holding you may know is owned directly by Sheikh Mohammed, and the COG contains Dubai Properties and Jumeriah a very well known hotel group with properties all over the world. Dubai quickly retaliated quixotically by having Emirates NBD, the largest bank in Dubai, unsubscribe to the S&P service. That’ll teach ‘em. Personally I think the guys at S&P probably high fived themselves when Emirates NBD dropped them. These guys helped drive the world over the cliff in 2004-2007 by issuing AAA ratings on securities that have turned out to be anything but. To have Dubai keep itself in the headlines for an extra day by “dropping S&P” after having themselves been dropped is the kind of publicity they want.

In the coverage of the tit for tat though I think something has been lost. S&P did not lower its rating because it was concerned about the figures, it dropped it altogether because it did not believe it was even getting reliable figures upon which to judge the creditworthiness at all. A conspiracy theorist explanation for this would be that there is some secret set of books that Dubai Holding uses to manage its own affairs and another that it presents to the outside world. Such a theorist would suspect Dubai Holding of bad faith and trying to mislead S&P who felt the numbers they were being given were misleading and so decided to drop coverage. It’s a possible explanation but I think it is an enabling fiction. If it were true then it would mean that Dubai has a handle on what is going on in its own finances but is seeking to obfuscate them from the rest of the world. I think the real answer is that Dubai itself has no idea what it’s true financial state is.

I recognize that my evidence for this is as circumstantial as the conspiracy theorist argument for a dual set of books. Here is my evidence. There is the letter from Nabulsi to the FT claiming that Sheikh Mohammed is promptly informed of any changes to the financial status of his holdings and a denial that anything is held back. Methinks the gentleman doth protest too much. Then there is the pledge of Abu Dhabi to shore up Dubai, the commitment of $10 billion and then the surprise reversal putting Nakheel outside the ring in November. This makes me think that perhaps Abu Dhabi was not initially informed of how dire the circumstances were and knowing what the cost of not informing them would have been Sheikh Mohammed was himself probably not informed. The summary termination of Sheikh Mohammed's lieutenants, this could have been in response to the revelations that conditions were actually much worse at the DIFC etc. than the Sheikh had been made aware. Then there is the passage of the fraud law with heft prison terms but amnesty for those who pay the money back. This is the kind of thing you would do if you weren't really sure where the money had gone and thus you actually hoped it had been stolen rather than simply lost because then you would have a chance of getting it back.

My guess is that the figures available to the powers that be in Dubai are no more reliable than those which were presented to S&P. As a result the restructuring of Dubai Inc. is going to be massively more complicated than anyone would normally expect which is why there remains radio silence on issues such as the Dubai World standstill request. A conspiracy theory is often comforting because it means that someone actually is in control. I think the reality in Dubai Holding is the reality of the world at large, it is unmanaged chaos.