Angela Merkel’s Frankenstein

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

Mary Shelley’s  Frankenstein 1818

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Now is the Time for Stronger Balance Sheets

Q:Do you know what a banker is?

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

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

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

The best time to:

(a) shop for umbrellas is before it rains,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tony Johnston

President

Compass North Inc.

www.CompassNorthInc.com

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

- revenues, profit & cashflow growth,

- debt & equity capital raised, and

- enterprise market value realized.

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

Welcome to the Roach Motel*

“When the blind lead the blind, both will fall in the water”

Old Chinese Proverb

In the last several months a number of politicians have been calling for a “firewall” to be erected between the PIIGS and the rest of Europe and the world that would stand in the way of the spread of financial contagion.

These clarion calls miss the point: Contagion is already here by virtue of the interconnectedness of  financial markets generally, and the central role played by the European Central Bank in backstopping each national banking market in Europe.

Not only are the limitations of the ECB arrangements becoming clear, the reality is now dawning on European bankers, politicians and policymakers that their efforts to contain the Greek, Irish and Portuguese debt problems have to date succeeded in only making the scale of the problems larger and render the probable outcome from this mess far more likely to involve a far more costly meltdown than would otherwise have been the case.

In the last year scarcely a month has gone by without the ECB announcing some kind of easement in its collateral rules thus enabling it to continue supplying liquidity to banks in the PIIGS and keep those Governments able to pay bills. Unfortunately this has only come at the cost of polluting its balance sheet with junk rated debt and vastly magnified the consequential risks and damages to its own solvency, and to its credibility as a central bank. [In March 2010 we downloaded the Operations Handbook of the ECB from its website.  It shows that the lowest rated collateral asset accepted by the ECB back then must have been rated at least single "A" by at least two major credit rating agencies. That document is available from us on request. As for the risk protocols today? Please read  Trichet's comments immediately below.]

In a related development, Jean Claude Trichet, the ECB President said that with Portugal now under the umbrella of the IMF and EU bailout, that the ECB would not seek minimum ratings requirements for Portuguese debt “until further notice”. The esteemed M. Trichet said that this was meant to remove “an element of pro-cyclicality on ratings agency announcements.” And in further reaction to the ratings agencies downgrading of Portugal, he stated that “a small oligopolistic ratings structure is probably not what is probably desirable at the level of global finance”  Zut, alors!! Plus ca change!!

We are now awaiting  M. Trichet’s reaction to the Moody’s downgrade of Ireland to “junk” status that was just announced today.

A few days ago, Bloomberg told us, that in an effort to stem deteriorating bond prices and escalating CDS spreads “European lawmakers voted in favor of a ban on short selling of government bonds in the EU unless traders have at least ‘located and reserved’ in advance the securities they intend to sell. The European Union Parliament in Strasbourg, France, also called for restrictions on traders’ use of credit-default swaps to profit from defaults on sovereign debt they don’t own.” The politicians apparently believe that If you don’t like what markets are telling you, then you should simply change the rules and paper over the inconvenient truths.

In the last 10 days revelations that the French plan to “re-profile” Greek debts would not pass the ratings agencies definitions of default provided further evidence that this is a problem that is growing like Topsy, but that is lacking a champion to tackle it. Anyone who has previously been involved in these kind of problem situations will recognize the importance of discussing these types of proposals with all affected parties – especially the ratings agencies – prior to approaching the market with any announcements. Clearly this was not done in this case, illustrating the lack of foresight, planning and communications protocols involved at the very highest levels of the decision-making structure.

Investors in Periperal EU sovereign debt issues, bank shares and short dated European bank paper have been flocking from those markets in droves, fearing the worst. Spanish and Italian CDS spreads have spiked to their highest levels since the creation of the Euro. The remaining PIIGS cannot fund in the open market.

Shares of European banks have dived, particularly in the PIIGS and the market is now fixating on the massive and looming debt rollover profiles of all European countries, but particularly the PIIGS.

These examples of recent developments amply illustrate that the entire debacle has so far featured “problem solving by committee” (and that no one on this “committee” has likely ever had to fund any portfolio or trade any assets – ever). Not surprisingly, the outcomes have been predictable.

The more the ECB compromises its balance sheet and the longer the EU/ECB/IMF Troika continues to insist that its remedies be applied in doctrinaire fashion, then the closer this crisis edges towards the inevitable blow-up and, it seems, towards an unwelcome event that will be far larger than any default may have produced a year ago. As a sidebar to illustrate this point in the case of Greece, whereas a haircut of 20% may have sufficed a year ago, now a write-down of at least 70% is probably required.

