The latest plan for the Euro, for the European banking system, for Greece, Italy, Portugal and for the union itself, is unlikely to work.

Here’s why.

Some economies require lower interest rates, some higher. Some need a stronger currency, some a weaker one. Some countries will need to run temporary deficits and some, surpluses. These fundamentals have been ignored in favour of a narrow solution to a particular symptom for a small group of countries. The Eurogroup has suggested that the fate of the Euro is directly related to the unity of the region, a broad and unsubstantiated claim.

The EFSF’s modus operandi is as yet unclear. What we do know is that we intend to establish and maintain a large scale cash flow CLO with the EFSF providing credit enhancement. It is hoped that surplus countries will step in to provide senior financing. The implied leverage will have serious consequences for the financial risks assumed by the EFSF. This is the main risk. Compounding this are credit correlation effects within the term structure of a single sovereign’s securities as well as across sovereigns. Such correlation effects could lead to unexpected losses even if average spreads in the underlying pool are unchanged. The risk management of the EFSF needs special attention. This is a technical issue that has escaped even some of the most sophisticated structured credit traders and the EFSF is at risk of overlooking it.

The credit rating of the EFSF must be questioned if it is providing first loss or subordinated debt to a levered structure. Depending on the implied leverage, small variations or haircuts in the underlying securities could decimate the EFSF’s balance sheet. Member countries’ implicit guarantees to the EFSF will be called and tested.

The 50% haircut negotiated with the banks holding Greek debt still require confirmation. Non-bank claim holders may not cooperate. There is no Chapter 11 process applicable to sovereign distress. The reorganization is therefore not analogous to a prepackaged petition and could be contentious. This is just in the cash securities. The situation in the synthetics is opaque since the quantity of side bets in bilateral credit derivatives is not fully quantified. It is not clear whether the proposed exchange is voluntary or not, and thus if it would represent a credit event under ISDA.

The recapitalization plan for the banking system contained a number, 9% and a date, 9 months down the road. The nature of the recapitalizations have not yet been articulated although bank recaps are known processes. Bank balance sheets remain opaque and or poorly understood and thus cannot be relied upon. Recapitalization to provide for current asset quality is hardly encouraging of bank’s propensity for the credit expansion Europe needs to revive economic growth.

For now at least, the measures are insufficient and not well defined. They are therefore far from a comprehensive solution. Expect failure within weeks.


Recommendations for the future:

Dismantle the Euro, or at least amputate the distressed bits. Free up exchange rates and interest rates as policy tools. Allow additional degrees of freedom for price discovery and resource allocation.

Establish an international Chapter 11 process for sovereign issuers. After centuries of sovereign defaults it is time to establish a process for orderly restructurings.

Create richer sovereign capital structures. The assets of the sovereign are not well defined, mainly because cash flow generation derives from taxes based on potentially fluid corporate and personal taxpayers. As a result, it is not easy to define an ordinal priority of claim against assets. It is, however, possible to define an ordinal claim on cash flows. Such cash waterfall structures resemble CLO structures. Such structures can be complex, as mentioned above, and need careful risk management. But by tranching the immediate liabilities of the sovereign rather than tranching the liabilities of an SPV owning the liabilities of a sovereign, some of the risks are mitigated. Or at least transformed to a less volatile (even if for reasons of serial correlation) form.

Cut marginal tax rates. Countries are basically purveyors of domicile. The elasticity of demand for domicile in a pre Globalized world was low. Today it is high. Reducing marginal tax rates will very likely raise tax revenues. Governments are cognizant of the impact of exchange rates on a country’s competitiveness, they have not yet come to the same realization on taxation.

Social security and welfare reform. Defined benefit schemes of healthcare, unemployment insurance, and pensions need to be reformed in favour of defined contribution schemes. It is beyond the scope of this discussion to delve into the details but the overriding concepts are to instill a greater sense of responsibility for one’s own economic fate, and to discourage the culture of entitlement.


The idea that a common currency implies common goals and aspirations, economic unification, strategic alignment and a common fate is not justified. The efforts of the Euro group have, if anything, exposed the deep differences and fissures within Europe. German pragmatism has clashed with French egalitarianism. Even the tenuous French and German bargain sparked irritation among the Italians. British meddling was warded off curtly by the French. Sometimes it is common ground that is most vigorously disputed.

A financial crisis in the Eurozone has been postponed due to the efforts of a gaggle of politicians overcoming the urge to assault one another and instead come up with an incredible plan to stave of immediate default by Greece and potential default by peripheral Europe.

