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Wake up, European bond auctions will start to fail, how much evidence do investors need?

Gijsbert Groenewegen
Dec 5, 2011

Markets keep on trading on “uplifting” headlines instead of digesting the grim fundamentals setting the markets up for a huge fall.

U.S. stocks closed sharply higher up 291 points on Monday as investors reacted to a report that a record number of shoppers turned out for Black Friday, the traditional start of the Christmas shopping season. Shops pulled $52.4bn over the four-day period that starts on Thanksgiving, up 16.7% from last year, according to figures from the National Retail Foundation. Though what we thought was the most surprising was that no financial commentators where asking the question how the Thanksgiving sales were financed considering the overwhelming debt we are facing.

In Europe, various reports pointed to a fresh bout of efforts by policymakers to stem Europe’s sovereign debt crisis. The Wall Street Journal reported leaders are moving closer to a fiscal union, which many analysts say is key to preventing euro-zone members from running up unsustainable debt levels. Though a lot people don’t seem to understand how long it will take to get all European states to agree next to that it is no solution for the unsolvable debt problems we are facing. Speculation flourished on other possible moves to keep the euro zone from falling apart, a dramatic outcome that has appeared more likely as investors have dumped Italian, Greek, French and Belgium debt. Though the International Monetary Fund denied a report in an Italian newspaper that it was considering a €600 billion ($801 billion) credit line for Italy. Also a story in a German newspaper reporting that Germany was considering issuing a joint bond with other triple-A rated European countries; the German finance ministry denied the report. The market is rife with speculation hence the incredible volatility in the markets we are facing.

Downgrades and rising interest rates are the last step before default

S&P downgrades Belgium’s credit rating from AA+ to AA on Friday November 25 following 10-y bonds rising 100 basis points (1%) over one week from 4.8% to 5.8%. Standard & Poor’s downgraded Belgium’s credit rating to AA from AA-plus on Friday, saying funding and market risk pressures are raising the chances the country’s financial sector will need more support. S&P said difficulties in the country’s banking system and the government’s inability to respond to economic pressures contributed to the downgrade. Belgium’s government debt position has worsened in recent months, particularly after it bought the Belgian arm of failing French-Belgian bank Dexia (DEXI.BR) earlier this year.

Moody’s downgraded Hungary’s sovereign debt to junk status, as was Portugal, because its uncertainty to meet its debt reduction goals and its dependence on foreign investors. The IMF warned about Japan’s ballooning budget deficit. Following bond auctions in Spain and Italy interest rates are jumping to unsustainable levels. Italian six month paper was auctioned on Friday for 6.5% up from 3.5% a month ago. The €8bn auction produced a yield of 6.504%, up from around 3.52% in October, according to Bloomberg. Demand weakened, with the total bids exceeding supply 1.47 times, down from a bid-to-cover ratio of 1.57 in October. 3-y paper was peaking at a yield of 8.13%!!

By comparison, Spain paid 5.2 percent to sell six-month paper at a much smaller short-term auction earlier last week, 10-y bonds were selling at 6.67%, after elections handed power to an austerity-committed conservative government. Though even Germany had problems raising €3.9bn, whilst targeting €6bn, with interest rates rising showing the biggest weekly jump for 34 months as German bonds were sucked into the Euro zone’s crisis. It is all Iceland and Greece revisited. It all is just a matter of time before we have the defaults at our hands. As we said in the first blog article we published the authorities are trying to plug one hole while at the same time creating other holes.

Record high yields threaten Rome’s planned gross issuance of €440bn for 2012 as interest payments on the country’s €1.9trn debt pile rise. Analysts say that, at current yield levels, the euro zone third-largest economy risks losing market access as redemptions totaling a massive €150bn for the February-April period approach. Traders said the ECB was buying Italian and Spanish bonds in an attempt to shore the market up. But given its reluctance to prop up high-debt euro zone governments, its bond-buying program has been conducted intermittently and so far not powerfully enough to provide more than short-term stability. New Bank of Italy Governor Ignazio Visco sums it up saying that short-term measures to tame Italy’s budget deficit would not be enough to solve the country’s economic problems and only structural reforms will generate growth. Markets are looking for quick and effective responses from European policymakers, such as a greater involvement of the European Central Bank.

