European Sovereign Debt Must Be Restructured

A debt crisis for an organization occurs when either its debt repayment cannot be covered by the cash flow being generated by the organization or the outstanding debt of the organization cannot be reduced sufficiently to reduce the debt repayment needs. 

In the case of a governmental organization, the cash flow needed to cover the debt repayment requirements comes from economic growth that is large enough to generate governmental revenues that cover the government’s cash outflow.

Or, the cash needed to reduce the amount of government debt outstanding comes from a cash surplus generated by the government’s prudent fiscal budgets.

If neither of these conditions is met, then the government is insolvent and the debt outstanding must be restructured.

What is so hard to understand?

The growth rate of many countries in the eurozone is exceedingly low or non-existent. 

The new budgets being generated in these countries do not reduce deficits sufficiently to reduce their ratio of government debt to Gross Domestic Product.

The current efforts of the effected governments produce a cumulative result that just exacerbates the situation.  If the deficits cannot be reduced sufficiently, the debt repayment crises continues which puts greater pressure on governments to reduce budget deficits, and so on, and so on.  The experience of the eurozone over the past few years just confirms this dilemma.   

This reality pervades the bond markets. 

But, this reality is still being evaded by eurozone officials. 

A movement to enact a “fiscal union” to go with Europe’s “currency union” cannot correct the current situation without a debt restructuring because it ignores the reality of what the current situation has inherited.

A “fiscal union” can only be achieved if, at the same time, a debt restructuring takes place in those nations that are fiscally insolvent.  That is, the resolution of the current problems can only be achieved when the fact of insolvency is dealt with AND some form of a “fiscal union” with sufficient power is put in place. 

The past must be dealt with and some hope must be established for the future.     

A debt restructuring will be costly because of the impact this restructuring will have on European banks…and other banks and financial institutions throughout the world.  Any new “fiscal union” combined with a debt restructuring must include some plans to “backstop” banks.  This “backstopping” may spillover into other countries, like the United States and the United Kingdom.

And, all of this will have further negative repercussions on economic growth…in Europe, in the Untied States, and elsewhere. 

As Milton Friedman warned, “There is no such thing as a free lunch.”  Well, it appears as if the “free lunch” we have been trying to live off of is just about over. 

European Banks Getting Around Capital Rules

Bloomberg posted an article yesterday titled “Financial Alchemy Foils Capital Rules in Europe.” (http://www.bloomberg.com/news/2011-11-09/financial-alchemy-undercuts-capital-regime-as-european-banks-redefine-risk.html) Commercial banks are up to their old tricks again.

“Banks in Europe are undercutting regulators’ demands that they boost capital by declaring assets they hold less risky today than they were yesterday.”

The issue has to do with “risk-weightings”, “the probability of default lenders assign to loans, mortgages and derivatives.”  The technical label: risk-weighted asset optimization.”

The issue has to do with how banks define how risky an asset is. 

Whoops, the whole problem depends on what the definition of is, is!

Regulators have a very tough job…and they always have had a very tough job.  Rules and regulations are put in place.  And, financial institutions have the time and the incentive to find ways to get around them.  So, financial institutions take the time and spend the resources to get around the rules and regulations.

This is just Economics 101: if there is an incentive for someone to do something to “get around” the rules…someone will find a way to “get around” the rules. 

I had direct experience of this when I was working in the Federal Reserve System around the time that a wonderful financial innovation came into existence…the Eurodollar deposit. 

The Eurodollar deposit was one of the inventions that allowed commercial banks to become “liability managers” rather than just “asset managers”.  These financial innovations allowed commercial banks, especially the larger ones, to get around the geographic restrictions faced by American banks at the time, and become fully competitive with their less restricted global competition. 

The word inside the Fed at this time was that the Fed was six months behind the banks.  That is, the Federal Reserve would institute some rules or regulations to constrain the use of these Eurodollar deposits and the commercial banks would then find ways to get around them.  However, it would take the Fed about six months to find out what the commercial banks were doing and institute some new rules or regulations to close the escape hatch.  And, the “cat and mouse” game would be played once more.

In that “primitive” time, I gained an appreciation of the inventiveness of the private sector and the frustration faced by the regulators.  The only time the rules and regulations really were strictly adhered to was in the case that the incentives for circumventing the rules and regulations were small enough so that the banks would not put out the time or resources to innovate.

Today, the sophistication and complexity of the banking system is such that regulators are at an even greater disadvantage than they were back in the “good old days.”  And, the primary reason that the bankers are some much further ahead is information technology. 

