This post is a guest con­tri­bu­tion by Niels Jensen*, chief exec­u­tive part­ner of London-based Absolute Return Part­ners.

Many of today’s pol­icy pro­pos­als start from the view that “greed” and “incom­pe­tence” and “poor risk assess­ment” are the ulti­mate source of what went wrong. In fact, they were not the true cause at all. More­over, even if they had been, it is fatu­ous to think that we will now cre­ate a post-crash gen­er­a­tion of bankers and traders who are not greedy, much less a new gen­er­a­tion of quants who will be able to assess and man­age risks much bet­ter than “the idiots” who have brought us to the cur­rent abyss. Greed can­not be exor­cised. Nor can the inher­ent inabil­ity of any quants to deter­mine the “true” prob­a­bil­ity dis­tri­b­u­tions of all-important events whose true prob­a­bil­i­ties of occur­rence can never be assessed in the first place.”

Woody Brock, SED Pro­file, Decem­ber 2008

Pol­icy mis­takes “en masse”
The last few weeks have had a pro­found effect on my view of politi­cians (as if it wasn’t already dented). All this talk about cap­ping salaries for senior bank exec­u­tives is quite frankly ridicu­lous. It is Nean­derthal pol­i­tics per­formed by pop­ulist lead­ers. That Gor­don Brown has fallen for it is hardly sur­pris­ing but I am dis­ap­pointed to see that Barack Obama couldn’t resist the temp­ta­tion. The mob wants blood and our lead­ers are deliv­er­ing in spades. The stark real­ity is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Pol­icy mis­takes — very grave mis­takes — per­mit­ted the sit­u­a­tion to spin out of con­trol. From the U.S. Fed­eral Reserve Bank under the stew­ard­ship of Alan Greenspan being far too gen­er­ous on inter­est rates to the British Chan­cel­lor of the Exche­quer — who now hap­pens to be our Prime Min­is­ter — advo­cat­ing ‘Reg­u­la­tion Light’.

Polic­ing must improve
If you really want to pre­vent a bank­ing cri­sis of this mag­ni­tude from ever hap­pen­ing again, the focus should be on the way banks oper­ate and not on how much they pay their staff. And, within that con­text, any dis­cus­sion must start and end with how much lever­age should be per­mit­ted. The French have actu­ally caught onto that, but their narrow-mindedness has dri­ven them to focus on hedge funds’ use of lever­age which is only a tiny part of the prob­lem. It is the gung ho strat­egy of banks which brought us down and which must be bet­ter policed. And guess what; if banks were bet­ter policed — and lever­age restricted — then prof­its, even at the best of times, would be much smaller and there would be no need to reg­u­late bankers’ com­pen­sa­tion packages.

It is pathetic to watch our prime min­is­ter attack­ing the bonus arrange­ments of our banks when the UK Trea­sury, on his watch, spent £27 mil­lion pounds on bonuses last year as reward for deliv­er­ing a pub­lic spend­ing deficit of 4.5% of GDP at the peak of the eco­nomic cycle. Even my old mother under­stands that gov­ern­ments must deliver bud­get sur­pluses in good times, allow­ing them more flex­i­bil­ity to stim­u­late when the econ­omy hits the wall. What Gor­don Brown has done to UK pub­lic finances in recent years is noth­ing short of criminal.

So, with that in mind, let’s take a closer look at the Euro­pean bank­ing indus­try. The fol­low­ing is not pretty read­ing. I have rarely, if ever, felt this appre­hen­sive about the out­look. So, if the cri­sis has made you depressed already, don’t read any fur­ther. What is about to come, will make your heart sink.

More lever­age in Europe
Let’s begin our jour­ney by point­ing out a reg­u­la­tory ‘anom­aly’ which has allowed Euro­pean banks to take on much more lever­age than their Amer­i­can col­leagues and which now makes them far more vul­ner­a­ble. In Europe, unlike in the US, it is only risk-weighted assets which mat­ter to the reg­u­la­tors, not the total lever­age ratio. Euro­pean banks can there­fore apply a lot more lever­age than their US coun­ter­par­ties, pro­vided they load their bal­ance sheets with higher rated assets, and that is pre­cisely what they have been doing.

That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset secu­ri­ti­sa­tions such as CLOs proved very pop­u­lar amongst Euro­pean banks, partly because they offered very attrac­tive returns and partly because Stan­dard & Poors and Moodys were kind enough to rate many of them AAA despite the ques­tion­able qual­ity of the under­ly­ing assets.

