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« Weighing the Week Ahead: Will the Volatility Continue? | Main | Weighing the Week Ahead: Waiting for the ECB »

November 16, 2011


Angel Martin

Mike, thanks for the pointer to the GMO paper. I will look at it some more but i think it is already obsolete wrt Italy because their current yields exceeds the 6% used in the "high interest rate scenario", in that scenario the paper has debt to gdp rising out of control.

For options strategy, i'm using shorter term 1-3 months OTM puts rather than leaps because all big financial crises in the past have occurred in the spring or the fall, so i only want to own the options during those periods. I'm prepared to lose as OTM options expire until either this trade works, or I see something that changes my assumptions on the outcome. Holding options only for the spring and the fall reduces the cost of the strategy by approx one half.

On your idea of "get the policy right, make a lot of money..." I'm not sure that's right. For this kind of thing, usually, the sequence of events surprises everyone, even if the outcome doesn't.

In 2008, if one had known in advance everything that the authorities would do wrt the TARP, TALF, TAF, Fed facilities, Fed balance sheet expansion, AIG, Fannie, Freddie, short sale bans, ZIRP, conversion to banks, equity investments in banks, etc... it might have led an investor to imagine that the crisis would be contained and not short the hell out of US financials, which was the right positioning.

Angel Martin

Jeff, I think the difference in our forecasts come down to:
-this situation can be resolved by more debt (leveraged with international creditors)
-this is excess debt that can only be cured by haircuts

Given that, check out this discussion from early 2010. The participants are Hugh Hendry and Joseph Stiglitz.

Stiglitz may be a nobel prize winner and one of the heavyweights of the economics profession, but almost everything he says has turned out to be wrong...


Angel -- Thanks for sharing your analysis. For the record, I would note that you made not only the three assumptions that I said would be required, but the additional assumption of a "bubble" level. There is an implied fifth assumption about timing.

The simple arithmetic approach is static and therefore too simple. What I see as the flaw in your argument is the "no one has that kind of money to give away."

That is not what I am suggesting will happen. It is not what happened in the US programs, despite the portrayal as bailouts. I think that various parties will make a calculation of self-interest and participate in a way that will be profitable for them. Each decision will be a piece. Some of the actions may be leveraged.

Another thing that I am not saying --- I understand that you could be correct in your speculative calculation. I just think that you are on the popular side of a trade that defies accurate calculation. Meanwhile, I think the other side is more likely.

We shall see.


Mike C

Angel, thanks for the are probably right which makes the situation even more precarious than I thought. If you haven't, you should check out the GMO site...they have an excellent white paper posted titled the Arithmetic of Sovereign Debt.

Just curious, are you just buying front-month way OTMs each month betting when the move comes it will be fast and furious and willing to just lose in the meantime? Why not just buy FXE LEAP puts?

Anyways, overall interesting discussion, and this situation is probably a great example that whoever gets the ultimate policy decisions right here has the potential to make alot of money as the outcomes that flow are pretty easy to get right if you get the policy decision right. I'm not quite as convinced of the ECB monetization but perhaps I'm somewhat naive they'll stay firm to what they've previously said.

Angel Martin

Jeff, wrt haircuts, one estimate I did assumed that since Belgium and France are "on the bubble" for joining the PIIGs; that they represent the maximum combinations of deficit and debt that markets would sustainably finance. That is, for sustainability, the PIIGs would need haircuts to get their debt and deficits reduced to no worse than France, or Belgium (or a linear combination of the two). The haircut to get to the ratios of Belgium or France was 1.6 trillion euros.

If that really is the size of the haircut, no-one in europe or anywhere else has that kind of money to give away, so I conclude that the resolution to this thing is going to be some combination of debt monetization and default.

I expect that there will be significant monetization attempted by the ECB. (I think we are now past the point where eurozone announcements to consider a transfer union, or eurobonds, or a common finance ministry... etc. can move markets much). If germany demands an early halt to monetization, at that point i expect forced defaults and euro exits. If germany allows the monetization to run, I expect a euro hyperinflation.

Even if the end of the eurozone is deflationary, i expect that the ensuing recession and resulting economic chaos that would follow would drive the euro down. The eurozone is close to recession now anyway. With forced exits, the situation will only get worse.

Once the euro drop starts in earnest, I expect an initial devaluation of at least 30% occurring in less than 3 months. A 30% devaluation is on the low side compared to historic norms. Recall, that the pound fell almost 30% against the dollar in late 1992 after exit from the ERM.

Given the assumption of a big decline in a short period of time, I am using out of the money options to play this, and have been doing so since late last fall. As a result, I've made money this fall, but lost in the spring and last year.

For Mike C's benefit, note that the eurozone in aggregate would NOT pass the "no worse than Belgium or France" deficit/debt test.


Angel - The need for additional haircuts is a calculation involving economic growth (thus revenue), interest rates, and spending levels. All three are in flux and mostly getting worse. I don't have an answer to your question and the ones I have seen are speculation.

Meanwhile, even if there are haircuts, the thesis of my article is that the stakes are high enough for many deep-pocketed players that an eventual solution is likely to be found.

You have been making money on your short euro posture, since the process continues to grind along slowly. What is your target? More importantly, what is your scenario for a final resolution?

I continue to enjoy your comments, and I'm sure that readers do as well.


Mike C

It is in the financial interest of the entire world to reach a solution.

This seems pretty general. What constitutes a "solution"? What will the solution be ccmprised of in your opinion? A series of "voluntary restructurings" like Greece across all the PIIGs (see Angel's question). Will the Germans finally cave and behind the scenes tell the ECB to buy up all the sovereign debt. Some analysts I have read have argued convincingly if the Eurozone were a single entity like the United States or Canada they'd be just fine but this would necessitate fiscal transfers from strong regions like Germany to the weaker neighbors like Italy and Spain. Can the political leaders of Germany sell their voters on the need to provide funding for Italy and Greece?

So if you are willing to take a stab at it, I think it would be interesting to see what concrete specifics you think will occur as part of the "solution"? Do you have an opinion on whether the ECB will eventually buy up all the sovereign debt?

The ECB has balked at doing this – rightly so, I might add (in a brief role as policy advocate). Their position is that the fiscal agent is elected by a democratic process and must solely take on the responsibility of achieving macroeconomic objectives outside of price stability.

If they finally fold, there is huge money to be made in stocks, commodities, and gold to the upside just like when the Fed did QE 1 and QE2.

Angel Martin

Jeff, as previously discussed I disgree with your contrary assessment on europe.

One reason is that I see the need for significant haircuts for the other PIIGs (including Spain and Italy).

Jeff, what is your assessment on the need for haircuts for any of the other PIIGs?

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