Europe on the Brink

And Then There Was Leverage

Too Big To Save

Those Wild and Crazy Swiss

A Positive Third Quarter?

New York and Maine

We have avoided Armageddon, at least for now. The cost to the US taxpayer has been a few trillion. Some in the media are loudly announcing the end of the recession. But we are not out of the

woods yet. There are a few more bumps in the road. Actually, some of them are quite steep hills. As big as the subprime problem? Maybe.

When asked a few weeks ago what was my biggest short-term concern, I quickly replied, “European banks have the potential to create significant risk for the entire worldwide system.” This week we will glance “over the pond” to see what gives me cause for concern. Then we briefly look at a few of the bumps I mentioned, which are likely to stretch out any recovery, and maybe even dip us back into recession.

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And now, let’s jump into the letter.

Europe on the Brink

Globalization is a two-edged sword. On balance, it has brought prosperity to those who have

embraced it, with rising lifestyles, better health, longer lives, and more. The

more we need each other, the less likely it is that we’ll shoot each other.

Shooting your customers is not a good business strategy. And while the growth

has not been even or smooth, only a Luddite would want to return to the early

1800s or 1900s, or even 1975.

The other edge of that sword? We are connected in so very many ways, far more than

most of the world suspected. Who thought that insane lending policies at US

mortgage banks would bring the world financial system to its knees, increasing

unemployment and leading to a global recession? World trade is down 20% or

more. US railroad shipments are down more than 20% year-over-year. Chinese (and

Asian) factories have seen their orders drop, as US consumers have gone on

strike. The US trade deficit was just $25 billion last month; and while our

exports are still dropping, our imports are dropping more. Oil is becoming a

bigger and bigger share of imports, and that does not come from Asian

exporters.

The US is far and away the country with the largest gross domestic product (GDP).

California would be the 7th largest country, but few think of California

in such terms. For this letter, at least, I would like to think of Europe as a

whole rather than as 27 countries. From that perspective, Europe is as

economically important to the world as the US. What happens in Europe makes a

difference in the US.

Last week we looked at the precarious position of Japan, the second largest economy

(or third if you think of Europe as a whole). It was a sobering letter. When

you realize the extent to which Japan has funded Asian expansion, what is

happening there cannot be good for the world.

But Europe’s banks have been much more aggressive in funding emerging-market

expansion than US or Japanese banks. Western European banks have lent $4.5

trillion to various emerging-market countries, businesses, and consumers. Many

Eastern European businesses borrowed in low-interest-rate euros. New homeowners

in Hungary and the rest of Eastern Europe borrowed in Swiss francs and euros,

and as their currencies have collapsed they now find they owe more on their

homes than they’re worth.

And here’s the problem. Europe’s banking system is in far worse shape than the US system. The losses may be bigger, and their capital to meet those losses is certainly less. Let’s look

at some charts. Remove sharp objects or pour another adult beverage.

As I noted last week, one of the

real benefits of writing this letter is that I get to see a lot of really

interesting information from readers and meet with very savvy investment

professionals. I recently had the privilege of sitting with a team of analysts

from Hayman Capital here in Dallas. Hayman runs a global macro hedge fund, so

they spend a lot of time thinking about how all the different aspects of the

global markets fit together. This week we again look at some of their analysis.

There was a lot of work (as in months) done here; and Kyle Bass, the founder of

the firm, graciously allowed me to share some of it with you (and kudos to Wes

Swank, who pulled this together). The graphs are theirs, and my discussion about

them is certainly informed by our meeting; but I am using the material as a

launching point, so they are not responsible for my conclusions and

interpretations.

And Then There Was Leverage

In the first few years of the G.W.

Bush administration, the banking authorities decided it would be OK to allow

five banks to increase their leverage from 12:1 up to 30:1. Which five banks,

you ask? Bear Stearns, Lehman, Merrill Lynch, JPMorgan, and Goldman Sachs. How

did that work out, just five years later? Three are gone and two survived with

large dollops of taxpayer money.

(Sidebar: Is it really any surprise

that Goldman and JPMorgan are making record profits on the underwriting and

trading side of the business? Hell, if I could eliminate 50% of my competition,

my profits would grow too! JPMorgan’s consumer credit, credit card, and other

business groups are losing money big-time.)

Thirty times leverage means that if

you lose 3.3%, you wipe out all your capital. And we watched as banks too big

to fail were bailed out with taxpayer dollars. Slowly, banks are buying time,

writing down assets. Remember, this month is the second anniversary of the

onset of the credit crisis. I wrote back then that the strategy would be to

stretch this out as long as possible. Time heals a lot of bad debts, especially

at a 0% Fed Funds rate.

