Thursday, 30 December 2010

Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet

The Goodwill issue is an important one to take into account when looking at possible Goodwill impairments on Banks Balance Sheets.

Why so?

When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.
As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital.

On June 29, 2001, The Financial Accounting Standards Board (FASB) unanimously voted in favor of Statement 142, Goodwill and Other Intangible Assets. Prior to this statement, goodwill was amortized over its useful life not to exceed forty years. Under FASB 142, goodwill will still be recognized as an asset, however, amortization of goodwill will no longer be permitted. Instead, goodwill and other intangibles will be subjected to an annual test for impairment of value. This will not only affect goodwill arising from acquisitions completed after the effective date, but will also affect any unamortized balance of goodwill.

According to the Financial Accounting Standards Statement No. 142, goodwill is not amortized but is instead tested for impairment at the reporting unit level at least annually.

An exemple of Goodwill Impairment Test can be found here:

Deutsche Bank Annual report:

On the 13th of February 2008, this was the situation for some well known American Banks:

Bank                       Goodwill/ Capital
Bank of America             53%
Capital One                     53%
Sovereign Bank               54%
Wachovia                        59%


And what is the return on goodwill? Probably zero given it cannot be easily deployed.

Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks:

Following the financial crisis, there have been a steady rise in Goodwill impairments for many financial institutions.

Charlotte-based Wachovia, now owned by Wells Fargo & Co., took more than 24 billion USD in goodwill impairment charges in 2008 as it struggled in the financial crisis.

Royal Bank of Canada took in April 2009 a non-cash related impairment of 850 millions USD impairment related to its US banking business impacted by the declining US housing market as stated below.

Global Banking News-20 April 2009-Royal Bank of Canada to take goodwill impairment(C)2009 ENPublishing -

"Royal Bank of Canada (TSX:RY) has announced that it is expecting to take a goodwill impairment charge.

The bank is expected to take a USD850m non-cash goodwill impairment charge for the second quarter on its US banking business. The bank said that the charge would be taken because of the declining US housing market and overall economy. The charge followed a two-step review started last quarter.

In a statement, the bank said, 'This expected charge reflects the impact of prolonged challenging economic conditions that have affected our international banking reporting unit. We have now completed the second step of the testing process and have determined that the international banking reporting unit goodwill is impaired, resulting in the expected charge to second quarter earnings."

More recently DBS posted a second quarter loss on a 747 Millions USD Impairment charge:

"DBS Group Holdings Ltd., Southeast Asia’s biggest bank, reported an unexpected second-quarter loss as it booked a one-time goodwill impairment charge at its Hong Kong unit because of pressure on interest margins.

The loss of S$300 million ($220 million) compares with net income of S$552 million a year earlier, the company said in a statement today. The average estimate of eight analysts surveyed by Bloomberg was for a profit of S$572.9 million. Excluding the S$1.02 billion goodwill charge, DBS’ net income for the second quarter rose 30 percent to S$718 million."

Goodwill impairment charge is sometime viewed that a bank or one of its franchise is impaired.

The questions you need to ask yourself when looking at the valuation of a bank is: What the bank is going to do with its business and the capital deployed in it, and, how it is going to increase the return on that capital?

"Banks wrote down more than $25 billion in good will in 2008, up sharply from $790 million a year earlier, according to data compiled by Frank Schiraldi of Sandler O’Neill & Partners. By the end of the year, banks still had $291 billion worth of good will on their books. An incomplete tally of write-downs from the first quarter showed that banks had taken a $3.5 billion hit to good-will values."


The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks.

As indicated clearly by Susan Osterfelt in her article Goodwill Hunting:

"A large amount of goodwill on a company's balance sheet could be an indication that the company's acquisition premiums, which may have been justified at the time of acquisition, may result in future write-downs based on the annual test for impairment. This puts us all in the position of being goodwill hunters."

As a reminder:

AOL Time Warner recorded a goodwill impairment of 54 billion USD in 2002, reflecting its "difficulty in realizing the value of the merger of AOL with Time Warner", which represented for me at the time the best representation of the internet bubble, when the over pumped AOL merged with the solid Time Warner. I know the story, it was different this time...

Large Goodwill Impairments increase the debt to equity ratio.

Bank of America had a total of 85.8 billion USD in goodwill counted as part of its 2.4 trillion USD in assets as of the end of the second quarter 2010. Bank of America Corporation reported a net loss of 7.3 billion USD, or 0.77 USD per diluted share, in the third quarter of 2010, including a non-cash, non-tax deductible goodwill impairment charge of 10.4 billion USD.

As we can see in the above example for Bank of America, Goodwill Impairments can hurt income significantly, without impacting capital. Countrywide represents 4.4 Billions USD of Goodwill in Bank of America's balance sheet.

