Achtung Baby:Germany Is Riskier than You Think

June 2012

2

Weaker Eurozone Countries Owe GermanyMoney on a Massive Scale

“If you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.”

– J. Paul Getty (1892-1976)

3

1. Germany becomes an export powerhouse because of the Euro

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

2. German banks financed the export boom

Financed the current account deficits of the periphery

Lent German excess savings into periphery housing bubbles

3. The Bundesbank has replaced the exposure to peripheral debt that the German banks reduced

Periphery debt is now the Federal Republic of Germany’s problem

Germany Made Bad Loans but Still Wants its Money Back

Source: Bank for International Settlements and Bundesbank.

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German Bank Claims on Periphery Countries Plus TARGET 2 Balances

BIS balance vis-à-vis periphery Target2 Balance

Private risks

Public risks

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Transmission Mechanisms Bring Periphery Debt Back to Germany

4. Fall in exports

3. Private bank losses

1. Bundesbank losses

2. Rescue payouts

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Germany Weighs Its Two Choices

Save the EuroLet the Euro Break Apart

Bundesbank Losses

Private Bank Losses

Severe Export Decline

Pay for Rescue Programs

Private Bank Losses

Export Decline

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The Market Doesn’t Understand the Magnitude of Germany’s Future Losses

Transmission Mechanism Euro Stays Together Euro Breaks Apart

Bundesbank Losses Through TARGET2 Balances €0 €637 Billion

Germany’s Share of the Rescue Funds (ESM/EFSF/EFSM) €419 Billion €94 Billion

Private Bank Losses from Exposure to Periphery Debt €80 Billion €200 Billion

Fall in Exports Over The Next 5 Years €80 Billion €375 Billion

Total Estimate €579 Billion €1.31 Trillion

Estimated Total Debt-to-GDP 103% Debt-to-GDP 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?

7

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 2007They 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

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

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

R² = 0.9628

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TARGET2 Claims are Rising Quickly

Bundesbank TARGET2 Claims Polynomial Regression

(in tri llions)

Debt € 2,095 € 211 € 190 € 18 € 26 € 2,539

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

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2. Germany’s Obligation for Rescue Programs Is €419 Billion and Could Increase

Germany’s debt-to-GDP would 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

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

Source: JPMorgan and CAM estimates.

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German Bank Exposure to GIIPS

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

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

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

Source: Bank for International Settlements.

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German Net Exports

Net Exports Euro Net Exports GIPS

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4. Exports Will Fall in the Next Several Years

For the twelve months ending Jan 2012, Eurozone countries were 57% of net exports

This figure has been as high as 81%

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 neo-Pesetas or neo-Drachmas and imports in neo-Deutsche Marks fall in price

Exports are currently ~40% of the German economy

Source: German Federal Statistics Office.

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German Debt-to-GDP

Plus estimated €1.3Tn losses in Euro breakup

Plus estimated €0.6Tn expense to "save" Euro

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

Source: IMF and CAM Estimates.

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German CDS is Likely to Widen

CAM Estfor Germany(Euro integration)

CAM Estfor Germany(Euro collapse)

EurozoneGDP Weighted Avg

Source: CIA World Factbook and Bloomberg

12

10-Year Bund Yields Could Go Negative

Inherent currency option in Bunds If bonds are redenominated into Deutsche Marks, currency gain can offset the yield loss

For the currency, we used the European Commission’s 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

Source: Bloomberg.

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German 10-Yr Bund Yields

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

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Preferred Investment:10-Year German CDS

Source: Bloomberg.

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Purchases of 10‐yr CDS

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Investment Summary

Rationale The market underestimates the risk to Germany posed by its exposure to periphery debt

Expected Return

We expect that within a year, German CDS will widen to 200, which would provide a 2.2x return on the premium we have spentEven at current levels the return will be 1.4x

Instrument

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

Cost/Capital Commitment

Appendix

How Did Periphery Debt Become Germany’s Problem?

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

Spanish builderborrows for a project Spanish bank borrows from

a German bank in the whole-sale 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

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)

2007: 10% equity 2007: 18x leverage (5.6% equity)

2007: 30x leverage (3.3% equity)

Simple example, but not that far from loss (~19% loss)

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Cumulative Changes of German Bank Claims on GIIPS Countries

Greece Ireland Italy Portugal Spain

Both Ireland and Spain hadlarge housing bubbles

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German Bank Asset Balances Developed as Housing Bubbles Appeared

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 Italy’s 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

Source: Bank for International Settlements.

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How the Balances Built Up and Where We Are Currently

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

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

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

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

Step 4: Simultaneously the NCB’s borrow and lend from the ECB

The German saver is unaware of what has happened

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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 Bundesbank’s Target2 claims do not constitute a risk themselves because…the idea that the monetary union would fall apart is absurd.” Jens Weidmann – Bundesbank President 3/15/12

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?

“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

Source: www.intrade.com.

Why Germany Cannot Afford the Euro to Break Apart

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

ECB

BUBA

BdEBoG

NCB4

NCB5

NCB17

The capital of the Eurosystem:Book Equity € 86BnRevaluation €399BnTotal €485Bn

As of May 11th, 2012

The capital of the ECB:Book Equity € 6BnRevaluation € 24BnTotal € 30Bn

As of December 31st, 2011

Key: BoG = Bank of Greece, BdE = Banco de España, BUBA = Bundesbank, NCB = National Central Bank of which there a currently 17

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

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ECB Exposure to Greece

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 amountThe Eurosystem as a whole has enough capital to bear this loss

Germany losses would amount to €43bn which is 32% of the Bundesbank’s capital

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

Source of ECB Exposure Amount As of date Data SourceSMP (Direct purchases of bonds) € 51,871,861,000 5/17/2012 BloombergGreek TARGET2 Balance € 103,735,616,784 3/31/2012 Bank of Greece

Total € 155,607,477,784

There Have Been Many Rumors of a “Grexit”; Could This Be the First?

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

ECB

BUBA

BdEBoG

NCB4

NCB5

NCB17

Key: BoG = Bank of Greece, BdE = Banco de España, BUBA = Bundesbank, NCB = National Central Bank of which there a currently 17

BoG

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.

Suddenly, the capital of theEurosystem looks more like thecapital of just the ECB, withlimited ability to absorb losses

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What Starts to Be Horrific for Germany Is the Situation Where Multiple Countries Exit

ECB

BUBA

BdEBoG

NCB4

NCB5

NCB17

Key: BoG = Bank of Greece, BdE = Banco de España, BUBA = Bundesbank, NCB = National Central Bank of which there a currently 17

BoGBdE

NCB17

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

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

How Will Germany Deal with Its Problem?

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What Is the End Game?

Current Situation

Breakup Full Union

Lots of pathways to these two endpoints

European monetary unions have been tried before and failed….

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?

2011 Debt to GDP = 86.4%

2011 Budget Deficit = 4.1%

Bank Assets to GDP = 3.1x

Bank leverage =19.0x

France currently has almost these exact numbersWould 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 Germany’s 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 1940’s 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 Germany’s 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 Minister-President 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?

Disclosure

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