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Last spin of the wheel for Europe’s banks
Faites vos jeux on a crisis bigger than US subprime

A Special Report by Leigh Skene and Melissa Kidd

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Last spin of the wheel for Europe’s banks
Faites vos jeux on a crisis bigger than US subprime A Special Report by Leigh Skene and Melissa Kidd

Contents
Faites vos jeux on a crisis bigger than US subprime Computer models versus looking at the facts Seven EA problems Governments and banks Recapitalizing banks is deflationary Defaults are guaranteed, exits are better The banking crisis Contagion to the US Global contagion Commodities are another problem area The coming crisis is financial, not economic Europe’s core challenge Alleviating and preventative measures Hope from the crisis-practised Emerging Markets Better Emerging Market Banks Conclusions 1 2 3 6 7 8 10 12 13 14 14 16 17 19 21 23

as the authorities have compounded the ultimate losses by treating solvency problems with excess liquidity. so would be better off outside it. That damage will spread globally. Since then. Europe’s counterproductive policies and the excessive leverage in European banks have made it the epicentre of today’s financial problems. Exits (and defaults inside the euro) will seriously damage the over levered EA banks. Blind faith in their ability to price complicated asset structures correctly and to accurately identify all possible sources of risk led to rapidly rising leverage – typified by the European sovereign debt/banking crisis. The more inflation prone Euro Area (EA) nations.1 Last spin of the wheel for Europe’s banks Faites vos jeux on a crisis bigger than US subprime The Efficient Markets Hypothesis led to Rational Expectations plus unquestioning faith in computer models. cannot prosper in a hard currency fixed exchange rate regime such as the euro. as many other nations suffer from several of Europe’s difficulties. but soared into prominence when Greek borrowing hit a brick wall in early 2010. . bond markets have generally interpreted the continuing declarations of successful negotiations and imminent solutions to debt problems negatively. often referred to as Club Med. which has been gestating for a long time. This report will show that the prevailing conditions that helped us escape from some previous episodes of excessive leverage have reversed into headwinds. Bond markets have been right so far. equity markets have generally interpreted them positively and currency markets have see-sawed back and forth.

but less leverage elsewhere will alleviate the pressure in other developed nations. they greatly underestimated financial risk by failing to incorporate obvious correlations as well as 1 The ABC of 21st Century Risk Lombard Street Research 2007 . Moreover. Banks are the core of the financial system. there are some alleviative and preventative measures that no authority has yet applied. Confidence rises over assets due to inadequate net tangible equity to a prolonged period of prosperity. Computer models versus looking at the facts In 1974.) Many analysts ignore financial debt when computing debt to GDP ratios – odd because financial debt is always a factor in financial crises. The rising -12% instability causes cycles of increasing severity until fear takes over and financial markets suffer a self-reinforcing spiral downward. so a capitalist absorb the losses. of itself. not an economic problem. % of GDP speculative and Ponzi finance. economy moves from hedge finance dominating its financial structure to increasing domination by 1. and Ponzi 1 putting more reliance on computer models (borrowers can’t pay either interest or principal out of income. ultimately enabling growth in developed nations appropriate to the real economy of production and income. Hyman Minsky explained the unfolding of credit cycles with his Financial Instability Hypothesis. That ‘Minsky Moment’ was a major turning point in global financial and economic history. As predicted in February 20071. computer models are very fallible. so Minsky correctly says bank balance sheets deteriorate until inability to service liabilities causes a ‘Minsky Moment’ – a debt crisis that forces bloated asset prices down to levels that are Greece -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% Contrary to the hype. so risk is minimal). so need the price of the asset to than common sense and rise to service their debts and defaults soar when 2 failing to purge their balance sheets of failing asset prices stop rising). It identifies three types of debt financing: hedge (borrowers can pay principal and interest from income. but is up 10% in Europe. speculative (borrowers can pay interest from income. International Investment Positions.2 Last spin of the wheel for Europe’s banks • March 2012 This is a financial. In addition. Financial markets and the Portugal economy are relatively stable Spain Italy when hedge financing France dominates. Japan has shown that deflation is. Emerging nations should fare best of all. Deflation is the necessary corrective mechanism as the problem is excessive monetary stimulation resulting in credit and asset bubbles. but become Ireland Austria ever more unstable as the Germany proportions of speculative and Netherlands Ponzi finance rise. bankers on both sides of the Atlantic are continuing two serious errors that were major factors causing the last banking crisis. (It changed the focus of most central banks from guarding against inflation to protecting banks from everything. so defaults rise when liquidity is impaired). but need liquid financial markets to refinance the principal at maturity. where the quality of sovereign debt has fallen as financial debt has risen. Europe’s abysmally bad policies have probably condemned the continent to depression. far from the disaster claimed by the authorities in Europe and the US. It began the correction of all the imbalances that have accrued since the last major turning point – the huge monetary stimulation in response to the Penn Central non-bailout in 1970. shifting the locus of the banking crisis to Europe. Financial debt in the US has fallen 20% from its high at the end of 2008. The questionable lending practices and the banking business models that caused the 2007–08 banking crisis and Great Recession certainly fit Minsky’s definition of Ponzi finance.

minimizing the 5 credit risk of all EA sovereign 4 debt. so can’t be As a result. Assets considered safe that prove not to be safe have created all crises and Europe is no exception. This assumption led to higher risk EA economies borrowing at low rates for a decade. a no-brainer. First. identify turning points. so all forecasts tend to be straight lines. (Unfortunately it was – literally!) They are neither rational nor linear. i. but failed completely to address the risks common to the entire securitized pool. keep diverging from equilibrium until the driving forces fade or stronger counter forces reverse them. so the the euro (see chart 2). Emotions exceeding known parameters cause extreme events. Ever-increasing desires for accumulating ever greater wealth faster and faster ignited a credit bubble that spiralled upwards until it burst in 2007 from a lack of new borrowers. they can’t give any reliable information on an extreme event – even after it has occurred – so the models still can’t incorporate the effects on economies and financial markets of the reversal from the ever increasing leverage of the past to the present deleverage. they do fluctuate within profligate) nations plummeted when they joined given parameters most of the time. Computer models don’t. For example. models can’t predict when an extreme event will occur. No model recognized the credit bubble or its collapse and no model is giving any indication of the plethora of problems now brewing in Europe. thereby building up excessive debts and external obligations (see chart 1). They are self-reinforcing spirals upward and especially downward that. This is a big ask and gives rise to another three problems that bedevil model predictions. especially CDOs was a major factor in the 2007–08 subprime crisis. However. In addition. Third. but for a different reason – the false assumption that a common monetary policy plus the political promise that no country in the region could default reduced idiosyncratic sovereign risk within the euro.3 being responsible for rating securities based on home equity loans and sub-prime mortgages AAA. interest rates in soft currency (read modelled. such as stock market booms and busts. Only external shocks divert models from moving towards the equilibrium position. the 3 misguided Basel zero risk rating 2 1 for all EA governments (that 0 can’t print the currency they -1 Jan 92 Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12 borrow. emotions. resulting behaviours can be modelled as long as . such as an economic downturn and rising unemployment. drive all human activity. 10-year government bonds. so are far more likely Spain Italy to default than governments that can) made European banks think loading up on peripheral nation such people exist or ever have existed.e. extreme events pop up far more frequently than mathematical theory predicts. In addition. Desires debt for a few extra basis points in yield was and fears. 10-year government bond spreads over Bunds for Spain and Italy heading into the currency union and until the financial crisis were very depressed (see chart 2). Second. Reliance on computer models also explains the failure to spot turning points. Seven EA problems Risky assets don’t create crises. Failure to adequately price complex financial instruments. Investors in the Euro Area (EA) mispriced sovereign debt for a prolonged period of time. spread over Bunds: Spain and Italy. models assume a universe populated with rational people who are acquainted with all the relevant facts and act accordingly. such as personal illness. once established. No the emotions stay neatly within the parameters and historical relationships continue. The multi decade credit bubble and its bursting were extreme events. Securitisation effectively hedged the specific factors leading to default. and probably never will. % Bank (ECB) acceptance of all EA sovereign debt as collateral 8 7 effectively guaranteed 6 repayment. Debt soared as a result. People who should have known better assumed that European Central 2.