It is therefore paramount to track goodwill impairments in relation to future banks earnings. As we can see in the case of Bank of America and DBS, the impact on the income can be very significant.

Wednesday, 29 December 2010

Inception - Bernanke's QE2 experiment

Like in the movie Inception, the Fed is trying to plant an idea into people's mind. Bernanke idea's with QE2 is to create a wealth impression which would increase consumption and economic growth, with the help of rising assets prices. We had the Greenspan put and the Bernanke put, we also now have to contend with the same bubble creation plan which was initially followed by Alan Greenspan.
We all know now the results of creating asset bubbles and the consequences.
It is a very dangerous game.

I agree with Cullen Roche from the excellent site Pragmatic Capitalist, that QE1 was not money printing and was necessary in order to alleviate the massive burden of toxic assets sitting on banks balance sheet.

"Over the last 15 years the Federal Reserve has essentially become a price fixing mechanism for an economy that has long struggled with severe structural problems. When problems have arisen in the economy the U.S. central bank has intervened to lessen the blow to the economy. In theory, this was intended to reduce the volatility of the business cycle. Unfortunately, many of their policies have simply exacerbated the problems or helped to generate even greater imbalances.

This all started well before the housing bubble or the Nasdaq bubble. After the 1987 crash Alan Greenspan was quick to reassure investors that the Fed was there to bolster markets. This “Greenspan put” was mastered with the bailout of LTCM as the Fed intervened in markets to make sure that losers didn’t have to become losers. LTCM was the epitome of failed economic theory at work in markets. A group of brilliant economists believed they had discovered the path to minting money in financial markets. On paper their equations appeared flawless. In reality, they were a disaster waiting to happen. In one fell swoop this collection of geniuses proved that EMH was flawed. And not two years later the Greenspan Put helped contribute to a market bubble like the United States had never seen. In the words of David Tepper, it was a “win win” market – or so they believed."

What if we had let LTCM fail in 1998? Would we have had a Lehman demise in 2008?

In his excellent post Cullen adds: "the modern day Fed has taken its role to an entirely new level. They are no longer just the lender of last resort – they have become the bailout mechanism of the capitalist system and ultimately a plaque build-up in a system that is increasingly unhealthy"

The outrage and the condemnation stem from the moral hazard of the situation of QE1, where Main Street had to step in to bail out Wall Street.

Cullen concludes his excellent post with the following comment:

"What these men haven’t stopped to ponder is whether any of this intervention was actually healthy for the markets. Perhaps the market crashed in 1987 because an irrational 40% climb in 8 months had created instability? Perhaps the Nasdaq never should have approached 5,000? Perhaps LTCM needed to fail? Perhaps housing was never intended to be a speculative asset? Perhaps these assets needed to be allowed to decline? The result has been a slow deterioration in the foundation of the system with each and every bailout."

Should the role of the Fed and its Central bankers be extended to preventing bubbles? Clearly some Central Bankers in other part of the world, think so. At least this is what the Central Bank of Canada has been following which meant that went the crisis occurred, they were in a better situation to face the financial carnage we witnessed. The Canadian Central Bank approach is highligthed in my previous post. Mark Carney, Governor of the Bank of Canada is right : "selected use of macro-prudential measures" are needed as a third line of defense in Central Banks policies, meaning deploying counter-cyclical capital buffers to lean against excess credit creation.

In the case of QE2, fear is justified, Bernanke has crossed the Rubicon.
When the Fed is starting to lend money to the US government, meaning no sterilization of the purchase of US treasuries, it is in fact money printing, let's be very clear about that. QE2 was not necessary and is very dangerous.

Paul Mortimer-Lee of BNP Paribas, in an article called "The night they killed Santa", commented in this article following Bernanke's television appearance that
"Until Tuesday, I believed QE2 was a monetary policy play designed to facilitate lower yields and avoid the threat of disinflation. Now it looks like the nice man with the white beard was just there to fund a fiscal expansion."

This is the greatest of moral hazard, when the central bank starts lending money to the US government. Is that what QE2 is all about?

Mortimer-Lee adds:
"Belief in the US as a pillar of stability has gone. We have written before about how the Fed's ultra-lax monetary policy is threatening the US dollar's role in the international monetary system. This week we saw any pretence of fiscal probity dumped."

He concluded his note with the following comment:
"Tuesday night was when I stopped believing in Ben Bernanke. I feel a bit foolish for having been gullible for so long, but a bit sad too."

"The night they killed Santa"

"One myth that's out there is that what we're doing is printing money. We're not printing money. The amount of currency in circulation is not changing." Federal Reserve chairman Ben Bernanke, December 5, 2010.

