Fixed currency and bankrupt states - Estonia next

One of the things about fixing your currency is that you can’t print whatever you are fixed to.

Indeed that is the advantage of fixing your currency. Fixing your currency forces and monetary credibility because it effectively removes the printing press as an option. But if you don't respect that force you pay a nasty price.

Its iconic – but when a country with weak economic credentials fixes its currency it tends to have an economic boom. The fixed currency in Argentina last time round was very popular because of this.

But – if you don’t maintain discipline on fiscal and monetary policy you hit the wall very hard indeed. The usual response to a downturn (just loosen monetary policy) becomes unavailable. As a result you get smashed.

So it is with this in mind that I report two stories from the Baltic Business News. The first one might have been triggered by my blog (which has been somewhat controversial in the Baltic States):

Hansabank Estonia CEO: devaluation would bankrupt Estonian economy

The Estonian CEO of Hansabank, Priit Perens, told aripaev.ee that in case loans have been handed out in EEK, devaluation would make the situation easier, but as loans are based on EUR, devaluation would bankrupt Estonian economy.

“Traditionally, ca 70-80 pct of loans in Estonia are based on EUR, so devaluating would make the situation worse. Devaluation would mean that in order to repay the loan, you’d need more EEK than before. It would, in essence, bankrupt Estonian economy,” Perens said and added: “No one is interested in devaluation right now – everyone would loose from it. In a situation, where loans were based on EEK, devaluation would help to ease the loan burden.”

To the question, whether Swedbank has been adding addition pressure to Hansabank lately, Perens responded with a curt: “No.”

Followed quite literally by the second article:

State doesn’t have money to pay pensions in 2009

Gertrud Levit

In 2009, pensions are growing by EEK 2.7 billion when compared to this year, taking up 21 pct of state budget. The state, however, can’t cover the growing pensions from social tax.

Pension index is recalculated every year and it depends on the yearly growth of consumer price index and accruing of social tax. That is why in the coming year a fifth of the planned state budget (EEK 20.4 bln) is taken up by pensions. The state can’t cover all of it from social tax, the Ministry of Finance shed light to the state budget, writes aripaev.ee.

Both inflation and the growth of social tax have been higher than expected, which is why pensions will be growing more than usual in the coming year as well.

The Ministry of Finance isn’t worried about only pensions. The capacity of foreign investments, co-investments and setting aside money for health insurance fund are jumping higher as well, but most of the money accrued to the state budget has a certain goal. Meaning that the funds can’t be used to cover holes, even if the state treasury has the needed amount of money.

You can’t make this stuff up but the last article is a little strong. Estonian politicians still hope to balance the budget.

The State is bankrupt and it can’t print money because the currency is fixed.

It can’t borrow because people expect it to devalue. They are about to have pretty severe austerity measures right into a recession...

The interest rate in Kroon is much higher than the interest rate in Euro – so the domestic population borrow in Euro.

What can I say other than so long and thanks for all the fish.

This is too familiar…

New Fannie - just like the old Fannie

I am a data driven kind of guy.

And every now and again I like to play with numbers in spreadsheets and the like.

I figure I am not alone in capital markets being a little like that.

And I like it when companies make it easier for me. Its part of being “transparent”.

I would like to comment on Fannie Mae’s new commitment to transparency.

I sent Investor Relations and email:

Do you release sets of financial data in spreadsheets - for instance the data in your quarterlies and annual reports and the data in your monthly reports?

I am finding it VERY frustrating not being able to get spreadsheets to do my calculations.

John Hempton

And the new open Fannie Mae replied:

Mr. Hempton,

We do not provide financial data in spreadsheet format on our website. However, using the Word version of any of our quarterly filings, you might be able to "cut and paste" any of the tables into Excel. The Word version of the documents is available from our web site at:

http://phx.corporate-ir.net/phoenix.zhtml?c=108360&p=irol-sec&secCat02.1_rs=26&secCat02.1_rc=25

Hope this helps.

Fannie Mae

Investor Relations

New Fannie – just like the old Fannie.

From the comments section - Latvian bank deposits

Hi! I am from Latvia. What do you think, what happens to people deposits in EUR at worst scenario? We have legislation, that government guarantees about 10 000 EUR for deposits. Where will they get this money?

Thanks

I have no idea how Latvia plays out and no useful knowledge of Latvian politics. But in Argentina they just converted everything to pesos at the old exchange rate:

http://www.commondreams.org/headlines02/0104-03.htm

If Argentina is a model your guarantee will be in Lats in the end...

However it has worked differently in some crisis situations.