By contrast. 5 expanding global markets. 4 rising costs of entitlements.0 0.4 Last spin of the wheel for Europe’s banks • March 2012 This structure could have worked only in the very unlikely event that the citizens of soft currency nations immediately saw the light and changed their individual choices to conform to Northern European (hard currency) values. soft currency nations became ever more uncompetitive within the euro as their borrowing created bubbles in real estate and government debt.2 0. 3 negative demographics.6 0. which needs exports to grow. making EA governments far more susceptible to default than others. they didn’t and are (rightly) accusing core nations of rigging the system. The EA efforts to rule out defaults too have guaranteed depression in the peripheral nations as long as they remain in the euro. guaranteeing aging populations.4 0. 3 Negative demographics Chart 3 below shows the medium variant of the UN’s 2010 estimates of the population growth of the five largest European economies and the US. This is the long-predicted demographic time bomb. EA banks took full advantage of this provision and blew up (metaphorically) their balance sheets with peripheral sovereign debt for a few basis points additional yield. 2 an externally imposed exchange rate. Meanwhile. EA nations face. Differential inflation rates destroyed every fixed exchange rate scheme prior to the euro that did not involve political union. 6 interest rates below nominal GDP growth rates and 7 strong private sector balance sheets. which is causing rapidly increasing age-related spending at the same time as labour force growth is shrinking to negative.2 -0. Nations have inflated and/or grown their way out of excessive deficits and debt in the past and the European elite want soft currency nations to do the same over the next several years. particularly age-related. Core nations are determined to keep the soft currency nations in the euro to hold the foreign exchange value of the euro down – but the former’s export dependency greatly disadvantages the latter. that governments have promised in perpetuity.8 0. 6 interest rates above nominal GDP growth rates and 7 excessive leverage that is creating continuing financial crises. 3. Future labour forces and incomes will be too small to pay for the entitlements. positive demographics. The five following problems extend far beyond the EA boundaries. The bubbles burst and exposed the lack of ECB guarantees. The factors that enabled nations to grow and/or inflate out of severe debt and deficit problems in the past have been.0 -0. ability to devalue. that’s impossible. Unsurprisingly. 5 increasing global competition. Growth is falling or negative in them all. Unfortunately. 1 externally imposed one-sizefits-all monetary policies. The metaphor became reality when higher inflation rates in peripheral nations raised their current account deficits and resulting debt burdens beyond sustainable levels. Basel regulations ignored this added risk and gave all EA sovereign debt a zero risk weight. easily reduced spending due to the ends of wars. 1 2 3 4 independent monetary policies. Estimated Annual Population Growth Rates 1. Governments have used monetary policy and currency devaluation extensively to grow and/ or inflate out of severe debt and deficit problems in the past.4 2010-15 2015-20 2020-25 UK 2025-30 Italy 2030-35 France 2035-40 2040-45 2045-50 US Spain Germany . The euro eliminates these escapes from debt problems. EA banks could own as much EA sovereign debt as they wanted with no impairment of capital. so fiscal deficits of 10% of GDP and more suddenly mattered.

France. including state and local debt. age-related spending was frozen at the estimated 2011 level of GDP. reform their labour markets to achieve competitiveness. First. globalization has added a billion or so workers in emerging nations to the global labour force. They all will also have to recapitalize their banks. Japan and the UK would be worst off with sovereign debts over 300% of GDP with the US not far behind at about 230%. The rest would have debt to GDP ratios between 100% and 200%. Sovereign finances have deteriorated since that study. . published in March 2010. Netherlands. If. 1 government revenue and non-age-related spending remained a constant percentage of GDP and 2 Congressional Budget Office and European Commission projections for age-related spending proved correct. most importantly. The next two sections show the odds of reversing the rising debt to GDP ratios are virtually zero. employment or worker incomes. Austria. would spiral out of control if. 6 Interest rates above nominal GDP growth rates Rising borrowing costs make it very unlikely that nominal GDP growth can rise to the current and expected future interest rates in Greece. Growth ranging from weak to negative and rising age-related spending have already pushed many sovereign debt to GDP ratios past 90% – the point at which both Reinhart and Rogoff and the BIS have shown debt becomes a drag on growth. albeit at a slower rate. where debt would stabilize at about 100% of GDP. small business is the biggest employer and household deleverage hurts small business disproportionately. most of the EA peripheral nations are already in a long and deep recession that is spreading into the core. Portugal. 5 Expanding global competition Growth requires investing more in productive facilities. so peripheral EA nation finances continue to spiral out of control until they default. Italy. so investment and production has shifted to emerging nations and put downward pressure on developed nation employment and incomes. Reducing structural deficits by 1% of GDP a year for five years would still leave all the nations with soaring debt to GDP ratios for the 30 years projected – except Italy. In addition. Italy and Spain. Emerging nation competition rules out private investment and the other measures will increase the short term pain. restructure entitlements to keep government spending from spiralling out of control again. all transactions have counterparties and rising leverage raised the probability of counterparties failing to fulfil their obligations. Spain. only Austria. Cost savings from this movement of production to emerging nations increased corporate profits and created 7 Excessive leverage is creating continuing financial crises The underlying theory of today’s financial system is that all risk can be hedged and the difference between the return on a security and the cost of hedging its risk can be skimmed risk free. Second. Japan. Ireland. Not only did this not happen (and cannot be cured) overnight. This vision of risk free return encouraged ever increasing leverage and debt to GDP ratios soared. but it also masked the fact that several other nations are headed into exactly the same problems. productivity gains in national accounts – but added nothing to production. concluded the debt to GDP ratios of all 12 nations studied. in addition. so employment and income growth have been disappointing in this recovery. depending on jurisdiction. However. Add in the tax increases intended to reduce deficits and real disposable incomes are falling faster than real incomes. The more inflationary policies of soft currency nations caused their rising uncompetitiveness. Greece. Germany and Netherlands would have peak debt to GDP ratios under 100%. increase private investment and.5 4 Rising costs of entitlements The Bank for International Settlements working paper #300 entitled The future of public debt: prospects and implications. Portugal. Real incomes are stable to falling. None of these reforms are on anyone’s agenda. France (et al) is not far behind and the April election is likely to bring about change for the worse – and debt restructuring is not enough. but that is not happening in Europe for two reasons. the UK and the US. Falling real incomes render sustained GDP growth impossible. Germany. They earn low wages by European standards. so their financial conditions will keep deteriorating until they radically reform their governments.

They were: 1 the Latin American credit bubble that burst in the early 1980s.2 1. In addition. if they’re atheists.0 1. but that tangible equity if they had to mark their assets to is unlikely in Europe today. so any default could be catastrophic.0 Germany France Italy Spain Greece Portugal Ireland Austria UK Cyclical average Feb 2012 The world of computer models doesn’t private debt onto public balance sheets simply encompass credit bubbles and bank crises.6 0.4 1. keep their weak borrowers afloat. so most cannot afford to book losses averages imply banks will suffer losses ranging – even if writing down debts would benefit both between 50% and 95% from the book values the lender and the borrower. as markets have recognized the valued at cost until the borrower defaults. so most This delay and increase in costs is most obvious banks kept increasing their leverage. Governments and banks Governments did their best to thwart most of the long overdue correction in asset prices by rushing in to protect banks during the Great Recession.8 0. 2 the savings and loan debt bubble that burst in the early 1990s. bank regulators and central banks didn’t more productive companies. Current unrealized losses make many banks technically price-to-book ratios compared to their 7½-year insolvent.4 0. 4 the LTCM/Russian credit bubble that burst in 1998 and 5 the housing bubble that burst with the sub-prime mortgage crisis in 2007–08. Fall in book value reflected in current PB ratio (vs cyclical average) or. None of them created major problems. European banks: price-to-book values 2. guaranteeing their liabilities and bailing out failing financial -10% -20% -30% -40% -50% -60% -70% -80% -90% -100% Germany France Italy Spain Greece Portugal Ireland Austria UK . of their resources to out to be underestimating them. In fact. These threats over valued assets pose to banks. This temporarily reversed the inability to meet liabilities and consequent fall in asset prices.6 1. and non-financial institutions. The still-inflated values of sovereign times net tangible equity and more. Spanish bank market. extending 0% and pretending. debt and loan collateral in both the household nearly all bank balance sheets still contain hidden and corporate sectors have generated rock losses because loans to weak borrowers and bottom price-to-book values across the European securities of distressed governments remain banking system. so permitted zombie companies to compete with banks.6 Last spin of the wheel for Europe’s banks • March 2012 The ever-increasing leverage created a string of five credit bubbles that burst when counterparties defaulted. them more costly in the long run.0 0. so every lender from the IMF to the bank on the corner is delaying and praying 5. They would have of their assets (see charts 4 and 5). if not all. They prices imply the smallest EA losses and may turn must use most. up to 50 in Europe. Financial very substantial (in some cases negative) net markets can exaggerate potential losses.2 0. This reprieve is only temporary because transferring bad 4.8 1. thus postponing the see any of them coming. 3 the Asian debt bubble that burst in 1997. The first four bubbles necessary corrections of imbalances and making were localized and their bursting easily contained.