In relation to Ben Bernanke's public intervention, the excellent Doug Noland commented in Asia Times in his weekly Credit Market Bulletin following Ben's intervention on television in December:

Bernanke was pilloried last week for his "we're not printing" comment from Sunday evening's 60 Minutes interview. I'll pile on, but from a different angle. It seems strange to me - perhaps disingenuous - for our Fed chairman to suddenly take such a narrow view of "money".

At US$917 billion, outstanding currency comprises just over 10% of the "M2" monetary aggregate (savings deposits are the largest component at $5.343 trillion). And I have argued over the years that "M2" is a much too narrow definition of "money" to provide a useful barometer of overall credit and liquidity conditions. Certainly, the expansion of paper currency has been inconsequential to the grand scheme of Washington stimulus.

In the "old days", the banking system dominated system credit creation. Bank lending was integral to credit growth, with new bank deposits created through the process of expanding bank loans. "M2" provided a good indication of bank lending - that was a decent indicator of overall credit conditions. As such, the Fed reigned supreme over the credit mechanism through its careful regulation of bank reserves. Rather mechanically, our central bank would add reserves - the fodder for new bank loans - when it sought a boost in lending. It would extract reserves when it preferred to lean against the wind. Bank deposits were the critical component of "money" supply, and our central bank judiciously monitored their expansion.

The financial world - certainly including monetary management - was turned upside down with the unleashing of (unconstrained) non-bank credit instruments. No longer did the banks dominate system credit creation. In a process that gained fateful momentum throughout the 1990s, the bank loan was relegated to second-class citizen in the age of the booming Wall Street securitization marketplace. Meanwhile, the Fed's entire process of manipulating bank reserves became moot. Fed policy immediately gravitated toward manipulating the securities markets, and Bernanke's predecessor at the Fed, Alan Greenspan - "The Maestro" - absolutely relished his new "activist" role.

I have defined contemporary "money" as the most precious of credit instruments. "Money" is as "money" does. The great Austrian economist Ludwig von Mises recognized the crucial monetary role played by "fiduciary media" that had the economic functionality of a more narrowly defined stock of money. Especially with the advent of non-bank credit, the definition of what might operate as "money" in the markets and real economy had to be broadened significantly. The greater the boom in marketable debt instruments the more paramount the role of market perceptions in determining the stability of our financial markets and real economy.

Over the years, I have explored the concept of the "moneyness of credit." Moneyness is driven by the marketplace's perception of safety and liquidity. Generally speaking, "money" is a debt instrument perceived as a highly liquid store of nominal value. Money has always enjoyed a special role and, hence, unique demand characteristics: folks simply can't get enough of it, which nurtures a propensity to create it in overabundance. Money operates with its own problematic supply and demand dynamics, and never has moneyness enjoyed such capacity to wreak global havoc as it does today. With all their good intentions, central bankers are nonetheless at the root of the problem.

The Fed may not be running the currency printing press around the clock, but Fed policies have certainly been instrumental to the unending expansion of Treasury borrowings. And, clearly, any meaningful definition of contemporary "money" must include government debt instruments. Indeed, with bank (and, more generally, private-sector) credit suffering from post-housing mania stagnation, never before has government debt so dominated system "money" and credit creation.

Importantly, the Federal Reserve's zero-rate policy and massive monetization program have been instrumental in maintaining the perception of "moneyness" in the face of unprecedented Treasury debt issuance. I can't envisage a more powerful bubble dynamic: the Fed intervenes and manipulates the Treasury market - the predominant debt market underpinning fixed income and securities markets more generally. Enormous fiscal stimulus then works to stabilize system incomes, corporate cash flows, state & local tax receipts, and asset prices more generally. In the final analysis, trillions of dollars of government-created purchasing power ensure that a structurally maladjusted US economy has, at the minimum, the appearance of viability - and the stock market booms.

The Fed may not be "printing", but its operations as "backstop bid" are fundamental to the US and global government finance bubbles. In a replay of how "backstop bid" of mortgage guarantors Fannie Mae and Freddie Mac, the Fed and the US Treasury created the "moneyness of credit" for mortgages and related securitizations, the Fed's quantitative easing program distorts market perceptions of various risks (credit, interest rate, liquidity and systemic) and promotes over-issuance. From this perspective, our central bank's operations are more dangerous than the traditional printing press.

