I receive a regular email from John Mauldin and last night he made this comment which sums up the Euro dilemma nicely...
"I continue to believe that Europe in general and Germany in particular have no
good choices. They can only choose between Disaster A, which is keeping the
eurozone together, and Disaster B, which is breaking the eurozone apart. Either
will cost trillions of euros and mean much pain. It is not a choice of pain or
no pain. It is simply a decision as to what type of pain you want and in what
doses you want to take it. Choose wisely."
The email from John contains various commentary that continues to speculate on different options to resolve the crisis. The most interesting suggestion is that the EuroZone should kick Germany out of the monetary union as it is Germany that refuses to agree with the others. Without Germany, the rest of the Zone can monetise it's debt, devalue it's currency and create inflation. Something they have always done prior to joining the EuroZone.
All very interesting.
Tuesday, June 26, 2012
Sunday, June 24, 2012
Euro Confusion
I have attached a link to a very short and interesting article that highlights the real problem of the Eurodollar and the common currency. Pease take time to read it because it goes to the heart of the problem – (that is) Euro countries that are uncompetitive with Germany but unwilling to increase productivity and unable to devalue their currency to achieve this.
http://www.davidmcwilliams.ie/2012/06/19/hard-and-soft-options
I find this whole situation quite amazing in the sense that the problems are obvious, as are the solutions, yet there is no political will to implement them.
Just to confuse you more, I thought I would stretch the limits of your mind to remind you all of the Bretton Woods currency system implemented after World War 2. If you read this attached Wikipedia article, you will note that the system was implemented to PREVENT COUNTRIES FROM DEVALUING THEIR CURRENCIES TO INCREASE COMPETITIVENESS!!! (Can your bear it?)
Just as a refresher, the Bretton Woods currency system linked many world currencies to the US Dollar and the US Dollar was exchangeable for gold – so effectively a peg – much like the Eurodollar (although you were able to keep your own currency – the Lira, the Aussie, so on and so forth).
http://en.wikipedia.org/wiki/Bretton_Woods_system
Anyway, the Bretton Woods currency system collapsed in the early seventies. Gosh! That would have been an economic catastrophe...surely...what – you don’t remember? Shame on you, how quickly we forget.
Have a good week.
http://www.davidmcwilliams.ie/2012/06/19/hard-and-soft-options
I find this whole situation quite amazing in the sense that the problems are obvious, as are the solutions, yet there is no political will to implement them.
Just to confuse you more, I thought I would stretch the limits of your mind to remind you all of the Bretton Woods currency system implemented after World War 2. If you read this attached Wikipedia article, you will note that the system was implemented to PREVENT COUNTRIES FROM DEVALUING THEIR CURRENCIES TO INCREASE COMPETITIVENESS!!! (Can your bear it?)
Just as a refresher, the Bretton Woods currency system linked many world currencies to the US Dollar and the US Dollar was exchangeable for gold – so effectively a peg – much like the Eurodollar (although you were able to keep your own currency – the Lira, the Aussie, so on and so forth).
http://en.wikipedia.org/wiki/Bretton_Woods_system
Anyway, the Bretton Woods currency system collapsed in the early seventies. Gosh! That would have been an economic catastrophe...surely...what – you don’t remember? Shame on you, how quickly we forget.
Have a good week.
Monday, February 6, 2012
Dinner Party Banter - Banks
Bank Funding – Liven up your Dinner Party!
In today’s article I will attempt to do the seemingly impossible. I am going to try and make an article on Bank Funding Costs interesting..........stay with me here. Today the Reserve Bank of Australia made their monthly (except January) decision to set the official cash rate. This decision results in a frenzy of media speculation and political bank bashing from both sides of politics – although we have been spared this time round as the RBA has kept rates steady. Regardless, my attempt today, may not win you friends at dinner parties, but may give you a better understanding of how our financial system works, and consequently, the small mindedness of the political point scoring.
So here goes.......firstly, I want to provide some context about what occurred during the Global Financial Crisis.
