October 2nd, 2012 Alex Jurshevski
The Maginot Line, named after the French Minister of War Andre 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 limits, 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.
July 24th, 2012 Alex Jurshevski
This month’s Recovery Partners Blog features a double-barreled treat: Direct access to the latest Ipsos Reid Global Advisor Analysis released just this morning, followed by commentary by Dr Lloyd Atkinson summarized from a speech he delivered in Toronto almost two months ago, and who, with his customary prescience, seems to have anticipated the very gloomy findings of the Ipsos Reid missive.
According to Canada’s leading pollster, “If economists and others expected a full recovery rebound based on this trajectory they would be sadly mistaken. The theory goes that a rebound looks like an alphabet letter: a “V” or a “U” or maybe a “W”. However, what is evident now is a new letter: “L”. This flat line has had a long run now so we can actually add it to the lexicon. Clearly the region that is the worst is Europe for obvious reasons and if not for Germany’s constant and robust confidence, it would be a forgone basket case.”
Further, according to Ipsos Reid, “By two months time we’ll probably know the measure of the malady. Let’s hope it’s a passing chill and nothing more.” The full release of the survey findings and analysis are provided here and the Ipsos press release is here.
Now let’s turn to the summary of the address given by Lloyd.
THE GLOBAL DEBT BOMB: CRISIS IN REALITY OR THINKING?
By Lloyd Atkinson
The global debt problem — especially the global sovereign debt problem is so pervasive and severe that we are virtually guaranteed several years of sub-par growth characterized by low employment growth, low inflation, low interest rates and low overall stock-market returns. About the only thing not likely to be low is financial market volatility. But it is not the only possible outcome. It could be so different, so much better, if our leaders were to adopt a very different approach, which I will discuss here. One warning however:, the policy prescriptions are so startlingly different from current policies virtually everywhere in the Western world that they are unlikely to be championed by most politicians or electoral majorities, at least for the next while.
Austere budget policies, in the form of expenditure cuts and/or tax increases, are the near-universal response to burgeoning government debt. Look at Greece, Portugal, Spain, Italy and virtually every other nation state in the European Union; look at the federal, provincial and municipal governments in Canada, and Federal and State & Local governments in the U.S. As many critics have pointed out, the implementation of such austere policies may actually make the debt/deficit problems worse. The proposed solution by those critics is clear: expand government spending and/or cut taxes to reinvigorate the economy. The problem with this view is that there are circumstances when expansionary fiscal policies will work, and other circumstances when they will not. Unfortunately, the debate over the matter almost never gets properly cast.
What was lost in all of this tumult and which is still not understood by a great many commentators is that each of the peripheral Euro-zone countries had violated the most fundamental law of macroeconomics: it is not possible for any economy to sustain a level of total economy-wide spending larger that its total economy-wide income. It can be done for a while by borrowing or by printing money but even those avenues have their limits: in the case of borrowing, the ultimate loss of confidence of lenders; and in the case of printing money, inflation, or in the extreme, hyperinflation.
We all need to be reminded of this basic fact: the total income available for distribution, or redistribution, is no more or less than the total value of its production of goods and services. If fiscal actions undertaken by government have the consequential effect of causing total national spending to exceed total national income, the outcome will not be sustainable. Borrowing, or, where available, printing money, are stopgap measures only. Either national spending has to be reined in, or total income increased in ways that are sustainable.
I am led to one ineluctable conclusion: Governments and their leaders can never see the writing on the wall until their backs are to it? Maybe that’s just human nature.
But is not the U.S. in more or less the same boat? What is taking place there is one of the messiest fights ever over the proper role and size of government, a debate that has never really taken place in Europe, and I dare say, in Canada. The U.S. tax code is a mess, and so are the Medicare and Medicaid programs. But don’t doubt that they can be fixed in ways that are much easier than in Europe. Second, the U.S. has the ability to print money, the most popular means these days being called quantitative easing (QE). Indeed, since quantitative easing is all about the purchase of assets “toxic and otherwise” by the U.S. Fed in exchange for money, the U.S. Central bank has accumulated a huge portfolio of securities in the past few years. And while the creation of money in that way was essential to the rescue effort following the 2008 crisis, there will come a day with the return of more normal financial market conditions when the Fed will have to unload its portfolio of securities which will present its own challenges.
