Long-time readers will be familiar with Michael Lewitt, one of my favorite thinkers and analysts. He has gone off on his own to write his letter, and I am encouraging him to write even more. I call Michael a thinker because he really does. He reads a lot of thought-provoking tomes and then thinks about them. And then writes, making his readers think. The world needs more Michael Lewitts.
Today, he roams the world, commenting as he goes, starting of course with Europe. I have permission to use the first half of this most recent letter as today’s Outside the Box, leaving off the investment recommendations that he shares with his subscribers. If you are interested you can subscribe at www.thecreditstrategist.com.
I am back from the Kilkenomics Economics Festival in Ireland, where there was a lot of attendee angst about their banks. They are not happy about taking on private debt with public money, and the mood in Ireland is to tell the ECB to take their debt and (insert your favorite personal expletive). Clearly, the rest of Europe wants the Irish to pay.
I told them to be patient. When the rest of European banks are upside down sometime next year and France, Spain, et al. have to pay, the mood among voters everywhere will be quite different. I said they could probably default on their bank debt at that point and no one would notice, amidst the massive debts that are going to implode on the Continent. My remarks excited a measure of schadenfreude-tinged laughter from the crowd.
Michael Lewitt agrees. Noting this interview with Oliver Sarkozy, the half-brother of France’s Nicholas Sarkozy, he says:
“Institutional funding has a three-year average life, so European banks need to generate more than $800 billion each month to fund maturing institutional borrowings. This is, in Mr. Sarkozy’s words, unsustainable. And the markets are saying so. The CDS market for European banks is back at or above the peak levels seen during the 2008 financial crisis. While Mr. Sarkozy does not come out and say it, TCS will – the likely future for European banks is Dexia SA, which was nationalized by France and Belgium when it ran aground a couple of weeks ago.”
I recommend you read Lewitt's entire letter by subscribing to John Mauldin's site, but here is the crux of his argument below:
One thing to focus on in Figure 3 above and in Figure 4 below is the fact that Germany, the country on which the economic fate of Europe largely rests, is itself heavily indebted. Germany carries a total non-financial debt-to-GDP ratio of 241 percent (government – 77 percent; corporate– 100 percent; household – 64 percent). One can see why it is far from certain that Germany will have the economic or political wherewithal to bail out its weak European neighbors even if it musters up the political will to do so.
Germany– Going, Going, Gone?One of the other points made in the BIS paper – something TCS discussed in the Introduction to The Death of Capital – is the enormous impact that aging populations will have on countries throughout the world. Figure 5, which appears on the next page (it appears on page 24 of The Death of Capital), was developed by the International Monetary Fund to show that spending on the 2008 financial crisis, which was in the trillions of dollars, is dwarfed by the projected costs of caring for aging populations. On average, aging populations will cost the advanced G-20 countries 14 times more than the financial crisis.
The point made in both the BIS study and my book is that it is incumbent upon advanced economies to bring their debt under control. Otherwise, the world is at risk of not having the resources to deal with the problems that they are going to face in the future. These problems include natural disasters (like Japan’s tsunami); environmental degradation and climate change; nuclear proliferation; terrorism; military conflict; pandemics, and hunger and poverty. Each one of these poses a potential threat to human survival (and is precisely the type of Black Swan for which most investors are not prepared). To continue to run our economies like a bunch of drunken sailors is incredibly reckless in the face of these future challenges.
Debt May Kill Us Before Old Age Does
It should also be noted that China, the Great Hope of the global economy, is hardly a paragon of fiscal rectitude. China’s total non-financial debt-to-GDP ratio is 174 percent (government debt –44 percent; household debt – 19 percent; corporate debt – 111 percent. This does not include the massive amounts of debt hidden on the balance sheets of opaque Chinese banks. China is concealing its own debt problem and the opaque nature of the situation renders it a bit of a wild card in the global economic picture.
The “ Occupy Wall Street” movement has received more than its fair share of media attention. There is no doubt that the protestors are emitting a primal scream against the system of “ capitalism for the poor, socialism for the rich” that characterized the steps that both led to the 2008 financial crisis and those that were taken to stem it. A growing percentage of the citizenry is coming to believe that a system that privatizes profits and socializes losses lacks legitimacy.
At the same time that protestors are railing against the current capitalist regime, and European leaders are doing everything in their power to perpetuate it, legal authorities in the United States are doing their part to insure that little will change. The recent insider trading prosecutions have properly attacked a flagrant and distasteful underside of the capital markets, although someday it will have to be explained how it is not insider trading when a well-known investor is permitted to accumulate a position in a company before publicly disclosing it and watching it soar in value. Leaving that aside, however, there is another legal assault that raises far more important systemic questions that the insider trading prosecutions.
