In turn the court levied the following judgments in favor of the plan participants:

• Failure to monitor recordkeeping fees and to negotiate rebates:    $13.4MM
• Failure to prudently select and retain investment options:             $21.8MM
• Improper use of “free float” interest on plan assets (Fidelity):        $  1.7MM

In all, the fines represent about 3% of the plan’s roughly $1.4B in assets.

Despite the landmark nature of this case (i.e. a judgment was issued, as compared to the preponderance of cases that end in settlements) plan sponsors in the small- and mid-sized markets, collectively $0-$100MM in plan assets, are likely to view these results as a concern limited to firms in the Fortune 1000.

However, even the sponsor of a $5MM plan should take note, as a proportional judgment against its plan ($150K) would likely be meaningful to that company’s bottom line.

Key findings stemming from the case include:

Failure to monitor recordkeeping and to negotiate rebates

The ABB retirement plan’s menu contained funds that used revenue sharing (a portion of the overall expense ratio of the funds) to pay for recordkeeping and administration of plan.  Although the court explicitly stated that the use of revenue sharing is not a fiduciary breach per se, failing to understand the amount and reasonability of the plan’s revenue sharing component was a deficiency.  Since ABB’s Investment Policy Statement (IPS) stated that revenue sharing was “to be used to offset or reduce the cost of providing administrative services to plan participants,” it stands to reason that ABB would need to know how much recordkeeping for a plan of their size and headcount would cost, independent of any revenue sharing relationships.  The court determined that ABB was negligent in never determining said costs.  Compounding matters, ABB was told by a retirement plan consultant that they were overpaying for services, and opted not to take action.

Implications for Small/Mid-Sized Plans:

1. Plan sponsors should have an IPS that contains a definitive set of rules regarding the selection, monitoring, and maintenance of their plan’s investments.
2. The IPS should be reviewed regularly and the processes outlined within it should be followed.
3. Plan sponsors are responsible for understanding the core set of services required to run their retirement plan, i.e. recordkeeping, administration, investment consultancy, and custody/trusteeship, and the industry-standard costs of each.

Failure to prudently select and retain investment options

ABB leveraged revenue sharing as a means to pay for plan services, in part, because the charges were less transparent.  Plan sponsors often opt to use revenue sharing specifically to avoid any top-line fees being billed to either the company or their participants.  The court found that selecting investments on that basis, as opposed to their underlying merits, was a blatant violation of the plan’s IPS and the company’s fiduciary duty to its participants.  In the case of one particular swap of the Vanguard Wellington Fund for one of Fidelity’s Freedom Funds, the court upheld that none of the stated IPS criteria for investment selection and monitoring, e.g. specific performance metrics, benchmarking, and watch-listing, were used.  In turn, the court was left to conclude that the primary motivation for the swap was the difference in explicit fees to the participants, which is not a reasonable fund selection criterion.  In addition, ABB’s IPS stated that an explicit goal of the plan was to use funds with the least expensive share classes.  Since revenue sharing is an add-on to a fund operating expenses, selecting share classes that engaged in that practice was a de facto violation of the IPS.

Implications for Small/Mid-Sized Plan Sponsors:

1. Selecting funds because of their ease of administration or revenue sharing amount alone is a fiduciary breach.
2. Simply having an IPS is not enough.  The company and its fiduciaries must follow the rules outlined within it.

Improper use of “free float” interest on fund assets

This portion of the judgment, levied against Fidelity, related to the use of interest earned on plan assets while temporarily parked in transitional holding accounts.  The court found that the interest earned on those assets are an asset of the plan, and as such, Fidelity’s crediting of that float to the mutual funds as a whole, instead of to the plan directly, was improper.

Implications for Small/Mid-Sized Plan Sponsors:

1. Sponsors should be aware of the actions of their vendors.
2. Vendor violations can increase the overall scrutiny of a plan and can ultimately pull a sponsor into litigation.

In summary, ABB, Inc. was found guilty of fiduciary breach in its retirement plan.  The members of its Pension Committee were also found in breach and are joint and severally liable for any shortfall in the company’s ability to satisfy the judgment.

