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Financial Contagion vs. Economic Contagion: Does the Market Underestimate the Effects of the Latter?
I am in the process of finishing up the Sovereign Debt Crisis series
with a massive global model of the interconnected relationships between
sovereign nations. In the building of this model the team and I came to
the conclusion that many pundits are truly underestimating the lose-lose
situation that the Eurozone, CEE and the UK are in. I have went to
lengths to demonstrate the interconnectedness of banks and the risk of
global financial contagion that they pose. See this excerpt from "The
Coming
Pan-European Sovereign Debt Crisis"
Sovereign
Risk Alpha: The Banks Are Bigger Than Many of the Sovereigns
This is just a sampling of
individual banks whose assets dwarf the GDP of the nations in which
they're domiciled. To make matters even worse, leverage is rampant in
Europe, even after the debacle which we are trying to get through has
shown the risks of such an approach. A sudden deleveraging can wreak
havoc upon these economies. Keep in mind that on an aggregate basis,
these banks are even more of a force to be reckoned with. I have
identified Greek banks with adjusted leverage of nearly 90x whose
assets
are nearly 30% of the Greek GDP, and that is without factoring the
inevitable run on the bank that they are probably experiencing. Throw
in
the hidden NPAs that I cannot discern from my desk in NY, and you have a
bank that has problems, levered into a country that has even more
problems.
Many countries
in the Eurozone will have to do some serious belt tightening, and I
don't mean just the current whipping boys of the media and red bull
juiced CDS traders either (from The
Coming
Pan-European
Soverign Debt Crisis, Pt 4: The Spread to Western
European Countries):
Expected higher fiscal deficit and bond maturities due in 2010
have increased the need for bond auction financing for all major
European economies.Amongst all major European economies, France and Italy have the
highest roll over debt due for 2010 of €281,585 million and €243,586
million, respectively.
While Germany and France are expected to have the highest fiscal
deficit of €125.1 billion and €96.0 billion, respectively in
absolute amount for 2010 (this is without taking into consideration any
possible bailout of Greece and/or the PIIGS, which will be a very
difficult political feat given the current fiscal
circumstances), Ireland
and Spain are expected to have the highest fiscal deficit as percentage
of GDP of 12% and 11%, respectively.
Overall, in terms of total financing needed for 2010 (which
includes 2010 bond maturities, short-term roll over debt and fiscal
deficit), France and Germany top the list with € 377.5 billion and
€341.6 billion, respectively while the total finance needed as
percentage of GDP is expected to be highest for Belgium and Ireland at
26.3% and 22.4%, respectively.
However, the recent spate of bond auction failures across Europe
is forcing governments to increase premiums on new bond auctions
(higher yields), which in turn is resulting in a decline in existing
bond prices.
PIIGS - A troublesome area
So, pray tell, what happens when austerity measures hit these
countries that need to reign in the debt from the (I say current, others
say past) financial crisis by raising taxes, cutting services, firing
state workers either outright or through attrition and reducing wages.
The quick answer: lower aggregate demand for goods and services. Raise
the price (through taxation), lower the demand. Lower income and wealth
(through taxation, layoffs and wage decreases) and you lower demand as
well.
What does this portend for the four or five largest
economies on Earth (US, China, Germany, Japan and the UK) all of which
also happen to be the largest exporters? Well, they obviously will be
exporting a lot less. This is even more notable when you take into
consideration those economies who are very heavily dependent on exports,
ex. China and Germany - the countries that are considered the anchors
of stability right now. Germany cannot be the export and economic
powerhouse that it currently is if the PIIGS, US, UK and the Eurozone
tighten their belts. China cannot bring the world out of recession if
the world won't buy lots of their stuff. This means that these two
countries will have to make a significant (negative) adjustment to
counter the drop in global exports.
I never believed the sell side
mantra of China leading the way out of this to begin with. See Can
China
Control the "Side-Effects" of its Stimulus-Led Growth? Let's Look
at the Facts - Explains the potential fallout of the
excessive fiscal stimulus in China. While not European, it is quite
likely to kick off the daisy chain effect. See also Signs
of
a
China Credit and Real Asset Bubble Are Now Unmistakable!
Now,
even assuming the bigger companies can handle it (even though, at the
very least it will dampen GDP), the smaller countries reliant on exports
may get crushed, transforming the economic contagion back into
financial contagion to be injected into the Eurozone. See The
Depression
is
Already Here for Some Members of Europe, and It Just
Might Be Contagious!:
Austria,
Belgium and Sweden, while apparently healthy from a cursory
perspective, have between one quarter to one half of their GDPs exposed
to central and eastern European countries facing a full blown
Depression!
Click to Enlarge...
