Credit - Chekhov's gun

"One must never place a loaded rifle on the stage if it isn't going to go off. It's wrong to make promises you don't mean to keep." -  Anton Chekhov

Listening with interest to our "Generous Gambler" aka Mario Draghi monthly ECB conference, where no doubt, our poker player has indeed regained some of his "Sprezzatura", given the dovish surprises contained in his latest press conference with his explicit reference to the planned balance sheet expansion of the ECB in the introductory statement, we reminded ourselves of Russian writer Anton Chekhov's dramatic principle when choosing this week's analogy given the continuous hope for the ECB to unleash at some point a QE program of its own:
"Remove everything that has no relevance to the story. If you say in the first chapter that there is a rifle hanging on the wall, in the second or third chapter it absolutely must go off. If it's not going to be fired, it shouldn't be hanging there." - Anton Chekhov

One could argue as well that Chekhov's analogy amounts simply to Tuco's philosophy from The Good, the Bad and the Ugly:
"When you have to shoot, shoot. Don't talk" - Tuco

And when it comes to central bankers, it looks to us that Bank of Japan has indeed recently applied Tuco's recommendation when it comes to its latest merry go round of QE but we ramble again...

Of course this post is a continuation of what we discussed in our last conversation in relation to the need of QE in Europe:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility." - Martin Sibileau

Therefore in this week's conversation we will discuss into more details the need for a European QE and the potential effects the various QEs have had on the real economy.

When it comes to QE and its impact on asset prices, we have largely discussed its effect in our September 2013 conversation "The Cantillon Effects":
"Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply.

We also commented at the time about the increase of money supply on the art market as posited by our friend Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":

"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.

Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

It is was therefore not a surprise for us  to hear that a Portrait by Edouard Manet reached $65M at a fall art sale in NYC, making this auction a new record for the artist (the previous record was $33.2 million for a Manet). Sotheby's sale totaled $422.1 million, the highest for any auction in its history. This is yet another sign of central bankers' "generosity" and a clear effective mean of measuring "Cantillon Effects". As per our previous conversation, a clear application of "Pascal's Wager":

The only "rational" explanation coming from the impressive surge in asset prices (stocks, art, classic cars, etc.) courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods".

Back in September 2012, in our conversation "Zemblanity", (Zemblanity being defined as the inexorable discovery of what we don't want to know), we discussed the relationship between credit growth and domestic demand and why ultimately our central bankers will fail in their useless reflationary attempts:
"credit growth is a stock variable and domestic demand is a flow variable"

We even asked ourselves at the time the following question:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

The importance of domestic demand being a flow variable should not be underestimated particularly in the case of Europe due to the lack or slack in aggregate demand thanks to high unemployment levels and in many cases what Richard Koo has coined as "Balance Sheet Recession" (think Spain and Ireland when it comes to real estate bubbles and "damaged" households balance sheet).

As a reminder from our conversation "Zemblanity", it is very important to understand the core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org from their post entitled - How central banks contributed to the financial crisis: "We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b). 
 To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit."  - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org

So you might wonder where we going when it comes to discussing "Chekhov's gun" and the impact QEs have had on real economy, Japan being a good illustration.

On that specific case, we agree with Richard Koo, chief economist at the Nomura Research Institute in his latest note from the 11th of November entitled "BOJ's surprise announcement: monetary easing by a currency interventionist":
"QQE has had almost no impact on real economy
What effect has QQE had in the 18 months since it began? It has clearly had a major influence on the forex and equity markets, where surprises can be very effective tools, but has had almost no impact on the real economy.

Figure 1 shows Japan’s monetary base, the money supply, and domestic bank lending before and after QQE. If we rebase these aggregates to 100 at the point just before Mr. Kuroda became head of the BOJ and announced QQE, we can see that while the monetary base had surged to 187 as of this October, the money supply—the money actually available for the private sector to use—had risen only to 105, while bank lending stood at 104. Indeed, the money available for the private sector to use is expanding no faster than it did under Mr. Kuroda’s predecessor, Masaaki Shirakawa, in spite of QQE. In other words, QQE had no effect on the growth rates for either of these aggregates.

Central bank-supplied liquidity has nowhere to go without real economy borrowing

As I have repeatedly pointed out, the central bank can supply as much base money (liquidity) as it wants simply by purchasing assets held by private-sector banks.

But a private-sector bank cannot give away that liquidity, it must lend it to someone in the real economy for that liquidity to leave the banking sector.

For the past 20 years, Japan’s private sector has not only stopped borrowing money but has actually been paying down existing debt and increasing its savings in spite of zero interest rates.

Traditional economics never envisioned this kind of behavior, but the collapse of debt financed bubbles in Japan in 1990 and the West in 2008 left many businesses and households owing as much or more than they owned, prompting them to focus on repairing their damaged balance sheets.

