Today, Moody’s warned that Iceland, Latvia and Hungary were stabilizing but that their economies remained fragile. The problem is high debt levels, which is restraining consumer spending. Recovery in the Eurozone has been the main aid to stabilization, the report said. Absent this support, the outlook is considerably worse.

Moody’s re-affirmed Iceland and Hungary’s ratings of Baa1 and Latvia’s of Baa3, one notch above junk. But, Moody’s refused to remove its negative outlook to the countries’ credit ratings.

The Wall Street Journal reported:

"These three countries are the only ones whose government ratings have experienced multiple downgrades over the past two years," says Kenneth Orchard, vice president in Moody’s sovereign-risk group. The ratings of these countries still carry negative outlooks, signaling the possibility of further downgrades in the next 12 to 18 months.

As I mentioned in my last post, it is the debt that is holding these countries back. The report states:

The domestic sides of the economies remain weak as households and corporates struggle with elevated debt levels, the aftermath of housing bubbles in the cases of Latvia and Iceland, and weak banking sectors that are unable or unwilling to extend credit.

As a result, the FX Team at brown Brothers Harriman think these countries are over-rated. In a note released today Win Thin said:

All three of these countries saw improvements in their sovereign risk profiles this past quarter, but all three still remain overrated.  Our model puts Iceland at B, Hungary at BB, and Latvia at B.  Moody’s has always been too generous with its Eastern European ratings, and we have to question why all three remain investment grade still…

All three are also likely to contract in 2010, so the stresses on their economies and their social fabric won’t be going away anytime soon.  Downgrade risks are likely to persist for these three well into next year, as well as for Estonia and Lithuania.

I can’t help but see this as yet another data point demonstrating that this whole house of cards is being stitched together via fiscal and monetary stimulus. Absent this stimulus, the U.S., the U.K., the Eurozone, Japan, and China would all relapse into recession, dragging weaker economies like Latvia or Spain deeper into Depression.

Watch for any signs of premature policy normalization in the the Eurozone or the U.S. as a prelude to a double-dip. The silver lining here is that Moody’s also upgraded Brazil to investment grade today, showing that the emerging markets outside of eastern Europe are doing quite well (story here).

Related posts:

• Hungary cut to a notch above junk by S&P
• More trouble in the Baltics as S&P downgrades
• Baltics: Fitch downgrade and more downgrades to come
• A bearish view on Eastern Europe
• The EU promises to bail out eurozone members

Both Latvia’s and Estonia’s debt ratings were downgraded by Standard and Poors.  Estonia was cut from A to A-, while Latvia was cut to BB+ to BB – its considered high yield securities aka junk bonds. This should come as no surprise as both countries have been in the news due to severe economic dislocations as they attempt to maintain currency pegs in the face of a severe debt deleveraging.

Latvia has been having severe difficulties getting its IMF monies disbursed due to the lack of fiscal belt tightening. Just today Latvia released dreadful economic news with statistics revealing a19.6% fall in gross domestic product. As macabre as the figures were, they were better than analyst expectations of a 22% fall. Nonetheless, S&P has decided to use this backdrop as an occasion to downgrade the country’s debt along with northern neighbour Estonia.

Win Thin, an analyst at Brown Brothers Harriman, had this to say about the downgrades (emphasis added):

Somehow, Lithuania escaped this time but it should have been cut from the current BBB, as we rate it BB- vs. actual BBB/A3/BBB.  The only surprise to us was that the downgrades weren’t deeper, as we see eventual junk status (below BBB-) for all three.  As we noted in our most recent FX quarterly, the ratings agencies have been overly generous with Eastern Europe, particularly the Baltics.  Our sovereign rating model puts Estonia at a BB/Ba2/BB rating, way below actual ratings of A-/A1/BBB+.  For Latvia, we rate it B- vs. actual BB/Baa3/BB+.  Others that are overrated in the region include Bulgaria (we rate it BB vs. actual BBB/Baa3/BBB-), Hungary (we rate it BB- vs. actual BBB-/Baa1/BBB, and Romania (we rate it BB vs. actual BB+/Baa3/BB+).

We fully expect Estonia, Lithuania, and Bulgaria to follow Latvia and Romania into IMF programs.  Our negative view on the Baltics still underscores our bearish calls on SEK given the high levels of Swedish banking exposure to the region, and helps explain why SEK was the worst performer today vs. USD and EUR… Just look at Latvia.  It just reported Q2 GDP as contracting 19.6% y/y vs. an 18% drop in Q1.  The banking regulator has reported that all overdue loans rose to 23.5% of total loans in June...  Those numbers will only get worse, as we see little relief in sight for the economy…

The long and short of it is: expect more pain in Latvia and Estonia, but also across Eastern Europe as well. As the global recovery seems to within reach, particularly in emerging markets, expect Eastern Europe to underperform.

Sources

Brown Brothers Harriman FX Team

Related posts:

• Baltics: Fitch downgrade and more downgrades to come
• Moody’s: Iceland, Latvia and Hungary in “fragile stabilization”
• A bearish view on Eastern Europe
• Hungary cut to a notch above junk by S&P
• CDS contracts and the implosion of several Eastern European economies

Back in April, I mentioned a story about BTA, a bank in Kazakhstan that had been nationalized by the state in February.  The interesting bit about the story was that interested parties from abroad (including Morgan Stanley) had significant Credit Default Swap contracts (CDS) written against losses in the banks bonds.  In essence, foreign investors would be better off if BTA failed than if it had not been seized by the State.  And this interest in the bank’s failure created a self-fulfilling prophecy. See my post “CDS contracts and the implosion of several Eastern European economies” for more details.

Fast forward to today and now we learn of a gargantuan $7.9 billion loss at BTA.  DealBook reports:

BTA, the largest Kazakhstani bank, confirmed losses and write-downs for 2008 of $7.9 billion in a financial statement issued Monday, even as it pursues the restructuring of its debt.

According to the bank’s financial statement, actions by previous management led its portfolio to deteriorate for the year, resulting in the loss of 1.188 trillion tenge, the Kazakh currency.

Explaining the causes of the loss, the bank said:

Certain loan documentation, including collateral and associated additional agreements, primarily relating to financing of projects outside Kazakhstan, is no longer available. In addition, many loans were transferred to new borrowers that do not have adequate sources of repayment. Moreover, no collateral was provided by these new borrowers. Consequently all transferred loans are unsecured. A number of significant borrowers, primarily registered outside Kazakhstan, have ceased servicing their loans, have not allowed the Bank to monitor collateral or failed to provide information about their financial performance.

BTA spokespersons were not immediately available for comment.

Fraud is an issue and the bank is now being sued by shareholders.  But, I do want to concentrate on the CDS issue and its role in forcing the bank’s hand. In my view, CDS contracts should be seen as a major change in how parties to a bankruptcies react. They distort incentives for interested parties, and create a whole new group of ‘stakeholders’ through naked CDS (i.e. where the holders of the CDS have no underlying interest in the bonds).

In situations of systemic stress as we have just witnessed, CDS have the potential of increasing the number of bankruptcies and volatility in the financial system.  In my view, that is why they must be regulated – and not just in the United States, but globally, as this case in Kazakhstan attests. If CDS contracts could help drive a major foreign company into bankruptcy and an American finance firm could suffer massive losses as a result (not the case for Morgan Stanley here), I imagine this is something that U.S. regulators would want to know and prepare for.

Source

Kazakh Bank Confirms $7.9 Billion in Losses – DealBook

Related posts:

• Georgia bank fails with $1.1 billion in assets
• JPMorgan Chase: Large exposure to real economy downturn
• Seven more bank failures brings total to 64
• Goldman loses $2.1 in the third quarter
• $467 billion in writedowns and counting

This comes via der Standard, an Austrian daily.  My translation below:

The international financial crisis has hit eastern Europe harder than previously expected, according to a press report. At least ten states are negotiating with the International Monetary Fund (IMF) for billion-dollar aid programs, Handelsblatt learned from within the IMF community. The applications’ status will be decided soon as possible. Given the continuing economic crisis a majority of the IMF’s management is in favor approval of further aid requests.

According to the report, among the countries which have requested assistance at the IMF for the fist time are Bulgaria, Croatia and Macedonia. Ukraine, Serbia, Romania, Belarus and Latvia speculate on receiving a faster payout or increased speculated IMF assistance. Hungary had not yet decided whether it needs more money from the fund. The IMF has recently approved the application of Bosnia, as the Bosnian Minister of Finance announced on Thursday. Bosnia-Herzegovina will receive a credit line of 1.57 billion U.S. dollars (1.13 billion euros) from the IMF.

In regards to emerging markets, this story makes clear how much worse the situation in Eastern Europe is than in Emerging Asia or Latin America.

Source

Zehn Staaten Osteuropas verhandeln mit IWF – Der Standard

Related posts:

• EU planning 200 billion euro package for Eastern Europe
• Quote of the day: Austrian banks
• Eastern European economic growth to crater in 2009
• European banks have hands out for more capital
• Bloomberg talks about the meltdown in Eastern Europe

I am not the only one who sees events in Latvia as a potential catalyst for further downside risk to the reflation trade.  Mary Stokes over at Nouriel Roubini’s site has a very readable post out on why we should be watching events in that tiny Baltic nation for potential signs of contagion elsewhere.  She notes:

The collapse of the Thai baht in July 1997 helped spark the Asian financial crisis. Could events in Latvia spawn a similar contagion? Eyes are focused on this small Baltic economy, amid growing talk of a devaluation, due to the potential for spillover effects into its fellow Baltics, Sweden and the broader Eastern European region.

Strong trade and financial linkages, not to mention similar macroeconomic vulnerabilities, mean a Latvian crisis would almost surely have knock-on effects on neighboring Estonia and Lithuania, as detailed in this RGE EconoMonitor post in early May. A Latvian crisis would also have negative spillover effects into Sweden via Swedish banks’ heavy exposure to the Baltic trio. The wildcard is how a Latvian crisis would affect the greater Central and Eastern European (CEE) region. Direct trade and financial linkages between Latvia and CEE economies, outside of the Baltics, are limited. Nevertheless, many of these countries – particularly Bulgaria and Romania – share similar macroeconomic vulnerabilities with Latvia, meaning a crisis there could ‘wake up’ investors to the potential for crises in the rest of the region.

Last July I was talking about the Baltics as the next Argentina, but it seems we are past that already now.  At present, the legitimate fear is ‘Latvia as the next Thailand.’  There’s a new meme for you.  While I am much more bullish about the reflation trade, I still harbour doubts, particularly when it comes to Eastern Europe. One of my ten predictions for 2009 was that Eastern Europe would infect the Eurozone and bring the European banking system to its knees (that was prediction #4 back in December).  I do think the situation is brighter.  Nevertheless, Eastern Europe is going to be a problem going forward and Latvia is merely the catalyst as Thailand was in Asia in 1997.

The broader CEE region has minimal trade and financial linkages with the Baltics. So the key channel of contagion between the Baltics and the broader CEE region would be via the ‘wake up channel’ – meaning a crisis in Latvia could serve as a wake-up call to investors, alerting them to similar vulnerabilities elsewhere. So far, the evidence suggests the rest of the CEE will not go unscathed if Latvia devalues, despite their limited linkages. For example, the recent sell-off in the Polish zloty and Hungarian forint was largely attributed to concerns over potential spillover effects from a Latvian crisis.

The full post is linked below.  But, I suggest you look over at FT Alphaville for more coverage on this situation.  They have run a number of good posts on both the Baltics and the CEE banking situations.  The guys over at A Fistful of Euros are on the case as well.

Back in May, Michael Robinson of the BBC released an amazing podcast that captures the situation in Latvia quite well – selling $3,000 flats for $200,000.  Nice!  In my view, this is probably the best on the ground look you will see by a journalist anywhere.  Listen to the podcast below.

