Whenever I think of Europe, one of the first images that comes to mind is the hilarious scene from National Lampoon’s European Vacation (you know the one, where Chevy Chase helplessly drives around and around the famous London traffic circle, unable to exit, endlessly exclaiming to the kids, “Look kids! Big Ben! Parliament! Look kids! Big Ben! Parliament!”. Nighttime falls, and they are still caught in the infamous roundabout…”Look kids! Big Ben! Parliament!”)
Around and around they go, unable to escape the seemingly endless traffic circle.
If you think about it, this is exactly where Europe is right now, caught in a vicious circle of debt…only it’s not so funny.
I had to bring Chevy Chase into this because I have a rather gloomy email for your Friday, and I want you to enjoy your weekend! So if you are feeling a bit blue after reading this, or just nostalgic for the crazy ’80’s, then I highly recommend renting it this weekend…it’s hilarious. 🙂
OK, now onto the meat! Due to popular demand I am going to postpone our Q&A until next week, because I received over 30 emails and comments asking me to please keep reporting on the Casey Conference! I’m so glad you find it interesting—I did, too, and I hope some more of you can join me in person for the next one!
Onto the report…
Today I bring you Michael Lewitt, Vice President and Portfolio Manager for Cumberland Advisors. He has an impressive resume that spans two pages in the program, and edits and authors The Credit Strategist newsletter that is widely read around the world. He is recognized as having been one of the few investors and strategists to forecast the financial crisis of 2008 as well as the credit crisis of 2001-2002 (which always gets my attention!) and serves as a regular financial columnist for the Spanish newspaper El Mundo and has written for The New York Times and many other publications.
I’m just scratching the surface here, but I’m going to stop with that little bio and get on with what he actually said so you can get onto your weekend!
Michael Lewitt — The End of Europe
Technically Michael’s talk was entitled, “The Importance of Europe”, but he said in his first sentence that he believed it was the end of Europe, and had a great deal of confidence that it would happen well before the “End of America” that Porter frequently discusses.
According to Michael, Europe faces far more serious and imminent problems than the U.S.
He talked about the importance of history, and apparently he is frequently asked by young people what the best preparation is for a career in money management. He first tries to talk them out of it :), but then tells them to study, in this order:
- Mass psychology
- Then and only then economics, as a distant third subject
(KFG Note: I wholeheartedly agree with this list!)
He gave a quick refresher on the EU…after WWII, everyone decided that they would never again allow such atrocities and war to happen.
Many years passed, and finally they came up with the European Union project.
One of the main things they wanted to ensure was that Germany would not be allowed to dominate the Continent again (ahem…there was much laughter here, as this obviously hasn’t worked out quite as planned).
According to Michael, what they came up with was a system that:
- Has economic union but no political union,
- Attempts to “control” Germany, but depends on Germany for economic support,
- Purports to be viable, but was never viable, and one that
- Was flawed at its inception and is impossible to fix without rendering many countries economically uncompetitive.
(Come to think of it, none of the speakers minced words at this conference!) 🙂
European governments and the ECB (the European Central Bank—Europe’s version of the Fed) are trying to “keep the game going as long as they can”, but as Michael says, the cracks are widening.
According to Michael, France is about to elect a Socialist president (note from KFG: the run-off election between Sarkozy and Hollande will be in just two days, on May 6th…), and the last time they elected a socialist was in 1981, Mitterand. Michael says that after the Mitterand election bond spreads spiked up and the stock market plunged.
Sarkozy has been seen as a partner of Merkel, and also as a big part in forcing austerity on the weaker countries in Europe.
He said the Netherlands government recently resigned over their austerity plan (although they have since quelled this and passed their budget), but that governments are having a difficult time dealing with the austerity measures Germany is imposing.
Michael believes that austerity might be the only solution, but said that nobody volunteers for austerity, for depression, for unemployment, or to lose their home, and worries that much more social unrest is yet to come.
Spain is already experiencing the same unemployment rate, or very close to it, that the U.S. faced in the 1930’s.
Greece is in a severe depression, and Michael says the European model is completely broken.
Why Should the U.S. Worry About Europe?
He showed a slide from Richard Duncan’s latest book, The New Depression: The Breakdown of the Paper Money Economy (which he highly recommended), showing the gross national derivative exposures of three of the largest financial institutions in the U.S. as of December 31, 2011:
JP Morgan: $71.2 trillion
Citigroup: $49.3 trillion
Bank of America: $68.6 trillion
(Yes those are “trillions”, with a “t”…)
He said that of course all of them (Jamie Dimon, etc.) will tell us that we can ignore these numbers because they are all “hedged” and “offset”, but that only applies if nothing goes wrong.
And in a crisis, counterparties don’t necessarily perform the way they are supposed to, if at all. (His words were “at that point, it’s the notional, not the net amounts that matter.”)