Over the last decade, I have constantly put forward the idea that finance is nothing more than information.  The whole basis for the field of financial engineering is that finance is information…and information can be cut up and re-arranged just about any way a person might find it useful to cut it up and re-arrange it.  In other words, “slicing and dicing” in a natural characteristic of information technology…that is, of financial practice.

Thus, I have been arguing for more than two years that any efforts to put new rules and regulations on financial institutions to prevent the financial crisis of 2008-2009 from occurring again are just an exercise in futility.  The Dodd-Frank financial reform act was “Dead On Arrival”…especially since most of the rules and regulations contained in the act were not even written at the time.

In fact, I would call the efforts of the legislatures and regulators in the eurozone and in the United States to control the financial industry more closely as the “regulatory employment effort of 2011”…or whatever.  In order to have any chance to know what is going on in the banking system the eurozone and the United States has had to hire hundreds if not thousands of new employees to write the rules and regulations, to interpret the rules and regulations, to enforce the rules and regulations, and to re-write the rules and regulations as it is observed that the rules and regulations are not working as expected.

And, financial institutions will still be out ahead of the politicians and the regulators.

The financial industry is going to be what it is going to be.  One thing that needs to be avoided, in my mind, is the environment of credit inflation that has existed for the last fifty years.  The environment of credit inflation just exacerbates the speed at which financial innovation takes place putting even more pressure on the government and the regulators to “keep up” and stay on top of events. 

And, what can be done?  I have been a constant advocate for increased openness and transparency in financial reporting.  Stop this hiding of assets.  Stop the switching of assets from one class to another.  Mark-to-market assets.  And so on and so on. 

Furthermore, incorporate market information into the early warning system of financial institutions. I have written about this many times before.  One such market-based early warning idea proposed by Oliver Hart of Harvard University and Luigi Zingales of the University of Chicago is based on Credit Default Swaps.  (See http://seekingalpha.com/article/207293-banks-disclosure-and-reform.) 

In my view, finance has gotten so complex and sophisticated that government regulation of the financial industry, as it is done today, is something of a lost cause.  The fact that politicians pass bills and acts to regulate the financial industry and can’t even initially write up the specific provisions of the rules and regulations and then when they do get written up it takes 3,000 pages to define the rule or regulation, is evidence of the futility of the exercise. 

Greater disclosure and market-based early warning systems seem to me to be the only real chance we have to monitor these financial institutions and then have some influence over the course of events. 

Until the politicians change their tune, however, we are going to continue to work in a financial world that is opaque and “out-ot-control.”   

Government Incentives Do Matter--The European Case

Gillian Tett’s essay in the Financial Times this morning gives us another example of how government policies can create incentives that have very serious consequences on an economic system, consequences that are very often detrimental to the health and welfare of the economic system.  Tett’s excellent piece “Subprime moment looms for ‘risk free’ sovereign debt,” (http://www.ft.com/intl/cms/s/0/88151ed6-0639-11e1-a079-00144feabdc0.html#axzz1cfzAfdXG) examines the consequences of European bank regulators assuming that all sovereign debt in Europe were “risk free”.

“When regulators drew up the Basel I capital adequacy framework in the 1980s, they gave western sovereign bonds a ‘zero’ risk weighting, in terms of how capital is calculated.  This was subsequently modified in Basel II, to give banks some theoretical discretion to raise reserves against sovereign risk.  In practice, this zero-risk weighting policy has prevailed.

In some senses it has been actually reinforced in the past five years because regulators have demanded that banks raise their holdings of liquid, safe assets, following the subprime turmoil.  Those ‘safe’ assets have been—you guessed it—mostly government bonds.”

Furthermore, one can add that in both applications of stress tests to judge the vulnerability of European banks to a financial crisis, no allowance was made for the writing down of sovereign debt in financial simulations.  Obviously, European banks came out looking pretty good.

And, in the “deal” constructed last week by officials of the eurozone, only ‘private’ holders of Greek debt were required to write down the debt by 50 percent, ‘public’ holders of the Greek debt, the ECB and other governmental organizations, did not have to write down the debt at all.  The ‘private’ holders represented only about 60 percent of the total amount of the Greek debt outstanding.

Of course, assuming that the sovereign debt of many of the eurozone countries was “risk free” allowed the governments to issue much more debt than they might have otherwise at the cheapest rates possible. 

In the essay, Ms. Tett also makes reference to the fact that assuming that sovereign debt is ‘risk free’ is one of the most basic assumptions of modern finance.

The result?

“If regulatory systems had not encouraged banks and investors to be so complacent about sovereign risk in the past, markets might have done a better job of signaling that structural tensions were rising in the eurozone—and today’s crunch would not be creating such a convulsive shock.”