BBC podcast below

Source

Is Eastern Europe on the Brink of an Asia-Style Crisis? – RGE Monitor

Related posts:

• A bearish view on Eastern Europe
• Bloomberg talks Eastern Europe as Latvia downgraded
• Violence erupts in Latvia
• More trouble in the Baltics as S&P downgrades
• Baltics: Fitch downgrade and more downgrades to come

Dollar bears are getting their way in the currency markets right now.  While most eyes are peeled on Sterling (up 3 big figures since Friday) and the Euro, all currencies are rising against the Dollar (including the Commodity Dollar Complex – Auusie, Kiwi, and Loonie).  For me, the most interesting currency is the Swiss Franc because it is approaching parity with the U.S. Dollar (now down near 1.06 on the dollar) .  The problem with Dollar/Swissy parity is Eastern Europe.

This brings us to EU East.  And by that I mean members of the European Union nations east of the Eurozone, which stops at Germany, Austria and Italy (Slovakia is also a Eurozone member as of Jan. 1st).  Countries in this region have seen fantastic growth rates over the past decade, but, also a huge increase in debt, asset prices, and current account deficits.  All of this points to excess.

The problem, of course, is the Impossible Trinity.  These countries want stable exchange rates, monetary policy control and free movement of capital.  But, with the excesses already highlighted, the first to go in this trio was always going to be the exchange rate.

Now, EU East loaded up to the nines with debt in Swiss francs, Euros and U.S. Dollars.  Companies, Individuals, even hospitals have huge foreign currency debt exposure (see my post “Reverse carry trade borrowing is deadly” from October).

The above is a quote from my post “The European Problem.”  And this is one reason I wouldn’t be long the Euro – because European banks are a lot weaker than is presently being admitted. But, I am writing here about the Swiss Franc, not the Euro.  As I see it, a strong Swiss Franc is not a good thing for anyone – Swiss bankers, debtors in Poland or the global economy.  But this is what we are getting right now.  Back in March I said this is exactly what Swiss central bankers are trying to avoid:

Apparently, the Swiss franc is too high — or so says the Swiss central bank.  As a result, they are selling francs in the foreign exchange market to get the franc to come down.  There has been a lot of speculation about the Swiss and their plans to devalue the Swiss franc, including on this site.  It now seems clear that devaluation is where things are headed. Quantitative easing (QE) may be next.

Watch this trade because it is going to create problems in Euroland where Eastern European debtors, struggling with a depression and in the last economies likely to recover, are going to come under increasing stress.  CEE stress means Swiss bank and Austrian bank stress and writedowns in particular – and this will have very serious consequences for Europe as a whole.  Market rallies that move too far too fast often sow the seeds of a whiplash trade down the line.

Related posts:

• The Swiss get on the QE2
• The dollar collapses
• The dollar is rising against floating currencies
• Why are the Swiss now issuing debt in U.S. Dollars?
• Switzerland threatened with bankruptcy

Marc Faber participated in a roundtable discussion on CNBC this morning about the dreadful figures coming out of Europe (see articles here and here).
At one point, the German CNBC correspondent made a very good comment about Eastern Europe getting killed by a falloff in internal demand due to a severe banking crisis and this being compounded by a falloff in external demand as Germans and others increase their savings. She asked whether over-indebtedness and excess consumption was what caused the problem. Why should that now be the solution?

Faber used this as an occasion to promote his thesis that much of the geopolitical tension and economic turmoil is associated with a passing of the baton of economic leadership from the west to Emerging economies. Whether you agree with his sentiments, it makes for a lively discussion. The video is below and runs about 7 minutes. Take a look.

There is also an associated blurb from CNBC Europe’s anchor Geoff Cutmore about the discussion that reads:

Prepare for War, the Death of capitalism and Bankruptcy of the US Government (not necessarily in that order)

A vintage performance from the author of “The Gloom, Boom & Doom Report”. This morning – living up to his reputation for bearishness – Marc Faber forecast a litany of unpleasant events ahead.

His key message is: buy real assets. He thinks it will take years for the global economy to recover, but when it does the effect of governments’ printing money will ultimately reignite inflation.

“If you’re in any field, you should own a farm because one day you will be grateful that you are able to grow your own agricultural produce.”

Recovery will be slow because government meddling in the markets will postpone it. He argues that the final low for markets and for growth will only come when the debt and losses have been cleaned out of the system.

Unless the system is cleaned out of losses, “the way communism collapsed, capitalism will collapse.”

“The best way to deal with any economic problem is to let the market work it through.”

The Fed is destabilizing, it’s creating “enormous volatility”.

Marc thinks the yields in government bonds bottomed out in December 2008 – rather than lend money to the US government he suggests buying a portfolio of large, quality blue chip stocks. They will grow and survive – and reposition to take advantage of the rising importance of the emerging economies.

“I think we are living through a major transition in the world… the economic bloc of emerging countries will be more meaningful than before.”

“I think that in Asia we have lots of sectors that are quite attractive. The banks, they don’t have the toxic assets that we have in the rest of the world.”

While not an optimist on the Chinese economy near term – Marc likes Asian currencies, and banks ex-Japan. He also thinks the real estate markets are improving. Both Russia and Turkey get a positive mention.

Cutmore follows this up with a summation of Faber’s market calls related to this view. See the link at the bottom for those calls.

Source
Cutmore: Marc Faber on Armageddon – CNBC

Related posts:

• Marc Faber: Dr. Doom goes bullish
• Marc Faber Raw
• Marc Faber on CNBC: bearish on oil and India
• Marc Faber: “I am 100% sure that the U.S. will go into hyperinflation”
• Marc Faber: I advise every American to hold his gold outside of the United States

This morning you may have read Gideon Rachman’s positive view on Hungary.  He said the panic is all but over and it looks like Hungry is going to get through this debt crisis.

The horror scenario envisaged a Hungarian banking collapse that would ripple back into the rest of Europe and then around the world. Many EU banks have lent heavily in central Europe. Austrian banks are thought to have lent the equivalent of more than 70 per cent of their country’s gross domestic product to the region. This idea – perhaps combined with a folk memory that the Great Depression had something to do with the collapse of an Austrian bank – helped heighten the panic about Hungary.

But, having just visited Budapest, I can return with good news. The immediate crisis is over. There was a moment when there was a real fear of a bank run. One Hungarian financier is quite precise about the date: Friday, March 13. However, confidence just about held up, the moment passed and so has the threat of imminent collapse.

The unfolding of the Hungarian crisis now looks like a microcosm of the world crisis. Fear of financial collapse is gradually giving way to worries about an unprecedented contraction in the economy – with all the social and political consequences that could imply.

The Hungarian government has predicted that the country’s economy will shrink by 6 per cent this year. It has not performed that badly since 1945. Unemployment is rising and so is inflation, because of the fall in the Hungarian currency.

Hungary has no room for the kind of counter-cyclical Keynesianism that is being tried in the US and the UK. Nobody thinks the markets would tolerate huge fiscal deficits, so instead the government is cutting spending and raising taxes. State pensions were sliced by about 8 per cent last week. Sales tax has just been increased. And this is just the start of an austerity drive.

So, to recap what Rachman is saying, Hungary is looking pretty awful, but it could be worse. But, is that really true?  I’ll come at this question via Latvia and the troubles now ongoing there.  Yesterday, we learned that Latvia’s economy shrank 18% in the period from Q1 last year to Q1 2009.  This is a Great Depression scenario for Latvia.  But, the other Baltics, Estonia and Lithuania, are imploding as well.  For example, at the end of April, Lithuania reported a 12.6% drop in year-on-year GDP – not as bad as Latvia, but a Depression with a Capital ‘D” nonetheless.  I had asked in July if the Baltics were the next Argentina.  The answer is obviously, yes.

So what does this have to do with Hungary?  A lot. Western banks piled into the former Soviet bloc in Eastern Europe during this decade’s boom.  And with growth coming off the boil those bets are coming a cropper.  Certainly, things look much worse in Latvia than they do in Hungary.  Hence, the optimism from Rachman.  But, the guys at Brown Brothers Harriman are not onboard with the all clear call.  They have a bearish view on Eastern Europe. Here’s what they had to say regarding sovereign credits today:

Moody’s has been busy today, downgrading Ukraine to B2 from B1 and Kazakhstan to Baa1 from A2.  Interestingly, Moody’s damned Mexico with faint praise yesterday by saying that it couldn’t see Mexico losing its investment grade rating.  Of course, that doesn’t rule out downgrades from the current Baa1 rating, and we note S&P just put its BBB+ on negative outlook.  Our EM sovereign rating model puts Mexico at BBB-/Baa3, and so the case is strong for a downgrade.  However, Moody’s appears to be correct about Mexico hanging on to its investment grade rating.  Our model puts Kazakhstan at BB+/Ba1, and so significant downgrades are warranted.  Again, we are incredulous that Moody’s put it at A2 in the first place.  We also put Ukraine at B-/B3, and so another downgrade there is warranted.  Given how poor 2009 is shaping up to be in terms of growth, capital flows, etc., we believe the rating agencies will continue to downgrade the weaker EM credits into 2010.  And it’s not just EM that the agencies are going after, with Fitch today moving Greece’s outlook to negative from stable (Greece was already downgraded by S&P in 2009, with agencies cutting Ireland, Portugal, and Spain this year too).  We reprint below our ratings outlook that was in the latest quarterly, since these views still hold:

The Baltics:  Despite seeing some downgrades already, Estonia, Latvia, and Lithuania remain highly overrated.  All still face serious crisis risks in 2009, and it’s likely that the other two will eventually follow Latvia into an IMF program.  None of them deserves an investment grade rating, and we look for multiple downgrades in 2009.  Note that IMF programs did not prevent downgrades during the Asian crisis.

EMEA:  Most of the other countries in this group are facing significant downgrade risk this year too, though perhaps the Czech Republic slightly less so.  Hungary’s rating is the most out of line and faces the most downgrade risk in 2009, followed by Iceland, Bulgaria and Romania.  We believe Poland and South Africa face moderate downgrade risk.

You should notice that Hungary is an outlier in their analysis with significant downgrade risk.  So, it is not a case of all clear at all, not for the Baltics and not for Hungary either.  Edward Hugh at “A Fistful of Euros” have been chronicling these events. Read his posts on these events over the last two days:

• The Agony Continues – Latvian GDP Falls By 18%
• “Not All East The European Economies Are The Same”
• Non-performing Loans In Latvia

So, while the outlook is much improved, the risks are far from over.  With regard to the crisis in Eastern Europe, most people had been focused on Austrian banks and Central Europe (Hungary, Poland, Slovakia, Czech Republic).  I have written on this on a few occasions as well, even throwing in a vague reference to the Great Depression a post called, “1931.”  But, the Scandinavian banks’ exposure to the Baltics is just as worrying and should be the place to watch before we give a definitive all-clear.

Related posts:

• Hungary cut to a notch above junk by S&P
• Baltics: Fitch downgrade and more downgrades to come
• More trouble in the Baltics as S&P downgrades
• Roubini’s RGE Monitor: Threat of ‘Asia-Style Crisis’ in Eastern Europe
• Moody’s: Iceland, Latvia and Hungary in “fragile stabilization”

Today I saw two blurbs about Eastern Europe which I want to pull together with a bit of added commentary about the automakers in the U.S.  The first blurb had to do with the Baltics and their probable downgrade to junk by the ratings agencies.  This is what Win Thin, a Senior Currency Strategist at Brown Brothers Harriman had to say earlier today in a market commentary.

Fitch cut the outlook for Bulgaria’s BBB- rating to negative from stable. The agency cut Bulgaria to BBB- from BBB back in Nov. Fitch cited the deterioration in the global outlook along with Bulgaria’s high current account gap (25% of GDP in 2008!) and large external financing needs as factors behind the outlook cut. IMF is now looking for 3.5% contraction in GDP this year and 1% in 2010, and also sees a big decline in net capital inflows, both portfolio investment and FDI shrinking noticeably. Our sovereign ratings model rates Bulgaria at BB vs. actual BBB/Baa3/BBB-, and believe that a junk rating is only a matter of months away. Bulgaria is not the only one in the region facing downward ratings pressure, and we continue to express amazement that so many were given investment grade ratings in the first place. Looking ahead, we see the three Baltic nations all moving into junk territory (only Latvia is junk right now). Bulgaria pegs the lev against the euro, and so far it has held up. However, if the Baltics continue to deteriorate, we cannot rule out broken pegs for all four (Estonia, Latvia, Lithuania, and Bulgaria). To us, Eastern Europe now looks very much like Asia did back in 1997, and we all know what happened then.

