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 »

“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 »

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 »

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.

Posted in Bank Loans, Bankruptcy, Bond Market, Crisis, EU, Loan Losses, Restructuring, Sovereign Debt | No Comments »

Now is the Time for Stronger Balance Sheets

Q:Do you know what a banker is?

A: “A banker is someone who happily rents you an umbrella when the sky is clear but quickly demands it back again at the earliest threat of rain”.

Laugh if you will at this cynically humorous description, but having been a Corporate Lender at BMO for over 5 years earlier in my career I know there is more than a nugget of truth in this.

So, in this vein, let me offer a reminder. One which soon may prove timely given the recent build-up of toxic debt on central and commercial bank balance sheets and the growing scarcity of investment-grade opportunities for all the risk capital that’s out looking around for safe-harbours to park boatloads of ‘manufactured’ cash in:

The best time to:

(a) shop for umbrellas is before it rains,

(b) strengthen your dyke is before the spring run-off begins, and

(c) build your ark is before the flood waters come.

Why do I say this now? Well, given the ‘big storm clouds’ that appear to be forming over the global economy, I think there a real risk we’re all going to get ‘really soaked.’ So, if you’re smart you’ll get yourself prepared before ‘all hell’ breaks loose and time runs out for those excessively optimistic (particularly on the business front), for when the market changes, it will do so in a big rush!

Now, beyond the threat of government debt contagion building everywhere these days, many of the informed observers we and Recovery Partners have recently talked to have developed a realtively jaundiced view of the “economic recovery” story. The sense of deepening pessimism relates to a variety of factors: including recent anti-inflation-driven moves in Europe and China to higher interest rates, the realization tha there are many weak economies, demonstrably out of control borrowing by both governments and consumers and the seemingly conspicuous-consumption-led high level of demand for basic economic inputs that clearly is outpacing the global supply of easily-accessible (cheap) resources.

And, with private equity investors and investment and commercial bankers complaining about the lack of good investment opportunities, the globalization and computerization fed growth in corruption and fraud that has occurred in governmental and capital markets over the past 20 years, the high levels of un- and under-employment around the world and the growing realization that our earth better go ‘green’ quick before we all end up killing ourselves, it all makes one wonder just how far beyond sustainability have we been living in recent years.

So, for those with open ears and minds to listen, (and brains that recall the talk two years ago about what type of Great Recession recovery we should expect – ‘V’, ‘W’ or ‘VW’?), I suggest it’s time to pay attention to these ominous ‘rumblings of thunder’ for they portend the high risk that the global economic recovery will get washed out sometime all too soon.

Worse still (and God forbid) is that we might be facing a ‘monsoon beginning’ to a ‘flood of biblical proportions’ if the current ‘US federal debt / borrowing limit crisis’ mushrooms into an actual crisis of confidence in the US economy and downgrades the safe haven status of the US Dollar and US markets in times of global financial and geopolitical stress.

Notwithstanding all of the above, I believe it’s best not to despair (particularly those of you who are mindful and prepared to act). There are constructive things that can yet be done if you act prudently and soon. There are ways still available to cut your risk of getting swept away by the looming economic catastrophe that seems to be almost here.

For those with investable funds, two choices to consider are: (1) parking your money in high quality money equivalents (gold anyone?); and (2) buying Hi-Grade corporate bonds while you wait for (another?) once-in-a-life-time buying opportunity to develop.

And if you or your business are user of third-party capital, I’d say now’s the time to strengthen your balance sheet. And for those corporates with business performance or balance sheet issues, best you opt for as much permanent capital as possible because, should the economic storm I’m concerned about break, accessible capital definitely will be in very short supply, if it’s available at all.

To reitreate the main message, (because it’s always too late to figure out how to keep a leaky boat afloat when the downpour comes) the best time to:

(a) shop for (more third-party capital or) umbrellas is before it rains,

(b) (buttress your defences or) strengthen your dyke is before the spring run-off begins, and

(c) (look for more equity capital or) build your ark is before the flood waters come.

Tony Johnston

President

Compass North Inc.

www.CompassNorthInc.com

Compass North Inc. provides CEO / CRO / CFO transition management, consulting and investment banking transaction advisory services that maximize Client Company:

- revenues, profit & cashflow growth,

- debt & equity capital raised, and

- enterprise market value realized.

Posted in Banks, Bond Market, EU, Economy, Loan Losses | No Comments »

Fantasyland

‘I can’t believe that!‘ said Alice.  

 ‘Can’t you?’ the Queen said in a pitying tone. ‘Try again: draw a long breath, and shut your eyes.’

 Alice laughed. ‘There’s no use trying,’ she said  ’one can’t believe impossible things.’

 ‘I daresay you haven’t had much practice,’ said the Queen. ‘When I was your age, I always did it for half-an-hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast. ‘

 

Wow!! What a Week! What a Month! What a Year so far!

The plethora of unexpected events witnessed in the last few months has been nothing short of remarkable. These include spiralling revolutions in the Middle East, Natural Disasters and Nuclear leaks in Japan, NATO airborne assaults on behalf of Libyan rebels and the still slow burning fuses attached to public finance debt bombs in the US, Japan and Europe.

Through it all, global currency, equity and fixed interest markets have remained remarkably placid and well-supported. The VIX index is in fact not registering fear of any kind.

