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ADV PART II
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Market Commentary

Bank Runs in Greece Trigger Needed “Hunkering Down.”
April 12, 2010, David Kotok, Chairman and Chief Investment Officer

Intensifying bank runs are the catalyst that will successfully test the mettle of the Greeks and the euro zone.  A Greek version of Lehman Brothers will be avoided.
 
Consider:
 
When Northern Rock got into trouble in the UK and depositors started to withdraw their funds, the run on the bank was stemmed by a guarantee of the UK regulatory authorities.  They are the Financial Services Authority and the Bank of England (BOE).  They had credibility.  Depositors knew the BOE could print whatever money was needed to pay them, and hence, they stopped taking their money out of the bank.
 
When IndyMac failed in the US, insured depositors knew the Federal Deposit Insurance Corporation (FDIC) would pay them.  Uninsured depositors lost money, but all insured deposits were promptly paid.  The FDIC spent nearly $11 billion to resolve IndyMac.  The FDIC is the most credible organization headquartered in Washington DC.  300 million Americans believe it will pay insured depositor’s claims in failed banks.
 
When the government of Argentina ran out of dollars and had to break its currency peg, it suspended payments on bank deposits to Argentine citizens.  It then resumed withdrawals from the banks at a new exchange rate between the Argentine peso and the US dollar.  Depositors lost about 70 percent of the value of their bank deposits.  To this day the banks in Argentina are not trusted and the government is held in contempt by the citizens.  I confirmed this attitude among Argentines as recently as three weeks ago on my last trip to that country.  Failure to honor bank deposits has permanently damaged the reputation of the authorities in Argentina.  Even now, when the deposits are denominated in the local currency, the banks and government are neither trusted nor respected when it comes to financial integrity.
 
Now to Greece. 
 
Banks in Greece are experiencing runs in the billions of euros.  Remember, depositors can remove their money and redeposit in another country in another bank and still do business in the euro.  There are sixteen countries in the euro zone.  The banking options for euro zone citizens are varied and abundant 
 
The bank deposit scheme in the euro zone leaves deposit guarantees in the hands of the national governments.  In this case Greece is the guarantor.  And since the country is in trouble because if its fiscal deficit issues, its banking system is also in trouble.  That is because the strength of the national banks deposit guarantees are dependent on the strength of the government’s finances.  Depositors in Greek banks now worry that a severe run would require the Greek government to put up vast sums of cash and that the Greek government would have trouble raising that cash on top of funding its deficit.  We see this issue as the real test coming for Greece.  This is why a rescue package is being assembled.
 
Furthermore, the system in the euro zone has monetary policy and the central banking functions headquartered at the European Central Bank (ECB).  The ECB has limitations on how it can deal with the value of Greek sovereign debt as collateral for lending to Greek banks and any other banks in the euro zone.  The ECB can lend to banks which have the correct collateral.  But Greek sovereign debt is a weak credit.  Fitch downgraded it to BBB- with a negative outlook just last week.
 
And the supervision of banks in Greece and the maintenance of deposit safety are in the hands of the Greek banking authorities and not the ECB.  That is why the assistance has to flow through the Greek government.
 
Hunkering down.
 
Examine the structure of the euro-zone settlement with the Greek government and watch how the pressure from the banking system will force the Greek government to advance its austerity plan in spite of all the demonstrations of the unions.  Greek citizens, business executives and public officials know the integrity of their banking system is now at stake.  They will either be another Argentina and live with the consequences for many years or they will hunker down and do whatever it takes to resolve this issue and close the deficit so they may continue to obtain financing. 
 
Hunkering down is winning over an Argentine style asado.  That is why the Greek bank stocks rallied on the news of an EU-IMF package.  Unlike the United States which allowed Lehman to fail and experienced multi-trillion dollar runs on repo and hundreds of bank closings, the Europeans are now committed to a “no-Lehman-no-AIG” course of action.
 
We believe there will be a Greek version of the “hunkering down” outcome.  We saw the Baltic version of this process recently in Latvia, where an austerity program cut the deficit in half last year and markets immediately resumed functionality. 
 
Furthermore, we believe the euro will not only survive this test but emerge stronger and more reliable after it.  The other EU countries are already moving to improve their fiscal process. 
 
For the present we are underweight Europe in our global portfolios and we are watching carefully before taking a bullish position on the euro.   Notwithstanding the recent news, it is still too soon to buy.  But when the buying opportunity comes it will come fast, and the nimble will benefit.  Surviving this crisis and successfully improving the internal European banking system are the key to the euro emerging as a battle-tested reserve currency.  
 
What we see happening in Greece and in the euro zone is monumental in monetary history.
 
David Kotok, Chairman and Chief Investment Officer
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