TCS is speaking of the lawsuits against the nation’s largest financial institutions for their sales of toxic mortgage securities. Last August, the Federal Housing Finance Agency sued 17 major Wall Street and European banks for selling more than $200 billion of these mortgage securities to Fannie Mae and Freddie Mac. At the same time, a number of state attorney generals are suing mortgage servicers for various abuses. Finally, there are a number of specific ongoing investigations (and a lawsuit or two) against specific underwriters for transactions similar to the Abacus abortion that brought so much shame on Goldman Sachs (and might one say that the Gods have exacted their revenge this year on John Paulson for his profiteering from that dirty business?). Where these legal proceedings will ultimately end up is anybody’s guess (although one can say with certainty that they will enrich the attorneys working on them).
TCS would like to raise a broader issue. The people camping out in Zuccotti Park are evidence of societal unease about the legitimacy of the current form of crony capitalism that has contributed to this country’s economic difficulties. Contributing to this unease has been the often-heard complaint that virtually nobody has gone to jail for causing the financial crisis. There is a very good reason for that, however. And that reason is not the one we heard from the U.S. Attorney with respect to its failure to bring charges against the incompetents who ran Washington Mutual, that the evidence did “ not meet the exacting standards for criminal charges.”
Of course there was no evidence of criminality – the perpetrators of the conduct are on the same side of the table as the prosecutors! The reason that blatantly dangerous and unethical behavior cannot be prosecuted under our current system of laws is that there is no independent, third party, arm’s-length arbiter of behavior for the system. The system is worse than one in which the fox is guarding the henhouse. In our system, the fox is the architect that designed the henhouse!
Our justice suffers from a design flaw. It requires an independent investigative/ prosecutorial arm that is part of the judicial rather than the executive or legislative branch of government. The only individuals that have truly stepped up and challenged the status quo that governs the political-financial ascendancy are federal judges such as Jed Rakoff. Judge Rakoff has given hell to the Securities and Exchange Commission over its bogus settlements with the large banks over settlements that are obvious political accommodations rather than true holdings to account. The judicial branch, which is certainly less beholden to large financial interests than the legislative branch (our bought-and-paid-for Congress) and the Executive Branch (our bought-and-paid-for President and Justice Department), is well positioned to serve as an independent arbiter of financial wrongdoing. It therefore offers the best opportunity to restore legitimacy to a system that has lost any right to judge its own conduct.
The Devolution of Wall Street
During the final segment of CNBC’s Strategy Session (which TCS will miss), David Faber made a very compelling comparison between two financiers – Michael Milken and John Paulson. Mr. Faber made the point that when he began his career as a Wall Street journalist (he started in the same year that I joined Drexel Burnham Lambert, Inc. –1987) the most highly compensated financier of the era was Michael Milken. Today John Paulson wears that crown. Mr. Milken famously earned $550 million in1987 (which pretty much sealed his legal fate regardless of the validity (or lack thereof) of the charges brought against him) while Mr. Paulson earned an astounding $5 billion in 2010 (and a couple of billion more in 2009 from his bet on subprime mortgages).
Mr. Faber then went on to point out that Mr. Milken created the high yield bond market, which has expanded into a major economic force that financed many new businesses such as telecommunications (MCI), cable television (John Malone), and casinos (Steve Wynn and others). In contrast, Mr. Paulson has created nothing and instead profited from mere speculation. The difference between how these two men made their fortunes not only says a lot about how Wall Street has devolved over the last 25 years, but also how the U.S. economy has deteriorated during that period.
I don't agree with Lewitt's last point on the devolution of the US economy based on speculation. It was around long before Milken "created" the high yield bond market. The only difference is that the financial oligarchs which include banksters and their large hedge fund clients were able to successfully lobby Democrats and Republicans over the years, ramming through deregulation. A friend of mine put it aptly: "It's the repricing of risk through deregulation that caused this mess."
Another point of contention I have with Lewitt's argument is that he's basically warning of a looming crisis -- a Greek-style debt debacle -- in Europe and the United States. I've said it before and I will say it again, neither the US , nor the Eurozone, nor any major country that can print its own currency, will go bankrupt in our lifetime. Won't happen, get that out of your heads.
Greece is on the verge of going bankrupt, no thanks to the political shenanigans being played out by the two major parties, but they have been exposed:
In fact, opinion polls suggest that if elections were held tomorrow – as some parties would like – there would be no clear winner, a coalition would have to be formed. Greek voters are displaying the consistency and maturity their politicians have failed to. Their message is that this crisis cannot be tackled through the compromised politics of the past but through at least some degree of cooperation. Even at this 11th hour, their leaders might yet absorb the message but their future has been sealed. They have been exposed as yesterday’s men, counting their political beans while the runaway wagon headed for the cliff.
Perhaps more by luck than design, Papandreou’s leftfield proposal to hold a referendum on the impending eurozone debt deal set in motion a chain of events that led to this denouement. Suddenly, politicians were stirred by the prospect that Greece’s membership of the eurozone and the European Union was coming to an end and that their next task would be to rebuild the country from the ashes of a bankruptcy. Samaras dropped his resistance to the new bailout, albeit with some caveats, while Cabinet ministers and PASOK MPs threatened to topple Papandreou if he carried through with a referendum that he seemed destined to lose.