The initial market reaction to UniCredit’s recent call for €7. they have continued to run down their assets in recent quarters. leaving the calculations immediately out of gap between the book value of complex date. however. . so further issues are likely. and further divestments of non-core operations have since been announced. The European Banking Authority’s (EBA) first two rounds of stress tests in the summers of 2010 and 2011 were woefully inadequate. based on September 2011 sovereign their respective banking systems to raise capital bond holdings. with risk-weighted assets falling by 5% in the year to end-September 2011. are shown in chart 6. capital shortfall (euro mn) tangible equity as a percentage Greece of total assets is now 9. including buying back debt below par. Q4 2011 survey data suggested credit conditions in the EA were already starting to tighten – before the full force of the deleveraging process has been felt.5% in Q4 Germany France 2008. but September 2011 prices were the financial crisis to help banks address the used. US and UK The final figures released by the EBA in late regulators were reasonably prompt in forcing November. The EA has failed to grapple adequately with the severe capital shortages of its banks. Pressures to boost capital buffers remain in the UK.7 debt holdings were included in the calculations Some financial regulators did take steps during for the first time. compared with the same period in 2010. The first round ignored potential haircuts on sovereign debt. even though their moves were controversial due to their drag on monetary growth. but remains seriously problematic. However. the two partly state-owned banks were banned from paying dividends and are unlikely to resume payouts for some time. with specific requests from the newly established Financial Policy Committee to prioritise earnings retention over bonuses and dividends. according to various sources – and further divestment announcements have been made since then. rights issues and selling blocks of equity to major investors.2%. such as sovereign wealth funds. the regulatory Portugal Belgium pressure to retain earnings Austria and restrain dividend growth Cyprus Norway remains because writing off the Slovakia Netherlands hidden losses on their balance 0 5000 10000 15000 20000 25000 30000 35000 sheets will necessitate raising further capital.8% in Q3 2011. divesting assets.5billion of new equity showed the market’s disinterest in the stocks of banks it deemed to have potentially fatal balance sheet problems. but neither further impairment of sovereign debt holdings nor acknowledgement of the potential bank funding disruptions that could ensue from sovereign defaults. The US banking sector’s net 6. Following tax-payer bailouts. The third attempt at estimating the capital needs of banks in the EA was an improvement. Even so. The four major UK banks reported core Tier 1 risk weighted capital ratios of around 10. Unrealised losses on ‘available for sale’ sovereign The banks affected have various choices in achieving the mandated 9% Tier 1 capital ratio. Spain Italy up from a low of 7. to cover the losses. cutting dividends. Recapitalizing banks is deflationary Not only is the 9% Tier 1 capital ratio insufficient to make the EA banking system resilient to potential shocks over the next 12-18 months. The second round took into account only the already-agreed Greek haircuts. The Bank of England’s latest Financial Stability report includes estimates of bank deleveraging plans as at December 2011 of between €500billion and €2trillion. Changes in sovereign debt holdings since structured finance securities backed by real the July stress tests were also taken into account. but it has also set in train a process of deleveraging in both European and non-European markets that could have seriously negative implications for global credit creation and financial market activity. estate and their underlying value. The appetite improved following the ECB’s program of unlimited auctions of three year money (LTRO). European banks.

to spend less and save more. Bank recapitalization ultimately depletes household incomes through a combination of higher taxes. so few are either willing or able to borrow. European banks are the main source of global trade credit. lowering demand growth in the economy. but adding to bank capital does not create an offsetting deposit. so the money supply falls by the amount of capital raised. Lacking either escape. Eurosystem M3 (April 1998 = 100) 240 220 200 180 160 140 120 100 80 Apr 98 Jul 99 Oct 00 Jan 02 Apr 03 Jul 04 Oct 05 Jan 07 Apr 08 Jul 09 Oct 10 sheets over the intermediate term. By contrast. the declines in each of the last three months (see chart 7) indicate recession and further declines in the money supply. The money supply falls by the amount of bank loans liquidated. Unsurprisingly. lack of investors in bank equity is forcing banks to shrink their balance sheets. The far greater size of the European banking system. exits are better EA restrictions combined with excessive leverage. The real estate woes of Spain and extremely slow growth in Italy mean they’re not far behind. According to Olivier Sarkozy. Turning bank reserves into money and credit also requires banks that are willing and able to lend. In addition. Their desperate need for capital makes them an even rarer species. Worse. European banks will be shrinking their balance Defaults are guaranteed. Loan contraction forces households and small and medium sized enterprises which have no alternative source of funding. Portugal and Ireland are unavoidably in deep depressions with no relief in sight. the rising cost of age-related entitlements. More borrowing merely increases the losses when the inevitable . However. its higher leverage of net tangible equity and its wholesale funding exceeding deposits make Mr. small business and bank balance sheets are repaired. European banks have $30 trillion of wholesale deposits (10 times more than American) and need to roll over $800 billion monthly. artificially low interest rates and increased bank charges. Sarkozy’s estimate that it needs $2 trillion of additional capital look conservative. Europe’s banking sector has $55 trillion of assets. There is not enough money on the planet to keep bailing out insolvent European governments and banks forever. hard currency nations are increasing the problems by imposing austerity in an effort to rule out sovereign defaults as well as the usual palliative. thereby 7. money and people are fleeing those nations in droves. Investors in bank equity would pay for their purchases of equity by drawing down their deposits. ECB purchases of illiquid sovereign debt did help reverse Jan 12 the decline in EA M3 in 2010–11. Growing and/or inflating out of their debt problems is impossible. Small business remains mired in the Great Recession while many households face falling real incomes and are trying to delever too. Repairing bank balance sheets is strongly deflationary (see also EA problem #7 above). negative demographics. so money and credit growth requires creditworthy borrowers that are willing to borrow – an endangered species. expanding global competition and nominal GDP growth below interest rates have made the current policy of funding more debt until Club Med grows out of debt problems impossible. Capital constraints on banks and borrower caution on adding new debt prevent the excess reserves from becoming loans and creating money. As a result. Even so. so the excess bank reserves central banks created by monetizing government have had no effect. four times larger than America’s. so their loan contraction will hurt global trade as in 2008–09. head of the Global Financial Services Group of the Carlyle Group. A $2 trillion or more hit to European incomes is out of the question. The probability of European banks being able to raise $2 trillion of capital is zero. Greece. Private borrowing is the mechanism that turns bank reserves into money. The traditional money making machine cannot function until household.8 Last spin of the wheel for Europe’s banks • March 2012 European banks must raise their equity ratios to cover the potential losses on assets with market values below book values. In practice. devaluation.

a 46% chance Ireland and a 35% chance Italy will default in five years. Liquidity can buy time. Fear of the inability to hedge is lowering demand from non-financial institutions for and raising the yields on debt – with the weakest credits suffering most. The situation is deteriorating with Portugal where Greece was last year and Italy where Portugal was last year. The European Financial Stability Facility (EFSF). The sharp increase in overnight deposits at the ECB. be a temporary palliative because. M3 has been falling in the last three. as explained above. Ultimately. Sovereign debt does not entail risk weighted capital. this accord would be the template for further defaults because it avoids a formal declaration of default. so the ECB version of QE has not been keeping up with loan shrinkage. has downgraded Germany to AA. so these loans enable capital-constrained banks to fund their governments with a handsome carry that will increase profits and add to capital. so EFSF debt has been downgraded – not for the last time.9 defaults occur. Greece received the €8 billion required to enable it to keep paying its bills in December – even though the October 26 accord had not been approved by the 17 EA nations at the time of writing and the proposed haircut of over 70% on privately held debt is still far too little to put Greece on a firm financial footing. As a result. the ECB bought distressed sovereign bonds under its mandate to buy government and private bonds as needed to provide “depth and liquidity to the markets”. They prefer to deposit overnight at low rates rather than bear higher credit risks in the interbank markets. Defaulting within the euro would. This will keep the banks liquid. highlights the ongoing solvency concerns among EA banks. Eurobonds wouldn’t be any better – borrowing can’t solve the problem of too much debt. a 61% chance Portugal. Rising leverage increases risk exponentially. Egan Jones. Assuming the accord is ratified and the militant hedge funds forced to comply. Adequate transfer payments are very unlikely.and it remains on negative watch. that’s the only way the euro can survive. The ECB has begun LTRO auctions at the policy rate. Financial markets have recognized European efforts to sustain the misallocation of capital will fail and recently have priced in a 94% chance Greece.73 trillion and the loan collateral is becoming ever more suspect and the liquidity created is augmenting. in the long term. To avoid a banking crisis pending a solution to the sovereign debt crisis. but the rapid deterioration of sovereign balance sheets make time an enemy. Efforts to restructure the Greek default into a not-default to avoid CDS payouts may change the rules on what triggers a payout retroactively. The bigger than expected take-up of €489 billion by 523 banks (net about €250 billion) on December 21 and the drop in yields in recent sovereign auctions endorse the design and value of the LTRO to maintain liquidity under extreme conditions. even the IMF can only postpone inevitable defaults. thereby eviscerating the hedging function of CDS. the only major lender-pay ratings company (borrower-pay ratings companies tend to follow it). at best. If fears about CDS hedging prove to be justified. The ECB balance sheet has exploded to €2. European corporate (and some sovereign) debt markets remain very thin and corporate borrowing has fallen significantly. currently 1%. a wholesale liquidation of risk assets that investors had believed to be hedged will occur and credit markets will shrink substantially. yet exits will occur only when all else has failed. . its successor the European Stability Mechanism. Nevertheless. soft currency nations cannot prosper in a hard currency monetary union without continual transfer payments. The monetary base has risen at an annual rate of over 50% rate in the last six months yet. with lowered collateral requirements. even though Asian nations have invested an estimated €1 trillion of their reserves in European bonds in an effort to sustain their European exports. Unsuitable nations leaving the euro are not a problem. the cadre of creditworthy guarantors of the €1. it will soon be back in this same predicament. so the soft currency nations will have long depressions unless they negotiate the re-denomination of their foreign held euro liabilities into their local currency and leave the euro. however. Private demand for Spanish and Italian debt apart from repos with the ECB is virtually zero. rather than reducing solvency problems (see page 12). so is deemed to be voluntary and doesn’t trigger CDS payouts. not a friend. but liquidity can do nothing to reduce their insolvency.1 trillion of debt now committed to holding the EA together is diminishing. Unsurprisingly. so appropriate hedging is vital to the high leverage in modern financial markets.

