Euro Crisis: Mike Platt on Bloomberg 21st May 2012

Does Greece leave the euro? And if so, who's next? And does the common currency survive? Here to dissect the crisis country by country and tell you how to trade the outcome is Michael Platt, co-founder and CEO of BlueCrest Capital Management. Michael, welcome to the Inside Track. Now tell us, the euro, is it a failed experiment or is it just taking a temporary tumble here?

I think we need to sort of look at the situation country by country. If you take the situation with Greece, in the opinion of the markets, Greece should never have been allowed into the euro in the first place. They've already defaulted on their debts. They nearly defaulted again on a hard currency bond last week. They're not in a position to pay their bills. They have a primary deficit still. They will continue to be excluded from the funding markets. And I think at this point in time, the interesting point is that as the market increasingly calls into question the credibility of the troika, they're continuing to put money into a situation which I think has clearly become hopeless.

Why does the troika keep putting money in? I mean, Greece is never going to give it back.

Greece is never going to give it back. I think that we've got some pretty clear evidence that this is the case now. I mean, they're not in a position to pay the money back. The situation in Greece has gone from mainstream politics to now communism being the likely dominant party at the next round. And the Communist Party have promised chocolate cake with no calories to the population: they can stay in the euro but abandon the program of austerity, which is not going to be the case. And the market is now openly speculating that Greece will exit the euro. Correct.

So Michael, it seems that the only unanswered question concerning a Greek exit from the euro is when. If the G8 leaders in Washington are prepared to talk about it, even in guarded terms, if German politicians are prepared to talk about it in very straightforward terms, how much longer do we have to wait?

I think part of the answer to that question will revolve around what happens to the Greek banks. We've seen a very gradual movement of money out of Greek banks. The deposit base has reduced from around 240 billion euros to 140 billion euros. We saw the pace of that stepping up recently. And the big worry would be if there's a stampede out of Greek banks which precipitates an earlier crisis while the country has no government. And that could move that way. If we go to a world where there's an election, and Syriza has a 30% share in the vote, and then can form a coalition, I think that they'll leave almost immediately.

What does it mean for the Greeks if we go back to the drachma in the long term? I mean, short term, it can't be good.

The total aggregate amount of debt the country has, if you add up the overdraft of the ECB, the debt the government has, corporate debt and bank debt, adds up to around one and a quarter trillion U.S. dollars. If they leave, I think the market will price in a very small probability of any of that being repaid, especially in the short run. So I think that the interesting thing that happens in the markets is that it will become apparent that the single currency is not irrevocable. It's not forever. It's basically the old ERM in drag.

In the last segment, we established Greece probably leaving the euro. Do you think it's going to be disorderly or orderly? And is it priced in?

I think that there's still a level of complacency in the markets. I think that estimates for the effect on European GDP are anywhere up to a 4% to 5% European GDP drop caused by this event. 4% to 5%? That's the latest Bank of America estimate. And you buy that? In the worst case, yeah.

So how do we get to the total financial impact of a Greek exit, and then we can talk about what the implications of that would be and the final endgame?

I think that the order of events would be Greek exit, shockwave across Europe, massive stress in banks. Spain turns into the battleground for the euro because of the stresses in their own banking system, and then we either get a very swift and strong European solution, or we get a hugely disorderly meltdown in Europe. Well, then, what's a swift and strong European solution? People have—the people watching right now have their pencils ready. What is the swift and strong solution? Well, let's take a look what the problem is in Spain at the moment. The estimate of the amount of money required to take Spanish banks to a proper 10% Tier 1 capital ratio is around 90 billion euros. There is, at the moment, no effective federal deposit insurance scheme in Spain.

It used to be 8 billion euros; it's now 300 million euros. It has forward losses of between 15 and 20 billion euros as a result of two Caja deals. So the risk is that people focus on the Spanish banking sector and that we witness strong outflows or runs out of Spanish banks.

Are these Spanish banks acknowledging their real estate positions, or are they really just closing their eyes and looking the other direction?

No, they're not. In a country with 24% unemployment, they have a 3% provision against their mortgage book.

3%?

