The USD's exorbitant privilege

For the crypto folks who embrace the libertarian philosophy of using a medium of exchange not issued by any national government, here are a couple of reminders of what the USD "exorbitant privilege" means in real life. 

The full post can be found here.

A warning on Canadian banks

I don`t write about my native Canada very much, but the last few weeks of December is usually a time for getting together with friends and financial professionals. During such occasions, the discussion often turn to the markets.

One of the topics of discussion this year was the outlook for the Canadian market and, in particular, the banking sector. Canadian banks have been a favorite of individual investors in Canada, largely because of their dividend yield and their superior returns in the last few years. In a recent post, local fund manager Tom Bradley of Steadyhand Funds wrote about the growing level of investor complacency in this sector:

I’m slow getting to this, but in the Report on Business a while ago John Heinzl addressed a common question from Canadian investors – ‘Why don’t I just have an all-bank portfolio?’

The question is not a surprising one given how profitable our banks are, what a powerful presence they have in our economy and how well their stocks have done. And it’s timely given questions about the impact a toppy housing market and troubled energy sector will have on the banks’ future. In his piece, however, John suggests that an all-bank portfolio is not a good idea. I concur.

Bradley went on to outline a number of risks facing the banks, including macro risks:

The Big 5 in Canada all have slightly different strategies, but they’re still tightly linked to the same economic factors: jobs, debt levels, commodity prices and the housing market. They will react similarly at times of stress.

From a big picture macro perspective, I would tend to agree. As the black line in the chart below shows, the Canadian financial sector has been beating the TSX Composite for about three years. However, there are a number of ominous signs suggesting that era of superior returns may be coming to an end.

In the above chart, I show a couple of other factors that are correlated with the relative market performance of financials. Credit, as measured by the relative price performance of Canadian corporate bonds (shown in blue), has been on an upswing - until recently. The recent negative performance of credit will likely create stresses in the banking system.

As well, we have seen the value/growth cycle in Canada (in purple) correlate well with the relative performance of financials. In 2014, value has rolled over against growth, which is another potential negative for financial stocks.

While I recognize that correlation is not causation, but these correlations are fundamentally driven. The macro factors that were once tailwinds for the outperformance of the financial sector, which is dominated by the Canadian banks, are now turning into headwinds.

Don't say that you weren't warned.

Don't get too excited about Cyprus

The financial markets sold off early Monday on the news of the weekend bailout of Cyprus, but while the risks of a financial meltdown, while real, they are overly exaggerated. As I write these words, US equities have recovered most of their losses and shrugged off the Cyprus news.


What happened?
To explain what happened, Cypriot banks got in over the heads with too much Greek debt and had to be rescued. The EU stepped in with a €10 billion rescue package, but with the conditionality that the government impose a 6.75% one-time levy on bank deposits under €100,000 and 10% for deposits over €100,000. The deal has yet to be ratified by the Cypriot parliament. If it isn’t, banks in Cyprus are certain to collapse and there are reports about how the deal is going to get modified.

The knee-jerk reaction was instantly negative. The fear is that if this can happen in Cyprus, it could happen elsewhere. What if Portugal, Spain or Ireland had to get bailed out, would depositor funds be at risk there too? What’s to stop the Portuguese, Spanish and Irish from pulling their euros out of their banks and putting into Deutschebank in Frankfurt, thus sparking an enormous bank run and threatening the health of the European banking system?


Bank run fears are overblown
I believe that any panic over a possible bank run in the eurozone is exaggerated. Wolfgang Münchau (see Europe is risking a bank run in the FT) highlighted the risks of a bank run but admitted that there are institutional barriers to a bank run on retail deposits:

There are some institutional impediments against bank runs within the eurozone. Some countries impose daily withdrawal limits, ostensibly as a measure against money laundering. Nor is it easy to open a bank account in a foreign country. In many cases, you need to have residency. You may need to travel there in person, and you need to speak the local language – or at least English.

While it is possible to get around these rules, the risks of a bank run that threatens the health of the banking system are low.

