The can gets kicked in Europe

Today, the ECB announced that 523 Euro banks borrowed €489 Billion (source: Bloomberg) of 3-year loans under its emergency lending program.

There have been a number of media comments that have misunderstood the purposes and effect of this program.  In sum, this is a liquidity facility which removes one risk but leaves solvency and capital issues unaffected.

All large banks finance a substantial portion of their assets through open market borrowings, as short as overnight.  In ordinary times, this is a very liquid market and funds are readily available at low rates.  The lenders are other banks, including US, Chinese, other Asian banks as well as US mutual funds, and other institutions that have short term funds to invest.  In the last quarter, the liquidity in this market had been "drying up" as US banks (among others) began to worry obsessively about "counterparty" risk.  One consequence of this can be seen in the negative yield on 1-month US Treasury bills.  There is simply a strong risk aversion in the global debt markets.   The cost of the overnight funds and other short term funds, the equivalent of auction CDs, for Euro banks has been increasing as availability has tightened.  Last month the Fed Reserve and other central banks announced facilities to provide virtually unlimited funds to European banks.  This IS important.  Without this reassurance, there could have been a modern day version of a "run on the bank".  As we all saw with MF Global, confidence is essential to funding large financial organizations.  On this issues, let me congratulate the ECB and the Fed for making an astute move.  This reassures all investors that no Euro bank is going to collapse because it could not roll-over short term debt. 

The balance sheets of the European banks are somewhat opaque, so we don't know if most of these funds are simply replacing other short term, but higher cost, debt; but this is my suspicion.  Because it was a requirement that all of these loans had to be collateralized, it does not seem like there will be excess funds to purchase additional sovereign debt or other assets.  Nevertheless, this program should create a substantial positive carry for participating banks, which will increase profitability.  This similar to the Fed's actions in 2009-10 in the US which allowed the major banks to earn their way out of the crisis.  But this program eliminates counterparty risk for the major money-center banks such as JPM, C, GS and MS.  The business model of the US money center banks (JPM, C, BAC) could be questionned in light of Dodd Frank and other regulatory initiatives, but the risk of European contagion from counterparties has been removed.  In fact, lending money to European banks will again be a very profitable niche business. 

BUT.....

The Euro banks still need additional capital for 3 primary reasons: (1) a special one time "buffer" against sovereign debt which is designed to reassure the financial markets. (2) additional capital to meet the Basel 3 requirements; and (3) additional capital to reach the 9% capital bench mark for risk weighted assets.    This is going to have to be resolved in the first half of 2012.  Historically, the Euro banks did not need to allocate capital to support sovereign debt because default was thought to be impossible. For purposes of calculating capital, sovereign bonds have not been marked to market.  (in some cases, they are marked-to-market for accounting purposes).   Today, part of the need for  additional capital is to allow sovereign debt to be marked to market, ahead of the Basel 3 requirement.  The remainder of the additional capital is for the purposes outlined in number 2 and 3 above. 

European banks are required to present plans in January 2012.  The European Banking Authority estimated the capital shortfall to be €114B.  The largest shortfalls are in Greece (€30 Billion), Spain (€26Billion), Italy (€15B), and Germany (€13B).  But the total amounts only tell half of the story.  The other part is the size of the shortfall in relation to the size of any specific institution.  In this regard, a few small-ish banks are facing large capital shortfalls when expressed as a percentage of their market capitalization. For instance, Commerzbank (PINK: CRZBY) is thought to need a capital injection of €5.8B according to the EBA, but this compares to a market capitalization of €6.8B.  This is a stock to avoid due to the risk of an "AIG-like" solution or massive equity dilution. This will be doubly challenging due to that institution's history of erratic operations and profitability.  On the other hand, Deutsche Bank (NYSE: DB) is thought to need capital of €3.2B according to the EBA, but this compares to a market cap of €27B.  Given the size of the entity, this is likely to be raised without major dilution to shareholders. 

The EBA has explicitly stated that these capital requirements are to be met by:

1. Retained earnings, including reduced bonus payments;
2. New common equity or other approved forms of capital; and
3. Sales of selected assets that do not impair lending capacity.

The EBA discouraged shrinkage of balance sheets, which would lead to contractionary pressures.  Although unstated, the national governments are the investors of last resort. 

A Definitive Solution is not in the cards

Most economists recognize that the "Geithner" solution would be the best way to proceed.  This would require a combination of the liquidity program (which is now in place) and a massive equity capital injection similar to TARP.  The mere availability of this equity capital would end the speculation about the solvency of the European banks and would free the banks to purchase government debt at something close to normal yields.  However, this would require a massive sum of money; at least €2T and perhaps double that amount.  Ultimately, it would be repaid, as TARP was largely repaid.  Banks would raise replacement capital over a period of time, and calm, with a good share coming from retained earnings.  But there is simply no political will for this program in the EU.  It is seen as the strong subsidizing the profligate and accordingly is simply DOA (dead on arrival).  So what is left????

Kick the can down the road, continue in small incremental steps, and hope that an economic recovery within the next decade will eventually bail out the sovereigns.  In the long term, this is workable; but the path is likely to be rocky and painful at times.



 

Reality sucks

Happy talk of Euro summit tested at today's Italian bond auction.  Reality takes hold as yields rise for 3 year notes to 6.47% from 6.29% of Nov auction.  Indicates lack of market confidence since the new money is going to 3-year notes not 10-year bonds and even these shorter maturities are at the magic 6.5% limit.  

The European Crisis Continues

The European Crisis Continues

American Equity markets are anxious for a definitive resolution to the European Debt/Fiscal crisis.  Despite the rhetoric surrounding the latest “solution”, they will be disappointed. 

First, lets cover some basics.

1.     The EU is not going to break up because it is in the individual interests of the all of the main players for it to continue.  It IS a political union (or Confederation) and for all of its shortcomings it has created the foundation for over a half-century of peace. 

2.     The Eurozone will survive in its present form.  I wouldn’t say it is impossible for Greece to leave but highly unlikely.  I am also NOT saying that there won't be a default.

3.     The European leaders will not accept a “real” solution, but will resort to smoke and mirrors accompanied by high-minded rhetoric.  The pseudo-solution will not solve anything but WILL kick the can down the road.  Eventually, over the next decade, higher economic growth will solve the current problem. 

