The Limits to Austerity

“An emphasis by bankers on the collateral value and expected value of assets is conducive to the emergence of a fragile financial structure.” Hyman Minsky, Stabilizing an Unstable Economy (1986).

More than 25 years ago the famed American economist Hyman Minsky postulated that financial stability would be weakened when lending in the economy became excessively dependent on the value of the underlying collateral rather than the income-earning potential of those same assets. In recent years his theories, this one included, have been vindicated by real world examples time and time again – the most obvious instance of a credit system run amok and dependant on rising asset prices was Japan in the Postwar period – everything was linked to real estate. They are still sweeping that one up….and even after more than twenty years of failure, most people in that economy remain oblivious to the incompetence of their bankers, policymakers, and government officials that led the country into the abyss.

Today in Europe (and elsewhere) we are witnessing the compounding of policy mistakes made not so much strictly in advance of the recent GFC (Global Financial Crash) but in the months and years since its sudden onset in 2008. These mistakes centre on a belief by the authorities that everything would be all right if collateral values just picked up, and their unshakeable conceit that what they have done and what they are doing to remediate the damage done by the crisis in this way is safe, efficient and correct.

In the face of it all, job prospects, particularly for Europe’s youth have worsened; plant closures have run apace, workers benefits have suffered, pensions and social services have been cut; yet the European economy remains stuck in neutral.

Last week for example thousands of workers again took to the streets to demand an end to the austerity measures that have seen a number of European countries wracked by social, strife, high unemployment, and despair. Most of the Euro-zone economies have remained mired in slow or negative growth mode for almost three years. With 26 Million out of work across the EU and the Eurozone registering its sixth consecutive quarter of negative growth, ordinary people are coming to the obvious conclusion : “….these policies do not work”.

In January, even the IMF got into the act by proclaiming that its austerity-based policy prescriptions may have been erroneous and could in fact be making things worse.

So its fairly easy to conclude that last week’s EU summit wasn’t exactly a warm and fuzzy family barbeque type of scenario. In fact the most recent set of meetings was probably the 250^th get-together involving politicians and government officials since the crisis began.   All of these jamborees have passed without a positive, workable solution to the crisis being tabled, much less implemented.

Last week was no different: Again, the usual platitudes were served up; accompanied by the usual hand-wringing from Europe’s brightest and best minds. No specific policies were discussed much less adopted that would have been aimed at steering away from austerity; and, importantly, there was no nod from  Germany and its po-faced representatives that they would in fact countenance such proposals if they were in fact seriously put forward.

The Vatican that is not the only Global Institution that is stuck in a rut!!

Artist: Jeremy Nell, The New Age, South Africa  -  3/15/2013

Moreover, we have said from the beginning that pursuing austerity policies in an effort to right the ship was a VERY long shot at best. In fact this interview from 2010 sums up our views on this matter quite neatly. In the intervening period since that segment aired it has also become obvious that there are a number of headwinds that are blunting the impact of aggressive expansionary policies. These factors are additional important reasons why the economies of the European countries (as well as those of the US, Canada, Japan) cannot seem to find any traction in generating growth significantly above “stall speed” despite the policy impetus:

• Government Debt loads have increased a lot and this has reduced policy flexibility while eating up revenues of cash strapped Governments;
• Rapidly developing demographic factors promise to chew up Government finances at both ends: lower tax revenues as people retire accompanied by higher pension, social assistance and health-care payouts;
• Basel III capital rules and other regulatory requirements are contractionary;
• Austerity has prompted significant increases in rent-seeking behavior and tax evasion;
• Financial repression has cut savers’ incomes and contributed to yawning pension shortfalls.
• There is more…….in fact the biggie is:

…….The Restructuring Deficit

For some time now it has been obvious that there have been no real attempts made to recognize, write down and remediate losses that occurred in the immediate wake of the GFC. In fact the entire focus of the policy response has been to avoid doing just that and to instead try and engineer a re-appreciation of collateral values in the economies so that investors, lenders and other creditors can see their asset exposures skate back onside.

“No Pain” is the Objective.

“Financial Repression” is the Name of the Game.

Unfortunately, these policies are not only delivering “Max Pain” for everyone but the creditors; they are risking the welfare and social peace of today’s generations of Europeans.

Under capitalistic forms of economic organization, Banks must ordinarily be held accountable to deal with their distressed credits promptly and the public balance sheet must not be used to subsidize bad risk decisions nor to prop up zombie companies at public expense and to the ultimate detriment of employees, taxpayers and other more efficient and productive entities.

However, this departure from the norm in order to favor creditor interests is exactly what has been happening.

These policies of Financial Repression have been followed before. The most obvious examples are failed communist states many of whom had to abandon the experiment over twenty years ago with the fall of the Berlin Wall and more recently, hyperinflationary Zimbabwe. Some examples in the developed economies include New Zealand in the late 1970’s / early 1980’s before the 1984 collapse and Germany in the immediate Post WWI “Weimar” period. In every instance, the outcome of these episodes was negative. Today, the Europeans (and  North America and Japan) are conducting policies of Financial Repression in a variety of formats.

The negative effects of these policies include restrained GDP growth, distorted asset markets, a drag on productivity, hidden credit risks, moral hazard, risk of higher inflation, misallocation of resources, destruction of savings, financial contagion and a de facto “theft” of market share and profitability from successful, non-zombie businesses. This has been accompanied in the austerity countries and many others in Europe (e.g. the UK) by rapid increases in debt levels.

Rising levels of debt may not be the only cause for alarm; particularly when one considers that they are accompanied by a single-minded focus to raise asset and collateral values. In those situations, (such as now) financial structures can become extremely precarious. This is because leveraged asset positions may not always generate enough spread revenue to either service or repay the debt. As a result, and according to Minsky, the financial system can become increasingly vulnerable to what would otherwise be relatively innocuous events, such as a small rise in interest rates or a decline in asset prices.

Italy 10 Year Bond Yield

As just one example in this regard, please note that prior to EMU, Italian bond yields were in the range of 11% and the Italian Treasury quite happily financed their deficits without any concerns. To compare, in today’s market a sustained rise in Italian yields above 6% would spell “Game-Over” for their economy – and for that of Europe.

Fascism on the Rise

A further non-trivial concern is that ominous storm clouds are forming over the European political landscape in reaction to the authorities’ tin-eared and single-minded focus on the solutions, inappropriate as they are, that they have been pursuing with vigor but with so far, none of the intended effect. Because of this, mainstream political parties are under pressure in many major Euro-zone countries. In Greece the far right parties’ membership comprise most of the police and security forces and have been rising in the polls. The Jobbik fanatics in Hungary are proposing a roll-back in social freedoms inconsistent with the EU Charter. Spaniards are trying to cope with secession risks and extremely high youth unemployment. The rise to prominence of Beppi Grillo’s Party in the recent Italian elections is being soft-pedaled by the mainstream media with the byline that “he is a comedian”. He is anything but. A cursory look at his website reveals hundreds of Anti-Semitic comments, diatribes and attacks while, at the same time, it shows him to be singing the praises of the fanatics that are running Iran, looting its Treasury, oppressing its people and exporting terrorism. Grillo’s party looks to be next in line to govern Italy.

It is worth remembering that Hitler and Mussolini were both elected by folks who didn’t want austerity

Unfortunately it seems that for now, the Brussels crowd is happy to be dancing on the edge of the volcano and, that nothing can convince them to take a less risky and saner path to recovery.

