Issue 62- May 24, 2010

Next Sequel

The crisis which had been smoldering around a potential Greek insolvency has finally broken out into a full fledged Euro Zone conflagration. The ECB has responded with promises of an impressive $1BB plan to address the immediate liquidity needs of the P.I.G.S.; however growing concern remains that the solvency problem will not be cured with additional debts.

This is not the first time we have seen this particular picture. It is not even the first time in very recent memory. In fact, what we are witnessing in Europe appears to be just the sequel to what began to transpire here in the US in 2008. We might call this “Credit Contraction 2.0”. Consider the following.

U.S. homebuyers encouraged by a perfect trinity of low interest rates, government policies, and unprecedented access to credit; became the driving engine of the U.S. housing system and economy for over five years. However, undisciplined underwriting and securitization standards coupled with rating agency rubber stamps created a universe of insolvent “investment grade” assets. Defaults ensued, massive losses were taken and domestic credit and growth were severely impaired.

In Europe, Portugal, Italy, Greece, and Spain, encouraged by a perfect trinity of low interest rates, government policies, and unprecedented access to credit, became a driving force in the Euro Zone economy for the better part of the last decade. However, undisciplined lending standards coupled with implicit ECB guarantees created a universe of insolvent “sovereign” assets. Defaults are on the horizon creating the possibility of massive losses within European banks who are the major bond holders. While the specifics of the next steps are hard to predict, all roads almost assuredly lead to diminished credit and lowered growth within the Euro Zone.

The headlines are indeed similar and the impacts are likely to be the same – a powerful deflationary global headwind.

2012

Once again the Federal Reserve has stated clearly their concerns. In the recent release of their minutes they cite the continuing slack in the overall economy, high levels of unemployment and underemployment, and 44 year lows in the primary measures of inflation. Now enter an impaired European Banking system and an “extended period” now looks more than ever like it means 2012 rather than the second half of 2010 as some bulls had hoped.

The FDIC list of troubled banks rose in the last week to 775 despite having shuttered 73 institutions already this year. For comparison, 140 banks were closed in all of 2009. Losses in commercial real estate are accelerating and many small and community banks are still holding onto a large inventory of foreclosed homes as they each attempt to navigate local markets which may already be saturated.

Recently it was reported that each major money center bank made money every single day in the first quarter. While that may strike us as an odd and even slightly “window dressed” result, it speaks volumes to the earnings power of healthy banks in a steeply sloped yield curve. Banks pay precious little for deposits and can turn around and buy US Treasuries and make a low risk, low capital cost profit. As we have noted before, this is very much by design. By keeping short rates low, the banks can manufacture earnings which can be used to offset real estate losses and increased capital requirements. The process is working, but as evidenced by the increasing size of the troubled list, it is going to still be quite some time before regulators get on top of the overall problem.

We have noted for some time that there is nothing particularly wrong with a slower growth trajectory economy so long as asset prices reflect the risk/value reality. Pundits have recently been doing too much cheerleading and not enough thoughtful analysis. Working our way through these problems does not mean that the problems have been immaculately solved, nor does it mean that they will never be resolved. The Euro crisis has in many ways brought a sobering reality to the market and this is not all bad news. The seeds of this financial crisis were laid out over many years and the recovery will also take quite some time. Healthy firms are highly advantaged over their lesser peers and outside of nature, nothing is quite as Darwinian as capitalism. Investors were able to ride a short wave of risky asset recovery in 2009, but as we enter this next chapter, liquidity, quality and income are paramount.

Best Wishes,

Patsy and Jen

• Next Sequel
• 2012