our neighbor’s house, banks and Grexit

This post could also be titled, “Why bank stocks have never been my favorites.”

a mortgage loan story

There’s a house down the street from us that has been empty for the past seven or eight years.  It’s worth maybe $150,000.  The former owner stopped making mortgage and property tax payments in 2008(?), mailed the keys back to the bank that gave him the loan and left for another part of the country.

The local sheriff has seized the house for non-payment of taxes, which total maybe $20,000, and has tried to auction it off a number of times.  The minimum bid, which no one has offered, is the taxes owed.

Why no bidders?

The bank still has a lien on the house for the $300,000 mortgage it granted almost a decade ago when all the loan craziness was going on.

why I don’t like bank stocks

The bank is apparently still unwilling to recognize the loss it made on this loan.  I presume this is because if its books were scrubbed of all the similar dud loans it is carrying, the bank’s financials would look pretty awful.  So it pretends the loans are still good.  To some degree, but not totally, investors can see through the pretense and the bank’s stock (I don’t know which bank) probably trades at a discount to book value.  But the reality is hard to see from the outside.   This is why bank stocks make me uncomfortable.

from Brexit to Grexit

What does this have to do with Grexit?

Bank stocks throughout the EU plunged when the “Leave” side won in the Brexit vote.  That has very little to do with the UK, in my opinion.  But if Britain can leave the EU, so too, can Greece, whose economy has been moribund for close to a decade.  Leaving would allow Greece to devalue its currency and thereby give its economy at least a temporary boost.  That would only work if the country defaulted on its sovereign debt at the same time.  So default is a probable consequence of Grexit.  That would be very damaging to the EU banks whose vaults are stuffed with Athens-issued bonds.

 

Brexit, Grexit and Lehman

Just about two weeks ago, Finnish finance minister Alexander Stubb called a British vote to exit the EU Europe’s “Lehman moment,” meaning it would signal the onset of an economic catastrophe similar to the one that shook the world when we found out that the US investment bank Lehman Brothers was bankrupt in 2008.

How apt is the comparison?

…not much at all.  In fact, I think it’s kind of crazy.

Lehman

US and EU banks spent the middle of the last decade creating increasingly exotic and risky derivatives based on packages of home mortgage loans.  When there were no mortgages left to grant that might have any prayer of being repaid, the banks manufactured even more preposterous securities based on mortgages that far exceeded the mortgagees ability to repay, and where the amount lent exceeded the value of the property by a lot.  When the music stopped in 2008, institutions like Bear Stearns or Lehman, whose audited financials showed them with billions of dollars in shareholders’ funds, were filled instead with worthless mortgage-backed securities and were actually bankrupt.

That wasn’t the bad part.

Commerce around the world is based on trust and on the financial soundness of banks.  Firms normally send goods to customers in advance of being paid.   They get a bank IOU on shipment, which they can cash in either on delivery or shortly after.  When companies realized that the middleman bank could possibly declare bankruptcy while goods were still in transit and they were holding trade IOUs–meaning they would be unsecured creditors in a bankruptcy proceeding, to be paid at best a small fraction of the IOU amount, and even that a long time in the future–they stopped sending any merchandise   …to anyone.  World trade came to a standstill.

Just as bad, enterprise control software systems showed managements right away how large the losses were that they were incurring by not being able to sell anything.  They responded with mass layoffs of employees.  That made the economic situation even worse.

In comparison, Brexit is a walk in the park.

Grexit

Of course, the rhetoric of Stubb and other pro-Remain politicians is one of the reasons for the panic that has seized financial markets once the “Leave” result was returned.

The only possible point of comparison I can see is that Brexit could lead to Grexit, Greece exiting the EU.  So far, the austerity regimen imposed by the IMF and the European Central Bank on Greece, when that country confessed to have falsified its national accounts for many years and to be unable to service its government debts, has created nothing but misery for Greece.  Leaving the EU and devaluing its currency would be an alternate solution to Greece’s financial woes.  Were it to do so, however, Greece would likely default on its sovereign debt.  That would hurt the EU banks who still hold large swathes of it.

 

discounting and today’s equity market

Discounting is the term Wall Street uses for the idea that investors factor into today’s prices, to a greater or lesser degree, their beliefs about the future (I wrote a detailed post about the process in October 2012).

 

Two of the major macroeconomic factors the market is wrestling with now are the timing and extent of the Fed’s future moves to raise interest rates from their current emergency lows, and the possibility that Greece will default on its debts and exit the euro.

 

My experience is that almost nothing is ever 100% discounted in advance.  There’s always some price movement when the event actually happens.  Having said that, the coming rise in interest rates in the US has been so anticipated–and talked about by the Fed–for such a long time that there may even be a positive market reaction to the first rise.  This would be on the idea that Wall Street would give a sigh of relief when there’s no more anticipatory tension to deal with.  More likely, there’ll be a mild negative movement, for a short period, but that’s all.

