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Achtung Baby: Germany Is Riskier than You Think

June 2012

Weaker Eurozone Countries Owe Germany Money on a Massive Scale

If you owe the bank $100, thats your problem. If you owe the bank $100 million, thats the banks problem. J. Paul Getty (1892-1976)

Germany Made Bad Loans but Still Wants its Money Back
German Bank Claims on Periphery Countries Plus TARGET 2 Balances
1,000

1. Germany becomes an export powerhouse because of the Euro


The effective exchange rate was set far too low vs. other Euro countries

800

Public risks
Billions

2. German banks financed the export boom


Financed the current account deficits of the periphery Lent German excess savings into periphery housing bubbles

600

400

Private risks
200

3. The Bundesbank has replaced the exposure to peripheral debt that the German banks reduced
Periphery debt is now the Federal Republic of Germanys problem

Mar-01 Jul-01 Nov-01 Mar-02 Jul-02 Nov-02 Mar-03 Jul-03 Nov-03 Mar-04 Jul-04 Nov-04 Mar-05 Jul-05 Nov-05 Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07 Mar-08 Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11 Mar-12 BIS balance vis--vis periphery Target2 Balance

Source: Bank for International Settlements and Bundesbank. 3

Transmission Mechanisms Bring Periphery Debt Back to Germany


1. Bundesbank losses

2. Rescue payouts

3. Private bank losses

4. Fall in exports

Germany Weighs Its Two Choices


Let the Euro Break Apart
Bundesbank Losses Private Bank Losses Severe Export Decline

Save the Euro


Pay for Rescue Programs Private Bank Losses Export Decline

The Market Doesnt Understand the Magnitude of Germanys Future Losses


Transmission Mechanism Bundesbank Losses Through TARGET2 Balances Germanys Share of the Rescue Funds (ESM/EFSF/EFSM) Private Bank Losses from Exposure to Periphery Debt Fall in Exports Over The Next 5 Years Total Estimate Estimated Total Debt-to-GDP Euro Stays Together 0 419 Billion 80 Billion 80 Billion 579 Billion 103% Debt-to-GDP Euro Breaks Apart 637 Billion 94 Billion 200 Billion 375 Billion 1.31 Trillion 131% Debt-to-GDP

The Cost to Save the Euro is Much Less Than to Let It Fall Apart, but Do the Germans Have the Political Will?
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1. Periphery Will Owe the Bundesbank 1 Trillion by the End of 2012


Periphery banks had to replace funding as the interbank market froze in 2007 They were forced rely on their own central banks as the funder of last resort
Since mid-2011 the need for this type of funding has accelerated

The Bundesbank has large exposures to the ECB and other central banks
TARGET2 Claims are Rising Quickly
1,200,000 R = 0.9628 1,000,000 Euros in Millions 800,000 600,000 400,000 200,000 0

German claims are on pace to increase from current amount of 657 billion to 1.1 trillion by end of 2012

If a member leaves the Euro the amount owed to the ECB becomes a loss for the remaining members

Bundesbank TARGET2 Claims

Polynomial Regression

7 Source: National Central Banks, J.P. Morgan and Bundesbank.

2. Germanys Obligation for Rescue Programs Is 419 Billion and Could Increase
Germanys debt-to-GDP would reach 100%
100.0% 98.0% 96.0% 94.0%
Debt-to-GDP

Germany's Debt-to-GDP Can Quickly Reach 100%

Well above the 90% that Reinhart and Rogoff suggest as slowing GDP growth

Cost for saving the Euro is approximately 579 billion


This compares with the estimated 1.4 trillion to reunify East and West Germany

92.0% 90.0% 88.0% 86.0% 84.0% 82.0% 80.0% Current Debt to GDP
(in trillions)

Any movements towards a fiscal not just monetary union will involve more explicit transfers

EFSF Exposure 211

ESM Exposure 190

EFSM Exposure 18

2012 Budget Deficit 26

Total

Debt

2,095

2,539

Source: JPMorgan and CAM estimates.