The banking crisis In previous episodes of deleverage. accelerating US money growth. but the cost of borrowing dollars in exchange for euros remains elevated. More than half of bank funding in continental Europe comes from institutional investors. so this contingent liability weighs ever more heavily on the remaining AAA rated nations as sovereign balance sheets deteriorate and ratings fall. which explains Northern Europe’s over emphasis on austerity. 2 governments are raising taxes. Reform of labour policies to lower unit labour costs. the long and deep recession that has now begun in Europe will cause soaring private sector defaults. and as a result. Some. not greater EA integration. The solvent EA nations guarantee the EFSF bonds. Even so. Reliance of EA banks on this funding is non-negligible. the costs of bailing out rise as the EFSF rating falls in line with those of its guarantors – threatening a downward spiral in ratings. Requests for further increases are running into stiff opposition. US money market funds: % change in exposure (May 2011 to Dec 2011) 80% 60% 40% 20% 0% -20% -40% -60% -80% -100% France Euro Zone Europe UK Nordic Australia Canada Japan 4 money has moved to the US. but not necessarily all. 5 Increase private investment. 1 EA banks are shrinking loans. 8. will sell bonds to outside investors. The section on the EA problems listed the seven factors that facilitated the rising private sector growth in the past that enabled the following six steps. European debt funds have reported regular outflows and a large amount of European US money market funds (MMFs) have been steadily reducing their exposure to European banks since May 2011 and replacing it with increased exposures to Australia. EA nations guarantee their bank deposits and fund deficiencies from bank failures by selling bonds. The three month Euribor rate rose to more than one percentage point over the generic European treasury bill rate last September. Weaker nations would have to sell the bonds to the bailout mechanism. Moreover. currently the EFSF. This funding is evaporating. as have Euro interbank lending rates. Bund yields remain at or below similar term Treasury yields. Japan and US Treasuries and Agency paper (see chart 8). dollar liquidity cannot offset euro deleverage. significant public sector deleverage began only after nominal GDP growth had rebounded. 6 Stabilize the housing market. which. Canada. in turn. 1 2 3 Recapitalize the banks to enable sustained loan growth. Devalue the currency to enable net export growth. even following a cut in the cost of dollar liquidity provision by the major central banks at the end of November. 3 workers are rioting against change (except . Like others. the reception to this idea is cool. so will have to pay any losses that occur. but its banks now pose more systemic risk than insolvent banks in other nations. Helpful as it is. with MMF exposures account for as much as 4% of short-term liabilities among European banks. The section on the EA problems also showed all seven facilitating factors have been headwinds since the 2007-08 banking crisis. warning of a probable banking crisis this year. Understandably. showing financial markets (correctly in our view) expect Club Med exits from the euro. Reduce government spending. putting many European banks in a liquidity squeeze so bank borrowing from the ECB has soared. Europe doesn’t have a monopoly on insolvent banks. The Fed has eased the consequent shortage of dollars with swap agreements with several central banks to keep the dollar down. The EA elite are trying to spread this liability across the globe through more IMF participation in the bailout mechanism.10 Last spin of the wheel for Europe’s banks • March 2012 Of course. of these steps are required to grow and/or inflate out of debt problems. In addition. Agreements with the EA already utilize half of the EFSF and of the IMF’s increased lending capacity. The greatest percentage decline was in France.

Instead. so counterparty risk is huge. No EA authority has shown the slightest flicker of comprehension that the credit bubble has burst. third highest in the world. The real problem is not in the Eurosystem. with the haircuts on both rising exponentially. which is owned by the 17 national central banks (NCB). the day-to-day transactions concentrate the lower quality collateral in peripheral NCB. so the Eurosystem is strengthening the links between the insolvent governments and their insolvent banks. Getting over this hurdle. A Greek or any other significant default will precipitate a European banking crisis in the foreseeable future. that the era of continuous borrowing from the future with excess debt creation is over and that the Eurozone is exacerbating the pain for its southern members. so markets have priced in very high risks of failure in some European bank equities. but their governments should be in better positions to absorb the hit. being able to force the recalcitrant owners of the debt maturing on March 20 to abide by that agreement without triggering CDS payouts and derailing the effort to put the new bonds in a legal jurisdiction with some teeth (private investors who unknowingly bought subordinated loans at senior loan rates want the next default to be a true one) will maintain the European Ponzi scheme of insolvent banks supporting the insolvent governments that are guaranteeing the liabilities of the insolvent banks.11 Ireland). Both Greek opposition to the imposed austerity and the impatience with the rising costs of Greece’s bailouts and its perpetual failure to meet targets are rising and the last payment to Greece has not yet been authorized (see page 9). far above the US at 355% and completely unmanageable in a currency union burdened with a one-size-fitsnone monetary policy and huge sovereign debt problems. Currency flight from the periphery to the core is building up big creditor positions for core NCB and equal debtor positions for the peripheral NCB. In fact it never can because falling GDP raises the ratio as fast as or faster than reduced deficits lower it. Insolvent European banks sold many CDS. but compounding it. it depends every three months on unanimous authorization of bailout funds by 27 nations plus the IMF. The Euro-system consists of the ECB. which it never does. Markets are already speculating on Portuguese negotiations for haircuts and Ireland can’t be far behind. it would still bankrupt Greek banks and decimate the value of the collateral held at the Greek NCB. 4 currency devaluation is impossible. For example. 5 private investment is shrinking and 6 ultra cheap mortgages are preventing the stabilization of housing. The Greek economy never recovered from the Great Recession and global conditions plus the imposition of increasing austerity give it no reasonable prospect of doing so in the foreseeable future. will only postpone dealing with the Greek default for one quarter. Authorization depends on Greece fulfilling targets for budget deficit ratios of GDP. Several countries are losing patience and any one of them can force a default by vetoing the agreement necessary to keep the heart of the Euro-system Ponzi scheme beating. NCB do the day to day transactions and the net position of each NCB with all other NCB in the system is recorded in real time at the ECB. EA debt is estimated to be 443% of GDP. Even so. but in the grossly over levered commercial banks. The NCB’s liabilities are its government’s liabilities. and each of the hurdles to come. as it elected the current government to negotiate haircuts on private holdings of bank debt. In addition. the Bundesbank had provided €496 billion to countries in trouble at the time of writing. markets will react violently when they discover that ECB liquidity has not been solving the problem. so its banking crisis would occur this autumn if a year or so is a normal incubation period. The European equivalent crossed 100 basis points in September 2011. Excess debt is causing the bank problems. The NCBs holding the offsetting creditor positions would have to write them down correspondingly. Only authorization of the October 26 agreement. so unit labour costs remain too high. . The Lehman default occurred 13 months after the US TED spread crossed 100 basis points. Assuming money transfers can be halted immediately upon a Greek default.

low inflation 4. but noncurrent loans are down by only 20% since their Q1 2010 peak.7% in the 2005-06 period – and stand to rise again if the US economy deteriorates in 2012. Club Med Germany & France UK % of total US bank equity capital: the Congressional Budget Office Non-bank private sector Public sector Banks predicts the Treasury’s tax take will rise by an average of 1½ percentage points a year from fiscal 2011 to fiscal 2014.5% in 2005-06. Indeed.0% 60% 7. but not in the US – so concerns over EA exposure are likely to resurface this year. 14% of US banks are 0. At the sector level.12 Last spin of the wheel for Europe’s banks • March 2012 Contagion to the US US interbank markets have also been showing the strain of problems in the EA.0% 80% contracted outright was in Q4 1989. Provisions were only $18. Quarterly provisions are currently around one-third of their 2008 average. 9.0 3.9% and that was only for one quarter. with the 3-month LIBOR-OIS spread tracking the upward trend in the cost of EA interbank lending (see chart 9). when in fact the opposite is the more likely outcome. According to data from the BIS. and the UK banking system. Raising the loan loss allowance to 100% of total noncurrent loans would require an extra $112 billion of provisions. banks must work through the remaining legacy of US banks are in a poor position to withstand the domestically-generated subprime crisis. Falling a European banking crisis. in addition to the amount needed to cope with current write-offs. Pre-provision net $600 billion of capital to absorb the cost of operating revenue has been flat.4% erode banks’ ability to generate net 0% interest income growth.5% Downward pressure on longer term 40% 1. the 100% last time annual net income growth 9. They appear well loan loss provisions (see chart 11) have delivered capitalised with assets 11. falling on an annual basis for the last three quarters 10.5 the subsequent pressure on overall 1.0 income – down from a peak of 35% -0.5 3. comprise around 80% of US banks’ total equity (see chart 10). In addition. at 6. bps 4.9 times net tangible practically all the sector’s net operating revenue equity. However. US banks’ total claims on Club Med banks. Q3 2011) on record (see chart 12). Bank claims on government and the private sector are reasonably transparent in the UK.5 Feb 07 Aug 07 Feb 08 Aug 08 Feb 09 Aug 09 Feb 10 Aug 10 Feb 11 Aug 11 Feb 12 in Q4 2009. Real estate net charge-offs are currently around $14 billion per quarter. 31. US banks’ exposure to the EA through lending to governments and exposures to financial and nonfinancial institutions is significant. US so growth will be minimal and defaults will rise.0 2.6% 8.0 Noncurrent real estate loans in the US remain elevated. Libor-OIS spread.5 still reporting negative quarterly net 0. their lowest since 2007 Q3.0 profitability. 4. In addition to this exposure to the EA crisis. US Banks: Breakdown of exposure to European regions by sector – the longest period of contraction (BIS data.3% 2. Noncurrent loans would have to fall quite sharply to justify this level of provisioning. plus Germany and France.5 2. Banks’ quarterly rate of provisioning looks inadequate to cope with even current levels of noncurrent loans. net interest income growth in particular has ground to a halt.3% yields from slow growth. The banks are ill placed to absorb increased loan loss provisions and 1.3% and Fed interventions will continue to 20% 10. but double the average of US EA UK 7. .6 billion in Q3 2011.5% of the total – compared with only 0. they need an estimated $400growth over the last two years.

