4/3/16: Can Cryan halt Deutsche Bank's decline? Euromoney

Recently, I wrote about the multiple problems faced by the Deutsche Bank (see post here http://trueeconomics.blogspot.com/2016/02/12216-deutsche-bank-crystallising.html).

Subsequently, Euromoney published a well-researched and wide-ranging article on the same subjects that is also worth reading, even though there are quite significant overlaps with my earlier post: http://www.euromoney.com/Article/3534126/Can-Cryan-halt-Deutsche-Banks-decline.html?single=true.

12/2/16: Deutsche Bank: Crystallising Europe’s TBTF Problems

This week was quite a tumultuous one for banks, and especially Europe’s champion of the ‘best in class’ TBTF institutions, Deutsche Bank. Here’s what happened in a nutshell.

Deutsche’s 6 percent perpetual bonds, CoCos (more on this below), with expected maturity in 2022, used to yield around 7 percent back in January. Having announced massive losses for fiscal year 2015 (first time full year losses were posted by the DB since 2008), Deutsche was under pressure in the equity markets. Rather gradual sell-off of shares in the bank from the start of 2015 was slowly, but noticeably eroding bank’s equity risk cushion. So markets started to get nervous of the second tier of ‘capital’ held by the bank - second in terms of priority of it being bailed in in the case of an adverse shock. This second tier is known as AT1 and it includes those CoCos.

Yields on CoCos rose and their value (price) fell. This further reduced Deutsche’s capital cushion and, more materially, triggered concerns that Deutsche will not be calling in 2022 bonds on time, thus rolling them over into longer maturity. Again, this increased losses on the bonds. These losses were further compounded by the market concerns that due to a host of legal and profit margins problems, Deutsche can suspend payments on CoCos coupons, if not in 2016, then in 2017 (again, more details on this below). Which meant that in markets view, shorter-term 2022 CoCos were at a risk of being converted into a longer-dated and zero coupon instrument. End of the game was: Coco’s prices fell from 93 cents to the Euro at the beginning of January, to 71-72 cents on the Euro on Monday this week.

When prices fall as much as Deutsche’s CoCos, investors panic and run for exit. Alas, dumping CoCos into the markets became a problem, exposing liquidity risks imbedded into CoCos structure. There are two reasons for the liquidity risk here: one is general market aversion to these instruments (a reversal of preferences yield-chasing strategies had for them before); and lack of market makers in CoCos (thin markets) because banks don’t like dealing in distressed assets of other banks. Worse, Asian markets were largely shut this week, limiting potential pool of buyers.

Spooked by shrinking valuations and falling liquidity of the Deutsche’s AT1 instruments, investors rushed into buying insurance against Deutsche’s default on senior bonds - the Credit Default Swaps or CDS. This propelled Deutsche’s CDS to their highest levels since the Global Financial Crisis. Deutsche’s CDS shot straight up and with their prices rising, implied probability of Deutsche’s default went through the roof, compounding markets panic.


Summing Up the Mess: Three Pillars of European Risks

Deutsche Bank AG is a massive, repeat - massive - banking behemoth. And the beast is in trouble.

Let’s do some numbers first. Take a rather technical test of systemic risk exposures by the banks, run by NYU Stern VLab. First number of interest: Systemic Risk calculation - the value of bank equity at risk in a case of systemic crisis (basically - a metric of how much losses a bank can generate to its equity holders under a systemic risk scenario).

Deutsche clocks USD91.623 billion hole relating to estimated capital shortfall after the existent capital cushion is exhausted. A wallop that is the third largest in the world and accounts for 7.23% of the entire global banking system losses in a systemic crisis.

Now, for volatility that Deutsche can transmit to the markets were things to go pear shaped. How much of a daily drop in equity value of the Deutsche will occur if the aggregate market falls more than 2%. The metric for this is called Marginal Expected Shortfall or MES and Deutsche clocks in respectable 4.59, ranking it 8th in the world by impact. In a sense, MSE is a ‘tail event’ beta - stock beta for times of significant markets distress.

How closely does Deutsche move with the market over time, without focusing just on periods of significant markets turmoil? That would be bank’s beta, which is the covariance of its stock returns with the market return divided by variance of the market return. Deutsche’s beta is 1.61, which is high - it is 7th highest in the world and fourth highest amongst larger banks and financial institutions, and it basically means that for 1% move in the market, on average, Deutsche moves 1.6%.

But worse: Deutsche leverage is extreme. Save for Dexia and Banca Monte dei Paschi di Siena SpA, the two patently sick entities (one in a shutdown mode another hooked to a respirator), Deutsche is top of charts with leverage of 79.5:1.

Incidentally, this week, Deutsche credit risk surpassed that of another Italian behemoth, UniCredit:

So Deutsche is loaded with the worst form of disease - leverage and it is caused by the worst sort of underlying assets: the impenetrable derivatives (see below on that).


Overall, Deutsche problems can be divided into 3 categories:

1. Legal
2. Capital, and
3. Leverage and quality of assets.

These problems plague all European TBTF banks ever since the onset of the Global Financial Crisis. The legacy of horrific misspelling of products, mis-pricing of risks and markets distortions by which European banks stand is contrasted by the rhetoric emanating from European regulators about ‘reforms’, ‘repairs’ and ‘renewed regulatory vigilance’ in the sector. In truth, as Deutsche’s saga shows, capital buffers fixes, applied by European regulators, have yielded nothing more than an attempt to powder over the miasma of complex, derivatives-laden asset books and equally complex, risk-obscuring structure of new capital buffers. It also highlights just how big of a legal mess European banks are, courtesy of decades of their maltreatment of their clients and markets participants.

So let’s start churning through them one-by-one.


