Volume 8 Issue 1
From Greece to America

Acamar Journal
Aug 1, 2011

The crisis in Greece is not so much about Greece, which is irrelevant in the greater scheme of things (at 2% of the EU economy). It is about the German, French and British banks and the consequences if Greece defaults, followed by Ireland, Italy, Portugal and Spain (the infamous PIIGS).

These countries will default on their sovereign debt; it's just a question of when. The ratings agencies were late to the game again but are now relentlessly downgrading PIIGS debt, making the solution more difficult.

Creditors worldwide had a combined direct exposure to the PIIGS of almost $2.4 trillion, according to the Bank for International Settlements, as at Dec 31, 2010.

To put this in context, the total profits of all the EU banks for the six months ended June 2010 were just €46.8 billion while total equity was €1.8 trillion, according to European Central Bank data.

In a surprising turn of events, US banks also have significant exposure to the PIIGS debt, as they have sold a substantial amount of Credit Default Swaps (CDS) to European banks. Yes, those CDS made infamous by the housing bust, which brought down AIG and other financial institutions during the financial crisis, after which taxpayers were forced to bail out Wall Street.

CDS are essentially insurance policies against debt defaults by the PIIGS and the US banks are betting that there will not be a default in the near-to-medium term or at all (in which case, they would pocket the premiums on the CDSs with no liabilities). This is, I believe, a spectacularly poor bet and the Europeans have happily laid off some of their exposure to these US banks.

Thus, while Bank of America only has $500 million of direct exposure to Greece, it has collected over $9.1 billion in CDS premiums covering the PIIGS by the end of 2010 (which means it has several multiples of potential liability against such premiums).

US creditors (primarily US banks), which own only 7% of debt directly, are on the hook for up to 42% of all indirect exposure, in case of default and contagion.

In addition, the European Central Bank is itself highly exposed to the PIIGS debt, which it took from European banks, just as the Federal Reserve took toxic assets off US banks. Both have become highly leveraged, with assets in the range of 15-20 times their capital.

You have to feel for the Germans. Having tried militarily to conquer Europe twice in the last century, this time they tried to dominate it economically. Their intention may even have been honourable: economic integration and the free movement of people and trade to help prevent the endless wars Europe has seen throughout history.

Their attempts to bring Europe together into a common market allowed countries like Greece to tap into capital markets at virtually the same rates of interest as the Germans, with just a 20 basis point spread on 10 year bonds.

Greece took on far more debt in an era of easy money than it could afford to pay back, with the government now so bloated that it accounts for 46% of GDP. The long-term solution is cutting back on government spending through austerity measures, despite the riots. But this not only causes pain through high unemployment and reduced government services, it worsens the problem in the medium term.

It is the high debt/GDP ratio that forced the crisis. Austerity measures require government to reduce spending, which shrinks GDP. This makes the debt/GDP ratio worse, precipitating more calls for cutting spending. It is a vicious downward cycle, as shown by Greece's first quarter GDP which fell 5.5%.

Now the spread between Greek and German 10 year bonds is 1,400% and its unemployment rate is 16.2%! And their public assets are to be privatised at fire sale prices.

Goldman Sachs helped make this excess possible, by helping to hide the level of debt that Greece took on when capital ran amok. But the average Greek, young and old, will pay a severe price for this chicanery. Unemployment is projected at between 17% and 23%, by the end of 2011. And, as GDP falls, many small businesses with less than five employees (which accounts for 97% of all registered business) are failing. 60,000 of them (out of 960,000) went out of business in 2010.

The food banks already cannot feed all the people in their line-ups and hungry people of all age groups are turned away. Unemployment benefits, at less than €500 per month, run out after one year and there is no safety net after that. A large segment of the population is being driven into grinding poverty.

The EU experiment itself is being severely tested. The Danish Parliament has now passed legislation introducing permanent customs controls, in violation of the Schengen Agreement. They first justified this as necessary to prevent eastern European gangs wreaking havoc in Denmark, then changed the reason to the need for tariffs. I suspect the real motive may be to intercept economic refugees fleeing high unemployment rates from the PIIGS countries.

Ironically the German people anticipated a north-south divide in the EU. I reported in the Acamar Journal in June 2008 that, before the worst of the crisis, 59% of Germans polled said they did not trust the Euro and were swapping Euros printed in Greece and other countries for those printed in Germany.

When the consumer and corporate debt crisis came in 2007-2008, it was massive government intervention that saved the global financial system. But governments took on unprecedented levels of debt and the next major crisis will arise from a sovereign debt default(s).

The problem is not limited to the EU, as the chart below from The Economist shows.

The debt problem lies fundamentally with the EU, North America and Japan. Conventional wisdom holds that a debt level over 100% of GDP is a tipping point. While Greek debt was 130% of GDP at the end of 2010 according to the IMF, Japan was 225%. Germany came in at 74%, France at 84%, Britain at 77%, Canada at 81%.

The US debt/GDP ratio stands at 93%. But the problem the Western developed countries face is a demographic one. Their populations are aging at a dramatic rate and living longer.

While US debt is currently $14 trillion, Professor Kotlikoff at Boston University estimates that the fiscal gap is 15 times worse, at $202 trillion. In a Bloomberg opinion piece titled "US Is Bankrupt And We Don't Even Know It" he says that the unfunded liabilities are simply unsustainable. It would take, for instance, a doubling of taxes to close the fiscal gap, or massive cuts to Medicare and Social Security.

So while the US government faces enormous political pressure to deal with its deficits (the next showdown in the US will be the August 2 deadline to raise the debt ceiling), Americans have generally not saved up for retirement.

In a March AP poll, 24% of US baby boomers, who began to retire last year, have no savings and say they will have to work till they die. Of the remaining 76%, only half have saved more than $100,000.

64% of boomers see Social Security as a keystone of their retirement earnings. But Social Security is already paying out more than it receives in contributions and its trustees expect it to run dry in 2036.

In Homer's epic poem Odyssey, Odysseus and his crew have to navigate between Scylla and Charybdis, two dangerous sea creatures that lay on either side of a narrow strait. The end result is that he barely survives but loses his men and ship in those dangerous waters. The developed countries are caught between the dangers of potential sovereign debt default if deficits are not reduced and populations heavily dependent on ever-expanding unfunded liabilities, which are rioting in protest as governments make painful budget cuts.

I took a year-long break from writing the Acamar Journal, waiting to see if the lessons from the financial crisis that I had predicted had been learnt. They have not.

Wall Street has passed on its losses to the taxpayers and is back to taking substantial risks and paying outrageous bonuses. The US Government is being lobbied to continue to transfer wealth from the middle class to the rich and is dramatically eroding civil rights. The European countries are trying to shield bondholders from the consequences of their improvident lending in yet another round of "privatised gains, socialised losses."

The pain imposed on the Greeks will become untenable and Greece will default at some point. The Greek riots may be a prelude of things to come in other developed countries. There is a real danger that there will be another, deeper financial crisis. The danger with a deep economic crisis, apart from the direct economic pain, is that it may spawn authoritarian regimes as people demand solutions at all costs. It will be truly ironic if the country that was the cradle of democracy helps initiates such a reversal.

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Acamar Journal

Disclaimer
The Acamar Journal is intended to provide factual and timely research on general economic trends, opinions about trends in specific industry sectors, information on specific companies, references to other publications and reports that may be of interest to investors, and information on general trading strategies. Zabina Ventures Inc. ("Zabina") is not a registered investment dealer or adviser.

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