Monday, July 20, 2009

Mauldin: Europe On The Brink

This has been an ongoing topic of mine for quite some time. And it is good to see that more than just a few primarily North American focused analysts are casting an eye across the pond and chiming in on what they see.

This week, John Mauldin takes out a knife and defines what he sees as a potentially mammoth shoe hanging overhead. His article can be read in its entirety here. I will post some excerpts.

But Europe's banks have been much more aggressive in funding emerging-market expansion than US or Japanese banks. Western European banks have lent $4.5 trillion to various emerging-market countries, businesses, and consumers. Many Eastern European businesses borrowed in low-interest-rate euros. New homeowners in Hungary and the rest of Eastern Europe borrowed in Swiss francs and euros, and as their currencies have collapsed they now find they owe more on their homes than they're worth.

And here's the problem. Europe's banking system is in far worse shape than the US system. The losses may be bigger, and their capital to meet those losses is certainly less. Let's look at some charts. Remove sharp objects or pour another adult beverage.
In the first few years of the G.W. Bush administration, the banking authorities decided it would be OK to allow five banks to increase their leverage from 12:1 up to 30:1. Which five banks, you ask? Bear Stearns, Lehman, Merrill Lynch, JPMorgan, and Goldman Sachs. How did that work out, just five years later? Three are gone and two survived with large dollops of taxpayer money.
Thirty times leverage means that if you lose 3.3%, you wipe out all your capital. And we watched as banks too big to fail were bailed out with taxpayer dollars. Slowly, banks are buying time, writing down assets. Remember, this month is the second anniversary of the onset of the credit crisis. I wrote back then that the strategy would be to stretch this out as long as possible. Time heals a lot of bad debts, especially at a 0% Fed Funds rate.
I am going to give you four charts showing the leverage of banks in the US, the United Kingdom, the Eurozone, and Switzerland. The bottom, blue portion is assets to common and preferred stock; the red is assets to common equity, which can include good will; and the purple is assets to tangible common equity.

Tangible common equity is all the rage, and that is what the recent "stress tests" measured, as opposed to tier 1 capital, which includes preferred stock (which would basically be the blue portion.) TCE only includes common shares. Now, let's start with the US. These graphs show leverage. The average leverage of tier 1 capital of the five largest banks is in the range of 12:1, and is actually down from ten years ago. (By the way, a very good and simple explanation of all this can be found at

While the TCE has obviously been rising and taking total leverage to rather lofty levels in the mid-40s, banks are raising capital, and over time leverage will come back down. It helps if you can borrow money at almost nothing and lend it out at much higher rates...But as the commercial says, "But wait, there's more!" Let's look at the Eurozone.

Leverage is now 35:1 and with TCE is almost 55. How did 35:1 work out for the US? Given the massive credit problems that Eurozone banks have with emerging markets (plus Spain's housing bubble, which is every bit as bad as that of the US), will this not end up in wailing and weeping?

Mauldin also shows UK and Swiss banking systems that are even more grossly overleveraged. I think this elucidates another very important fact. While many may assume that the "excesses" have been worked off as a result of the autumn panic and subsequent clampdown by regulators, reality appears to show otherwise. The banking system has become MORE leveraged, not less. In addition to the growing amount of leverage, the systemic risk that the large institutions pose has increased. JP Morgan is now one with Bear Stearns and Washington Mutual. Wells Fargo joined with Wachovia. Bank of America is now Countrywide and Merrill Lynch all tied up. PNC added National City to its balance sheet. The list goes on. If any one of these was too big to fail back then, what of it now? Back to the article:

And here's the real issue. They have no Paulson and Bernanke. Now some of my Austrian-economist friends will say, "Good, they should all be allowed to die;" but that is a very cavalier attitude when you start talking about actually increasing the unemployment rate to something like 20%. I agree that management should be changed (as well as the regulators: 35:1 to 1 - really? What were they thinking?) and shareholders wiped out, but I do not want the system to collapse. And this is a global risk, not just localized to Ireland or Spain or Austria. Sure, the pain might be worse in the local region, but we will all feel it.

The European Central Bank, at least as of now, cannot step in and start saving individual banks. How do you save a Spanish bank and not an Austrian bank? Austria's banks have made large loans to Eastern Europe, in euros and Swiss francs, and are going to have large losses, far more than 3%, which would wipe out their capital. But bank assets in Austria are 4 times GDP. What we have are banks that are too big to save for relatively small Austria. And for Italy, Spain, Greece, et al. More on this below.