QE without private demand for funds only generates mini-bubbles

While Japan’s private sector finally cleaned up its balance sheet around 2005–06, the debt trauma lingered on. That, together with the collapse of Lehman Brothers in 2008, led to a situation in which Japan’s private sector is still saving 5.7% of GDP in spite of zero interest rates and aggressive quantitative easing.

Unless the government borrows and spends this 5.7%, the funds supplied by the BOJ under quantitative easing would never leave the banking system and neither the money supply nor private credit would have increased—in fact, they might actually have decreased.

No matter how much the BOJ eases policy during this kind of balance sheet recession, the liquidity it supplies will not enter the real economy as long as there are no private sector borrowers. The only result is likely to be the creation of mini-bubbles in the financial markets.

While funds supplied under quantitative easing may provide a temporary boost to the prices of stocks and other assets, at some point those prices will correct unless they are justified by corporate earnings growth and other appropriate measures, and that will be the end of the mini-bubble." 

- source Richard Koo, Nomura Research Institute

If domestic demand is indeed a flow variable, the big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.
QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.

In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.

Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.

In relation to Europe, the decrease in imports and lower GDP means consumer have indeed less money to spend. We cannot see how QE in Europe on its own can offset the deflationary forces at play.

In the case of Europe, deflationary forces can be ascertained by slowing global trade in the shipping industry as we discussed in our conversation of  January 2013entitled "The link between consumer spending, housing, credit and shipping - a follow-up":
"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending".
Any changes in consumer spending will directly impact global containerized traffic volumes. Containerized traffic is dominated by the shipment of consumer products."

The latest warning in slowing global trade sent across by shipping leader and giant Maersk as reported in the Financial Times in their article entitled "Maersk warns of slowing global trade" should not be ignored:
"“We see a slowdown in emerging markets, partly driven by a lower need for raw materials from China. Europe – it’s very slow growth, if any, at the moment, and there’s no reason to expect a big change here,” said Nils Andersen, Maersk’s chief executive." - source Financial Times

As indicated by the weaker outlook in shipping for Europe, QE on its own will therefore not be sufficient to have an impact on the real economy given the "japanification" process at play and as illustrated by Japan.

On the subject of the risk of continued QE and its negligible impact on AD and the real economy, we read with interest RBS's take on the subject in their note entitled "The Silver Bullet - The risks of QE infinity:
"The supporting idea for QE is that a positive wealth shock can support spending and confidence, and absorb other negative shocks to the economy. But what happens if QE continues, and consumers expectations' adapt to a QE-after-QE environment? 

In a basic (rational) economic model of consumption, households try to maximise lifetime income, i.e. the maximum value they can achieve with their wages. In a QE infinity world with stable/low interest rates and flat/negative inflation, the price of goods stays stable or declines over time, while the value of financial assets is expected to grow. The incentive for those holding financial assets can become to delay spending or investment. 

There are of course many factors in play when it comes to consumer spending and corporate investment decisions: expectations of long term permanent income, the life cycle, interest rates, confidence, etc. 

But there's consistent evidence across some points:

1. Rich people save more and spend less. There's plenty of historical evidence on this. As we show in the chart above, the saving rate for the top 1% and top 5% of the population is a multiple than the bottom 50% (see also  Do the Rich Save More?). 

2. Income inequality has increased since the crisis. The share of wealth owned by the top 0.1% is now over 20% in the US, vs around 15% in the 2000s. Inequality measured as such is as high as it was in 1916, according to the  Economist. The  debate still goes on, but there's evidence that QE may have contributed to rising inequality, and central bankers including the Fed are becoming more vocal on the topic.

3. The marginal impact of an increase in wealth to translate into consumption is lower for the richer brackets of the population. A recent ECB paper shows this clearly: as you can see in the chart above, the propensity to spend if wealth increases is 2-3x higher for the bottom 50% of the population.

4. Even when it comes to corporate investment, there is little relationship between QE and lower interest rates and more investment, which instead depends on other factors (economic outlook, fiscal policy, etc.)

Adding up points 1-4 highlights one risk. If QE is accompanied by other policies – like fiscal spending or a reduction in taxes – then it can work effectively. But if central banks are left alone with the burden of stimulating the economy, the risk of entering a cycle of QE after QE, or QE infinity is high, and the results can be self-defeating. 

For now, credit investors continue to anticipate more action from the ECB (and BoJ) – the next one being potential purchases of corporate bonds. But the impact on the real economy still depends on government action on spending, and support to the ABS programme, and so far we have seen little of it. 

