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Faites vos jeux on a crisis bigger than US subprime
A Special Report by Leigh Skene and Melissa Kidd
Contents
Faites vos jeux on a crisis bigger than US subprime 1
Computer models versus looking at the acts 2
Seven EA problems 3
Governments and banks 6
Recapitalizing banks is deationary 7
Deaults are guaranteed, exits are better 8
The banking crisis 10
Contagion to the US 12
Global contagion 13
Commodities are another problem area 14
The coming crisis is fnancial, not economic 14
Europes core challenge 16
Alleviating and preventative measures 17
Hope rom the crisis-practised Emerging Markets 19
Better Emerging Market Banks 21
Conclusions 23
Last spin of the wheel
for Europes banks
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1
Last spin of
the wheel
for Europes
banks
Faites vos jeux on a crisis
bigger than US subprime
The Efcient Markets Hypothesis led to Rational
Expectations plus unquestioning aith in
computer models. Blind aith in their ability to
price complicated asset structures correctly and
to accurately identiy all possible sources o riskled to rapidly rising leverage typifed by the
European sovereign debt/banking crisis, which has
been gestating or a long time, but soared into
prominence when Greek borrowing hit a brick
wall in early 2010. Since then, bond markets have
generally interpreted the continuing declarations
o successul negotiations and imminent solutions
to debt problems negatively, equity markets have
generally interpreted them positively and currency
markets have see-sawed back and orth. Bond
markets have been right so ar, as the authorities
have compounded the ultimate losses by treating
solvency problems with excess liquidity.
This report will show that the prevailing conditions
that helped us escape rom some previous
episodes o excessive leverage have reversed into
headwinds. Europes counterproductive policies
and the excessive leverage in European banks
have made it the epicentre o todays fnancial
problems. The more ination prone Euro Area (EA)
nations, oten reerred to as Club Med, cannot
prosper in a hard currency fxed exchange rate
regime such as the euro, so would be better o
outside it. Exits (and deaults inside the euro)
will seriously damage the over levered EA banks.
That damage will spread globally, as many other
nations suer rom several o Europes difculties.
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3
being responsible or rating securities based on
home equity loans and sub-prime mortgages
AAA. Reliance on computer models also explains
the ailure to spot turning points. Only external
shocks divert models rom moving towards the
equilibrium position, so all orecasts tend to
be straight lines. Computer models dont, and
probably never will, identiy turning points.
Failure to adequately price complex fnancial
instruments, especially CDOs was a major actor
in the 200708 subprime crisis. Securitisation
eectively hedged the specifc actors leading
to deault, such as personal illness, but ailed
completely to address the risks common to the
entire securitized pool, such as an economic
downturn and rising unemployment. Investors in
the Euro Area (EA) mispriced sovereign debt or
a prolonged period o time, but or a dierent
reason the alse assumption that a common
monetary policy plus the political promise that
no country in the region could deault reduced
idiosyncratic sovereign risk within the euro. This
assumption led to higher risk EA economies
borrowing at low rates or a decade, thereby
building up excessive debts and external
obligations (see chart 1). For example, 10-yeargovernment bond spreads over Bunds or Spain
and Italy heading into the currency union and
until the fnancial crisis were very depressed (see
chart 2).
In addition, models assume a universe populated
with rational people who are acquainted with
all the relevant acts and act accordingly. No
such people exist or ever have existed. Desires
and ears, i.e. emotions, drive all human activity.
They are neither rational nor linear, so cant be
modelled. However, they do uctuate within
given parameters most o the time, so the
resulting behaviours can be modelled as long as
the emotions stay neatly within the parameters
and historical relationships continue. This is a big
ask and gives rise to another three problems thatbedevil model predictions. First, extreme events
pop up ar more requently than mathematical
theory predicts. Second, models cant predict
when an extreme event will occur. Third, they
cant give any reliable inormation on an extreme
event even ater it has occurred so the models
still cant incorporate the eects on economies
and fnancial markets o the reversal rom the
ever increasing leverage o the past to the present
deleverage.
Emotions exceeding known parameters causeextreme events, such as stock market booms and
busts. They are sel-reinorcing spirals upward
and especially downward that, once established,
keep diverging rom equilibrium until the driving
orces ade or stronger counter orces reverse
them. Ever-increasing desires or accumulating
ever greater wealth aster and aster ignited
a credit bubble that spiralled upwards until it
burst in 2007 rom a lack o new borrowers. The
multi decade credit bubble and its bursting were
extreme events. No model recognized the credit
bubble or its collapse and no model is givingany indication o the plethora o problems now
brewing in Europe.
Seven EA problems
Risky assets dont create crises. Assets considered
sae that prove not to be sae have created all
crises and Europe is no exception. People who
should have known better
assumed that European Central
Bank (ECB) acceptance o all
EA sovereign debt as collateraleectively guaranteed
repayment, minimizing the
credit risk o all EA sovereign
debt. In addition, the
misguided Basel zero risk rating
or all EA governments (that
cant print the currency they
borrow, so are ar more likely
to deault than governments
that can) made European
banks think loading up on peripheral nation
debt or a ew extra basis points in yield was
a no-brainer. (Unortunately it was literally!)
As a result, interest rates in sot currency (read
proigate) nations plummeted when they joined
the euro (see chart 2). Debt soared as a result.
-1
0
1
2
3
4
5
6
7
8
Jan 92 Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12
2. 10-year government bonds, spread over Bunds: Spain and Italy, %
Spain Italy
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4 Last spin of the wheel for Europes banks March 2012
This structure could have worked only in the very
unlikely event that the citizens o sot currency
nations immediately saw the light and changedtheir individual choices to conorm to Northern
European (hard currency) values.
Unsurprisingly, they didnt and are (rightly)
accusing core nations o rigging the system. Core
nations are determined to keep the sot currency
nations in the euro to hold the oreign exchange
value o the euro down but the ormers export
dependency greatly disadvantages the latter,
which needs exports to grow. Meanwhile, sot
currency nations became ever more uncompetitive
within the euro as their borrowing createdbubbles in real estate and government debt.
The bubbles burst and exposed the lack o ECB
guarantees, so fscal defcits o 10% o GDP and
more suddenly mattered. Nations have inated
and/or grown their way out o excessive defcits
and debt in the past and the European elite want
sot currency nations to do the same over the next
several years. Unortunately, thats impossible.
The actors that enabled nations to grow and/or
inate out o severe debt and defcit problems in
the past have been;
1 independent monetary policies,
2 ability to devalue,
3 positive demographics,
4 easily reduced spending due to the ends o
wars,
5 expanding global markets,
6 interest rates below nominal GDP growth rates
and
7 strong private sector balance sheets.
By contrast, EA nations ace;1 externally imposed one-size-
fts-all monetary policies,
2 an externally imposed
exchange rate,
3 negative demographics,
4 rising costs o entitlements,
5 increasing global
competition,
6 interest rates above nominal
GDP growth rates and
7 excessive leverage that is
creating continuing fnancial
crises.
Governments have used monetary policy and
currency devaluation extensively to grow and/
or inate out o severe debt and defcit problemsin the past. The euro eliminates these escapes
rom debt problems, making EA governments
ar more susceptible to deault than others.
Basel regulations ignored this added risk and
gave all EA sovereign debt a zero risk weight. EA
banks could own as much EA sovereign debt as
they wanted with no impairment o capital. EA
banks took ull advantage o this provision and
blew up (metaphorically) their balance sheets
with peripheral sovereign debt or a ew basis
points additional yield. Dierential ination rates
destroyed every fxed exchange rate schemeprior to the euro that did not involve political
union. The metaphor became reality when
higher ination rates in peripheral nations raised
their current account defcits and resulting
debt burdens beyond sustainable levels. The EA
eorts to rule out deaults too have guaranteed
depression in the peripheral nations as long
as they remain in the euro. The fve ollowing
problems extend ar beyond the EA boundaries.
3 Negative demographics
Chart 3 below shows the medium variant o the
UNs 2010 estimates o the population growth
o the fve largest European economies and
the US. Growth is alling or negative in them
all, guaranteeing aging populations. This is the
long-predicted demographic time bomb, which is
causing rapidly increasing age-related spending at
the same time as labour orce growth is shrinking
to negative. Future labour orces and incomes
will be too small to pay or the entitlements,
particularly age-related, that governments have
promised in perpetuity.
