We looked at one of them yesterday in my article entitled Private Equity Hit & Run, where I analyzed a recent article from TheDeal.com discussing the maturation of more than $400 billion in senior debt in the Private Equity Market.
Today I'd like to discuss a few others. Nobody I have read so far in either the U.S. media or the foreign press has put all of the pieces of the defaults puzzle together, so I want to do that today.
(4) Inflation (The UK is our Canary in the Coal Mine)
Insolvent European Banks
It [European Central Bank] said it is expecting fresh bank writedowns to hit $283bn (£173bn) by the end of next year..."The deterioration in the macro-financial environment has continued to test the shock-absorption capacity of the euro-area financial system. Prospects for a significant turnaround in the short term are not promising," it said. In a ghastly day for Europe's lenders, Moody's downgraded 25 Spanish banks as rising defaults eat into reserves...The ECB's report said eurozone bank losses would reach $649bn by late 2010: split between $218bn on securities, largely written down already; and $431bn on loans, where the real damage lies. The banks have written down $150bn of loan losses so far. The report said accounting rules were lax in some countries and there may be "under-reporting". There is a risk that "write-off rates could increase by more than currently anticipated".
In what is another prooftext for the argument that no amount of regulation can prevent financial crises, the highly regulated banking system on the Continent, seems to be in even worse a position than the U.S. banks, including several that have been taken over by the FDIC. Western Europe is reeling from the near-default status of several Eurozone countries (Greece, Ireland, and Spain), while Northern Europe and Switzerland are on the hook for the now out of control downward spiral in Eastern Europe, especially Latvia. Sweden, which had previously been insulated from many of the problems besetting the rest of Continental Europe, is now acutely endangered by virtue of its disproportionate share of Latvia's consumer debt orgy. The Kronor's independence of the Euro had been one of the strengths of the Swedish economy. It could quickly turn into its Achilles' heel.
Assuming these write-downs are only as bad as projected, the situation looks grim, not only for a recovery in Europe, but in the United States as well. Europe's spuriously perceived resilience (particularly Germany, in light of its dogged refusal to engage in the government spending binge advocated by Gordon Brown and Barack Obama) was, if not a silver lining around the storm-clouds, at least a candle in the midst of pitch-darkness. Those ill-conceived notions are all but abandoned today, yet the American financial press and Mr. Market seem to ignore this fact regularly.
Massive write-downs in Europe can lead to only three outcomes:
(a) Government-bailouts
(b) Capital markets crowd-outs
(c) Defaults
(a) At least in Germany (assuming Angela Merkel's government is returned to power in the Autumn elections), the prospect of bailouts seems slim. However, Germany is in a classic catch-22. If they do not assist in preventing defaults in the rest of the Eurozone, they risk a severe devaluation of the Euro, hurting German purchasing power, and significantly altering the realities surrounding existing German industrial policy. If they do assist, however, they will only undermine their own national fiscal policy efforts to maintain a disciplined and reasonable approach to the situation in addition to the prospects of inflation that would be raised in light of massive pan-European bank bailouts (see #4 below for the implications of quantitative easing as a means for bank bailouts with the UK as our shining example).
(b) The European banks can of course go to the capital markets like the U.S. banks have, and raise additional capital. Investors in U.S. banks did not have the benefit of watching this process, and if they had, the banks would have either had greater difficulty in raising capital or else would have been forced to raise it at far less desirable valuations. European banks now must go to investors who have watched the continued drag on U.S. bank investors and consider the prospects of good returns in light of the foregoing reality. In my view, at least, this is why the European banks have not raised more capital from the private sector. Sovereign investors from Asia and the Middle East are shying away from the risk currently surrounding the developed world's banking system. Even if the Euro banks can raise capital in the private sector, the amount needed to sustain themselves through the next round of the crisis is likely to be so substantial that it will adversely affect other private sector enterprise on the Continent, forestalling recovery even longer.