Shouldn’t we be asking ourselves whether the markets’ faith in the future reflects far too rosy an interpretation of the developments and probable outcomes in key economies? Could the markets be setting themselves up for another big dump? To this end we present our “Top Six” hit parade of impossible beliefs held by the markets currently. Let’s take a closer look:

The Top Six Impossible Beliefs  

1. The Chinese Economy is not in a Bubble
2. The Japanese Disasters will not threaten Global or US Economic Prospects
3. Large Banks in Europe and the US are solvent
4. The Sovereign Debt Crisis in Europe is under control
5. The US Fiscal situation is under control
6. There will be no more QE after QE2

We are not optimistic that today’s lawmakers and policymakers have the skill, inclination or fortitude to handle the pressing issues that require due care and attention. Expect co-ordinated QE, know that we are already on the path to high inflation, and expect at least another one or two of these situations to go sideways and precipitate another financial crisis within the event horizons shown below.

The Sorry Details Start Here

(1) There is remarkable complacency over the stability of the Chinese economy. “According to an economic outlook report from an Asia Pacific Economic Cooperation (APEC) business advisory body, China’s economy is expected to remain strong in 2011 and 2012, but inflationary pressures are likely to rise further due to rising food prices.”

Most commentators do not look behind the numbers. If they did then what they might find as regards the sustainability and quality of Chinese economic growth might give them some pause. We only consider two issues: significant mal-investment; and the cost to China’s economy of GDP growth in terms of externalities such as pollution and desertification.

Can people with bad haircuts and clad in cheap suits (ie: government bureaucrats) make better decisions than the market? Apparently this is what Chinese central planners think. Maybe this is why they have set out plans to build millions of new housing units, and yes even entire cities, in the absence of market demand . Perhaps that is why at last count there were 64 million unoccupied housing units in China with more under construction. Entire cities have been built that now stand completely empty. Why the empty units? Consider the fact that many experts believe that Chinese property prices may have outstripped purchasing power by up to 70%.

Now consider that adjusted for population, relative housing prices and the size of the economy, that the Chinese housing overhang described above is about 2-3 times larger than the deplorable residential housing market situation in the US. This does not take into account the mal-investments in infrastructure and coimmercial real estate that have accompanied the housing developments. Is it not probable that there are some serious non-performing loan problems at Chinese banks as a consequence? Is it also not surprising that in recent days that Jiang Jianqing, the Chairman of ICBC, one of China’s four main lenders was protesting that the $100 Bn of lending to local authorities that his bank undertook does not represent a threat to his bank’s stability?

This is only one example of egregious mal-investment by the Chinese government and the state-owned banks. There is an ample supply of others.

Then consider this report, which reveals the fact that Chinese desertification may take over three hundred years to reverse Another study conducted by the OECD also spells out the scale and severity of the ecological crisis now engulfing the country, poisoning its people and holding it back economically. Over 400 million people drink contaminated water every day. Seventy five per cent of lakes rivers and the near oceans are polluted and toxic. Taken together, the externalities of desertification and pollution effectively negate China’s 10% economic growth rate, leaving it no better off each year, facing a large and growing clean up bill, a sickened population  and in urgent need of new sources of clean water.

The problem for China is that if it stops growing increased social unrest will result. If it addresses the issues of mal-investment and economic externalities it must stop growing. However if it does not stop the externalities from accumulating and stop investing in redundant plant, equipment and real estate development, then the bubble will pop anyways, resulting in social unrest. 

Catch-22 ?

Event Horizon : Chinese Bubble Pops. Zero to three years.

(2) According to the Washington Times and most other news outlets, the Japanese Earthquake is unlikely to threaten Global growth or affect the US. In fact, in recent days more than two thirds of the news reporting out of Japan has focused on the nuclear situation at the Fukushima reactor site. The bulk of the remainder of the reporting has focused on the plight of the locals. These reports stress that the worst thing to fear from the Japanese natural disaster is the threat of nuclear contamination. Nothing could be further from the truth. In fact this misplaced focus by the amusement park media completely ignores all of the science on nuclear radiation that has been accumulated since the Chernobyl disaster.

To be sure, there are several stories here which bear mentioning here. As per the foregoing, the first is that the nuke contamination fears are completely overblown. The second is that the Japanese have done a remarkable job of getting control of a huge disaster in a very short span of time and with little outside help. Compare and contrast to Hurricane Katrina and the more recent BP oil spill in the Gulf of Mexico. Both instances featured an abdication of responsibility at the Presidential level, a failure to identify the problem and apply solutions in a timely manner and almost zero accountability among the officials involved. Countless billions were wasted through mismanagement and corruption in the USA. Not so in Japan.

The real problem issues with the Japan disaster is that it has severely hurt that economy and the ability of many of its top companies to contribute specialized goods into the global supply chain and to meet growth and  earnings targets. What many folks do not know is that most large factories in Japan have thousands of “Mom and Pop” suppliers who sometimes work out of garages and improvised workshops in residential areas. It is too early to tell how many of these suppliers are even still in existence,  and the effect that their disappearance might have on the likes of Sony, Mitsubishi and Toyota.

