WHO’S NEXT AFTER CYPRUS?

The Cyprus debacle seems to have taken a course towards a resolution of some sort, with the announcement last week of a bailout plan that includes, among other measures, a one-time tax levy on wealthy (supposedly Russian) depositors in Cyprus banks, even when reports are now surfacing that the Cyprus banking system has been experiencing steady capital flight for several months now, with savvy Russian depositors being tipped-off by money managers way in advance of things reaching their dramatic climax over last week. The bailout deal sets a significant precedent, and fires a warning shot towards European jurisdictions who have allowed their banking systems to become offshore parking lots for hot money, to the tune of multiples of national GDPs.

I distill 4 fundamental lessons from this episode:

1) Capital controls are back, clearly embedded in the bailout terms: Capital controls are an extraordinary breach of basic EU rules, which allow freedom of labor and capital movement. Indeed, article 63 of Europe’s internal market rules explicitly states that “all restrictions on the movement of capital between member states and between member states and third countries shall be prohibited” unless there is an issue of “public security”. But there are few signs of the EU enforcing article 63 when it comes to Cyprus, even when the capital controls proposed are currently treated as temporary measures.

2) All deposit accounts are at risk, and some euros are more equal than others: the latest plan, which will see accounts with less than €100,000 protected, has established a new template for future bank bailouts: that depositors’ cash above the “insured” amount can and will be raided.

3) “Too big to fail” still holds: Some will argue that as big savers in the Bank of Cyprus and Laiki, the island’s two biggest banks, are taking such a haircut, the “too big to fail” mantra no longer works. But in truth the banks were minnows within the euro zone. Their near-collapse tells you that the ECB will do all it can to protect banks it regards as “systemic”, but will let the others go hang.

4) EU stress tests are worthless: The European Banking Authority’s annual health check on euro zone banks at the height of the euro crisis in July 2011 revealed significant concerns about just eight banks – five Spanish, one Greek and two Austrian. The Cypriot banks – Bank of Cyprus, Laiki, and Hellenic – passed what was supposedly a grueling assessment. Bank of Cyprus chief executive officer Andreas Eliades said at the time: “The stress test results justify the group’s strategic choices and actions, and illustrate its very strong capital base even under the most extreme, difficult and adverse scenarios.” Make of that what you will.

So who’s next to follow Cyprus’ path in the euro zone? Speculations have been swirling as of late, identifying Slovenia, Malta, Slovakia, or even Luxembourg as potential next domino piece to fall. In essence, Cyprus fell into its mess due to four fundamental factors that converged at a particular point in time, namely: weak fiscal situation, large debt overhang, banking sector size too big (and too weak), and too much reliant on foreign funding. I figured if I plot those 4 dimensions based on latest data observations (2012) for a host of euro zone countries, maybe one can discern possible next targets? Below is my attempt at a visualization in Tableau software. The x and y axis are self explanatory, depicting the debt and fiscal situation respectively, the relative size of the bubbles represents the size of the banking sector relative to national GDP, and finally he bubble color represents the extent of which that banking sector is reliant on foreign deposits (the more red, the “hotter” the funding). The data was sourced from the latest IMF World Economic Outlook edition, and the ECB’s Eurostat. Voila!

Basically, we’re looking for big, red bubbles that are closer to the upper right quadrant of the chart. Cyprus is right there, along with Portugal, France, Spain, Malta, Ireland, Belgium, Slovenia, Slovakia, Austria and Hungary, to name a few culprits. Malta looks particularly worrying, but consider this: Despite the size of Malta’s banking sector, assets held by the more important banks are slightly more than twice the country’s GDP. This is half the EU average. More importantly though is that the vast majority of deposits and loans administered by these banks are domestically derived: Maltese banks have very little exposure to foreign government bonds, have more than enough cash reserves to cover their loan portfolio and adopted over the years a very conservative low-risk approach to investment.

Slovenia has had its share of rumors lately, and the chart above shows it to be on the edge of the danger zone. These fears could be well founded: Slovenian GDP is set for a deeper-than-expected 1.9pc contraction this year, compared with an earlier estimate of 1.4pc, according to official forecasts released on Friday. The revised forecast brings government predictions in line with the IMF’s gloomier verdict that that the economy will shrink 2pc this year, the most in the European Union after Greece and Cyprus. As such, Slovenia’s cost of borrowing soared to a record high on Wednesday, with yields on two-year debt tripling over the past week, jumping from 1.2pc to 4.26pc before falling back slightly on Thursday. Ten-year yields have reached a post-EMU high of 6.25pc. Add to it the Russian connection, and you’ve got yourself a self-fulfilling prophecy.

Personally, I would be nervous about Belgium, particularly after the IMF’s latest assessment, which states: “The economy has entered a second year of near zero growth amid persistent vulnerabilities. While an improvement in external conditions, even if gradual, should support the recovery, the economy’s capacity to rebound and create jobs is constrained by structural rigidities and a loss of competitiveness. The financial sector has been transformed and downsized in the aftermath of the financial crisis, but vulnerabilities remain. Combined with the fragile situation of public finances, these vulnerabilities could, in an adverse environment, undermine macroeconomic stability.” Hum, zero growth, large and weak banks, lousy fiscal, large debt overhang, and an IMF warning to boot? That’s hard numbers. Does the market agree? Belgium bond yields went lower, so maybe the market knows something I don’t, or maybe it’s just a prelude.

By the way, the Tableau visualization above is interactive and dynamic (and Hungary is hiding behind Austria, conveniently), so feel free to click on data points and bubbles and explore around, then write to me or in the comments section below and tell me which euro zone country would be next to fall to the all-new, all-improved punishing bailout treatment.

