Streetwise Professor

October 28, 2011

Tweek’s Gnomes Do Europe

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 9:32 am

In an early South Park episode, desperate for help on a school project requiring them to formulate a business plan, Stan, Kyle, Kenny, and Cartman enlist the aid of their jittery friend Tweek’s Underpants Gnomes (h/t KW).  The Gnomes’ foolproof plan?:

  1. Collect Underpants
  2. ?
  3. Profit

The Gnomes see to have taken their brilliance to Europe, because the vaunted rescue scheme hatched over the last few days looks like:

  1. Announce grandiose plan
  2. ?
  3. End Crisis

Each major element of said grandiose plan has many “?”.

Take the bank “recapitalization”–please.  How do the Eurognomes know that banks will respond to the capital requirement by adding equity capital, rather than dumping assets and contracting their balance sheets?  If the banks do decide to raise capital, who is going to invest?  Is compliance with the capital ratio going to be determined using legit asset valuations–particularly on Euro debt, or some mark to fantasy accounting?  What happens if the banks don’t meet the new requirement?

Next consider the “haircuts.”  The IIF (a banking industry group) cross-its-heart-hope-to-die promised that banks would volunteer to take a 50 percent haircut on Greek debt.  Will the banks actually respond to the call?  Is 50 percent really adequate to address Greece’s problems?  Recall that just last week it was revealed that 60 percent reductions in Greek debt were necessary to put the country on a sustainable path: 50 percent of 50 percent of Greece’s overall debt is less than 50 percent of the way to 60 percent.  And is it really 60 percent?  There are evidently “sweeteners” in the deal: where is that money going to come from?  And doesn’t every Euro in financial HFCS just reduce the amount of Euros the vaunted EFSF has to backstop other countries?  If Greece gets a 50 percent haircut (OK, 25 percent), what effect will that have on the Portuguese, Italians, etc.?

And speaking of the EFSF, let us turn to “leveraging” it.  Where is the additional money going to come from?  Where is the money going to come from?  Where is the money going to come from?  (Repeat as needed.)  ECB money–out.  Sarkozy is going to China, hat in hand.  The Eurognomes are hinting broadly that the BRICs, the IMF, your Aunt Fanny, are all welcome to invest in some CDO/SPV contraption that will buy debt from shaky Euro countries.  The EFSF will take the first 20 percent of the default losses.  But investors could buy debt in the secondary market or at auction at prices that reflect estimates of default probabilities and recovery rates.  What is the real benefit of getting involved in the Gnomes’ financial engineering scheme?

No, this entire scheme is aspirational.  It defines the end state that the Euros would like to achieve, but does not specify an even remotely credible path to get there. Just like the Underpants Gnomes’ dreams of profit.

Nonetheless, the equity market and the Euro staged a euphoric Tinker Bell rally yesterday–one of the most frenzied yet.  Ominously, however, today’s Italian bond auction was not a success, with low participation and yields on the 10 year at over 6 percent.

Betting on the Eurognomes foolproof plan is, IMO, foolish.  They are failing to grapple with the fundamental arithmetic, and the fundamental choices: amputation or gangrene, socialization or monetization.  Until they do, you’re better investing in Tweek’s Gnomes’ strategy for financial security.

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    Pingback by EU Politics - Hamsterwheel - Page 32 - PPRuNe Forums — October 28, 2011 @ 9:40 am

  2. To carry forward a Rumsfeld comment, the chocolate makers of Europe are now specializing in Fudge – the issue for markets is how long this can be carried on. Supposedly the banks have till June to come up with plans. don’t you love the Euro’s sense of urgency?

    Judging from comments in FT today, the banks do not plan on issuing shares, but shrinking their balance sheets – they also mention cutting dividends or issuing script dividends, cutting bonuses and other politically acceptable bromides that will have little material impact.

    If they are going to fund internally this means that they are going to have to generate some serious profits – how will that go down politically?

    Meanwhile the political elites are warning about not squeezing credit by shrinking their balance sheets “excessively”, whatever that means. Possible translation – you better lend or else.

    Talk about internal contradictions!

    Already some pretty sharp companies in the shadow banking world are gearing up for assets to be unloaded from the Banks. If this is done and funded through, say, CP, wouldn’t we be increasing systemic risks of a credit revulsion? If not, what funding vehicles are going to be there – more conduits, quasi money equivalents with risk – this time explicitly highlighted? last time we had the no bid preferred that all maxed out and couldn’t be liquidated for months. This time the investors would hopefully be forewarned.