I hope this argument sounds familiar because it is something I have been saying since last Summer (I also mentioned similar comments from BBH earlier this month.

Fine. But, then I saw a Blurb from Gillian Tett of the FT. She is the same Gillian Tett who wrote “Saving The Sun” a look at a Japanese bank restructuring in the aftermath of the lost decade in Japan. In this case, she was looking at a bank in Kazakhstan (for your cycling and cinema enthusiasts, this is home to Alexandre Vinikourov and Borat).

Here’s what she says:

As the financial crisis virus has swept around the globe in recent months, Kazakhstan’s banking sector has been engulfed in turmoil. This is not just creating a headache for the Kazakh government and Western creditors, but also highlighting issues about the credit derivatives market that extend well beyond those far-flung steppes.

Take the case of Morgan Stanley’s dealings with BTA, Kazakhstan’s largest bank. A few years ago, BTA – like many of its Eastern brethren – was an up-and-coming darling of the capital markets world, with investment bankers furiously competing to float its bonds, provide loans, and much else.

But earlier this year, when funding dried up for Kazakh banks, BTA fell under the control of the government. Initially BTA wanted to keep servicing its loans, and its creditors, such as Morgan Stanley, appeared happy to play along.

But last week Morgan Stanley and another bank suddenly demanded repayment. BTA was unable to comply, and thus tipped into partial default. That sparked fury among some other creditors, and shocked some Kazakhs, who wondered why Morgan Stanley would have taken an action that seemed likely to create losses.

One clue to the US bank’s motives, though, can be seen on the official website of the International Swaps and Derivatives Association. One page reveals that just after calling in the loan, Morgan Stanley also asked ISDA to start formal proceedings to settle credit default swaps contracts written on BTA.

Does this sound familiar? No. Well, I did just mention earlier today that CDS contracts were going to be an impediment to a good workout at Chrysler and GM:

CDS insurance writers. Get ready for major pain. If bond holders are getting screwed, you know the companies who guaranteed credit default swaps (CDS) are not going to be very happy here. Question: are bond holders playing chicken because they have insurance? If so, you can consider the CDS writers another negotiating party that did not get a seat at the table and are going to be left holding the bag – a reason to want some major changes in how the CDS market is run.

Let me pull these threads together. If one thinks that a bankruptcy of a systemically important organization in any country can proceed normally without the potential for mischief, one had better read Tett’s account.

What’s more, in the case of Chrysler and GM, the complexity of a Chapter 11 bankruptcy will be very large. The Obama team says “three months and you’re done.” That ain’t gonna happen. United took three years. LTV took five and Delphi, the auto parts maker is still in bankruptcy 4 years later. So, lets get realistic here.

Bringing this full circle, we come back to Europe. And there, we have a problem, – specifically, because what has happened in Ukraine is going to happen in places like Bulgaria, Latvia, Lithuania or Estonia.

In my view, the events in the home of Borat and the possibilities in Eastern Europe or with the U.S. automakers present a good example why Warren Buffett calls derivatives financial weapons of mass destruction.

The credit default swap market needs regulation – and fast.

Source
Insight: Kazakh bank falls foul of CDS – Gillian Tett, Ft.com

Related posts:

• Eastern European economic growth to crater in 2009
• Baltics: Fitch downgrade and more downgrades to come
• More trouble in the Baltics as S&P downgrades
• Large bank loses $7.9 billion: CDS involved
• Ten eastern European countries now looking to IMF for bailouts

The first time I wrote about the Baltics was back in August in a post entitled, “Are the Baltics the new Argentina?.” Since then, things have gotten progressively worse and the Baltics are clearly in Depression with Latvia leading the way to the downside. The credit ratings agencies have caught on to this and Fitch is marking the countries down near and into junk territory with negative outlooks. Win Thin of Brown Brothers Harriman has a good read on what to make of this:

Fitch downgraded the Baltics and kept the outlooks at negative. Estonia was cut to BBB+ from A- Latvia was cut to BB+ from BBB-, and Lithuania was cut to BBB from BBB+. The only surprise to us was that the downgrades weren’t deeper, as we see eventual junk status (below BBB-) for all three. As we noted in our most recent FX quarterly, the ratings agencies have been overly generous with Eastern Europe, particularly the Baltics. Our sovereign rating model puts Estonia at a BB/Ba2/BB rating, way below actual ratings of A/A1/BBB+. For Lithuania, we rate it BB+ vs. actual BBB/A2/BBB. For Latvia, we rate it B+ vs. actual BB+/Baa1/BB+. Others that are overrated in the region include Bulgaria (we rate it BB- vs. actual BBB/Baa3/BBB-), Hungary (we rate it BB vs. actual BBB-/Baa1/BBB, and Romania (we rate it BB vs. actual BB+/Baa3/BB+).

By the way, we still expect Bulgaria, Estonia, and Lithuania to join the others in IMF programs this year. EMEA remains the weak link in emerging markets, as a glance at our vulnerability table will verify, and we continue to question the viability of the pegs in the Baltics and Bulgaria. Investors have turned more positive on EM in recent weeks, but are surely differentiating between the good (Brazil, China, etc.), the bad (South Africa, Turkey, etc.), and the ugly (Baltics, Bulgaria, Hungary, etc.). We cannot see investors piling back into the EM countries with the worst fundamentals even if the global crisis continues to abate.

Much worse is coming to Eastern Europe and the Baltics are the worst of the lot.  You should note that Sweden has significant exposure in the Baltics and downgrades there will weigh heavily on that country.  Marc Chandler of BBH also picks up this theme:

Austria and Belgium have a higher percentage of their GDP in Eastern European exposure than Sweden, but are protected to some extent by being in the eurozone. Sweden’s exposure is concentrated in the Baltics. It’s currency floats freely. The Fitch downgrade and negative outlook for the Baltics has seen the krona hit. The euro hit a high on of SEK10.9840 in response and this represents a new high on the month. The SEK11.00 is a important barrier, around where stops are thought to lie. The euro is moving above the 20 day moving average for the first time since March 11th. A break of SEK11.00 could see a quick move toward SEK11.10-SEK11.20.

Related posts:

• More trouble in the Baltics as S&P downgrades
• CDS contracts and the implosion of several Eastern European economies
• A bearish view on Eastern Europe
• Moody’s: Iceland, Latvia and Hungary in “fragile stabilization”
• Estonia and Latvia: headed for the rails

This comes via Angus Robertson over at Research Recap:

Fitch Ratings forecasts that Emerging Europe (EE) will suffer its steepest fall in real GDP since the collapse of the Communist planned economic system in the early 1990s, reflecting the severity of the trade and financial shocks that have hit the region. However, the aggregate forecasts conceal a wide range in growth prospects across the region.

Fitch forecasts GDP growth to contract by 3.1% this year in Emerging Europe: a severe and abrupt recession after growth of 4% in 2008 and an average of 6.8% in the five years to 2007.

Moreover, it expects only a modest recovery of 1.4% in 2010, insufficient to prevent further rises in unemployment and pressure on public finances.

Fitch notes that the divergence in growth prospects this year – from +2.5% in Azerbaijan, to (minus) – 12% in Latvia – underlines the need to differentiate between countries rather than treat EE as a homogenous block, as reflected in different sovereign rating levels and rating actions since the onset of the global financial crisis. The agency has downgraded the sovereign ratings of 10 countries in EE, by a total of 14 notches, since August 2008. Ten countries are now on Negative Outlooks and none on Positive Outlooks.

According to Fitch, the economies most exposed to the dramatic decline in global trade and financial flows and ‘deleveraging’ process are Hungary (’BBB’/Negative Outlook) and Kazakhstan (’BBB-’ (BBB minus) on Rating Watch Negative), while Poland (’A’/Stable Outlook) and Turkey (’BB-’ (BB minus)/Stable Outlook) are least exposed, albeit not immune, to these shocks.

Out of 21 countries it covers in the region, Fitch forecasts GDP to contract in 19 of them, be flat in one and grow in only one. Of the largest economies, Fitch forecasts both Russia and Turkey to shrink by 3% and growth to be 0% in Poland.

“Most countries will be adversely affected by deleveraging and see a sharp slowdown or reversal of private capital inflows and credit growth Those with large current account deficits, high bank loan/deposit ratios and/or dependence on foreign financing – particularly the Baltic and Balkan states, as well as Hungary, Kazakhstan and Ukraine – will suffer falls in domestic demand as they have to rapidly correct macroeconomic imbalances. In some countries, difficulties will be compounded by a drop in asset prices and the presence of foreign-currency debt on balance sheets.”

Angus has a nice chart on historical GDP growth as well. If you’re interested in Eastern Europe, you should definitely read Edward Hugh’s in-depth analysis of Estonia, “How Not To Convince People You Are Capable Of Having An Internal “Devaluation”.” It makes for sobering reading.

Source
Emerging Europe GDP to Contract 3.1% This Year – Angus Robertson

Related posts:

• Baltics: Fitch downgrade and more downgrades to come
• Hungary cut to a notch above junk by S&P
• A bearish view on Eastern Europe
• CDS contracts and the implosion of several Eastern European economies
• EU: Banks ask for a bailout for poor lending in Eastern Europe

If you want to know what a modern-day depression looks like, try Ukraine.

Growth in the ex-Soviet state, hit by shrinking markets for its steel and chemical exports, stood at 5.8 per cent of gross domestic product in the same period of 2008. ”We were ill-prepared to confront the crisis and its first blow was painful and difficult…,” Mr Yushchenko told parliament in his state of the nation annual address.

”The consequence of this was a slowdown in GDP growth in 2008 to 2.1 per cent… and a destructive fall of 25-30 per cent according to figures from January-February 2009.” He said he was quoting the figures despite ”determined efforts to conceal them”.

The State Statistics Committee has stopped publishing monthly GDP growth rates and now releases them only quarterly, three months after the event.

Source
Ukraine economy ‘shrank by up to 30%’ – FT

Related posts:

• The Economy Is Definitely In Recession
• FT: Ukraine must pay Russia market prices for gas
• Russia cuts Europe off completely from its gas
• Russia: playing chicken with Ukraine over natural gas
• Three views of the global economy

Standard and Poors had their hands full today cutting credit ratings.  They cut Ireland. But, they also cut Hungary, putting the country just above a junk credit rating.  I don’t think these will be the last sovereign debt ratings downgrades, especially in emerging markets — economies worldwide are deteriorating.

The Brown Brothers Harriman currency group has released a view that includes South Africa, Poland, Mexico and Korea as well as Hungary.

Here is what Win Thin, a senior currency strategist in the group, had to say about the downgrades:

S&P has been busy today. Besides downgrading Ireland, it also cut Hungary by one notch to BBB- with the negative outlook kept. Just like they missed the mark with regards to subprime, so too did these agencies overrate many of the weaker EM credits (was Iceland really AAA?). Our internal sovereign ratings model (which we just updated for the latest FX quarterly) puts Hungary at a BB- rating vs. BB last quarter and actual ratings of BBB-/A3/BBB actual. Yes, Moody’s still puts Hungary at A3 (equivalent to A-). We think junk status is in the cards shortly for Hungary, and to reiterate our rather frank view, most of these EMEA credits really never deserved to be investment grade in the first place. Our model points to severe downgrade risks in the Baltics and the Balkans. We think Poland and South Africa face modest downgrade risk in 2009, as does Korea and Mexico. Otherwise, we believe the lion’s share of downgrades this year will be in the EMEA region. EUR/HUF likely to retest the 317 high.

Obviously emerging market risk still remains quite elevated and will not diminish for some time to come.

