More from Kotok in Paris

My great appreciation to my friend David Kotok for his insightful post :

Report from Paris – 3
December 13, 2011

 The rain, fog, and mist have returned to Paris.  Along with them came our deeper probing into eurozone central banking and bank-related issues.  Some of the interconnections among the seventeen national central banks (NCB) within the eurozone remain clouded in mystery.  We summarize our observations with the following bullets:

·  Europeans themselves are questioning the interrelationships of the seventeen national central banks (NCB) that compose the European Central Bank.  In some respects they all function alike, such as in the interchange of payments via their TARGET2 payment-clearing mechanism.  In other respects they operate under different rules, such as the Emergency Liquidity Assistance facilities (ELA) each NCB can have with the commercial banks within its particular country.

·  The European Central Bank (ECB) presents aggregate data in a similar way to the Federal Reserve in the United States.  The ECB has only a minimal balance sheet of its own, so the depiction of its assets and liabilities that we see and use in our macro-monetary and economic examination really consists of the assets and liabilities of the seventeen NCBs.  That is similar to the construction in the United States, in which the Board of Governors of the Federal Reserve has no balance sheet of its own.  The Federal Reserve System essentially has a balance sheet that consists of the allocation of assets and liabilities distributed among the twelve regional Federal Reserve Banks.

·  Within the US and the Federal Reserve, no concern is given to solvency of the twelve regional Federal Reserve Banks.  In the US, we clear payments, issue currency, and deal with central banking functionality daily.  We never give central bank credit risk a second thought.  In the eurozone, the construction was based upon that same concept.  The presumption was that sovereigns would not default, that sovereign debt was absolutely creditworthy, and that the central banks of each country would fully and completely honor all obligations that occurred between and among the seventeen members of the eurozone.

·  That underlying assumption of the eurozone is now flawed because of the lack of creditworthiness of the government of Greece.  Everyone knows Greece is insolvent, and everyone recognizes that Greece must have a haircut on its sovereign debt and must restructure.  Negotiations towards an eventual more sustainable and durable solution involving Greek debt are constant.  The current operative framework is simply a small advance of funds to keep liquidity flowing through the Greek system while the next round of negotiations occurs.  The Greeks have no choice but to participate, and the leadership of Greece understands that they must either comply to advance the restructuring agenda or they will run out of money and default.

·  Greece is bleeding cash.  Its banks are experiencing runs and withdrawals.  Its commercial enterprises, economic activity, and employment characteristics are all deteriorating.  Capital is leaving Greece.

·  Similar activity is underway in other peripheral countries.  One by one, an investor, depositor, commercial enterprise, or individual account – any agent within the economies of Portugal, Italy, or others that senses growing insecurity in the banking and financial system – one by one they move their euro balances to safer venues.  We see withdrawals coming out of Italian banks and being deposited in German and other banks.  There is a movement of finance from the periphery to the core of Europe, since the core is perceived as safer and more creditworthy.

·  The flows of funds that flow from weaker eurozone members to stronger eurozone ones create an imbalance among the seventeen central banks.  The NCBs of the weaker peripheral countries have growing liabilities to the euro system, and the stronger NCBs of countries such as Germany have growing assets.  Those assets and liabilities are all balanced through the ECB, so Germany’s claim on the ECB grows and Greece’s liability to the ECB grows, and that process has not been arrested by the political negotiations to date.

·  Two issues are essential:  the TARGET2 payment system and the issuance of currency occur through the mechanics of adjustment that take place at the ECB.  To understand them is to understand the flows of funds between the NCBs and how they clear through the ECB according to the “capital key.”  The capital key is the structure in which the financial characteristics of the ECB are apportioned among the seventeen member countries.  Germany is the largest at 27%.

·  The ELA activity is a separate function.  It occurs between each NCB and its internal, national commercial banks.  ELA is specific to each nation and not governed by the ECB unless the Governing Council of the ECB overrules an NCB by a two-thirds majority vote.  In the case of Greece, ELA involves collateral that is not qualified for direct pledge to the ECB.  The rules that apply to the ELA in Greece may differ from the rules that apply to the ELA in another country.  The data reporting on ELA is somewhat obscure.  It is difficult to find, it is simply listed by NCB, and the reporting time frame is not precise.  From what we were able to observe in Europe, the NCB emergency ELA lending in Greece now exceeds 40 billion euros.  It appears to be by Greek commercial bank-pledged collateral, which is of lesser credit quality than that acceptable by the ECB.

·  ELA is taking place in other eurozone member venues as well.  The total is estimated above 100 billion euros and steadily growing.  ELA can indicate any number of characteristics.  A key one is that the commercial banks within the country have exhausted the use of ECB-eligible collateral.  Since they can no longer obtain additional funds from the ECB, they must use the NCB’s ELA  facility.

·  The assets of each NCB are still merged into the ECB assets and liabilities, so that if the NCB of Greece lends to a commercial bank and takes collateral below the ECB standard in return, those assets and liabilities of the Greek NCB appear in the aggregate data of the ECB.  One can find the aggregate lumped into categories, which do not reveal the specific characteristics of each of the NCBs.  It takes considerable investigation to sort out these details.

·  The process by which NCBs clear their payments is a simple either/or system.  They either pay or fail.  In the end, it comes down to the creditworthiness of each NCB.  It is theoretically possible for the government of Greece to take a haircut on its outstanding sovereign debt and restructure it, while the Greek NCB continues to pay its obligations within the euro system without default.  The central bank payment exchange mechanism is different from the sovereign debt pledge.  The contingent liability of the ELA is not counted in the nation’s debt aggregate.