In addition, the disaster places even more stress on the public finances of Japan as tax revenues will be lower than forecast, support costs for the public relief effort are going to be enormous along with an estimated $250-300 billion price tag for the reconstruction. The other issue of course is how this reconstruction is to be financed. Japan has almost $3.0 Trillion of net foreign assets but it is unlikely that it will liquidate these to support reconstruction. US and European political pressure will more probably dictate that Japan finance this through a QE merry go round which will see the yen Money Supply pumped up in order to accommodate JGB issuance from the Ministry of Finance.

The bottom line is that Global Growth will suffer and Japan’s balance sheet will be further stressed by additional dollops of Zombie Finance.

Event Horizon:  Weak Japanese growth. Deterioration in public finances. Zero to three years

(3) Banks in Europe and the US are solvent. This past Friday the Federal Reserve announced that certain banks among the 19 tested were allowed to increase their dividends only if they passed “stress tests” conducted by the Federal Reserve to see if their balance sheets were strong enough to weather another recession. The Fed said it had completed those tests and expects that “some” banks will increase or resume dividend payments, buy back shares or repay government capital. The Fed did not reveal the names or number of banks that are expected to do so. Notable for their absence from the list were Citigroup Inc. and Bank of America Corp., the nation’s largest bank.

The Fed singled out the two “Too Big To Fail” institutions and whacked them on the wrist. Big Deal.

The elephant in the room in all of this is the absence of any discussion of mark-to-market accounting treatment for ANY bank portfolios. Recall that mark-to-market accounting was abolished by the Fed and US regulators in April 2009. The latest wheeze by the US regulators and central bank is thus nothing more than a scheme to lure more investors to put money into bank shares and for banks to pay out money to institutional investors hungry for cash such as pension funds, insurers and mutual funds by pretending that all is well. Of course, bank executives also get to line their pockets as a result of this decision. The money to pay the dividends is, of course, freshly minted by Dr Bernanke acting as agent for the US Treasury and his member bank shareholders.

 Similarly, the European regulators have announced another round of stress tests upcoming in order to achieve the same result with the markets ie: “Nothing to see here. Move along. Move along”. Here again the methodology leaves us more than a little short of endorsing the robustness of the entire procedure. Some stresses such as interest rate and equity market stresses, look a little light. But the killer is that again regulators are not permitting any consideration of sovereign default or restructuring.

 Are all of the big banks solvent? Unlikely!!

 Event Horizon: Large US or European Bank Fails. Zero to 18 months (see below)

(4) The Sovereign Debt Crisis is Europe is under control. March has featured a summit marathon for the EU and euro area. Since the version of the Treaty on the Functioning of the European Union (TFEU) currently in force does not admit a permanent anti-crisis mechanism, the EU Member States must agree on a Treaty amendment. Two sentences are to be added to Article 136 TFEU with effect from January 1, 2013. As of that date euro area countries will be allowed to install a permanent stabilisation mechanism granting financial assistance with conditions attached. The other issues that were discussed include amendment of the European Financial Stability Facility (EFSF) as part of the existing crisis mechanism; how the European Stabilisation Mechanism (ESM) is to be fleshed out as successor to the EFSF and financial aid from the Commission; and an economic governance package.

Consequently, for the past month European leaders have been meeting in order to address these amendments to the EU governance matters and concerns regarding the stability of heavily indebted member nations. The process is designed to allay concerns that the Euro is under threat and that certain EU countries may default and walk away from the obligations. The concerns of the politicians are well founded. Look at the chart below. This is what has been giving Cameron, Merkel, Sarkozy, King and Trichet sleepless nights. If any one of the European Sovereign borrowers defaults and walks away, then the banks that have lent all that money will face significant capital issues.

For this and other reasons the entire EU restructuring process has been conceived and is being managed in order to AVOID ANY HAIRCUTS and to pass the cost of lending excesses on to taxpayers of the various countries involved. This process involves the imposition of austerity measures, the requirement that countries accept bailout monies, the requirement that they must cede a portion of their sovereignty and agree that there are no reductions in the amounts owing.

The unravelling of this scheme is only just beginning. The EFSF is inadequate, ill-conceived; and has been  ill-managed. This week saw renewed riots in the UK prompted by austerity measures, strikes against user fees in Greece and the fall of the government in Portugal. Moreover the escalation in market rates for the debt of the various Zombie Nations is in most cases already at levels that will not permit the continued economic rollover of obligations as they come due.

The fuse on this debt bomb has long been lit and there is still no competent UXB team in sight.

Event Horizon: EU area debtor country defaults and demands haircuts. Zero to 18 months

(5) US Fiscal prospects are being capably managed. As the US military was launching over 100 Tomahawk cruise missiles at pro-Quadaffi targets in Libya, Obama was to be found on his way to South America for a five day junket through the region, in part “to secure jobs for Americans”. Obama couldn’t have gone to better place. Both Brazil and Chile, two of the countries on his itinerary, sport lower unemployment rates than does the US; and better economic prospects. Perhaps Obama plans to subsidize the emigration of the US unemployed to South America:  Fly to Rio courtesy of Uncle Sam. Enjoy the Beach. The Feds will pick up the tab of moving you and your family as long as you never come back. We are sure that all of this could be done for less than $50,000 per household. This figure is about one tenth the cost of the last big stimulus program launched by this Administration. A bargain at the price.

