In a recent post titled Easy Money, we shared our concerns around capital flight in China.  The outflows appear to be accelerating and the risks are real, but dwarfed by bank runs in Europe today as Europe’s leaders have just opened up Pandora’s Box, openly acknowledging that a country could abandon the Euro.  Michael Pettis recently described how policymakers in Europe may have just set in motion a chain of events that will ultimately break up the EU.  His logic is paraphrased below.

• As soon as any depositor realizes that bank deposits are likely to be redenominated into drachma, he will pull his deposits out of the banks so as to protect the value of his savings (this has been ongoing in Greece already).? But obviously only a few depositors will be able to do this before forcing the bank into closing. In order to prevent the resulting collapse in the banking system, the only thing Athens can do is to freeze bank deposits long before most depositors have had a chance to cash out.

• But depositors know this. As the probability of Greece’s leaving the euro rises – and clearly it rose dramatically this past week – anxious depositors eager to prevent their deposits from being frozen and redenominated in a weaker currency know that they will have to speed up their withdrawal of deposits from banks.  And of course as anxious depositors withdraw their deposits, the likelihood of a banking crisis rises, and with it the likelihood of Greece’s being forced to freeze deposits and leave the euro.?

• We are caught, it seems, in one of those self-reinforcing loops that almost always presage a collapse. Rational behavior by individual agents leads towards a catastrophic event the threat of which reinforces the behavior.

• Without a credible intervention this process almost always ends the same way. There is in my opinion a very high probability that within weeks, or months at most, Greece will be forced to freeze bank deposits as a prelude to leaving the euro. Mexico in 1994 and Argentina in 2001 chose the Christmas/New Year holiday season to announce their devaluations. Will Greece follow suit??

It is remarkable how closely Greece is following the Argentina experience.  The charts below are from JPM’s Sovereign Default Time Capsule.  Note that in each case, IMF and other bail-outs did not end the crisis.  Without a devaluation, short-term fixes and bridge loans do little do solve underlying structural issues.  Pettis asks the difficult question, “As households from Italy, Spain, Ireland, Portuguese, and other vulnerable countries read every day about hardships faced by Greek families, what will they do?”  And answers, “Once Greece goes, even the least sophisticated households in other countries will know what the consequences for depositors will be . . . This is simply part of the logic of sovereign financial distress – declining credibility causes stakeholders to act in ways that reduce credibility further.”

For those looking for a quick summary of the European Crisis, this short clip should do the job.  In short, bankrupt governments are doing everything in their power to keep bankrupt banks on life support, while bankrupt banks try to prop up bankrupt governments.

We provided investors with our interpretation of recent events in Europe last week.  While the news-flow out of the EU is coming at a rapid-fire pace, and rumor mill is spinning even faster, we thought it was worth sharing, so an excerpt from our letter is available below:

Last month, risk assets globally celebrated the “solution” to Europe’s debt crisis with one of the strongest one-month rallies in equity prices.  It is important to understand that rallies of this magnitude are hallmarks of “bear markets” and are prone to fantastic failure. Two particular developments sparked October’s short-covering rally. The first component was better US economic data that exceeded overly pessimistic expectations. “Hit your head with a hammer long enough and it just stopping feels great,” is the best analogy we’ve heard for the recent “improvement” in economic indicators. The second factor was the latest “Band-Aid” to patch Europe’s credit crisis. In this letter, we’ll provide additional color on both developments, in addition to our understanding of the implications.  In short, we think the coming hangover from last week’s risk party will be painful. 

The few investors that saw even a remote probability of recession a month ago have now vanished, along with any aversion for risk, after learning that GDP grew 2.5% last quarter. Put simply, the consensus is assuming that because the economy grew last quarter, it will not contract in future quarters.  We prefer to look ahead while managing the portfolio, rather than staring in the rear view mirror. The forward looking evidence still suggests that the US, as well as the EU, is in recession or at least staring over the edge. This is clearly a non-consensus view after October’s market rally, but it is important to recognize that the recovery of initial losses after early signs of economic weakness is not unusual, and is often followed by more abrupt and more severe losses. My friend Marcus Griffin, Chief Investment Officer of Glenmore Advisors in Atlanta, shared the chart below with us this week, which clearly illustrates this point.