Notwithstanding the extensive use of quantitative easing, and major fiscal stimulus, the U.S. economy has been performing sub-par. In part this has to with the fact that the 2008 crisis hit the economy so hard that all these measures provided only partial offsets. Monetary policy, in the form of near zero interest rates and quantitative easing, has been the only policy tool holding the whole thing together.
It would appear that Canada has fared quite well by comparison, the result in part of a more conservatively managed and regulated financial sector that has stood up well against the onslaught, and a good bit of luck, most notably the strengthening in commodity prices that provided much welcome offsets to the weaknesses taking place elsewhere in the economy. But to acknowledge this good fortune, it would be wrong to conclude that all is well. When one looks at the combined Federal, Provincial, Municipal debt/deficit totals, there is not a lot to brag about: as percentages of GDP, both are not much different from the U.S., and by further comparison with the U.S., we have a lot less tax wiggle room.
It should be apparent from this discussion that the task facing the world economy of righting the ship listing under the weight of global debt is indeed daunting. But in truth, that is only the half of it!! The globe not only must struggle with burdensome sovereign debt matters, it has to do it at the same time as it tries to meet the crushing new demands being imposed by the relentless aging of populations
The challenges posed to policymakers by aging populations are double barreled. To meet the needs of the elderly, whose average life expectancy keeps advancing, ever greater resources must be provided by those who are producing the country’s goods and services, in other words, from those who are working. However, over time, and at an increasingly rapid pace, the percentage of the population made up of workers will be shrinking. To illustrate, Canada this year, for the first time, is experiencing more exits from its workforce than entrants. And although today there are about 4 workers per 2 retirees, by 2030, the numbers will be 2 to 2.
Why are these ratios so important? Because meeting the resource demands of the elderly must come from each country’s national income; that is, from the employed population. The alternative? To pare back the support for the elderly: cut social security payouts; cut health care benefits; cut other elderly programs; impose or expand inheritance taxes. This would be construed as an assault on hard-earned entitlements. And as the elderly continue to make up an increasingly large percentage of the eligible voters, this concentration of political power is unlikely to change dramatically even if the young get out to vote.
Virtually every major country is drowning in debt. Debt service costs eat up huge amounts of the budget, a situation that can only get worse once interest rates move from their current emergency low levels to more normal levels as the economic picture stabilizes and then improves, as it most assuredly will, maybe four to five years down the road. Because of a double whammy effect, continued sluggish growth as the world economy struggles to bring debt down to more manageable levels resulting in only a slower pace of sovereign debt growth, not a decline; and the gradual increase in interest rates as world growth strengthens, carrying with it further increases in sovereign debt to meet higher debt service costs, the overall debt burden has little or no prospect of being much lighter four or five years from now, unless economic growth were to speed up significantly.
So what is the prospect of a sharp advance in global growth in the years and decades ahead?
As far as labour force growth is concerned, the numbers almost everywhere promise to be low. For decades the birth rates in most of the so-called developed world have been well below the 2.1 rate needed to replace the population. In any event, the point to be made is abundantly clear: if labour force growth is all we can rely on, then we are in for some very challenging times. Bluntly put, it will not be possible to both service significantly larger amounts of government debt and meet the needs of an aging population without very material increases in taxes and/or sharp cuts in program spending.
This of course leads naturally to the discussion of productivity. Improving productivity is, the only reliable and sustainable way of getting out of the mess we find ourselves in. To get to 4% real growth in the economy year after year, which is what I estimate is necessary to throw up the revenue needed by government to meet current program requirements and service the debt — means compound growth in labour productivity of almost 3% per year. To achieve anywhere near that rate will be judged by some as near impossible given that, notwithstanding a great many government initiatives in that direction, including material cuts in corporate taxes, we in Canada have been able to eke out productivity gains of barely 0.5% annually for a long time.
A great many things can be done to improve production efficiency. At the top of the list has to be business investment, the well-documented source of strong productivity growth over time and across countries. Why business investment in Canada has been so weak in the past few years is a mystery to me, even after taking account of the uncertainties created by the financial crisis in 2008. The strong Canadian dollar combined with the notable improvements in many business balance sheets should have been a much stronger spur to investment. But it did not happen.