Posted in Bankruptcy, Crisis, EU, IMF, Loan Losses, Restructuring | No Comments »

La Ligne Maginot

The Maginot Line, named after the French Minister of War André Maginot, was a military defensive construct consisting of a deep line of concrete fortifications, tank obstacles, artillery casements, machine gun posts, and other defenses, which France constructed along its borders with Germany and Italy, during the interwar period between WWI and WWII.

Military experts extolled the Maginot Line as a work of genius, believing at that time that it rendered France impregnable against invasion from Germany. In the event, while the fortifications successfully acted to dissuade direct attack, they were completely ineffective from a strategic military standpoint. This obvious defect was laid bare at the beginning of WWII when the German Blitzkrieg easily outflanked the Maginot Line by moving through the Ardennes forest and Holland, completely sweeping past the heavily defended fortifications and conquering France in less than six weeks. Although constructed at huge public expense and using the best minds and materials available at the time, the Maginot Line has heretofore become emblematic of any plan or announced remedial strategy that people hope will prove effective but instead fails miserably.

When Lehman Brothers was sent to the knacker’s yard by its street rivals at Goldman Sachs and Morgan Stanley following closed door sessions with Government officials during the summer of 2008, the Best Minds on Wall Street and Constitution Avenue thought that they were protected from the fallout of a mega credit event by their risk management models and counterparty legal arrangements that included margin requirements, collateral postings and mark-to-market protocols. In fact with all major counterparty banks in place and able to continue functioning as market participants, the effect of the mega crash could have been contained, minimized and worked out. Before Dick Fuld and his management team was sent to the proverbial gibbet, the preponderance of derivatives contracts and exotic securities positions could have been settled out in a reasonably orderly fashion over time. However, with Lehman out of the way, the “netting” of derivatives and other exposures between institutions could no longer take place and someone had to step in to buy up the toxic waste that resulted from the abrupt halt to the “pass the hot potato game”. With Lehman out of the loop, the toxic waste had to end up on “someone’s” book.

The consequential effects of the secondary detonations in the securities and derivatives markets in the US following the demise of Lehman unleashed a wave of re-rating of sovereign risk which fell primarily onto the Europeans, who more than a decade ago had abandoned their treaty-bound commitments to fiscal probity and restraint in order to consummate a flawed monetary union riddled with institutional shortcomings and massive governance problems. “Someone” had to prop up Government Finance in the Euro-zone in order to give the pretence that things were still manageable or all of the banks there would have gone down the gurgler.

The “someone with the hot potato” in the US is the Fed which since the event has been mainly concerned with somehow papering over the losses, minimizing them, and possibly inflating them away. In Europe, the “someone” is the ECB which has under the prodding of its client institutions been stretching out the remediation process in order to dragoon the taxpayers of the various Euro-zone countries to shoulder the load of bailing out greedy banks and their profligate government clients.

The story of the Global Financial Crash is far from over. Nothing has been solved; and as we have repeatedly stated in our interactions with the public through speaking engagements, or on TV, or in the press, the policies that have been implemented so far have simply narrowed the degrees of freedom for future policy steps while at the same time increasing the likelihood of negative unexpected consequences being visited on markets (potentially with a heretofore unseen ferocity).

There are therefore still a few more chapters to play out in this unfolding narrative.

The present chapter opened around three weeks ago when, after a sleepy summer where nothing much happened, ECB President Draghi announced that he was going to do “whatever it takes” to save the Euro-zone and support the bond markets of all the deadbeat Euro-countries through central bank purchases of bonds (something that only a year ago had been definitively ruled out). At the time, most pundits fell into line and proclaimed that this “brilliant” move had effectively ended the crisis and all risk assets rallied sharply.

Since then, reality has set in. In fact, Draghi can no more proclaim to have unlimited resources to solve Euro-Crisis that he can claim to be able to solve world hunger. As we have said repeatedly in the past the democratic fact is that voters in the affluent Euro-core are not going to go for what these solutions imply. Moreover as the ECB expands its balance sheet “without limit” the credit quality declines and the risk profile of the ECB shareholders correspondingly increases. The expansion at Europe’s Central Bank is off-set with a deterioration of the national credit quality of the nations so that the entire construct sets itself up for the possibility of being further downgraded. We pointed this obvious flaw in this strategy out on the air around a year ago.

To complicate matters further, most securities analysts have been paring back earnings forecasts and published data has turned rather negative. In fact over 80% of the world’s manufacturing capacity is now in contraction.

On this side of the pond we were treated to Dr Bernanke going “All-in” with his open-ended commitment to print money through QE3 (an event that we have been predicting since QE1 was announced ). Without belaboring all of the issues, we have with Mr Bernanke’s implied claims that he knows better that the markets what interest rates should be and how capital and lending flows need to be directed at a particular point in time; let us just examine a small example of his fatal conceit that we have drawn from the speech he gave yesterday in Indianapolis.

“The securities that the Fed purchases in the conduct of monetary policy are held in our portfolio and earn interest. ……. Ultimately, the securities held by the Fed will mature or will be sold back into the market. So the odds are high that the purchase programs that the Fed has undertaken in support of the recovery will end up reducing, not increasing, the federal debt, both through the interest earnings we send the Treasury and because a stronger economy tends to lead to higher tax revenues and reduced government spending.(Page 7)”

While Dr Bernanke so glibly proclaims that “the securities held by the Fed will mature or will be sold back into the market” as if this operation was some kind of benign voodoo magic with no real-world consequence, we would ask the good Doctor what will happen to the issuing institutions whose securities are “maturing” on the Fed’s books? Won’t these notes have to be re-financed to support asset positions or ongoing activities at the borrowing institution? Who will conveniently show up to buy this re-issued paper in the amounts that the Fed has so done in the past, and, more importantly, at what price?

This is debt management 101.

In deference to the esteemed Fed Chairman, we will only ask one more question that flows from this fantastical description of his policy: If this is the magic bullet, and printing money actually reduces debt painlessly as you so describe, then why have we ever bothered with trying to do things any other way?

Now, after having read his speech yesterday and having managed to regain cognitive equilibrium, we offer on sober reflection that the ECB and Fed policy announcements boil down to acts of desperation that are now, so shortly after being introduced, becoming obvious to the markets. Market participants know that all they have to do is wait for the cracks to appear before pouncing and bleeding the central bank players for significant trading profits.

The bottom line thus is that all Draghi and Bernanke did with their “Big Bazooka” announcements is buy some time, much in the same way that the French Military planners bought some time in constructing the Maginot Line before the German Military planners found a way to beat it. The only question is, “How much time have they bought?” Our expectation is that within a few short months, the ECB and Fed policies will again fail to prove equal to the task. Unfortunately the two biggest central bank players in the world have gone “All-in” on a policy which amounts to an ill-advised high stakes game of poker with the markets. There can be no retreat now.

This is the worst position a gambler can be in because it exposes their strategy to significant event risks and unanticipated outcomes.

The next card that is dealt could in fact blow the hand that they are jointly holding completely out of the water.

Postscript: A little known fact is that the Maginot Line and the Federal Reserve Building in Washington DC were both completed in the same year: 1937, during a period in history when failed financial policies and regional hostilities were driving the world towards catastrophe. In the just two short years following, there ensued an outbreak of general hostilities that led to WWII which brought with it global privation, outbreaks of disease, the directed mass extermination of ethnic groups, the mentally challenged and LGB populations; the first detonation of nuclear devices over heavily populated areas, the forced resettlement of hundreds of millions of people and the death of tens of millions.

Posted in Bankruptcy, Banks, Crisis, EU, Fed Policy, Gambling, IMF, Loan Losses, Restructuring, Sovereign Debt, USA | No Comments »

There is No Altruism Between Nations

Somebody should have referred to the title quote before the EMU was launched on a hope and a prayer only 13 short years ago. Yesterday we were again interviewed on the Euro-crisis as that event took another turn for the worse and continued its torturous progress towards what now seems increasingly likely – an uncontrolled dissolution of parts of the Grand Experiment.