Ms. Tett compares this “mis-pricing” exercise to the earlier experience of the subprime market.  In the latter case, subprime securities were repackaged into bonds that the rating agencies gave Triple A ratings to.  Again, this pricing facilitated the purchase of these securities and allowed many financial institutions to acquire the securities, comfortable that they were holding assets of the highest quality.  But, one cannot ignore the pressure put on mortgage originators, lenders, rating agencies and such, by governmental officials pushing hard to provide home ownership to more and more people.   And, this situation, too, resulted in “a convulsive shock.”

My point is that in both cases, the financial institutions and their executives have been blamed or are being blamed for the mess and are assessed the title of “greedy bastards”!

As many people know from reading my blog posts over the past three years, I feel the same way about the credit inflation created by governments in the eurozone and in the United States.  I have argued over and over that the credit inflation that has existed over the last fifty years has provided incentives for banks, businesses, and individuals to leverage up their balance sheets to excessive levels.   This credit inflation has also promoted excessive risk taking and the financing of long-term assets with short-term liabilities.  And, this credit inflation has created perhaps the most desirable environment possible for financial innovation. 

Yet the consequence of people responding to these incentives has resulted in the worst financial and economic collapse since the Great Depression of the 1930s. 

In addition, these incentives have also produced the most skewed income/wealth distribution in the history of the United States since the 1920s.  The wealthy, top executives, and people with access to information and markets can protect themselves from inflation or even take advantage of inflation.  The less wealthy, etc., cannot even hold their own against inflation.

Again, those that responded to the incentives created by this extended period of credit inflation and benefitted from them are labeled “greedy bastards.”

And, nothing is said about the politicians, another set of “greedy bastards” that originally created the incentives because they wanted to get re-elected!

Ms. Tett is correct in wondering what might happen if people change their assumptions about the sovereign debt, assuming now that all sovereign debt is not “risk free”.

She argues that “more realistic assessments” of the debt “would probably fore banks to hold more capital, and raise borrowing costs.”

More realistic assessments might “force the central banks to change how they conduct money markets operations, and impose tougher haircuts not just for obviously impaired debt, but bonds carrying potential risk, too.”

Or, “The other 800 lb—or $500 trillion—gorilla in the room is the derivatives market.  Until now, sovereign entities have generally ot posted collateral for derivatives, partly because of that risk free tag.  But, Manmohan Singh, an economist at the IMF, believes that this anomaly has helped to create a severe under-collateralization problem, worth $1.5 trillion--$2.0 trillion for the 10 largest banks alone.  If ‘true’ counterparty risk were ever recognized in derivatives, in other words, the implications could be brutal.” 

One of the reasons why European public officials are denying that the problem they face are ones of solvency is because someone might discover that a good deal of the blame for the insolvency is due to what they have done in the past.   One of the nice things for politicians about economics is that the consequences of economic policies usually take a long time to work themselves out.  Because of this people find it difficult to connect the policy with the consequences of the policy or may even fail to identify any sort of a connection. 

This is where work like that provided by Ms. Tett is so enlightening and helpful.      

Why Banks Aren't Lending

Remember the old story about commercial banks?  Commercial banks only lend to people who don’t need to borrow.

Well, that seems to be the “truth” about bank lending now.  The story going around is that the larger banks have increased their business lending, but the lending is really only going to those institutions that have a lot of cash on hand.  Otherwise, the commercial banks will sit on their excess reserves.

This also seems to be the story in Europe: commercial banks are just not lending anywhere. (http://www.nytimes.com/2011/09/23/business/global/financing-drought-for-european-banks-heightens-fears.html?ref=todayspaper)

And, the relevant question is not “Why aren’t commercial banks lending?”  The relevant question is “Why should commercial banks be lending at this time?”

The first reason why many banks shouldn’t be lending right now is that there is still a large number of banks who may be severely undercapitalized or insolvent.  Many commercial banks have assets on their balance sheets whose economic value is substantially below the value the asset is accounted for on that balance sheet.

The most notorious case of this is the sovereign debt issues carried on the balance sheets of many European banks.  The values that many of these banks have on their balance sheets for these assets have the credibility that the recent “stress tests” administered to more than 90 banks by European banking authorities. (Note that the European Union moved today to recapitalize 16 banks, http://www.ft.com/intl/cms/s/0/49d6240e-e527-11e0-bdb8-00144feabdc0.html#axzz1Yj4RAJ9F.)    

But, the problem is not limited to Europe.  How many assets on the books of American banks have values that need to be written down to more realistic market values.  For example, small- and medium-sized commercial banks in the United States have a large portion of their loan portfolios in commercial real estate loans.  The commercial real estate market is still experiencing a depression and market values continue to decline in many areas.  The write off of these loans can take large chunks out of the capital these banks are still reporting. 