"Moneyness" was fundamental to the doubling of mortgage debt in just about six years during the mortgage finance bubble. Over time, the expanding gulf between market perceptions of moneyness and the true underlying state of mortgage credit ensured a crisis of confidence. Moreover, the trillions of additional mortgage credit had played havoc with spending and investing patterns and, increasingly over time, the underlying economic structure. These days, the attribute of "moneyness" in Treasury debt is on track to ensure the doubling of federal borrowings in the neighborhood of four years. For this round, the "expanding gulf" is much more pernicious and the consequences of a crisis of confidence potentially more devastating.

Money has throughout history demonstrated its dangerous side. Abuse money and "moneyness" at your own peril - although this fundamental lesson is invariably unlearned given enough time (and the seductiveness of monetary booms). The fiascos are always a little different, inevitably created by clever new wrinkles in the many faces of "money" and credit.

We are in the midst of another sordid episode. John Law's experimentation with paper "money" in France ended with the spectacular bursting of the Mississippi Bubble in 1720. Today's backdrop is much more complex: the Fed and global central bankers are working diligently to control an experiment in electronic "money" and credit gone terribly awry.

If it were only the printing press, it would be easier to appreciate what was developing and how to administer some restraint. Instead, the Fed has banked everything on its capacity to inflate marketplace liquidity, sustain massive government debt issuance, and maintain market perceptions of moneyness."

Where Doug makes his point is the role played by the Fed in maintaining what he calls "moneyness". The Fed acts as a backstop bid as well as maintaining perception of value. In fact, what he means I think is that the game of the Fed is to maintain perception of value by inflating assets prices through QE, moneyness being the perception of safety.

The point he makes and we all know that, the Fed is great at creating bubbles after bubble and QE is already creating the seeds for another one. It will end up in tears.

Gold will therefore continue its meteoric rise, supported by the misguided QE2 policy. Oil got my attention when it was recently trading at 75 USD in October. I am not surprised we are getting closer again to the 100 USD level. I think we will reach 100 USD in early 2011.

Oil in 2010:

Also at the current level of VIX, buying insurance for a market correction is once again cheap, and as in April, before the May sell-off, I wrote it was the right time to buy some protection. Again this time around, I think it is a good time to start buying some protection for some downside risk in early 2011.

Facts on current vols levels:
-EuroStoxx 50 is at the lowest level in the last four years. One month Implicit Vol was on the 15th of December at 17.3%, the lowest point was 6th of April 2010 at 15.5%, we know what happened in May... Implicit Vol 1 year was at 22.8% on the 15th of December.
-V2X has never drop as fast as it did between the 5th and the 15th of December since 2004. 19.7% as of the 15th of December, lowest point in 2010 was 19.8% on the 26th of March 2010. This is the lowest point since 30th of May 2008. V2X was at 31.1% on the 30th of November 2010 as a reminder.

Merry Christmas to all!

Martin T.

PS: Happy Birthday to my blog, it has been more than a year now and it is well alive and kicking. I would like to thank all my friends who have provided me with reports and some Bloomberg specific graphs which have helped me to illustrate my point of view. Please don't hesitate to comment on the posts to make this blog more interactive.

Tuesday, 14 December 2010

Low rates environment and the risk of evergreening à la Japanese

In this new environment, corporate balance sheets appears to be in outstanding shape whereas banks balance sheets still appears to be bloated with toxic assets (non-performing loans).

This is can be reflected in the massive divergence between the Itraxx 5 year CDS Main index in Europe (125 CDS names) versus the Itraxx Financial Senior 5 year index:

As you can see the spread is now at around 62 bps between both indices.

UK Banks sub debt is as well following the trend for wider SUB CDS 5 year spreads, as of the 12th of December as indicated below:

As illustrated below, some corporate CDS 5 year spreads are tighter than both sovereign as well as banks senior CDS spreads, in this example, large European Chemicals versus Banks Senior 5 year CDS spreads:

It is interesting to see that Rabobank being one of the only AAA rated bank in the world, is trading wider than single A rated BASF as well as Dow Chemical currently rated BBB- by S&P, the lowest investment-grade rating.

Reason being is the following, corporate leverage has continued to decline in the third quarter of 2010, approaching its lowest level in two decades. In addition to this, large corporations are sitting on very high level of cash. They have been hoarding cash.

U.S. companies are hoarding almost 1 trillion USD in cash!

As per Reuters:
Cisco Systems (CSCO.O) has the largest cash balance, at 39.86 billion USD, Microsoft (MSFT.O) is second with 36.79 billion USD according to Moody's. Google (GOOG.O) has the third-largest balance with 30.06 billion USD, followed by Oracle (ORCL.O) with 23.64 billion USD and Ford Motor Co (F.N) at 21.89 billion USD.

Technology companies held the most cash as a sector, at $207 billion, followed by pharmaceuticals with $124 billion, energy at $105 billion, and consumer products with $101 billion, Moody's said.