Unfortunately the plan misses the most important point. To understand this, we need to understand the Chapter 11 process in US bankruptcy. Basically, the basis of a debt restructuring in the case of an indebted and distressed enterprise is whether the business is viable in the first place. Only then is a new capital structure proposed. The analogous question therefore is, is Greece a viable economy in current form and if not, what needs to be done to make it a viable economy. We are not talking about Greek debt yet, only if it is a going concern. The answer to the question is, no, Greece is not a viable economy in current form and what needs to be done is to have a viable tax collection mechanism as well as structural reform in the form of a 30 – 40% deflation in Euro, or less painfully, a Drachma that can be immediately marked to achieve such a deflation. This is to make Greece competitive. Any debt restructuring without such ‘structural reform’ is merely refinancing a non-viable economy.

So it is a good thing that markets are rising once again. We need higher valuations to begin shorting. Again.

What should we be buying or selling? As markets rise, it makes sense to start shorting cyclicals again. The natural candidates will be expensive Emerging Market listings of businesses exposed to Europe and the US. The usual suspects are the exporters. The natural candidates to be buying remain in the resilient luxury sector as well as in the export sectors exposed to Emerging Market economies but listed in depressed developed markets such as Europe. Its an old story that will one day reverse but for now the game of chicken carries on.

Has anyone read the actual Euro Summit Statement?

Item 3, The EU must improve its growth and employment outlook… Very laudable. A roadmap to achieving this would be even more useful.

Item 4 is a statement of affirmation to continue with fiscal consolidation and reform. What kind? You mean like Maastricht? Well there were no details so we can optimistically hope for Maastrict type criteria or pessimistically wait for Godot.

Item 10 is an admission that the only chaps responsible for policing the austerity policies in Greece will be the Greeks. Time will tell how useful this is considering the Greek’s abilities thus far in tax collection.

Item 12 actually has numbers in it which is a guarantee of 100 billion euros of additional financing till 2014. The haircut on current Greek debt is also specified here, a whopping 50%. The precise language speaks of an invitation to develop a voluntary exchange at a nominal discount of 50%. The appropriate response of a creditor might be, no thanks I mate. You can pay me the whole thing. Presumably the EU has convinced the banks to agree but how about other bond holders? And what about CDS? Perhaps someone would like to consult ISDA on their take on this so-called voluntary exchange.

Item 13 is a step in the right direction. It commits the future cash flows of Helios and other privatisation revenues to reduce indebtedness. Hope they can make this stick. Especially as they plan that these cash flows will restore the EFSF. Cash trapping and cash waterfalls are a great concept for security and risk tranching.

Item 16 has all member states solemnly reaffirming their inflexible determination to honour their individual commitments to unspecified reforms and fiscal conditions. Its more useful to specify something you require unwavering adherence to. As opposed to ‘I promise to be good, honest.’


Item 19 talks about leveraging the EFSF basically requiring the EFSF to provide subordinated debt financing to support further leverage. This would provide more firepower to the bailout efforts. Consider this, however, that the EFSF commands a AAA rating, alright, so that means they are as solid as some mortgage backed CDO tranches, but by providing subordinated financing to insolvent sovereigns, the potential for loss becomes significant it not high. Even the a ratings agency would not be so blind as to not downgrade the EFSF. Providing guarantees to the EFSF would render it a mere conduit. The Germans and French may as well wire cash to the Greeks. The administrative costs that would save are significant.

Item 21 is a bit precarious. It calls for the Eurogroup to finalise terms and implementation in November, basically implying that terms have not been finalized and that nothing is yet under implementation.


Items 24 through 29 are statements of intent regarding economic and fiscal coordination, not a concrete plan. The intent is laudable but there are no action points.

The rest is governance which the Euro members can spend up to March 2012 debating.

Not a mention of the 1 trillion euros.

But markets are up today and not by a bit. Its total and utter relief that the Europeans have at last found resolution to the credit woes of Greece, Italy, Spain and Portugal. For Greece at least there is a respite. But while they remain in the Euro they are commercially inefficient and are likely burning through the capital lent them. Time will tell.

The Euro Summit Statement is a true product of Brussels, long on words and short on details, very few numbers, very few action points, very few deadlines, and lots of rhetoric about principles, broad objectives and a warm fuzzy feeling. For now the markets have forgotten the fear of the last 2 months. But absent a more well defined, clearly specified, quantified and milestoned plan, we’ll be back here if not in months then inside of 3 years. Bet on it.

I’ve been in Asia for a year now and I still don’t get the double handed business card pass. When an Asian does business in the UK, I don’t see them in bowler hats and tails with a James Smith cane or umbrella. Only James Bond villains dress like that. So I have to assume that any gwei lo in Asia bending over at the waist and proferring their business card like some sacred offering must be some kind of villain.