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
2010-15 2015-20 2020-25 2025-30 2030-35 2035-40 2040-45 2045-50
Spain UK Italy France Germany US
3. Estimated Annual Population Growth Rates
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5
4 Rising costs o entitlements
The Bank or International Settlements working
paper #300 entitled The future of public debt:prospects and implications, published in March
2010, concluded the debt to GDP ratios o all 12
nations studied, Austria, France, Germany, Greece,
Ireland, Italy, Japan, Netherlands, Portugal, Spain,
the UK and the US, would spiral out o control i;
1 government revenue and non-age-related
spending remained a constant percentage o
GDP and
2 Congressional Budget Ofce and European
Commission projections or age-relatedspending proved correct.
Reducing structural defcits by 1% o GDP a year
or fve years would still leave all the nations
with soaring debt to GDP ratios or the 30 years
projected except Italy, where debt would
stabilize at about 100% o GDP. I, in addition,
age-related spending was rozen at the estimated
2011 level o GDP, only Austria, Germany and
Netherlands would have peak debt to GDP ratios
under 100%. Japan and the UK would be worst
o with sovereign debts over 300% o GDP withthe US not ar behind at about 230%, including
state and local debt. The rest would have debt to
GDP ratios between 100% and 200%.
Sovereign fnances have deteriorated since that
study. Growth ranging rom weak to negative
and rising age-related spending have already
pushed many sovereign debt to GDP ratios past
90% the point at which both Reinhart and
Rogo and the BIS have shown debt becomes
a drag on growth. In addition, most o the EA
peripheral nations are already in a long and deeprecession that is spreading into the core. The next
two sections show the odds o reversing the rising
debt to GDP ratios are virtually zero.
5 Expanding global competition
Growth requires investing more in productive
acilities, but that is not happening in Europe
or two reasons. First, globalization has added
a billion or so workers in emerging nations to
the global labour orce. They earn low wages
by European standards, so investment and
production has shited to emerging nations andput downward pressure on developed nation
employment and incomes. Cost savings rom
this movement o production to emerging
nations increased corporate profts and created
productivity gains in national accounts but
added nothing to production, employment or
worker incomes.Second, small business is the biggest employer
and household deleverage hurts small business
disproportionately, so employment and income
growth have been disappointing in this recovery.
Real incomes are stable to alling, depending on
jurisdiction. Add in the tax increases intended
to reduce defcits and real disposable incomes
are alling aster than real incomes. Falling real
incomes render sustained GDP growth impossible.
The more inationary policies o sot currency
nations caused their rising uncompetitiveness. Notonly did this not happen (and cannot be cured)
overnight, but it also masked the act that several
other nations are headed into exactly the same
problems, albeit at a slower rate.
6 Interest rates above nominal GDP
growth rates
Rising borrowing costs make it very unlikely that
nominal GDP growth can rise to the current and
expected uture interest rates in Greece, Portugal,
Italy and Spain, so their fnancial conditions will
keep deteriorating until they radically reorm their
governments. France (et al) is not ar behind and
the April election is likely to bring about change
or the worse and debt restructuring is not
enough. They all will also have to recapitalize their
banks, reorm their labour markets to achieve
competitiveness, increase private investment and,
most importantly, restructure entitlements to
keep government spending rom spiralling out
o control again. None o these reorms are on
anyones agenda. Emerging nation competition
rules out private investment and the othermeasures will increase the short term pain, so
peripheral EA nation fnances continue to spiral
out o control until they deault.
7 Excessive leverage is creating
continuing fnancial crises
The underlying theory o todays fnancial system
is that all risk can be hedged and the dierence
between the return on a security and the cost
o hedging its risk can be skimmed risk ree.
This vision o risk ree return encouraged everincreasing leverage and debt to GDP ratios soared.
However, all transactions have counterparties
and rising leverage raised the probability o
counterparties ailing to ulfl their obligations.
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6 Last spin of the wheel for Europes banks March 2012
The ever-increasing leverage created a string o
fve credit bubbles that burst when counterparties
deaulted. They were:1 the Latin American credit bubble that burst in
the early 1980s,
2 the savings and loan debt
bubble that burst in the
early 1990s,
3 the Asian debt bubble that
burst in 1997,
4 the LTCM/Russian credit
bubble that burst in 1998
and
5 the housing bubble that
burst with the sub-prime
mortgage crisis in 200708.
The world o computer models doesnt
encompass credit bubbles and bank crises, so
banks, bank regulators and central banks didnt
see any o them coming. The frst our bubbles
were localized and their bursting easily contained.
None o them created major problems, so most
banks kept increasing their leverage, up to 50times net tangible equity and more. In addition,
nearly all bank balance sheets still contain hidden
losses because loans to weak borrowers and
securities o distressed governments remain
valued at cost until the borrower deaults. These
unrealized losses make many banks technically
insolvent, so most cannot aord to book losses
even i writing down debts would beneft both
the lender and the borrower. They would have
very substantial (in some cases negative) net
tangible equity i they had to mark their assets to
market, so any deault could be catastrophic. Theymust use most, i not all, o their resources to
keep their weak borrowers aoat, so every lender
rom the IMF to the bank on the
corner is delaying and praying
or, i theyre atheists, extending
and pretending.
Governments and banks
Governments did their best to
thwart most o the long overdue
correction in asset prices byrushing in to protect banks
during the Great Recession,
guaranteeing their liabilities
and bailing out ailing fnancial
and non-fnancial institutions. This temporarily
reversed the inability to meet liabilities and
consequent all in asset prices. This reprieveis only temporary because transerring bad
private debt onto public balance sheets simply
permitted zombie companies to compete with
more productive companies, thus postponing the
necessary corrections o imbalances and making
them more costly in the long run.
This delay and increase in costs is most obvious
in Europe. The still-inated values o sovereigndebt and loan collateral in both the household
and corporate sectors have generated rock
bottom price-to-book values across the European
banking system, as markets have recognized the
threats over valued assets pose to banks. Current
price-to-book ratios compared to their 7-year
averages imply banks will suer losses ranging
between 50% and 95% rom the book values
o their assets (see charts 4 and 5). Financial
markets can exaggerate potential losses, but that
is unlikely in Europe today. In act, Spanish bankprices imply the smallest EA losses and may turn
out to be underestimating them.
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
Germany France Italy Spain Greece Portugal Ireland Austria UK
4. European banks: price-to-book values
Cyclical average Feb 2012
-100%
-90%
-80%
-70%
-60%
-50%
-40%
-30%
-20%
-10%
0%
Germany France Italy Spain Greece Portugal Ireland Austria UK
5. Fall in book value reflected in current PB ratio (vs cyclical average)
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8 Last spin of the wheel for Europes banks March 2012
European banks must raise their equity ratios to
cover the potential losses on assets with market
values below book values. Investors in bankequity would pay or their purchases o equity by
drawing down their deposits, but adding to bank
capital does not create an osetting deposit, so
the money supply alls by the amount o capital
raised. In practice, lack o investors in bank equity
is orcing banks to shrink their balance sheets.
The money supply alls by the amount o
bank loans liquidated. Loan contraction orces
households and small and medium sized
enterprises which have no alternative source o
unding, to spend less and save more, thereby
lowering demand growth in the economy. Worse,
European banks are the main source o global
trade credit, so their loan contraction will hurt
global trade as in 200809.
Repairing bank balance sheets is strongly
deationary (see also EA problem #7 above).
According to Olivier Sarkozy, head o the Global
Financial Services Group o the Carlyle Group,
Europes banking sector has $55 trillion o assets,
our times larger than Americas. In addition,
European banks have $30 trillion o wholesaledeposits (10 times more than American) and need
to roll over $800 billion monthly. The ar greater
size o the European banking system, its higher
leverage o net tangible equity and its wholesale
unding exceeding deposits make Mr. Sarkozys
estimate that it needs $2 trillion o additional
capital look conservative.
The probability o European banks being able
to raise $2 trillion o capital is zero. Bank
recapitalization ultimately depletes household
incomes through a combination o higher taxes,artifcially low interest rates and increased bank
charges. A $2 trillion or more hit to European
incomes is out o the question. As a result,
European banks will be shrinking their balance
sheets over the intermediate term. Private
borrowing is the mechanism that turns bank
reserves into money, so money and credit growthrequires creditworthy borrowers that are willing to
borrow an endangered species. Small business
remains mired in the Great Recession while many
households ace alling real incomes and are
trying to delever too, so ew are either willing or
able to borrow. Turning bank reserves into money
and credit also requires banks that are willing
and able to lend. Their desperate need or capital
makes them an even rarer species.