The bottom line here is that commercial banks that still have problems are not willing to take on any more risk than they have to while they still have to “work out” these depreciated assets, or, at least, wait until the markets recover and asset values rise once again to former levels.  If you don’t make another loan…it will not go bad on you…so why take the risk of making a new loan.

And there are 865 commercial banks on the FDIC’s list of problem banks and many more surrounding that total that have not met the specific criteria of the FDIC to be considered a problem bank. 

The second reason why many banks shouldn’t be lending right now it that the net interest margin they can earn on loans is hardly sufficient to cover expense costs.  I have talked with many bankers now that say the only way to make any money through bank operations is to charge for transactions.  That is, to generate fee income. 

A general figure that represents the expense ratio of a bank is by taking expenses and dividing them by total assets.  Recent data indicate that this expense ratio is in excess of 3 percent, being around 3.15 percent to be more exact.  This means that on basic lending operations a commercial bank must earn a net interest margin of 3.15 percent in order to “break even”. 

Is there a problem here?  You betcha’!

Adding to this dilemma is the fact that the Federal Reserve has added on a new “operation twist” to the mix.  All these banks need is a flatter yield curve. (See my post http://seekingalpha.com/article/292286-will-bernanke-policy-destroy-credit-creation-bill-gross-is-worried-it-will.) 

There are two ways to respond to a flatter yield curve.  First, one can take on more risk in their lending. (See http://seekingalpha.com/article/293893-some-banks-are-stretching-for-risk.) Or, commercial banks can attempt to earn more money through additional fees, or principal investments (private equity or venture capital), or through the assumption of systematic risk taking. (See http://seekingalpha.com/article/292446-will-bernanke-policy-destroy-credit-creation.) 

Is this what the Fed wants?  The Fed seems to be caught in the bind that it must be seen as doing something, even though that something may not be very productive (QE2) or even counter productive (leading to bubbles and other speculative activity). 

The take on Fed behavior during the Great Depression has been that the central bank did not do enough.  Hence, Mr. Bernanke and crew are taking the position that history will not brand them with the same interpretation.  For the past three years they have operated so as to avoid the claim that they did not do everything in their power to counteract the forces causing a great recession, slow economic growth, or economic stagnation.

And, here they face the possibility of “unintended consequences”.  If the flattening of the yield curve results in even less bank lending than would have occurred otherwise, the Fed could actually be exacerbating the situation.  The stock market declined upon hearing the Fed’s policy.

The third reason why banks may not be lending now is the absence of loan demand.  Fifty years of government created credit inflation has resulted in excessive debt loads being carried by individuals, families, businesses, governments (at all levels) and not-for-profit institutions.  People, faced with under-employment, declining asset values, and income/wealth inequities, are attempting to de-leverage.  This de-leveraging will continue until people feel more comfortable with their debt loads, or, the Fed creates sufficient inflation so that people will start to take on more debt again. 

If the Fed achieves the latter, then we have returned to the credit inflation situation that has existed for the past fifty years.  This period of credit inflation has resulted in an 85 percent decline in the purchasing power of the dollar, more and more under-employment of labor, and greater income/wealth discrepancies within the society. 

The fourth reason is the uncertainty created in “the rules of the game.”  The Dodd-Frank financial reform act has created a great deal of uncertainty within the financial community.  For one, only about 25 percent of the regulations have actually been written and only a portion of these have passed.  As a consequence, commercial banks don’t know what rules they will have to follow…or, even more important, what rules they will have to find ways to circumvent.  Another new set of rules, these on taxation, were introduced by President Obama this week.  George Shultz, former Secretary of the Treasury, has argued that new, complex tax proposals not only lead to short-term uncertainty about what must be dealt with, but that over time “the wealthy and GE” will find ways to manipulate the tax laws in their favor. (See my posts of September 20 and 22:  http://maseportfolio.blogspot.com/.)  But, unfortunately, people, families and businesses, will devote time and resources to dealing with these “rules of the game” and not allocate this time and resources to more productive activities.

Again, I raise the question “Why should banks be lending?”, not the question “Why  aren’t banks lending?”   

Europe: More of the Same

I haven’t written anything recently about the Europe financial crisis because…little has changed.

Still the same old “kicking the can down the road.”

I am in the same place as Stephen King, chief economist at HSBC: “The totality of financial claims in now too big to be supported by the new economic reality.  In this world of economic permafrost, someone, sometime, will have to accept losses.  Will those losses accrue to taxpayers, recipients of public services, equity investors, bondholders, domestic debtors or foreign creditors?” (http://www.ft.com/intl/cms/s/0/c3451258-da07-11e0-b199-00144feabdc0.html#axzz1XSP5Pmbe)

His answer: “…any resolution seems a long way off.”