Some of the breaches were the result of acts of commission, while others were more of omission.  In either case, however, several themes were apparent.  First, plan sponsors should have a “deliberative process” when it comes to the implementation and maintenance of their retirement plan and its associated investments.  Secondly, simply having the process, i.e. an Investment Policy Statement, is not enough; that process must also be followed.  Lastly, firms that chose to ignore their responsibilities, the actions of their vendors, and the advice of industry experts run the risk of being found in breach of their fiduciary duty.

The piece centers on 12-b1 fees in retirement plans. 12b-1 fees are marketing charges that are built into a mutual fund’s operating expense ratio (OER). Leidy’s article provides a brief history of 12b-1s as well as an exploration of the challenges and conflicts that can arise from using them.

Read the entire article by following this link:  401k Plan Sponsor Warning: DOL May Sacrifice Fee Purity for Fee Transparency

To view Jonathan’s appearance, follow this link:  http://www.ktvu.com/videos/news/palo-alto-apple-dividend-payout-signals-major/vGbj3/

Apple is currently sitting on ~$100B in cash and liquid investments, representing ~20% of the company’s total value.  Institutional investors, e.g. mutual funds, hedge funds, pensions, etc., have put increasing pressure on the tech giant to pay a dividend or “share the wealth.”  However, issuing a dividend also suggests that Apple’s pipeline of new products and innovations may be waning to some degree.  And with a share price that already makes AAPL the largest company in country, it seems reasonable to question how much further it can run.

Apple’s board of directors also approved up to a $10B buyback of shares over the next 3 years.

The piece, entitled Retirement Remedies for Physicians, highlights the challenges that physicians face when attempting to save for retirement due to ERISA rules.  Through 2 fictional doctors, Dr. Salary and Dr. Freelance, Leidy compares and contrasts the opportunities that exist for physicians that work for a medical group/hospital foundation versus those who have ventured out into private practice.

Leidy’s article is located in the Practical Concerns section of the magazine’s print version (p25).

Or to read the article here in its entirety, follow this link:  http://ow.ly/9GiYL

Lily pads double once every day. There is a pond that, on the first day, has one lily pad floating in it. Assuming the pond will be completely covered by the 30^th day, when is the pond half full with lily pads?

Although the knee-jerk reaction might be to blurt out the 15^th day, the answer, as the name of the riddle implies, is the 29^th day. The moral of the story is that exponential, or non-linear, growth is sneaky. One minute things appear manageable, even benign, when in fact we may be a mere “day” away from total saturation.

And with the world’s population toping 7 billion this year, it only seems fitting to future-cast a little, with a specific eye towards the effects that this global population explosion will likely have on investors’ portfolios.

What is Hockey Stick Growth?

“Hockey Stick” growth is a return pattern with an exponential kink. Below we see the kink in global population growth occurring at or around 1950. Prior to that point, more people were being born than were dying each year, but the rate at which the populous was growing was fairly steady. Combine the fall of the Third Reich with the rise of the American middle class, and domestic population growth kicked into high gear.

At the same time, emerging market countries, like China and India, were just beginning to boom. Fueled by the same sort of urban drift that dominated the first 30 years of the 20^th century in America, China’s population grew from roughly 500 million in 1950 to 1.3 billion people today. Compare that to the last half of the 19^th century, where China only added about 20 million people during that same time span. India fashioned a hockey stick of its own, adding more than 700 million people over the last 60 years.

By comparison, the US grew from 150 million to roughly 300 million people.

So What Does All this People-Making Mean?

For investors, the trend is quite promising. Population growth, specifically in developing nations with burgeoning middle classes, portends significant economic growth. That leads to the now somewhat hackneyed conclusion that emerging markets will make for good long-term investments. Nevertheless, the US and the rest of the developed world will continue to shrink in relative size, and hence global significance, over the next several decades; Emerging markets, and the multi-national corporations that work with them e.g. MacDonald’s, Tiffany’s, and Daimler-Benz, are likely to remain very attractive investments.