These exposed countries are
surrounded by much larger (GDP-wise and geo-politically) countries who
have severe structural fiscal deficiencies and excessive debt as a
proportion to their GDPs, not to mention being highly "OVERBANKED" (a
term that I have coined).
... Countries in this region are
highly dependent on foreign trade, with exports accounting for more than
50% of GDP for many countries. Sharp declines in exports have triggered
a series of internal predicaments including rampant and rising
unemployment as well as declines in domestic demand that exacerbate
trade account imbalances through declines in imports. However, the
problems for these countries have been aggravated by huge foreign
indebtedness and the resultant interest and income payments that put
additional pressure on the balance of payments. While currency
depreciation could have provided some much needed respite (although that
can be seriously debated), for countries like Latvia, Estonia,
Lithuania, Bulgaria and Ukraine which have a fixed currency peg to Euro,
the option is not available. As a result, Latvia, Lithuania and Estonia
have witnessed double digit negative real growth in GDP and are
witnessing structural issues of deflationary pressures (owing to price
and wage cuts) and very high unemployment levels. Click any graphic
to enlarge...
Source: IMF, European Commission
The
banking crisis (borne from reliance on boom/bust cycle economics)
deposited a very large problem in the lap of the economy. Simply
transferring half of the problem to sovereigns while changing accounting
rules to hide the other half does absolutely nothing to solve or even
ameliorate hide the problem. At the very best, sovereign nations my have
succeeded in quelling the risk of financial contagion leading to part
two of the crisis in exchange for exporting economic contagion that will
(on the optimistic side) restrain growth for at least a couple of years
and quite possibly send us back into a global recession (and
increasing possibility).
The
upcoming presentation of the Sovereign risk model will tie the Economic
vs. Financial contagion thesis together in a very big way. We are also
going through the proposed austerity measures and plans of all of the
major contributors to this contagion to inform subscribers of the
practical likelihood of success, and if unsuccessful, the timing of the
potential fall.
Subscription material
detailing those entities which we feel are most vulnerable can be found
here:
Banks exposed to Central and Eastern Europe- Greek Banking Fundamental Tear Sheet
- Italian Banking Macro-Fundamental
Discussion Note - Spanish Banking Macro Discussion Note
Prior posts on this topic:
2. The
Coming
Pan-European Sovereign Debt Crisis - introduces the
crisis and identified it as a pan-European problem, not a localized one.
3. What
Country
is
Next in the Coming Pan-European Sovereign Debt Crisis? -
illustrates the potential for the domino effect
4. The
Pan-European
Sovereign Debt Crisis: If I Were to Short Any Country, What
Country Would That Be.. - attempts to illustrate the highly
interdependent weaknesses in Europe's sovereign nations can effect even
the perceived "stronger" nations.
5. The
Coming
Pan-European Soverign Debt Crisis, Pt 4: The Spread to Western
European Countries
6. The
Depression
is Already Here for Some Members of Europe, and It Just Might
Be Contagious!
7. The
Beginning
of the Endgame is Coming???
8. I
Think It's Confirmed, Greece Will Be the First Domino to Fall
9. Smoking
Swap
Guns Are
Beginning to Litter EuroLand, Sovereign Debt Buyer Beware!
- advertisements -
Reggi,
you always make a lot of fuss about the three baltic countries Lithuania, Latvia, and Estonia.
You should also provide the key statistic that these countries together have a combined GDP of less than 0,57% in relation to the Eurozone GDP, for example. (None of these countries belongs to the Eurozone by the way).
Hey Reggie...
Have you been privy to any economic studies whereby the subject would pertain to the best economic model with regards to taxation and the economy ?
ie Which model would produce the most vibrant economy in a 10 year period etc....?
Says Denninger today in When the gun Is in YOUR Mouth…(CDS/Merkel): Note that I've been calling for these things to be either exchange-traded with central counterparty "blinding" (on purpose) as is the case with the regulated option and futures markets or be torn up since The Ticker began publication.
Why? Because it is my position and remains so that unless you have this sort of market these contracts are all a scam…
The solution to this is simple, it's elegant, and I've been railing about it since The Ticker began publication, but there's no time like the present to re-state the demands and make sure they're clearly communicated to everyone.
In short, we must make all of these derivatives, including interest rate, currency and credit swaps:
1. Trade on public exchanges where blinding of counterparties takes place. This is exactly identical to what is done with the OCC for listed options and the CFTC for listed futures. If I buy a PUT on a company I have no idea who sold that PUT in the market, and further, if I exercise a long PUT the person who originally sold it may not be the one who gets assigned - that's handled by lottery among all who are short that contract. This makes abuse of these contracts by the buyers, who then seek to destroy the sellers, extremely difficult as they have no idea who to target.
