Thursday, June 17, 2010

Backed into a Corner

The governments of Germany, France and Spain have officially made the commitment to open the financial kimono towards the end of June/early July and reveal banking stress test results. Based on the stated objections of the head of Germany's landesbanken, I'd say there will be some ugly results. But this is an absolute necessity to move forward.

Ever since the Minsky Moment, the eurobanks have played the carry game, borrowing for free from the ECB and buying sovereign debt. Their capital requirements are low for this type of asset but still allow some yield with PIIGS sovereign debt. So while the US and the UK forced their banks to clean up and recaptialize with proper funds (we think), the ECB simply allowed banks to lower asset risk, lowering capital requirements and  allowing them to avoid a costly recapitalization.

Unfortunately, the banks now own a ton of PIIGS sovereign debt, so what was until now a concern about the sovereign solvency of the PIIGS has moved to a concern about the solvency of the core euro country banks, and by association, the core euro sovereign solvency. It seems a fair bet that Germany is facing the double whammy of low grade PIIGS sovereign and impaired commercial assets. Spain has the impaired commercial assets plus Portugal and France maybe only the PIIGS sovereign exposure.

Collectively, the sovereign balance sheets backing the Euro are about to get a lot worse in the mark to market event that is the stress test. The good news is that should be the end of the bank solvency uncertainty and allow investors to operate with better information. The bad news is that the results will likely put more pressure on the core countries to cut budgets, kill near term GDP growth and set the western world up for a very tough 2H'10 and '11.

That suggests monetary tools will be more important and low rates for longer and more deflation. It seems that in order to avoid an insolvency debt trap, the budget cuts will be big and economic growth ugly for a while. I don't know if that's the right decision, but it is the one that governments appear to be making. I am starting to wonder if one of the results of the stress test reveal will be a big hit to gold; after all, we will finally have known financial balance sheets. Gold is for the unknown.

Still liking the rally, looking for a bigger right shoulder. Have been hugely oversold and expect more bounce. Micron numbers coming in a couple weeks, should kick off a strong tech rally into the quarter. Own oil - the GoM crisis is hideous, but doesnt it make oil more expensive? The counter argument and I think longer term one is that the above notes on crap GDP growth mean oil goes lower. Long the GBP, ISSI, AAPL, BAC, AMAT. Starting to look at long dated S&P Taleb puts...

Wednesday, June 16, 2010

The Minsky Moment Clean Up Continues

We're not finished with the Euro banking crises. Spain and Germany are the key concerns due to the large state controlled portion of their respective banking systems - the Cajas and Landesbanken. These two country's banking systems are the only ones in Europe of size that were impacted by both a private sector crisis and a sovereign crisis.

While we are getting some clarity on the condition of the private sector banks' exposure to these problems, we still have little clarity on the public sector banks' problems. There seems little political willingness to reveal the problems - the high level of under performing assets and the resulting need for significant recapitalization.

The US and the UK banking systems have gone through this process and while they are still exposed to ongoing asset impairment, at least we know the story. We don not have a similar baseline for Spain and Germany; both countries have been trying to play "whistle past the graveyard" and hope for a recovery that would allow them to keep the problems under cover.

But it is now clear that they will have to improve transparency - really, really soon - if they want the capital markets to continue funding their balance sheets. The ECB/IMF have stepping into the gap and will continue to provide stop gap funding, but they both will expect clarity soon themselves.

The markets need this transparency to complete the Euro portion of this western balance sheet recession reset. Only then can we make intelligent and informed risk adjusted decisions. In the meantime, I am long the GBP and DIG assuming that the UK gets paid for being clear about the problems and is moving to solve them and the oil sector has been oversold on the GoM calamity. I am looking at some other oil plays that have suffered - things like TOT. I suspect I will try to trade some AAPL into the quarter and have added to AMAT.

I have averaged down on BAC. I'm not sure why. Banks are cheap but EPS will get hit this Q, I'm unsure whether there will be much improvement in impaired assets and regulatory events are still negative. In general I am wondering if corporate profitability has now peaked, meaning that companies need to see an uptick in revenues for the next leg in stocks. I am not convinced that can broadly happen - but there will be some pockets - in a consumer driven economy where the consumer is still delevering. Is the market's right shoulder starting to form?