Another investment theme that will probably be rewarding is the increasing scarcity of commodities. In a standard supply and demand economy, scarcity dictates price. So even if you are not a Malthusian Doomsdayer of the n^th order, logic suggests that buying your share of the world’s resources (including real estate) today, will likely pay off tomorrow. Similarly, infrastructure investments, specifically in countries like Brazil (host of the 2014 World Cup and 2016 Summer Olympics), also seem sensible.

In several decades the world’s population will not only be larger, it will be significantly older as well. As the table below suggests, populations across every time zone will be aging, leading to probable upswings in the healthcare and biotech industries. Imagine… in 40 years, rest homes may be more overcrowded than prisons.

Within the next several decades new territories of cheap labor will also be fledged. As China and India ascend, Africa and Central/South America will look to take their place as the next set of strong backs upon which the global economy will be built. These new emerging market economies will likely experience increased stability and productivity that will in turn attract capital.

Of course all of this growth will not come without consequences. And just like the riddle suggests, what appears relatively innocuous on the 29^th Day can be nothing short of toxic on the 30^th. Whether measured by carrying capacity or ecological footprint, the Earth’s maximum population threshold is rapidly approaching. In fact, some scientists estimate that humans were already consuming at a rate 20% above long-term sustainability at the turn of the millennium.

In order to address this ecological predicament, mankind will need to innovate. Many of the fledgling renewable alternatives like solar, wind, and tidal are certain to play a greater role in the world’s energy fabric. Similarly waste management and recycling technologies will become a bigger part of the economy in the future, as will simple space-saving solutions and transportation mechanisms for densely populated areas.

However, population growth must be vigilantly monitored. For just as markets and asset classes exhibit mean reversion, or gravitation towards their long-term averages, so might global population. And despite mankind’s seemingly endless ability to manufacturing greater and greater efficiencies, some forces, like those of Mother Nature, might not ultimately be able to be out-engineered.

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The graph below (courtesy of www.mymoneyblog.com) is no different.  It tracks the since inception performance of the S&P 500-mimicking SPDR ETF (Symbol: SPY) from State Street Global Advisors.

Click Graph to Enlarge

As the red line depicts, missing the 10 best trading days over this roughly 17-year period was costly. Simply buying and holding $100,000 of SPY from January ’93 to June ‘10 (the blue line above) yielded an investor $324,330, or ~7.2%/yr. Whereas, had you missed the 10 best trading days, a mere .2% of the total trading days during the period, your account only grew by ~2.7%/yr to $156,234. Given the dramatic difference in return relative to the small number of trading days in question, this type of analysis is used often to justify a buy-and-hold strategy.

Of course, after seeing a multitude of these studies, others began to ask an equally valid question, i.e. what if an investor were able to avoid the 10 worst trading days over a given period? As expected, the results were dramatically better than buy-and-hold. For the same 17 year period, an investor that was skillful enough to avoid the 10 worst trading days was able turn $100,000 into $692,693, representing a return of better than 12%/yr (the yellow line above).

So what then is the green line? The green line shows the result of missing both the 10 best and 10 worst trading days for SPY since January ’93. Notably, the green line performed only marginally better than the simple buy-and-hold strategy (the blue line).

What’s more, the returns associated with the blue line were remarkably easy to achieve, whereas the returns of the red and yellow lines were not. Obviously one produced a much more desirable result than the other, but both relied equally on an investor’s ability to identify just 10 out of 4,284 days correctly.

Ironically, the green line was the most difficult performance of all to reproduce. In order to achieve green line performance, which was almost identical to blue line performance, an investor would have needed to make 20 über-prescient decisions over the same period.

Seems like a lot of work, given the rewards associated with the much more elegant (and effortless) buy-and-hold.