In addition, ECB head Mario Draghi has said in the past that he would do “whatever it takes” to save the eurozone. However, he has also made it clear that rescues come at a price. The Cypriot rescue conforms with the EU and ECB principle of the imposition of “conditionality” on rescues. In the case of Cyprus, the banks had insufficient equity to withstand the shock of a write-down of Greek debt and it didn’t have enough senior bond holders to cushion the pain without rendering the banking system insolvent. The only ones left to take the hit were the depositors. It didn’t hurt politically that Cyprus was known as an offshore banking haven, mainly for Russian oligarchs. So it was easy for Angela Merkel to sell a bailout involving shared pain to the German people.

I believe that bailouts of other eurozone countries, should they be necessary, will conform to a different template of conditionality other than the imposition of a tax on bank deposits. For example, the ECB has made it clear that it will backstop Spain, but on condition that the government undertake structural reforms and austerity. In the case of Spain, Rajoy has yet to swallow the bitter pill that comes with an OMT bailout.

Based on my analysis, the worst fear of the pessimists, which is a bank run in the eurozone, will not materialize.


Key risks
However, there are two key risks to this forecast. First, I am assuming that the Cypriot parliament will approve the rescue package and approval isn’t fully assured. If the deal were not to be ratified, it would likely introduce a new element of risk to the eurozone banking system and possible contagion into the global banking system. In that case, all bets are all.

The second is the French elephant in the room. The French economy is negatively diverging from Germany and France needs to take steps to align itself with Germany and the core eurozone economies. While the EU can rescue Greek and Cyprus, France is at the heart of the EU and much too big to save.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Another test of the banking lobby's powers

Last Friday, Yves Smith at Naked Capitalism wrote that the LIBOR scandal may create "a day of reckoning" for Barclays from litigation that "regulators and politicians" couldn't or wouldn't do [emphasis added]:

As the Economist points out:

The sums involved might have been huge. Barclays was a leading trader of these sorts of derivatives, and even relatively small moves in the final value of LIBOR could have resulted in daily profits or losses worth millions of dollars. In 2007, for instance, the loss (or gain) that Barclays stood to make from normal moves in interest rates over any given day was £20m ($40m at the time). In settlements with the Financial Services Authority (FSA) in Britain and America’s Department of Justice, Barclays accepted that its traders had manipulated rates on hundreds of occasions.

And the idea that one party’s loss from the manipulation was another’s gain is irrelevant to those on the losing side:

….banks will be sued only by those who have lost, and will be unable to claim back the unjust gains made by some of their other customers. Lawyers acting for corporations or other banks say their clients are also considering whether they can walk away from contracts with banks such as long-term derivatives priced off LIBOR.

I expect the firms involved to face a locust swarm of litigation. Lawyers may accomplish what regulators and politicians refused to do: strip the banks of ill gotten gains and bring their preening CEOs and “producers” down a few notches. A day of reckoning may finally be coming.

The article from The Economist quoted by Smith documented the potential legal fallout [emphasis added]:

Over the past week damning evidence has emerged, in documents detailing a settlement between Barclays and regulators in America and Britain, that employees at the bank and at several other unnamed banks tried to rig the number time and again over a period of at least five years. And worse is likely to emerge. Investigations by regulators in several countries, including Canada, America, Japan, the EU, Switzerland and Britain, are looking into allegations that LIBOR and similar rates were rigged by large numbers of banks. Corporations and lawyers, too, are examining whether they can sue Barclays or other banks for harm they have suffered. That could cost the banking industry tens of billions of dollars. “This is the banking industry’s tobacco moment,” says the chief executive of a multinational bank, referring to the lawsuits and settlements that cost America’s tobacco industry more than $200 billion in 1998. “It’s that big,” he says.

 

We've been down this road before
This will, indeed, be another test of the powers of the banking lobby. We've been down this road before. The robo-signing and liar loans excesses that led to the mortgage crisis are well known. But there's more. Yves Smith wrote in November 2010 about the robo-foreclosure scandal in the United States (see Servicer-Driven Foreclosures: The Perfect Crime?):

I’ve been in contact for over the last six months with attorneys involved in foreclosure defense. Unlike the foreclosure mills, which seem to coin money, the attorneys on this front are either laboring pro bono or making considerably less than they could in other lines of work. They also can back up their views with depositions and trial transcripts.

One thing they stress is that a significant number of their clients facing foreclosure has made every single mortgage payment. . Read that again.