They are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty.
Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet.

These are effects you can see in a balance sheet recession as I posted earlier in "Honey I shrunk the balance sheet"

The deleveraging process will take years.

In relation to the title of the post, in the latest speech of the Governor of the Bank of Canada (thanks TPC for posting the link on your site, Mark Carney clearly highlights the risk of a prolonged low rates environment and the risk of creating asset prices inflation (a must read):

"Past experience has shown that low policy rates allow “evergreening,” or the rolling-over of non-viable loans. The classic example was Japan in the 1990s when banks permitted debtors to roll over loans on which they could afford the near zero interest payments but not principal repayments. By evergreening loans instead of writing them off, banks preserved their capital, but this delayed necessary restructuring of industry. Moreover, the presence of non-viable (or “zombie”) firms limited competition, reduced investment and prevented the entry of new enterprises."

Spot on Mark Carney! What crucified Japan in its lost decade were its zombie banks evergreening their toxic assets. It is better to restructure and fast. As I blogged about Ireland in September (Zombieland 2...The sequel...), Ireland is impaired by its zombie financial system.
In relation to the current predicament of US banks, I have argued as well the need for a new Resolution Trust Corporation (RTC II), similar to the one established following the Savings and Loans Crisis in the nineties.

What is as well outstanding from the speech from the Governor of the Bank of Canada is how well Canada has managed its financial sectors using strong regulations and using "selected use of macro-prudential measures" as a third line of defense. I hope the FED and Bank of England are taking notes. Outstanding work. Canada is indeed Canada, a great exemple of successful structural reforms and efficient banking regulation.

"In broader asset markets, counter-cyclical capital buffers can be deployed to lean against excess credit creation. Importantly, following the agreement of G-20 leaders in Seoul, the Basel Committee endorsed the Canadian-led proposal for this framework."

The role of Central banks as so clearly illustrated by Canada should be extended to prevent the creation of credit bubbles. Alan Greenspan, Ben Bernanke please read carefully, you might learn something...

"In the housing market, the Canadian government has already taken important measures to address household leverage. These include a more stringent qualifying test that requires all borrowers to meet the standards for a 5-year fixed-rate mortgage as well as a reduction in the maximum loan-to-value ratio of refinanced mortgages and a higher minimum down payment on properties not occupied by the owner."

As a reminder about the Austrian Business Cycle Theory:

"Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.

According to the Austrian School business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "credit-fuelled boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. Economist Steve H. Hanke identifies the financial crisis of 2007–2010 as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by Austrian school economic theory."

Quod erat demonstrandum

In the post "The inflation debate or why you can have inflation in a deflationary environment", I reviewed the Austrian Business Cycle Theory in conjunction with Fisher's formulation of debt deflation and the following chain of consequences.

Those who cannot remember the past are condemned to repeat it."
George Santayana (16 December 1863 – 26 September 1952)

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867
I used this quote in "Creative destruction and the Minsky moment" in May 2010, at the start of the Greek sovereign crisis.

Financial fragility levels move together with the business cycle.

In relation to banks current conundrum with their impaired balance sheets bloated with toxic assets, Mark Carney stated in his speech: "For example, over the past year and a half, banks have used low short-term funding rates to rebuild capital by investing in long-term government bonds. This strategy is effective to a point, provided complacency does not set in over the duration of low policy rates. Making consistent positive carry may diminish the sense of urgency with which banks reduce leverage or write down bad assets. Financial institutions may also take this game too far, underestimating the risks."

It is therefore critical to avoid evergreening à la Japanese, the sooner the restructuring of debt, the better and the faster the economic recovery.

I will conclude this post quoting again the Governor of the Bank of Canada, "a massive deleveraging has barely begun across the industrialised world."

"Cheap money is not a long-term growth strategy. Monetary policy will continue to be set to achieve the inflation target. Our institutions should not be lulled into a false sense of security by current low rates."

Thursday, 9 December 2010

Europe - The end of the Halcyon days

"Hi, I'm a _______ (add country) and I'm addicted to credit."

Greece, Ireland, now Portugal:
Banco Comercial Portugues SA (SUB) 5 Year CDS:
1472 bps +194 bps on the 6th of December +15%
Banco Espirito Santo SA (SUB) 5 Year CDS:
1467 bps +137 bps wider on the 6th of December +10.36%

These were the levels we had on the 22nd of November as published in the post Dominos in Europe:

From the 22nd of November until the 6th of December, Banco Comercial Portugues SA (SUB) 5 Year CDS has moved from 974 bps to 1472 bps, a mighty 51% increase. Banco Espirito Santo SA (SUB) 5 Year CDS, has moved from 974 bps as well to 1467, similar widening of 51% of the spread.