3. German Banks Could Lose Substantial Portions of Their Current Equity


German Bank Exposure to GIIPS
1,000,000 900,000 800,000 700,000 600,000
Euros in millions

The 438 billion of exposure is still 40% greater than the estimated 310 billion of German bank equity As late as December 2011, German banks had 33 billion of exposure to Greece
This does not count the CDS on Greece that German Banks have written

500,000 400,000 300,000 200,000 100,000 0


Jun.1999 Jun.2000 Jun.2003 Jun.2006 Mar.2001 Mar.2004 Mar.2007 Jun.2009 Dec.2001 Dec.2004 Dec.2007 Mar.2010 Sep.2002 Sep.2005 Sep.2008 Dec.2010 Sep.2011

Should the Eurozone split, German banks would likely suffer both large credit losses and currency losses

Source: Bank for International Settlements. 9

4. Exports Will Fall in the Next Several Years


German Net Exports
120.0 110.0

For the twelve months ending Jan 2012, Eurozone countries were 57% of net exports
This figure has been as high as 81%

LTM Net exports in Bn

100.0 90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0

Should the Euro dissolve, we would expect that net exports would fall to at least where they were at the beginning of the Euro (1999) Germany could become a net importer as exports become more expensive in neoPesetas or neo-Drachmas and imports in neo-Deutsche Marks fall in price Exports are currently ~40% of the German economy

Mar-08

Mar-09

Mar-10

Mar-11

Jun-08

Jun-09

Jun-10

Sep-08

Sep-09

Sep-10

Jun-11

Sep-11

Dec-07

Dec-08

Dec-09

Dec-10

Net Exports Euro

Net Exports GIPS

Source: German Federal Statistics Office.

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Dec-11

Debt-to-GDP Will Rise and German Credit Default Will Widen


German Debt-to-GDP
140
600

German CDS is Likely to Widen

125

Plus estimated 1.3Tn losses in Euro breakup


Current 10-yr CDS Spreads

Spain 500 Italy

110

400 Eurozone GDP Weighted Avg 300 France 200 China Germany 100 CAM Est for Germany (Euro integration) CAM Est for Germany (Euro collapse)

95

Plus estimated 0.6Tn expense to "save" Euro

Iceland

80

65

50
0 40

US

UK

35

60

80 100 120 140 YE 2011 Debt-to-GDP Ratio

160

180

Source: IMF and CAM Estimates. 11

Source: CIA World Factbook and Bloomberg

10-Year Bund Yields Could Go Negative


Inherent currency option in Bunds
German 10-Yr Bund Yields
10

If bonds are redenominated into Deutsche Marks, currency gain can offset the yield loss

For the currency, we used the European Commissions own estimates of Real Effective Exchange Rates For liquidity, we examined the moves in the US Treasury post Lehman Brothers default For where rates should be, we used the Taylor rule
We added the average shape of the yield curve and made an adjustment for the need to keep the markets liquid

Bund yields can trade in this range given the markets fear of redenomination, liquity needs and desire for safe haven

-2

Source: Bloomberg. 12

100

150

200

250

50

13
Jan09 Mar09 May09 Jul09 Sep09 Nov09 Jan10 Mar10 May10 Jul10 Sep10 Nov10 Jan11 Mar11 May11 Jul11 Sep11 Nov11 Jan12 Mar12 May12 Jul12 Sep12 Nov12

Source: Bloomberg.

Preferred Investment:10-Year German CDS

Purchasesof10yrCDS CAMestimatedtradingrange

Investment Summary
Rationale The market underestimates the risk to Germany posed by its exposure to periphery debt 10-year credit default on the Federal Republic of Germany (first purchased in June 2011) Our notional amount is much larger than our Spain CDS position Average of 0.8% of notional per annum effectively an option premium on the default of Germany during the next 10 years We expect that within a year, German CDS will widen to 200, which would provide a 2.2x return on the premium we have spent Even at current levels the return will be 1.4x

Instrument

Cost/Capital Commitment

Expected Return

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Appendix

How Did Periphery Debt Become Germanys Problem?