All kidding aside; the fiscal crisis that is engulfing US Government finances shows every sign of accelerating, not in the least because Democrats at every level of Government are refusing to acknowledge the need for fiscal restraint of any kind. Red ink is also killing Municipal and State finances. The latest monthly Government deficit number for the Feds at over $220 Billion is in nosebleed territory. Not only does Obama not even want to secure agreement of a symbolic $100 Billion of budget cuts; the US Government is no longer even pretending to have any sort of fiscal discipline in place at all. The Federal Government is operating with no official budget  and is coming up fast against the debt ceiling. (As a line item, Obama had no fiscal authority to order military units to support the operation in Libya. Under the continuing resolution which is in place until April 8^th, the only funded war-fighting operations are in Iraq, Afghanistan and Central Asia.)

It appears that under any circumstances forecasted by the CBO, the CEA or the US Treasury that Trillion plus dollar deficits will continue indefinitely; in combination with the $50 Trillion or so in unfunded but known liabilities, this makes any discussion of imposing fiscal discipline a round table on Fantasy Finance.

Event Horizon: US fiscal problems cause investor revolt and downgrade. Zero to 36 months

(6) Widespread market expectations point to no renewal of QE after the current round (QE2) ends in June. In fact several Fed Governors have gone on record saying that QE2 is the last QE. We have explained the real reasons for QE in a previous post. Although advertised as stimulus for the economy, the reality behind QE has in fact little to do with stimulus and much,  much more to do with the gaping deficits at the Fed, an insolvent Banking system and Washington’s fiscal deficit which can no longer be properly funded in the open market. Nothing has changed since the time of that analysis to cause us to alter our opinion. In fact, recent events in Japan and Europe now argue even more strongly for a continuation of this program.

Even before the disaster that struck Japan, she and other foreign investors were quietly paring back on their purchases of Treasury Bonds and Notes. The entire volume of new supply has in fact been entirely taken up by the Fed through its QE operations. At this point the Feds have two alternatives: they can stop QE and bet that markets will continue to absorb Treasuries at yields that are quite arguably far below actual (rather than reported) inflation. Or the Feds can continue with QE and try to continue to maintain the fiction that everything is fine: the recovery is on track, jobs are being created and inflation is under control.

These choices amount to the following: choice (1) means that the Feds  admit to the problems, stop the fantasy finance of QE, clean up insolvent banks, implement swingeing cuts in public expenditures; and then take the associated economic pain which would be followed by renewed, durable growth. Or under choice (2) the politicians avoid the hard alternatives, continue promising bread and circuses to the public and hope that they (the politicians) can retire with an inflation-indexed pension before the economic firestorm starts.

The stark reality is that there is no politician of any stripe that would opt for choice (1) at the present time. This would be political suicide.

The path of least resistance therefore is to continue kicking the can down the road. US leaders, like the Europeans, Chinese and Japanese don’t have the courage to promote AND implement painful, but necessary adjustments. QE will continue because the default position for not only the US but for Europe, China and Japan is that the solution to the solvency issues amongst banks and sovereigns lies in inflating away the value of the debts and bad assets. The alternative of making good on debts and paying them off in full in a low-growth, low-inflation world is simply not a credible prospect when one looks at the finances of Ireland, Portugal, Greece, Japan the United States and other countries.

In the case of the United States we calculate that an increase of between 8 and 12 times the current price level is required to bring Government debt ratios and debt servicing capacities  back into balance. This means that we are likely looking at an inflationist program that lasts at least until QE6 (assuming that the size and duration of the operations match QE2). The path of least resistance for other cebtral banks is to accomodate. Thus,  US inflation will be exported worldwide and will likely be the last hurrah for the USD as the principle reserve currency.  

Clearly, the central, glaring risk of this strategy is that the money printing and increases in bond supply will result in pressure on term rates and a subsequent financial meltdown in many countries due to debt servicing shortfalls and balky issuance markets. While the authorities will make every effort to forestall this development, rising interest rates are inevitable and will be the final nail in the coffin for those countries burdened with aging populations; extravagant entitlements programs, shrinking tax revenues, high unemployment, a sluggish economy and a political class unwilling or unable to make the correct choices. Savers, retirees and other owners of capital will be decimated by persistent and elevated levels of inflation unless they take protective actions soon.

Event Horizon: QE3…QE6+. QE3 starts in 3-5 months

End Notes

We are not optimistic that today’s lawmakers and policymakers have the skill, inclination or fortitude to handle the pressing issues that require due care and attention. Expect co-ordinated QE, know that we are already on the path to high inflation, and expect at least another one or two of these situations to go sideways and precipitate another financial crisis within the event horizons shown.

  [Courtesy of Leonard Cohen, follow this link to a track that will make our communal descent into inflationary dystopia a little easier to bear.]

Posted in Bank Loans, Bankruptcy, Banks, Crisis, EU, Fed Policy, Loan Losses, Middle East, Sovereign Debt | No Comments »

Zombie Banks, The FDIC and Directors’ and Officers’ Insurance Premiums

Those who cannot remember the past are condemned to repeat it.” George Santayana

There is a direct connection between the banks, legislative changes and directors’ and officers’ insurance premiums. Relaxation of regulation and poor policies and procedures intensified and increased the losses associated with the S&L Scandal of the 1980’s and early 1990’s. But just enough time passed since then to give decision makers the excuse to forget the lessons learned from that sorry episode. Not surprisingly all of the same issues have resurfaced prior to the onset of the Global Financial Crisis (GFC) thereby contributing to the causes of the GFC and importantly to the failure of US Banks so far and the extremely weakened condition of the entire banking sector.

