Abe-nomics, Bazookas and Cognitive Dissonance

In modern social psychology, cognitive dissonance is the feeling of discomfort when simultaneously holding two or more conflicting cognitions: ideas, beliefs, values or emotional reactions in your mind at the same time. The theory of cognitive dissonance proposes that people have a motivational drive to reduce dissonance by altering existing cognitions, adding new ones to create a consistent belief system, or alternatively by reducing the importance of any one of the dissonant elements.

Source: Wikipedia

Following last week’s announcement by Bank of Japan Governor Kuroda that it will “do anything it can” to get Japanese inflation up to 2%, JPMorgan said in a communication that the Japanese, European and U.S. central banks are now in the same camp when it comes to monetary stimulus. The JPM economist who provided that assessment is undoubtedly well-remunerated, being in the regular habit of taking obscurantist developments and putting them in language that his less erudite bosses find comforting, easy to understand and easy to pass on as Gospel to the bank’s clients and investors.

In fact, based on actual statements made recently by these various central banking institutions, it seems that nothing could be further from the truth.

In January, Bloomberg blared the headline “Bernanke Dissatisfied With Growth Will Press on With QE Pace”. The Fed seems to be expecting growth and NOT inflation to be the result of its QE program.

Based in his recent comments ECB Governor Draghi is also focused on pushing a form of QE in the hopes that Euro-Zone Growth can recover to a more stable and higher growth path.

However, in contrast, the BOJ is hoping for inflation, and not growth. The specifics are simply that Governor Kuroda announced plans to double the BOJ’’s monthly bond purchases and achieve 2 per cent annual inflation within the next 2 years. This follows the smaller-sized, though entirely similar, expansionary policy that in the last two years has caused the Yen to fall almost 20 percent against the majors. Only the Venezuelan Bolivar and Malawian Kwacha have fallen by more over the same period.

The reality is that over the last 4 years one of the most enduring fictions promulgated by the authorities and their handmaidens on 19^th Street, is that central bank money printing and central government pump priming will act together to generate self sustaining growth in the economies hit by the Global Financial Crisis. This is an elaborate fantasy on which we have commented before.

There is in fact no amount of funny money and deficit finance that can steer things back onto a sustainable path unless the obstacles to growth and recovery are removed. All of the serious economic research and actual economic history that we have reviewed supports this central truth.

And now we have evidence that the world’s central bankers do not even agree on what it is possible to achieve through QE.

Is it inflation or is it growth??

This is like asking you if the objective of your exercise regimen is to gain more muscle or more fat and you actually believe that you can achieve either by following the same plan.

The real reason for the QE being pursued in the various economies of the G7 and the Euro-Zone is that Government finances in certain key countries are hemorrhaging and that this is interfering with the ability of certain Governments  to even keep up the pretence that financing requirements can be funded in the normal course.

As such the latest BOJ announcement is a sign of weakness and cause for concern rather than renewed hope. The markets which rallied on the news have got it wrong.

Source: The Japan Times

Beyond this, there are additional problems and concerns specific to the just announced Japanese policy update. For example

• Financial Policy. THis latest policy wheeze is nothing more than another salvo in an ongoing currency war. Therefore it is only likely that Japan’s trading partners will pressure the Government there to slacken their efforts to weaken the Yen in order to preserve their own growth prospects. This could lead to international tensions over economic policies;
• Monetary Policy Flexibility. The BOJ has been expanding its QE more aggressively than either the the FED and ECB, burdening its balance sheet with riskier assets and making even the possibility of an exit from this policy nothing more than a wistful fancy;
• Investor and Consumer Behavior. The QE policy distorts price signals; obscures the risk and risk/reward properties of investments; penalizes savers at the expense of borrowers (The Government being the biggest with the biggest interest tab. See above.) and encourages mal-investment;
• Starting Point Risk. This policy does not sufficiently take into account the very serious structural problems in the Japanese economy which have hampered growth and resulted in deflation. These include, most importantly the failure to properly remediate weakness in bank balance sheets, the effects of an aging population, including waning tax receipts; and the fact that Japan already has the largest (and effectively unsustainable) debt load on the face of the planet;
• Re-entry Risk. Monetary Policy implementation is a very uncertain process and the transmission mechanisms and relationships are not stable or predictable in even the medium term. There is no plan, no way to reverse what is being proposed, not in Japan, not in Europe and not in the US. If these policies do act on inflation and money demand drops as the policymakers wish, then it may trigger a self reinforcing bout of price  inflation that (a) will be hard to control; (b) will cause a variety of easily anticipated economic problems, and (c) very likely create new unanticipated problems, stresses and conflicts relating to the policies of competitive devaluation that are being pursued.

Of course we are sure that the policy wonks at the BOJ (and the FED and the ECB) are completely aware of the dangers and problems regarding their policies and of which we write. It is just that they cannot muster the intestinal fortitude, leadership and political will to opt for a solution that does not amount to a combination of bargain basement wallpaper, cheap glue and a snappy sales patter.

Therefore, at this juncture it is of only one thing we can be certain: if there is a limit to “safe money printing” (as if this term is not an oxymoron in and of itself), then the current set of central bank incumbents seem dead-set on finding it.

“…nobody is qualified to wield unlimited power.”

Friedrich von Hayek, The Constitution of Liberty, 1960

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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.