He also showed the foreign exchange contracts for each of those three banks…$8.8 trillion, $5.5 trillion, $5.6 trillion respectively, and questioned just how many of those are with Spanish banks, French banks, and Italian banks…he thinks more than a few!
And many Spanish, French, and Italian banks are insolvent…and he said that if in fact the system does break down and we have another crisis, which looks increasingly likely, this (our huge derivative exposure) is the reason why everybody should be worried about Europe.
(And you thought you could sleep tonight!) 🙂
What Have they Tried To Do?
Europe has tried many things to ward off this crisis. I can’t really say “solve” the crisis because they are far from that. They’ve made multiple bailouts to Greece and Ireland and have created multiple European rescue funds, but the money has been spent and Italian and Spanish bond spreads are back up and rising.
If you look at the ECB’s balance sheet, it bears “an uncanny resemblance” to the Federal Reserve’s balance sheet.
And, it only represents a fraction of the €68 trillion of total debt in the Eurozone against its €14 trillion GDP. Ouch.
The ECB’s balance sheet has tripled since 2007 and has doubled in the last year.
Basically, it has grown entirely through the creation of fiat money unbacked by any productive capacity that could actually generate income to service this new debt.
He then showed us a series of bond spread slides that show the vast differences in the cost of capital for the different countries in the Eurozone. The slides illustrated the fact that many countries are at a huge disadvantage because of the cost of capital (it is so much more expensive for Spain to borrow money, for example, than it is for Germany), and therefore the businesses within these countries are disadvantaged, too.
The most troubled countries are Spain, Italy, and Greece, where it is virtually impossible for businesses to compete with businesses in stronger Eurozone countries.
He also pointed out that right now Germany has a negative real yield on its 10-year bonds!
Kung Fu Girl Note: Here is a quick excerpt on that phenomenon from the WSJ on January 10th of this year:
“Investors agreed to pay the German government for the privilege of lending it money. In an auction Monday, Germany sold €3.9 billion ($4.96 billion) of six-month bills that had an average yield of negative 0.0122%, the first time on record that yields at a German debt auction moved into negative territory.
This means that unlike most other short-term sovereign debt, in which investors expect to be repaid more than they lend, investors agreed to be paid slightly less. And they are willing to do that because they are so worried about the potential for big losses elsewhere.”
He then went on to skewer the LTRO (Long-Term Refinancing Operation).
LTRO was designed to address the fact that many European banks had suffered a liquidity crisis, so the ECB loaned these European banks €1 trillion at 1% interest for 3 years. (Of course these banks were also suffering from a solvency crisis, but the ECB pushed that off for another day…).
Anyway, the result, much like in the U.S., was that the banks took the money and parked it on their balance sheets.
And many banks, particularly ones in Spain and Italy, used this money to BUY Spanish and Italian sovereign debt! They were able to make a positive spread on that debt, and are now parking that debt on their already over-leveraged balance sheets, which are already filled with “less than comfortable quality” assets.
Now they are going to sit there for the next three years with that debt on their balance sheets, and three years from now they are unlikely to be able to pay back the debt, because they will be stuck in a recession or worse, and will not have earned a lot of money in that period. Three years from now they will have even more leveraged balance sheets, with more bad debt on them and less money available to pay back that debt.
Michael asserts that they may have solved their liquidity problem in the short-term, but they have dramatically worsened their solvency problem.
These banks will not mark these assets to market, but instead they will hide their solvency problems, delay their liquidity problems, and continue to stick their heads in the sand.
And the most unfortunate fact is that none of this money ended up circulating in the economy where it might have (gasp!) actually done some good and promoted some economic growth!
So LTRO, while intended to buy a few years’ worth of time, really only bought a few months, and it was designed to reduce the spreads on Spanish and Italian bonds, but those same bond yields are already back to where they were before LTRO.
The ECB basically printed €1 trillion worth of euros, pure fiat money, and that money is now sitting in the bank accounts of Spanish and Italian banks at the ECB….a failed program.
Michael also called it a Ponzi scheme, because this LTRO allowed Spanish banks to purchase 111% of all Spanish sovereign bonds issued since December of last year (2011). (Kung Fu Girl Note: I do not understand how it is more than 100%, but I am positive I didn’t write it down wrong…if anyone knows please let me know!)
Michael then went on to discuss something called “TARGET 2″…
(You will love this acronym, get this: “Trans-European Automated Real-Time Gross Settlement Express Transfer”)
(Just one of the many reasons I will never be a politician nor a bank official…that and the fact that I would never pass the background check!) 🙂
But I digress…
Anyway, this is the ECB’s interbank payment transfer system that was designed to “facilitate trade” between the EU member countries. A perk of belonging to the EU, if you will.
However, apparently this has grown into yet another underground financing mechanism for the weaker countries in Europe, and Michael called it an “interesting study in unintended consequences”.