Our view here remains: don't confuse QE with growth. If anything, QE infinity could be self-defeating without fiscal and reform support, as the ECB itself has warned. We expect more tightening in investment grade and double-B bonds on potential ECB action, but fundamentals for banks and lower-rated firms will remain weak into year-end and 2015, hurt by deflationary and weak growth (IFO institute head Hans Werner-Sinn just warned about an economic crisis being "really close", even in Germany).The ECB ABS plan is potentially a game-changer, and the ECB may start buying over the coming days, as Yves Mersch said yesterday. Let's hope that this time around, they'll get some help from governments." - source RBS 

Our take on QE in Europe can be summarized as follows:

Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?

When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend as indicated by Nomura by Alastair Newton on the 11th of November in his note entitled "Civil unrest: Going global - More economies look prone to protests":

"Common factors

The (largely) common factors remain those I identified last year, ie:

-A high level of economic inequality (using the World Bank’s assessment of individual economies’ Gini coefficient);

-A high level of perceived corruption (using Transparency International’s (TI) index);

-A 'local' – sometimes minor and often hard to anticipate – issue sparking widespread protests rooted in general unhappiness with the regime;

-Increased 'middle-classing' of civil society, often confirmed by a ‘core’ of the protestors being in or having had tertiary education;

-Effectively leaderless protests organised primarily over social networks, ie, in common with the 'Arab Spring';

-A shared sense among the protestors of not being listened to by allegedly corrupt and self-serving elites;

-Widespread protester use of mobile phone cameras in the 'propaganda war'; and,

-Allegations of police brutality escalating, rather than deterring, the protestor numbers.

As the recent demonstrations in Hungary underline, we should not assume that civil protest is limited to emerging markets. Notably in many EU countries we are increasingly seeing what are essentially protest parties capturing a significant share of the popular vote in elections. In 2015, look out in particular, therefore, for UKIP in the 7 May UK general election and for Podemos in Spain’s December elections (not forgetting the – related, in my view – drive towards independence in Catalonia)." - source Nomura

Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)

On a side note and on this "French" matter, we think it is time to revisit our August 2012 OAT / Bund Yield Spread Widener as per our conversation "France - Playing the nonchalance". While we highlighted at the time the lack of catalyst, this trade had been put in the drawer given market capitulation and Japanese investment support in buying French bonds.

We still believe France should be seen as the new barometer of Euro risk, particularly when one realizes that France will issue €188 billion of bonds in 2015 (same record amount as in 2010) and for the following reasons:

-The European Commission latest macroeconomic forecast for France expects a budget deficit of -4.5% in 2015 and -4.7% in 2016. France will be the worse European country in terms of budget deficit. If indeed global trade is slowing down, there is indeed a high probability the deficit could even reach the important psychological level of 5%.

-With the recent comments from Hedge Fund manager David Einhorn, fast money could potentially put back the trade on.

-While Japanese investors have in the past been very supportive of French OAT bonds, the real yield of US Treasuries (0.6%) in conjunction with a rising US dollar make the US bond market much more appealing than the French bond market. 

As a reminder from our conversation "Big in Japan", Japanese have been net buyers of OATs in 2012 to the tune of 4.07 trillion JPY (44.2 billion US), the most since 2005. The gain in yen was 26% versus 15% for US Treasuries and they only bought for 3.35 trillion JPY worth of US debt in 2012.

This makes more likely a slowdown of the Japanese support for French OAT bonds in 2015. If one looks at GPIF assets and expected changes in portfolio allocation as displayed in Nomura's Japan Navigator number 593 published on the 3rd of November, the greatest change will be on international stocks rather than international bonds:

- source Nomura

French 10 year OAT vs German 10 year Bund - graph source Bloomberg:

On current levels, this trade appears to us very "convex". Downside appears to us limited to 10 bps, roughly 1 point on OAT Futures on current sensitivity levels, carry is around -35 bps over one year. One can target 20 to 50 bps of widening in the next 6 months if indeed there is finally a catalyst playing out. One could as well play the trade flat carry by buying more German bund, which would of course be an even more bearish growth outlook trade. Why not...

This trade could be seen as a little convex trade versus a book of high beta risky assets (periphery credit, equities, etc.). 

Moving back to our "Chekhov's gun" theme of European QE and in the case of Europe, the equity rally that followed the press conference of Mario Draghi doesn't appear warranted as it seems to us that investors have jumped the proverbial "Chekhov's gun". On this subject, we agree with Deutsche Bank's Behavioral Finance Daily Metals Outlook note from the 7th of November entitled "The far-out-of-the-money Draghi Put:

"Anyone who thought Mario Draghi would strike a more conciliatory tone in yesterday’s ECB press conference, following a Reuters report of dissatisfaction with his leadership style among members of the Governing Council, was doubly unsettled. Not only did he not backpedal on any of his more contentious statements about QE and the future size of the Bank’s balance sheet, he even made them more explicit, and presented an endorsement of his stance signed by all members of the Council. This dovishness lit a fire under European asset prices. Equity benchmarks rallied strongly as investors priced in the prospect of broad-based asset purchases. This reaction was perhaps overenthusiastic because the pre-condition for QE is that the economic situation in the eurozone worsens and/or that the current measures prove inadequate (which means precious time would have been spent finding out). So a ‘Draghi Put’ exists, but it is struck far-out-of-the-money. Even gold in euro terms recorded its first positive session in over two weeks.

