Sunday, January 29, 2012

Rage against the machine.

Mitt Romney was a good governor of Massachusetts.

That alone should disqualify him from being the Republican nominee. Like Bill Weld and Frank Sargent before him, he was part of the cyclical antidote to the deeply rooted Democrat machine politics of the state, the periodic salve to the status quo.

And he could be a good president, but the longer this goes on, the less likely it is that we will ever find out. Newt Gingrich—a man more in love with his own voice than any in memory—can smell blood. Who knows if it is Romney’s blood, or the blood seeping from dying Republican dreams of taking over the nation’s capitol.

Romney’s weaknesses are well known—his pro-choice past and creation of Obamneycare—but these are failings that could be turned to positives in the suburban Pennsylvania and Ohio suburbs that loom to be ground zero in the battle for the White House. The choice for Republicans always looked to be nominating from the right and going to war with a motivated base, or accepting Romney—liberal warts and all—and fighting for the independent center.

The world is different now from a decade ago when W. strategists Karl Rove and Matthew Dowd crafted a political strategy in a world with no center. Today, the center looms, and whatever the illusions of Rick Santorum, Republican chances are zero if they cannot win the suburbs.

But Newt's campaign is not about a political position. It is about Newt, and what he chooses to say at any given moment in time.

To hear Gingrich attack Romney for paying an income tax rate of 15%, one forgets for a moment that there is no hint of impropriety in Romney’s tax returns. It is all legal. He paid what he owed. He did not write the tax code. He never served in Congress, and thus cannot even be accused of sanctioning those inequities. He is just the Republican version of Warren Buffett, a very rich guy who benefits from how we tax investment income.

To hear Gingrich attack Romney for earning his fortune in private equity, one could easily disregard the fact that private equity—like venture capital—is one of the best functioning sectors of our capital market. Private equity groups raise money privately, they invest in real companies—either nurturing young, emerging ones, or redeploying the assets of failing ones—their funds have no real or implied public guarantees and investors fully accept that their money is at risk. He was not a hedge fund trader, simply making money from money, or from the part of Wall Street that took the world financial system down.

It has been odd to watch these attacks coming from Gingrich. Without doubt, the Obama campaign was poised to raise exactly those arguments against Romney in the fall, and just as assuredly, Republicans would have dismissed those attacks as reflective of Democrat ignorance of how the real world works. Now, by choosing to attack Romney from the left, Gingrich has essentially endorsed that line of attack and undermined one more of Romney’s potential defenses.

Romney was badly hurt in the wake of those attacks. As shown in the graph below from Intrade—a prediction market website that allows individuals to take positions on political events in the form of traded futures contracts—the price of a contract betting that Romney will be the Republican nominee plummeted from its peak at $92—comparable to a 92% chance—on January 18th to $65 six days later in the face of Gingrich’s withering assault.

Romney was bruised by the assault, but recovered, as illustrated in the graph showing his bounce back to $88. He finally acceded to demands and published his tax returns, and within days Republicans came to their senses and realized that, in fact, they are Republicans, and making money is not supposed to be a disqualifier.

But the damage was done. While Romney has bounded back to nearly $90, the beneficiary of the Gingrich scorched earth strategy has been the President, whose odds ticked upwards at the same time as the Romney crash, and now remain at $55, and solidly above 50-50 threshold for the first time in months.

Gingrich insists that he is in it for the long haul. Campaigning in Florida he asserted that he will remain in the race through the convention. “Romney’s got a very real challenge in trying to get a majority at the convention. This party is not going to nominate somebody who is a pro-abortion, pro-gun control, pro-tax increase liberal. Look, it’s not going to happen.”
Grand Old Party stalwarts Bob Dole and John McCain see the damage that is being done as the party has moved farther away from its orderly and disciplined past, but their efforts to return order to the process and avert the train wreck that they fear have been to no avail. Speaking for the grass roots this weekend, Sarah Palin—who has a way with words like no other—said it best. “You’ve got to rage against the machine at this point in order to defend our republic and save what is good and secure and prosperous about our nation. So, if for no other reason, rage against the machine. Vote for Newt, annoy a liberal, vote Newt, keep this vetting process going, keep the debate going.”
Unless Newt comes to his senses, or—more likely—lightening strikes, David Plouffe and the President will continue to watch as the campaign that once loomed to be an uphill battle becomes easier every day.

Sunday, January 22, 2012

The worm turns.

Negotiations to avert a default by Greece continue to move haltingly. The closer the parties get to a resolution—presumably replacing existing short-term debt with new, long-term bonds with a reduced coupon—the clearer it is becoming that a solution may require 100% participation of bondholders while sustaining the illusion of “voluntary” investor participation.

