Achtung Baby: Germany Is Riskier than You Think. June 2012

Transcription

1 Achtung Baby: Germany Is Riskier than You Think June 2012

2 Weaker Eurozone Countries Owe Germany Money on a Massive Scale If you owe the bank $100, that s your problem. If you owe the bank $100 million, that s the bank s problem. J. Paul Getty ( ) 2

3 Germany Made Bad Loans but Still Wants its Money Back 1,000 German Bank Claims on Periphery Countries Plus TARGET 2 Balances 1. Germany becomes an export powerhouse because of the Euro The effective exchange rate was set far too low vs. other Euro countries 800 Public risks 2. German banks financed the export boom Billions Private risks Financed the current account deficits of the periphery Lent German excess savings into periphery housing bubbles 3. The Bundesbank has replaced the exposure to peripheral debt that the German banks reduced - Periphery debt is now the Federal Republic of Germany s problem Mar-01 Jul-01 Nov-01 Mar-02 Jul-02 Nov-02 Mar-03 Jul-03 Nov-03 Mar-04 Jul-04 Nov-04 Mar-05 Jul-05 Nov-05 Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07 Mar-08 Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11 Mar-12 BIS balance vis-à-vis periphery Target2 Balance 3 Source: Bank for International Settlements and Bundesbank.

4 Transmission Mechanisms Bring Periphery Debt Back to Germany 1. Bundesbank losses 2. Rescue payouts 3. Private bank losses 4. Fall in exports 4

5 Germany Weighs Its Two Choices Let the Euro Break Apart Bundesbank Losses Private Bank Losses Severe Export Decline Save the Euro Pay for Rescue Programs Private Bank Losses Export Decline 5

6 The Market Doesn t Understand the Magnitude of Germany s Future Losses Transmission Mechanism Euro Stays Together Euro Breaks Apart Bundesbank Losses Through TARGET2 Balances Germany s Share of the Rescue Funds (ESM/EFSF/EFSM) Private Bank Losses from Exposure to Periphery Debt Billion 419 Billion 94 Billion 80 Billion 200 Billion Fall in Exports Over The Next 5 Years 80 Billion 375 Billion Total Estimate 579 Billion 1.31 Trillion Estimated Total Debt-to-GDP 103% Debt-to-GDP 131% Debt-to-GDP The Cost to Save the Euro is Much Less Than to Let It Fall Apart, but Do the Germans Have the Political Will? 6

7 1. Periphery Will Owe the Bundesbank 1 Trillion by the End of 2012 Euros in Millions TARGET2 Claims are Rising Quickly 1,200,000 R² = ,000, , , ,000 Periphery banks had to replace funding as the interbank market froze in 2007 They were forced rely on their own central banks as the funder of last resort Since mid-2011 the need for this type of funding has accelerated The Bundesbank has large exposures to the ECB and other central banks German claims are on pace to increase from current amount of 657 billion to 1.1 trillion by end of 2012 If a member leaves the Euro the amount owed to the ECB becomes a loss for the remaining members 200,000 0 Bundesbank TARGET2 Claims Polynomial Regression 7 Source: National Central Banks, J.P. Morgan and Bundesbank.

8 2. Germany s Obligation for Rescue Programs Is 419 Billion and Could Increase Debt-to-GDP 100.0% 98.0% 96.0% 94.0% 92.0% 90.0% 88.0% 86.0% 84.0% 82.0% Germany's Debt-to-GDP Can Quickly Reach 100% Germany s debt-to-gdp would reach 100% Well above the 90% that Reinhart and Rogoff suggest as slowing GDP growth Cost for saving the Euro is approximately 579 billion This compares with the estimated 1.4 trillion to reunify East and West Germany Any movements towards a fiscal not just monetary union will involve more explicit transfers 80.0% Current Debt to GDP (in trillions) EFSF Exposure ESM Exposure EFSM Exposure 2012 Budget Deficit Total Debt 2, ,539 Source: JPMorgan and CAM estimates. 8

