Latest Hussman

"The developing global downturn is likely to have a disproportionate effect on debt-to-GDP ratios across Europe. [...C]ontraction of GDP doesn't simply raise the debt-to-GDP by virtue of a smaller denominator. Rather, weak GDP predictably results in revenue shortfalls and the need for counter-cyclical spending, all of which causes a disproportionate jump in debt levels relative to GDP. If you think European debt-to-GDP problems are bad, wait a few quarters."

Monday Night

• The Telegraph has a very interesting article today, "When, oh when, will Europe face the truth?". It seems like the conversation in Europe is moving in the direction of reverting to national currencies. That seems like the British view and the S&P ratings view, at least. The money quote, "If this were just an issue of insufficient liquidity, then it surely would have been solved by now, given the expansion of central bank balance sheets which has already taken place"
• That was the British perspective. For the German perspective, here is a random CEO of a German industrial firm, who correctly points out that "the willingness of crisis countries to reform themselves is abating if, in the end, the European Central Bank steps in." The Germans have started doing the math and realizing that having weaker countries leave the Euro, resulting in a stronger Euro, results in a net benefit even according to their fuzzy mercantilist math.
• In the U.S., one of the Fed mouthpieces is talking about tightening monetary policy! This is a far cry from QE3! Notice, one of Prechter's predictions (and arguments for deflation) was that, even though central banks could theoretically monetize all of this debt, political constraints would prevent them from doing so.
• ZH (clumsily) points out an unintended consequence of the ECB purchases of sovereign debt that are intended to prop up those markets. The ECB refuses to share in any "haircuts" that are negotiated between lenders and insolvent countries, because the ECB is so highly leveraged that they cannot afford haircuts. The result is that a bond is effectively senior if owned by the ECB and subordinated if it is not. And that means that for every bond that the ECB buys to prop up the market, the remaining bonds should be paradoxically worth less, because there is less recovery remaining for them to share.
• Enough about central banks (ugh). Did you know that your probability of dying during a given year doubles every 8 years or so? Which means that your mortality rate is increasing exponentially? Which means that the probability of surviving to a particular age is falling super-exponentially! [This is a cool blog, by the way.]
• A great paper from the same author: The problem of shot selection in basketball. He creates a very interesting model for deciding whether a player should take a shot or wait for a better opportunity, depending on how much time is remaining. He notices a discrepancy between the observed and the theoretically optimal shooting behavior of NBA players, in that they seem to be unwilling to settle for moderately high-quality shot opportunities early in the shot clock, believing that even better opportunities will arise later. One explanation for this is overconfidence.
• Overconfidence is an interesting subject. If someone is overconfident, it means that their confidence intervals are miscalibrated: they overestimate the precision of their own forecasts. I have previously posted about managerial miscalibration and about the potentially adaptive advantages of overconfidence. 
• Latest Hussman column is out: "the investment implications are very asymmetric. A slow but steady stream of modestly good economic news is largely priced in by investors, but a recession and the accompanying earnings disappointments would destroy some critical pillars of hope that investors are relying on to support already rich valuations. We're always open to shifting our investment stance and outlook in response to new evidence, but the "optimistic" evidence that many observers are using to discard recession concerns is generally based on coincident or lagging data."

Monday Morning Thoughts

Both the EURUSD and the Chinese stock market have broken through their October lows. Meanwhile, the dollar index has broken out to a higher high than October. There is a divergence between these markets and the US equity market. I would expect the US equities to follow them, by declining.

Hussman has another great column out tonight:

"[T]here still remains some short-run ability of policymakers to distort market forces, to badly misallocate capital in the process, and to wreck the economy more thoroughly in the long-run. The hope for QE3 continues to mount, despite the lack of evidence that QE2 had any meaningful effect except to bring a some pent-up demand forward and create a speculative investment environment that constantly depends on new doses of sugar to prop it up."

Read what he says about economic "surprises." It's hard to believe how poorly Hussman's fund has done over the past ten years, given what a brilliant analyst he is. That may be due to the constraints associated with running a mutual fund.

"Banks resist European pressure to buy government debt"

Banks are unlikely to come to the aid of debt-ridden eurozone countries, with many planning to ignore political pressure to use cheap money from the European Central Bank to fund purchases of sovereign bonds.

Why Wait to Reduce Your European Credit Exposures?

Seriously - why wait?

The plans for "fixing" the inherent problems with the EU invariably consist of a scheme for Germans to bear the loss on bad loans to Mediterranean countries. Losses that have already been incurred but not recognized.

Since these losses are enormous even in relation to German GDP, the plans are invariably nonstarters. As Hussman very aptly put it, investors want someone to buy the bad debt "and willingly take a loss on it so the money doesn't ever actually have to be repaid." Thus, the market currently prices in a complacent scenario, when it is actually very hard to imagine a way for the Euro to survive intact, or for loans made to the PIGS countries to be repaid in real terms.