Beginning with the obvious, the downgrade caused the global markets to go berserk, producing a multitude of indisputably outsized numbers:

• The Dow Jones Industrial Average experienced an unprecedented 4 consecutive trading days during which the index moved by 400 points or more, in  either direction.
• Volatility exploded, with August futures on the VIX (the market’s volatility index) trading at a record 100,000+ contracts/day for 3 days in a row
• Gold hit a nominal high of greater than $1,800/troy oz., and is only a karat or two away from its inflation-adjusted high of ~$2,250/troy oz., established in 1980

S&P’s US downgrade was an unmistakable watershed event, causing everyone from the President to the proletariat to take a long, hard look at the lackluster numbers that have typified the US economy for months. Perhaps equally noteworthy during the tumult, however, was the sheer quantity of contradictions, ironies, and paradoxes that arose throughout the downgrade process. They sprung from all sides, ranging from the subtle to the downright staggering, and yielded a portrait of a country desperate for direction. What follows is a chronicle of these incongruities.

Congress Holds the Country Hostage

The debt ceiling debate, and the bitter backbiting that followed, has received mountains of coverage. However, it warrants reiterating that the entire debate centered on Congress’s unwillingness to authorize revenue generation, i.e. bond issuance, to cover debts that they had already approved a mere 3 months prior during the 2011 fiscal budgeting process.

If Congress had objections about the amount of debt that the country was incurring, then how could they, in good conscious, pass the budget? And if the budget did indeed pass muster, it must have been with the understanding that there was not enough revenues to support it. So how then could Congress contemplate welching when it came time to cover the shortfall? This sort of flagrant disregard for fiscal integrity, calls into question the very purpose and validity of the budgeting process itself… not to mention the ensuing debt ceiling debate.

A Ricochet Across the Bow

S&P’s downgrade of the US marked the first time in history where the sanctity of the county’s credit rating was legitimately called into question. In doing so, S&P expressed their mounting concern about the US’s ability to make good on their existing debts and projected future liabilities. Of course there is the palpable irony that S&P, one of the handful of ratings agencies that played a major role in the ’08 credit crisis, was now passing judgment upon the world’s most liquid “super credit.” However, using S&P’s historical failures against it, as the administration subsequently attempted to do, is equally amusing. How can S&P continue to do business, if every time they contemplate a credit change, their past is used to discredit their current judgment? Said differently, should S&P continue to do a lousy job rating credits just because they have done so in the recent past?

Cooling Off Turns Up the Heat

Heaping a few more irony logs onto the fire, S&P suggested that their rationale for waiting until the afternoon on Friday, August 5^th, to announce the downgrade was so that markets would have the weekend to digest the news. In truth, markets cannot do much over the weekend, let alone process the unprecedented violation of one of the few believed-to-be immutable laws of financial physics. Instead of offering the information directly to market participants, S&P offered it first to the media for a frenzy-filled weekend of joyriding. On Monday, the 8^th, the stock market opened down more than 5%. Retrospectively, it appears that slathering a weekend’s worth of headline risk on top of what was already a healthy helping of uncertainty wasn’t exactly the Pepto the market needed.

The Great Discounter Gets Discounted

The stock market is universally viewed as a leading indicator, where securities prices move well in advance of information and the actual economy. So when S&P began telegraphing the possibility of a US downgrade, traders and talking heads alike decried the alleged negative effects it might have on the market. Price stability in the weeks leading up to the debt ceiling showdown was used as evidenced that “The Street” was coolly indifferent to S&P’s opinions. “They aren’t telling us anything the market doesn’t already know,” was the deafening refrain.  Yet shortly thereafter so were investors’ cries of “uncle” as the market dropped precipitously following S&P’s announcement, directly calling into question what the market really “already knew.”

AA+ Becomes the New AAA

S&P’s downgrade of the US, formerly one of the world’s few AAA-rated credits, suggests the need for a whole slew of additional “recalibrations.” To S&P’s credit, they have at least marginally attempted to follow the downgrade chain to its logical terminus. After the US’s ignominious peg-knocking, S&P downgraded a host of banks and credit instruments that were heavily dependent upon US bonds for either collateral or prefunding.

