Euro

Chris Cook

The new UK government, which will present its first Budget next Tuesday, has pledged to learn its lessons from the retrenchment in Canada between 1994 and 2000. Good for them: Paul Martin did much right.  He realised that, if you are going to rein in a colossal structural deficit, you need a wide consensus. The Canadian regime has also recognised that consolidation requires you to cut where the fat is. It did not salami-slice every budget, but went for where there were savings to be found.

But the Ottawan lesson only goes so far. As Paul Krugman says, it doesn’t help the UK with the macroeconomics of cutting. Its retrenchment took place as the US was booming. The political pain of cutting would have been much higher, the process much more difficult and the results less successful if its giant cousin to the south hadn’t had its nose in the punchbowl.

Britain is going to cut its deficit in what will probably be a weak neighbourhood. German manufacturing has been roaring, but the eurozone is weak and vulnerable. The whole continent’s states are tightening their belts. So while the weak pound might help the UK build market share, the market might be sickly. George Osborne’s confidence that Britain can grow while consolidating looks like hubris.

So what is to be done? Well, the chancellor of the exchequer should press ahead with his ambition to rein in the structural deficit. I don’t really want the government spending more on pay and pensions to prop up output. Stimulus needs to be temporary programmes that come to a defined end. Raising structural spending, only to slash it when the economy recovers, is bonkers. So Mr Osborne should work out temporary packages to offset the deflationary effects of his structural cutting.

The FT has come to the view that Mr Osborne needs to prepare stimulus measures, and so has Martin Wolf. In his open letter to George Osborne, he asked the chancellor:

Are you going to stand by if the economy goes into a steep decline? … In such circumstances, the most effective instrument might be central bank financing of additional public spending. But your commitment to pre-programmed spending cuts would seem to rule this out. The alternative might be a temporary reduction in taxes, of the kind you condemned under the previous government. In any case, the UK should have a plan for growth of nominal demand at a rate of 6 per cent and preferably more, for some years. Who is to take responsibility for this and how?

There are major attractions to setting out plans for stimulus measures now. Moving towards a clearer rule-based system for discretionary fiscal policy would make it possible to take stimulatory action without spooking holders of gilts. You can make sure they’re ready to go where they’re needed. The Treasury should compile a list of names and addresses to which it could post cheques. In case the UK’s troubles are longer-term, the finance ministry should prepare a list of infrastructure projects it would like to build.

Setting out such contingency plans would require a bit of political bravery. Mr Osborne would be the first chancellor to admit that he is not, in fact, in charge of the economy and not its master. He would be required to admit there is uncertainty in the world and limits to his powers and foresight.

Now that would be new politics.

James Mackintosh

Thought the short sellers were up to no good? You’re not alone, at least when it comes to short-selling collateralised debt obligations (CDOs), one of the acronyms behind the financial crisis. And now you can sing along to the tune. US hedge fund Magnetar, according to an investigation by ProPublica, took a leading role in pumping up subprime debt by helping create the CDOs it then went on to short. Even better than the article, which should be a must-read for everyone involved with Wall Street, is the music, put together to go with it by This American Life (h/t Daily Intel).

However, we already knew that John Paulson’s Paulson & Co, together with Goldman Sachs, Deutsche Bank and other banks, had done something similar. But the scale of the Magnetar CDO creation seems to set it apart: it sourced the bulk of the CDO market in late 2006, shorting some of the CDO debt it had helped create while buying the super-toxic CDO equity, which CDO creators usually found tough to shift. Its losses on the equity were in at least one case more than covered by the eventual profits from the debt when the CDO tanked, ProPublica reports. Worth noting is Magnetar’s explanation: it insists it was net long all its own CDOs, which means it would lose money when they defaulted, and that it ran a market-neutral strategy, meaning it aimed to make money whether the mortgage/CDO market went up or down.

James Mackintosh

While hedge funds are the focus of attacks on “speculators” from Greek, French, German, Spanish and Portuguese politicians for allegedly trashing the euro and Greek bonds, the funds don’t seem to have made money from it.

According to Hedge Fund Research, which tracks the industry, so-called “macro” hedge funds – those trading interest rates, currencies and government debt around the world – have lost money this year, suggesting they were betting the wrong way on Greece, lost big money elsewhere or had ignored the Greek trade altogether (although there are exceptions – at least one was coining it at the start of the crisis, while others deliberately closed their trades because they expected a political fracas).

But Bloomberg reports on a lovely irony: at least one of those betting against Greek bonds using the dreaded CDS was an American mutual fund. Fully regulated, respectable, and run by one of America’s oldest fund managers. The mission of Eaton Vance, according to founder Charles Eaton:

Professional investment management entails an obligation of responsibility of the highest order. It is a very serious matter to accept the obligation to be responsible for the investment of anybody’s money.

The eurocrats currently planning to ban the use of “naked” CDS to make such bets – a bad move with worse motivation – must be choking into their cappuccinos. They’ll be even more annoyed when they realise that a ban in Europe will have no impact at all if the US continues its opposition to such a move and allows CDS to be used not just to protect existing bond holdings, as Europe wants, but also to speculate.