Do you remember a company called RAMS Home Loans? Sure, it still exists today, but certainly not in the same form it did back then (indeed, the franchise is now owned by Westpac). RAMS was part of the Home Lending revolution in the late 1990’s that really saw the Non Bank Lenders (Aussie Home Loans being another) stick it to the major banks. They did this by introducing a new form of home loans that was financed by Mortgage Backed Securities (MBS). The new kids on the block were able to slash the interest rates that were being offered by the major banks and they took a reasonable chunk of market share. This was achieved via the plentiful and cheap funding of the MBS market plus the low cost base of their business model – fewer branches and no transactional banking. Times were good, good enough in fact for John Kinghorn, the founder of RAMS Home Loans, to pocket $650 million when he floated RAMS in July 2007 (with hindsight, a brilliant decision given what happened next!).
You see, because RAMS was not a deposit taking institution it was therefore not regulated by the Australian Prudential Regulation Authority (APRA). Without this prudential oversight, RAMS was able to raise much of its funding by issuing short term bonds in the MBS market.Unfortunately for them, much of this funding matured just as the Sub Prime crisis began to blow up in July 2007, not long after RAMS listed on the Australian Stock Exchange. The consequence? Bond investors either wanted their money back or rolled over at a much higher rate. And that was that. In Australia the MBS market pretty much died overnight and RAMS ceased to exist in its original form.
Now the reason I thought I would tell you about this is that it puts into context that our “Banks” in Australia simply cannot do this. This is because part of the conditions of being a licensed deposit taking institution in Australia is that you allow APRA to monitor your activities in your day to day banking duties. Put simply, Australian Banks are not allowed to borrow (take deposits) short term and invest (lend) long term. Australian Banks are required to match the “duration risk” of their deposits against their loans to borrowers. APRA oversees this.
So when we hear about the reserve Bank setting the “Official Cash rate” this is simply the overnight rate used by banks to settle their outstanding credits or debits in the banking system for that day. This has indeed become a de facto indicator of what sets the banks’ interest rates, even though it has little bearing on the overall pricing of a single bank’s loan book. Put simply, a bank cannot ask for an unlimited line of credit from the RBA at the current overnight cash rate, and, even if it could (interestingly, the European Central Bank has recently done exactly that....), APRA would not allow this to occur as it would shorten the duration of the bank’s liabilities, putting it at risk much like RAMS.
Adding to the cost pressures, the Banks also are required to finance part of their loan book by issuing Bonds overseas. The global credit crunch is also impacting the Banks ability to do this successfully. International investors are demanding higher returns when lending to Australian Banks, despite their sound credit ratings and seemingly safe location. Australia is a country that relies heavily on Foreign investment and as a result we are beholden to the mood of Global Credit markets. So this is why we have to be very wary of media reporting and political point scoring that demands that our financial institutions set their variable rates based on the official cash rate. It simply does not work like that.
(BTW, there is a lot more to the make up of funding for banks, but to go into more detail would risk your dinner party guests walking out).
At this stage of your dinner party, you might have upset some of your guests by defending the Banks, but why not further incite them by discussing the Banks “obscene” profits? Firstly I think it is important to point out that having a profitable local banking sector sure beats having the European version..... a collapsing, bail out ready banking sector. Warren Buffett put it beautifully in one of his Annual Reports a few years back when he stated.
“Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed”.
So having a well functioning banking sector is vital for the growth of our economy. Have they made mistakes? Yes. Have they been allowed to swallow up their competition? Yes. Do they pay their executives too much? Yes. But are we lucky to have the banks we do in Australia? Yes!
But let’s look at the alternative? A shrinking banking sector results in contracting credit that would inevitably lead to falling housing prices.....not an ideal outcome. We must also consider the wider implications of the political bank bashing because there are a few other unintended consequences. Pressure on bank profits will result in lower dividends to retirees, superannuation funds and personal investors. These lower dividends are also likely to result in lower share prices. Keep in mind also that the political pressure is on home loan rates – so banks may cave in to this pressure but leave business banking rates unchanged. It is no consolation if your home loan rate falls but you lose your job because your employer can’t obtain reasonably priced credit. So Wayne Swan et al, be very careful what you wish for.