    Assuming that they can generate profits, that is going to come from wider spreads – much like many of the larger American Banks had during 2008.5-2010. This means getting rid of low pays and boosting spreads on everything else . Again, will this be palatable?

    To summarize I think the best way to explain this is that they have raised some liquidity to buy time till June – then everyone will go on vacation, and by then they hope this minor inconvenience will have gone away.

    Comment by Sotos — October 28, 2011 @ 10:54 am

  3. @sotos–Exactly right. Fire sales w/purchases funded by short term shadow banking liabilities. What could possibly go wrong? They are just trying to buy time for miracles. Why does anybody take anything they say seriously?

    The ProfessorComment by The Professor — October 28, 2011 @ 12:41 pm

  4. Because up t o now their checks have cleared. even now they are first on the let’s get he loot line.

    Comment by Sotos — October 28, 2011 @ 4:51 pm

  5. The Underwear Gnomes episode was the most brilliant passage ever created on Southpark. Underwear gnomes and their complete deficit of understanding of “step 2”–the lack of an actual value production process between the idea and the end profit, was absolute genius and can be witnessed in politics and finance and common business practice everywhere today. A stroke of genius that episode. I often refer to it in conversation with colleagues all of whom understand the reference. Underwear gnomes business strategy has taken over the real world.

    Trey Parker and Matt Stone will be remembered for the Underwear Gnomes when the rest of their tedious cartoon antics are long forgotten.

    Thanks for being yet another appreciator of the absurd business fraud of the Underwear Gnomes and their ubiquitous presence in contemporary economics.

    Comment by gardener1 — October 29, 2011 @ 1:00 am

  6. Re: BRICS investing, looks like China is already unraveling. Chanos(one time reader of SWP 😉 is constantly talking about how the real estate market is declining rapidly… Perhaps next year China slow down might take the center stage.

    Comment by Surya — October 29, 2011 @ 7:13 am

  7. I don’t know if you’ve seen this yet, a hilarious explanation of how the EU’s “plan” will work:

    Comment by Nina — October 29, 2011 @ 8:18 am

  8. @Nina–Very Funny. Very true.

    @Surya–I hope to post something about China today or tomorrow. Yes, me and my old buddy Jim have been expecting that China will be the next–and biggest–shoe to drop. Michael Jackson economies usually don’t end well.

    The ProfessorComment by The Professor — October 29, 2011 @ 8:35 am

  9. @Surya–Here’s a video of Chanos talking about Europe & China.

    The ProfessorComment by The Professor — October 29, 2011 @ 8:39 am

  10. The Euro discusson is surreal, with folks like Soros calling for more power at the top to create a central bank that bails everyone out.

    Now, what if Los Angeles went bankrupt? Like Greece, it has about 10 million people in a wider alliance of more than 320 million. What would such a failure do to the value of the dollar in the long run? Would we kick them out of the US dollar as a solution to their problem, so they could devalue their own currency in an effort to preserve the lion’s share of their structurally bankrupt government?

    Likewise, would the answer to their economic hardships be that Texas taxpayers bail out the folks living in Los Angeles? Who would suggest such an answer and why would they do so?

    Even more pertinent to the current Euro discussioni, would the US government inform its citizens that it needs even more power to tax in a special treasury operation that would allow it to bail out California, New York and other states who have for years ignored their fiscal inevitabilities for reasons frighteningly similar to the case studies of Greece and Italy?

    Some readers may object to the comparisons of the EU to the USA. I suggest that the differences underline the reasons why the answers must still be the same; a resounding and echoing NO!

    Certain government philosophies inevitably fail. Fortunately, forgiveness and renewal is a part of life. And even corrupt governments like Russia have shown a remarkable aptitude to recover when ill-conceived spending and loans are finally ended.

    There is only one ending to this story; a 60-80% haircut and a drastic reduction in the welfare state. That can come sooner or later. But if it comes later, it will be all the worse.

    Comment by Jim — October 30, 2011 @ 10:53 am

  11. @Jim–Euro discussion definitely surreal. Re your hypothetical of the US government bailing out CA, NY, etc. . . I don’t think it’s all that hypothetical. The “Jobs Bill” attempts to do that by stealth. The stimulus bill did so. Believe me, it’s not going away.

    The ProfessorComment by The Professor — October 30, 2011 @ 4:09 pm

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