Confidence or else

In the final scene of Le Corniaud, a classic of French movie comedies, as they ride to the police station, a gangster (played by de Funès), is explaining to the naïf who helped in his capture (played by Bourvil) how to multiply his prize money.  The naïf is doubtful and de Funès can’t help but blurt out: “Don’t you trust me? But really, don’t you trust me?”

The US, Europe and China face their own economic problems, but the common obstacle towards their recovery is the lack of trust in which their citizens hold politicians.  And of course, the greater the needed sacrifices, the more people will insist that politicians be both competent and fair-minded.

Take the Greeks.  Here they were, spending their merry and voilà, they got into the EU, no questions asked.  And not only could they keep overspending, but now they could borrow all the money they wanted almost as cheaply as Germany. Was it their fault if they took free money, or was it the fault of the markets that threw the money their way?

The problem is that markets now want Greeks to become German-like overnight.  Other European countries would give Greece more time, if they trusted it.  And the Greeks themselves would likely bite the bullet, if they trusted that the pain would be shared among all parties, rich and poor, foreign creditors and fellow European nations.   

But whom to trust to lead them?  The Panhellenic Socialist Movement (PASOK) was in power when Greece joined the euro-zone; the New Democracy succeeded it and it was on its watch that serious deficiencies in public finance accounting were recorded; finally, PASOK came back in 2009 but its current leader, George Papandreou, has seen popular support evaporate.

With responsibilities for mistakes so evenly shared, it is understandable that no party is viewed as a savior and that the Greek population seems to prefer a coalition government.  Still, even if this is what happens, the task of the new government will be extremely difficult.  More austerity looks unlikely as not politically feasible.  Increasing the “haircut” on foreign creditors wouldn’t reduce public debt that much, and if it reached 75%, the whole exercise would look more like repudiation than restructuring.  A meaningful debt reduction would necessitate the ECB, the IMF and several governments accepting to take a loss on their loans, which is possible but, in some instances, would be a first.

Even if some combination of the above were achieved, Greece would still need to grow and become more competitive.  It is regrettable than privatizations, which could both help reduce the debt and form the basis of a more competitive economy, have been deemphasized lately.  This leaves only three possibilities: cutting salaries further, introducing permanent transfer payments within the EU or devaluing the currency. 

As I noted earlier, I think that further cuts in salaries are not in the cards.  Setting up permanent transfer payments is a possibility.  After all, exports account for 1/3 of Germany’s GDP, and of these, 63% go to the EU (35% or so go to the euro zone countries).  It is clear that countries like Germany (and the Netherlands) need a healthy Europe to which they can export in euro terms; their exports outside the euro zone benefit from being denominated in euro, rather than in a stronger deutsche mark.  For the richer members, it makes sense to permanently share some of these benefits with the poorer members of the euro zone.  But again, it is unlikely to occur in the near term.  Finally, there is devaluation, i.e. exiting the euro; this would offer immediate and sizeable financial benefits provided that such a move was accompanied by very tight management of public spending and inflationary expectations.

I think that the odds are 50/50 that Greece stays within the euro zone.  Staying, in my view, would necessitate the following: (1) the ECB, the IMF and European governments taking a “haircut” on their loans; if my memory is correct, some supranational institutions took a loss on their Argentine loans a decade ago; (2) the privatization program being expanded to up to $100 billion and implemented as soon as possible, with some features akin to the Chilean capitalismo popular in order to give the Greek population a share in its upside potential; (3) the coalition government implementing the adjustment program  more effectively than its predecessors, and (4) some sort of medium to long term transfer system at the euro zone level (there again, confidence will be key, confidence by the euro zone members that Greece will deliver on its promises, confidence by the Greeks that richer euro zone members will deliver on theirs).

Unless all sides can show results, confidence will collapse and we will be left with the exit scenario.  External financial assistance will be cut; this won’t be so difficult if European banks are recapitalized and Italy mends its ways.  The Greek population will refuse to sacrifice further, will reject traditional political parties and leaders; unrest and violence will grow; parties outside the mainstream will gain influence and by the end of 2012 the possibility of a military coup will have greatly risen.  Contrary to popular opinion, military coups usually occur because a sizeable portion (at least 1/3) of the population wants it, not because some general feels like grabbing power.  This would isolate Greece politically and economically and precipitate its exit from the euro zone.