Meanwhile, investors are lending to the PIGS, to highly leveraged banks with tons of PIGS loan exposure, and to individuals and corporations in the PIGS countries - all at single digit rates of interest. (Well, not to Greece anymore.)

I've written in the past about the loans to individuals and corporations in the PIGS countries as an area of particular concern that is ignored by the market. The value of a mortgage loan is the present value, at an appropriate discount rate, of the periodic principal and interest payments over the life of the loan.

With a loan made in Greece or Italy and denominated in Euros, there is a very high probability that the cash flows will switch to a devalued currency sometime during the remaining life of the loan. Because of this risk, investors should be much more wary of financial institutions that have significant non-sovereign debt exposures in the PIGS countries.

The best way that I have found to play this is to short a structurally inferior security (the noncumulative preferreds or NCPs for short) of European financial firms that are massively leveraged and have exposures to PIGS debt that are multiples of their market capitalization.

Look at a NCP from the perspective of the bank that issues one. They have the option at any time to stop making coupon payments. They can suspend them indefinitely. The preferreds are perpetual, so the coupon payments are the only source of value.

The buyers of the NCPs are short this option!! And they have sold it for a yield premium of a mere one or two hundred basis points.

I have been thinking about this from a game theory perspective. The equilibrium is that no one is ever able to issue a NCP because there are no suckers dumb enough to buy one; certainly not at a yield that would make sense for the issuer. However for some reason, the market broke out of this equilibrium over the past decade and now these securities exist again. The new equilibrium is for the issuers to suspend the coupon payments, let the price of the NCPs crater, and then buy them back at a huge discount. It's like the fable of the scorpion and the frog.

Hussman on Europe

From this week's column:

Europe doesn't face a liquidity problem. It faces a solvency problem. What investors really want isn't just for someone to buy distressed European debt, but for someone to buy that debt and willingly take a loss on it so the money doesn't ever actually have to be repaid. That isn't going to happen easily. Short of major fiscal improvements in Europe (which appear increasingly hopeless in the face of an oncoming recession) any solution will have to explicitly or implicitly impose losses on someone. In my view, the best "someone" is the investors who willingly made the loans in expectation of earning a spread, and who knowingly took a risk.

Exactly. Since it is obvious that these sovereign loans are bad the strategy is to try to sell them to the public at par. That is the strategy that U.S. banks tried in 2007 and early 2008, and you can see how well it worked. It isn't going to happen.

Nomura Raises the Euro Redenomination Issue

FT Alphaville has written an excellent post in response to Nomura research on what happens to Euro denominated debts in countries that leave the eurozone:

Let’s say the Greek parliament passes legislation — call it the Drachma Conversion Law, whatever — on 31 March 2012, ruling that the New Drachma will become Greece’s sole domestic currency from midnight, 1 April 2012. (It’s a weekend! Much easier to go round the ATMs with technicians, train border guards to spot suitcases stuffed with cash, and so on.) Euro-denominated obligations in Greece will be converted to New Drachma at so-and-so a statutory conversion rate, the legislation further provides.

The reason that this is such a big deal is that converting a Euro-denominated obligation to new drachma would instantly and significantly devalue it.

Be sure to look at the table of redenomination risk on eurozone assets.

This Week's Hussman Letter is Excellent

Even more notably, the Greek 1-year yield hit 240% last week, with Greek debt of every maturity trading below 37% of face value, and below 28% of face value on maturities of 5 years or more. Even if you were to cut the interest and principal payments on the 5-year bond to half their stated value, the current price of the 5-year implies a yield-to-maturity of nearly 18%. This suggests a credibility problem for the widely assumed 50% writedown figure - not that any Greek debt exchange has actually even been implemented yet. We wonder where this debt is currently valued on the balance sheets of European banks. Given the nearly 40-to-1 leverage common among European banks, it appears likely that much of the European financial system will be nationalized before this is all over.

Great Comment On EMU

“What if the Euro experiment, instead of introducing the new currency, had simply been the proposition that all EU countries issue their sovereign bonds denominated in Deutsch Marks? Wouldn't it have been clear immediately that certain problems with such a scheme were unavoidable? And isn't that essentially where we are now?”

EMU

“I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.”

Thursday Links

• "A 23.53-acre property at the Las Vegas Beltway and Hacienda Avenue that sold for $30.2 million in 2007 and was later foreclosed upon has been sold for $4.4 million."
• "The wheels are falling off the China story. A massive wave of malinvestment since 2008 is cresting, and the stupendous stimulus provided by gargantuan local government and private lending is expiring."
• "German Federal Constitutional Court To Challenge Greek Bailout, Claims Action Is Unconstitutional"
• Lots of skeptical articles about Groupon coming out.
• "As Warren Buffett’s Alpha Goes Down, The Value of A Lunch With Him Goes Up"
• Ugh, I can imagine how painful this is for Falcone: Endless LightSquared Headaches.
• Here's the problem with Bill Gross: he acknowledges that Japan has a "moribund, dead, lost-decade kind of economy" - but he thinks the U.S. situation is different!