The Saudi Arabia of Legal Problems

Deutsche has been slow to wake up and smell the roses on all various legal settlements other banks signed up to in years past. Deutsche has settled or paid fines of some USD9.3 billion to-date (from the start of the Global Financial Crisis in 2008), covering:

• Charges of violations of the U.S. sanctions;
• Interest rates fixing charges; and
• Mortgages-Backed Securities (alleged) fraud with respect to the U.S. state-sponsored lenders: Fannie Mae and Freddie Mac.

And at the end of 2015, Deutsche has provided a set-aside funding for settling more of the same, to the tune of USD6 billion. So far, it faces:

1. U.S. probe into Mortgages-Backed Securities it wrote and sold pre-crisis. If one goes by the Deutsche peers, the USD15.3 billion paid and set aside to-date is not going to be enough. For example, JP Morgan total cost of all settlements in the U.S. alone is in excess of USD23 billion. But Deutsche is a legal basket case compared to JPM-Chase. JPM, Bank of America and Citigroup paid around USD36 billion on their joint end. In January 2016, Goldman Sachs reached an agreement (in principle) with DofJustice to pay USD5.1 billion for same. Just this week (http://www.businessinsider.com/morgan-stanley-mortgage-backed-securities-settlement-2016-2) Morgan Stanley agreed to pay USD3.2 billion on the RMBS case. Some more details on this here: http://www.reuters.com/article/us-deutsche-bank-lawsuit-idUSKCN0VC2NY.
2. Probes into currency manipulations and collusion on its trading desk (DB is the biggest global currency trader that is yet to settle with the U.S. DoJustice. In currency markets rigging settlement earlier, JPMorgan, Citicorp and four other financial institutions paid USD5.8 billion and entered guilty pleas already.
3. Related to currency manipulations probe, DB is defending itself (along with 16 other financial institutions) in a massive law suit by pension funds and other investors. Deutsche says ‘nothing happened’. Nine out of the remaining 15 institutions are pushing to settle the civil suit for (at their end of things) USD2 billion. Keep in mind of all civil suit defendants - Deutsche is by far the largest dealer in currency markets.
4. Probes in the U.S. and UK on its alleged or suspected role in channeling some USD10 billion of Russian money into the West;
5. Worse, UK regulators are having a close watch on Deutsche Bank - in 2014, they placed it on the their "enhanced supervision" list, reserved for banks that have either gone through a systemic failure or are at a risk of such; a list that includes no other large banking institution on it, save for Deutsche.
6. This is hardly an end to the Deutsche woes. Currently, it is among a group of financial institutions under the U.S. investigation into trading in the U.S. Treasury market, carried out by the Justice Department. 
7. The bank is also under inquiries covering alleged fixings of precious metals benchmarks.
8. The bank is even facing some legal problems relating to its operations (in particular hiring practices) in Asia. And it is facing some trading-related legal challenges across a number of smaller markets, as exemplified by a recent case in Korea (http://business.asiaone.com/news/deutsche-bank-trader-sentenced-jail).

You really can’t make a case any stronger: Deutsche is a walking legal nightmare with unknown potential downside when it comes to legal charges, costs and settlements. More importantly, however, it is a legal nightmare not because regulators are becoming too zealous, but because, like other European banks, adjusting for its size, it has its paws in virtually every market-fixing scandal. The history of European banking to-date should teach us one lesson and one lesson only: in Europe, honest, functioning and efficient markets have been seconded to manipulated, dominated by TBTF institutions and outright rigged structures more reminiscent of business environment of the Italian South, than of Nordic ‘regulatory havens’.

CoCo Loco

CoCos, Contingent Convertible Capital Instruments, are a hybrid form of capital instruments that are designed and structured to absorb losses in times of stress by automatically converting into equity should a bank experience a decline in its capital ratios below a certain threshold. Because they are a form of convertible debt, they are counted as Tier 1 capital instrument ‘additional’ Tier 1 instruments or AT1.

CoCos are also perpetual bonds with no set maturity date. Banks can be redeemed them on option, usually after 5 years, but banks can also be prevented by the regulators from doing so. The expectation that banks will redeem these bonds creates expectation of their maturity for investors and this expectation is driven by the fact that CoCos are more expensive to issue for the banks, creating an incentive for them to redeem these instruments. European banks love CoCos, in contrast to the U.S. banks that issue preferred shares as their Tier 1 capital boosters, because Europeans simply love debt. Debt in any form. It gives banks funding without giving it a headache of accounting to larger pools of equity holders, and it gives them priority over other liabilities. AT1 is loved by European regulators, because it sits right below T1 (Tier 1) and provides more safety to senior bondholders on whose shoulders the entire scheme of European Ponzi finance (using Minsky’s terminology) rests.

In recent years, Deutsche, alongside other banks was raising capital. Last year, Credit Suisse, went to the markets to raise some CHF6 billion (USD6.1 billion), Standard Chartered Plc raised about $5.1 billion. Bank of America got USD5 billion from Warren Buffett in August 2014. So in May 2014, Deutsche was raising money, USD 1.5 billion worth, for the second time (it tapped markets in 2013 too). The fad of the day was to issue CoCos - Tier 1 securities, known as Contingent Convertible Bonds. All in, European banks have issued some EUR91 billion worth of this AT1 capital starting from 2013 on.

Things were hot in the markets then. Enticed by a 6% original coupon, investors gobbled up these CoCos to the tune of EUR3.5 billion (the issue cover was actually EUR25 billion, so the CoCos were in a roaring demand). Not surprising: in the world of low interest rates, say thanks to the Central Banks, banks were driving investors to take more and more risk in order to get paid.