But where does it end… or begin, for that matter? Are France and the UK still AAA credits given all of their structural challenges? Both countries have lagged US GDP growth for decades. Or is it any more plausible that the US is only a marginally better credit than Abu Dhabi or Estonia? Similarly, what was the threshold for debt to GDP that finally got S&P thinking… 100%? Either the US is a credit that should have been downgraded years ago, as debts were beginning to snowball, or nothing has dramatically changed about the nation’s ability and willingness to pay its debt… not both.

Pop Goes the Default

The bond market certainly disagreed with S&P. Following the US downgrade, equities tumbled, sending investors flocking for… wait for it… US Treasuries. In perhaps the most ironic turn of events in this whole imbroglio, 10-year treasury prices skyrocketed, driving yields to all-time lows and undercutting yield spreads for the remaining AAA-rated nations. Hence another paradox formed whereby the very borrower that S&P maligned actually became the debtor of choice. By this logic, S&P could continue to cut the US’s credit rating to deep junk status, which would in turn drive bond prices up even further, take rates straight through zero, and investors would eventually be paying the Treasury to hold its “junk” debt. Equally ridiculous (and ironic, of course) is the idea that investors, while flocking to Treasuries, engaged in the wholesale dumping of companies with far superior balance sheets than the US itself.

What’s a 13-Figure Error Among Friends?

Prior to the downgrade, S&P stated that any debt ceiling deal that was not accompanied by at least $4T in cuts would likely precipitate action on their part. The debt deal that ultimately passed, engendering only $2.4T in cuts, lead S&P to make good on its word. Yet less than 48 hours later it was revealed that S&P had made a serious “rounding error” by overestimating the US’s future deficit by roughly $2T. This miscue, not only fully debunked their mathematical rationale for the downgrade, but it also reinforced the jaundice with which S&P was being regarded as a result of their 2008 failings. When questioned as to how they could continue to maintain their downgrade given their enormous error, S&P quickly turned to political gridlock as the “new” primary driver behind the move. And it gets better… the entity responsible for unearthing the error… the US Treasury. The message is clear; the Treasury may be fiscally challenged, but at least they can add.

No Defaults Here

The fact remains that the US Treasury, despite all of the country’s current challenges, is still the most liquid government debt security in the world. Before the US would ever opt to default on its debt service, it would fire up the printing press and reel off sheet after sheet of ever-depreciating greenbacks.

Moreover, S&P’s revised rationale for the downgrade, i.e. political infighting, as thoroughly odious as it has been, is not even a criterion for downgrade within their own ratings algorithm. According to their most recent publication on sovereign credit evaluation, S&P ratings covers a “sovereign’s ability and willingness to service financial obligations to nonofficial, in other words commercial, creditors.”

The US’s ability to pay its debts, even if predicated on currency debasement, is unquestionable. In terms of willingness, the debt ceiling had already been raised prior to the downgrade. So in yet another contradiction, as soon as the US fully complied with S&P’s ratings criteria, they were downgraded. In addition, S&P’s methodology only applies to “commercial,” i.e. non-sovereign creditors. Given that more than 30% of US debt is held by other sovereigns, the US’s ability/willingness to meet its obligations, by S&P standards, is even less in question.

Congress Confirms S&P’s Worst Fears

As irony-laden as this entire scenario has been, there is more. For when S&P was forced to restate their reasoning for the US downgrade from fiscal to political, Congress proceeded to validate that very argument. In addition to all of the floundering and finger pointing that seems to be the hallmark of recent political responses to fiscal crises, Congress upped the ante with the creation of the “Super Committee.” According to the LA Times, as of Friday, August 18^th, the committee had “extraordinary new power to cut the deficit, but so far no meeting room, no staff director, no clear rules and no signs of compromise by either party.” When the dust finally settles on the Super Committee, it stands to reason that the only thing that will have been “super” about it will be the amount of time and money it wasted… just the sort of thing that S&P was deriding in the first, well actually second, place. 