9 3. German Banks Could Lose Substantial Portions of Their Current Equity Euros in millions 1,000, , , , , , , , , ,000 0 German Bank Exposure to GIIPS Jun.1999 Jun.2000 Mar.2001 Dec.2001 Sep.2002 Jun.2003 Mar.2004 Dec.2004 Sep.2005 Jun.2006 Mar.2007 Dec.2007 Sep.2008 Jun.2009 Mar.2010 Dec.2010 Sep.2011 The 438 billion of exposure is still 40% greater than the estimated 310 billion of German bank equity As late as December 2011, German banks had 33 billion of exposure to Greece This does not count the CDS on Greece that German Banks have written Should the Eurozone split, German banks would likely suffer both large credit losses and currency losses Source: Bank for International Settlements. 9

10 4. Exports Will Fall in the Next Several Years LTM Net exports in Bn German Net Exports Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Net Exports Euro Net Exports GIPS For the twelve months ending Jan 2012, Eurozone countries were 57% of net exports This figure has been as high as 81% Should the Euro dissolve, we would expect that net exports would fall to at least where they were at the beginning of the Euro (1999) Germany could become a net importer as exports become more expensive in neo- Pesetas or neo-drachmas and imports in neo-deutsche Marks fall in price Exports are currently ~40% of the German economy Source: German Federal Statistics Office. 10

11 Debt-to-GDP Will Rise and German Credit Default Will Widen 140 German Debt-to-GDP 600 German CDS is Likely to Widen 125 Plus estimated 1.3Tn losses in Euro breakup 500 Spain Italy Plus estimated 0.6Tn expense to "save" Euro Current 10-yr CDS Spreads Eurozone GDP Weighted Avg China US France Germany UK CAM Est for Germany (Euro integration) Iceland CAM Est for Germany (Euro collapse) YE 2011 Debt-to-GDP Ratio Source: IMF and CAM Estimates. Source: CIA World Factbook and Bloomberg 11

12 10-Year Bund Yields Could Go Negative German 10-Yr Bund Yields Bund yields can trade in this range given the markets fear of redenomination, liquity needs and desire for safe haven Inherent currency option in Bunds If bonds are redenominated into Deutsche Marks, currency gain can offset the yield loss For the currency, we used the European Commission s own estimates of Real Effective Exchange Rates For liquidity, we examined the moves in the US Treasury post Lehman Brothers default For where rates should be, we used the Taylor rule We added the average shape of the yield curve and made an adjustment for the need to keep the markets liquid -2 Source: Bloomberg. 12

13 Preferred Investment:10-Year German CDS CAM estimated trading range Purchases of 10 yr CDS Jan 09 Mar 09 May 09 Jul 09 Sep 09 Nov 09 Jan 10 Mar 10 May 10 Jul 10 Sep 10 Nov 10 Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May 12 Jul 12 Sep 12 Nov 12 Source: Bloomberg.

14 Investment Summary Rationale The market underestimates the risk to Germany posed by its exposure to periphery debt Instrument 10-year credit default on the Federal Republic of Germany (first purchased in June 2011) Our notional amount is much larger than our Spain CDS position Cost/Capital Commitment Expected Return Average of 0.8% of notional per annum effectively an option premium on the default of Germany during the next 10 years We expect that within a year, German CDS will widen to 200, which would provide a 2.2x return on the premium we have spent Even at current levels the return will be 1.4x 14

15 Appendix

16 How Did Periphery Debt Become Germany s Problem?

17 Until 2007, German Savings Helped Build Projects in High Growth Areas Spanish builder borrows for a project Spanish bank borrows from a German bank in the wholesale market; lends to the builder German bank takes deposits from German savers and not finding interesting German investments, lends the money to a Spanish bank in the wholesale market German saver takes his hard earned savings and puts it into a German bank What is at risk If the project fails the developer loses his equity, but then it is owned by the bank Once the bank owns the property, losses beyond the equity of the bank are shared with the lenders 2007: 10% equity 2007: 18x leverage (5.6% equity) Once the bank eats through its own equity, the losses should be shared with lenders 2007: 30x leverage (3.3% equity) Depositors are usually guaranteed by a deposit fund, which is funded by banks but backstopped by taxpayers (depositors) Simple example, but not that far from loss (~19% loss) 17