Papandreou, the joker in Greece’s dog-eared political pack, was not done, though. Despite the pressure from his party, he attempted to dodge the commitment to initiate coalition talks and then stand aside. This was an act of self-interest and self-preservation too far. Even those within the crumbling system realized it and it now looks as if Papandreou is on his way out. His wavering was matched by Samaras’s petulant reaction before and after Friday’s confidence vote. New Democracy’s boycotting of the debate and its leader’s curt statement demanding elections afterwards were hardly the maturity demanded by the critical circumstances. Saturday’s exchange of pointless statements between the two, confirmed to the watching world and desperate Greek public that these were just two boys unwilling to let go of their toys.
The one blessing of this frantic week has been that the pathogeny of Greek politics has been laid bare. Until recently, for many people abroad this crisis was caused by the lazy Greeks, the corrupt Greeks, the Greeks who don’t pay their taxes and the Greeks who retire at 50. The Greek people are not blameless but perhaps now the world has a better idea of where to locate the roots of this country’s problems: in the backyards of decision makers who shirked their responsibilities, who ruled for their own benefit and who always took the easy options. How ironic that these men and women now have to make the toughest decision they could have imagined, one which will decide if Greece stumbles toward salvation or if it will tumble into oblivion.
Ironic indeed! And kudos to James Meadway, senior economist at the New Economics Foundation, for writing an article blasting John Humphrys on being wrong about Greece:
A fresh arrival in austerity-stricken Athens over the weekend, as John Humphrys joins the ranks of IMF inspectors and faceless ECB technocrats currently descending on Greece. He’s in town to present Radio 4’s flagship Today programme, where the “glorious weather” stands in stark contrast to grey November London. Lucky Mr Humphrys.
Unlucky Greece. In a series of interviews, Greeks are told they were “foolish”. Their pensions are “staggeringly generous”. Greece “spent too much for too long”.
This is drivel. Humphrys repeats almost every Greek myth in the Bild handbook. The facts speak for themselves. Greeks are neither profligate, nor lazy.
- Greece spends less on its public sector, as a share of GDP, than the EU average.
- Greeks work amongst the longest hours in Europe, and retire later, on average, than Germans.
- Greek public pensions account for roughly 11 per cent of GDP, around the same as Germany and France.
This is not a Greek crisis. It’s a European crisis, imposed on Greece. At its heart is the paradoxical weakness of the major European economies. Productivity growth in Germany, powerhouse of the European economy, has been sluggish for a decade or more. Greece, like other southern European countries, has seen productivity improve rapidly over the same period.
But the German economy is a vast exporter, both across Europe and into the rest of the world. To maintain this position in the face of sharpening competition, two things happened. First, real incomes in Germany were hammered, with social benefits removed and wages stagnating. Second, the creation of the euro fixed relative exchange rates across member countries. Germany entered at a low rate. Greece, like Portugal and Spain, entered at a high rate. German exports became cheap for southern Europe. Germany and other northern European economies began exporting more and more into southern Europe, creating huge surpluses.
You cannot have a surplus in one country without there being a deficit elsewhere. The two, by definition, balance. So surpluses in northern Europe were matched by deficits in the south. Blaming the debt crisis on Greek deficits makes no more sense than blaming it on German surpluses.
European financial institutions, notably those in France and Germany, recycled surpluses earned in the north as cheap credit for the south, who could, in turn carry on purchasing northern exports. Indebtedness, public and private, rose steadily. This flow of debt southwards kept the system running – right up until the financial crisis of 2007-8.
That crisis burst the whole set up wide open. Debts and deficits everywhere shot upwards as governments struggled to cope with a severe recession and collapsing financial systems. Inside the Eurozone, banks loaned huge sums to national governments – apparently in the belief that they could not default.
Default has now become an inevitability for Greece. Its national debt is unpayable. And as the economy shrinks, the relative burden of debt grows, dragging the economy further down. The EU deal, struck on 27 October, recognises this much in proposing a 50 per cent “voluntary” write-off for Greek debt – in exchange for worsening austerity. If approved, however, this reduction is unlikely to be enough to halt the death-spiral of debt and recession. The EU/IMF/ECB Troika, in a confidential report leaked ahead of the deal, suggest “at least” a 60 per cent default would be necessary. The true figure may be far higher; but a sharper default threatens banks across Europe, and will not be countenanced by its officials.
The hardships now being visited on ordinary Greeks are not punishments for past sins, despite Humphrys’ moralising. They are carrying the burden of a European economic system that is fatally flawed. It remains to be seen how long they will tolerate being made its scapegoats.
Greeks are not blameless in all of this but Mr. Meadway is right, they're being made scapegoats and carrying the burden of a European economic system that is fatally flawed.
Finally, in a whacky and ironic twist, there is a new reality TV show from the Britain's Channel 4, Go Greek for a Week, which will allow three British families to experience the "tax, pensions and work practices" that has completely destroyed the Greek economy.
Got to love those Brits. As their economy is going through the austerity wringer, killing their pensions, they decide to poke fun at Greeks, perpetuating every Greek myth in the book. Greeks are hardly amused and have come up with their own version of the trailer, mocking this new reality TV show depicting life in Greece (see both trailers below). And if you really want to laugh, watch this.