It is commonly understood how to definitively solve the current fiscal crisis.  As Secretary Geithner points out repeatedly the EU must create a “shock and awe” wall of money that will assuage the worries of the global credit markets.  The problem is that this will require at least €2 Trillion, and the principal funding source, Germany, is simply politically unable to make the required commitment.  The latest “solution” suffers from the same problems as the previous attempts.  It is simply too little and too undefined.  

The Structural Agreements

The European Summit agreed on basic budgetary principles that would limit “structural deficits” to 0.5% of GDP with “automatic correction measures” when national deficits violate the target..   This is in addition to a tightening of the disciplinary procedures for countries that violate the limit of deficits over 3% of GDP.  These principles would apply to the 17 Eurozone countries. On its face, this solution is implausible and unworkable. 

This first prong of the framework is a Treaty amendment to attempt to establish greater fiscal discipline.  The new plank is a requirement for the member states to adopt a sort of balanced budget amendment that will be deemed satisfied if “structural deficits” are limited to 0.5% of GDP.  Each nation is expected to adopt constitutional “automatic correction mechanisms” pursuant to principles to be established by the European Commission.  In addition, the existing limit on deficits to 3% of GDP will be strengthened by additional (undefined) “automatic consequences” for failure to adhere to this limit.  Why the reference to structural deficits?  This relieves countries that might suffer temporary deficits due to recessions—such as occurred in France and Germany (!!!) in 2008-09, and continues in France today.  The “automatic corrections” or the increased “disciplinary” actions have yet to be defined or implemented.  Even if they were legitimate, they would be highly contractionary. 

Little of this debate is new. 

The issue of acceptable budget deficits was anticipated and debated in the early 1990s in connection with the adoption of the convergence standards in the Maastricht Treaty in 1992.  The German position has not changed.  Germany worried about the profligate Italians at that time and they accepted two “solutions”.  One was an independent central bank, the ECB, that would adopt the strong German-oriented anti-inflationary fiscal policy.  The powers of the ECB were carefully negotiated.  The powers reflect a compromise of the divergent views of monetary policy within the EU and are unlikely to be radically changed. 

In addition, fiscal deficits of the participants in the Eurozone were restricted to 3% of prior year GDP, except for temporary exigencies, in the Maastricht Treaty in 1992. The problem is that ALL of the Eurozone countries, including Germany, violated the limit during 2008-10.  France is still in violation of the limit and is hoping to get back to it in 2012.  (However, the question is whether the French public will support the changes necessary to bring expenses back into line. )

During the last decade the European Commission abandoned its cherished dream of fiscal harmonization, which is a necessary predicate to fiscal or political union, due to an inability to harmonize the BIG issues.  This is nearly a decade-old process and it is not going to be reversed.  The BIG issues are the places in which there is BIG money: pensions, medical care, labor regulation, and other social benefits.  Americans see all of continental Europe as a bunch of aging socialist countries.  There is a large dose of truth in this, but it masks very significant differences, both in terms of social benefit structure, savings rate and demographic makeup.  Harmonization, and, therefore fiscal union, has not occurred because it is simply intractable. 

American investors find Chancellor Merkel to be a difficult myopic personality. Actually, she merely reflects German culture and her life experience.  There is no “equity market” culture in Germany. Investment in publicly traded equities is confined to a tiny portion of the populace.  Ms. Merkel grew up in East Germany, and is educated as a physicist.  She has no intuitive feel for the relevance of the capital markets.  In Germany, capital is the responsibility of banks, supplemented by a small coterie of wealthy private family businesses.  Germany is simply not a dynamic market based economy, and frankly, rejects every suggestion that it become one.  American hand wringing about dithering misses the point. Providing certainty to the equity markets to encourage investment and innovation is simply not a goal of policy makers because their equity markets don’t provide that function in their societies.  There is greater concern for the Bond market, but primarily insofar as it relates to local Banks. 

The German goal is for each nation in the Eurozone to fix its own problems with only limited support from the other member states, i.e., the Italians must fix Italian problems.  The Germans really don’t care how they do it: higher taxes, higher poverty etc.  They are willing to provide a limited amount of backstop support but as little as possible.  In this regard, Ms. Merkel is reflecting German public sentiment.  Frankly we are watching a multi-dimensional game of “chicken”.  Ms. Merkel wants to provide the smallest commitment possible that will achieve economic stability (Germans love stability).  This is a TRIAL AND ERROR process.  It will continue inching along until they find equilibrium.  No German leader is going to be hurried. 

There is one certainty.  The solution will not be “real”.  It will not really address the fundamental drivers of government spending: the large welfare state that is financed by a decreasing number of workers.  Sarkozy is proposing to extend the retirement age for some workers, but this is still tinkering around the edges.  And he is encountering fierce resistance.  But over the next 30 years, as the baby boom ages, the problem will simply fester for another generation of leaders to deal with.  Second, the solution will be highly contractionary.  Europe is headed for a recession in 2012 in any event and the actions taken will exacerbate.

The Money game

While much attention has been focused on the purported benefits of the greater coordination of fiscal discipline, this will not solve the current short term funding issues in Europe.

The Summit took two actions, but the math is fuzzy.  When math is fuzzy there is a reason.  First, there was agreement to make €200 Billion of additional funding available from the European central banks to the IMF with a plea for more money from non-EU nations.  Apparently, the understanding is that this would be lent back to the European nations in some form.  This commitment apparently involves “real” money. 

Secondly, the new European Stability Mechanism was accelerated by a year to mid 2012 and would operate side by side with the existing EFSF until its expiration in  mid-2013.  However, the total amount allowed to the combined EFSF/ESM was limited to €500 Billion. However, this limit would be reconsidered in March.  In this case, the actual cash contributions were limited to 15% of the Funds with the rest to be obtained through “leverage”.

It seems that in the current best case, there is €700 Billion possibly available to solve short term funding issues in Europe. Apparently, the IMF is being used to avoid some of the constitutional restrictions on actions of the ECB.

