What if Greece Just Says No?

I've been trying to figure out what happens if Greece simply defaults.

It's easy to dismiss the cries of protest emanating from the Greek populace about the terms imposed by the European leaders as part of a bailout package.

After all, the thinking goes, the Greeks lived well beyond their means for many years. Borrowing levels soared, and a corrupt and in-bred government did little if anything to improve basic government functions like tax collections.

And yet, the terms of last week's deal are incredibly draconian. Greece is expected to accept austerity measures for the next 10 years. Unemployment will soar, probably in excess of 20%, for years to come. Public services will be cut and the standard of living of most Greeks will deteriorate further.

All this so the big European banks can be repaid for loans that never should have been made to begin with.

I'm not defending Greece - they could have stopped this train wreck long ago - but I am also questioning whether the medicine is more than most populations would reasonably be expected to take.

A number of commentators have begun to say maybe Greece should just default. Yes, the near term consequences could be dire, but longer term the country could wind up ahead.

Iceland, for example, told its bank creditors to take a hike back in 2008 when it was in the middle of its own credit crisis. As Bloomberg news wrote earlier this year:

Unlike other nations, including the U.S. and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its largest lenders in receivership. It chose not to protect creditors of the country's banks, whose assets had ballooned to $209 billion, 11 times gross domestic product.

http://www.bloomberg.com/news/2011-02-01/iceland-proves-ireland-did-wrong-things-saving-banks-instead-of-taxpayers/

And where is Iceland today? Quoting Bloomberg:

In the beginning, banks and other financial institutions in Europe were telling us 'Never again will we lend to you' {one Iceland official} said. "Then it was 10 years, then 5. Now they say they might soon ready to lend again"

The political winds are considerably different than 2008, when the world was told that we were facing financial Armageddon if the banks were not bailed out.

At this point I think the risks are much greater for French and German banks - and I think that Greek Prime Minister Papandreou had figured this out long ago.

The More Things Change, The More They Stay the Same

French diplomat Charles Maurice de Talleyrand once famously said that the Bourbon family dynasty that "had learned nothing and forgotten nothing."

This quote came to mind when reading about the fall of MF Global.

The investment "bets" that MF Global had made were not on the surface particularly aggressive. From what I read, the firm had amassed huge positions in short sovereign debt of countries like Italy which are trading at a modest discount to par in the secondary market.

The idea was simple: at the end of the day, it seems very likely that all of most, if not all, of the debt would be repaid in a year or so.

The problem is the fact that MF Global borrowed heavily to buy as much of the sovereign debt as it could. When its creditors turned skittish, and pulled their credit lines, MF Global tried to get out of its positions, but there is obviously not a particularly strong bid for euro bonds these days.

Exit MF Global.

This strategy seems very similar to the ones followed by Long Term Credit Management (LTCM) back in the late 1990's. There again, a group of very smart investors decided to leverage up their investments in sovereign bonds issued by countries like Russia. When Russia defaulted, LTCM collapsed.

Ironically, one of the firms that helped liquidate LTCM was Goldman Sachs, headed by none other than Jon Corzine. Corzine, of course, is the head of MF Global, and pushed MF Global to make the same type of leveraged bets on sovereign debt that LTCM had done.

And now MF Global has reached the same fate as LTCM.

Roger Lowenstein wrote an excellent book about the hubris that ultimately lead to the demise of LTCM called "When Genius Failed: The Rise and Fall of Long Term Capital Management". He wrote a column for Bloomberg yesterday which discussed the similarities of LTCM and MF Global:

MF Global was leveraged 30 to 1, shades of LTCM. And of MF Global’s roughly $40 billion in assets, more than $6 billion were in volatile European sovereign debts. Corzine was the author of the firm’s strategy of risking its own capital. He wanted a firm like {LTCM}, and he got one. Corzine also approved the strategy of loading up on European debt. According to the Wall Street Journal, he told a company executive that “Europe wouldn’t let these countries go down.” Just as, 13 years ago, traders believed that Russia wouldn’t default.

Corzine’s bet may still prove correct; “these countries” -- Italy and Spain, for instance -- may emerge from the current crisis solvent. But if they do, MF Global will not be around to reap the gains. Because the firm was so highly leveraged, and because it was dependent on short-term financing, its liquidity dried up and it failed. This seems to be the lesson that Wall Street never learns.

http://www.bloomberg.com/news/2011-11-02/corzine-forgot-lessons-of-long-term-capital-roger-lowenstein.html

As Talleyrand might have said: Plus ca change, plus c'est la meme chose (the more things change, the more they stay the same).