Any similarity with what has happened with Irish Banks Sub CDS 5 Year, which jumped above 1000 bps in September, would be of course be purely fortuitous...

Italian Financials SUB Cds are widening as seen on the 8th of December:

By accepting too early to guarantee its banking system, Ireland sealed its fate and part of its Sovereignty to Europe and the IMF. Private debt from the dodgy Irish banks have been in fact transferred to the Irish taxpayers. The Black Hole in the Irish banking system is too strong to resolve the outstanding issues as I pointed out back in November (The Irish Black Hole).
According to Dr Constantin Gurdgiev in his last post, the bailout package won't be enough to save both the Irish budget and the Irish banks. Something will have to give:
Economics 6/12/10: IMF stress tests for Irish banks
"It appears that the IMF was either not given the full realistic picture of the Irish banks balance sheets, or it is seriously underestimating the demand for future losses cover in the banks."

"Either way, the numbers continue to suggest that the €67 billion package of loans will not be enough to provide simultaneously a cover for Exchequer deficits and the funds required to underwrite losses and capital requirements of the banks. Somehow, the Irish Exchequer will have to make up for this shortfall."

Either bondholders of Irish banks debt agree take a haircut on both the sub and senior debt, or the Irish Goverment will have to cut more spending, which means more austerity for the Irish people.

On the 9th of December Fitch downgraded Ireland to BBB+ from A+, which automatically means a downgrade for Irish banks as well.

The Dominos keeps falling in Europe and France will also have to face the music at some point.
"France 'next' in Euro debt
firing line
" by Hysni Kaso, 6th of December.

"The country's deficit is much, much higher than anyone realises. My view is that the markets are not prepared to finance it any more unless there is serious, structural reform. No one, not even France, can hide anymore."

These were the comments made by Xavier Rolet, CEO of the LSE. Mr Rolet is right, Germany has made great stride in implementing structural reforms which are today paying off (GDP growth, lower unemployment) whereas France has postponed structural reforms for too long. Time is running out.
France is a difficult country to reform. We have recently witnessed the difficulty, with the strikes and demonstrations relating to the increase in the retirement age from 60 to 62 then 67, when, it had already been set at 67 in many European countries.

France, like many other European countries has kicked the can down the road for to long, and now is running out of road. Structural reforms are needed, but given the looming presidential elections coming in 2012, don't expect any radical reforms in France anytime soon.
The solution for Europe is binary, it is either further integration or disintegration.

Peripheral Europe which is now the politically correct term for PIIGS, represents 17% of Pan-European GDP. Core European banks have 900 Billions USD in peripheral Europe. The ECB now owns or repo 350 Billions Euros of peripheral bonds. A nice transfer from the private hands to the public hands.

Although peripheral Europe is still sinking, macro fundamentals are very good for the likes of Sweden, Germany and Norway, to name a few.

The German economy expanded 3.90 percent in the third quarter of 2010:

The Swedish economy expanded 6.9 percent in the third quarter of 2010.

The major difficulties of the ongoing crisis is due to the characteristic of this recession being a balance sheet recession. In the post "Honey I shrunk the balance sheet", I indicated that in a balance sheet recession, and due to the amount of excess, the deleveraging process is a slow and painful and the road to repair households balance sheet is indeed a very long one. In previous recoveries, the GDP growth following a recession had been much more pronounced. Due to the nature of this particular nasty recession linked to the housing bubble, the recovery is at a much smaller pace as we can see in GDP growth figures in many countries.
What is making the crisis as well more acute in Spain, Portugal and Ireland is the high private sector leverage to GDP compared to other countries: Above 150% for Portugal, around 220% for Spain and close to 300% for Ireland.

The Euro can survive provided there is stronger integration and a tougher approaches to structural issues. France and Germany led the European project from the start. Germany seems to be left on its own to drive the project forward, given the lack of progress of reforms so far in France.

Jean-Claude Juncker and Giulio Tremonti's proposal was an interesting one.
So far both Germany and France are refusing the idea of issuing Euro-bonds.
A way of reducing the burden of debt for peripheral countries, would be to create a European Compensation house and to do some debt compression. They would need to allow creditors to swap the debt of peripheral countries into more solid Euro-bonds issued at the ECB level, provided their is a haircut on the existing peripheral debt. Unfortunately the game of kicking the can down the road is still well alive with French and German politicians. At some point restructuring of the debt for some peripheral countries will have to happen.

Owed to Germany:

Countries Cross-border bank exposure:

Monday, 6 December 2010

Macro and Markets - the importance of studying the past and making its own judgement.