The traditional money making machine cannot
unction until household, smallbusiness and bank balance sheets are
repaired. Capital constraints on banks
and borrower caution on adding new
debt prevent the excess reserves rom
becoming loans and creating money, so
the excess bank reserves central banks
created by monetizing government have
had no eect. By contrast, ECB purchases
o illiquid sovereign debt did help reverse
the decline in EA M3 in 201011.
However, the declines in each o the
last three months (see chart 7) indicaterecession and urther declines in the money
supply.
Deaults are guaranteed,
exits are better
EA restrictions combined with excessive leverage,
negative demographics, the rising cost o
age-related entitlements, expanding global
competition and nominal GDP growth below
interest rates have made the current policy o
unding more debt until Club Med grows out odebt problems impossible. Even so, hard currency
nations are increasing the problems by imposing
austerity in an eort to rule out sovereign deaults
as well as the usual palliative, devaluation. Lacking
either escape, Greece, Portugal and Ireland are
unavoidably in deep depressions with no relie
in sight. Unsurprisingly, money and people are
eeing those nations in droves. The real estate
woes o Spain and extremely slow growth in Italy
mean theyre not ar behind.
There is not enough money on the planet to keepbailing out insolvent European governments and
banks orever. Growing and/or inating out o
their debt problems is impossible. More borrowing
merely increases the losses when the inevitable
80
100
120
140
160
180
200
220
240
Apr 98 Jul 99 Oct 00 Jan 02 Apr 03 Jul 04 Oct 05 Jan 07 Apr 08 Jul 09 Oct 10 Jan 12
7. Eurosystem M3 (April 1998 = 100)
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9
deaults occur. The European Financial Stability
Facility (EFSF), its successor the European Stability
Mechanism, even the IMF can only postponeinevitable deaults. Eurobonds wouldnt be any
better borrowing cant solve the problem o too
much debt. Deaulting within the euro would,
at best, be a temporary palliative because, in the
long term, sot currency nations cannot prosper in
a hard currency monetary union without continual
transer payments. Adequate transer payments
are very unlikely, so the sot currency nations
will have long depressions unless they negotiate
the re-denomination o their oreign held euro
liabilities into their local currency and leave the
euro.
Unsuitable nations leaving the euro are not a
problem. Ultimately, thats the only way the euro
can survive, yet exits will occur only when all else
has ailed. Greece received the 8 billion required
to enable it to keep paying its bills in December
even though the October 26 accord had not
been approved by the 17 EA nations at the time
o writing and the proposed haircut o over 70%
on privately held debt is still ar too little to put
Greece on a frm fnancial ooting. Assuming the
accord is ratifed and the militant hedge undsorced to comply, it will soon be back in this same
predicament. Nevertheless, this accord would be
the template or urther deaults because it avoids
a ormal declaration o deault, so is deemed to
be voluntary and doesnt trigger CDS payouts.
Rising leverage increases risk exponentially, so
appropriate hedging is vital to the high leverage
in modern fnancial markets. Eorts to restructure
the Greek deault into a not-deault to avoid CDS
payouts may change the rules on what triggers
a payout retroactively, thereby eviscerating thehedging unction o CDS. Fear o the inability to
hedge is lowering demand rom non-fnancial
institutions or and raising the yields on debt
with the weakest credits suering most.
To avoid a banking crisis pending a solution
to the sovereign debt crisis, the ECB bought
distressed sovereign bonds under its mandate to
buy government and private bonds as needed to
provide depth and liquidity to the markets. The
monetary base has risen at an annual rate o over
50% rate in the last six months yet, as explainedabove, M3 has been alling in the last three, so
the ECB version o QE has not been keeping up
with loan shrinkage. The ECB has begun LTRO
auctions at the policy rate, currently 1%, with
lowered collateral requirements. This will keep
the banks liquid, but liquidity can do nothing to
reduce their insolvency. Liquidity can buy time,but the rapid deterioration o sovereign balance
sheets make time an enemy, not a riend.
Sovereign debt does not entail risk weighted
capital, so these loans enable capital-constrained
banks to und their governments with a
handsome carry that will increase profts and add
to capital. The bigger than expected take-up o
489 billion by 523 banks (net about 250 billion)
on December 21 and the drop in yields in recent
sovereign auctions endorse the design and value
o the LTRO to maintain liquidity under extremeconditions. The sharp increase in overnight
deposits at the ECB, however, highlights the
ongoing solvency concerns among EA banks. They
preer to deposit overnight at low rates rather
than bear higher credit risks in the interbank
markets. The ECB balance sheet has exploded to
2.73 trillion and the loan collateral is becoming
ever more suspect and the liquidity created is
augmenting, rather than reducing solvency
problems (see page 12).
As a result, the cadre o creditworthy guarantors
o the 1.1 trillion o debt now committed to
holding the EA together is diminishing, so EFSF
debt has been downgraded not or the last
time. Egan Jones, the only major lender-pay
ratings company (borrower-pay ratings companies
tend to ollow it), has downgraded Germany to
AA- and it remains on negative watch. Financial
markets have recognized European eorts to
sustain the misallocation o capital will ail and
recently have priced in a 94% chance Greece,
a 61% chance Portugal, a 46% chance Ireland
and a 35% chance Italy will deault in fve years.The situation is deteriorating with Portugal where
Greece was last year and Italy where Portugal was
last year.
Private demand or Spanish and Italian debt
apart rom repos with the ECB is virtually zero.
Unsurprisingly, European corporate (and some
sovereign) debt markets remain very thin and
corporate borrowing has allen signifcantly, even
though Asian nations have invested an estimated
1 trillion o their reserves in European bonds
in an eort to sustain their European exports. Iears about CDS hedging prove to be justifed, a
wholesale liquidation o risk assets that investors
had believed to be hedged will occur and credit
markets will shrink substantially.
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10 Last spin of the wheel for Europes banks March 2012
O course, Europe doesnt have a monopoly
on insolvent banks, but its banks now pose
more systemic risk than insolvent banks in othernations. Like others, EA nations guarantee their
bank deposits and und defciencies rom bank
ailures by selling bonds. Weaker nations would
have to sell the bonds to the bailout mechanism,
currently the EFSF, which, in turn, will sell bonds
to outside investors. The solvent EA nations
guarantee the EFSF bonds, so will have to pay
any losses that occur, which explains Northern
Europes over emphasis on austerity. The EA elite
are trying to spread this liability across the globe
through more IMF participation in the bailout
mechanism. Understandably, the reception to thisidea is cool, so this contingent liability weighs
ever more heavily on the remaining AAA rated
nations as sovereign balance sheets deteriorate
and ratings all. Moreover, the costs o bailing out
rise as the EFSF rating alls in line with those o
its guarantors threatening a downward spiral in
ratings.
Bund yields remain at or below similar term
Treasury yields, showing fnancial markets
(correctly in our view) expect Club Med exits
rom the euro, not greater EA integration. Evenso, European debt unds have reported regular
outows and a large amount o European
money has moved to the US, accelerating US
money growth. More than hal o bank unding
in continental Europe comes rom institutional
investors. This unding is evaporating, putting
many European banks in a liquidity squeeze so
bank borrowing rom the ECB has soared, as have
Euro interbank lending rates. The three month
Euribor rate rose to more than one percentage
point over the generic European treasury bill rate
last September, warning o a probable banking
crisis this year.
US money market unds (MMFs) have been
steadily reducing their exposure to European banks
since May 2011 and replacing it with increasedexposures to Australia, Canada, Japan and US
Treasuries and Agency paper (see chart 8). The
greatest percentage decline was in France. Reliance
o EA banks on this unding is non-negligible, with
MMF exposures account or as much as 4% o
short-term liabilities among European banks.
The Fed has eased the consequent shortage o
dollars with swap agreements with several central
banks to keep the dollar down, but the cost o
borrowing dollars in exchange or euros remains
elevated, even ollowing a cut in the cost o dollarliquidity provision by the major central banks at the
end o November. Helpul as it is, dollar liquidity
cannot oset euro deleverage. In addition, the
long and deep recession that has now begun in
Europe will cause soaring private sector deaults.
