Third Times the Charm? A Commentary on the Most Recent European Debt Crisis 'Fix'

Early yesterday morning, word trickled out that a new "comprehensive" deal to "fix" the euro-debt crisis had been cemented. Investors in Europe and abroad were thrilled; markets rallied an average of 3%. Analysts were less enthusiastic, somehow universally agreeing to use the term "cautious-optimism" to qualify the deal. While the media and analysts are still digesting the hard data (many in the negotiations were quoted saying they had trouble understanding many of the components of the deal), a few things are certain. Greek debt holders will take a 50% haircut on the face value of their paper (much more than previously agreed upon this summer), banks will have to raise their tier-1 capital to 9% of the banks' holdings, and the EFSF will be leveraged to a total of 1.4 trillion euros to meet all previous obligations without being totally zapped.

While this is indeed great news (primarily because we now know the EU has come to their senses and will not expect Greece to fully pay all of its unrealistic debt), many details remain to be determined. One particularly interesting detail yet to be negotiated is the fate of credit-default swaps (CDSs) on the Greek bonds. The EU deal has chosen to classify the 50% haircut as a "voluntary" write-down. While these losses are, in reality, far from voluntary, the deal is trying desperately to avoid a "credit event" that would trigger pay-outs of the CDSs. However, if this massive write-down isn't a "credit event", despite the fact that it is clearly a default (albeit an "orderly" default), what the heck is? With the EU saying the nearly 4 billion euros worth of CDSs purchased on Greek bonds wont be triggered (think your fire insurance refusing to pay because only half of your house burnt down), this will, in my opinion, trigger a credit-event of a different kind. The liquidity of the CDSs market will all but disappear, at least on sovereign paper. What would make sense, at least to me (and we all know I am more of the outsider-looking-in than any kind of real expert), would be for the CDSs to pay out what is written down. That was the original intention of the CDSs in the first place, to insure against losses of any kind. In theory, the sellers of swaps should not be all that surprised that Greece is defaulting, and should have more than enough cash to cover half of the losses. The risk of default, when calculated accurately, should be reflected in the price of the CDSs. I have a hard time believing that banks (or whoever originated the CDSs, or later bought the puts) would sell a Greek bond swap at the same rate as a US swap. And they didn't. The International Swaps and Derivatives Association would be far better suited to NOT bend to the will of the EU, and declare the haircut a credit event, therefore triggering payouts. After all, the negative implications on future derivatives markets should be of much bigger concern to the association in charge of it than a puny €2 billion, since the default was only on 50% face value). For the sake of the future of swaps and derivatives (at least on sovereign debt), I hope the ISDA holds firm.

(sources: The Economist)

Moody's and Fitch Downgrade Europe, Dexia bailed out...where does it end?

This week will surly go down as one of the worst, in global economic terms, since October 2008. Fitch downgraded the credit worthiness of several European countries, including Italy, Spain, Portugal, as well as placing some countries once presumed totally solvent up for review, such as Belgium. Between this, the Moody's downgrade of 12 UK banks, Greece's struggle to meet austerity requirements for their next bail-out tranche, and the forced recapitalization of Franco-Belgian bank Dexia, it looks like the catastrophe in Europe is coming to a head. And all of this coming on the heels of a bad end to a bad quarter...what comes next?

Well, as the markets this week reflect, I think the solution is coming sooner rather than later. With ECB President Jean-Claude Trichet scheduled for retirement next month, we can only hope that the new regime will take into consideration the aforementioned crisis and deal with the real issue at hand: deflation. While Trichet has been spending much political and actual capitol on battling inflation with more than one rate hikes since January, the money flow has all but ground to a halt. If I were a betting man, I would gamble that we are going to see a real-life TARP-like bail-out of banks in Europe, as well as a few shotgun mergers just to be safe. What is to be done about Greece is a different battle, and personally I think Europe would be better without Greece in the Euro.

S&P Downgrades US Debt

To top off the worst week in recent memory, the ratings agency Standard & Poor's downgraded the long term United States debt from triple A to AA+. While most US based banks and institutions that hold these bonds have recently renegotiated self-imposed restrictions against holding lower than perfect rated debt in their vaults, the effects this downgrade will have on international institutions is has yet to be determined. But one question remains: why did S&P downgrade T-Bonds, even after the debt ceiling deal?