There was, as always there is, a pesky little wrinkle. CoCos are convertible to equity (bad news in the case of a bank running into trouble), but they are also carrying a little clause in their prospectus. Under Compulsory Cancelation of Interest heading, paragraphs (a) and (b) of Prospectus imposed deferral of interest payments on CoCos whenever CoCos payment of interest “together with any additional Distributions… that are simultaneously planned or made or that have been made by the issuer on the other Tier 1 instruments… would exceed the Available Distributable Items…” and/or “if and to the extent that the competent supervisory authority orders that all or part of the relevant payment of interest be cancelled…”

That is Prospectus-Speak for saying that CoCos can suspend interest payments per clauses, before the capital adequacy problems arise. The risks of such an event are not covered by Credit Default Swaps (CDS) which cover default risk for senior bonds.

The reason for this clause is that European regulators impose on the banks what is known as CRD (Combined Buffer Requirement and Maximum Distributable Amount) limits: If the bank total buffers fall below the Combined Buffer Requirement, then CoCos and other similar instruments do not pay in full. That is normal and the risk of this should be fully priced in all banks’ CoCos. But for Deutsche, there is also a German legal requirement to impose an additional break on bank’s capital buffers depletion: a link between specified account (Available Distributable Items) balance and CoCos pay-out suspension. This ADI account condition is even more restrictive than what is allowed under CRD.

This week, DB said they have some EUR1 billion available in 2016 to pay on EUR350 million interest coupon due per CoCos (due date in April). But few are listening to DB’s pleas - CoCos were trading at around 75 cents in the euro mark this week. The problem is that the markets are panicked not just by the prospect of the accounting-linked suspension of coupon payments, but also by the rising probability of non-redemption of CoCos in the near future - a problem plaguing all financials.

DB is at the forefront of these latter concerns, because of its legal problems and also because the bank is attempting to reshape its own business (the former problem covered above, the latter relates to the discussion below). DB just announced a massive EUR6.8 billion net loss for 2015 which is not doing any good to alleviate concerns about it’s ability to continue funding coupon payments into 2017. Unknown legal costs exposure of DB mean that DB-estimated expected funding capacity of some EUR4.3 billion in 2017 available to cover AT1 payments is based on its rather conservative expectation for 2016 legal costs and rather rosy expectations for 2016 income, including the one-off income from the 2015-agreed sale of its Chinese bank holdings.

Earlier this week, Standard & Poor’s, cut DB’s capital ratings on “concerns that Germany’s biggest lender could report a loss that would restrict its ability to pay on the obligations”. S&P cut DB’s Tier 1 securities from BB- to B+ from BB- and slashed perpetual Tier 2 instruments from BB to BB-.

Beyond all of this mess, Deutsche is subject to the heightened uncertainty as to the requirements for capital buffers forward - something that European banks co-share. AT 1 stuff, as highlighted above, is one thing. But broader core Tier 1 ratio in 4Q 2015 was 11.1%, which is down on 11.5% in 4Q 2014. In its note cutting CoCos rating, S&P said that “The bank's final Tier 1 interest payment capacity for 2017 will depend on its actual net earnings in 2016 as well as movements in other reserves.” Which is like saying: “Look, things might work out just fine. But we have no visibility of how probable this outcome is.” Not assuring…

DB is also suffering the knock-on effect of the general gloom in the European debt markets. Based on Bloomberg data, high yield corporate bonds issuance in Europe is down some 78 percent in recent months, judging by underwriters fees. These woes relate to European banks outlook for 2016, which links to growth concerns, net interest margin concerns and quality of assets concerns.


Badsky Loansky: A Eurotown’s Bad Bear?

Equity and debt markets repricing of Deutsche paper is in line with a generally gloomy sentiment when it comes to European banks.

The core reason is that aided by the ECB’s QE, the banks have been slow cleaning their acts when it comes to bad loans and poor quality assets. European Banking Authority estimates that European banks hold some USD 1.12 trillion worth of bad loans on their books. These primarily relate to the pre-crisis lending. But, beyond this mountain of bad debt, we have no idea how many loans are marginal, including newly issued loans and rolled over credit. How much of the current credit pool is sustained by low interest rates and is only awaiting some adverse shock to send the whole system into a tailspin? Such a shock might be borrowers’ exposures to the US dollar credit, or it might be companies exposure to global growth environment, or it might be China unwinding, or all three. Not knowing is not helpful. Oil price collapse, for example, is hitting hard crude producers. Guess who were the banks’ favourite customers for jumbo-sized corporate loans in recent years (when oil was above USD50pb)? And guess why would any one be surprised that with global credit markets being in a turmoil, Deutsche’s fixed income (debt) business would be performing badly?

Deutsche and other european banks are caught in a dilemma. Low rates on loans and negative yields on Government bonds are hammering their profit margins (based on net interest margin - the difference between their lending rate and their cost of raising funds). Solution would be to raise rates on loans. But doing so risks sending into insolvency and default their marginal borrowers. Meanwhile, the pool of such marginal borrowers is expanding with every drop in oil prices and every adverse news from economic growth front. So the magic potion of QE is now delivering more toxicity to the system than good, and yet, the system requires the potion to flow on to sustain itself.

Again, this calls in Minsky: his Ponzi finance thesis that postulates that viability of leveraged financial system can only be sustained by rising capital valuations. When capital valuations stop growing faster than the cost of funding, the system collapses.