The FDIC provides a chronology of S&L events on their website, and in a book,. These should be made mandatory reading for every employee of every bank, insurance company, rating agency, securities dealer, accounting firm and law firm. There are at least of few people in every level of a company who can smell a problem long before the executives are willing to do anything about it. And now, those employees can even profit from this knowledge.  The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010, includes a provision SEC. 21F, called “SECURITIES WHISTLEBLOWER INCENTIVES AND PROTECTION”. This provision looks to incent whistleblowers with an award of 10% to 30% of the monetary sanction over $1 million.  Therefore, if one were to take the average cost of the top six most recent FCPA settlements and multiply by the lowest award, it would means a $47 million compensatory windfall to the employee who blows the whistle on these bosses.

The FDIC book on the S&L scandal suggests that total FDIC recovery from 1986 through 1996 from professional liability suits was $5.1 billion (outside counsel costs were $1 billion – ie a significant incentive for lawsuits), with $1.3 billion of that coming from D&O claims, and, surprisingly, only $300 million from fidelity bond insurers. The account does not specifically say that the D&O recovery was from insurance policies, but there is no doubt that these insured losses were material to the insurance industry.

In those days, Insured vs. Insured exclusions, and trustee/regulator exclusions and limited severability were much more common in the D&O policy. And, the policies were not as heavily extended to cover loss of the corporate entity, and other parties and matters, as they are today. Also unique to that period was the length of time that D&O insurers had to prepare for potential loss. A noticeable uptick in bank failures was identifiable as early as 1982, but the actual assets losses and deposit insurance losses were not material until 1988.  The period of 1997 through 2007 saw so few bank failures that the slate was wiped clean as if the past never existed. But this time, the asset losses and deposit insurance losses, which, in the 1980’s took seven years to develop, happened in one year. And these losses occurred on the basis of only the modest increase in the number of banks that the FDIC, Fed, Treasury and the OCC have so far made public.

Therefore, with the speed of the recent downturn, the larger average size of the failed banks, the broader policy wordings (more coverage for the corporate entity), and the resources of plaintiff counsel, it might ultimately be impossible to compare the S&L debacle with the GFC.

NERA Economic Consulting released their “Failed Bank Litigation Report” in August 2010, providing a lot of details comparing and contrasting the S&L with recent bank failures, including the resulting D&O and Professional Liability litigation. The first part of the report presents statistics on recent bank failures and the characteristics of their assets, loan portfolios and performance relative to banks that have not failed.  The remainder of the report discusses failure factors and litigation in both periods.

This becomes an even more interesting having read Recovery Partners’ blog entitled “Hubris Meets Nemesis”, which estimates that “…the number of insolvent and/or severely impaired banks in the US to be well over 2000 institutions”, and goes on to point out that the suspension of FASB 157 (“the abolition of “mark-to market” accounting”)  and the failure to activate the Prompt Corrective Action Law. is hiding the true extent of the deterioration in bank balance sheets in the US.  If this analysis is in the ballpark, that will mean that the GFC hit in the US will vastly eclipse the losses from the S&L scandal. Of the 2,912 bank failures from 1980 to 1994, many were private and a lot smaller than the average failure today. It has been suggested that the scandal crisis cost over $150 billion and represented 3% of US GDP. Today, $150 billion is the cost to ‘bailout’ one insurer.  According to the DandO Diary blog, there have been 118 bank failures in 2010, and 165 in two full previous years. Recovery Partners estimates that the Deposit Insurance Fund losses from the GFC are currently in the range of some $500 to $700 billion. See also Chris Whalen’s Institutional Risk Analytics website for similar views on this issue.

The FDIC is starting to sue failed bank directors and outside professionals. FDIC filed two separate lawsuits in the Northern District of Georgia against outside law firms for the failed Integrity Bank of Alpharetta, Georgia. FDIC filed a separate suit against former directors and officers of Integrity Bank. They provide an updated list of failed banks on their website, and a separate list of authorized suits against individual directors and officers.

FDIC litigation in the S&L period was the primary source of litigation. Today the follow-on claims in private litigation by investors and creditors, and criminal proceeding by the DoJ, are very creative in order to avoid FDIC priorities and onerous pleading requirements (scienter hurdle of 10(b)-5.) This could mean that private litigation could cause even more “insured” loss than the FDIC. The “Failed Banks” topic section of the DandO Diary, provides significant detail and resources on the primary claims, third party professional claims, and on follow-on civil litigation.

The Canadians in this group are not insulated from this issue. A majority of the market share of D&O insurance premium written in this country is by insurers who are exposed to US claims. Even if they are not directly writing Bank D&O policies, bank failures affect the lawyers, accountants, pension and investment fund investors, and the ‘bricks, clicks and mortar’ companies who rely on these banks.  There has been a flight to safety for insurers, and that is why we have more than 27 companies writing directors’ and officers’ liability insurance in Canada. Every one of theses firms will have difficulty avoiding the direct and/or reinsurance costs of US losses in spite of the fact that insurance companies typically spread theor risks across all of their insureds, whether these insureds are inter-listed, large public, private or non-profit companies.