But putting it in perspective, the Big 4 Australian Banks are VERY BIG. The balance sheet for the Commonwealth Bank (CBA) alone lists $668 billion in Assets for a profit of almost $10 billion before tax (2011 Annual Report). That makes for a return of just 1.5% on assets which is actually pretty poor. The Banks, however, are a little different to most Industrial Companies. This is because they are highly leveraged operations. The balance sheet for CBA also shows liabilities of $630 billion resulting in net assets or “book” equity of just $38 billion. The before tax profit return on this “book” equity is much better at 26%. Unfortunately for potential investors, the share market has valued the “book” equity in the CBA differently as its market capitalisation (share price multiplied by number of shares on issue) is almost $80 billion – twice its book value!!! So the profit is not as attractive at 12.5% (before tax) if you buy the shares on market today.
But think about that, buying shares in a company which has geared its “book” equity 17 times – I would want to be handsomely rewarded for taking on that risk, wouldn’t you?[Footnote: Banks profits are currently circa $30 billion per annum which results in tax revenue of around $9 billion. If the Federal Government really wants to achieve its budget surplus in 2012/13, it had better be careful not to bite the hand that feeds it!!!!]
Monday, January 16, 2012
Europe: The Problem, the Solution and Other Minor Inconveniences
Welcome to my first post in 2012. I hope to make regular contributions during the year to keep you updated with what is going on with the global economy and how it affects you. My aim is to do this on a basis that makes the financial markets and the politics of the same, easier to understand. So forget the convoluted language of your economists and commentators – here you will get the naked truth as frightening as it may be!
So we pick up in 2012 where we left off – that is, the Eurozone in crisis. In fact, the Eurozone has been the issue for most of 2010, 2011 and now indeed will remain so for the foreseeable future.
How did the Eurozone end up in such a apocalyptic situation? For those of you that haven’t heard, and I am sure there are not many who haven’t, Euro governments have borrowed too much money. This has come about as too many Europeans rely on their government to fund their lifestyle, either via employment (i.e. public servants) or by transfer payments (age pensions, unemployment benefits et al).
So how much can a government borrow? Milton Freidman, a renowned economist once said “Government will borrow whatever they can get away with, and a little bit more”, and I think that pretty much sums it up. The European situation is quite unique because Europe simply has so much history. The Europeans have been at war with each other for all of modern history and everything preceding that. So you have to understand that this constant fighting has left many Europeans pretty tired of confrontation. The 20th century saw two major conflicts WW1 and WW2 which resulted in complete destruction of parts of Europe and decimation of generations (incidentally, the Spanish Flu that spread throughout the world in 1918 killed more people then WW1).
So following WW2 (not withstanding the Cold War) Europe wanted to have closer economic ties to ensure that any future conflict would be decidedly less likely because they would all have too much to lose. So the European Union (EU) was born and then the Eurozone. Not all members of the EU are in the Eurozone (the Eurozone are the nations that have adopted the Eurodollar as their currency) the United Kingdom being a notable exception.
So everything went along grandly for some time. The Greek government was able to borrow money at the same rates as the German Government, the French workers demanded and got a 35 hour week, the Italians were able to continue to avoid paying tax but retire early on government pensions (Southern Italians I am told), the Europeans introduced taxes to make their manufacturing uncompetitive (ETS), so on and so forth. So everyone was happy because the increased government debt allowed more people to be paid more money and this translated into “economic growth” and the party kept going (sounds a bit like a Ponzi Scheme.................).
But then the music stopped. The US Sub Prime crisis blew up, creating a global credit crunch. When a credit crunch occurs everyone decides they don’t trust anyone anymore. People don’t want to lend money to other people and banks don’t want to lend to other banks. This drop in confidence and withdrawal of credit feeds on itself. This is because financial institutions are “highly geared”. They use a small amount of equity to lend a lot of money. If the financial institution suffers losses, this “equity” is quickly wiped out and the banks become insolvent. Insolvent banks require government support. In Iceland the banks simply had too much debt for the country to take over. They collapsed taking Iceland with it. In Ireland, the banks had too much debt as well, the government in Ireland has bailed them out, but this has forced Ireland into technical insolvency. In the UK, banks were bailed out to ensure credit kept flowing.
