The reckless, irresponsible seizure of Washington Mutual: please read in Washington DC

I lost money on this – so you can take my analysis with the caveat of a slightly angry grain of salt.

But I still think the seizure of Washington Mutual is the most capricious government action of this cycle and possibly the worst thing that has happened to American Capitalism this cycle. But that takes a little explaining.

Lets do it on a typical current account deficit country bank. In a country with a current account deficit the loan to deposit ratio of the bank is usually something like 130. That is banks in current account deficit countries have more loans than deposits. Banks intermediate the current account deficit. I have blogged about that extensively – see here and here amongst others.

Here would be the typical capital structure of such a bank rebased so that total assets and liabilities equal 100.

Cash, securities, other semi-liquids 8
Loans 76
Other assets 16
Total assets 100


Deposits 59
Secured funding (say pledging assets - which happens in America more than other jurisdictions) 19
Other liabilities 3
Senior borrowing 6
Junior borrowing 3
Preferred stock 1
Equity 8
Total liabilities 100

Loan to deposit ratio 129%

I cannot spell out how common this sort of structure is. It would be a typical bank in most current account deficit countries other than that the secured borrowing may be unsecured in other countries. In the US banks can pledge assets to the Federal Home Loan banks – which is secured funding essentially backed by the US Government. In the UK there would be much less equity in the structure than in other jurisdictions. In America slightly more. If I were to rebase the balance sheet the equity in the US would be typically about 8%, in Australia about 7%, in Spain a little thinner and in the UK about 4%. After you adjust for goodwill these numbers are another percent or two lower.

Now generally (and I am talking in good times) the equity was a high return piece that got good returns under the understanding it could go to zero. Every equity holder knew (or at least should have known) that a wipeout was a possibility. The preferred stock was typically a very long dated instrument (say 30 years) with no security whatsoever and a dividend that could be suspended. There usually wasn’t much of it but anyone that thought rationally about it knew it could be wiped out. It also yielded say 500bps more than Treasuries. It was junk at pretty well all banks - though it could sometimes have a fancy rating.

But the senior debt in this structure was often medium dated, yielded say 120bps more than treasuries and was considered pretty safe.

After all – to wipe out the senior debt the equity, preferreds and junior debt needed to go first.

In this example above 12 had to be bad to touch the senior debt and 18 had to be bad for the senior debt to be worthless. As there was only 76 in loans in this table then 18/76 = 23 percent had to be bad. That was before you considered that the business would typically have some pre-tax, pre provisions earnings. So to wipe out the senior debt typically 30% of the loans had to be bad. As most of the loans in most banks in current account deficit countries are mortgages and would have a recovery rate maybe 50% of the loans need to default. With a bank diversified across a country that seems implausible even in these times of mortgage stress.

For the senior debt holders even to be hurt 30% of the loans probably needed to default. It was always possible – but the senior debt holders have (with some considerable intellectual justification) acted as if it were unlikely they would be nicked. They had plenty of protection – provided by equity, preferreds and junior debt.

Now if you notice in this capital structure the difference between loans and deposits – the lending that makes current account deficits countries possible – happens as either secured borrowing or unsecured senior borrowing. In countries without the Federal Home Loan Banks (which provide secured funding) the difference between loans and deposits is funded almost entirely with the senior.

What makes this structure possible is order of creditors and the reliability that governments/liquidators etc will honour that order of creditors and ensure that the senior debt instruments at least (and all the other debt instruments) will get a fair shake when things go pear shaped. If in a liquidation the senior was considered parallel the equity or preferred then the senior wouldn’t exist.

The seniors knew they took a risk. We know that because of the 120bps they charged. But these people think (with some justification) that they took very little risk. They relied for that justification on the notion that governments had rules which shifted the losses where they belonged, on equity, preferreds, juniors and seniors in that order. If they didn’t believe that then all senior funding would disappear and all institutions that were reliant on that senior funding would fail.

Ok – there was a minor bait-and-switch in this post. The ratios that I put out there were Washington Mutual in their final published results as a bank holding company. They are however not atypical – and the variants are fairly described in the following paragraph.

Now what has the Government done here. It has confiscated the institution and sold everything except the liabilities marked equity, preferred, junior and senior. It confiscated the liquidation rights of the senior and junior debt. [It confiscated the liquidation rights of the preferreds to but that is an understood risk in owning preferreds. And whilst I lost money here I am far more angry about the other…]

If WaMu had been placed in liquidation I am pretty sure the seniors would have got something. If the senior debtors had been allowed to conduct an auction for WaMu (compromising all the junior stuff including the prefs I owned) then they would have got something.

Except that the liquation rights – well established order-of-creditor rights – were denied by a swift US Government action.

Now I understand that there is a strong policy presumption in favour of a quick government disposal of a failing institution – and that policy presumption might at some stage trump the rights of some holders of paper. However a pretty strong case must be made.

Now lets compare the WaMu case with the IndyMac case. In the IndyMac case I think the government acted fairly. The main issue with the IndyMac case is that there is accountability. The government is liquidating the IndyMac loans in full public glare – and it is clear that they have lost (considerable) moneys. The senior debt (if there were much) would know pretty clearly that they were toast because they could see the results of the liquidation.

This visibility is not available in the WaMu case as there is no public liquidation – instead the assets were confiscated and flicked to JPMorgan as part of essentially the same transaction. The confiscation of WaMu would not have happened when it happened if there had not been a simultaneous buyer. So the senior debt holders never got their order of creditors.

The lack of visibility creates a lack of accountability. Sunlight (visibility of the liquidation) is the greatest disinfectant. In the WaMu case senior debt holders from the outside look as if they had their rights taken from them (and those rights were valuable) by a government official without any method whatsoever of auditing the decisions of said official. That is why the actions of the Government were capricious in this case. [Some comments on this blog have wondered why I think it was capricious. I stand by that wording...]

It would of course be more acceptable if there was a large body of evidence that the government put forward to justify their complete disregard for quite senior rights here. The evidence for instance in the Bank of Credit and Commerce International was pretty strong. BCCI was a criminal organisation and the dosh was simply stolen. There were criminal prosecutions. There was sunlight… and so we could be sure that the government acted with justification.

But in this case the Feds did very little to justify their decision. Lets run through some of it.

• On September 8 WaMu changed its CEO and announced it had entered a Memorandum of Understanding with the Office of Thrift Supervision.
  

WaMu also announced that it has entered into a Memorandum of Understanding (MOU) with the Office of Thrift Supervision (OTS) concerning aspects of the bank’s operations, principally in several areas of its risk management and compliance functions, including its Bank Secrecy Act compliance program. In addition, WaMu has committed to provide the OTS an updated, multi-year business plan and forecast for its earnings, asset quality, capital and business segment performance. The business plan will not require the company to raise capital, increase liquidity or make changes to the products and services it provides to customers.

