Friday, September 23, 2011

Models for a Greek Sovereign Default

I am on a plane - long-haul over the Pacific - and someone asked me to spell out what I thought would happen with a Greek sovereign default. As this is drafted on a plane it is designed to outline extreme views (you know the ones after two glasses of wine). If people want to explore more modest views that is for the comments. Still all options look bad.

I see two broad variants - both of course stick most of the losses on Germany and France. Some variants are totally disastrous.

Variant 1 - the Argentine option: Default and de-peg the currency. 

When Argentina defaulted not only did the government default but they forced a private default. If you had a debt in US Dollars in Argentina prior to the default you were forced to pay it back in Peso. Indeed it was illegal to make payment in US dollars.

Likewise if you had a US dollar asset you got back Peso. A dollar deposit in Citigroup in Buenos Aires  became a peso deposit. If you really wanted to keep your dollars you needed to make your Citigroup deposit in New York.

The forced private sector default was necessary for Argentina. The Argentine banks all had lots of US dollar funding. If you devalued without forcing their default then they would all have uncontrolled defaults (a true disaster) and the country would lose its institutions. Telefonica Argentina would have failed too - failing to replay USD debts.

The same applies in Greece. If the Greek Government were to devalue the new Drachma (to perhaps a third the value of the Euro) then the banks (which are loaded with Greek Sovereign paper) would default. Even Hellenic Telecom would default because they would be forced to repay their billions of Euro borrowings whilst collecting only Drachma phone bills.

The Argentine economy was doing quite nicely after the devaluation. The lesson was that devaluation worked - provided you simultaneously forced private sector default.

If you were Greece you would take this option without hesitation.

However this option has explosive implications for Europe. You see a bank deposit in Athens is going to turn your Euros into Drachma. Overnight it will lose 70 percent of its valuation.

So it has to be done quickly and with an element of surprise (as per Argentina when most people did not get their dollars over the border). Without surprise people will rush their money to Deutsche Bank in Munich.

One weekend we will just find that the Greeks have done it.

But now suppose Greece does pull this trick. The day after we have a Drachma - deposits are in Drachma. We might print a single 10 drachma note and allow it to settle against the Euro - then over time print more. This should work for Greece.

Now if you are Irish or Italian or Portuguese (or even Spanish) you know the rules. You get to get your Euro out of the PIGS and into the core (Germany) as fast as possible. So max all your credit cards (for cash), draw all your bank deposits and load them in the boot of your car and make the drive to Switzerland or Germany. Somewhere safe. Otherwise you are going to lose half the value the day that the rest of the PIGS do a Greece.

And this bank run – a run including tens of thousands of Italians driving their Fiats - will surely blow apart every Italian bank. And their Euro-skeloritic compatriots will sign the death knell for for all their banks too.

If you are going to go the devaluation route you are going to have to do it all at once. Like the big-bank weekend (maybe coinciding with a week long bank holiday) in which all core European countries get their own currency back.

There is a precedent. It is not a pretty one. When the Austro-Hungarian empire collapsed there was a single currency over a huge area covering much of what is now Euroland. In this case the rather Germanic Austrians were in charge (or rather were in charge until their empire collapsed).

What they did was put troops on all the borders and made it illegal to take cash (or wire cash!) across borders. Then all Austro-Marks in each country was stamped - converted to Drachma for Greece, Marks for Germany, Peseta for Spain or whatever the currencies of the day were [If someone remembers the 1918 border splits better than me they are welcome to say...]

In this conception all Spanish debts become Peseta debts. All German debts become Mark debts. All Greek debts become Drachma debts. Unstamped currency goes worthless.

If you are going to split the currency I see no alternative to a big bang - and if you do that I see no alternative to troops at the border stopping transfers (and wire transfers) because shifting cash North looks so profitable against a sudden devaluation. Suddenly – and against all historic hope – its time again to guard the French-German (and every other European border) with troops for a week whilst the money is stamped.

Note however almost every country borrowed in hard currency (Marks) and got to repay in soft currency (Drachma). This is a scheme which shifts the loss home to Germany and with little compensating benefit except that they get their beloved Mark back. Its a scheme that is way better for the periphery because they get to keep their institutions. In two years they should bounce back like Argentina bounced back after their default.