And finally, the EFSF is tapped out and its remaining resources are insufficient to fund another country meltdown. The authorities have blown the heavy artillery on a set of smaller problems, have failed to cure or contain them, and do not have sufficient firepower left in terms of Balance Sheet and Credibility to tackle what is now clearly coming down the track.

Leaderless. Aimless. Europe is about to take a dunking.

 ————-

“There is no Plan B to avoid default”

Olli Rehn EU Economic and Monetary Affairs Commissioner

* “Roach Motel” is a trademark of the Black Flag Corporation. Amongst traders, it also denotes a transaction structure that is impossible to get out of without losing a significant amount of money.

Posted in Bank Loans, Banks, Crisis, EU, IMF, Sovereign Debt | No Comments »

FATCA : The Empire Strikes Back

In this blog our friends at US Tax outline a key development in US tax policy as it affects US expatriates. Passed as a “stealth” component of the Hiring Incentives to Restore Employment Act of 2010 (”HIRE”), the Treasury and IRS hope to significantly increase expat tax payments and compliance rates. As Dr Thomas Walford and his colleagues Darlene Hart and Alan Cohen argue in this short note, there is substantial room to increase compliance rates and collections from the almost 7 million US citizens that live outside its borders…..Alex Jurshevski

What is happening?

Just over a year ago, we realized the impact that the new Foreign Account Tax Compliance Act (”FATCA”) legislation in the US  would have on the international community.   This requires all banks, finance houses, investment managers, insurance and trust companies to either:

1. send reports each year to the US IRS on those clients who are, or who have rights to, American Citizenship or are Green Card holders, or
2. suffer a 30% withholding tax on all income, dividends on any US Assets including US Dollars and the gross proceeds of sale of any US investment (equity or bonds).

To opt for the first, the financial institution needs to sign an agreement with the US Government which covers the reporting requirements and obligations necessary.

Why did the US do this?

After 2008/9 the US was left with a substantial deficit following the bail out of the banks and Insurance companies after the Lehman collapse and the sub-prime mortgage disaster.

In 2009, the IRS reported to Congress on the position of Non-resident Americans and their tax affairs.  Currently they are aware of 7,000,000 Americans who live outside the US, and each one needs and always has needed to complete a US tax return every year.  The US taxes on the basis of citizenship or residency.  In 2009 they received only 462,000 tax returns, a figure which represents only seven per cent of the total.  As a result we know that 93% of non-resident Americans are not tax compliant.

So why is it important?

The US taxes its people on Citizenship or Residency.  As a result anyone who has American citizenship (and income over $10,000pa) has to complete a US tax return each year and pay any tax that may be owing. 

If you are an US person, not completing a US Tax return is a criminal offence.

If the individual also lives in a country which has a Double Taxation Treaty with the US, then they can obtain a credit for the tax they have paid and only pay any premium over that amount to the US Government. As a result an employed person with no assets probably owes little in tax as income tax rates are higher in many countries than in the US.  However there are frequently situations where there are US taxes owing.

Is that all that is required?

No.  There are also penalties for anyone who has not completed a tax return form and submitted it within the correct timeframe.  These can amount to a substantial sum of money.  Up until 2009 it was rare for the US to assess penalties – but now in the new economic climate it has become quite regular.

Most non-resident Americans will operate a bank account in the country in which they live; probably more than one.  As part of the annual returns to the US Government American Non Resident individuals need to submit a Foreign Bank Account Form (FBAR).  If this is not submitted there is a minimum penalty of $10,000 per account per year that it has been missed.  If the US can show that the omission was deliberate or willful then the fine rises to $100,000 per account per year or 50% of the maximum balance.

These fines can amount to an extremely large sum.

So who does this apply to?

Anybody who has US Citizenship, a right to US Citizenship or Green Card Holders.  This means that it will include all people who:

• Were born in the US
• Have taken up American Citizenship
• Green Card Holders
• Anyone who has one parent who is American and lived in America for 5 years after the age of 14.

It does not matter if you have dual citizenship or live in another country.

Why is it important to Canada?

Canada has the largest proportion of Americans in the population compared with any other country in the world.

Analysis of number of Non-Resident Americans

                               
Population Stats from http://en.wikipedia.org/wiki/List_of_countries_by_population

Number of Americans from National Taxpayer Advocate 2009 Annual Report to Congress

Is there any way out?