But it was far from being the most sought-after asset of the day; investors still preferred the dollar and US-based assets. If the global economic situation becomes gloomier, they reasoned, the Fed would probably still take more aggressive action than the ECB, and sooner. The strike price of the ‘Yellen Put’ is much closer to the money." - source Deutsche Bank

Indeed, when it comes to the ECB we have a case of "Chekhov's gun, whereas when it comes to the Fed and the Bank of Japan it is more akin to Tuco's philosophy: "When you have to shoot, shoot. Don't talk"

What we find of interest is that both the Fed and the Bank of Japan have been trigger "QE " happy, As we have argued in our last conversation, investors' belief in central bankers' omnipotence and deity status enabling them to sustain over extended asset price levels is being threatened we think by the changes in the communication of the conduct of monetary policy as indicated by Richard Koo, chief economist at the Nomura Research Institute in his latest note:
"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants.
Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered “acceptable” for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).
Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members.

Kuroda abandons forward guidance
It was because of this approach that the Fed has been able to conduct policy now known as forward guidance based on expectations of its future actions, something that had not been possible in the past. It was precisely because the Fed avoided surprises that market participants trusted it when it said it would keep interest rates at exceptionally low levels for a considerable amount of time.
Policymaking evolved in this direction because of a growing awareness that monetary policy has a major impact on the economy and is fundamentally different from intervention on the currency market, which basically involves only a handful of participants.
But with the 31 October easing announcement Mr. Kuroda deliberately chose to shock the markets. By doing so, he effectively removed forward guidance from the BOJ’s toolkit.
When the head of the central bank enjoys surprising the market, market participants will no longer take anything he says at face value. Mr. Kuroda claimed in his Upper House testimony just three days before the announcement that the economy was making “steady progress” towards achieving the 2% price stability target even as he was secretly moving ahead with preparations for the surprise easing.

Ending QE will now be far harder for BOJ than for Fed
The BOJ governor’s decision to utilize the element of surprise could lead to major problems when it comes time to bring quantitative easing to an end. Careful dialogue with the market—including forward guidance—is essential when winding down such a policy, as the IMF has repeatedly warned.
There is, of course, no guarantee that the exit from QE will proceed smoothly simply because the central bank maintains a close dialogue with the markets. Even Mr. Bernanke, with his reputation for being a good communicator, caused a great deal of turmoil in both the developed and the emerging economies when his remarks on 22 May 2013 concerning the possibility of tapering sent US long-term interest rates sharply
higher.
The Fed’s intensive forward guidance under both Mr. Bernanke and his successor, Janet Yellen, succeeded in calming markets by persuading them the Fed had no intention of raising rates in the near future. It remains to be seen how Mr. Kuroda will respond when he finds himself in the same situation.
In summary, the BOJ’s shock announcement could make it far more difficult for the Japanese central bank to end quantitative easing than it has been for the Fed." - source Richard Koo, Nomura Research Institute

To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but, when it comes to winding down QE, the exit from the program will not proceed that smoothly, rest assured.

While it has been easy to somewhat front-run the QE cowboys thanks to "Pascal's Wager", the end of QE in the US coincide with a renewed period of weaker global trade, historically high asset price levels and record low bond yields making it more likely we will see a return of higher volatilities regime in the near future making future equities return questionable and long bond US Treasuries enticing (we are keeping on our very long duration exposure via ETF ZROZ).

On a final note we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled "Humiliation, Hubris & Gold" displaying Japan's free-float market cap as a percentage of world:

"Tokyo's all-out War against Deflation
Finally, Japan’s humiliating decline as % of world market cap (Chart 10) and the explicit war on deflation launched by the Bank of Japan keeps us overweight Japan, in contrast to China and Europe. In addition, Japan has high operating leverage and stronger earnings momentum. Our bullish view on volatility, particularly currency volatility, is strengthened by the knowledge that liquidity trends in the US and Japan will be moving in different directions over coming quarters." - source Bank of America Merrill Lynch.

"Every gun makes its own tune." - Blondie, The Good, the Bad and the Ugly

Stay tuned!

Shipping is a leading credit indicator - A follow up.

"With deflation, banks’ bad debts increase and are likely to reinforce the banks’ unwillingness to take risks, curtailing provision of credit." - Manmohan S. Kumar - Deflation The new threat?