Nevertheless, €700 Billion is not close to adequate to refinance the sovereign debt due in 2012 which Bloomberg estimates to be over €1 Trillion with an additional €500 Billion of European bank debt also needing to be refinanced and at least €100 Billion of bank capital to be raised in the first half of 2012.  In effect, the EU is leaving Italy, Spain, and the other heavily indebted countries to live with the market reality of their position.  The onus is on them, as the Germans desire, to create budgets that restore the confidence of the bond markets and reduce borrowing rates to a sustainable level.  The ESM/EFSF and IMF will stand as a kind of last resort to plug any small gaps but will not to be the supra-financing vehicle that the Fed Reserve is in the US.  The simple fact is that Germany is not willing to increase its assistance to the other nations of the Eurozone

The summit was long on rhetoric and short on funding.  It is a continuation of the Euro leadership’s response to the crisis: an elaborate fudge.  Initially the global equity markets seem content while global bond and currency markets are more wary.  But the reality of the situation will set in during the first quarter of 2012 when European bond auctions occur. 

The net result of the latest machinations is that the “can is simply being kicked down to road” to the next summit in March 2012.

Don't be misled by the drop in the Unemployment Rate

November Labor report

The November labor report indicated that employers added 120,000 jobs in the month of November.  The unemployment rate, measured by the household survey, dropped to 8.6% from 9%.    Superficially, this seems like evidence of an economic expansion, or at the least the beginning of one.  However, the leading indicators within the labor report indicate continued stability in the US labor force with no indications of either a meaningful improvement or a recession.   

The “break even” number for maintaining the unemployment rate is generally accepted to be 150,000 new jobs.  How could a mere 120,000 new jobs cause a four-tenths of one percent decline in the unemployment rate?  The easy answer is “technical factors” which are discussed below.  The key leading indicators within the report do not show signs of an improving labor market.

For reasons discussed below the best that can be said about this report is that it indicates stability in the labor force.  It is NOT indicative of a “double dip” recession, but it is also NOT indicative of an incipient expansion.  Within the report the “leading indicators” were all flat, not up.  All of these indicators show a labor market that has improved since the end of the recession but is now largely stable with perhaps a tiny bias toward improvement.  A focus on the improvement in the unemployment rate, to 8.6%, would be misleading.

Some key elements of the report.

1.     Hours worked for production workers declined slightly to 33.6 from 33.7.  This is a leading indicator of an improving economy and labor market.   In an expanding economy, employers respond to increased demand by lengthening the hours worked in the initial phase since uncertainty is high and the cost in overtime is justified by flexibility.  Normally, production work is the most variable part of the work force and is very sensitive to changes in demand.  I wouldn’t attribute any significance to the small decline but merely point out that this is NOT indicating further expansion.

2.     The average hours worked for all employees remained flat at 34.3 hours, the same as in September and October.  Generally this is a leading indicator of a labor market improvement.  Similarly Overtime hours remained flat compared to October at 4.1.  Overtime is also an immediate source of flexibility for employers in responding to increases in demand. 

3.     The number of Temporary workers (seasonally adjusted) increased 1% in November compared to October and 7.8% compared to prior year.  In October, the increase over prior year was 8.1%.  Year over year gains have moderated throughout 2011. 

4.     The penetration rate of Temporary workers increased slightly to 1.77% of the workforce from 1.76% in October.  The penetration rate is highly influenced by production workers.  The rate has been improving since the bottom of the recession.  This small improvement is consistent with the trend of a stable labor market. 

5.      Unemployment among college graduates remained flat at 4.4% compared to October, although a significant improvement from the 5.1% of prior year.  This is a key statistic.  It is partly a leading indicator since these are the most employable people in the labor force and partly because purchasing power is highest in this group. 

These are important signals in the November Labor report that there is little risk of a double dip recession, which was greatly feared as recently as October.  In previous recessions, these indicators turned down for many months before a recession was evident.  On the other hand there is little evidence, in this data, of the economy entering into an expansionary phase strong enough to reduce the record unemployment rate. 

The most encouraging data, the decline in the unemployment rate, is misleading as an indication of future activity.  In fact, the unemployment rate is likely to increase in coming months.  The decline in the unemployment rate was a function of two factors in the household survey that is used to measure it.  First, the reduction in the total labor force in the household survey accounted for about half of the change in the unemployment rate or 0.2%.  This reduction is due to discouraged workers dropping out of the workforce.  Hardly a good sign; and perhaps influenced by seasonal factors.   Second, the household survey contained a larger increase in the number of people employed compared to the establishment survey; this accounted for about half of the improvement or 0.2%.  For many reasons the Household survey and the Establishment survey frequently differ; in this environment, the Household survey is probably a better view of new job formation, so let assume the 0.2% is real.  Nevertheless, the nominal 0.4% improvement in the unemployment rate is unlikely to be sustainable.  As the labor market recovers, more individuals will be drawn back into the work force, which will, paradoxically, cause the unemployment rate to increase. 

The lingering Housing Crisis--Changing perceptions of Home Ownership

The Housing crisis has lingered and is clearly contributing factor to the slow growth recovery.  The crisis has defied all of the government’s attempts to fix it. For the reasons discussed below, I think housing is going to continue to be a drag on the economy for several years—far longer than most forecasts.  In addition to the problems of collapsing housing prices—which are showing signs of stabilizing, there is a secular shift that is occurring in terms of the perception of the attractiveness of home ownership.  This perception has been largely overlooked but ultimately will be the source of a continuing drag on the recovery of the housing market even in the medium term. 

Housing used to be a “slam dunk” for most middle class Americans.  The formula was simple:

Shelter+ROI+Tax breaks+30 year mtge+easy credit=JUST DO IT (apologies to NKE)

--Shelter means the provision of the proverbial “roof over your head”

--ROI means the return on your investment since over any 10 year period since WWII housing prices have risen; conventional financial advice found in any money oriented magazine of talk show discussed housing as the "largest asset" of most families.

--Tax breaks means the mortgage interest deduction

--30 year fixed rate mortgage:  unreal, especially with only 10% downpayment

--Easy credit means the proclivity of banks to lend BEFORE the sub prime mess

Really, what was there to think about? 

Contrast today’s situation:

Shelter:  Same—you gotta live somewhere

ROI:  can’t count on it; equity may be at risk!!