November Starts on a Rocky Note

I'm worried about how quickly the apparent Greek debt accord reached just last week in Europe is unraveling.

The decision by Greek Prime Minister Papandreou to put the European Community's plan to a vote in the Greek Parliament illustrates very clearly which country is in control. And, no, it's not Germany - it's Greece.

John Maynard Keynes once famously observed that "If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has."

Greece knows that if it defaults on its debt obligations, and it is forced out of the eurozone, the consequences will be huge for all of the remaining members.

The major euro players are trying to force draconian austerity measures on Greece in return for more financial help. But my suspicion is that Papandreou knew this wouldn't fly in Athens, but went along anyway last week. Some observers noted his almost surreal calm in the midst of the conference; maybe he is a better poker player than the other leaders thought.

German Chancellor Merkel - who expanded so much political capital on last week's agreement - must be hugely frustrated at this point.

My real concern is what happens next. I doubt they will convene another European summit if the Greek parliament does not agree to the terms imposed last week. And the ECB is not the Fed - it can't just print money to intervene in the capital markets.

I am getting the uneasy feeling that we saw this meeting before, in 2008. Could the collapse of MF Global be this year's Lehman Brothers?

Debt Continues to Haunt Global Economies

Even though there's snow on the ground, and many homes in New England are without power, it's Halloween.

It seems appropriate, then, to on the "debt ghosts" coming back to haunt us in the economy.

If the specter of this past weekend's storm wasn't enough to haunt you (we just got power back this morning), consider this discussion of the global debt burden that arose at a recent conference sponsored by the Economist magazine (I have added areas of emphasis):

Typically, however, the other striking speech came from Kyle Bass, the investor, which illustrated the other side of the problem. He pointed out that total global credit rose from $80 trillion in 2000 to $210 trillion today. In many nations, debt is three to four times GDP. These figures have normally been seen only in the course of major wars (i.e 1914-1918 and 1939-1945) when the result was a complete wipeout for creditors of the losing states.

http://www.economist.com/blogs/buttonwood/2011/10/unemployment-and-deleveraging?fsrc=nlw%7Cnewe%7C10-28-2011%7Cnew_on_the_economist

Mr. Bass's figures include the so-called shadow banking system, which are entities that exist outside the normal banking channels (e.g., money market funds) that also provide credit.

These debt figures are obviously staggering. Now, to be sure, some would argue that they could be overstated, since much of what is considered "debt" are actually credit derivatives that probably will not be exercised.

But still: $130 trillion in a decade?

The Financial Times also picked up on some of the figures that Mr. Bass discussed, noting (again, I have added emphasis):

A study by the Financial Stability Board of the 11 largest economies with significant shadow banking found the sector, which previously peaked at $50,000 bn in 2007, dropped to $47,000 bn in 2008, but is now back up to $51,000 bn. It now constitutes more than a quarter of the financial system and is about half the size of traditional banks....

Regulators fear {non-bank credit} remains a big threat to long-term stability, particularly as more activities move out of the bank sector to escape tighter regulation there.

http://www.ft.com/intl/cms/s/0/39c6a414-00b9-11e1-930b-00144feabdc0.html#axzz1cNzz8NPv

In short, while we continue to talk about paying off past debts and getting our global economy on a sound footing, the numbers would suggest that in fact we're heading in the opposite direction.

One final thought: Imagine if the shadow banking system was subject to the same capital rules as the banks? It might make the system more stable in the long run, but the shorter term consequences would be very negative.

European Banks

The markets had a huge rally yesterday with the news of the apparent resolution to the Greek debt problems.

European bank share prices soared, led by a rise of more than +20% in French bank stocks.

As I will explain, I can understand why banks are rallying - they're getting bailed out (again).

What I can't figure out is why the solution is anything but very bad news for European economies.

Here's the part that I'm focused on: the plan calls for banks in Europe to raise capital between now and the end of June next year. The figures being thrown around are around 110 billion euros, or about $150 billion.

The idea is laudable: banks need to raise more capital in the event of other sovereign credit problems, especially in countries like Ireland, Spain, Portugal or even (gulp) Italy.