Greece may still choose to exit the euro zone in a democratic fashion if it decides that it cannot bridge the productivity gap with the core of the euro zone, or if it decides that the costs of such an effort outstrip its benefits.

What is clear is that Europe must be rethought as it is becoming fragmented.  At present, we have the 10 non-euro countries, some of which have sizeable and vibrant economies (Poland, Sweden and the UK), we have a strong core euro zone (with the likes of Germany, France, the Netherlands, Finland), we have a weak euro periphery (Portugal, Greece, Cyprus) and finally some countries which could move into any of the above categories (Italy, Spain and Ireland).

If a euro zone with 27 members is not feasible, at least for a long time, what should Europe stand for?  If its purpose is to strengthen the economies of its members, wouldn’t a free trade zone achieve that, without the need for a common currency?  If the purpose is enhanced security, what is the need for a common fiscal policy?  What is the sense of a common central bank if this bank is not the lender of last resort?  Harmonizing fiscal and monetary policies is much more demanding than it sounds when one realizes that this necessitates harmonizing social, labor and defense policies too.   

For a thousand years, France, England and Germany’s predecessors have followed a policy of triangulation to advance their interests and keep rivals in check.  In a sense, the European Union was a way to keep tabs on each other, to get not so close as to surrender sovereignty yet close enough to discourage confrontation.  It might have worked if the Union had been limited to its founding members.  It wasn’t.  The status quo will not work.  Each nation, the wiser for the experience, must now decide what it wants and what price it is willing to pay. 

I think that the current financial crisis can be contained in a relatively short period of time if confidence can be restored.  It will take years to solve it and longer still for a new Europe to emerge.

Are European banks undercapitalized?

This is the subject of fierce discussions nowadays.  My view is that they are, and by a significant margin.

Capital is the ultimate cushion to absorb unexpected losses and to inspire confidence from market counterparties and customers.  In other words, carrying sufficient capital is an essential element of risk management and a cost of doing business.  Banks and their critics have argued that other elements need be considered as well, such as funding, customer profiles and reserve policies.

All of this is true.  European banks, by and large, rely more on wholesale funding than their US counterparts; this is evident when one compares ratios of loans to core deposits.  On the other hand, European banks point out that they do not net out derivative positions as American banks are allowed to do, and this is also true.

Perhaps the most telling indicator that European banks are undercapitalized is the fact that their risk weighted assets, against which they need to carry capital, represent a much lower proportion of total assets than they do at American banks.

To illustrate this point, we have selected four of the largest and best European and American banks.  Both European and American exponents include one bank with strong exposure to investment banking and one with a greater exposure to traditional commercial banking.  They are JP Morgan (JPM) and Wells Fargo (WFC) on one side of the Atlantic and BNP Paribas (BNP) and Deutsche Bank (DB) on the other.  For the European banks, we have also used their adjusted total asset numbers, meaning as reduced by netting out derivatives positions.

The results are eye opening:

	JPM at 9/30	WFC at 9/30	BNP at 6/30	DB at 6/30
Total adjusted assets	$2,289	$1,305	$2,175	$1,750
Risk weighted assets per Basel I	$1,221	$982	$863	$464
Ratio of TA/RWA	53%	75%	40%	27%

Let me reiterate that all four banks are presenting their financial results in accordance with the rules and regulations applicable to them.  I would also note that Wells Fargo is the closest to traditional banking, so that it makes sense that it has the highest TA/RWA ratio.  But recent history has shown that there is no such thing as a riskless financial asset.  Based on this observation, BNP and DB carry much less capital in relation to their total assets than JPM and WFC, and they are more exposed to a riskless asset, like a sovereign bond, suddenly becoming "risky" and therefore deserving of a capital cushion. 

From a common sense point of view, I submit that it is less risky to make relatively small loans to millions of customers who have checking and savings accounts with you than to hold billions in sovereign bonds or to extend billions in credit lines to banks whose actual risk profile is known, if at all, only to their management.