The post is well worth reading in its entirety. She wrote that gist of the problem is that mortgage servicers, either deliberately, or are sloppy by design, mis-process payments so that borrowers are flagged to be late and therefore the lender can tack on services fees. This makes the mortgage appears to be delinquent (if the borrower doesn't catch the mistake and complain) and that's an excuse for the lender to foreclose.

Smith also documented mortgage documentation fraud where, for a price, a firm will fabricate whatever documentation is necessary for a lender to foreclose on a property. Barry Ritholz has also extensively covered this problem (see his foreclosure fraud linkfest here). At the heart of the problem is Ritholz's contention of Why Foreclosure Fraud Is So Dangerous to Property Rights.


Enter the Mortgage Settlement
So what happened? The mortgage settlement happened. In February 2012, Smith wrote again about The Top Twelve Reasons Why You Should Hate the Mortgage Settlement. The first and most important reason (IMHO) is [emphasis added]:

1. We’ve now set a price for forgeries and fabricating documents. It’s $2000 per loan. This is a rounding error compared to the chain of title problem these systematic practices were designed to circumvent. The cost is also trivial in comparison to the average loan, which is roughly $180k, so the settlement represents about 1% of loan balances. It is less than the price of the title insurance that banks failed to get when they transferred the loans to the trust. It is a fraction of the cost of the legal expenses when foreclosures are challenged. It’s a great deal for the banks because no one is at any of the servicers going to jail for forgery and the banks have set the upper bound of the cost of riding roughshod over 300 years of real estate law.

She concluded:

As we’ve said before, this settlement is yet another raw demonstration of who wields power in America, and it isn’t you and me. It’s bad enough to see these negotiations come to their predictable, sorry outcome. It adds insult to injury to see some try to depict it as a win for long suffering, still abused homeowners.

A well-traveled road
Now we have Barclays and the LIBOR manipulation scandal. We saw extensive litigation as a result the mortgage and foreclosure frauds, now we are likely going to see extensive litigation with LIBOR manipulation. Can we expect a result from the litigation where "regulators and politicians" couldn't or wouldn't do?

The banking lobby made the mortgage mess go away for roughly $2,000 per loan. Will things get swept under the rug again? Admittedly, the mortgage scandal was in the United States and pitted the power of the financial system against the ordinary householder. The LIBOR scandal will be a test of strength in the UK, a different jurisdiction, between institutions.

Any way you look at it, this will be another test of the powers of the banking lobby.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

An upside-down perspective

For a different perspective, it's always useful to look at a stock chart differently. Consider the following chart whose identifying labels have been removed, would you buy this stock?

The pattern certainly looks constructive. The "stock" has certainly been forming a wide saucer base and undergoing an uptrend. Would you buy it?
What about this next one?

This chart of this second "stock" is similar to the first one, except that the pattern is a little better developed inasmuch as it has broken out of resistance and undergoing a classic bullish cup and handle formation.

I don't want to keep everyone in suspense. The first chart is the Euro STOXX 50 viewed upside-down, which is the market's signal of the ongoing problems in the eurozone, and the second is the upside-down chart of the yield on 10-year Treasury Note (TNX), an indicator of the risk-off safety trade. Here I present the original charts, without further comments or annotations.

These charts have mixed messages as to the timing of a break. The inverted chart of TNX suggests that the time to tactically get defensive is now, while the chart of the Euro STOXX 50 indicates a breakdown is more likely in 1Q. Much could happen next week as we approach the Marseilles summit, but many obstacles remain.

My inner investor tells me to be afraid, very afraid. My inner trader tells me to be prepared for volatility in the next two weeks, which will see an ECB meeting, an EU summit and an FOMC meeting. Anything can happen in the short-term.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The poisoned bank recap chalice

We don't have the full details of the eurozone Grand Plan to be unveiled on Wednesday, but some details are clear. One of the key components of the proposal is to force a number of major European banks to recapitalize their capital base to 9% within a relatively short period. Banks would be encouraged to seek capital privately first. If that is not available, the bank could then turn to the individual member state, and failing that, to the EFSF.

This is a version of the Swedish solution, whereby shareholders and bondholders take the first hit in any recapitalization before the state injects equity. I have long been an advocate of this approach, but even that proposal needs a re-think. That's because the eurozone problem stems from too much sovereign debt accumulated by a number of EU member states and much of that debt was stuffed into eurozone banks. So the solution of the state rescuing the banks who lent the state too much money becomes a circular problem of trying to insure yourself.