The Eurodollar rates, the cost of swapping three-month Euro funds into dollars, rose to their highest levels since 2008 showing the increasing uncertainty in the system hence also the sharp drop in the US$/€ exchange rate last week from 1.36 to 1.32. We are witnessing a clear flight for safety towards the US Dollar and treasuries. And although the yield on the 10-y treasuries is less than 2%, purely as result of the Fed action and thus are not reflecting the default risk in the US, US treasuries in our point of view are purely being sought after for technical reasons, it is the only market ($10trn) that is liquid enough in order to enable large sums of money to move in and out when needed. And thus the US treasury market can be seen as a “storage facility” till investors know in which asset classes they want to invest in.

It is an illusion to believe the US is in a better shape than Europe

We want to emphasize that from a fundamental point of view we don’t believe that the US market is in any better shape than the European markets with US monthly deficits totaling on average $110bn a month in 2011 and showing a record deficit of $223bn for the month of February. The Super committee was not able to reach an accord, triggering automatic cuts that only kick in 2013 (so much for dealing with an acute deficit problem), in order to save at least $1.2trn over ten years (only $120bn a year!!) whilst the debt ceiling was extended by $2.1trn, which is most likely to be used up by year end 2012. It is clear that Washington is not serious in actively dealing with the US debt problems. Same old story: no leadership! This is a sign of the times we are living in which will continue as long as the politicians can get away with it.

Fitch said Monday November 28 that it will keep its rating for long-term U.S. debt at the top AAA level, despite a congressional panel’s failure to agree on long-term deficit cuts. But it is lowering its outlook to negative. Moody’s and S&P warned that they could lower their ratings if Congress backed off the automatic cuts. S&P downgraded long-term U.S. debt in August to the second-highest level, AA-plus, and switched its outlook to negative. It was the first time the credit rating agency had lowered the nation’s AAA rating since granting it in 1917.

Why are investors so naïve?

What amazes us is that investors still don’t seem to be able to wake up to how grave the situation is and still believe that we can fix the situation in an orderly way. Wake up, it will not happen, there is too much debt in the world and we think it is extremely naïve to believe that what has resulted in the current situation of structural imbalances over the last 30-40 years can be solved by throwing money at the system in a time span of 12-24 months. We need to have a different way of looking at the problems in the world. There are still too many people trying to protect their fiefdoms, they have too much to lose. Next to that Wall Street is not served by accepting a doomsday scenario. Why do you think gold has risen from $255/oz in 2001 to almost $1,700/oz +560% because of jewelry demand (accounting for 75%+ in the past)? Think again, it is because investors don’t believe all the hollow promises of the politicians anymore hence their quest for real value. Banks are facing a similar fate that is why unsecured debt is quickly diminishing in popularity.

Market is moving from paper to intrinsic value, security

Banks can still issue secured debt but senior unsecured issuance not backed by any assets. According to some industry experts of the €106bn that according to the stress test for the 70 banks is needed, in our opinion far too low considering the sovereign debt exposure, only 5-10 would be able to raise money. European banks have sold $413bn worth of unsecured bonds in 2011 equivalent to just 2/3 of the $654bn that is due to be returned to investors in 2011 as debts mature (Dealogic data) in other words the funding gap for the banks is $241bn in 2011. If we would include covered bonds $744bn was raised by the banks whilst $888bn is maturing resulting in a funding gap of $144bn. Unsecured debt is of course more expensive than covered debt. Looking at the covered bonds issued by the banks it should be considered that “The advantage of someone is the disadvantage of another”. What makes covered bonds safer for investors poses risks to other bank creditors (Financial Times). Bondholders get securities backed by loans that stay on the banks’ books and carry a bank guarantee and are even protected in case of a “bankruptcy”!!!