Originally it started innocently (supposedly) several years ago, and had a net balance of €7 billion in 2006.
The Bundesbank was on one side, with a receivable of €7 billion, and on the other side were the weaker EU countries (the PIGS), who collectively owed the Bundesbank €7 billion.
Today, however, the Bundesbank has a receivable of over €600 billion, and the PIGS owe that €600 billion to the Bundesbank!
This represents a staggering 72% of the Bundesbank’s balance sheet. WOW.
(The second largest “asset” on the Bundesbank’s balance sheet is gold, coming in at 14.5%!)
Michael said this sort of snuck up on everyone and has happened slowly and accelerated over time…but the Bundesbank’s balance sheet is now equivalent to 60% of Germany’s annual budget!
And according to Michael this is really an ECB liability, but apparently ECB liabilities are actually the pro-rata liabilities of the 17 members of the EU (and Germany represents the largest share of that at 28%).
But countries like Greece, Spain, Portugal, and Italy are in NO position to pay their liabilities if they need to be paid, so effectively the Bundesbank has a receivable that’s not collectible. (Rather like if you ran your own business and sold a ton of services to the customer, but the customer couldn’t pay you…this would show up as an “asset” on your books, a “receivable” because it is money that’s owed to you that you will presumably collect…unless of course you are Germany and your customer is Greece).
So, this has snuck up on everyone because the liability is not on the ECB’s balance sheet (surprise, surprise…); instead they are recorded as individual liabilities on the individual balance sheets of each of the countries’ national central banks hidden in the footnotes!
This was yet another hidden subsidy for weaker countries because it allowed them to continue trading when they couldn’t get credit any other way; for example, Greece could get credit and borrow at much lower subsidized rates because it was a member of the EU.
But this is yet another distortion and hidden problem in the market and represents more debt that needs to be paid back (and prospects are dubious that it will be repaid).
More bad news…
(Because I just can’t dump enough doom and gloom on you on your Friday…)
Money (bank deposits) is fleeing Europe in droves, and is moving from weaker countries to stronger ones, which is more bad news for weak countries. Michael believes this trend will only accelerate as Spain falls further into Depression.
Spain’s unemployment rate is 24%, and their youth unemployment rate is approaching 50%, which is tragic.
Michael made the point that when you have almost 50% youth unemployment, you have an entire generation losing faith in the political system, and it is very difficult to get that back.
He pointed to the social unrest that has happened in Greece and says they are likely to have more, and pointed to the violence and social unrest happening in Spain and says they are likely to have more.
Spain has already told the ECB that they are not going to meet their “austerity” budget target of 3% of GDP…they simply cannot do it.
Their housing bust was worse than ours, and prices are still dropping.
Michael asserts that Spain is heading toward certain default, but that they won’t call it a “default”; they will call it a restructuring. Spain is much larger than Greece…it is the fourth largest country in Europe and its “restructuring” will have huge ramifications on markets.
He reminded us of the derivative slide that he showed us at the beginning and said that there will be real losses.
He also pointed out that during the Greek restructuring, the ECB treated the debt that they held as structurally senior to that of private lenders who held Greed debt (like banks and hedge funds). The ECB did NOT take the same write-off as private lenders did!
This is a significant development because it makes people in the private sector MUCH less likely to buy any sovereign debt of any European country now, because the ECB will “cram them down” (apparently that’s a junk bond term…) and this likely will happen again in the Spanish restructuring.
The vice is tightening on Spanish banks, and the interbank lending market is closed for Spain (Spanish banks cannot borrow money from other banks in Europe now).
LTRO was designed to deal with that, but it is over, and now Spanish banks have nowhere to turn, so they have no more money to buy Spanish sovereign debt so the Spanish bond rates are rising again (because who will buy Spanish debt?).
Either way, Michael forecasts the ECB printing a LOT more money.
If they do not, Spain will go into restructuring and then the ECB will HAVE to print more money.
So Michael says that’s another reason why gold is a good investment, because fiat money will continue to be printed to “solve” these problems.
What’s Ahead for Europe?
Unfortunately, more of the same course:
- more fiat money printing
- political instability
And in turn this will impact the U.S. markets with more volatility. Michael concluded by saying that Spain is out of options…when their 10-year bond hits 7% (that magic number…) they will be forced into restructuring (and the ensuing consequences).
Well! Gee, aren’t you glad you opened up my cheery (hah!) email today? 🙂 I’m so sorry…I wish I had more cheery news to report!
But I will leave you with a happy note… here is the Chevy Chase clip I referred to above for your weekend pleasure:
(I think the owner disabled the embed function so you’ll be taken to the YouTube site to watch…it’s only about a minute long). 🙂
I honestly DO hope you have a wonderful weekend!
Thank you so much for all of your recent comments and emails! Please keep them coming and let me know what you think about Europe (and the effect it will have on the U.S.!).
To your financial success,
—Kung Fu Girl