A story of a Russian tourist

Dear readers,

Last week we received what looked as a funny entertaining story at first, but it made us think about the true reasons behind it. Surprisingly this has been one of the topics we have been writing about recently and could not be more topical.

The story goes as follows:

In a small town on the South Coast of France, with the holiday season supposed to be in full swing, but unfortunately it is raining so there is not too much business going on.

Everyone is heavily in debt. Luckily, a rich Russian tourist arrives in the foyer of the small local hotel. He asks for a room and puts a Euro100 note on the reception counter, takes a key and goes to inspect the room located up the stairs on the third floor.

The hotel owner takes the banknote in a hurry and rushes to his meat supplier to whom he owes €100.

The butcher takes the money and races to his wholesale supplier to pay his debt.

The wholesaler rushes to the farmer to pay €100 for pigs he purchased some time ago.

The farmer triumphantly gives the €100 note to a local prostitute who gave him her services on credit.

The prostitute goes quickly to the hotel, as she owed the hotel for her hourly room use to entertain clients.

At that moment, the rich Russian is coming down to reception and informs the hotel owner that the proposed room is unsatisfactory and takes his €100 back and departs..

There was no profit or income. But everyone no longer has any debt and the small town people look optimistically towards their future.

At the end of the e-mail they raise the question whether this could be the solution to the current crisis. Or is there a catch 22?

Unfortunately indeed there is. Over the last couple of months we have been writing about quantitative easing and the central banks who need to take over the Shadow Banking system as without them the money supply, M2, would collapse which in turn has a negative impact on economic growth.

Remember our equation: GDP = M2 * V

In the example above the Russian tourist plays surprisingly the role of central banker. It is obvious that growth in this cosy little village came to a standstill as their velocity of money turned to zero. The visit of our Russian tourist to the hotel could be seen as the central bank injecting extra money into the village’s micro economy, this to jumpstart the economy again.

The major problem in the town was that previously the inhabitants went on a spending spray and burried themselves in debt. The money injection from the Russian tourist triggered a deleveraging process, similar to what we are seeing right now among US consumers. People within the village also decided to pay off their debts first before they would start spending again.

This illustrates very well the limitations of central banks in generating growth in the current environment. As we previously noted, growth will only be achieved when V at least stays stable and certainly is not zero.

But there is even a bigger problem. At first sight, the story above looks like a happy ending. The hotel owner recuperates his EUR 100 note in time before the Russian tourist comes down from his inspection.

In the real world life is not that kind to us. Chances are high that the hotel owner spends the money again before the Russian tourist returns. In this case this would achieve the initial goal of the central bank, that is creating growth. This will create some new dynamism in the little village and as a result the butcher-farmer- etc will start to adjust their prices again.

However at a certain stage the central bank needs to withdraw the money it has injected in the system before as inflation starts to rise. And this is the moment when our Russian tourist comes down the stairs, and disappointed from the room he has seen, asking his money back.
The catch is that the central bank will come too late. Their track record in the past has been very poor in that matter. The mismatch in timing of monetary rate policy versus economic growth is something central banks always struggle with. If one compares the change in federal fund rates with the average growth rate in GDP terms during the previous two years one gets a clear view of the overshooting of monetary policy of the Fed.

Figure 1: 2 Year Nominal GDP Growth versus Fed Fund Rates 1960 – 2008


Source: Bloomberg data

As Figure 1 clearly shows this was not a one off incident. In 1974 the Fed cut rates aggressively from 10.5% to 5 % over a period of 2 years. In the second year though the economy was already taking off again and the Fed wanted to catch up their previous monetary easing which contributed to the banking crisis of the eighties. The central banks intervention can almost be compared with a pendulum which goes from one extreme to another. The major reason behind this mismatch in timing is the lack of focus by central banks in monitoring asset price developments in the price indices.
Going back to our story, the Russian tourist does not pay attention to what is happening with his EUR 100 note while he is inspecting the room upstairs either. By default he comes downstairs and assumes the money is still there.
Unfortunately in our example the money will be most probably gone. We have all read stories in the press on how Russians are keen on recuperating their money and what happens to the people involved when they can not pay them back. We certainly will not envy our beloved hotel owner as he will face some very rough times…

Smoke and Mirrors

We keep on being puzzled by the recent stock hysteria. The last couple of weeks we have been shouting from the roof top that we have not seen the bottom (read our Smugglers Bottom article) and soon the market would resume its downturn. Apparently we are wrong as in the meantime the market steamed further ahead and since this week the S&P 500 is showing a positive return year to date.