Last week, European policymakers announced a new plan during the final hours of a self-imposed deadline.  While the plan may have reduced the short term risk of a disorderly default, upon closer inspection of the “new” plan, investors should recognize that there is really nothing “new” here at all – it is simply a leveraged version of the “old” plan. We discuss the three components of the announcement below:

• European Financial Stability Fund (EFSF) - Leaders of the Eurozone countries agreed to more than double the size of their rescue fund to 1 trillion euros, but still failed to elaborate on who will foot the bill. It’s worth noting that the EFSF is not actually a “rescue fund” in its current structure.  It is simply a plan with no actual capital, but roughly 250 billion euros promised (net of the funds already committed to bail out Greece) from the same EU countries in need of assistance, seeking additional funding from private investors, not yet identified. Got that? Essentially European leaders have promised to borrow money that they do not have, in order to leverage these funds four or five times, to be able to buy enough debt that they will issue to pay back existing debt. No wonder markets are so excited. Unfortunately, stocks aren’t the only thing making new highs on this announcement. European debt spreads, a measure of the cost of borrowing, are rising across Europe as shown below. The basic idea of leveraging the EFSF is flawed. The “protection” offered does nothing but potentially delay default IF it entices outside investors to cover the 1.5 trillion euros of Italian and Spanish sovereign funding needs for the next few years (which completely ignores several trillions more in bank rollovers). IF investors are unwilling to buy bonds from these governments today, we wonder who will buy EFSF bonds backed by these same governments when the markets have decided that these countries are no longer credit worthy. Apparently, very few, as the EU just postponed a 3 billion euro bond issue due to “market conditions.”

• Capitalisation of Banks: The European Council concluded that, “There is a broad agreement on requiring a significantly higher capital ratio of 9% of the highest quality capital . . . to be attained by 30 June 2012 . . . Banks should first use private sources of capital . . . If necessary, national governments should provide support, and if this support is not available, recapitalization should be funded via a loan from the EFSF in the case of Eurozone countries.” While well intended, European estimates of just 106 billion euros to recapitalize the banks, are simply inadequate. The IMF recently increased their estimate of bank capital needs to 300 billion euros a few weeks ago. At the same time, these capital estimates do not take into consideration the impact of the current economic contraction underway, resulting in an increased pace deleveraging, additional asset sales, and ultimately, capital requirements which could be multiples of current guestimates.

Furthermore, Tier 1 capital, or “the highest quality capital” required by Europe’s Heads of State, is an utterly useless measure of solvency during times of stress.  Dexia was supposedly at 12% right up to its ultimate bankruptcy. It is ridiculous to treat the same government bonds at risk of default as “riskless” assets when determining capital adequacy. Rather, investors should only consider the simplest form of capital that can absorb losses – tangible common equity. On this basis, we can easily identify the banks and banking sectors most at risk. In addition to Dexia, which had a tangible common equity to total assets ratio of 1%, French and German banks stand out as the ones most in need of capital injections. Seen in this light, the reluctance to accept additional “haircuts” from their southern neighbors is quite obvious.  Both the German and French governments have significantly less fiscal flexibility to bail out their reckless peers once you consider the cost of recapitalizing their banks at home. And per former Bundesbank President Axel Weber, as the sole guarantor to the EFSF, “Germany could end up with a debt of 314 percent of GDP in an extreme case.”

Source: BCA Research

•  Beware Greeks Bearing Debt: Under the deal, private sector banks “voluntarily” agreed to a 50% haircut on Greece’s debt burden, which would potentially cut its debt to 120% of GDP by 2020 (in line with Italy’s massive debt burden today) from 160% currently. Once again, this is not enough as the ECB, one of the largest holders of Greek debt, does not appear to be subject to the haircut. This is not a sustainable debt level considering the lack of growth in the country and in the Eurozone. 

The flurry of news out of Athens over the past week has been nothing short of spectacular.  Rather than recap the Papandreou Circus Show, which might require an additional letter in itself, we thought this illustration below provided a good sense of the antics we have been watching and the market’s reaction to every word emanating from Europe. The bottom line is that the Greek Prime Minister’s ridiculous maneuverings forced policymakers to openly admit that a country could actually leave the Eurozone.  Europe is crumbling and the likelihood of a messy default is increasing by the day.

The current condition has all the elements of the classic “prisoner’s dilemma” where there is temptation for each party to deviate from agreement at every step of the way, even if it ends up being extremely counterproductive to everyone. The evidence speaks for itself – approaching two dozen “Summits” over the past two years and we are no closer to resolving the problem of too much debt, with more debt. Instead, we are a lot closer to the end of the European Union as we know it. European policymakers may still prevent a disorderly sovereign default with a “grand and comprehensive” solution, but they cannot prevent the recession which is already in progress. Consequently, we are sticking with our credit default swaps, which cost us during the recent rally, but should see much higher prices ahead.

