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EUROPE HAS PROBLEMS

EUROPE HAS PROBLEMS

“He who asks is a fool for five minutes, but he who does not ask remains a fool forever.”
-Chinese Proverb

DEBT LEVELS IN G-7 COUNTRIES

We continue to be positive on Asia. One of the major reasons we currently favor Asia is the fact that public debt in the G-7 nations (U.S., Britain, France, Canada, Germany, Japan, and Italy) is expected to be over 119% of their combined GDP in 2014; a stunning figure.

Imagine owning a business with gross revenues of $1 million, outstanding debts of $1.19 million, and cash flow from your business to service the debt of about 5% of gross revenues. This means the company has only $50,000 per year to service the outstanding debt. If the average interest rate on the company’s debt is 5%, the debt load on your company would be increasing your debt each year. Your repayment of $50,000 would be less than your interest expense about $59,500.

Imagine further that you forgo using the cash from the business for debt payment, and choose to borrow more to keep your debt payments current. Bankruptcy would seem to be only a matter of time for the company. At some point, finding suckers (lenders) will be difficult.

DEBT LEVELS IN EMERGING ASIA
By 2014, emerging Asia is expected to see their debt burden decline from 35% of GDP to 32% of GDP.
THE CRISIS OF THE EUROPEAN SOCIALIST MODEL

Greece’s problems have been widely reported. It is rumored and expected that Ireland, Spain, Portugal, and Italy may soon join them in asking for handouts from their neighboring European countries.

The problems stem from the countries’ highly-paid government employees and the long-term promises made to government employees. Relative to the private sector, public sector employment does little to generate GDP growth. The European welfare states handed out politically-expedient gifts to large public employee unions, and now the countries are facing bankruptcy as a result.

In a recent London Telegraph article by Ambrose Evens-Pritchard, the author captures German sentiment by quoting an article in a German newspaper, theFrankfurter Allgemeine. The German paper asked why taxpayers should bail out the debts of a country that thinks it an outrage to raise the retirement age to 63. “Should Germans have to work in the future until 69 instead of 67 so that Greeks can enjoy early retirement?”

Evans-Pritchard goes on to say, “Europe’s leaders still refuse to face the awful truth: that monetary union is unworkable as constructed. That different labour markets, different sensitivities to interest rates, different economic structures, have caused the gap between north and south to grow ever wider; that a chunk of Europe…is on the cusp of a debt deflation spiral.”

This spells big belt-tightening in the aforementioned five heavily indebted European countries. It also puts the entire Euro community in danger of losing its common currency over time; it is possible that several countries will have to leave the Euro and reestablish their own currencies at devalued levels.

Below is a link to an important New York Times article about how global investment banks helped Greece and other countries hide the truth about their finances for many years.
New York Times

Wall St. Helped to Mask Debt Fueling Europe’s Crisis
By. Louise Story, Landon Thomas Jr., and Nelson D. Schwartz
Published: February 13, 2010

Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece and undermining the euro by enabling European governments to hide their mounting debts.

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting.

The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.

It had worked before. In 2001, just after Greece was admitted to Europe’s monetary union, Goldman helped the government quietly borrow billions, people familiar with the transaction said. That deal, hidden from public view because it was treated as a currency trade rather than a loan, helped Athens to meet Europe’s deficit rules while continuing to spend beyond its means.

Athens did not pursue the latest Goldman proposal, but with Greece groaning under the weight of its debts and with its richer neighbors vowing to come to its aid, the deals over the last decade are raising questions about Wall Street’s role in the world’s latest financial drama.

As in the American subprime crisis and the implosion of the American International Group, financial derivatives played a role in the run-up of Greek debt. Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere.

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting.

The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.

It had worked before. In 2001, just after Greece was admitted to Europe’s monetary union, Goldman helped the government quietly borrow billions, people familiar with the transaction said. That deal, hidden from public view because it was treated as a currency trade rather than a loan, helped Athens to meet Europe’s deficit rules while continuing to spend beyond its means.