In addition to the direct and indirect US exposures, Canada is seeing a material change in homegrown loss experience. The decision in the IMAX class action securities case, was a denial of the defendant’s motion for leave to appeal the K.van Rensburg J. decision to certify class proceedings. We all know what happens to settlement amounts when a court decision goes in favour of the plaintiff class. The underlying securities litigation commenced September 20, 2006, when Siskinds LLP,  and Stutts, Strosberg LLP, brought their case alleging misrepresentation and breach of duty of care. This was the first case to be brought under Ontario’s new, at the time, “Bill 198”, aka, part XXIII.1 of the Ontario Securities Act (the “Act”), section 138.3, which provides a statutory cause of action for secondary market misrepresentation.

The insurance implication is that the IMAX 2005 information circular listed a D&O policy with a $70 million limit of liability. The circular does not provide a lot of detail, and I am not privy to any inside information, but it does say they had a split deductible of $100,000 “for each claim under the policy other than claims made under U.S. securities law as to which a deductible of $500,000 applies”, and paid an annual premium of $962,240.

There is no regulation of D&O or E&O policy wordings in Canada, and there are hundreds of versions of policy wordings, applications and endorsements that can mean the difference between coverage and personal financial loss. In the IMAX case, the split deductible (and the level of premium) would suggest that the policy provided at least some level of coverage for the separate and distinct loss of the corporate entity. If this policy structure, or an undisclosed policy, did not include a separate limit of liability for individual directors and officers, and their non-indemnified claims, then this $70 million is subject to erosion or even full exhaustion by loss incurred by the corporation.

Unfortunately, most directors and officers make a critical assumption that their D&O policy is designed to cover their personal liability. For many directors and executives, this “sharing of limits” problem is only identified after a lawsuit has been launched. The confusion is that this extension is marketed as “securities coverage”, which can be misleading to the individual directors. Some insurance brokers have sold this coverage by suggesting it is the only way to get coverage for claims brought by shareholders. Such a statement is absolutely false. The traditional D&O policy was always meant to apply to claims brought by shareholders, but only those claims brought against individual insured persons, not those brought against the corporation. 

Much more information on Canadian securities class actions can be found in the NERA report, here.

With a relatively small premium base, when compared with the personal and commercial property and casualty market, the specialty casualty insurance marketplace can be materially affected by isolated industry events. Even within this isolated industry (if you can call US Banks an isolated industry) there was a significant historical learning opportunity. With the degree of correlation between contributing factors of the S&L event and the recent bank failures, it is not a stretch to suggest the S&L learning opportunity was completely ignored by far too many decision makers.

If the horse has already left the barn, (which, based on D&O losses to date, has not been determined), then there are two things to do: First, identify and mitigate the current and ongoing risks of this event; and then identify the contributing factors (and people) and take appropriate notice and initiate action, so the market can retain this information and use it to avoid similar situations in the future.

Based on, 1) larger bank asset losses, 2) larger FDIC losses, 3) higher D&O policy limits and broader wordings, 4) deeper pockets in the executive ranks, 5) a new profit incentive to blow the whistle to regulators and the media (and not report concerns to the audit committee and independent board members), 6) the motivation of significant plaintiff lawyer contingency damage awards, and 7) an increase in follow-on civil litigation, insured losses will increase and the risk of D&O and Professional Liability insurance premium increases and coverage limitations is therefore extremely material.

Policy expiry dates, market swings and claims rush forward very quickly. Therefore, timing is crucial. All directors, executives, officers, compliance and legal staff, and other outside professionals should be doing the following:

1)             Request a personal contractual indemnity agreement from the corporation or partnership. Indemnification provisions are built into the Canadian Business Corporations Act, the Ontario Business Corporations Act, many corporate by-laws, and into most of industry specific acts, but, they are not all created equal, and none of them are as good as a well vetted individual contractual indemnity;

2)             Recognize that D&O insurance is not a panacea. It should not be a priority over good commercial general liability, property or operation specific products, like professional liability, errors and omissions liability (“E&O”), environmental, fidelity/crime, and cyber/media/privacy insurance policies.  D&O is also not a priority over good governance, risk management and compliance (GRC) activities;

3)             Know the expiry dates of all policies. Notice I did not say renewal dates, because a D&O/Fidelity/E&O renewal is never guaranteed;

4)             Know your “notice” obligations and opportunities to report claims and “circumstances” to the insurers and trigger your current policy for future loss (no matter when that claim is eventually launched;

5)             Have your broker identify all areas of “limits sharing” within your policies. Limit sharing is very sneaky, because it is not isolated to an insuring agreement; it can be found in the applications (which forms part of the policy,) exclusions, allocation provisions, severability provisions, and even in the definitions;

6)             Treat the D&O purchase decision as it being based on the limit liability, not on the insurance premium. The limit of liability has, or should have, a value that is material to the corporation, often the premium does not. Even for a small non-profit, it is a one or two million dollar decision; for a small publicly traded company it is a five to twenty five million dollar decision; and for a large public company it can be a $100 million decision. The purchase decision deserves this level of attention; and,

7)             Examine the skill, ability and independence of your broker (not just your brokerage.) There are far too many brokers who are passing themselves off as experienced, when in fact they have limited or no direct experience with D&O policies and claims. There are also many brokers who marketed (even convince) themselves they are independent, even when they owned by, or have a material debt or non-standard remuneration agreement with, an insurance company. It is therefore appropriate to, a) request full disclosure of ownership and all potential conflicts of interest, including any “exclusive insurer” programs, b) ask all brokers to explain to your satisfaction the key issues regarding all coverage options as they relate to your operations, and, c) request of all brokers not approach any insurance markets on your behalf until you have made your choice of broker.

