Wednesday, February 22, 2017

Calm Before the Financial Storm?

Widely watched statistics recently give the impression of modest growth in the economy. Nothing to worry about, it seems. Slight movements up or down in a number of statistical categories don't seem meaningful, but some very significant negative numbers aren't being mentioned at all. For example:

A growing number of U.S. companies are going bankrupt. In 2016 there were 37,823 of these. That's a whopping 26 percent more than in 2015. And American individuals are filing bankruptcies at the fastest rate in years. In January 2017, they filed 55,421 bankruptcies, 5.4 percent more than in January 2016. Those are not the kind of statistics you would expect from a healthy, growing economy. Another unhealthy statistic is median household income. It did not increase as all in 2016. In real dollar terms, it is now 2 percent (-$1,666) below its peak in 2008.

On January 13, 2017, the Education Department said it had overstated student loan repayment rates at most colleges and trade schools. The new numbers show that at 1,029 schools more than half of the students had already defaulted or failed to pay even one dollar down within seven years of leaving school. Student loan debt is growing at 20 percent per year, which is far higher than the economy or the rate inflation is growing. Student loans total more than auto loans or credit card debt and are almost 4 times larger than all the debts of Greece.

The stock market today is one of the few economic aspects widely viewed as positive because stock prices have held up, but this requires a closer look. The upsurge in stock prices has been fueled by mergers and acquisitions and buybacks. According to Goldman Sachs, buybacks have been the biggest driver of stock prices since the financial crisis, with companies spending $2.5 trillion on share buybacks. A buyback is when a company buys back its stock from shareholders. This reduces the number of shares on the market and raises a company's earnings per share, which makes the company look good—it may pay a higher dividend—and may lift its stock price, but it doesn't make a company any more profitable. Low interest rates have allowed companies to borrow cheaply to buy their shares, as opposed to expending capital on business improvements, hiring and growing earnings.

Earnings on the Standard & Poor's 500 peaked in 2014, but stock prices have kept on rising. The latest price-to-earnings ratio (cyclically-adjusted) of the S&P 500 is 28.6—which is its highest level since the “dot-com” bubble of 2000.

Another indication that stocks are overpriced is the fact that in the first quarter 2017, companies of 61 stocks in the S&P 500 gave negative estimates of future earnings while only 29 gave positive estimates. Rising stock prices correlate to higher earnings or the expectation of higher earnings; and if earnings are disappointing, stock prices will adjust accordingly.

Still another indication that stocks are overpriced is the growth in margin debt, which means stocks are increasingly purchased with borrowed money. This is usually a good indication of rising speculative interest associated with market tops. You can see in the following chart that stock market margins are higher now than at the peaks of the stock market in 2000 and 2007—just before sharp declines in the market.
Chart courtesy of

The bursting of the housing/mortgage bubble precipitated not only a stock market crash and the Great Recession in the U.S. but had enormous repercussions on foreign banks and economies, particularly in Europe. Another U.S. stock market crash now will do the same. Conversely, foreign banking troubles now have the potential to create havoc not only in markets and banks in Europe but in the United States.

The center of the Italian banking crisis is Monte dei Paschi di Sienna, Italy's third largest bank and the oldest in the world, dating from 1472. Burdened by bad loans, it would be bankrupt in two or three months without external help. It was looking for a bailout, but the experience in recent years with bailouts—particularly in Greece—led to a change in European banking regulations. When Cyprus wanted a bailout, what it got instead was a “bail-in.” The difference is this: a “bailout” provides rescue funds from governments or foreign banks; a “bail-in” requires that bank owners, shareholders, junior bond holders, sometimes senior creditors and even depositors take a loss before public funds can be used for the rescue. This is what happened in Cyprus.

The bail-in approach was also tried last year with four small banks in Italy. The government is keen not to see a repeat of the protest demonstrations and two suicides which occurred. In one case a man who hanged himself left a suicide note that his entire life savings of €100,000 had been seized to rescue the bank, leaving him penniless. In the other case, Antonio Bedin put a bullet in his head after he lost his savings in the same manner. If banks' subordinated bonds are forced to take a hit in a bail-in, it will affect not just wealthy owners and other banks but an estimated 600,000 small savers like those two, many of whom were fraudulently sold these bonds as risk free.

