Banking on Banks

So was it a structural problem, or just a liquidity problem?

Around the world big banks are paying back the government aid that they received during the height of the financial crisis of 2008. The latest bank to formulate an exit plan is Dexia Bank, Belgium’s largest financial conglomerate. In 2008 the financial giant received billions in support from the European Central Bank.

Late last week the bank announced that it would be selling a number of business lines and investment assets in a strategy designed to raise capital and allow it to pay back the ECB ahead of schedule. They want to get off the government dole and begin to pay out dividends like the big regional banks over here. It’s hard to justify paying dividends to shareholders when you still haven’t paid taxpayers back—hence the accelerated plan.

Ironically, this arrangement will result in a short-term loss, but the shares traded up anyway, perhaps because of the prospect for increased payouts to shareholders in the not-so-distant future. Dexia is big in Europe; it’s every bit as significant as Wells Fargo or Bank of America.

I’ve argued before that most of the banks in the US were fine, and only a few major institutions like Fannie or AIG needed the government’s extraordinary help during the crisis. With Europe’s biggest recipient exiting the program early, that thesis just got stronger.

Douglas R. Tengdin, CFA
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The End of the World (As We Know It)?

Once again the world hasn’t ended.

Since you’re reading this, you’re aware that the world didn’t come to an end as predicted by Harold Camping some half-dozen times or so. But clearly, he’s not the first person to predict the End—just the most recent. Unshaven men with sandwich boards declaring “The End is Near,” were a staple of editorial cartoons of the ‘50s and ‘60s. And “millenarian thinking”—the believe that the world-order will be turned upside-down and a new, golden age will appear—has been with us for thousands of years.

Apocalyptic predictions aren’t just for the religious: Marx predicted that a secular millennium would arise from the Communist Revolution; Y2K and UFO Religions offer a technological doomsday. And there are aspects of environmental apocalypticism in the global warming forecasts that are out there. There’s something deep inside us that expects calamity.

I’ve noticed, however, that these predictions seem to proliferate around times of modest prosperity. During the Crash of ’08 we weren’t reading about the end of the world—we were seeing it, at least the end of the financial world as we had known it. The Heaven’s Gate group committed suicide in 1997, when the economy was fairly good. William Miller and the Seventh Day Adventists got their start in the 1830s, a time of tremendous expansion in the US.

So I’m actually encouraged by these prophecies of the end. It often means that things are getting better. And if the end does come, we probably won’t be looking for it.

Douglas R. Tengdin, CFA
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Of Words and Waterfalls

She’s baaaack.

Not content to listen to the commentary that suggests that she doesn’t know what she’s talking about, Meredith Whitney is on the interview circuit again defending her assertion that there will be hundreds of muni defaults this year totaling hundreds of billions of dollars.

Only this time she’s redefining what the word "default" means. Usually it means that a party to a contract doesn’t pay what is owed. But Meredith is using the word in a more elastic manner. In a Wall Street Journal op-ed, she notes that state taxpayers have seen "defaults" through higher taxes and lower benefits. Municipal employees will see "defaults" when their contracts are renegotiated. And these will precede cash defaults to bondholders.

Obviously she has a different understanding of what the word "is" is. Her argument is reminiscent of Humpty Dumpty, who declares in "Through the Looking Glass" that a word means whatever he wants it to mean. But Humpty Dumpty analysis is sloppy analysis. You can’t change a word’s meaning just because you got careless on TV.

Meredith’s basic thesis is that cutbacks on the Federal level will stress State finances which will waterfall down to put pressure on local communities. It’s not a bad thesis, but she takes it too far. States and towns have lots of options, and we’re not facing Armageddon. Too bad Meredith can’t just say she goofed.

Douglas R. Tengdin, CFA
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Of Words and Waterfdalls (Part 3)

So why should we care about Greece?

To borrow a phrase, it’s the banks, stupid. Greek debt is held by a variety of European banks. Most of those banks—the public ones—are subject to mark-to-market accounting rules. So they’re already had to write down their Greek debt by 30-50%; their Irish bonds by 20-30%, and Portugese debt by 30-40%. So publicly traded banks like Deutsche Bank or BNP Paribas or Banco Bilbao have already taken a hit to their capital.

But government owned banks like the Landesbanks in Germany or the Cajas in Spain haven’t had to charge off their debt. And if they do, that could lead to a capital squeeze in Europe similar to the way that the sub-prime fiasco led to bank failures and tighter credit over here. It’s hard to get a loan to start a small business, here, in part because the banks are under pressure from the regulators to increase their capital standards, just at a time when the economy needs more small business loans.

A capital shortage in Europe would hurt, because the European economy is almost as big as the US economy. Also, a lot of their growth over the last decade has come from gains due to increased trade. The vast majority of international trade is done with neighboring states. If the Euro fails—or looks like it might—those trade gains could reverse, leading to a new round of Euro-sclerosis.

Greece matters because European banks matter. And European banks matter because Europe matters. So while Greece may seem to be a lightweight, it punches above its weight.

Douglas R. Tengdin, CFA
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The Reluctant Hegemon

What’s up with Germany these days?

With the Greek bailouts, they’ve conspicuously said that they don’t want to lead the Euro-zone, they just want everyone else to follow the rules. But Germany is the undisputed kingpin of continental Europe. They have the largest economy, largest population, and largest trade surplus. Since German manufacturers compete on quality, not on price, a stronger Euro doesn’t hurt their exports all that much.

Germany has become the indispensible nation. No solution to the European debt crisis is possible without their assent, or without their input. That’s one of the ironic twists of the Strauss-Kahn fiasco: the Frenchman had excellent communications with both the Greek and German leaders.

But Germany doesn’t like being indispensible. It means that they’re always wrong. In foreign policy, if they’re aggressive they’re establishing a Fourth Reich; when they abstained in the Libyan vote they were accused of being pacifists. Because Angela Merkel insisted on institution of austerity programs in Greece, Ireland, and Portugal before pledging hundreds of billions towards a bailout , it is German meanness, not generosity, that is noted.

If a populist figure arises in Germany who could exploit the public’s resentment of its involuntary leadership, Germany could pull back from full engagement. But that doesn’t seem likely right now. Instead, we have a Germany that must choose—between provincialism and a global role.

Douglas R. Tengdin, CFA
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Potholes on the Road (Part 2)

What else can go wrong? The economy seems to be chugging along, albeit at a modest pace. Is there something out there that could knock it off track?

One possibility is higher interest rates. Rates are at rock-bottom levels. Cash yields nothing. Short bonds yield almost nothing. To get a government bond yield equal to the average inflation rate of the last 10 years, you have to buy bonds that don’t mature for seven years—until 2018. To buy tax-exempt bonds that keep up with inflation, you have to go out 10 years.

These rates that punish savers make capital cheaper for borrowers. Top rated corporations can borrow 3-year money at 1% and can issue 30-year bonds at 5.5%. That makes it really, really easy to raise cash for new projects. That’s the theory behind the Fed’s ultra-low rates. But it also makes it easy to speculate, which may be one reason we’ve seen gold and silver prices zoom up and crash down. Oil has done the same thing. Lower rates may be having an impact on volatility.

So as the economy comes out of the doldrums the Fed is likely to bring rates back up to a normal level. If inflation is running at 2%, short rates should be there as well. Medium rates should be at 3%, and 10-year Treasuries at 4%. But this could depress stock prices. For one thing, if government bonds yield 3.5%, on average, they compete much more effectively with dividend-paying stocks. For another, they raise the cost of capital for corporations—by about 1.5%, on average. That may not seem like much, but it matters on the margin.

Higher rates might not derail the market, but they could take some steam out of the engine. Just one more factor to watch out for.

Douglas R. Tengdin, CFA
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What is Normal? (Part 2)

The stock market has been strong, earnings have been growing, but a commodity price surge threatens to derail consumer spending. What’s normal for the stock market during a recovery?

To look at historical averages, the first year of a recovery the market rises 30-40%, the second year 10-15%, the third year 5-10% and the fourth year stocks struggle.

The first year of this recovery the market roared, rocketing 60%. We need to think back to those times, though. In 2009 there were serious fears of a depression. Once those concerns had been allayed through TARP, stress-testing, and stimulus spending the market returned to recessionary levels about 25% higher.

So the first year’s return from these normalized levels was about 35%, right in line with historical averages. The second twelve months we saw a 16% return. So far in the third year the market has gone up another 4%, suggesting that historical patterns may continue. Interest rates are rising around the world (albeit slowly), profit margins are near their all-time highs, and economic growth is decelerating.

This suggests that while the bull may have further to run, its best returns may be behind it. There may be reasons that this cycle breaks the pattern, but we should keep a sharp eye out. Bulls are strong, but they don’t live forever.

