Wednesday, December 28, 2011

Volatility Lurks

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The European Union is putting its money where its mouth is. Never taking the slightest blame for euro woes, its New York employees are moving to new offices at 666 Third Avenue. The EU's United Nations delegation will "take about 45,000 square feet .... and pay about $60 a square foot annually for 15 years...." reported Bloomberg on December 23, 2011. Negotiations with its prospective new landlord, Tishman Speyer Properties L.P., are nearing completion. The real estate company should consider an anti-EU hedge at the moment the EU signs up.

Sixty Euro employees will occupy the space (per
Bloomberg). This works out to a 25-by-30 square-foot office for each. "Austerity" is imposed on the lower 99%, but not yet in Brussels, Strasbourg, or points west.

The potential break up of the European Union is more a consideration for a landlord holding a fifteen-year lease agreement than for the average investor. Yet, current havoc and future bedlam are clearly underpriced in all markets. European and U.S. mispricings will be discussed here.

The S&P 500 volatility index - the VIX - is a measurement of volatility expectations. It has fallen 50% since the (latest) agreement to save the euro was announced. From 30.59 on December 8, 2011, (the Eurocrats trumpeted their fiscal union pact on December 9, 2011) the VIX fell to a 20.72 close on December 23, 2011.

Whether or not fiscal continence is the route to euro salvation does not seem to matter. As discussed in
The Rotten Heart of Europe, the Euro establishment (Brussels, banks, and bond markets) vectored towards that conclusion. Having done so, the implied volatility of markets is a derivative of what negotiators accomplished on December 9th.

European Voice
, a Brussels-based, English-language newspaper "maintains an independent stance regarding the affairs of the European Union." So it claims. It is owned by the Economist Group. This disabuses the notion of neutrality. The Economist's heart, soul, liver, and spleen promote the European Union over national sovereignty.

Van Rompuy Sends European Leaders Draft of Fiscal Union Pact, published on December 14, 2011, distills the best efforts of euro fans to promote the fiscal union pact. We learn that Herman Van Romney, the president of the European Council, has (on December 14) sent a draft of an inter-governmental treaty that will seek to boost economic discipline in the eurozone. It will enter into force once nine of the 17 eurozone member states have ratified it. It contains tougher rules on economic discipline. [Underlined words to be explored - FJS]

Since the purpose of the pact is to convince skeptics of the euro's stability, Van Rompuy must be planning an early retirement. Maybe next week.

The "draft" will transmogrify into a treaty by March 2012. (This and what follows is gathered from
European Voice.) How many of the still (somewhat) sovereign states will sign is unknown. We do know that most countries "have shown interest." Whether any more is expected of countries is not clear: "If a eurozone country does not ratify it, it will not be bound by the new rules." That's the problem with the euro today.

However, an EU official told
European Voice that rejection by a country would "make life politically very uncomfortable for a non-ratifying member." Here is the mailed fist of the lifetime bureaucrat. The EU official continued: "It ["It' seems to mean the state's sovereignty - FJS] would not be durable for long." The second decade of the 18th, 19th, and 20th century were marked by continental European skirmishes. Four-in-a-row looks plausible.

European Voice
reports there are references in the treaty to "work jointly towards an economic policy fostering growth through enhanced convergence and competitiveness." Yet, these references - "remain vague." Please recall that markets, by and large, believe the Eurocrats will prevent a euro breakdown.

"Once adopted, the treaty will force countries to run a balanced budget and enshrine that rule in
their constitutions." This is the out-to-lunch attitude of the bureaucrat: expecting, by the beginning of March 2012, the parliaments of nine - or is it 17? - European countries to cede their parliamentary authority (and the opportunity to hand out vote-gathering favors) regarding respective national budgets, at a time voters are ready to lop off parliamentary heads.

Standards to enforce fiscal discipline were ignored in 2005 when "Germany and France helped loosen the rules when they forced through the relaxation of the anti-debt stability pact..." (From:
The Rotten Heart of Europe.) That was during a time of relative prosperity. Actually, it was a time when all countries could borrow and spend with abandon, the very problem that has caused the euro's decline.

In any case, an
inter-government pact is unenforceable since "the European Commission cannot take member states to court when they breach budget rules." This is worth $60 a square foot?

Amidst this incoherence, gold and silver wallow. The VIX rose from a fat, dumb, and happy 17.56 on July 22, 2011 to 48.00 on August 8, 2011. It was during that time Standard & Poor's cut the credit rating of the U.S. government and the debt ceiling terrified the nation. Should another rating agency do so (Fitch has been making noises) one should expect volatility.
(Washington Post headline, December 27, 2011: "Obama to Ask for Increase in Debt Ceiling")

Jim Bianco
[], president and television star at Bianco Research, explained the potential problem in an interview with Kate Welling (Welling@Weeden). When a country loses its AAA-rating, Basel III capital requirements and central bank rules require banks to apply haircuts against the downgraded bonds. This would create a problem in repo markets, among others. Borrowers in the repo market (somewhere around $4 trillion for U.S. banks) would need to find additional collateral. (Here is the problem of falling standards of collateral leading to demands for more collateral, again.)

Bianco explained the potential rumpus: "Since [Moody's and Fitch] are still at triple-A, we can pretend S&P did nothing. The next downgrade, if Moody's or Fitch were to follow S&P's lead, would actually matter a lot.... The next one that issues a downgrade would make the U.S. a split-rated double-A-plus, which would change some of the rules."

If the VIX falls to 18, call options are worth considering.