Unilateral Greek default and devaluation without planning for the periphery to do the same - well that is a true mess. Too ugly almost to think about - and it would be unilateral for less than a week. The rest of Europe falls into that abyss with maximum movement of deposits and cash in the meantime.

The second variant on Greek default. Greece defaults and stays in the Euro 

The second variant on Greek default is the one that Germany prefers – Greece defaults and stays on the Euro. (Credit Agricole also prefers this.*)

In the second variant Greece has a huge problem after the default - which is that its banks are insolvent. They own a whole lot of Greek Paper. Moreover Hellenic Telecom does not look that great either.

The recession goes from bad to worse and the government deficit goes from bad to worse. The Germans wind up owning the banks and the telephone company as partial offset to their losses lending to them. The Greek Institutions are captured by the Germans. (All your base are belong to us.)

They also wind up getting paid a little more as Greek austerity - as long as it lasts and that might be a long time - partially reduces German losses but at huge social costs.

The Eurozone becomes really dysfunctional - with the whole periphery totally unable to work their way out and having lost all their key institutions to the Germans who neither know how to run them nor really want them.

Moreover Greece stays expensive and unproductive and becomes more socially fractious. The likelihood of them staying the the Eurozone would be pretty low. (After all what have the Germans ever done for me!)

Europe would be held together by a massive and compulsory German aid budget. If they can't get that agreed on on day dot (and Merkel and the German constitutional court are not of that mind) then my guess is that is is in Greece's interest to go the Argentine route and let the rest of Europe fend for themselves.

And for that Europe will need troops on borders. Armed and dangerous.

Bring out the guns.


*I have a known partiality to that stock but do not own it at the moment...


Anonymous said...

And what of SRW's Interfluidity suggestion of debt to equity conversion?
I fear it may be rather too technocratic to gain popular/political support but then again, the masses wouldn't likely riot over the idea of a cash handout!
Would it actually help to reduce the real deficits and facilitate growth in your opinion though?
It might placate the PIIGS public for long enough to slip some of the unavoidable and necessary austerity/reform past them, and distruct digruntled voters in Germany and France for the time being...


John Hempton said...

You mean the solution for Greece is to admit that the Germans own them entirely - to totally surrender?

The default option keeps some German sovereignty.

If you do not default you have to in the context that the Germans will be forever benevelont - ie Eurobonds and a solid European empire.

Spartakus said...

Hi John,
in case the Greek government defaults, the budget deficit will not get worse-it will stop..they would have to (finally) restructure credibly in order to get new funding (i.e. investment flows)...

Anonymous said...

Very good thoughts there. The policy commitment toward the Euro is too strong and a Greek exit will not only blow up the Eurozone as you so well described, but also the EU/Schengen area (there no controls now.)

Plus, I am sceptical that any local currency/devaluation will make Greece more competitive. Industry was destroyed and public service was overstuffed long before the Euro. Tourism will do better but I guess it does fine for the moment anyway.

In addition, any coordinated weekend action is IMPOSSIBLE in Greece as the ruling political and business classes will get the nod to transfer money out before (if they've kept anything in anyway). Leaking a devaluation has great precedents in Greece during the 1980s.

Haircut and recap followed by 5-10-year-long grovelling is the only solution to change a people's mentality. (Which is the actual problem.) And the haircut only after some additional Greek bonds have been repaid so that a larger part of the debt is transferred to the aid package.

Anonymous said...

What if one were to drop kick political correctness out the window and suggest that a German takeover of Greece might not be the worst thing ever?
If we swap debt for equity. We might as well go ahead and trade politically driven development of the EU for soverign M&A!
A new 'board of directors' in Greece to help put the country back on track might allay concern that the Greek system simply isn't capable of sufficient growth on its own. Sprinkle a pinch of German work ethic over the Greek public sector...
And I don't think we need worry about German benevolance if there is enough potential profit in it for them.
Can Europe truely achieve her full potential with everyone sitting on the fence? The French and German constitutions still take precidence over EU legislation. Soverignity is a reasonably recent invention. 'Germany' didn't even exist 200 years ago. I'm sure we would get over a little re-shuffle quickly enough.
But you are right, however much one sugar coats it, it would be a bitter pill for the Greeks to swallow.


epicaricacy said...

