Euro Bailouts - The Good, The Bad & The Ugly

By: Axel_Merk

The markets appear euphoric about the ability for European policy makers to deliver on new promises. Low market expectations were met. We, too, have a positive takeaway, but only because of one detail of the grand plan; actually, let's call it a "grand sketch," as many details are still unknown.

The Good

Just as the U.S. bailout fund "TARP" was used to bolster U.S. banks as opposed to buying toxic securities in the market, the most effective tool to bolster confidence in the Eurozone is to ensure banks are able to stomach losses on their sovereign debt holdings. The movement to focus on banks in earnest started earlier this month. On October 5, 2011, German chancellor Merkel embraced the notion that bank capital must be bolstered; we turned significantly more positive on the euro that day. Her change of heart came after the market had provided ample "encouragement," in the form of widespread selling of bank shares and debt; the process had been enabled by European stress tests that disclosed sovereign debt holdings in detail.

This is real money that banks will need to raise. The financial system, as a result, will be substantially more robust. Relevant for the euphoria is that there is a focus on bank capitalization. Regulators have started to embrace market value assessments, another huge positive.

Just like many, we would like even higher capital targets. One has to be realistic, though, that bank capital alone will not unfreeze interbank lending markets. Banks with a tier one ratio of 9% must still finance 91 percent of their balance sheet. We must move away from myopic bank regulation coercing banks to favor domestic sovereign debt to a pan-European approach where corporate debt (the interbank lending is lending amongst financial institutions, which are corporations) is valued on its merits rather than regulation.

The Bad

Greece. A debt write-off before a country has been able to achieve a primary surplus (budget deficit before interest payments) is counter-productive, as it takes away a powerful incentive to invest and engage in further reform. Having said that, this is mostly bad for Greece; financial institutions have now been warned that they must have adequate buffers going forward. We avoided a 60% write-off, and may end up with two 50% write-offs. Consider, though, that 18 months ago pundits called for an implosion of the financial system should Greece default. Then, the euro was trading around 1.20 versus the dollar. Now Greece clearly defaults (even if it is possible to avoid the triggering of credit default swaps), but the euro is trading at over 1.40.

The Ugly

The European Financial Stability Facility (EFSF) that's touted to protect one trillion euros is a scheme where even policy makers don't yet know what exactly it is going to look like. It is not a "bazooka," as it cannot refinance itself at the European Central Bank (ECB). Indeed, gearing it up appears to be done through the back door, by making it an insurance scheme. Even so, it only has a fraction of the capital paid-in of what its commitments are going to be. As such, it's a smokescreen, albeit a very powerful one. In a leveraged world, appearances count for a lot. However, it would be far healthier for policy makers to finally realize that de-leveraging is the answer, not to put up ever-greater commitments that -particularly in the case of Greece - may well be called upon.

The good news is that the markets will be vigilant. When the current euphoria is over, the bond market will have little mercy with those ducking from their responsibilities. And that's a good thing that should continue to prove wrong those that have called for the demise of the euro. Long live the euro! Starting November under new leadership at the ECB. Talking about leadership: Has anyone noticed that the Federal Reserve might be paving the way for QE3?

By Axel Merk

Manager of the Merk Hard, Asian and Absolute Return Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies. Axel Merk wrote the book on Sustainable Wealth; order your copy today.

The Merk Absolute Return Currency Fund seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

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