the Fed’s by about one180% third. The collapse of the credit bubble shows Ponzi debt had pervaded the credit structure. Banking problems are becoming more acute and Europe is the canary.000 0 Q1 1984 Q3 1986 Q1 1989 Q3 1991 Q1 1994 Q3 1996 Q1 1999 Q3 2001 Q1 2004 banking crisis without significant failures. The ECB didn’t prevent broad money from beginning to fall – even though it increased its balance sheet by almost half in the last seven months of 2011.000 100.13 marking their toxic assets to market.7 trillion. The same is likely to happen in other developed nations. but slow economic growth and deteriorating sovereign balance sheets are pushing many of them in the same direction. the Bank of England’s by 160% over one-fifth and the ECB’s by 140% one-sixth. not far short of triple the equity of American banks. but deleverage is absolutely essential to restore optimum growth. $mn 120. Printing money on 120% this unheard of scale reversed a 100% significant part of the 2008-09 80% losses in asset markets – but 60% 40% the cost has been the rising 20% insolvency of governments and 0% banks. As a result. so deleverage and a drop in asset prices to levels that incomes and production could Insolvency will keep dragging the EA economy down until sovereign and bank balance sheets are repaired. Other developed nations are in less dire straits than the EA. Q1 2009 Q3 2011 . Q1 1984 Q3 1986 Q1 1989 Q3 1991 Q1 1994 Q3 1996 Q1 1999 Q3 2001 Q1 2004 Q3 2006 12. The next section will offer some ways of minimizing the damage and preventing recurrences. Global contagion Global financial assets were only slightly greater than global GDP in 1980 but 3 3/8 times greater in 2010 with the increase in debt outstanding rising from a fraction of GDP to 2½ times accounting for the rise. % of noncurrent loans and leases of 43% a year over the last five 200% years.000 60. US banks: loan loss allowance. Professor Robert Reich of the University of California at Berkeley wrote that Wall Street’s total exposure to the EA totals about $2.000 40. Total industrial production in the OECD remains below the pre Great Recession peak and widespread falling real incomes show the Q3 Q1 Q3 lower income brackets are in 2006 2009 2011 a depression. Eliminating the Ponzi debt without fracturing the entire credit system is impossible. the People’s Bank of China balance sheet has expanded by an average rate 11.000 80. Net interest income.000 20. which raises their effective leverage to 19 to 28 times – too high to weather the recession and European sustain was necessary. Governments immediately engaged in an all-out battle to prevent this necessary correction. In addition.

not economic In spite of the gyrations in asset markets in recent years. The prices of the most traded commodities rose immediately upon its announcement – over two months before actual purchases began. The destruction of wealth from falling asset prices will hurt the economies of the highly levered developed nations. the most notable result of QE2 was increased risk seeking in asset markets. This. Congress instructed the Commodities and Futures Trading Commission (CFTC) to institute position limits on any participant who is not a bona fide hedger. investment bank commodities funds are long only – so the speculative positions are virtually all longs. Real supply and demand determined prices. energy and equity prices. By contrast. real GDP is at or near record highs in many nations and there’s no reason for the coming deleverage to cause dire economic consequences. The overvaluation of equities far exceeded anything seen in the last couple of centuries. the Toronto Stock Exchange diversified metals and mining index rose about 40% a year from May 2003 to May 2011. That could take a long time as Wall Street is challenging the cap in the courts. The deep ‘V’ in trade caused an even deeper ‘V’ in commodity. French banks reining in their lending is at least partly responsible for the commodity indexes turning south again in 2011 before reaching the 2008 highs. Similarly. long before the real demand could have fallen. the poorest have suffered the most through food and energy prices being far higher than necessary. The dot. The limits will apply to 28 physical commodity futures and their financially equivalent swaps and come into effect 60 days after the agency defines the term ‘swap’. Cyclically adjusted P/E ratios (CAPE) in most markets remain well above average. combined with falling inflation in emerging markets will hold commodity prices down. The coming banking crisis will cause another sharp drop. speculation has risen to 80% and hedging has fallen to 20% since 1990. but the CFTC finally voted to cap the number of futures and swap contracts that any single speculator can hold. indicating prices will fall below the 2009 . The restoration of bank liquidity further explained the speed of the subsequent rise.14 Last spin of the wheel for Europe’s banks • March 2012 Commodities are another problem area Different factors determine the real supply of and demand for various commodities. Effective lobbying from Wall Street created long delays. yet the prices of the most traded commodities have become ever more correlated in recent years. French bank difficulties after the Lehman default explain the sharpness of the fall in global trade. Producers and investment banks raked in fabulous profits from turning commodities into assets. The coming crisis is financial. i. but the rise in real incomes due to falling commodity. As usual. long before QE2 could have raised the real demand. particularly in commodities at that time. High correlations among their prices are most unusual. For example. commodity futures markets were 70% hedging and 30% speculation with speculative positions more or less equally split between long and short positions over time. problems at French banks will cause a spectacular drop in commodity prices. build and/or consume energy. They always fall well below average before the bear market ends. In an effort to limit profiteering in commodity markets. Current P/E ratios have dropped to below average levels. Non-producers have paid the price for profiteering in commodities with slow global growth and declining per capita real incomes in many developed nations. energy and real estate prices will benefit the lower income brackets of emerging nations more. as in 2008–09. As a result. but longer term valuations remain elevated. The reason is clear. pushing equity P/E ratios into a downtrend that won’t reverse for another four of five years. Fortunately for all the people in the world who eat.com bust began once-in-a-lifetime corrections in stock prices in 2000. Up to 1990. but the insolvency of the French banks won’t be so easily papered over this time. The only possible result of almost 80% of orders being from investors on the buy side is commodity prices rising to ridiculous heights when investment demand is high and dropping back to real supply and demand levels when investor demand is absent – so commodities are now priced above their economic value much of the time. In addition.e. risk avoidance rose in asset markets near the end of QE2 and commodity prices dropped – i. making the future pattern look more like an ‘L’ than a ‘V’.e. Trade lending will also shrink considerably. thereby ending the excess speculative buying of commodities.

nominal ‘risk free’ interest rates should average about 2% for short terms and 2½% to 3% for longer terms. . but nominal rates will begin to rise as global saving drops from record levels. Fear is already incorporated into stock prices. deflation’s effect on commodity prices will be far more consistent. the total replacement value divided by the market capitalization. the two factors that made this rise in commodity prices the fastest and the most extensive in history were the amount of excess liquidity injected by central banks and the explosion in speculation described on page 14. massive government deficits add more to corporate revenues than to their costs. Weather was a big factor in the rise in food prices and precious metals are not commodities. so can only go up. shows about the same level of overvaluation as CAPE. More importantly. so will correct real estate prices far more in overleveraged and overpriced markets. The 2000-08 commodity bubble convinced most people that soaring emerging market demand would keep commodity prices rising for decades. That decision placed them on a path that led to the credit bubble collapse in 2007-08. central bank policy and short term interest rates have hit all time lows. The global banking crisis will usher in deflation. Two factors determine the level of interest rates. The secondary factor is monetary policy which. the public and private sectors usually competed for resources and inflation ultimately reversed the drops in real interest rates from excessively loose monetary policy. The desire to save exceeding the desire to invest (the Eurasian savings glut) pushed real interest rates down in the 21st century. put more downward pressure on interest rates.15 lows in developed nation equity markets. Up to the early 1980s. Earnings outperform stock prices near major P/E lows. devalue equities relative to bonds. equities would then be significantly undervalued relative to normalized earnings and replacement cost. high yield bond spreads correlate to inflation better than TIPS. but the falling profits are not. Deflation will keep downward pressure on margins. With inflation turning to deflation. so supplies on hand are small. The resulting burgeoning private debt caused a banking crisis in 2007-08. Tobin’s Q. However. which could stabilize S&P 500 earnings in the 70 area. Food and precious metals prices spiked higher in 2011 than 2008. Most important is the balance between the desire to save and the desire to invest. that competition has been absent and excess liquidity from monetary policy has created a series of asset bubbles. In fact. so prices will probably trough during or soon after the banking crisis at levels lower than their respective 2009 lows. Central bank efforts to avoid the consequent deflation reduced real and nominal rates to levels at which no economy can function properly. both in 2000-01 and since mid 2007. even centuries. creating the conditions for a sustainable rally. Markets have priced the risks of high grade bonds much lower than equities as the interest rate on 10 year Treasuries recently fell below dividend yields for the first time in decades. so monetary policy has remained too loose since the late 1990s. the year central banks decided to print money in a major way because they couldn’t trust markets to supply adequate liquidity. Real rates are now rising as inflation falls. then falling profits with the onset of deflation pushing prices down faster than costs. Deflation’s function is to reduce asset prices to levels consistent with incomes. This promises that the interaction between the desire to save and the desire to invest will determine the level of interest rates for the first time since 1970. High quality sovereign. A level modestly below its 2009 low would give a P/E of around 9 and about a 4% dividend yield. As a result. but this idea (like many others in this inject-as-much-liquidity-as-possible world) has been taken to ridiculous extremes. but deflating costs catching up with prices and growing volumes will maintain or increase profits. With central banks hors de combat after this next banking crisis. However. Equity prices and credit spreads tend to move together. these nominal rates will represent a significant rise in real interest rates. That real estate prices depend on location is well known. Most central banks (wrongly) don’t view rising asset prices as inflation. equities with P/E of 9 and a 4%-5% dividend yield will greatly outperform 2%-3% Treasuries and negatively yielding TIPS. (Commodities are produced for consumption. However. First fear. Equities will overshoot on the downside and start recovering before the economy stabilizes and starts to recover. Since then. They have fallen by up to 3½ percentage points (except Japan) since 2000 to the lowest levels in over three decades. which are ridiculously expensive. They will temper the fall in corporate earnings.

