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Leveraging & Contagion

|Includes:EF, SPDR Gold Trust ETF (GLD), TBT
Last week, news broke regarding the EU bond deal. EU policy makers announced a deal whereby private investors (a.k.a. “banks”) take a 50% haircut and the European Financial Stability Facility (“EFSF”) is leveraged four or five fold. Clearly policy makers are working toward ensuring that the Greek crisis remains contained. However, the haircut represents an acknowledgement that the situation is not good, and it appears that leveraging is required because finding additional money is not an easy of a task. None of this appears to address the concern that Ireland, Portugal or other sovereign “might-could” seek a similar deal.   
 
Acknowledgement that the situation is dire is a positive development. I say this because as a risk manager, real risk management occurs in the discussion. Often a “holdout” bogs down leadership with details of right or wrong, skirting the issue and/or confusing the decision makers. The proverbial elephant in the room is never discussed. It goes without saying - risk management is nested in probabilistic events. Pretending an exact science is to ignore the probabilistic roots of risk management.   
 
It is positive in the sense that change can now happen. Change grounded in real economics tends to be for the better. To understand the change required, I highly recommend reading the September IMF Global Financial Stability Report (web link http://www.imf.org/external/pubs/ft/gfsr/index.htm).   

Basically, there are a few points I would like to highlight in today’s newsletter. From the Iceland experience, we learned that GDP vs. bank asset size matters. From the Greek crisis, we learned that debt to GDP matters. Lastly, from both examples, large international banks relying on wholesale financing arrangements experience sudden liquidity issues when large deposits are relocated.    
 
Considering the above, it stands to reason that if liquidity is provided by a sovereign to support a large financial institution, the debt to GDP ratio as well as the sovereign's credit standing is impacted.  For example, data shows that Italy while having the lowest concentration of bank assets (compared to GDP a little more than 50%), it has the highest debt to GDP ratio – in excess of 100%. As such it is important to understand last week's haircut announcement and subsequent leveraging of the EFSF.  
 
As with any haircut, haircuts impact cash on hand. Replenishing the cash calls on the liquidity supporting the margin call. In the real world, variance margin is cash.  Basically, variance margin is a cash call to support overnight changes in value.  A cash call has to be met or the asset is liquidated and a claim filed.  In leveraging, timing is everything. Leverage works only when the cash “in” versus cash “out” vary over time. This is why market stress forces de-leveraging – correlations approach one (1).  Real market stress follows a margining process that brings into the here-in-now the net present value. In other words, using a leveraged facility to support sovereign debt would only work if only one sovereign requires support.  This is similar to an issue regulators face regarding settlement risk. Having a probabilistic amount of capital will only address the conditions when the settlement failure is smaller than the set aside - in this case, one or two to of the sovereigns facing stress. 

So why leverage at all?  There is a chance it will work. As in any game, adding time to the board should help in putting up more points.  The most likely scenario is that leveraging provides more time for policy makers to find the cash.  In my humble opinion, the leveraging of the facility actually presents a contagion “catalyst”.
  
In other news, US natural gas has managed to rally thru the downtrend that has been in place since early June. The rally opens upside targets as expected given the beginning of the winter heating season. Crude has pushed thru the downtrend that his been in place since the May $114.83 highs and appears to be consolidating in low 90’s.  Gold & silver have bullish stories as well. I think in the weeks ahead we will hear more about the pressure on the Super Committee to provide a viable debt and deficit reduction plan. Additionally, the surrounding chatter regarding European crisis and the US Presidential race will only “amp” the issues at hand. Overall, I remain cautious.      
 
Thank you for reading my newsletter - have a great weekend!
 
Kind regards,
Frank Hayden
 
email: frank@riskanddecision.com
Stocks: GLD, TBT, EF-RETIRED