But still we can not let go that same feeling we had late 1999 and early 2000 when the NASDAQ day after day was setting new records on the board. Also during that period we almost had to go into therapy as we didn’t participate in the rally and saw the people around us their monopoly wealth rising to multi millionaire levels. However we know by now that party ended up in tears as well. The question remains: “Will it be different this time?”

Without being negative or giving the impression we start looking like Waldorf and Stadler, the two grey, old and bitter men on the balcony top of the Muppet Show, we question a couple of things we have seen passing by lately and what is giving hope to a large number of people who think we are out of the woods.

As said earlier on the S&P 500 is back in positive territory since the beginning of the year. A remarkable rally of over 30% was needed from the lows since mid March to establish this. However we still have clear indications the big money managers are not taking part in this rally. There are more signs this is driven by hedge fund managers who are caught by surprise since the G20 at the beginning of last month and have short covered themselves as the bears are driven to the hills.

We have come reasonably unharmed out of the season earnings and some investors have interpreted this as a signal we have seen the worst. Banks quadrupled, obviously leading the pack as they were slaughtered the most of the last couple of months, on phenomenal profit reports. But are they as profitable as they say they are? First of all there is a big difference between operational profit and solvency. The stress-tests on US banks, the government (still) has to publish, will prove this.

Although we have to wait the concrete outcome of the results, it already seems that 10 out of
19 banks will not fulfil the test. In other words they are insolvent. BoA for instance would need $ 34 bln of extra capital to continue their business for the time being. There is also no guarantee they will have to come to the market again 6-9-12 months down the road to raise even more capital.

The IMF calculated in their Q1 report, US banks would still have to write down a joint amount of $ 2.7 trillion on their outstanding loans. Mr. Roubini is even expecting a total of $ 3.6 trillion.

Furthermore bear in mind that the stress tests have been made on a couple of macro economic assumptions which are to us at least very optimistic as well. Probably the government is getting carried away by Chairman Bernanke’s green shoots. One of the parameters the stress tests rely upon is unemployment. The government’s worst case scenario for Q1 unemployment was set at 7.9%. The real result is at 8.06% and is expected to go much higher this year than they expect. So here is already a clear prove the stress tests are based upon highly unstable fundamentals.

An interesting piece on this was written by John Mauldin earlier this week. Refreshingly he made the connection between mortgage failures and job losses. People often forget the correlation between these two parameters. Realty Trac, a company that lists the majority of the foreclosures in the US housing market, detected that job losses result in a foreclosure 10% to 15% of the time. In this case the job losses are a leading indicator. If job losses narrow from the monthly average of 670,000 in the first quarter to let’s say 325,000, almost 3 million more jobs will be lost before year end. Taken into account the above percentages this would result into another 300,000-450,000 foreclosures, and an unemployment rate of almost 11%.

This makes us believe that the re-capitalisation of banks is far from over. It also shows what kind of a vicious circle we potentially are in. The housing market needs to stabilise before banks are out of the wood. And for that the labour market needs to bottom out. On its turn it needs demand picking up again so companies can start hiring again. This summarizes the de-leveraging process we are still in.

When we have a closer look at the Q1 profits of banks we have two observations. First their profits should not be a surprise. The current environment of zero short term interest rates is extremely kind to banks. One should be hung on the highest tree if you would not succeed in making money. But are the profits really what they look like? Let us not forget that banks’ accounting rules have been changed in their advantage.

Take a look at Citygroup’s $ 1.5 – 1.6 bln profit for example. The only way they were able to show this result was by booking a profit of $ 2.7 bln on the decline of their own debt. Under the new accounting rules banks can book a one-time gain equivalent to the decline in their bonds, because in theory they can buy back their own debt cheaply and save $ 2.7 bln over time. This is only paper profit. In hard cash Citi’s real result would have been - $ 1.1 bln. They also reduced the loan loss reserves by $ 1.3 bln this during a time that consumer credit quality is worsening. If you would adjust this to reality (taking into account that Average Joe’s consumer credit is going south) the result of Citigroup would have been a los of around $ 2.4 bln.