Credit crunches are very destructive. Banks stop lending to business and also individuals that want to buy houses. This negative feedback loop results in falling property prices, businesses cutting back on investment and job losses. Keynesian economics dictates that government must fill this gap and spend. This is of course what they did and borrow and spend is what they have done (Australia is no exception – Kevin Rudd went from a self proclaimed fiscal conservative to a social democrat in a matter of weeks!)
And now we have the hangover. Europe, the USA, the UK and many other developed countries have simply borrowed too much and the prospect of paying it back seems enormous.
So why is the Eurozone the current problem and not the USA or UK – given the USA and UK have massive amounts of public and private debt? It all comes down to the ability to use all the devices available to them. The USA and UK each control their own Central Bank and therefore currency. The Eurozone does not! The European Central Bank is effectively controlled by 17 different governments, some of which are reasonably healthy and others that are decidedly unhealthy.
What would normally occur in a situation where an economy is in strife is that the currency of that country would depreciate to make it workers and manufacturing more competitive (think Australia during the Asian Financial crisis in 1998 – our currency “plummeted” to 50 cents US and saved us from recession). The Eurozone, which has the Euro dollar, does not have this luxury. The Eurodollar as a currency reacts to the health of all of the 17 countries within it of which some are going OK and others are failing. So yes, the Eurodollar has depreciated, which has been of great benefit to exporting nations such as Germany, but by not nearly enough that would benefit Greece.
So ultimately, the Eurozone economies have a half baked system. They have monetary Union, but they also need Fiscal (government taxation and spending) union as well. Indeed, they probably require Political Union or “The United States of Europe”! They also need unified labour laws. Public servants in Greece are paid 30% more than public servants in Germany. Guess who probably works harder.....and you then realise that the system sure is broke.
On some levels, it shows how the culture of “entitlement” has now riddled the developed countries. By this, I mean that once a government “awards” an entitlement to a constituent, it is very hard to take that away. In Greece, it is high public service salaries or an Government Pension at age 55 , in Australia it is Family Tax benefits for middle class Australia. This is because people begin to establish their lifestyle on that increased entitlement and that allows them to spend more, borrow more, enjoy more. Taking that away is not easy for politicians who have to ensure they are re-elected at the next ballot.
At the other end of the scale, this entitlement culture also dominates board rooms in our listed companies. CEO’s earn multi-million dollar salaries and bonuses based on what is deemed “responsibility”. Even worse, some company boards actually reset performance hurdles when executives look like not achieving them to make the payment of bonuses more likely (see recently Wesfarmers and Bluescope). Not good and not healthy.
So Europe continues to lurch towards their solution. Essentially there is only one solution, and that is the write down of government debt to more sustainable levels. Simply put, Greece will never repay its debt and it will continue to grow in perpetuity unless it is written off. The holders of this debt which is mainly European banks will see a fall in their assets (equity) which will make them insolvent. The governments of each of these countries will then be required to prop up these banks by providing them with Capital (and I would suggest wiping out shareholders in the process) and this will of course require governments to borrow more....yes, I know this is insane – it will actually result in say Germany taking on more debt to effectively forgive Greek debt!
This increased debt load that will be the result of this exercise is unsustainable (as all developed countries have governments that spend too much to fund entitlements) and the final piece to the puzzle will be that the European Central Bank will begin the purchase of government bonds, or the fancy people call it Quantitative Easing – I just call it money printing. This exercise pushes additional money into the banking system to provide more money to buy more government debt. Although this sounds silly (OK, it is silly) it eventually results in inflation. Inflation is the great tool in a governments armoury as it is tax increases by stealth. Although the government does not announce an increase in taxation, taxation revenues increase as inflation makes people earn more in nominal terms but the level of debt stays the same as it is fixed. However, this is not a magic pudding because although peoples income and assets may rise in nominal terms, their “real” after inflation wealth is sure as hell going to decrease. Those with a long enough memory may remember the 1970’s and 1980’s when this similar policy was used......so we have been there before.