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Cognitive Dissonance*

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

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

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

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

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

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

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

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

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

The answer is “No”.

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

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

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

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

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Ratings Agencies take Aim at Large Banks

Late yesterday the Moody’s Ratings agency announced that it was considering a downgrade of a number of Euro-zone, US and Canadian banks including Canada’s largest and arguably its most venerable banking institution, the Royal Bank of Canada (RBC). Readers might recall that Moody’s stripped the RBC of its Aaa rating in December 2010.

At the time this was not much of a surprise because the bank had been placed on negative credit watch earlier in that year largely due to an announcement by the RBC that it was seeking to generate a larger share of its total bottom line from Capital Markets businesses. The downgrade also occurred despite RBC having emerged from the Global Financial Crisis (GFC) relatively unscathed and in much better shape than most of its offshore competitors. Other agencies soon followed suit with their own downgrades for the bank.

The RBC is currently rated AA- by S&P and Aa1 by Moody’s. Fitch, and DBRS the other major agency and Canada’s domestic credit watchdog respectively, both peg the RBC credit quality at AA. Thus while the latest Moody’s announcement will bring their ratings assessment into line with their major competitor, it still remains above the credit assessment given by the two smaller agencies

The recent ratings action again pays reference to that fact that RBC’s announced business plans are running into strong headwinds, not in the least due to the furor over implementation of the Volcker rule, but also because the markets that it is seeking to exploit in the search for revenues are running into difficulties in the form of widening spreads, lower volumes, poor funding conditions and deteriorating investor appetite.

Other Banks under review for possible downgrades include Citigroup, Bank of America, Goldman Sachs, JPMorgan Chase and Morgan Stanley; and Moody’s said it is  extending its reviews on whether to lower ratings on Credit Suisse, Macquarie, Nomura, UBS, Barclays, BNP Paribas, Credit Agricole, Deutsche Bank, HSBC, Royal Bank of Scotland and Societe Generale. Moody’s also extended ongoing reviews for downgrades on 11 companies.

Pointing to regulatory, balance sheet and liquidity the agency said in a statement after markets closed last night: “These difficulties, together with inherent vulnerabilities such as confidence-sensitivity, interconnectedness, and opacity of risk, have diminished the longer term profitability and growth prospects of these firms”.

The Moody’s news came hard on the heels of credit downgrades for a number of Euro-zone countries including Italy, Portugal and Spain because of uncertainty over the weakening profile of economic activity in Europe and a growing credibility gap regarding the advisability of the polices being forced on debtor countries by the EU/ECB/IMF “Troika”.

Do these Announcements now make the World now “Safer” from Financial Calamity?

Nothing could be further from the Truth.

In our opinion here at Recovery Partners, this latest wheeze from the Ratings Agencies is comparable to the fevered activity of Balinese pool boys trying to rearrange deck chairs in the middle of a force-5 Typhoon.

While EU leaders have droned on for the last several years about their intentions of putting a “firewall” around the banks and nations most afflicted by the euro zone debt crisis, nothing of the sort has occurred. In fact, the recent Long Term Refinancing Operation (“LTRO”) in Europe and ongoing easements in collateral rules make a massive outbreak of contagion more likely rather than less likely because, systemic risk is increasingly becoming a function of the credit quality of the weakest banks, rather than the strongest banks. The ratings agencies’ recent focus on the stronger banks such as the RBC only serve to underscore the  point that these announcements are largely a sideshow.

As we know, mark-to-market rules have either been overtly suppressed by regulators in Europe and North America or ignored.

In fact, given the unrelenting stresses in the interbank markets in Europe and elsewhere, we are wondering whether or not we are close to an explicit “event of diktat” similar to what was recently announced by the Chinese authorities. Not widely publicized, a particular example of how bad things are is given by China, the authorities there have recently commanded the banks to roll over maturing loans to local authorities in full knowledge that they are non-performing and cannot be, and will not be, paid back even under the rosiest of scenarios because they are backed by asset positions that are largely worthless and non-income producing. In the wake of the GFC, Chinese Banks lent the equivalent of 25% of Chinese GDP to local authorities. This is not a small problem.

Having the central government tell the Chinese banks to represent (to the regulator controlled by it no less!)  that the loans are sound will not make them pay off nor reduce the eventual chop that the banks will have to take. This subterfuge only postpones the inevitable day of reckoning and contributes to further uncertainty.

A notch or two on RBC’s rating or on the ratings of similar banks is hardly an issue that anyone  should lose sleep over in the current environment. There are much, much bigger demons out there.

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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

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Frau Merkel, Just Say “Nein”!

“Was fällt, muß man nur noch stoßen”  Friedrich Nietzsche <PgDn for translation>

Dear Madam Chancellor,

This week will likely mark a critical turning point for Europe. The seriousness of the situation is underscored by the fact that this Euro-summit will also be attended by participants from the US Administration, the IMF and other third parties not normally seen at gatherings of the Eurozone political leadership.

You alone among the Euro leadership have consistently understood and have attempted to communicate that we should stop kidding ourselves that this crisis can be solved without a lot of pain.

By this point it should be clear that the tried and tested solutions for dealing with insolvency and default must be pursued. This means that Europe needs triage and restructuring, not additional “can kicking” and “monetary fakery” as some would suggest.

It also means that the “incremental” approach followed in the past 3 years has not only failed, it has become extremely counterproductive, and must be replaced by an action plan that features decisive and rapid action that will offer markets a clear roadmap to recovery.