Related posts:

• Baltics: Fitch downgrade and more downgrades to come
• A bearish view on Eastern Europe
• More trouble in the Baltics as S&P downgrades
• Moody’s: Iceland, Latvia and Hungary in “fragile stabilization”
• Greece sees credit rating cut by S&P

The remittanc income from Mexican and Central American immigrants working in the United States bck to their home nations is not the only huge remittance flow in the world.  One of significant import is in Europe, where millions of indivuals from the former Eastern Bloc now work in Western Europe.  However, as in the U.S. – Mexican connection, these remittances will be nosediving.

Below is an analysis from Morgan Stanley (with my boldng):

The Central European economies (Czech Republic, Hungary, Poland, Romania) are heavily influenced by developments in their richer western neighbors. Developed Europe accounts for around 70% of all CE exports; its banks dominate lending, with a market share of around 80% on average; and FDI inflows from western European companies have proved to be a significant engine of growth over recent years.

We look at yet another channel of contagion: remittances flows. In the years that followed EU accession (2004 for most accession countries; 2007 for Bulgaria and Romania), large numbers of migrants left their countries and migrated to core EU countries, in particular the UK, Ireland, Germany, Spain and Italy. Among the countries we look at in this piece, this issue is particularly relevant for Poland and Romania: large numbers of Poles migrated to the UK, Ireland and Germany, whereas Romanians migrated mostly to Spain and Italy. BoP data show that remittances inflows account for 4.5% of GDP in Romania and around 2% in Poland. They therefore ‘finance’ around a third of the overall C/A gap in both countries.

We think these remittances inflows will slow markedly in the coming months. This is due to the fact that economic conditions in the countries where most Poles and Romanians migrated to have turned sour, so there will be less money to send home. Also, especially for Poles in the UK, the slide in GBP makes working abroad less attractive: in 2004, GBP/PLN was trading at around 7.0; currently it is around 4.85, after approaching 4.0 last summer (when PLN strength was at its peak). Note, however, that the gap remains large.

I should also point out that Eastern European immigrants in countries like Ireland are getting the sack in droves as that economy has entered a depression. Nevertheless, this puts these individuals in a bit of a pickle because their home economies are facing equally severe downturns.

In my view, intra-EU immigration will become a larger problem within the Eurozone as this crisis unfolds.

See the link below for more of what Morgan Stanley has to say about the remittance issue.

Source
Dwindling Remittances – Pasquale Diana & Alina Slyusarchuk, Morgan Stanley

Related posts:

• EU planning 200 billion euro package for Eastern Europe
• EU: Banks ask for a bailout for poor lending in Eastern Europe
• A bearish view on Eastern Europe
• UBS does not see the need for panic over Eastern Europe
• Bloomberg talks Eastern Europe as Latvia downgraded

While most people have their attention tuned to the spectacle over at AIG, financial institutions in Europe are having their own difficulties. In the last day, I have seen multiple news stories of European banks looking for ways to raise capital in order to shore up their weakening balance sheets. Let me focus on three stories in particular: Nordea, Bank Austria and HVB.

This story about Nordea comes via the Danish paper Berlingske Tidene. Below is my translation (note my highlights):

On Friday Nordea will offer 1,430,059,525 shares to existing shareholders, with the drawing taking place from 20 March to 3 April. The price of a stock is set at 13.5 dollars – less than half of Monday’s closing price of 29.4 dollars per share.

A rights issue has put the share price under pressure, because more shares dilute the value of the existing. But the dilution already happened last week, according to Nordea, when the conditions for drawing the right came out. Nevertheless, there may well be a moderate pressure on the stock price for a few days yet.

Existing shareholders who do not want to buy more Nordea shares can sell subscription rights. It requires 20 warrants to be able to buy a Nordea share.

On 17 April, Nordea will publish the final breakdown of who has bought how many shares.

My take on this news is that Nordea, weakened by exposure to loan losses in the Baltics, is a forced seller of shares. They need the capital because a tsunami of losses is about to hit shore and they want to have adequate capital with which to resist the wave. These maneuvers will add nearly 23 million kroner of capital to Nordea’s capital base (over 3 billion USD at an exchange rate of 6.72 NOK/USD).

Next up is Bank Austria. They have the same problem. Huge expected exposure to Eastern Europe, problems in Ukraine being a big factor (333 million euros in writedowns). But rather than try and issue shares, Bank Austria is going directly to the government to get bailout funds.  Below is a translation of a Kurier article:

Bank Austria may apply for a maximum of 2.7 billion euros in state aid. With this amount, the equity participation of the Republic of Austria for the bank reaches its cap as measured by balance sheet ratios. To bring the government’s return to 8 per cent – it will be exclusively ‘participation’ capital – the bank will need a participation of 30 percent  ”private” capital.  Erich Hampel, the bank boss, is convinced that this will succeed.

When UniCredit CEO Alessandro Profumo spoke of the 2.7 billion euros, which Bank Austria, the business responsible for Eastern Europe, could receive from the Austrian government, Hampel only wanted to address a sum which was theoretically possible in state aid — which when weighted at 2 percent of risk assetsworks out arithmetically to 2.7 billion euros, accoring to his company.

Why is Bank Austria getting money from the government? Because UniCredit, its parent, is hemmoraghing losses. Just today, the German subsidiary HVB Group announced a loss of nearly 700 million euros due to writedowns due to exposure to… you guessed it, Eastern Europe. As a result, UniCredit needs cash from both the Austrian and Italian governments. The FT explains:

UniCredit, one of Italy’s top two banks, is to seek up to €4bn in state aid, joining a growing list of European banking groups turning to governments to boost their capital base as they grapple with the global financial crisis.

The bank, which has expanded into central and eastern Europe and as far as Kazakhstan in the past decade, said on Wednesday it would ask the Italian and Austrian governments for the cash.

Austria is already in talks about investing in Raiffeisen, the third largest Austrian bank, and Italy has approved a €12bn scheme that would see the state buying bonds issued by Italian banks.

UniCredit, which by some measures is the biggest lender in central and eastern Europe, announced the move as it reported 2008 annual results that were ahead of market expectations.

Results ahead or not, given UniCredit’s outsized exposure to Eastern Europe – a subject of much speculation – I have a feeling that the UniCredit story will start to become a front page item soon enough.  Nordea may escape that fate.  Of course, all of this is wholly predictable.

Sources
1,5 milliarder nye Nordea-aktier på fredag – Berlingske Tidene
Bank Austria will 2,7 Mrd. Euro vom Staat – Kurier
Here We Go Time Draws Near With Unicredit – Edward Hugh
UniCredit’s HVB Has EU671 Million Loss on Writedowns – Bloomberg.com
UniCredit seeks €4bn aid – FT.com
Bank Austria mit 1,1 Milliarden Gewinn – Standard Austria

Related posts:

• Quote of the day: Austrian banks
• Is this Austrian real estate company a canary in the coalmine?
• EU planning 200 billion euro package for Eastern Europe
• EU: Banks ask for a bailout for poor lending in Eastern Europe
• Earnings results at Swedish banks show large writedowns in Baltics

After Europe emerged from the worst war in human history, its cities lay in ruins. Its economy was in tatters. It was in this environment that an Iron Curtain fell over Europe dividing it into east and west, separating Europeans from each other for four decades. Now, another twenty years later, we risk another great divide in Europe, the Ukrainian Prime Minister Yuliya Tymoshenko has warned.

Below is my translation of a German-language article in Austrian daily Der Standard. 

The Ukrainian Prime Minister Yuliya Timoshenko warned in a newspaper commentary of a new “Iron Curtain” in Europe and calls on the European Central Bank to support those countries not in the euro zone. The euro should not lead to an Iron Curtain, which puts non-Euro countries into a  higher risk class, which investors would no longer dare trust, Timoshenko wrote in Le Figaro.

Ukraine has asked the International Monetary Fund (IMF) for emergency aid to stabilize the economy. The country has been hit hard by the global crisis. The currency has lost more than 40 percent of its value since the autumn. The IMF, however, has delayed the transfer of the second loan tranche of a total of 16.4 billion U.S. dollars (13 billion euros) and called on the country to make its crisis management more urgent.

After the Fed also offered currency swaps to Brazil, Mexico and South Korea, Tymoshenko has  called for a similar scheme in Europe: “The ECB should also provide access to these tools to countries outside the monetary area.”

My view here is that Tymoshenko is going to be one of the last countries in the queue, so she had better demonstrate some seriousness about managing this crisis domestically or even the monies promised by the IMF will not be forthcoming.  The EU has its hands full with the Baltics and Central Europe, not to mention Club Med’s economic woes and Ireland and Austria’s banking crises.

Does this mean a new ‘Iron Curtain’ is forming?  I doubt it.  However, one should be very concerned here given the strategic importance of Ukraine as a transit route for gas.  Having them fall into the abyss is good for no one in Europe.

By the way, the term Iron Curtain comes from a famous 1946 speech by Winston Churchill:

From Stettin in the Baltic to Trieste in the Adriatic an “iron curtain” has descended across the Continent. Behind that line lie all the capitals of the ancient states of Central and Eastern Europe. Warsaw, Berlin, Prague, Vienna, Budapest, Belgrade, Bucharest and Sofia; all these famous cities and the populations around them lie in what I must call the Soviet sphere, and all are subject, in one form or another, not only to Soviet influence but to a very high and in some cases increasing measure of control from Moscow.

Sources
Timoschenko warnt vor einem neuen “Eisernen Vorhang” – Standard Austria
Iron Curtain – Wikipedia

Related posts:

• Russia cuts Europe off completely from its gas
• FT: Ukraine must pay Russia market prices for gas
• Russia: playing chicken with Ukraine over natural gas
• Ukraine: economy shrank 25-30% in first two months
• EU planning 200 billion euro package for Eastern Europe

About a week ago I reported on an Austrian story that the EU was gearing up for a bailout of any eurozone members which found themselves in difficulty (see my post, “EU planning 200 billion euro package for Eastern Europe“. This report is now being confirmed by multiple sources including Joaquin Almunia, the economics commissioner of the European Union.

Ambrose Evans-Pritchard of the Telegraph writes:

Joaquin Almunia, the economics commissioner, said EMU economies in distress can count on EU solidarity if they get into trouble, rather than having to go cap in hand to the International Monetary Fund.

“It is clear that there are serious problems in certain countries. If a crisis emerges in one eurozone country, there is a solution before visiting the IMF. We are equipped intellectually, politically and economically to face this crisis scenario. It’s not clever to tell you in public. But the solution exists,” he said.

Mr Almunia said the probability of a eurozone break-up is “zero”, despite the surge in interest spreads on Greek, Irish, Austrian, and Italian 10-year bonds above German Bunds. “Who is crazy enough to leave the euro area? Nobody. The number of candidates to join is growing,” he said.

Officials are keeping a close eye on renewed stress in Europe’s credit markets. The iTraxx Crossover index measuring default risk on low-grade corporate bonds jumped above 1,100 yesterday, nearing the panic levels after the Lehman collapse last year.

Certainly, downturns in Greece, Ireland and Spain are part of this. However, at issue here as well is the recent acknowledgement by market participants that there is serious exposure in countries like Austria to downturns in Central Europe, the Balkans, and the Baltics and Eastern Europe.  Some of those countries are doing their own PR campaign in order to distance themselves from their more challenged EU brethren.

The central banks of the Czech Republic, Bulgaria, Poland, Romania and Slovakia have issued a joint statement defending their economies.

They said that recent warnings about their economies were “misleading”.
Eastern European countries have come under scrutiny in recent weeks amid fears about their economic prospects and reliance on foreign debt.

The countries’ currencies and stock markets have also fallen sharply as the downturn has intensified.

Mixed picture
Hungary’s central bank later said it supported the statement issued by it counterparts.
The central banks urged investors to look at the prospects of individual countries and not assume that Eastern Europe was a “homogenous region”.

Better-off countries like Czech Republic and Poland feel that they are unfairly lumped together with places such as Hungary or Latvia, which have been particularly hard hit.
They expressed concern at the warnings made recently made by credit ratings agencies and other bodies, saying it could undermine financial stability in the region.