·  What the European restructuring is attempting to accomplish is to facilitate a haircut on the sovereign debt of a country like Greece, and create a mechanism by which debt can roll until it can be restructured and market access obtained.  These political changes are expected to occur, while at the same time the eurozone members preserve the payment system within the seventeen eurozone countries.  This is an intricate, difficult task, but it is possible to obtain such an outcome.  European leaders are determined to work toward that end.

·  We attempted to examine the structure of the NCBs and European Central Bank under the most extreme terms.  Suppose a new Greek government were to take office, repudiate all debt, withdraw from the European Union and from the eurozone, launch a new drachma, and for all intents and purposes default on all of its euro-denominated liabilities.  We know the holders of sovereign debt of Greece would suffer 100% loss.  However, what about the internal payment structure of the European Central Bank?  The NCB of Greece would not pay.  Its liabilities to the ECB would remain unpaid; in addition, it has liabilities created through the ELA, directly between the NCB and the commercial banks of Greece.  Those liabilities of the NCB also would not be paid.  Where are the assets?  The assets that are collateralized from the Greek commercial banks are in one category; they are internal to Greece.  However, the liabilities of the NCB run though to the ECB, either directly or indirectly.  They are part of the composition of the ECB balance sheet.  If Greece has 100 billion euros of NCB liability to the euro system, and the Greek government defaults along with the NCB of Greece, those liabilities would be unpaid.  Who would suffer this loss?  As far as we can determine, the loss would end up distributed among the remaining sixteen members of the ECB.  Germany, for example, with 27% of the ECB, would take 27% of the loss.  It would have to make up that portion of the capital deficiency in the ECB.  Could the ECB or its other member countries assert claims against the NCB of Greece or against its government?  Of course; there is international law that deals with some of these issues, but they would take years to resolve.  The uncertainties surrounding such claims and how they would be resolved are clearly unknown.  We admit, too, that this is an extreme case and not likely to happen.  We leave Europe with the puzzle that the answers to these claims and how they are asserted and what is their priority is indeterminate.

Our conversations involved nearly fifty people during our stay in Paris.  They represented observers of Europe with many years of experience and great skill: central bankers, economists, market professionals, money managers.  We found several characteristics that gave us a European view of how this process might unfold.

Europeans understand that the deleveraging taking place worldwide and especially in Europe has a deflationary characteristic.  They recognize that they are going from a system in which debt was expanding faster than income and faster than growth, to a new system in which debt will have to contract or expand more slowly than growth.  This is a transition that is difficult for Europe due to its many promised social obligations.  It is not impossible to manage.  Difficult but not impossible.  European intent is to find a way to bridge from the old paradigm of debt-financed expansion to a new paradigm of debt control, growth, and rising income-financed expansion.

Can the Europeans accomplish this?  That remains to be seen.  I leave Europe with the view that it is possible; but the outcome is still unclear, hence the uncertainty premium is high.  Do Europeans want to do this?  The answer universally seems to be yes.  Continental Europe understands that any option other than a durable European Union and sustainable eurozone will be much more painful than working through the difficulties they currently face.  In the case of Greece, which is the extreme example, withdrawal from the eurozone could condemn Greece to a generation of poverty.  About that there is universal agreement.

Another important take-away from this trip is the response of Europeans to what they see and read in the American media when the eurozone is discussed.  Europeans universally feel they are not understood, that their problems are not correctly identified, and that there is much hyperbole coming from the American media.  Having examined this issue from both sides of the Atlantic, I believe the Europeans are right.  My own experience in gauging television and mass media in public debate over the issues is that Americans do not understand the payment mechanisms in Europe.  They do not take the time to do the research.  Instead they jump to conclusions and make dramatic assertions.  In fact, they do not delve into the details, where the devil dwells – and where the answers may be revealed.

I believe the eurozone will continue to exist and that the European leaders will eventually restructure their debt-determined problems.  They are in a struggle; it will be volatile with uncertain moments, but their determination to succeed is clear.  Europe is on a path to strengthen itself as an outcome of this current test of its monetary experiment.  Continental Europe is headed for a more robust fiscal union, which is what it needs to get to the restructuring of its debt.

We leave Paris to return to the US and face the rest of the difficulties that exist in financial markets worldwide.  The best thing to do now is to leave you with recommendations and comments about some Parisian restaurants:

Aux Anysetiers du Roy, 61, rue Saint-Louis en L’Isle 01-56-24-84-58.  This is a recurring favorite.  Tell Lilliane I sent you. Try her lapin or cassoulet.  Her foie gras is homemade.  Yum.

Dorr, Place de Vosges, 33 bv Beaumarchais, 01-48-87-98-92.  Take the metro to Bastille and walk three blocks. An exciting place for oysters, crab, and shellfish.  They make a good soupe de poisson.

Chez Francis, 7 Place de l’Alma, take #9 metro to Alma, 01-47-20-86-83.  Delicious food and lovely view of the Tower.  Kidneys with a mustard sauce made a marvelous lunch.

Chez Flottes, 2 rue Cambon 01-42-60-80-89.  Always a favorite. Close to Concorde.  They have never missed and are a regular stop for me.

Vent et Marée, restaurant de poissons, 165 rue Saint-Honore, 01-42-86-06-96,  This restaurant is a new addition to my list.  Near the Louvre and with a somewhat nondescript exterior, it is a real gem for seafood. Their soupe de poisson was extraordinary.  A superb masterpiece, as was the lobster salad and an excellent dame blanche for dessert.


Bon Nuit.


David R. Kotok, Chairman and Chief Investment Officer


For Cumberland Advisors Investment Portfolio Styles:


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