We’ve avoided armageddon -- at least for now. The cost to the US taxpayer has been a few trillion. Some in the media are loudly announcing the end of the recession, but there are a few more bumps in the road -- some of which are more like steep hills. As big as the subprime problem? Maybe.
When asked a few weeks ago what my biggest short-term concern was, I quickly replied, "European banks have the potential to create significant risk for the entire worldwide system." This week, we’ll glance over the pond to see what gives me cause for concern. Then we’ll briefly look at a few of the bumps I mentioned -- which are likely to stretch out any recovery, and possibly dip us back into recession. Europe on the Brink
Globalization is a double-edged sword. On balance, it’s brought prosperity to those who have embraced it, in the form of enhanced lifestyle, better health, longer life, and more. The more we need each other, the less likely we'll shoot each other (eliminating your customers isn’t a good business strategy). And while the growth hasn’t been even or smooth, only a Luddite would want to return to the early 1800s or 1900s -- or even 1975.
The other edge of that sword? We’re connected in so very many ways -- far more than most of the world suspected. Who would have thought that insane lending policies at US mortgage banks would bring the world financial system to its knees, increasing unemployment and leading to a global recession? World trade is down 20% or more. US railroad shipments are down more than 20% year-over-year.
Chinese (and Asian) factories have seen their orders drop as US consumers have gone on strike. The US trade deficit was just $25 billion last month, and while our exports are still dropping, our imports are dropping more. Oil is becoming a bigger and bigger share of imports, and it doesn’t come from Asian exporters.
The US is far and away the country with the largest gross domestic product (GDP). If California were a country, it would be the seventh largest, but few think of the state in such terms. For this letter, I’d like to think of Europe as a whole rather than as 27 countries. From that perspective, Europe is as economically important to the world as the US -- what happens there makes a difference in the US.
Last week, we looked at the precarious position of Japan, the second largest economy (or third, if you think of Europe as a whole). It was a sobering letter. When you realize the extent to which Japan has funded Asian expansion, what’s happening there can’t be good for the world.
But European banks have been much more aggressive in funding emerging-market expansion than US or Japanese banks: Western European banks have lent $4.5 trillion to various emerging-market countries, businesses, and consumers. Many Eastern European businesses borrowed in low-interest-rate euros. New homeowners in Hungary and the rest of Eastern Europe borrowed in Swiss francs and euros, and as their currencies have collapsed, they now find they owe more on their homes than the homes are worth. And here's the problem: Europe's banking system is in far worse shape than that of the US. The losses may be bigger, and their capital to meet those losses is certainly less. Let's look at some charts. (Pour yourself an adult beverage.)
As I noted last week, one of the real benefits of writing this letter is that I get to see a lot of really interesting information from readers and meet with very savvy investment professionals. I recently had the privilege of sitting with a team of analysts from Hayman Capital here in Dallas. Hayman runs a global macro hedge fund, so they spend a lot of time thinking about how all the different aspects of the global markets fit together. This week we look again at some of their analyses.
There was a lot of work (as in months of it) done here. And Kyle Bass, the founder of the firm, graciously allowed me to share some of it (and kudos to Wes Swank, who pulled this together). The graphs are theirs, and though my discussion about them is certainly informed by our meeting, I’m using the material as a launching point. Hayman Capital isn’t responsible for my conclusions and interpretations. And Then There Was Leverage
In the first few years of the G.W. Bush administration, the banking authorities decided it would be okay to allow 5 banks to increase their leverage from 12:1 up to 30:1. Those included: Bear Stearns, Lehman (now absorbed into Barclays
(BCS)), Merrill Lynch, JPMorgan
(JPM), and Goldman Sachs
(GS). Just 5 years later, 3 are gone and 2 survived with large dollops of taxpayer money.
(As a quick aside, is it really any surprise that Goldman and JPMorgan are making record profits on the underwriting and trading side of the business? Hell, if I could eliminate 50% of my competition, my profits would grow too! JPMorgan's consumer credit, credit card, and other business groups are losing money, big-time.)