We recently read a piece from a manager we respect who is now “fully invested” largely based on the following premise – “IF we are not in a recession, and IF we are not going to have one, and IF the European “can kick” means no repeat of the Lehman systemic meltdown – IF all these “IF’s” are likely to be realized – then the bear is going into hibernation for the winter and the surprise will be to the upside.” While we would love nothing to be so optimistic, we can’t help but notice that those are A LOT of IF’s!!  As prudent managers of your capital, we believe that having some insurance in case all those “IF’s” don’t line up perfectly, is a necessity in the world we live in today. 

Our goal is to try to generate attractive returns in any market environment, so we use a variety of strategies to protect capital during difficult periods.  Risk protection must be in place at all times since the timing and magnitude of market dislocations are unpredictable. As such, insurance creates a drag on our profits because timing inherently unpredictable events is impossible, but well worth the cost during periods like last quarter. The Wall of Worry is high enough that positive surprises could lead to higher stock prices near term.  In fact, the cycle work we follow points to another “high” in December. Our best guess for how far a rally could run is shown in the chart above, which does not leave a lot of upside potential from here. Given deteriorating fundamentals, slowing growth and increasing financial market stresses, we view the risk-reward profile today as less than compelling – a fact that becomes abundantly clear when viewing the risk levels shown above.  Of the 11 “waterfall declines” since 1929 identified by Ned Davis Research, we have not seen a single case historically where the market has exceeded pre-crash highs within eight months.  In the eight cases where the crash lows had been broken, the market went on to break to lower lows 75% of the time.

Consensus still believes Australian banks are among the most conservatively run institutions in the world.  Funny how easily these “conservatively run” banks can get caught up in America’s past time.  This particular piece from News.com.au brings to light some questionable lending practices in place about a year ago, or right around the peak of the Australian housing bubble:

• Mortgage House will offer a home loan equivalent to 105 per cent of the property’s value.
• The company also offers a 99 per cent loan-to-value ratio loan
• Westpac raised its LVR for new customers from 87 per cent to 92 per cent.
• ANZ also last week raised the maximum LVRs from 95 per cent to 97 per cent for existing customers, and from 90 per cent to 92 per cent for new borrowers.
• Commonwealth Bank has left its LVRs unchanged, at 97 per cent.

It’s worth noting that these LVR’s are substantially different than the “average” LVRs the bank’s claim on their current books.  As we learned in the states, “average” doesn’t mean a whole lot, if say, half of your loans are “money good” . . . while the other half are something less than “good.”  Time will tell.

Disclosure: At the time of publication, the author was short various Australian financials via traditional and derivative investment vehicles, although positions may change at any time.

This week, the German Constitutional Court ruled that Germany’s role in supporting the EU’s periphery was not unlawful.  The market’s knee-jerk reaction was to blast higher on the news, as the alternative would have been a total disaster.  Upon closer inspection, it appears that smooth sailing into the future is far from certain. The court stressed that the decision was not a “blanket” approval for future bail-outs and demanded that the German Government “ask permission” of the Budget Committee before handing out any more cash to their southern neighbors.  At the end of the day, this means that future bail-outs will be even more difficult to execute as the process is slowed further by administrative tape around afternoon siestas.

This is important.  Time is quickly running out for the EU. The lack of a comprehensive solution after two years of “can kicking” means that the periphery’s disease has infected the core and the odds of a disorderly default have increased substantially. Rather than proactively addressing the challenges in the region – restructuring debt, recapitalizing banks, promoting growth, etc. – policymakers have waited for market’s to force their hand and only then, did they plug another hole in the periphery with their finger.  With one year Greek debt within spitting distance of 100% yields, they are now running out of fingers.  With Italian and Spanish yields back on the rise, the holes are getting too large to plug.  Something’s gotta give.

Unfortunately, this is not just a government debt issue.  The debt overhang encompasses households, corporations and financial institutions as well. Many European banking systems are two to three times larger than their respective economies.  European banks have raised roughly half the capital raised by US banks since March 2009 and are much more reliant on volatile wholesale funding, particularly with deposits steadily drifting to Swiss safe-havens.  So yes, we adamantly agree with new IMF Head, Christine Lagarde’s tough message, “Banks need urgent recapitalization. … If it is not addressed we could easily see the further spread of economic weakness to core countries, even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization — seeking private resources first, but using public funds if necessary.” If it is not addressed, the coming sovereign debt crisis will make Lehman look like a walk in the park. It is actually quite sad that most folks in Europe are ready to throw her under the bus for even hinting that banks might be a tad undercapitalized.  If European banks held sufficient capital, one would think that they would have written down the value of impaired sovereign debt on their balance sheets.  That is not the case.  As the FT highlights in, Auditors Under Fire Over Greek Debt, these banks are marking their books more or less arbitrarily, with write-downs ranging from more than 50% to less than 20% on Greek debt.  These are not obscure, difficult to value assets.  They are government bonds.  The price of which is crystal clear, yet the range of carrying values is as absurd as the perception that these banks are solvent.