However, an exception to the new banking rules was “found” (or perhaps “interpreted”) to allow a government bailout for Monte dei Pasche and other banks, and the Italian Parliament authorized 20 billion euros for this purpose in December 2016. The problem now is that it had been estimated Monte dei Pasche would require €2.8 billion, but the actual number is turning out to be closer to €6 billion. What would be left of the €20 billion would not be enough to cover the other troubled banks even under the most optimistic assumptions. Goldman Sachs estimates Italy's most fragile banks need €38 billion to be adequately capitalized. Italy’s banks hold double the amount of bad loans they held five years ago. In December 2016 a Forbes article estimated there is roughly €240 billion of Monte dei Pasche-type bank debt scattered around Italy. Italy's top 12 banks lost more than half their stock value in 2016. The sheer magnitude of Italy's banking problems rules out bailouts or bail-ins—but lack of a solution leads inevitably to the likelihood of Italy leaving the euro zone.

Otmar Issing is an economist who was brought in by the European Central Bank to design the monetary framework for a new currency, the euro. Known as the “Father of the Euro,” he now says the ECB has become “dangerously overextended” and is a “house of cards ready to collapse.” He said the ECB “betrayed the principles of the currency project by bailing Greece out in 2008,” and he condemns that action “as a bailout for French and German banks who had loaned to them.” [a point we had made in our book The Impending Monetary Revolution, the Dollar and Gold.

Issing goes on to state, “Market discipline is done away with by ECB interventions. So there is no fiscal control mechanism from markets or politics. This has all the elements to bring disaster for monetary union.”  

Economist Wolfgang Munchau is considered one of the world's foremost experts on the eurozone. He writes a regular column for Financial Times, in which he wrote: “An Italian exit from the single currency would trigger the total collapse of the eurozone within a very short period. It would probably lead to the most violent economic shock in history, dwarfing the Lehman Brothers bankruptcy in 2008 and the 1929 Wall Street crash.”

While the exact timing of the coming Italian banking collapse cannot be predicted, a likely timeline has emerged for another threat to the European Union—a threat which will accelerate the Italian exit from the EU if that hasn't already occurred. I'm speaking here of the situation in Greece. Under the terms of its third bailout, in 2015, Greece would allow periodic inspections of its progress in reducing its deficits under austerity measures and tax-and-spending policies that had been agreed upon. The inspections would be carried out by a Troika of officials from the ECB, the European Commission and the International Monetary fund. Their approval of the Greek government's progress would be necessary before the next tranche of funds from the 2015 bailout would be disbursed.

But in December 2016, after a year of relative calm, the Greek government issued a series of welfare benefits and suspended a sales tax increase that had been scheduled. Eurozone officials expressed surprise and frustration that Greece had taken these measures without notifying them in advance and said they appear to be “not in line with our agreements.” In retribution the European Stability Mechanism, the agency that provides the bailout loans, announced it would not honor an accord to ease the burden of repayment obligations on Greece's debts. The German ministry supported putting the debt relief on hold.

Germany has said it will not agree to any debt relief for Greece unless the International Monetary Fund participates. The IMF has said in two recent policy papers that it will not do so. The IMF has been criticized, both internally and by outside experts, for the role it took in earlier bailouts, which violated its own rules. But if the standoff is not resolved and Greece does not get the remaining funds from the last bailout, there is no way it is going to be able to make payment on the €6 billion that is due creditors in July 2017. And even if it is able to make the July payments, that is no assurance of a fourth bailout for Greece, because the IMF has insisted upon additional austerity measures that Greece cannot accept. So come July Greece could be out of the EU.

The pressure will then be on Italy to exit, too. As we pointed out, the ECB is already “dangerously overextended,” and the magnitude of Italy's needs is too big for a bailout or a bail-in. Remember that the initial bailout of Greece was undertaken to save French and German banks, which would likely go under if Greece wasn't rescued. If the bailout was a success, Greece would be able to pay back the French and German banks, which otherwise stood to lose heavily—perhaps everything—on their investments. But success never arrived for that bailout. Or the next one. Or the next one. Italy is now in a similar situation, only worse.  The total exposure of French banks and private investors alone to Italian government debt exceeds €250 billion. Germany holds €83.2 billion worth of Italian bonds; Deutsche bank alone, nearly €12 billion; Spain, €44.6 billion; the U.S., €42.3 billion; the UK, €29.8 billion; and Japan, €27.6 billion. Keep in mind that these are just the direct investments in government securities; they do not include corporate bonds or other financial paper denominated in euros, including banks which own them in addition to government securities.