Question (FXE)

How, exactly, is a PIIGS bailout bullish for the Euro?

Why does the Euro rally on news that, "don't worry, European banks are insolvent but we will print more Euros to cover it up"?

How We Know that Greece Will Leave the Euro (FXE)

* EU'S JUNCKER SAYS `STUPID' TO TALK OF GREECE EURO EXIT
* EU'S JUNCKER SAYS `NO WAY' GREECE WILL LEAVE EURO AREA

Good Euro/Bad Euro

If no one else has already, I would like to stake out the phrase "good euro / bad euro" as a play on the "good bank / bad bank" idea that was talked about in 2008 back when people acknowledged that banks were, by and large, insolvent.

Gold/Euro Rising Again Today (GLD, FXE)

Handy chart of the gold/euro spread.

Gold (GLD) Versus Euros (FXE)

So I think everyone knows that I am short-term bearish or at least ambivalent about gold. Tonight, I have been thinking about gold versus euros, that is short euros (FXE) and long gold (GLD).

Here's a three year chart of the gold/euros trade. You'll notice that there has been a new breakout in the chart.

Obviously, I am not early to this party, but I think that this trade gets less attention than the dollar/euro or gold/dollar. As a contrarian I find that very attractive. Here's some evidence in support of my point. These are the number of Google search results for the indicated search phrases.

GLD/EUR 734
EUR/GLD 793
EUR/USD 5,340,000
USD/EUR 1,690,000
GBP/USD 2,230,000
NOK/USD 154,000
GBP/NOK 85,900
"gold versus euro" 11,400
"usd versus eur" 369,000

I am basically bullish on gold long-term, I just feel that too many people own it right now. It makes me uncomfortable. I like this GLD/FXE trade because I'm much more bearish on the euro than on the dollar. See my recent posts on why the euro is doomed to fail and how we know the European financial crisis is not going away.

The yield on the FXE is now almost zero, so the cost of carry on this trade is not too bad.

Great Analysis of the Euro (FXE) by Matthew Lynn

This article from Bloomberg columnist Matthew Lynn is the best analysis on the Euro crisis that I have seen so far:

When the euro was launched, it was a big bet that sharing the same currency would make a group of very different economies converge, and so allow the European Central Bank to operate a single monetary policy for all of them.

It was an interesting theory, but it turned out to be wrong. The economies are just too different to allow a single central bank to manage all of them. Interest rates are always wrong everywhere. How that expresses itself varies. In Greece, it was a fiscal crisis. In Ireland, a banking collapse. In Spain, a construction bubble that burst. In Germany, a massive trade surplus. But, like a river looking for the sea, it always comes out somewhere.

This crisis will keep moving from country to country. The only permanent fix is splitting up the euro into more manageable currency areas. Until the euro area’s leaders recognize that simple truth, every bailout they come up with is only going to shift the attacks elsewhere.

Matthew Lynn is also the author of Bust: Greece, the Euro and the Sovereign Debt Crisis, a forthcoming book on the Greek debt crisis. I have pre-ordered a copy.

Naturally, any sort of centrally planned economy is inevitably going to fail, but his explanation of why the EMU is failing is very eloquent.

There has been almost two year quiet period, a respite from the global depression. That was a chance, in theory, to fix problems instead of kicking them down the road. That no one even attempted to fix the problems during that period suggests to me that the problems are intractable.

I am really hard on complacency - both in the market and in public life - in this blog. I believe that complacency has caused human civilization to become extremely brittle.

Weekend Roundup: Standard Pacific, Dollar Lows, Phoenix Residential Stagnation

Quick facts before the weekend:

• Dollar index hit an all time low today. It has lost about 3% since the September rate cut. I am long Euros through FXE, which is yielding 3.36%.
  
• Someone from a Standard Pacific Homes IP address just did a Google search for "standard pacific bankruptcy." For those of you new to the site, Credit Bubble Stocks does offer continuing coverage of Standard Pacific. I have continually rated SPF a "sell" since March and still own the puts. The homebuilder stocks rallied today on the strength of a 12% rise in orders at NVR. Points:
  
• A 12% rise in orders is not that meaningful. How many will close?
• NVR is the best positioned builder. Their slight strength doesn't imply anything about SPF. They build in practically opposite markets. I bought puts into the SPF and Beazer strength today.
  
• Valley resale market enters holiday slowdown. Matches the projection from my October 3 post, meaning that Phoenix metro has a massive inventory overhang.