There is also much more that Government can do. But in order to justify the more it could do, there first has to be a better acknowledgement of the magnitude of the daunting tasks we face to meet both the debt/deficit challenges and those of our aging population. Only then could we set about the task of rooting out inefficiencies wherever we find them
The point of the whole exercise to improve productivity is that there will result a higher level of national income, and we are all aware that higher incomes generate higher tax revenues.
Sticking with the revenue theme, there is much more that governments could do to generate savings that could be used to meet the needs of the elderly and debt service/retirement. Consider major reform of public sector pensions and benefits that have been talked about ad nauseum in the press; significantly raising the age of eligibility for CPP/QPP and OAS to possibly 75; rewriting the Canada Health Act to permit private enterprise. This suggests that no one should kid himself that anything less than draconian measures will bring about the conditions necessary to meet the needs of current and future generations. And as draconian as the measures must be here, rest assured they will be more gut-wrenching overseas in Europe.
Lloyd Atkinson is an economic superstar who offers authoritative perspectives on international economies, financial markets and global trends. A captivating speaker, he has the ability to explain complex issues in applicable, understandable terms.
For nine years, Dr. Atkinson served as Vice Chairman, Chief Investment Officer, and Chief Strategist at Perigee Investment Counsel Inc.
Prior to joining the investment management industry in 1994, Dr. Atkinson was Executive Vice-President and Chief Economist at the Bank of Montreal where he also served as the head of the bank’s Investment Committee of the Pension Fund Society. Previously, he spent four years working for the United States government in Washington, D.C., first as Senior Advisor at the Joint Economic Committee of the U.S. Congress, and then as Deputy Assistant Director of the U.S. Congressional Budget Office. He taught economics and finance at a number of American universities, including the University of Michigan and the University of Maryland, and has also served as a consultant to the U.S. delegations at the International Monetary Fund and the World Bank.
June 26th, 2012 Alex Jurshevski
Somebody should have referred to the title quote before the EMU was launched on a hope and a prayer only 13 short years ago. Yesterday we were again interviewed on the Euro-crisis as that event took another turn for the worse and continued its torturous progress towards what now seems increasingly likely an uncontrolled dissolution of parts of the Grand Experiment.
Today we heard that Euro politicians are drafting federal plan to save the Euro-zone, that Moody’s has downgraded 28 Spanish banks, that a fellow named Yannis Stournaras has been named as Greece’s new finance minister, but also that the Greek Deputy Shipping Minster has resigned. And…wait, let’s not forget that Silvio Berlusconi has just thrown his hat into the ring to be Italy’s next Minister of Finance…You win some, you lose some.
Hope now fixes on the upcoming Euro-zone meetings this week. Euro-zone finance ministers are expected to hold a conference call tomorrow to discuss Spain and Cyprus’s requests for financial help, and there will inevitably be a lot more posturing ahead of the EU Summit scheduled for this Thursday and Friday
Again there are calls for Germany to take on the mantle of leadership and somehow bail everyone out. So far the Germans have been balking at calls for an end to the austerity push, to support the unification of fiscal policies and the issuance of jointly guaranteed Eurobonds and for the creation of an EU-wide deposit insurance mechanism. The problem with this view, that if only Germany were to change its stance, and then everything could be easily solved, is that it is naive in the extreme.
As I mentioned during the interview, even if Germany were to agree to all of these Grand Plans, the structural imbalances that gave rise to the crisis in the first place will not be resolved, economies will not resume growing, and a new crisis will rear its head in short order. Quite simply the periphery countries have a productivity disadvantage relative to Germany and also have uncompetitive wage structures relative to the Northern Europeans. This cannot be easily patched.
Moreover, we also know that in order for Germany to agree to such modifications to its membership in the EMU, it requires the Government to hold a public referendum on all of these changes. We also know that an overwhelming majority of Germans are not in favor of these new policies which see them subsidizing the zombies. (In fact, a recent poll showed that 69% of Germans want the Greeks out of the Euro)
Isn’t it time for the leadership of Europe to start talking about solutions that are actually possible instead of fantasizing about magic bullets?
Isn’t it time for the Europeans to stop the madness of throwing vast sums of money at what is in effect a bad trade?
"Quick operator, gimme the number for 911!!"