Until 2007, German Savings Helped Build Projects in High Growth Areas

Spanish builder borrows for a project

Spanish bank borrows from a German bank in the wholesale market; lends to the builder

German bank takes deposits from German savers and not finding interesting German investments, lends the money to a Spanish bank in the wholesale market

German saver takes his hard earned savings and puts it into a German bank

What is at risk If the project fails the developer loses his equity, but then it is owned by the bank Once the bank owns the property, losses beyond the equity of the bank are shared with the lenders 2007: 18x leverage (5.6% equity) Once the bank eats through its own equity, the losses should be shared with lenders Depositors are usually guaranteed by a deposit fund, which is funded by banks but backstopped by taxpayers (depositors) Simple example, but not that far from loss (~19% loss)

2007: 10% equity

2007: 30x leverage (3.3% equity)

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German Bank Asset Balances Developed as Housing Bubbles Appeared


Cumulative Changes of German Bank Claims on GIIPS Countries
300

German banks lent directly into the asset bubbles in Spain and Ireland Lending to Italy was smaller than lending to Ireland despite the fact that Italys economy was 8x the size (2007 numbers) German private lenders realized their mistakes and have withdrawn 478bn from the GIIPS between June 2008 and December 2011

250

200

Euro in Billions

Both Ireland and Spain had large housing bubbles


150

100

50

18

Source: Bank for International Settlements.

Mar.2000 Sep.2000 Mar.2001 Sep.2001 Mar.2002 Sep.2002 Mar.2003 Sep.2003 Mar.2004 Sep.2004 Mar.2005 Sep.2005 Mar.2006 Sep.2006 Mar.2007 Sep.2007 Mar.2008 Sep.2008 Mar.2009 Sep.2009 Mar.2010 Sep.2010 Mar.2011 Sep.2011
Greece Ireland Italy Portugal Spain

How the Balances Built Up and Where We Are Currently

Spanish builder is having difficulty, gets extension on loan from Spanish bank

The German saver is unaware of what has happened Step 4: Simultaneously the NCBs borrow and lend from the ECB

Step 3: needing to replace financing, Spanish bank borrows from Banco de Espana

Step 2: German bank looking for safety places at the Bundesbank

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Step 1: German bank refuses to roll loan to Spanish bank returns to German bank

Who Ended Up Taking the Risk?

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TARGET2 Ballooned as Banks Became Fearful of Lending to One Another


TARGET2 stands for Trans-European Automated Real-time Gross Settlement Express Transfer System
Allows for imbalances that have built up in the system to balance out

Typically this is taken care of in the interbank market


Normally, if the Spanish bank loses some interbank funding it would agree to pay some more and borrow from a different bank in the Euro-system, keeping balances low

But when the interbank market stops functioning efficiently, TARGET2 balances build up

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These Balances Are a German Asset if the Euro Breaks Apart


The Bundesbanks Target2 claims do not constitute a risk themselves becausethe idea that the monetary union would fall apart is absurd. Jens Weidmann Bundesbank President 3/15/12 The way things are going,the Euro area has a significant risk of breaking up. Olli Rehn European Commissioner for Economic and Financial Affairs 5/31/12

Odds a country leaves the Euro by YE 2013

So long as the Euro remains in place these balances do not present a risk
But this is akin to saying that so long as my creditor keeps paying, I have no credit risk.

As countries exit the Union, the temptation to default on amounts owed to the ECB/EU/IMF will be high
Greece owed 104bn as of 3/31/12

The ECB would need to be recapitalized by the member countries


Would weak countries really be able to pay?
Source: www.intrade.com. 22

Why Germany Cannot Afford the Euro to Break Apart

What Is the Capital of the ECB/Eurosystem to Absorb a Euro Break-Up?


The capital of the Eurosystem:
BUBA

BoG

BdE

Book Equity Revaluation Total

86Bn 399Bn 485Bn


As of May 11th, 2012

ECB
NCB 4 NCB 5

NCB17

The capital of the ECB:


Book Equity Revaluation Total 6Bn 24Bn 30Bn

As of December 31st, 2011


Revaluation accounts for the increase in the value of asset holdings, mostly Gold

Key: BoG = Bank of Greece, BdE = Banco de Espaa, BUBA = Bundesbank, NCB = National Central Bank of which there a currently 17
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There Have Been Many Rumors of a Grexit; Could This Be the First?
ECB Exposure to Greece
SourceofECBExposure SMP(Directpurchasesofbonds) GreekTARGET2Balance Total Amount 51,871,861,000 103,735,616,784 155,607,477,784 Asofdate 5/17/2012 3/31/2012 DataSource Bloomberg BankofGreece

We believe that the current number is higher as the last TARGET2 balance sheet date was almost a quarter ago
During this time Greek banks have experienced deposit flight

A Greek exit from the Eurozone would cost the ECB at least this amount
The Eurosystem as a whole has enough capital to bear this loss Germany losses would amount to 43bn which is 32% of the Bundesbanks capital