Why couldn't Greece either restructure their debt through default or exiting the Euro, while the remaining governments re-capitalize the losses of this for their own institutions. Finally, the ECB buys up massive amounts of sovereign debt to ensure borrowing costs for the recap remain reasonable. If it's done credibly there's no reason the ECB would loose money on the operation, and Germany's exporters get a more competitive currency.

John Chew said...

Having fun playing in the extremes? Then it would be more than just troops at the borders because of the digitally connected nature of the financial universe today.

It could mean cyberwarfare units going in and disabling Euro interbank systems. Limited tranfers to quarantined accounts for controlled currency conversion...

I can see no political will to realise this. It will be catastrophic and I think the horse has long since bolted - those of means who can move money out of Greece already have. The rest will simply burn their own homes.

Mr Wang Says So said...


you're forgetting Executive Order 6102.

No wonder people says that we are getting a re-run of the 1930s Great Depression.

Anonymous said...

If the currency bloc breaks, there's also the cost to Germany of having a soaring new mark. That will kill their export industry and unemployment will increase. German workmanship and engineering is worth a premium but if the new mark appreciates 15+%, it will only benefit USA and Japan and Korea who also make precision equipment.

Baltazar said...

I like the first version, although John’s post makes it sound like the Greek government would “pro-actively” institute bank holidays. New currency introductions occur “re-actively” because of perceived lack of liquidity or perceived lack of redemptive/settlement value. There is usually a series of half-measures by the government and intl funding bodies to prevent the inevitable. The bank holiday becomes a foregone conclusion of the bank run in the making.

But Greece is already a foregone conclusion. We are now witnessing a far bigger Euro-system bank run, reminiscent of Creditanstalt. This is a more intriguing topic of speculation. Who can backstop the European CDS chain? (will ECB/SocGen play the same as Fed/AIG)? Or will we have a repeat of 1932/33 freeze?

Anonymous said...

I don't think fiscal means alone could do squat here. Greece is not dysfunctional because of Euro, it is because, pardon me, greeks aren't working. Not as germans or even french. And - they expect living standards of germany or france. Devaluation, default, whatever - it's just not a very sustainable idea.

Obviously devaluation scenario is supposed to help with that too (it will instantly cut household incomes appropriately), but then you discover that the local industry cheap currency is supposed to support is virtually nonexistent in Greece. You can make an "economical miracle" either off people who work for food (most East) or off people who just work (western variant + japan), you can't make it with productivity of the former and salaries of the latter.

Besides, it wouldn't be wise for Greece to "stick it up" to Germans in radical manner - even if that could work in short term, if Germany holds a grudge, Greece will feel it.

So what I see is they either really end up "surrendering to Germany", or they one way or another set themselves up for a miserable life. Or both.


Will said...

"and if you do that I see no alternative to troops at the border stopping"
you don't need to do that- european bank notes already have a stamp of the original country- why not just deem that all greek bank notes across the eurozone with a Y on it are greek and now worth 30c on the €.

David said...

I don't think the Greeks have a strong bargaining position. Their best industries are shipping and tourism. Tobacco used to be big but the EU stopped subsidizing it (which besides the obvious points is a good thing as it was corrupt).

If they make too much noise who'll support them in the next 5 year budget to be agreed to in 2012?

Perhaps the best solution would be to agree to debt forgiveness if Greek fiscal policy were to be put under administration for a number of years.

Anonymous said...

From what I read, it seems like the best solution would be for the strong fiscal countries to leave the Euro and set up their own currency. After all, they are going to pay for the bailout in one fashion or another, so why not do it in a way that could offer a structural solution?

No political will for this though.

Mike T said...

I think the most likely outcome is a default / compromise, where the Greek banks are recapitalized by some EU Authority, the Germans forgive a chunk of Greek sovereign...

Then, we have a long period of adjustment where labor costs can fall in Greece.

Greek labor costs are too high. This is the root of the problem. The trick is to drag out the period of adjustment to prevent a "mad max" world where political authority completely breaks down.

