sovereign debt crisis

The EU ‘Rescue Fund’ – Part of The Problem Not The Solution

There is still much to be decided before EU leaders can claim to have provided a comprehensive and credible plan to end the sovereign debt crisis. The rescue fund itself has met with significant obstacles, with demand in doubt and delays to capital raising leading to question marks over its ability to borrow on behalf of those that can’t. Instead of improving sentiment, it may cause it to deteriorate. Details, commitment, growth, structural reforms and greater consolidation of governance, fiscal policy and politics are needed. This has become a global issue.

Deutsche Bank, Germany’s biggest bank, and Credit Agricole, the largest retail banking group in France, rallied more than 19% over the last week in October after certain ‘positive’ news was announced at EU Summit. Measures included the leveraging of the rescue fund to €1tn, a voluntary default of Greek debt and bank recapitalisation. However, this may involve a dangerous derivative structure with insurance coverage not guaranteed and demands not going far enough.

Delays could hit sentiment, deadline looming

The European Financial Stability Fund (a.k.a. the ‘rescue fund’) was created to borrow on behalf of those countries that found themselves unable to borrow (read Greece, Ireland, Portugal etc). However, Wednesday’s attempt to raise capital met a substantial obstacle – limited demand, leaving the fund itself unable to borrow. The €3bn 10-year bond offering had to be postponed, in the hope conditions would improve but a ‘red flag’ has been raised. If this fund is already having issues, at its current size with a lending capacity of €440bn, how will it manage with demands up to €1tn? Inadequate demand could cause sentiment to deteriorate, worsening the very situation it was meant to improve.

Demand from the East now in doubt

Plans to leverage the current fund to enable this €1tn of firepower seem to be heavily reliant on demand from the likes of China and Japan. This makes their apparent lack of interest in this recent bond offering most worrying. Investors have maintained the situation is too opaque and the risk/reward potential too skewed to the downside.

Dangerous derivative structure

The ‘Special Purpose Investment Vehicle’ which would allow this leveraging to occur has been likened to a CDO – collateralised debt obligation and the instrument that was at the heart of the subprime crisis, by insuring investors against loss. The bonds act as collateral so investors effectively buy junk sovereign debt with a certain level of guarantee from the fund.

The Greek ‘haircut’ has highlighted some of the risks. The ‘writedown’ of debt was structured as ‘voluntary’. It was agreed that private bond holders should offer to write off half of the amount Greece owed them versus a formal, official, enforced default. The latter would be classified as a credit event and trigger any insurers to pay up. However, the former doesn’t. Therefore investors who insured against losses paid a premium for cover but won’t get paid out to offset the losses suffered. The risk of a debt ‘default’ may not always be mitigated.

 Doesn’t cover all that is needed

More details are needed to understand how bailout facilities will be implemented and hopes for the first signs of commitment from the IMF, China and Japan were dashed at the G20 Meeting last Thursday and Friday. Moreover, the recapitalisation of the banks, which was set at €140bn will need to be increased dramatically. The IMF already put the level at €200bn, with analysts advising a number nearer €275bn.

Finally, the fund does not compensate for what the EU really needs: growth, structural reforms and greater consolidation of governance, fiscal policy and politics. The EU’s jobless figures are the highest they’ve been since the launch of the euro. Draghi may have put the focus back on growth by cutting interest rates, in a move that surprised the markets, from 1.5% to 1.25% but admitted growth forecasts are likely to be downgraded so the EU economy will remain fragile for some time. Accounting for approximately 24% of global GDP and with lower demand hitting export-oriented Asian countries, as for example Taiwan expands at its slowest rate for 2 years.

This is a global issue.

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Banks Slash Jobs but Severe Headwinds Remain

As banks all over the world slash jobs, we ask ourselves – will this produce more streamline firms ready to generate significant profits, or a sign of the poor outlook for the sector? Unfortunately, stifling regulation repressive and a false bubble has driven this move and severe headwinds remain through exposure to struggling economies and substantial funding needs.