Agreements with the EA already utilize hal o the
EFSF and o the IMFs increased lending capacity.
Requests or urther increases are running into sti
opposition.
The banking crisis
In previous episodes o deleverage, signifcantpublic sector deleverage began only ater nominal
GDP growth had rebounded. The section on the
EA problems listed the seven actors that
acilitated the rising private sector growth
in the past that enabled the ollowing six
steps. Some, but not necessarily all, o
these steps are required to grow and/or
inate out o debt problems.
1 Recapitalize the banks to enable
sustained loan growth.
2 Reduce government spending.
3 Reorm o labour policies to lower
unit labour costs.
4 Devalue the currency to enable net
export growth.
5 Increase private investment.
6 Stabilize the housing market.
The section on the EA problems also showed all
seven acilitating actors have been headwinds
since the 2007-08 banking crisis, and as a result;
1 EA banks are shrinking loans,
2 governments are raising taxes,
3 workers are rioting against change (except
-100%
-80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
France Euro Zone Europe UK Nordic Australia Canada Japan
8. US money market funds: % change in exposure (May 2011 to Dec 2011)
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11
Ireland), so unit labour costs remain too high,
4 currency devaluation is impossible,
5 private investment is shrinking and
6 ultra cheap mortgages are preventing the
stabilization o housing.
No EA authority has shown the slightest icker
o comprehension that the credit bubble has
burst, that the era o continuous borrowing rom
the uture with excess debt creation is over and
that the Eurozone is exacerbating the pain or its
southern members.
The Greek economy never recovered rom the
Great Recession and global conditions plus theimposition o increasing austerity give it no
reasonable prospect o doing so in the oreseeable
uture. Instead, it depends every three months
on unanimous authorization o bailout unds by
27 nations plus the IMF. Authorization depends
on Greece ulflling targets or budget defcit
ratios o GDP, which it never does. In act it never
can because alling GDP raises the ratio as ast
as or aster than reduced defcits lower it. Both
Greek opposition to the imposed austerity and
the impatience with the rising costs o Greecesbailouts and its perpetual ailure to meet targets
are rising and the last payment to Greece has not
yet been authorized (see page 9).
Only authorization o the October 26 agreement,
being able to orce the recalcitrant owners o
the debt maturing on March 20 to abide by
that agreement without triggering CDS payouts
and derailing the eort to put the new bonds
in a legal jurisdiction with some teeth (private
investors who unknowingly bought subordinated
loans at senior loan rates want the next deaultto be a true one) will maintain the European
Ponzi scheme o insolvent banks supporting the
insolvent governments that are guaranteeing the
liabilities o the insolvent banks. Getting over this
hurdle, and each o the hurdles to come, will only
postpone dealing with the Greek deault or one
quarter. Several countries are losing patience and
any one o them can orce a deault by vetoing
the agreement necessary to keep the heart o the
Euro-system Ponzi scheme beating.
The Euro-system consists o the ECB, which isowned by the 17 national central banks (NCB).
NCB do the day to day transactions and the
net position o each NCB with all other NCB in
the system is recorded in real time at the ECB.
Currency ight rom the periphery to the core is
building up big creditor positions or core NCB
and equal debtor positions or the peripheral
NCB. For example, the Bundesbank had provided496 billion to countries in trouble at the time o
writing. In addition, the day-to-day transactions
concentrate the lower quality collateral in
peripheral NCB.
The NCBs liabilities are its governments liabilities,
so the Eurosystem is strengthening the links
between the insolvent governments and their
insolvent banks, with the haircuts on both rising
exponentially. Assuming money transers can be
halted immediately upon a Greek deault, it would
still bankrupt Greek banks and decimate the valueo the collateral held at the Greek NCB. The NCBs
holding the osetting creditor positions would
have to write them down correspondingly, but
their governments should be in better positions
to absorb the hit. The real problem is not in
the Eurosystem, but in the grossly over levered
commercial banks, so markets have priced in
very high risks o ailure in some European bank
equities. Even so, markets will react violently when
they discover that ECB liquidity has not been
solving the problem, but compounding it.
Excess debt is causing the bank problems.
EA debt is estimated to be 443% o GDP,
third highest in the world, ar above the US
at 355% and completely unmanageable in a
currency union burdened with a one-size-fts-
none monetary policy and huge sovereign debt
problems. Insolvent European banks sold many
CDS, so counterparty risk is huge. A Greek or
any other signifcant deault will precipitate a
European banking crisis in the oreseeable uture.
Markets are already speculating on Portuguese
negotiations or haircuts and Ireland cant be arbehind, as it elected the current government to
negotiate haircuts on private holdings o bank
debt. The Lehman deault occurred 13 months
ater the US TED spread crossed 100 basis points.
The European equivalent crossed 100 basis points
in September 2011, so its banking crisis would
occur this autumn i a year or so is a normal
incubation period.
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12 Last spin of the wheel for Europes banks March 2012
Contagion to the US
US interbank markets have also been showing the
strain o problems in the EA, with the 3-monthLIBOR-OIS spread tracking the upward trend in
the cost o EA interbank lending (see chart 9).
US banks exposure to the EA through lending to
governments and exposures to fnancial and non-
fnancial institutions is signifcant. According to
data rom the BIS, US banks total claims on Club
Med banks, plus Germany and France, and the
UK banking system, comprise around 80% o US
banks total equity (see chart 10). Bank claims on
government and the private sector are reasonably
transparent in the UK, but not in the US soconcerns over EA exposure are likely to resurace
this year.
In addition to this exposure to the EA crisis, US
banks must work through the remaining legacy o
the domestically-generated subprime crisis. Fallingloan loss provisions (see chart 11) have delivered
practically all the sectors net operating revenue
growth over the last two years. Pre-provision net
operating revenue has been at.
Noncurrent real estate loans in the US remain
elevated, at 6.5% o the total compared with
only 0.7% in the 2005-06 period and stand
to rise again i the US economy deteriorates in
2012. Banks quarterly rate o provisioning looks
inadequate to cope with even current levels
o noncurrent loans. Quarterly provisions are
currently around one-third o their 2008 average,
but noncurrent loans are down by only 20%
since their Q1 2010 peak. Provisions were only
$18.6 billion in Q3 2011, their lowest since 2007
Q3. Noncurrent loans would have to all quite
sharply to justiy this level o provisioning, when
in act the opposite is the more likely outcome.
Raising the loan loss allowance to 100% o totalnoncurrent loans would require an extra $112
billion o provisions, in addition to the
amount needed to cope with current
write-os. Real estate net charge-os
are currently around $14 billion per
quarter.
The banks are ill placed to absorb
increased loan loss provisions and
the subsequent pressure on overall
proftability. 14% o US banks are
still reporting negative quarterly netincome down rom a peak o 35%
in Q4 2009, but double the average o
7.5% in 2005-06. At the sector level,
net interest income growth in particular
has ground to a halt, alling on an
annual basis or the last three quarters
the longest period o contraction
on record (see chart 12). Indeed, the
last time annual net income growth
contracted outright was in Q4 1989,
and that was only or one quarter.Downward pressure on longer term
yields rom slow growth, low ination
and Fed interventions will continue to
erode banks ability to generate net
interest income growth. In addition,
the Congressional Budget Ofce
predicts the Treasurys tax take will rise
by an average o 1 percentage points
a year rom fscal 2011 to fscal 2014,
so growth will be minimal and deaults will rise.
US banks are in a poor position to withstand
a European banking crisis. They appear well
capitalised with assets 11.9 times net tangible
equity. However, they need an estimated $400-
$600 billion o capital to absorb the cost o
9. Libor-OIS spread, bps
US EA UK
-0.5
0.00.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Feb 07 Aug 07 Feb 08 Aug 08 Feb 09 Aug 09 Feb 10 Aug 10 Feb 11 Aug 11 Feb 12
0%
20%
40%
60%
80%
100%
Club Med Germany & France UK
10. US Banks: Breakdown of exposure to European regions by sector(BIS data, Q3 2011)
BanksPublic sectorNon-bank private sector
2.6%
1.3%
9.0%
4.9%
10.3%
7.5%
8.4%
4.3%
31.0%
% of total US bank equity capital:
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13
marking their toxic assets to market, which raises
their eective leverage to 19 to 28 times too
high to weather the recession and European
banking crisis without signifcant ailures. In
addition, Proessor Robert Reich o the University
o Caliornia at Berkeley wrote that Wall Streets
total exposure to the EA totals about $2.7 trillion,
not ar short o triple the equity o American
banks.