I see these statements from some governments in Eastern Europe as self-serving and an every-man-for-himself action which can only divide Europe as it seeks to deal with this crisis.

Ultimately, everyone is looking to Germany here. The Germans have deep pockets and are the largest EU member. For weeks, much speculation has centred on whether the Germans would bail out another eurozone member in trouble. Now, we see they just may. How this plays out with the German politicians’ domestic constituency gearing up for national elections is another story.

Sources
EU pledges eurozone rescue – Ambrose Evans-Pritchard, Telegraph
East Europe banks back economies – BBC News

Related posts:

• The Eurozone and the spectre of banking collapse
• EU planning 200 billion euro package for Eastern Europe
• Remittances to Eastern Europe to slow dramatically
• Peer Steinbrueck says Germany might bail out the Austrians
• The case against the Euro

The following article comes from Absolute Return Partners’ Niels Jensen. Absolute Return Partners LLP is a London based private partnership which provides independent asset management and investment advisory services globally to institutional as well as private investors, charities, foundations and trusts. Visit www.arpllp.com to learn more about them.  You can reach them by email at info@arpllp.com.

Update 05 Mar 2009: I should note that Niels makes mention of edits to an article in the Telegraph about European toxic asset exposure which I also spotted in my post “Are European banks sitting on 16.3 trillion in toxic assets?”

Now, Niels Jensen:

The Absolute Return Letter March 2009

“Many of today’s policy proposals start from the view that “greed” and “incompetence” and “poor risk assessment” are the ultimate source of what went wrong. In fact, they were not the true cause at all. Moreover, even if they had been, it is fatuous to think that we will now create a post-crash generation of bankers and traders who are not greedy, much less a new generation of quants who will be able to assess and manage risks much better than “the idiots” who have brought us to the current abyss. Greed cannot be exorcised. Nor can the inherent inability of any quants to determine the “true” probability distributions of all-important events whose true probabilities of occurrence can never be assessed in the first place.”

Woody Brock, SED Profile, December 2008

Policy mistakes ‘en masse’

The last few weeks have had a profound effect on my view of politicians (as if it wasn’t already dented). All this talk about capping salaries for senior bank executives is quite frankly ridiculous. It is Neanderthal politics performed by populist leaders. That Gordon Brown has fallen for it is hardly surprising but I am disappointed to see that Barack Obama couldn’t resist the temptation. The mob wants blood and our leaders are delivering in spades. The stark reality is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Policy mistakes – very grave mistakes – permitted the situation to spin out of control. From the U.S. Federal Reserve Bank under the stewardship of Alan Greenspan being far too generous on interest rates to the British Chancellor of the Exchequer -who now happens to be our Prime Minister – advocating ‘Regulation Light’.

Policing must improve

If you really want to prevent a banking crisis of this magnitude from ever happening again, the focus should be on the way banks operate and not on how much they pay their staff. And, within that context, any discussion must start and end with how much leverage should be permitted. The French have actually caught onto that, but their narrow-mindedness has driven them to focus on hedge funds’ use of leverage which is only a tiny part of the problem. It is the gung ho strategy of banks which brought us down and which must be better policed. And guess what; if banks were better policed – and leverage restricted – then profits, even at the best of times, would be much smaller and there would be no need to regulate bankers’ compensation packages.

It is pathetic to watch our prime minister attacking the bonus arrangements of our banks when the UK Treasury, on his watch, spent £27 million pounds on bonuses last year as reward for delivering a public spending deficit of 4.5% of GDP at the peak of the economic cycle. Even my old mother understands that governments must deliver budget surpluses in good times, allowing them more flexibility to stimulate when the economy hits the wall. What Gordon Brown has done to UK public finances in recent years is nothing short of criminal.

So, with that in mind, let’s take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don’t read any further. What is about to come, will make your heart sink.

More leverage in Europe

Let’s begin our journey by pointing out a regulatory ‘anomaly’ which has allowed European banks to take on much more leverage than their American colleagues and which now makes them far more vulnerable. In Europe, unlike in the US, it is only risk-weighted assets which matter to the regulators, not the total leverage ratio. European banks can therefore apply a lot more leverage than their US counterparties, provided they load their balance sheets with higher rated assets, and that is precisely what they have been doing.

That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset securitisations such as CLOs proved very popular amongst European banks, partly because they offered very attractive returns and partly because Standard & Poors and Moodys were kind enough to rate many of them AAA despite the questionable quality of the underlying assets.

Now, as long as the economy chugs along, everything is dandy and the AAA-rated assets turn out to be precisely that. But we are not in dandy territory. Many asset securitisation programmes are in horse manure to their necks, so don’t be at all surprised if European banks have to swallow further losses once the full effect of the recession is felt across Europe. The two largest sources of asset securitisation programmes are corporate loans and credit cards. Senior secured loans are still marked at or close to par on many balance sheets despite the fact they trade around 70 in the markets. The credit card cycle is only beginning to turn now with significant losses expected later this year and in 2010-11.

Not much of a cushion left

Citibank has calculated that it would only take a cumulative increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the European banking industry down to the bare minimum of 4.5%¹. By comparison, bad debts rose by a cumulative 7% in Japan in 1997-98. One can only conclude that European banks are very poorly equipped to withstand a severe recession. Seeing the writing on the wall, they are left with no option but to shrink their balance sheets. Despite talking the talk, banks will use every trick at their disposal to reduce the loan book. No prize for guessing what that will do to economic activity.

The wheels are coming off

But that is not the whole story. It is not even the most worrying part of the story. For the true horror to emerge, we need to turn to Eastern Europe for a minute or two. Nowhere has the credit boom been more pronounced than in Eastern Europe. And nowhere is the pain felt more now that credit has all but dried up. One measure of the credit fuelled bonanza is the deterioration of the current account across the region. Credit Suisse has calculated that in four short years, from 2004 to 2008, Eastern Europe’s current account went from +6% to -6% of GDP². That is a frightening development and is likely to cause all sorts of problems over the next few years.

Meanwhile Western European banks, eager to milk the opportunities in the East after the iron curtain came down, have acquired many of the region’s banks (see chart 1). Now, with many Eastern European countries in free fall, ownership could prove disastrous for an already weakened banking industry in the West.

The problem is widespread

To make matters worse, the problems in the East are beginning to look systemic. Credit Suisse has produced an interesting scorecard where they rank a number of countries around the world on factors usually taken into consideration when assessing the credit quality of sovereign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Iceland – hardly surprising considering their current predicament. More importantly though, of the next 14 countries on the list, 8 are Eastern European – not what you want to hear if you are an already undercapitalised European bank with huge exposure to Eastern Europe.

Swedish banks are already reeling from their exposure to the Baltic countries. Austrian banks are in even worse shape, having been the most acquisitive of any European banks. Some Italian banks could be dragged under by their Eastern European exposure and even the conservative banking sector in Switzerland doesn’t look like it can escape the mayhem.

Worst of all, the problems in the East are just about to unfold at a point in time where the European banking industry is bleeding heavily from massive losses already incurred in other areas. With no access to private funding, banks find it virtually impossible to re-build their capital base with anything but tax payers’ money.

US banks are better off

US banks are in less of a pickle. Unlike the subprime debacle which hit both the US and the European banks hard, US banks have little exposure to Eastern Europe. To prove my point, according to the IMF, European banks have 75% as much exposure to US toxic debt as American banks, but 90% of all cross border loans to Eastern Europe originate from Western European banks. And, to add insult to injury, European banks have been much slower than US banks in terms of recognising their losses. Write-offs now total about $750 billion in the US and only about $325 billion in Europe.

The great mortgage show

The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn’t anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking.

Credit Suisse has calculated that net foreign liabilities (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local currency values (see chart 3 – and don’t ask me why Credit Suisse has included South Africa in Eastern Europe!).

Chart 4: Eastern European vs. Asian Crisis

Source: Wall Street Journal

Back in 1997-98 Asia went through a similar currency crisis. However, as you can see from chart 4, Asian current account deficits were much smaller than Eastern European deficits are now. So were debt levels. Despite that, the Asian crisis did enormous damage to the local economy. Eventually Asia came good, primarily because the devalued currencies allowed the Asian countries to export more. Eastern Europe does not share this luxury. With over 90% of the world’s GDP in recession, who are they going to export to anytime soon?

Austria is in greatest trouble

According to the latest estimates from BIS, Eastern European countries currently borrow $1,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About $350 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about $300 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%³.

An extra $250bn to the IMF

Hungary, Latvia and Ukraine have already received emergency loans from the IMF and both Serbia and Romania are reportedly considering asking for help. Meanwhile the IMF’s coffers are draining quickly and it has asked leading industrial nations for new funding. At their summit a week ago, EU leaders coughed up an extra $250 billion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hopelessly inadequate. Our leaders must grow up. Measuring everything in billions is so yesterday. Trillions are the new billions, like it or not.

Conspiracy or…?

On the 11th February the Daily Telegraph’s Brussels correspondent Bruno Waterfield wrote an article under the header: “European banks may need £16.3 trillion bail out, EC document warns.” In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union’s finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article’s header was changed to “European bank bail-out could push EU into crisis” and two paragraphs had mysteriously disappeared. Here they are:

“European Commission officials have estimated that “impaired assets” may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the ‘trading book’ total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets.

In addition, so-called ‘available for sale instruments’ worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion.”

Do yourself a favour – read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don’t know and I probably never will. But one thing is certain. If the EU Commission’s estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well.

Public debt to rise and rise

Even if actual losses prove to be much, much smaller (and I sincerely hope so), the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers’ money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free.

BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest (see charts 5a and 5b).

For that very reason, and as pointed out in last month’s Absolute Return Letter, there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn’t work), why wouldn’t they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things.

Can Germany rescue us?

Most investors remain convinced that Germany will come to the rescue – in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea.

The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis.

Given this outlook, do you really want to be long euros?

Niels C. Jensen 

Related posts:

• EU planning 200 billion euro package for Eastern Europe
• UBS does not see the need for panic over Eastern Europe
• Bloomberg talks Eastern Europe as Latvia downgraded
• EU: Banks ask for a bailout for poor lending in Eastern Europe
• European banks: still undercapitalised

Yesterday, Latvia was downgraded to junk. Despite its diminutive size, this is a big deal. Fist, it is a harbinger of what is to come for the rest of Eastern Europe. But, more importantly, it is a signal that Western European banks lending in the former Soviet Bloc are overexposed and threatened by large loan losses. In a global economy in which European banks lend at home, but also have significant U.S. mortgage debt and Eastern European loan exposure, events in Latvia will have a snowball effect.

While the EU, IMF and World Bank are all busily drafting up crisis solutions, the videos below should give a little colour on what this means for the economy, credit and investing.

Related articles
Latvian debt is given junk status – BBC News

Related posts:

• EU planning 200 billion euro package for Eastern Europe
• Roubini’s RGE Monitor: Threat of ‘Asia-Style Crisis’ in Eastern Europe
• Bloomberg talks about the meltdown in Eastern Europe
• UBS does not see the need for panic over Eastern Europe
• A bearish view on Eastern Europe

This comes from Austrian Daily Kurier:

A plan to stabilise the economies of Eastern Europe exists. What is missing is a united EU.

During and after the Eastern Europe tour by Austrian Vice-Chancellor and Finance Minister Josef Pröll, the Ministry always profusely denied that there was a plan to support the new [EU] countries. The talk was of 150 billion euros. Well, the number was not so wrong, because -apparently with the cooperation of the National Bank [Austrian Central Bank] and the ECB – a plan to stabilize Eastern Europe is quite concrete.

The plan
Eastern Europe countries, which are members of the EU, will receive a further balance of payment support of 100 billion euros. This assistance is currently capped at 25 billion euros, of which ten for Hungary and Latvia have already been used. Above all, Romania and Bulgaria will likely need help. In Hungary, a second aid package is being considered. Because of the EU election and the change in the EU Commission, Europe will be largely incapable of decision-making in the summer. As a result, the increase should act as a protective shield.