The Other Ratings Agencies Hold Firm

Moody’s and Fitch, the other major ratings agencies, opted to leave S&P on the bleeding edge by holding fast on their assessment of US’s credit rating. The President and both aisles of Congress, presumably attempting to restore confidence, lauded the stalwart credit agencies for not succumbing to the pressure created by S&P’s lead. As previously noted, the government and the media concurrently lashed out at Standard and Poor’s, calling into question their abilities in light of their not so distant shortcomings. However, weren’t there a couple other credit rating agencies that experienced equally monolithic meltdowns in their algorithms during the credit crisis?  Hmmm.

Further, both Moody’s and Fitch pointed to the same mounting debt issues and political intransigencies observed by S&P as causes for a possible US downgrade in the near-term. So in point of fact, their determinations were only marginally different than the one being trounced by pundits.

S&P: The US’s Closet Savior?

Despite all of the backlash and bad math that S&P has created over the past few weeks, their forcing of the US’s hand in the longer-term fiscal austerity debate may one day be regarded as move of epic significance.  Up until now, America has blithely traipsed along, while bloated entitlement and defense spending has blown right through tenable.  A wake up call was long overdue.  So will it matter 5 or 10 years from now that the bucket used to douse the sleeping populous was actually more of a sieve?  Probably not… but it will be quite ironic.

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DFA Funds are the pinnacle of low cost, tax-efficient investment vehicles. A byproduct of the seminal research conducted by professors Eugene Fama and Ken French, Dimensional Funds are dynamically engineered using a rigorous, academic approach. 

Portico principal, David Tarantino, is very pleased to be an approved provider of Dimensional Funds.

“As fiduciaries, we are always looking for ways to bring more value to our clients. DFA Funds allow us to gain unique exposure to a variety of marketplaces at a very low cost. They make a great addition to our stable of options and their reputation for providing industry-leading research is second to none.”

Portico is authorized to begin using the funds for individual investors immediately, although they will be phasing in existing clients subject to tax and other considerations. Portico was already approved to use Dimensional Funds for their retirement plan clients earlier this spring.

Larkspur, California-based Portico Wealth Advisors is a Registered Investment Advisor and a boutique provider of custom wealth management solutions for individuals. Portico also serves as a retirement plan consultant to local and national firms, helping them improve the cost, quality and structure of their plans.

Dimensional Fund Advisors is a provider of low-cost, institutional-grade investment products. Founded in 1981 as an offshoot of the University of Chicago, the firm leverages the research of prominent academics, including Eugene Fama, Ken French, Robert Merton, and others. The firm is currently based in Austin, TX, with additional offices in Santa Monica, Chicago, London, Sydney and Vancouver. As of June 2011, assets managed by Dimensional are in excess of $230B.

The piece is entitled Optimizing Your Financial Horizons and details several local advisors’ opinions on retirement, with a particular emphasis on the challenges/opportunities facing individuals in Marin. Leidy’s opinions on investing for retirement, risk management, and cash flow planning are included. There is also a callout section on renting versus buying, Reassessing the American Dream, to which Jonathan was the sole contributor.

You can find the article in the July issue of the magazine or online:  http://www.marinmagazine.com/Marin-Magazine/July-2011/Optimizing-Your-Financial-Horizons/ .

Despite the most recent vote by its leaders to rein in spending, Greece really has little choice but to permanently restructure its debt. According to the major credit rating agencies, restructuring (or “reprofiling” as it has been euphemistically branded) will likely constitute a technical default. Compounding matters, the civil unrest resulting from continued spending cuts is gouging deeply into Greece’s number one source of income, tourism.

So how significant is the credit worthiness of one tiny, sun-soaked nation in Southern Europe?  In short… very. Admittedly, Greece is far from an economic Orion. Its 2010 GDP was just 2.9% of the European Union’s (EU) and a mere .44% of the world’s as a whole. However, its debt crisis stands as a monument to our ever-increasing global interconnectedness. Greece’s fate is now the fate of Western Europe and perhaps for many, more distant, economically-developed nations as well.

Episode

A Greek default has many undesirable consequences, some of them much more latent and far reaching than others.