Now, as long as the econ­omy chugs along, every­thing is dandy and the AAA-rated assets turn out to be pre­cisely that. But we are not in dandy ter­ri­tory. Many asset secu­ri­ti­sa­tion pro­grammes are in horse manure to their necks, so don’t be at all sur­prised if Euro­pean banks have to swal­low fur­ther losses once the full effect of the reces­sion is felt across Europe. The two largest sources of asset secu­ri­ti­sa­tion pro­grammes are cor­po­rate loans and credit cards. Senior secured loans are still marked at or close to par on many bal­ance sheets despite the fact they trade around 70 in the mar­kets. The credit card cycle is only begin­ning to turn now with sig­nif­i­cant losses expected later this year and in 2010-11.

Not much of a cush­ion left
Citibank has cal­cu­lated that it would only take a cumu­la­tive increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the Euro­pean bank­ing indus­try down to the bare min­i­mum of 4.5%. By com­par­i­son, bad debts rose by a cumu­la­tive 7% in Japan in 1997–98. One can only con­clude that Euro­pean banks are very poorly equipped to with­stand a severe reces­sion. See­ing the writ­ing on the wall, they are left with no option but to shrink their bal­ance sheets. Despite talk­ing the talk, banks will use every trick at their dis­posal to reduce the loan book. No prize for guess­ing what that will do to eco­nomic activity.

The wheels are com­ing off
But that is not the whole story. It is not even the most wor­ry­ing part of the story. For the true hor­ror to emerge, we need to turn to East­ern Europe for a minute or two. Nowhere has the credit boom been more pro­nounced than in East­ern Europe. And nowhere is the pain felt more now that credit has all but dried up. One mea­sure of the credit fuelled bonanza is the dete­ri­o­ra­tion of the cur­rent account across the region. Credit Suisse has cal­cu­lated that in four short years, from 2004 to 2008, East­ern Europe’s cur­rent account went from +6% to –6% of GDP. That is a fright­en­ing devel­op­ment and is likely to cause all sorts of prob­lems over the next few years.

Mean­while West­ern Euro­pean banks, eager to milk the oppor­tu­ni­ties in the East after the iron cur­tain came down, have acquired many of the region’s banks (see chart 1). Now, with many East­ern Euro­pean coun­tries in free fall, own­er­ship could prove dis­as­trous for an already weak­ened bank­ing indus­try in the West.

Chart 1: West­ern Euro­pean Own­er­ship of East­ern Euro­pean Banks

Source: FT.com

The prob­lem is wide­spread
To make mat­ters worse, the prob­lems in the East are begin­ning to look sys­temic. Credit Suisse has pro­duced an inter­est­ing score­card where they rank a num­ber of coun­tries around the world on fac­tors usu­ally taken into con­sid­er­a­tion when assess­ing the credit qual­ity of sov­er­eign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Ice­land — hardly sur­pris­ing con­sid­er­ing their cur­rent predica­ment. More impor­tantly though, of the next 14 coun­tries on the list, 8 are East­ern Euro­pean — not what you want to hear if you are an already under­cap­i­talised Euro­pean bank with huge expo­sure to East­ern Europe.

Swedish banks are already reel­ing from their expo­sure to the Baltic coun­tries. Aus­trian banks are in even worse shape, hav­ing been the most acquis­i­tive of any Euro­pean banks. Some Ital­ian banks could be dragged under by their East­ern Euro­pean expo­sure and even the con­ser­v­a­tive bank­ing sec­tor in Switzer­land doesn’t look like it can escape the mayhem.

Worst of all, the prob­lems in the East are just about to unfold at a point in time where the Euro­pean bank­ing indus­try is bleed­ing heav­ily from mas­sive losses already incurred in other areas. With no access to pri­vate fund­ing, banks find it vir­tu­ally impos­si­ble to re-build their cap­i­tal base with any­thing but tax pay­ers’ money.

US banks are in less of a pickle. Unlike the sub­prime débâ­cle which hit both the US and the Euro­pean banks hard, US banks have lit­tle expo­sure to East­ern Europe. To prove my point, accord­ing to the IMF, Euro­pean banks have 75% as much expo­sure to US toxic debt as Amer­i­can banks, but 90% of all cross bor­der loans to East­ern Europe orig­i­nate from West­ern Euro­pean banks. And, to add insult to injury, Euro­pean banks have been much slower than US banks in terms of recog­nis­ing their losses. Write-offs now total about $750 bil­lion in the US and only about $325 bil­lion in Europe.