James Mackintosh

Politicians across Europe and the US worrying about credit default swaps and the supposed speculative attack on Greece should put this article by Sam Jones at the top of their reading list.

Hedge funds stand accused of using CDS – which allow bets on the creditworthness of a country’s or company’s bonds – to undermine the Greek economy by sparking fear. I explained yesterday why this is nonsense, but Jones has dug into the data and found that the CDS are actually encouraging bond spreads to move tighter, thanks to what is known as “negative basis”.

Basically, the hedge funds that used CDS to short Greece over the past year or two are now covering their positions, writing insurance for other people who are worried about their exposure to Greece, particularly banks. As a result, if anything, hedge funds are actually helping keep Greek bond yields lower than they otherwise would be (although I suspect the effect is tiny, just as the shorting had little, if any, effect – the bond market is far far bigger).

This should be essential reading for Christine Lagarde, French finance minister, Spanish politicians, and German and US regulators, before they rush into ill-considered new bans on the use of CDS to short. Apart from anything else, hedge funds would just use slightly less convenient methods, anyway.

James Mackintosh

Here we go again. Germany, France, Spain, Greece and Portugal are talking about extra regulations on credit default swaps, the insurance-like derivatives that let investors bet on debt problems, accusing the international media of a conspiracy or shouting about “speculators”. Some of the more excitable reports even suggest governments have called in the secret services to keep an eye on the hedge funds, although in typical German fashion Berlin called in its financial regulator, instead.

New regulations are already being mooted, with Jean-Claude Juncker, who chairs the eurozone finance ministers, warning of “torture equipment” ready to be used against speculators. But we’ve been here before. At the height of the banking crisis, short-selling bank equity (and in the US much other equity too) was banned, as short-sellers were blamed for the problem – including by John Mack (head of Morgan Stanley, then the biggest servicer of hedge funds wanting to short) and the Archbishops of York and Canterbury (the Church of England invested in hedge funds).

It is true that aggressive, co-ordinated short selling could create a problem at a bank by damaging confidence, starting a run on its short-term funding. But that could only create a liquidity problem. It turns out, of course, that the short-sellers were shorting precisely because there was already a confidence problem caused by the (correct) belief that the banks had a solvency problem. If there was any co-ordinated shorting – which remains unproven, but is being investigated – that was not the problem.

In Greece, the same argument applies. Is a loss of confidence causing the problem, or is the Greek economy like souvlaki – totally skewered?

A loss of confidence is much harder in a country than a bank: you can’t have a run. But theoretically the price of raising sovereign debt, and so commercial debt, could be pushed up, costing the country more. This is happening – but it isn’t happening because of the “shorting” effect of hedge funds buying CDS protection.

Quite the opposite. Hedge funds are – or at least were – buying CDS protection years before the problems emerged, because they believed the market had too much confidence in Greek debt. Greece is a serial defaulter, had a credit-fuelled bubble created by importing German interest rates, and saved far too little.

On top of that, Adair Turner, chairman of Britain’s Financial Services Authority, on Tuesday pointed out that short selling was not the big deal it is being made out to be. He is no fan of CDS – he has warned several times that some financial instruments are “not socially useful” – but he is also pragmatic, having been happy with the short selling ban on banks.

Here’s what Turner told MPs, according to Reuters:

It is important that even if we look at this issue we don’t overstate it. A fundamental issue that can drive volatility on spreads on Greek bonds is a whole load of long investors not being willing to buy.

I believe the total amount of CDS short positions in the area of Greek problem debt is only 3-4 per cent of outstanding Greek sovereign debt. The biggest driver is confidence levels and actions of long investors.

In other words, pension funds and other “good” investors are shy of buying Greek debt, not surprisingly. So not only is it not bad that hedge funds were shorting Greek debt, they weren’t even driving down its price by doing so. The current bail-out talk is already creating the risk of a short squeeze, bringing in spreads, as the WSJ points out.

None of this is likely to stop eurozone finance ministers blaming nasty foreign Anglo-Saxon casino capitalists for their troubles; some hedge funds closed out their short positions on troubled countries weeks ago because they feared exactly this political intervention (although they are now shorting the euro as a whole instead).

However, there is a genuine debate to be had about whether the use of CDS to take speculative positions, rather than simply to hedge existing positions, should be banned. Taking out insurance on something you do not own (which is akin to a “naked” CDS trade) is banned precisely because it creates the incentive to do what you can to damage the thing insured – in this case Greek debt. Plenty of people have argued CDS should be treated on a par with other forms of insurance, famously including Warren Buffett and most recently James Rickards, the former LTCM general counsel, and FT columnist Wolfgang Münchau.

I tend to the view that the incentive is different to fire insurance, and best controlled through regulation; owners of shares, after all, have an incentive to drive up the price through foul means, which we are quite happy to see controlled through regulation. But perhaps the CDS market cannot be made transparent enough, and liquid enough, to prevent it being used for large-scale manipulation, in which case it should be restricted.

In Greece, though, it does not appear to be manipulation by hedge funds which is causing the wide bond spreads. So finance ministers should address their problems at home, before trying once again to turn speculators into scapegoats.