What Europe has needed from the very beginning is a reckoning and write down of the bad debts. They are on the books and won’t go away no matter how many policies are changed and how many bailouts are doled out. This “avoidance of loss recognition” has been the central aim of the bailout policies from the beginning. As we can now easily see, clinging to this strategy is causing a worsening of the loss position, causing a loss of confidence and contagion and promises to only increase the eventual size of the financial hole. This is being pursued nonetheless in the faint hope that the losses can avoided or pushed onto third parties that had no hand in manufacturing the crisis in the first place.(The taxpayers of other countries and future generations)
The only certainty that we now see regarding this miserable state of affairs is that there will be massive losses and that the eventual bill when it comes due will be much, much larger than it would have been two years ago when there was still a chance to nip this thing in the bud. Let us hope that that is where the similarities of our present condition with the 1930’s will end.
June 13th, 2012 Alex Jurshevski
(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.
May 22nd, 2012 Alex Jurshevski
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.
April 19th, 2012 Alex Jurshevski
“There is a sucker born every minute” PT Barnum
Recent events in Toronto must be causing David Pecaut, to spin in his grave.
Over the past few months the legislative agenda at City Hall has imploded, throwing the political process into turmoil and imperiling the budgetary and planning imperatives. This ongoing political circus was temporarily upstaged by the Donald Trump circus, which moved into town briefly last week for the grand opening of the Trump Hotel and Condo Tower; a garish and undersold property development at the corner of Bay and Adelaide.
We then were treated to a story in Toronto’s tabloids about the owner of the Bunny Ranch bordello in Nevada declaring his intentions to expand his business into Canada. Sixty-five year old, Dennis Hof, together with his business partner and pneumatically-gifted paramour, Cami Parker (twenty-five), told the papers in part that his establishment aimed for Toronto, will allow patrons to dress up as Captain Kirk and play with Princess Leia. Perhaps. But to me the thought of someone more than ten years older than me calling a woman that is younger than my oldest daughter, his girlfriend leaves me more than a little weirded out. Isn’t the general rule for these type of age-difference relationships half your age plus seven years?
No matter, the trailer park theme moved into absolute top gear when the issue of allowing Casinos into the City was again raised by a number of City councillors. Coincidentally, one of the casino supporters was past brothel-booster Giorgio Mammoliti who said that Single mothers could hit the jackpot with a Toronto Casino. Appearing as a guest on Mayor Rob Ford’s Newstalk 1010 show, Mammoliti floated the idea that a casino in Toronto could create 10,000 jobs for residents. The idea appeared to get additional legs when opinion surveys of dubious provenance were trotted out to demonstrate that a small majority of Torontonians were in favor of the casino idea. Some councillors have even gone so far as to advocate extending tax breaks to Casino operators in order to attract them to Toronto.
The reasons why local politicians want to expand gambling as a form of industrial and jobs initiative is understandable on one level: Any new initiative which brings with it the allure of thousands of new jobs, expanded tax revenues and economic development can give the appearance of economic salvation. However, the degree to which this motivation is being exploited by gambling interests and their supporters and to where this could lead if the issue was left un-evaluated on its true merits is a serious matter that should concern all Canadians, and not only those residing in Toronto and environs.
Until recently, most research on the effects of gambling on local economies was conducted by special interests friendly to the gambling industry; or, in more brazen cases, by the very people and gaming companies in search of new places to exploit people through the legalized gambling mechanism. In fact, in 1999 the United States published a very comprehensive study of legalized betting in the United States. The Gambling Impact Study called for more research into what was then the largely unexplored area of the social and economic costs of legalized gambling.
Since then, a large body of evidence and data-based research has been established on the basis of years of experience with legalized gambling in the US, Canada and elsewhere which addresses in detail what the social costs and second order effects are, and why it is important not to just consider the jobs and spending parts of the equation in isolation.
For example, with the exception of the cluster services associated with gambling, casinos tend to put pressure on surrounding businesses. In Atlantic City and elsewhere, small business owners testified to the loss of their businesses when casinos came to town. As evidence of this impact, few businesses can be found more than a few blocks from the Atlantic City boardwalk. Many of the local businesses remaining are pawnshops, cash-for-gold stores and discount outlets. One witness noted that, in 1978 [the year the first casino opened], there were 311 taverns and restaurants in Atlantic City. Nineteen years later, only 66 remained, despite the promise that gaming would be good for the city’s own.
