Europeans Facing More of a "Haircut" Than Preciously Thought

News is leaking out that the “haircuts” on European Sovereign debt are going to be greater than imagined just several weeks ago!  “EU looks at 60% haircuts for Greek debt.” (http://www.ft.com/intl/cms/s/0/66bdcbc0-fc11-11e0-b1d8-00144feab49a.html#axzz1bRwsVH3F)

Three months ago European officials agreed to a 21 percent haircut.  Then, in the last several weeks, the figure moved to around 50 percent.

And, still officials are dawdling.

European banks are troubled, and we hear about how the “French Banks Fought Oversight.“  Seems as if French banks and French regulators consistently ignored the reality of the situation within the banks claiming that no problems ever existed. 

Of course, bankers are notorious for claiming that problems do not exist on their balance sheets!  But, this is not new. (See my http://seekingalpha.com/article/300076-european-bankers-balk-at-big-write-downs.)  The bankers’ denial of any problems on their balance sheets is maintained right up to the time hey begin to argue that “It was not our fault!”

The problem I have with all this is that attention is being deflected from the real issues while blame is being diverted from the real culprit.

The real culprit, to me, is the post-World War II attitude in America, the UK, and Western Europe that the creation of debt, especially by governments, could keep unemployment at low levels and this would end the possibility of social unrest caused by masses of unemployed persons.  The result was that the latter half of the twentieth century became the “poster child” for the benefits of what can be called credit inflation. 

Creating debt, especially government debt, was not just a policy of the left, but it was also the policy of the right.  The creation of debt would resolve almost all social issues since it kept people at work.  This would also help politicians get re-elected.

In the 1960s we added to the goal of keeping people working the goal of seeing to it that every family owned their own home.  This was especially the case in the United States.  I was working for a cabinet secretary in the early 1970s in a “conservative” administration, and one of the major goals of this administration was the development of mortgage-backed securities.

The reason for the development of this instrument was certainly not an economic one.  The reason for the development of the mortgage-backed security was to get politicians re-elected.  The argument was that if more Americans owned their own home, the more willing they would be to re-elect those Senators, Representatives, and Presidents that supported this goal. 

The government’s development of the mortgage-backed security, of course, brought several new things to the financial markets, like ‘slicing and dicing’ cash flows, that paved the way for the financial innovation that was to take place later in the century.

Of course, the major driver behind all of this was the continual efforts of the national governments to create credit through deficit spending to hire large numbers of people themselves, to almost continuously stimulate the economy to keep unemployment low, and to continue to find ways to put more and more people into their own homes. 

This is the essence of credit inflation!  And, the central banks, fundamentally, helped the national governments to write the checks.

The undisciplined creation of debt, however, does not end well.  This is the story that Carmen Reinhart and Kenneth Rogoff tell in their book “This Time is Different.”  And, for the United States, the UK, and Western Europe, this time was not different and financial crisis arose.

The point I am getting at is that the resolution of a financial crisis is not a unique action.  However, many of those in authority are crying out “This time is different”!

One of the boldest “criers” is Fed Chairman Ben Bernanke.  I have written my opinion of him in an earlier post. (http://seekingalpha.com/article/300076-european-bankers-balk-at-big-write-downs)  But, Mr. Bernanke is not the only authority at the central bank that is searching for a new or better way to conduct monetary policy. (http://professional.wsj.com/article/SB10001424052970203752604576643510352250474.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj)

Gillian Tett also writes in the Financial Times that “Central Bankers must update outdated analytical toolkit.” (http://www.ft.com/intl/cms/s/0/877b7bfa-fb21-11e0-bebe-00144feab49a.html#axzz1bRwsVH3F)  

Let me just say in answer to this situation we are in: This time is not different!

The problem is too much debt!  The cause of the problem was 50 years of credit inflation in the United States, the UK, and Western Europe.  This debt must be worked off and it takes time to work off excessive amounts of debt.  Again, I recommend you check the Reinhart and Rogoff book.  I have also just written a post on this: http://seekingalpha.com/article/300450-the-u-s-economy-will-continue-to-grow.

And, the lessons from this experience are not new.  Don’t issue too much debt!  Don’t just focus on short-run goals…like fiscally stimulated low unemployment, like everyone owning their own home, like governments hiring all their own supporters…and so on and so forth.

The problem is not financial innovation or greed or speculators.  These things will never go away. 

The problem has been that the credit inflation created in the last 50 years has created huge incentives to develop financial innovation, to exercise greed, and to benefit from speculation.  And, in the frenzy, things got out-of-control.

That is where we are today.  The haircuts that are now necessary are large and if something is not done about them soon, the haircuts will get even larger!  What if the write-down on Greek bonds were 90 percent?  What if the write-down on the bonds of Italy were 50 percent?  Portugal…60 percent? Spain…?  And, France…?

Over the last fifty years or so, people in the United States, the UK, and Western Europe have been living pretty well.  They can live well again.  But, we need to get away from Keynesian policies that promise something for nothing and return to some fundamentals that have played well over the years.