In part to address the market sentiment, Deutsche is talking about deploying the oldest trick in the book: buying out some of its liabilities - err… senior bonds (not CoCos) - at a discount in the markets to the tune of EUR5 billion across two programmes. If it does, it will hit own liquidity in the short run, but it will also (probably or possibly) book a profit and improve its balance sheet in the longer term. The benefits are in the future, and the only dividend hoped-for today is a signalling value of a bank using cash to buy out debt. Which hinges on the return of the markets to some sort of the ‘normal’ (read: renewed optimism). Update: here's the latest on the subject via Bloomberg http://www.bloomberg.com/news/articles/2016-02-12/deutsche-bank-to-buy-back-5-4-billion-bonds-in-euros-dollars

Back to the performance to-date, however.

Deutsche Bank's share price literally fell off the cliff at the start of this week, falling 10 percent on Monday and hitting its lowest level since 1984.

On bank’s performance side, concerns are justified. As I noted earlier, Deutsche posted a massive EUR6.89 billion loss for the year, with EUR2 billion of this booked in 4Q alone. Compared to 2014, Deutsche ended 2015 with its core equity Tier 1 capital (the main buffer against shocks) down from EUR60 billion to EUR52 billion.

Still, panic selling pushed DB equity valuation to EUR19 billion, in effect implying that some 2/3rds of the book of its assets are impaired. Which is nonsense. Things might be not too good, but they aren’t that bad today. The real worry with assets side of the DB is not so much current performance, but forward outlook. And here we have little visibility, precisely because of the utterly abnormal conditions the banks are operating in, courtesy of the global economy and central banks.

So markets are exaggerating the risks, for now. Psychologically, this is just a case of panic.

But panic today might be a precursor to the future. More of a longer term concern is DB’s exposure to the opaque world of derivatives that left markets analysts a bit worried (to put things mildly). Deutsche has taken on some pretty complex derivative plays in recent years in order to offset some of its losses relating to legal troubles. These instruments can be quite sensitive to falling interest rates. Smelling the rat, current leadership attempted to reduce bank’s risk loads from derivatives trade, but at of the end of 2015, the bank still has an estimated EUR1.4 trillion exposure to these instruments. Only about a third of the DB’s balance sheet is held in German mortgages and corporate loans (relatively safer assets), with another third composed of derivatives and ‘other’ exposures (where ‘other’ really signals ‘we don’t quite feel like telling you’ rather than ‘alternative assets classes’). For these, the bank has some EUR215 billion worth of ‘officially’ liquid assets - a cushion that might look solid, but has not been tested in a sell-off.


In summary: 

Deutsche’s immediate problems are manageable and the bank will most likely pull out of the current mess, bruised, but alive. But the two horsemen of a financial apocalypse that became visible in the Deutsche’s performance in recent weeks are worrying:
1) We have a serious problem with leverage remaining in the system, underlying dubious quality of assets and capital held and non-transparent balance sheets when it comes to derivatives exposures; and
2) We have a massive problem of residual, unresolved issues arising from incomplete response to markets abuses that took place before, during and after the crisis.

And there are plenty potential triggers ahead to derail the whole system. Which means that whilst Deutsche is not Europe’s Lehman, it might become Europe’s Bear Sterns, unless some other TBTF preempts its run for the title… And there is no shortage of candidates in waiting…



Links: 
DB’s 2015 report presentation deck: https://www.db.com/ir/en/download/Deutsche_Bank_4Q2015_results.pdf
DB’s internal memo to employees on how “ok” things are: https://www.db.com/newsroom_news/2016/ghp/a-message-from-john-cryan-to-deutsche-bank-employees-0902-en-11392.htm

15/12/15: Europe’s Refugees Crisis: Some Economic Perspectives

In recent months, we have observed an ever-increasing cost estimates for Germany (and by a corollary Europe) of absorbing the 2015 inflows of refugees.

Central to these estimates have been numbers released by the Ifo Institute. These estimates started with the assumed inflows of 800,000 refugees in 2015 and were first pegged at EUR10 billion, “just to cover accommodation and food”. I covered these estimates earlier here: http://trueeconomics.blogspot.ie/2015/09/22915-germanys-ifo-refugees-to-cost-ten.html.

Subsequent estimates raised both the number of refugees (to 1,100,000) and the cost per refugee, raising the estimate to EUR21.1 billion (covered here: http://trueeconomics.blogspot.ie/2015/11/111115-new-cost-estimates-of-european.html) and per Ifo including “accommodation, food, creches, schools, German courses, training and administration” over 12 months.

In part, very high costs estimates are premised on the assumed ability of refugees to integrate into German labour markets (http://www.cesifo-group.de/ifoHome/presse/Pressemitteilungen/Pressemitteilungen-Archiv/2015/Q4/pm-20151204_Bildung_Fluechtlinge.html) due to lack of language skills, work skills and education. These assumptions - based on population averages and aggregate scores for key countries of origin for refugees - appear to be in line with German employers’ perception of refugees as generally lacking in key basic skills as noted here: http://www.cesifo-group.de/ifoHome/presse/Pressemitteilungen/Pressemitteilungen-Archiv/2015/Q4/press_20151126_sd22_fluechtlinge.html.

Taking Ifo Institute’s estimate of EUR19,000 in annual costs per refugee, and based on the EU Commission estimate that some 4 million Syrian refugees currently are in Turkey, Lebanon and Jordan, with some also in Egypt, Iraq and Libya, what are the chances that EU’s latest ‘aid’ to Turkey of a miserly EUR3 billion is going to be enough to address the problem?

If research also attempts to quantify cost/benefit assessment of the refugees inflows. In a more recent note (http://www.cesifo-group.de/cesifo/newsletter/1115/From_the_Editor_November_2015.html) the Institute states that “…Europe, with its ageing societies, needs new workers. Germany alone theoretically needs more than 30 million young immigrants until 2035 to keep the old-age dependency ratio constant at the current pensionable age, and maintain both the pension and contribution rates in its pay-as-you-go system unchanged. So, could the newcomers be the solution?”