In another example, bankruptcies in Iowa increased at a rate significantly above the national average in the years following the introduction of casinos. Nine of the 12 Iowa counties with the highest bankruptcy rates in the state had gambling facilities in or directly adjacent to them. After gambling was legalized in South Dakota, gambling become one of the leading causes of business and personal bankruptcies.
Data from other US states is consistent with this general profile and the bankruptcy phenomenon also prevails in Canada, as these pictures of downtown Niagara Falls which were taken after the Casinos moved in, will attest.
According to the US National Research Council, As access to money becomes more limited, gamblers often resort to crime in order to pay debts, appease bookies, maintain appearances, and garner more money to gamble. In Maryland, a report by the Attorney General’s Office stated:[c]asinos would bring a substantial increase in crime to our State. There would be more violent crime, more juvenile crime, more drug- and alcohol-related crime, more domestic violence and child abuse, and more organized crime. Casinos would bring us exactly what we do not need: a lot more of all kinds of crime. Another study found that gambling behavior was significantly associated with multiple drug and alcohol use.
In a Canadian study casinos were positively associated with both rate of theft and robbery. And a recent RCMP investigation conducted in British Columbia found legalized and other forms of gambling intimately connected with gangs, the Mafia, money laundering, prostitution, drug addiction, robbery and extortion.
Obviously law enforcement costs escalate in these situations
Once gambling enters a community, it has been established that the community undergoes many changes one of which is that local government becomes a dependent partner in the business of gambling. Politicians end up being beholden to the gambling industry whether explicitly or implicitly. In recognition of the problem of corruption, in some US states, it is now illegal for officials to accept contributions from gambling interests.
Individuals with gambling problems constitute a very high percentage of the homeless population. The Atlantic City Rescue Mission reported to the Commission that 22 percent of its clients are homeless due to a gambling problem. A survey of homeless service providers in Chicago found that 33 percent considered gambling a contributing factor in the homelessness of people in their program. Other data also substantiate this link. In a survey of 1,100 clients at dozens of Rescue Missions across the United States, 18 percent cited gambling as a cause of their homelessness. Interviews with more than 7,000 homeless individuals in Las Vegas revealed that 20 percent reported a gambling problem.
But what about these high-paying Gambling jobs?
The reality is that there aren’t many high-paying jobs. After the initial fillip to the economy provided by the construction of the facilities, casinos are far more eager to place slot machines into the building rather than to hire and train thousands of dealers and other casino employees. This is because each slot machine can bring in $100,000 per year of revenue and doesn’t demand a sick day, benefits or overtime and needs only the occasional dusting for maintenance. Casino workers pay averages around $24-30,000, not high-paying by any stretch.
Moreover, recent Canadian research has shown that Ontario casino workers are at exceptionally high risk for developing gambling problems and the attendant side effects. Employees’ gambling behaviors were found to relate to various workplace influences and employment variables. Casino employees in Ontario interviewed in the study exhibited problem gambling rates over three times greater than those of the general Canadian population.
Gambling Addiction has been recognized as a clinical psychological disorder. Today, millions of families suffer from the effects of problem and pathological gambling. As with other addictive disorders, those who suffer from problem or pathological gambling engage in behavior that is destructive to themselves, their families, their work, and even their communities. This includes depression, drug and alcohol abuse, divorce, homelessness, and suicide, in addition to the individual economic problems discussed previously. While the impact of these problems on the future of our communities and the next generation is indeterminable, it is clearly much larger than zero.
If you are a single Mom, do you now still crave those jobs as Mammoliti suggests you should?
The Bottom line
Unfortunately, this is not where this sobering news ends. Research in the US indicates that for every dollar legalized gambling contributes in taxes, it usually costs the taxpayers at least three dollars. These costs to taxpayers are reflected in: (1) infrastructure costs, (2) relatively high regulatory costs, (3) expenses to the criminal justice system, and (4) large social-welfare costs. Another researcher, Professor Grinols, found that Casino gambling in the US causes up to $289 in social costs for every $46 of economic benefit. Put differently, Grinols said, “The costs of problem and pathological gambling are comparable to the value of the lost output of an additional recession in the economy every four years.”
Accordingly, several US state legislators have called for at least partially internalizing these external costs by taxing all legalized gambling activities at extremely punitive rates.
It is for all of the reasons enumerated above that Putin’s Russia outlawed gambling and casinos in 2009.