The 50 largest banks around the world have announced almost 60,000 job cuts. UBS are laying off 5.3% of their workforce, blaming stricter capital requirements and slowdown in client trading activity; Credit Suisse cutting jobs by 4% to save SFr1bn and Lloyds a whopping 14%.

Restrictive regulation make banks more stable but less profitable

Stricter capital requirements were just the type of new regulatory measures the Chief Executive of Standard Chartered feared at Davos back in January, would “stifle growth”. At this time we saw banks such as Credit Suisse missing earnings targets and downgrade their expectations severely going forward (from above 18% return on equity to 15%, which turned out to still be too high).

UBS has seen costs in their investment banking division soar to 77% of income and net profit fall almost 50% from a year earlier. Stricter capital requirements mean banks have to hold a higher amount of capital in order to honour withdrawals if hit with operating losses. Furthermore, restrictions on bonuses led to increases in fixed salaries and an inflexible cost base.

Backtracking on a false bubble

Job cuts should also be set within the context of occurring after a ‘false bubble’. Post the 2008 financial crisis and bank bankruptcies and proprietary trading layoffs, the fixed income, currency and commodity business of the remaining players boomed as competition dropped. Banks began expanding. UBS’s proposed cuts of 3,500 jobs comes after an expansion of 1,700 to the workforce and incomparable to the 18,500 job losses experienced during the crisis.

Exposure to struggling economies is a key threat

Crucially, these cuts do nothing to solve the biggest problem these banks are struggling with. They have substantial exposure to struggling EU economies. In Germany, bank exposure to the PIIGS (Portugal, Italy, Ireland and Spain) amounts to more than 18% of the countries GDP. Just last month Commerzbank suffered a €760m write-down from holding debt that is unlikely to be repaid, which all but wiped out their entire earnings for the second quarter of the year. Further fuelling fear of the spread of the crisis from periphery to core is that French banks are among the largest holders of Greek debt.

Here in the UK we’re by no means immune. Our banks have £100bn connected to the fate of these periphery economies. RBS, 83% owned by the British taxpayer is so heavily exposed to Greek debt that it has written off £733m so far this year.

Severe funding needs and fear of lending exacerbate the problem

90 EU banks need to roll €5.4tn over the next 24 months. This will be funded at higher rates and with disappearing demand as investors become more wary, exacerbating the problem. In addition these banks need to raise an extra $100bn by the end of the year. An inability to borrow to satisfy current obligations, not withstanding any expansive moves, is a serious obstacle to profit generation. 

Moreover, job cuts do nothing to boost confidence to encourage banks to lend. Just two weeks ago, EU banks deposited €107bn with the European Central Bank overnight than lend to each other. If banks are not even lending to each other, losing out on a valuable opportunity to make money, then how encouraged are we as investors to get involved?


Europe – Lacking a Long-Term Solution

Over the last few days we have seen a tremendous amount of volatility in the markets, epitomising the lack of clarity with which many investors have struggled. The contagion continues to spread as we hear rumours of a possible downgrade of French government debt although it is far more likely to occur for Italy first. Fundamentally, there is a lack of a long-term solution and the knee-jerk reaction by some EU countries to ban short selling not only misses the point, it may negatively impact the very stocks it is trying to protect. So as we see movement to safe havens, we also see room for opportunistic buying – as long as you invest with those with strong balance sheets unlikely to be hit in future earnings downgrades and have a long enough time horizon to withstand the volatility.

Italy and France to be downgraded? The Contagion Continues to Spread

The markets are already betting for the ratings agencies to downgrade France’s debt with credit default swap spreads widening to double their level at the beginning of July. A rising expense to insure against default implies the market believes it to be more likely. However, Italy is the more likely downgrade candidate in the short-term. The reasons given behind Portugal’s downgrade a few months back apply equally to Italy – an unsustainable debt burden (Italy has the third largest in the word at €1.8tn) and a low likelihood of being able to repay these obligations (as it dips back into recession). The European Financial Stability Fund is losing its credibility since even its increase to €440bn is not enough to cover future potential bailouts and would need to amount to at least €2tn. The crux of the problem, as I’ve iterated before, is that you can’t solve the problem of debt with debt and austerity does not foster growth. Instead debt burdens are increasing at a faster rate than GDP growth in many western economies so the situation is only getting worse.

