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Tuesday, November 15, 2011

Wishful Thinking

The Europeans have finally announced a solution to their debt problem: We Wish We Had a Couple Trillion Dollars. Now to peddle the plan to the Chinese, the IMF, the Brazilians and the Americans. None have yet expressed much interest.

It reads a bit like Dickens. The once wealthy, now profligate landlord, goes hat in hand, to who used to be his tenant, looking for a loan, promising to be more austere in the future.

Part of the deal calls for banks to revalue their holdings of Greek bonds to fifty cents on the dollar. But this is not to be labeled a default or else those who sold credit default swaps (CDS) as insurance against such an event would have to pay. Now if I’d bought bonds at 100 and was only to get 50 at maturity, I’d consider that a default. On the other hand, those who bought bonds at 30, where they were recently trading, may have scored a home run.

What did buyers of CDS get for their money? Probably a lawyer or two are lining up for the coupon date. Coming soon will be either huge payments settling, or write-offs against those trades. Perhaps interest rates should actually reflect the likelihood of default.

European sovereign debt is looking increasingly like the no-doc mortgages that helped blow up the housing industry. “Of course it’s AAA,”say the bankers. “Countries don’t not pay.” Privately however, the cost of Credit Default Swaps tell a different story. Once the bonds are sold the real game goes on in the unregulated markets of derivative trading where institutions bet on the likelihood of higher interest rates if not outright default. This has been highly profitable (so far).

Who’s next? So far the “agreement” cost Greece its government and leaves them with a ratio of debt to GDP, after the write-down, of a still unsustainable 120%. Attention has turned to Italy, where interest rates spiked to the highest since 2008 and have cost Silvio Berlusconi his job as well. Who is next in line? Will it be France or the US when the debt commission fails to find $1.5 trillion in savings over the next decade?

US markets initially rose on the day Europe gave voice to their wishful thinking. But that rally may have had more to do with US GDP being estimated higher at 2.5% and some fairly robust earnings announcements. So far twenty-seven of the thirty Dow stocks have reported third-quarter earnings. On average, earnings rose 22% on 13% higher sales compared to the same quarter a year earlier. This continues the good news from the second-quarter when earnings rose 14% on 10% higher sales. There is also some evidence bank lending is increasing.

Though Europe looks like they might be in one, the US may avoid falling back into recession. In the meantime, stocks are very inexpensive relative to interest rates.