For the negotiations that are upcoming the choice therefore is clear: you must either (1) lead Germany (and Europe) down a path of delusion and pain, submitting to the “funny money” Brussels elites who are calling for bond buying and money printing and inflicting significant cost and suffering on the peoples of Northern Europe (Germany and France being the key players) who have not over-borrowed or otherwise badly managed their economies, in order to bail out certain other nations who have done just that; all at the risk of huge expense yet with no guarantee of sustainable success; or (2), you must lay the groundwork for an orderly restructuring of the Monetary Union, which will see certain nations leave the Euro-zone (Greece, Ireland, Portugal, Spain; with Italy remaining within the EMU as a possible “Associate Member”), so that these exiting nations might catch their breath and recover. Accession plans for other nations would be put on indefinite hold.

Do not listen to the Brussels elites that believe that the problems can be papered over in the same fashion that US policymakers believe that they have done in the US. These types of gambles have never worked and inevitably have led to worse problems. It is a tacit axiom of international relations that there is no “altruism between nations” and therefore no legal, moral or ethical principle exists that would suggest the profligate countries should continue to benefit from the largesse of their neighbors at whatever the cost and without sanction. Now is the time to restructure out the countries that are not suited to, or capable of, following the fiscal and monetary discipline required as per the agreements they acceded to when they entered the Eurozone. Contrary to the advice that you may be offered by others connected to this situation, the plans for fiscal union and the role of the ECB should be sorted out after the membership structure has been adjusted. Moreover, in order to exit the crisis there is absolutely no need to add to the powers of the ECB.

There are some who say that breaking up the Eurozone would be an expensive mistake that Europe cannot afford. We say it is a course of action that Europe cannot afford not to take. There are political as well as financial reasons for this.

Following reunification Germany had a period of adjustment which was expensive, painful and lengthy. Your recent elections have shown that the German people do not want to see these sacrifices and achievements squandered. In fact, most of your neighbors are fully supportive of your policies during the recent crisis period and are looking to Germany to supply continued reasoned and reliable stewardship of this situation.

This crisis and the crisis in the United States are evidence that the West is wounded and its way of life is at risk. That means repairing (not bailing out) the financial system and insolvent countries quickly as possible. Therefore any plan that promises to restore stability at a minimum of risk and cost should be greeted favorably by all Europeans, Americans and their allies. Already too much time and money has been squandered pursuing unworkable solutions aimed at preserving some kind of idealistic and now unattainable, “status quo ante” in the Euro area.

The US should be in favor of this for that very reason, and also because a festering crisis in Europe imposes strong headwinds on the fragile growth potential in the United States, restraining activity and complicating the job of economic management there. The same is true for the UK. And the same should be true of the Euro-zone countries now under financial pressure and having to deal with austerity programs without the ability to devalue the currency that they use. In the latter case it is extremely unlikely that the austerity programs will bear fruit before a time bomb of social upheaval and popular discontent explodes and drives these nations even further into chaos.

Caption: An anti-austerity protester holds a placard with the Greek flag and swastika reading "NO to the 4th Reich" after a student parade in Athens, on Friday, Oct. 28, 2011. The student march, in commemoration of the 71st anniversary of Greece's entry into World War II, went on without major incident, but in other cities officials were heckled and in Thessaloniki, Greece's second city, a military parade was canceled. They also wrote “1941-2011 The enemy is the same”. Some shouted slogans “Germany Out from the EU”. (AP Photo/ Thanassis Stavrakis)

Europe is no stranger to currency crises. We saw enough of those throughout the 1970’s, 1980’s, and 1990’s. With the exception of the UK in the 1970’s the IMF has never before intervened in European affairs. This crisis is a European problem, and there is no strong rationale for IMF lending under the existing IMF articles. In fact the IMF does not even have sufficient resources to render any offer of assistance credible. Moreover some of the less wealthy members of the IMF would begin to register legitimate complaints about co-opting the IMF to bail out large wealthy nations. Europe has lots of money and no balance of payments problem. The Euro is a reserve currency. You and your country can do a lot to fix this problem, and using the Bundesbank, the German Treasury and the ECB, you can do everything that the IMF can do.  We are sure that the very experienced people on 19^th Street in DC understand the difference between a bad risk and a good one, know that they have scarce resources, and would welcome the chance to step aside.

Part of the costs will be the default of the Greeks, Irish, Portuguese and the Spanish and possibly the Italians, and needed bank recapitalizations in those economies and for banks in other Eurozone countries. The costs for the leavers can be estimated by looking at past crises. According to the IMF which has examined  over 100 currency and banking crises, the data show that for countries that have experienced a banking and a currency crisis (the most severe combination of adverse events) that the average output loss is about 18.8 percent, and that the average time to full output recovery is around 2.6 years. The Eurozone problem countries have already experienced these types of losses in the three years since the crisis descended upon them, but there is no recovery in sight. On the present course there is also no end game, no guarantee that the bailouts will prove successful and no estimate of the final bill.

Your national treasure will be better spent on a program of triage and recovery accompanied by the needed reforms to the EMU beyond the exit of the wayward countries. This combination of measures will deliver finite costs within a reasonably finite timeframe and, we believe, will ultimately prove politically palatable to the peoples of Europe and their neighbors.