This is not to say that European banks should be demonized or punished.  It is close to impossible for major banks not to hold bonds from their own governments, and the dicier public finances get, the greater the pressure heaped on them to increase these holdings.  It is also understandable that, as the European Union developed and matured, they would want to expand their operations in neighboring countries.  Italy, now in the gun-sight of everybody, was a founding member of the European Community for Coal and Steel, back in 1951, and of every subsequent iteration up to the present day EU.

In that sense, these banks were not guilty of gross misbehavior, like making loans to borrowers who could not afford to pay current interest.  I can sympathize with European CEOs who clamor for their countries to get their act together and shore up their budgets and public borrowing needs.

But at the end of the day, counterparties and customers will determine the profitability and even the fate of European banks, or at least of their management and shareholders.  In this regards, European banks have been too cute, relying on rules that were too good to be true.  Perhaps because they enjoy much closer rapport with their governments than American ones do, they have forgotten that markets can quickly get unforgiving and ignore the best Power Point presentations.

With some exceptions, European banks need to raise fresh capital, now.

Dr Strangelove: or how I stopped worrying and love the debt

Major T.J. “King” Kong: “The contents of your survival kit is... one pair of nylons, five condoms, one .45 caliber pistol with two magazines, $200 in gold coins, 2 packs of chewing gum, one miniature bible and combination Russian phrase book... OOOOOWEEE, a feller could have a pretty good time in Vegas with all that!

To many investors there is a new doomsday machine, the European sovereign debt crisis, and they can be forgiven if they are mistaking European politicians for the cast of Stanley Kubrick’s famous black comedy, President Merkin Muffley, Premier Dmitri Kissoff, Group Captain Lionel Mandrake and General “Buck” Turgidson among others.

Unlike the doomsday machine though, this crisis can be stopped if decisive action in taken.  The one lesson of past financial crises is that authorities must get ahead of events and stop them by applying massive force.  Mexico in 1994 is perhaps the best example of that.

Unfortunately, the EU has done the opposite, partly out of pride (no, this is not Latin America, and no, we don’t need the IMF) and partly out of inexperience.  While the initial tab was put at €30 billion, it is now in the trillions.

As I have argued in this blog, there is no way for Greece to pay off or even service its public debt, and as a result, there is little incentive for it to make drastic adjustments; the Greeks, and other countries in the same situation, have to understand that they need to sacrifice as much for their own benefit as for that of their creditors.  This presupposes that the debt be significantly reduced both via “haircuts” and large scale privatizations.

Whether Greece remains a full member of the EU or not is not easy to answer.  In either case, it would need to make profound structural changes, as did Chile in the 1980s, otherwise, it would continue to stagnate (if it stayed in the EU) or would expose itself to exploding inflation (if it exited).  My view is that if Greece exited the EU it would probably not come back; as much as sticking to the euro would represent a headwind, being a member of the EU would maintain pressure on Greece to practice good economic management.  All things considered, it is probably best for it to stay in the EU.

The heavy lifting is really about Italy, and to a much lesser degree, Spain.  Quite simply, there is no EU without Italy. Germany and the rest of Northern Europe should know it and act in consequence.  Likewise, Italy should realize that not making the kind of adjustments that are necessary will sink the euro, and they will sink with it.

So for all of you in Berlin, Paris, Rome, Brussels and elsewhere in Europe, here is, one more time, Major T.J. Kong:

“Well, boys, I reckon this is it - nuclear combat toe to toe with the Roosskies. Now look, boys, I ain't much of a hand at makin' speeches, but I got a pretty fair idea that something doggone important is goin' on back there. And I got a fair idea the kinda personal emotions that some of you fellas may be thinkin'. Heck, I reckon you wouldn't even be human bein's if you didn't have some pretty strong personal feelin's about nuclear combat. I want you to remember one thing, the folks back home is a-countin' on you and by golly, we ain't about to let 'em down. I tell you something else, if this thing turns out to be half as important as I figure it just might be, I'd say that you're all in line for some important promotions and personal citations when this thing's over with. That goes for ever' last one of you regardless of your race, color or your creed. Now let's get this thing on the hump - we got some flyin' to do.”