The response from the international capital markets?  Fear!

Yesterday the ten-year government bond of Germany closed at 1.88 percent; the ten-year United States Treasury bond closed at 1.99 percent.  Never thought I would see rates like this in my lifetime.  

The fear is driving investors into the safest things that they can get their hands on.  And, within this “flight to safety”, Europe…and the United States…just plods along with business as usual. 

Although we don’t agree with his prescribed remedy, Mr. King and I agree with what was written by Martin Wolf this past week. (http://www.ft.com/intl/cms/s/0/079ff1c6-d2f0-11e0-9aae-00144feab49a.html#axzz1Wbu6HxQ0)  Mr. Wolf argued that the major problem behind all the “pussy-footing” around is that there is a substantial lack of leadership on the world scene. (http://seekingalpha.com/article/290934-struggling-with-a-great-contraction)

This lack of leadership comes out in so many ways.  Just take the case of Greek bonds and the value at which these bonds are carried on the balance sheets of European banks.  It seems as if these European banks can do just about anything they want to in terms of writing down the value of the Greek bonds they hold.

Floyd Norris writes in the New York Times: “British banks were most willing to swallow bad medicine and admit the bonds were worth far less than par value. Some German banks were equally forthcoming, but others were less so. Italian banks seem to have done as little as they could, but did take write-downs. French banks went the farthest to find ways to act as if Greek bonds were just fine.” (http://www.nytimes.com/2011/09/09/business/european-banks-apply-slippery-standards-on-greek-bond-valuations.html?ref=business)

So much for the “strong” rules and enforcement actions of international accounting and banking standards supposedly coming out of Europe.

Oh, yes, these are the European regulators that gave us the “stress” tests that were such a laughable matter.

The reason, to me, that no politician wants to stand up and take a strong position is that there are no good short-run solutions to the problems at hand.  The difficulty in taking a strong, longer-run position is that people are currently in pain and politicians must focus on “muddling through” to prepare themselves for the next election.

After all, the number one job of the politician is to get himself or herself re-elected. 

The difficulty faced by the politician is captured in the sub-heading of the New York Times article “Europe Steers Into a Zone of Uncertainty.   This sub-heading reads, “Path Out of Debt Crisis Involves Pain and Time.” (http://www.nytimes.com/2011/09/09/world/europe The /09europe.html?_r=1&ref=todayspaper)

Imposing more “pain” is not a good way to get re-elected and taking too much time to achieve results does not match the timing of the politician’s next election.

And, where does the pain start?

Let me quote King once more:  “someone, sometime, will have to accept losses.”

Many of the governments in Europe are fragile because of the sovereign debt crisis.  Many of the banks in Europe are fragile because of the sovereign debt crisis.  There is rioting in the streets in Europe because of the efforts of governments to cut back budgets or raise taxes.

Yet, these same governments and public officials will not accept the reality of the situation…and so the crisis continues.

Steven Erlanger, tin the New York Times article just mentioned writes the following: “most experts agree that Europe’s crisis will persist until it adopts a far tighter fiscal and monetary union, expels weaker economies or divides into two, with different currencies. 

The hope among experts and economists is that the changes, if carried out with skill, may allow Europe to further isolate Greece and its unsustainable debts from other countries, reducing the risk of contagion and buying time for other countries to fix their budgets and work on how to better centralize control of fiscal policy. Though abstract on the surface, the changes will provide more flexibility to bail out or further restructure Greek debt, to aid Italy and Spain with their bond sales and even to recapitalize some European banks, weakened by their exposure to sovereign debt in the form of Greek, Portuguese, Spanish and Italian bonds.”

Notice three things: first, the reference to “experts”; second, the statement “if carried out with skill”; and third “though abstract on the surface.”  Sounds like success is just around the corner. LOL

It took fifty years or so to create this financial crisis.  We are not going to get out of it “overnight” and we are not going to get out of it without more pain. 

Again, “someone, sometime, will have to accept the losses,” regardless of what the “experts” say.

This is what happens when you become a “debt junkie.’

Just How Bad Off Are the Banks?

Here we are, how many years after the start of the financial crisis, and we still have questions about the status of individual banks and the banking system…in both the United States and Europe.

European banks have gone through two “stress” tests.  The United States banks have gone through their own “stress” tests.  And, still, there are questions about the solvency of individual banks and the banking system. 