Outlook for banks: Headwinds for banks remain

European banks remain highly correlated to the future of the periphery. German banks, for example, have exposure to the PIIGS (Portugal, Ireland, Italy and Spain) amounting to more than 18% of German GDP. Commerzbank revealed that a €760m write-down for Greek debt holdings wiped out their entire Q2 earnings. That’s before we look at France who have an even higher exposure and here in the UK, our banks have nearly £100bn exposed to struggling economies. Furthermore, these banks need to refinance maturing debt (at a rate of €5.4tn over the next 24 months) at higher rates and with demand shrinking.

Will the ban on short-selling help? No, it misses the point

The markets are concerned with government fiscal credibility not its regulatory might. Instead, the ban could increase volatility and negatively impact the very stocks it is trying to protect. ‘Shorting’ was acknowledged by the Committee for European Securities Regulators as beneficial for “price discovery, liquidity and risk management” just last year, so we may well see higher volatility than we would have without. Secondly, it limits fund ability to bet on financials going up. Hedge funds use shorts to remove market risk, buying shares in one bank and borrowing and selling shares in another. If they are forced to close these ‘borrowed’ positions, they will have to sell the other bank shares they have bought outright, causing further selling pressure and price falls. Most interesting was the timing of the implementation, just before an announcement was made that the Greek economy shrank by 7% in Q2 – fuelling fears the ban was needed since there’s more bad news to come.

How to trade these markets: Movement to safe haven offering opportunities

So how can you invest in these markets? A possible support to the stock markets is the ‘search for yield’. Sitting on cash can’t be satisfying for long, with rates as low as they are, and the dividend yield on the Eurostoxx is now double the 10 year German ‘bund’ yield. This means that even if markets go sideways, the return generated from holding European stocks could be more attractive than either if the other options. In addition, valuations are looking reasonable, at a near 8x forward earnings. Therefore we may see flows returning to the markets. However, be warned, we are starting to see earnings downgrades and volatility may remain. Therefore invest in companies with strong balance sheets and maintain a medium to longer-term time horizon.

The US Debt Ceiling: The How, Why and What Could Happen?

The deadline for delivering a deal to allow the US to continue to borrow and spend, August 2nd, is approaching. Mirroring issues in the EU, a problem of debt cannot be solved by yet more debt. With the threat of a downgrade looming, any rise in interest rates could make the situation worse, hitting the tax payer and US exporters. Moreover, an increase in this ‘benchmark’ rate could impact the UK and hurt our property market, and a weaker dollar could result in job losses in our export sector. Further afield, with China the largest holder of US debt, the concern could spread globally towards countries relied upon to drive future growth. But failing to raise the ceiling isn’t an option and may cause an eventual default further down the line. Therefore, a deal will be struck and a balance found between demands for more spending cuts and aspirations for tax increases.

The US has ‘maxed out its credit card’

The US debt ‘ceiling’ is the maximum amount of bonds the US can issue, i.e. the maximum amount the US can borrow to finance its spending. The limit is currently set at $14.3tn but with the country spending approximately $120bn more than it takes in terms of revenue each month, after funding its participation in 2 world wars, rescuing the financial system post-Lehmans and pumping the economy with new capital to boost economic growth, the debt limit was reached on May 16. Put another way, the US has maxed out its credit card.

The issue echoes EU troubles: Debt cannot solve the problem of debt

Instigated in 1917, the debt ceiling has in fact been raised 74 times since 1962 alone. It should be noted; raising the limit does not increase fiscal spending but merely allows current obligations to be met and annual deficits to be financed. Nevertheless, in the current environment, with sovereign debt crises in Europe, investors and rating agencies are becoming acutely aware that cannot solve a problem of debt with more debt and the extent to which the ceiling would have to be expanded is troublesome. Obama’s proposed budget will require a ~$2.2tn hike just to meet next year’s obligations.