Note that the business plan in this press release did not require that the bank either raise capital or increase liquidity. Moreover it did not require that the bank forecast liquidity.

• On the 11th of September the bank noted its available liquidity was about 50 billion dollars and that the bank continued to be capitalised significantly above the well capitalised levels.

• On the 17th of September the bank confirmed what everyone knew, which was that the bank was for sale. TPG (the private equity group) waved their pre-emption rights with respect to any transaction.

• On the 24th of September there were no bidders for the common equity.

• On the 25th of September it was taken over.

Now in the middle of this sequence the press became alive with stories about how bad it was at WaMu. Lots of people close to the deal were talking – as I noted in this (unfortunate) post. They were talking their book – that is spreading nasty rumours about WaMu.

We know that there was a run on deposits starting on the 15th of September with a net deposit loss of 16.7 billion. That run was almost certainly triggered by the wave of stories about WaMu and that wave of stories was triggered by investment bankers trying to buy WaMu on the cheap. In other words government action was as responsible as anything else for the run.

Moreover – and nobody has denied this – WaMu had 50 billion in liquidity. Only deposits above 100K will run if the government publicises that FDIC deposits are safe. 50 billion of liquidity less the 16.7 that ran left plenty. Its almost certain that WaMu had sufficient liquidity left to deal with its jumbo deposits. WaMu after all was a retail bank – and jumbo deposits were not the driver.

Now the clincher – in the OTS fact sheet on the WaMu liquidation is this little zinger:

Maintaining Capital – In late 2006 and 2007, WMB began to build its capital level through asset shrinkage and the sale of lower-yielding assets. In April 2008, WMI received $7.0 billion of new capital from the issuance of common stock. Since December 2007, WMI infused $6.5 billion into WMB. WMB met the well capitalized standards through the date of receivership.

Note the OTS thought that – at least as of the date in which they confiscated the bank – it was well capitalised. It was probably also liquid - after all 50 minus 16.7 is a lot when we are talking in billions.

Now the future of WaMu was uncertain. They clearly had plenty of losses coming at them. The company estimated those losses as 19 billion. JPM has estimated 31 billion. On both those numbers incidentally the senior debt holders in WaMu should – in an orderly liquidation – be made whole. Get that – on JPM’s own numbers the senior debt holders should have been made whole – and yet the rights of these debt holders were confiscated.

I don’t know the future, the OTS doesn’t know the future, and JPM doesn’t know the future. Nobody really knows what the end result for WaMu would be in an orderly liquidation. Everyone knew that WaMu was in some trouble. That was clear.

The OTS/FDIC carried a risk – the risk being that the losses would be so large that would wind up costing the government money.

The government solved its problem – and it did it by taking away the rights of the senior debt holders to an orderly liquidation – when on the numbers given by the ultimate acquirer the senior debt was likely to be whole or near to whole.

The Government did this seemingly capriciously. It changed the order of creditors and the basis on which banks all across America raise wholesale funds.

Now there is not much raising of wholesale funds by banks at the moment. But after this deal there is likely to be less. It is simply the case that there is now a new risk for people who provide wholesale funding – and that risk is that the government will unilaterally abrogate their rights – without appeal, without due process and without accountability.

In the process the OTS and the FDIC have effectively removed the main low-cost source of funds of pretty well all banks in America. They will have put the fear-of-Government into such people globally. This is the opposite of moral hazard. In the Moral hazard case people take too many risks because they believe the government will reimburse their losses. But in this case people are going to take too few risks because they know that government might unilaterally remove their rights and property.

This was – by far – the least justified government action of this credit cycle. And it spells doom for any bank in America that is ultimately reliant senior (and hence well protected) but unsecured financing because it is so capricious.

Those banks are many – but we can start with Wachovia whose destiny (failure) is now nearly certain – and for whom the precedent is set. But after that we can go for all the banks including the champions such as Bank of America and Citigroup. Creditors now face confiscation of their rights by the US Government without oversight or audit or even process.

At that point there is no creditors and the economy collapses. The trust needed to make capitalism worked has been removed. I am not a conservative - but I will argue - along with many conservatives - that the most important function of government in a capitalist society is provision of a framework by which property rights can be defined and enforced as this is the key to making a capitalist society function. The Government is now acting as if the framework does not apply to them. That is bad whatever your political persuasion.

What next

The FDIC and OTS have won the battle with respect to WaMu. They got rid of WaMu without any cost to the taxpayer. The WSJ lauded that achievement. They really did get out of their WaMu risk quite neatly – and I will bet the heads of those organisations went to bed feeling pretty pleased with themselves.

But in the process they have doomed about two thirds of the US banking system.

I am still a believer that government – whilst not stuck with great incentives will grope for right solutions. But that belief of this former (competent) public servant is being shaken to the core.
And whilst Wachovia and dozens of others will eventually hit the wall because of this decision the Government will work out that it has a bad process before Bank of America fails.

But I think it is time that the process is short circuited. The heads of the OTS (John Reich) and of the FDIC (Sheila Bair) should be sacked now and for cause. Mr Paulson better get control of this situation and let it be known that the US has a process for dealing with senior creditors and making sure that their rights are honoured.

Otherwise heaven help us.



John Hempton

Hookers that cost too much, flash German cars and insolvent banks: an introduction to Swedbank’s Baltic homeland

I have been sitting on this post for a while. It helps if you read my post on the Norwegian bank collapse before you read this.

But otherwise enjoy a post that breaks all the rules. I am loudly calling the likely collapse of a politically sensitive country. Its one of those circumstances when shouting fire can cause the tragedy. To some extent I take comfort in my low readership.

I promised when I started this blog to have a global focus. I haven’t mostly because the most interesting story around is what is happening in the US financial market. But I hope to remedy that in this post as I give you, dear readers, a financial tour of Sweden, Latvia, Estonia and Lithuania.

I shouldn’t shout this story – but it is such a good story I can’t resist. The title is a little sensational too – but not unfair.

Before I start I need to introduce you to a model of bank collapse.

The fixed currency model of bank collapse

First observation: banks intermediate the current account deficit

· Countries that run big current account deficits have banks with loan to deposit ratios above 130. (See Australia or New Zealand for examples.)

· Countries that run big current account surpluses have loan to deposit ratios of 70 or less. (See my post on 77 Bank for an example.)

· Another way of saying this is that banks in current account deficit countries are generally reliant on wholesale funding. [It’s the crisis in wholesale funding that is causing the problems in American banks now.]

Second observation: fixed exchange collapse with currency runs

When a country has a fixed exchange rate that is too high (evidenced by unsustainable current account deficits) they become subject to runs on the currency. This happens as follows:

· Some speculator (eg George Soros) shorts-sells the currency and buys whatever it is fixed to. They do this by borrowing the target currency or by withdrawing lending in the target currency.