What's more, the spectacle of EU states trying to rescue themselves has become too big. John Hussman put some scale to the size of the problem this week [emphasis added]:

My guess is that European leaders will force a bank recapitalization within days - probably 100 billion euros, preferably 200 billion, but the larger number is doubtful because at present market values, European banks would have to sell new shares in nearly the same quantity as their current outstanding float in order to acquire the new capital. Yet Stratfor correctly notes that even in the event of a 200 billion recapitalization, a 50% haircut on Greek debt "would absorb more than half of that 200 billion euros. A mere 8 percent haircut on Italian debt would absorb the remainder." So a good chunk of the present EFSF could end up recapitalizing banks, especially if too little is raised from private investors. This would leave little ammunition against any further strains, should they develop.

The current rumor is that size of the forced bank recapitalization will be about  €108 billion, which would be roughly half the value of market float at current prices. Bank CEOs who are incentivized by their share prices would be highly reluctant to go to the market and dilute their equity base by being a forced seller. By demanding that banks recapitalize quickly, the risks is that banks shrink their balance sheet by calling in loans in order to conform with the 9% capital target. This would result in an old-fashioned credit crunch, and in the face of the latest European PMI already pointing to recessionary conditions, such a policy would topple Europe's fragile economy into a deeper abyss.


€2 trillion = 20% of global FX reserves
If those aren't the solutions, then where else could the EU get the money? I wrote on Sunday that Europe has three choices:

• Get more money internally from the strong states within the EU such as Germany;
• Get more money externally, e.g. the US or BRIC countries; or
• The ECB prints the money.

Given that Merkel is already on thin ice by asking the Bundestag to approve the latest EFSF proposals, the prospect of more funds from Germany is off the table. What about the United States, BRIC and Gulf State SWFs? While stories such as Norway's SWF is ready to invest are helpful, STRATFOR (sorry no link) put the scale of the problem into context:

[T]o put the magnitude of Europe’s crisis in context, it would take nearly 20 percent of the worlds accumulated foreign exchange reserves to account for the approximately 2 trillion euros needed to contain the EU debt crisis for a mere 3 years. The unlikelihood of such funds materializing is compounded by the fact that most of the foreign currency reserves are held by low-income countries with little political room to bail out one of the world’s wealthiest economic zones.

The kinds of shock-and-awe eurozone rescue figures that have been bandied about have been in the order of €2 trillion, which amounts to roughly 20% of global foreign exchange reserves? China has already signaled its reluctance to step up and help in a meaningful way. How likely are the other emerging market countries come to the rescue?

In short, forcing European banks to drink from the poisoned bank recapitalization chalice today could the policy mistake that plunges Europe and the world into a synchronized global slowdown. Don't expect other players, such as the IMF or emerging market economies to come to the rescue because the scale of the problem is just too big.

I guess it's all up to Super Mario now.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Banking liquidity vs. solvency

In the past few weeks I have had a number of discussions with investors. Virtually everyone knows that there is a banking crisis brewing in Europe but some have only a vague understanding of the mechanics of the crisis of its resolution. For the benefit of everyone, here is a primer on banking.

Here is an idealized model of a bank. Bank ABC takes in $100 in deposits (so it owes the depositors $100). To make money, it lends out its deposits. To be prudent (because loans can go sour), it lends out $93. It has $5 in common equity and an additional $3 in preferred share equity and bonds.

Supposing that Bank ABC makes 1% on the spread between its deposits and loans. Since the ratio of deposits to common equity is 20 to 1 ($100 to $5), that equates to a 20% return, before paying expenses, such as salaries, rent, etc.


What happens in a liquidity crisis
Let's assume the economy is doing fine, but there are whispers on the street that Bank ABC is unstable. Depositors rush to the bank and withdraw their money. What happens then?

The bank has an obligation to give the depositors their money (it is their money, after all). The bank has a health porfolio of loans. That's called a liquidity crisis.

In order to have the funds on hand to pay out its depositors it borrows from other banks, or to the central bank as a lender of last resort. It may be required to put up collateral to fund those loans.