The answer depends on which model one uses to estimate costs/benefits of inflows. “There have been different calculations about the benefit that refugees bring to the recipient countries. While a Keynesian model using a multiplier analysis until 2035 (!) comes to the conclusion that there are positive net benefits for the incumbent population, generational accounting models come up with frighteningly large loss estimates for the state, reaching between 79,000 and 450,000 euros per person in present value terms. This burden might well prove unsustainable if the number of immigrants continues unabated.” In other words, if you believe in a world where Government spending on anything (be it digging of ditches or building refugees shelter or hospitals) is a positive contributor to growth in the long run, things are just fine. If you believe that there can be misallocation of resources in investment and there can be inefficient transfers across generations as a result of multi annual policy commitments, things are pretty costly.

As usual, there is no agreement amongst the economists on the subject of economic impact of refugees. Which is not to warrant any statement about ethical and human dimension of how Europe should be addressing the crisis (economics, of course, is by far not the only consideration on this matter). But it is a good starting point (albeit a bit late for the current crisis) to have a debate as to the merits of different models for selecting refugees based on specific characteristics, such as prior work experiences, basic skills and education. It is also a good point to start thinking about how the balance between humanitarian assistance and development supports (in countries of origin) as well as social supports and workplace integration incentives in the host countries should/could be structured.

Ifo Institute position on the subject of host countries labour market and social supports structures is to stress the need for reducing minimum wage (Hartz IV) barriers to labour market entry. Without endorsing this view, here is an interesting link to a study that covered impacts of social welfare nets on entrepreneurship amongst migrants in the US, Canada and the UK (with Canadian experience being very interesting as Canadian model of highly selective migration filters is being advocated for Europe): http://trueeconomics.blogspot.ie/2010/02/economics-07022010-human-capital.html.

The refugees crisis of 2015 (and possibly 2016 and on) is testing European systems (labour markets, social welfare, capital structures etc) along the economic dimension. The debates and policy responses so badly needed today should have taken place years ago. Absent these, we are now staring at the possibility that this crisis will alter our political systems, while stressing our economic and social systems. A right response would, in my opinion, involve recognising first and foremost the humanitarian dimension of the crisis, while accelerating the process for developing long term economic responses.


Note: this post is a follow up on my appearance on Bloomberg Radio last morning discussing the topic of economic impact of the refugees crisis.

13/9/15: Some Insightful Links on European Refugees Crisis

There has been a lot written about the migration crisis or refugees crisis or whatever one might choose to call the crisis on European borders. I am not about to add to the continuously expanding literature on the subject (at least not yet).

But here are a couple of links / summary data tables worth checking out.

First, an excellent essay in the Foreign Policy showing the extent of discontinuity between the Central European self-interest-driven humanitarian values of the 1990s and the region's current attitude toward migration.

But then again, Eastern and Central Europe has been re-writing its own history at will, on one occasion after another, to suit one master or the other, one nationalist leader or the next... here's a good reminder from earlier this month from one side, and the same view from another, both valid (by the way).

So here's a table of facts on European attitudes toward refugees, so hard to re-shape to suit a particular political narrative:

There is a neat summary of key issues behind the current crisis in the Vox but for all the facts and all the good discussions, the Vox article just can't get itself around to one topic - the role of the U.S. in all of this (and the role of the U.S. allies), so for the sake of not re-writing history, here's an alternative angle on that too.

And for all the headlines about the current crisis being the worst in European history since WW2... there's this handy chart from Globe & Mail:

Source: http://www.theglobeandmail.com/news/world/europes-migrant-crisis-eight-reasons-its-not-what-youthink/article26194675/

Nor is the problem tied into Syrian crisis alone as the following chart from the same Globe & Mail article shows:

Which leads to the conclusion. And an unpleasant one. Either the Schengen is going to go bust... or we are going to hear - pretty soon - a call for yet another *Genuine* Union, this time around a Genuine Migration Union or a Genuine Borders Union, for any solution to all European crises must always involve greater harmonisation of something.

25/4/2013: IMF's 'End of Austerity' Napkin Sketch Is Soggy Wet

IMF catches up with 'End Austerity' bandwagon and overtakes the EU 'policymakers' in providing a general blueprint. From today's comments by IMF First Deputy Managing Director David Lipton (emphasis is mine):

"...Europe needs to act on several fronts. Countries will need to have clear and specific commitments to medium-term fiscal consolidation, with the appropriate pace to be evaluated on a case-by-case basis. Careful consideration should also be given to the composition of fiscal measures. The European Central Bank (ECB) should maintain its very accommodative stance, he said, but noted that eliminating financial fragmentation – whereby households and companies in some countries face clogged credit channels and lending rates well above those in the core – will probably require the ECB to implement some “additional unconventional measures.”

So the Fiscal Compact of 'One Policy Target & Timeframe Fit All' is out of the window then? If timeframe (pace) were to be set on a case-by-case basis, there is hardly any real discipline left. Here's why. Suppose Italy takes slower path to deflating debt levels to the target of 60% than that mandated by the Fiscal Compact (FC) (5% adjustment per annum). France, then, can demand either a slower pace for its drawdown of debt or it can opt to demand slower reductions in deficits. Which means Spain will also have its list of requests ready, all in breach of the FC.

"As we see it, countries that can afford to support the economy need to do so—but in ways that encourage the private sector to invest and boost demand..."

Ok, but what does it mean? AAA countries borrowing to stimulate? Suppose they succeed. What happens to growth rates and income levels in Euro area? Right - divergence will be amplified and with it, mismatch of monetary and FX policies too. 