The holders of the Greek debt range from European banks to hedge funds. The European banks—for decades among the titans of the world financial system and the envy of U.S. banks—have been a shadow of their former selves since 2008. Many were essentially insolvent in the wake of the 2008 collapse, and only survived through a combination of sovereign guarantees, public injections of capital and actions by the U.S. Federal Reserve Bank.

Those banks are the largest holders of Euro-denominated sovereign debt of Eurozone members, in large part because they viewed that debt as carrying an implied guaranty—much as U.S. banks viewed the mortgage-backed securities that were their undoing—and because those bonds were eligible collateral for their borrowing from the European Central Bank. In a larger sense, however, those purchases reflected the extent to which the banks have become an integrated part of the public policy apparatus of the new Europe, where the boundaries between the public and private sectors have becoming increasingly blurred.

Hedge funds, on the other hand, live with no such ambiguity. Hedge fund buyers of Greek bonds are in it for financial gain. If a fund trader buys a medium-term Greek bond, they do so in anticipation of being able to sell that bond in the future at a higher price or in the extreme case holding the bond until it matures at 100% of its par value. To effectively protect against downside risk, they might concurrently enter into a credit default swap that would pay off in the event Greece were to default on its payment obligation. Ideally, a well-structured trade provides an upside to the hedge fund regardless of the outcome for Greece. Heads they win, tails they win, and only the math would tell you which way they would win more.

But in the new world order, things are not so simple. There are many participants involved, and each has their own set of metrics for a successful outcome of the Greece workout. The proposed resolution would provide for a swap of currently outstanding Greece bonds for new bonds that would pay out over a longer term, at lower rates. In theory participation is voluntary, but clearly some are kicking and screaming as they seem to be voluntarily coming to the table.

For the banks, the proposed swap is not such a bad outcome. First, because their holdings are of both short and long-term bonds, and based on the complex portfolio accounting, what they lose on swapping their short-term bonds in the deal, they make up in part at the long end. Second, as part of the complex public-private Euro-policy apparatus they have been told by their new political masters to play ball. But finally, and of critical importance, the European banks want to avoid an official default—or any outcome that could be defined as a “credit event” by ISDA, the International Swap Dealers Association—on Greek debt, as those banks are the primary providers of the credit default swap insurance purchased by the hedge fund community, and they want very much not to have to pay out on those derivative contracts.

For Greece, the objective is clearly to survive the restructuring with a balance sheet that causes as little domestic pain as possible, and to retain access to new borrowing going forward. To any rational observer, this outcome seems counter-productive, as it is hard to imagine that such continued market access for new borrowing will not lead all of the parties back to the table for a new workout down the road. Same script, another year.

For the hedge funds, this may be, to use that paternalistic cliché—a teachable moment. The banks seem to be getting out of the deal what they need—putting off a hit on their capital and avoiding a credit event under their credit default swap exposure. For its part, Greece seems to have garnered increasing leverage the longer the negotiations drag on, at least in part through its threat to recast the terms of the bonds. The bonds were sold under Greek law, and someone seemed to have realized that the Greek parliament could have the power to unilaterally change the terms of the outstanding obligations. It is hard to fathom that such an action would be legal, but no doubt Greek legislators would be only too eager to vote on the matter. It is the hedge funds that seem to have ignored the extent to which rules in the financial markets are increasingly subject to political intervention, and they may find themselves to be the odd man out.

The deal on the table is evidence of the growing interplay between the financial markets and political forces. Like the GM bondholders, the hedge funds are finding themselves subject to massive political and coercive pressures to consent to a workout that takes away both the upside that they thought they owned and the downside protection that was their fallback. In the most ironic of twists, hedge fund managers have threatened to sue in the European Court of Human Rights to prevent the usurpation of their economic rights through the proposed “voluntary” restructuring. Perhaps they are right on the merits, but it may be that trading and making a profit on the life and death of nations is not going to be as easy as it once seemed.

Early on, the new, dynamic interaction between the private financial markets and the political world was evident in the enormous pressure felt by Greek politicians to vote to cut public sector salaries, pensions and services. Now, the worm seems to have turned and the politicians have the upper hand and are turning the screws on the hedge funds.

Somehow, this Greek saga that was once front page news has drifted into the background, though its outcome may yet rock the financial markets. But the roles are shifting, and it is now apparent that the Greek politicians are not as dumb as they seemed, nor the hedge fund traders as smart as they thought.