Banks that are reporting so far

this quarter seem to be saying that the write-offs will start to level off in

about two quarters, although banking expert Chris Whalen says that the level

may stay higher than we think for longer than we think. There are a lot of

assets to write off, and they are just now getting to the commercial real

estate problems. This is going to take time. (For an interesting interview on

CNBC with Maine fishing buddy Chris Whalen, click here:

http://www.ritholtz.com/blog/2009/07/christopher-whalen-banking/.)

The point, before we get to Europe,

is that here there was a central bank and a government that not only could step

in but was willing to. I know former Treasury Secretary Paulson had his

critics, but I am not one of them. Did he do some things that in hindsight he

might like to take a “mulligan” on? Sure. But he dealt with the problems in the

best manner he could. The time to have taken action was when we were making

liar and no-doc loans and calling then AAA, or allowing banks to go to 30:1 leverage.

Paulson had to deal with eggs that were already broken. That the system did not

crater is to his credit. Securitizing what he and everyone else should have

known would be garbage while he was head of Goldman Sachs is not to his credit.

But I digress.

I am going to give you four charts

showing the leverage of banks in the US, the United Kingdom, the Eurozone, and

Switzerland. The bottom, blue portion is assets to common and preferred stock;

the red is assets to common equity, which can include good will; and the purple

is assets to tangible common equity.

Tangible common equity is all the

rage, and that is what the recent “stress tests” measured, as opposed to tier 1

capital, which includes preferred stock (which would basically be the blue

portion.) TCE only includes common shares. Now, let’s start with the US. These

graphs show leverage. The average leverage of tier 1 capital of the five

largest banks is in the range of 12:1, and is actually down from ten years ago.

(By the way, a very good and simple explanation of all this can be found at

http://baselinescenario.com/2009/02/24/tangible-common-equity-for-beginners/.)

While the TCE has obviously been rising

and taking total leverage to rather lofty levels in the mid-40s, banks are

raising capital, and over time leverage will come back down. It helps if you

can borrow money at almost nothing and lend it out at much higher rates. Now,

let’s turn to the United Kingdom. This is uglier.

Regulators

in the UK allowed 20:1 leverage on a regular basis. It is now almost 40: and with

TCE is around 55. The assets of UK banks are about five times as large as UK

GDP. By comparison, for the US the ratio is barely 2:1.

Think

about that for a second. The UK has banking assets which are five times as

large as the annual domestic output of the country. They also had a housing

bubble. They have their own bailouts to deal with, which are massive and will potentially

get much larger. But at least they have a central bank and government that can

try to fix the problems.

But as the commercial says, “But

wait, there’s more!” Let’s look at the Eurozone.

Leverage

is now 35:1 and with TCE is almost 55. How did 35:1 work out for the US? Given

the massive credit problems that Eurozone banks have with emerging markets (plus

Spain’s housing bubble, which is every bit as bad as that of the US), will this

not end up in wailing and weeping?

Too Big To Save

And

here’s the real issue. They have no Paulson and Bernanke. Now some of my

Austrian-economist friends will say, “Good, they should all be allowed to die;”

but that is a very cavalier attitude when you start talking about actually increasing

the unemployment rate to something like 20%. I agree that management should be

changed (as well as the regulators: 35:1 to 1 – really?

What were they thinking?) and shareholders wiped out, but I do not want the

system to collapse. And this is a global risk, not just localized to Ireland or

Spain or Austria. Sure, the pain might be worse in the local region, but we

will all feel it.

The

European Central Bank, at least as of now, cannot step in and start saving

individual banks. How do you save a Spanish bank and not an Austrian bank?

Austria’s banks have made large loans to Eastern Europe, in euros and Swiss

francs, and are going to have large losses, far more than 3%, which would wipe

out their capital. But bank assets in Austria are 4 times GDP. What we have are

banks that are too big to save for relatively small Austria. And for Italy,

Spain, Greece, et al. More on this below. For now, let’s turn our eyes to

Switzerland.

Those Wild and Crazy Swiss

We

think of Switzerland as a stodgy, by-the-numbers, clockwork type of banking

country. I have done business with Swiss private bankers, and they are

conservative. But somewhere, somehow, UBS and Credit Suisse ran up a little

leverage. Before the crisis, they were over 40:1. And now they’re nearly at a

nosebleed-high 70!

As

an aside, I was in Switzerland about two years ago, meeting with some very well-known

Swiss, let’s call them dignitaries. In a very off-the-record conversation, they

told me UBS was technically bankrupt. As it turns out, there were a lot of

banks around the world that were technically bankrupt.

Now,

the next graph underscores the problem of “too big to save.” Let’s say the US

will eventually pump $1 trillion into the banking system (in taxpayer losses).

That is about 7% of US GDP. We may not like it, but it doesn’t stop the game.