Act I:  Blood, Sweat, and Teargas

Most obviously, Greece’s financial woes are bad for Greece. The country’s latest debt restructuring is conditioned on the continued adoption of austerity measures by its parliament. The move is part of the original €110B bailout approved in May of 2010. This latest injection of €8.7B (part of the €110B) serves as a momentary reprieve. Come fall, however, it is estimated that an additional €80-90B could be required to keep the ailing country afloat.

Bailouts also come with negative carry-on effects for Greece. Assistance is conditioned upon Greek cutbacks. Cutbacks lead to rioting, which leads to fewer tour buses idling outside the Acropolis, which inevitably leads to further cutbacks. Thus bailouts themselves are antagonists in this ill-fated drama.

Act II: Something is Rotten… in Athens to Denmark

Regionally, Greece has become the poster child for a host of similarly debt-laden European sovereignties. Portugal, Ireland, Spain and Italy are all anxiously waiting in the proverbial wings to see what sort of precedent is set by their Hellenic neighbors. If Greece receives clemency, why shouldn’t the rest? And if the rest of the troubled Eurozone is allowed to sidestep its financial indebtedness, the euro will be in an all-out sprint with the US dollar, vying for the dubious title of World’s Most Defamed Currency.

Greek default would also spell disaster for the reserve capital of many European banks. In particular, four French banks (BNP Paribas, Credit Agricole, Societe Generale, and Natixis) hold ~€38B of Greek debt. Germany holds ~€24B of the perilous paper, the UK holds ~€9B, and beleaguered Portugal holds ~€7B. Add to those figures the fact that the European Central Bank (ECB) is sitting on roughly €80B of previously absorbed Greek debt, and you can see that the bell doth toll for Europe en masse.

The debt itself is only the beginning. Whenever a portion of a bank’s reserve capital is diminished, it must mark the debt to market and adjust its lending ratios accordingly. Assuming a lending reserve requirement of 10%, a total Greek default could translate into a €780B decline in liquidity… a huge move in what is an already fragile economic recovery. What’s more, the ECB would be precluded from absorbing any more Greek debt, should default occur.

Act III: When Greece Sneezes…

The interdependency of today’s global economy makes the tragedy in Greece even more harrowing. Gone are the days of isolationism and contagion containment. Now even the smallest fiscal sickness can cause the entire world to catch a cold.

Globally, Eurozone bailouts mean fewer euros available for imported goods. Declines in import/export numbers portend a similar move in global employment. Hence a Greek default could indirectly lead to additional job losses throughout the US, the UK, and Japan.

Restructuring Greek debt seems like the only viable solution. However, that may carry consequences of truly epic proportions. For although US banks hold very little Greek debt, they have taken the lead role when it comes to insuring it. American banks, the same troupe that took center stage in the recently reviled production known as “The Great Recession,” have written roughly $35B in credit default swaps (CDSs) on Greek debt.

Ratings agencies Fitch, Moody’s, and Standard & Poor’s have all so much as said that any restructuring of Greek debt involving significant concessions on the part of current bond holders would constitute a technical default. And default, technical or otherwise, will mean that not only will European banks need to be recapitalized, but US banks will be forced to cover. Making matters worse, US banks also hold $54B in CDSs on Ireland and another $41.2B on Portugal. Even the sanctity of money market funds may be in question, with ~44% of all US deposits invested in European bank instruments.

Exode

“Monetary union without political union is increasingly untenable and leaves global financial authorities with one hand tied behind their back.”  Michael Lewitt, The Credit Strategist

Developed financial markets in Europe and around the world are staring directly into the abyss. On one hand, it is plain to see that the only long-term solution to the decades of financial profligacy in Greece (and beyond) is to restructure. On the other hand, there is very little political will to do so. Moreover, restructuring could lead to wide-spread default among Europe’s worst credits, which could in turn lead to the complete undoing of any economic recovery we have experienced over the last 2 years.

So is Greece the next Lehman Bros.? It’s certainly not out of the question. If we could only convince those pesky ratings agencies to revert to their pre-2008 ways, all of this default nonsense might magically disappear.

After all, what’s a tragedy without a bit of good, old-fashioned irony added to the mix?

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