Tax breaks:  under threat

30 year mortgage: still the best deal going, but need 20% down payment now

easy credit:  Hold the phone

Objectively, home ownership is just not the no-brainer it used to be.  You can make a good case that renting is better; or at least it is a simple economic decision in a particular geographic market, comparing monthly rent to a monthly mortgage payment plus the implied opportunity cost of the (larger) down payment.  In fact, risk adjusting the ROI on an investment in property, renting would have to be much more expensive to force a rational dispassionate investor to buy a home--even at today's low interest rates. 

 In 1940, home ownership reached a century low of 43.6% (source: Census Bureau & Wikipedia) before growing strongly after the end of WWII to reach over 60% in 1960, only a 20 period. Home ownership peaked at 69% in 2004, and has now declined to 66.9%. (source: US Census Bureau)  This is the largest drop in home ownership in any decade (sic) since 1930s. Home ownership is probably going to decline further before stabilizing, but the question is at what level.

 If the cyclical decline were to equal the depression era decline of 4%, we would be roughly half way through the cycle.  This feels optimistic given the structural challenges of the economy including high unemployment (16% counting under-employment and those no longer seeking work), and low income growth.    If we extrapolate the impact of the changed perception of home ownership to the broader economy, we are facing several years of sub-par  economic growth. 

Sources: Wikipedia and US Census Bureau

EU rescue: Fact or Fiction

With great drama, the EU announced a package of measures designed to end the current fiscal crisis sweeping Europe.  Most economists polled in the last 24 hours are cautious as to whether the plan will work.  As with everything with the EU, it is one step forward and......simply hard to say whether it is also a step back.

The package contains: (1) a "voluntary haircut" on Greek debt held by banks (but not the debt held by the ECB) of 50%.  This seems rational, but the irrational part is that it was accompanied by a statement that the Greek debt is to reach a level of 120% of GDP by 2020!!!.  Of course, 2020 is a long time, which implies that the Greek debt load is way out of balance today and benchmarks long in the future have a tendency to get diluted over time when the spotlight moves away.  This latter term is highly speculative for reasons I have discussed previously.  Simply restated: the cut in Greek spending is so large as to imply a massive cultural change, not just a tinkering with the Budget.  This cultural change  must be unprecedented in the annals of economic history; at least since the hyper-inflation of the 1930s.  Finally, there is no real discussion of how much money Greece, Italy, or Spain, will need in the short term or how it will be financed.  But see below.  Finally, this deal is "voluntary" only as it relates to large Euro banks (who will be forced to accept the deal) and will not be considered a default under the terms of standard CDS instruments.  What about the other holders: hedge funds and non-Euro investors?  They might not be so accommodating. 
(2) The EFSF fund is going to be leveraged "4 to 5x" and will reach $1.4T.  First, we don't actually know how big the Fund is today, but assuming the math is right, it implies that the fund is down to something around $300B from €440B .  Second, it is a bit of a mystery how  this leveraging is going to take place.  If outside lenders/investors don't join, isn't this just going to lead back to France and Germany who effectively guaranty the bonds of the EFSF today?   On what terms will outsiders lend or invest?  Will the Chinese or IMF make an investment with any risk of loss, or will they, particularly the Chinese, require concessions or other quid pro quo?  Doesn't this lead right back to France and Germany being the funders of last resort?  (Italy and Spain don't have the cash, and the others are too small to matter).  The EFSF will have two roles apparently: (a) to provide funds to bailout EU governments; and (b) to purchase Sovereign bonds in the market.  But even $1.4T doesn't go very far.  Apparently, the bond purchases are designed to hold bond rates down, and provide financing of a last resort to the beleaguered  sovereigns (e.g., Greece);  but this reminds me of currency intervention and we all know how well that has worked.  Also, is the ESEF willing to take a loss on the bonds that it purchases? Apparently not;  which makes it is a sort of Ponzi scheme in which the EFSF buys bonds and then lends money to the sovereigns to pay the interest on the bonds just purchased.  If outside investors in the EFSF are going to be guaranteed against loss to some extent, isn't this leveraging merely creating a contingent liability of France and Germany--as the largest countries in the Eurozone?  Whew. 
(3) Banks will be forced to raise capital by June 2012 to bring capital ratios to 9%.  Apparently, in addition to discounting Greek debt by 50%, the banks must discount Spanish Debt by 3%.  I haven't seen anything on Italian debt.  This equity will be raised through all sources including cuts in dividends and bonuses, sales of assets, contraction of assets and sales of equity with the sovereigns, not the ESEF, being the investors of last resort.  Since the French banks are rumored to have the largest problems, doesn't this lead back to France and their vulnerable AAA rating.  Or will this become basically the "mother of all sales" on French bank equity?  Economists have been critical of the capital requirement because they see it as highly contractionary--at a time of Euro recession. 

You have to ask the question: Why all the machinations?  Why not just the obvious simple solution?  Well, of course, the Germans are trying to limit their exposure and save Merkel's government, and the French are trying to save their AAA rating and Sarkozy's career.  At the same time, EU leaders know that they have to provide a "shock and awe" blast to the markets to cool the fear of contagion.  Again, we are short on the "details".  Probably, this plan will work, with periodic agony, over a period of time; but we have just lived through one Black Swan event, and now we remain vulnerable to another.   "Kicking the can down the road" has become the fiscal strategy of choice outside of the UK.

As the (Old) World Turns: Is the European fiscal crisis drawing to an endgame?

On Oct 9,  Ch. Merkel and M. Sarkozy announced that they “will reach an agreement regarding the recapitalization of Europe’s banks”.  Since then news reports have indicated that the European Central Bank is considering a requirement that European banks increase Tier I common equity capital from a minimum of 7% to 9% within 9 months.  If they cannot raise private capital, they will be required to accept some form of government aid.  In the meantime, the “troika” of international auditors are supposed to approve Greece’s next distribution of funds from the EU.  There is great risk in both of these steps which are fundamental to solving the European fiscal crisis. 

The Merkel-Sarkozy agreement is only a statement of principle and not in any sense a real agreement.  It fudges the main issue dividing the two countries.  There are two schools of thought.  The Germans want to see recapitalizations handled on a country-by-country basis.  Lets call this the “Irish Solution”.  The French want to handle it on a consolidated European-wide basis.  Lets call this the “French Solution”.