Global contagion
Global fnancial assets were only slightly greater
than global GDP in 1980 but 3 3/8 times greater
in 2010 with the increase in debt outstanding
rising rom a raction o GDP to 2 timesaccounting or the rise. The collapse o the credit
bubble shows Ponzi debt had pervaded the credit
structure, so deleverage and a drop in asset prices
to levels that incomes and production could
sustain was necessary. Governments immediately
engaged in an all-out battle to prevent this
necessary correction. As a result, the Peoples Banko China balance sheet has
expanded by an average rate
o 43% a year over the last fve
years, the Feds by about one-
third, the Bank o Englands by
over one-fth and the ECBs by
one-sixth. Printing money on
this unheard o scale reversed a
signifcant part o the 2008-09
losses in asset markets but
the cost has been the rising
insolvency o governments andbanks.
Insolvency will keep dragging
the EA economy down until
sovereign and bank balance
sheets are repaired. Eliminating
the Ponzi debt without
racturing the entire credit
system is impossible. The next
section will oer some ways
o minimizing the damage
and preventing recurrences,but deleverage is absolutely
essential to restore optimum
growth. Total industrial
production in the OECD
remains below the pre Great
Recession peak and widespread
alling real incomes show the
lower income brackets are in
a depression. Other developed
nations are in less dire straits
than the EA, but slow economic growth anddeteriorating sovereign balance sheets are pushing
many o them in the same direction. Banking
problems are becoming more acute and Europe is
the canary. The ECB didnt prevent broad money
rom beginning to all even though it increased
its balance sheet by almost hal in the last seven
months o 2011. The same is likely to happen in
other developed nations.
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
Q1
1984
Q3
1986
Q1
1989
Q3
1991
Q1
1994
Q3
1996
Q1
1999
Q3
2001
Q1
2004
Q3
2006
Q1
2009
Q3
2011
11. US banks: loan loss allowance, % of noncurrent loans and leases
0
20,000
40,000
60,000
80,000
100,000
120,000
Q1
1984
Q3
1986
Q1
1989
Q3
1991
Q1
1994
Q3
1996
Q1
1999
Q3
2001
Q1
2004
Q3
2006
Q1
2009
Q3
2011
12. Net interest income, $mn
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14 Last spin of the wheel for Europes banks March 2012
Commodities are another
problem area
Dierent actors determine the real supply o
and demand or various commodities. High
correlations among their prices are most unusual,
yet the prices o the most traded commodities
have become ever more correlated in recent
years. The reason is clear. Up to 1990, commodity
utures markets were 70% hedging and 30%
speculation with speculative positions more or
less equally split between long and short positions
over time. Real supply and demand determined
prices. By contrast, speculation has risen to 80%
and hedging has allen to 20% since 1990. Inaddition, investment bank commodities unds
are long only so the speculative positions are
virtually all longs.
The only possible result o almost 80% o orders
being rom investors on the buy side is commodity
prices rising to ridiculous heights when investment
demand is high and dropping back to real supply
and demand levels when investor demand is
absent so commodities are now priced above
their economic value much o the time. For
example, the most notable result o QE2 wasincreased risk seeking in asset markets. The prices
o the most traded commodities rose immediately
upon its announcement over two months beore
actual purchases began, i.e. long beore QE2
could have raised the real demand. Similarly, risk
avoidance rose in asset markets near the end o
QE2 and commodity prices dropped i.e. long
beore the real demand could have allen.
Producers and investment banks raked in abulous
profts rom turning commodities into assets. As
a result, the Toronto Stock Exchange diversifedmetals and mining index rose about 40% a year
rom May 2003 to May 2011. Non-producers have
paid the price or profteering in commodities with
slow global growth and declining per capita real
incomes in many developed nations. As usual,
the poorest have suered the most through ood
and energy prices being ar higher than necessary.
In an eort to limit profteering in commodity
markets, Congress instructed the Commodities
and Futures Trading Commission (CFTC) to
institute position limits on any participant who is
not a bona fde hedger.
Eective lobbying rom Wall Street created long
delays, but the CFTC fnally voted to cap the
number o utures and swap contracts that any
single speculator can hold. The limits will apply
to 28 physical commodity utures and their
fnancially equivalent swaps and come into eect60 days ater the agency defnes the term swap.
That could take a long time as Wall Street is
challenging the cap in the courts.
Fortunately or all the people in the world who
eat, build and/or consume energy, problems at
French banks will cause a spectacular drop in
commodity prices, as in 200809. French bank
difculties ater the Lehman deault explain the
sharpness o the all in global trade, particularly
in commodities at that time. The restoration o
bank liquidity urther explained the speed o thesubsequent rise. The deep V in trade caused an
even deeper V in commodity, energy and equity
prices. French banks reining in their lending is at
least partly responsible or the commodity indexes
turning south again in 2011 beore reaching the
2008 highs. The coming banking crisis will cause
another sharp drop, but the insolvency o the
French banks wont be so easily papered over
this time. This, combined with alling ination
in emerging markets will hold commodity prices
down, making the uture pattern look more
like an L than a V, thereby ending the excessspeculative buying o commodities. Trade lending
will also shrink considerably.
The coming crisis is fnancial,
not economic
In spite o the gyrations in asset markets in recent
years, real GDP is at or near record highs in many
nations and theres no reason or the coming
deleverage to cause dire economic consequences.
The destruction o wealth rom alling asset prices
will hurt the economies o the highly levereddeveloped nations, but the rise in real incomes
due to alling commodity, energy and real estate
prices will beneft the lower income brackets o
emerging nations more. The dot.com bust began
once-in-a-lietime corrections in stock prices in
2000, pushing equity P/E ratios into a downtrend
that wont reverse or another our o fve years.
The overvaluation o equities ar exceeded
anything seen in the last couple o centuries.
Current P/E ratios have dropped to below average
levels, but longer term valuations remain elevated.Cyclically adjusted P/E ratios (CAPE) in most
markets remain well above average. They always
all well below average beore the bear market
ends, indicating prices will all below the 2009
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15
lows in developed nation equity markets. Tobins
Q, the total replacement value divided by the
market capitalization, shows about the same levelo overvaluation as CAPE. Earnings outperorm
stock prices near major P/E lows, so prices will
probably trough during or soon ater the banking
crisis at levels lower than their respective 2009
lows. However, massive government defcits add
more to corporate revenues than to their costs.
They will temper the all in corporate earnings,
which could stabilize S&P 500 earnings in the 70
area. A level modestly below its 2009 low would
give a P/E o around 9 and about a 4% dividend
yield. More importantly, equities would then be
signifcantly undervalued relative to normalizedearnings and replacement cost, creating the
conditions or a sustainable rally.
Equity prices and credit spreads tend to move
together. In act, high yield bond spreads correlate
to ination better than TIPS, which are ridiculously
expensive. The global banking crisis will usher in
deation. First ear, then alling profts with the
onset o deation pushing prices down aster
than costs, devalue equities relative to bonds.
Fear is already incorporated into stock prices, but
the alling profts are not. Equities will overshooton the downside and start recovering beore the
economy stabilizes and starts to recover. Deation
will keep downward pressure on margins, but
deating costs catching up with prices and
growing volumes will maintain or increase profts.
As a result, equities with P/E o 9 and a 4%-5%
dividend yield will greatly outperorm 2%-3%
Treasuries and negatively yielding TIPS.
Markets have priced the risks o high grade bonds
much lower than equities as the interest rate on
10 year Treasuries recently ell below dividendyields or the frst time in decades. High quality
sovereign, central bank policy and short term
interest rates have hit all time lows, so can only
go up. Two actors determine the level o interest
rates. Most important is the balance between
the desire to save and the desire to invest. The
desire to save exceeding the desire to invest (the
Eurasian savings glut) pushed real interest rates
down in the 21st century. The secondary actor
is monetary policy which, both in 2000-01 and
since mid 2007, put more downward pressureon interest rates. They have allen by up to 3
percentage points (except Japan) since 2000 to
the lowest levels in over three decades.