Solvency crisis: What if the loans aren't any good?
Supposing the rumors were right. A part of the $93 in loans that the bank lent out have largely gone sour. The loan portfolio is now worth $90 (and $3 in loan losses).

In that case, the shareholders take the first hit. Their $5 in equity is now $2. If there are further loan losses, then shareholders get hit further, then the preferred shareholders are next, followed by bondholders.

Supposing that Bank ABC were to get hit with $10 in loan losses instead of $3. They now have negative equity. This is called insolvency - and no amount of liquidity injection from the central bank can save Bank ABC.


European fears
Yesterday, we had news of coordinated USD liquidity injection into the European banking system, largely on the basis that European banks had trouble finding USD deposits.

Will that be enough or is that just a band-aid?

Investors' worst fear about European banks is that they are insolvent, not merely illiquid. Supposing that Greece were to default - and their loans are suddenly worth, say, 30c on the dollar. Other peripheral European countries follow: Portugal, Ireland and possibly Spain and Italy.

The European banking system would become insolvent.

Bruce Krasting took apart SocGen boss Frederic Oudea's discussion of his bank and concluded that SocGen is in a very precarious position:

The market cap of SOGN as of the close was E12b. That is the bottom of a pile of assets that total E1.3T. The market cap to assets is only 1.0%. Compare that to Wells Fargo @ 10.0% and you see the problem. Even stinky old BAC has a 3.30% of market cap to its balance sheet.

Krasting went on to diss the prospect of SocGen shoring up its equity through a rights offering or preferred shares, as well as its efforts to de-lever and shrink its balance sheet through asset sales:

This is both accurate and scary. The clear suggestion is that many of the banks in Europe face much steeper problems than SocGen. I thank the CEO for this important clarification.

Don't confuse a solvency problem with a liquidity problem. If SocGen is the tip of the European banking iceberg, then we do have much to worry about.


Judging the effectiveness intervention
If a problem were to appear, watch how the authorities intervene. The cleanest approach is the Swedish solution that I wrote about before. Let's go back to the previous example where Bank ABC suffers a $10 loan loss and becomes insolvent. Under the Swedish solution, the government comes in and injects new equity to make the depositors whole. The shareholders get wiped out. The preferred shareholders and bondholders either take haircuts or get wiped out.

On the other hand, we have the US approach in 2008, or what I call the TARP solution. In effect, the authorities said, "I know that these loans are not worth face value, but we'll pretend that that they are and we'll make you whole on the loans." In effect, they bought those loans for roughly face value on the fear that if they didn't, the entire banking system would go down.

Notwithstanding the inequity of the arrangement, let's consider the relative cost of the Swedish solution compared to the TARP solution. If you were to spend $1 to recapitalize a bank that is levered 20 to 1 under the Swedish solution, you would have to spend $20 (20 to 1 leverage) under the TARP solution.

Reuters reported that Tim Geithner is proposing to lever EFSF 10 to 1 and implement a TALF program to the Europeans at their meeting in Poland today. Initial reactions have been negative. Felix Salmon writes:

The point here is that the EFSF was specifically designed as a fiscal alternative to the ECB; if the ECB wasn’t happy putting up $440 billion of its own money for such schemes, it’s unlikely to put up $2 trillion.

FT Alphaville went on to point out the shortcomings of TALF:

Talf, you’ll remember — and as wonderfully explained and pilloried by Tracy Alloway — involved the US Treasury offering credit protection to the NY Fed, which then loaned out money to investors with the explicit intent of using the loans to buy asset-backed securities.

But the design was deeply flawed — not least because the loans were non-recourse, meaning that borrowers could simply default, surrender the crap ABS collateral, and walk off into the sunset with nary a remedy for the Fed to pursue.

Watch this space. Once you understand the mechanics of banking you will begin to understand the problem and the likely effectiveness of any intervention.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Banks not out of the woods despite the BAC deal

As the news of the Berkshire/Bank of America deal hit the tape, BAC rallied and so did the banking sector. I had written about the systemic risks that Mr. Market was indicating in the banking system, how does this BAC rescue change the picture?

The answer is, "Not very much."