Christine Lagarde, Managing Director of the International Monetary Fund, received all sorts of criticism from the remarks she made last Saturday concerning the status of the European banks and the fact that they “need urgent recapitalization.” 

Early this week we read about how various European banks are writing down the values of the distressed Greek government debt they hold.  Some banks are taking have taken a 50 percent write down while others have taken haircuts of slightly more than 20 percent.  There are no standards for taking such write downs leaving each bank to follow its own path. (http://professional.wsj.com/article/SB10001424053111904199404576540291609289616.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj)

American banks are not coming off much better.  One looks at the discounts being assessed against US banks in the stock market and the legal efforts that they face and one wonders what is real.   Are these banks really solvent?

Bank of America has become the poster-child of the mismanaged large banks in the United States.  Warren Buffett brought it some relief with his “pussy-cat” deal.  Yes, Mr. Buffett can say that he (and other wealthy people) should pay more taxes as he cuts such sweet deals with such nice tax benefits for himself.  Yet, some are taking the Buffet bailout of Bank of America as a signal that maybe a closer look needs to be given the position of Bank of America. (http://dealbook.nytimes.com/2011/08/31/buffett-investment-could-erode-confidence-in-wall-st/)

Just look at some of the numbers.  Bank of America has  stated that slightly less than 20 percent of its residential mortgage loans as either delinquent or nonperforming, a rate that is similar to that of Wells Fargo.  JPMorgan Chase has about 24 percent falling in this class while the fourth of the big four, Citigroup, has less than 14 percent. 

And, “Not only does the bank still face billions in legal settlement costs from Countrywide Financial deals, but it also has to buy back billions in faulty mortgages.  Bank of America’s questionable foreclosure practices continue to drag it down, and, in addition, it faces Securities and Exchange Commission investigations into the actions of its subsidiary, Merrill Lynch, in the lead-up to the financial crisis.”

In addition, bank profits are falling (http://www.nytimes.com/2011/08/29/business/top-banks-confront-leaner-future-by-cutting-jobs.html?_r=1&scp=1&sq=profits%20falling,%20banks%20confront%20a%20leaner%20future&st=cse) and with the Fed promise that it will keep interest rates low for the next two years, bank interest rate margins and, hence, bank profits can be expected to remain squeezed for the near term. 

And, why is the Federal Reserve keeping interest rates so low for the next twenty-four months?

One reason for keeping interest rates so low is that the Fed will continue to provide the banking system with substantial liquidity so that banks can work themselves out of their bad loan situation and that failing banks can be removed from the banking system with the least disruption possible.

Furthermore, commercial banks in both Europe and the United States are cutting back on their employment by not just thousands of people, but tens of thousands of people when all the layoffs are added together.   

We look at all this information and we wonder, “Just how bad off are the banks?”  The regulators have been working on this situation for at least three years.  And, we still have all these questions?

The only conclusion one can draw from this is that the regulators and the people “in the know” did not want us to know how bad things were.  And, they still are reluctant to let any of this information out.  Notice how upset people got when Ms. Lagarde let the “cat-out-of-the-bag” on Saturday.

So much of this dilemma goes back to the discussion about the need for financial institutions to mark their assets to market.

I know how hard this is to do in the case of some assets without active markets.  And, I know how painful this is to do “after-the-fact”, that is, after the asset values drop underwater.

But, this is a lame excuse that has been allowed to go on for too long!

If banks take risky bets on interest rate movements, they should only do so with the knowledge that if the markets move against them they will have to pay a price by marking the assets to market.  I also don’t buy the argument that they will hold the assets to maturity.  If the banks “place the bet” they must pay the consequences.

Same thing with risky assets: as banks take on more and more risky loans in an effort to “beef-up” their return on capital they are overtly exposing the bank.  Again, when the assets go south the banks need to own up to the bets they placed. 

And, if these mark-to-market efforts are done on a more timely basis then the banks will have to move to correct their asset problems earlier and they will not get into the deep “doo-doo” they now find themselves in.

Sooner or later these bank problems are going to have to be taken care of.  Stringing things out as the regulators and politicians have done only postpones the day we can move off into the future.  It is a prerequisite for finally achieving more robust economic growth. 

The fact that the problems we continue to read about still exist three years after the financial collapse took place only raises further questions and continues to add uncertainty to the economic climate.  No wonder that people are so risk averse today and only want to buy US Treasury securities or gold. (http://seekingalpha.com/article/290934-struggling-with-a-great-contraction)   

Now Back to Europe

Silvio Berlusconi, Italy’s prime minister spoke to the Italian Parliament yesterday about the economic and financial situation facing Italy. 