Today we heard that Euro politicians are drafting federal plan to save the Euro-zone, that Moody’s has downgraded 28 Spanish banks, that a fellow named Yannis Stournaras has been named as Greece’s new finance minister, but also that the Greek Deputy Shipping Minster has resigned. And…wait, let’s not forget that Silvio Berlusconi has just thrown his hat into the ring to be Italy’s next Minister of Finance…You win some, you lose some.

Hope now fixes on the upcoming Euro-zone meetings this week. Euro-zone finance ministers are expected to hold a conference call tomorrow to discuss Spain and Cyprus’s requests for financial help, and there will inevitably be a lot more posturing ahead of the EU Summit scheduled for this Thursday and Friday

Again there are calls for Germany to take on the mantle of leadership and somehow bail everyone out. So far the Germans have been balking at calls for an end to the austerity push, to support the unification of fiscal policies and the issuance of jointly guaranteed Eurobonds and for the creation of an EU-wide deposit insurance mechanism. The problem with this view, that if only Germany were to change its stance, and then everything could be easily solved, is that it is naive in the extreme.

As I mentioned during the interview, even if Germany were to agree to all of these Grand Plans, the structural imbalances that gave rise to the crisis in the first place will not be resolved, economies will not resume growing, and a new crisis will rear its head in short order. Quite simply the periphery countries have a productivity disadvantage relative to Germany and also have uncompetitive wage structures relative to the Northern Europeans. This cannot be easily “patched”.

Moreover, we also know that in order for Germany to agree to such modifications to its membership in the EMU, it requires the Government to hold a public referendum on all of these changes. We also know that an overwhelming majority of Germans are not in favor of these new policies which see them subsidizing the zombies. (In fact, a recent poll showed that 69% of Germans want the Greeks out of the Euro)

Isn’t it time for the leadership of Europe to start talking about solutions that are actually possible instead of fantasizing about magic bullets?

Isn’t is time for the Europeans to stop the madness of throwing vast sums of money at what is in effect a bad trade?

"Quick operator, gimme the number for 911!!"

What Europe has needed from the very beginning is a reckoning and write down of the bad debts. They are on the books and won’t go away no matter how many policies are changed and how many bailouts are doled out. This “avoidance of loss recognition” has been the central aim of the bailout policies from the beginning. As we can now easily see, clinging to this strategy is causing a worsening of the loss position, causing a loss of confidence and contagion and promises to only increase the eventual size of the financial hole. This is being pursued nonetheless in the faint hope that the losses can avoided or pushed onto third parties that had no hand in manufacturing the crisis in the first place.(The taxpayers of other countries and future generations)

The only certainty that we now see regarding this miserable state of affairs is that there will be massive losses and that the eventual bill when it comes due will be much, much larger than it would have been two years ago when there was still a chance to nip this thing in the bud. Let us hope that that is where the similarities of our present condition with the 1930’s will end.

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“Thou Hast Seen Nothing Yet”

(This title is attributable to Miguel de Cervantes Saavedra – “Don Quixote”)

Recovery Partners was interviewed last Friday and again this past Monday regarding developments in the European debt crisis. Unfortunately these interviews only allow a little time to get some sound bites in and not a whole lot of time for reasoned analysis. Therefore  this blog is aimed at adding some needed color and insight to the SUN TV and BNN interviews that underline the seriousness of the situation.

The simple reality is that not much has been done to solve any of Europe’s financial problems since they started over three years ago and, as a consequence, the available runway that European policymakers have left with which to craft workable solutions to the debt mess is getting very short. What is extremely concerning therefore, is that the latest events indicate that the Euro-strategy of incrementalism and trying to stretch out the process before hard decisions have to be made is being pursued by the Eurocrats and politicians there with even more vigor now.

After dithering for years about the rot in the Spanish banking sector and botching the recapitalization of several failed banks a few short weeks ago, the political authorities there finally and reluctantly agreed to accepting aid from the Eurozone this past weekend. In flippant style, Spanish Prime Minister Rajoy triumphantly declared that he had arranged a “handy credit line” and that the crisis was “now over” before jetting off to Poland to see the Spanish footballers tie the Azzurri 1-1 in Gdansk.

When have we heard this type of denial before?

There is in fact much to worry about in the wake of the news regarding the Spanish bank bailout not in the least because there are more questions than answers coming out of this series of announcements

As we mentioned  in the TV interviews, these issues include:

• The fact that the EUR 100 MM amount mentioned, while much larger than the authorities may have admitted they were short in the past, is still likely far below the amounts that are really required. Certain estimates place the size of the hole at around EUR 400 Billion.
• The housing and real estate markets have been artificially propped up in Spain for years. Not only does this mean that it is now almost impossible to understand values without significant due diligence, this strongly suggests that there may be another downleg to the real estate bust there that would see even those lofty bailout requirements climb.
• This “credit line” as Rajoy so euphemistically termed the panic decision involving EUR 100 Billion (or more) piles more debt onto the very large debt load that Spain already has. Spanish central government funding requirements approach EUR 220 Billion for 2012 and almost EUR 170 Billion for 2013. Unfortunately, Spain is all but foreclosed from the traditional bond markets. Where will that funding and the not insubstantial funding for local governments not included in those requirements come from?
• But even before we consider the source of general Government funding requirements it is not even clear where this bank bailout money is going to come from or the specific terms of the deal. This table, drawn from a speech we recently delivered at an RBC Dexia client seminar, shows that for all intents and purposes that the EFSF mechanism is already tapped out. After accounting for dud guarantees and monies already earmarked, there is almost nothing left over. Note that the “Bank Recap” line in the table refers to the EUR 110 Billion that was only a few short months ago estimated by the ECB and IMF that the entire European Banking system needed. Now we find that Spain itself has gobbled up EUR 100 Billion. Also please note that the EFSF/ESM mechanism has been unable to fund itself and has been dowdgraded.
• What will the Greeks, Portuguese and Irish now think about the deals that they agreed to and will they now demand a “look-back” adjustment to the terms of those deals? Almost equally as important: What will now happen to the Italians who have mountains of debt to refinance and a government that, as admitted by Prime Minister Monti last week, is in its death throes and will likely have to call a snap election before its term expires next Spring? Italy is next in line to be punished by the markets and everyone knows it, yet there is no lifeline in place and moreover, none of the myriad zombie problems festering away elsewhere in Europe have been durably fixed.
• Similar to the Greek re-boot, this transaction calls into question the seniority of existing Spanish government debt obligations, potentially subordinating those to the creditor group that will make the “handy credit line” (ie BAILOUT) money available. This action has increased the risk of these obligations and has thus cast significant doubt over the ability of the Spaniards to raise any money at all from domestic and international bond markets.

Boiling all of this down, we come to the conclusion that we are seeing a tragedy play out in Spain that is very similar to the one still underway in Greece: The central Government has been foreclosed from raising money in the open market; there is an accelerating bank run in progress; to cope,  a hastily conceived bailout patch is applied by the ECB, IMF and EU which results in the very significant probability that Spain will continue to be unable to meet its financing requirements in the normal course. This Financial Frankenstein thus threatens to run smack into the refinancing obligations that loom just ahead.

Given the magnitude of Spain’s funding requirements and the cross border exposures it has to the rest of Europe, this policy is thus far from being a “handy credit line” as described by Prime Minister Rajoy. It rather more completely resembles a financial time bomb with the detonator already having been set in motion.

Nothing in this is therefore any cause for renewed confidence.