US bank assets are only twice US GDP. Switzerland and Ireland are over 7 times,

the UK is over 5, and the Eurozone is at 4 times. And so it goes.

Eurozone

banks are already reeling from losses from US subprime-related problems. They

are now getting ready to deal with even deeper losses from their own lending

portfolios. If the losses were just 5% of the portfolio (an optimistic

assumption), it would be 20% of Eurozone GDP. But each country is responsible

for its own banks. While it is thought Germany will be able to handle its problems,

the prognostication for Austria and Italy is not so sanguine. Italy is already

running a massive deficit, and has no central bank to monetize its debt. The

same goes for Portugal, Spain, Greece, and Ireland. 5% loan losses in Ireland

would be 40% of GDP, the equivalent for my fellow US citizens of about $5

trillion. Where does Europe find a few trillion dollars?

I

was writing in late 2006 that the subprime lending market would end in tears.

And I think the European banking crisis that is on the horizon has the

potential to be every bit as big a problem as subprime loans. The world

depended on Europeans banks for much of the lending that allowed for growth and

development. Like their counterparts in the US, they are going to have to

reduce their loan portfolios. Deleveraging is not fun.

It takes time to build up a banking

infrastructure that can raise the capital necessary to make and process loans.

A lot of time. Europe is a big customer of the US and Asia. Their businesses

are going to be hit hard by the lack of capital, which is of course no good for

employment, etc. We are all connected. What happens in Rome no longer stays in

Rome.

Let me reprint a graph from last

week. Burn it into your mind. The world is going to need to find $5 trillion to

finance government debt issuance. And we need to fund private business and

consumer debt. Where is all this money going to come from? “If you lend me $5

trillion today, I will gladly repay you Tuesday.”

A Positive Third Quarter?

Those

who are calling for the end of the recession are shouting that the third

quarter may be positive in terms of GDP. And that is possible. But only for

statistical and not for fundamental reasons. For instance, lower imports are a

net positive for GDP. But lower imports mean a weaker economy. Government

spending adds to GDP. Normally, if the government spends too much, then we get

inflation, which is subtracted from nominal GDP to give us real (after-inflation)

GDP. But inflation is low and getting lower, so there is not going to be much

to subtract from nominal GDP. Are government spending and massive deficits a

sign of fundamental strength?

It

is quite usual for there to be a positive quarter in the middle of a recession.

Watch the fundamentals: industrial production, unemployment, capacity

utilization, tax receipts, etc. When those turn up, or at least level off, the

recession is over. Then we get to the long recovery.

Quick point. As I have noted,

unemployment is at 9.5% and going to 11% and hopefully no higher. Average hours

worked per week is at an all-time low. The number of people working part-time

but wanting full-time work is another 7%! And that part-time number is rising

very rapidly.

When the recovery actually does

begin to manifest itself, and it eventually will as we find the New Normal,

what do you think employers are going to do? Hire new workers? Or give their

current employees more hours? The latter, of course. This is going to be a

long, slow, painful, jobless recovery. Unemployment is going to remain

stubbornly high.

And this Congress wants to raise

taxes on small business. 75% of the “rich” are small businesses. How do you

expand your business in California or New York, where taxes will be over 60% by

the time you add in local taxes? We will talk about this next week; but as a

preview, from an economic viewpoint, massively raising taxes in the middle of a

recession is about as dumb as you can get. But it looks like we are headed

there. Green shoots, my foot.

New York and Maine

I’ll

head to Maine in early August with youngest son Trey to fish with my friends

and talk economics. Meanwhile, # 2 daughter Melissa will soon have to have her

gall bladder removed. Amanda gets married next month. Two more grandchildren

(in addition to the one I had last month) in the next five months. Watching #2

son struggle with a budding family, and getting fewer hours as even the health-care

business slows down. UPS is giving #1 son fewer hours than he needs. Life is

always interesting with seven kids.

I

can remember really struggling as a young entrepreneur in my 20s and 30s. There

were many nights I couldn’t sleep as I worried about payroll or a bill coming

due. No one gave me a course in basic business. I had to learn it “on –the

–job,” as they say. It wasn’t always pretty. It was a struggle starting

out in the ’70s, but you got up every morning and did your best. It was not

easy. And now, I watch my kids do the same thing. It is a struggle for them, too.

It is a reminder how just lucky I am. I truly feel I am one of the most blessed

of men.

Have

a great week, and remember that the world will not come to an end. It is

important to find the good in life and enjoy it, even in the midst of the

fight. Somehow, we will all figure out how to Muddle Through together.

Your ready to find some wine analyst,



John Mauldin

John@frontlinethoughts.com

Copyright 2009 John Mauldin. All Rights Reserved

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