Through aggressive competition among insurance companies and under-educated and overzealous insurance brokers, policies have been “broadened” to such an extent that they are now a possible detriment to the appointment of directors. Claims made against the corporate entity and coverage for non-traditional parties and matters are now fair game under many D&O policies. This level of coverage can be very attractive to aggressive plaintiffs, and their even more attractive to aggressive plaintiff’s lawyers, because a broader policy means a better chance for at least a modest settlement. A modest settlement reduces the down-side risk of pursuing what might be a long-shot chance of discovering a smoking gun that will produce the home run settlement (entire policy limits, plus corporate contribution, plus third party contribution, plus individual director and officer contribution.)  However, there is only one limit of liability that will be shared by all parties for all claims.

We have yet to see how US bank failures will play-out for D&O insurance buyers, but given what we already know, it behooves executives, directors, corporate risk managers and their advisors to meet this issue proactively and forcefully.

This is a guest blog by Greg Shields, a Partner and commercial insurance broker with Mitchell Sandham Insurance Services in Toronto, specializing in D&O, E&O and Fidelity insurance. His blog posts can be found at http://mitchellsandham.wordpress.com/, and he can be reached directly at gshields@mitchellsandham.com, or at 416 862-5626.

 

Posted in Bank Loans, Bankruptcy, Canada, Crisis, Insurance, Loan Losses | No Comments »

What’s QE all About Anyways? (or Why it’s too Early to Buy the Banks or Bank Assets)

Yesterday, following an interview on BNN we received quite a bit of email in response to the remarks I made on-screen regarding Mr Bernanke’s policy of Quantitative Easing (QE). There seems to be a great difference of opinion, and we might add, confusion, as to what this program actually entails and why it is being pursued.

The announced aim of QE is to raise asset prices above their market clearing levels in order to add a fillip to growth prospects in the US.  Ben Bernanke, speaking recently contends:  “I think we are underestimating and continue to underestimate how important asset prices, very specifically equity values are, not only for shareholders and the like, but for the economy as a whole.” 

The proposition that Monetary Policy can exert a growth impact on the real economy through an asset channel, AND that it will be significant,  AND that the Fed can predictably control this effect within reasonable tolerances and timeframes as contemplated by Bernanke, is highly speculative at best. One needs only to review the available literature in this area or to do the math on the potential impact of the announced QE program to arrive at this conclusion. Once past the hurdle of needing to treat the Fed Chairman’s pronouncements with a dose of healthy scepticism, and given the size of the intervention, the obvious conclusion one must draw is that the intended effect of QE is perhaps directed at certain other policy objectives that the Fed deems to be at least as important as raising employment and economic growth prospects. Bernanke’s recent admission that unemployment would remain high until at least 2014/15 – essentially saying to the unemployed “There is nothing we can do for you folks beyond issuing dole checks” –  underscores this interpretation.

There are in fact three interlinked goals of QE in combination with ZIRP (Zero Interest Rate Policy). The first has to do with the condition of bank balance sheets; the second with the condition of the Fed’s balance sheet and the last with the funding requirements of the US Government.

 Bank Balance Sheets

The FDIC Claims that it has 860 banks on its watch list, the most since the S&L debacle which occurred almost 30 years ago. As a regulator/policymaker there are three things that you can do in a situation where you have failing banks on your hands:

 (1)     Liquidate the banks – Fire everyone; sell of the good bits and manage down the junk. Prosecute the criminals and fraudsters

(2)     Put into receivership or conservatorship –  Fire management. Restructure Business and off to the races again. Prosecute the criminals and fraudsters

(3)     Subsidize – Give money to fix TEMPORARY Problems. Everything else stays the same. This assumes that the business is basically healthy and there has been no accounting control fraud.

 …..and to execute any one of these strategies you need to ensure the following Best Practice Guidelines are met:

(1)     Transparency. Ensure that the markets understand what is going on i.e. how bad the issues are and what the intended results are

(2)     Assertiveness. Need to act aggressively and with purpose to stem the problems in the early stages

(3)     Accountability. Hold executives etc responsible and measure performance during the restructuring , liquidation or subsidy period.

(4)     Clarity. Explain the markets EXACTLY what forms of assistance that the banks are getting and why

We have written in that past about the fact that the zombie bank problem is much, much larger than what the authorities have been telling the markets. In fact we estimate that the scale of the problem in the US is on the order of USD 500 to 700 billion dollars. Therefore what is being attempted in the US (and in Europe) to cure the zombie bank problem is a stealth subsidization approach complemented by liquidation of only the most rotten of the zombie banks (e.g. in the US those banks, for example, that have a gross asset impairment ratio of over 20%). In pursuing this policy the Fed, the OCC and FDIC have implicitly adopted an approach that assumes that the institutions are basically sound and all they need is a bit of money and some time and the problems will take care of themselves. In fact the chart below shows that the Fed’s usual trick of lowering the Fed Funds rate opening a wide spread against term rates and thereby allowing the zombie banks to re-capitalize themselves by riding the curve is not working at all as well in the present situation as it has in past years. This is why QE, which gives the banks more cash to play with, is being aggressively pursued.