FOREVER BLOWING BUBBLES

We’ve had an intense fascination with blowing bubbles since the day we’re born. Whether it’s soap bubbles, balloons, bubble gum, we’re forever blowing them, the more the better, the bigger the better. We watch in awe and anticipation as the bubble gets bigger and bigger, and we snap back in excitement (and a little surprise) as the bubble bursts, often in a messy and dramatic fashion. Did we not expect it to blow up? Then we blow another one. and another.

It’s quite the similar story with adults in the financial world: we create, often through breakthrough financial engineering advances, investment opportunities that look too good to pass up, we fuel the bubble with a toxic mix of greed, cheap credit, intense lobbying, and minimal regulation, we market the opportunity as a low risk/high return affair (as if this concept actually ever existed in real life), and we feed it to the people who can least afford it, sometimes forcefully, sometimes fraudulently. And finally, when the bubble bursts, we borrow the government’s bailout mop to clean up the mess left behind. History is riddled with financial boom-bust-bailout episodes, and one does only need to look in the recent past for some of the more striking examples of leveraging and excess gone wild. It has even been shown in a rather comprehensive and thorough way by Reinhart and Rogoff in their excellent seminal treatise on the history of financial crises that this boom-bust cycle has been getting shorter and shorter, with more devastating consequences and spilovers on the global economy (you can download the entire excellent dataset of the book for free here).

So you wake up every morning and you wonder “What is the next financial bubble, how big is it, and who’s blowing it?”. Or maybe you don’t, but you should, since we’ve already experienced in very stark detail (and still do) how someone else’s big messy pile can quickly turn into your own sour bill to pay. And like with every other question I have, I turned to Google search to get started on an answer. I typed “next financial bubble” in the search box and got the following random candidates for the US economy, in no particular order: derivatives, student loans, credit card debt, the stock market (and more recently social media stocks), and healthcare. There are many more bubbles outside the US market, like commodities, China, emerging markets, and other lurking risks, but we can examine those in a different post.

The the $1.2 quadrillion (one thousand trillions) derivatives market has been dubbed “one of the biggest risks to the world’s financial health”. It’s complex, it’s unregulated, and it ought to be of concern that its notional value is 20 times the size of the world economy (note though that we’re talking here about notionalvalues, not net values). U.S. commercial banks currently hold a notional value of $244 trillion in derivatives, with Net Current Credit Exposure of commercial banks to derivatives of $353 billion (due to bilateral netting), and that’s the number we’ll use for the US market. See the latest OCC report for further details. College tuition costs are soaring and forcing the young to bear obscenely high levels of student loan debt, while a ballooning $1 trillion student loan bubble shares a strikingly scary resemblance to the toxic subprime mortgages of six years earlier (and are just as likely to be repaid). Credit card debt is as american as apple pie, and rising healthcare costs prompted ObamaCare, while stock market bubbles are a recurring and familiar scene. While the U.S. Higher Education, credit cards, and healthcare bubbles aren’t an asset bubble like stock or real estate bubbles, it is a bubble-like phenomenon with very similar risks and implications as asset bubbles.

I couldn’t quite seperate media hype from real risk, so to test the claim that a particular phenomenon is a bubble or not, and to compare the claims side-by-side, I resorted to a simple visualization technique called (what else?) the bubble chart, whereby I plot the bubble phenomena on a three-dimensional graph according to 1. overall growth since 2001 (in multiplier form), 2. latest yearly growth rate vs average yearly growth rate (also in multiplier form), and 3. with the size of the chart bubble indicating it’s relative size to US GDP in real life. These dimensions basically illustrate the total amount of growth in the past 10 years (vertical), the most recent rate of growth relative to the 10-year average growth rate (horizontal), and the size of the “problem” relative to GDP (size and color of bubble). The crude and preliminary results look something like this:

Three basic observations: the fastest growing recent trend can be observed in college debt, the biggest increase in the past 10 years has been in the derivatives market, and the biggest exposure to the overall size of the economy can be found in the stock market, albeit at a much slowing pace (due mostly to the great correction of 2008).

The current price to earnings ratio of the overall U.S stock market stands near its long-term historical average of 15, so it seems that overall valuation is where it should be. I’ll go on a limb and say that credit card debt seems to be under control, owing to a recent 3 year episode of consumer credit deleveraging following the shock of 2008. The derivatives market looks like a runaway train on the chart above, but it relatively small in net terms, and considering that the derivatives market is in its infancy pretty much, and hence starting from a low base, such great rates of growth are expected. Which leaves us with skyrocketing healthcare and education costs, among other things, to get alarmed about.

The cost of healthcare, like college education, has exploded in recent years, far outpacing wage growth and the overall rate of inflation:

Healthcare spending as a share of the US economy reached an all-time high of 18.2 percent in 2011, an incredible threefold increase since 1960. The sad fact is that Americans spend twice as much on healthcare compared to other developed countries, but get lower quality care and less efficiency. Like any other industry, the healthcare industry is tied to the health of the overall economy and when their services become even more unaffordable for vast portions of the population, such as in the next recession, the industry will experience some form of a collapse. The popping of the healthcare bubble will cause all levels of the U.S. healthcare industry to downsize in the form of layoffs, salary cuts, hospital and medical office closures. As with housing, healthcare will always be needed, but the US healthcare industry’s current levels of largesse and parasitic profits cannot be sustained.

On student loans and the alarming, crisis-like levels it reached, I point you to this succint piece in the Pulse, and this cartoon:

Bubbles this big simply have to be closely monitored and kept in check. The government should seek sharpening of monetary policy and macro-prudential tools to deal with these, due to their implications for the economy and the strength and stability of the financial system, as well as the overall well-being of the society.

-Samer