For weeks now, S&P has been threatening to downgrade US debt if the government did not improve its ability to meet payments. The agency said it would spare the US if the debt ceiling deal included at least $4 trillion in cuts over the next decade. According to the bipartisan Congressional Budget Office, the deal cut less that $2 trillion. Despite a $2 trillion dollar mathematical error that postponed S&P's downgrade announcement Friday, the agency stuck to its guns. Politically, this controversial move was necessary if only to show the public that the agency would make good on its threats. This is especially important when reminded of the role the ratings agencies played leading up to the financial crisis; many highly questionable mortgage backed securities were stamped triple A with little or no due diligence performed.

Despite S&P's claims that politics in Washington threaten the ability of the government to pay its bills, and the historical contextual importance of proving the agency is both comptent and willing to judge financial instruments faithfully, one question remains: what about Fitch and Moody's? How can two of the "big three" ratings agencies believe the US to be triple A worthy and not the third? Judging by their ratings of other nations' debt instruments, it is not accurate to say that S&P is consistently more critical, while the other two are consistently more generous. By and large, the only reasonable explanation I can come up with to account for the lack of consensus amongst the agencies regarding our credit worthiness is the high degree of subjectivity that comes with rating debt. The actual difference between a bond rated triple A and AA+ would be difficult to quantify. Although I cannot prove this theory, it is possible that the complex bureaucratic web that makes up an agency (and the nuanced differences between the makeups of the three agencies) permit different conclusions between them, even if their mathematical models were identical (and we must assume they are not). It will be interesting, if nothing else, to see how the international markets react to this news. All we can do is wait and see.

Debt Ceiling: Is the US Government Still Threatened by a Downgrade?

In an article on thestreet.com, Robert Holmes tells the story of Jeffrey Sica, a money manager, and his politically unpopular view that Standard and Poor, the ratings agency, should make good on its threat to downgrade US paper, despite the debt ceiling deal reached today. This move would be nothing short of necessary for the ratings agency to retain its credibility, especially after a dismal track record of rating dangerous securities triple-A during the pre-recession MBS bubble. This statement resonantes with many Americans still frustrated with the trajectory of federal spending, many noting that no individual or corporation could possibly maintain access to cheap capital with anything close to the spending/revenue ratio we are currently seeing. While S&P has not yet issued a statement regarding this latest debt deal, the markets have reflected the continuing uncertainty felt by many regarding the recent revisions of the first quarter's GDP, and well as recalculations of inflation and manufacturing outputs. Treasury rates are also up, indicating bond investors are not yet willing to embrace "mission accomplished" on the debt problems plaguing the government. Could we be witnessing the decline of modern Keynesian Economics?

EU Sets Terms of Greek Bailout, Bond Holders Take a Hit

Recently, European Union policy makers agreed on the terms for the next round of bailout money to be released to Greece. While much of the plan is formulated around minimizing the moral hazard of yet another large bailout of a sovereign nation, the terms are rather generous (interest rates on the bailout loans have been cut by a third), not to mention placing some of the fiscal responsibility upon private debt holders as well as the country itself.

By far the most debated aspect of the new plan was bond holder participation, so-called private sector involvement (PSI) in the bailout. This complex and somewhat paradoxical scheme intended to save Greece billions by restructuring much of its forthcoming bond debt actually punishes bondholders and EU taxpayers. The problem with the outstanding bond debt is the outrageous interest rates and face-value discounts Greece had to offer to induce investors to purchase the bonds. Now, not surprisingly, Greece cannot afford to pay these rates, and as each payment cycle arrives, the debt total climbs almost exponentially. The solution ---a mercifully favorable solution for Greece --- is what is referred to as debt restructuring. This means that the issuer alters the terms of the loan, or bond in this case, to be more favorable; in this case, cheaper for Greece. This, however, means the bondholders are getting the short end of the stick, about 21 percent less on average than what was stated at the time of purchase. To avoid what could become a riotous situation in the banking community, the debt restructuring program is being offered as "voluntary", as forcing the debt holders to take a hit would be nothing short of criminal. Despite being elective, the EU expects more than 90 percent of all eligible debt will be restructured in one of four offered options: three different swap plans, a rollover option, as well as some buybacks.

Now here's the rub. Except for banks that hold these bonds in their vaults, I cannot see any incentive for the individual investor to participate in these restructuring options (perhaps individuals only account for 10 percent of the outstanding debt held, and was therefore already taken into account, I am not sure). It would clearly behoove a non-institutional bond investor to take at least a small speculative position on Greek bonds when the interest rates were at all-time highs. For that investor, nothing could compel him to take a 21 percent hit unless his only other option was to not get paid at all.