Who knows ….if you can pull this off, one day a re-energized, institutionally more robust and better managed Euro might supplant the USD as the Number One Reserve Currency for the world.

Best Regards and Good Luck,

 

Recovery Partners

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Frau Merkel, sagen Sie einfach “Nein”!

“If you see anything that is falling, give it an extra push for good measure”  Friedrich Nietzsche

Sehr geehrte Frau Bundeskanzlerin,

Diese Woche wird wahrscheinlich markieren einen wichtigen Wendepunkt für Europa. Der Ernst der Lage wird durch die Tatsache, dass diese Euro-Gipfel wird auch von Teilnehmern aus der US-Regierung, dem IWF und anderen Menschen in der Regel nicht bei Versammlungen der Eurozone politische Führung gesehen besucht werden unterstrichen.

Sie allein unter den Euro-Führung haben stets verstanden und haben versucht zu vermitteln, dass wir aufhören sollten, uns gegenuber zu sherzen, dass diese Krise ohne große Schmerzen gelöst werden kann.

An diesem Punkt sollte klar sein, dass die bewährten Lösungen für den Umgang mit Insolvenz ausgeübt werden müssen. Dies bedeutet, dass Europa muss Triage und Schuldenumstrukturierung folgen, und nicht zusätzliche „Can kicking” und „Monetary fakery“ wie manchen würden vorschlagen.

Es bedeutet auch, dass die “inkrementelle”-Ansatz das in den letzten 3 Jahren verfolgt wurde, hat nicht nur versäumt, es hat sich extrem kontraproduktiv vorgestellt und muss durch einen Aktionsplan, der entscheidende und rasches Handeln, das Angebot Märkte einen klaren Fahrplan, um Recovery-Funktionen ersetzt werden.

Für die kommende Verhandlung ist est also klar: Sie müssen entweder (1) führen Deutschland (und Europa) auf einen Weg der Täuschung und des Schmerzes, die sich dem “funny money” Brüsseler Eliten, die für die Anleihe zu kaufen und Geld drucken anrufen und fügt erhebliche Kosten und Leid über die Völker des nördlichen Europa (Deutschland und Frankreich zu den wichtigsten Akteuren), die nicht über over-geliehen oder anderweitig schlecht ihre Volkswirtschaften geführt, um aus der Patsche helfen bestimmte andere Nationen, die genau das getan haben, alle an das Risiko von großen Lasten noch mit keine Garantie für nachhaltigen Erfolg, oder (2), müssen Sie den Grundstein für eine geordnete Umstrukturierung der Währungsunion, die unter bestimmten Ländern verlassen die Euro-Zone (Griechenland, Irland, Portugal, Spanien lag ; mit Italien noch in der EWU als mögliche “Associate Member”), so dass diese spannende Nationen könnte zu Atem zu kommen und wieder wachsen konnen. Beitritt Pläne für andere Nationen würden auf unbestimmte Zeit gehalten werden.

Mann kann nicht die heutigen Probleme mit Tapete verstecken. Diese Arten von Glücksspielen haben noch nie gearbeitet und unweigerlich zu schlimmeren Problemen geführt haben. Es ist eine stillschweigende Axiom der internationalen Beziehungen, dass es keine “Altruismus zwischen den Nationen” gibt und damit auch keine rechtlichen, moralischen oder ethischen Grundsatz gilt, dass würde vorschlagen, die verschwenderische Länder sollten weiterhin von der Großzügigkeit ihrer Nachbarn an, und ohne Sanktion. Jetzt ist die Zeit zur Umstrukturierung aus den Ländern, die nicht geeignet sind, oder in der Lage, im Anschluss an die fiskal-und geldpolitische Disziplin gemäß den Vereinbarungen sie, wenn sie in die Eurozone beigetreten erforderlich. Im Gegensatz zu den Rat, den Sie bereits vielleicht schon erhalten haben, sollten die Pläne für das Geschäftsjahr Union und die Rolle der EZB aussortiert werden, nachdem die EWU-Mitgliedschaft Struktur angepasst hat. Darüber hinaus, um die Krise zu beenden gibt es absolut keine Notwendigkeit, die Befugnisse der EZB hinzuzufügen.

Es gibt einige, die Auflösung der Eurozone wäre ein teurer Fehler, dass Europa es Sich nicht leisten kann, werden sagen. Wir sagen, es ist ein Vorgehen, dass Europa Sich nicht leisten kann, nicht zu nehmen. Es gibt politische als auch finanzielle Gründe.

Nach der Wiedervereinigung hatte Deutschland eine Phase der Anpassung, die teuer, schmerzhaft und langwierig war. Ihre kürzlichen Wahlen haben gezeigt, dass das deutsche Volk will nicht diese Opfer und Leistungen verschwendet zu sehen. In der Tat sind die meisten Ihrer Nachbarn voll und ganz hinter Ihrer Politik während der Krise Zeitraum und sind in Deutschland auf eine weitere vernünftige und zuverlässige Verwaltung von dieser Situation zu liefern.

Diese Krise und die Krise in den Vereinigten Staaten sind der Beweis, dass der Westen verwundet ist und seine Art zu leben ist in Gefahr. Das bedeutet, dass die Reparatur (nicht „Bailout“) des Finanzsystems und insolventen Ländern so schnell wie möglichpassieren soll. Daher ist jede Plan, um die Stabilität bei einem Minimum an Risiko und die Kosten wieder Versprechungen positiv von allen Europäern, Amerikanern und ihren Verbündeten begrüßt. Schon zu viel Zeit und Geld verschwendet worden verfolgt undurchführbar Lösungen zur Erhaltung einer Art idealistischen und nun unerreichbar, “status quo ante” in der Euro-Zone ab.