Make no mistake, this is going to be ugly. For Europe, it will be a tough decade or two. Investors will need to be highly disciplined and ensure that their portfolios are highly diversified and retain a structure to ensure they rebalance their holdings on a periodic predetermined basis. Remember, successful investors purchase assets when prices are low – not high. Do not be tempted to follow the herd. Also, be particularly wary of the doomsayers as they will provide some very enticing evidence for the end of the world as we know it (The Mayans may seem to be spot on – for Europe anyway!). Ultimately, Australians are extremely lucky that we are geographically located where we are, we sit in a dustbowl and brilliant economic management for the two decades preceding 2007 placed our government fiscal position well ahead of major developed economies. The bounce back in the Australian Share market is likely to be quick and impressive, although the timing of this is beyond my ability to predict!
Humans have an in seemingly intractable ability to adapt in the face of adversity. Assuming the politicians have the aptitude to face this reality, the light at the end of the tunnel may soon appear.
So we pick up in 2012 where we left off – that is, the Eurozone in crisis. In fact, the Eurozone has been the issue for most of 2010, 2011 and now indeed will remain so for the foreseeable future.
How did the Eurozone end up in such a apocalyptic situation? For those of you that haven’t heard, and I am sure there are not many who haven’t, Euro governments have borrowed too much money. This has come about as too many Europeans rely on their government to fund their lifestyle, either via employment (i.e. public servants) or by transfer payments (age pensions, unemployment benefits et al).
So how much can a government borrow? Milton Freidman, a renowned economist once said “Government will borrow whatever they can get away with, and a little bit more”, and I think that pretty much sums it up. The European situation is quite unique because Europe simply has so much history. The Europeans have been at war with each other for all of modern history and everything preceding that. So you have to understand that this constant fighting has left many Europeans pretty tired of confrontation. The 20th century saw two major conflicts WW1 and WW2 which resulted in complete destruction of parts of Europe and decimation of generations (incidentally, the Spanish Flu that spread throughout the world in 1918 killed more people then WW1).
So following WW2 (not withstanding the Cold War) Europe wanted to have closer economic ties to ensure that any future conflict would be decidedly less likely because they would all have too much to lose. So the European Union (EU) was born and then the Eurozone. Not all members of the EU are in the Eurozone (the Eurozone are the nations that have adopted the Eurodollar as their currency) the United Kingdom being a notable exception.
So everything went along grandly for some time. The Greek government was able to borrow money at the same rates as the German Government, the French workers demanded and got a 35 hour week, the Italians were able to continue to avoid paying tax but retire early on government pensions (Southern Italians I am told), the Europeans introduced taxes to make their manufacturing uncompetitive (ETS), so on and so forth. So everyone was happy because the increased government debt allowed more people to be paid more money and this translated into “economic growth” and the party kept going (sounds a bit like a Ponzi Scheme.................).
But then the music stopped. The US Sub Prime crisis blew up, creating a global credit crunch. When a credit crunch occurs everyone decides they don’t trust anyone anymore. People don’t want to lend money to other people and banks don’t want to lend to other banks. This drop in confidence and withdrawal of credit feeds on itself. This is because financial institutions are “highly geared”. They use a small amount of equity to lend a lot of money. If the financial institution suffers losses, this “equity” is quickly wiped out and the banks become insolvent. Insolvent banks require government support. In Iceland the banks simply had too much debt for the country to take over. They collapsed taking Iceland with it. In Ireland, the banks had too much debt as well, the government in Ireland has bailed them out, but this has forced Ireland into technical insolvency. In the UK, banks were bailed out to ensure credit kept flowing.
Credit crunches are very destructive. Banks stop lending to business and also individuals that want to buy houses. This negative feedback loop results in falling property prices, businesses cutting back on investment and job losses. Keynesian economics dictates that government must fill this gap and spend. This is of course what they did and borrow and spend is what they have done (Australia is no exception – Kevin Rudd went from a self proclaimed fiscal conservative to a social democrat in a matter of weeks!)
And now we have the hangover. Europe, the USA, the UK and many other developed countries have simply borrowed too much and the prospect of paying it back seems enormous.
So why is the Eurozone the current problem and not the USA or UK – given the USA and UK have massive amounts of public and private debt? It all comes down to the ability to use all the devices available to them. The USA and UK each control their own Central Bank and therefore currency. The Eurozone does not! The European Central Bank is effectively controlled by 17 different governments, some of which are reasonably healthy and others that are decidedly unhealthy.