Yes – the US Government has announced a voluntary disclosure Initiative (OVDI). This allows people to come forward who may not be in compliance and, if accepted, pay a fine and with immunity from criminal prosecution.  The fine is calculated as 25% of assets and they need to pay the back tax owed over the last 8 years.  Under certain circumstances the fine can be reduced to 5% for non -resident Americans who are Tax compliant in the country in which they live.

This scheme is only open until 31^st August 2011.  There is a 90 day extension if necessary and once accepted into the scheme, to complete all the tax returns required.

Any one who comes through the OVDI will be fully up-to-date with their tax responsibilities and hopefully will have an easy job in finding financial institutions to represent them.

What has changed?

The tax obligations of US persons has not changed.  What has changed is that the US Government may now receive a report of all US persons who are clients starting on 1^st January 2013 from any financial institution which opts to avoid the 30% withholding tax.  Most financial institutions are expected to do so.

What should US persons do?

They need to get their tax affairs up to date urgently.  Otherwise they risk being a named as a criminal and subjected to possible arrest and detention.

Who can help?

US Tax and Financial has an office in Tel Aviv and provides tax advice and consultancy services to individuals, companies and trusts as well as financial institutions.

US Tax has offices in London, Zurich Geneva and Tel Aviv and as such can help with a wide range of issues.

Please consult

Dr Thomas Walford

Telephone +44 20 7357 8220 or Cell +44 7769 707020

t.walford@ustaxonline.com

www.ustaxonline.com

Posted in Economy, Regulatory, USA | No Comments »

Fun With Numbers

“I am concerned about the fact that the recovery that we’re on is not producing jobs as quickly as I want it to happen,”  POTUS Barack Obama

President Obama has recently been chastising Americans for being too pessimistic about the future while at the same time continuing to push his high-spending agenda down the nation’s throat. Continued reliance on PR spin and blaming George W Bush for the country’s ills is no substitute for substantive steps to stem the red ink and deterioration of financial risk profile that his and his various predecessors’  policies have produced. Unfortunately, it is not only Obama, but perhaps the entire US leadership of the two mainline parties that have been ignoring the grim reality of the situation unfolding around them.

It is therefore of no surprise to us that Austan Goolsbee resigned several days ago as Obama’s Chief Economic Advisor in the wake of a slew of troubling economic numbers  (To which we might add, “Mr. President: What “recovery” are you referring to?”)

In this blog we examine some interesting statistics that we came across recently that these folks might do well to reflect on. For example, the unofficial number (based on the 1980’s calculation methodology) for the Misery Index at 25.3%, is now higher than it was under Jimmy Carter (21.8%) . Other statistics show that the US Government is now spending almost all tax revenues on entitlement programs while (ominously) financing the balance of its budgetary obligations by printing money. Paranthetically, no mention is being made by this Administration, or anyone else inside the Beltway, of the lack of Congressional spending authority for the warfighting operations in the Libyan quagmire and the newly disclosed “secret” operations in Yemen.

Here we go:

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)

Posted in Bankruptcy, EU, Economy, Fed Policy, Hockey, IMF, USA | No Comments »

Disappointment is Sinking In

Last week we were interviewed on the European debt situation a number of times. You can view the interviews on our webpages in the Newsroom section here and here.

As serious as the situation in Europe is, it is merely a distraction from the much bigger debt crisis now unfolding in the United States. Ominously, the latest jobs numbers and other statistics show that the US economy might be rolling over again. Without the boost provided by the 206,000 jobs magicked up by the birth/death hand-adjustment, the May jobs figures would have beeen minus 153,000 workers. Not only are the jobs numbers weak, real wages are shrinking as well, providing scant reason for any optimism that the consumer can support the economy going forward. In fact, retail sales are arguably showing negative growth (as is the real economy) if we were to adjust the nominal numbers using inflation statistics from the MIT Billion Prices Project (running at 7% annulaized in the last 3 months) rather than the deflators normally applied by the Commerce Department.

Moreover, in the last few weeks we have seen data that show hoouse prices falling to new lows, weakness in bank lending and a drop off in consumer sentiment. This and other soft economic numbers is probably why Ben Bernanke in a speech today suggested that monetary policy was likely to remain ultra-loose for some time.