But aren’t Singapore and Nevada big success stories?
If there are all of these costs and negative externalities why is Singapore still a prosperous city-state with two mega-casinos located within its borders? Simple, this is because only foreigners can patronize casinos for free. Citizens and permanent residents must pay a $70 entrance fee or a $1400 annual pass to enter a casino. The hefty admission price, which is collected by the government, discourages impulse gambling, a Singapore official explained. To fill the casinos, promoters ferry in high-stakes gamblers, known as whales, from neighboring countries.
Nevada is also unique. Roughly 85 percent of Nevada’s gambling revenues come from out-of state tourists. Thus, Nevada receives the economic benefits of the dollars lost to gambling, while the attendant social and economic impacts of unaffordable gambling losses are inflicted on the families and communities in the states and countries from which those individuals come. Every gambling venue in Canada is far more reliant on spending by citizens in a far more concentrated geographic area and so would never be able to position itself to reap this kind of benefit unless it imposed Singapore-type disincentives on the local population (in which the case the known costs would still be inflicted on someone else, and more importantly the fundamental rationale gambling interests have for locating the Casinos in Canadian cities would evaporate)
A destination gambling mecca was never any part of David Pecaut’s vision for Toronto and it is hard to see how it is a part of any rational vision for the city or for Canada now or at any time in the future either. The promised benefits do not exist in the magnitudes advertised and are in any event significantly outweighed by the expected costs. Moreover, the predictable second-order effects of casino activity as described in the research are positively nightmarish.
Torontonians and all Canadians should not allow themselves to be buffaloed into a rash and unwise decision on this matter by the large-scale gambling interests and any venal, shallow-thinking facilitators that they might be connected with, and who are in positions of decision-making authority.
The facts are out there and it is time to consider them seriously.
Alex Jurshevski was intimately involved with the GBP 1500 MM acquisition of UK gaming company William Hill Bookmakers by Nomura International in 1997 and, far from being puritanical on the issue of wagering, is an avid poker, blackjack, bridge, backgammon and snooker player.
If anyone wants a full bibliography of the research material on which the forgoing article is based beyond the hyperlinks provided above, then please drop us a line.
March 11th, 2012 Alex Jurshevski
The recent discussions of the possible adoption of the Canadian Dollar by Iceland as a domestic unit of account and medium of exchange seem to have shot out of nowhere like a bolt from the blue. In fact, this opportunity was born of the financial crisis some four years ago and has been akin to a stew pot at the back of the stove quietly burbling away until good and ready. The writer has some knowledge of this as he had been discussing the adoption of loonie with a variety of Government officials more than two years ago. This was around about the same time that Iceland was in the midst of the Icesave referendum and being harangued by various international agencies into accepting bailout monies that it did not need, along with other financial measures that should not have and did not adopt.
Last week Canada’s Ambassador to Iceland cancelled a scheduled press conference where it was expected that he would lay out the benefits of a monetary concordat with Canada in detail. Why? Well, because the arrangement probably makes too much sense and would provide too many benefits both political and economic – to both Canada and Iceland. An assortment of vested interests, largely the same ones that were bludgeoning Iceland several years ago did not approve, and their lobbying against rationality appears to have gone into overdrive when it became readily apparent that this idea was getting some legs.
The history between Iceland and Canada stretches back well over a hundred years. Outbound emigration of Icelanders to Canada began in earnest following famines and the collapse of a set of flawed monetary arrangements within Denmark beginning in the 1870’s. Today there are sizable Icelandic communities in Canada. Gimli, Manitoba is in fact home to largest Icelandic community outside of Iceland. At the University of Manitoba students can learn the Icelandic language and literature. Each year the Icelandic Festival draws tens of thousands of people to Gimli including prominent politicians such as the Prime Minister of Iceland Johanna Sigurdsdottir.
This modern history of Iceland and Canada also includes a number of similarities: A keen devotion to democracy and fairness. Tolerance and respect for others. A respect for the rule of law. An affinity with nature and awareness of its frequent cruelties and the consequential need to prepare for bad times in good times and to prepare for changing weather and seasons. A sense of neighborliness accompanied by national pride, and a steely resolve to defend one’s interests. Emphasis on education and personal growth. A devotion to outdoor pursuits no matter what the temperature is.