The Greek financial crisis has also been in the news for a long time.  But we don’t have the same extensive history of behavior during past economic cycles to draw on, the way we do with the Fed.  We do have Argentina as a case study in what happens to the defaulting country (personally, I expect the consequences of default for Greece would be pretty terrible for its citizens).  But the focus of investors’ concern is what damage might be done to the EU by Greece’s leaving.  In addition, lots of non-economic factors are involved in this situation.  There’s Greece’s central role in Europe’s beliefs about its own exceptionalism.  There’s the Greek portrayal of the EU’s requirement that Greece implement structural economic reform as a condition for debt relief as 21st-century Nazism.  There’s the status quo in Greece that has benefited from the country’s profligate borrowing.  There’s fear of the unknown that must be urging politicians to paper over Greece’s problems.

In addition, my sense is that the markets’ overriding emotion so far is denial–hope that the whole situation will go away.  Current thinking seems to be that the parties will arrange for some sort of default, along with capital controls to restrict the flow of euros out of Greece, that will allow Greece to stay in the EU.  Still, I find it very hard to calculate odds or even to anticipate what the worst that can happen might be, or the best.  This makes me think that very little of the possible negatives of “Grexit” are factored into today’s prices.

More tomorrow.

Grexit a 50/50 possibility…

…according to financier George Soros.

Personally, I have a hard time dealing with Mr. Soros’s Donald Trump-ish nature.  In his book The Alchemy of Finance, for example, he claims to have invented the thesis-anti-thesis-synthesis explanatory pattern that was introduced to European thought by Hegel in 1807 and developed by Marx later in that century.  Hard to believe Mr. Soros, who studied philosophy, is completely unaware of either of these seminal figures.  I’ve also thought that a significant amount of the success of his Quantum Fund was due to Soros’ less well-known partner, Jim Rogers.

If there’s one thing, George Soros knows about, however, it’s currencies and politics.  So his view that it’s a flip of a coin whether Greece stays in the EU or leaves, is well worth listening to.

The short story of Greece’s woes is that after joining the EU it racked up so much sovereign debt using the implicit repayment guarantee of being in the euro (kind of like having a credit card that can’t be maxed out) that it can’t possibly pay all of it back.  The gravity of the situation came to light several years ago when a newly installed (and now gone) government announced  the previous administration had been falsifying the country’s national economic accounts  for years.

Greece has since been negotiating for debt concessions in return for ending its spendthrift ways.  Its strategy so far has been to promise reform in return for debt relief   …but to do nothing.    This tactic seems to have recently passed its “sell by” date.  The EU and the IMF now appear to believe that the moral hazard risk of continue to accommodate Greece is worse than the potential damage to the Eurozone from expelling it.

As I see it, the ball is now clearly in Athens’ court.

For what it’s worth, I think Grexit would turn out to be a genuine tragedy for Greece, but far less damaging to the euro than is commonly believed.  Rather than giving encouragement to breakaway movements in the UK, Spain and elsewhere, I think Greece outside the EU–substantial currency depreciation, loss of access to external finance–would serve as a cautionary tale instead.    Think Argentina without the farm wealth.

My guess is that the euro would decline a bit on Grexit.  The banks might have a rocky time, too.  It’s very possible, though, that the markets would be happy just to have the situation resolved–and that any fallout would be small and short in duration.

 

 

investment wildcard: Grexit

My first employer on Wall Street had an unusually aggressive negotiating style.  At one time, a big brokerage firm wanted to buy the company he founded.  They agreed on a price after lengthy negotiations.  Two weeks later, my boss reopened the negotiations and successfully raised the bid.  Then he did it again.

On the day the contracts were going to be signed, he asked for another 5%, figuring, I think, that the buyer would have no choice but to acquiesce rather than see all the time and effort it had put into the deal go up in smoke.

The buyer walked out the door instead.

According to the Japanese companies I’ve talked to over the years, Chinese government officials use the same psychological ploy–agree, let the other side relax and celebrate  …and then ask for more.  The one difference with China is that twenty years ago manufacturing there gave you both a labor cost and a capital cost advantage over making things elsewhere (the only instance of this I’ve seen in thirty years as an analyst).  So there was no question of going elsewhere.

From my casual observation, Greece has been using this same negotiating style with the rest of the EU over the past few years.  I suspect, however, that Greece’s position is closer to that of my old employer rather than China’s.

How so?

–Greece is small, representing only about 3% of the EU’s GDP.  Arguably, the most important thing it brings to the union is the cachet of once having been the cradle of democracy.

–EU financial institutions are much better able to withstand the shock of a Greek exit from the union than they were in the depths of the financial crisis.

–Greece has complied with virtually none of the dozen-plus structural reform mandates required by the current bailout, which expires at the end of this month.  This gives the EU no reason to believe that Greece will follow through on any terms it agrees to now

–allowing an unrepentant Greece to remain in the EU under far more relaxed standards than afforded to, say, Spain, could easily prove more destabilizing to the EU than cutting ties

–the negative economic consequences for Greece of Grexit could be enormous–enough to provide a cautionary example for other states, or regions within states to reconsider separatist movements.

my take

I think Greece is holding a much weaker hand than is commonly perceived.  I think that the chances Greek government negotiators will take the one step too far that will cause the other side to leave the room are significant–although I have no idea how to quantify that.  Finally, I think any negative reaction to an actual Grexit, ex Greek stocks, which I imagine would do very poorly, would be shorter and milder than the consensus thinks.