Kicking the Can Down the Road
December 17, 2010
By John Mauldin
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How often did we as young kids go down the street kicking a can? “Kicking the can down the road” is a universally understood metaphor that has come to mean not dealing with the problem but putting a band-aid on it, knowing we will have to deal with something maybe even worse in the future.
While the US Congress is certainly an adept player at that game, I think the world champions at the present time have to be the political and economic leaders of Europe. Today we look at the extent of the problem and how it could affect every corner of the world, if not played to perfection. Everything must go mostly right or the recent credit crisis will look like a walk in the Jardin des Tuileries in Paris in April compared to what could ensue.
From the point of view of not wanting to so soon endure another banking and credit crisis, we must applaud the leaders of Europe. The PIIGS collectively owe over $2 trillion to European and US banks. German, French, British, Dutch, and Spanish banks are owed some $1.5 trillion of that by Portugal, Ireland, Spain, and Greece by the end of June, 2010. That figure is down some $400 billion so far this year, which means that the ECB is taking on that debt, helping banks push it off their balance sheets. For what it’s worth, the US holds, according to the Bank for International Settlements, about $353 billion, or 17%, of that debt, which is not an inconsequential number.
Robert Lenzner notes something very interesting about the latest BIS report, out this week:
“What’s curious, though, is that for the first time the BIS has broken out a new debt category termed ‘other exposures, which it defines as ‘other exposures consist of the positive market value of derivative contracts, guarantees extended and credit commitments.’ These ‘other exposures’ – quite clearly meant to be abstruse – amount to $668 billion of the $2 trillion in loans to the PIIGS.
“So, bank analysts everywhere; you now have to cope with evaluating derivative contracts that could expose lenders to losses on sovereign debt. Be on notice!”
What did I write just last week? That it is derivative exposure to European banks that is a very major concern for the world and the US in particular. It is not just a European problem. I predicted in 2006 that the subprime problem would show up in Europe and Asia. This time around, European banks present a similar if not greater risk to the US.
A collapse of a major European bank could trigger all sorts of counterparty mayhem in the US banking system, at least among our major investment banks. And then people would want to know which bank was next. This is yet another reason why the recent financial-system reform was not real reform. We still have investment banks committing bank capital to derivatives trading overseen by regulators who don’t really understand the risk. Who knew that AIG was a counterparty risk until it was? Lehman was solid only a month before until it evaporated. On paper, I am sure that every one of our banks is solid – good as gold – because they have their risks balanced with counterparties all over the globe and they have their models to show why you should go back to sleep.
Kicking the Can Down the Road
And that is why I applaud the ECB for stepping in and taking some risk off the table. We do not know how close we came to another debacle. Does anyone really think Jean-Claude Trichet willingly said, “Give me your tired, your poor, your soon-to-default sovereign debt?” Right up until he relented he was saying “Non! Non!” He did it because he walked to the edge of the abyss and looked over. It was a long way down. Bailing out European banks at the bottom would have cost more than what he has spent so far. It was, I am sure, a very difficult calculation.
I remember writing a letter not so long ago, quoting Trichet on that very topic. He was vehemently opposed to any ECB involvement in something that looked like a bailout. And then he wasn’t. I do hope he writes a very candid memoir. It will be interesting reading. The reality is that there was nowhere else to turn. There were no mechanisms in the Maastricht Treaty for dealing with this situation. What I wrote the following week (or thereabouts) still stands. This was and is a bailout for European banks in order to avoid a banking crisis. Many European banks, large and small, have bought massive sums on huge leverage of sovereign debt, on the theory that sovereign debt does not default. Some banks are leveraged 40 to 1!
The ECB is now earnestly continuing to kick the can down the road, buying ever more debt off the books of banks, buying time for the banks to acquire enough capital, either through raising new money or making profits or reducing their private loan portfolios, to be able to deal with what will be inevitable write-downs. It they can kick the can long enough and far enough they might be able to pull it off.
There is historical precedent. In the late ’70s and early ’80s, US banks figured out that if you bought bonds from South American countries at high rates of interest and applied a little leverage, you could practically mint money. And everyone knew that sovereign countries would not default. That is, until they did.
Technically, every major bank in the US was insolvent then. I mean really toes-up, no-heartbeat bankrupt. So what happened? Mean old Paul Volker – he who willingly plunged the US into recession to vanquish the specter of inflation – allowed the banks to carry those South American bonds on their books at full face value. He kicked the can down the road. And the banks raised capital and made profits, shoring up their balance sheets.
In 1986 Citibank was the first bank to begin to write down those Latin American bonds. Then came Brady bonds in 1989. Remember those? Brady bonds were as complicated as they were innovative. The key innovation behind their introduction was to allow the commercial banks to convert their claims on developing countries into tradable instruments, allowing them to get the debt off their balance sheets. This reduced the concentration risk to the banks. (To learn more about Brady bonds, and a very interesting period, go to http://en.wikipedia.org/wiki/Brady_Bonds and also google “Brady bonds.”)
So it worked. Kicking the can down the road bought time until the banks were capable of dealing with the crisis.
Different Cans for Different Folks
The ECB has chosen a different way to kick that old can (and a large and noisy one it is!), but it is not without consequences. Trichet has let it be known that dealing with sovereign-debt default issues should not be the central bank’s problem, it should be a problem for the European Union as a whole. And I think he is right, for what that’s worth.
If the ECB were to keep this up, even in a deflationary, deleveraging world it would eventually bring about inflation and the lowering of the value of the euro against other currencies. That is not the stuff that German Bundesbankers are made of. So they have been pushing for a European Union solution.
At first, the political types came up with the stabilization pact in conjunction with the IMF. But this was never a real solution, other than for the immediate case of Greece … and then Ireland. It has some real problems associated with it. It could deal with Portugal but is clearly not large enough for Spain. It is worth nothing that the political leaders of both the latter countries have loudly denied they need any help. Hmm. I seem to remember the same vows just the week before Ireland decided to take the money.
One of my favorite writers, Michael Pettis penned this note:
“Its official – Spain and Portugal will need to be bailed out soon. How do I know? In one of my favorite TV shows, Yes Minister, the all-knowing civil servant Sir Humphrey explains to cabinet minister Jim Hacker that you can never be certain that something will happen until the government denies it.”
Ultimately, the EU has three options. But before they get there – or maybe better said, before there is a crisis that forces them to get there – they will continue to kick the can down the road. They are really very good at it. We will consider those options in a little bit; but first, let’s look at just one aspect of the problem that will lend some context to the various paths among which they must choose. And that will take us on a detour back to our old friend Greece, where this all started.
More Debt is NOT the Solution to Too Much Debt
Greece is being forced into an austerity program in order to be able to continue to borrow money. But it has come with a cost. Unemployment is now at 12.6%, up from less than 7% just two years ago. And Greek GDP continues to slide. Let’s look at some charts and data from my favorite slicer and dicer of data, Greg Weldon (www.weldononline.com for a free 30-day trial).
Notice that Greek GDP is down over 7% for the last 9 quarters, and there is no reason to believe there will be a reversal any time soon.
A declining GDP is just not good for the country, but it also makes it more difficult for Greece to get back into compliance with its EU fiscal deficit-to-GDP requirements. The problem is that GDP is declining faster than the fiscal deficit. Normally, a country would devalue its currency (and thus its debt), maybe restructure its external debt (or default), and then try to grow its way out of the crisis.
Let’s go back and look at what Iceland did, as compared to Ireland, which is trying to take on more debt to bail out its banks, that is, to bail out German and French and British banks.
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