Tuesday, August 9, 2011

Gotterdamerung: S&P pours fuel on the fire, world leaders struggle to put it out

Sorry for the delay. I hosted a dinner party last night so I could not get straight to writing. I'll just go over the market action yesterday and the major news that drove it.

Of course the top story was Friday's downgrade. As I mentioned in my Sunday night post I did not think that the markets had absorbed the possibility of a US downgrade and it would seem that they had not. So Sunday night the markets in Asia started us off with a respectable sell off and, once the CME overnight trading portal (GLOBEX) opened, T-bonds sold off as well and the Euro rallied though both of these moves had reversed themselves by the London open.

The ECB Counter Attack

So, as I mentioned in my post of last Friday, after the European close on Friday the Italians announced that they had negotiated a package of reforms with the European Central Bank that would push forward thier fiscal consolidation, would free up the labor markets and amend the Italian Constitution to balance the budget. This, it was theorized, would enable the ECB to add Italy to its program of bond buying. Indeed, yesterday morning the ECB leapt into the European bond markets with guns blazing.

Buying Spanish and Italian government bonds in $50 million clips the ECB was able to jam the yields on both of them to around 5.5%, well under the 6% danger zone that most investors consider unsustainable and where they have recently been. This encouraged markets in the European morning and they actually rallied off the Asian lows. London actually opened higher but the joy was short lived. While it was true that the ECB was able to jam Spanish and Italian bonds below a 6% yield, German bonds remained remarkably well bid.

This is important because German bonds in Europe are considered the local safe haven. In order for things to return to “normal” it is not enough for Spanish and Italian yields to drop, money has to come out of Germany and into the riskier economies. The stubbornly low German yields indicate that investors are not selling out of Germany and are therefore not following the ECB into Spanish and Italian paper. Even more disconcerting was the divergence of France from Germany. France and Germany are considered “Core” Europe. Those crazy sun addled Mediterraneans and the Guinness besotted Irish may indulge in absurdist levels of debt to GDP but France and Germany are viewed as above the fray. Well, once the US went over the AAA cliff on Friday, investors have been taking a hard look at France and do not like what they see. So while the ECB counterattack against the speculators in Spanish and Italian bonds was a major tactical success, at the strategic level things remained touch and go. Not a good sign.

The S&P Conference Call

Yesterday morning S&P held a conference call to discuss the US downgrade from Friday. S&P has come under some criticism for its downgrade. The US remains the most solid credit on Earth. This could be seen by the fact that within a few hours of the GLOBEX open USTs had reversed their decline and were headed higher. There is also the widely reported “$2 trillion error.” On the face of it, it's not hard to laugh at S&P's assertion that the error is not material because well, 2,000,000,000,000 is not a small number. The really depressing fact is that when thinking about US indebtedness it actually is a small number. The difference turned out to be whether the US would have a 86% or 92% debt to GDP ratio in 2022. As it turns out, either number is high enough to cast serious doubt on the long term credibility of the US and would easily justify the ratings cut so S&P is actually right in this case.

Even so, they were VERY aggressive on their conference call. Yesterday they downgraded several thousand other borrowers who are dependent on the US Treasury for income including Fannie Mae and Freddie Mac, the real estate holding companies backed by the Feds. They also downgraded Israel because, believe it or not, the US guarantees Israeli sovereign debt. This would have been grim enough news on its own but they went further than that. They said that they were many other AAA and AA+ credit in the world with a view to reorienting the worlds risks given the lower rating they assigned to the US. They did this with particular reference to US States, specifically US states which are heavily dependent on federal spending and transfers. There was a Q&A session in which many of those on the call attacked the S&P methodology. S&P was dismissive of it's critics and very assertive about its decision to downgrade the US, to keep it on negative watch and to look deeply into all its other ratings in light of the US downgrade.

This is of course a fiasco for two very specific sets of borrowers: European countries and US states. To have the ratings agencies reconsider all Europe in light of the US downgrade in the middle of a speculative attack is a serious blow. The idea that no European country at the AAA or AA+ has a safe rating is a shot across the bow of “core” Europe. Remember the mechanics of the EFSF, it functions essentially as a wealth transfer from the “Core” European countries to the periphery but calls on ALL European states for contributions. It in effect blurs the balance sheets of all the European countries and many of the commitments are so large that, if fully drawn down, they would significantly worsen the debt to GDP ratios of all Eurozone states. In addition to this, the level of cooperation that will be necessary at the EU level in order to fully fund or amend the functioning of the EFSF will be so fraught it will make the US debt ceiling debate look like the instant consensus of philosopher kings in comparison. This is likely to make the respite bought by the ECB counterattack remarkably brief.

In addition they put the US states on notice. This is a pretty serious problem. It is well known that the pension obligations of the US states are absolutely massive and that generally the financial position of many US states is extremely precarious. This is very interesting because, unlike municipalities, there is no bankruptcy code for states. In the event that a state went into default it would have to negotiate with its creditors almost as a sovereign but within the confines of federal law. Congress considered writing such a law but decided against it because it thought a significant number of states would file for bankruptcy immediately if such a law existed and this would raise borrowing costs for all states.