· They then take the borrowed currency and give it to the central bank/currency board who swap the domestic currency for foreign reserves at the fixed exchange rates. In doing so they reduce domestic money supply causing short term interest rates to rise. If they do this enough they induce a recession (ugly). This creates pressure (political and otherwise) for a deviation.

· Alternatively the central banks sterilises the money supply change. However if they continue to do this they will run out of foreign currency reserves – and the fixed exchange rate collapses anyway.

Many a fixed currency has been broken this way. George Soros did it with the pound. Nameless speculators did it across Asia. The Mexican Peso and Argentine Peso both had fixed currency pegs that didn’t hold.

Third observation: a currency run results in the banks being de-funded.

· Given that most the lending in the “target currency” is to banks and the banks in current account deficit countries are generally dependent on wholesale funds – the run on the country causes funding pressure to banks.

· This funding pressure when it is particularly intense will cause those institutions most dependent on foreign currency to become illiquid and hence collapse. The currency crisis morphs into a run on bank wholesale funding.

Past currency crises have been associated with bank collapses. In Thailand (which was precisely to this model) the finance companies actually collapsed and the banks almost collapsed. In Korea both the banks and currency collapsed.

But you need to be really careful of countries with fixed exchange rates and huge, unsustainable current account deficits.

Never much fun shorting the banks in such countries

If you had picked the collapse of the Thai Banks you might have cleverly shorted the stocks. It would not have helped much. Suppose you shorted $100 worth of a Thai bank. It collapsed down 95% (corrections in the comments). So you had $95 in profit. The only problem is that you have the profit in the pre-crisis exchange rate. The currency also dropped almost 90%. So you were left with about $10 profit. That is fine-and-dandy but it is not much reward for effort of picking a system that is about to collapse.

You would of course be much better just shorting the currency – or shorting the ADRs of the target stock (the ADRs being priced in a hard currency).

The real exception is that if you find a bank in a hard currency that is totally exposed to the debacle country you can make a fortune. You can guess now that Swedbank is my bank. It is not the only one – but is very spectacular.

Current account deficits, fixed exchange rates and Eastern Europe

Eastern Europe is full of vulnerable currencies. Most of the countries have fixed their exchange rate to the Euro (hoping I guess for Euro membership at some stage) and have massive current account deficits.

Latvia is particularly bad. The exchange rate is pegged (as per this page from the central bank of Latvia). The current account is enormous, almost 25% of GDP. There is no doubt whatsoever this exchange rate is not sustainable. Not close.

As the Latvia economy watch blog will point out Latvia is suffering the results of the beginnings of the credit crisis caused by fixed exchange rates and a run on the capital account.

Estonia is not much better. It too has a large current account deficit and its currency (the Kroon) is also fixed to the Euro.

Estonia’s economy is also suffering the effects. The current account deficit never got quite so bad in Estonia – but it not pretty.

Lithuania is a little better – maybe only marginally more unsustainable than the United States.

Manifestations of the Baltic madness

Argentina in the days of the fixed peso was a party for the middle class. The middle was the main beneficiary of the fixed currency – and when it was over the middle class rioted.

A similar party is visible in the streets of Riga. Mercedes are everywhere. Bentley has opened a dealership. However this ignores my favourite take on Riga. It’s the rise and fall of the bucks parties…

When travel to Latvia opened up it was eye-popping for an awful lot of British lads. Here was a country where the women were Baltic Beauties – and poor. To the London lads this was bucks party heaven. It became more so when Ryan Air put on a Friday evening flight from London to Riga. Ryan Air even tried a Riga-Shannon route to service the Irish lads. The locals even got to classifying all Brits as Ryanair sex tourists as this club review shows.

Well due the crazy exchange rate the bucks parties got too expensive. I am not going to lead your round the internet to stories about over-priced hookers – but the bucks parties are moving to Prague. The Shannon-Riga flight has been cancelled. Ryan Air has recently announced a Friday night Birmingham to Prague flight.

Manifestations of the Baltic Madness in bank balance sheets

The largest Baltic bank is Hansabank – a wholly owned subsidiary of Swedbank. The last Swedbank annual report contains this fascinating summary table:

For the currency challenged – there are about 6 Swedish Kroner to the USD.

The deposits are 102 billion kroner, loans 177 billion. That is a loan to deposit ratio of 174%. That would be pretty high for a country – but it turns out that Swedbank (via Hansa) gets 177% by having a massive deposit share – as seen in the following table:

In Lithuania the loan to deposit ratio looks sensible. In Estonia – despite a 62% deposit share and only a 49% lending share the loan deposit ratio is 163 percent. In Latvia the loan deposit ratio is a 176%.

The observant amongst you might have noticed that the loan to deposit ratio in the two tables doesn’t match. I can’t work out why either…

Whatever Hansa Bank is very wholesale funded. This can be seen in Hansa’s balance sheet (from the English Language version of Hansa’s annual report).

Again for the currency challenged there are 0.45 Lati to the USD.

The key observation here is that deposits are 1.7 billion Lati and loans are 4.2 billion. The loan to deposit ratio is 244 percent.

Again the observant will notice that this ratio is different to Swedbank’s annual report – suggesting that when talking to analysts Swedbank seems to think that a lot of wholesale funding in Latvia is deposits. Other than that (cynical) line I have no explanation.

The main source of funding is in the line: due to financial institutions. There is 2.7 billion Lati due to financial institutions.

Fortunately Hansa Bank tells us more about that. Here is a table from the Hansabank annual report about the money due to financial institutions…

So now we can see it. Swedbank funds the Latvian current account deficit. It funds it in Euro.

So what happens next?

Well if the Lati devalues (as would seem inevitable) then Hansa Bank has to pay Euro to Swedbank – and as its assets are in Lati it would be insolvent.

If the Lati doesn’t devalue its only because people (ie Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can’t be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

This is a very big problem for Swedbank. Swedbank’s equity is 68 billion SEK – but 20 billion is intangibles. Swedbank is probably solvent at the end of this – but only just. Swedbank will (at best) lose its independence. Swedbank is in turn wholesale funded – and the chance of it becoming Swedish Government property is not low.

Having lent that much to a country with a phoney fixed exchange rate in a currency they can’t print – Swedbank management deserve it. Bad things happen to bad banks and this is a bad bank.

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I wrote this post before SwedBank's great looking 2Q results. They made it all work - by lending even more to the Baltics. Latvian deposits are actually falling despite high inflation and rapid (but declining) loan growth.

I used to think Swedbank would probably survive. I now think it probably goes to zero.