Next to the banking sector we forget the troubling car industry. Fiat, who is also a troubled car maker, is trying to take over a virtually bankrupt Chrysler and the European arm of GM, aka Opel. Their ambition is to become one of the leading car manufacturers in the world. We are highly sceptical of these plans. The industry is already buried under excess capacity. Merging these two-three car makers together will cause even greater over supply as they are both fishing in the same pool. This can only end up in further massive lay-offs. Not to mention the end game for Fiat themselves. How are they going to fund this operation? This reminds us of the Fortis saga who wanted to join in the take-over of ABN-Amro. We all know how this ended. Right! In tears…

Furthermore most market participants are not taking into account the impact of a failure of Chrysler, and probably GM later on, on the pension funds that have been a stone mill around the neck of the US carmakers in general over the past decade.
Like there is the Federal Deposit Insurance Corporation (FDIC) to safeguard the deposits of at US banks (up to a USD 100,000 per deposit) there is also the Pension Benefit Guaranty Corporation (PBGC) which is a quasi-governmental agency that insures defined benefit pension plans. They will take over the plan in case a corporate would file for bankruptcy in order that the pension benefits of employees are saved. However there is a pitfall in this so-called safety net. When the PBGC takes over a pension plan the benefits they will have to pay out to the employees are capped to a certain amount, being $ 51,750 a year to be exact. This number is for the people older than 65. For those who are younger the cap is even put at a much lower amount. The first consequence of a Chapter 11 of Chrysler will automatically mean that tens of thousands of people will receive lower benefits than promised or are currently receiving. (Chrysler’s pension plan counts 250,000 participants)
The second catch is, the PBGC is underfunded too. Imagine what the impact is going to be on the funding position of the agency when a player like Chrysler and GM fall. Either the government will have to start an extra money printer to inject new money into it or less/no money available for other potential corporate bankruptcies. The first option is most probably the outcome.
The third pitfall, which is not an issue right now but will become an issue in 3-4 years from now, is the benefits paid out by the PBGC are not inflation adjusted. The pledges that are taken over by the agency become static and will not follow the rise of inflation which will be a disastrous consequence in 10-15 years from now.
In this respect it is not Chapter 11 itself that is an issue right now, but the indirect impact for more than a quarter of a million of workers at the Chrysler factory (and probably GM later on) who will see their live savings being sharply reduced. This will have consequences on future consumer behaviour.
These are only a couple of examples of problems which are making this recovery hype very early days. Mr. Bernanke may be right that in Q4 of this year the US economy might show some modest growth. The plunge in housing starts took out 0.9% of GDP over the last quarters. If the housing market would show signs of stabilisation the .9% hit to GDP would become 0%.
The production cuts which took out 1-2% out of GDP, as companies had to lower their inventories, might stabilise as well as inventories will dry up eventually. As a consequence the decline in GDP from these production cuts can come back to 0% too.
Add to that the tax refunds that people will start to spend temporarily and we might have indeed a slightly positive GDP number at the last quarter of the year.
But this growth is going to be very weak and fragile. At this moment it is based upon a public sector that is taking over the functioning of the private sector. The government is on the board of the banking, insurance and car industry and is controlling the housing market. This is an economy driven by BIG government as Minsky describes in his masterpiece “Stabilizing an unstable economy”. This is a phenomenon we have seen during the mid seventies as well. After the 74-75 US banking crisis we went through a prolonged period of very low growth too.
We are aware that during that period the sky was about to fall as well and it didn’t thanks to the huge government interventions. But don’t forget the leverage at that time was much lower as it is now.
In the meantime equity markets are having a blast. People who had no idea there was anything wrong with the world financial system two years ago, now say the problem has been fixed. Who fixed it? The people who had no idea what was wrong with it, of course. What did they fix it with? The same thing that caused the problem they didn't see - debt. Who makes sure it won't break again? The people who didn't notice the wheels coming off the last time.

I am off to another session at my shrink…