Mr. Berlusconi “pointed the finger at speculators, global economic weakness and general problems in the eurozone.” (http://www.ft.com/intl/cms/s/0/088747fc-bdf5-11e0-ab9f-00144feabdc0.html#axzz1TyUqwXts) 

These words were an almost exact copy of those issued by the Greek government, the Irish government, and many others from within the eurozone over the past year or two. 

Gotta stay on message…the problem is “out there”!

Now that we have a modest pause in the news coming from the United States concerning sovereign debt and all that, we can return to the European sovereign debt situation…which is far from resolved.

When are people in Europe (remember that there are no leaders in Europe, “In Europe the Issue is Leadership”, http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership) going to realize that “kicking the can down the road” is not going to get them out of the situation they are in. 

In fact, as southern Europe continues to burn, the banking system in Europe is having to endure greater and greater stress. (See, for example major articles in the New York Times, http://www.nytimes.com/2011/08/04/business/global/europes-banks-struggle-with-weak-bonds.html?ref=business, and the Wall Street Journal, http://professional.wsj.com/article/SB10001424053111903885604576486671709242408.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj.) Only very short term loans seem to be available between banks but even these loans require borrowers to pay a premium over similar borrowing costs in the United States. 

The cost of borrowing 10-year money in Italy has now risen above the “crisis” level of 6 percent this week and Spain is now borrowing at interest rates not seen since the creation of the Euro.  Even Belgium and France are facing near term highs in borrowing costs.

As I wrote yesterday, the problem is that there is too much debt outstanding in Europe (and America) both in the private as well as the public sectors.  We, in the Western world, have lived off of the debt idol for too many years (See http://seekingalpha.com/article/284276-the-problem-too-much-debt).    

 How do we determine whether or not there is “too much debt outstanding”? 

In my opinion, an exact answer cannot be given.  We try and measure this by using statistics like government debt to GDP ratios, or, government deficit to GDP ratios, and the like.  But, we are dealing with human beings and ratios like these can only provide hints at debt loads and clues to times when debt burdens become excessive and unsustainable.

When do people start to realize that they have to make decisions about how they allocate their income rather than just keep spending on everything they want?  When do governments realize that they can’t fund every good social cause presented to them?  When do businesses realize that they just can’t continue to raise their return on equity by adding more financial leverage to the balance sheet?

There is no exact answer to these questions.  Economics is not an exact science no matter how much economists like to project this image to the world. 

And, the Keynesians argue that added spending stimulus will cause consumption expenditures to increase and this will get the economy going again, or, incentive for businesses to increase capital investment will get the economy going again.

Keynesian models have never adequately handled the issue of debt and financial leverage.  One reason is that debt levels and financial leverage are not always limiting factors in consumer and business spending.  In fact, during the early stages of a period of credit inflation, the greater availability of debt and financial leverage may have a positive influence on consumer and business spending. 

That is, debt levels and financial leverage may be positive influences on economic activity…before they become a negative influence. 

This is one of the problems in trying to understand human behavior.

But, back to the situation in Europe.  The world has changed.  The old models are not working and new ideas must be introduced into the efforts being made to get control over the crisis. 

Maybe this is not going to happen until the “old guard” of top government officials is replaced by someone new.  Continuing to try and govern using the assumption that the problem is “out there” is not going to work. 

The problem is with the governments and their officials and until this is recognized I don’t see Europe getting its act together. 

And, the longer it takes for the eurozone to get its act together the greater the opportunity for the BRICS and other emerging nations to prosper and overtake the “ancient regime” now governing Europe.

The United States cannot ignore this dilemma for it faces similar problems.  And, the government of the United States is emulating Europe by claiming that the cause of its problems is “out there” and by postponing any real solutions until a later date. 

The world has changed.  As the West went through a philosophical and social change after the Second World War, we are now going through another sizeable and traumatic change.  But, to stick with existing models of the world and, consequently, say that the problems are “out there” will just “kick the can further down the road”.  It will solve little or nothing.

Restructuring Big Banks

The “new” trend amongst the big banks is to cut jobs.

The “big” HSBC has announced that it will be cutting 10,000 jobs in the near future, part of what many analysts expect to be part of a 30,000 reduction in jobs that will occur over time. 

This joins the efforts of other major banking organizations to scale down such at the Swiss banks Credit Suisse which announced earlier that it was eliminating 2,000 positions and UBS which said it was eliminating at lest 5,000 jobs.

In the UK, Lloyds Banking Group stated in June that it was cutting about 15,000 jobs which follows the news that the Royal Bank of Scotland has already dropped 28,000 positions with more to come in the near future.  Goldman Sachs is also cutting staff, as is Barclays Bank. 