Christmas in July: a falling US dollar is just a bowl of cherries

Australia is sweltering hot at Christmas. Everyone sits down with extended family when it is 40C (104 Fahrenheit) and indulges in an excessive roast lunch. Christmas is sweat and family dramas.

The saving grace of a mid-summer Christmas is cherries. The cherries are just coming on in December and are fantastic. You buy boxes at roadside stalls as you drive the long distances to your home town and eat half before you see your family.

A Winter Christmas

There is a new emerging Australian tradition – which is to have a winter Christmas celebration. Christmas in July is hams, puddings and wood fire. This new tradition is really strong amongst Australians who have spent some time in the Northern Hemisphere and pine for a white Christmas.

But Christmas in July is without cherries and that doesn’t feel quite right.

Until now.

On Saturday night my wife and I went to a delightful Christmas in July. This was a stylish affair with fairy-tale lights and good bubbly wine. And we took a bowl of cherries.

The cherries came from California. And they were $15 a kilo (say $7 a pound) at Paddy’s Market. Five years ago they were unaffordable. But then the US Dollar halved relative to the Australian dollar and now we have affordable cherries in the depths of winter.

Cherries and the US current account deficit

And as I indulge in another bowl of cherries I think the falling US dollar is wonderful. And so does some Central Valley farmer. Of course my (incremental) purchase of American cherries drives the price up for most Americans (poor you). And so in the smallest of ways there is a shift in the American economy from US domestic demand to exports.

Exports are the only part of the US economy doing well. Export driven businesses are shooting the lights out. (If you don’t believe me read the Federal Reserve’s Beige Book.) If there is a single really good global trend it is away from US domestic driven businesses and towards US export driven businesses. It is symmetrically against foreign businesses that compete with US exporters. (Think GE over Siemens, Boeing over Airbus.)

The Bronte Capital thesis on this is as follows:

• The US current account deficit is huge

• The subprime crisis has shown that you can’t endlessly and profitably lend to American consumers therefore the economy will need to shift to radically bring down the current account deficit.

• This means you need to avoid US domestic sectors and fall in love with US export driven sectors.

• Alas rising oil prices are driving up the current account deficit slightly faster than the changing terms of trade are driving it down which means we are only beginning on the export driven trend.

If you want a decade long trend its US exports.

You should be on it. And life will be a bowl of cherries.

The end-goal of any bailout or government takeover

The US is a current account deficit country.  Get used to it.  You (and I am not an American so I can say you) have been spending more than you earn for years. 

I can’t speak too rashly though because Australia and Aoeteroa (New Zealand) – the two countries to which I am closest – are also current account deficit countries.

If you run a current account deficit for long enough your financial system will be NET short deposits.  There will be (say) 130 of loans for 100 of deposits.  [If you are the UK it can be much more extreme – with Northern Rock having a loan to deposit ratio of a few hundred.]  Individual banks will have sufficient deposits but everyone is vulnerable.

Banking can be profitable even if you are short deposits.  Indeed it was silly-profitable for more than a decade before the insane lending started.  The high levels of profitability meant that people would lend to banks unsecured in quantity at thin spreads.

Banks became totally dependent on their ability to roll the loans.  If they can’t roll this senior unsecured funding they will fail.  No ifs, no buts.  That results in failure.

Most banks in current account deficit countries have such funding.  In Australia it is called Bank Bills.  Here it is called lots of names only because financial innovation has found lots of ways to name the same stuff. 

I have calculated out the losses of banks in the US numerous times – and in no sense are the losses not able to absorbed (at some cost) by the highly productive US economy.  There may be a period of austerity as America adjusts – but the economy should bounce back.

Under the presumption it can finance itself.

But it can’t finance itself unless it can assure unsecured lenders that it is a sensible place to lend. 

The end of this financial crisis will occur when unsecured lenders feel safe lending to financial institutions again.  If this does not happen the crisis will not end – and there will be a great-depression level event in the US.  That is real – factories will be idle, and good people will be roaming looking for jobs and unable to feed their children.  

So I am going to set up policy guideline here for a bailout and for all FDIC action.  All policy should be geared towards making unsecured lenders feel safe.  New regulation should be geared that way.  The takeover of banks will be well done if it gives the appearance of respecting the rights of unsecured lenders.  The WaMu deal was bad.  The Wachovia one was better (only from the position of an unsecured lender but that is the only position that matters).  

America has – through decades of excess spending become beholden to the whims of unsecured lenders. 

Face reality.  That is who you have to please.

Incidentally the Swedish/Norwegian solution did that but wiped out almost all equity and preferred shareholders.  Bank stocks would go down a bundle from here with anything that looks like Scandinavia. 

 

 

John Hempton

 

PS.  I have no dog in this race.  I am short a few bank stocks, long a few preferreds and have no position whatsoever in senior debt of banks.

Zero in Japan versus zero in America

I don’t have a solid economic model of different types of zero interest rate policies. I guess the number of instances historically doesn’t give us enough material to get a classification. But this is worth stating.

Zero in Japan looks very different from how zero in America looks right now.

How Japan looks

One of the first posts on my blog was about 77 Bank. 77 is a typical mid sized Japanese regional bank. It has vast excess deposits. It has plenty of liquidity – but almost nobody to lend it to. Competition to attract worthy borrowers is intense – and is led by prices. Loans are typically made on less than 50bps of margin.

The banks are bizarrely unprofitable. At 12 times leverage and a spread after costs of about a third of a percent the return on equity – before tax and provisions – is about four percent.

Businesses – at least ones with any claim to be credit worthy – have no trouble borrowing at all in Japan.

There is however a problem with these low spreads – a very big problem. Japanese banks are vulnerable to very low levels of credit losses. A loss rate of a third of one percent wipes out profit. A loss rate of 2 percent sustained over a couple of years would wipe out half the capital.

Summary: Japan has zero rates and the banks can’t make a spread because they have no willing borrowers. The banks have no liquidity problems – but they have a capital problem whenever losses rise to merely low levels from extremely low levels. The reason banks stopped lending was that there were insufficient willing borrowers.

The broken bank in Japan is a “zombie” (living dead). It has insufficient capital and not enough spread to rebuild capital over even a decade. It has enough liquidity to limp on for many years. However it often is attracted to riskier loans in a vain effort to find some spread – and it is prone to blow ups. For a long time Nishi Nippon City bank looked like that.  

Note that Japan is now facing credit losses of a couple of percent - and that is high enough to cause widespread devastation to the low-spread Japanese banking system.  

How the US looks

Most US banks have spreads after costs well above two percent of assets. Wells Fargo for a long time has had an interest spread above five percent. Spreads are still that high or higher.

In the good times background loss rates were one percent or more. Indeed there were plenty of businesses in the US which worked fine with three percent background loss rates (much car lending for instance).