Institutionally on the other hand, this is exactly what banks want to hear. €35 billion is to be used as collateral for the new bonds issued in exchange for the old, to guarantee a triple-A rating. While this does mean the interest rate is substantially lower, it also means banks in Europe are allowed to carry them on their banking books (as opposed to trading books that have more lenient debt quality requirements). For the banks, this is a welcome solution. However, for the taxpayer, this means €35 billion that could be used in other ways (and there are many in Europe today) is doomed to sit in a government vault in Athens to guarantee payout of these new bonds.

While this deal is far from ideal from every perspective, it is a leap in the right direction for a sustainable future in Greece as well as the greater European Union.

Gof6 Budget Plan: Will it Help Raise the Debt Ceiling?

For some reason, the answer appears to be, no. Surprisingly enough, the criticisms regarding the plan drafted by the "Gang of Six" and its inclusion into debt ceiling negotiations came from both sides of the aisle. House republicans have already begun to critique the plan because of inclusion of "tax hikes" in the plan. Senate Democrats have been cited saying the proposal comes too late to be included in the debt ceiling negotiations.

Despite what is being said, it does not appear that any new taxes are included in the proposal. While 26% of the dollar total of the bill comes from "revenue", as I read it, the proposed money comes from closing tax loopholes and streamlining the confusing tax codes. While this will generate up to $1 trillion in revenue over the next ten years, the technical data reveals an actual "$1.5 trillion tax cut".

While this is a leap in the direction of austerity that America desperately needs, the implementation of any plan resembling this one is likely not to be even discussed in Congress until August 3rd (assuming the debt ceiling is raised).

Breaking News: Gang of Six Proposes Budget Plan

http://online.wsj.com/article/SB10001424052702303661904576456042405686316.html?mod=e2fb

Balanced Budget Amendment; Would it Solve...Anything?

Next week the House of Representatives is set to vote on the so-called "Cut, Cap, and Balance" bill, aimed at achieving a viable path towards a more sustainable future. While the intentions of such a plan are indeed admirable, we learn from studying economics that intentions are meaningless; only incentives and results matter in the end. A most interesting aspect of this "Cut, Cap, and Balance" plan is the "Balance", meaning implementing a balanced budget amendment to the Constitution. A recent Sachs/Mason-Dixon poll revealed 65 percent of Americans support a balanced budget amendment. But would requiring the federal government to balance the books solve anything? And what does it mean to balance the budget?

While it sounds simple enough, there are some common misconceptions regarding both balancing a budget and how requiring the government to do so every year could affect the economy. Let us begin with what it means to "balance a budget". To have a balanced budget is to equate revenues with expenditures. In other words, you bring in as much as you put out, or spend. The literal meaning of a balanced budget is to run neither a deficit (to spend more than you bring in during a given year) nor a surplus (to bring in more than you spend). This particular definition is very narrow, implying that every cent is matched exactly a year in advance. Some would concede that running a budget surplus would not be excluded under a balanced budget amendment, however I have no reason to believe, based on my research, that this provision is included in this particular bill.

As counter intuitive as it may be, running a strict budget could actually create an environment that incentivize unnecessary spending. This can be seen in the corporate world all the time. For example, if the R&D department at a particular company ran under budget (producing a budget surplus) for a year, it is very likely that the budget for that department would be cut the next year to reflect the fact that they had been allotted "too much" the previous year. The provides incentives for every department of the company to spend every penny of the budget, whether it is needed or not. It would not be hard to imagine a branch of the government spending their way up to their limit at the end of the fiscal year in order to maintain the maximum available appropriation for the next year.

In addition, many economists prefer to have a degree of elasticity to run a surplus during the "boom times" and a deficit during the "bust times". Requiring every dollar to be accounted for would not allow the government to efficiently reap the benefits of good times or to borrow in times of great need, as we did in the wake of the 2008 recession. Most economists prefer what is referred to as a "cyclically balanced budget", which is to balance a budget not annually but per economic cycle. This, however, can only be interpreted and analyzed in retrospect, after each economic cycle is completed, and would therefore be impossible to regulate.

While a balanced budget amendment may not solve our nation's woes, it is clear to most Americans that something must be done to hold the government accountable for its spending. However, if it was possible to regulate or legislate our way to fiscal responsibility, I am sure we would have implemented it by now.

News Corp: What does Les Hinton have to do with News of the World?

News broke today that Dow Jones CEO Les Hinton resined as part of a damage control campaign in Rupert Murdoch's News Corp empire. While most media outlets did not make much of this, I was perplexed! Why would a largely liked CEO of an American news corporation resign because of a scandal involving a British tabloid? Granted, Dow Jones is held by News Corp just as NotW was, but if the incidents in England were isolated as they have been reported by Murdoch, why is Hinton resigning? Now, I am far from a specialist in the field of corporate formalities, but as an FBI investigation is underway in America, it seems that the resignation of Hinton could be a case of abdicating responsibility. When viewed through the lens of a skeptic, this act looks an awful lot like admission of guilt, rather than polite formality.