Douglas R. Tengdin, CFA
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Potholes on the Road (Part 1)

What could disrupt the global economy?

The economy has grown for seven consecutive quarters, and any future downturn seems remote. Leading indicators are trending higher. But portfolios don’t prosper via complacency. It’s worthwhile to look at what might a problem.

What worries me is trade. Not current trade. Our exports and imports have been growing quite well, and global trade volumes have been accelerating. What seems to be difficult now is the political calculus around trade.

The math is straightforward: David Ricardo demonstrated the Law of Relative Advantage almost 300 years ago: when people do what they do best, the total economic pie grows, apart from education, technology, or population growth. This truth has been at the foundation of global economic prosperity since the Marshall Plan. US idealism and economic hegemony benefitted the world.

But there seems to be a chilling in the political atmosphere around trade. There are fears that if the Chinese invest too much in the US they will somehow "own" America; criminal charges against the IMF head in New York have elevated the fortunes of the nativist National Front party in France; elsewhere in Europe the sovereign debt crisis threatens the unified Euro zone. And xenophobia doesn’t need help: people are always afraid that immigration will take their jobs.

If trade decreases and barriers to free exchange multiply, global growth will slow. That won’t be good for anyone. We need to keep a close eye on anti-trade political movements. If they gain serious traction, watch out.

Douglas R. Tengdin, CFA
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What is “Normal”?

A prominent investment manager has been either celebrated or condemned (depending on your point-of-view) for trumpeting of a "new normal" of lower growth, higher inflation, and higher unemployment. Is this justified?

Exhibit A in the evidence for a new normal has been the slow recovery. Almost 9 million jobs were lost in the recession; only a million have been recovered. By this point in every prior post-war recession, jobs had surpassed their previous high point. Advocates of government intervention suggest that we could be doing better if we’d only been willing to spend more.

But that ignores the nature of the recent downturn. Growing economies may all be alike, but each recession is unhappy in its own way. In the first place, by being centered on real estate this recession did a lot of damage to the credit system, which still hasn’t healed. It’s not just the banks; a system of asset-backed bonds, bond insurance, and distribution to a wide swath of institutional investors has been disrupted. As a result, the funds just aren’t available to finance business creation or expansion.

Second, regulatory concerns are inhibiting the recovery of the financial sector. The regulators largely missed this one, and so like generals fighting the last war, they are bent on preventing a repeat of the latest disaster. Banking and securities regulators are tightening their standards, just when the economy might need more slack.

Finally, the decline was so massive that massive infusions of government cash and credit were needed to stabilize the system. Some of that help was misguided, easing the short-term pain rather than laying the groundwork for long-term growth. Still, the spending had to be borrowed, at the cost of a major increase in the government’s total debt burden. The debt level has restrained further growth in government spending, which has been supporting employment by local governments.

None of these factors is permanent. Productivity is still growing at 2%; population at 1%. That means that potential GDP is up 3% per year. Once we get past the credit crunch, there’s no reason solid growth can’t resume again.

Douglas R. Tengdin, CFA
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Central Casting

Central banking is fun. That’s why everyone wants to do it.

Ha. Not really. Bernanke’s press conference was a tour-de-force, and not just because he said “Hi” to his mother at the end. Bernanke is a stable, capable spokesman who can give a speech or field a question without batting an eye. He learned early on from a stray comment he made to a financial journalist that “loose lips” can sink markets. Through a combination of self-discipline and rigorous rehearsal, he carried off his historic press conference without a hitch.

At first I questioned whether this was such a good thing. After all, what if we have someone less stable in the driver’s seat? But we just have to put “manages press conferences” into the job description. There are certainly competent, capable adults out there who are financially literate and can take questions without blowing up the markets. If the Europeans can do it—and they have for years—there’s no reason why the Fed can’t.

The ECB will soon be selecting a new leader, and for the most part they have been an institution carved out of the Bundesbank mold: stable, solid, boring. Recently, their currency fell because of what Mr. Trichet didn’t say: he left out the “super-extra-vigilent” language and the Euro fell precipitously. What you don’t say can matter as much as what you do.

Currently, the favorite to be the next ECB president is Mario Draghi of Italy. Apparently, the European leaders don’t want a German to head up the agency. Just so long as he can speak well.

Douglas R. Tengdin, CFA
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