Per paying attention to the composition of fiscal measures: it is a fine objective. Except in the case of European leaders, this means, usually, hiking taxes even more instead of cutting spending. IMF knows that this is counterproductive, but whilst correctly arguing that policies should be reflective of heterogeneity between member states' economies, IMF is incorrectly ignoring the political reality of Europe, where more spending = good, lower taxes = bad.

More: "Another country responsibility is better structural policies. Countries should press on to tackle long-standing rigidities in order to raise medium-term growth prospects. Southern Europe, and even some of the core, needs to increase its competitiveness in the tradeable goods sector, especially through labor and product market reforms. So far, much of the reduction in current account deficits has come because demand is sluggish.  For a stronger, sustained improvement -- enough to boost exports that will create jobs for the unemployed -- countries need a broader and more durable improvement in competitiveness, based on structural reform. In Northern Europe, even where national competitiveness is not the issue, reforms could help generate a more vibrant services sector."

Again, usual tool kit deployed by the IMF: structural reforms are needed (no real innovation as to what these might be) and exports must be increased (who will be buying these exports in the world where every country is being told by the IMF to increase its exports?).

I wonder why would Mr Lipton label ECB current stance as being accommodative. ECB interest rate is above G7 average and ECB's 'panacea' of OMT is yet to make any real purchases. ECB has attempted to sterilise all past 'accommodative' interventions and is now pleased with winding up LTROs. In brief, setting aside war-time rhetoric from the ECB, Frankfurt is accommodating very little.

One has to agree with the need to eliminate financial fragmentation, but IMF is fully aware that European system will have to continue deleveraging. There is too much debt in the pipeline to de-clog it by simply pushing through more credit at lower cost.

"...the Single Supervisory Mechanism [is] “a key step” and ...the IMF supports a market-based bail-in approach as being considered in the European Union Directive on Bank Recovery and Resolution, which would require banks to hold a minimum amount of securities with features that permit them to be written-off or converted to equity if capital buffers fall too low..."

So getting Cyprused is  the future for Europe, then.

Mr Lipton is dead on right, saying that "In our preoccupation with sovereign debt, we tend to overlook the huge overhang of private debt in some countries that could be a deadweight on demand and bank balance sheets for a long time. We’ve already seen the hit that households have taken in the periphery economies because of the sharp correction in home prices (e.g. Ireland). This could only worsen without renewed growth (e.g. Spain, Belgium and the Netherlands)." And more: "On the corporate side, we know how much the level of debt has increased over the past decade, particularly in the periphery. We elaborated on this development in our recent Global Financial Stability Report.  ...Measured on a debt-to-equity basis, a portion of Italy's corporate sector is rising into stressed levels. In the event of a prolonged stagnation, corporate profits would slacken further, putting pressure on companies to deleverage and increasing the risk of debt distress. Corporates are not being helped by bank retrenchment back into home markets. This is most pronounced from the periphery; French and German banks reduced their exposures to these markets by some 30-40 percent between mid 2011 and the third quarter of last year."

Conclusion (relevant to 'being Cyprused' above): "None of this bodes well for banks in a stagnation scenario. They are already weak. But higher levels of corporate and household defaults and credit losses would threaten a second round of bank balance sheet deterioration."

Net result: IMF has no new ideas on what to do if 'austerity' path were to be altered. There's a good reason as to why they don't - borrowing cash to burn it on Government spending (traditional European way) is out of question, given the risk of raising costs of borrowing, slow growth and higher interest bills that await. And using monetary policy to full extent is infeasible because IMF has no hope for ECB in its current state.

'Austerity' might be overdone, but 'Not Austerity' is unlikely to be any different...

25/3/2013: The False Vacuum of the EU: a must-read essay

On rare occasions does one come across an essay so brilliantly argued and provocative in its depth. A must-read: Nucleating the False Vacuum of the European Union

15/6/2012: Few links worth checking out

Few worthy links accumulated over recent weeks:

What about that jobs creation by MNCs? Well, actually, its a net jobs loss: link here. Note that the net rate of jobs destruction amongst MNCs in the 2008-2011 period is roughly-speaking around 8-9%. Which is below that for the whole economy, but looks to be above that for the economy less construction and retail sectors. Hmmm...

EU Commission issued its guidelines for dealing with 'future' banking crises (assuming we end this one with some banking left for the future crises to challenge): link here.

Quick quote from Lobard Street Research on subordination in the Spanish 'rescue' case - the topic I covered for ages and that I believe is now also related to the ECB reluctance in engaging with secondary markets purchases of peripheral sovereign debt - link here.

Meanwhile, Spanish banks have now surpassed Italian bank in ECB borrowing: here.

Excellent as ever NamaWineLake blog on 18% performing loans ratio at NAMA: here. Stay tuned for my Sunday Times column this weekend where I cover European data on commercial real estate mortgages backed securities that will make Nama look, relatively, not that bad...

BIS blog post on their Q2 2012 quarterly: here. Some nice charts on international debt issuance, showing pick up in debt issuance in the wake of LTROs.

A position paper by Daniel Gros and Dirk Schoenmaker on Spain and Greece backstops: here. With some elements of the solutions that I've been advocating in my Sunday Times articles over the last few weeks - including deposits insurance. I disagree with them on the point that ESM should be used to recapitalize insolvent banks which are to be held in SPVs, presumably until they are 'repaired' to be fit for disposal. This is simply a prescription for de fact protectionism and politically motivated preservation of incumbents. In the end it will lead to European banking becoming fully politicised and ineffective. ESM can be used to cover losses in the banks, but insolvent banks should be shit down and their assets sold off to private investors and other banks to make certain that state-ESM-controlled zombies do not block the banking system.