A month ago in our conversation "Shipping is a leading deflationary indicator" we argued: "Shipping is in fact an important credit and growth indicator, but, more importantly a clear deflationary indicator."

In fact the surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fuelling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008  at 11,440;  with the index touching a low point of 680 in January 2012  -  Evolution of Baltic Dry Index from 1990 until today - source Bloomberg:

For us the Baltic Dry Index is another indicator in the deterioration of credit as well as an indicator in deteriorating credit conditions leading to a surge in Non-performing loans on Banks' Balance Sheets.

In fact losses from shipping are increasing, as indicated by Niklas Magnusson in Bloomberg - Commerzbank Losses From Shipping Loans Seen Increasing:

"As soaring fuel costs and slumping freight rates leave shipping companies struggling to pay their creditors, Commerzbank AG may face shipping-loan losses of as much as 441 million euros ($588 million) this year.

Commerzbank’s 2008 takeover of Dresdner Bank AG increased its stake in shipping lender Deutsche Schiffsbank to 92 percent, doubling the size of its maritime-loan portfolio, just before the industry entered its biggest crisis since World War II. The loan losses increase the woes of Germany’s second-largest bank, which is already seeking to pare its balance sheet and raise 5.3 billion euros by the end of June.

Shipping loan losses probably will rise to 2.1 percent of such lending at Commerzbank this year, Morgan Stanley analysts Henrik Schmidt and Doug Hayes wrote in a March 20 note. That’s more than the 1.8 percent projection for the U.K.’s Royal Bank of Scotland Group Plc, and the 1.5 percent or less at Norway’s DNB ASA, Italy’s UniCredit SpA and France’s BNP Paribas SA.

“Shipping is one of the reasons behind Commerzbank’s underperformance in the past 12 months,” said Dirk Becker, a Frankfurt-based analyst at Kepler Capital Markets, by phone. “It is a risky business, as risky as many parts of commercial real estate. There’ll be a time of reckoning at some point.”

Last year issues surrounding liquidity issues and difficulties in accessing dollar funding mean most European banks are paring back on their Structured Finance Operations:

Definition of Structured Finance business - source Credit Agricole CIB:
"The Structured Finance business consists in originating, structuring, and financing operations involving large-scale exports and investments in France and abroad, often backed by collateral security (e.g. aircraft, ships, corporate real estate, or commodities), as well as complex and structured loans.


The Structured Finance division comprises nine finance segments: aviation and rail / shipping finance / tax-based leases / natural resources, infrastructure and power / real estate and lodging / export and trade finance / acquisition finance / transactional commodity finance / structured finance advisory."

From the same Bloomberg article:

"The shipping industry’s troubles, coupled with stricter capital rules for banks, Europe’s debt crisis and concessions lenders had to make for bailouts during the global financial rout, have caused banks to scale back shipping operations or retreat from new lending altogether.

Thirteen of the world’s 19 largest shipping banks stopped new loans to the industry amid an “extreme” vessel surplus that cut cash flows and led to vessel seizures, Dagfinn Lunde, a member of DVB Bank SE’s managing board, said on March 9. Rotterdam-based DVB, which finances 1,500 vessels through 450 loan agreements, is one of only six banks funding shipping. As many as 100 were lending four years ago, Lunde said."

In our conversation "Money for Nothing", we touched on the impact the Baltic Dry Index was having on the Danish Banking sector given, according to Bloomberg, both Danske Bank (27% share of total Danish lending) and DNB Bank (11% share in syndicated shipping loans) have a large exposure to Shipping Financing. Therefore it wasn't a surprise for us to learn that Danske Bank decided to tap the Danish equivalent of the ECB's LTRO to the tune of 2.7 billion dollars when the facility opened on the 30th of March:
Danske Bank Will Tap $2.7 Billion From Central Bank Facility - Christian Wienberg - Bloomberg:
"Danske Bank A/S, said it will draw 15 billion kroner ($2.7 billion) from the central bank’s first offering of three-year loans today as policy makers try to drag the Nordic economy out of recession.
Danske will use assets from its bond portfolio as collateral for the loan, the Copenhagen-based lender said today by e-mail."

"It is still a game of survival of the fittest", we previously argued.

The consequences of European banks paring back on Structured Finance in particular, and lending in general can been seen in the latest EMEA lending figures which according to IFR (International Financing Review) as indeed fallen from the proverbial cliff - EMEA lending falls off a cliff:
"Syndicated lending in Europe, the Middle East and Africa reached a paltry US$129bn in the first quarter of 2012, according to Thomson Reuters data, as banks shrank their balance sheets and companies remained wary of debt.


It was the lowest first-quarter loan volume in EMEA since 2002, down 47% from the same period last year, and the deal count of just 193 loans was the lowest for a first quarter for 18 years and 49% lower than the 378 loans completed in the first three months of 2011.