In this latter regard it is little known, but the first Olympic Hockey Gold Medal ever was won by Canada in 1920 with a team from Manitoba named the Winnipeg Falcons. Most of the players were Icelandic Immigrants, some had even fought for Canada in the First World War before achieving sports immortality in the Olympic Games.
So the bonds run deep.
But why does this matter and why adopt a different currency?
This matters because Iceland knows that it must take some important steps to establish financial risk management firewalls that will protect against a repeat of the last debacle and to also pave the way for stable, predictable growth. Not in the least this is also because Iceland now has a substantial debt burden which must be responsibly managed. Iceland has never had a large debt burden and therefore this latter issue is very important.
In the case of Iceland the costs and benefits of an altered currency arrangement are clear. In the first instance the Canadian Dollar is tied to an economy that is much larger and more stable than Iceland’s yet its composition is broadly similar. Therefore the ability of Icelandic consumers, businesses and Governments to plan their activities would be greatly enhanced.
There is zero downside to this policy except that it would foreclose the possibility of adopting the Euro, an alternative that certain others have been touting. As we said two years ago to the Government: Why would you want to join a club where they beat you up at the door and rob you as the price of admission? Now we understand that today 60% or more of Icelanders agree with our earlier assessment. Moreover, the Eurozone is the grip of an intractable crisis that is being mis-managed and before it is over will make it seem like what happened in Iceland since 2008 like a walk in the park. In reaction to these policy failures, Europe is fast becoming more and more undemocratic, technocratic and desperate in its efforts to cling on to the last vestiges of a failed project.
For these and other reasons, an agency like the IMF, for example, should be in favor of the adoption by Iceland of the Canadian Dollar because it would help stabilize the Icelandic economy and provide a strong bulwark against the possible recurrence of any future financial crisis similar to the last one. And apart from this, there are many other benefits that adopting the Canadian Dollar would bring, including :
- lower borrowing costs for everyone in Iceland;
- a wider and deeper pool of investors for Icelandic bank, corporate and government debt;
- The availability of deep hedging markets that would make it easier for banks, governments and companies to manage balance sheet and income statement risks. This would likely make it possible to abandon the indexation of consumer financial contracts that caused so much pain and social division during the crisis.
- Access to the North American Free Trade area becomes a possibility;
- There would be no loss of sovereignty or resource rights as there would clearly be if Iceland opted to jump into the Eurozone.
- It would be a boost to trade flows;
- The financial efficiencies would improve productivity and competitiveness in Iceland;
- Closer cooperation on stewardship and management of Arctic and undersea resources would result in a bigger voice in international fora such as the Arctic Council;
- The Loonie would provide an almost impregnable defense against any attempts to run the currency against the Icelandic Central Bank and necessitate exchange controls;
- Access to an acknowledged first rate financial and regulatory system also becomes a possibility, and even if not adopted, the forgoing benefits would trigger a changed and hugely positive ratings picture for Iceland.
Iceland does not need anyone’s permission to adopt another currency, but it would be a boon if this were done in cooperation with Canada.
This article also appears under Alex Jurshevski’s byline in the Icelandic daily Pressan and can be viewed at this link
February 16th, 2012 Alex Jurshevski
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 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 â€œfirewallâ€ 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.
January 31st, 2012 Alex Jurshevski
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.
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 filesÂ 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 â€” 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
December 12th, 2011 Alex Jurshevski
“It’s interesting to note that 20 years later we have realized we have succeeded in creating a more stable foundation for that economic and monetary union, and in so doing we’ve advanced political union and have attended to weaknesses that were included in the system.” Angela Merkel, 9th December 2011
The weekend headlines blared a mixture of adulation and success: Resurgent Germany, Shrewd Sarkozy, Britain Isolated. In fact Germany is far from resurgent, Sarkozy is more reacting to events rather than leading solutions, and Great Britain’s refusal to submit to fiscal control from Brussels is hardly a surprise given that she is not a member of the Monetary Union.
Had the agreement for fiscal union been reached prior to the launch of the Euro that would have been extremely favorable news; and the fiscal controls, had they been made to work would likely have muted the breadth and depth of the current Eurozone crisis. But alas, we are not living in 1991. It is 2011 and the promised reforms are just that: promised, they still are subject to debate and ratification by each member nation. And then there is the question of sanctions against members who violate the proposed fiscal rules. If the enforcement mechanisms are too stringent, no national government will ratify the fiscal proposals. If they are too lax, the agreement will be toothless and incapable of serving as a bulwark against some future crisis.