If this causes others to leave, recapitalizing the ECB would become harder, more expensive with more of the burden falling on Germany

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If Greece Leaves, the Bundesbank Has to Rely More Heavily on Just the ECB
BoG
BUBA

Suddenly, the capital of the Eurosystem looks more like the capital of just the ECB, with limited ability to absorb losses
BdE

BoG

ECB
If the BoG leaves, the concept that no country can leave the Euro will be broken. NCBs of weaker countries will be called into question.
NCB 4 NCB 5
NCB17

Key: BoG = Bank of Greece, BdE = Banco de Espaa, BUBA = Bundesbank, NCB = National Central Bank of which there a currently 17
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What Starts to Be Horrific for Germany Is the Situation Where Multiple Countries Exit
BoG BdE
BUBA

Rather than being recapitalized, the ECB now becomes a debtor to the remaining countries Those debts are what the ECB owes from the TARGET2 system Far from being a worthy debtor, the ECB has no assets at this point

BoG

BdE

ECB
NCB 4 NCB 5
NCB17

NCB17

It would be forced to print to repay

Recapping the ECB is supposed to be weighted by GDP, but only 4 countries lend to the ECB via Target2 the real risk lies on them

Key: BoG = Bank of Greece, BdE = Banco de Espaa, BUBA = Bundesbank, NCB = National Central Bank of which there a currently 17
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How Will Germany Deal with Its Problem?

What Is the End Game?


European monetary unions have been tried before and failed.
Current Situation
Latin Monetary Union (Belgium, Italy, Switzerland, France, Greece) Scandinavian Monetary Union (Sweden, Denmark, Norway)

But in the case of German Customs Union (Zollverein), it ended with a single nation state What would a US of E look like economically?
Lots of pathways to these two endpoints 2011 Debt to GDP = 86.4% 2011 Budget Deficit = 4.1% Bank Assets to GDP = 3.1x Bank leverage =19.0x Breakup Full Union

France currently has almost these exact numbers Would the US of E trade about where France is now?

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Keeping the Euro Together Will Be Hard


The EMU is the most dispersed actual or potential monetary union shown
All countries that begin with the letter M are less different than the EMU

Stitching together a separated Germany was slow and expensive (1.4 trillion)
This despite strong cultural, even familial connections What will be the ultimate cost of holding Europe together?

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What Would Work Only Temporarily


The LTRO pumped 1 Trillion of liquidity in to Eurozone banks and stabilized them for a short time
But this program effectively subordinates other liability holders (including depositors) and seems to have tied up much of the available collateral

Pan-European Deposit Scheme have the ECB or some other European body guarantee all the deposits of Eurozone banks
This might help banks that have been experiencing deposit flight for credit reasons (Spain) But unlikely to help those that are experiencing deposit flight because of fear currency redenomination (Greece)

Eurobonds bonds issued by a European body that are joint and severally liable
If the issuing body is to be given unlimited issuing power, we do not believe that this would pass under Germanys Federal Constitutional Court If it is limited, we do not see much difference to the current ESFM/EFSF/ESM system

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What Would Work Long-Term


A United States of Europe central taxing authority, popularly elected head of state, ability to move funds freely from state to state, single set of regulations
We view this as almost impossible to achieve politically

A Marshall Plan for the periphery be it grants, loan forgiveness or write-offs a direct transfer of funds from creditor nations to debtor nations within the Eurozone
This is possible politically

The Marshall Plan was originally sold to the US body politic as a way to spur markets for their goods, which we think is reasonable in this case
But the ravages of war were clear in the late 1940s and the US also feared the rise of the Communist Party in Europe Currently, the debtor nations are seen as being profligate by the creditor nations and there is no ideological bogey man

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Can Germanys Past Currency Union Provide the Roadmap?


Starting in 1818, the Zollverein or Customs Union created a large single currency and trade union amongst the principalities of German speaking people In 1862, Otto von Bismarck was appointed MinisterPresident of Prussia and in the next decade succeeded in forging a unified German State While much of the work was done through diplomacy, Bismarck was unafraid to use military power as well
The great questions of the time will not be resolved by speeches and majority decisions,but by iron and blood. - Otto von Bismarck (Sept 30, 1862)

Will a leader emerge in the current crisis to draw Europe together? Will it be possible without bloodshed?

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