The implications of the drop in volume for banks’ revenue and headcount are frightening if low levels of activity persist, bankers said.

Any impact on profitability could start to show up in banks’ first-quarter results, which will be released across Europe in late April and May. The expected hit to income may be mitigated, however, because although banks are lending less they are charging higher fees."

EMEA lending falls off a cliff - source Reuters:

A game changer, as indicated by the IFR article, in the game of "survival of the fittest", leading to a change in the banking pecking order:
"German banks replaced French banks at the top of the league tables after an active first-quarter refinancing round by German companies, including Henkel, HeidelbergCement and Schaeffler. Deutsche Bank headed the first-quarter EMEA bookrunner league table while Commerzbank was third.


This time last year, the top three slots were taken by Credit Agricole, BNP Paribas and Societe Generale respectively. Credit Agricole is now second, BNP is in fifth place and Societe Generale is 10th.


US banks used the market dislocation to increase their market share. Bank of America Merrill Lynch, JP Morgan and Citigroup climbed to fourth, sixth and seventh place respectively."

The sharks are circling the European stricken ship - Wilbur Ross Plans Shipping Expansion as Industry Distress Grows, by Michelle Wiese Bockmann, Bloomberg, 30th March 2012:

"Billionaire Wilbur Ross said he’s considering further investments in shipping as financial distress within the maritime industry intensifies.

The chairman and founder of WL Ross and Co., who manages about $10 billion, is evaluating further purchases of oil-product tankers after last year participating in the acquisition of 30 of the vessels through Greenwich, Connecticut-based Diamond S Shipping. He’s also considering liquefied natural gas and liquefied petroleum gas carriers, he said by e-mail

yesterday.

“The number of distressed shipping deals grows daily, mostly from individual owners of small numbers of ships,” Ross said. “We do expect further opportunities over the next 12 months. You never know where the exact bottom is until after the recovery has begun, but it is clear that we are already much closer to the bottom than the top.”

The combined market value of the world’s 80 biggest publicly traded shipping companies plunged by $101.7 billion in the four years to March 23, figures compiled by Bloomberg show. A glut of vessels cut earnings below levels that cover operating costs, triggering bankruptcies and loan breaches."

Historical 5 year Old Dry Bulk Ship Prices (2006-Present, US$, Millions) - Source Deutsche Bank/Clarkson Research Services:

"Beware of little expenses. A small leak will sink a great ship."
Benjamin Franklin

"Beware of little lending. A small leak will sink a great European ship."
Macronomics

Stay Tuned!

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:

Honey, I Shrunk the Balance Sheet...

This crisis is very acute because it is a Balance Sheet Recession and the implications will be severe for many years to come, given the extent of the repairs that needs to be achieved following the catastrophic damages inflicted by the cheap credit fuelled bubble we have been victims of.

The Balance Sheet Recession:

http://www.ft.com/cms/s/0/3d89a930-220d-11de-8380-00144feabdc0.html

In an article published by Roger Altman (chairman and CEO of Evercore Partners and former deputy Treasury secretary in the Clinton Administration) in the Financial Times, we have a very good summary of the damages inflicted to Households and the implications for the recovery.

"What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. These weaknesses mandate sub-normal levels of consumer spending and overall lending for about three years.

In contrast, most postwar recessions had a different sequence – rising inflationary pressures, a monetary tightening to counter them and, then, a slowdown in response to higher interest rates. This was the pattern of the sharp 1980-81 slowdown.

None of that happened here. Instead, we saw a housing and credit market collapse that caused enormous losses among households and banks. The result was a steep drop in discretionary consumer spending and a halt to lending. To see why recovery will be slow, we can look at the balance sheet damage. For households, net worth peaked in mid-2007 at $64,400bn (€47,750, £43,449bn) but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big – especially when household debt reached 130 per cent of income in 2008."

You can clearly see in the graph below the severity of the damages inflicted to US households in the current recessions compared to previous ones:



Furthermore on Balance Sheet Recession:

http://www.adamsmithesq.com/archives/2009/04/the_balance_sheet_recessi.html

"Recessions as described or dissected by Econ 101 are income-shock driven, not balance-sheet shock driven. Typically, rising inflation compels the Fed to tighten money and raise interest rates and the predictable slowdown follows as (a) business investment contracts because of higher funding costs (b) causing all the industries and suppliers associated with that investment to contract (c) laying off their workers and cutting their orders to their own suppliers (d) leading to further employment contraction (e) decreased consumer spending (f) decreased demand for business products and services, and so on until inflation is tamed and the Fed can ease off the brake and back onto the gas.