Source: Financial Times

While the rest of the world has put all its chips on the creation of a “Eurobond,” the German Court appears to have shattered those hopes for now, stating that the German Parliament “is prohibited from establishing permanent mechanisms . . . which result in an assumption of liability for other states’ voluntary decisions.” Granted, this could change quickly should markets begin to riot, but speculating on the outcome of backdoor politics has a success rate only matched by economists. It is difficult to handicap American politics. Next to impossible to do so for the multiple constituencies across Europe. But for some background on the Germans, we can turn to one of our favorite financial author’s, Michael Lewis, who explains, It’s the Economy, Dummkopf!  The full Vanity Fair article offers fantastic insight into the German people and at a minimum makes for entertaining weekend reading.  Per Lewis, “Germans longed to be near the shit, but not in it. This, as it turns out, was an excellent description of their role in the current financial crisis.”

For better or for worse, the Germans now own Europe.  They have essentially accomplished economically, what they failed to accomplish militarily decades ago.  The geopolitical implications of this shift in power are of great consequence.  This analysis from the folks at Stratfor provides additional insight into the origins of the Eurozone and implications of the “New Europe.” Lewis makes an excellent point that for the Germans, the Euro isn’t just a currency.  It’s a device for flushing the past. “There is a common German expression . . . which translates directly as “Lick my ass.” To this hearty salutation the common reply is “You lick mine first!” Fitting, given German public-opinion polls against the Greeks. Get the popcorn ready.  We are approaching the grand finale of this slow motion train wreck.

Last weekend, Barron’s ran a story titled China’s Banks: Worse Than you Think.  The article highlights the concerns expressed in Red Capitalism, written by Carl E. Walter and Fraser Howie.  If you haven’t already read it, we urge you to do so.  If you are pressed for time, and would prefer to spend your day watching the movie rather than untangling the web of the Chinese banking system, you are in luck.  The series of videos below offer a spectacular insight into the Chinese banking system and the politically driven economy’s history of reform, or lack thereof. In addition to Carl E. Walter, the interviews also include insights from Victor Shih, author of Factions and Finance in China: Elite Conflict and Inflation, another “must read” for those closely linked to the Chinese economy. For those that cannot spare a few hours to read the books, or even imagine listening to an hour long discussion between academics and economists, we have provided the cliff notes below.  We believe that this chain of events, described by Carl Walter, sums up the risk to the Chinese growth model quite succinctly:

“If the economy continues to misallocate capital, high earning loans will increasingly be replaced by low yielding paper from the MOF. The banks will no loner have the ability to lend. If they can’t lend, growth slows. If growth slows, unemployment increases. If unemployment increases, the people are not happy and we have a larger problem in China.”

And before finally moving on to the notes, Michael Pettis recently provided us with some arithmetic on investment growth:

“Command economies tend to have much more rapid investment-driven growth during the good times and much more difficult and longer-lasting adjustments. No matter what your expectations were for future Chinese GDP growth, the arithmetic of rebalancing meant that you had to assume a sharp slowdown in investment. In the past, China has had rapid GDP growth driven largely by even more rapid increases in investment. The result is that investment has become a gradually larger share of GDP and household consumption a gradually smaller share.  This has gone on to the point where China is seriously unbalanced and urgently needs to adjust. In fact, given weak global conditions and rising Chinese debt, adjustment is only a “choice” for a few more years at best. After that, economic adjustment will be forced onto China. Weak foreign demand and anger on trade will prevent China’s trade surplus from driving growth, and excessive domestic debt will prevent investment from driving growth. In that case, GDP growth will drop sharply to some level well below the household consumption growth rate. This is what rebalancing means – that household consumption growth outpaces GDP growth.