The issue with the Irish Solution is that the sovereign debt of the home countries would escalate dramatically, which (1) could lead to a down grade by the rating agencies and certainly would lead to an increase in spreads in the financial markets; and (2) it would highlight the political fallout of a bailout for ‘bankers'.   The French solution would involve the use of the European Stability Fund but augmented in some way.  The French feel that they have already contributed to this fund by their guaranty of payment and it should be used first. 

The plan is supposed to be announced no later than early November at a meeting of the G-20 but the October 23 meeting of EU leaders will be an early test of the resolution. 

In the meantime, Greece has announced a new round of budget austerity measures designed to both cut expenses and raise revenues.  Again, there are many unanswered questions and the plan looks fudged.  The plan relies on property tax since Greeks are notorious cheaters on income tax.  But property tax is also problematic since there is no systematic record of property ownership in Greece.  Moreover, what is reported is often based on unrealistically low appraisals relating back many years.  So tax collection has an element of “volunteerism” that is likely to be ignored by  many Greeks.  There is also a plan to reduce government employment and a further reduction in government salaries (40% in total reductions).  The latter are good ideas in a country in which civil servants obtain salaries that are said to be 2-3x of the private sector with generous pensions and yet corruption is still rampant.  The only problem is that the real reductions in employment are still to come.  The Greek “austerity” plan is really a dramatic cultural change with a smaller and more efficient civil service that will be paid closer to levels of the private market.  This seems ambitious for a plan that is to be implemented in just 2-3 years.  There is plenty of room for disappointment—meaning default.  Assigning compliance to the “troika” seems to set the stage for a default at some point; if not in November, then early in 2012.  

The history of this saga has been filled with half-measures that are taken only when the EU has been forced to act by external factors.  The world’s equity markets seem now to believe that this cat is going to change its stripes and now act decisively and definitively.  There is plenty of room for disappointment.

Housing Crisis Continues

Almost all Americans recognize that one of the most serious obstacles to an economic recovery is the lingering after-effects of the housing crisis.  Apparently, the Federal Government hasn’t caught on yet.

Many Americans have differing opinions about the origin of the housing crisis.  Was it greedy bankers, or greedy thieving homeowners?  Or a little of both?  In any event, the housing bubble pushed up prices across the entire spectrum of US real estate fueled by easy money and a willing Federal government.  The consequences were widespread and nearly catastrophic. 

 American citizens have watched massive bailouts of the banking system due to reckless or incompetent investments in mortgage securities.  I have long supported TARP as the only pragmatic way to address a systemic problem that threatened all of us.  Thereafter, led by the left-leaning Obama administration, the Federal Government  attempted to implement mortgage modifications for defaulting homeowners in order to “keep them in their homes”.  Curiously, despite the “best” intentions, the re-default rate has been extraordinarily high which confirmed the view that many of these people should have never been lent money in the first place.  This latter program has been more controversial since it might in some, many or most instances, depending on your point of view, reward borrowers for misbehavior.  Again, it is simply a reasonable pragmatic response to an unprecedented problem.  It would be nice to say that misbehaving borrowers would not be assisted, but the Government does not exercise discretion very well.  In any event, the program has been far from successful. 

Both parties have failed to recognize the political and moral consequences that have flowed from these decisions.  Homeowners who are still paying their inflated mortgages aren’t receiving any government assistance.  This is a huge class of people in all walks of life  and it is difficult to generalize.  But clearly the decline in house prices (the largest financial asset of most people) has created a reverse “wealth effect” which is constraining the economic recovery.  One category that calls for some special attention are borrowers who now have mortgages that exceed the value of their house, in some cases by substantial margins.  (I am excluding any home equity loans from this discussion).  This phenomenon also calls for a pragmatic solution in the form of mortgage modification simply for the purpose of stabilizing the economy. This is not limited to subprime loans.  Among all homeowners, 20% are “underwater” and there is little difference between subprime and prime borrowers. The New York Times estimated the size of negative equity as $700-800 Billion.  

Many banks are willing to make some accommodation to “underwater” borrowers, and the Federal government appropriated funds to share a portion of the modification.  A frequent formula is that a modification (i.e., a reduction) of up to $100,000 would be shared equally between the Feds and the Bank. But guess what the principal roadblock is????

Fannie, Freddie, the VA, and the FHA do not allow reductions of mortgages which they hold or which they have securitized.  The result is that few mortgages have actually been modified.  Their rationale is that such a loan modification would create a “moral” hazard by encouraging subsequent borrowers to over-extend themselves in the future.  Again, this is not a case of subprime loans; virtually all of the Freddie and Fannie loans are prime. You might ask why NOW is the Federal Government getting morality? Apparently, the White House is unable to order a change in the practices at Freddie and Fannie despite the fact that they are now owned by the Feds.  This seems an odd place to suddenly become moralistic for a nation that pays people more not to work than can be earned by working and pays unwed mothers more for each subsequent child.   Most evidently, the bailout of the banking industry has created a widespread sense of unfairness (thanks, Tea Party).  At this point, we (the Government) need to do everything possible to restore equilibrium in the housing market.  The President strongly suggested that banks assist borrowers in refinancing at lower rates.  That is a good idea in that it provides a benefit, albeit limited, to many homeowners who are paying their mortgages.  But mortgage modification for “underwater” mortgages is also a useful and necessary step.

As I said in the beginning, we are simply in the business of pragmatism at this point.  We are all going to benefit from an improving economy.

(Source: The New York Times, October 6, 2011)

Europe redux (again)

The EU governments continue to walk a tightrope with respect to the fiscal crisis that they are facing. Ch Merkel said yesterday that Greece will NOT default but that there will be no “big bang” solution to end the debt crisis. 

She correctly, in my opinion, said that a Greek default would have unpredictable consequences, and could lead to speculative attacks on other vulnerable countries.  This would in turn risk a negative impact on the German economy. (source: Bloomberg).  But Merkel admitted that her “entire council” of economic advisers said that Greek debt should be restructured—advice that she is not prepared to accept for political reasons.  She questioned that if a “haircut” were to be imposed on Greek debt, where would it end?  Would there be a line of countries asking for similar relief.  This would of course disadvantage German taxpayers who had lived in a more prudent fashion.