"Life can only be understood backwards; but it must be lived forwards."
Søren Aabye Kierkegaard (5 May 1813 – 11 November 1855)

When approaching Macro trends as well as markets, it of the utmost importance to study what has happened in the past, in order to move forward and making its own judgement, meaning evaluating the evidence in the making of a decision with great humility.

Reading through some fantastic book: The Intelligent Investor by Benjamin Graham, Contours of the World Economy by Angus Maddison, Fooled by Randomness by Nassim Taleb, I came to a similar conclusion on different levels.
In this era of information overload, it is becoming increasingly difficult to select important information/data from noise.
By moving back and forth and studying the past with the present, it enables oneself to make better assumption of the evolution of a market or a macro situation.

As Mark Twain once said: "History doesn't repeat itself, but it does rhyme."

There are many so called experts. I do not pretend to be one. The last two years have been an eye opener in revealing the ignorance of the so-called experts in the very subject they were deemed master of. The list of the so-called experts is too long.
Some great minds foresaw the unfolding of the subrime and financial crisis. These very few, were often derided. The list is too small.

What is interesting is that many of the so-called experts who were wrong, were wrong yesterday and the day before, are still wrong today. Yet they keep voicing their so-called expertise in the media.

On January 7, 1973, the New-York times featured an interview with Alan Greenspan, the future Federal Chairman urged investors to buy stocks without hesitation: "It's very rare that you can be as unqualifiedly bullish as you can now". 1973 and 1974 turned out to be some of the worst years for economic growth and the stock market since the Great Depression. From 1973 to 1974, US stocks lost 37%.

I could go on and on, about Mr Alan Greenspan expertise in creating bubble after bubble, refusing regulation and so forth, but this is not the subject of this post.

Can experts time the market any better than Alan Greenspan? No, most of the time.

As the wise Benjamin Graham told us, the intelligent investor must never forecast the future exclusively by extrapolating the past. But at least one need to study clearly the events and causes.

There have been some bold writers in the past:
To name a few:
Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market - (Oct 1999) by James K. Glassman and Kevin Hassett.
Dow 40000: Strategies for Profiting from the Greatest Bull Market in History by David Elias (Jun 1999).
DOW 40,000: The Stocks to Own to Outperform Today's Leading Benchmark by David Elias and Jeff Zabin (7 Nov 2001).

To be fair 1999 and early 2000, bull-market "baloney" was everywhere. Valuation did not count anymore, and the most dangerous sentence in the world was being used extensively: "It's different this time".

December 7, 1999:
Kevin Landis, portfolio manager of the Firsthand mutual funds on CNN Moneyline telecast about wireless telecommunication stocks being overvalued or not: "It's not mania", "Look at the outright growth, the absolute value of the growth. Its big".
January 18, 2000:
Robert Froelich, chief investment strategist at the Kemper Funds commented in the Wall Street Journal, "It's a new world order. We see people discard all the right companies with all the right people with the right vision because their stock price is too high-that's the worst mistake an investor can make".
April 10, 2000:
BusinessWeek, Jeffrey M. Applegate, then chief investment strategist at Lehman Brothers asked rethorically: "Is the stock market riskier today than two years ago simply because prices are higher? The answer is no."

Dow Jones at the time of Mr Applegate's comment was at 11,187, Nasdaq index was at 4,446. By the end of 2002, Dow was at around 8,300 level and Nasdaq around 1,300.

Source, The Intelligent Investor, revised edition, Commentary on Chapter 3.

On March 10, 2000, the very day Nasdaq hit the all time high Jim Cramer wrote he had been tempted to sell Berkshire Hattaway short: "ripe for the banging".
Warren Buffet during that period was derided for not participating in the Technology Boom and Bust.

Closer to us as well, many predicted that the subprime crisis in the summer of 2007 was a blip. Many commented that the sovereign crisis which erupted violently this year was contained following the bail out of Greece and the "wonderful" results of the Banks Stress Test.

Although market timing is extremely difficult, long macro trends as highlighted by the work of Angus Maddison are easier to spot. In a previous post about long term macro views, I pointed that long historical trends can give us at least a good insight into the development of specific regions. For instance, there is an ongoing redistribution of the World trade shares, from the West to the East. This evolution is a rebalancing act, not a new trend as indicated by the work of Angus Maddison. It is more a return to the mean for Asia.

Yes, history does rhyme as Mark Twain once quoted.