Then, of course, there are the European banks in Ireland, Spain, Greece, and elsewhere that are facing massive amounts of restructuring. 

The big banks have had a fifty-year ride becoming over time huge global empires.  They have gone into this business and they have gone into that business without taking a breath in the process.  As “Chuck” Prince, former Chairman of Citigroup said…the music kept playing, so that the dancers had to keep dancing.

Which led to the situation that I discussed in my last post,  “Can Anyone Manage the ‘Too Big To Fail’ Banks?” (http://maseportfolio.blogspot.com/). 

A problem associated with this situation is whether of not these “Too Big To Fail” banks can be regulated.  There is, of course, some belief that these banks cannot really be controlled, especially with the advances that are taking place in the world of information technology. (See my “The Future of Banking: Dodd-Frank at One Year”, http://seekingalpha.com/article/281090-the-future-of-banking-dodd-frank-at-one-year.)

The question I asked in the first post mentioned was whether or not their shareholders could significantly influence these large commercial banks so that some control could be established over bank managements to reign in “undisciplined” growth and risk taking.  That is, could market performance become a sufficient reason for shareholder governance in the case of these financial institutions that were deemed “Too Big To Fail”? 

The basic reason given for the reduction in jobs given by the banks mentioned above was that revenue growth had deteriorated and cost cutting was needed to bring return the banks to greater profitability.  

Banks profits rebounded after the financial crisis, first, because of trading profits earned in volatile financial markets, and, second, due to reductions in provisions for loan losses. 

However, the banks have not been able to continue producing higher profits due to these factors and with lending, even at the larger banks, so anemic, managements have had to look elsewhere to beef up margins. 

In my mind, this effort at cost cutting does not answer the fundamental question about the future of the large commercial banks. 

Cost cutting is one, immediate management response that can improve profit margins.  The fundamental question to me is whether or not this cost-cutting is connected in any way with a management effort to restructure an organization so as to make sense establish the economic rationale of the bank and to be able to better manage the risk profile of the bank. 

The concern here is that the cost cutting is tactical and not strategic. 

These large financial institutions have grown almost without limit for fifty years and have added businesses more often than not just to increase the size of the organization and have added risk to their business structure without sufficient knowledge or control of what was being assumed.  Furthermore, many organizations used accounting “gimmicks”, financial leverage, and inadequate risk-taking oversight to achieve reported performance goals, which hid basic structural weaknesses.

The fundamental question has to do with whether or not bank managements are to be held accountable for their poor performances.  Will the focus of bank management’s change? 

Many times a change in the focus of bank management will only occur if there is new leadership of the management team.  In the case of HSBC, Lloyds, and Barclays, there has been a change in the past year.  These “new” leaders are expected to shift the direction of their organizations.  Citigroup and Bank of America have had new leaders in the past two years or so.  Citi has seemingly undergone a significant change in direction although better performance is still in the future.  Bank of America seems to be going nowhere, fast.

HSBC also announced another move that seems more “strategic” in nature.  It has agreed to sell 195 branches in upstate New York to First Niagara bank.  This effort, along with the closing of branches in Connecticut and New Jersey, is part of an attempt to rationalize its branch network, worldwide.  HSBC is also seeking to sell its credit card business.    Other areas of the bank are under scrutiny.

Of course, these moves are only “strategic” if they are more than just the “fad” of the moment.  And, this is the ultimate question.  Cost cutting can be a fad.  Other organizations are doing it so I cannot be criticized for cost cutting since others are doing it. 

This “strategy” can be extended to other efforts that only last until “things start to pick up again.”  That is, this “strategy” will only continue until the music starts to play again and everyone must get out, once again, on the dance floor.

Thus, one can still ask, “Can anyone manage the ‘Too Big To Fail’ banks?”

My view is that it is too early to tell. 

Right now the incentive is to re-trench and re-structure.  However, in man circles, especially in the United States, there is still a lot of pressure for governments to inflate credit.  (Need one mention Paul Krugman of the New York Times, “The President Surrenders”, http://www.nytimes.com/2011/08/01/opinion/the-president-surrenders-on-debt-ceiling.html?_r=1&hp.) 

If credit inflation remains the policy of choice of the United States…and others…and continues to dominate the economic scene then I believe that the “fad” will end and the financial institutions will start to dance again.            

If debt deflation dominates, then I truly believe that we will see better management in the financial sector and financial conglomerates will become more rational and risk-taking will be better controlled.  As I have written elsewhere, this is the other side of the process where government provides too much stimulus for an extended period of time, people and businesses respond accordingly, and then, since this situation becomes unsustainable, people and businesses must adjust back to a position that is more sound, economically, and therefore more sustainable.