Alternatively, of course, a single sector can become a bubble unto itself (the dot-com boom or the S&L crash of the 1980's) or an exogenous shock (the OPEC price spike of the early 1970's) can prompt a recession, but the single-sector bubbles are typically self-contained and parochial in scope and the exogenous shock bring forth a plethora of innovation and plain old readjustments (turn down the thermostat and stock up on sweaters?) that hasten recovery.

This time is different.

This time everyone--households, small businesses, big busineses, banks, investment banks, and yes, law firms--has seen their net worth hosed. The problem with recovering wealth is that it takes so much longer than it does to recover income."

The fall in networth implies that everyone is working hard to repair balance sheets.
This produces weak demand for funds and credit. It will take years to go through the deleveraging process.
Households and Companies are moving from profit maximization to debt minimization.
Everyone is hoarding cash. Cash is king. According to the Federal Reserve, businesses are hoarding about 1.8 trillion USD in cash.





Consumer Credit Collapsing and Banks Hoarding Cash as well:



David Rosenberg in his Breakfast with Dave article on the 16th of August, analyses the cash hoarding situation and implications:

https://ems.gluskinsheff.net/Articles/Breakfast_with_Dave_081610.pdf

"BANKS LENDING ALL RIGHT ... TO UNCLE SAM!"

"The banks are still sitting on an unprecedented cash hoard and doing nothing with it. Consider that on a 13-week rate change of basis:
•
C&I loans are down at a 1.2% annual rate.
•
Home equity lines of credit are down at a 4.1% annual rate.
•
Residential mortgages are down at a 2.9% annual rate.
•
Commercial real estate loans are down at a 9.2% annual rate.
•
Credit card loan balances are down at a 6.7% annual rate.
Meanwhile, cash on bank balance sheets have expanded at a 10% annual rate over this time frame and purchases of government securities have ballooned at a 21.3% annual rate. In fact, since the end of June, the banks have bought a huge $83 billion of government/agency bonds, the third most over such a short time frame. Just in case you were wondering who has been the culprit behind this phenomenal rally in the Treasury market."


Households in the US are deleveraging big time:



And they are deleveraging at an incredible fast rate:



How far will debt to income fall?



We can see a big surge in the amounts in personal savings in the US:





At the same time the government is trying to make up for the big drop in consumer spending by running a huge deficit!



What are the implications of a Balance Sheet Recession and why Japan is a very bad exemple to follow in a Balance Sheet Recession:

In his latest weekly letter, John Mauldin quotes Charles Gave, writer as well as founder of the excellent Macro Research house Gavekal:

http://www.2000wave.com/article.asp?id=mwo091010

"The only way that one can expect Keynesian policies to break the 'paradox of thrift' is to make the bet that people are foolish, and that they will disregard the deterioration in their balance sheets and simply look at the improvements in their income statements.

"This seems unlikely. Worse yet, even if individuals are foolish enough to disregard their balance sheets, banks surely won't; policies that push asset prices lower are bound to lead to further contractions in bank lending. This is why 'stimulating consumption' in the middle of a balance sheet recession (as Japan has tried to do for two decades) is worse than useless, it is detrimental to a recovery.


TPC from the excellent website "The Pragmatic Capitalist" does a great job as well in analysing the deleveraging process induced by this acute Balance Sheet Recession:

http://pragcap.com/the-deteriorating-macro-picture

Businesses and consumer are using their surpluses to pay down their debts and increases their savings due to the damages they have suffered in the dowturn as well as increased uncertainties instead of spending or investing.





Keynes argued that in a liquidity trap, consumers and businesses are so fearful to spend or invest that they hoard cash, this is excactly what is happening right now. And because the Federal Reserve cannot lower interest rates below zero, it runs out of room to force more money into the economy.

What could be a solution to reverse the course?

How could the Balance Sheet be rapidly repaired?

Tax cuts stimulate the economy when they involve reductions in tax rates!

Permanent cuts in marginal rates of the payroll tax, capital gains tax and double taxation of dividends could be positive to stimulate investment as well as employment.
The negative dynamics such as anticipated future tax increases are the main reason why consumers and companies are hoarding cash.

Instead of having an already inefficient stimulus, how about 1 trillion USD in tax cuts? Would we need more? Would that restore confidence? Entice people to invest and recruit? Would that help small businesses to drag us out of the recession given they have always pulled the economy out of a recession when they thrive?

Tax cut would be appropriate given it would increase consumer's credit lines. The consumer would either consume more or save more (and maybe buy Goverment bonds in the process...).

Economic 101 reminder:
GNP = C + I + G + NX

where:

C = consumption spending by individuals
I = investment spending (business spending on machinery, etc.),
G = government purchases
NX = net exports

Consumer spending typically equals two-thirds of GNP.

Reducing taxes, pushes out the aggregate demand curve as consumers demand more goods and services with their higher disposable incomes. Supply side tax cuts are aimed to stimulate capital formation. If successful, the cuts will shift both aggregate demand and aggregate supply because the price level for a supply of goods will be reduced, which often leads to an increase in demand for those goods.