Problem is, most bank stocks in Europe are trading below book value, just like in the U.S.

Issuing equity capital below book value is a sure-fired way to kill your stock value, and it seems logical that most bank managements will be reluctant to do so.

Which then leads to the real heart of the matter. For this, let me show you a very simplified bank balance sheet:

Assets

Loans and Investments 100

Total Assets 100

Liabilities & Capital

Deposits, Borrowings* 94

Bank Capital 6

Total Liabilities and Capital : 100

What you can see here is a fairly typical balance sheet which has 6 euros supporting 100 euros of loans and investments. This ratio - 6 euros for 100 euros of assets - is 6%, which is roughly where most of the European banks currently stand. This 6% figure is called the capitalization ratio.

The agreement reached yesterday called for bank capitalization ratios to be raised to 9%. The question is: how can this be done when bank stocks are trading below book value?

Simple algebra will tell you that if you're not going to sell stock, you have to reduce your assets.

If you have 6 euros in capital, and you want the capitalization ratio to go to 9%, you have to shrink the amount of assets to 67 euros, or about one-third less than their current levels.

If this is the case, this will be hugely depressing for Europe. Reducing loan portfolios by 33% between now and next June doubtlessly will entail economic pain. Shrinking the debt markets so quickly means less credit available for all kinds of meaningful economic purposes.

Now, some of the people I have spoken to say I am being too pessimistic.

First, it was announced yesterday that the authorities will be watching the banks very carefully to make sure they don't just shrink their balance sheets in the manner I am suggesting. Honestly, I don't know how effective moral suasion can be in this case, but maybe it will work.

Second, the banks themselves are claiming that they can simply retain more earnings and build capital through business operations. Well, maybe, but these are big numbers, and loan growth in Europe is really slow.

Oh, and the banks might cut their dividend payouts (as French PM Sarkozy suggested yesterday) to retain more earnings. But how does this make bank shares attractive to investors to provide needed capital?

Maybe the banks don't need to shrink their balance sheets: maybe they can just sell off huge chunks of their loan portfolios to other investors, which means that the credit will still remain in the system.

Problem with this happy scenario is that it implies that banks will be able to sell their loan portfolios at attractive prices. We tried this in the U.S. in 2008, and essentially failed - the bids were at huge discounts to book.

If you are a buyer of bank loans, and you knew the banks had to sell, are you really going to make an aggressive bid?

I could go on, but you can see my problem. If the politicians force their solution on the banks, and the "happy" solutions don't pan out, it has the danger of tipping a fragile economic situation into something more serious.

More more ominous note: Almost immediately after the Greek deal was announced yesterday, the Irish Prime Minister was quoted as saying, hey, we would like that deal also - why should we be forced to pay back all of our debt at face value if the Greeks only have to pay 50%?

Look for the rest of Southern Europe to follow Ireland.

Lots to ponder this weekend.

BTW: The funding of the loans is largely done through deposits and borrowing. In the case of the European banks, they make extensive use of the money markets. This makes the Europeans more vulnerable to changes in credit perceptions, since lines can be quickly pulled if any lender becomes nervous.

Richard Rosenbloom

One of my favorite clients died earlier this week.

Although Boston Private Bank prides itself on confidentiality, I think I can make an exception in this case, because Dick Rosenbloom was more than a client to me.

I first met Dick in the spring of 2000. He was still teaching at the Harvard Business School, where he was the David Saranoff Professor of Technology. In the summer, Dick and his wife Ruth would head out to the Bay Area, where he was consulting at Hewlett Packard. He was also on the board of Arrow Electronics.

Although I was managing an equity portfolio for Dick, I often felt like I was learning more from him than vice versa. His insights on the world in general, and technology in particular, were incredibly interesting and helpful.

Dick made a terrific market call in August 2000. He had just finished reading Robert Shiller's book Irrational Exuberance, which described the incredible overvaluation of the stock market at that time. Although I was on vacation, Dick called me and told me to sell nearly all of the stocks in his portfolio.

The S&P 500 then started the swoon from which it has yet to recover; the market is off nearly -20% from the time Dick told me to sell.

Dick took the proceeds from his stock sales and moved them into bonds, where he also did very well. Here again his instincts were uncanny: In the midst of the credit crunch in the fall of 2008, for example, he pushed us to invest in bonds issued by banks and brokers, correctly surmising that the government would never let our largest financial institutions fail.