A thought-provoking presentation on the state of the global economy by Raoul Pal: here.

25/11/201: Growth is the only solution to Europe's crisis

My latest post for Canada's The Globe and Mail is up - link here.

Please note, when I say 'growth' or 'economic growth' I obviously do not have in mind a bubble re-inflation or growth based on weak fundamentals. Hence, the concept of growth I accept and support is growth that is anchored in both demand and supply fundamentals, aka sustainable growth.

Enjoy and comment.

07/11/2011: Don't blame 'Johnny the Foreigner' for Western markets collapse

Global current account imbalances have been at the forefront of policy blame game going on across the EU and the US. In particular, the argument goes, savings glut in net exporting (mostly Asian) economies was the driving force behind low cost of investment flows around the world, producing a credit creation bubble via low interest rates. The deficit countries - the US, EU etc - have thus seen easing of lending conditions and world interest rates fell. The credit boom, therefore, was fueled by these savings surpluses, increasing risk loading on investment books of banks and other lenders and investors in the advanced economies.

Much of this orthodoxy is rarely challenged, so convenient is the premise that it is the Chinese and Indians, etc are to be blamed for what has transpired in the West. The mechanics of the process appear to be straight forward with current account imbalances going the same way as the causality argument - from surpluses in the East to deficits in the West.

A recent paper from the Bank for International Settlements, authored by Claudio Borio and Piti Disyatat and titled "Global imbalances and the financial crisis: Link or no link?" (BIS WP 346, May 2011), however, presents a very robust counter point to the orthodox view.

According to authors, "The central theme of the Excess Savings (ES) story hinges on two hypotheses: 

(i) net capital flows from current account surplus countries to deficit ones helped to finance credit booms in the latter; and 

(ii) a rise in ex ante global saving relative to ex ante investment in surplus countries depressed world interest rates, particularly those on US dollar assets, in which much of the surpluses are seen to have been invested. 

Authors' objection to the first hypothesis is that "by construction, current accounts and net capital flows reveal little about financing. They capture changes in net claims on a country arising from trade in real goods and services and hence net resource flows. But they exclude the underlying changes in gross flows and their contributions to existing stocks, including all the transactions involving only trade in financial assets, which make up the bulk of cross-border financial activity. As such, current accounts tell us little about the role a country plays in international borrowing, lending and financial intermediation, about the degree to which its real investments are financed from abroad, and about the impact of cross-border capital flows on domestic financial conditions." In other words, looking at current account deficits and surpluses, tell us little, in authors' view, about the financial flows that are allegedly being caused by these very current account imbalances.

This kinda makes sense. Imagine a MNC producing goods in country A, selling them to country B. Current account will record surplus to A and deficit to B. But the MNC might invest proceedings in country C via a fourth location, country D. Net current account position becomes indeterminate by these flows. Thus, per authors, "in assessing global financing patterns, it is sometimes helpful to move away from the residency principle, which underlies the balance- of-payments statistics, to a perspective that consolidates operations of individual firms across borders. By looking at gross capital flows and at the salient trends in international banking activity, we document how financial vulnerabilities were largely unrelated to – or, at the least, not captured by – global current account imbalances."

The problem arises because in traditional economics framework, savings (income or output not consumed in the economy) is investment. But in the real world, investment is not saving, but rather financing - a "cash flow concept… including through borrowing". Thus, per authors', "the financial crisis reflected disruptions in financing channels, in borrowing and lending patterns, about which saving and investment flows are largely silent." So ignoring the difference between the savings and investment financing, the current account hypothesis ignores the very nature of imbalances it is trying to model.

With respect to the second hypothesis, "the balance between ex ante saving and ex ante investment is best regarded as determining the natural, not the market, interest rate. The interest rate that prevails in the market at any given point in time is fundamentally a monetary phenomenon. It reflects the interplay between the policy rate set by central banks, market expectations about future policy rates and risk premia, as affected by the relative supply of financial assets and the risk perceptions and preferences of economic agents. It is thus closely related to the markets where financing, borrowing and lending take place. By contrast, the natural interest rate is an unobservable variable commonly assumed to reflect only real factors, including the balance between ex ante saving and ex ante investment, and to deliver equilibrium in the goods market. Saving and investment affect the market interest rate only indirectly, through the interplay between central bank policies and economic agents’ portfolio choices. While it is still possible for that interplay to guide the market rate towards the natural rate over any given period, we argue that this was not the case before the financial crisis. We see the unsustainable expansion in credit and asset prices (“financial imbalances”) that preceded the crisis as a sign of a significant and persistent gap between the two rates. Moreover, since by definition the natural rate is an equilibrium phenomenon, it is hard to see how market rates roughly in line with it could have been at the origin of the financial crisis."

In other words, the second hypothesis above confuses the observed market cost of capital - interest rates charged in the market - for the equilibrium natural rates that prevail in theory of balanced goods and services flows. The latter do not really exist in the market and cannot be referenced in investment decisions, but are useful only as benchmarks for long term analysis. Natural rates are "better suited to barter economies with frictionless trades" while the market rates are best suited to analyzing "a monetary economy, especially one in which credit creation takes place". And the market rates are driven by largely domestic (investment domicile) regulation, monetary policies, market structure, etc. In other words, market rates are caused by the US, EU etc policies and environments and not by Chinese trade surpluses.

The main conclusion from the study is that while current accounts do matter in economic sustainability analysis, "in promoting global financial stability, policies to address current account imbalances cannot be the priority. Addressing directly weaknesses in the international monetary and financial system is more important. The roots of the recent financial crisis can be traced to a global credit and asset price boom on the back of aggressive risk-taking. Our key hypothesis is that the international monetary and financial system lacks sufficiently strong anchors to prevent such unsustainable booms, resulting in what we call “excess elasticity”."