We reiterate the point that we have been making for several years now: Nothing has been solved by the various policy patches that have been applied by the Fed and other Central Banks together with the politicians in Europe and North America. Since the onset of the Global Financial Crisis all that has been achieved are temporary delays and the imposition of growing and severe constraints on future policy flexibility, while at the same time the risk of unanticipated open-ended outcomes, second order effects and other nasty surprises (Black Swans) has been vastly increased because of the approach followed. There is now a non-trivial risk that this Black Swan phenomenon could overwhelm the ability of existing institutions to successfully and properly cope with the various problems unless decisive action – loss recognition, write-down and remediation – is taken soon.

The experience so far easily proves that anything short of swallowing that bitter pill simply won’t work.

Posted in Bank Loans, Bankruptcy, Banks, Bond Market, Crisis, EU, IMF, Loan Losses | No Comments »

Cognitive Dissonance*

There was a fantastic universal sense that whatever we were doing was right, that we were winning. . . .So now, less than five years later, you can go up on a steep hill in Las Vegas and look West, and with the right kind of eyes you can almost see the high-water mark—that place where the wave finally broke and rolled back.” Hunter S. Thompson, Fear and Loathing in Las Vegas

The Great Bull Market is winding down much in the same fashion as when the World moved past Hunter Thompson’s Go-Go Sixties and slipped into the stagflationary dystopia of the 1970’s. No better bellwether of this phenomenon is given today than the transformation of Facebook (Nasdaq: FB) from IPO darling to abused foster child in the few short days since the shares made their debut. Today with the Nasdaq ending flattish, Facebook moved lower for the second day and its shares are now changing hands at more than 17% below IPO levels despite frantic efforts by the dealer group to hold the line on price.

With the shares trading north of 75 on a P/E basis and earnings proving hard to grow rapidly, the Facebook IPO was probably a major disconnect with financial reality much in the same way that other disconnects are playing out across the globe.

In fact this “Facebook Flop” could be the sign of a major top.

More evidence of a “disconnect” comes from Greece. For example 75% of the population want to keep the Euro; while 75% of the population want to abandon austerity – the condition precedent the previous government bound the country to precisely in order to stay in the Euro. In a similar vein, polls in the Hellenes are still showing that more than half of the population expect a civil war there in the near future.

So, it looks like we will likely be in for some “shooting and looting” before this is over.

In what has now been framed as a debate between the supporters of the Hair Shirt of Austerity , most  notably Frau Merkel and her German countryfolk; against the Growth crowd, championed by Krugman, Obama, and many Euro countries, it is increasingly hard to maintain any confidence in the longevity of the EU in its current form; or for that matter the ability of politicians to chart a stable path to renewed prosperity.

In fact, the probable contagion impact of events that are flowing out of this policy impasse should be feared  because Europe and the US will not achieve a way out of this quagmire through either growth OR austerity, unless and until a key pre-condition for restarting those regional economic engines is met.

This is quite simply that we must have a reckoning and write-down of bad debts. Until now this has been resisted at all costs by banking and investor interests, aided and abetted by the world’s largest central banks and the IMF. Surely, the experience of Japan’s two “Lost Decades”, as an object lesson of what happens when you avoid the reckoning and write-down, should be reason enough to swallow the bitter pill and get on with the task at hand. Nonetheless Europe’s policymakers dither while patching over problems in place of applying durable solutions. What in fact was the Greek Bailout other than a mechanism to buy some time for the creditors? What was the failed effort to get Iceland to swallow its IMF-led bailout, other than a thinly-veiled attempt to hang the costs of bad bond positions on Icelandic taxpayers instead of the offshore banks that had gotten themselves burned? Why is the US Government not addressing the bank solvency problem that it has been obscuring from public view, or its structural deficit problem? Are any of these policies in any way socially sustainable beyond the very short run?

The answer is “No”.

Not surprisingly therefore, it looks like no one has confidence any longer that that the current set of plans will stick. Some are now suggesting a Greek exit (“Grexit”) as a way out coupled with a “firewall” for the rest of Europe to contain the contagion. This is fantastical thinking. In the first instance, the time window for that type of a move has long since closed – as we had repeatedly advised early on in the crisis, the best strategy would have been for the Greeks to have defaulted and negotiated a “soft exit” from the Euro some two years ago. This did not happen in time and now the terms of the Greek Bailout and the much larger size of the Greek liability make a default a very risky prospect for the Greeks, and for Europe. In the second instance the concept of a “firewall” is simply not credible in the current context. The only true “firewall”, to the extent it is possible to implement such a thing is: adherence to sound risk management, non-invasive but effective regulation, and a neutral “Hands-off” government policy posture that sets the stage for stable economic growth, development and trade.

At present, more, not less, European sovereigns are looking shaky, the EFSF/ESM bailout mechanism in Europe is unfunded and unworkable and the ECB is stretched. The recapitalization of Europe’s banks which last summer was being trumpeted to be completed by October 2011 has not progressed at all. In the US the situation is hardly different with many more insolvent banks being allowed to continue in business on the pretence that they are OK; the US economy is in “Nowheresville”, vast swathes of the personal sector suffering under some form of financial duress and the Fed is increasingly looking at a significant diminution in its menu of available policy options.

No one will be sheltered and no economy will properly recover until the rot and ruin of past excesses are carved away such that new shoots of durable economic activity can take root. This will not happen as long as there are zombie borrowers and zombie banks feeding off of the productive parts of the global economy at everyone else’s expense.

* Cognitive dissonance is a discomfort caused by holding conflicting cognitions(e.g., ideas, beliefs, values,, emotional reactions) simultaneously. In a state of dissonance, people may feel surprise, dread, guilt, anger, or embarrassment. The theory of cognitive dissonance in social  psychology proposes that people have a motivational drive to reduce dissonance by altering existing cognitions, adding new ones to create a consistent belief system, or alternatively by reducing the importance of any one of the dissonant elements.

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Trailer Park Toronto

“There is a sucker born every minute” PT Barnum

Recent events in Toronto must be causing David Pecaut, to spin in his grave.

Over the past few months the legislative agenda at City Hall has imploded, throwing the political process into turmoil and imperiling the budgetary and planning imperatives. This ongoing political circus was temporarily upstaged by the Donald Trump circus, which moved into town briefly last week for the grand opening of the Trump Hotel and Condo Tower; a garish and undersold property development at the corner of Bay and Adelaide.

We then were treated to a story in Toronto’s tabloids about the owner of the Bunny Ranch bordello in Nevada declaring his intentions to expand his business into Canada.  Sixty-five year old, Dennis Hof, together with his business partner and pneumatically-gifted paramour, Cami Parker (twenty-five), told the papers in part that his establishment aimed for Toronto, will allow patrons to “dress up as Captain Kirk and play with Princess Leia.” Perhaps. But to me the thought of someone more than ten years older than me calling a woman that is younger than my oldest daughter, his “girlfriend” leaves me more than a little weirded out. Isn’t the general rule for these type of age-difference relationships “half your age plus seven years”?

No matter, the trailer park theme moved into absolute top gear when the issue of allowing Casinos into the City was again raised by a number of City councillors. Coincidentally, one of the casino supporters was past brothel-booster Giorgio Mammoliti who said that “Single mothers could hit the jackpot” with a Toronto Casino. Appearing as a guest on Mayor Rob Ford’s Newstalk 1010 show, Mammoliti floated the idea that a casino in Toronto could create “10,000 jobs” for residents. The idea appeared to get additional legs when “opinion surveys” of dubious provenance were trotted out to demonstrate that a small majority of Torontonians were in favor of the casino idea. Some councillors have even gone so far as to advocate extending tax breaks to Casino operators in order to attract them to Toronto.