Michael Phelps and me

I am a masters swimmer who particularly enjoys the 200 and 400 medley events.  As the new season begins, each member on our team sets his goals for 2011-2012.  Suppose for a second that our captain should tell me that my goals are too modest, that instead they should be to beat Michael Phelps and train in consequence, that anything less would be viewed as failure and evidence that I was a slacker.  I love swimming, I love training, but I think beating Michael is not in my cards.

Today, the Greek public debt represents anywhere between 160% and 170% of GDP, and with GDP shrinking hard, that percentage is more likely to rise than to drop.  The Greeks know it, the EU knows it and creditors know it too.  In fact, Greece is as likely to pay its debt as I am to beat Michael.

Yet the fiction of quasi full debt service (quasi because of the 21% haircut proposed on 2011-2014 maturities) is maintained.  This is proving little incentive for the Greeks (why should we sacrifice for an unattainable goal?), the creditor banks (why should we recapitalize now if we might drag this for another year) and the rest of the EU (Germany will eventually have to step up to the plate).  Worse, the whole affair is shaping up as a dangerous game of musical chairs, where the actors keep a wary eye on each other, ready to jump at a second’s notice, and where markets are gradually seizing up.

A better strategy would be to accept reality and provide the basis for a successful workout.  Greece can only pay a fraction of its debts but that should not result in a regional or global market and economic catastrophe.  Indeed, I believe that such a strategy would result in a sharp recovery in confidence and thus stock and bond valuations. 

Such a strategy would rest on two pillars: the first would be to reinforce those European banks that need it, most likely via capital subscriptions from the European Financial Stabilization Fund.  Bank valuations are so depressed now that relying on private capital is not feasible, except perhaps for a fraction of the amounts needed.  In this regard, it is crucial that the terms of the EFSF capital injection not be punitive, and this for two reasons: banks can be castigated for making bad loans but not so much for buying their country’s sovereign debts, and it is important for the future that private investors want to buy bank stocks.  TARP is a good example to follow.

The second pillar of the strategy would be to provide an incentive for Greece to make tough decisions.  This means that creditors should share in the pain and that Greece should share in the rewards of making sacrifices and revamping its economy.  The idea is not new and there are many ways to do so.  Obviously, refusal by Greece to try hard should be sanctioned severely by the rest of the EU.

It is the ancient Greek mathematician, Archimedes, who said “give me a fixed point and I will raise the world with a lever”.  What modern Greeks need is a lever to raise their energies, i.e. a reasonable baseline with a clear upside and downside.  And what I need is for Michael to give me a one minute head start, on the 200 that is.

Mrs. Merkel makes a good move

The widely leaked existence of a Plan B whereby Germany would support its banks and insurance companies should Greece default on its debt is a constructive move forward:

1. It attempts to delink Greece from the European and world financial markets.  As Mrs. Lagarde noted last month, banks are unfortunately very efficient instruments of contagion, so that strengthening them is the best way to contain the Greek crisis;

2. It sends a very clear message to Greece that Germany is not obliged to bail it out, particularly if it doesn’t fulfill its commitments.  By announcing Plan B, Mrs. Merkel defuses any possible blackmail from Athens;

3. Finally, it forces France, Italy and others to provide similar protection to their own banks, which in turns should stabilize the financial markets and set the stage for a realistic Greek debt workout.

Bond and stock markets have lost a multiple of Greece’s public debt in value.  It shouldn’t be, and this move by Mrs. Merkel is welcome.

Longer term, it is getting ever clearer that the Greek debt will be restructured along realistic lines.  While I originally thought that a wider privatization program could keep the total “haircut” at or below 20%, I no longer feel that confident.  Even if Greece embraced a €100 billion program, I don’t see how the haircut could be less that 40%.

Finally, the Merkel move is also a warning to Portugal and Ireland, although their prospects are not as dim.  As for Spain and Italy, there is no European plan yet.  Spain seems to be taking measures to reduce its deficit, but Italy is further behind, appears less committed and represents a much bigger challenge.  No doubt Mrs. Merkel will need to keep working hard.