“No matter how optimistic you are about Chinese growth over the next five to ten years, you have to believe that investment growth rates will decline sharply, maybe extremely sharply. It is hard to put together a plausible scenario in which China rebalances and investment rates don’t come sharply down. Even the most optimistic outlook for China requires that investment growth rates drop by at least a quarter. Slightly more realistic scenarios require that investment growth rates drop by more than half. And of course, if my prediction is correct – that Chinese growth will slow to 3% – a rebalancing China will see investment growth drop by at least two thirds and probably a lot more.”

Part I

• Every decade for the past sixty years, the banks have gone bankrupt.
• These banks were recently listed in Hong Kong, and now have international institutions as shareholders.
• The banking sector has always been the pillar to China’s investment driven economy.  The money supply is greater now than anytime before.
• China’s banking system didn’t exist in 1949.  The new government put in place a centrally planned economy with a passive banking system working with Russian advisors until everything “blew up.”
• After a series of crises, the Asian Financial Crisis catalyzed the awareness in the government to strengthen the weakest link in their economy, the banks.
• “These things aren’t banks.”  There were no audits.  They had no general ledgers.  And they didn’t have any capital.  Nor did they need any capital in the context of a centrally planned economy.
• In the late 90s, there was this transformation where the government tried something different.  There was major hesitation towards privatizing the banks.
• Most emerging markets don’t have complete control of the banking sector.  What you have in China is a closed system, very different than other emerging markets.
• One of the reason the stock exchanges were created in 1991, was to concentrate the trading of government bonds. Gradually, banks became the primary investors in government bonds.
• It is inconceivable that the Chinese government would permit any banks to encounter a liquidity problem.  If they did have one, we’d never know about it.
• Things began to change prior to the crisis, but it all went out the window after Lehman crashed, as the party ordered banks to lend to drive growth.
• Things are now frozen in time. The banks have stopped in their tracks. Interest rate reform is gone.  The bond market is a joke.  And foreign exchange is not going to appreciate much do to export concerns.
• Right now, nobody sees the problems.  These banks have “super” market capitalizations so they are the clear global “winners.”
• The Olympics marked the peak of Chinese development.

Part II

• Once you engage in an entire year (or two) of carefree lending, you rack up a huge amount of potential non-performing loans.
• In 2009, all the banks received an order to lend.  In the space of four weeks in February 2009, they approved $2 trillion in investment projects!!
• Local governments did not borrow directly.  They created private enterprises, Local Government Financing Vehicles (LGFVs), to hide the debt off the central government balance sheet.
• The central government is the key for confidence.  They must show that they are a conservative, responsible fiscally strong entity, by moving debt off balance sheet.
• It is impossible to ignore the debt of the local governments and bank balance sheets which ultimately belong to the sovereign.
• Bulls believe that future growth will be driven by consumption, but consumers are being taxed in every direction by government policy.
• Household depositors, the foundation of the system, are being paid 3% on their money, as dictated by the government.  With inflation over 6%, this is financial repression.

Part III

• The last ten years have seen two rounds of inflation. This one has been the worst.
• It is clear that they are throwing insane amounts of money – $10 trillion per year for two years or 30% of GDP growth – to cover the problem and drive investment growth which is over 50% of GDP.
• The government is less concerned with inflation and much more worried about the effects of a credit crunch, because this would uncover the structural issues.  Inflation helps to cover this up.
• PBOC has implied that total LGFV loans outstanding was $14.4 trillion at year-end 2010.
• The real estate bubble in China has been driven by over-borrowing by SOEs which have too much money, which ultimately flows into real estate.
• Last time they “cleaned up the banks” we saw 20% recovery rates on $440 billion!!
• The most likely vulnerability is capital flight.  The risk is not on the asset side.  This can be covered up for a long time.
• On the liability, side depositors have the ability to withdraw capital and we are beginning to see that.
• It is no longer difficult to move money off shore, but right now they can make more money in real estate onshore. What happens when this changes?

Part IV

• Before they move the bad assets to asset management companies, the banks have to admit there are non-performing loans.  They are not even willing to do this now.
• New loans to cover up bad loans are being made on a massive scale in China now to avoid recognizing NPLs.
• You can continue taking these loans off bank balance sheets, but it ultimately ends on MOF balance sheet instead.
• Everyone has known this model has been in place forever.  It will go on for a long time becuase there is no alternative.  Investment growth is driven by bank loans.
• The system is extremely prone to event risks.  The longer this financial profligacy continues, the more these problems are hidden, the bigger the problem will become over time.
• The status quo will continue unless there is some kind of crisis and new leadership.
• If you believe that exports will no longer be the big driver of growth, then you are dependent on the banks to fuel investment growth, which by definition, must also slow.