This time is not different!  Discipline and integrity are winners and have always been winners.  But, in a state of chaos, returning to discipline and integrity is difficult and painful.  The historical lesson, however, is that if people do not return to a condition of discipline and integrity the pain and suffering does not end…and in many cases it will only get worse!   

Are There Bubbles All Around?

One thing we learned in the 1990s and the 2000s is that there can be asset bubbles in the economy without growth in either money stock variables or increases in consumer (flow expenditure) price inflation. The financial system seems to be flexible enough so that it can leverage up where it wants to even though monetary policy and consumer spending seem to be “in control”. This is the lesson of modern “financial engineering.”

However, the monetary statistics are not benign for most of the time period from January 1961 up to September 2008. During this time period, the monetary base which is supposedly under the control of the Federal Reserve System rose at a compound annual rate of slightly more than 6%. Total credit during this time period rose much more rapidly. Consequently, the United States experienced a period if “credit inflation” that dominated everything going on during this 47 years or so. This secular inflation drove the financial innovation that took place as the whole financial system took on more-and-more leverage and more-and-more risk.

Since September 2008, the Federal Reserve has caused the Monetary Base to increase explosively by more than 130%. However, the banking system is not lending and much of these funds seem to have ended up on the balance sheets of the banking system. Excess reserves in the banking system went from about $2 billion in August 2008 to almost $1.2 trillion in February 2010. Excess reserves for September 2010 averaged slightly below $1 trillion.

Even with all of these excess reserves, the current concern is whether or not the economy will go into a period where prices actually decline. That is, might the United States be headed for a period of deflation?

Everything mentioned above is true. Yet, there is more going on in the economy than just what we see here. In some areas, a lot is going on and in these areas we are seeing lots of upward price movement which leads one to ask whether or not these price movements are bubbles or indications of something else taking place. Certainly, the “bubbles” are not increasing employment, or capacity utilization, or getting the economy going again.

I have written about this before: “Where the Action is: The Bond Market”, http://seekingalpha.com/article/230048-where-the-action-is-the-bond-market. I wrote in this post:

“There is a lot of money in the financial markets…in the shadow banking system…and worldwide.
Where is the action taking place?
Well, for one, in the bond market. We have major companies issuing bonds at ridiculously low interest rates.”

Of course we know that government bond prices are inordinately high causing yields to be excessively low. But, this is also true in the market for high-grade corporate debt and for junk bonds. One could certainly argue that there might be “asset bubble” in the bond markets.

Thank you shadow banking system!

And, the cash continues to build up on the balance sheets of “healthy” large corporations. It also appears as if many hedge funds and private equity funds are attracting “large bunches” of new money.

But, capital is almost perfectly mobile in the modern world: it can escape almost everywhere.

Because of this, writers like Martin Wolf have argued that one of the goals of American leadership is to “inflate the world” in order to get United States economic growth going again.

So, are we seeing the results of this?

Well, we might be seeing this flow of capital going into world commodity markets and also into emerging markets. There is the possibility that bubbles may be occurring here.
The movement in commodities seems to be worldwide but repercussions are being felt domestically in the United States. (See “Dilemma Over Pricing: From Cereal to Helicopters, Commodity Costs Exert Pressure”, http://professional.wsj.com/article/SB10001424052702304741404575564400940917746.html?mod=ITP_marketplace_0&mg=reno-wsj.) This article indicates that, year-over-year, corn prices are up by 34%, wheat prices are up 34%, milk is up 32%, copper is up 30%, and oil is up 14%. It is also the case that sugar is up about 50% year-over-year.

The question many companies are facing is, “How can we raise prices to cover these costs when the economy is so weak?” A real dilemma!

Funds are also flowing into emerging markets. All one has to do is watch the stock exchanges in those countries. And, all indications are that large companies are looking to locate in many of these markets or acquire firms in these markets. We are also seeing the hedge funds and private equity funds looking in this direction. (See for example, “Buy-outs set to divide private equity”, http://www.ft.com/cms/s/0/726ce11e-dc6d-11df-a0b9-00144feabdc0.html.)

In a world where there is a fluid movement of capital, money is not going to stay at home if the home economy is not strong, structurally. The American economy is having major problems in its economy. Why would “big” money want to invest here? (See, for example, “Globalized Finance: Advantage China”, http://seekingalpha.com/article/229600-globalized-finance-advantage-china.)

The Federal Reserve, and the federal government, may need to change their economic models to include the fact that organizations other than domestically chartered commercial banks can create credit and can cause bubbles to occur anywhere in the world where an opportunity exists.

Modern finance with internationally mobile capital does not seem to exist in the models the leaders of the United States are using. This is one reason for my skepticism of all the new financial reform systems that are being constructed. (See my post “Banking at the Speed of Light”, http://seekingalpha.com/article/208513-banking-at-the-speed-of-light.) Money is becoming more and more fluid and hence less and less controllable.

The American banking system may currently be dormant, but there seems to be plenty of money and plenty of action, elsewhere.

Yes, there are bubbles all around.

