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It’s Good To Be The King
Neosho Capital
By Chris Richey
May 1, 2012


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In Mel Brooks’ 1981 comedy History of the World, Part I, in the wake of multiple insults, abuses, and fatalities he inflicts on various maidens, peasants, and courtiers, Brooks’ King Louis XVI turns to the camera and exclaims, “It’s good to be the King!”   

 

In March, with the same insouciance, Greece defaulted on its privately-held sovereign debt, informing those debt holders that whether they like it or not, they would only be getting about 30 percent of their principal returned. While many predicted this default, what was not foretold was the indifference that would greet this event. Perhaps after all the talk and worry about such an event, investors and financial types worldwide were well prepared psychologically for its actual occurrence. The default may have been “orderly”, but it was definitely a default: all holders of credit default swaps (CDS) were paid in full per the terms of their contracts.

 

Perhaps another reason the investing world was so ho-hum about the Greek default was the realization that Greece might only be the warm-up act for the headliner, Spain. Greece only accounts for two percent or less of total EU GDP, Spain accounts for about 10 percent of EU GDP, so it will be harder to be as blasé about Spain as it was for Greece. While yields on Spanish bonds have yet to reach stratospheric Greek levels, they remain in the six percent range, perilously close to the magical/deadly seven percent level presumed to represent the tipping point into the abyss of unsustainability. The Spanish budget deficit of 5.3 percent is above the four percent rate targeted by EU, Spanish, and IMF officials, mainly due to the profligacy of Spanish municipalities and provinces. The central government has threatened to “take over” the local budgets in order to bring spending under control, an act that will certainly not go down well in the “Autonomous Regions” of Catalonia (i.e. Basque country) and Valencia. 

 

With Spanish unemployment running at 24 percent and the total sovereign debt to GDP ratio at 90 percent, Spain is now undertaking extreme measures to combat its potential insolvency, including banning cash transactions in excess of €2,500 in order to reduce tax evasion and requiring Spanish citizens to report foreign bank account balances.  In total, the Spanish government believes these measures will bring in a total of about €8 billion against a sovereign debt in the area of €1 trillion, or less than one percent. Why, might you ask, would Spain undertake measures that will probably only encourage even greater and more open disregard for their laws? Certainly not for their fiscal impact, but more for the real audience of these measures: the other members of the EU, who will ultimately have to approve a bailout of Spain. The difficulty with bailing out Spain is that it would completely swamp the EU bailout fund, leaving nothing for the Portuguese, Irish, Belgian, or, worst of all, Italian economies. The next time a tree falls in the EU forest, there will be no ignoring it.   

 

One of the pillars of modern financial theory has been the Capital Asset Pricing Model (“CAPM”) and the concept of the “risk-free rate” as the foundation for pricing all other assets. The “risk-free rate” has generally been assumed to be the interest rate that a sovereign would pay on its obligations, with the idea being that, because the sovereign may tax, print money, or otherwise confiscate the wealth of its subjects, the sovereign will always “make good” on its debts.

 

It should be clear to all in the wake of Greece, and with the possibility of further national defaults in the horizon, that the “risk-free” description of sovereign debt is not just a stretch, but fatally inaccurate. In their book, This Time It’s Different: 800 Years of Financial Folly, authors Reinhart and Rogoff catalog scores of sovereign defaults by sixty-six countries across five continents going back to the 1300’s. Starting with England’s default on its debts to Italian creditors in 1340 under the reign of King Edward III and extending on up to the global credit crisis of 2008/2009, Rogoff and Reinhart make it plain that far from being an exception, sovereign defaults are the rule.

 

Over the past 212 years, at any time no less than 10 percent of all independent states were in outright default or in the process of restructuring their debts, with peaks of between 30 percent and 50 percent of all independent states at any given time were reneging on their promises of repayment. What is surprising is that given the origins of CAPM and its risk-free sovereign debt proposition were in the late 1950’s and early 1960’s, less than ten or twenty years from a period when half of all debt-issuing nations were in default, we have to wonder what possessed the fathers of CAPM (Bill Sharp and Jack Treynor building on the work of Harry Markowitz) to believe that sovereign debt was anything close to “risk-free.”   

 

We also wonder, given both recent and more ancient history, why any thoughtful observer of finance would believe there is anything such as a risk-less asset. Yet, highly educated people without much practical experience do not let reality get in the way of elegant theory backed by equations with Greek letters. For example, the IMF warned in its new Global Financial Stability Report that “[i]n the future, there will be rising demand for safe assets, but fewer of them will be available, increasing the price for safety in global markets.” The IMF went on to identify $74.4 trillion of “safe assets” such as gold, investment grade government bonds and corporate debt, and covered bonds. Thus, according to the highly paid and eminently educated experts at the IMF, gold is safe at $1,600 an ounce, despite the fact that those that purchased it at $1,800 an ounce have now lost 11 percent of their investment. Also, they deem “investment grade” sovereign and corporate debt  are safe, though we note that Greek bonds were “investment grade” two years ago and Lehman Brothers was a AA credit just minutes before collapsing. Finally, according to the IMF, covered bonds (debt secured by mortgages or public sector loans) are safe, although the U.S. housing crisis would tell you otherwise and we will simply refer you back to Greece as far as loans guaranteed by the public sector.

 

“This time” is never different and it is a good indicator that things are about to take a turn for the worse when you begin hearing arguments to the contrary. There is no such thing as a “risk-free” or “safe” asset, whether it is in the form of a security (and, ultimately, a dollar bill is a security) or in the form of a real, tangible asset, such as farmland, a bar of gold, or an office building. Investing is the art of choosing between less risky and more risky assets, but not risk-less assets.

 

And thanks to the prerogatives and power of government and our limited memories, the fact remains that when it comes to repaying sovereign debt “it’s good to be the King.” 


Chris Richey

Neosho Capital LLC

22 years of investment and securities experience

Brandes Investment Partners (1996-2003)
Director of Mutual Fund Portfolio Management


Cooley Godward Huddleson and Tatum (1993-1996)

Associate, Securities Law

Union Bank of Switzerland (1989-1990)
Credit Officer, Leveraged Buy-outs

Marine Midland Bank (1986 - 1989)
Credit Officer, Leveraged Buy-outs

Education:
Stanford University Law School - Juris Doctor (1993)
Oxford University – Master of Philosophy, Management Studies (1986)
Southern Methodist University Bachelor Business Administration (1983)

Member, State Bar of California

CFA Charterholder (2000)

Kenneth Rogoff and Carmen Reinhart, This Time It’s Different: 800 Years of Financial Folly, (Princeton University Press, 2009).

April 18, 2012 Update at the IMF website: http://www.imf.org/external/pubs/ft/gfsr/

 

 

(c) Neosho Capital

www.neoshocapital.com


 

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