18 German Bank Asset Balances Developed as Housing Bubbles Appeared Euro in Billions Cumulative Changes of German Bank Claims on GIIPS Countries Both Ireland and Spain had large housing bubbles German banks lent directly into the asset bubbles in Spain and Ireland Lending to Italy was smaller than lending to Ireland despite the fact that Italy s economy was 8x the size (2007 numbers) German private lenders realized their mistakes and have withdrawn 478bn from the GIIPS between June 2008 and December Mar.2000 Sep.2000 Mar.2001 Sep.2001 Mar.2002 Sep.2002 Mar.2003 Sep.2003 Mar.2004 Sep.2004 Mar.2005 Sep.2005 Mar.2006 Sep.2006 Mar.2007 Sep.2007 Mar.2008 Sep.2008 Mar.2009 Sep.2009 Mar.2010 Sep.2010 Mar.2011 Sep.2011 Greece Ireland Italy Portugal Spain 18 Source: Bank for International Settlements.

19 How the Balances Built Up and Where We Are Currently Spanish builder is having difficulty, gets extension on loan from Spanish bank Step 4: Simultaneously the NCB s borrow and lend from the ECB The German saver is unaware of what has happened Step 3: needing to replace financing, Spanish bank borrows from Banco de Espana Step 2: German bank looking for safety places at the Bundesbank 19 Step 1: German bank refuses to roll loan to Spanish bank returns to German bank

20 20 Who Ended Up Taking the Risk?

21 TARGET2 Ballooned as Banks Became Fearful of Lending to One Another TARGET2 stands for Trans-European Automated Real-time Gross Settlement Express Transfer System Allows for imbalances that have built up in the system to balance out Typically this is taken care of in the interbank market Normally, if the Spanish bank loses some interbank funding it would agree to pay some more and borrow from a different bank in the Euro-system, keeping balances low But when the interbank market stops functioning efficiently, TARGET2 balances build up 21

22 These Balances Are a German Asset if the Euro Breaks Apart The Bundesbank s Target2 claims do not constitute a risk themselves because the idea that the monetary union would fall apart is absurd. Jens Weidmann Bundesbank President 3/15/12 The way things are going, the Euro area has a significant risk of breaking up. Olli Rehn European Commissioner for Economic and Financial Affairs 5/31/12 Odds a country leaves the Euro by YE 2013 So long as the Euro remains in place these balances do not present a risk Source: 22 But this is akin to saying that so long as my creditor keeps paying, I have no credit risk. As countries exit the Union, the temptation to default on amounts owed to the ECB/EU/IMF will be high Greece owed 104bn as of 3/31/12 The ECB would need to be recapitalized by the member countries Would weak countries really be able to pay?

23 Why Germany Cannot Afford the Euro to Break Apart

24 What Is the Capital of the ECB/Eurosystem to Absorb a Euro Break-Up? BoG BUBA BdE The capital of the Eurosystem: Book Equity Revaluation Total 86Bn 399Bn 485Bn As of May 11 th, 2012 ECB NCB 4 NCB 5 NCB17 The capital of the ECB: Book Equity 6Bn Revaluation 24Bn Total 30Bn As of December 31 st, 2011 Revaluation accounts for the increase in the value of asset holdings, mostly Gold Key: BoG = Bank of Greece, BdE = Banco de España, BUBA = Bundesbank, NCB = National Central Bank of which there a currently 17 24

25 There Have Been Many Rumors of a Grexit ; Could This Be the First? ECB Exposure to Greece Source of ECB Exposure Amount As of date Data Source SMP (Direct purchases of bonds) 51,871,861,000 5/17/2012 Bloomberg Greek TARGET2 Balance 103,735,616,784 3/31/2012 Bank of Greece Total 155,607,477,784 We believe that the current number is higher as the last TARGET2 balance sheet date was almost a quarter ago During this time Greek banks have experienced deposit flight A Greek exit from the Eurozone would cost the ECB at least this amount The Eurosystem as a whole has enough capital to bear this loss Germany losses would amount to 43bn which is 32% of the Bundesbank s capital If this causes others to leave, recapitalizing the ECB would become harder, more expensive with more of the burden falling on Germany 25