(c) The specter of default must still loom on the horizon. Though the EU finance quango will not allow outright defaults, we must monitor the "behind the scenes" actions of the Eurocrats to discern when these pseudo-defaults are occurring. We will likely see some forced M&A activity tantamount to the BofA and JPM deals arranged by the Federal Reserve. Then there will be most likely a couple of "credit lifelines" tossed to then-Too Big To Fail banks rather than dozens of smaller bailouts. I do not expect honest outright defaults and bankruptcy proceedings simply because it will be too politically damaging for the Eurocrats who were drubbed in the recent European Parliament elections and who are scrambling to save face and stave off their doomsday scenario of a Referendum on the European Constitution Lisbon Treaty in the UK.
Given that there are no pain-free options here, it seems that the insolvency of Europe's banks poses an indeed significant barrier to the Developed World's recovery, and even more likely will contribute to a second crisis.
Credit Card Defaults
The troubles sound familiar. Borrowers falling behind on their payments. Defaults rising. Huge swaths of loans souring. Investors getting burned. But forget the now-familiar tales of mortgages gone bad. The next horror for the beaten-down financial firms is the $950 billion worth of outstanding credit-card debt--much of it toxic. That's bad news for players like JPMorgan Chase and Bank of America that have largely sidestepped--and even benefited from--the mortgage mess but have major credit-card operations. They're hardly alone. The consumer debt bomb is already beginning to spray shrapnel throughout the financial markets, further weakening the U.S. economy. "The next meltdown will be in credit cards," says Gregory Larkin, senior analyst at research firm Innovest Strategic Value Advisors. Adss William Black, senior vice-president of Moody's Investors Service's structured finance team: "We still haven't hit the post-recessionary peaks [in credit-card losses], so things will get worse before they get better." What's more, the U.S. Treasury Department's $700 billion mortgage bailout won't be a lifeline for credit-card issuers.
This would be bad enough under normal conditions, or even in a situation we are facing today on its face, but there is another layer of complexity that will make this segment of the crisis even more difficult to handle. Unlike the mortgage market, where there are assets (although devalued ones) to back up the bad debt, the revolving credit market does not benefit from simply repossessing the property the loans were used to acquire, since in many cases these revolving credit lines weren't used to buy any durable property at all. The cost of litigation is high, and not only is it not scalable, it suffers from the truth of the old adage about getting blood from a turnip. Suing consumers with no net worth is a losing prospect for everybody. So the financial institutions are going to have to absorb the losses and write them down. Market forces are cleaning out all of the misallocated capital in the economy, even as the government and the Federal Reserve system are trying to infuse more capital to prop up the malinvestment.
Furthermore, under normal circumstances, the credit card companies would have the ability to adjust the prices, terms, and conditions in order to recover some of their losses. Higher fees, higher interest rates, etc., could normally be employed to limit their damage. But Capitol Hill and the Obama Administration have made it clear that they will not allow this to happen, and are in the process of passing a series of new regulations under the guise of consumer protection that will only complicate matters further.
We should expect the Credit Card tailspin to double down the U.S. economy independent of any Hail Mary the Europeans can achieve with their banks.
U.S. Sovereign Debt Rating
Technical analyst Robert Prechter on Monday said he sees the United States losing its top AAA credit rating by the end of 2010, as he stuck by a deeply bearish outlook on the U.S. economy and stock market. Prechter, known for predicting the 1987 stock market crash, joins a growing coterie of market heavyweights in forecasting the United States will lose its top credit rating as the government issues trillions of dollars in debt to fund efforts to bail out the economy. Fears about the long-term vulnerability of the prized U.S. credit rating came to the fore after Standard & Poor's in May lowered its outlook on Britain, threatening the UK's top AAA rating. That move raised fears that the United States could face a similar risk, with the hefty amounts of government debt issued in both countries to pay for financial rescues causing budget deficits to swell...Despite the government and Federal Reserve's massive rescues for financial companies and securities markets, Prechter expects credit markets to clam up again as they did in the first phase of the global financial crisis and for the U.S. economy to sink into a depression. Although U.S. banks' recently passed government "stress tests" that assessed the adequacy of their capital levels to absorb losses and have been able to raise some capital in debt and equity markets, "the banking sector is in severe trouble," as more loans turn bad, he said. The economy "is obviously heading toward a depression," despite the government's efforts to dodge one, said Prechter. Federal Reserve Chairman Ben Bernanke has not averted a re-run of the 1930s Great Depression, even though investors are becoming firmly convinced that the Fed has avoided disaster and that the economy has hit bottom. "It's the next leg down (in stocks) that will make it clear that these things are not true," Prechter said.