Die USA sollten sich für diese gerade aus diesem Grund, und auch, weil eine schwärende Krise in Europa auferlegt starken Gegenwind auf der fragile Wachstumspotenzial in der USA, einstweilige Aktivität und erschweren die Arbeit des ökonomischen Managements gibt. Das gleiche gilt für das UK. Und das gleiche sollte auch für die Länder der Eurozone nun unter finanziellem Druck und mit mit Sparprogramme ohne die Fähigkeit, die Währung abzuwerten, die sie verwenden viel. Im letzteren Fall ist es äußerst unwahrscheinlich, dass die Sparprogramme wird Obst vor einer Zeitbombe des sozialen Umbruchs und der Unzufriedenheit in der Bevölkerung explodiert tragen und treibt diese Nationen noch weiter ins Chaos.

Europa ist kein Fremder in Währungskrisen. Wir sahen genug von diesen ganzen 1970er Jahre, 1980er und den 1990er. Mit Ausnahme von ber UK in den 1970er Jahren hat der IWF noch nie zuvor in europäischen Angelegenheiten eingegriffen. Diese Krise ist ein europäisches Problem, und es gibt keine starken Gründe für IWF-Kredite im Rahmen der bestehenden IWF-Artikel. In der Tat der IWF nicht einmal über ausreichende Mittel verfügen, um ein Angebot der Unterstützung glaubhaft zu machen. Darüber hinaus einige der weniger wohlhabenden Mitglieder des IWF beginnen würde, um legitime Beschwerden über die Kooptierung des IWF zur Rettung von großen wohlhabenden Nationen registrieren. Europa hat viel Geld und keine Zahlungsbilanz Problem. Der Euro ist eine Reservewährung. Sie und Ihr Land können eine Menge tun, um dieses Problem zu beheben, und mit der Bundesbank, die deutsche Finanzminister und der EZB, können Sie alles tun, dass der IWF tun können. Wir sind sicher, dass die sehr erfahrene Leute an der 19th Street in DC der Unterschied zwischen einem schlechten Risiko und ein gutes Verständnis, wissen, dass sie knappe Ressourcen haben, und würde die Chance, beiseite zu treten willkommen.

Ein Teil der Kosten ist dass die Griechen, der irischen, portugiesischen und spanischen und möglicherweise die Italiener, Bankrott sind und auch benötigt Rekapitalisierungen der Banken in den Volkswirtschaften und für die Banken in anderen Ländern der Eurozone. Die Kosten für die Abiturienten können, indem Sie auf vergangene Krisen geschätzt werden. Nach dem IWF, die über 100 Währungs-und Bankenkrisen untersucht hat, zeigen die Daten, die für die Länder, dass eine Bank-und eine Währungskrise (die schlimmste Kombination von unerwünschten Ereignissen), die mittlere Ausgangsleistung Verlust über 18,8 Prozent erlebt haben, und dass die durchschnittliche Zeit bis zur vollen Leistung Erholung um 2,6 Jahre. Die Eurozone Problem Länder haben bereits diese Art von Verlusten in den drei Jahren seit der Krise auf sie herab erlebt, aber es gibt keine Erholung in Sicht. Auf dem gegenwärtigen Kurs gibt es auch kein Ende Spiel, keine Garantie, dass die Rettungsaktionen als erfolgreich erweisen werden und keine Schätzung der Endabrechnung.

Ihr nationaler Schatz wird besser auf ein Programm der „Triage-und Recovery“ durch die notwendigen Reformen des EMU begleitet über den Ausgang des eigensinnigen Ländern ausgegeben werden. Diese Kombination von Maßnahmen werden endlich die Kosten in einem angemessenen Zeitrahmen zu liefern und endlich, wie wir glauben, sich letztlich als politisch schmackhaft zu den Völkern Europas und ihre Nachbarn.

Wer weiß…. wenn Sie dies zu erreichen, einen Tag mit eine neuer Energie, institutionell robuster und besser verwaltet Euro könnte der USD als Nummer eins der Reserve Währung für die Welt zu verdrängen.

Mit freundlichen Glückwunschen,

Recovery Partners

Posted in Banks, Crisis, EU, IMF, Restructuring, Sovereign Debt, USA | No Comments »

The Canary in the Coal Mine Part II

In our last blog installment we asked, given the present unsettled state of the world the real issue for clear-thinking people is: “What comes next after these “Occupiers” fade into the sunset?”

Well, here in Toronto the OWS has been dispersed, the “Library Yurt” in St. James’ Park has been dismantled and its “defenders” bundled off; and who better to provide some insight into that question than The Right Honourable Tony Blair, the former Prime Minister of Great Britain from 1997 to 2007 and since then the Official Envoy to the Middle East for the Quartet? 

Recovery Partners attended a dinner last week where Mr Blair was the keynote speaker. A key message that he delivered was that the world is shifting very fast, and it is more interdependent and interconnected than ever before. Following that theme, he said that today’s politicians must quickly get used to the fact that they have to make “Big Decisions” and they must the right ones and make them quickly or risk losing control of the situation the West confronts today. This message ran through his entire address.