The reasons why local politicians want to expand gambling as a form of industrial and jobs initiative is understandable on one level: Any new initiative which brings with it the allure of thousands of new jobs, expanded tax revenues and economic development can give the appearance of economic salvation. However, the degree to which this motivation is being exploited by gambling interests and their supporters and to where this could lead if the issue was left un-evaluated on its true merits is a serious matter that should concern all Canadians, and not only those residing in Toronto and environs.

Until recently, most research on the effects of gambling on local economies was conducted by special interests friendly to the gambling industry; or, in more brazen cases, by the very people and gaming companies in search of new places to exploit people through the legalized gambling mechanism. In fact, in 1999 the United States published a very comprehensive study of legalized betting in the United States. The Gambling Impact Study called for more research into what was then the largely unexplored area of the social and economic costs of legalized gambling.

Since then, a large body of evidence and data-based research has been established on the basis of years of experience with legalized gambling in the US, Canada and elsewhere which addresses in detail what the social costs and second order effects are, and why it is important not to just consider the jobs and spending parts of the equation in isolation.

Increased Bankruptcies

For example, with the exception of the cluster services associated with gambling, casinos tend to put pressure on surrounding businesses. In Atlantic City and elsewhere, small business owners testified to the loss of their businesses when casinos came to town. As evidence of this impact, few businesses can be found more than a few blocks from the Atlantic City boardwalk. Many of the “local” businesses remaining are pawnshops, cash-for-gold stores and discount outlets. One witness noted that, “in 1978 [the year the first casino opened], there were 311 taverns and restaurants in Atlantic City. Nineteen years later, only 66 remained, despite the promise that gaming would be good for the city’s own.”

In another example, bankruptcies in Iowa increased at a rate significantly above the national average in the years following the introduction of casinos. Nine of the 12 Iowa counties with the highest bankruptcy rates in the state had gambling facilities in or directly adjacent to them. After gambling was legalized in South Dakota, gambling become one of the leading causes of business and personal bankruptcies.

Data from other US states is consistent with this general profile and the bankruptcy phenomenon also prevails in Canada, as these pictures of downtown Niagara Falls which were taken after the Casinos moved in, will attest.

Increased Crime

According to the US National Research Council, “As access to money becomes more limited, gamblers often resort to crime in order to pay debts, appease bookies, maintain appearances, and garner more money to gamble.” In Maryland, a report by the Attorney General’s Office stated: “[c]asinos would bring a substantial increase in crime to our State. There would be more violent crime, more juvenile crime, more drug- and alcohol-related crime, more domestic violence and child abuse, and more organized crime. Casinos would bring us exactly what we do not need: a lot more of all kinds of crime.” Another study found that gambling behavior was significantly associated with multiple drug and alcohol use.

In a Canadian study casinos were positively associated with both rate of theft and robbery. And a recent RCMP investigation conducted in British Columbia found legalized and other forms of gambling intimately connected with gangs, the Mafia, money laundering, prostitution, drug addiction, robbery and extortion.

Obviously law enforcement costs escalate in these situations

Corruption

Once gambling enters a community, it has been established that the community undergoes many changes one of which is that local government becomes “a dependent partner in the business of gambling.” Politicians end up being beholden to the gambling industry whether explicitly or implicitly. In recognition of the problem of corruption, in some US states, it is now illegal for officials to accept contributions from gambling interests.

Homelessness increases

Individuals with gambling problems constitute a very high percentage of the homeless population. The Atlantic City Rescue Mission reported to the Commission that 22 percent of its clients are homeless due to a gambling problem. A survey of homeless service providers in Chicago found that 33 percent considered gambling a contributing factor in the homelessness of people in their program. Other data also substantiate this link. In a survey of 1,100 clients at dozens of Rescue Missions across the United States, 18 percent cited gambling as a cause of their homelessness. Interviews with more than 7,000 homeless individuals in Las Vegas revealed that 20 percent reported a gambling problem.

But what about these high-paying Gambling jobs?

The reality is that there aren’t many “high-paying” jobs. After the initial fillip to the economy provided by the construction of the facilities, casinos are far more eager to place slot machines into the building rather than to hire and train thousands of dealers and other casino employees. This is because each slot machine can bring in $100,000 per year of revenue and doesn’t demand a sick day, benefits or overtime and needs only the occasional dusting for maintenance. Casino workers pay averages around $24-30,000, not “high-paying” by any stretch.

Moreover, recent Canadian research has shown that Ontario casino workers are at exceptionally high risk for developing gambling problems and the attendant side effects. Employees’ gambling behaviors were found to relate to various workplace influences and employment variables. Casino employees in Ontario interviewed in the study exhibited problem gambling rates over three times greater than those of the general Canadian population.

Gambling Addiction has been recognized as a clinical psychological disorder. Today, millions of families suffer from the effects of problem and pathological gambling. As with other addictive disorders, those who suffer from problem or pathological gambling engage in behavior that is destructive to themselves, their families, their work, and even their communities. This includes depression, drug and alcohol abuse, divorce, homelessness, and suicide, in addition to the individual economic problems discussed previously. While the impact of these problems on the future of our communities and the next generation is indeterminable, it is clearly much larger than zero.

If you are a single Mom, do you now still crave those jobs as Mammoliti suggests you should?

The Bottom line

Unfortunately, this is not where this sobering news ends. Research in the US indicates that for every dollar legalized gambling contributes in taxes, it usually costs the taxpayers at least three dollars. These costs to taxpayers are reflected in: (1) infrastructure costs, (2) relatively high regulatory costs, (3) expenses to the criminal justice system, and (4) large social-welfare costs. Another researcher, Professor Grinols, found that Casino gambling in the US causes up to $289 in social costs for every $46 of economic benefit. Put differently, Grinols said, “The costs of problem and pathological gambling are comparable to the value of the lost output of an additional recession in the economy every four years.”

Accordingly, several US state legislators have called for at least partially internalizing these external costs by taxing all legalized gambling activities at extremely punitive rates.

It is for all of the reasons enumerated above that Putin’s Russia outlawed gambling and casinos in 2009.

But aren’t Singapore and Nevada big success stories?

If there are all of these costs and negative externalities why is Singapore still a prosperous city-state with two mega-casinos located within its borders? Simple, this is because only foreigners can patronize casinos for free. Citizens and permanent residents must pay a $70 entrance fee or a $1400 annual pass to enter a casino. The hefty admission price, which is collected by the government, “discourages impulse gambling,” a Singapore official explained. To fill the casinos, promoters ferry in high-stakes gamblers, known as “whales,” from neighboring countries.

Nevada is also unique. Roughly 85 percent of Nevada’s gambling revenues come from out-of state tourists. Thus, Nevada receives the economic benefits of the dollars lost to gambling, while the attendant social and economic impacts of unaffordable gambling losses are inflicted on the families and communities in the states and countries from which those individuals come. Every gambling venue in Canada is far more reliant on spending by citizens in a far more concentrated geographic area and so would never be able to position itself to reap this kind of benefit unless it imposed Singapore-type disincentives on the local population (in which the case the known costs would still be inflicted on someone else, and more importantly the fundamental rationale gambling interests have for locating the Casinos in Canadian cities would evaporate)

A “destination gambling mecca” was never any part of David Pecaut’s vision for Toronto and it is hard to see how it is a part of any rational “vision” for the city or for Canada now or at any time in the future either. The promised benefits do not exist in the magnitudes advertised and are in any event significantly outweighed by the expected costs. Moreover, the predictable second-order effects of casino activity as described in the research are positively nightmarish.