The implications of the U.S. government's sovereign debt rating being downgraded cannot be underestimated. Even if the ratings agencies shift their "outlook" to negative, the consequences could be severe. We should pay careful attention as the next several months unfold to see if there is any appearance of political pressure on the independent ratings agencies to maintain both the AAA rating and a Positive Outlook for U.S. sovereign debt. It will be ironic, considering the fact that the present administration has levied substantial criticism against the ratings agencies for playing favorites and turning a blind eye on corporate credit ratings in the past. But nobody has ever accused politicians of being above some good old fashioned hypocrisy.
So when the credit rating is cut, interest rates will skyrocket. There will be major crowding-out as the Treasury tries to keep itself afloat in the private debt market. There will be increasing pressure on the Federal Reserve (and increasingly will call its independence into question) to engage in yet more quantitative easing, which can and will only lead to inflation. There is no other course. The only other alternative is for the current Congress and Administration to radically reverse course on spending policy, something that has about as small a chance of happening as Mahmoud Ahmadinejad voluntarily stepping down as President of Iran.
Higher rates or inflation (or both, which is what is most likely), far from boding well for a recovery, are merely further circumstances that call into doubt these fantasy claims of recovery.
Inflation / Staglation & the British Canary
The Consumer Prices Index (CPI) - the Government's preferred measure of inflation - fell to a 16-month low of 2.2pc from 2.3pc in April, but it was a smaller fall than City economists had predicted. However, that had been anticipated and factored into economists' forecasts, and it was the so-called discretionary spending categories which prevented the expected fall in inflation..."We continue to see upward pressure in 'high street' prices and we continue to attribute this in part to the sharp depreciation in sterling seen over the past quarters, notwithstanding the significant rally posted in recent weeks," said David Page, economist at Investec. Inflation has now come in above economists' expectations in five of the past seven months.
It should be noted that it was the Bank of England that first embarked on the policy of quantitative easing in the Developed World. That inflation has now several times surprised economists' expectations in the UK should not surprise those of us who believe in sound money. It is almost humorous that these economists are baffled by the twin prospects of inflation and economic contraction, as if they have a completely blocked out the lessons of 1970s stagflation. For Gordon Brown and the already beleaguered Labour Party, the Winter of Discontent should haunt their dreams. Nevertheless, the rest of the world, at least those whose futures are tied to the Dollar, should take note: quantitative easing has consequences. Either we will sustain severe stagflation or else the Federal Reserve will be forced to abandon its easy money policies once again to tame the inflation beast, thrusting the American economy directly back into the throes of recession. Recession of course is the best medicine for malinvestments, and had the government permitted the recession to run its course, we would at least be closer to the path to recovery. Instead, government and Federal Reserve policies tried to avoid the pain of recession by manipulating the markets with massive infusions of cash which will either have to be pulled out or allowed to run their course.
The further problem we should observe in this situation is that avoiding a further massive contraction becomes ever-more costly. For it is not only a matter of leaving the current inflationary dollars in the system that is required to keep the economy on life support, it is the need to continually feed the monster with more and more newly-minted money. Virtually any policy pursued by the Federal Reserve at this point will have adverse circumstances.
Conclusion
So what's an investor/entrepreneur to do? The answer is to look to the handful of countries pursuing responsible economic policies. The trouble is, you won't find many. The Developed World has gotten itself into a position where it bet everything on Red 15 and the roulette ball landed on Black 7. Doubling down on its debts in the hope that the new bets would pay off has only doubled downed the consequences (both immediate and long-term) of our current unpleasantness. There is plenty of capital sitting on the sidelines today, and it has to have a place to go. Developing Countries with stable monetary systems offer some haven for investors looking to escape the uneasiness of the over-leveraged developed world. Emerging market equities in Asia, and Latin America's stable countries have a far greater chance of holding the value and outperforming investments in the developed world not only in the short-term, but over time.
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