but European banks are a major stumbling block. compared with in excess of 400% in 2004. Recessions in Europe and the US plus lower growth in emerging nations indicate the fall in commodity indexes since April 2011 will continue and. excessive debt burdens in the nonfinancial corporate sector from too-low lending rates in the periphery in the years running up to the crisis.2%. Exits from the euro income. Italy. Sovereign defaults are this would take the loan loss allowance to only painful as they impose unpopular reforms to 110% of current NPL and overwhelm annual net correct the previous excesses. the inability to limit production and the liquidation of hidden inventories will push the prices of most commodities below their marginal costs of production. most commodity price indexes failed to reach their 2008 peaks. operating income. Ireland. That the European Banking Authority found Intesa Sanpaolo and especially Credit Agricole adequately capitalized in the latest round of stress tests shows the extreme level of denial of the gravity of the situation. 50% haircut on periphery debt holdings corporate sector. also pose a threat. The Bank of Spain recently Messy sovereign defaults and/or exits from the mandated a further €50 billion of provisions. control of fiscal and monetary policy would greatly ease the way forward. having already declined in 2010 for seven of them. 6% Operating income fell for all nine major listed Spanish banks 4% in 2011. but euro are now very likely. Regaining 8% . The comparable ratio for the largest five US banks is 9. Rising productivity will account for much of the return to real profits for producers. For example. The evaporation of excess liquidity and speculative demand. Future losses will most likely overwhelm would impose equally painful reforms. Chart 13 shows shareholders’ equity as a percentage of total assets for nine major banks. The major EA banks are highly vulnerable to losses on their sovereign debt holdings. Lower highs and lower lows indicate bear markets. This would take shareholders’ equity to close to or less than 2% of total assets in four of the nine banks. Current loan loss provisions are already 70% of ignorance or denial of the gravity of the situation. the chart shows the same ratio if the banks were to take a 50% haircut on their holdings of sovereign debt in Spain. which are bound to keep rising. In addition. they will fall below their 2009 lows in the coming banking crisis. Loss from high levels of troubled sovereign debt is far from the only problem facing the EA banks.16 Last spin of the wheel for Europe’s banks • March 2012 precious metals are produced to keep so supplies on hand dwarf production.) Peak prices for energy and base metals in 2011 fell far short of their 2008 peaks. the most egregious bankster assault on public welfare with central-bank-provided liquidity will end. and politicians are either in Chart 13 Shareholders’ equity as a percentage of total assets 10% Spain gives the clearest example of the threat of non-financial sector debt to EA banks. Portugal. Greece and Belgium – which could arise from either default or exit and devaluation. The overhang of already-soured lending and declining profitability mean these banks are simply not profitable enough to build up sufficient reserves against future bad loans – especially with the EA facing a deepening recession. The 2% Spanish banking sector’s loan loss allowance is currently less 0% than 80% of non-performing Santander BNP BBVA Deutsche UniCredit Societe Intesa Credit Commerzbank Generale Sanpaolo Paribas Bank Agricole loans (NPL) to the non-financial Shareholders' equity/Total assets SE/TA. so food and precious metals notwithstanding. Europe’s core challenge Europe cannot repair both sovereign and bank balance sheets simultaneously in the context of recession/depression. like equities. the idea of commodities as an investment class will rot in the dust bin of history and this.

Alleviating and preventative measures The unexpectedly large ripple effects of the Lehman Brothers bankruptcy panicked governments into assuming the huge liabilities of failing and near failing banks in 2008-09. 1 any institution from acting as any combination of an investment bank a commercial bank and an insurance company and 2 any officer. What can be done to alleviate the situation? in 2007. TBTF banks are too big to exist. director. history shows governments would rush in with taxpayer funding at the first sign of trouble. commercial banks and insurance companies to keep systemically dangerous institutions from threatening capitalism (and by extension democracy) again. the rosy predictions spewed out by computer models are totally oblivious to the effects of the ‘Minsky Moment’ ending the credit cycle. the investment bank cum insurance company remaining after the commercial bank has been separated may still be TBTF. in response to abuses similar to those committed by current too-big-to-fail institutions. The Irish government went so far as to guarantee all unsecured bondholders in its nationalized banks. In plain English. Second. Higher funding costs and the imposition of higher capital and liquidity ratios on such institutions could help to limit their size. making the claims of politicians. while the UK government now owns 84% of Royal Bank of Scotland and 41% of Lloyds. The only way out of this downward spiral is debt for equity swaps on both sovereign and bank liabilities.17 Spanish banks. However. bankers and bank regulators that most European banks are adequately capitalized spurious. all assets should be suitable to deposit taking institutions. Regardless of the procedures. just as the global banking crisis was coming to the fore. Only the complete separation of commercial banking from investment banking and insurance activities can prevent retail deposit guarantees from extending to investment banking and insurance activities. although nationalization is a threat for institutions failing to meet the EBA’s capital targets. most European banks (and a considerable number of other banks) are insolvent. making them unable to support the crumbling Spanish government finances. director. In addition. the 2008 financial crisis exposed the high additional risks to banks from having liabilities significantly in excess of their deposits. The only way to restore properly functioning capitalism is to break them up into pieces that are not systemically dangerous. creating immense moral hazard. The major liabilities of European banks still remain contingent. Regulators have tried to tackle the TBTF problem with restrictions on capital and leverage ratios and structural reform of the banking system. as already discussed. executives of financial institutions that believe they’re ‘too big to fail’ (TBTF) have exploited their ability to pocket (sometimes phantom) profits and saddle the public with their losses. had (rightly) prohibited. The EA would have absolutely no reason for trying to prevent haircuts on bank debentures or to delay the Greek default if this were not true. The basic problem is that banks have structured themselves so that the government retail deposit guarantee extends to all the activities in the non-retail part of the bank. the new 9% Tier 1 capital ratio in the EA barely scrapes the surface of the balance sheet problems. the imposition of Glass Steagall separation won’t solve two other problems. or employee of a securities firm serving as an officer. However. For example. Writing assets down to fair value and recapitalizing banks is the first priority in restoring economic growth after banking crises. However. The US Financial Services Modernization Act of 1999 created TBTF by gutting the Glass Steagall Act of 1933 which. the bank rescues privatized gains and socialized losses in direct contravention of capitalist principles. Utilizing risk weighted capital coupled with a lack of teeth doomed the former to massive manipulation and. Unsurprisingly. All major nations would have to pass laws mandating the separation of investment banks. Structural reform to remove the implicit government guarantee that socializes losses has proven to be equally difficult. the Spanish banks’ much lauded dynamic provisioning process meant that loan loss reserves started falling . First. or employee of any member bank. so the liabilities of any institution accepting government insured deposits should be limited to deposits.