Mike, keep going. 3% provision against the mortgage book. The mortgage book of Ireland has a 10% provision. What's been going on in Spain is that 22% of Spanish mortgages have been reworked, half of them more than twice. In other words, there's evidence that the banks have been evergreening loans. In which case, you would have to take another allowance of 7% to get it to Irish levels, against 650 billion. That's another 50 billion euros there. And the same is going on in the loans to small and medium enterprises.

Let's go back to this binary outcome: a swift and strong response from Europe or a disorderly meltdown. What could possibly be swift and strong enough? Who has enough money to backstop Europe from the disorderly meltdown?

I think on the day that Greece leaves, in order to try and circumvent bank runs and market mayhem, there would need to be an enormous announcement from the EU, possibly along the lines of... Well, there are two things that I think could be effective. I think we can probably rule out an enormous money-printing operation by the ECB. But I think that the announcement of a Eurobond for Europe would be something that would buy an enormous amount of time. But it would have to be massive, wouldn't it? Yes, it would.

But also... Sorry, continue.

I think the problem is, issuing a Eurobond, I can't see that a hasty and ill-conceived monetary union can be solved by a hasty and ill-conceived fiscal union,

without a common taxing authority.

They'd have to somehow pass that overnight. Governments would need to cede sovereignty over their domestic spending to a central European entity. And I just can't see that happening.

But you said a Eurobond will buy time. How does time create a solution here? And who is the governing body who can actually push these sovereign countries? This isn't the United States.

No. I think that there's a misconception also in the markets that Germany can ultimately pay for everything. The truth is that the European area is an economy as big as the United States, and Germany is 78 percent smaller than the United States.

Michael, we've talked about the $13 trillion or so that were put to work in various forms here in the United States to prevent another depression. How much money do you think would be required to keep Europe from a similar fate in this disorderly meltdown type of scenario?

What we need to do in Europe is we do need a growth policy, because it doesn't matter how much money you throw at this problem. If the economy of Europe continues to contract, and more particularly continues to contract at an alarming pace in the southern area, it doesn't really matter how much money you throw at it. I mean, we've just seen Spain's deficit was really 8.9% for last year. I mean, they're going to continue to have an increasing unemployment rate of 1% a quarter, and they're going to continue to be unable to reduce that deficit. So you get to the point where it's not about money, it's really about a growth policy for Europe, and that would need an enormous amount of spending to jumpstart, and also an enormous amount of structural change for Europe.

Then what are Germany's options here? If Germany just doesn't have the money to really support the rest of Europe, wouldn't their correct outcome be, 'Let me just get out of here and be on my own'?

Yeah, I think an elegant solution, and I know it's not politically acceptable, would be for Germany to manage an exit for itself from the euro, control its currency versus the euro, and then the remaining euro region could then print money, buy bonds, and instantiate a Fed mandate for the ECB, which would have a mandate to minimize the loss of the economy versus inflation and unemployment. So, elegant, but realistic? No, I don't think it's politically on the agenda in Germany. I think that the first thing on the agenda in Germany will be a Eurobond. Michael, how do you trade Europe right now? The problem is, you can make a pretty sensible argument for almost any outcome in Europe. It could be a run on the banks very quickly.

The Greeks could end up staying in for a little bit longer. They could vote to take themselves out. There could be a Eurobond. The whole situation could be overtaken by events. We could have bank runs in Spain.

We could have LTRO again.

We could have LTRO. We could have a concerted bond buying action from the ECB. I mean, you can make a sensible argument for almost any outcome. It's in such a state of flux right now. I think that when you get into these sorts of situations, the first thing you want to do is you want to ensure that your money is in a place where you like the credit risk, so that if there is a major banking problem, you're not going to lose money on credit.

And where's that?

The reason why the Treasury market is doing so well—Treasuries and the short end of Europe in German government bonds, with two years now yielding essentially zero.

So when we talk about money flowing out of Greek banks, Spanish banks, and into Germany, what are they buying? Are they opening up accounts with German banks? Are we seeing people buy real estate in Berlin?

I think that buying real estate in Berlin is just too illiquid. I don't think people have got time to do that. I think that money is going into banks, for sure. I think it's actually going into, you know, they're calling their stockbrokers and they're buying German government bonds.

Is there no other asset class, Michael, in your opinion, that offers enough of a margin of safety beyond treasuries and short-term German government debt?