Athens did not pursue the latest Goldman proposal, but with Greece groaning under the weight of its debts and with its richer neighbors vowing to come to its aid, the deals over the last decade are raising questions about Wall Street’s role in the world’s latest financial drama.

As in the American subprime crisis and the implosion of the American International Group, financial derivatives played a role in the run-up of Greek debt. Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere.
In dozens of deals across the Continent, banks provided cash upfront in return for government payments in the future, with those liabilities then left off the books. Greece, for example, traded away the rights to airport fees and lottery proceeds in years to come.

Critics say that such deals, because they are not recorded as loans, mislead investors and regulators about the depth of a country’s liabilities.

Some of the Greek deals were named after figures in Greek mythology. One of them, for instance, was called Aeolos, after the god of the winds.

The crisis in Greece poses the most significant challenge yet to Europe’s common currency, the euro, and the Continent’s goal of economic unity. The country is, in the argot of banking, too big to be allowed to fail. Greece owes the world $300 billion, and major banks are on the hook for much of that debt. A default would reverberate around the globe.

A spokeswoman for the Greek finance ministry said the government had met with many banks in recent months and had not committed to any bank’s offers. All debt financings “are conducted in an effort of transparency,” she said. Goldman and JPMorgan declined to comment.

While Wall Street’s handiwork in Europe has received little attention on this side of the Atlantic, it has been sharply criticized in Greece and in magazines like Der Spiegel in Germany.

“Politicians want to pass the ball forward, and if a banker can show them a way to pass a problem to the future, they will fall for it,” said Gikas A. Hardouvelis, an economist and former government official who helped write a recent report on Greece’s accounting policies.

Wall Street did not create Europe’s debt problem. But bankers enabled Greece and others to borrow beyond their means, in deals that were perfectly legal. Few rules govern how nations can borrow the money they need for expenses like the military and health care. The market for sovereign debt — the Wall Street term for loans to governments — is as unfettered as it is vast.

“If a government wants to cheat, it can cheat,” said Garry Schinasi, a veteran of the International Monetary Fund’s capital markets surveillance unit, which monitors vulnerability in global capital markets.

Banks eagerly exploited what was, for them, a highly lucrative symbiosis with free-spending governments. While Greece did not take advantage of Goldman’s proposal in November 2009, it had paid the bank about $300 million in fees for arranging the 2001 transaction, according to several bankers familiar with the deal.

Such derivatives, which are not openly documented or disclosed, add to the uncertainty over how deep the troubles go in Greece and which other governments might have used similar off-balance sheet accounting.

The tide of fear is now washing over other economically troubled countries on the periphery of Europe, making it more expensive for Italy, Spain and Portugal to borrow.

For all the benefits of uniting Europe with one currency, the birth of the euro came with an original sin: countries like Italy and Greece entered the monetary union with bigger deficits than the ones permitted under the treaty that created the currency. Rather than raise taxes or reduce spending, however, these governments artificially reduced their deficits with derivatives.

Derivatives do not have to be sinister. The 2001 transaction involved a type of derivative known as a swap. One such instrument, called an interest-rate swap, can help companies and countries cope with swings in their borrowing costs by exchanging fixed-rate payments for floating-rate ones, or vice versa. Another kind, a currency swap, can minimize the impact of volatile foreign exchange rates.

But with the help of JPMorgan, Italy was able to do more than that. Despite persistently high deficits, a 1996 derivative helped bring Italy’s budget into line by swapping currency with JPMorgan at a favorable exchange rate, effectively putting more money in the government’s hands. In return, Italy committed to future payments that were not booked as liabilities.

“Derivatives are a very useful instrument,” said Gustavo Piga, an economics professor who wrote a report for the Council on Foreign Relations on the Italian transaction. “They just become bad if they’re used to window-dress accounts.”