but stopped short of full separation. The same technique could greatly alleviate bank and sovereign debt problems without disadvantaging any noncomplicit entity. the UK banks’ retail activities would take place in subsidiaries that are ‘legally. banks are starting to swap bonds due to be called in 2012 for longer maturities. Each bank will have to set out plans to return to health in the event of a fresh crisis and how it will secure an orderly wind-up if the plans fail. The plans will have to be regularly updated and approved by the new Prudential Regulatory Authority. The Volcker rule doesn’t deal with TBTF. The UK attack on TBTF is to institute living wills – Recovery and Resolution Plans. Another solution needs to be found. This would be a complete reversal from the totally unrealistic European effort to make taxpayers pay the costs of misguided investments in bank securities. they ignored TBTF and did their utmost to socialize losses until the Greek debacle forced a U-turn. Under this structure. The Basel rule for zero risk weights on sovereign debt denominated in a currency the governments couldn’t print was the biggest factor in creating the European debt problems. The claims of private holders of bank debentures are being eroded by the senior claims of public entities and a flurry of covered bond issuance. neither of which is available – and for good reason. The Financial Services Authority has suggested the plans include emergency cash calls. is nearing collapse. Worse. the wasted four years has compounded the scale of problems. The UK Independent Commission on Banking (ICB) is trying to go a step further by recommending ringfencing retail banking from investment banking and wholesale funding. Continental European banking authorities have yet to deal with either TBTF or socializing losses. it adds an additional 7-10% to the primary loss-absorbing capacity of banking institutions including so-called “bail-in” bonds (regulators could write them down) and bonds that convert to capital under specified conditions (CoCos). the elimination of dividends. Bondholders will have to share in the pain. while banking services to large domestic non-financial companies could be in or out. the unbelievably big. Bank structures will have to be simplified and clear knowledge of all counterparty exposures and how the banks’ positions can be unwound is necessary to even begin constructing a living will. so is politically unacceptable in the short term and probably in the long term too. Who in their right mind would buy sovereign debt under those conditions? In addition. As a result. corporate bankruptcies are usually settled with most creditors accepting equity positions in lieu of the debt owed to them. In addition to raising the equity capital requirement to 10% and ring-fencing retail banking. the credit protection they bought in good faith threatens to be worthless. Nothing proposed so far has any chance of saving the EA banks. The EA Ponzi scheme outlined on page 11 and abetted by the ECB. The trade should have broad appeal because recovery rates for subordinated debt in failing banks will be very small. but some plans are in process. More realistically. Unfortunately. Wholesale and investment banking activities would be outside the ring-fence. or putting the entire business of a bank up for sale. Bailouts have demoted investors who paid senior credit prices for their bonds to subordinated creditor status. Debt for equity swaps would be a logical next step. The collapse of the resulting credit bubble means developed nations must eliminate as much debt as possible as fast as possible in the least disruptive way possible. A fundamental principle of capitalism is that investors in profitable ventures reap the rewards due to their investments and investors in unprofitable ventures suffer losses according to the seniority of their claims. but the ICB report does. This lets them both book a capital gain from buying back debt below par value and reduce rollover risk. Instead.18 Last spin of the wheel for Europe’s banks • March 2012 Unfortunately. powerful and wealthy banking lobbies have prevented significant progress in the battle to end TBTF. Legislation forcing conversion of bank debentures in reverse order of seniority into an equivalent amount of equity as needed to maintain adequate net tangible equity would restore solvency to many banks without penalizing taxpayers – or bondholders who should welcome the receipt of face value in securities with growth potential in exchange for the eroding claims of their bonds. economically and operationally separate’. The US Volcker rule prevents banks from trading on their own account while socializing losses with retail deposit guarantees is a step toward separating retail and investment banking. but prospects for equity holdings in the . the banks need copious quantities of equity and wholesale funding. Realization of the enormous costs of continuous bailouts replaced their fears of allowing banks to fail.

Of course. . which is why fiscal stimulation yields such poor returns. Studies show infrastructure spending is governments’ most powerful stimulative weapon. 2 reduce speculation and financial engineering and 3 create a fund to bail out banks that get in trouble in the future. Public capital spending on projects with positive returns administered to rise as private capital spending falls and fall as private capital spending rises would vastly outperform the present arcane welter of automatic stabilizers and policy on the hoof. Best practice accounting would show the return on most programs is negative.003% on transactions of bonds maturing in more than five years reduced the trading volume by 85%. Like so many things. Italy and Spain. investment. Club Med has assumed significant external liabilities that would have to be negotiated into the domestic currency in case of exit from the euro. The only thing better than stopping it here and now would be to impose limits below current levels. it would end high frequency trading. Government spending has quintupled and more in less than a century. In addition. a tax of that magnitude on foreign exchange futures would create a field day for the Law of Unintended Consequences by raising the cost of commercial foreign exchange transactions by between 1.000 times. Asia and Russia in 1998. and culminated in financial meltdowns. Most government spending is non-productive. Less trading increases market volatility (thereby decreasing confidence) in markets and lowers tax receipts far below estimates. A tax in Sweden of only 0.000 and 10. which is not only increasing volatility. cross shareholdings. This would require. drives capitalist economies. if steps one and two had been done a few decades ago. Banks converting other bank debentures could create inappropriate. not consumption. perhaps illegal. but on a grand scale. The private sector is playing an ever increasing role in infrastructure and other government programs through public/private initiatives. such as sovereign corporations. Portugal. This sounds like a panacea for all financial problems. Hope from the crisis-practised Emerging Markets Club Med now faces a similar style of financial crisis to that experienced by several major emerging markets over the last twenty years. the present accounting systems most governments use are not sophisticated enough to calculate the return on money spent. so that growth has to stop somewhere. These crises – Mexico in 1994. In addition to large current account deficits and government debt. but netting out cross holdings of bank securities would raise capital ratios by shrinking bank balance sheets. Bondholders would exchange their debt for shares in a private company that owned former government assets. As in bank debt swaps. Brazil. 1 raising government accounting up to the sophistication required of private companies. Apart from debt for equity swaps. a lot of governments would have avoided the trouble they are now in without ever needing step three. bond and derivative trades to.19 same banks properly capitalized would be much better. Turkey in 2001. but is also probably illegal because it more often than not front-runs client accounts. revenue producing properties and non-revenue producing infrastructure with either a guaranteed income or rights to charge users in exchange for operating and maintaining the facilities to an agreed standard. Many public/private initiatives have yielded good results for both sides. Ireland. but some haven’t. Politicians have proposed a tax of 0. such equity offers better long term prospects than sovereign debt in Greece. However. Accurate valuations and precise delineation of rights and duties are essential.1% on all stock. 1 make banks repay a bit of what they have taken from the public. However. Argentina in 2002 – were driven by fixed exchange rate regimes leading to the accumulation of external liabilities by governments. corporations and banks. 2 setting an inviolate proportion of GDP for average government spending including capital investment and 3 administering the capital budget counter cyclically. Its ability to rein in the most destructive element in financial markets may be worth all the problems and aggravation of designing and implementing a modified version of this tax. the most useful thing politicians can do is introduce cyclical budgeting. the devil is in the detail. Sovereign debt for equity swaps would be similar. By contrast.

Making full use of currency flexibility and looser monetary policy. currency depreciation can be more of a threat than a blessing. Some EM currencies depreciate sharply in times of weak global appetite for risk. China may Korea be the epicentre of the next Taiwan global crisis. would affect emerging markets via their varying dependence on (a) world trade. markets including Brazil. counterbalancing weaker economic demand. South Africa. avoiding excessive current account deficits. % of GDP external debt obligations should therefore be least Brazil affected. Indonesia. Indeed. some central banks would relish the opportunity to aggressively decrease their policy interest rates. high nominal interest rates in many EMs mean there is plenty of room to cut rates as the European crisis unfolds. in an attempt to stimulate investment while casting off the legacy of past inflationary periods. 0% 10% 20% 30% 40% 50% 60% 70% 80% Where developed economies have largely exhausted room for conventional monetary support to the economy. Mexico. and with scope to stimulate domestic activity using conventional policy approaches. if it were to happen. . of course. requires a sound financial position. maintaining adequate foreign currency reserves and greater banking oversight – have helped to place some of these markets in a strong position to weather the current financial crisis. so belongs in a category of its own. Indonesia. This also makes economies closely tied to China’s outlook – Korea and Taiwan in particular – more vulnerable. Argentina and Korea have experienced one or some combination of abandoning fixed exchange rate regimes in the last twenty years. in Central and Eastern Europe. Foreign bank ownership. and (b) world financing. for example. once perceived as a sign of strength. The broad lessons learned from this experience – limiting foreign-currency denominated debt. Exports constitute around 30% or less of GDP in these countries (see chart 14).20 Last spin of the wheel for Europe’s banks • March 2012 Brazil. Even better. Current accounts are either in surplus. unlike China and Korea. the outlook for many emerging economies (EMs) is much better. The transmission mechanism from a euro break-up. some EMs could exit the fall-out from a European banking crisis with strong growth potential. Indeed. S Africa given China’s unique position Mexico in particular. For markets where either governments. Russia. EA banks will shed their most favourable EM assets. the rupee.g. also leaves credit supply in some markets vulnerable to EA region deleveraging. generalizations about Indonesia EMs are fraught with hazard. rand and Turkish lira all depreciated by around 16% in the second half of 2011. Turkey India However. Banking sectors are small and stable relative to GDP. Turkey. there is a risk that in their desperation to lift capital ratios. banks or the private sector have taken on large external obligations. Relatively closed economies with limited 14. Indeed. while retaining poorer quality European assets for which there are few buyers. and growth is not dependent on ever-expanding global market share. and India should withstand a European financial crisis reasonably well. Indeed. much of the heavy-lifting for the EMs that are highly sensitive to global risk appetite. or deficits are easily covered by stable inflows of foreign direct investment. excess application of these principles – especially in Asia – contributed to the current crises via the global savings glut. real. Indeed. These are the markets most likely to suffer as Europe works through its financial crisis. Without the debt overhang of the developed markets. requiring defensive monetary policy tightening. free floating exchange rates can do On the other hand. lured by lower international interest rates e. Emerging market exports. Mexico. defaulting on domestic or external debt and banking crises. While the developed markets (DMs) are struggling to cope with the consequences of their pre-2007 credit binge.