Unsurprisingly, a number of establishment economists such as Paul Krugman are now calling for yet more fiscal and monetary stimulus in order to “create” more growth. What these folks and their many acolytes do not seem to undestand is that there is no shred of data that supports the idea that fiscal stimulus can produce any type of predictable growth response in the economy at all (this is most eloquently argued by our friend Steve Hanke in a recent piece in the FP). Moreover, mainstream economic thinking also ignores the corrosive balance sheet effects of large deficits and monetary experiments that involve neophyte bond traders – Ben Bernanke -  laying down fixed income risk positions that amount to a non-trivial share of US GDP in terms of nominal size. The bottom line is that this situation will contribute to a continuing impasse in the US as regards needed fiscal reform and consequent inertia in reining in an out-of-control deficit picture. Finally, the probability of a QE3 to follow a short time after the conclusion of the current highly experimental QE2 monetary stimulus program has now become almost a certainty – as we have been predicting for some time now.

 Buckle up. The ride is going to get bumpy again

Posted in Bankruptcy, Crisis, EU, Economy, Fed Policy, USA | No Comments »

Le Tigre Enchaîné

This past weekend we came across two really interesting items while reading the New York Times.

One was an op-ed by Paul Krugman that we actually happen to side with. In it, Krugman writes about the “Unwisdom (sic) of Elites” in terms of the reasons that the policies that got us into the financial mess in the US were more typically a product of narrow self interest of policy elites than demands by the public at large. It was this narrow self interest of the elites, according to Krugman, that got the US into trouble, so it is no use blaming the electorate for asking for “tax and spend” policies that pumped up real estate and the financial markets before the inevitable bust occurred three years ago.

In this connection, Krugman would do well to heed his own counsel in the matter of negotiating an exit from ruinous debt-based problems by continuing to recommend elitist solutions that pile on more debt.

…….Which brings us to the next gem that we found nestled in the pages of the venerable old paper; namely, the arrest of IMF Managing Director Dominique Strauss-Kahn at JFK Airport on charges of attempted rape and forcible confinement of a hotel chambermaid. This is not the first of such peccadilloes that have marked the career of this man. Indeed before the ink was dry on that story another woman had come forward with stories of unwelcome advances by the IMF’s top dog. Strauss-Kahn was denied bail at a hearing today.

The irony of this situation is not lost on many as the cartoon would indicate. It is the IMF together with its partner-in-arms, the ECB which has most strongly resisted any talk of restructuring debts for any Euro-zone countries. Today, ECB Economics Chief Juergen Stark even took to the airwaves to denounce any suggestion of restructuring as something that would inflict “massive harm” on the Euro-zone.

To us, it seems that the European authorities are again reverting to type. A year ago, the EU Sovereign Debt problem was “solved” with the creation of the EFSF (which would “never be needed” according to the ECB at the time). Then as the need for action became more obvious, massive bailout loans were forced onto a variety of countries. [The one exception here was Iceland which was all set to take on vast new debts in obeisance to the ECB and IMF until Recovery Partners addressed the issue directly with the Government there. The IMF / Nordic loan package was never closed and Iceland today is recovering albeit slowly and without the millstone of additional debt. The Icesave settlement has been pushed off as we had also earlier advised the Althingi to do.]

And, after the loan packages were doled out to the over-indebted countries, they were proclaimed healthy again by the EU honchos.

Now as the vacuity of this policy response is becoming clear, clarion calls denouncing restructuring of the debts are once again being mounted in order to avert any losses being pushed back onto the lending banks.

There is no way out of a debt problem by adding more debt to the mix. The unfortunate history here is that the IMF is an extremely creditor-friendly institution, as is the ECB. Their constituency consists in part of the largest banks in the world, and it is because of that, that these institutions are reluctant to recommend any policies that would act against the interests of these constituents, that a strict “no haircut” stance has been maintained by both.

The reality is that the debt problem in the EU is far from over. It is related as much to the lack of a framework of institutional bailout arrangements and enforcement mechanisms within the EU as it is to bad borrowing decisions by EU governments as well as bad lending decisions by Euro-zone banks. Eventually the piper will have to be paid. And, as we have observed in the past, the history of Governments under austerity succeeding in cutting back debt on a sustained basis is not encouraging. Moreover, the people of the EU have no desire to effectively become permanent tax slaves of the banks.

The impact of Mr Strauss-Kahn’s arrest on the ongoing debt talks in the EU is likely not going to have a material effect on the outcomes here. John Lipsky will do just as good a job in delivering the party line this week, and a permanent successor to Strauss-Kahn will soon be found. Over time however, the reality that some EU Governments are going to need more than just more debt and that  EU banks are going to have to take a chop and likely be restructured themselves (in certain cases) will assert itself.