As for the situation in Europe Mr. Blair strongly advised that leaders there must recognize that the Eurozone is shifting from the “Politics of the Grand Design” to the “Politics of the Grand Plan”. It is the Grand Plan that has eluded decision-makers there. Unfortunately for Europe, however, Mr. Blair emphasized that, in this regard, the Eurozone and its leaders cannot afford to rely on a strategy that makes incremental changes that lead to incremental gains. This requires that the current Eurozone leadership realize that the crisis there is not a situation to be “managed: Today’s leaders have to take Big Decisions at an Existential and Fundamental level (which in itself is an act that risks or provokes a collapse of the system unless the right decisions and plans are implemented). The key realization here is that the single currency crisis has exposed a need for reform, it has not created that need.

Mr. Blair went on to say that the true operative timeframe now for the Euro rescue must be measured in weeks not months if the Eurozone is to be saved. This means that everyone in Brussels and in the Euorzone countries needs to get behind the Euro. In the longer term decisions need to be taken about a European Fiscal Union and Fiscal Reform. There are clear flaws in the Monetary Union Project, but for now a crisis management solution must be implemented quickly.

Everything is preferable to a breakup as the consequences are serious for both creditors and debtors therefore people on all sides of the negotiating table should be motivated to find a decision. Based on the foregoing there is simply is no “middle course” according to Mr Blair.

Similarly, the US Economy requires dramatic decisions that the Leadership there has avoided. Mr. Blair enumerated several “huge challenges” facing the US including debt levels, deficits, needed reform of the tax code, and an urgent need to rebalance the economy in favour of a more equitable division of National Income. He was unequivocal in saying that needed decisions have been deferred and have been piling up for years and these imperatives can now no longer be ignored.

As noted above Mr. Blair has spent a good deal of time since leaving office preoccupied with events and developments on the Middle East. His main message here, following from above, was that the Arab Spring, the Israeli Palestinian conflict, and Islam’s relationship to the West are all not only interconnected, they are key agenda items.

While it has become obvious that a variety of  regime shifts have going on in the Middle East, it is less obvious to note that most lack stability. In many countries modernization has outstripped to ability of the economy and population to keep up. Here, the main difference between Eastern Europe and the Fall of the Berlin Wall and what is going on in the Middle East today, is that with the Fall of Communism there was: (1) Unity among the Eastern Bloc population on what they wanted to get rid of; and, (2) unity among those peoples on their desire to adopt a Western Way of life, its aspirations and values.

Mr. Blair explained that in this regard, today in the Arab world there is no cohesion around what the population would like to structure in place of deposed regimes and dictators. Therefore it would be a huge mistake for the West to assume that people there just want to move towards a stable democracy. The simple model of modernization conveniently ignores the deep influences or tribalism and religion in many of these countries.

Therefore it is not obvious what the outcome in many of these countries will actually be. That means that unless we take strong positive action to get people into the right frame of mind that there will be problems with the transition.

Many of the regimes outside the West are quite strong and resistant to “Arab Spring” type events. They afford a measure of political stability. The folks who are a serious threat to these regimes or the status quo in those countries are usually either co-opted or neutralized

To underscore this point Mr. Blair said that many prominent people in these countries are extremely nervous about making ANY move, let alone the RIGHT move….and that this is happening throughout the region. Therefore he emphasized that we in the West we have to stay engaged with these populations. Specifically he stated that we have to assist with change, help these societies cope with modernization and at the same time, challenge them. The West needs to demonstrate that democracy is not only about a constitution and right to vote, it is also about: (1) an attitude to life, (2) freedom of expression, (3) freedom of religion, (4) freedom to work and transact in open, transparent and fairly-regulated markets, and (5) the requirement to live with tolerance and diversity.

The World no longer revolves solely around the US and Europe regarding strategies and political imperatives based around territorial interests. In fact the West must understand that the main message it must represent going forward is a Way of Life: Freedom, Democracy, Justice, and Tolerance being but some of the watchwords. Through leadership and vision we should impress upon the emerging and newly middle income economies to come to the conclusion that they would do far better to emulate the West rather than if they did something else.

Mr Blair’s remarks were warmly received and appreciated. Clearly in command of the subject matter and charismatic, he could probably have gone on for several hours. From our persepctive his address was as much an observation on the current state of affairs as it a warning to all of us that unless a more constructive approach to our problems is pursued by politicians both in Europe, North America and elsehwhere, that the consequences could be extremely undesireable.

This week financial markets in Europe remained on a knife edge and the US political class again showed that it continues to behave in a manner that is completely unresponsive to market discipline. The indicatiors on the threat board continue to flash yellow and red.

I am reminded of a luncheon I attended in Tokyo shortly after the fall of the Berlin Wall, when the then Russian Foreign Minister, Andrey Kozyrev, was asked by a member of the press how things would turn out in Russia. His response was that “No one is in full control, any one of hundred outcomes are possible and most of them are ones that people really won’t like.” As events have shown since then, it appears that the world and Russia herself has largely lucked out.

We may not be so fortunate this time.