if not substantial. e. however – the underlying asset Exposure among EMs is varied. scope to ease fiscal and monetary policy in 2012 to support domestic economic activity. Brazil has been able to cut the overnight rate by 2 percentage points since mid-2011 to 10. and neither does lower leverage – EM markets. delayed monetary tightening in the 2010/11 recovery phase means this policy arsenal cannot be fully deployed until inflationary pressures abate further. net profit has been flat for DM banks. India in particular. This gives a sense of the scale of the presence of foreign banks in the funding of these economies. across the public. while several other EMs are not at all dependent on excess reliance on foreign wholesale funding and . Chart 15 shows the claims of the Euro Area on several EM markets. however. have 600 had monetary policy on hold 500 since the middle of 2010. In this Financial pressures in the euro area – not least simple comparison. The foray into complex securitization products and explosion in leverage to generate returns all seem to have been for nothing. higher levels of equity capital capital raising plans by banks – could translate by no means restrict banks’ ability to generate into monetary pressures in some emerging profits. with Central quality and future profitability of China’s banking and Eastern Europe the most vulnerable. Over the last five years. private and financial sectors. The picture is not rosy for all EM the financing of corporations and governments. which could have significant effects on with 19 for DMs. 100 Brazil also has a sturdy fiscal 0 primary surplus. and therefore -100 2005 2006 2007 2008 2009 2010 2011 scope to stimulate the Q3 Q3 Q3 Q3 Q3 Q3 Q3 economy from that side. EM and DM Banks: Net Profit. Mexico and South Africa. Throughout the last decade. For Brazil.5% and 5. relative to the size of domestic financial sectors. but has increased six-fold for EM banks (chart 16). until late in 2011 has created a money and credit EM banks have also had persistently higher overhang. compared with less than 5% for DMs. % of domestic banking sector's total assets S Africa Korea India Indonesia Brazil Russia Turkey Poland Mexico Hungary Czech Rep 0% 100% 200% 300% 400% 500% 600% All of these markets have at least some. respectively. For some.g. EM Banks DM Banks Turkey would also join this favourable group.21 15. compared lines. Better Emerging Market Banks EM banks as a whole have been much better able to generate profits than DM banks. EA financing. while reliance on short-term capital capital ratios than their DM peers – averaging inflows to finance the current account deficit around 7% shareholders’ equity to total assets. the global deflationary environment and downward pressure on commodity prices only makes the policy decision easier.5%. 400 but still have room to cut if 300 necessary. but system being the most obvious threat. Activity of foreign banks: EA total claims.5%. banking sectors. with policy rates at 200 4. This profit growth has not been at the expense of 16. as a percentage of total assets of the domestic banking systems. but failure to tighten monetary policy financial stability. via asset sales or the withdrawal of credit banks are currently 14 times leveraged. remains significant. too. Q4 2005 = 100 Other central banks.

boosted by bouts of high inflation and higher risk premiums. The aggregate corporate debt burden is around 1/3 less for listed EM companies than DM – net debt is 1. As a result. While total assets of UK banks were almost 4 times larger than UK GDP in 2010. where institutional failure would cause collateral damage to the economy. % of GDP Mexico Indonesia Russia Turkey Brazil India Korea S Africa China Taiwan 0% 20% 40% 60% 80% 100% 120% 140% The corollary of smaller banking sectors is far more limited indebtedness of EM private sectors. compared with 2. Credit remains a low percentage of GDP in many.22 Last spin of the wheel for Europe’s banks • March 2012 a persistent NPL problem are issues for Korea’s banks. as shown in chart 17. have prevented the build-up of a credit overhang. many EM banking systems do not have a ‘too big to fail’ category. Banking sector total assets. 17. Mortgages are not widespread and corporate borrowing is low. EMs do not face the painful debt write downs necessary in Europe or the UK. the total assets of publicly listed EM banks are only a small portion of national GDP. sensible asset growth. some EM banking sectors have substantial scope for further. Less developed debt markets and higher borrowing costs.1 times for DMs. . While developed market governments have become beholden to their over-large banking sectors.4 times earnings before interest and taxes.

Unexpectedly high inflation in emerging nations permitted some adjustment in the recovery – even though inflation in developed nations was unexpectedly high. Rule #1 for preventing credit bubbles is “No bailouts at any time for any reason!” The first bailout begins the journey down the slippery slope of moral hazard to collapsing credit bubbles. The discussion above has shown that all three are impossible. by extension.) Rule #2 is “Small is beautiful!” Few worry about the collapse of entities with assets totalling less . The only way to prevent credit bubbles from crashing into deflation and depression is to prevent the bubbles from inflating. the events surrounding the collapse of this credit bubble have proven beyond a shadow of doubt that Irving Fisher and Hyman Minsky were right. over levered supra national agencies for the first time in history. as is global leverage. falling inflation in emerging nations is putting downward pressure on inflation in developed nations. The banking crisis and consequent defaults will add to that pressure. however. so inflation differentials are the only means of correcting them. (Note: government and central bank loans at penalty rates against top quality collateral with appropriate haircuts are not bailouts: loans not fulfilling all those conditions are. Now. so rising defaults will cause a banking crisis. but most are beyond the scope of this report. Much of the debt will default in the absence of a combination of accelerating growth and inflation and/or rising asset prices.23 Conclusions Currency manipulation by some emerging nations prevents nominal exchange rates from correcting the disparities in unit labour costs that led to the big global imbalances of saving and investment. The wider implications are huge. This will put intolerable pressures on global banking systems. which will be in the context of over levered governments and. Global imbalances of saving and investment are unprecedented. which focuses on the economy and financial markets. However. virtually guaranteeing deflation.

say. Meanwhile. This will set the stage for strong. Greek unemployment is nearly as high. Rubbish! The Great Depression was an unparalleled event in history. Leverage compounds risk. Either way. are small. so it will suffer most from the serial bank failures. Europe is the epicentre of the over leverage. (Remember the 1980s?) US cash is the best place for investors to ride out the banking crisis. especially banks. so it will rise and complaints about the dollar being too high should become common. Instituting debt for equity swaps on the scale required in time to avoid serial bank failures is unlikely. regardless of size. in effect. they wouldn’t need a bailout or would have sufficient quality collateral to qualify for a loan under the explanation of rule #1. Say deflation and people immediately think Great Depression. If they were. It will even provide a decent return to non-Americans.2 Governments and supra national agencies will have shot all their fiscal and monetary bullets when the banking crisis occurs. so keeping rule #1 is easy when companies. the losses will be far bigger than most banks will be able to withstand. Commodities rebounded from their 25 year slump and that cycle will continue to be a positive influence in the global economy for the next dozen to 15 years. The longer term future should be very bright. so avoiding depression in the EA would.01% of GDP. Rule # 2 applies to governments too. None. innovations such as the hydraulic fracturing that made the gargantuan reserves of shale gas and shale oil economic have postponed the prospect of peak gas and oil for at least decades. Computer driven watering systems can greatly increase yields using up to 90% less water. 2 Trends. rather than in productive enterprises that could have produced returns to augment incomes in the difficult days ahead. EA reliance on tax increases and cuts in infrastructure investment torpedoed any possible chance of growing/inflating out of their debt problems. Breakthroughs in nanotechnology and genetics offer limitless opportunities. Rapidly deteriorating economic conditions have consigned the periphery to default or exit from the euro. The Kondratieff cycle turned up in the late 1990s. 23% in Spain with youth unemployment at 50%. Such close peaks in those two cycles had never happened before and may never happen again. are worth bailing out. so it will rebalance all of the imbalances accumulated over the last three decades. maybe centuries. Cycles & Revolutions. at which time fortune will reward those with lots of dry powder and cool heads with once-in-a-lifetime bargains. 0. Lombard Street Research 2011 . The effects will diminish geometrically as leverage levels drop. Low leverage and dependency ratios should make emerging nations the first ones to regain sustainable growth. The dollar is the only asset that benefits from deleverage. some of which will not be repaid.24 Last spin of the wheel for Europe’s banks • March 2012 than. especially through invention and innovative applications of old technologies. catch-up growth – reminiscent of the 1950s and 1960s – for at least the following decade and possibly a lot longer. but explaining that is far beyond the scope of this report. Current account surplus nations unwisely invested much of their saving in debt. Yet people invariably overestimate the frequency and effects of extremely rare events – both positive and negative. The political pressure to bail out organizations rises geometrically as their size rises. The Kondratieff cycle turned down in 1920 and the credit cycle turned down in 1929. Unemployment is high and rising. Emerging nation growth should foster developed nation growth as a by-product. a necessity for the world to keep feeding its ever more affluent population in the style to which it wants to become accustomed. be a miracle.

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