Torontonians and all Canadians should not allow themselves to be buffaloed into a rash and unwise decision on this matter by the large-scale gambling interests and any venal, shallow-thinking facilitators that they might be connected with, and who are in positions of decision-making authority.

The facts are out there and it is time to consider them seriously.

Alex Jurshevski was intimately involved with the GBP 1500 MM acquisition of UK gaming company William Hill Bookmakers by Nomura International in 1997 and, far from being puritanical on the issue of wagering, is an avid poker, blackjack, bridge, backgammon and snooker player.

If anyone wants a full bibliography of the research material on which the forgoing article is based beyond the hyperlinks provided above, then please drop us a line.

Posted in Bankruptcy, Canada, Crminal Activity, Economy, Gambling | No Comments »

The “Restructuring Deficit”

Financial Repression is being implemented by Monetary and Financial Authorities in many developed economies. The specific measures range from overt manipulation of traded markets, acquisition of toxic assets at off-market prices, an aversion to implementing needed restructuring of bankrupt entities, through to indirect forms of intervention such as we are witness to in Canada. The short term consequences of these types of policies include restraining economic growth, employment and productivity. Longer term consequences include inducing a greater predisposition towards inflationary policies by the monetary authorities, loss of competitiveness, moral hazard, below potential GDP growth and depressed rates of capital formation.

The Canadian Experience

In Canada so far our Central Authorities have refrained from overtly intervening in markets as noted above. That job has been left to the Crown Corporations. The Economic Action Plan announced in 2008 provided the Crowns with additional capital and a mandate to use that capital to support Small and Medium sized businesses in Canada (SMEs). Since then the Crowns have made no secret of their extended mandate.

Thus, one need not look far to find evidence of this “stealth bailout”. In Canada we have seen rapid increases in personal bankruptcies that mirror the weakness in the jobs picture and the cost-cutting efforts of many firms desperate to remain in business. Also, the number of personal bankruptcies has escalated rapidly, consistent with the scale of job losses in the early stages of the GFC. However, on the business side of the coin, the situation in Canada reflects the perverse nature of this stealth bailout. This is the fact that since the onset of the GFC the business bankruptcy statistics are not telling a tale of undue financial stress. In fact, the latest twenty four months of data show that the incidence of corporate failures in Canada has actually gone down! The data show that there were 38% fewer bankruptcies coast-to-coast in the year to October 2011 than  2007 just prior to the GFC.

The “Pig in the Python”

At the same time according to the chart, at the peak in 2010 there waa an almost foufold increase in Gross Impaired Loans (GIL) in Canada. In 2011 the GIL numbers were still almost three times higher than in 2007 and prior to the GFC. Yet, corporate bankruptcies have gone down! Moreover, if you speak to them most insolvency professionals report that business has been at it lowest ebb that they have seen over their entire careers! A number of Canadian restructuring firms have sharply cut back staff, gone out of business or have otherwise greatly curtailed their operations. Per the above-noted chart the chief cause is that the banks are not reprocessing their NPL assets in a manner consistent with past cycles and have instead been exercising extreme forbearance.

The bottom line is the fact that a large volume of restructuring that would have normally been expected to occur on the wake of the Global Financial Crisis (GFC) in 2008/2009 has simply not occurred.

Quantitative Analysis

The statistical records on corporate failures in Canada that have been maintained by the Superintendant of Bankruptcy extend back almost sixty years. The behavior of this time-series is akin to that of a step function. Historically there has always been a sharp increase in the incidence of corporate failure in the immediate aftermath of an economic slowdown or recession. This relationship has held up through numerous cycles up to, but not including the GFC. And, in looking at past cycles, the increase in the failure rates on a twelve month moving average basis was at times as high as 60% peak to trough.

The past decade has seen three distinct phases of restructuring activity in Canada. Between 2000-2003 in the wake of the Telecoms, Internet and Media bust, Canadian banks resorted to bulk sales to divest themselves of unwanted assets and distressed files. Two of the more motivated banks in this regard were CIBC and the TD. Then, between 2004-2007 the bulk of off-strategy and distressed files  were pieced out by way of bilateral loan sales to leveraged loan funds that were relatively credit and price insensitive. Both of these periods saw significant levels of activity where banks were actively repositioning credit risk in their portfolios. Following that and since 2008, and up to the present, there has been very little activity despite a sharp run up in Gross Impaired Loans balances. There has been a corresponding lack of activity in business failures and active restructuring of loan files.

To examine the history further we have used three quantitative approaches to estimate a possible shortfall in the number of business failures that have occurred since the GFC:

The first test we ran tested the null hypothesis that the distribution of failures before the GFC had the same statistical properties as the distribution of failure events following the GFC. The results here show that it is not possible to reject the hypothesis that the distributions are different. This provides some statistical support for the contention that we are in a different behavioral phase with bankruptcies and corporate restructuring in Canada now relative to what went on before the GFC.

We then used two other methods to drag some more information out of the data set. The objective of both tests was to try and determine if the level of business failures that we have experienced in Canada since the GFC is “unusually low” and is so by how much. In summary this exercise suggests that there is at present a “restructuring deficit” of between some 6,000 and 13,000 businesses that could have been expected to have gone bust in the last three years but did not (This translates into between approximately one-half to one percent of all SME businesses in Canada). Translating those figures into potential monetary exposures Recovery Partners estimates that there are at least $20 to $30 billion of loan-related charge offs and or restructuring candidates that are bottled up on chartered bank balance sheets and elsewhere.

Zombie finance works only once. At the time this strategy was implemented the expectation was that the significant stimulus that was pumped into the economy would have resulted in a fairly rapid pace of recovery. In turn this would have refloated the businesses that were underwater allowing them to return to profitability and pay down their debt. This clearly has not happened. And, it is unlikely that the old zombies will be able to pull off another rescue financing particularly if the economy continues to grind along at a low rate of expansion or if it falters and maybe another downturn works its way into the mix.

A Rising Default Environment

A number of macro-economic factors affecting credit markets worldwide, including in Canada, suggest that all credit markets are entering a rising default rate environment. Both US and Canadian consumers are beginning to exhibit substantial signs of spending fatigue simultaneously with a significant, and accelerating, renewed softening of residential real estate markets in the US — the source of a substantial portion of consumer spending and employment growth in the last decade. Moreover the widening crisis in the Euro zone has already knocked EU growth for a loop as a recession is now expected there. The inevitable contagion will likely lead to confidence problems in North America as well threatening a more protracted slowdown here as well.

Therefore, for the banks, time is running short. Further cracks are appearing in the banking system and the economy and the authorities cannot stop them from spreading. In fact our views on the Stress Tests reflect the opinion that the problems in the banking system are far from having been properly resolved. In the US, in aggregate, banks remain significantly undercapitalized. Moreover, numerous US Banks that have earlier qualified for TARP funds now have more toxic (Level 3) assets on their books than before the financial crisis began. Other areas of concern include credit cards, commercial mortgages, and of course the fact that anecdotal and other evidence continues to reflect an anemic US economy whose consumers are tapped out and who have either fallen into unemployment or under-employment in vast numbers, where a substantial portion of the housing stock is under water, and whose Government is in a deepening fiscal hole.

In Canada, the situation may be even riper for a downturn in the credit cycle, especially in the export sector. The Canadian dollar has appreciated against the US dollar by more than 40% substantially eroding profit margins for Canadian exporters. For many of the banks as well, it is a case of “they do not know what they do not know”. Quite simply this means, that because of the distortions caused by zero interest rates, the lax forbearance practices and easements in lending covenants and loan servicing, many banks cannot today reliably identify all of the zombies and at-risk obligors in their portfolios. There is thus a substantial recognition lag built into the required solution to this problem.