Anonymous said...

Germany, France, Italy, Spain, Holland, Belgium and Portugal were not part of the Austro_Hungarian empire.

There is so little paper currency in circulation that stopping the physical flow of money is probably not necessary.

It is likely that the richest people in Southern Europe have already moved their money out of their home countries. Your option two could make sense if coupled with a legislated roll back of wages and pensions in Greece to have the same effect as a currency devaluation.

Australian Institute of Polish Affairs said...

Hey, Greece could default without leaving the currency. That'd knave them with an internal devaluation, but tha could be easier without carrying all of that (now defaulted) debt...

Australian Institute of Polish Affairs said...

By the way, the Austro-Hungariqn empire, in which my father was born in 1916 and in which, incidentally, they drove on the left hand side of the road before the Americans left all of their left-hand drive cars in Europe after coming late for World War I, was split up into Austria, Hungary, the Northern part of Yugoslavia (Croatia, Slovenia, Bosnia and the Voivodina part of Serbia), the Transylvanian, Banat and Bukovina parts of Romania, Czechoslovakia including Carpaotho-Ukraine, the Galician part of Poland, with the South Tyrol going to Italy.

dmitry@sg said...

Why not go TARP style route with ecb guaranteepre for recapitalization of troubled financial institutions. Surely inflation in the north and massive devaluation of eur....risk are there but politically it has the lowest costs. Not a real solution of trade disbalance but could keep going EU and EUR for a while.

Reg said...

One sign of the interconnectedness of our globalized world is that your two glasses of wine over the pacfic give the heebie-jeebies to a fellow in Japan. :)

What happens to Euros held in Banks in Tokyo?

Anonymous said...

John, it is an interesting blog post, but what do you see as the most likely outcome? Have you postioned your portfolio to profit from the eurcrisis?

Anonymous said...

There's no need to post guards at the borders - Euro's are already stamped with their country of origin. The printing press codes are: Y=Greece,M=Portugal,T=Ireland and X=Germany. Hoarders have been playing this game for years now - good luck finding a "X" note.

Anonymous said...


(off topic) Actually, most of Austria did not change to right-hand drive until the Anschluss in 1938, and Hungary changed in 1941.

As for everything else, there is a Wikipedia article.

Ian Allman said...

Another excellent blog post; and written on a plane!
I'm intrigued to know which PIIGS nation is due to have an election in which a more extremist party could come to power and trigger a default/euro exit scenario. The electorate has the final say in this debate I fear.

Anonymous said...


I'm not sure it has to be that harsh. Greek bonds are trading 50 cents in the euro, which seems about right.

Why not the Brady solution. Buy the crap at 50 cents in the dollar, re-issue them under the new asset program and then make sure they sell their assets to repay the remaining debt.

I don't think it has to be as bad as it sounds.

While this is happening, keep the boot firmly on the neck while the keep firing public sector workers.

Greece stays in.

Anonymous said...

And following up from 9:52 on the political and practical impossibility of an imminent uncontrolled default, many people talk about Greece as the Lehman etc etc. I haven't seen anywhere that perhaps Greece is the AIG of Europe, simply because the EU/IMF funds is used to repay third parties while the debtor passes under the control of creditors who may offer initial hard terms but then, when/if things look up, they can renegotiate their severity. The AIG model worked fine. AR

tiru said...

2 glasses of wine? Or of scotch? Ha!! Loving it. Bring on the carnage!

L. said...

Just so we put things into context, guarding the borders is impossible not only because the entire armed forces of europe hardly suffice to guard the french-dutch border, but also because soldiers too, have, presumably savings in euros.

If we (Greece) pull a Buenos Aires, there won't be any time for preparations and there will also be no warning. Portugal will follow suit, then Spain, Italy etc. The only thing that can stop this.

Now your analysis was brilliant but you missed the really fun part: The Germans will have to pay for all that southern cash that will flood their banking system in anticipation of the new Drachmas and Escudos. This is because of the target2 settlement mechanism, which dictates that when a guy in lisbon withdraws 10 000 euros in cash, drives to Munich and makes a 10 000 deposit at Deutsche Bank, the bundesbank takes a liability of 10 000 (because sight deposits are CB liabilities) which it expects to be paid by the new Portuguese CB, which can only wire Escudos.