Anyway covered bonds encumber bank assets leaving less for other creditors. The long-term reliance on covered bonds or other secured borrowing threatens to leave all other creditors, including governments extending deposit guarantees, with no security. According to the Financial Times and Dealogic unsecured senior debt the main bank funding dropped from 38% of total borrowed funds in the second half of 2011 from 51% in 2000. Covered bonds saw an opposite trend rising from 29% of total borrowings to 45% in the recent months. And as above mentioned unsecured loans carry higher interest rates whilst covered bonds exhaust/lock up all guarantees for recourse of other creditors. By the way what is the value of a deposit guarantee if the governments are bankrupt or if they guarantee with money that is not worth the paper it is written on? The conclusion is that the trend in the financial markets is towards intrinsic value as is shown by the rising gold price, +560% since 2001.

Default is not without consequences

In 2001, Argentina, had a debt/GDP ratio of 54% at the time, defaulted on $100bn mostly foreign debt. Non-government investors, amongst them large pension funds, incurred haircuts of 2/3 of their investments. The only creditor that was paid in full was the IMF which was owed $9.8bn. It should be emphasized that a default is not free, although Argentina enjoyed large exports of agricultural products, high commodity prices, its foreign trade surplus and currency devaluation (Greece has non of this), a decade later Argentina has still not been able to re-enter the global credit market. This all despite Argentina’s economy having grown by more than 8% a year since 2003 and tourism that flourished following the devaluation of the peso.

At present, Argentina is looking to enter the credit markets again though it will first have to settle $9bn it owes to the Paris Club of creditor nations, a group of 19 countries with some of the biggest economies. Even if Argentina would be able to settle with the Paris Club it would probably have to pay twice the 10-y rate of 4.5% Brazil pays. And don’t forget commodity prices can also decline, especially of China falters (real estate transactions are down significantly and there are a lot of properties vacant) and as such could also dramatically reverse the riches of the commodity lead economies. Nonetheless we would like to emphasize that default is a serious matter with a lot of negative financial consequences that are likely to take many years to work out.

Conclusion: there is too much hope!

How much evidence do investors need that default is just a matter of time? Although national sentiment in Italy (57% of the $1.9trn public debt is held by Italians with households accounting for 14%), Spain and Belgium might short term help bond auctions we all know this is not sustainable. The fate of the sovereign debt and health of the banks are inextricably linked and have to be viewed as one and the same. The idea that Germany could save the Euro zone is not realistic. Why would the Germans “rescue” the Greeks and Italians who have a shadow economy of between 25-30% according to estimates. As we have said before it is all about taking responsibility for what we do and if that is not done we have to learn. The authorities still have a few tools left such as Eurobonds, the full backing of the ECB and QE3 in the US. As we mentioned 30-40 years of increasing imbalances can not be salvaged in 12-24 months, it is about the structure of the societies we are living in, the living beyond our means with contingent liabilities (pensions) that can never be paid and the total lack of fiscal discipline.

Anyway the problems banks have issuing senior unsecured debt is a clear indication of the lack of confidence in just paper promises. Even Greeks that wanted to pay their hotel rooms in London using their Greek credit card were rebuffed and had to pay cash! There is a clear shift going on from intangible assets to tangible assets. When we are facing defaults watch out for the currencies, the ultimate benchmark of one’s wealth. We believe gold and silver, which have intrinsic value, will prevail. Though it will be not unlikely that when the markets sell off, when all tools have been exhausted, at first the US dollar and the treasuries will be the biggest beneficiaries for a short while purely because it is the only place where large sums of money can be stored and quickly trade in and out of. All other asset classes are likely to have a correlation of one and sell off in the profit taking or going liquid process. Though mid and long term physical gold and silver, gold and silver producing mining companies, agricultural land and fertilizers and water should be considered.


Nov 30, 2011
Gijsbert Groenewegen

Groenewegen Report

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