Thirty times leverage means that if you lose 3.3%, you wipe out all your capital. And we watched as banks too big to fail were bailed out with taxpayer dollars. Slowly, banks are buying time, writing down assets. Remember: This month is the second anniversary of the onset of the credit crisis. I wrote back then that the strategy would be to stretch this out as long as possible. Time heals a lot of bad debts -- especially at a 0% Fed Funds rate.
Banks that are reporting so far this quarter seem to be saying that the write-offs will start to level off in about 2 quarters, although banking expert Chris Whalen says that the level may stay higher than we think for longer than we think. There are a lot of assets to write off, and they’re just now getting to the commercial real estate problems. This is going to take time. (For an interesting interview on CNBC with Whalen, click here
.) The point, before we get to Europe, is that here there was a central bank and a government that not only could step in, but was willing to do so. I know former Treasury Secretary Paulson had his critics, but I’m not one of them. Sure -- he did some things that in hindsight, he might like to take a mulligan on. But he dealt with the problems in the best manner he could.
The time to have taken action was when we were making liar and no-doc loans and calling them AAA, or allowing banks to go to 30:1 leverage. Paulson had to deal with eggs that were already broken. That the system didn’t crater is to his credit. Securitizing what he and everyone else should have known would be garbage while he was head of Goldman Sachs isn’t, however, to his credit. But I digress.
I’m going to give you 4 charts showing the leverage of banks in the US, the United Kingdom, the Eurozone, and Switzerland. The bottom, blue portion is assets to common and preferred stock; the red is assets to common equity, which can include good will; and the purple is assets to tangible common equity.
Tangible common equity (TCE) is all the rage, and that’s what the recent stress tests measured. In opposition, there’s tier-1 capital, which includes preferred stock (this would basically be the blue portion). TCE only includes common shares.
Now, let's start with the US. These graphs show leverage. The average leverage of tier-1 capital of the 5 largest banks is in the range of 12:1, and is actually down from 10 years ago. (A very good and simple explanation of all this can be found here
While the TCE has obviously been rising and taking total leverage to rather lofty levels in the mid-40s, banks are raising capital. Over time, leverage will come back down. It helps if you can borrow money at almost nothing and lend it out at much higher rates.
Now, let's turn to the United Kingdom. This is uglier.
Regulators in the UK allowed 20:1 leverage on a regular basis. It’s now almost 40: and TCE is around 55. The assets of UK banks are about 5 times as large as UK GDP. By comparison, for the US the ratio is barely 2:1.
Think about that for a second. The UK has banking assets that are 5 times as large as the annual domestic output of the country. They also had a housing bubble. They have their own bailouts to deal with -- which are massive and will potentially get much larger -- but at least they have a central bank and government that can try to fix the problems.
But wait, there's more! Let's look at the Eurozone.
Leverage is now 35:1 and TCE is almost 55. How did 35:1 work out for the US? Given the massive credit problems Eurozone banks have with emerging markets (plus Spain's housing bubble, which is every bit as bad as that of the US), won’t this end up in wailing and weeping?Too Big to Save
And here's the real issue. They have no Paulson or Bernanke. Some of my Austrian economist friends say, “Good. They should all be allowed to die.” But that’s a very cavalier attitude when you start talking about actually increasing the unemployment rate to something like 20%. I agree that management should be changed, as well as the regulators (35:1 to 1 -- what were they thinking?), and shareholders should be wiped out. But I don’t want the system to collapse. And this is a global risk, not just localized to Ireland, Spain or Austria. Sure, the pain might be worse in the local region, but we’ll all end up feeling it.
The European Central Bank, at least as of now, can’t step in and start saving individual banks. How do you save a Spanish bank and not an Austrian bank? Austria's banks have made large loans to Eastern Europe in euros and Swiss francs, and are going to have large losses -- far more than 3%, which would wipe out their capital. But bank assets in Austria are 4 times GDP. What we have are banks that are too big to save for relatively small Austria. And that goes for Italy, Spain, Greece, et al. More about this below, but for now, let's turn our eyes to Switzerland. Those Wild and Crazy Swiss
We think of Switzerland’s clockwork banking style as stodgy and by-the-numbers. I’ve done business with Swiss private bankers, and indeed they are conservative. But somewhere, somehow, UBS
(UBS) and Credit Suisse
(CS) ran up a little leverage. Before the crisis, they were over 40:1. And now they're nearly at a nosebleed high of 70!