But the real story is that the proposed agreement does not address any of the urgent and important issues that the Eurozone is facing right now. These stresses threaten the continued existence of the common currency. Last week’s entire exercise, and the posturing before, during, and after therefore must be judged as a lost opportunity of significant dimensions
None of the structural problems relating to pensions and entitlements spending in a large number of countries has been adequately dealt with;
At last count, large European banks are undercapitalized to the tune of over EUR 120 Bn. Moody’s Investors Service downgraded the three largest banks in France on Friday and said there was a “very high” probability that the French government would be forced to step in to support them if conditions worsened.
Fifteen out of Seventeen EU countries were placed on negative Creditwatch last week by Standard and Poors.
Greece, Ireland, Italy, and Portugal and Ireland cannot fund themselves at economical levels. Spain is arguably close to the borderline as is Belgium. Over the next 12 months the aggregate funding requirements for these countries amount to EUR 1000 Bn.
The EFSF is broken and no credible mechanism yet exists to replace it. Announcement of the formation date of the ESM as being in 2012 in place of 2013 does not make money available sooner until the ESM is actually funded. No updated funding plans were announced in the wake of the recent dud China funding effort launched in spectacularly disastrous fashion by Klaus Regler, the EFSF honcho.
There is no relief for countries suffering with austerity. The solution, according to Merkel and Sarkozy appears to be More Austerity!!. As we have said in the past, the track record of these programs is not good, and that reflects cases where countries were able to devalue their currencies. In the present scenario no Soft Exit from the Euro for the PIIGS and other sufferers is being countenanced by the Euro Leaders. It is only a matter of time before large scale social unrest erupts in one of these places and/or the austerity programs are abandoned.
- The IMF is washing its hands of this mess. In fact, there may no longer be any legal or politically palatable way to re-engage the IMF after this episode. Similarly, the US is adopting a hands-off approach.
- One recurring theme of this crisis in Europe (and North America) was also played out yet again in that it was obvious that there is no political will to force banks that made all of the bad bets to pay for their oversights.
- The other recurring theme is that markets have again been asked to wait “another three months” for the next installment of this sorry saga.
Looking at the list above it becomes apparent that there are actually more and deeper problems on the boil now than in the late Fall when the crisis seemed to be close to a blow-off phase.
The Euro Leaders are likely taking comfort from the fact that there has been a muted to slightly positive market reaction to the announcements of last week. The reality is that what they are really admiring is the market reaction to the efforts of the Euro spin doctors hired to generate false headlines, and not developments that are substantive and likely to contribute to renewed and durable confidence in Eurozone economic management or the Euro itself.
Being suspicious of free markets, what the current Euro Leadership does not recognize is that markets do not necessarily follow a rational path in reacting to information and do not process it in a temporally consistent and predictable manner. Recovery Partners believes that although a measure of calm has returned, it will prove temporary. This is because the ongoing failure of the Euro politicians to implement appropriate measures with enough speed and force to counter market pressures that are threatening the Euro’s survival is risking evaporation of what remains of the opportunity to turn things around. This is the fourth kick at the can this year. Each time anyone has looked for substantive progress, they have been left wanting.
For now, the relative calm in the markets is therefore more a reflection of year end book flattening and position squaring behavior rather than a true reaction to last week’s efforts of the Euro people to fix the problems. In a sense, it appears that a Prozac Bubble has formed to shield the markets from bad news in what is supposed to be a happy time of year.
Unless something intervenes to prick this Prozac Bubble, we will have to wait until the New Year to fund out what Mr. Market really thinks about the latest Euro-wheeze. Whatever the timing, in our opinion the reaction won’t be pretty.
Happy and I’m smiling,
walk a mile to drink your water.
You know I’d love to love you,
and above you there’s no other.
We’ll go walking out
while others shout of war’s disaster.
Oh, we won’t give in,
let’s go living in the past.
Once I used to join in
every boy and girl was my friend.
Now there’s revolution, but they don’t know
what they’re fighting.
Let us close our eyes;
outside their lives go on much faster.
Oh, we won’t give in,
we’ll keep living in the past
Ian Anderson, Jethro Tull