Its also highly impractical. In a large group I tend to deal my cards out like a croupier at the Rendezvous Club. In smaller groups I use a single hand exchange where I deliver between thumb and index and receive between index and mid. The counterparty can symmetrically engage. Its quick and efficient. If everyone in the room practices the double handed delivery we’d take all day to exchange business cards. And if we also have to bow, the likelihood is that the taller gwei lo is going to head butt the oriental on the way down. In my book assaulting a counterparty is not a good start to a business relationship.

The Occupy Wall Street protestors are dreaming if they think they’ll find any perps in daylight or that signs and slogans are a substitute for garlic, a crucifix, holy water and a sharp wooden stake.

But they miss the point. Principal businesses but risk shareholders’ capital which while dastardly only punishes those wealthy enough to own shares or silly enough to entrust their wealth to a fund manager or pension trustee.

No. The villains are those who run agency businesses. These are the chaps who insist that they work for you and your interests while placing rather too big a bet on red with your money while the croupier chants les jeux sont faits. Generally I avoid eating food cooked by emaciated botulism-wracked chefs. If you want to represent me, put up some capital ahead of me or alongside me. Don’t ask me for trust as refusal may offend.

When principal businesses blow up, its suicide with collateral damage. I’ve yet to see an agency business fail. When they do fail, they fail their customers, which is a bit more like premeditated homicide.

Ask the investors who owned AAA CDOs, securities sold to them by an agent, constructed by some hedge fund manager looking for unsuspecting prey, and with a shelf life shorter than sashimi on a tropical afternoon.

Look at the conspirators after the fact, the entire distribution chain which ends in bank sales desks and relationship managers stuffing German banks and insurance companies as well as private high net worth individuals alike. This is old news but these are crimes that remain unpunished.

Decrying the bailouts is barking up the wrong tree. Unless one is happy to live with more Lehman style collapses. And why not? Why has the capitalist system lost its stomach for creative destruction? Why are we trying to save every lemming like bank from a Greek default? Because they helped us buy a house we could not otherwise afford? Oh. That’s why We have to bail Them out? Fair enough then.

String up the central banks. Each and everyone is trying to engineer the right amount of inflation to erode the huge pile of sovereign debt. Controlled demolition is best left to engineers not central bankers. Recall how they collectively missed the last blow up royally when even a child looking at the Miami skyline could tell you that the cranes hadn’t moved an inch in hours. These central bankers mean to debase the money that even now sits precariously in your bank account as they go about printing away government debt. These are the chaps who cut interest rates and extend massive swap lines every time a Golden Sacks or Morgue M Stanley threatens to go belly up. Phil Silvers’ Sgt Bilko did this once at a casino. In the end someone stopped giving him money and gave him a revolver instead. All suicidal tendencies magically vanished. I’m sorry but a golf game where every third shot is a mulligan simply isn’t cricket. Its not even bloody golf.

And next time an American wants to buy colorful plastic novelty items made in Shenzhen, hold the vouchers, pay for it with real money instead please. The Americans misunderstand the Chinese. The Chinese couldn’t care less about the exchange rate beteen US treasuries and RMB, they care very much about the exchange rate beteen US treasuries and stuff made in the USA. Think about it. The Chinese are the ones who got the raw deal. They thought they were exchanging 10 thousand pairs of cotton knickers for an Apple iPad. Now its going to be 250 thousand pairs of knickers. And the iPads are being made by a Korean company with a factory in Guangdong anyway. You don’t see the Chinese Occupying PuDong or TianAnMen do you? Granted the last time they tried that it didn’t go too well.

Advice to Occupy Anything movements. Anyone who’s ever run up a ton of debt to buy a house they couldn’t afford, clothes they could never fit their lardy behinds into, cars they never had the reflexes to drive, or other novelty paraphernalia, should pack it up and go home. Do some homework. Learn some finance and economics; not from CNBC which thinks its all about handwaving, yelling as loudly as possible and proclaiming the end of the world as we know it on the eve of every recovery, learn it from first principles. Its not that hard. If you borrow you have to repay. No matter who you borrow from, ultimately you only borrow from your own future. Its that simple. There is nothing wrong with the American dream but there is no need to turbocharge it with recreational drugs such as a Home Equity Line Of Credit. And don’t take all that the politicians are saying at face value. Vote wisely. America’s bipartisanship is an ugly manifestation of what happens when the pie shrinks. The Europeans disarray is the manifestation of the desperation as the ship sinks.

We all lived beyond our means. We were aided and abetted by those who lent or invested beyond their means. Some of us will have to save more and consume less. Some of us will have to take losses on our loans and investments. Its not the end of the world. But for many it will feel like it. For those out of work, who’s skills are no longer relevant in a more sober and rational world. Politicians need to get real and help these chaps. If they don’t get that help, a man has to live. They will do their part for the free market and send an economic signal to their congressman. Possibly by holding up a liquor store and getting some free calories and smokes. Now that insider trading is no longer feasible.