Up to the early 1980s, the public and private
sectors usually competed or resources and
ination ultimately reversed the drops in real
interest rates rom excessively loose monetarypolicy. Since then, that competition has been
absent and excess liquidity rom monetary policy
has created a series o asset bubbles. Most central
banks (wrongly) dont view rising asset prices
as ination, so monetary policy has remained
too loose since the late 1990s. The resulting
burgeoning private debt caused a banking crisis
in 2007-08. Central bank eorts to avoid the
consequent deation reduced real and nominal
rates to levels at which no economy can unction
properly. Real rates are now rising as ination
alls, but nominal rates will begin to rise as globalsaving drops rom record levels.
This promises that the interaction between
the desire to save and the desire to invest will
determine the level o interest rates or the frst
time since 1970, the year central banks decided to
print money in a major way because they couldnt
trust markets to supply adequate liquidity. That
decision placed them on a path that led to the
credit bubble collapse in 2007-08. With central
banks hors de combat ater this next banking
crisis, nominal risk ree interest rates shouldaverage about 2% or short terms and 2% to
3% or longer terms. With ination turning to
deation, these nominal rates will represent a
signifcant rise in real interest rates.
That real estate prices depend on location is
well known, but this idea (like many others
in this inject-as-much-liquidity-as-possible
world) has been taken to ridiculous extremes.
Deations unction is to reduce asset prices to
levels consistent with incomes, so will correct
real estate prices ar more in overleveraged andoverpriced markets. However, deations eect on
commodity prices will be ar more consistent.
The 2000-08 commodity bubble convinced most
people that soaring emerging market demand
would keep commodity prices rising or decades,
even centuries. However, the two actors that
made this rise in commodity prices the astest and
the most extensive in history were the amount o
excess liquidity injected by central banks and the
explosion in speculation described on page 14.
Food and precious metals prices spiked higherin 2011 than 2008. Weather was a big actor in
the rise in ood prices and precious metals are
not commodities. (Commodities are produced
or consumption, so supplies on hand are small;
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16 Last spin of the wheel for Europes banks March 2012
precious metals are produced to keep so supplies
on hand dwar production.) Peak prices or
energy and base metals in 2011 ell ar short otheir 2008 peaks, so ood and precious metals
notwithstanding, most commodity price indexes
ailed to reach their 2008 peaks.
Lower highs and lower lows indicate bear
markets. Recessions in Europe and the US plus
lower growth in emerging nations indicate the
all in commodity indexes since April 2011 will
continue and, like equities, they will all below
their 2009 lows in the coming banking crisis. The
evaporation o excess liquidity and speculative
demand, the inability to limit production andthe liquidation o hidden inventories will push
the prices o most commodities below their
marginal costs o production. Rising productivity
will account or much o the return to real profts
or producers, the idea o commodities as an
investment class will rot in the dust bin o history
and this, the most egregious bankster assault on
public welare with central-bank-provided liquidity
will end.
Europes core challenge
Europe cannot repair both sovereign and bankbalance sheets simultaneously in the context o
recession/depression, and politicians are either in
ignorance or denial o the gravity o the situation.
Messy sovereign deaults and/or exits rom the
euro are now very likely. Sovereign deaults are
painul as they impose unpopular reorms to
correct the previous excesses. Exits rom the euro
would impose equally painul reorms. Regaining
control o fscal and monetary policy would
greatly ease the way orward, but European banks
are a major stumbling block.The major EA banks are highly vulnerable to losses
on their sovereign debt holdings. Chart 13 shows
shareholders equity as a percentage o total
assets or nine major banks. The comparable ratio
or the largest fve US banks is 9.2%. In addition,
the chart shows the same ratio i the banks
were to take a 50% haircut on their holdings o
sovereign debt in Spain, Portugal, Ireland, Italy,
Greece and Belgium which could arise rom
either deault or exit and devaluation. This would
take shareholders equity to close to or less than2% o total assets in our o the nine banks.
That the European Banking Authority ound
Intesa Sanpaolo and especially Credit Agricole
adequately capitalized in the latest round o stress
tests shows the extreme level o denial o the
gravity o the situation.
Loss rom high levels o troubled sovereign debt
is ar rom the only problem acing the EA banks.
For example, excessive debt burdens in the non-
fnancial corporate sector rom too-low lending
rates in the periphery in the years running up to
the crisis, also pose a threat. The overhang o
already-soured lending and declining proftability
mean these banks are simply not
proftable enough to build up
sufcient reserves against uture
bad loans especially with the
EA acing a deepening recession.
Spain gives the clearest example
o the threat o non-fnancial
sector debt to EA banks.
Operating income ell or all
nine major listed Spanish banks
in 2011, having already declined
in 2010 or seven o them. The
Spanish banking sectors loan
loss allowance is currently less
than 80% o non-perorming
loans (NPL) to the non-fnancial
corporate sector, which are
bound to keep rising, compared
with in excess o 400% in 2004.
Current loan loss provisions are already 70% o
operating income. The Bank o Spain recentlymandated a urther 50 billion o provisions, but
this would take the loan loss allowance to only
110% o current NPL and overwhelm annual net
income. Future losses will most likely overwhelm
0%
2%
4%
6%
8%
10%
Santander BNPParibas
BBVA DeutscheBank
UniCredit SocieteGenerale
IntesaSanpaolo
CreditAgricole
Commerzbank
Shareholders' equity/Total assets SE/TA, 50% haircut on periphery debt holdings
Chart 13 Shareholders equity as a percentage of total assets
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17
Spanish banks, making them unable to support
the crumbling Spanish government fnances.
The only way out o this downward spiral is debtor equity swaps on both sovereign and bank
liabilities.
In plain English, most European banks (and
a considerable number o other banks) are
insolvent. The EA would have absolutely no
reason or trying to prevent haircuts on bank
debentures or to delay the Greek deault i this
were not true. Writing assets down to air value
and recapitalizing banks is the frst priority in
restoring economic growth ater banking crises.
However, the rosy predictions spewed out bycomputer models are totally oblivious to the
eects o the Minsky Moment ending the credit
cycle, making the claims o politicians, bankers
and bank regulators that most European banks
are adequately capitalized spurious. What can be
done to alleviate the situation?
Alleviating and preventative
measures
The unexpectedly large ripple eects o
the Lehman Brothers bankruptcy panicked
governments into assuming the huge liabilities
o ailing and near ailing banks in 2008-09. The
Irish government went so ar as to guarantee all
unsecured bondholders in its nationalized banks,
while the UK government now owns 84% o
Royal Bank o Scotland and 41% o Lloyds. The
major liabilities o European banks still remain
contingent, although nationalization is a threat
or institutions ailing to meet the EBAs capital
targets. Regardless o the procedures, the bank
rescues privatized gains and socialized losses
in direct contravention o capitalist principles,creating immense moral hazard. Unsurprisingly,
executives o fnancial institutions that believe
theyre too big to ail (TBTF) have exploited their
ability to pocket (sometimes phantom) profts and
saddle the public with their losses.
Regulators have tried to tackle the TBTF problem
with restrictions on capital and leverage ratios and
structural reorm o the banking system. Utilizing
risk weighted capital coupled with a lack o teeth
doomed the ormer to massive manipulation and,
as already discussed, the new 9% Tier 1 capitalratio in the EA barely scrapes the surace o the
balance sheet problems. For example, the Spanish
banks much lauded dynamic provisioning process
meant that loan loss reserves started alling
in 2007, just as the global banking crisis was
coming to the ore. Structural reorm to remove
the implicit government guarantee that socializeslosses has proven to be equally difcult. The basic
problem is that banks have structured themselves
so that the government retail deposit guarantee
extends to all the activities in the non-retail part o
the bank.
TBTF banks are too big to exist. The only way
to restore properly unctioning capitalism is
to break them up into pieces that are not
systemically dangerous. The US Financial Services
Modernization Act o 1999 created TBTF by
gutting the Glass Steagall Act o 1933 which, inresponse to abuses similar to those committed by
current too-big-to-ail institutions, had (rightly)
prohibited;
1 any institution rom acting as any combination
o an investment bank a commercial bank and
an insurance company and
2 any ofcer, director, or employee o a securities
frm serving as an ofcer, director, or employee
o any member bank.