There is no shortage of willing borrowers. Indeed there are plenty of worthwhile projects at the moment that have a hard time being funded because the banks don’t have any money available. Banks can’t fund themselves as the market for senior bank funding has shut down. The reason banks have stopped lending is that there are insufficient people willing to provide funds to banks. In plan parlance banks don’t lend because they can’t borrow.

Some observations

It is trite – but the key difference is between a current account deficit country and a current account surplus country.

The deficit country has to borrow from abroad. Banks intermediate the deficit and the banks are subject to hot money flows.

Being subject to hot money flows the banks are subject to runs – very big and destructive runs.

The banks in those countries fail fast. Japanese banks by contrast remain as zombies (living dead) with insufficient capital but enough liquidity to last decades.

In current account deficit countries nationalisation or part nationalisation is a common end-game for a financial crisis.  

Lots of people talk about Sweden (or better Norway) because they did their nationalisation well. But another example is Korea – where the bank blew themselves up too – and were critically dependent on (Japanese) money which became rapidly unavailable.

Help please

I know how these things look. I don’t have a decent model grounded in facts-on-the-ground.

I am surprised at the tone of the WSJ story about Japanese regional banks needing a bailout. They don’t need it from a liquidity perspective – they need it from a capital perspective. The WSJ story does not make this clear.

In America and the UK the banks have (serious) liquidity problems. I am not sure they have capital problems. Indeed my view is that there is no capital problem in the system – but the banks individually might have issues. The reason there is no capital problem in the system is that the underlying pre-tax pre-provision profitability is about 400 billion per annum.

Am I right that the system has adequate capital?

This view looks really controversial. It is just assumed – more or less by all pundits – that the banks are insolvent. Krugman’s latest piece on zombie banks is just one of many.

But the pre-crisis net tangible capital of the US banks was about 1.4 trillion. About 500 billion has been raised or defaulted since the crisis began. So call it 1.9 trillion. The pre-tax, pre-provision profitability has added another 400 billion per year to the pool – so we are at 2.3 trillion or more. A few hundred billion of the losses are borne outside the banking system.

If total losses get to the 3 trillion numbers that Roubini talks about. the system will get to neutral capital in two years and be fully recapitalised in five. If those numbers are right this is not a capital problem – it’s a liquidity problem.

The problem is serious though – and nationalisation may be the right prescription. It appears – as a matter of fact – to be the end game in countries which have current account deficits and banking crises (see Korea, Sweden, Norway). I am just not sure how to do it right – and when people (like Krugman) borrow the expression “zombie banks” from Japan I think they are substituting words for clear thinking.

I guess the thinking is hard though. If I thought all this stuff through clearly enough I would have that Nobel Prize in economics. Alas I did my last academic economics twenty years ago.

John Hempton

PS.  UK banks have (a) lower spreads and (b) lower starting capital.  The problems in the UK are thus more serious even with a lower level of losses than the US.  I am not sure that Barclays can ever be made solvent.  Barclays by comparison think they are solvent now.  But then I am a noted doubter of Barclays as one of my early posts show.  

PPS.  I was a little quick when I described Nishi Nippon City bank.  It is in fact a merger of two banks (Nishi Nippon and Fukuoka City bank).  Both were zombies.

The Norwegian bank collapse – a fixed currency model with a current account deficit

In my post about the Japanese bank collapse I showed how insolvent banks could remain liquid and hence operating for decades provided that they had (a) sufficient deposit funding and (b) low enough interest rates. [Please read the Japan post before you read this one.]

Given that the Japan situation required sufficient deposit funding I argued the Japanese deflation model was not a good model for how the US situation would wind up. I promised to talk about the Scandinavian bank collapse in a follow up post.

As I wrote this post I realised that I did not know enough about the Scandinavian collapse generally to write a useful post. But I know plenty about the Norwegian collapse.

This is helped by the Norwegian Central Bank (Norges Bank) who have published a long English language description of the Norwegian banking debacle and its aftermath. You will find it online here – and it is free. This is the single most useful document I have ever read on decoding that sort of banking disaster – and anyone that claims to speak knowledgeably about this sort of banking collapse who has not read it should probably be ignored for spouting theory rather than data. (Ideology abounds amongst the pundits – ignore it.)

The Norwegian case is held up by many pundits (including Krugman and myself) as the best model for how government and central banks should behave in a financial debacle. For reasons that will become clear in this post I am not sure that is always the case.

Anyway Norway had a few preconditions not all of which are necessary but which are often associated with bank failure:

• It had a recently deregulated financial system where new forms of lending and new processes of credit approval were rapidly introduced
• It had a current account deficit
• It had a fixed exchange rate and
• It had a fairly recent adverse terms-of-trade change (namely a big fall in the oil price).

Of these – in my view – and probably in Norges Bank’s view – the most important factors were the fixed exchange rate and current account deficit.

Financial institutions and current account deficits

Financial institutions intermediate current account deficits. Joe Sixpack is hardly borrowed a couple of hundred thousand for his mortgage by going to the global financial market. Instead he goes to a local bank and the local bank raises the money in global markets either by issuing debt in its own name or by securitisation, covered bonds or some other route. This is true everywhere that there are current account deficits. When there are sustained current account deficits banks on average lend more than they take in deposits.

If there is a run on a fixed currency – meaning people want to take money out of that currency – that in effect becomes a run on the wholesale funded banks.

Norway had a current account deficit and naïve wholesale financed banks. They were naïve because recent deregulation meant that they really knew relatively little about wholesale funding risks or the new types of lending they were doing. Worse it had a fixed exchange rate. This was a nasty set of preconditions.

Further, in the early 1990s there were several countries that had fixed exchange rates in anticipation of European monetary union. In some of those countries (especially the current account deficit countries) the exchange rates were too high – and were vulnerable to speculative attack. By far the most famous speculative attack was against the UK pound. George Soros famously made a billion pounds “breaking” the bank of England. To this date the UK has never never even looked like again fixing its currency to the Eurozone.

The Scandinavian countries were likewise subject to speculative attack. The Norwegian attack was the most severe because the current account was getting massively worse. [Norway – an oil rich economy – had a massive spending boom financed by bank lending as the oil price crashed towards $10.] The speculative attack quite literally ran the banks out of money. There was thus an economy wide crash.

It is worth making an aside here. When the banks actually run out of money they can’t lend. Asset prices depend critically on the ability to borrow against them (and that includes the price of current mortgages in the secondary market). When the banks can’t lend asset prices can fall to very low – indeed insanely low levels. At the height of the crisis some 2 bedroom apartments walking distance from the centre of Oslo (one of the richest cities in the world) and with full 180 degree fjord views traded hands for USD15000. You would have easily made 30 times your money buying those properties. Property prices can fall to very low levels without any bank lending. Indeed the ability to borrow to buy assets is often crucial in maintaining their prices…

Now at this point it is worth noting that the banks are illiquid and point-in-time insolvent. When property prices had fallen to such (absurdly) low levels the entire market was upside-down and if you were to liquidate the banks they would be grotesquely insolvent.

