Tuesday 15 November 2011

Jersey is heavily invested in the bond 'bubble'

Jersey is heavily exposed to the bond market according to Senator Ozouf, the paltry 9.17% return on Jersey's fund of funds, which would have been 30%+ had the fund simply bought gold instead, is riding the largest bubble in history - government bonds or sovereign debt.

Capital is seeking security in bonds
But bonds are not particularly secure
One nation after another crashes
Jersey's reserves are in that market
Jersey has about £1.3 billion which would meet government expenditure for about two years, but this includes the social security and employee pension funds.

Imagine this scenario: A major government has been forever borrowing from Peter to pay Paul, never lifting a finger to cut its deficits. 

Suddenly, global investors pull the plug: They dump the government's bonds like a hot potato. They drive bond prices into the gutter. And they make it impossible for the government to borrow another cent without paying sky-high, budget-busting interest rates.

To persuade investors to resume buying its bonds, the government is eventually forced to pass Draconian austerity measures — mass layoffs of police and other public employees ... deep cuts in pensions and health benefits ... plus tax hikes across the board.

Result: Mass protests, riots, and national strikes ... another big blow to the economy ... a new exodus by investors ... and louder demands for even greater cutbacks or taxes.

Sound familiar? It should — because that's precisely what we've just witnessed in Greece. Meanwhile, Italy is heading down the same path, passing draconian austerity measures just this weekend.

Sure, global investors rejoiced. But even while Rome was performing emergency surgery, the European debt cancer had metastasized to an even larger economy — France, the next likely victim of the debt contagion.

Suddenly, French bonds had plunged; and suddenly, the interest premium the French government would have to pay for 10-year money (compared to the German government) had surged to 168 basis points (1.68 percentage points). What's worse, the cost of insuring French government debt against default had also gone through the roof.

To help understand exactly what this means, let's say you've been buying French government bonds for yield and safety. To protect yourself against a future default, you can buy insurance in the form of a "credit default swap."

As with any insurance, if the risk of failure is low, your premium cost will be low; if the risk surges, your cost will surge. And that's precisely what we've just seen happen with the default insurance premiums on French government bonds:
Right now, to insure $10 million in 5-year French government bonds against default, you'll have to pay $203,001 in yearly premiums. That's DOUBLE the peak level during the debt crisis of 2009 and TRIPLE the peak of 2008!

How bad is that? For the answer, look at Greece and consider these facts ...

Fact #1. Three years ago, around the time when the Greek debt crisis first burst onto the scene, if you wanted to buy the equivalent insurance to cover a Greek default, you would pay only $174,761 (the exact cost of a 5-year Greek credit default swap on November 19, 2008, according to Bloomberg data.)

That's $28,240 LESS than what investors are paying for French default protection today!

In other words, according to the market for default insurance, French bonds today are RISKIER than Greek bonds were at the onset of the Greek debt crisis!

Taken in isolation, are French government finances really weaker today than Greece's were three years ago? Perhaps not. But its banks are far weaker. And so Europe as a whole! Therefore, the markets see these new risks as important factors that dramatically increase the threat to investors in French bonds.

Fact #2. S&P, Moody's and Fitch are apparently ignoring these new risks, choosing to grade the French government as if it were an island onto itself.

Result: They still give France a triple-A rating today, far higher than the single-A rating (or lower) which they gave Greece three years ago.

In sum ...
• The markets say French debt is RISKIER today than Greek debt was three years ago. But ...
• The major rating agencies say French debt is far SAFER today than Greek debt was three years ago.

Who's right? The markets or the rating agencies? That leads me to ...

Fact #3. In its Moody's Analytics of October 6, 2011, Moody's graphically admits that, when it came to evaluating the true risk of Greek debt, the markets were right and Moody's was wrong.

The chart clearly shows that the true rating of Greek bonds — as implied by their market price and the cost of default insurance — fell a lot sooner and a lot lower than Moody's rating.