Take a look at the relative performance of the BKX compared to the market. Notwithstanding the fact that the Buffett rescue was a sweetheart deal (not everyone can get a 6% coupon on preferred shares senior to the common, so that if everything blows up the common shareholders eat the loss first, plus Buffett gets common share warrants as a "sweetener"), the banks have rallied but remain in a relative downtrend. I would like to see the relative downtrend broken and, ideally, a rally above the relative support line (which has become resistance) broken in June.

The performance of the Regional Banks, which are less exposed to European sovereign risk,  tells the same story. This was a nice rally, to be sure. But it was not enough to change the picture of a banking sector that is deteriorating.

Let's see if Bernanke can ride to the rescue, but I am on record as stating that such a possibility is doubtful. Add to the equation the observation that corporate bonds spreads are starting to blow out, Mr. Market is telling us that the systemic risks are rising in the financial system. Until the banks can stage a significant follow-through on the rally on Thursday, I remain of the opinion that a Euro-disaster is still menacing the global financial system much in the same way that Irene is menacing the US east coast.

Banking system like 2008? What about 1998 and LTCM?

Recently there has been some discussion about the stress showing up in the banking system. Cullen Roche at Pragmatic Capitalism pointed out that the CDS market in the selected European banks is showing higher levels of stress than 2008:

Don Fishbach pointed out that the average CDS level for US banks is higher than levels seen in March 2008, which is worse than the Bear Stearns peak but lower than the worse stress seen during the Lehman Crisis:

I wrote about this indicator in May 2011. My own indicator of the BKX relative the the market is now in freefall. There were two occasions in the past when this indicator was in freefall after breaking down through a relative support level. The first time was in 1998 just before the Russia Crisis took down Long Term Capital Management. The second occasion was more benign, as the stock market outperformed the banks during the 1999 run-up to the NASDAQ peak of March 2000.

Right now, we have the stock price of Bank of America in a waterfall decline and European banks teetering at the edge. If the real stress in the financial system lies with Europe, which I believe it is, then we have real trouble as the ECB and EU have shown that they are paralyzed and anything that Bernanke Fed announces Friday at Jackson Hole is likely to be a sideshow.

Signs of the Apocalypse?

As we approach Halloween, here are some signs of the Apocalypse:

• The average American credit score is now 666. Does this mean it's time to watch the Rapture Index more closely?
• The US has slipped to 22nd in the global corruption ranking tables, a historic low. In the Americas, this puts the country behind Canada, Barbados and Chile. Nancy Boswell, the president of Transparency International which conducted the survey, said: "We're not talking about corruption in the sense of breaking the law. We're talking about a sense that the system is corrupted by these practices. There's an integrity deficit."

Do you think that examples such as the banks hiding behind the slogan of "paperwork technical problems" when there was widespread fraud and claiming that no one was thrown out of their home who shouldn't have might have something to do with the "integrity deficit" in America?

Could China be ahead of the curve on Basel III?

In the wake of the announcement of the Basel III standards, there have been numerous calls that the standards are too relaxed (see comments here, here, here and here).


Last Friday, the following statement appeared on the PBoC website on the topic of banking in China:

Bank lending is concentrated on local government financing vehicles, the infrastructure sector and big corporations. With the speeding up of structural economic adjustments, there is clearly a rising possibility of loan losses. The quality of loans to the property industry is currently still sound. But we need to be on high alert as to the impact of property price fluctuations on such loans. The NPL ratio of credit card loans is rising rapidly and the potential risks demand attention. By the end of 2009, bad credit card loans reached 7.8 billion yuan, up from 3.5 billion yuan a year earlier. The NPL ratio of such loans stood at 2.8 percent.

...but banks continue to have a dual mandate

Banks should continue to support exporters to help a recovery in exports and support domestic firms venturing abroad. Banks need to increase recapitalisation efforts and replenish their core capital base via retained earnings and fresh injections of capital from shareholders.

...and they expect to implement Basel III:

China will restrain the blind expansion of banks by implementing stricter capital requirements in line with the Basel Accord. China will open up the banking sector in a timely manner and actively attract foreign financial firms that will help the country to better serve small businesses and agriculture and to boost domestic consumption.

If official government policy is that the banking system is to support "a recovery in exports and support domestic firms venturing abroad" and the banking system is fragile, then something must be done to ensure that banks don't drag the system down. There was also a Bloomberg story that China may impose a 15% capital ratio for the biggest banks.