All this ended very rapidly. The government guaranteed bank liquidity – and wound up with ownership. The mechanism by which they nationalised the banks is beyond the scope of this post. Most importantly they floated the Kroner – and the currency driven run on the banks ended almost overnight. Certainly the crisis had seriously abated within three months.

When the run ended the banks were again liquid – so they could again lend. Property prices rapidly rose returning to something that looked more normal (if not expensive by global standards) and the banks were solvent. This was a strange crisis because if the underlying assets were priced rationally the banks were solvent always – they were just illiquid.

There is a proof of this assertion. Paul Krugman suggests in the NYT that the Scandinavian bank bail-out cost a lot of money. But the Norwegian government actually made a profit on the bank bail out. The loans wound up not-very bad and the Norwegian government wound up owning most of the banking sector which they again privatised. Norway is as close to the case of illiquid but solvent banks as I am aware of.

What does this mean in the US context?

It is regularly asserted that the Norwegian model is the superior model for dealing with banking crises. The economy bounced back very fast (and isn’t that the goal?). The government didn’t wind up insolvent. Indeed all was indeed well.

But this misses the point. Norway was the case example of illiquid but solvent banks. Bailing out illiquid but solvent banks is the right thing to do (if you can trust the government to identify illiquidity without insolvency). Bailing out insolvent banks tends to reward behaviour that makes you and insolvent. And it is costly. If you think that the Norway experience can be duplicated in any bank bail out – then unfortunately you are sadly mistaken. I doubt the average government can identify the difference between illiquidity and insolvency. Certainly the bulk of the investor population couldn’t (or the banks would not have been illiquid). The Norwegian government got really lucky because the banks it chose to bail turned out just fine.

What does this mean generally?

For investors there is a simple lesson: be careful of fixed exchange rates and current account deficits. I have already pointed to Spain. I have a post coming which points to what I believe is a huge forthcoming financial crisis with nasty geopolitical implications. Oh, and a great investment idea.

But dear readers, you will have to wait for that one…

John

Globalizing the Australian Intergenerational Report – thinking about long term sovereign solvency in Australia, the US, New Zealand, Japan and China

In the financial crisis governments seemingly regularly guaranteed their banks to stop their banks from collapse. This worked in preventing mass bank collapse and a consequent Great-Depression-Event. But it transferred the risks to government. Since then yield on bank debt has tended to converge with yield on the domestic sovereign. And the financial crisis has morphed into a sovereign debt crisis.

The crisis-of-the-moment is Greece. Greece runs a fiscal deficit which is a low teens percentage of GDP (a couple of points worse than America) but unlike America it does not control its printing press* (Greece uses the Euro) and (believe it or not) its political system looks more dysfunctional than the US.

I do not want to blog about Greece. I blogged about the issues with Spain and the issues are the similar. It is just that Greece was first to the breaking point.

This post is not about short term sovereign solvency. Short term a sovereign is insolvent when it can't find anyone to lend to it and it is seemingly impossible to pick the moment of panic. People have talked about Portugal, Italy, Greece and Spain (the so-called PIGS) being insolvent for many years. It is not as if the collapse of one was unlikely. [I thought it would be Spain first – but hey – I was wrong...] Today people add Ireland to the list (since it guaranteed huge banks) and talk about the PiiGS. If you picked that it would be Greece first and that it would be 2010 that the crisis happened then you are better a the short term stuff than me. (Italy always struck me as a marginal member of the PIGS but I could be wrong about that too.)

This is a post about long term solvency – the things that we do now that determine whether we have an economic crisis in twenty or thirty years. In that sense this is a post about Australia, the US, New Zealand, Canada and Japan and possibly even China. The PIGS have rolled their dice. Most the rest of us are still shaking the dice in the tumbler.

I will start with the Australian Treasury Intergenerational Report – a report required of the Australian Treasury every five years. Whilst the projections (including economic growth projections for forty years) are to be taken with a grain of salt the basic tradeoffs are the ones detailed in the report. Let me summarize quickly:

Australia – like much of the developed world – has a demographic problem from aging baby boomers. Our dependency ration (the ratio of people of non-working age to working age) is increasing and likely to increase dramatically. Moreover the dependent group will shift from young people (who impose schooling expense) to old people who impose nursing home and medical expense. Old people generally cost more than young people and as we live in a country with (semi) socialised medicine that expense is likely to fall (heavily) on the Federal Budget.

Australia's national budget will thus become a little tighter each year. [This is in contrast to the glory days of the 70s and 80s where economic growth and baby boomers going through their years of peak productivity made the budget just a little easier to balance every year.]

The net effect is that something has to give. Either

(a) Australia cuts benefits to old people (and with socialized medicine that means deciding when you turn the respirator off) or

(b) Australia sharply increases taxes or

(c) Australia sharply change the mix of our population by having more babies or importing more people through immigration.

Some smaller things can work at the margin. For instance Australia can change ages at which people qualify for various pensions. This should keep old people in the workforce longer and hence reduce the dependency ratio. Also – as the working age population become the scarce factor wage levels for those still working should rise. The higher wages will attract some older people back into or into staying in the workforce. However these are effects are likely to be too small to overwhelm the main thesis.

With a good size baby boom and old people driving government expenditure (something that is certainly the case in the US) the problem is real and will remain intense.

The problem could be solved with very rapid economic growth – but the Australian Treasury models a quite high real rate of growth and Australia still has a problem. If economic growth were to decline to Japanese levels the fiscal imbalance by (say) 2030 would become very intense. [Australia could get very lucky with sharp increases in commodity prices. That sort of luck is possible because Australia is small – however that sort of luck will not bail out the US.]

By far the easiest solution is (c) - changing the mix of the population. Societies are not good at rationing health care expenditure for the elderly and there are limits to the ability of smaller open economies (such as Australia) to keep increasing taxes. [Though in my view a little of both these things will happen.]

Everyone that matters in Australia knows that the easiest solution is (c). Peter Costello – Australia's last Treasury (in the US context read Secretary of the Treasury) knew this and advocated women having three children – one for mum, one for dad and one for the country. **

Costello had his eye on the future fiscal balance (as he should) but there is an undertone of racism in his pronouncement. Australia's population is a matter of choice because there is an endless supply of skilled and/or needy immigrants who want to live in Australia and the main case for having babies over importing people is that the babies are probably white.

Anyway the core way that Australia is balancing the long term budget is through immigration. If you want to solve the problem that way you need very large immigration now so that in 30 years the you get the right dependency ratio. That – for better or for worse – is what the government is currently doing. Australia's immigration rate is massive – roughly 1 percent of the population per year. That level of immigration will have Australia on the path to a 50 million population (currently 21 million) by the year 2050. Australia will – in resource use and population over fertile areas – look about as crowded as the US.