Should the economy slow from here or enter a recession, institutions that hold large quantities of bad or deteriorating credits that have hitherto been slow in dealing with these exposures will find themselves competing against each other to unload or otherwise cope with these problems. Moreover, to existing exposures we have to add the new zombies that will have gone to ground because of continued weakness in overall activity.

This article is an abridgment of a longer research piece written by Alex Jurshevski, Managing Partner of Recovery Partners with research assistance from David R Fine, Director Credit Asset Management at Recovery Partners and appears in the January 2012 edition of Canadian Hedgewatch

Posted in Bank Loans, Bankruptcy, Banks, Canada, Crisis, Loan Losses, Restructuring, USA | No Comments »

The Brazil Trade

Quis custodiet ipsos custodes? (Who guards the guardians?)

Juvenal

It all seems to be coming down to the wire: Slowdwn in the US and Europe, downgrade of economic propects in Canada; Greece on the brink of default and financial contagion feared as a consequence. Since the onset of the Global Financial Crisis (GFC) the markets have repeatedly received asurances from the authorities that the situation was containable and under control and that the policy path set by them was appropriate. Now it seems that these assurances were misplaced. Where did it all go so horribly wrong?

The “Brazil Trade” was a joke scenario that was bandied about on many of the trading desks that I have worked on in years past. Basically the story goes as follows: you pick your trades ahead of a set of economic releases, do them in huge size and with leverage, and then buy a one-way ticket to Rio de Janeiro and go to the airport. Leave one of the traders on the trading desk to watch the screens and the blotter. After the numbers release, you phone your desk from the airport to find out what happened (yes, this storyline involves communications technology that pre-dates the Blackberry, I-Pads, and proliferation of digital news screens). If your positions go onside big time, then you leave the airport go back to the desk in anticipation of a big bonus payout, and life continues as usual. If, alternatively, you blow up, you get on the plane and live off of your previously accumulated pelf in moderate confort on the beach in Rio. (The Nick Leeson / Barings debacle in 1994 was a criminal variant of the Brazil Trade that involved a luxury yacht.)

The bottom line of the Brazil Trade is thus simple: if you win the low probability bet; you win really big and life goes on as before and is even better; if you lose, life as you know it is over because you are now a fugitive living in purgatory.

Any prudent banker or trader knows that you need to blow the bad deals and bad trades out of your portfolio before the next cycle of profit making starts. However, the entire approach to crisis management in North America and Europe over the last three years has been to attempt a short circuit of this process and to foist the impression on the markets and the public that no reckoning or adjustment was or is needed in order for life to go on as before.

And, in implementing this vision of the way out of the crisis, vast amounts of taxpayer dollars have been put at risk.

Now the strategy is starting to fray in earnest. In Europe political support for the bailout strategy is faltering, Germany appears to be positioning for Greek default, while the other peripheral countries slip closer to the edge and major banks’ share prices plummet – short selling ban or no. The resignation in the last few months of two senior ECB officials – Juergen Stark and Axel Weber (note: Weber was the heir-apparent to Trichet over Draghi) – signals deep policy divisions at the Central Bank. For the policy hawks unfortunately, these two resignations represent a victory of the bailout-supportive policy doves and, most likely, a continuation of present ECB policies.

In the US the latest wheeze in the form of the Obama Jobs Plan signals just how far removed from the reality of the markets the policymakers and politicians there are. What of the recent bust up over the debt ceiling and the stated need of the Debt Reduction Super Committee to find $4 Trillion in cuts before the end of 2011? Apparently this does not matter any more – $450 billion will be spent on extending unemployment benefits and other transfers before consideration of the funding mechanism is settled. More fundamentally, in our opinion the whole package boils down to a “potluck” policy grab bag that can only incentivize the unemployed in the US to stay unemployed. If passed by Congress, it will not achieve anything meaningful outside of an increase in the US Federal debt.

Canada is not immune. Not only are our debt levels very high by international standards, the can has been kicked down the road by the authorities here while our economy remains vulnerable to accelerating slowdowns in the US, Europe and China. There should be no question, but that the de-risking of the economy here from exposure to another major credit event must be a policy priority. For the avoidance of doubt we are not advocating more stimulus (in fact the very opposite) but more active risk management of the Zombie situation and more predictable control over government finances at all levels of public administration.

We are in this unfortunate situation because the authorities in North America and Europe never encouraged the markets to make the needed adjustments three years ago. Had they let the markets find a solution and refrained from meddling:

 The eventual price tag would have been lower and much more predictable,
 Inflation risks would be less,
 Unemployment would be lower,
 The number of sovereign, corporate and banking zombies would be MUCH LOWER,
 Sovereign debt burdens would be MUCH LOWER,
 The risks of an uncontrolled debt deflation and credit market collapse would be MUCH LOWER,
 The economies of America and Europe would be recovering.

The rapidly escalating crisis has swept the outcome of last weekend’s G-7 in Marseilles into the dustbin along with the sports pages and classified ads. This week we have more policy and political meetings in Europe; and next week we have the Federal Reserve Open Market Committee in a two day meeting down on L Street. The markets are now saying a Greek default is inevitable, other countries and buisnesses are edging closer to the precipice and yet the policymakers continue to bang the same drums.

Is anyone packed for a long trip?

Posted in Bank Loans, Bankruptcy, Banks, Canada, Crisis, Crminal Activity, EU, Fed Policy, Loan Losses, Sovereign Debt, USA | No Comments »

Money for Nothing and Checks for Free

“Those whom the gods wish to destroy they first make mad.”   Anonymous Ancient Greek Proverb

Wow, what a crazy week. About everything that could happen did happen, except for the delivery and signing into law of a credible deficit reduction and debt control plan by the American Legislative and Executive Branches.

In the wake of that failure, investors in the US Dow Jones index rewarded President Obama on the marking of his first half century of walking on this planet by shaving 500 points or almost 5 % off of that stock market gauge. By the end of the week global bourses had shed around $2.5 Trillion of value.

The debt ceiling debacle wasn’t the only motivator behind the gloomy sentiment weighing on markets:  renewed fears that the global economy might be entering a double dip were fanned by weak purchasing reports from Germany, flattish consumption-related and employment numbers in North America, and growing doubts about the fiscal sustainability of the debt-laden laggards in Europe, now to include, most notably, Italy.

On Friday the markets looked set for another big dump following weak employment readings announced early in the  day by the US Labor Department. It is unmistakable that some foreknowledge of the reduction in the S&P US long term debt rating that was announced following the market close was given to the US Government. Therefore it is our surmise that the Plunge Protection Team swung into action to prevent another swingeing setback following on the heels of the 500 point plunge the day previous. Thus,  after a wild intraday ride, the Dow closed on a dead cat bounce, up 61.

These events prompted G-7 and G-20 country governments to convene a set of emergency consultations over the course of the weekend to discuss measures to combat the malaise sweeping global markets and to contain any contagion effect from exacerbating conditions further. The price action on several markets so far today does not engender optimism for a placid trading week ahead.

With the apparent exception of the United States and a few people here in Canada (see below) a growing realization that fiscal stresses in Western economies mean that Government spending needs to be cut back, entitlements need to be cut back, and Government generally needs to right size and reconsider its role. The bottom line is that the social safety net has become too expensive and people need to be made more reliant on their own efforts rather than rely on handouts from Governments.

It is in this context that we read an article last week in the Financial Post entitled “Only More immigrants can save Canada’s Economy” . In this piece, the author, who is associated with the New Frontier Institute, contends that in order to “save” Canada’s pension system that we need to allow immigration to reach a million people per year as an urgent  matter of policy.