Recognizing that many of the lending decisions that led to the current situation were bad is the only way that we can begin to dig our way out of this situation. The sooner that this happens, the better.

In the meantime, the important thing for those countries in debt difficulties is to ensure that they obtain timely, high-quality advice and have robust crisis management plans in place that will enable an exit from these problems with a miinimum of stress and social upheaval. 

Posted in Bank Loans, Banks, Crisis, EU, IMF, Restructuring | No Comments »

Euro-Danger

Last week Alex Jurshevski was interviewed on BNN regarding the just announced Portuguese Bailout.

Our opinion continues to be that the approach taken by the authorities in Europe is doomed to fail because it does absolutely nothing to address the underlying problems that led to the crises in these various countries in the first place. Portugal’s debt crisis has been brewing for over a decade and has very little to do with the Global Financial Crisis of 2008 except in the sense that it accelerated the tipping point for Portugal and certain other countries (Iceland comes to mind). Portugal was destined to fall over anyways because it was running an unsustainable policy mix that led to over-consumption, mal-investment, chronic current account deficits and budget deficits nigh of 5% of GDP for around a decade. The economic problems of Greece, Spain, Ireland and others are different. However the common denominator is that banks in all these countries are either overtly insolvent (Ireland) or in great danger of becoming overtly insolvent (everyone else in Europe)

Adding more debt to this mix, even at below market interest rates, does nothing to help out of this quagmire. A recognition must be made of the poor investment decisions by past lenders and a reckoning and triage be undertaken to get everyone back to a point of financial sustainability. However, the position and the IMF, ECB and the large countries continues to be that restructurings are to be avoided at all costs because this would threaten the financial stability of large numbers of banks. We agree. Large numbers of banks made lending decisions that did not adequately compensate them for the risks incurred. Moreover, they were encouraged in this by Basel Capital Rules that promoted Sovereign and quasi-Sovereign debt investments relative to infrastructure, corporate and retail lending.

This is the sad history.

In the present we note that the current Bailout Policy is part of a stealth subsidization strategy that aims to see banks re-capped away from the brink of insolvency by allowing them to “trade while insolvent”. Another component of these plans are to provide these banks with low-cost central bank funding that is plowed back into the markets against bond investments, yielding the banks  net carry. The bad debt problems are thus being snowplowed into the future in the hopes that underlying asset markets recover in response to looser than required monetary policy, and consequently, loan books skate back onside; while the carry income shores up capital deficiencies.

In our view this is a long shot plan because the problems are simply too big and widespread and the economies in question are too weak and in need of significant fiscal re-tooling. Thus, in part, the risks of this policy stance include much higher inflation (and ultimately a worse future crash) because of a slow central bank response to current signs of accumulating price pressures.  Other risks include a collapse of confidence in certain banks; (and as the dominoes continue to fall) ever heightening social and political instability in response to crammed-down austerity programs; and, an outbreak of bankruptcies as slow growth fails to produce needed revenue increases for many companies. Changes in the way these Governments run their Treasuries and Debt Offices must also be considered for the these plans to have any long term hope of success, but this too is being ignored in favor of temporary IMF technical support.

Et apres ca, la Deluge?

Posted in Bankruptcy, Banks, Crisis, Sovereign Debt | No Comments »

The Large Print Taketh Away and the Fine Print Giveth

“AAA/A-1+’ Rating On United States of America Affirmed; Outlook Revised To Negative

We have affirmed our ‘AAA/A-1+’ sovereign credit ratings on the United States of America.

The economy of the U.S. is flexible and highly diversified, the country’s effective monetary policies have supported output growth while containing inflationary pressures, and a consistent global preference for the U.S. dollar over all other currencies gives the country unique external liquidity.

Because the U.S. has, relative to its ‘AAA’ peers, what we consider to be very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable.

We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.”

Nikola G Swann, Standard and Poor’s 18^th April 2011

The “bombshell release” yesterday by Credit Ratings Agency Standard and Poor’s was greeted by most media as a “Wake Up Call”, that a “Government Bubble was targeted” and that the Ratings Agencies “now mean business when dealing with the US Government and its spendthrift ways”.

In reality the announcement yesterday seems to us more of a giant PR wheeze that doesn’t necessarily mean that anything much will change at all. In fact, in our opinion, the intent of the entire exercise is to allow the can to be kicked a little further down the road rather than to initiate substantive action.