Obviously if Australia chooses to go the high population path (and there seems little doubt that Government is adopting that path) then environmental pressures (of almost all kinds) will increase sharply. The Report focuses on greenhouse gas pressures (population growth will make it harder for Australia to meet any given emissions target) however it could focus on almost any environmental amenity. Dr Henry (the Secretary of the Treasury) is known to be personally in favor of rationing Australia's limited water with pricing – but also said to be in favor of replacing petrol taxes with congestion taxes on Australia's (and particularly Sydney's) overcrowded roads. Whatever – the high population path will increase pressure on Sydney – a city that is becoming famously dysfunctional with poor public transport and congested road systems.

By going the high-population route Australia replaces intergenerational financial pressure with a litany of environmental and resource use problems.

But by going the high population route the government can remain solvent even with the baby boom. The government is currently running too high a deficit – but most of that is temporary. And the longer run seems to work (albeit with environmental costs described).

The same position sort of applies to the US. Medicare (the US version of single-payer socialized medicine) ensures that an aging population will put enormous stress on government finances. (Whereas US Social Security funds are nearly solvent the Medicare equivalent is unambiguously bankrupt.) However with enough economic growth and some population growth the US will get through. The starting budget position in the US is considerably worse than (say) Australia – but it is only really worse by the cost of the Bush tax cuts, the excess Bush-and-terrorism induced military expenditure and maybe one smaller tax hike. None of those would be hard to achieve with a functional political system (though it is becoming increasingly hard to argue that the US has a functional political system)...***

On the plus side, the US – more than almost any other country – has the sort of economic system that might produce the innovation-led economic growth that would help solve the problem. Australia could luck into a solution (through commodity prices). But the US has – I think – a higher background level of innovation. Not enough to solve the problem entirely – but probably enough that the current level of immigration is almost enough. Things have to give – but with functional politics solutions could be found.

On the minus side – the US with a much larger population than Australia – would require many more immigrants to adopt the population growth solution. Also the US seems very poor at pricing and protecting environmental amenity – and that is in my view a key part of the population growth solution.

New Zealand – a country where I used to be a senior Treasury official – is alas long run insolvent by any count. Its population doesn't grow much even with immigration – and net migration has resulted in sharp negative productivity per head of population as skilled workers tend to move (to Australia) and unskilled workers are imported. The tax and welfare system also does not add up. [New Zealanders are paranoid about Australia as the response to this joke showed. However in truth New Zealand will one day beg to be the seventh Australian state and we will refuse. Also the Treaty of Waitangi is deeply inconsistent with the Australian sensibilities and (I think) law– but that is the subject of another post...]

Far more serious than New Zealand is Japan. They too have a baby boom – but unlike the either Australia or the US they have very limited immigration. The underlying reason is racism. Japan is a deeply racist country.

I know I am going to get into trouble for saying that – so I will defend it. I was walking through downtown Fukuoka. The area my hotel was in looked like a red-light district. I peered into a brothel (which the Japanese call “soaplands” and which was illustrated with the pictures of a Turkish bathhouse). The doorman rushed out – and almost violently – and in broken English – said “ no foreigners”. Brothels that will not take your money because you are the wrong race set a new standard for racism. A country that does that is hardly likely to solve it's demographic problem with high immigration.

Now in all of this I did not mention the country with the largest forthcoming shift in dependency ratio. That country is China – and the explosive ratio change (which will occur later than the US) was self-induced – a product of the one-child policy. China is – of course – not going to solve that problem by massive immigration. China is too big – and even with a population crash will remain too crowded. The forthcoming population crash in China is one reason why Chinese elderly can never get the sort of Western socialized medical care or old age social security that people in Australia just expect. But there is something to make the Chinese budget balance in their forthcoming population crash. And that is that the Chinese – more than all other people – have accumulated vast piles of claim-checks from rest of the world in form of Treasuries and direct ownership of equities and other property. One day they will need to cash them to produce what their aging population with its high dependency ratio cannot.

The economic problem of our time is – as much as anything – excess Chinese savings and how the world deals with them. I blogged about that – when – to slightly exaggerate the point - I blamed the financial crisis on the Chinese one-child policy. The economic problem of a future time will be huge Chinese dis-saving as they deal with a massive increase in the dependency ratio. Unlike Japan however the sovereign will not go insolvent because unlike a Western country the Chinese will never get committed to state support of the elderly.

John

Post notes:

*One of my German friends – a well-to-do guy worried about the future of Europe – notes with alarm that one of the printing presses for the Euro is physically located in Greece. He seriously believes that Greece –through control of the press – could blow apart the whole of the European economy. I have no opinion on this – other than to note my friend is nervous about European monetary zone expansion.

**Just so people get the titles right – the Treasurer in Australia is the senior political appointment in economic policy – the equivalent of the Secretary of the Treasury in the US or the Chancellor of the Exchequer in the UK. The Secretary of the Treasury in Australia (Dr Ken Henry) is the senior public servant in the area of economic policy. There is no obvious equivalent in the US but the Permanent Head is the equivalent in the UK.

***I note that almost everything I suggested to balance the budget is a tax hike. Get used to it. True deficit hawks know that you can’t fix a US budget without either large tax hikes and/or large cuts to defense and benefits to old people. There is not enough “waste” or “discretionary expenditure” to solve the problem any other way. If you are prepared to cut defense and turn the respirator off on medicare expenses then you can do with lesser tax hikes. But unless you are prepared to deal with such things you are not really a deficit hawk – more a deficit peacock.

-----------

Finally a little post-script is required. The PIGS (or is it PIIGS) are bundled together but they look different. Greece is a fiscal disaster area. Spain looks like one now (running a large government deficit) but it has not always been one. Spain looks more like Latvia - a fixed exchange rate and a profligate private sector. Bundling them together oversimplifies the problem.

The one thing they all have in common is a fixed (Euro) exchange rate and large current account deficits.

A second postscript: Ampontan (Bill Sakovich) writes a blog about Japan which I have been (irregularly) reading for some time. He obviously has not been reading me as he refers to me as "some Australian blogger". He suggests I should observe Australian racism (something incidentally I have commented on several times on this blog). He uses the usual glass houses line.

The question in this post was whether Japan would be willing to import anything like enough people to offset its demographic crash. That looks unlikely to me. Japan is famously xenophobic (a word with lesser connotations than racist) and that xenophobia has manifested itself over very long periods of Japanese history. That said the BBC has suggested that attitudes to immigration are beginning to change for reasons outlined in this post - and if Bill Sakovich wants to take up attitudes to immigration I am very willing to listen as he knows far more about Japan than me. (He is an immigrant in Japan so his knowledge would be detailed and specific.)

