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
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
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:
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
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.
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.
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.
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
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.
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
Those Wild and Crazy Swiss
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
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.
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.
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?
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
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?
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?
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
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
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
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.
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
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,
Copyright 2009 John Mauldin. All Rights Reserved
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John Mauldin is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.