Posted in Crisis, EU, Economy, Middle East, OWS, USA | No Comments »

The Canary in the Coal Mine – Part I

“Now if I tell you that you suffer from delusions; You pay your analyst to reach the same conclusions; You live your life like a canary in a coalmine; You get so dizzy even walking in a straight line”

Sting and The Police

Monday’s news of the failure of the debt ceiling negotiations in the US ahould not have come as a surprise to anyone who has followed this issue. Disheartening, sad, and ultimately dangerous to our economic well-being and Global Stability, yes, but unexpected, no. Recovery Partners was interviewed on that very topic yesterday and the full interview is avialable here in part 1 and part 2 or you can watch an abridged version on our site.

On Monday  Zerohedge posted a note on Austria, entitled “35 Seconds Of TV Air Time Explaining Why Austria’s AAA Rating Is Doomed“. Most of the discussion focused on the massive Central and Eastern European credit exposure. According to them, massive bank credit losses and a sovereign downgrade is a sure bet as well as the fact that contagion has spread to several Central and Eastern European economies.

Elsewhere on the Continent, the Sovereign obligations of Eurozone countries were getting smoked as spreads against German bonds blew out across the board.  Looking ahead at the heavy borrowing calendars for many of these countries the picture does not look good.

In related news, European stock markets dropped Tuesday after an expensive bond auction for Spain and as data showed that the U.S. economy grew at a slower pace in the third quarter than initially estimated.

Also today, IMF Managing Director Christine Lagarde said in an e-mailed statement to accompany a press release annoucing the creation of a new IMF fast-track liquidity facility. “This is another step toward creating an effective global financial safety net to deal with increased global interconnectedness.”  It is no surprise as these announcements came as Europe’s crisis threatens to spread to Spain and France. The real “non-announcement” here is that this is happening because the Euro-people have yet to implement the Bailout plans agreed to weeks ago in part because the EFSF has become non-functional and incapable of producing needed funding for cash-starved Euro-governments. This despite the recent publicly announced intentions to ramp up the EFSF to between EUR 1 and 2 Trn. How ironic it is that just over a year ago on the establishment of the EFSF, that Olli Rehn, EU commissioner, boasted that the EFSF would “never need to be used”. Now it is obvious that, apart from some half-completed bailouts, it has proven to be of extremely limited effectiveness and can no longer function.

And earlier this morning it was reported by the FT that the Chinese Banking Regulator (the CBRC) announced that the Chinese Property slump exceeded the test limits of the Chinese bank stress tests. In April, the CBRC told banks to test their loan books against a 50 per cent fall in prices, and also a 30 per cent fall in transaction volumes. In October, however, property transactions fell 39 per cent year on year in China’s 15 biggest cities, according to government data. The weaknesses in the Chinese scenarios echo earlier problems with stress testing in the EU, where regulators underestimated the potential impact of a sovereign debt crisis.

Joining the party, the Fed announced new stress tests for the top 19 US banks to take place between now and January and having the results announced by March 2012. There are six large banks that are going to attract particular focus according to the Fed press release and accompanying statements.

Watch this space.

Early Warning Systems and all That

During my time in New Zealand I remember seeing lorry loads and trainloads of sheep, cattle and pigs being packed off  to the slaughter houses and knacker’s yards. Over the time I was in that beautiful country, I observed the behaviours of these animals as the transport vehicles rumbled past and this left me with the indelible impression that these creatures somehow knew that something ominous was afoot….even though they could not read, write or understand a sentence of English, much less the road map.

 This brings to mind the OWS movement which appears to have swept the globe as a phenomemenon that defies definition. The OWS movement seems a jumble of contradictions: it professes respect for the enviroment but its activities have destroyed parkland and befouled inner cities with garbage and human waste; it professes respect and fellowship for citizens of the countries in which it staging its protests, yet it’s activities have significantly interfered with the commercial interests of small businesses and their employees, threatened passersby with violence and has otherwise commanded the attention of our law enforcement authorities to the deriment of others who might actually have benefited more from their attention at a particular time; and yet all along it professes to be able to “see the future” and is therfore justified in attempting to change that “fate” for everyone’s benefit. Moreover, in conversation, not one of the OWS protesters has been able to articulate a coherent vision, objective or group mission that all OWS protesters can agree with.

 The ultimate irony of the OWS “movement” however lies not in the paucity of substance, it lies in the fact that what little substance its demands and prescriptions contain, all seem to feature demands for exactly the wrong thing. This is quite simply that  the common thread among OWS protesters is that they are screaming for : more Government, more state control, more handouts, and generally speaking, for the Government or some other central authority to “solve” their problems. This is precisely the wrong prescription delivered at a time when the reality is that the cause of many of our challenges today is that the modern Welfare State has run out of rope, our political structures have not responded well to recent challenges and, combined with the demographic picture, that there is simply is no more “wealth” to be “spread around”. The choices Western society confronts today all revolve having to make do with less. That is the Bottom Line that the OWS is ignorant of at a fundamental level.

This “movement” in its present state will therefore likely fade away shortly and none too soon. Although the OWS folks sense that “something is wrong” in the world, they, like the animals on the way to the slaughterhouse, cannot articulate what it is they sense and fear, and, because of that and other inherent limitations, they are in no way equipped to devise strategies or action plans to avoid whatever fate awaits them, nor by the same token, to be able profess that they can render such advice to anyone else.

Given the present unsettled state of the world the real issue for clear-thinking people is: “What comes next after these “occupiers” fade into the sunset?”

For more on that, please dial in to Part II of our Canaries Blog series in 24 hours.