She concluded that the only way forward was collectively; that there was no prospect of Germany going it alone—like Switzerland.  Earlier today, Ms. Merkel said she would support bank recapitalization if there was a "joint assessment" that it was needed and the rules were "uniform".

While this is a dynamic situation that is shifting rapidly, Ch Merkel’s remarks lead to a conclusion that the Euro leaders are likely to continue on the current course:  put pressure on the heavily indebted countries to heal themselves while providing a modicum of expensive Euro level financial aid to assist in the task.  This would create a continuing period of uncertainty, and a restraint on global growth as the major European countries adopt austerity measures from a budget standpoint. 

Many have predicted the death of the Euro (e.g., Pimco), but the reality may be worse—it will survive but go through a very long slow rough patch.  Ms. Merkel has clearly tied the existence of the Euro, and the EU, to German foreign policy (sic) noting that this is one of the fundamental pillars of peace in Europe. 

I would still advocate a TARP-like recapitalization of the major European banks, with a further facility available for additional problems.  This could be financed on a state-by-state basis.  Of course, this only increases the pressure on sovereign debt (see Ireland), but it creates a firewall against contagion.  Hopefully, the affected banks can find private capital in due course, but the sovereigns would be the investors of last resort.  Politically, this is not going to be too popular; but it is simply a reality that no European government (aside from Greece) is going to allow their banks to go bankrupt.  

The US equity markets seem poised to move higher today bolstered by a potential rate cut in Europe on the retirement of Trichet, the Euro bank recap plan, and slightly positive US employment data.  Of course at this point, the life of a rally is measured in days or less. 

Tidbits from Oct 5

The US stock market rallied hard at the end of the session.  Is this real?  I don't think we will see a "real" bull market rally until there is better evidence that the US will avoid a recession.  Otherwise, it has the feel of short covering at the bottom end of the trading range (around 1100 on the S&P), and now a rise up towards the top of the trading range.  BUT,  the ADP report today, and the DOL jobs report on Friday,  could be market moving.  I think the recession talk has been overdone, so I expect a bounce off this data.  Starting next week, we will begin to see earnings reports for Q3 and, more important management guidance for Q4.  Again, my expectation is that these will be mildly positive and will spur a short term rally.  One key to watch is whether there is a breakout above 11,500 on the Dow (1200 on the S&P), and a breakdown in correlation of stocks.

There has been unusual correlation of individual stocks to the movement in the market averages.  Normally, it is a market of stocks not a stock market, but since August, most stocks seem to rise and fall based on the movement of the indices rather than fundamentals affecting the particular stock.  This seemed to break down a little in the last 10 days, which is a positive sign for bullish investors.

Update on Europe--The equity markets have been spooked for months on the prospects that there could be another "Lehman" with a large financial institution going bankrupt.  As I pointed out previously, this is just not going to be allowed to happen in Europe for many reasons.  Yesterday, this view was confirmed as the French and Belgian governments announced a plan to rescue Dexia, guaranty its deposits, and its funding.  (sound familiar?)  Furthermore, there is discussion in Europe today of a "recapitalization" plan for European banks.  I have advocated for some time that the first step ought to be a serious stress test followed promptly by a TARP like capitalization plan.  This would quiet the speculation about the future of Euro banks, and put them in a stronger position to deal with troubled sovereign debt write-downs.  But instead of acting definitively early on, the Euro governments have vacillated and taken half measures hoping to avoid a more far-reaching restructuring.  Ultimately, they will be dragged to the logical conclusion.  But this will put more pressure on sovereign debt across Europe (like in Ireland) and force the ECB into a more accommodating stance  which will reduce the value of the Euro v. the US$

  Its a case of pay now or pay later.  usually pay now is cheaper. 

China syndrome

The Chinese authorities have been taking actions for some time to cool the Chinese economy to allay fears of over-heating.  Inflation is high (6.2% in August) forcing the Financial Ministry into a tight money policy.   In addition, the Chinese are tightening requirements for home ownership to slow the red-hot property market.  It is always difficult to gauge what is going on in China and the economic reports are not consistently credible.  Nevertheless, the government's actions seem to be taking effect.  The question is whether this will be a hard or soft landing.  In Western experience, "soft" landings are rare.  Will the Chinese experience be different? 

Chinese GDP growth has been slowing for the last several quarters to 9.7% in Q1 to 9.5% in Q3, to an estimated 9% in Q3, and forecasted 8.4% in Q4.  Currently, the soft landing view is prevailing, especially after the release over the weekend of Chinese PMI (Purchasing Manager's Index) at 49.9.  The index has been stable for 3 months at approximately the same level even though a reading under 50 is thought to show contraction.

You also get different answers to the question of how dependent the Chinese economy is on exports v. local consumption.  I have heard various answers from credible economists.  the range is from 75/25 in favor of domestic consumption to 25/75.  It is a wide range.  I tend to favor the former from my readings.  Nevertheless 25% is still a major commitment to exports, and a slowdown in the Western economies would hurt.  Moreover, there are many Western companies manufacturing products in China for export to their home markets, including IBM, Dell, EMC, and CISCO.  I mention these because they were clients of my old company.  In 2008, these companies slashed manufacturing in China during the Great Recession. 

We are living in a funny world.  The world is becoming more dependent on one of the most opaque economies in the world; an economy whose currency is still not freely traded or floating.  to compound concerns, Chinese companies do not have the same credibility (as bad as it is) as Western companies in terms  of corporate disclosure policies.  Chinese economic growth has been impressive; and the rural to urban migration underpins continuing growth forecasts.  Nevertheless, I would still retain a dose of caution. 

pre market Friday Sept 30--worrying signs in Europe

German Retail Sales slid 2.9% in the month of August compared to July, and compared to the estimate of .5%.  Signs of slowdown are all over Germany which has been the engine of Europe.

Luxury Good retailers have escaped the worst of the market downturn, but appear to be weakening.  Stocks of European luxury goods makers, like Burberry, have declined in early European trading today on worries about a slowdown in China.  Few have noticed the rapidly rising exposure of these companies to China.  Burberry, 33% of Revenues, and Tiffany, 38% of Revenues, are examples.  