Mauldin is correct when he says the Austrian solution to "let them die" is very cavalier. That doesn't, however, make it wrong. And should it be allowed to happen, the 20% unemployment figure cited will have no reason to prove anything but temporary. The question should be what is morally justifiable, rather than what would cause the least short term pain.

Eurozone banks are already reeling from losses from US subprime-related problems. They are now getting ready to deal with even deeper losses from their own lending portfolios. If the losses were just 5% of the portfolio (an optimistic assumption), it would be 20% of Eurozone GDP. But each country is responsible for its own banks. While it is thought Germany will be able to handle its problems, the prognostication for Austria and Italy is not so sanguine. Italy is already running a massive deficit, and has no central bank to monetize its debt. The same goes for Portugal, Spain, Greece, and Ireland. 5% loan losses in Ireland would be 40% of GDP, the equivalent for my fellow US citizens of about $5 trillion. Where does Europe find a few trillion dollars?

I was writing in late 2006 that the subprime lending market would end in tears. And I think the European banking crisis that is on the horizon has the potential to be every bit as big a problem as subprime loans. The world depended on Europeans banks for much of the lending that allowed for growth and development. Like their counterparts in the US, they are going to have to reduce their loan portfolios. Deleveraging is not fun.

It takes time to build up a banking infrastructure that can raise the capital necessary to make and process loans. A lot of time. Europe is a big customer of the US and Asia. Their businesses are going to be hit hard by the lack of capital, which is of course no good for employment, etc. We are all connected. What happens in Rome no longer stays in Rome.

The entire article is well worth the read. But I think the most important point here is that what appeared to be a temporary "fix-it" for the US financial system last year is not politically possible in Europe because of the complications involved over sovereign borders. Minyan Peter of is a former executive of a large US Bank. His name and the bank remain anonymous, but his insight is always worth the read. And he had a few words of his own to add to Mauldin's article:

If you haven't already read John Mauldin's piece this morning on the challenges facing European banks, I encourage you to do so. In it, he discusses the fact that many European banks are far greater in size than their home country economies.

But to me, there's an even greater significance to his report: For most banks, their vast banking empires extend well beyond their local borders -- for some, the bulk of their assets (both good and bad) are abroad.

Bailing out banks because of their domestic missteps is one thing; asking local taxpayers to bail out a bank's foreign failings is another.

As a consequence, I expect that the long-term price paid by the "empire" banks (largely Swiss, British, Belgian, Dutch and German) will be a far, far smaller foreign footprint. (And, for what it's worth, the Swiss Central Bank has already created a 2-tiered capital requirement system: One level for domestic activities and another, higher, level for foreign business.)

But as necessary as these steps may feel to local politicians and central bankers, to the untrained eye, politically driven retrenchment looks a lot like protectionism.

To me, this is where it is going to get very interesting, particularly as governments pressure super-sized financial services firms to shrink. (And here I will digress once more to remind readers that, at the top of AIG's (AIG) divestiture plan, is none other than the firm's foreign operations. Or how about Bank of America's (BAC) sale of its investment in China Construction Bank? Or dare I suggest GM's sale of Opel, its European subsidiary? It will be interesting to watch other financial services firms -- from Citigroup (C) to Wells Fargo (WFC) -- to see if they follow suit.)

I don't pretend to know how this will fully play out. But at this point, the course is set. In an increasingly politically driven global financial system, the priorities are clear; and those priorities are being driven more and more by the voting booth.

And as any politician will tell you, local always wins.

Whether you call it protectionism, political populism or something else, the structure of multinational financial institutions will be receding for the foreseeable future. It is a key reversal in attitudes from those of the last 30 years, where cooperation and compromise ruled the day. Those values have been cast aside. It's gonna be a no-holds-barred scrap for TCE. If that means abandoning foreign liabilities, I highly doubt voters will blame legislators for making those decisions.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.


Roger J said...


Here's a very interesting article about the potential euro collapse. It discussed the topic from many angles:

Roger J said...

Apologizes... the link should have been:

Matt Stiles said...

Thanks Roger,

I'll be sure to have a look at that.

View My Stats