But there was more to Dick than investing - much more. He was totally devoted to his family. He loved talking about his three children, and their activities were always a source of interest. When his wife Ruth became ill, he became a full-time caregiver, and never complained about the burden. Her death left a void in Dick's life, but he continued to live life as best as he could even after the loss of his best friend.

I always enjoyed meeting with Dick to catch up on the markets as well as family. To be sure, Dick could be very challenging, as all good teachers can be to students.

For example, Dick disliked the idea that institutional investors had diversified portfolios, and pushed me to put only my very best ideas into his accounts, regardless of whether it increased volatility. Thanks to his prodding, I must confess that my equity performance numbers in Dick's portfolios were among the best in my client book.

Dick moved to New York City in his last years, and loved the energy and vitality of the City. While I had not seen him as much as I would have liked after he moved, we talked occasionally on the phone, and our conversations were always pleasurable.

Dick will be missed not only by me, but several other members of the Boston Private Bank community who knew him well.

More on Bank Stocks

We had a long and heated discussion here at the bank this morning about investing in the financial sector.

The S&P 500 has slightly more than 13% weighting in the financials. Underweight the sector in client portfolios, and financials rocket ahead like they did at the end of 2010, your relative performance suffers.

On the surface, the group looks incredibly cheap. The money center banks in particular are trading at a price/book ratio not seen in 30 years, so it would seem that they are ripe for investment opportunity.

But not to me.

Yes, I recognize that the problems of the financial sector are widely known, and that any "good news" from Europe could cause the group to soar.

Moreover, if the glimmers of economic resurgence continues, financials historically have done very well when economies are healing.

My main problem with the group relates in part to the post from yesterday about Ray Dalio. Dalio's company Bridgewater Associates focuses on what they don't know as much as what they believe, which is an approach I favor as well.

So, what is it that we don't know about the financial sectors health?

Plenty, I would argue.

For example (quoting from Monday's Financial Times Lex Column):

Try this on your credit card company: your creditworthiness has weakened, so you write down the value of what you owe to reflect the greater risk that you will not pay it all back and credit the difference to your personal account. That is exactly what accounting allows; the top five big US banks - Citigroup, Bank of America, JP Morgan, Morgan Stanley and Goldman Sachs - have just reported gains equivalent to more than four-fifths of their quarterly $16bn net profit as a result of falls in the value of their own debt and credit standing. Now European banks are set to report with the same system.

http://www.ft.com/home/us

Bank of America reported reasonably good earnings last week - until you stop to consider that it needed 15 separate "one-time" boosts to get to a reasonable earnings number.

This, by the way, was on the heals of the 16 different "one-time" boosts that BofA employed in the second quarter.

So, in fact, we really have no idea what banks are even making.

Then there is the simple problem of low interest rates. Banks typically make a good chunk of their earnings from the spread between short term and long term interest rates. However, with loan demand tepid, and rates on Treasurys at 1% or less on all but the longer maturities, there is no spread available.

This becomes particularly important to banks at the present time, when they are being inundated with deposits. As Monday's New York Times pointed out:

Normally, banks earn healthy profits by taking in deposits and then investing them or lending them out at substantially higher interest rates than what they pay savers. But that traditional banking model has broken down...

Today, banks are paying savers almost nothing for their deposits. As it turns out, the banks are not minting money on those piles of cash. Lending levels have not bounced back from only a few years ago and the loans going out are not keeping pace with the deposits rushing in.

http://www.nytimes.com/2011/10/25/business/banks-flooded-with-cash-they-cant-profitably-use.html?_r=1&scp=1&sq=banks%20cash&st=cse

And what do we know about the quality of bank balance sheets? Nothing. Banks have been reluctant to write down non performing loans since they do not want to recognize losses.

In short, we don't know what banks are actually earning, nor do we know anything about credit exposure. With the economy mired in de-leveraging mode, prospects for loan growth do not seem promising.

So what is the catalyst for bank stocks? I'm hard pressed to find one, but I will continue to look.

One final point: one of my fellow managers kept insisting that "everyone" is bearish on the financial sector, and banks in particular. He concludes that the contrarian play, then, is jumping back in the sector.

However, financials still represent the second largest sector weighting in the S&P index, despite massively underperforming the rest of the market this year.

The stock market that by definition has to have a buyer for every seller, there apparently are still lots of folks that believe that the banks are about to turn.