Is China ahead of the curve on this?

AEI says "Why can't we be like Canada"???

I sat here on a lazy Sunday night at my house in Vancouver, which is about 15 minutes away from Cypress Bowl, one of the venues of the Vancouver 2010 Olympics. I contemplated the friendly* but fierce rivalry in men’s hockey between Canada and the United States.


A change of heart?
Down south, there was an article from Mark Perry, a visiting scholar at the American Enterprises Institute, entitled Due North: Canada’s Marvelous Mortgage and Banking System. In the article, Perry pointed out some of the marvelous features of the Canadian banking system, which made it more stable.

I found it curious that a conservative think tank like the AEI would publish such a piece, particularly when conservative commentators have derided liberal commentators for comments like “Why can’t we be more like foreigners, like Denmark, or France…”

Now the AEI is publishing a piece that essentially says “Why can’t we be like Canada” ?!

Nothing in life is every free and choices have tradeoffs. In another era, the AEI would have been denouncing some of the anti-competitive practices of the Canadian system. Today, Mark Perry is extolling the Canadian banking system for its stability and points to the following reasons (comments in parenthesis are mine):

• Full Recourse Mortgages in Canada. (Agreed.)
• Shorter-Term Fixed Rates in Canada. (These are the equivalent of ARMs in the US, with terms of 1-5 years, though 7-10 year terms are available in Canada. Wasn’t the existence of low-rate teaser ARMs what got the US system in trouble in the first place?)
• Mortgage Insurance Is More Common in Canada than in the United States. (Agreed, though that just puts potential stress onto mortgage insurance. Remember that the CDS didn’t solve any problem, but exacerbated them.)
• No Tax Deductibility of Mortgage Interest in Canada. Home mortgage interest has never been tax-deductible in Canada, so there is no tax advantage to home ownership in Canada over renting. (In Canada, there is no capital gains tax on the sale of a principal residence. There are ways of making mortgage interest deductible. For example, if you fully owned your house and mortgaged it to make an investment, the interest is deductible.)
• Higher Prepayment Penalties in Canada. (Agreed.)
• Public Policy Differences for Low-Income Housing. To promote affordable housing for low-income households, the Canadian government has not used public policies like the Community Reinvestment Act in the United States. (The gap between rich and poor in Canada is far lower than the US. The impetus for legislation like the Community Reinvestment Act is therefore lower.)
• Differences in Canada’s Bank Concentration and Greater Diversification. (The tradeoff is oligopolistic practices. Banks are stodgy up here and act like the Post Office. Notwithstanding Paul Volcker’s remark about the only useful banking innovation is the ATM, Citi has a useful online credit card tool where you can generate a credit card number for one-time use, which is handy for internet transactions. I have never seen a Canadian bank come up with innovations like that.)
• A Few Other Differences that Contribute to Bank Safety in Canada. There is a much lower rate of loan originations by mortgage brokers in Canada (only 35 percent) than in the U.S. (70 percent), far less mortgage securitization in Canada than here, and a much smaller subprime mortgage market. Banks in Canada keep and service 68 percent of the mortgages on their own balance sheets that they originate and underwrite, which encourages prudent lending since banks are putting much of their own capital at risk. Finally, almost all mortgage payments in Canada are made electronically by an automatic payment arrangement, which minimizes late payments. (I am not sure the size of the benefits that electronic or automatic payment confer. However, during the boom years, conservative think tanks like the AEI would have been decrying the lack of imagination of Canadians in fully developing a mortgage securitization market.)

There is no free lunch
The Canadian banking system represents a low-beta system, whereas the US system is a higher beta system. It just so happens that the financial system underwent a shock - an environment where low-beta systems outperform. During the boom years, the AEI would have been celebrating the "innovative" nature of the higher beta US system.

Richard Nixon famously said “we are all Keynesians now.”

In light of Canada's record setting gold medal haul at the Winter Games, are we all Canadians now?

Do we want to be?


Addendum: I was initially ambivalent about the Olympics in my city, but now that the Closing Ceremonies have come and gone, I am glad that to see that our visistors had such a marvelous time.

[*] TV coverage showed the Canadian troops in Afghanistan holding a sign that read Brothers in arms, but not on the ice.