I think the one thing that you can say is that you can't really think up a good scenario other than Germany accidentally bankrupting itself trying to support the whole of Europe, where Germany isn't the best credit to have. So I think that people have realized that. People have bid up the German government bond level to almost bubble levels. Certainly in two years it's zero. I think they're pricing to some extent the possibility that you might hold a German piece of paper and end up getting re-denominated into D-Marks, which could give you a substantial gain. But I think in this situation where you can make an argument for almost any outcome, the right thing you want to own is option volatility, VIX, interest rate vol, because you'll be in a position to trade it correctly in any direction if you own the volatility.

And I think that volatility in markets, honestly, is still quite cheap.

We didn't mention France and Italy. What's your take?

I think Spain is the battleground. I think that they come after. I think it will all be resolved in terms of where we end up with Spain, honestly. If Spain leaves... I think if Spain comes to a position where it has to leave, I think you'll end up in a situation where either Spain leaves or Germany leaves.

Do you think a run on banks has already begun?

Yeah, I think money is being... I think that it's been a crawling slow run for a long period of time. 650 billion euros via the TARGET2 system has found its way into Germany and that has come from the deposit base elsewhere in Europe. And as the stresses increase and we go towards a situation where Greece might actually... You come to the realization that a euro in a Spanish bank and a euro in a Portuguese bank are not worth as much as a euro in a German bank.

Michael, as you know, we welcomed you here because we needed to hear your views on Europe, and we needed to go back to our conversation of last year and really figure out where we stand now. But we've all read about the position that BlueCrest fund may have on the other side of JPMorgan relative to the London Whale and JPMorgan's $2 billion trading losses.

And last year, you were quite negative on banks in general.

Okay, European banks in particular. What can you share with us?

I think JPMorgan, you know, I think it's well known in the street. And I want to be very kind to JPMorgan as my biggest trading counterparty and former employer.

My first job was at J.P. Morgan on Wall Street when I was 23. So I've got a very... good disposition towards that bank. But I would say that a bank in its normal course of its business has exposure to mortgage markets, has exposure to corporate counterparties. And the activities that they undertook in their Chief Investment Office just increased them. So I don't think they could be described in any way as a hedge. They're not out of those positions. And if we end up with a catastrophe in Europe in the short run, they're probably not positions that anyone will want to have.

But would you just call this a trading loss or is it something broader than that? I mean, at this point, there's all sorts of investigations going on.

I think it's a trading loss. They deliberately put the positions on. The London Whale, who has subsequently been harpooned, put the positions on. And, yeah, other people on the street. BlueCrest, on our credit fund, in the normal course of our business, in a small way, not in any way looking to try and cause them any problems, we found some anomalies in the market. And I think that a number of credit funds found anomalies caused by these very large transactions and possibly have taken the other side to provide market-making.

Based on what you know, and let's remind everybody, as you pointed out, you've only got a small piece of this, is there any way for a bank like J.P. Morgan to elegantly extract itself from this situation, or is it simply a situation where there is no one on the other side whom they could use to exit this trade and they have to write it down all the way to the bottom?

So the losses could get much bigger?

That's the big question. There's always a price. There's always a price to get out of anything. It might not be a price you like, but there's always a price. So that's true. I mean, it is in very high-grade credit in the United States. So I think that they would ultimately be able to exit this position, yes.

If you were back there, if you were still working at J.P. Morgan, if you were involved in this trade on the other side, and that's a huge hypothetical, would you be doing the same thing as Jamie Dimon says he's doing, maximizing the economic value of the trade over the long term, even if it's going to come with some serious mark-to-market pain between now and then?

Absolutely, I would, yeah. I mean, there are other hedges. I mean, if corporate American credit really blows out, it's likely that there are much bigger problems elsewhere. There are other instruments to hedge it. So yeah, I would be looking, if I was in that position, creatively at finding other avenues to reduce the value at risk of the book.

You're a man who loves liquidity. When you hear structured credit, do you think, why would they be in this space?

I don't like anything that's illiquid. I think the last time I was on this show, I mentioned that I wouldn't touch something illiquid with a barge pole. That's still the case. Especially if what happens in Europe, you know, turns out to be as bad as possibly it could be.

All right, Michael, it's always great to see you, and please come back again soon. Michael Platt, he is the founder and CEO of BlueCrest, a $32 billion hedge fund. You just heard his insights on Europe, how to trade it, and a little bit of interesting stuff.