The former means, frankly speaking, that bashing China et al is not a good path to achieving investment markets stability and sustainability. The latter means that hammering out a new, more robust risk pricing infrastructure back at home, in the advanced economies, is a good path to delivering more resilient investment markets in the future. No easy "Johnny the Foreigner made me do it" way out for the West, folks.

15/08/2011: Italian "reforms" 2011

So Mr Berlusconi's plan for Italy is now clearly outlined, but as usual with Italian government, it remains to be seen if:

1. There will be effective government push to implement it, and
   
2. There will be a government to implement it.

Italy's new austerity budget is the country only political and macroeconomic response to the increase in bond spreads and its reliance on ECB purchases of the Government paper. In a clear concession to the emergency of the situation, the new budgetary measure were passed by decree, and are now subject to a 2 months-long debate and amendments by the Parliament. Which, of course, is risk number one – the Parliament amendments can significantly reduce the bill effectiveness.

Overall, the bill plans for budgetary savings of €20bn in 2012, and €25.5bn in 2013.

Majority of the reductions will be driven by higher taxes, which means:

• They will have a longer-lasting adverse impact on growth, and
• Cannot be seen as permanent or even long-term, as point (1) above implies that for an already heavily taxed economy (with General Government total revenue accounting for 45.5-46% of the country GDP in 2010-2011 against G7 average of 35.2-35.4%), Italy will have to come off higher tax path sometime in the near future.
  

Given that the country already runs low rates of economic growth (with IMF latest projections for the average growth of under 1.3% per annum in 2011-2016), low personal income base (with GDP per capita adjusted for price differentials expected to return to pre-crisis levels some time in 2013 – the latest of all Big-4 Euro area economies), high unemployment (8.6% in 2011 against G7 average of 7.6%), the gross government debt of 119% this year, and the worst current account deficit of 3.4% this year amongst the Euro area Big-4 economies, it is hard to imagine that the country can actually master these tax increases.

Overall, based on IMF data, the estimated impact of the budgetary plan announced yesterday will take out roughly €1,980 per working person in new taxes and spending cuts, which amounts to 9.3% reduction in the per capita income, adjusted for price differentials. Accounting for this, IMF projections for Italy suggest that Italian real disposable incomes will not return to their pre-crisis peak anytime before 2016. And this is based on IMF's rather rosy assumptions for growth in 2011-2013, which were compiled prior to the onset of the recent economic slowdown.

Of course, in a typical Italian fashion, the new plan is virtually devoid of the structural spending cuts and reforms on the spending side. Overall spending cuts include:

• Central government ministries cuts of €6bn in 2012 and €2.5bn in 2013.
• Savings on the funds allocated to town councils, regions and provinces of €6bn in 2012 and €3.5bn euros in 2013.
• State pension system savings of €1bn in 2012 alongside the increase in retirement for women in the private sector by 5 years to 65. In addition, there will be restrictions on retirement funds for public sector workers who retire early.
• Burden sharing with senior politicos was achieved by restricting MP's reimbursements for flights only to the economy class costs.
• All public bodies with fewer than 70 employees will be abolished (excluding economics and finance functions).
• Provincial governments with less than 300,000 inhabitants and covering less than 3,000 square kilometres will be abolished. Town councils with less than 1,000 inhabitants will be merged. It is estimated this will mean the abolition of up to 29 of Italy's 110 provincial governments.

In terms of revenue increases:

• There is a new "solidarity tax" on high earners, to be levied for three years from this year, as an additional 5% on income above €90,000 per year and 10% on income above €150,000
• Increase in taxation of income from financial investments from 12.5% to 20% - which is a regressive measure for Italy, where investment is running at 19.9% of GDP this year, down from the average of 21.6% of GDP in pre-crisis years
• Increases on a so-called "Robin Hood" tax on energy companies
• Increase in the base rate for corporation tax
• Higher tax on lotteries and betting and higher excise duties on tobacco – the latter being a personal blow to the devotees of the Italian MS (aka Morto Sicuro) cigarettes, like myself
• Further curbs in tax evasion – a set of policies that has been promised more often than the Italian Governments' went to elections, and yet to be delivered in any meaningful measure. Of course, the tax increases above are only going to add incentives to evade taxes in the future, and
• Finally, in a silly season way, all non-religious public holidays will be celebrated on Sundays, to reduce their disruptive effects on national output (note to Berlusconi - outlawing Italian siesta hours in services would do some marvels to output too).
  

According to the IFC Paying Taxes 2011 report, Italy's total tax rate stands at 68.6%, compared to the EU rate of 44.2% and the world-wide average rate of 47.8%. The country ranks 128 in the world in Ease of paying taxes, 49th in the world in terms of Tax payments, 123rd in the world in terms of the time cost of complying with the tax codes and 167th in the world in total tax rate burden. (www.pwc.com/payingtaxes)

The only structural reform promised by Berlusconi emergency measures is, as of yet completely unspecified liberalisation of national labour contracts.

Good luck to all who would go long Italy on the back of these 'measures'. In my opinion, there is about 25% chance of the Italian Government actually delivering on revenue raising targets from this package and about 10% chance we will see noticeable reductions in the costs of the state sector in Italy, with one slight exception – the local and regional reforms. However, there is a good 75-90% chance that Italy will slide into a recession in Q3-Q4 2011 and its 2011-2016 average growth rate will likely slide from 1.31% projected by the IMF back in April 2011, to ca 1.02%. Which, of course, will mean that its debt will top 120% of GDP mark in 2012 and is
unlikely to alter the path set out for it in the IMF projections.

Here are few charts: