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Last spin of the wheel for Europes banks


Faites vos jeux on a crisis bigger than US subprime

A Special Report by Leigh Skene and Melissa Kidd

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Last spin of the wheel for Europes banks


Faites vos jeux on a crisis bigger than US subprime A Special Report by Leigh Skene and Melissa Kidd

Contents
Faites vos jeux on a crisis bigger than US subprime Computer models versus looking at the facts Seven EA problems Governments and banks Recapitalizing banks is deflationary Defaults are guaranteed, exits are better The banking crisis Contagion to the US Global contagion Commodities are another problem area The coming crisis is financial, not economic Europes core challenge Alleviating and preventative measures Hope from the crisis-practised Emerging Markets Better Emerging Market Banks Conclusions 1 2 3 6 7 8 10 12 13 14 14 16 17 19 21 23

Last spin of the wheel for Europes banks


Faites vos jeux on a crisis bigger than US subprime
The Efficient Markets Hypothesis led to Rational Expectations plus unquestioning faith in computer models. Blind faith in their ability to price complicated asset structures correctly and to accurately identify all possible sources of risk led to rapidly rising leverage typified by the European sovereign debt/banking crisis, which has been gestating for a long time, but soared into prominence when Greek borrowing hit a brick wall in early 2010. Since then, bond markets have generally interpreted the continuing declarations of successful negotiations and imminent solutions to debt problems negatively, equity markets have generally interpreted them positively and currency markets have see-sawed back and forth. Bond markets have been right so far, as the authorities have compounded the ultimate losses by treating solvency problems with excess liquidity. This report will show that the prevailing conditions that helped us escape from some previous episodes of excessive leverage have reversed into headwinds. Europes counterproductive policies and the excessive leverage in European banks have made it the epicentre of todays financial problems. The more inflation prone Euro Area (EA) nations, often referred to as Club Med, cannot prosper in a hard currency fixed exchange rate regime such as the euro, so would be better off outside it. Exits (and defaults inside the euro) will seriously damage the over levered EA banks. That damage will spread globally, as many other nations suffer from several of Europes difficulties.

Last spin of the wheel for Europes banks March 2012

This is a financial, not an economic problem. Deflation is the necessary corrective mechanism as the problem is excessive monetary stimulation resulting in credit and asset bubbles. Japan has shown that deflation is, of itself, far from the disaster claimed by the authorities in Europe and the US. In addition, there are some alleviative and preventative measures that no authority has yet applied. Europes abysmally bad policies have probably condemned the continent to depression, but less leverage elsewhere will alleviate the pressure in other developed nations. Emerging nations should fare best of all, ultimately enabling growth in developed nations

appropriate to the real economy of production and income. The questionable lending practices and the banking business models that caused the 200708 banking crisis and Great Recession certainly fit Minskys definition of Ponzi finance. That Minsky Moment was a major turning point in global financial and economic history. It began the correction of all the imbalances that have accrued since the last major turning point the huge monetary stimulation in response to the Penn Central non-bailout in 1970. (It changed the focus of most central banks from guarding against inflation to protecting banks from everything.) Many analysts ignore financial debt when computing debt to GDP ratios odd because financial debt is always a factor in financial crises. Financial debt in the US has fallen 20% from its high at the end of 2008, but is up 10% in Europe, shifting the locus of the banking crisis to Europe, where the quality of sovereign debt has fallen as financial debt has risen. Moreover, bankers on both sides of the Atlantic are continuing two serious errors that were major factors causing the last banking crisis;

Computer models versus looking at the facts

In 1974, Hyman Minsky explained the unfolding of credit cycles with his Financial Instability Hypothesis. It identifies three types of debt financing: hedge (borrowers can pay principal and interest from income, so risk is minimal); speculative (borrowers can pay interest from income, but need liquid financial markets to refinance the principal at maturity, so defaults rise when liquidity is impaired); and Ponzi 1 putting more reliance on computer models (borrowers cant pay either interest or principal out of income, so need the price of the asset to than common sense and rise to service their debts and defaults soar when 2 failing to purge their balance sheets of failing asset prices stop rising). Confidence rises over assets due to inadequate net tangible equity to a prolonged period of prosperity, so a capitalist absorb the losses. economy moves from hedge finance dominating its financial structure to increasing domination by 1. International Investment Positions, % of GDP speculative and Ponzi finance. Financial markets and the Portugal economy are relatively stable Spain Italy when hedge financing France dominates, but become Ireland Austria ever more unstable as the Germany proportions of speculative and Netherlands Ponzi finance rise. The rising -12% instability causes cycles of increasing severity until fear takes over and financial markets suffer a self-reinforcing spiral downward. Banks are the core of the financial system, so Minsky correctly says bank balance sheets deteriorate until inability to service liabilities causes a Minsky Moment a debt crisis that forces bloated asset prices down to levels that are
Greece

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

Contrary to the hype, computer models are very fallible. As predicted in February 20071, they greatly underestimated financial risk by failing to incorporate obvious correlations as well as 1 The ABC of 21st Century Risk Lombard Street Research 2007

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being responsible for rating securities based on home equity loans and sub-prime mortgages AAA. Reliance on computer models also explains the failure to spot turning points. Only external shocks divert models from moving towards the equilibrium position, so all forecasts tend to be straight lines. Computer models dont, and probably never will, identify turning points. Failure to adequately price complex financial instruments, especially CDOs was a major factor in the 200708 subprime crisis. Securitisation effectively hedged the specific factors leading to default, such as personal illness, but failed completely to address the risks common to the entire securitized pool, such as an economic downturn and rising unemployment. Investors in the Euro Area (EA) mispriced sovereign debt for a prolonged period of time, but for a different reason the false assumption that a common monetary policy plus the political promise that no country in the region could default reduced idiosyncratic sovereign risk within the euro. This assumption led to higher risk EA economies borrowing at low rates for a decade, thereby building up excessive debts and external obligations (see chart 1). For example, 10-year government bond spreads over Bunds for Spain and Italy heading into the currency union and until the financial crisis were very depressed (see chart 2). In addition, models assume a universe populated with rational people who are acquainted with all the relevant facts and act accordingly. No the emotions stay neatly within the parameters and historical relationships continue. This is a big ask and gives rise to another three problems that bedevil model predictions. First, extreme events pop up far more frequently than mathematical theory predicts. Second, models cant predict when an extreme event will occur. Third, they cant give any reliable information on an extreme event even after it has occurred so the models still cant incorporate the effects on economies and financial markets of the reversal from the ever increasing leverage of the past to the present deleverage. Emotions exceeding known parameters cause extreme events, such as stock market booms and busts. They are self-reinforcing spirals upward and especially downward that, once established, keep diverging from equilibrium until the driving forces fade or stronger counter forces reverse them. Ever-increasing desires for accumulating ever greater wealth faster and faster ignited a credit bubble that spiralled upwards until it burst in 2007 from a lack of new borrowers. The multi decade credit bubble and its bursting were extreme events. No model recognized the credit bubble or its collapse and no model is giving any indication of the plethora of problems now brewing in Europe.

Seven EA problems

Risky assets dont create crises. Assets considered safe that prove not to be safe have created all crises and Europe is no exception. People who should have known better assumed that European Central 2. 10-year government bonds, spread over Bunds: Spain and Italy, % Bank (ECB) acceptance of all EA sovereign debt as collateral 8 7 effectively guaranteed 6 repayment, minimizing the 5 credit risk of all EA sovereign 4 debt. In addition, the 3 misguided Basel zero risk rating 2 1 for all EA governments (that 0 cant print the currency they -1 Jan 92 Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 borrow, so are far more likely Spain Italy to default than governments that can) made European banks think loading up on peripheral nation such people exist or ever have existed. Desires debt for a few extra basis points in yield was and fears, i.e. emotions, drive all human activity. a no-brainer. (Unfortunately it was literally!) They are neither rational nor linear, so cant be As a result, interest rates in soft currency (read modelled. However, they do fluctuate within profligate) nations plummeted when they joined given parameters most of the time, so the the euro (see chart 2). Debt soared as a result. resulting behaviours can be modelled as long as

Last spin of the wheel for Europes banks March 2012

This structure could have worked only in the very unlikely event that the citizens of soft currency nations immediately saw the light and changed their individual choices to conform to Northern European (hard currency) values. Unsurprisingly, they didnt and are (rightly) accusing core nations of rigging the system. Core nations are determined to keep the soft currency nations in the euro to hold the foreign exchange value of the euro down but the formers export dependency greatly disadvantages the latter, which needs exports to grow. Meanwhile, soft currency nations became ever more uncompetitive within the euro as their borrowing created bubbles in real estate and government debt. The bubbles burst and exposed the lack of ECB guarantees, so fiscal deficits of 10% of GDP and more suddenly mattered. Nations have inflated and/or grown their way out of excessive deficits and debt in the past and the European elite want soft currency nations to do the same over the next several years. Unfortunately, thats impossible. The factors that enabled nations to grow and/or inflate out of severe debt and deficit problems in the past have been; 1 2 3 4 independent monetary policies, ability to devalue, positive demographics, easily reduced spending due to the ends of wars, 5 expanding global markets, 6 interest rates below nominal GDP growth rates and 7 strong private sector balance sheets. By contrast, EA nations face; 1 externally imposed one-sizefits-all monetary policies, 2 an externally imposed exchange rate, 3 negative demographics, 4 rising costs of entitlements, 5 increasing global competition, 6 interest rates above nominal GDP growth rates and 7 excessive leverage that is creating continuing financial crises.

Governments have used monetary policy and currency devaluation extensively to grow and/ or inflate out of severe debt and deficit problems in the past. The euro eliminates these escapes from debt problems, making EA governments far more susceptible to default than others. Basel regulations ignored this added risk and gave all EA sovereign debt a zero risk weight. EA banks could own as much EA sovereign debt as they wanted with no impairment of capital. EA banks took full advantage of this provision and blew up (metaphorically) their balance sheets with peripheral sovereign debt for a few basis points additional yield. Differential inflation rates destroyed every fixed exchange rate scheme prior to the euro that did not involve political union. The metaphor became reality when higher inflation rates in peripheral nations raised their current account deficits and resulting debt burdens beyond sustainable levels. The EA efforts to rule out defaults too have guaranteed depression in the peripheral nations as long as they remain in the euro. The five following problems extend far beyond the EA boundaries.

3 Negative demographics
Chart 3 below shows the medium variant of the UNs 2010 estimates of the population growth of the five largest European economies and the US. Growth is falling or negative in them all, guaranteeing aging populations. This is the long-predicted demographic time bomb, which is causing rapidly increasing age-related spending at the same time as labour force growth is shrinking to negative. Future labour forces and incomes will be too small to pay for the entitlements, particularly age-related, that governments have promised in perpetuity.

3. Estimated Annual Population Growth Rates


1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 2010-15 2015-20 2020-25 UK 2025-30 Italy 2030-35 France 2035-40 2040-45 2045-50 US

Spain

Germany

5
4 Rising costs of entitlements
The Bank for International Settlements working paper #300 entitled The future of public debt: prospects and implications, published in March 2010, concluded the debt to GDP ratios of all 12 nations studied, Austria, France, Germany, Greece, Ireland, Italy, Japan, Netherlands, Portugal, Spain, the UK and the US, would spiral out of control if; 1 government revenue and non-age-related spending remained a constant percentage of GDP and 2 Congressional Budget Office and European Commission projections for age-related spending proved correct. Reducing structural deficits by 1% of GDP a year for five years would still leave all the nations with soaring debt to GDP ratios for the 30 years projected except Italy, where debt would stabilize at about 100% of GDP. If, in addition, age-related spending was frozen at the estimated 2011 level of GDP, only Austria, Germany and Netherlands would have peak debt to GDP ratios under 100%. Japan and the UK would be worst off with sovereign debts over 300% of GDP with the US not far behind at about 230%, including state and local debt. The rest would have debt to GDP ratios between 100% and 200%. Sovereign finances have deteriorated since that study. Growth ranging from weak to negative and rising age-related spending have already pushed many sovereign debt to GDP ratios past 90% the point at which both Reinhart and Rogoff and the BIS have shown debt becomes a drag on growth. In addition, most of the EA peripheral nations are already in a long and deep recession that is spreading into the core. The next two sections show the odds of reversing the rising debt to GDP ratios are virtually zero. productivity gains in national accounts but added nothing to production, employment or worker incomes. Second, small business is the biggest employer and household deleverage hurts small business disproportionately, so employment and income growth have been disappointing in this recovery. Real incomes are stable to falling, depending on jurisdiction. Add in the tax increases intended to reduce deficits and real disposable incomes are falling faster than real incomes. Falling real incomes render sustained GDP growth impossible. The more inflationary policies of soft currency nations caused their rising uncompetitiveness. Not only did this not happen (and cannot be cured) overnight, but it also masked the fact that several other nations are headed into exactly the same problems, albeit at a slower rate.

6 Interest rates above nominal GDP growth rates


Rising borrowing costs make it very unlikely that nominal GDP growth can rise to the current and expected future interest rates in Greece, Portugal, Italy and Spain, so their financial conditions will keep deteriorating until they radically reform their governments. France (et al) is not far behind and the April election is likely to bring about change for the worse and debt restructuring is not enough. They all will also have to recapitalize their banks, reform their labour markets to achieve competitiveness, increase private investment and, most importantly, restructure entitlements to keep government spending from spiralling out of control again. None of these reforms are on anyones agenda. Emerging nation competition rules out private investment and the other measures will increase the short term pain, so peripheral EA nation finances continue to spiral out of control until they default.

5 Expanding global competition


Growth requires investing more in productive facilities, but that is not happening in Europe for two reasons. First, globalization has added a billion or so workers in emerging nations to the global labour force. They earn low wages by European standards, so investment and production has shifted to emerging nations and put downward pressure on developed nation employment and incomes. Cost savings from this movement of production to emerging nations increased corporate profits and created

7 Excessive leverage is creating continuing financial crises


The underlying theory of todays financial system is that all risk can be hedged and the difference between the return on a security and the cost of hedging its risk can be skimmed risk free. This vision of risk free return encouraged ever increasing leverage and debt to GDP ratios soared. However, all transactions have counterparties and rising leverage raised the probability of counterparties failing to fulfil their obligations.

Last spin of the wheel for Europes banks March 2012

The ever-increasing leverage created a string of five credit bubbles that burst when counterparties defaulted. They were: 1 the Latin American credit bubble that burst in the early 1980s, 2 the savings and loan debt bubble that burst in the early 1990s, 3 the Asian debt bubble that burst in 1997, 4 the LTCM/Russian credit bubble that burst in 1998 and 5 the housing bubble that burst with the sub-prime mortgage crisis in 200708.

and non-financial institutions. This temporarily reversed the inability to meet liabilities and consequent fall in asset prices. This reprieve is only temporary because transferring bad

4. European banks: price-to-book values


2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Germany France Italy Spain Greece Portugal Ireland Austria UK

Cyclical average

Feb 2012

The world of computer models doesnt private debt onto public balance sheets simply encompass credit bubbles and bank crises, so permitted zombie companies to compete with banks, bank regulators and central banks didnt more productive companies, thus postponing the see any of them coming. The first four bubbles necessary corrections of imbalances and making were localized and their bursting easily contained. them more costly in the long run. None of them created major problems, so most This delay and increase in costs is most obvious banks kept increasing their leverage, up to 50 in Europe. The still-inflated values of sovereign times net tangible equity and more. In addition, debt and loan collateral in both the household nearly all bank balance sheets still contain hidden and corporate sectors have generated rock losses because loans to weak borrowers and bottom price-to-book values across the European securities of distressed governments remain banking system, as markets have recognized the valued at cost until the borrower defaults. These threats over valued assets pose to banks. Current unrealized losses make many banks technically price-to-book ratios compared to their 7-year insolvent, so most cannot afford to book losses averages imply banks will suffer losses ranging even if writing down debts would benefit both between 50% and 95% from the book values the lender and the borrower. They would have of their assets (see charts 4 and 5). Financial very substantial (in some cases negative) net markets can exaggerate potential losses, but that tangible equity if they had to mark their assets to is unlikely in Europe today. In fact, Spanish bank market, so any default could be catastrophic. They prices imply the smallest EA losses and may turn must use most, if not all, of their resources to out to be underestimating them. keep their weak borrowers afloat, so every lender from the IMF to the bank on the corner is delaying and praying 5. Fall in book value reflected in current PB ratio (vs cyclical average) or, if theyre atheists, extending 0% and pretending.

Governments and banks


Governments did their best to thwart most of the long overdue correction in asset prices by rushing in to protect banks during the Great Recession, guaranteeing their liabilities and bailing out failing financial

-10% -20% -30% -40% -50% -60% -70% -80% -90% -100% Germany France Italy Spain Greece Portugal Ireland Austria UK

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debt holdings were included in the calculations Some financial regulators did take steps during for the first time, but September 2011 prices were the financial crisis to help banks address the used, leaving the calculations immediately out of gap between the book value of complex date. Changes in sovereign debt holdings since structured finance securities backed by real the July stress tests were also taken into account. estate and their underlying value. US and UK The final figures released by the EBA in late regulators were reasonably prompt in forcing November, based on September 2011 sovereign their respective banking systems to raise capital bond holdings, are shown in chart 6. to cover the losses, even though their moves were controversial due to their drag on monetary growth. The US banking sectors net 6. European banks, capital shortfall (euro mn) tangible equity as a percentage Greece of total assets is now 9.2%, Spain Italy up from a low of 7.5% in Q4 Germany France 2008. However, the regulatory Portugal Belgium pressure to retain earnings Austria and restrain dividend growth Cyprus Norway remains because writing off the Slovakia Netherlands hidden losses on their balance 0 5000 10000 15000 20000 25000 30000 35000 sheets will necessitate raising further capital. The four major UK banks reported core Tier 1 risk weighted capital ratios of around 10.8% in Q3 2011. Even so, they have continued to run down their assets in recent quarters, with risk-weighted assets falling by 5% in the year to end-September 2011, compared with the same period in 2010, and further divestments of non-core operations have since been announced. Pressures to boost capital buffers remain in the UK, however, with specific requests from the newly established Financial Policy Committee to prioritise earnings retention over bonuses and dividends. Following tax-payer bailouts, the two partly state-owned banks were banned from paying dividends and are unlikely to resume payouts for some time. The EA has failed to grapple adequately with the severe capital shortages of its banks. The European Banking Authoritys (EBA) first two rounds of stress tests in the summers of 2010 and 2011 were woefully inadequate. The first round ignored potential haircuts on sovereign debt. The second round took into account only the already-agreed Greek haircuts, but neither further impairment of sovereign debt holdings nor acknowledgement of the potential bank funding disruptions that could ensue from sovereign defaults. The third attempt at estimating the capital needs of banks in the EA was an improvement, but remains seriously problematic. Unrealised losses on available for sale sovereign The banks affected have various choices in achieving the mandated 9% Tier 1 capital ratio, including buying back debt below par, cutting dividends, divesting assets, rights issues and selling blocks of equity to major investors, such as sovereign wealth funds. The initial market reaction to UniCredits recent call for 7.5billion of new equity showed the markets disinterest in the stocks of banks it deemed to have potentially fatal balance sheet problems. The appetite improved following the ECBs program of unlimited auctions of three year money (LTRO), so further issues are likely.

Recapitalizing banks is deflationary


Not only is the 9% Tier 1 capital ratio insufficient to make the EA banking system resilient to potential shocks over the next 12-18 months, but it has also set in train a process of deleveraging in both European and non-European markets that could have seriously negative implications for global credit creation and financial market activity. The Bank of Englands latest Financial Stability report includes estimates of bank deleveraging plans as at December 2011 of between 500billion and 2trillion, according to various sources and further divestment announcements have been made since then. Q4 2011 survey data suggested credit conditions in the EA were already starting to tighten before the full force of the deleveraging process has been felt.

Last spin of the wheel for Europes banks March 2012

European banks must raise their equity ratios to cover the potential losses on assets with market values below book values. Investors in bank equity would pay for their purchases of equity by drawing down their deposits, but adding to bank capital does not create an offsetting deposit, so the money supply falls by the amount of capital raised. In practice, lack of investors in bank equity is forcing banks to shrink their balance sheets. The money supply falls by the amount of bank loans liquidated. Loan contraction forces households and small and medium sized enterprises which have no alternative source of funding, to spend less and save more, thereby
7. Eurosystem M3 (April 1998 = 100)
240 220 200 180 160 140 120 100 80 Apr 98 Jul 99 Oct 00 Jan 02 Apr 03 Jul 04 Oct 05 Jan 07 Apr 08 Jul 09 Oct 10

sheets over the intermediate term. Private borrowing is the mechanism that turns bank reserves into money, so money and credit growth requires creditworthy borrowers that are willing to borrow an endangered species. Small business remains mired in the Great Recession while many households face falling real incomes and are trying to delever too, so few are either willing or able to borrow. Turning bank reserves into money and credit also requires banks that are willing and able to lend. Their desperate need for capital makes them an even rarer species. The traditional money making machine cannot function until household, small business and bank balance sheets are repaired. Capital constraints on banks and borrower caution on adding new debt prevent the excess reserves from becoming loans and creating money, so the excess bank reserves central banks created by monetizing government have had no effect. By contrast, ECB purchases of illiquid sovereign debt did help reverse Jan 12 the decline in EA M3 in 201011. However, the declines in each of the last three months (see chart 7) indicate recession and further declines in the money supply.

lowering demand growth in the economy. Worse, European banks are the main source of global trade credit, so their loan contraction will hurt global trade as in 200809. Repairing bank balance sheets is strongly deflationary (see also EA problem #7 above). According to Olivier Sarkozy, head of the Global Financial Services Group of the Carlyle Group, Europes banking sector has $55 trillion of assets, four times larger than Americas. In addition, European banks have $30 trillion of wholesale deposits (10 times more than American) and need to roll over $800 billion monthly. The far greater size of the European banking system, its higher leverage of net tangible equity and its wholesale funding exceeding deposits make Mr. Sarkozys estimate that it needs $2 trillion of additional capital look conservative. The probability of European banks being able to raise $2 trillion of capital is zero. Bank recapitalization ultimately depletes household incomes through a combination of higher taxes, artificially low interest rates and increased bank charges. A $2 trillion or more hit to European incomes is out of the question. As a result, European banks will be shrinking their balance

Defaults are guaranteed, exits are better


EA restrictions combined with excessive leverage, negative demographics, the rising cost of age-related entitlements, expanding global competition and nominal GDP growth below interest rates have made the current policy of funding more debt until Club Med grows out of debt problems impossible. Even so, hard currency nations are increasing the problems by imposing austerity in an effort to rule out sovereign defaults as well as the usual palliative, devaluation. Lacking either escape, Greece, Portugal and Ireland are unavoidably in deep depressions with no relief in sight. Unsurprisingly, money and people are fleeing those nations in droves. The real estate woes of Spain and extremely slow growth in Italy mean theyre not far behind. There is not enough money on the planet to keep bailing out insolvent European governments and banks forever. Growing and/or inflating out of their debt problems is impossible. More borrowing merely increases the losses when the inevitable

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defaults occur. The European Financial Stability Facility (EFSF), its successor the European Stability Mechanism, even the IMF can only postpone inevitable defaults. Eurobonds wouldnt be any better borrowing cant solve the problem of too much debt. Defaulting within the euro would, at best, be a temporary palliative because, in the long term, soft currency nations cannot prosper in a hard currency monetary union without continual transfer payments. Adequate transfer payments are very unlikely, so the soft currency nations will have long depressions unless they negotiate the re-denomination of their foreign held euro liabilities into their local currency and leave the euro. Unsuitable nations leaving the euro are not a problem. Ultimately, thats the only way the euro can survive, yet exits will occur only when all else has failed. Greece received the 8 billion required to enable it to keep paying its bills in December even though the October 26 accord had not been approved by the 17 EA nations at the time of writing and the proposed haircut of over 70% on privately held debt is still far too little to put Greece on a firm financial footing. Assuming the accord is ratified and the militant hedge funds forced to comply, it will soon be back in this same predicament. Nevertheless, this accord would be the template for further defaults because it avoids a formal declaration of default, so is deemed to be voluntary and doesnt trigger CDS payouts. Rising leverage increases risk exponentially, so appropriate hedging is vital to the high leverage in modern financial markets. Efforts to restructure the Greek default into a not-default to avoid CDS payouts may change the rules on what triggers a payout retroactively, thereby eviscerating the hedging function of CDS. Fear of the inability to hedge is lowering demand from non-financial institutions for and raising the yields on debt with the weakest credits suffering most. To avoid a banking crisis pending a solution to the sovereign debt crisis, the ECB bought distressed sovereign bonds under its mandate to buy government and private bonds as needed to provide depth and liquidity to the markets. The monetary base has risen at an annual rate of over 50% rate in the last six months yet, as explained above, M3 has been falling in the last three, so the ECB version of QE has not been keeping up with loan shrinkage. The ECB has begun LTRO auctions at the policy rate, currently 1%, with lowered collateral requirements. This will keep the banks liquid, but liquidity can do nothing to reduce their insolvency. Liquidity can buy time, but the rapid deterioration of sovereign balance sheets make time an enemy, not a friend. Sovereign debt does not entail risk weighted capital, so these loans enable capital-constrained banks to fund their governments with a handsome carry that will increase profits and add to capital. The bigger than expected take-up of 489 billion by 523 banks (net about 250 billion) on December 21 and the drop in yields in recent sovereign auctions endorse the design and value of the LTRO to maintain liquidity under extreme conditions. The sharp increase in overnight deposits at the ECB, however, highlights the ongoing solvency concerns among EA banks. They prefer to deposit overnight at low rates rather than bear higher credit risks in the interbank markets. The ECB balance sheet has exploded to 2.73 trillion and the loan collateral is becoming ever more suspect and the liquidity created is augmenting, rather than reducing solvency problems (see page 12). As a result, the cadre of creditworthy guarantors of the 1.1 trillion of debt now committed to holding the EA together is diminishing, so EFSF debt has been downgraded not for the last time. Egan Jones, the only major lender-pay ratings company (borrower-pay ratings companies tend to follow it), has downgraded Germany to AA- and it remains on negative watch. Financial markets have recognized European efforts to sustain the misallocation of capital will fail and recently have priced in a 94% chance Greece, a 61% chance Portugal, a 46% chance Ireland and a 35% chance Italy will default in five years. The situation is deteriorating with Portugal where Greece was last year and Italy where Portugal was last year. Private demand for Spanish and Italian debt apart from repos with the ECB is virtually zero. Unsurprisingly, European corporate (and some sovereign) debt markets remain very thin and corporate borrowing has fallen significantly, even though Asian nations have invested an estimated 1 trillion of their reserves in European bonds in an effort to sustain their European exports. If fears about CDS hedging prove to be justified, a wholesale liquidation of risk assets that investors had believed to be hedged will occur and credit markets will shrink substantially.