Chart 2: Coun­try Vul­ner­a­bil­ity Scorecard

Click here for a larger image.

The great mort­gage show
The prob­lems in East­ern Europe begin and end with their large exter­nal debts. In recent years, ordi­nary peo­ple all over the region have con­verted their tra­di­tional mort­gages to EUR– or CHF-denominated mort­gages. Some have even switched to JPY mort­gages. Who can pos­si­bly resist 3% mort­gages? Didn’t any­one inform them of the risk? As cur­ren­cies across the region have fallen out of bed in recent months, these mort­gages have sud­denly become 30–50% more expen­sive. No won­der the local econ­omy is sud­denly tanking.

Chart 3: East­ern Europe’s Net For­eign Lia­bil­i­ties as % of GDP

Credit Suisse has cal­cu­lated that net for­eign lia­bil­i­ties (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local cur­rency val­ues (see chart 3 — and don’t ask me why Credit Suisse has included South Africa in East­ern Europe!).

Chart 4: East­ern Euro­pean ver­sus Asian Crisis

Source: Wall Street Journal

Back in 1997–98 Asia went through a sim­i­lar cur­rency cri­sis. How­ever, as you can see from chart 4, Asian cur­rent account deficits were much smaller than East­ern Euro­pean deficits are now. So were debt lev­els. Despite that, the Asian cri­sis did enor­mous dam­age to the local econ­omy. Even­tu­ally Asia came good, pri­mar­ily because the deval­ued cur­ren­cies allowed the Asian coun­tries to export more. East­ern Europe does not share this lux­ury. With over 90% of the world’s GDP in reces­sion, who are they going to export to any­time soon?

Aus­tria is in great­est trou­ble
Accord­ing to the lat­est esti­mates from BIS, East­ern Euro­pean coun­tries cur­rently bor­row $1,656 bil­lion from abroad, three times more than in 2005 and mostly denom­i­nated in for­eign cur­ren­cies (ouch!). 90% of that can be traced to West­ern Euro­pean banks. About $350 bil­lion must be repaid or rolled over this year. Not an easy task in these mar­kets. Aus­trian banks alone have lent about $300 bil­lion to the region, equiv­a­lent to 68% of its GDP accord­ing to the Finan­cial Times. A default rate of 10% on its East­ern Euro­pean loans is con­sid­ered enough to wipe out the entire Aus­trian bank­ing sys­tem. EBRD has gone on record stat­ing that defaults in East­ern Europe could end up as high as 20%.

An extra $250 bil­lion to the IMF
Hun­gary, Latvia and Ukraine have already received emer­gency loans from the IMF and both Ser­bia and Roma­nia are report­edly con­sid­er­ing ask­ing for help. Mean­while the IMF’s cof­fers are drain­ing quickly and it has asked lead­ing indus­trial nations for new fund­ing. At their sum­mit a week ago, EU lead­ers coughed up an extra $250 bil­lion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hope­lessly inad­e­quate. Our lead­ers must grow up. Mea­sur­ing every­thing in bil­lions is so yes­ter­day. Tril­lions are the new bil­lions, like it or not.

Con­spir­acy or…?
On the 11th Feb­ru­ary the Daily Telegraph’s Brus­sels cor­re­spon­dent Bruno Water­field wrote an arti­cle under the header: “Euro­pean banks may need £16.3 tril­lion bail out, EC doc­u­ment warns.” In the arti­cle, the reporter revealed that he has seen a secret doc­u­ment pro­duced by the EU Com­mis­sion which briefed the union’s finance min­is­ters on the true extent of the bank­ing cri­sis. Less than 24 hours later, the article’s header was changed to “Euro­pean bank bail-out could push EU into cri­sis” and two para­graphs had mys­te­ri­ously dis­ap­peared. Here they are:

“Euro­pean Com­mis­sion offi­cials have esti­mated that “impaired assets” may amount to 44pc of EU bank bal­ance sheets. The Com­mis­sion esti­mates that so-called finan­cial instru­ments in the ‘trad­ing book’ total £12.3 tril­lion (13.7 tril­lion euros), equiv­a­lent to about 33pc of EU bank bal­ance sheets.

In addi­tion, so-called ‘avail­able for sale instru­ments’ worth £4trillion (4.5 tril­lion euros), or 11pc of bal­ance sheets, are also added by the Com­mis­sion to arrive at the head­line fig­ure of £16.3 trillion.”

