Neosho Capital: The Ongoing Eurozone Debt And 'Risk-Free Rate'

by: Chris Richey, CFA

A Tree Falls in the Forest and No One Cares, Even If They Heard It

Greece defaulted in the first quarter of 2012 and pretty much everyone shrugged and then went about their other business. Private sector Greek sovereign debt holders were informed in early March that, whether they like it or not, they'd only be getting about 30% of their principal returned.[1] While we predicted last quarter that the Greeks would default, what we did not predict was the indifference to the event. Perhaps after all the talk and worry about such an event, investors and financial types worldwide were well prepared psychologically for its actual occurrence. The default may have been "orderly." but it was definitely a default: all holders of credit default swaps were paid in full per the terms of their contracts. We note that the Greeks will hold national elections in early May, which may result in a coalition that could repudiate the promises of austerity by the current regime.

Perhaps another reason the investing world was so ho-hum about the Greek default was the realization that Greece might only be the warm-up act for the headliner, Spain. Greece only accounts for 2% or less of total EU GDP, Spain accounts for about 10% of EU GDP, so it will be harder to be as blasé about Spain as it was for Greece. While yields on Spanish bonds have yet to reach stratospheric Greek levels, they remain in the 6% range, perilously close to the magical/deadly 7% level presumed to represent the tipping point into the abyss of unsustainability. The Spanish budget deficit of 5.3% is above the 4% rate targeted by EU, Spanish, and IMF officials, mainly due to the profligacy of Spanish municipalities and provinces. The central government has threatened to "take over" the local budgets in order to bring spending under control, an act that will certainly not go down well in the "Autonomous Regions" of Catalonia (i.e., Basque country) and Valencia.

With Spanish unemployment running at 23% and the total sovereign debt to GDP ratio at 90%, Spain is now undertaking extreme measures to combat its potential insolvency, including banning cash transactions in excess of €2,500 in order to reduce tax evasion and requiring Spanish citizens to report foreign bank account balances. In total, the Spanish government believes these measures will bring in a total of about €8 billion against a sovereign debt in the area of €1 trillion, or less than 1%.[2] Why, might you ask, would Spain undertake measures that will probably only encourage even greater and more open disregard for their laws? Certainly not for their fiscal impact, but more for the real audience of these measures: the other members of the EU, who will ultimately have to approve a bailout of Spain. The difficulty with bailing out Spain is that it would completely swamp the EU bailout fund, leaving nothing for the Portuguese, Irish, Belgian, or, worst of all, Italian economies. The next time a tree falls in the EU forest, there will be no ignoring it.

The "Risk-Free" Rate

This brings us to our last topic of the quarter: the pivotal "risk-free rate" upon which Capital Asset Pricing Model ("CAPM") is based. CAPM has been the single most important model for explaining the pricing of financial assets and is built upon concepts of investor rationality and equality, liquidity, costless transactions, no taxation, instant and universally known information, and other silly assumptions. In equation form, the CAPM looks like this:

E(Ri) = Rf + β(E(Rm) - Rf)

In everyday language, CAPM states that your expected rate of return on an asset is equal to the Risk Free Rate plus the Risk Premium of that asset. Or, in even plainer language, you can expect to get paid more for taking a risk greater than the return you'd get for your safest investment alternative.

Our professors and textbooks defined the vessel for that "risk-free rate" as sovereign debt, i.e., the IOU's issued by the U.S. government, the Bank of England, Bank of Japan, etc. Of course, even in our pre-professional naïveté, we understood the assumptions of "no taxes, complete rationality, costless trades, etc." were obviously unrealistic, much like in 5th grade we understood that plaster volcanoes filled with baking soda and set off with vinegar were not really how volcanoes worked. However, at the time we were taught CAPM and for many years afterwards, we did not realize that the whole concept of the sovereign's debt as being "risk-free" was a fantasy as well. After all, we were told, these government entities controlled both the printing presses and the power to tax their citizens.