This is the funniest part of the wholo story, Germans waking up to realise that the bundesbank has a capital hole of 600b or so (for comparison, consider that right now the bundesbang has over 150b of claims versus Mediterranean CBs, which correlate almost perfectly with deposit flight from the periphery).

If it wasn't for the Target2 mechanism and the explosion in intra-eurosystem Bundesbank assets, the Germans would already have thrown us to the sharks.

more fun facts and figures:

and I also recommend this Alphaville blogpost:

Anonymous said...

Perhaps Germany should leave the euro and start printing its marks again...

Mac said...

This is a good piece in identifying what would happen if Greek defaulted - something extremely ugly that is well outside the experience of the developed world over the last 50 years. It is a bad piece at forecasting what will happen.

Your calls on the Baltics 3 years ago were similar - your view that devaluation would have catastrophic consequences spot on, but it never happened.

Instead after a very sharp decline in GDP, a very strong V shape recovery took hold with GDP levels in all three countries now above early 2007 levels, while Swedbank and SEB share price soared.

The people running the EU are not total crazies. They know that to have governments suddenly defaulting or totally changing the game with massive FX devaluations could fundamentally destabilise Europe - economically, politically and socially. They have not forgotten where that led before.

What fixed the Baltics was quickly balancing budgets, while keeping households alive with ultra low euro mortgage rates (this was why there was never an explosion in mortgage NPLs).

In Greece the solution is structural government reform to fix their finances, with long term very low interest rate loans from the EU to allow them to make this adjustment.

Would be very interesting to hear your thoughts on Greece in the context of what happened in the Baltics. This is likely to prove a much better roadmap than the Argentina calls which prove so long the last time the EU had similar issues.

Anonymous said...

There is indeed a wikipedia article about everything. From

After the end of the First World War it was initially hoped that the Krone could continue as a common currency of the Empire's successor states, but in January 1919 the Kingdom of Serbs, Croats, and Slovenes (later Yugoslavia) became the first successor state to overstamp the Austro-Hungarian Bank's notes to limit their validity to its own territory. Czechoslovakia followed suit in February 1919, and on 12 March 1919 the new Republic of Austria stamped the notes circulating in its territory with "DEUTSCHÖSTERREICH".

Anonymous said...

Interested to hear your thoughts on strong countries leaving the Euro for own currency. This was mentioned by one of the posters and I have seen it talked about on Mish's blog. Seems like the best of bad options t me. The weak countries don't have to pay back money in a strong currency while theirs is weak and the strong countries just need to take care of their own banks who will now receive the weak Euro. Exports will be hurt as well, but must be an easier sell for Germany to help German banks than to hand out cash to perceived lazy Greeks.
Your thoughts?

Anonymous said...

It would seem that the more thoughtful goldbugs of Europe are ahead of the game. In Asia real gold and silver is patiently accumulated at artificially low prices. Don’t be surprised to see a force majeure in the New York and London gold and silver pits in the next 12 months

狂猪 said...

Is the current situation worse than the height of the cold war when there are enough nukes on hair trigger to destroy the world many times over?

To deal with that, the world had a powerful tool. It is call Mutual Assured Destruction -- aka MAD. This tool is so powerful, it has protected the world to this day.

It is difficult to argue today's situation is some how more dire or more difficult to contain than at the height of the cold war.

By the way, MAD is so powerful, US, Japan, and even the developing countries are jumping in to help!

Lastly, let's not forget, Europe's debt are in euro. Ultimately the choice facing ECB is death or the printing press. What ECB will do is obvious and the evidences are very strong.

* Consider the ECB still accepts Greek bond as collateral.

* Consider the ECB is already buying Italian and Spanish bonds.

Let's face it, the ECB printing press is already on!

Nemo Incognito said...

Lets look at two of the PIIGS - Greece and Ireland. Ireland is going down the Baltic route - GDP is growing semiannually despite the mess, it is ultimately a very open and liberal market for labour and everything else and never ran big government deficits. Ultimately, what determines whether you can stay in a currency union is how tightly integrated two economies are but also how similar they are in productivity growth, institutions etc.
Baltic states are a lot like Ireland - ultimately pretty open, reasonably good governments and a lot more German than mediterranean.