For starters, there was nothing in the report that is new information as far as the US fiscal situation is concerned. Nor does the report set out what would constitute grounds for a return to stable ratings status other than some vague language about “deficit cuts greater than $4 Trillion”. This is an obvious soft target for politicians on both sides of the House and Senate to aim for and hit at some pint in the next three years.

Secondly a variety of academic studies have shown that credit ratings have and announcements of ratings changes tend to have almost zero predictive power. Typically these announcements are made after the event and tend to confirm what the market is already reflecting in terms of relative risk. What is surprising here is that the markets have held up as well as they have to this point.

Thirdly, the US Government has been on negative ratings watch before. Fitch put U.S. debt on a “negative ratings watch” in November 1995 until spring 1996, and Moody’s put some U.S. government bonds on review for a possible downgrade in January 1996.

Fourthly, The Chinese for their part laid down the gauntlet in November 2010 when Dagong Credit Rating Agency downgraded the US to A+ with a negative outlook. “Who listens to Dagong?” one might ask. The answer is that they only need one client – the Chinese Government – and if the ratings threaten to fall below single “A” (the typical investment cut-off for central banks and Governments); what that client does or what it tells the market in intends to do with its holdings of US dollars and US Treasury debt is of vast significance. We already know that the Chiness have cut back on their Treasury holdings. What this tells us is tha the largest offshore holder of Treasuries thinks that they have already turned into a bad deal, not that they someday might.

Fifthly, having been myself involved in Sovereign Ratings negotiations as a Sovereign Debt Manager I can assure our readers that much of what was announced yesterday and the reaction to it by Treasury and Fed officials was long planned and stage-managed in advance through a cooperative effort between the US Government and the Ratings Agency in question. Typically nothing is left to chance – in this case including the opportunity for Treasury and Fed spokespeople to flood the airwaves AHEAD of the S&P annoncement with their views on US creditworthiness. 

What we also find hugely risible (if were not so deadly serious) is the references the S&P makes to “effective monetary policy” and “unique external liquidity” in the US. The reality is that QE is an untested experiment that has been shown to feature a variety of unanticipated second order effects, some of which are contributing to various asset bubbles and civilian unrest; and that by itself, QE poses a huge re-entry problem for the Fed and US Financial markets (if not a treadmill to financial oblivion). Moreover, US “liquidity” is simply the ability of the Fed to print money at will. What S&P is really doing here is lending its credibility (or what is left of it) to supporting the massive money printing that the Fed has engineered. This policy is attracting huge and unprecedented criticism, even from within the Fed, but we are supposed to beleive that this is “AAA” finacial leadership for the world?

The practical effect of the announcement was thus designed in many ways is to provide positive support (through the imprimatur of the S&P analysts for a continuing AAA rating) for the current financial posture of the US rather than to apply a rational, transparent analytical framework to US finances and come up with a coldly objective assessment of creditworthiness. If the S&P had done the latter, they would undoubtedly have come to the same conclusion as the IMF did almost one year ago when the economists on 19th Street concluded that the US needed a fiscal adjustment on the scale of Ireland or Greece to stabilize matters, rather than some nebulous level of deficit cuts “above $4 Trillion”. Ireland is rated BBB+ (also a wheeze – they are bankrupt) and Greece is rated BB- The latter just auctioned 2 year bonds at yields in excess of 20%.  Note that the US fiscal position has measurably eroded from one year ago as has the economic outlook.

In view of the foregoing one must ask whether the country still rates an “AAA” rating by any conceivable rational and objective yardstick.

Some two weeks ago at a Euromoney Conference here in Toronto, our friend Barry Allan, Founder and President of Marrett Asset Management, summed up his views of Credit Ratings Agencies thusly:

“I don’t understand the reason for the existence of these organisations. In the first place they operate from a privileged position because any borrower who wants a rating needs to pay them to obtain one. This opens up the whole process to significant risk of professional conflict. And then, if the ratings provided are shown to be too sanguine by subsequent developments (and they frequently have been), there is no financial or other sanction assessed against the Ratings Agencies for the misdiagnosis and consequent losses to investors. This does not conform to any other rational business model that I know of.”

Posted in Banks, Bond Market, Crisis, Economy, Fed Policy, IMF, Sovereign Debt, USA | No Comments »

Fantasyland

‘I can’t believe that!‘ said Alice.  

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

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

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

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

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

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

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

The Top Six Impossible Beliefs  

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

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

The Sorry Details Start Here

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

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

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

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

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

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

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

Catch-22 ?

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

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

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

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

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

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

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

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

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

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

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

 Are all of the big banks solvent? Unlikely!!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

End Notes

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

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

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