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Last spin of the wheel for Europes banks March 2012

Of course, Europe doesnt have a monopoly on insolvent banks, but its banks now pose more systemic risk than insolvent banks in other nations. Like others, EA nations guarantee their bank deposits and fund deficiencies from bank failures by selling bonds. Weaker nations would have to sell the bonds to the bailout mechanism, currently the EFSF, which, in turn, will sell bonds to outside investors. The solvent EA nations guarantee the EFSF bonds, so will have to pay any losses that occur, which explains Northern Europes over emphasis on austerity. The EA elite are trying to spread this liability across the globe through more IMF participation in the bailout mechanism. Understandably, the reception to this idea is cool, so this contingent liability weighs ever more heavily on the remaining AAA rated nations as sovereign balance sheets deteriorate and ratings fall. Moreover, the costs of bailing out rise as the EFSF rating falls in line with those of its guarantors threatening a downward spiral in ratings. Bund yields remain at or below similar term Treasury yields, showing financial markets (correctly in our view) expect Club Med exits from the euro, not greater EA integration. Even so, European debt funds have reported regular outflows and a large amount of European

US money market funds (MMFs) have been steadily reducing their exposure to European banks since May 2011 and replacing it with increased exposures to Australia, Canada, Japan and US Treasuries and Agency paper (see chart 8). The greatest percentage decline was in France. Reliance of EA banks on this funding is non-negligible, with MMF exposures account for as much as 4% of short-term liabilities among European banks. The Fed has eased the consequent shortage of dollars with swap agreements with several central banks to keep the dollar down, but the cost of borrowing dollars in exchange for euros remains elevated, even following a cut in the cost of dollar liquidity provision by the major central banks at the end of November. Helpful as it is, dollar liquidity cannot offset euro deleverage. In addition, the long and deep recession that has now begun in Europe will cause soaring private sector defaults. Agreements with the EA already utilize half of the EFSF and of the IMFs increased lending capacity. Requests for further increases are running into stiff opposition.

The banking crisis


In previous episodes of deleverage, significant public sector deleverage began only after nominal GDP growth had rebounded. The section on the EA problems listed the seven factors that facilitated the rising private sector growth in the past that enabled the following six steps. Some, but not necessarily all, of these steps are required to grow and/or inflate out of debt problems. 1 2 3 Recapitalize the banks to enable sustained loan growth. Reduce government spending. Reform of labour policies to lower unit labour costs. Devalue the currency to enable net export growth.

8. US money market funds: % change in exposure (May 2011 to Dec 2011)


80% 60% 40% 20% 0% -20% -40% -60% -80% -100% France Euro Zone Europe UK Nordic Australia Canada

Japan

4 money has moved to the US, accelerating US money growth. More than half of bank funding in continental Europe comes from institutional investors. This funding is evaporating, putting many European banks in a liquidity squeeze so bank borrowing from the ECB has soared, as have Euro interbank lending rates. The three month Euribor rate rose to more than one percentage point over the generic European treasury bill rate last September, warning of a probable banking crisis this year.

5 Increase private investment. 6 Stabilize the housing market. The section on the EA problems also showed all seven facilitating factors have been headwinds since the 2007-08 banking crisis, and as a result; 1 EA banks are shrinking loans, 2 governments are raising taxes, 3 workers are rioting against change (except

11
Ireland), so unit labour costs remain too high, 4 currency devaluation is impossible, 5 private investment is shrinking and 6 ultra cheap mortgages are preventing the stabilization of housing. No EA authority has shown the slightest flicker of comprehension that the credit bubble has burst, that the era of continuous borrowing from the future with excess debt creation is over and that the Eurozone is exacerbating the pain for its southern members. The Greek economy never recovered from the Great Recession and global conditions plus the imposition of increasing austerity give it no reasonable prospect of doing so in the foreseeable future. Instead, it depends every three months on unanimous authorization of bailout funds by 27 nations plus the IMF. Authorization depends on Greece fulfilling targets for budget deficit ratios of GDP, which it never does. In fact it never can because falling GDP raises the ratio as fast as or faster than reduced deficits lower it. Both Greek opposition to the imposed austerity and the impatience with the rising costs of Greeces bailouts and its perpetual failure to meet targets are rising and the last payment to Greece has not yet been authorized (see page 9). Only authorization of the October 26 agreement, being able to force the recalcitrant owners of the debt maturing on March 20 to abide by that agreement without triggering CDS payouts and derailing the effort to put the new bonds in a legal jurisdiction with some teeth (private investors who unknowingly bought subordinated loans at senior loan rates want the next default to be a true one) will maintain the European Ponzi scheme of insolvent banks supporting the insolvent governments that are guaranteeing the liabilities of the insolvent banks. Getting over this hurdle, and each of the hurdles to come, will only postpone dealing with the Greek default for one quarter. Several countries are losing patience and any one of them can force a default by vetoing the agreement necessary to keep the heart of the Euro-system Ponzi scheme beating. The Euro-system consists of the ECB, which is owned by the 17 national central banks (NCB). NCB do the day to day transactions and the net position of each NCB with all other NCB in the system is recorded in real time at the ECB. Currency flight from the periphery to the core is building up big creditor positions for core NCB and equal debtor positions for the peripheral NCB. For example, the Bundesbank had provided 496 billion to countries in trouble at the time of writing. In addition, the day-to-day transactions concentrate the lower quality collateral in peripheral NCB. The NCBs liabilities are its governments liabilities, so the Eurosystem is strengthening the links between the insolvent governments and their insolvent banks, with the haircuts on both rising exponentially. Assuming money transfers can be halted immediately upon a Greek default, it would still bankrupt Greek banks and decimate the value of the collateral held at the Greek NCB. The NCBs holding the offsetting creditor positions would have to write them down correspondingly, but their governments should be in better positions to absorb the hit. The real problem is not in the Eurosystem, but in the grossly over levered commercial banks, so markets have priced in very high risks of failure in some European bank equities. Even so, markets will react violently when they discover that ECB liquidity has not been solving the problem, but compounding it. Excess debt is causing the bank problems. EA debt is estimated to be 443% of GDP, third highest in the world, far above the US at 355% and completely unmanageable in a currency union burdened with a one-size-fitsnone monetary policy and huge sovereign debt problems. Insolvent European banks sold many CDS, so counterparty risk is huge. A Greek or any other significant default will precipitate a European banking crisis in the foreseeable future. Markets are already speculating on Portuguese negotiations for haircuts and Ireland cant be far behind, as it elected the current government to negotiate haircuts on private holdings of bank debt. The Lehman default occurred 13 months after the US TED spread crossed 100 basis points. The European equivalent crossed 100 basis points in September 2011, so its banking crisis would occur this autumn if a year or so is a normal incubation period.

12

Last spin of the wheel for Europes banks March 2012

Contagion to the US
US interbank markets have also been showing the strain of problems in the EA, with the 3-month LIBOR-OIS spread tracking the upward trend in the cost of EA interbank lending (see chart 9). US banks exposure to the EA through lending to governments and exposures to financial and nonfinancial institutions is significant. According to data from the BIS, US banks total claims on Club Med banks, plus Germany and France, and the UK banking system, comprise around 80% of US banks total equity (see chart 10). Bank claims on government and the private sector are reasonably transparent in the UK, but not in the US so concerns over EA exposure are likely to resurface this year.
9. Libor-OIS spread, bps
4.0 3.5 3.0 2.5 2.0

Noncurrent real estate loans in the US remain elevated, at 6.5% of the total compared with only 0.7% in the 2005-06 period and stand to rise again if the US economy deteriorates in 2012. Banks quarterly rate of provisioning looks inadequate to cope with even current levels of noncurrent loans. Quarterly provisions are currently around one-third of their 2008 average, but noncurrent loans are down by only 20% since their Q1 2010 peak. Provisions were only $18.6 billion in Q3 2011, their lowest since 2007 Q3. Noncurrent loans would have to fall quite sharply to justify this level of provisioning, when in fact the opposite is the more likely outcome. Raising the loan loss allowance to 100% of total noncurrent loans would require an extra $112 billion of provisions, in addition to the amount needed to cope with current write-offs. Real estate net charge-offs are currently around $14 billion per quarter.

The banks are ill placed to absorb increased loan loss provisions and 1.5 the subsequent pressure on overall 1.0 profitability. 14% of US banks are 0.5 still reporting negative quarterly net 0.0 income down from a peak of 35% -0.5 Feb 07 Aug 07 Feb 08 Aug 08 Feb 09 Aug 09 Feb 10 Aug 10 Feb 11 Aug 11 Feb 12 in Q4 2009, but double the average of US EA UK 7.5% in 2005-06. At the sector level, net interest income growth in particular has ground to a halt, falling on an annual basis for the last three quarters 10. US Banks: Breakdown of exposure to European regions by sector the longest period of contraction (BIS data, Q3 2011) on record (see chart 12). Indeed, the 100% last time annual net income growth 9.0% 80% contracted outright was in Q4 1989, 4.9% and that was only for one quarter. 31.0% 60% 7.5% Downward pressure on longer term 40% 1.3% yields from slow growth, low inflation 4.3% and Fed interventions will continue to 20% 10.3% 2.6% 8.4% erode banks ability to generate net 0% interest income growth. In addition, Club Med Germany & France UK % of total US bank equity capital: the Congressional Budget Office Non-bank private sector Public sector Banks predicts the Treasurys tax take will rise by an average of 1 percentage points a year from fiscal 2011 to fiscal 2014, In addition to this exposure to the EA crisis, US so growth will be minimal and defaults will rise. banks must work through the remaining legacy of US banks are in a poor position to withstand the domestically-generated subprime crisis. Falling a European banking crisis. They appear well loan loss provisions (see chart 11) have delivered capitalised with assets 11.9 times net tangible practically all the sectors net operating revenue equity. However, they need an estimated $400growth over the last two years. Pre-provision net $600 billion of capital to absorb the cost of operating revenue has been flat.

13
marking their toxic assets to market, which raises their effective leverage to 19 to 28 times too high to weather the recession and European sustain was necessary. Governments immediately engaged in an all-out battle to prevent this necessary correction. As a result, the Peoples Bank of China balance sheet has expanded by an average rate 11. US banks: loan loss allowance, % of noncurrent loans and leases of 43% a year over the last five 200% years, the Feds by about one180% third, the Bank of Englands by 160% over one-fifth and the ECBs by 140% one-sixth. Printing money on 120% this unheard of scale reversed a 100% significant part of the 2008-09 80% losses in asset markets but 60% 40% the cost has been the rising 20% insolvency of governments and 0% banks.
Q1 1984 Q3 1986 Q1 1989 Q3 1991 Q1 1994 Q3 1996 Q1 1999 Q3 2001 Q1 2004 Q3 2006

12. Net interest income, $mn


120,000

100,000

80,000

60,000

40,000

20,000

0 Q1 1984 Q3 1986 Q1 1989 Q3 1991 Q1 1994 Q3 1996 Q1 1999 Q3 2001 Q1 2004

banking crisis without significant failures. In addition, Professor Robert Reich of the University of California at Berkeley wrote that Wall Streets total exposure to the EA totals about $2.7 trillion, not far short of triple the equity of American banks.

Global contagion
Global financial assets were only slightly greater than global GDP in 1980 but 3 3/8 times greater in 2010 with the increase in debt outstanding rising from a fraction of GDP to 2 times accounting for the rise. The collapse of the credit bubble shows Ponzi debt had pervaded the credit structure, so deleverage and a drop in asset prices to levels that incomes and production could

Insolvency will keep dragging the EA economy down until sovereign and bank balance sheets are repaired. Eliminating the Ponzi debt without fracturing the entire credit system is impossible. The next section will offer some ways of minimizing the damage and preventing recurrences, but deleverage is absolutely essential to restore optimum growth. Total industrial production in the OECD remains below the pre Great Recession peak and widespread falling real incomes show the Q3 Q1 Q3 lower income brackets are in 2006 2009 2011 a depression. Other developed nations are in less dire straits than the EA, but slow economic growth and deteriorating sovereign balance sheets are pushing many of them in the same direction. Banking problems are becoming more acute and Europe is the canary. The ECB didnt prevent broad money from beginning to fall even though it increased its balance sheet by almost half in the last seven months of 2011. The same is likely to happen in other developed nations.

Q1 2009

Q3 2011

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Last spin of the wheel for Europes banks March 2012

Commodities are another problem area


Different factors determine the real supply of and demand for various commodities. High correlations among their prices are most unusual, yet the prices of the most traded commodities have become ever more correlated in recent years. The reason is clear. Up to 1990, commodity futures markets were 70% hedging and 30% speculation with speculative positions more or less equally split between long and short positions over time. Real supply and demand determined prices. By contrast, speculation has risen to 80% and hedging has fallen to 20% since 1990. In addition, investment bank commodities funds are long only so the speculative positions are virtually all longs. The only possible result of almost 80% of orders being from investors on the buy side is commodity prices rising to ridiculous heights when investment demand is high and dropping back to real supply and demand levels when investor demand is absent so commodities are now priced above their economic value much of the time. For example, the most notable result of QE2 was increased risk seeking in asset markets. The prices of the most traded commodities rose immediately upon its announcement over two months before actual purchases began, i.e. long before QE2 could have raised the real demand. Similarly, risk avoidance rose in asset markets near the end of QE2 and commodity prices dropped i.e. long before the real demand could have fallen. Producers and investment banks raked in fabulous profits from turning commodities into assets. As a result, the Toronto Stock Exchange diversified metals and mining index rose about 40% a year from May 2003 to May 2011. Non-producers have paid the price for profiteering in commodities with slow global growth and declining per capita real incomes in many developed nations. As usual, the poorest have suffered the most through food and energy prices being far higher than necessary. In an effort to limit profiteering in commodity markets, Congress instructed the Commodities and Futures Trading Commission (CFTC) to institute position limits on any participant who is not a bona fide hedger. Effective lobbying from Wall Street created long delays, but the CFTC finally voted to cap the number of futures and swap contracts that any

single speculator can hold. The limits will apply to 28 physical commodity futures and their financially equivalent swaps and come into effect 60 days after the agency defines the term swap. That could take a long time as Wall Street is challenging the cap in the courts. Fortunately for all the people in the world who eat, build and/or consume energy, problems at French banks will cause a spectacular drop in commodity prices, as in 200809. French bank difficulties after the Lehman default explain the sharpness of the fall in global trade, particularly in commodities at that time. The restoration of bank liquidity further explained the speed of the subsequent rise. The deep V in trade caused an even deeper V in commodity, energy and equity prices. French banks reining in their lending is at least partly responsible for the commodity indexes turning south again in 2011 before reaching the 2008 highs. The coming banking crisis will cause another sharp drop, but the insolvency of the French banks wont be so easily papered over this time. This, combined with falling inflation in emerging markets will hold commodity prices down, making the future pattern look more like an L than a V, thereby ending the excess speculative buying of commodities. Trade lending will also shrink considerably.

The coming crisis is financial, not economic


In spite of the gyrations in asset markets in recent years, real GDP is at or near record highs in many nations and theres no reason for the coming deleverage to cause dire economic consequences. The destruction of wealth from falling asset prices will hurt the economies of the highly levered developed nations, but the rise in real incomes due to falling commodity, energy and real estate prices will benefit the lower income brackets of emerging nations more. The dot.com bust began once-in-a-lifetime corrections in stock prices in 2000, pushing equity P/E ratios into a downtrend that wont reverse for another four of five years. The overvaluation of equities far exceeded anything seen in the last couple of centuries. Current P/E ratios have dropped to below average levels, but longer term valuations remain elevated. Cyclically adjusted P/E ratios (CAPE) in most markets remain well above average. They always fall well below average before the bear market ends, indicating prices will fall below the 2009

15
lows in developed nation equity markets. Tobins Q, the total replacement value divided by the market capitalization, shows about the same level of overvaluation as CAPE. Earnings outperform stock prices near major P/E lows, so prices will probably trough during or soon after the banking crisis at levels lower than their respective 2009 lows. However, massive government deficits add more to corporate revenues than to their costs. They will temper the fall in corporate earnings, which could stabilize S&P 500 earnings in the 70 area. A level modestly below its 2009 low would give a P/E of around 9 and about a 4% dividend yield. More importantly, equities would then be significantly undervalued relative to normalized earnings and replacement cost, creating the conditions for a sustainable rally. Equity prices and credit spreads tend to move together. In fact, high yield bond spreads correlate to inflation better than TIPS, which are ridiculously expensive. The global banking crisis will usher in deflation. First fear, then falling profits with the onset of deflation pushing prices down faster than costs, devalue equities relative to bonds. Fear is already incorporated into stock prices, but the falling profits are not. Equities will overshoot on the downside and start recovering before the economy stabilizes and starts to recover. Deflation will keep downward pressure on margins, but deflating costs catching up with prices and growing volumes will maintain or increase profits. As a result, equities with P/E of 9 and a 4%-5% dividend yield will greatly outperform 2%-3% Treasuries and negatively yielding TIPS. Markets have priced the risks of high grade bonds much lower than equities as the interest rate on 10 year Treasuries recently fell below dividend yields for the first time in decades. High quality sovereign, central bank policy and short term interest rates have hit all time lows, so can only go up. Two factors determine the level of interest rates. Most important is the balance between the desire to save and the desire to invest. The desire to save exceeding the desire to invest (the Eurasian savings glut) pushed real interest rates down in the 21st century. The secondary factor is monetary policy which, both in 2000-01 and since mid 2007, put more downward pressure on interest rates. They have fallen by up to 3 percentage points (except Japan) since 2000 to the lowest levels in over three decades. Up to the early 1980s, the public and private sectors usually competed for resources and inflation ultimately reversed the drops in real interest rates from excessively loose monetary policy. Since then, that competition has been absent and excess liquidity from monetary policy has created a series of asset bubbles. Most central banks (wrongly) dont view rising asset prices as inflation, so monetary policy has remained too loose since the late 1990s. The resulting burgeoning private debt caused a banking crisis in 2007-08. Central bank efforts to avoid the consequent deflation reduced real and nominal rates to levels at which no economy can function properly. Real rates are now rising as inflation falls, but nominal rates will begin to rise as global saving drops from record levels. This promises that the interaction between the desire to save and the desire to invest will determine the level of interest rates for the first time since 1970, the year central banks decided to print money in a major way because they couldnt trust markets to supply adequate liquidity. That decision placed them on a path that led to the credit bubble collapse in 2007-08. With central banks hors de combat after this next banking crisis, nominal risk free interest rates should average about 2% for short terms and 2% to 3% for longer terms. With inflation turning to deflation, these nominal rates will represent a significant rise in real interest rates. That real estate prices depend on location is well known, but this idea (like many others in this inject-as-much-liquidity-as-possible world) has been taken to ridiculous extremes. Deflations function is to reduce asset prices to levels consistent with incomes, so will correct real estate prices far more in overleveraged and overpriced markets. However, deflations effect on commodity prices will be far more consistent. The 2000-08 commodity bubble convinced most people that soaring emerging market demand would keep commodity prices rising for decades, even centuries. However, the two factors that made this rise in commodity prices the fastest and the most extensive in history were the amount of excess liquidity injected by central banks and the explosion in speculation described on page 14. Food and precious metals prices spiked higher in 2011 than 2008. Weather was a big factor in the rise in food prices and precious metals are not commodities. (Commodities are produced for consumption, so supplies on hand are small;

16

Last spin of the wheel for Europes banks March 2012

precious metals are produced to keep so supplies on hand dwarf production.) Peak prices for energy and base metals in 2011 fell far short of their 2008 peaks, so food and precious metals notwithstanding, most commodity price indexes failed to reach their 2008 peaks. Lower highs and lower lows indicate bear markets. Recessions in Europe and the US plus lower growth in emerging nations indicate the fall in commodity indexes since April 2011 will continue and, like equities, they will fall below their 2009 lows in the coming banking crisis. The evaporation of excess liquidity and speculative demand, the inability to limit production and the liquidation of hidden inventories will push the prices of most commodities below their marginal costs of production. Rising productivity will account for much of the return to real profits for producers, the idea of commodities as an investment class will rot in the dust bin of history and this, the most egregious bankster assault on public welfare with central-bank-provided liquidity will end.

control of fiscal and monetary policy would greatly ease the way forward, but European banks are a major stumbling block. The major EA banks are highly vulnerable to losses on their sovereign debt holdings. Chart 13 shows shareholders equity as a percentage of total assets for nine major banks. The comparable ratio for the largest five US banks is 9.2%. In addition, the chart shows the same ratio if the banks were to take a 50% haircut on their holdings of sovereign debt in Spain, Portugal, Ireland, Italy, Greece and Belgium which could arise from either default or exit and devaluation. This would take shareholders equity to close to or less than 2% of total assets in four of the nine banks. That the European Banking Authority found Intesa Sanpaolo and especially Credit Agricole adequately capitalized in the latest round of stress tests shows the extreme level of denial of the gravity of the situation. Loss from high levels of troubled sovereign debt is far from the only problem facing the EA banks. For example, excessive debt burdens in the nonfinancial corporate sector from too-low lending rates in the periphery in the years running up to the crisis, also pose a threat. The overhang of already-soured lending and declining profitability mean these banks are simply not profitable enough to build up sufficient reserves against future bad loans especially with the EA facing a deepening recession.

Europes core challenge


Europe cannot repair both sovereign and bank balance sheets simultaneously in the context of recession/depression, and politicians are either in
Chart 13 Shareholders equity as a percentage of total assets
10%

Spain gives the clearest example of the threat of non-financial sector debt to EA banks. 6% Operating income fell for all nine major listed Spanish banks 4% in 2011, having already declined in 2010 for seven of them. The 2% Spanish banking sectors loan loss allowance is currently less 0% than 80% of non-performing Santander BNP BBVA Deutsche UniCredit Societe Intesa Credit Commerzbank Generale Sanpaolo Paribas Bank Agricole loans (NPL) to the non-financial Shareholders' equity/Total assets SE/TA, 50% haircut on periphery debt holdings corporate sector, which are bound to keep rising, compared with in excess of 400% in 2004. Current loan loss provisions are already 70% of ignorance or denial of the gravity of the situation. operating income. The Bank of Spain recently Messy sovereign defaults and/or exits from the mandated a further 50 billion of provisions, but euro are now very likely. Sovereign defaults are this would take the loan loss allowance to only painful as they impose unpopular reforms to 110% of current NPL and overwhelm annual net correct the previous excesses. Exits from the euro income. Future losses will most likely overwhelm would impose equally painful reforms. Regaining
8%

17
Spanish banks, making them unable to support the crumbling Spanish government finances. The only way out of this downward spiral is debt for equity swaps on both sovereign and bank liabilities. In plain English, most European banks (and a considerable number of other banks) are insolvent. The EA would have absolutely no reason for trying to prevent haircuts on bank debentures or to delay the Greek default if this were not true. Writing assets down to fair value and recapitalizing banks is the first priority in restoring economic growth after banking crises. However, the rosy predictions spewed out by computer models are totally oblivious to the effects of the Minsky Moment ending the credit cycle, making the claims of politicians, bankers and bank regulators that most European banks are adequately capitalized spurious. What can be done to alleviate the situation? in 2007, just as the global banking crisis was coming to the fore. Structural reform to remove the implicit government guarantee that socializes losses has proven to be equally difficult. The basic problem is that banks have structured themselves so that the government retail deposit guarantee extends to all the activities in the non-retail part of the bank. TBTF banks are too big to exist. The only way to restore properly functioning capitalism is to break them up into pieces that are not systemically dangerous. The US Financial Services Modernization Act of 1999 created TBTF by gutting the Glass Steagall Act of 1933 which, in response to abuses similar to those committed by current too-big-to-fail institutions, had (rightly) prohibited; 1 any institution from acting as any combination of an investment bank a commercial bank and an insurance company and 2 any officer, director, or employee of a securities firm serving as an officer, director, or employee of any member bank. Only the complete separation of commercial banking from investment banking and insurance activities can prevent retail deposit guarantees from extending to investment banking and insurance activities. However, the imposition of Glass Steagall separation wont solve two other problems. First, the 2008 financial crisis exposed the high additional risks to banks from having liabilities significantly in excess of their deposits, so the liabilities of any institution accepting government insured deposits should be limited to deposits. In addition, all assets should be suitable to deposit taking institutions. Second, the investment bank cum insurance company remaining after the commercial bank has been separated may still be TBTF. Higher funding costs and the imposition of higher capital and liquidity ratios on such institutions could help to limit their size. However, history shows governments would rush in with taxpayer funding at the first sign of trouble. All major nations would have to pass laws mandating the separation of investment banks, commercial banks and insurance companies to keep systemically dangerous institutions from threatening capitalism (and by extension democracy) again.

Alleviating and preventative measures


The unexpectedly large ripple effects of the Lehman Brothers bankruptcy panicked governments into assuming the huge liabilities of failing and near failing banks in 2008-09. The Irish government went so far as to guarantee all unsecured bondholders in its nationalized banks, while the UK government now owns 84% of Royal Bank of Scotland and 41% of Lloyds. The major liabilities of European banks still remain contingent, although nationalization is a threat for institutions failing to meet the EBAs capital targets. Regardless of the procedures, the bank rescues privatized gains and socialized losses in direct contravention of capitalist principles, creating immense moral hazard. Unsurprisingly, executives of financial institutions that believe theyre too big to fail (TBTF) have exploited their ability to pocket (sometimes phantom) profits and saddle the public with their losses. Regulators have tried to tackle the TBTF problem with restrictions on capital and leverage ratios and structural reform of the banking system. Utilizing risk weighted capital coupled with a lack of teeth doomed the former to massive manipulation and, as already discussed, the new 9% Tier 1 capital ratio in the EA barely scrapes the surface of the balance sheet problems. For example, the Spanish banks much lauded dynamic provisioning process meant that loan loss reserves started falling

18

Last spin of the wheel for Europes banks March 2012

Unfortunately, the unbelievably big, powerful and wealthy banking lobbies have prevented significant progress in the battle to end TBTF, but some plans are in process. The UK attack on TBTF is to institute living wills Recovery and Resolution Plans. Each bank will have to set out plans to return to health in the event of a fresh crisis and how it will secure an orderly wind-up if the plans fail. The plans will have to be regularly updated and approved by the new Prudential Regulatory Authority. The Financial Services Authority has suggested the plans include emergency cash calls, the elimination of dividends, or putting the entire business of a bank up for sale. Bondholders will have to share in the pain. Bank structures will have to be simplified and clear knowledge of all counterparty exposures and how the banks positions can be unwound is necessary to even begin constructing a living will. The US Volcker rule prevents banks from trading on their own account while socializing losses with retail deposit guarantees is a step toward separating retail and investment banking. The UK Independent Commission on Banking (ICB) is trying to go a step further by recommending ringfencing retail banking from investment banking and wholesale funding, but stopped short of full separation. Under this structure, the UK banks retail activities would take place in subsidiaries that are legally, economically and operationally separate. Wholesale and investment banking activities would be outside the ring-fence, while banking services to large domestic non-financial companies could be in or out. The Volcker rule doesnt deal with TBTF, but the ICB report does. In addition to raising the equity capital requirement to 10% and ring-fencing retail banking, it adds an additional 7-10% to the primary loss-absorbing capacity of banking institutions including so-called bail-in bonds (regulators could write them down) and bonds that convert to capital under specified conditions (CoCos). Continental European banking authorities have yet to deal with either TBTF or socializing losses. Instead, they ignored TBTF and did their utmost to socialize losses until the Greek debacle forced a U-turn. Realization of the enormous costs of continuous bailouts replaced their fears of allowing banks to fail. Unfortunately, the wasted four years has compounded the scale of problems. Bailouts have demoted investors who paid senior credit prices for their bonds to subordinated creditor status. Worse, the credit protection they

bought in good faith threatens to be worthless. Who in their right mind would buy sovereign debt under those conditions? In addition, the banks need copious quantities of equity and wholesale funding, neither of which is available and for good reason. The EA Ponzi scheme outlined on page 11 and abetted by the ECB, is nearing collapse. Nothing proposed so far has any chance of saving the EA banks. Another solution needs to be found. The Basel rule for zero risk weights on sovereign debt denominated in a currency the governments couldnt print was the biggest factor in creating the European debt problems. The collapse of the resulting credit bubble means developed nations must eliminate as much debt as possible as fast as possible in the least disruptive way possible. A fundamental principle of capitalism is that investors in profitable ventures reap the rewards due to their investments and investors in unprofitable ventures suffer losses according to the seniority of their claims. As a result, corporate bankruptcies are usually settled with most creditors accepting equity positions in lieu of the debt owed to them. The same technique could greatly alleviate bank and sovereign debt problems without disadvantaging any noncomplicit entity. The claims of private holders of bank debentures are being eroded by the senior claims of public entities and a flurry of covered bond issuance. Legislation forcing conversion of bank debentures in reverse order of seniority into an equivalent amount of equity as needed to maintain adequate net tangible equity would restore solvency to many banks without penalizing taxpayers or bondholders who should welcome the receipt of face value in securities with growth potential in exchange for the eroding claims of their bonds. This would be a complete reversal from the totally unrealistic European effort to make taxpayers pay the costs of misguided investments in bank securities, so is politically unacceptable in the short term and probably in the long term too. More realistically, banks are starting to swap bonds due to be called in 2012 for longer maturities. This lets them both book a capital gain from buying back debt below par value and reduce rollover risk. Debt for equity swaps would be a logical next step. The trade should have broad appeal because recovery rates for subordinated debt in failing banks will be very small, but prospects for equity holdings in the

19
same banks properly capitalized would be much better. Banks converting other bank debentures could create inappropriate, perhaps illegal, cross shareholdings, but netting out cross holdings of bank securities would raise capital ratios by shrinking bank balance sheets. The private sector is playing an ever increasing role in infrastructure and other government programs through public/private initiatives. Sovereign debt for equity swaps would be similar, but on a grand scale. Bondholders would exchange their debt for shares in a private company that owned former government assets, such as sovereign corporations, revenue producing properties and non-revenue producing infrastructure with either a guaranteed income or rights to charge users in exchange for operating and maintaining the facilities to an agreed standard. As in bank debt swaps, such equity offers better long term prospects than sovereign debt in Greece, Portugal, Ireland, Italy and Spain. Many public/private initiatives have yielded good results for both sides, but some havent. Like so many things, the devil is in the detail. Accurate valuations and precise delineation of rights and duties are essential. Politicians have proposed a tax of 0.1% on all stock, bond and derivative trades to; 1 make banks repay a bit of what they have taken from the public, 2 reduce speculation and financial engineering and 3 create a fund to bail out banks that get in trouble in the future. This sounds like a panacea for all financial problems. However, a tax of that magnitude on foreign exchange futures would create a field day for the Law of Unintended Consequences by raising the cost of commercial foreign exchange transactions by between 1,000 and 10,000 times. A tax in Sweden of only 0.003% on transactions of bonds maturing in more than five years reduced the trading volume by 85%. Less trading increases market volatility (thereby decreasing confidence) in markets and lowers tax receipts far below estimates. By contrast, it would end high frequency trading, which is not only increasing volatility, but is also probably illegal because it more often than not front-runs client accounts. Its ability to rein in the most destructive element in financial markets may be worth all the problems and aggravation of designing and implementing a modified version of this tax. Apart from debt for equity swaps, the most useful thing politicians can do is introduce cyclical budgeting. This would require; 1 raising government accounting up to the sophistication required of private companies, 2 setting an inviolate proportion of GDP for average government spending including capital investment and 3 administering the capital budget counter cyclically. Government spending has quintupled and more in less than a century. Most government spending is non-productive, so that growth has to stop somewhere. The only thing better than stopping it here and now would be to impose limits below current levels. In addition, investment, not consumption, drives capitalist economies. Studies show infrastructure spending is governments most powerful stimulative weapon. However, the present accounting systems most governments use are not sophisticated enough to calculate the return on money spent. Best practice accounting would show the return on most programs is negative, which is why fiscal stimulation yields such poor returns. Public capital spending on projects with positive returns administered to rise as private capital spending falls and fall as private capital spending rises would vastly outperform the present arcane welter of automatic stabilizers and policy on the hoof. Of course, if steps one and two had been done a few decades ago, a lot of governments would have avoided the trouble they are now in without ever needing step three.

Hope from the crisis-practised Emerging Markets


Club Med now faces a similar style of financial crisis to that experienced by several major emerging markets over the last twenty years. These crises Mexico in 1994, Brazil, Asia and Russia in 1998, Turkey in 2001, Argentina in 2002 were driven by fixed exchange rate regimes leading to the accumulation of external liabilities by governments, corporations and banks, and culminated in financial meltdowns. In addition to large current account deficits and government debt, Club Med has assumed significant external liabilities that would have to be negotiated into the domestic currency in case of exit from the euro.

20

Last spin of the wheel for Europes banks March 2012

Brazil, Mexico, Russia, Turkey, Indonesia, Argentina and Korea have experienced one or some combination of abandoning fixed exchange rate regimes in the last twenty years, defaulting on domestic or external debt and banking crises. The broad lessons learned from this experience limiting foreign-currency denominated debt, avoiding excessive current account deficits, maintaining adequate foreign currency reserves and greater banking oversight have helped to place some of these markets in a strong position to weather the current financial crisis. Indeed, excess application of these principles especially in Asia contributed to the current crises via the global savings glut.

much of the heavy-lifting for the EMs that are highly sensitive to global risk appetite. Some EM currencies depreciate sharply in times of weak global appetite for risk, counterbalancing weaker economic demand. Indeed, the rupee, real, rand and Turkish lira all depreciated by around 16% in the second half of 2011. Making full use of currency flexibility and looser monetary policy, of course, requires a sound financial position. For markets where either governments, banks or the private sector have taken on large external obligations, lured by lower international interest rates e.g. in Central and Eastern Europe, currency depreciation can be more of a threat than a blessing, requiring defensive monetary policy tightening. These are the markets most likely to suffer as Europe works through its financial crisis. Foreign bank ownership, once perceived as a sign of strength, also leaves credit supply in some markets vulnerable to EA region deleveraging. Indeed, there is a risk that in their desperation to lift capital ratios, EA banks will shed their most favourable EM assets, while retaining poorer quality European assets for which there are few buyers.

While the developed markets (DMs) are struggling to cope with the consequences of their pre-2007 credit binge, the outlook for many emerging economies (EMs) is much better. Without the debt overhang of the developed markets, and with scope to stimulate domestic activity using conventional policy approaches, some EMs could exit the fall-out from a European banking crisis with strong growth potential. The transmission mechanism from a euro break-up, if it were to happen, would affect emerging markets via their varying dependence on (a) world trade; and (b) world financing. Relatively closed economies with limited 14. Emerging market exports, % of GDP external debt obligations should therefore be least Brazil affected. Turkey
India However, generalizations about Indonesia EMs are fraught with hazard, S Africa given Chinas unique position Mexico in particular. Indeed, China may Korea be the epicentre of the next Taiwan global crisis, so belongs in a category of its own. This also makes economies closely tied to Chinas outlook Korea and Taiwan in particular more vulnerable.

0%

10%

20%

30%

40%

50%

60%

70%

80%

Where developed economies have largely exhausted room for conventional monetary support to the economy, high nominal interest rates in many EMs mean there is plenty of room to cut rates as the European crisis unfolds. Indeed, some central banks would relish the opportunity to aggressively decrease their policy interest rates, in an attempt to stimulate investment while casting off the legacy of past inflationary periods. Even better, free floating exchange rates can do

On the other hand, markets including Brazil, Mexico, South Africa, Indonesia, and India should withstand a European financial crisis reasonably well. Exports constitute around 30% or less of GDP in these countries (see chart 14), and growth is not dependent on ever-expanding global market share, unlike China and Korea, for example. Current accounts are either in surplus, or deficits are easily covered by stable inflows of foreign direct investment. Banking sectors are small and stable relative to GDP.

21
15. Activity of foreign banks: EA total claims, % of domestic banking sector's total assets
S Africa Korea India Indonesia Brazil Russia Turkey Poland Mexico Hungary Czech Rep 0% 100% 200% 300% 400% 500% 600%

All of these markets have at least some, if not substantial, scope to ease fiscal and monetary policy in 2012 to support domestic economic activity. For some, India in particular, delayed monetary tightening in the 2010/11 recovery phase means this policy arsenal cannot be fully deployed until inflationary pressures abate further. For Brazil, however, the global deflationary environment and downward pressure on commodity prices only makes the policy decision easier. Brazil has been able to cut the overnight rate by 2 percentage points since mid-2011 to 10.5%.

EA financing. Chart 15 shows the claims of the Euro Area on several EM markets, across the public, private and financial sectors, as a percentage of total assets of the domestic banking systems. This gives a sense of the scale of the presence of foreign banks in the funding of these economies, relative to the size of domestic financial sectors.

Better Emerging Market Banks


EM banks as a whole have been much better able to generate profits than DM banks. The foray into complex securitization products and explosion in leverage to generate returns all seem to have been for nothing. Over the last five years, net profit has been flat for DM banks, but has increased six-fold for EM banks (chart 16). This profit growth has not been at the expense of

16. EM and DM Banks: Net Profit, Q4 2005 = 100 Other central banks, e.g. Mexico and South Africa, have 600 had monetary policy on hold 500 since the middle of 2010, 400 but still have room to cut if 300 necessary, with policy rates at 200 4.5% and 5.5%, respectively. 100 Brazil also has a sturdy fiscal 0 primary surplus, and therefore -100 2005 2006 2007 2008 2009 2010 2011 scope to stimulate the Q3 Q3 Q3 Q3 Q3 Q3 Q3 economy from that side, too. EM Banks DM Banks Turkey would also join this favourable group, but failure to tighten monetary policy financial stability. Throughout the last decade, until late in 2011 has created a money and credit EM banks have also had persistently higher overhang, while reliance on short-term capital capital ratios than their DM peers averaging inflows to finance the current account deficit around 7% shareholders equity to total assets, remains significant. compared with less than 5% for DMs. In this Financial pressures in the euro area not least simple comparison, higher levels of equity capital capital raising plans by banks could translate by no means restrict banks ability to generate into monetary pressures in some emerging profits, and neither does lower leverage EM markets, via asset sales or the withdrawal of credit banks are currently 14 times leveraged, compared lines, which could have significant effects on with 19 for DMs. The picture is not rosy for all EM the financing of corporations and governments. banking sectors, however the underlying asset Exposure among EMs is varied, with Central quality and future profitability of Chinas banking and Eastern Europe the most vulnerable, but system being the most obvious threat, while several other EMs are not at all dependent on excess reliance on foreign wholesale funding and

22

Last spin of the wheel for Europes banks March 2012

a persistent NPL problem are issues for Koreas banks. While developed market governments have become beholden to their over-large banking sectors, many EM banking systems do not have a too big to fail category, where institutional failure would cause collateral damage to the economy. While total assets of UK banks were almost 4 times larger than UK GDP in 2010, the total assets of publicly listed EM banks are only a small portion of national GDP, as shown in chart 17.

17. Banking sector total assets, % of GDP


Mexico Indonesia Russia Turkey Brazil India Korea S Africa China Taiwan 0% 20% 40% 60% 80% 100% 120% 140%

The corollary of smaller banking sectors is far more limited indebtedness of EM private sectors. EMs do not face the painful debt write downs necessary in Europe or the UK. Credit remains a low percentage of GDP in many. Mortgages are not widespread and corporate borrowing is low. Less developed debt markets and higher borrowing costs, boosted by bouts of high inflation and higher risk premiums, have prevented the build-up of a credit overhang. The aggregate corporate debt burden is around 1/3 less for listed EM companies than DM net debt is 1.4 times earnings before interest and taxes, compared with 2.1 times for DMs. As a result, some EM banking sectors have substantial scope for further, sensible asset growth.

23

Conclusions
Currency manipulation by some emerging nations prevents nominal exchange rates from correcting the disparities in unit labour costs that led to the big global imbalances of saving and investment, so inflation differentials are the only means of correcting them. Unexpectedly high inflation in emerging nations permitted some adjustment in the recovery even though inflation in developed nations was unexpectedly high. Now, however, falling inflation in emerging nations is putting downward pressure on inflation in developed nations. The banking crisis and consequent defaults will add to that pressure, virtually guaranteeing deflation. This will put intolerable pressures on global banking systems. Global imbalances of saving and investment are unprecedented, as is global leverage. Much of the debt will default in the absence of a combination of accelerating growth and inflation and/or rising asset prices. The discussion above has shown that all three are impossible, so rising defaults will cause a banking crisis, which will be in the context of over levered governments and, by extension, over levered supra national agencies for the first time in history. The wider implications are huge, but most are beyond the scope of this report, which focuses on the economy and financial markets. However, the events surrounding the collapse of this credit bubble have proven beyond a shadow of doubt that Irving Fisher and Hyman Minsky were right. The only way to prevent credit bubbles from crashing into deflation and depression is to prevent the bubbles from inflating. Rule #1 for preventing credit bubbles is No bailouts at any time for any reason! The first bailout begins the journey down the slippery slope of moral hazard to collapsing credit bubbles. (Note: government and central bank loans at penalty rates against top quality collateral with appropriate haircuts are not bailouts: loans not fulfilling all those conditions are.) Rule #2 is Small is beautiful! Few worry about the collapse of entities with assets totalling less

24

Last spin of the wheel for Europes banks March 2012

than, say, 0.01% of GDP, so keeping rule #1 is easy when companies, especially banks, are small. The political pressure to bail out organizations rises geometrically as their size rises. None, regardless of size, are worth bailing out. If they were, they wouldnt need a bailout or would have sufficient quality collateral to qualify for a loan under the explanation of rule #1. Rule # 2 applies to governments too, but explaining that is far beyond the scope of this report. EA reliance on tax increases and cuts in infrastructure investment torpedoed any possible chance of growing/inflating out of their debt problems. Unemployment is high and rising, 23% in Spain with youth unemployment at 50%. Greek unemployment is nearly as high. Rapidly deteriorating economic conditions have consigned the periphery to default or exit from the euro. Either way, the losses will be far bigger than most banks will be able to withstand. Instituting debt for equity swaps on the scale required in time to avoid serial bank failures is unlikely. Current account surplus nations unwisely invested much of their saving in debt, some of which will not be repaid, rather than in productive enterprises that could have produced returns to augment incomes in the difficult days ahead, so avoiding depression in the EA would, in effect, be a miracle. Leverage compounds risk. Europe is the epicentre of the over leverage, so it will suffer most from the serial bank failures. The effects will diminish geometrically as leverage levels drop. The dollar is the only asset that benefits from deleverage, so it will rise and complaints about the dollar being too high should become common. (Remember the 1980s?) US cash is the best place for investors to ride out the banking crisis. It will even provide a decent return to non-Americans. Low leverage and dependency ratios should make emerging nations the first ones to regain sustainable growth, at which time fortune will reward those with lots of dry powder and cool heads with once-in-a-lifetime bargains. Emerging nation growth should foster developed nation growth as a by-product. Yet people invariably overestimate the frequency and effects of extremely rare events both positive and negative. Say deflation and people immediately think Great Depression. Rubbish! The Great Depression was an unparalleled event in history. The Kondratieff cycle turned down in 1920 and the credit cycle turned down in 1929.

Such close peaks in those two cycles had never happened before and may never happen again.2 Governments and supra national agencies will have shot all their fiscal and monetary bullets when the banking crisis occurs, so it will rebalance all of the imbalances accumulated over the last three decades. This will set the stage for strong, catch-up growth reminiscent of the 1950s and 1960s for at least the following decade and possibly a lot longer, especially through invention and innovative applications of old technologies. Breakthroughs in nanotechnology and genetics offer limitless opportunities. Meanwhile, innovations such as the hydraulic fracturing that made the gargantuan reserves of shale gas and shale oil economic have postponed the prospect of peak gas and oil for at least decades, maybe centuries. Computer driven watering systems can greatly increase yields using up to 90% less water, a necessity for the world to keep feeding its ever more affluent population in the style to which it wants to become accustomed. The Kondratieff cycle turned up in the late 1990s. Commodities rebounded from their 25 year slump and that cycle will continue to be a positive influence in the global economy for the next dozen to 15 years. The longer term future should be very bright.

Trends, Cycles & Revolutions, Lombard Street Research 2011

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