Greece is another matter entirely, big deficits, history of default, shocking tax code even more poorly implemented and piss-poor productivity growth. I can happily bet on Ireland being more German because really, they aren't all that far away but betting on Greece becoming more German is mission impossible from my vantage point. To that end I think the Argentina example is a lot more apt for Greece. And that is why I think the ECB will print - though much more likely they will print to buy BTPs and see how Italy and Spain manage and leave the bank bailouts to sovereign states.

狂猪 said...

It would seem my crystal ball is extra crystal clear. I wrote my last comment before I went to bed.

Here is the news this morning.

$2 Trillion sounds about right compare to what the US brought to bear in 2009. It involves both leverage and the ECB! Also a 50% hair cut for Greek bond will result in a positively healthy debt to GDB of only ~70%!

Crisis don't happen when everyone who can do something about it can see the crisis coming a mile away.

For those of us who can only watch the show from a distance, we need more doomsday blogs. The more dire the better. The more dire the less likely it will happen. In the end, we'll all benefit.

My bet is on MAD.

Eddie Bravo said...

well thought out post but
curious about this line
"You see a bank deposit in Athens is going to turn your Euros into Drachma. Overnight it will lose 70 percent of its valuation."
Is this actually based on calculations you have done or read elsewhere? I.e it would imply that you (or someone) thinks Greece suffers from something like 3x overvaluation, this seems pretty hardcore.
I've seen 20% being bandied around in Spain's case, see below

WellRed said...

A very minor point: Why would it be beneficial to max out a euro-denominated credit card ahead of an anticipated default? The liability would still be denominated in euros. Am I missing something here?

Second,it strikes me that given Germany's current fiscal position and the massive cost of bailing out their financial system should the nightmare scenario play out (too many assets denominated in non-German 'euros'), then they would no longer be one of the best sovereign credits out there. This aspect of the generally accepted wisdom deserves further scrutiny.

Martin said...

I would argue the root problem is not fixing the root cause. Austerity might be the solution, but then agian, if it's the wrong medicin, in the long haul, euro is doomed onw way or the other.

The analysis in the link makes me worried everytime someone thinks German rule over Greece is the medicin.

Alex said...

Did anyone notice that the telephone company already belongs to the Germans? DTAG bought a controlling stake in OTE some years ago.

Hurricane said...

Congratulations on the mention in Floyd Norris' NY Times article yesterday! You're becoming a celebrity.

Hurricane said...


Mike13 said...

Why does greece have to go back to the "drachma"? I think it could just convert euro deposits into a "greek euro" worth 1.40 euros. Simple. Do you have to redominate at a rate of one-to one with a view to a quick depreciation? I dont think so- but most do

Do you know any good articles on the practicalities of this approach? Greece would need fx reserves to pay creditors, and I think it could turn to Chinese lenders. Both civilizations have a lot of affinities, something that Greece and Germany don't share.

Anonymous said...

Dmitry my dear, how do you know that greeks aren't working?! I work 40 hours a week for 800 euros, I pay my taxes, buy food with a tax of 23%, buy gas for 1.65/ lt, pay for medicine with a 13% tax, pay more taxes with my electricity bill, have to rent an appartment for 400/month and so on! That is the situation in Athens and now you come here telling me that we don't work?! We work longer hours than anyone else in the EU does, we get paid less and yet we buy most of our stuff way more expensive than you do!

Thomas W said...

What's critical now, is to backstop Spain. If Greek fails before Spain can be backstopped, the domino chain will become unstoppable.

We may see the Euro's future, play out in front of us over the next 2 months.

Spain next: Banks weakening, urgent action to save the Euro

Anonymous said...

Interesting to note that After this Monday's Whit Day, The next EU-wide bank holiday won't be until Assention Day on Aug 15th

David Schawel said...

John- I linked this post of yours to a recent blog that I wrote on Economic Musings. Hopefully the attribution was appropriate. Enjoy your work. All the best,

David Schawel

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