2. Have the exchange is the buyer for every seller and the seller for every buyer. Since the transaction is effectively "blinded" from the counterparties the exchange is thus in the position where it must make certain that anyone who is short has the capital posted and held as margin to guarantee performance or the exchange will wind up insolvent. The exchange has nothing to gain and everything to lose by allowing people to "game" collateral and margin requirements - thus, it doesn't happen. Further, as volatility rises the exchanges tend to increase margin requirements in order to protect themselves against sharp and unexpected moves - exactly what would be expected of a prudent counterparty. In short this process makes the market "safe" for both buyers and sellers, and even in times of extreme stress such as the 1987 crash nobody has ever had a regulated futures or options contract fail to be honored.
3. Break up those "custom" contracts that are so esoteric that only a handful of people want to trade them into standardized contracts that a lot of people want to trade. Let's say that someone wants a custom derivative that is comprised of the price of oil and the price of John Deere's stock. Perhaps they're a major farming interest that is concerned not only about the possibility of Deere failing (they have combine orders stacked up that would be VERY expensive to replicate on the spot market) but also the price of oil since they have to fuel those combines. That's a custom contract that almost nobody would want to trade, but it can be deconstructed into a PUT on John Deere and a short on the oil futures. In essentially every case these "custom" contracts can be deconstructed into two or more things that lots of people will want to trade, which immediately destroys the argument for "custom" OTC contracts.
…Congress must take this action now, and if it will not, then the executive must by whatever means are necessary - including executive order. It's all the better if Merkel, Sarcozy and others on the world stage have finally come to realize what I've been saying now for the last three years when this mess first began:
These over-the-counter derivatives are an outrageous-destabilizing force and, in many cases, are outright fraudulent instruments as the selling entity lacks the capacity to perform as agreed.
The essence of the AIG mess was that the company lacked the financial capacity to perform. It really is that simple. Knowingly entering into hundreds of billions of dollars of financial commitments without the ability to perform should be treated as a felonious act, but apparently we have no cops anywhere in the world interested in massive and outrageous acts of this sort, as I have yet to see hundreds of perp walks up and down Wall Street.
http://market-ticker.denninger.net/
One minor error Ukraine's currency, hrynia, is not fixed or pegged to the Euro, but is freely floating. Otherwise, excellent analysis!
thanks.
Pyramids built on Mercantilism always fall.
This one will be quite loud.
Reggie,
your analysis of Europe does not clarify who is in the Euro or EU and who not.
For example, UBS is in Switzerland and thus no member of the EU and does not have the Euro; otherwise excellent analysis.
In Europe are rumours that new currencies might be planned.
One Video shows currency ticker "FRF" (=French Franc) on a NYSE board.
http://www.youtube.com/watch?v=ncC_Re1xeas
15 sec into the video.
The reporter asked at the NYSE what the ticker symbol is about but got only the answer that the exchange gets a feed from a supplier.
Your articles provide some explanation why that rumour of new currencies might have some truth.
The reason is because this is no longer about Europe and the eurozone but about the linkages and transmission mechansims that will deliver both economic and financial contagion to the various and disparate players involved. Athinking Eurozone will cause you to miss the risks in the US, Asia, and far flung corners of Europe.
In the sense that the mess is interconnected I agree.
For example German banks lent ~400 billion $ to Britain and a similar amount to the so called PIGS.
Reggie is Morphious--the matrix is in trouble.
IMF balance of payments per country.
http://www.imf.org/external/datamapper/index.php?db=BOP
Reggie -
The poor analysis continues (GGP, banks in 2009) on your end.
Sure, deflation kills asset-backed lending and increases indebtedness levels. Inflation (even the small 2% variety) cures all these ills and the opposite of what you describe happens. Debt levels (% of gdp) fall drastically. Tax receipts climb enormously (and will grow over $1T/ann in the next 3 years).
Why forecast the big deflation case?
Why not the small inflation, growth case?
1) It sure look like that the trajectory of things -- Q4 GDP 5.7%, some small inflation coming back, Q1 already looks good on both measures, no?
2) Dont you watch banks? Credit losses look like they have already topped. Q1 will beat expectations at all major banks (again). Loan-loss reserves are extremely high and steep curve means revs are enormous.
This is an other -- "Reggie says short GGP".
Then he'll say -- "I was mainly right."
-BBH
Credit losses look like they have already topped
That statement alone shows you have no clue about bank balance sheets.
Loan-loss reserves are extremely high
That statement alone shows you have no clue about bank balance sheets.
let me you in on a little secret....the group of 19 is insolvent or near insolvent.
now, if you would like to retort, please do so by an analysis of the FASB FAS 157 changes as well as the 166/167 changes and those impacts 1.5 yrs from now. Please offer just a brief description of second lien residential matters for the big 4. Please offer how shrinking loan books and contract of new credit will produces these "enormous" earnings.
You clearly dont know how to read bank balance sheets...