Only the complete separation o commercialbanking rom investment banking and insurance
activities can prevent retail deposit guarantees
rom extending to investment banking and
insurance activities. However, the imposition o
Glass Steagall separation wont solve two other
problems. First, the 2008 fnancial crisis exposed
the high additional risks to banks rom having
liabilities signifcantly in excess o their deposits,
so the liabilities o any institution accepting
government insured deposits should be limited to
deposits. In addition, all assets should be suitable
to deposit taking institutions.
Second, the investment bank cum insurance
company remaining ater the commercial bank
has been separated may still be TBTF. Higher
unding costs and the imposition o higher
capital and liquidity ratios on such institutions
could help to limit their size. However, history
shows governments would rush in with taxpayer
unding at the frst sign o trouble. All major
nations would have to pass laws mandating the
separation o investment banks, commercial banks
and insurance companies to keep systemicallydangerous institutions rom threatening capitalism
(and by extension democracy) again.
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18 Last spin of the wheel for Europes banks March 2012
Unortunately, the unbelievably big, powerul
and wealthy banking lobbies have prevented
signifcant progress in the battle to end TBTF, butsome plans are in process. The UK attack on TBTF
is to institute living wills Recovery and Resolution
Plans. Each bank will have to set out plans to
return to health in the event o a resh crisis and
how it will secure an orderly wind-up i the plans
ail. The plans will have to be regularly updated
and approved by the new Prudential Regulatory
Authority. The Financial Services Authority has
suggested the plans include emergency cash calls,
the elimination o dividends, or putting the entire
business o a bank up or sale. Bondholders will
have to share in the pain. Bank structures willhave to be simplifed and clear knowledge o
all counterparty exposures and how the banks
positions can be unwound is necessary to even
begin constructing a living will.
The US Volcker rule prevents banks rom trading
on their own account while socializing losses
with retail deposit guarantees is a step toward
separating retail and investment banking. The
UK Independent Commission on Banking (ICB) is
trying to go a step urther by recommending ring-
encing retail banking rom investment bankingand wholesale unding, but stopped short o ull
separation. Under this structure, the UK banks
retail activities would take place in subsidiaries
that are legally, economically and operationally
separate. Wholesale and investment banking
activities would be outside the ring-ence, while
banking services to large domestic non-fnancial
companies could be in or out. The Volcker rule
doesnt deal with TBTF, but the ICB report does. In
addition to raising the equity capital requirement
to 10% and ring-encing retail banking, it adds anadditional 7-10% to the primary loss-absorbing
capacity o banking institutions including so-called
bail-in bonds (regulators could write them
down) and bonds that convert to capital under
specifed conditions (CoCos).
Continental European banking authorities have
yet to deal with either TBTF or socializing losses.
Instead, they ignored TBTF and did their utmost
to socialize losses until the Greek debacle orced
a U-turn. Realization o the enormous costs
o continuous bailouts replaced their ears oallowing banks to ail. Unortunately, the wasted
our years has compounded the scale o problems.
Bailouts have demoted investors who paid senior
credit prices or their bonds to subordinated
creditor status. Worse, the credit protection they
bought in good aith threatens to be worthless.
Who in their right mind would buy sovereign debt
under those conditions? In addition, the banksneed copious quantities o equity and wholesale
unding, neither o which is available and or
good reason. The EA Ponzi scheme outlined
on page 11 and abetted by the ECB, is nearing
collapse. Nothing proposed so ar has any chance
o saving the EA banks. Another solution needs to
be ound.
The Basel rule or zero risk weights on sovereign
debt denominated in a currency the governments
couldnt print was the biggest actor in creating
the European debt problems. The collapse othe resulting credit bubble means developed
nations must eliminate as much debt as possible
as ast as possible in the least disruptive way
possible. A undamental principle o capitalism
is that investors in proftable ventures reap the
rewards due to their investments and investors
in unproftable ventures suer losses according
to the seniority o their claims. As a result,
corporate bankruptcies are usually settled with
most creditors accepting equity positions in lieu
o the debt owed to them. The same technique
could greatly alleviate bank and sovereign debtproblems without disadvantaging any non-
complicit entity.
The claims o private holders o bank debentures
are being eroded by the senior claims o public
entities and a urry o covered bond issuance.
Legislation orcing conversion o bank debentures
in reverse order o seniority into an equivalent
amount o equity as needed to maintain adequate
net tangible equity would restore solvency to
many banks without penalizing taxpayers or
bondholders who should welcome the receipt oace value in securities with growth potential in
exchange or the eroding claims o their bonds.
This would be a complete reversal rom the totally
unrealistic European eort to make taxpayers
pay the costs o misguided investments in bank
securities, so is politically unacceptable in the
short term and probably in the long term too.
More realistically, banks are starting to swap
bonds due to be called in 2012 or longer
maturities. This lets them both book a capital
gain rom buying back debt below par valueand reduce rollover risk. Debt or equity swaps
would be a logical next step. The trade should
have broad appeal because recovery rates or
subordinated debt in ailing banks will be very
small, but prospects or equity holdings in the
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19
same banks properly capitalized would be much
better. Banks converting other bank debentures
could create inappropriate, perhaps illegal, crossshareholdings, but netting out cross holdings
o bank securities would raise capital ratios by
shrinking bank balance sheets.
The private sector is playing an ever increasing role
in inrastructure and other government programs
through public/private initiatives. Sovereign debt
or equity swaps would be similar, but on a
grand scale. Bondholders would exchange their
debt or shares in a private company that owned
ormer government assets, such as sovereign
corporations, revenue producing propertiesand non-revenue producing inrastructure with
either a guaranteed income or rights to charge
users in exchange or operating and maintaining
the acilities to an agreed standard. As in bank
debt swaps, such equity oers better long term
prospects than sovereign debt in Greece, Portugal,
Ireland, Italy and Spain. Many public/private
initiatives have yielded good results or both sides,
but some havent. Like so many things, the devil
is in the detail. Accurate valuations and precise
delineation o rights and duties are essential.
Politicians have proposed a tax o 0.1% on all
stock, bond and derivative trades to;
1 make banks repay a bit o what they have
taken rom the public,
2 reduce speculation and fnancial engineering
and
3 create a und to bail out banks that get in
trouble in the uture.
This sounds like a panacea or all fnancial
problems. However, a tax o that magnitude on
oreign exchange utures would create a feldday or the Law o Unintended Consequences by
raising the cost o commercial oreign exchange
transactions by between 1,000 and 10,000 times.
A tax in Sweden o only 0.003% on transactions
o bonds maturing in more than fve years
reduced the trading volume by 85%. Less trading
increases market volatility (thereby decreasing
confdence) in markets and lowers tax receipts ar
below estimates. By contrast, it would end high
requency trading, which is not only increasing
volatility, but is also probably illegal because itmore oten than not ront-runs client accounts. Its
ability to rein in the most destructive element in
fnancial markets may be worth all the problems
and aggravation o designing and implementing a
modifed version o this tax.
Apart rom debt or equity swaps, the most
useul thing politicians can do is introduce cyclical
budgeting.This would require;
1 raising government accounting up to the
sophistication required o private companies,
2 setting an inviolate proportion o GDP or
average government spending including
capital investment and
3 administering the capital budget counter
cyclically.
Government spending has quintupled and more
in less than a century. Most government spendingis non-productive, so that growth has to stop
somewhere. The only thing better than stopping
it here and now would be to impose limits
below current levels. In addition, investment, not
consumption, drives capitalist economies. Studies
show inrastructure spending is governments
most powerul stimulative weapon. However, the
present accounting systems most governments
use are not sophisticated enough to calculate the
return on money spent. Best practice accounting
would show the return on most programs is
negative, which is why fscal stimulation yields
such poor returns. Public capital spending on
projects with positive returns administered to rise
as private capital spending alls and all as private
capital spending rises would vastly outperorm the
present arcane welter o automatic stabilizers and
policy on the hoo. O course, i steps one and
two had been done a ew decades ago, a lot o
governments would have avoided the trouble they
are now in without ever needing step three.
Hope rom the crisis-practisedEmerging Markets
Club Med now aces a similar style o fnancial
crisis to that experienced by several major
emerging markets over the last twenty years.