Follow up: News Corp

An interesting graph from The Economist regarding News Corp's operating profit by division:

Public Confusion: The Debt Ceiling

With the August 2nd deadline just 18 days away, I awoke to yet more disappointing news regarding the impasse of a debt ceiling resolution. I personally cannot imagine how anyone would use the well being of our national economy as a bargaining chip. As an article in The Economist put it, our politicians are not even in agreement that hitting the debt ceiling would be catastrophic, let alone in agreement over how to raise it. All this despite testimony from Federal Reserve Chairman Bernanke stating that even a technical government default would be calamitous.

Perhaps even more striking is a recent Gallup Poll revealing that less than one quarter of Americans actually favor raising the debt ceiling. I can only hope these numbers reveal a lack of understanding regarding the terms "debt ceiling" and "technical default", rather than a genuine desire to force our government to decide between paying our soldiers or our doctors, not to mention the tail risk in the bond market. So, for the sake of clarity for all five of my readers, let us discuss the definitions and implications of these terms:

The debt ceiling is the result of a rather quirky law that caps the amount of money the government can borrow to cover expenses. We, as in the government, spends much more than we take in via taxes, so we borrow money to cover the difference. One must remember that we are the only "first world" country in the world that has a debt ceiling at all, but we are one of many that operates on a continuing budget defecate.

Perhaps the confusion regarding the debt ceiling is a misconception that raising the debt ceiling somehow authorizes new spending programs. This is not the case. The debate on where money goes is the business of Appropriations Committees. The raising the debt ceiling would do little more than allow the government to cover its current bills, such as Social Security and the salaries of public workers.

The term "technical default" is also a common source of confusion. Many Americans seem to believe that America, if a debt ceiling agreement is not reached in time, can simply pay off its bond debt obligations with money cut from entitlement programs that would be cut. While the likelihood of the Treasury Department putting foreign banks in line ahead of Medicare beneficiaries is questionable at best, the simple fact that we are in financial trouble at all would constitute a technical default; the primary ramification of which would be a hike in rates demanded by bond holders for acquiring the added risk of holding paper of a country in trouble. Therefore the total debt of the government to bond holders would actually be higher under a debt ceiling impasse than there would be otherwise.

So despite widespread panic and confusion, the numbers (the only real facts in this debate) indicate the need for an increase in the debt ceiling. The long overdue discussion regarding spending, taxes, and entitlement programs is better suited for the campaign trail and the budget committees.

Could The "News of the World" Scandal Spell the End of the News Media As We Know it?

The British tabloid "News of the World" was recently shuttered due to a phone and voicemail hacking scandal. As of today, it is hard to tell exactly how high up the corporate ladder the scandal goes, but the FBI did announce today that they would be investigating a similar case involving News Corp and the families of 9/11 victims.

Depending on how all of this pans out, we may very well see some of America's biggest news networks radically changed, if not shutdown. However, it is not all doom and gloom. As I see it, this could present a unique opportunity to reinvent the way news is broadcast and paid for in America. Allow me to elaborate:

Since its conception in 1986, the Fox News Network has changed the face of news. Rupert Murdoch's News Corp has been credited with creating the "echo chamber" style news network. Say what you will about Fox, but it has the highest ratings of any news channel in America. Although the creation of Fox was largely in response to a void of mainstream conservative news outlets, it is now a titan of industry, making nothing short of a killing from advertisement revenues. However, if News Corp faces indictment over the alleged 9/11 phone hackings, this behemoth may come crashing down.

This (hypothetical) situation does pose an interesting question: what are the consequences of a publicly traded news company? As we know, a publicly traded company is LEGALLY REQUIRED to act in the interest of the shareholders. In other words, the company is required to keep profits as high as possible. When it comes to news and journalism, should our country's citizenry be trusting ANY public company with reporting the truth and what needs to be reported? This is especially thought provoking when looking at the News Corp model: keep viewership high by being provocative and tailoring stories to the preference of the audience. This has been a very successful model in the eyes of the shareholders; the stock of News Corp (NWS) has risen 500% since going public in the 80's.

But the question is, were the hackings in England (and possibly America) fueled by a need, whether spoken or not, to fulfill the company's obligations to the shareholders? While that direct link may be a stretch, it is clear that nearly ALL broadcasting companies are guilty of inflating provocative stories, misrepresenting crises abroad (such as the Euro-Zone trouble and the "Arab Spring") and marketing to a targeted demographic.