  

The effort to keep the true condition of banks cloaked also explains why the US authorities suspended (without formal announcement) the application of the “Prompt Corrective Action Law“ and strong armed the FASB into striking down the mark to market rules allowing insolvent institutions to continue to “mark-to-fantasy” and avoid liquidation. These policy actions are all related to maintaining the impression that almost all banks in the US are still healthy. Recall that our view of the Bank Stress Tests in the US (and Europe) is that they were designed to make the banks appear to be sounder than they really are. In the case of US banks, the stress tests did not properly stress real estate risks; and in the case of the European test, it was Sovereign Debt exposures that got the once over lightly treatment. Look at where we are today. How credible do the test procedures seem now in the wake of renewed concerns regarding the European Sovereign Debt situation and persistent weakness in US housing markets and the looming rollovers of commercial real estate loans there?

Hence we can infer that similar objectives have lain behind the refusal of banks and policymakers in Europe to consider debt write downs. This is why the bailout packages being forced onto the peripheral European countries are considered to be very rickety solutions in our opinion. They do not accommodate the needed reckoning and write down of the bad loans made by banks to those economies, pile more debt onto them that is then expected to be funded by taxpayers who, as a consequence of the situation, effectively become tax slaves.  This situation is not socially nor politically stable in the medium term, and certainly will not last long enough for these economies to dig themselves out of the mess by using these means. Refer to our previous comments on the history of fiscal remediation efforts.

(Compare the actual actions of the authorities as described to the Best Practices Guidelines shown above)

As long as the banks remain weak, look for the US authorities to maintain their “extend and pretend” policies; and look for QE to make another encore appearance. (Similar motivations, namely the need for a blanket solution to the Sovereign Debt Crisis in Europe is why the European Central Bank has just re-started its QE program.)

What would we have done? See here.

The Fed and the Treasury

There are two other reasons for running the QE, namely to help the Fed and the Treasury to dig themselves out of the holes that they are in:

The Fed needs to find a way out of the “roach motel” it created for itself when it re-discounted toxic waste from the market at par (instead of market value)  to keep the worst of the insolvent banks afloat, and when it bought back huge MBS inventories from Fannie Mae and Freddie Mac. The “elevator boots” afforded by its ability to massively leverage its footings without regard to capital considerations or credit risk are certainly helping it achieve this objective. Recent disclosures by the Fed regarding its lending operations and counterparties do not tell the entire story. Moreover, the fact that the Fed is not, and never has been, subject to mark-to-market rules or disclosure requirements as to its activities, in theory allows it to play this game until the combination of money printing and yield curve trading covers its internal asset valuation deficit. The fact that the QE undertaken so far is insufficient to cover this shortfall is one more reason why we will likely continue to see additional QE after this round is completed.

At 14.5 % of GDP, US Federal Tax revenues are off sharply from the usual 18-19% run rate. In combination with the various stimulus measures and entitlements ramp up, this has opened up a huge funding requirement. The Treasury needs a helping hand to fund its deficit as it is becoming clear that there is significant congestion in US bond markets as evidenced by recent price action and the withdrawal of foreign players from the buy side. There is in fact more than some reason to believe that the Treasury does not want to expose itself to funding risks because they want to maintain the fiction that they have no problem closing the deficit. Recent results of the coupon passes show that on-the-run bonds are being submitted back to the Fed, and thus even the pretence that these operations are not designed to monetise the deficit has evaporated. The Chinese for their part laid down the gauntlet a month ago when Dagong Credit Rating Agency downgraded the US to A+ with a negative outlook. “Who listens to Dagong?” one might ask. The answer is that they only need one client – the Chinese Government – and if the ratings threaten to fall below single “A” (the typical investment cut-off for central banks and Governments); what that client does or what it tells the market in intends to do with its holdings of US dollars and US Treasury debt is of vast significance. By way of this indirect method, the Chinese are showing the US that they are in possession of some pretty big political and economic levers. We know the Chinese are upset with the QE and the “meddling” by the US as regards the yuan/US exchange rate. How this policy tussle shakes out is something that we will be watching with interest. Finally, the fact that there is at present almost no recognition among the US leadership that the US needs to get its fiscal house in order is a third reason that adds to the probability that the continuation of QE beyond the current program is very likely.

 Risky Business

Note that the dangers of the QE and ZIRP stance are substantial and numerous. These include growing geopolitical tensions, social unrest, the intensification of imbalances and fiscal stresses in emerging and other economies, rising inflation and a loss of credibility for the Fed. Moreover, far from being a set of policies solely designed to re-start the economy, the discussion above suggests that the financial underpinnings of the US are on a very precarious footing, that the Fed knows this, and that this is why it has chosen this untested and risky policy path involving QE and ZIRP.

As measured against Bernanke’s announced intentions of lowering the dollar, lowering bond yields, raising stock and property prices, and boosting the economy the QE program must be judged a failure. However, the jury is still out as to whether the Fed will be successful in achieving its unannounced goals as described above, and if in fact QE and ZIRP are the appropriate tools for all of these jobs or just a perilous policy patchwork assembled and implemented in haste.

Posted in Banks, Bond Market, Fed Policy, Loan Losses, Sovereign Debt | No Comments »