In other words, Moody's grossly and consistently overstated the safety of Greek bonds. It wasn't until Greece was on the brink of near certain default that Moody's eventually caught up to the market reality.

But for investors, that was far, FAR too late. Banks and individuals who relied on the S&P, Moody's and Fitch ratings lost hundreds of billions of dollars.

Are the rating agencies making the same mistake with France? For the answer, consider ...

Fact #4. Last week, S&P sent a notice to its private subscribers stating that its AAA rating of France was on the chopping block; that a downgrade was in the works. France reacted with great outrage. And, surprisingly, S&P responded by sheepishly stating that the message was an "accident."

But no matter who or what pressed the wrong buttons, where there's smoke there's fire. And given the clear market signal that risk on French debt is surging, the true outrage is that S&P is still telling the public it's not preparing to downgrade France.

Fact #5. S&P, Moody's and Fitch accept large yearly fees from debt issuers in order to assign them credit ratings. Bluntly speaking, their ratings are bought and paid for by the very same institutions they're rating.

If they downgrade countries like France, they must also downgrade banks and other on-the-brink institutions that depend on those countries for bailouts. But those institutions are some of their best customers, paying them the biggest fees!

This is an egregious conflict of interest and helps explain WHY they're so reluctant to downgrade countries like Greece or France, delaying the appropriate action for months or even years.

Fact #6. Weiss Ratings, give France a C (approximately the equivalent of a BBB+ by S&P). Unlike S&P, Moody's or Fitch, they never accept a dime from debt issuers for their ratings. They have no conflicts of interest. And they never delay downgrades for financial or political reasons.

One reason France still gets a unanimous triple-A from S&P, Moody's and Fitch is because the rating agencies are afraid to rock the boat. The rating agencies know that, without the triple-A ratings, France would be disqualified from contributing to the European bailout fund and the entire European rescue plan would fall apart.

They also know that, in that scenario, their very best customers — the banks that pay them huge fees for their ratings — would collapse. And they know their own revenues would plunge in the resulting chaos.

Weiss Ratings base grades strictly on the facts, and those facts say that France fully merits its C rating:
  • France, along with Germany, is the keeper of all their deadbeat brothers and sick sisters — not only in the euro zone, but also in Eastern Europe. 
  • France's banks hold the bulk of the bad government debts. 
  • France's treasury is now burdened with the bailouts for both the wayward banks and the sickly governments. 
  • And France also has a big pile of government debts of its own to refinance.
One more key point: Unlike the triple-A of most rating agencies, Weiss Ratings C rating for France IS in sync with the rising cost of default insurance on French debt. 

Fact #7. The Greek debt crisis has shaken the global marketplace to its foundations. But the French economy is over EIGHT times larger than Greece's. So its debt problems are likely to have at least eight times greater impact on global financial markets than Greece has had.

Meanwhile, speculation continues to grow that Germany will exit the Euro and re-launch the Deutsche Mark at 1.95 DEM to 1.00 EUR (the level at which they went in).

Listening closely to what is being said by Angel Merckel and the German finance minister they are refusing to rule out ANY solution and are looking at ALL possible outcomes. The bailout is more about protecting domestic German banks (who have been the greatest beneficiary of the Euro experiment) and other European nations are stepping in to do the same.

They have ruled out the issuance of a European bond and refused to turn on the printing presses and have the European Central Bank print its way out of trouble. The concern of the Germans is for price stability and when questioned about Germany coming out of the Euro, the finance minister did not simply state, "Don't be ridiculous", instead he spent six minutes explaining to the German people that price stability would be more easily achieved in the Euro rather than returning to the Deutschemark.

It has been carefully explained to the German people that any cheque being written is not to sovereign nations, but to domestic banks to protect the domestic taxpayer.

The preparations for a German exit are being made, the Euro has one more sovereign debt crisis left. Let's hope the new social security minister adjusts the investment strategy accordingly.

1 comment:

  1. Very interesting Darius, thanks for posting this, shame you didn't get elected. I think you have a batter grasp of the big issues than the majority in the house.

    ReplyDelete