How about cutting corporate taxes?

Here is what Peter Ferrara in Forbes, thinks about it:

http://www.forbes.com/2009/02/04/tax-cut-stimulus-opinions-contributors_0204_peter_ferrara.html

"Here are the components of a plan that would work to restore economic growth precisely because they do focus on governing economic incentives. America's corporations suffer from a federal corporate tax rate of 35%, close to 40% with state taxes. This is the second-highest rate in the industrialized world, just a bit behind Japan, which may cut its rate soon. The European Union cut its average corporate tax rate from 38% in 1996 to 24% in 2007. Germany and Canada each recently adopted a top corporate rate of 19%, with Canada's slated to fall further to 15%. India and China have lower corporate rates as well.

Ireland adopted a 12.5% corporate rate in 1988, when it had the second-lowest per capita income in Europe. Today, Ireland enjoys the second-highest incomes in Europe, and it raises more in corporate taxes as a percent of gross domestic product than the U.S. does with a tax rate three times higher.

For the U.S. economy to remain internationally competitive, the federal corporate rate should be slashed to 20%. The heavily burdensome federal corporate capital gains rate should also be cut from 35% to the current individual rate of 15%, and that individual rate and the dividends tax rate of 15% should be made permanent. The capital gains tax is a second level of taxation on capital, not a loophole providing lower rates for capital income."

We need to do whatever we can to boost the private sector:

"The reduction in rates improves incentives for savings, investment, business creation and expansion, job creation, entrepreneurship and work by allowing people to keep a greater percentage of the reward produced by these activities."

Also Peter Ferrara makes a very important point:

"In addition, America needs deregulation to unleash the private sector to produce more oil and natural gas, from offshore and onshore, and to build more nuclear power plants. This would build a powerful energy industry, adding to GDP and creating jobs."

Why America needs urgent deregulation and massive investment from the private sector in the Energy sector?

John Mauldin told us why in his latest letter:

http://www.2000wave.com/article.asp?id=mwo091010

"If the US is going to really attempt to balance the budget over time, reduce our personal leverage, and save more, then we have to address the glaring fact that we import $300 billion in oil (give or take, depending on the price of oil).

This can only partially be done by offshore drilling. The real key is to reduce the need for oil. Nuclear power, renewables, and a shift to electric cars will be most helpful. Let us suggest something a little more radical. When the price of oil approached $4 a few years ago, Americans changed their driving and car-buying habits.Perhaps we need to see the price of oil rise. What if we increased the price of oil with an increase in gas taxes by 2 cents a gallon each and every month until the demand for oil dropped to the point where we did not need foreign oil? If we had European gas-mileage standards, that would be the case now.

And take that 2 cents a month and dedicate it to fixing our infrastructure, which is badly in need of repair. In fact, the US Infrastructure Report Card (www.infrastructurereportcard.org), by the American Society of Civil Engineers, which grades the US on a variety of factors (the link has a very informative short video), gave our infrastructure the following grades in 2009: Aviation (D), Bridges (C), Dams (D), Drinking Water (D-), Energy (D+), Hazardous Waste (D), Inland Waterways (D-), Levees (D-), Public Parks and Recreation (C-), Rail (C-), Roads (D-), Schools (D), Solid Waste (C+), Transit (D), and Wastewater (D-).

Overall, America's Infrastructure GPA was graded a "D." To get to an "A" would requires a 5-year infrastructure investment of 2.2 trillion dollars.

That infrastructure has to be paid for. And we need to buy less oil. And we know price makes a difference. The majority of that 2 cents would need to stay in the states where it was taxed, and forbidden to be used on anything other than infrastructure.

(And while we are at it, why not build 50 thorium nuclear plants now? No fissionable material, no waste-storage problem, and an unlimited supply (at least for the next 1,000 years) of thorium in the US. The reason we chose uranium was to be able to produce nuclear bombs, among other reasons.) We'll get into this and more when we get to the chapter on the way back for the US."

Why not try something else rather than pointless Government spending, which is no substitute for real growth coming from a repaired private sector.

As a conclusion let me quote Brian S. Wesbury and Robert Stein in an article published in Forbes:

http://www.forbes.com/2008/12/08/friedman-cut-taxes-oped-cx_bw_rs_1209wesburystein.html

"There are many positive alternatives that are not being formally discussed. This is a mistake. And more to the point, the last time the government tried to bail out the economy with drastic action, we ended up in the Great Depression. If we really want to "change" the way government and the private sector interact, why is the U.S. government still trying the same old policies that failed in the past? Tax cuts have worked before, so if deficits don't matter, why not try a different kind of surge--a private-sector, incentive-creating one?"