Thursday, September 29, 2011

Francesco Guerrera's Flawed Euro Debt Solution in the WSJ

I read with some degree of disbelief How To Repair Continent's Ills, a column by Francesco Guerrera in Tuesday's edition of The Wall Street Journal. Guerrera is evidently the paper's Money & Investing editor. Perhaps that explains how his bad idea for resolving the Euro debt crisis managed to escape onto the pages of the Journal that day.

Here's the last part of his piece, where, after describing his understanding of the problem and alternative solutions, he proposes his own,

"There is, however, a third way and it passes through Omaha. Europe should copy the way Warren Buffett buys into companies in times of trouble.

In 2008, when Goldman Sachs Group Inc. and General Electric Co. needed cash and a jolt of confidence, the legendary investor demanded nonvoting preferred stock with a fat annual dividend and warrants to buy shares at reduced prices in the future. He recently struck a similar deal with Bank of America Corp.

Translated into Europe, the Sage's playbook could work thus: Ailing European banks would issue contingent convertible bonds, affectionately known as co-cos, to European authorities, and, crucially, private investors.

The bonds would pay a big annual interest to entice buyers as well as carrying the promise that they will convert into equity if banks' capital falls below a specified level by, say, 2013.

This approach would achieve two symbiotic aims.

It would enable EU institutions to support banks without having to own them. And it would offer investors a belt-and-suspenders approach: a tasty dividend every year and free equity if banks' capital levels slip.

Banks and their shareholders, who are at risk of being diluted if the co-cos convert, might not like the idea of diverting profits to pay outsiders but, then again, beggars can't be choosers.

A more relevant question is whether investors would participate in such a plan. Unwilling to take my own word for it, I asked two fund managers—one from a savvy hedge fund and another from a large bond fund.

"With a big dividend, I would go for it," said the hedgie. "If the governments are in and there is the prospect of conversion, there is money to be made here." The bond-fund honcho also sounded positive but, being less outspoken, muttered something about being adequately compensated for risk.

Coupled with other programs—namely the provision of day-to-day liquidity from the European Central Bank—the "Buffett recap" might be the best way to avoid a ruinous credit crunch in Europe.

Now all we need is action."

It's tough to know where to start shredding Guerrera's bad thinking. But I'll try.

Let's start with the Buffett example. Guerrera is mistaken if he thinks Buffett's preferred equity investments in GE, Goldman and BofA can simply be copied for every potentially troubled European bank.

Buffett knew, in 2008, that GE and Goldman were both "too big to fail," and reasonably good bets for long term survivability. They weren't in trouble because of basic business weakness, so much as poor decisions to fund short in a market that suddenly dried up. With BofA this summer, it's still "too big to fail," only this time actually written into law, plus, again, a sense that the worst outcome is a smaller BofA, not an insolvent one.

If Buffett thought it was worth doing this for SocGen, UBS, or any other continental bank, well, I'm sure he'd be doing it, and we'd have heard about it already. Chris Flowers, in his remarks on Bloomberg Tuesday, mentioned something I didn't include in yesterday's post. He noted that US banks typically have more deposits than liabilities in the form of loans, while European banks are the opposite, relying heavily on purchased money for funding.

European banks simply aren't identical in structure or nature to their American cousins. And the US dollar is the world's reserve currency, is controlled by just one nation, and, thus, is unlikely to, itself, disintegrate in the wake of a financial sector panic. You can't say that of the Euro, which is the currency in which one assumes the bonds would be issued.

Further, the "co-co's," as Guerrera calls them, are hardly doubly-safe. Kyle Bass derides anyone who thinks the banks which would be issuing these liabilities have any reliable long term equity value. So investors could easily lose the dividend as the bank fails, thus also losing the principal, too.

Strike One.

Next, Guerrera overlooks the simple reality that Europe is not America. See my post discussing Kyle Bass' remarks on this crucial topic. It's just not true that the many European sources of financial, political and legislative power are as concentrated and able to stave off financial and economic catastrophe as was the US.

Strike Two.

Finally, we have Guerrera hanging his entire thesis' evaluation on the opinions of two anonymous hedge fund managers. Or people employed at hedge funds. Perhaps not even their wealthy, savvy founders/owners.

Why are hedge fund the right segment to which to listen for this evaluation? How about private equity? Aren't they, as Chris Flowers was asked, the type of firm to express support and interest in this sort of thing? Because Flowers indicated his firm has increased cash levels and is basically staying on the sidelines, away from the Euro problems.

Then, if you felt hedge fund employees are the right group to ask for an opinion on Euro solutions, how much credibility do you attach to only two of them? Perhaps if Guerrera divulged that he'd talked with the founders of 10-20 large hedge funds, and provided their total assets under management, to indicate size, skill and potential influence in and affect on markets, it would be different.

But he didn't, so it's not.
Moreover, Guerrera downplays the two sources' misgivings, which he actually mentioned. They aren't trivial points, if you reread them.

Strike Three, Francesco.

You're idea's out.

What puzzles me is why the Journal's senior management let Guerrera publish an idea containing so many flaws.

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