These crises Mexico in 1994, Brazil, Asia and
Russia in 1998, Turkey in 2001, Argentina in 2002
were driven by fxed exchange rate regimes
leading to the accumulation o external liabilities
by governments, corporations and banks, and
culminated in fnancial meltdowns. In addition
to large current account defcits and governmentdebt, Club Med has assumed signifcant external
liabilities that would have to be negotiated into
the domestic currency in case o exit rom the
euro.
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20 Last spin of the wheel for Europes banks March 2012
Brazil, Mexico, Russia, Turkey, Indonesia,
Argentina and Korea have experienced one or
some combination o abandoning fxed exchangerate regimes in the last twenty years, deaulting
on domestic or external debt and banking crises.
The broad lessons learned rom this experience
limiting oreign-currency denominated debt,
avoiding excessive current account defcits,
maintaining adequate oreign currency reserves
and greater banking oversight have helped to
place some o these markets in a strong position
to weather the current fnancial crisis. Indeed,
excess application o these principles especially
in Asia contributed to the current crises via the
global savings glut.
While the developed markets (DMs) are struggling
to cope with the consequences o their pre-2007
credit binge, the outlook or many emerging
economies (EMs) is much better. Without the
debt overhang o the developed markets, and
with scope to stimulate domestic activity using
conventional policy approaches, some EMs could
exit the all-out rom a European banking crisis
with strong growth potential. The transmission
mechanism rom a euro break-up, i it were to
happen, would aect emerging markets via theirvarying dependence on (a) world trade; and (b)
world fnancing. Relatively
closed economies with limited
external debt obligations
should thereore be least
aected.
However, generalizations about
EMs are raught with hazard,
given Chinas unique position
in particular. Indeed, China may
be the epicentre o the nextglobal crisis, so belongs in a
category o its own. This also
makes economies closely tied
to Chinas outlook Korea and
Taiwan in particular more vulnerable.
Where developed economies have largely
exhausted room or conventional monetary
support to the economy, high nominal interest
rates in many EMs mean there is plenty o room
to cut rates as the European crisis unolds. Indeed,
some central banks would relish the opportunityto aggressively decrease their policy interest rates,
in an attempt to stimulate investment while
casting o the legacy o past inationary periods.
Even better, ree oating exchange rates can do
much o the heavy-liting or the EMs that are
highly sensitive to global risk appetite. Some EM
currencies depreciate sharply in times o weakglobal appetite or risk, counterbalancing weaker
economic demand. Indeed, the rupee, real, rand
and Turkish lira all depreciated by around 16% in
the second hal o 2011.
Making ull use o currency exibility and looser
monetary policy, o course, requires a sound
fnancial position. For markets where either
governments, banks or the private sector have
taken on large external obligations, lured by
lower international interest rates e.g. in Central
and Eastern Europe, currency depreciation canbe more o a threat than a blessing, requiring
deensive monetary policy tightening. These
are the markets most likely to suer as Europe
works through its fnancial crisis. Foreign bank
ownership, once perceived as a sign o strength,
also leaves credit supply in some markets
vulnerable to EA region deleveraging. Indeed,
there is a risk that in their desperation to lit
capital ratios, EA banks will shed their most
avourable EM assets, while retaining poorer
quality European assets or which there are ew
buyers.
On the other hand, markets including Brazil,
Mexico, South Arica, Indonesia, and India should
withstand a European fnancial crisis reasonably
well. Exports constitute around 30% or less o
GDP in these countries (see chart 14), and growth
is not dependent on ever-expanding global market
share, unlike China and Korea, or example.Current accounts are either in surplus, or defcits
are easily covered by stable inows o oreign
direct investment. Banking sectors are small and
stable relative to GDP.
0% 10% 20% 30% 40% 50% 60% 70% 80%
Taiwan
Korea
Mexico
S Africa
Indonesia
India
Turkey
Brazil
14. Emerging market exports, % of GDP
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21
All o these markets have at least some, i not
substantial, scope to ease fscal and monetary
policy in 2012 to support domestic economicactivity. For some, India in particular, delayed
monetary tightening in the 2010/11 recovery
phase means this policy arsenal cannot be ully
deployed until inationary pressures abate urther.
For Brazil, however, the global deationary
environment and downward pressure on
commodity prices only makes the policy decision
easier. Brazil has been able to cut the overnight
rate by 2 percentage points since mid-2011 to
10.5%.
Other central banks, e.g.Mexico and South Arica, have
had monetary policy on hold
since the middle o 2010,
but still have room to cut i
necessary, with policy rates at
4.5% and 5.5%, respectively.
Brazil also has a sturdy fscal
primary surplus, and thereore
scope to stimulate the
economy rom that side, too.
Turkey would also join this
avourable group, but ailure
to tighten monetary policy
until late in 2011 has created a money and credit
overhang, while reliance on short-term capital
inows to fnance the current account defcit
remains signifcant.
Financial pressures in the euro area not least
capital raising plans by banks could translate
into monetary pressures in some emerging
markets, via asset sales or the withdrawal o credit
lines, which could have signifcant eects on
the fnancing o corporations and governments.
Exposure among EMs is varied, with Central
and Eastern Europe the most vulnerable, but
several other EMs are not at all dependent on
EA fnancing. Chart 15 shows
the claims o the Euro Area on
several EM markets, across thepublic, private and fnancial
sectors, as a percentage o total
assets o the domestic banking
systems. This gives a sense o
the scale o the presence o
oreign banks in the unding
o these economies, relative to
the size o domestic fnancial
sectors.
Better Emerging
Market BanksEM banks as a whole have been much better
able to generate profts than DM banks. The
oray into complex securitization products and
explosion in leverage to generate returns all seem
to have been or nothing. Over the last fve years,
net proft has been at or DM banks, but has
increased six-old or EM banks (chart 16). This
proft growth has not been at the expense o
fnancial stability. Throughout the last decade,
EM banks have also had persistently higher
capital ratios than their DM peers averaging
around 7% shareholders equity to total assets,
compared with less than 5% or DMs. In this
simple comparison, higher levels o equity capital
by no means restrict banks ability to generate
profts, and neither does lower leverage EM
banks are currently 14 times leveraged, compared
with 19 or DMs. The picture is not rosy or all EMbanking sectors, however the underlying asset
quality and uture proftability o Chinas banking
system being the most obvious threat, while
excess reliance on oreign wholesale unding and
0% 100% 200% 300% 400% 500% 600%
Czech Rep
Hungary
Mexico
Poland
Turkey
Russia
Brazil
Indonesia
IndiaKorea
S Africa
15. Activity of foreign banks: EA total claims,% of domestic banking sector's total assets
-100
0
100
200
300
400
500
600
2005
Q3
2006
Q3
2007
Q3
2008
Q3
2009
Q3
2010
Q3
2011
Q3
16. EM and DM Banks: Net Profit, Q4 2005 = 100
EM Banks DM Banks
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22 Last spin of the wheel for Europes banks March 2012
a persistent NPL problem are issues or Koreas
banks.
While developed market governments havebecome beholden to their over-large banking
sectors, many EM banking systems do not have
a too big to ail category, where institutional
ailure would cause collateral damage to the
economy. While total assets o UK banks were
almost 4 times larger than UK GDP in 2010,
the total assets o publicly listed EM banks are
only a small portion o national GDP, as shown in
chart 17.
The corollary o smaller banking sectors is
ar more limited indebtedness o EM private
sectors. EMs do not ace the painul debt write
downs necessary in Europe or the UK. Credit
remains a low percentage o GDP in many.
Mortgages are not widespread and corporate
borrowing is low. Less developed debt markets
and higher borrowing costs, boosted by bouts
o high ination and higher risk premiums, have
prevented the build-up o a credit overhang. The
aggregate corporate debt burden is around 1/3less or listed EM companies than DM net debt
is 1.4 times earnings beore interest and taxes,
compared with 2.1 times or DMs. As a result,
some EM banking sectors have substantial scope
or urther, sensible asset growth.
0% 20% 40% 60% 80% 100% 120% 140%
Taiwan
China
S Africa
Korea
India
Brazil
Turkey
Russia
Indonesia
Mexico
17. Banking sector total assets, % of GDP
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Conclusions
Currency manipulation by some emerging nations
prevents nominal exchange rates rom correcting
the disparities in unit labour costs that led to the
big global imbalances o saving and investment,
so ination dierentials are the only means o
correcting them. Unexpectedly high ination in
emerging nations permitted some adjustment inthe recovery even though i