Loan-loss reserves are about 1.5x non-performing. How is this too low? Even with ZERO recovery in default and ALL the current non-perf defaulting... were 50% short of reserves.
Oh yeah, and banks have been able to INCREASE reserves each Q. (Looks like actual write-offs peaked in Q4, this will amp EPS going forward).
FASB 157 -- This was exactly the problem one year ago. MTM for banks is one of the dumber idea ever and drove the huge crisis. How do you "m-t-m" for illiquid assets? In a crisis no one wants to buy. See GGP converts which were priced at $0.03. That's 3 cents, one year ago. Today they are 103. 33x return. Lyondell Chemical bonds were priced at 7... today at 90. 15x return with coupon.
Suspension of mark-to-market made perfect sense. Its a dumb idea for banks. AND NOW the "market" is up 100% or more across the board. Most high-quality bonds are up from 50-60 to 90-100. Even Subprime bonds are up 50-100% since 1-yr ago.
Why do you think MTM is a problem?
Do you not look at credit markets and bond prices?
The fact that you quote "second lien residential" furthers cements your ignorance. This is <5% of the notional of total real-estate mortgages. (And its already taken the bulk of its pain). How can something that's 5% be the "next shoe" in 1 yr?
How silly.
-BBH
Just a couple of questions -I am NOT the smartest guy in the room here that is for sure and I wanna make sure I am following here .. You say "banks have been able to INCREASE reserves each Q. (Looks like actual write-offs peaked in Q4, this will amp EPS going forward)". If everything is A-OK why are they continuing to amass reserves especially if the peak has been hit? Actual writeoffs have peaked ? Has that really been proven yet ? Should we give that 2-3 Qtrs to see if models being used are correct or flawed? When the FDIC or when banks takeover another they mark the assets to market being when the assets were held at the failed banks they were marked to myth between 25% and 40% over market values(more banks on this end of the spectrum who failed)>Thousands of more banks are expected to fail into 2012 (not my thought but the FDIC's ).Would you say regionals are being fairly priced in this market or over priced knowing they have overvalued assets at 25-40%? How much shadow inventory is on banks books should I be worried how those assets are valued? Has the government put a cap on overpricing assets on banks books ? example can a bank say an asset is worth 5 times more than it is ? Now that the crisis is over ,as you said , is it time to go back to mark to market being buyers are back and these assets aren't illiquid any longer just overvalued on the banks books ? In your opinion is the crisis over ? are you still waiting to see ? or This crap is behind us forever let's move on? Like I said I am not the smartest guy in the room -FASB is something I called my ex wife once . I have never actually read it. As for me I am bearish still and think the banks and the economy have some major hurdles to end this .The biggest being unemployment and consumption #'s being second .
Why do you say:
"wait to see if models being used" / when we can see that MARKET prices for credit bonds are UP more than stocks?
"regionals... have overvalued assets at 25-40%" / when assets have been systematically under-valued for 1-yr? thats likely to continue.
"these assets arent illiquid any longer" / when structured debt assets (homes and home mortgages, etc) are ALWAYS illiquid. Stocks are liquid, you dont seem to understand liquidity?
You make some other better points. Especially about "waiting 1-2 quarters" to see if peak has been hit. This is true. It will play out over the next few quarters. Problem IS... you have to play AHEAD of the market. The best gains come early.
These annoyances interfere with the time I want to spend catching up with Kim Kardashian.
This should get the job done faster http://www.xuk.ru
RM.....
YOU are awesome....
This is a fantastic summary and viewpoint....
...............................
Here is an interesting angle....
Assume that all of the developed economies shift their economic activity down by a minimum of 25%....
In response....the developed countries governments....due to the necessity of bowing to populist voters....will increase taxes and print more money....
Thus raising taxes and printing more money...which necessitates higher prices....are all further brought down...because of the causal further weakening of buyers ....by this very action....
Raising taxes and printing money...although is somewhat of a constant.....is an economic weakener....not a stabilizer...not helpful ....not in the right direction....
The right direction meaning....enabling and strengthening the core economy....
The only move that any of the populist ice cream governments can make....in order to first make it possible for the core economy to strengthen ....is to totally restructure taxes....
From reviewing all the possibilities....the tax structure would have to be the most widely distributed such that its structure would quickly strengthen the core economy....
This would be a consumption tax to the order of about 15%....and absolutely no other taxes....particularly on securities....which would most quickly create new equity....
A land value tax in place of a swathe of existing taxes would be more efficient, effective and equitable than (an increasing) consumption tax. Raising a consumption tax will reduce demand and is more easily avoided - just ask the Greeks!
If governments are not willing to tax rentiers (FIRE sector, I am talking to you!) and reduce government expenditure commensurate to reduced tax receipts then they are stuffed.