The ECB, which aims to keep annual gains in consumer prices just below 2 percent, said earlier this month that inflation may average 2.6 percent this year and 1.7 percent in 2012. Economic growth may weaken to 1.3 percent next year from 1.6 percent in 2011, it said.  (Bloomberg)

European stocks are down across the Board this morning, signaling a US decline at the opening.

Obama's re-election challenge

Most people are aware that President Obama's approval rating has fallen dramatically in the last 12 mos and is now below 50%.  While he still wins most of the hypothetical races against his Republican challengers, this is largely due to the differences in name recognition between an incumbent President and challengers that are not household names at this point in the election cycle.  Obama's election chances would be slim if the election were held today.  Of course, the election is over a year in the future and "a week is a long time in politics" much less a year.

President Obama has lost ground since 2008 in critical voter demographic groups such as Independent , Jewish voters, Young and, even black Americans.    With unemployment over 9% and hitting blue-collar and youth employment particularly hard, the President is vulnerable in many states.  Many of his core constituents, especially young, Jewish and Black Americans, are less enthusiastic about Obama today than in 2008.  Even a 5% decline in turnout among these key Democratic demographic groups, and others, such as union members, would be a serious problem for the President. 

In analyzing his 2012 election prospects we need to start with an analysis of 2008.  Obama's election victory is widely misunderstood.  Since the end of WWII, only once has a party held the Presidency for 3 consecutive elections: Reagan/Bush in 1980-88.  In fact since 1900, it has happened only 3 additional times.  It is the nature of American politics that once a President serves 2 terms, the public is likely to want a change (remember, "Hope & Change"). The Outsider can always run on a platform of "its time for a change".  President Obama was particularly adept at using this theme, but don't forget that Bill Clinton was also. 

Despite the advantage of running in an environment in which the Republican incumbent was extraordinarily unpopular, the 2008 election was much closer than understood due to the vagaries of the electoral college.  Obama won the election with 365 electoral votes, or 95 more than the 270 necessary to win.  But consider that the election in the following states in 2008 was very close. These states might easily swing to the Republican nominee in 2012 especially if the economy continues to be weak and unemployment high. (The electoral votes shown below represent the votes allocated in the 2012 election not the 2008 election due to the changes resulting from the 2010 census.)

NC 15 Electoral votes, O margin of victory 14,000 votes,
CO 9 Electoral votes, O margin of victory 200,000 (4%)
FL  29 Electoral votes, O margin of victory 200,000 votes (1.25%)
NM 5 Electoral votes, O margin of victory 120,000 votes (7%)
Ohio 18 Electoral votes, O margin of victory 200,000  (2%)
VA 13 Electoral votes, O margin of victory 220,000 (3%)
IN 11 Electoral votes, O margin of victory 24,000 votes (less than 1%)
=total 100 Electoral votes, O margin of victory !,000,000 (less than 1.0% of national votes)

Close McCain Wins were MO 10 Electoral Votes, and MT 3 Electoral votes. 

These are likely to be the battleground states in the 2012 election, along with PA (20 Electoral votes).  If you eliminate NM, VA, IN, MT and CO as traditionally Red States, the battleground states have a familiar ring:  OH, FL, PA, MO for a total of 77 Electoral votes in these key "Super" swing states.  In the latest polls from Real Clear Politics, Obama leads Romney by 1 or 2 percentage points (within the margin of error) in OH, FL and PA. 

If we look at 2010 mid term elections, several Blue states won by Obama in 2008 are vulnerable to a moderate Republican nominee, such as Wis (Rep Gov), IL (Rep Senator), MN (Rep Gov), NH (not happy with President Obama), IA, Nev and even Mich. Very few McCain states, other than MO, are vulnerable.  If any of these Blue states turn Red, it would cushion a Dem victory in PA.   

From this standpoint, it is not surprising that President Obama is focusing on shoring up his standing about his base.  If he has further slippage, he will suffer the same fate as Mondale, or Carter.

German Parliament backs expansion of rescue fund

The lower house of parliament passed the measure with 523 votes in favor and 85 against, granting the fund powers to buy bonds in secondary markets, enable bank recapitalizations and offer precautionary credit lines. It raises Germany’s guarantees to 211 billion euros ($287 billion) from 123 billion euros.
source--Bloomberg

Both main German parties supported the move, strengthening Ch. Merkel's political position.

NBA strike: is anyone listening

Last week, the NBA announced that a portion of the pre-season games would be cancelled due to the strike/lockout.  It barely made the fine print of the local Sports sections.  Compare this to the daily hysteria over the lack of offseason training camps of NFL teams and then the delay in the start of offical training.  The NBA has a real problem.  Michael Jordan, Magic, and Bird lifted the NBA to first class entertainment status.  Since then, even with LeBron and Kobe, the league is suffering in terms of its popularity and image.  The fall sports calendar is crowded with the Baseball playoffs and World Series, college football and the NFL.  Is anyone paying attention to the NBA before January?  Basically this is a joint screwup between the players and the owners, just like the NFL.  For the sake of the internecine battle to divide Billions of $$$ (during a recession), they are losing the hearts and minds of their core fans.  There are too many alternatives.  You guys should get real--and fast!!

Another Day of Greek tragedy (continued)

Secretary Geithner, in his interview last week with Jim Cramer, said that it was impossible that a European bank (outside of Greece) would be allowed to fail.  This is manifestly true.  The French Government is not going to let any French bank fail, nor is the German Gov't, etc.  This is easy since there is a precedent--TARP.  Although the media keeps talking about the $400 B of outstanding Greek bonds, the rescue package for European banks only needs to replenish lost capital, a small fraction of the total loss, say 10-20%.  This would allow the banks to refinance over a longer period outside of the current panic-y climate.  I very much doubt there is much exposure to Greek debt within the US banking system. 

I think there is greater recognition this week that the EU is going to have to craft a definitive plan and not just keep kicking the can down the road.  However, with 17 countries, there is always someone who is out of the loop or who wants to grandstand.  In the end, the Germans will push through what they want, even if it is a little squeaky. 

today's stock market action (+150 pts)

The US stock market has rallied for three consecutive sessions, with today's gain over 150 pts on the Dow Jones average.  Is the fear over? No, not yet, as shown by the sharp sell off in the closing hour in which the DJ gain fell by over 150 pts.  While this is not a repeat of 2008, the market is still weak from a fundamental perspective.