What claptrap.

 Nowhere in this article is it mentioned that Canada does not have the capacity to admit that many immigrants into the country. In the last five years the amount of annual jobs growth has been well below 200,000 per annum. Where and how are we going to employ these immigrants? What of the strain on our already overstressed medical, educational and public security infrastructures? No mention. Yet the author makes reference to a recent speech by the Minister of Immigration, Jason Kenney that does clearly spell out all of the constraints and considerations involved in setting immigration policy.

Arctic Circle Cartoons 

What of recent studies that demonstrate that Canada’s immigration policies admitting as they do a few hundred thousand folks per year actually cost the public purse significant money? This is given short shrift. Ivory Tower schemes are suggested to hand over immigration policy to the provinces, magically reduce the cost of admitting immigrants and to assume away the host of logistical and social challenges implicit in this proposal, all in the name of ensuring that Canada can “fund the Baby Boom generation’s retirement obligations.”

And what of the political and social implications of such a policy? Namely that, if implemented, within one generation we effectively would be handing over electoral control of our entire country to a demographic that has no long term  relationship to this place. In exchange for what? A pension bailout that benefits a narrow slice of the population, much of which is quite well off without Government help.

The reality is that the pension deficits are real. Most pension funds are insolvent in Canada, and therefore this is a problem that requires urgent attention. The reasons for these deficits are many. Some reasons include faulty design, poor management, venal politicians agreeing to over-rich settlements with public sector unions, bad luck or bad markets, theft, fraud, perverse incentives, or the fact that some plans ail from all or a subset of the foregoing impairments. None of this however means that they should be bailed out. This makes no sense, particularly in the context of what we already know to be the case of the retirees at Nortel, Enron and numerous other companies that failed to provide safeguards for the pension obligations they had to  their retiring employees. The reality is that in any conceivable context, the prudent, economic, legally and morally correct course of action is to write down benefits in order to meet the resources extant within each of these funds and share them out to the retirees. There can and should not be a bailout unless we intend to become the next Argentina or Venezuela.

 No doubt pension reform is a large problem and one fraught with political and economic risks. However throwing away Canada’s entire future to try and paper over mistakes made by the same ”Baby Boomers” that this writing suggests need help is pure madness.

 The New Frontier website lists a number of prominent people as being part of their Advisory Board, among them Ruth Richardson, former Minister of Finance in New Zealand;  and Sir Roger Douglas, the architect of the economic reforms in New Zealand that served as a blueprint for leading the country out of the abyss of subsidies, government interventions and meddling that caused the catastrophic meltdown there in 1984. At the same time, the website is extremely coy about where it receives its funding from, leading us to surmise that it may be acting as a shill for a set of vested interests that want to bias public policy in favor of themselves rather than proposing policies that make long-term sense for Canada as a whole.

I worked under Ruth when I was managing New Zealand’s Sovereign Asset and Liability portfolios in the mid 1990’s and I have met Sir Roger a number of times. The prospect that Ruth or Sir Roger would endorse the policy recommendations as spelled out in the New Frontier article, and in the context of the commentary we provide above and as reflected in Minister Kenney’s recent remarks, is in my opinion a very low probability outcome unless there has been a massive sea change in how they view the role of Government and the constituents of effective policy. If the New Frontier Institute believes that this is not the case, we invite rebuttal, accompanied of course by the math that supports the “million immigrant a year” proposal.

 Who knows what the future might bring? Flush with a majority Government and a five year term in office ahead of him, shamefaced clarion calls for bailouts of their entitlement programs by special interests may be setting up Stephen Harper for his very own “Scargill Moment”.

Posted in Bankruptcy, Canada, Crisis, EU, Fed Policy, Restructuring, Sovereign Debt, Stock Market, USA | No Comments »

Angela Merkel’s Frankenstein

 “The astonishment which I had first experienced on this discovery soon gave place to delight and rapture. After so much time spent in painful labor, to arrive at once at the summit of my desires, was the most gratifying consummation of my toils. But that this discovery was so great and overwhelming, that all the steps by which I had been progressively led to it were obliterated, and I beheld only the result. What had been the study and desire of the wisest men since the creation of the world was now within my grasp. Not that, like a magic scene, it all opened upon me at once: the information I had obtained was of a nature rather to direct my endeavors so soon as I should point them towards the object of my search, than to exhibit that object already accomplished. I was like the Arabian who had been buried with the dead, and found a passage to life, aided only by one glimmering, and seemingly ineffectual, light.”

Mary Shelley’s  Frankenstein 1818

The passage above could easily have substituted for the press communiqué issued by the EU yesterday which laid down the agreement reached in Brussels regarding the European debt crisis and the measures adopted by lead Ministers to forestall contagion spreading from the PIIGS to other countries.

 Illustration from the “Frankenstein” edition published by Colburn and Bentley, London 1831.  Public Domain.

The nuts and bolts of the bailout package according the that document are as follows:

        – There will be new financing in the amount of EUR109 Billion for Greece;

       – Loan rates on existing debt will be cut to 3.5% from as much 5.5% for Greece, Ireland and Portugal, and maturities will be extended to 15 and as much as 30 years;

       – “Voluntary” private sector contribution to the Greek package would see creditors taking a haircut of 21 per cent. There would be no relief of this kind for Portugal or Ireland;

       – The EFSF and its successor the ESM (The EU bailout funds) will obtain new powers to intervene in national bond markets in Europe and to recapitalize banks, but only with the go-ahead of the ECB;

       – Greece will be given a “Marshall Plan” by the EU to help refloat its economy. Brussels is forming a team to help Greece administer the aid.

       – No mention was made of any need to address issues in any other EU countries or of any plans to increase the size of the bailout mechanism from the present EUR 440 Bn.

The voluntary private sector participation which will result in haircuts amounting to around EUR 37 Billion is expected to result in only a short technical default that therefore will not trigger default clauses in existing CDS contracts, thus averting the nightmare scenario.

Similar to Dr Frankenstein’s violation of every principle of medical ethics and morals involved in his grave-robbing and gruesome experimentation, by reaching this agreement the EU leadership has breached every principle on which the European Union was founded. On the kindest interpretation, this must be regarded as a measure of the desperation the EU leadership must have been feeling in the wake of recent market events and the growing levels of social unrest in a number of southern European countries.

While the intention is to provide this support only until Greece, Ireland and Portugal can re-finance themselves in private markets, the reality is that this new deal effectively gives those countries a commitment of indefinite support. What if other countries fall further into crisis and need to be bailed out? Will they end up with a Carte Blanche as well?

 The deal as announced does little to address the key issues and much of the detail appears not to have been fleshed out. The haircuts apply only to Greece, and even at that, are miles short of what the market has been signaling is really required (we estimate around 70%) and the interest rate subsidies do nothing to address the fact that they apply to mountains of accumulated debt that under the terms of the deal will not go away. How the rate fakery will play in Spain and Italy who are having to pay what the market demands is also not clear. There are now evermore committees involved in trying to operate on the patient. The extension of new powers to the managers of the bailout funds, who on their creation in early 2010 assured the markets that they would “never be used”, make them an easy mark for hedge funds who do not have to trade by committee……Watch this space.

 After the initial euphoria expressed by Dr Frankenstein, we all know how the story ends: the Monster kills a number of people in most horrible ways – including a child and Dr Frankenstein’s bride – causes the death of others, and then ends up committing suicide and dying a most horrible death in the frigid waters of the Arctic Ocean. The immoral abomination is fated to die a grisly death from the moment of its creation.

This monstrous deal will suffer a similar fate, and not too far down the road.

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