Those countries in the region, that are non-EU countries, will be supported with 50 billion euros. this concerns mainly the southern Balkans (Serbia, Croatia), but also Ukraine. The money could also come via the European Investment Bank, which would issue a bond. As the EU’s house bank can finance itself a lot cheaper, it would be possible to give the countries more favorable terms.

The European System of Central Banks may already supply Euros to third parties. There are such agreements with Switzerland and the United States. In Eastern Europe, these so-called “repurchase agreements” could be made: Euros would flow into the area against securities in local currency as collateral. This would significantly help to stabilize crisis currencies — at a minimum because such an announcement would discourage currency speculators.

Even the International Monetary Fund (IMF) would participate in such an action. World Bank President Zoellick called for 60 billion U.S. dollars for Eastern Europe. How the amount will come together is unknown, but it [the information] comes from internal papers of the IMF. What is indisputable is that the European Central Bank (ECB) will discuss the topic of Eastern Europe in March. In general, a rate cut in the euro zone in March is considered a certainty, but there just might be additional safeguard measures.

Slow
On the other hand, European politics is moving more hesitantly. When EU finance ministers meet in March, Eastern Europe will play no role; the EU is arguing vigorously again, as to why the big EU countries have not consulted the smaller regarding the coming regulation of financial markets. Poland and Belgium are fairly put off. Economists such as the (pro-union) German Professor Gustav Horn see these delays as a real threat. “Germany is not behaving European at the moment,” he criticized. An assessment, which he shares with conservative governments like those in France.

Horn also questions the construction of the ECB. “It is not prepared for such crises.” For example, the ECB cannot buy new government bonds; the Fed can. This facilitates the financing of the massive relief and economic packages.

Source
Hilfspaket: 200 Milliarden für Osteuropa – Kurier

Related posts:

• Ten eastern European countries now looking to IMF for bailouts
• EU: Banks ask for a bailout for poor lending in Eastern Europe
• Remittances to Eastern Europe to slow dramatically
• A bearish view on Eastern Europe
• The EU promises to bail out eurozone members

The following post is from John Mauldin, who is a Best-Selling author and recognized financial expert. He is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore

The Risk in Europe

I mentioned last week that European banks are at significant risk. I want to follow up on that point, as it is very important. Eastern Europe has borrowed an estimated $1.7 trillion, primarily from Western European banks. And much of Eastern Europe is already in a deep recession bordering on depression. A great deal of that $1.7 trillion is at risk, especially the portion that is in Swiss francs. It is a story that could easily be as big as the US subprime problem.

In Poland, as an example, 60% of mortgages are in Swiss francs. When times are good and currencies are stable, it is nice to have a low-interest Swiss mortgage. And as a requirement for joining the euro currency union, Poland has been required to keep its currency stable against the euro. This gave borrowers comfort that they could borrow at low interest in francs or euros, rather than at much higher local rates.

But in an echo of teaser-rate subprimes here in the US, there is a problem. Along came the synchronized global recession and large Polish current-account trade deficits, which were three times those of the US in terms of GDP, just to give us some perspective. Of course, if you are not a reserve currency this is going to bring some pressure to bear. And it did. The Polish zloty has basically dropped in half compared to the Swiss franc. That means if you are a mortgage holder, your house payment just doubled. That same story is repeated all over the Baltics and Eastern Europe.

Austrian banks have lent $289 billion (230 billion euros) to Eastern Europe. That is 70% of Austrian GDP. Much of it is in Swiss francs they borrowed from Swiss banks. Even a 10% impairment (highly optimistic) would bankrupt the Austrian financial system, says the Austrian finance minister, Joseph Proll. In the US we speak of banks that are too big to be allowed to fail. But the reality is that we could nationalize them if we needed to do so. (And for the record, I favor nationalization and swift privatization. We cannot afford a repeat of Japan’s zombie banks.)

The problem is that in Europe there are many banks that are simply too big to save. The size of the banks in terms of the GDP of the country in which they are domiciled is all out of proportion. For my American readers, it would be as if the bank bailout package were in excess of $14 trillion (give or take a few trillion). In essence, there are small countries which have very large banks (relatively speaking) that have gone outside their own borders to make loans and have done so at levels of leverage which are far in excess of the most leveraged US banks. The ability of the “host” countries to nationalize their banks is simply not there. They are going to have to have help from larger countries. But as we will see below, that help is problematical.

Western European banks have been very aggressive in lending to emerging market countries worldwide. Almost 75% of an estimated $4.9 trillion of loans outstanding are to countries that are in deep recessions. Plus, according to the IMF, they are 50% more leveraged than US banks.

Today the euro rallied back to $1.26 based upon statements from German authorities that were interpreted as a potential willingness to help out non-German (in particular, Austrian) banks.

However, this more sobering note from Strategic Energy was sent to me by a reader. It nicely sums up my concerns:

“It is East Europe that is blowing up right now. Erik Berglof, EBRD’s chief economist, told me the region may need e400bn in help to cover loans and prop up the credit system. Europe’s governments are making matters worse. Some are pressuring their banks to pull back, undercutting subsidiaries in East Europe. Athens has ordered Greek banks to pull out of the Balkans.

“The sums needed are beyond the limits of the IMF, which has already bailed out Hungary, Ukraine, Latvia, Belarus, Iceland, and Pakistan — and Turkey next — and is fast exhausting its own $200bn (e155bn) reserve. We are nearing the point where the IMF may have to print money for the world, using arcane powers to issue Special Drawing Rights. Its $16bn rescue of Ukraine has unravelled. The country — facing a 12% contraction in GDP after the collapse of steel prices — is hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch. Pakistan wants another $7.6bn. Latvia’s central bank governor has declared his economy “clinically dead” after it shrank 10.5% in the fourth quarter. Protesters have smashed the treasury and stormed parliament.

“‘This is much worse than the East Asia crisis in the 1990s,’ said Lars Christensen, at Danske Bank. ‘There are accidents waiting to happen across the region, but the EU institutions don’t have any framework for dealing with this. The day they decide not to save one of these one countries will be the trigger for a massive crisis with contagion spreading into the EU.’ Europe is already in deeper trouble than the ECB or EU leaders ever expected. Germany contracted at an annual rate of 8.4% in the fourth quarter. If Deutsche Bank is correct, the economy will have shrunk by nearly 9% before the end of this year. This is the sort of level that stokes popular revolt.

“The implications are obvious. Berlin is not going to rescue Ireland, Spain, Greece and Portugal as the collapse of their credit bubbles leads to rising defaults, or rescue Italy by accepting plans for EU “union bonds” should the debt markets take fright at the rocketing trajectory of Italy’s public debt (hitting 112pc of GDP next year, just revised up from 101pc — big change), or rescue Austria from its Habsburg adventurism. So we watch and wait as the lethal brush fires move closer. If one spark jumps across the eurozone line, we will have global systemic crisis within days. Are the firemen ready?”

While Rome Burns

I hope the writer is wrong. But the ECB is dithering while Rome burns. (Or at least their banking system is — Italy’s banks have large exposure to Eastern Europe through Austrian subsidiaries.) They need to bring rates down and figure out how to move into quantitative easing. Europe is at far greater risk than the US.

Great Britain and Europe as a whole are down about 6% in GDP on an annualized basis. The Bank Credit Analyst sent the next graph out to their public list, and I reproduce it here. (www.bcaresearch.com) In another longer report, they note that the UK, Ireland, Denmark, and Switzerland have the greatest risk of widespread bank nationalization (outside of Iceland). The full report is quite sobering. The countries on the bottom of the list are also in danger of having their credit ratings downgraded.

This has the potential to be a real crisis, far worse than in the US. Without concerted action on the part of the ECB and the European countries that are relatively strong, much of Europe could fall further into what would feel like a depression. There is a problem, though. Imagine being a politician in Germany, for instance. Your GDP is down by 8% last quarter. Unemployment is rising. Budgets are under pressure, as tax collections are down. And you are going to be asked to vote in favor of bailing out (pick a small country)? What will the voters who put you into office think?

We are going to find out this year whether the European Union is like the Three Musketeers. Are they “all for one and one for all?” or is it every country for itself? My bet (or hope) is that it is the former. Dissolution at this point would be devastating for all concerned, and for the world economy at large. Many of us in the US don’t think much about Europe or the rest of the world, but without a healthy Europe, much of our world trade would vanish.

However, getting all the parties to agree on what to do will take some serious leadership, which does not seem to be in evidence at this point. The US almost waited too long to respond to our crisis, but we had the “luxury” of only needing to get a few people to agree as to the nature of the problems (whether they were wrong or right is beside the point). And we have a central bank that could act decisively.

As I understand the European agreement, that situation does not exist in Europe. For the ECB to print money as the US and the UK (and much of the non-EU developed world) will do, takes agreement from all the member countries, and right now it appears the German and Dutch governments are resisting such an idea.

As I write this (on a plane on my way to Orlando) German finance minister Peer Steinbruck has said it would be intolerable to let fellow EMU members fall victim to the global financial crisis. “We have a number of countries in the eurozone that are clearly getting into trouble on their payments,” he said. “Ireland is in a very difficult situation.

“The euro-region treaties don’t foresee any help for insolvent states, but in reality the others would have to rescue those running into difficulty.”

That is a hopeful sign. Ireland is indeed in dire straits, and is particularly vulnerable as it is going to have to spend a serious percentage of its GDP on bailing out its banks.

It is not clear how it will all play out. But there is real risk of Europe dragging the world into a longer, darker night. Their banks not only have exposure to our US foibles, much of which has already been written off, but now many banks will have to contend with massive losses from emerging-market loans, which could be even larger than the losses stemming from US problems. Plus, they are more leveraged. (This was definitely a topic of “Conversation” this morning when I chatted with Nouriel Roubini. See more below.)

The Euro Back to Parity? Really?

I wrote over six years ago, when the euro was below $1, that I thought the euro would rise to over $1.50 (it went even higher) and then back to parity in the middle of the next decade. I thought the decline would be due to large European government deficits brought about by pension and health care promises to retirees, and those problems do still loom.

It may be that the current problems will push the euro to parity much sooner, possibly this year. While that will be nice if you want to vacation in Europe, it will have serious side effects on international trade. It clearly makes European exporters more competitive with the rest of the world, and especially the US. It also means that goods coming from Asia will cost more in Europe, unless Asian countries decide to devalue their currencies to maintain an ability to sell into Europe, which of course will bring howls from the US about currency manipulation. It is going to put pressure on governments to enact some form of trade protectionism, which would be devastating to the world economy.

Large and swift currency swings are inherently disruptive. We are seeing volatility in the currency markets unlike anything I have witnessed. I hope we do not see a precipitous fall in value of the euro. It will be good for no one. It is a strange world indeed when the US is having such a deep series of problems, the Fed and Treasury are talking about printing a few trillion here and a few trillion there, and at the very same time we see the dollar AND gold rising in value. Which all serves as a good set-up to the next section.

Back to the Basics

“Stocks for the long run” has been weighed in the balance in Baby Boomers’ retirement accounts all over the world and has been found wanting. The S&P 500 is now roughly where it was 12 years ago, although earnings in 1997 were higher than those projected for 2009. The Dow closed at 7466 on Thursday, a six-year low, giving all those who follow Dow Theory a clear bear market signal, suggesting there is more pain ahead.

In 1997 I was a young 49. For me to make the advertised 8% average annual returns in my equity portfolio, the Dow would have had to go on a tear for the next 8 years. 8% compound from 1997 would have the Dow well over 30,000 now. Remember those silly books which predicted such nonsense? (Seriously, what statistically flawed analysis, yet people bought it.) Now the market would have to do 18% a year for the next 8 years to get to 30,000. Anyone want to make that bet? Let’s look at a few paragraphs I wrote in Bull’s Eye Investing.

Living in Paradise

Would you like to live in paradise? There’s a place where the average daily temperature is 66 degrees, rainy days only occur on average every five days, and the sun shines most of the time.