In Greece, the financial wizardry went even further. In what amounted to a garage sale on a national scale, Greek officials essentially mortgaged the country’s airports and highways to raise much-needed money.

Aeolos, a legal entity created in 2001, helped Greece reduce the debt on its balance sheet that year. As part of the deal, Greece got cash upfront in return for pledging future landing fees at the country’s airports. A similar deal in 2000 called Ariadne devoured the revenue that the government collected from its national lottery. Greece, however, classified those transactions as sales, not loans, despite doubts by many critics.

These kinds of deals have been controversial within government circles for years. As far back as 2000, European finance ministers fiercely debated whether derivative deals used for creative accounting should be disclosed.

The answer was no. But in 2002, accounting disclosure was required for many entities like Aeolos and Ariadne that did not appear on nations’ balance sheets, prompting governments to restate such deals as loans rather than sales.

Still, as recently as 2008, Eurostat, the European Union’s statistics agency, reported that “in a number of instances, the observed securitization operations seem to have been purportedly designed to achieve a given accounting result, irrespective of the economic merit of the operation.”

While such accounting gimmicks may be beneficial in the short run, over time they can prove disastrous.

George Alogoskoufis, who became Greece’s finance minister in a political party shift after the Goldman deal, criticized the transaction in the Parliament in 2005. The deal, Mr. Alogoskoufis argued, would saddle the government with big payments to Goldman until 2019.

Mr. Alogoskoufis, who stepped down a year ago, said in an e-mail message last week that Goldman later agreed to reconfigure the deal “to restore its good will with the republic.” He said the new design was better for Greece than the old one.

In 2005, Goldman sold the interest rate swap to the National Bank of Greece, the country’s largest bank, according to two people briefed on the transaction.

In 2008, Goldman helped the bank put the swap into a legal entity called Titlos. But the bank retained the bonds that Titlos issued, according to Dealogic, a financial research firm, for use as collateral to borrow even more from the European Central Bank.

Edward Manchester, a senior vice president at the Moody’s credit rating agency, said the deal would ultimately be a money-loser for Greece because of its long-term payment obligations.

Referring to the Titlos swap with the government of Greece, he said: “This swap is always going to be unprofitable for the Greek government.”


OUR MARKET VIEWS

GOLD AND CURRENCIES

We believe the current and ongoing European crisis gives gold an impetus to move higher. We have been adding to our gold positions at current levels and will continue to buy if prices fall.
Yesterday’s transparent attempt by the IMF to scare the gold market down by announcing a sale of gold by European IMF contributors has been a failure. This reminds us very much of the situation in the 1970’s when the IMF gold sale was met with strong demand. When the markets recognized that there was strong demand in spite of the IMF sales, gold moved much higher within a few months.

Today, it is clear that there is large demand for gold from central banks. China, India, Sri Lanka, and Russia have been buyers at these price levels, and we are sure there are others. Many nations have openly discussed their intention to expand the gold component of their reserves. Technically, gold look remarkably strong in the face of attempted downward manipulation.

The Australian and Canadian dollars appear to be building technical bases and will resume their rise. On the other hand, we remain bearish on the Euro and prefer the U.S. dollar to that currency.

GLOBAL STOCKS

On dips, we are gradually accumulating Chinese, Thai, Malaysian, Indonesian, and other undervalued foreign stocks.

Within the developed world, we are focusing on Canadian and Australian energy and precious metals companies, and a few U.S. technology companies which are fast-growing and selling at low valuations.

OIL

We are buying oil related companies which we believe will make substantial new discoveries in coming months.

SUMMARY

In general, we prefer to be conservative; making purchases on market weakness to capitalize on the current volatile, and often irrational, markets. After China finishes raising interest rates to reign in run-away real estate prices, and rising food prices, we expect the faster growing countries’ stock markets will resume their rising pattern.

Thanks for listening.


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