Since July 21, the DJ has fallen from over 12,724 into a trading range of 11,613 on the high side on August 31 and 10,713 (August 11, but 10,733 on Sept 22--5 days ago).  But volatility has been phenomenal with six declines of over 500 points in a two month period.  This compares to 3 declines of the same magnitude in the prior 10 months of the year. 

Two issues have dominated investor thinking over the last two months, i.e., since July 21.  One is the concern about a meltdown of the EU as a result of fiscal crises in Greece, Portugal, Ireland, Italy and Spain.  But clearly investor concern has been focused on Greece, and the feat that a contagion could spread more broadly through Europe.  As I have advocated in prior posts, this is a solvable problem.  In the meantime, the drip, drip, drip of the crisis has exacerbated market sentiment.  A solution to the European fiscal crisis would reduce volatility dramatically.  However, even a definitive solution would not fuel the US equity markets above the current trading range. 

The second issue is the slowdown in economic growth, both in the US but more broadly in Europe and Asia.  This is a medium term issue; hopefully only a year or two years in duration.  All economic data continues to point to a slowdown at best in economic growth.  Many analysts think that things will deteriorate further into a "double dip".  While anything is possible, there is no data supporting that view.  For instance, weekly US initial unemployment claims continue to hover over 400,000.  While this is clearly not good, and indicative of the economic slowdown since it is not improving, it is not climbing.

The biggest drag on the US economy relates to housing.  This is the most worrisome data point since it is slowly worsening in some respects, such a declining housing starts, with continuing high foreclosure rates and lack of financing creating a drag on that market.  This is one of the two most important markets for the US, both psychologically, and economically.  The other major market is the equity market, again both psychologically and financially.  Many Americans have their 401k invested in equities, and declines in the equity markets have an immediate impact on the American psyche, even of ordinary people. 

While the equity markets have stayed within a narrow range, two important developments have occurred in the last several days.  First, Gold, the biggest indicator of fear, has declined sharply in value-- against all predictions.  Second, the US$ has strengthened against the Euro and other currencies such as the GB£ and CDN$.  These are positive signs for the future.

For the present, I would advise caution.  The economic facts have not changed, and until they do, there is no fuel for a long term rally, just bargain hunting.  This lack of underlying positives from an economic standpoint leaves the equity market vulnerable to any new negative whisper or rumor about Greece or the EU.  Also, we are approaching earnings season in less than a month.  It is likely that some companies will be reporting reductions in guidance due to slower GDP growth.  While this should be already discounted in prices, I would be cautious and believe it when I see it.  

Normally, I would say this is a time to sell into rallies and buy on dips.  But in many cases, the "highs" are lower, and the dips are just as severe.  For instance, companies like CAT, ETN,  JCI, MAN, are all over sold but still suffering lower highs and lower lows.  In the long term, these are all good companies at bargain basement price levels, but they could go lower.  Again, this is a time for caution.  Not fear, just caution.  With a long enough time horizon, I would recommend buying some of the leading brand names which have seen their dividend yields rise to a level that is above 10 year treasuries.  The dividends are relatively safe, and there is a good potential for price appreciation for the medium term.  But I would still not fully commit to equities at the moment.  It is still time for caution until the economic horizon looks a little brighter.

The European Crisis

The world's financial markets are currently swaying to and fro on a daily basis in reaction to every twitch and whisper of key Euro leaders with respect to the European fiscal crisis, in the PIGS, but also Italy and even Belgium. What is the issue and solution?

The issue is that Greece is heavily indebted beyond its ability to repay its government bonds. But a default would create ripples throughout Europe, especially among European banks that hold Greek debt. The write off of Greek debt that would be required would jeopardize their capital ratios. But more broadly, it would create a market perception of likely default by other heavily indebted nations, first Portugal, and then Ireland. These are all small countries on the periphery of Europe, both economically and geographically. But if this perception were to spread (called "contagion") to larger heavily indebted countries, especially Spain and Italy, then the economic disruption, and the threat to the Global banking system, not just European banks, would be far greater.

What should be done? Many commentators casually suggest that this is the end of the EU. I think this is a superficial and foolish analysis. The heart of the EU is the Franco-German alliance, and neither of these countries is going to abandon the EU very easily. Why? Because it is in their respective economic and financial interest for the EU to survive. There is a deep psychological thread in the German psyche dating back to its creation in 1870 of being isolated in Europe between enemies (Russia and France). The EU has created the longest period of peace in Europe for centuries. As a result, the Germans will work to preserve the EU unless it becomes prohibitively expensive for them. Of course, the French want to be in the EU because it strengthens their trade relations with the member states, and protects them from more competitive markets in Asia, and even the US. Add in the historic trading partners of each, The Netherlands, Belgium and Luxembourg, and this core of Europe accounts for over 50% of EU GDP.

Similarly, this core group is going to fight to retain the Euro which has brought great economic and financial advantages to them as exporting countries with heavy manufacturing bases. The Euro has become one of the leading currencies in the world and a counterweight to the US$. This was impossible when each country had a separate currency. Again, France and Germany, see the Euro as very much in their respective interests, for slightly different reasons, but will fight for its survival.

What is the solution to the Crisis? There are three problems that have to be addressed, and they are interlinked.
1. Ring fence Greece so that a default is either impossible, or the Euro banks are protected via a Euro-TARP with respect to capital ratios. This has to be definite and certain. If Greece defaults, then simultaneously, the EU will have to announce step 2 to halt any further deterioration in credit in the Eurozone. Currently there is too much uncertainty about the likelihood of a default and the likelihood of a ECB rescue plan. These risks have to be taken off the table.
2. Some method of funding the other crises in Europe, including Portugal, and Ireland. The chance of default of these countries MUST BE RULED OUT ONCE AND FOR ALL. The message to the financial markets must be: IT STOPS HERE. For example, all financing after a Greek default could be made through Eurobonds and not national bonds.
3. Some method of controlling future deficits within the EU. For instance, a council of finance ministers that monitors sovereign budgets and uses its persuasive power to insure that future deficits are within a range of reason.