As an aside, I was in Switzerland about 2 years ago, meeting with some very well-known dignitaries. In a very off-the-record conversation, they told me UBS was technically bankrupt. As it turns out, there were a lot of banks around the world that were technically bankrupt.
The next graph underscores the problem of "too big to save." Let's say the US will eventually pump $1 trillion into the banking system (in taxpayer losses). That’s about 7% of US GDP. We may not like it, but it doesn't stop the game. US bank assets are only twice US GDP. Switzerland and Ireland are over 7 times, the UK is over 5, and the Eurozone is at 4 times. And so it goes.
Eurozone banks are already reeling from losses from US subprime-related problems. They’re now getting ready to deal with even deeper losses from their own lending portfolios. If the losses were just 5% of the portfolio -- an optimistic assumption -- they’d be 20% of Eurozone GDP.
But each country is responsible for its own banks. While it’s thought that Germany will be able to handle its problems, the prognostication for Austria and Italy isn’t so sanguine. Italy is already running a massive deficit and has no central bank to monetize its debt. The same goes for Portugal, Spain, Greece, and Ireland: 5% loan losses in Ireland would be 40% of GDP -- the equivalent for my fellow US citizens of about $5 trillion. Where does Europe find a few trillion dollars?
I was writing in late 2006 that the subprime lending market would end in tears. And I think the European banking crisis that’s on the horizon has the potential to be every bit as big a problem as subprime loans. The world depended on Europeans banks for much of the lending that allowed for growth and development. Like their counterparts in the US, they’re going to have to reduce their loan portfolios. Deleveraging isn’t fun.
It takes a lot of time to build up a banking infrastructure that can raise the capital necessary to make and process loans. Europe is a big customer of the US and Asia. Their businesses are going to be hit hard by the lack of capital, which is of course no good for employment. We’re all connected -- what happens in Rome no longer stays in Rome.
Let me reprint a graph from last week so you can burn it into your mind. The world needs to find $5 trillion to finance government debt issuance. And we need to fund private business and consumer debt. Where’s all this money going to come from? A Positive Third Quarter?
Those calling for the end of the recession are shouting that the third quarter may be positive in terms of GDP. It’s possible, but only for statistical -- not for fundamental -- reasons. For instance, lower imports are a net positive for GDP, but lower imports mean a weaker economy. Government spending adds to GDP. Normally, if the government spends too much, then we get inflation, which is subtracted from nominal GDP to give us real (after-inflation) GDP. But inflation is low and getting lower, so there won’t be much to subtract from nominal GDP. Are government spending and massive deficits signs of fundamental strength?
It’s quite usual for there to be a positive quarter in the middle of a recession. Watch the fundamentals: industrial production, unemployment, capacity utilization, tax receipts, etc. When those turn up, or at least level off, the recession is over. Then we get to the long recovery.
Quick point: As I’ve noted, unemployment is at 9.5% and going to 11% -- hopefully no higher. Average hours worked per week is at an all-time low. The number of people working part-time but wanting full-time work is another 7%. And that part-time number is rising very rapidly.
When the recovery actually does begin to manifest itself -- and it eventually will, as we find the new normal -- employers are going to give their current employees more hours, not hire new workers. This is going to be a long, slow, painful, jobless recovery. Unemployment is going to remain stubbornly high.
And this Congress wants to raise taxes on small business, but 75% of the "rich" are small businesses. How do you expand your business in California or New York, where taxes will be over 60% by the time you add in local taxes? We’ll talk about this next week.
And as a further preview, from an economic viewpoint, massively raising taxes in the middle of a recession is about as dumb as you can get. But it looks like that’s where we’re headed. Green shoots, my foot.