26 If Greece Leaves, the Bundesbank Has to Rely More Heavily on Just the ECB BoG BUBA Suddenly, the capital of the Eurosystem looks more like the capital of just the ECB, with limited ability to absorb losses BoG BdE NCB 4 ECB NCB17 If the BoG leaves, the concept that no country can leave the Euro will be broken. NCBs of weaker countries will be called into question. NCB 5 Key: BoG = Bank of Greece, BdE = Banco de España, BUBA = Bundesbank, NCB = National Central Bank of which there a currently 17 26

27 What Starts to Be Horrific for Germany Is the Situation Where Multiple Countries Exit BoG BoG NCB 4 BUBA ECB NCB 5 BdE NCB17 Key: BoG = Bank of Greece, BdE = Banco de España, BUBA = Bundesbank, NCB = National Central Bank of which there a currently 17 BdE NCB17 Rather than being recapitalized, the ECB now becomes a debtor to the remaining countries Those debts are what the ECB owes from the TARGET2 system Far from being a worthy debtor, the ECB has no assets at this point It would be forced to print to repay Recapping the ECB is supposed to be weighted by GDP, but only 4 countries lend to the ECB via Target2 the real risk lies on them 27

28 How Will Germany Deal with Its Problem?

29 What Is the End Game? European monetary unions have been tried before and failed. Current Situation Latin Monetary Union (Belgium, Italy, Switzerland, France, Greece) Scandinavian Monetary Union (Sweden, Denmark, Norway) But in the case of German Customs Union ( Zollverein ), it ended with a single nation state Breakup Lots of pathways to these two endpoints Full Union What would a US of E look like economically? 2011 Debt to GDP = 86.4% 2011 Budget Deficit = 4.1% Bank Assets to GDP = 3.1x Bank leverage =19.0x France currently has almost these exact numbers Would the US of E trade about where France is now? 29

30 Keeping the Euro Together Will Be Hard The EMU is the most dispersed actual or potential monetary union shown All countries that begin with the letter M are less different than the EMU Stitching together a separated Germany was slow and expensive ( 1.4 trillion) This despite strong cultural, even familial connections What will be the ultimate cost of holding Europe together? 30

31 What Would Work Only Temporarily The LTRO pumped 1 Trillion of liquidity in to Eurozone banks and stabilized them for a short time But this program effectively subordinates other liability holders (including depositors) and seems to have tied up much of the available collateral Pan-European Deposit Scheme have the ECB or some other European body guarantee all the deposits of Eurozone banks This might help banks that have been experiencing deposit flight for credit reasons (Spain) But unlikely to help those that are experiencing deposit flight because of fear currency redenomination (Greece) Eurobonds bonds issued by a European body that are joint and severally liable If the issuing body is to be given unlimited issuing power, we do not believe that this would pass under Germany s Federal Constitutional Court If it is limited, we do not see much difference to the current ESFM/EFSF/ESM system 31

32 What Would Work Long-Term A United States of Europe central taxing authority, popularly elected head of state, ability to move funds freely from state to state, single set of regulations We view this as almost impossible to achieve politically A Marshall Plan for the periphery be it grants, loan forgiveness or write-offs a direct transfer of funds from creditor nations to debtor nations within the Eurozone This is possible politically The Marshall Plan was originally sold to the US body politic as a way to spur markets for their goods, which we think is reasonable in this case But the ravages of war were clear in the late 1940 s and the US also feared the rise of the Communist Party in Europe Currently, the debtor nations are seen as being profligate by the creditor nations and there is no ideological bogey man 32

33 Can Germany s Past Currency Union Provide the Roadmap? Starting in 1818, the Zollverein or Customs Union created a large single currency and trade union amongst the principalities of German speaking people In 1862, Otto von Bismarck was appointed Minister- President of Prussia and in the next decade succeeded in forging a unified German State While much of the work was done through diplomacy, Bismarck was unafraid to use military power as well The great questions of the time will not be resolved by speeches and majority decisions, but by iron and blood. - Otto von Bismarck (Sept 30, 1862) Will a leader emerge in the current crisis to draw Europe together? Will it be possible without bloodshed? 33

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