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.