Welcome to Dallas, Texas. As most know, however, the weather in Dallas doesn’t qualify as climate paradise. The summers begin their ascent almost before spring arrives. On some days the buds almost wilt before turning into blooms. During the lazy days of summer, the sun frequently stokes the thermometer into triple digits, often for days on end. There are numerous jokes about the Devil, hell, and Texas summers.

Once winter arrives, some days are mild — perfect golf weather. Yet the next day might be frigid, with snow or the occasional ice storm. That’s good for business at the local auto body shops, though it makes for sleepless nights for the insurance companies. Certainly the winters don’t match the chilly winds of Chicago or the blizzards of Buffalo, but Dallas is far from paradise as its seasons ebb and flow.

For the year though, the average temperature is paradisical.

Contrary to the studies that show investors they can expect 7% or 9% or 10% by staying in the market for the long run, the stock market isn’t paradise either. Like Texas summers, the stock market often seems like the anteroom to investment hell.

Historically, average investment returns over the very long term (we’re talking 40-50-70 years) have been some of the best available, but the seasons of the stock market tend to cycle with as much variability as Texas weather. The extremes and the inconstancies are far greater than most realize. Let’s examine the range of variability to truly appreciate the strength of the storms.

In the 103 years from 1900 through 2002, the annual change for the Dow Jones Industrial Average reflects a simple average gain of 7.2% per year. During that time, 63% of the years reflect positive returns, and 37% were negative. Only five of the years ended with changes between +5% and +10% — that’s less than 5% of the time. Most of the years were far from average — many were sufficiently dramatic to drive an investor’s pulse into lethal territory!

Almost 70% of the years were “double-digit years,” when the stock market either rose or fell by more than 10%. To move out of “most” territory, the threshold increases to 16% — half of the past 103 years end with the stock market index either up or down more than 16%!

Read those last two paragraphs again. The simple fact is that the stock market rarely gives you an average year. The wild ride makes for those emotional investment experiences which are a primary cause of investment pain.

The stock market can be a very risky place to invest. The returns are highly erratic; the gains and losses are often inconsistent and unpredictable. The emotional responses to stock market volatility mean that most investors do not achieve the average stock market gains, as numerous studies clearly illustrate.

Not understanding how to manage the risk of the stock market, or even what the risks actually are, investors too often buy high and sell low, based upon raw emotion. They read the words in the account-opening forms that say the stock market presents significant opportunities for losses, and that the magnitude of the losses can be quite significant. But they focus on the research that says, “Over the long run, history has overcome interim setbacks and has delivered an average return of 10% including dividends” (or whatever the number du jour is. and ignoring bad stuff like inflation, taxes, and transaction costs).

The 20-Year Horizon

But how long is the “long run”? Investors have been bombarded for years with the nostrum that one should invest for the “long run.” This has indoctrinated investors into thinking they could ignore the realities of stock market investing because of the “certain” expectation of ultimate gains.

This faulty line of reasoning has spawned a number of pithy principles, including: “No pain, no gain,” “You can’t participate in the profits if you are not in the game,” and my personal favorite, “It’s not a loss until you take it.”

These and other platitudes are often brought up as reasons to leave your money with the current management which has just incurred large losses. Cynically restated: why worry about the swings in your life savings from year to year if you’re supposed to be rewarded in the “long run”? But what if history does not repeat itself, or if you don’t live long enough for the long run to occur?

For many, the “long run” is about 20 years. We work hard to accumulate assets during the formative years of our careers, yet the accumulation for the large majority of us seems to become meaningful somewhere after midlife. We seek to have a confident and comfortable nest egg in time for retirement. For many, this will represent roughly a 20-year period.

We can divide the 20th century into 88 twenty-year periods. Though most periods generated positive returns before dividends and transaction costs, half produced compounded returns of less than 4%. Less than 10% generated gains of more than 10%. The P/E ratio is the measure of valuation reflected in the relationship between the price paid per share and the earnings per share (”EPS”). The table below reflects that higher returns are associated with periods during which the P/E ratio increased, and lower or negative returns resulted from periods when the P/E declined.

Look at the table above. There were only nine periods from 1900-2002 when 20-year returns were above 9.6%, and this chart shows all nine. What you will notice is that eight out of the nine times were associated with the stock market bubble of the late 1990s, and during all eight periods there was a doubling, tripling, or even quadrupling of P/E ratios. Prior to the bubble, there was no 20-year period which delivered 10% annual returns.

Why is that important? If the P/E ratio doubles, then you are paying twice as much for the same level of earnings. The difference in price is simply the perception that a given level of earnings is more valuable today than it was 10 years ago. The main driver of the last stock market bubble, and every bull market, is an increase in the P/E ratio. Not earnings growth. Not anything fundamental. Just a willingness on the part of investors to pay more for a given level of earnings.

Every period of above-9.6% market returns started with low P/E ratios. EVERY ONE. And while not a consistent line, you will note that as 20-year returns increase, there is a general decline in the initial P/E ratios. If we wanted to do some in-depth analysis, we could begin to explain the variation from this trend quite readily. For instance, the period beginning in 1983 had the lowest initial P/E, but was also associated with a two-year-old secular bear, which was beginning to lower 20-year return levels.

Look at the following table from my friend Ed Easterling’s web site at www.crestmontresearch.com (which is a wealth of statistical data like this!). You can find many 20-year periods where returns were less than 2-3%. And if you take into account inflation, you can find many 20-year periods where returns were negative!

Look at the 20-year average returns in the table above. The higher the P/E ratio, the lower (in general) the subsequent 20-year average return. Where are we today? As I have made clear in my last two letters, we are well above 20. Today we are over 30, on our way to 45. In a nod to bulls, I agree you should look back over a number of years to average earnings and take out the highs and lows of a cycle. However, even “normalizing” earnings to an average over multiple years, we are still well above the long-term P/E average. Further, earnings as a percentage of GDP went to highs well above what one would expect from growth, which is usually GDP plus inflation. Earnings, as I have documented in earlier letters, revert to the mean. Next week, I will expand on that thought.

And given my thesis that we are in for a deep recession and a multi-year Muddle Through Recovery, it is unlikely that corporate earnings are going to rebound robustly. This would suggest that earnings over the next 20 years could be constrained (to say the least).

In all cases, throughout the years, the level of returns correlates very highly to the trend in the market’s price/earnings (P/E) ratio.

This may be the single most important investment insight you can have from today’s letter. When P/E ratios were rising, the saying that “a rising tide lifts all boats” has been historically true. When they were dropping, stock market investing was tricky. Index investing is an experiment in futility.

You can see the returns for any given period of time by going to http://www.crestmontresearch.com/content/Matrix%20Options.htm.

Now let’s visit a very basic concept that I discussed at length in Bull’s Eye Investing. Very simply, stock markets go from periods of high valuations to low valuations and back to high. As we will see from the graphs below, these periods have lasted an average of 17 years. And we have not witnessed a period where the stock market started at high valuations, went halfway down, and then went back up. So far, there has always been a bottom with low valuations.

My contention is that we should not look at price, but at valuations. That is the true measure of the probability of success if we are talking long-term investing.

Now, let me make a few people upset. When someone comes to you and starts showing you charts that tell you to invest for the long run, look at their assumptions. Usually they are simplistic. And misleading. I agree that if the long run for you is 70 years, you can afford to ride out the ups and downs. But for those of us in the Baby Boomer world, the long term may be buying green bananas.

If you start in a period of high valuations, you are NOT going to get 8-9-10% a year for the next 30 years; I don’t care what their “scientific studies” say. And yet there are salespeople (I will not grace them with the title of investment advisors) who suggest that if you buy their product and hold for the long term you will get your 10%, regardless of valuations. Again, go to the Crestmont web site, mentioned above. Spend some time really studying it. And then decide what your long-term horizon is.

If I Had a Hammer

Let me be very candid. As the saying goes, if you only have a hammer, the whole world looks like a nail. Many investment professionals only have one tool. They live in a long-only world. If the markets don’t go up, they don’t make a profit. So, for them the markets are always ready to enter a new bull phase, or stocks are always a good value. That is what they sell, and that’s how they make their money. What mutual fund manager would keep his job if he said you should sell his fund? Frankly, it is a tough world.

About half the time they are right. The wind is at their backs and they look very, very good. Genius is a riding market. And then there are those times when it is just no fun to be them OR their clients. Driving to the airport today, I had CNBC on. They had a mutual fund manager on who was talking about why you should ignore the down periods and invest today. He used every hackneyed bromide I have heard and a few new ones. “You have to do it for the long run.” “If you aren’t invested, you miss the bull when it comes.” (Which is SO statistically misleading! Maybe next week I will go at that one!) “Long-term valuations are very good.” “The economy looks to turn around in the latter half of the year, so now is the time to buy, as the market anticipates the rebound by six months.” Etc. He was selling his book.

Again, back to basics. In terms of valuations, markets cycle up and down over long periods of time. These are called secular cycles. You have bull and bear secular cycles. In a period of a secular bull, the best style of investing is relative value. You are trying to beat the market. These periods start with low valuations, and you can ride the ups and downs with little real worry. Think of 1982 though 1999.

But in secular bear cycles, the best style of investing is absolute returns. Your benchmark is zero. You want positive numbers. It is much harder, and the longer-term returns are probably not going to be as good. But you are growing your capital against the day the secular bull returns. And, as bleak as it looks right now, I can assure you that bull will be back. Some time in the middle of the next decade, maybe a little sooner, we will see the launch of a new secular bull.

Why? Because low valuations act just like a coiled spring. The tighter it gets wound, the more explosive the result. You just have to have patience.

Now let’s look at two charts from Vitaliy Katsenelson. They illustrate my basic point: markets go from high valuations to low valuations and then back. The first uses one-year trailing earnings and the second uses a smoothed 10-year trailing earnings stream. But however you look at them, you see a very clear cycle. By the way, the one-year chart is a few months old, so the numbers would look even worse after the horrific earnings from the 4th quarter of last year.

It is time to hit the send button. Next week, we will look at a very simple method for timing the markets within the cycles, which can help you avoid the real downturns. While it may seem obvious that avoiding bear markets will do wonders for your portfolio, a lot of investment professionals say you can’t do it. To that I politely say, garbage.

The tables above clearly lay out how you can time the markets in broad patterns. You can’t pick the absolute highs and lows, but you don’t need to. You just need to know the direction of the wind and where you want to sail.

Source
While Rome Burns – John Mauldin, Thought from the Frontline

Related posts:

• Remittances to Eastern Europe to slow dramatically
• The EU promises to bail out eurozone members
• EU planning 200 billion euro package for Eastern Europe
• Quote of the day: Austrian banks
• Eastern European economic growth to crater in 2009

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• Swine Flu video primer from the Wall Street Journal
• Bloomberg talks Eastern Europe as Latvia downgraded
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Europe is having a problem right now. In truth, it is many problems more than a single problem. Countries in the former Soviet bloc are in a deep downturn which has been significantly worsened by turmoil in currency markets. Western European banks are hemorrhaging losses – some will probably be nationalized. Spain, the U.K. and Ireland have all seen massive property bubbles implode. Greece, Ireland, Spain, Portugal and Italy have all seen credit warnings and downgrades. And Ukraine, Hungary and Latvia are but three nations that have been forced into the arms of the International Monetary Fund for a bailout. Clearly, the credit crisis has moved to Europe in a massive way. In my view, this was always inevitable given the available evidence after the panic in September. I have written a number of posts on this very issue:

• Are the Baltics the new Argentina? (Jul. 2008)
• Switzerland: politicians need to act now (Oct. 2008)
• Currency crisis is gathering storm (Oct 2008)
• A shift to Eastern Europe and emerging markets too (Oct 2008)
• Is Ireland the next Iceland? (Nov 2008)
• The emerging markets crisis (Nov 2008)
• Top ten predictions for the 2009 global economy (Dec 2008)

Anyone who tells you this crisis came out of the blue is lying or ignorant. Yet, policy makers have largely had their heads buried in the sand. The Germans, in particular, took a very hard line. But, now that the German economy is in tatters, they have come ’round. The question is: will the crisis in Europe lead to a catastrophic outcome? My answer is no, despite the challenges.