In any event, there may soon be an opportunity for the news media landscape to be radically transformed. If that day comes, I hope those in charge can find feasible model upon which to build their business, that puts honest, insightful, and public serving reporting above profit taking.

The Debt Ceiling: What Happens if We Don't "Raise da Roof"?

Never before have we had a problem raising the debt ceiling in America. However, due to the current political environment at home and fear stemming from the debt crises in the Euro-Zone, we now have a problem. While conceptually there should be no reason to think that we won't raise our debt limit on time (the 30 year Treasury note has been trending down as the ceiling limit nears), the rhetoric grows more fierce by the day. So what could we expect to see if the ceiling is not raised in time? According to an article in The Economist, it is difficult to say.

It is clear that once the government is out of money, the Treasury will go into default. However, exactly what that means is up for debate. Some believe that bond interest rates will be quickly adjusted and most of us will go about our marry way without notice. However, this is only true if the fallout period is relatively short and the ceiling is raised shortly after the technical default. As we can see from the technical default in 1979, even a momentary lapse in payment can cost us. The '79 default is largely considered to be the result of systems and bookkeeping errors, however it ended up costing the government millions.

Unlike in the late seventies, the domestic and global economy is more interconnected than ever. Banks all over the world hold T-Bills (around 30% of total collateral) in their vaults, the Repo market employs almost exclusively treasuries, and the interest rates set by the Federal Reserve work in tandem with bond interest rates. Even a momentary spike in rates would almost certainly freeze the already fragile credit markets and impact lending to businesses and individuals that rely on credit to survive.

However, there are a few "back-up" plans, including Senator McConnell's creative resolution to increase the debt ceiling in installments that are systematically proposed by the President, whereon the Republicans would offer a disapproval resolution, which would then be vetoed by the President, and protected from and override by the Democrats in Congress. While far from the textbook way of solving disputes in Washington, we may be seeing more and more of this kind of political maneuvering in the days to come.

College and Jobs: America's Education and Professional Dilemma

As you may have heard, the Federal Government released the latest unemployment numbers last Friday, stating that the official nationwide unemployment rate rose to 9.2%. While that is up slightly from analysts' estimates, this number does not tell the whole story. The private sector actually created more jobs than expected in this last month, but those numbers were offset by sweeping layoffs in the public sector, leading to a net gain of only 18,000 jobs. However, the numbers reported do not take into consideration "underemployment", or those working part time that would rather be working full time. The national rate of underemployment is around 17%.

Particulars aside, the picture is grim. But why is it taking so long to recover from a recession that has been technically over for a year? Are companies simply not hiring? The answer is a complicated one, and overall it exposes more questions than answers:

As an economically conscious college student, I like to think that I am setting myself up for success since I am doing the "right thing" and going to a four year institution. While it is true that college grades have a dramatically lower underemployment rate than non-grads, the numbers are not all that great; around 8.7% underemployment for college grads last month. Many of my personal friends that recently graduated are experiencing a much more difficult time finding a job than they had anticipated. How could it be that someone with a stellar GPA from a great school and work experience can't find a job?

Another factor in the educational equation is debt. The school I attend is currently running at about $48,000 a year for tuition, room and board. If a student was to finance his education at my school, he would be left with nearly a quarter or a million dollars in student debt and (probably) no job to boot. Although my school is on the absolute highest end of the price spectrum, student debt nationwide did surpass consumer debt last year as the number one credit expense in America. So is a fancy education even worth it?

The underlying problem exists between the education market and the job market. In America, the most in-demand college degrees are in engineering (chiefly mechanical and electrical), accounting, and computer sciences. Additionally, a recent report on NPR (I cant remember the particular show, my apologies) revealed that job openings in hard science related jobs often go unfilled for over a year! So how can it be that college grads are unemployed while employers are sitting on a vacancy for 12+ months?

It seems that what we are told about education and what actually matters in the job market are two different stories. I know at my school we do not even offer classes in engineering, finance, or computer science! The only of the top 5 most in-demand majors that is offered is accounting, which one can be successfully trained, tested and registered for at a community college or professional program in half the time and less than one year's cost than at my four year, accredited university.

It seems to me that America's unemployment problem has roots deeper than the numbers may suggest. While enrollment at institutions of higher learning are at record highs, the numbers lead me to believe that getting your masters degree in philosophy is not going to increase your job prospects. There is no way we will see a significant rise in real employment until students can find cheaper methods to obtain the relevant and applicable knowledge employers are seeking.