Posted in Bond Market, Canada, Crisis, Crminal Activity, EU, Fed Policy, IMF, OWS, Sovereign Debt, USA | No Comments »

Greeks ‘R Us

“Money for nuthin’ and checks for free” Dire Straits

While the world’s attention this week has been focused on the sovereign debt crisis in Europe, a time bomb planted much closer to home has continued ticking away, yet it is virtually unnoticed. That problem is the massive debt piled up by American state and municipal governments over the past several decades.

Lavish spending on social programs together with an unwillingness to even consider raising new revenues means a number of American states, most notably California, are heading down the same road as Greece and other European countries. Social programs such as EBT, which are richly satirized in this video, combined with the pillaging of the state treasury by the public sector unions have resulted in the impending bankruptcy of America’s largest state.

And nobody seems to care.

California is governed by, and for the benefit of, it’s elected and other public officials. The State legislature has gerrymandered itself into highly partisan electoral districts where the incumbents for each party are safe. They each play up to their base; the Democrats by buying people off with taxpayer dollars, and the Republicans by refusing to raise taxes in any circumstances. So everyone gets re-elected while the state slides inexorably towards bankruptcy.

Today, in 2011, the average Californian has debts of $ 78,000, and an income of $ 43,000, so blowing borrowed money is normal to them. Similar to Greece this virtual bankruptcy of the state is not a temporary situation brought on by a recession or a blip in economic activity. It is institutionalized. It is built into the way Californian power brokers run their state. It has become standard operating procedure. Overspending, openly bribing public sector unions with ever more generous pay and benefits, and refusing to raise new revenues in any and all circumstances, is the “new normal” in sunny California, home of the original Fantasyland.

As Michael Lewis points out in his new book “Boomerang”, California will spend $32 billion dollars on pay and benefits this year, up 65% over the past 10 years. Meanwhile education spending is down 5%, and health and human services payments are up only a scant 5%. Here are some example of the insanity: In California a prison guard who started his career at age 45 can retire after 5 years with a pension nearly equal to his salary. The head psychiatrist for the California prison system makes $838,706. In the meantime the state’s share of the budget for the University of California has fallen from 30% to 11 %. Tuition at the University of California has gone from $776 in 1980 to $13,218 today. “Everywhere you looked the long term future of the state was being sacrificed”, according to Lewis.

Governor Schwarzenegger tried to change things. He thought he had been given a mandate to do so. He tried working with Republicans. No dice. He tried working with Democrats. Nothing doing. He tried to sweet talk, he tried to cajole and he even tried to bully them. Nothing. So he then tried going over their heads to the people directly in a special election based on four reforms: limiting state spending, putting an end to gerrymandering of the state electoral districts, limiting public employee unions spending on elections and lengthening the time it took for public school teachers to get tenure. All four were defeated by sizeable majorities. Toward the end of his second term Governor Schwarzenegger finally managed to pass a slight tax increase by persuading four Republicans to help him create the supermajority necessary to pass the measure. Californian voters thanked these four brave souls by promptly defeating every one of them in the next election.

Closer to home things are not much better in Ontario. Over the past eight years the McGuinty government has so mismanaged Ontario’s finances that Ontario now has a budget deficit of almost $17 billion dollars and has increased the provincial debt by $100 billion to $ 235 billion. This was quite a feat considering that McGuinty created new taxes one after another and raised other existing levies.

Apparently, nobody in public life in Ontario believes that the McGuinty’s Liberal government debts will ever need to be re-paid. In last month’s provincial election barely a word was uttered by anyone about deficits, debt, and the manner in which the onus of re-payment can strangle an economy. Friday’s job loss figures in Ontario’s manufacturing sector is but one indication. Even the ostensibly “free market” Ontario PCs never mentioned that there might be a need for Ontarians to live within their means, for fear of frightening voters with the revelation that Ontario might not be able to borrow and spend in perpetuity.

As events in Greece have proven, democracy only works when citizens act in an informed and responsible manner in the best interest of the community as a whole. Grabbing as much as you can get and sticking someone else with the bill has not been a recipe for long term success. The combination of self serving and cowardly politicians and an uninformed and demanding public that insists on living in a world of make-believe in places like California and Ontario will have devastating consequences for anyone hoping to receive even basic public services in the very near future.

The recent speech by Edmund Clark, Chief Executive of the Toronto Dominion Banking Group is a laudable attempt by one of our most respected business leaders to bring these issues into sharp focus. It would be encouraging if more of our business and political leaders were to pick up on this message and become prepared to throw their weight behind a movement towards awareness and appropriate reform designed to create a sustainable fiscal path for our economy. There is literally no time to waste in trying to turn this state of affairs around, we are living beyond our means and there are no painless solutions.

Do Canadians want to see their future generations suffer from our legacy of profligacy or are we going to make the hard choices necessary to turn back the tide of self interest and greed in order to ensure that we avoid driving our society into the ditch?

If we allow the unthinkable to happen, we will only have to look in the mirror in order to see who is responsible for our miseries a few short years from now.

This Blog was written under the pseudonym of “Caol Isla” whose professional qualifications include the practice of law, two stints in the Prime Minister’s Office, Chief of Staff to two Cabinet Ministers and to two Leaders of the Opposition in Ottawa, comprising a total of 34 years of service at senior levels in the Federal Government and public affairs in Canada.

Posted in Canada, Crisis, EU, 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 »