The Swiss

I will explain why I see a deep downturn but no catastrophic outcome using the case of Switzerland as an example. Just two days ago, I profiled a somewhat sensationalistic analysis of the situation in Switzerland from the Swiss daily Tagesanzeiger. This post received a lot of traffic because it highlighted the severity of the problems besetting Europe if the Swiss were being considered a potential Iceland.

Once upon a time, Switzerland, as banking mecca and the fifth wealthiest country in the world (one notch behind Iceland), was considered the paragon of stability and prudence. The Swiss franc was backed by gold and had importance far beyond the Swiss economy’s size. Switzerland is home to some of the world’s largest companies in a wide range of industries from pharmaceuticals to banking to consumer products.

But, during the great moderation, the Swiss lost their way. The Swiss National Bank lowered interest rates to extremely low — dare I say it, Japanese — levels. The SNB starting selling their gold at depressed prices. And Swiss banks, known the world over for safety, secrecy and security, started to muscle their way into the globalized financial arena of investment banking and trading.

The result has been a dangerous increase in Swiss franc credit abroad and a similarly dangerous increase in the balance sheets and leverage of the two remaining large Swiss banks, Credit Suisse and UBS. This presents a problem in a world of deleveraging and asset deflation because the Swiss are a small nation of 7 million without the protection of the European Union or the Euro to fall back on. This makes them vulnerable. Hence the doomsday pronouncement from Artur Schmidt about Swiss bankruptcy.

I do not believe the Swiss will go bankrupt simply because they are too wealthy, too interconnected and too important to fail. No one wants a run on the franc. No one want a collapse of Swiss banks. As a result, policy makers will address the Swiss problem and work out a solution.

Nevertheless, the lack of specifics in the previous paragraph should give one great pause. I am merely making a reasonable conjecture. I am not saying that the problems with writedowns, bad loans, and deleveraging are going to go away.

They may, in fact, become much greater because of Switzerland’s interconnectedness with the rest of Europe. Which brings us back to the broader question of Europe’s many problems.

I would break the Europe down into four distinct spheres: The Eurozone, the non-Eurozone West (like the UK, Sweden and Denmark), the EU East (like Poland, Hungary and Latvia) and the non-EU East (like Ukraine and Croatia). The problems and potential outcomes in each of these regions is different. The crux of the matter is the Impossible Trinity of a fixed exchange rate, independent monetary policy and free movement of capital. You can have two, but you cannot have all three. Paul Krugman says it best in an article from 1999:

The point is that you can’t have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain–or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).

The Eurozone

The Eurozone members have decided to forgo independent monetary policies. Individual member nations have free capital movement and a fixed exchange rate but zero control over monetary policy. That rests with the European Central Bank (ECB) in Frankfurt.

The problems mount in recession. Some members are getting devastated. Spain, for instance, is in depression already with unemployment at 14%. Ireland’s national budget is imploding with estimates for deficit reaching 10-12% of GDP. If you are Spain or Greece, you would like to print money– a lot of it. But that’s not happening in the Eurozone yet.

The result is a potential national bankruptcy for the likes of Ireland, one reason their credit rating is suffering. Will Ireland go bankrupt?  Perhaps.  It is unclear how willing other Eurozone members would be to support the country were it to run into that kind of difficulty.  The Germans are furious for having abandoned the Deutsche Mark for the Euro, which they see as a ‘weak’ currency.  Bailing out a Eurozone member would come with many strings attached.

Then, there is the case of Austria.  They too are in the Eurozone.  They have a weak banking system because of excessive lending to Eastern Europe — reaching a full 85% of Austrian GDP.  (Whether the Austrians were mentally re-creating their lost Empire, stripped after World War I, is a case for the Austrian psychologist Freud). If the Eastern Europeans run into problems, Austrian banks will fail en masse, requiring help from other Eurozone members (read France and Germany).

EU East

This brings us to EU East.  And by that I mean members of the European Union nations east of the Eurozone, which stops at Germany, Austria and Italy (Slovakia is also a Eurozone member as of Jan. 1st).  Countries in this region have seen fantastic growth rates over the past decade, but, also a huge increase in debt, asset prices, and current account deficits.  All of this points to excess.

The problem, of course, is the Impossible Trinity.  These countries want stable exchange rates, monetary policy control and free movement of capital.  But, with the excesses already highlighted, the first to go in this trio was always going to be the exchange rate.

Now, EU East loaded up to the nines with debt in Swiss francs, Euros and U.S. Dollars.  Companies, Individuals, even hospitals have huge foreign currency debt exposure (see my post “Reverse carry trade borrowing is deadly” from October).  A reader from Poland said it well:

Situation in Poland: 2008.07 – 1CHF = 2.0PLN – you can go to ANY bank and take a loan for 120% value of you new flat/apartment. i live in Warsaw, lot of my friends took that loan. unemployment rate – 10% but in Warsaw was close to 0% especially if you have a master degree and skills to work in office such as advertising agency or as financial advisor or similar type of job. Now – you cannot take a loan or rent a money from bank. one square meter is down close to 25% from 2008.07. franc is up – 1CHF = 3.3PLN within my friends unemployment rate is close to 20%. banks are full of CHF loans, even if you sell the apartment you have close to half of the money you borrowed. did i mentioned that the loans we’ve given in rates even for 50 years?

Events in Poland are mirrored throughout the region. Obviously, if Austria, Ireland and Switzerland are having problems, you can imagine it is much worse in Poland, Latvia and Hungary. Hungary and Latvia have already asked for and received IMF assistance. I expect we will see a similar turn in Poland, Estonia and elsewhere. Moreover, these nations are part of the European Union. The possibility still exists that they could receive increased transfer payments in order to mitigate the worst of things. However, the Germans would be even less willing here, I suspect — not to mention countries like Britain and Sweden, which have their own worries.

Non-EU East

Then there are those countries east of the Eurozone that do not have a rich uncle. We are talking about places like Serbia, Croatia, and Ukraine. Ukraine looks to be imploding. Other countries will surely see a severe contraction in GDP. The Impossible Trinity asserts itself here again as it did for the EU East. The biggest difference for these countries is they are outside the European Union. This means countries like Ukraine will go bankrupt, no ifs ands or buts. What this means for stability in the region is unclear given the strategic importance of Ukraine as an energy transit route. If Ukraine implodes, knock-on effects for the likes of Belarus will be severe. Russia is a whole different ball of wax that I am not considering. But, again, for much of non-EU East, the problem is foreign currency loans.

Floaters

And that brings us full circle back to Switzerland. The Swiss are not a member of the Eurozone. They are not even a member of the EU. Like Norway (and Iceland, for that matter), the Swiss are on their own. This has benefits. The Impossible Trinity is a non-sequitur. One can print money and devalue at the heart’s content. The Brits have shown us the power of devaluing a currency from 2.11 per U.S. Dollar to 1.43 per U.S. Dollar. Surely, the Swiss can do the same. In fact, in the case of the Swiss, devaluation would mean that their debtors will be able to repay their loans more easily. I fully expect the Swiss National Bank understands this and is prepared to crank up the presses if they have not begun to do so already. However, in the end, printing money is not much of a solution to what ails Europe. Banks are undercapitalized and some countries are overly indebted. This speaks to bankruptcy for individuals, companies, banks, and, yes, nations. My advice on remedies is fourfold:

1. Consolidate the financial services sector through merger, bankruptcy and nationalization
2. Recapitalize banks full-stop.  Whether this is done with public or private monies is secondary
3. Increase intra-EU transfer payments.  The European Union and the Eurozone are supposed to be analogous to the United States.  Call it the United States of Europe, if you will.  But, this analogy is false because Europe is much more heterogeneous than the United States.  There is an insufficient movement of private capital and people as an automatic stabilizer.  Translation:  European people and money stay put, American money and people do not.  In recession, you want movement because it evens out the rough spots.  In the absence of movement in the private sector, the public sector will have to step in.
4. Capital controls.  The whole European mess is a result of an asset and credit bubble that failed to understand the importance of incompatibilities between stable exchange rates, free capital movement and independent monetary policy.  If you eliminate free capital movement, as Willem Buiter suggests, Europe would stand a chance of weathering the storm.

None of my ‘remedies’ is pain-free and there is considerable ideological resistance to the last remedy of capital controls.  But, Europe is in a bit of a pickle.  If politicians do not take on this challenge with both hands, much worse is to be expected.

Sources
O Canada – Paul Krugman, Slate

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• Swiss Franc at Dollar parity?
• Switzerland threatened with bankruptcy
• The Swiss get on the QE2
• EU planning 200 billion euro package for Eastern Europe
• Greece sees credit rating cut by S&P

FT Alphaville has a post up indicating that the UBS EMEA economics team is much more sanguine about prospects in Eastern Europe than many market participants. The most important part of the UBS contents reads as follows:

We don’t normally respond directly to articles in the financial press, but quite a number of clients have requested clarification on recent reports that Eastern Europe is now facing a financial “meltdown”, and one that threatens to take the stability of Western European banking systems down with it (this theme has suddenly appeared in quite a few articles, including those on gold, commodities and banks, but the one that was forwarded to us most often was “Failure To Save East Europe Will Lead to Worldwide Meltdown“, Daily Telegraph, 17 February 2009).

This is heady stuff, and of course has helped call attention to the state of Eastern European economies (for most economists, the irony here is that all the press notice comes at a time when nothing has really changed in terms of the underlying regional situation; we’ve been writing about Eastern Europe’s problems for a good long time now). However, we need to stress our view that the conclusions above are also highly exaggerated, with at least as much “hype” as hard analysis.

Read more at the link below.

Source
UBS: No Eastern European meltdown – FT Alphavlle

Related articles
“Europe is now the epicenter” – FT ALphaville

Related posts:

• EU planning 200 billion euro package for Eastern Europe
• Roubini’s RGE Monitor: Threat of ‘Asia-Style Crisis’ in Eastern Europe
• Bloomberg talks Eastern Europe as Latvia downgraded
• EU: Banks ask for a bailout for poor lending in Eastern Europe
• Remittances to Eastern Europe to slow dramatically

This video does not mention Austria by name, focusing instead on Ireland, Spain and Greece, but Austria is more of the problem for the Germans as they are leveraged to Eastern Europe.

German Finance Minister Peer Steinbrueck became the first senior policy maker to broach the topic this week, saying some of the 16 euro nations are “getting into difficulties” and may need help. French officials are also concerned about market tensions as the cost of insuring Irish, Greek and Spanish debt against default rises to records and bond spreads widen.

The nightmare for Angela Merkel and Nicolas Sarkozy is that widening deficits will prompt investors to shun the debt of some countries, sparking a region-wide crisis. While few investors are yet forecasting any defaults, the mere risk of it may prompt the bloc’s two richest economies to ignore the European Central Bank and announce their willingness to come to the rescue.

“When push comes to shove Germany, France, the larger players will bail out those smaller peripheral players,” said Alex Allen, chief investment officer of Eddington Capital Management. “You can’t let one part of the system fail because it leads to failure of the whole system.”

Update at 1315 EST on 18 Feb 2009: The FT Lex column says:

In relative terms, Austria’s exposure is also highest by far, at nearly 70 per cent of GDP. Sweden follows on 30 per cent, through Baltic activities, with Greece on 19 per cent, largely in the Balkans. Austria’s Raiffeisen also has the highest relative exposure among banks, with 54.5 per cent of its risk-weighted assets in eastern Europe, Moody’s estimates. Little wonder Vienna is leading calls for increased European Union support to its eastern neighbours.

Source
Germany, France May Face Bailout of Nations, Not Just Banks – Bloomberg.com

Related posts:

• Quote of the day: Austrian banks
• The EU promises to bail out eurozone members
• European banks have hands out for more capital
• EU: Banks ask for a bailout for poor lending in Eastern Europe
• Swiss Franc at Dollar parity?