What would normally occur in a situation where an economy is in strife is that the currency of that country would depreciate to make it workers and manufacturing more competitive (think Australia during the Asian Financial crisis in 1998 – our currency “plummeted” to 50 cents US and saved us from recession). The Eurozone, which has the Euro dollar, does not have this luxury. The Eurodollar as a currency reacts to the health of all of the 17 countries within it of which some are going OK and others are failing. So yes, the Eurodollar has depreciated, which has been of great benefit to exporting nations such as Germany, but by not nearly enough that would benefit Greece.
So ultimately, the Eurozone economies have a half baked system. They have monetary Union, but they also need Fiscal (government taxation and spending) union as well. Indeed, they probably require Political Union or “The United States of Europe”! They also need unified labour laws. Public servants in Greece are paid 30% more than public servants in Germany. Guess who probably works harder.....and you then realise that the system sure is broke.
On some levels, it shows how the culture of “entitlement” has now riddled the developed countries. By this, I mean that once a government “awards” an entitlement to a constituent, it is very hard to take that away. In Greece, it is high public service salaries or an Government Pension at age 55 , in Australia it is Family Tax benefits for middle class Australia. This is because people begin to establish their lifestyle on that increased entitlement and that allows them to spend more, borrow more, enjoy more. Taking that away is not easy for politicians who have to ensure they are re-elected at the next ballot.
At the other end of the scale, this entitlement culture also dominates board rooms in our listed companies. CEO’s earn multi-million dollar salaries and bonuses based on what is deemed “responsibility”. Even worse, some company boards actually reset performance hurdles when executives look like not achieving them to make the payment of bonuses more likely (see recently Wesfarmers and Bluescope). Not good and not healthy.
So Europe continues to lurch towards their solution. Essentially there is only one solution, and that is the write down of government debt to more sustainable levels. Simply put, Greece will never repay its debt and it will continue to grow in perpetuity unless it is written off. The holders of this debt which is mainly European banks will see a fall in their assets (equity) which will make them insolvent. The governments of each of these countries will then be required to prop up these banks by providing them with Capital (and I would suggest wiping out shareholders in the process) and this will of course require governments to borrow more....yes, I know this is insane – it will actually result in say Germany taking on more debt to effectively forgive Greek debt!
This increased debt load that will be the result of this exercise is unsustainable (as all developed countries have governments that spend too much to fund entitlements) and the final piece to the puzzle will be that the European Central Bank will begin the purchase of government bonds, or the fancy people call it Quantitative Easing – I just call it money printing. This exercise pushes additional money into the banking system to provide more money to buy more government debt. Although this sounds silly (OK, it is silly) it eventually results in inflation. Inflation is the great tool in a governments armoury as it is tax increases by stealth. Although the government does not announce an increase in taxation, taxation revenues increase as inflation makes people earn more in nominal terms but the level of debt stays the same as it is fixed. However, this is not a magic pudding because although peoples income and assets may rise in nominal terms, their “real” after inflation wealth is sure as hell going to decrease. Those with a long enough memory may remember the 1970’s and 1980’s when this similar policy was used......so we have been there before.
Make no mistake, this is going to be ugly. For Europe, it will be a tough decade or two. Investors will need to be highly disciplined and ensure that their portfolios are highly diversified and retain a structure to ensure they rebalance their holdings on a periodic predetermined basis. Remember, successful investors purchase assets when prices are low – not high. Do not be tempted to follow the herd. Also, be particularly wary of the doomsayers as they will provide some very enticing evidence for the end of the world as we know it (The Mayans may seem to be spot on – for Europe anyway!). Ultimately, Australians are extremely lucky that we are geographically located where we are, we sit in a dustbowl and brilliant economic management for the two decades preceding 2007 placed our government fiscal position well ahead of major developed economies. The bounce back in the Australian Share market is likely to be quick and impressive, although the timing of this is beyond my ability to predict!
Humans have an in seemingly intractable ability to adapt in the face of adversity. Assuming the politicians have the aptitude to face this reality, the light at the end of the tunnel may soon appear.
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