Finally if you read Ampontan he lets you know his viewpoint - check out his "what readers say" section...

The Latvian mess

I have posted on how Latvia runs a massive current account deficit - which is unsustainable and unable to be repaid.

It is funded on Swedbank's tab - and as a result I believe Swedbank is near insolvent.

Anyway - lets just put the current account deficit figures for Latvia up on public display. I got these from Swedbank's own second quarter factsheet.


Over the forcast period Latvia looks to be borrowing nearly a year's GDP! That is in a country which is clearly in some economic difficulty right now!

These current account deficit figures (which are insanely large) come from Swedbank itself.

And Swedbank funds it.

Good luck.

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PS. To all the new readers - welcome.

The hookers no longer cost too much: geopolitics and the price of prostitutes in the Baltic States

There is a article about me and about the Bronte Capital blog in the Sydney Morning Herald today. It mentions that I diagnosed the economic problems in Eastern Europe by analysing the price of hookers. That is true as far as it goes – though the original post was more nuanced than that.

The blog however owes a thank you to the (now suffering) people of Latvia. Before I mentioned their forthcoming problems I had about 50 readers. A post about the price of prostitutes got me my first 1000 reader day and my first mention in the main stream media (the Estonian business press).

For those that are new the argument was as follows:

• Latvia and to a lesser extent Estonia and Lithuania had a massive and unsustainable current account deficit. That means they bought more from the rest of the world than they sold (just like America buys far more from China et al than they sell). The current account deficits (relative to GDP) was however much bigger in Latvia.

• In a floating exchange rate regime this would usually be remedied by the currency falling dramatically, increasing the competitiveness of exports (and increasing the price of imports). The market provides a solution. With America this can't happen because the Chinese fix their currency against the US dollar. In the Baltic States the currency is fixed against the Euro.

• Normally to fix the exchange rate a central banker needs to buy the currency that is tending weaker. They buy it and remove it from circulation. In so doing the reduce the money supply in the weaker currency causing interest rates to rise and a mild monetary deflation (increasing the competitiveness of local industry versus foreign competition) and hence over time remedying the current account deficit.

• Unfortunately this monetary deflation causes a recession in the country with the naturally weaker currency. Ultimately that makes fixed rates unpopular in countries with chronic relative economic under-performance – because the populace doesn't like more or less continuous mild recessions. Some countries dealt with this through periodic competitive devaluations (Spain, Italy). Other just gave up on fixed exchange rates (UK). Generally the world has tended towards permanently fixed exchanges (Europe inside the Eurozone) or floating exchange rates (eg Australia).

• Now there is one exception to the idea that the country with a fixed exchange rate and a lack of competitiveness has a sort-of-perpetual monetary squeeze and low-level recession. And that is if somebody cheaply finances your current account deficit ad-infinitum. Then you can have the nice strong currency and spend it and not have any domestic price pressure. Unfortunately you also wind up owing your foreign benefactors just way too much money.
  

• The party has to end. And it can end quite sharply when the foreign benefactor becomes less willing to lend to you.

When that happens you are going to get a really big recession. If this sounds like the once seemingly endless willingness for foreigners to fund American spendthrift consumers you are right.

But in Latvia the situation was (at least) three times as unsustainable as the US. And ultmately Latvia has less credibility in repaying those loans than say the US.

When it ended in America we got a big recession.

In Latvia it ended when the Swedish banks providing the funding (Swedbank and SEB) themselves got into trouble. Latvia is experiencing something more akin to a depression. Latvian GDP has now dropped almost 20% - about the same proportionate drop as America in the Great Depression. And it is going to get worse still. This is really truly ugly – and the street riots I predicted in the original post have unfortunately happened in all the Baltic States. The governments (and the people can feed themselves) because of foreign aid – mostly through IMF packages funded by the Scandinavian governments.

Well what has all this got to do with the price of hookers?

At least partly for effect I noted that one of the most important (perhaps the most important) export industries in Latvia has been tourism. And it is not any type of tourism – it has traditionally been sex tourism. Latvians are beautiful Scandinavian people (if you like that Northern European look). They also have a more Scandinavian sexual morality and they were relatively poor. This meant that Ryanair put on discount flights and filled them with salivating Irish and English lads. Swill beer on the Friday flight over. Party all weekend, soil the plane on the way home. You could not walk around Riga as a single English guy and not be thought of as a Ryanair sex tourist.

The only problem is that the ridiculous exchange rate made the hookers very expensive.

Ryanair canceled the Shannon/Riga flight (and the Irish lads now go to Prague). The London Riga flights are less full. There are plenty of complaints on the web about over-priced bars and rip-offs in Riga. The oldest and one of the most dependable of professions was – due the ridiculous exchange rate situation – just priced out of existence.

Still markets are correcting in the end. Now that there is a Great Depression in Latvia there is price deflation. Lots of it.

The faster the deflation happens the faster Latvia will again become competitive. [Hint to the IMF – just float the currency and deal with the consequences of the new exchange rate rather than try to defend the old rate.]

Anyway the problem is that most industries have contractual arrangements which fix prices. Wages are very hard to flex downwards. Rents are fixed over sustained periods and the like. All of this means that people go bust rather than reduce prices – simply because prices are sticky.

Well – most prices. The contractual terms of prostitution are short (an hour, a night) and entry to the industry is unconstrained. That means that the prices are very flexible. Extraordinarily flexible.

The price – looking at websites I will not link for decency's sake – has fallen by at least two thirds in the past year – and the advertised price (for a non-English speaking young woman) is LVL30 – or less than 60 US dollars. I am sure the rip-offs are still there – but anecdotal evidence suggests the hookers no longer cost too much.

The first question is how far do other prices have to fall – and how bad will it get in Latvia before it improves.

I did say this was ultimately about geopolitics. The Baltic States all have sizable Russian Minorities. Russia under Putin is very concerned about the state in which those minorities live – and has been prepared to take military action to protect what it perceives as the interest of the Russian people. [Read Georgia/South Ossetia.]

Now I am not going to opine on the validity of the Russian claims. Tensions run very high on all sides.

I will note the Russian-Estonian relation riots in Estonia in particular have been lethal in the past (see the story of the Bronze Soldier).

And I will leave you with a somber note. In Latvia the hookers did cost too much. They don't any more – but most things still do – and there is no easy fix. However what is a classic text-book macroeconomic problem fast risks becoming a geopolitical one. And whilst there are big difficulties bailing out the Baltic economies one of them is not the size of the check you will need to write. These places are small and the checks disappear in a US or even European Budget.

And there are big difficulties allowing the Baltics to drown in their economic problems. Geopolitically a bailout looks like the cheap option.




John