As well as understanding macro trends and data, it is of the utmost importance to study history as it often rhymes.
A great example in the use of history and strategic thinking can be attributed to the US General George S. Patton. General Patton had studied in depth ancient history and battles. It made him excel at predicting strategic moves.
On the 19th of December 1944, during the German Ardennes Offensive Eisenhower asked Patton how long it would take to turn his Third Army (located in northeastern France) north to counterattack . Patton answered he could attack with three divisions within 48 hours, to the disbelief of the other generals present. Before he had gone to the meeting, however, Patton had ordered his staff to prepare three contingency plans for a northward turn with at least three divisions strength.
Eisenhower: "When can you start?"
Patton: "As soon as you're through with me".
Eisenhower: "When can you attack?"
Patton: "The morning of December 21, with three divisions".
Eisenhower: "Don't be fatuous George. If you try to go that early, you won't have all three divisions ready and you'll go picemeal. You will start on the twenty-second and I want your initial blow to be a strong one! I'd even settle for the twenty-third if it takes that long to get three divisions."
Extract from Patton, A Genius for War, Carlos d'Este, published in 1996.

Carlos D'Este comments: "Eisenhower was dead wrong: It was not Patton the boastful but Patton the student of war at his absolute best."

Patton had studied history and knew where the next German offensive would come. Patton always demonstrated an extraordinary desire for information of all kinds. Combined with his knowledge of history and military tactics, three different plans were ready when the Ardennes offensive started. He was already expecting an offensive as early as the 25th of November 1944.

Back to the subject of macro trends and history, the current European crisis has not been resolved, not with Greece, not with Ireland.

One of the authors of "This time is different" (a must read...), Kenneth S. Rogoff clearly indicates that the Euro is only at Mid-Crisis in a very good article indicated below:

"Unfortunately, no. In fact, we are probably only at the mid-point of the crisis. To be sure, a huge, sustained burst of growth could still cure all of Europe’s debt problems – as it would anyone’s. But that halcyon scenario looks increasingly improbable. The endgame is far more likely to entail a wave of debt write-downs, similar to the one that finally wound up the Latin American debt crisis of the 1980’s."

Kenneth Rogoff brilliantly conclude this must read article by stating:

"As European policymakers seek to move from one stage of denial to another, perhaps it is time to start looking ahead more realistically. As any recovering alcoholic could tell them, the first step is admitting, with Merkel, that Europe has a problem."

I could not agree more. Following the credit binge which led to the current hangover, it is time for our European leaders to face the sobering facts and admit that they have been indeed addicted to cheap credit.
The Twelve-Step program for recovery from a credit addiction, as originally proposed by Alcoholics Anonymous (AA), involves the following:
-admitting that one cannot control one's addiction or compulsion;
-recognizing a greater power that can give strength;
-examining past errors with the help of a sponsor (experienced member);
-making amends for these errors;
-learning to live a new life with a new code of behavior;
-helping others that suffer from the same addictions or compulsions.

"Progress, far from consisting in change, depends on retentiveness. When change is absolute there remains no being to improve and no direction is set for possible improvement: and when experience is not retained, as among savages, infancy is perpetual. Those who cannot remember the past are condemned to repeat it."
George Santayana (16 December 1863 – 26 September 1952)

Wednesday, 1 December 2010

European Government Bonds - Back to the Future?

"From 1997 until 2010 Portugal's Government Bond Yield for 10 Year Notes averaged 4.70 percent reaching an historical high of 7.01 percent in April of 1997".

"From 1993 until 2010 Italy's Government Bond Yield for 10 Year Notes averaged 5.95 percent reaching an historical high of 13.75 percent in March of 1995 and a record low of 3.22 percent in September of 2005".

"From 1998 until 2010 Greece's Government Bond Yield for 10 Year Notes averaged 5.20 percent reaching an historical high of 12.45 percent in May of 2010 and a record low of 3.23 percent in September of 2005."

"From 1993 until 2010 Belgium's Government Bond Yield for 10 Year Notes averaged 5.10 percent reaching an historical high of 8.68 percent in September of 1994 and a record low in January of 1993."

"From 1991 until 2010 Ireland's Government Bond Yield for 10 Year Notes averaged 5.72 percent reaching an historical high of 10.47 percent in December of 1992 and a record low of 3.06 percent in September of 2005."

And finally just for fun:

"The United Kingdom's Government Bond Yield for 10 Year Notes rallied 18 basis points during the last 12 months. From 1989 until 2010 The United Kingdom's Government Bond Yield for 10 Year Notes averaged 6.32 percent reaching an historical high of 12.84 percent in April of 1990 and a record low of 2.93 percent in September of 2010."

Ireland has in the past faced economic difficulties as well as high interest rates and recovered. Could it be really different this time? Could Ireland not recover from this crisis? What sunk Ireland so fast was its financial sector. Time will tell.

Ireland - Interest as percentage of Tax Revenue - 1992 to 2009:

Because of its crumbling financial system, Ireland suffered a massive cash call to shore up its ailing banks.
View My Stats