A lose-lose situation could hit tax payers and US exporters

Even if the ceiling is raised, there are other issues to tackle. S&P in April threatened reduce the credit rating of US debt. The importance of this threat should not be underestimated. With a ‘AAA’ status and ‘stable’ outlook’, any downgrade would threaten its role as the safest place to store savings. To retain their position, the US needs to address how it will not only plug this short-term gap, but also meet longer-term challenges. A hit to confidence would increase the rate of interest demanded by investors to compensate for a higher perceived risk of loss. This would increase borrowing costs for the US, worsening their debt burden and further limiting the amount of new debt they would be able to issue. It has been estimated that even an increase of 25 basis points could cost tax payers $500m more per month. With less demand for US treasuries, there would be less demand for the dollar to fund these transactions, making the products the country exports more expensive abroad and again hitting their balance sheet.

The issue could hit the East and future global growth

In its extreme, uncertainty could spark another financial crisis as well as put the dollar’s status as the world reserve currency at risk. (Interestingly, a McKinsey investigation reported less than 20% of business executives expect its dominance to continue to 2025). For this isn’t an isolated incidence. Dollar-denominated US debt is held world-wide (especially $1.1tn by China), spreading the problem towards the very countries many are lauding as growth drivers of the future.

UK jobs, home prices and recovery could be hit

There could be dire consequences felt even in the UK. The US is our largest export partner, spending $50bn for our products last year alone. A weaker dollar would damage American buying power, making these products more expensive and damaging demand. This would cause companies producing these goods to suffer and jobs would be lost. Furthermore, if fears over the ability of the US government to repay its debts led to investors demanding more to lend to the UK government, mortgage rates would become more onerous and it could be harder for buyers to purchase a property. With less investors able to buy and therefore lower demand, sellers may be forced to lower asking prices to get a sale.

Failing to raise the ceiling wouldn’t cause an immediate but an eventual default

In the near-term, the US could continue to function. Failing to be able to increase borrowing would necessitate spending cuts: to military salaries, social security, medicare and unemployment benefits. Furthermore, some of their debt could be rolled over so long as the overall amount of treasuries outstanding didn’t rise. However, this is unsustainable in the medium to longer-term and would lead to an eventual default.

With too much at stake a deal is likely to be reached

The issue is currently being used as a negotiating chip by Republicans to get deeper cuts and long-term reforms whilst refusing to raise taxes, versus the White House aiming to cap tax exemptions and reduce ‘inequalities’ benefitting big business. Nevertheless, with such serious ramifications possible, it is unlikely a deal will not be struck.

Opportunities for Careful Investors

THE current financial climate is making it harder to decipher where investors are going to find returns. The rates on holding cash are low, bond yields in general have narrowed substantially and there is much uncertainty on the outlook for the stock market. In addition, with macro risks on our minds and the sovereign debt crisis raising concerns, risk aversion is on the rise. In this environment, investing in something tangible that could provide a potentially uncorrelated return is attractive. Nevertheless, there has been a vast difference in returns from various investments in this market. Therefore, it will pay to be particular.

There has been a stark divergence of fortunes between property prices inside and outside of London. Location within or access to the city is a price-setter. Fundamentally, prime assets in attractive sectors should see a level of demand providing a floor on prices. Foreign investors have been quoted as spending £3.7bn per annum for London residences, due to the inviting exchange rate, national ties, as well as in some case the greater political stability that our city can offer. The emergence of an appetite for second homes has created demand in another segment of property investing, where the right location will again be crucial.

Students are another opportunity. Regional student housing is the UK’s best performing sector with around a 15 per cent ROI last year thanks to a shortage of suitable one-bed apartments. Broadly speaking, this is a “buy-to-let” approach. Rental rates are at all-time highs and the short-let market is booming. It is predicted that for the Olympics, rates will increase six-fold.

Therefore, depending on your strategy, timing may also be crucial. To play the school or student market, the run up to September is a key window of opportunity. The challenge is in finding the investments that fit your aspirations, and putting your plan into action at the right time. In a desired area, properties can attract multiple buyers, making this task tougher.

Nevertheless, with inflation one of the biggest threats to the market currently, implementing the right strategy and picking the right property will help provide some protection.

This article was featured in CityAM.