Do your­self a favour — read those two para­graphs again. News­pa­per edi­tors do not change con­tent light-heartedly. Did the Tele­graph edi­tor receive a call from Down­ing Street? Or Brus­sels? Did he have sec­ond thoughts about the avalanche that he could pos­si­bly insti­gate? I don’t know and I prob­a­bly never will. But one thing is cer­tain. If the EU Commission’s esti­mate of £16.3 tril­lion of impaired assets is cor­rect, then the cri­sis is far worse than any of us could ever imag­ine. Not only would we have to get used to the prospects of a sys­temic melt­down of our bank­ing sys­tem, but entire nations may go down as well.

Pub­lic debt to rise and rise
Even if actual losses prove to be much, much smaller (and I sin­cerely hope so), the bank­ing sec­tor can­not, in the cur­rent envi­ron­ment at least, raise suf­fi­cient cap­i­tal to stay afloat, so more, pos­si­bly a lot more, tax pay­ers’ money will have to be put for­ward. This can only mean one thing. Pub­lic debt will rise and rise. The offi­cial esti­mate for the UK for next year is already approach­ing 10% of GDP, an esti­mate which will almost cer­tainly rise fur­ther. We prob­a­bly have to get used to run­ning 10–15% deficits for a few years, a fact which seri­ously under­mines the notion of gov­ern­ment bonds being next to risk-free.

BCA Research has cal­cu­lated the effect on pub­lic debt in a num­ber of coun­tries, as a result of fur­ther bank losses being under­writ­ten by tax pay­ers. Obvi­ously, those coun­tries with the largest bank­ing indus­tries (as a % of GDP) will be hit the hard­est (see charts 5a and 5b).

Chart 5a & 5b: East­ern Europe’s Net For­eign Lia­bil­i­ties as % of GDP

For that very rea­son, and as pointed out in last month’s Absolute Return Let­ter, there is a real risk that investors will demand much higher risk pre­mi­ums on gov­ern­ment debt. Only a few days ago, Ire­land issued 3-year bonds at almost 250 basis points over cor­re­spond­ing Bunds. As more and more debt is trans­ferred to sov­er­eign bal­ance sheets, we will likely see the spreads between good and bad paper rise fur­ther but we will also wit­ness increas­ingly des­per­ate mea­sures being applied by the men in power. If they could pro­hibit short-selling of banks on the stock exchange (which didn’t work), why wouldn’t they con­sider pro­hibit­ing short-selling of gov­ern­ment bonds? Not that it would nec­es­sar­ily work any bet­ter, but des­per­ate peo­ple do des­per­ate things.

Can Ger­many res­cue us?
Most investors remain con­vinced that Ger­many will come to the res­cue — in my opin­ion not as sim­ple a solu­tion as widely per­ceived given the enor­mity of the cri­sis. One pos­si­ble solu­tion which has been men­tioned fre­quently in recent weeks is for all the euro­zone nations to get together and start issu­ing joint bonds. This would undoubt­edly help the weaker nations, but the idea was shot down by the Ger­man Finance Min­is­ter only a few days ago when he said that closer eco­nomic har­mony across the euro­zone would be needed before Ger­many would be pre­pared to enter­tain such an idea.

The most obvi­ous trick left in the book, there­fore, is to inflate us out of this mess. With the enor­mous amounts of pub­lic debt being cre­ated at the moment, years of defla­tion à la Japan would be cat­a­strophic. You will never get a cen­tral banker to admit to it, but a healthy dose of infla­tion is prob­a­bly our best prospect of sur­viv­ing this cri­sis. Given this out­look, do you really want to be long euros?

* Niels Jensen has 24 years of invest­ment bank­ing, pri­vate bank­ing and asset man­age­ment expe­ri­ence. He founded Absolute Return Part­ners LLP and is its chief exec­u­tive partner.

Dr. Prieur du Plessis is an investment professional with 26 years' experience in investment research and portfolio management. More than 1,200 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns, including his blog, Investment Postcards from Cape Town. He has also published a book, Financial Basics: Investment. Prieur is Chairman and principal shareholder of South African-based Plexus Asset Management, which he founded in 1995. The group conducts investment management, investment consulting, private equity and real estate activities in South Africa and a number of foreign countries. He also serves as Honorary Consul of Slovenia for South Africa, actively developing economic, cultural and scientific relations between Slovenia and South Africa. Prieur is 54 years old and live with his wife, television producer and presenter Isabel Verwey, and two children in Cape Town, South Africa. His leisure activities include long-distance running, traveling, reading, motor-cycling and scripophily. Read more from the author/contributor here.

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