Dexia: The Next Lehman? – Oct 7, 2011

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. Dexia: The Next Lehman? Last week, I drove by the Brussels headquarters of Dexia.  It is interesting to contrast the calm external appeal of corporate operations and beautiful office space with the true turmoil within.  In case you were wondering how legitimate the recent European bank stress tests were, we offer Dexia as a prime – or should we say “subprime” – example.  Has so much changed in 90 days since Dexia was considered to be strong enough to withstand further market pressures?

From a market cap of nearly 40 billion dollars, Dexia has fallen to nearly 1.5 billion.  The stock was off 42% this week, which tragically wasn’t that many pennies.  Troubled assets at the bank are over $250 billion.  Mind you, 90 days ago these assets were still in the category of troubled; but it didn’t seem a material fact at the time.

Reality is setting in for anyone that owns Sovereign Debt. They will lose money, and they are out of time for reporting those assets at or near full value.  In Europe, the era of mark-to-make-believe is over.  It is an acceptable accounting gimmick, but astute investors are not hanging their hats on it any longer.

Basel III requirements will likely change to prevent such legerdemain and require a mark-to-market accounting approach, as the current accounting system fails to recognize existing balance sheet weaknesses (which you would assume to be imperative in a real stress test).  An overleveraged institution has been allowed to carry on the charade of solvency until this final break in equity prices has forced the issue of either bankruptcy liquidation or a split into good bank/bad bank (to hold the losing assets) institutions.  Recall Maiden Lane vehicles were similarly structured to keep the bad assets off the market and from precipitating a collapse in similar asset prices held by other financial institutions. Since the Belgians have been unable to organize a government for over 500 days, can we assume that the French government will shoulder the responsibility?  Oy Vey!!  (Yiddish, not French – in case you were wondering.)

Why labor over the Dexia issues?  Simply put, all of the European banks run through the official stress tests and given a passing grade should be reconsidered as depository institutions.  I’ll rephrase that … the mattress is looking pretty good right now.

2. ECB, EU, UK, and the PRC: The ECB has been active in providing loans to the market this week, with the unique characteristic of one-year maturities instead of the three-month and shorter term loans usually on offer.  Whatever the ECB is concerned with, it doesn’t think the issue will be shortly resolved.  For now, the issues of liquidity may take center stage as at least a dozen UK lenders and half as many Portuguese banks were downgraded this week.  Spain and Italy both took a single grade cut on their long-term credit ratings by Fitch, with Italian government bonds getting hit three notches to A2 by Moody’s.  The real issue is solvency, as we’ve often stated, but the market focus will continue to be more immediately on liquidity.

In the event UK banks or Her Majesty’s Government run short on pocket money, Mervyn King has lined up an immediate £75 billion.  Those freshly minted notes (digital credit, more likely) are already marked for QE – buying up government debt.  Many economists see £500 billion as a more realistic sum for this second round of debt monetization, or QE2 (Quantitative Easing – not Queen Elizabeth, although the double entendre is fun).  King’s concern: “The world is facing the worst financial crisis since at least the 1930s, if not ever.” King or Queen, the outlook in the UK is less than ideal.

As if we didn’t have enough to keep our eyes on, US politicians this week have insanely attempted to score points with voters by casting the Chinese as a real threat (desperately diversionary).  The Senate voted Monday to move ahead with debate over an anti-China currency bill designed to punish China for undervaluing its currency.  If you have the time, you might call your elected representative and help them recall Mr. Smoot and Mr. Hawley.  Remind them that Britain pushed us, and we were the ones that shoved back.  In this instance, our legislators are pushing. Should the Chinese decide to shove back, we will pay dearly for it.  It’s generally unwise to make an enemy of your chief creditor, unless of course you know and they know that you are already planning on some sort of default.

3. The Last Straw:  The Fed, the ECB, the BoE, and the IMF (here to save the people that fund it!) saved the markets over the last week. In doing so, they indicated that they are prepared to “cork” the global financial issues, beginning with those specific to the eurozone.

The BoE announced that it will spend another £75 billion to foster growth.  Pay no mind to the fact that its last stimulus package of £200 billion (initiated in early 2009) failed to create anything economically meaningful – except inflation and job losses, of course.  The remainder of the aforementioned monetary clan has issued only promises thus far. Details as to the size of the checks to be written and how the funds are to be used remain unknown at this point.  To be clear, though, the objective is to recapitalize or keep solvent the banks, preventing panic – or “runs,” if you will – in the face of certain bankruptcy, starting with Greece.

However silly, the markets acted with the pretense in mind that more QE would in fact inject “growth” back into the ailing paradigm. Strangely enough, the idea of more easing and growth breathed life back into productive assets, while recently blessed “defensive” areas struggled.

On the week, stocks rallied, gaining around 3% on average. Transports were up 4.5% (aided by weaker oil prices over the last month), while bonds were clipped, with the 10-year Treasury yield up 16 basis points.  The 30-year Treasury gave up less ground (yield rising only 10 bps), supported by operation “twist,” which begins next week.  The dollar rose 0.33%, gold was up 0.71% and silver 4.03%.  Commodities in general rose a mild 0.62% (based on the CCI index), but oil spiked 4.63%.

The U.S. economic data continues to misguide investors.  The panic rally in Treasuries, in our opinion, has produced a latent but temporary boost to economic activity.  Falling rates equal healthy refinancing and, consequently, healthy spending.  It comes as no real surprise then that the economic data for August and September tipped into positive territory.

Construction Spending, the ISM Manufacturing and Prices Paid indexes, Total Vehicle Sales, and employment figures all came in better than expected.  Consumer credit even fell from $11.965 billion in July to $9.5 billion in August.   However, the most recent downtick in home refinancing (MBA index down 4.3% ending Sep 30th, previously up 9.3%) suggests that the net benefit of falling rates is fading as we move into October.

Overseas, a Greek bankruptcy seems to be a foregone conclusion. Austerity measures and offered bailout terms have proved insufficient to stop the crisis from spreading.  Italy, Spain, and Portugal are next, while the ECB seems to be transitioning from stimulus to “fox hole” mode, targeting only the solvency of its main banks – an effort we can appreciate.  To us, there is a big difference as it pertains to future economic health in printing money for consumption purposes (modus operandi for previous stimulus) vs. maintaining liquidity during a debt workout phase.

That said, the markets may be in for a great deal of pain in coming months, especially in stocks, as mass government support begins to wane.  As we have stated here many times, governments are trapped. Money printing at this stage in the business cycle now produces more inflation than growth, making things worse, not better (thereby forcing bankruptcy and moderating QE).

The main question we have, which is shared by many metals investors, to be sure, is whether the markets will be so bold as to favor Treasuries (instead of metals) in the next downturn.  To this, we can only say, “not as much as the last time.”  Technical indicators suggest that the selling pressure in the metals is abating, but further shocks, however short-lived we expect them to be, are not impossible.

Best regards,

David McAlvany
President and CEO
MWM LLLP

David Burgess
VP Investment Management
MWM LLLP

2014-10-06T21:07:45+00:00