James Mackintosh

Some smart hedge funds have already pulled out of the crushing attack on Greece, fearing that the market logic could be ovewhelmed by political intervention, as I pointed out earlier this week.

On Thursday night Christine Lagarde raised exactly this issue on the BBC (link may not be accessible from outside the UK).

Asked what message the eurozone countries wanted to send to “speculators”, she said (my transcription):

Number one I think they had better be careful. There is clearly a statement of solidarity – we are closing ranks. Whether we are big member states or small member states we are all in this together and we are not going to let any of us down. That’s point number one.

Point number two, I think that, you know, what we are going to take away from this crisis is certainly a second look at the validity, the solidity of CDS on sovereign debt. Clearly we need to look deeply at that and propose changes.

Number three, it confirms our determination to actually bring more transparency into this equation.

Lorien Kite

As European leaders edged towards the Greek rescue plan announced today, conservative commentators were struggling to contain their delight at all the porcine wordplay. For Edmund Conway, writing in the Telegraph, the EU’s dilemma was simple: “Does it admit that currency union was a mistake and dismantle it, or does it press on and create an effective European economic government to fill in the missing gap?” Daniel Hannan, meanwhile, used his Telegraph blog to remind us again of why we have been spared Greece’s fate.

Across the Atlantic, the mood of schadenfreude was even more pronounced.

James Mackintosh

In the hunt for hedge funds profiting from the Greek crisis and the contagion spreading into Spain, Portugal, Greece, Ireland and the euro, the obvious candidate has been ignored.

Mark Hart, based in Fort Worth, Texas, was the first to set up a dedicated fund to bet on problems within the eurozone, at the end of 2007.

His European Divergence Fund, run in partnership with GaveKal, the Hong Kong-based analysts who have a separate joint venture with London’s Marshall Wace, has done fabulously well from the crisis thanks to its early bet that the eurozone was unstable.

“The thesis was that European credits should not all be trading as if they were one, because they have divergent economies,” says one investor. “On top of that the conditions [for entry] were fudged.”

James Mackintosh

Speculators are back in the news, at least in Spain. Could there be something behind the claim by José Blanco, Spain’s development minister, of a conspiracy by international markets to bring down the euro? Frankly, no.

What there is, though, is valid concern among some serious investors that regulators could step in to help save the euro. The spread over German Bunds of Greek, Spanish, Portuguese, Irish and Italian CDS has soared as investors use the CDS to bet against the price of the bonds (CDS= credit default swaps, labelled financial weapons of mass destruction by Warren Buffett, and the Monster that ate Wall Street by Newsweek. They are basically a side bet on the performance of a bond, a type of insurance policy which pays out if the company or country which issued it defaults).

Take the parallel with the banks. US regulators ignored CDS when they stepped in to stop shorting of bank equities in 2008. But in the UK, the FSA banned all forms of shorting – including taking net short CDS positions.

Could something similar be done to try to rescue Europe’s struggling periphery? It doesn’t seem that likely that the British, and certainly not the Americans, would want to step in. After all, there are valid reasons to be worried, as the countries being hit are all in deep financial trouble and have no opportunity to devalue.

But the risk is there. One manager of a big hedge fund told me he closed out all his short positions on the euro and eurozone government bonds to avoid being caught out by any action – even though he knew this would mean missing out on profits.

“There’s a chance of a regulatory backlash,” he told me.

James Mackintosh

The start of work on an expensive new headquarters often marks the high tide for a company, from Time Warner and the New York Times through Volkswagen (with its VW Autostadt) and others.

So it is appropriate that it was only in December that the European Central Bank announced plans to press ahead with a new €500m HQ. The headquarters curse has already hit: the break-up of the eurozone headed by the ECB has become the subject of frenetic discussions following the financial crisis in Greece and the spread of worries to Spain and Portugal. The value of the single currency has plunged from an 18-month peak of $1.50, almost exactly on the day of the HQ announcement, to $1.37. Hedge funds have record levels of short positions betting on further declines, as the Greek financial crisis infects Spain and Portugal.

Euro decline

Many outside the single currency region are gloating, highlighting the unsustainable pressures caused by putting countries with such different performances as Greece and Germany under the same monetary regime. They are wrong to do so: the crisis may be bad for the euro but that is bad news for competitors, such as the US and UK, too.

In effect, prices of exports to the eurozone countries have risen about 9% since December. The new weakness of the euro will hinder the growing US export machine, and stamp on the green shoots of manufacturing confidence in Britain. In the race to export themselves back to health, Britain and America just lost their advantage. The only consolation is that the euro is reversing some of its gains, and had been a lot weaker a year ago.

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Christopher Cook is an FT editorial writer. Before joining the FT in 2008 as a Peter Martin Fellow, he worked for three years for the Conservative party.

Lorien Kite is deputy comment editor, a post he took up in 2009 after four years as a commissioning editor on the analysis page. He joined the FT in 2000.

Ian Holdsworth became assistant features editor in 2009 and was previously chief production journalist for the features pages.


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