S&P downgrading a state on the back of the US downgrade would have immediate and serious consequences. The US sovereign has had its borrowing costs lowered because it is still the safest borrower on Earth and so has benefitted from a quasi-paradoxical flight to quality in the light of the downgrade. Will the same effect occur if California or New York are downgraded? Hell no. Their borrowing costs go up immediately which would have the effect of widening the fiscal gaps which drove the downgrades in the first place. What's more is that the states are, like Europe, looking at multiple simultaneous downgrades. This means that investors will not be able to switch from one state to another with confidence and may simply flee the municipal bond market entirely selling the safe and the risky, raising the funding costs for all.

In the event that there is a downgrade cascade that leads to a default cascade the US will be plunged into a VERY interesting but also VERY serious political crisis. It is widely assumed that the Federal government would step in to rescue the states in the same way that it did the banking system. I think this is unlikely to happen and that, if it comes to it, the State defaults will be extremely messy. This is because such a bail out would be extremely politicized. First of all the fiscal gaps the states are facing over time as their pension and health obligations increase with the retirement of the baby boomers are, across all the states, on the order of hundreds of billions of dollars. Trillions if you go out far enough in your calculations. Given the massive battle that just went on you can imagine the appetite in Washington for taking on more debt from the states is nil. Then you have to consider the opportunity that a cascade of state bankruptcies would present the Republican party.

The largest expense of any state is the salaries and benefits of its public employees. These employees are, by and large, unionized. Therefore they collect dues and use them to finance political campaigns of pro-union politicians, that is to say, Democrats. Public sector unions contribute over $100 million a year to the Democratic party at the federal level and several times that at the local level. A cascade of state bankruptcies which forced the states to seek funds from a federal government in which the House of Representatives are controlled extremely financially conservative Republicans presents an incredible opportunity to destroy a major source of Democratic campaign finance. Do I think the GOP is willing to play politics with this? Given that they were willing to put the country into default over much less, there's not a doubt in my mind.

Obama's speech

Naturally the United Sates can't take the downgrade lying down so Barak Obama planned to make a statement at 1PM. This was delayed until 1:30. It's a sign of how rapidly the markets are moving that the S&P 500 dropped a percent and a half during the delay. In the event the markets were not comforted by Obama's remarks.

Obama said that the US is still a AAA country and he quoted Warren Buffet as saying that there should be a AAAA rating and the US should have that. He then said that the main issue was not whether the US could pay or whether there were ideas about how to cope with the deficit but that the main issue was the political infighting. He said that all that was necessary was to make minor adjustment to medicare and to make the wealthy pay their fair share. He then called for unity and said that America would get through this and then made a reference to the deaths of the Navy Seals over the weekend in Afghanistan. The moment he said the words “Tax reform that will ask those who can afford it to pay their fair share and modest adjustments to health care programs like Medicare” the markets started dropping and plunged two more percent, had a last gasp rally and then closed on their lows.

When interpreting something like this it is very hard to speak for the markets without actually speaking for yourself. At this point I should admit that my market analysis is heavily formed by my own views. I think the markets sensed that Obama does not understand the depth of the problem he is facing. The markets are now fully alive to the scale of the US debt crisis and it is massive. Under the optimistic CBO projections which include the repeal of the Bush tax cuts and the end of the wars in Afghanistan and Iraq the federal debt grows by $10 trillion in the next ten years. If you look out over the next 30 the fiscal gap is in the high tens of trillions. This can not be solved by “asking those who can afford it to pay their fair share” or making “minor” adjustments to medicare. Think of it this way, this year the deficit is $1.6 trillion. The US collected around $1.1 trillion in income taxes, $650 billion of this came from the top 10%. So if you DOUBLED the taxes on the top 10% of income earners, which by the way not even the Democrats are actually suggesting, you close only a third of the deficit. That is to say, the problem is vastly greater than the simple solution of raising taxes on the rich.

Do you notice how in the debates no one ever actually refers to the data? They prefer comfortable sounding phrases like “make the wealthy pay their fair share.” That is, yes Mr. & Mrs. John Q. Public, there is going to be some pain but it won't be borne by you. The markets no longer buy it. To actually solve this problem is going to require very real pain across the whole of society. The debt ceiling debate showed how difficult it is to get a trivial amount of deficit reduction passed. In my opinion Obama's insistence that there isn't really a problem with the rating, and that what problem there is can be solved relatively painlessly if people agree to cooperate doesn't hold water. The reason people cannot cooperate is that the pain that will have to be borne is very real and they don't want to bear it. Until the politicians admit this to themselves and then to the voters we are going to continue to struggle.

And though we may get a relief rally today I don't think the fallout from the US is over by a long shot and my next few posts will describe what think will unfold in the coming weeks.

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