It should be clear to all in the wake of Greece, and with the possibility of further national defaults in the horizon, that the "risk-free" description of sovereign debt is not just a stretch, but fatally inaccurate. In their book, "This Time It's Different: 800 Years of Financial Folly", authors Reinhart and Rogoff catalog dozens and dozens of sovereign defaults by sixty-six countries across five continents going back to the 1300's.[3] Starting with England's default on its debts to Italian creditors in 1340 under the reign of King Edward III and extending on up to the global credit crisis of 2008/2009, Rogoff and Reinhart make it plain that far from being an exception, sovereign defaults are the rule. Acknowledging that pre-Industrial Age economies may be an unfair comparison to our modern industrial and post-industrial economies, Rogoff and Reinhart demarcate 1800 as a fair starting and provide the following chart to demonstrate their point:

(Click to enlarge)

The vertical axis is the percentage of independent states in default or restructuring in a given year, and the horizontal axis is the year. From the chart, we see that over the past 212 years at least 10% of all independent states are in default or restructuring, up to the peaks of between 30% and 50%.[4] Only in the apparently magical years of between 1820 and 1830 do we find a period where it can be said that holding sovereign debt was a "risk-free" investment, and, even then, it would have been something of a stretch. What is surprising is that given the origins of CAPM and its risk-free sovereign debt proposition were in the late 1950's and early 1960's, less than ten or twenty years from a period when half of all debt-issuing nations were in default, we have to wonder what possessed the fathers of CAPM (Bill Sharp and Jack Treynor building on the work of Harry Markowitz) to believe that sovereign debt was anything close to risk-free.[5]

We also wonder, given both recent and more ancient history, why any thoughtful observer of finance would believe there is anything such as a risk-less asset. Yet, highly educated people without much practical experience do not let reality get in the way of elegant theory backed by equations with Greek letters. For example, the IMF warned in its new Global Financial Stability Report that "[i]n the future, there will be rising demand for safe assets, but fewer of them will be available, increasing the price for safety in global markets." The IMF went on to identify $74.4 trillion (such precision!) of "safe assets" such as gold, investment grade government bonds and corporate debt, and covered bonds. Thus, according to the highly paid and eminently educated experts at the IMF, gold is safe at $1,600 an ounce, despite the fact that those that purchased it at $1,800 an ounce have now lost 11% of their investment. Also, they deem "investment grade" sovereign and corporate debt are safe, though we note that Greek bonds were "investment grade" two years ago and Lehman Brothers was a AA credit just minutes before collapsing. Finally, according to the IMF, covered bonds (debt secured by mortgages or public sector loans) are safe, although the U.S. housing crisis would tell you otherwise and we will simply refer you back to Greece as far as loans guaranteed by the public sector.

"This time" is never different and it is a good indicator that things are about to take a turn for the worse when you begin hearing arguments to the contrary. There is no such thing as a "risk-free" or "safe" asset, whether it is in the form of a security (and, ultimately, a dollar bill is a security[6]) or in the form of a real, tangible asset, such as farmland, a bar of gold, or an office building. Investing is the art of choosing between less risky and more risky assets, but not risk-less assets. While the underlying concept behind CAPM is theoretically alluring (a precisely quantifiable spectrum of risk which may be exploited to the extent of the investor's courage), the reality is that even the most timid location on that spectrum is still fraught with substantial and largely unknowable risk, including having that investment become worthless.

1 Of course, the public sector holders of Greek sovereign debt (the EU, the IMF, and the European Central Bank) were excluded from the de facto default. As Mel Brooks' Louis XVI said in the movie "The History of the World - Part I", "It's good to be the King."

2 Total Spanish government debt (central and local) is roughly €700 billion and the debts of Spanish banks, which we believe will ultimately "put" onto the central government, total to roughly €300 billion.

3 Kenneth Rogoff and Carmen Reinhart, This Time It's Different: 800 Years of Financial Folly, (Princeton University Press, 2009).

4 We'd also like to point out that "de facto default" through currency debasement, i.e.. paying in full but paying with an inflated and, therefore, less valuable form of payment, is not included in this definition of default, yet can represent just as real a form of less than full repayment.

5 However, we will point out that "return-free risk" is very much a reality, not just a fair assumption, in the current environment in which one-year and ten-year U.S. Treasury obligations yield less than 0.2% and 2.0%, respectively. With even a heavily-doctored Consumer Price Index of 2.5%, at a decades low, does any holder of these assets believe they are actually achieving any sort of real return?

6 Every nation now operates under "Fiat Money", that is, paper bills and coins that are declared by their issuing government to have a nominal value as a mechanism of exchange. As such, when the printing presses and metal stamping machines are running at high speed and the amount of currency in circulation expands at a pace faster than the growth in the underlying value of the nation's economy, it inevitably devalues that currency (for example, the first issuer of fiat money, China's 10th Century A.D. Song Dynasty, or, later, Germany's Weimar Republic, particularly 1923 to 1933).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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