The State of the Bailout

Treasury Secretary Paulson gave a press conference yesterday and indicated that things had changed…that the focus of the bailout effort would not be on the purchase of ‘toxic assets’ but would be aimed to assist the capital needs of financial institutions and consumer finance. This ‘shift’ in focus has been duly noted by the press.

Is the ‘bailout’ program having any success?

To answer this question, I am roughly in the same spot of someone I heard being interviewed on Marketplace on NPR radio: the ‘expert’ was asked the following question “Has the efforts to add liquidity to financial markets and financial institutions shown any results to date?” His reply: “I think things are better than they would have been if the efforts had not been made.”

Does that give you a lot of confidence?

I just don’t think that at this time anyone can say more. We are in the middle of a situation that no one present has ever been through. Fed Chairman Ben Bernanke, an expert on the Great Depression, has seen to it that financial markets and financial institutions have been flooded with liquidity. From the banking week ending September 10, 2008, Reserve Bank Credit has risen from about $890 billion to $2.1 trillion in the banking week ending November 5, 2008. This is roughly a 210% increase in a matter of 8 weeks. (Dare I remind you that it took 94 years for the total of Reserve Bank Credit to reach just $890 billion and only eight weeks to add $1,167 billion more!)

The $700 billion bailout bill…is now turning into a provision of capital for financial institutions…a provision that the Treasury hopes will buy time for institutions to work out their bad asset problems. The unknown question here is whether or not $700 billion is enough or will Congress have to float more funds.

The underlying rationale for the provision of all this liquidity is that either (1) officials are going to be blamed for allowing another MAJOR economic bust to take place or (2) these officials are going to have a problem cleaning up for all the liquidity that they have supplied to the financial markets on such short notice. Success, in the eyes of the officials means that they will have to clean up all the liquidity once the financial markets begin working again. Failure…”is not an option.”

No one knows at this time what is going to happen…

The idea is to keep tossing more and more liquidity into the pot until financial institutions feel that enough is enough! No one has been here before! This is all new!

Your guess is as good as mine…

And then there is the need for fiscal stimulus. The Congress is going to consider a stimulus package which seems to be similar to the first stimulus package they passed earlier this year. It will be aimed at consumers and, although it may not be any more effective than the first package, it can be done quickly, and it will show that the Congress IS doing something AND any little stimulus to the economy will be appreciated.

But, a second stimulus bill is being talked up. This one would be more capital intensive and aim at real projects like projects to rebuild the United States infrastructure. The idea here is that consumers are not going to start spending much until their job security is enhanced and they are sure that they will hold onto their homes. Businesses are going to have to restructure their balance sheets and have some confidence that consumers are going to start spending again before they loosen their purse strings and begin to invest in capital projects again. We seem to be a long way from either of these so the argument goes that the Government needs to engage in some real “Keynesian” pump-priming. The problem with a Government expenditure program like this is that it takes time to prepare and then, once the bill is passed, it takes time for the projects to be implemented. So, help does not come quickly.

And, what about the stock markets? When are they going to come back? Well, we hear all the time that the price an investor is willing to pay for a stock is dependent upon future cash flows. Right now, market expectations concerning future cash flows are pretty depressed and uncertain. Investors must be able to sense a turnaround in future cash flows for them to develop any confidence to begin purchasing stocks. And, investors don’t really know the value of the assets on the books of a large number of companies. To me, a good argument can still be made for more asset charge offs, more bankruptcies, and more depressed forecasts of future cash flows. In my mind, we are not near the bottom here, particularly given the situation described above.

What about uncertainty?

There is lots of it. Much of the uncertainty pertains to the programs that will be coming out of the new administration and the leadership that is put into place by that administration. It is still a long way until January 20, 2009. The current administration has been reluctant to do anything in the past until it became absolutely necessary to do something about the financial markets and the economy. They still want to pass on as much of the decision making as possible to the newly elected administration. So, we are still in a limbo as far as the national leadership is concerned.

What about the international situation and international leadership?

Also an unknown. People are talking about a new Bretton Woods…the international financial structure set up after the second world war. First off, that conference had two years of preparation and negotiation before the meeting was held. There has basically been little or no preparation for the meetings to take place this weekend. Second, the first Bretton Woods conference had seasoned world leadership behind it. That is not the case at the current time. Third, there is almost no intellectual consensus concerning the cause of the current situation and what should be done about it. Fourth, the world is still going through a economic downturn with more countries declaring every week that they are now in a recession.

International coordination and cooperation are going to have to be vital components of the world economic and financial markets in the future but for right now, I don’t think that we can expect much concrete to be forthcoming from the world community.

So, in my view, we will continue to see a downward drift to stock markets with a substantial amount of volatility. What else is new?

For bond markets, United States government securities are going to continue to be the pick for risk-averse investors and spreads will continue to rise between the least risky debt and that considered to be more risky. I saw that the spread between Baa corporate bonds and Aaa corporate bonds exceeded 300 basis points last week. For even lesser credits the spread has been increasing at an almost exponential rate. If there is any indication that the credit crisis is NOT over, it can be picked up from the market place.

The only thing that seems to be positive news at this time is that the Bush plan to get the price of oil below $60 a barrel has been tremendously successful so far!