--

One person (someone who thinks I am wrong) in the comments section points to a Hansa Bank executive pointing out that Estonia goes bankrupt if the Kroon devalues:

http://www.balticbusinessnews.com/Print.aspx?ArticleID=ba4449d7-bd41-4fe2-b7ba-bbf713312f8c

No. Estonia is bankrupt right now. The Kroon devaluing is just Estonia hitting the rock of reality.

And the Estonian CEO of Hansa is right. There is no pressure from Swedbank. Its head-in-the-sand stuff there.

Wachovia will walk-over-you

I get about two emails a day seeking my views on Wachovia. I am going to disappoint people who want a really detailed examination.

But I will give my quick views before I get to the real point of this post:

Wachovia is a bank with a credibility problem and a funding problem. Whereas I think a smash-em-up insolvency is unlikely at WaMu because WaMu has enough core deposits the same is not true at Wachovia. Core deposits at Wachovia are 390 billion and falling slightly. Total deposits (including hot-money deposits) are 435 and rising. [The deposit trends at Wachovia are worse than at WaMu - though as you will see later the research for this post is giving me some concern at WaMu.]

Loans are 476 billion and rising. The reasons for the rising loan balance are not entirely apparent (and leaves me suspicious). But whatever the reason, rising loans represent rising need for funding.

There is a lot of wholesale funding (especially loans pledged with the FHLB and the Federal Reserve). Bluntly is a shortage of ready funding at Wachovia and Wachovia needs more.

And as the loan problems at Wachovia look a lot worse than average it’s unlikely the capital markets will be generous. They might lend to Wachovia – but they will demand collateral, high rates or both.

So what does a bank in that position do?

It pays up for deposits. Big time.

I got this email – which, so far, I have not confirmed:

Wachovia, in two markets I do business in as a financial planner, has begun offering special rate CD way higher than any other market participants. 5% for three years! Non jumbo btw regular deposits and they claim they can offer double insurance protection by using their bank of Delaware Sub.!

What I can confirm however is that Wachovia is trying very hard to get deposits. Here is the featured deposit advert if you go look on their website. It varies a little by zip code – but they appear to have this high-rate offer in most states.

They are offering an APY of 4.25% on a 12 month CD, minimum deposit 5 grand.

And here are the high rate CDs as listed on BankRate.com.

Wachovia – through its many branches – is offering a rate as high as all but a few diabolical brokered bank CDs. It is paying top dollar.

Now I got to observe something here. The only banks that have a higher rate than Wachovia are Amtrust Direct, Heritage Bank and Corus. Even GMAC bank has a lower rate.

But when I did this survey yesterday WaMu wasn't on the list. Now it is. Comment to come... but this weakens my case for WaMu preferred...

I guess 4.25 percent for deposits is not top dollar when your credit default swap is where it is at the moment. But if you have to pay that much over the odds for money then it rather eats into your margin.

If you are not convinced that Wachovia really is paying over the odds – then have a look at Wells Fargo CD rates (choosing California as jurisdiction). The advantage of not having a funding problem is large at the moment. [I have no opinion as to whether Wells is a good stock or not – but it does have a funding advantage!]

Moral

Banks that are highly dependent on hot-money CDs for their funding have a problem. If Wachovia is competing with you for those large branch CDs then Wachovia will walk-over-you.

Or, tempted by high rates, maybe your customers will just walk-over-to-them. Either way – if your funding is “non core” your margins will be under pressure.

A request

I used to look at bankrate.com to find out which banks were “keen” for funds. But the Wachovia rate is not advertised on bankrate.com. [I used to look for short candidates amongst the banks that were prepared to pay up – and I wasn’t alone – so maybe banks are not reporting to bankrate.com any more.]

If my precious readers scattered all over the world now notice banks that are advertising very high rates locally could they email me. I would really appreciate it. I am very interested in Norway - but I have only a few readers there. Please!

John

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.

-----------

PS. To all the new readers - welcome.

I used to be a public servant - but I couldn't have written this!

This link will find you an English Language version of the Memorandum of Understanding (MOU) on how the Swedish, Latvian, Estonian and Lithuanian central banks will work together to solve a financial crisis.

The MOU is a exercise in deliberage vagueness in the mould of central bankers almost everywhere.

Enjoy.

Yesterday's post: a short version

I was discussing yesterday's post with a hedge fund manager (HFM) who gives that useful (and false) impression of being not too bright.

I starting explaining the Swedbank thing to him. You could tell he was only half listening.

Until I got to the statistics for Latvia. His ears pricked up when I said the current account deficit was well over 20 percent of GDP.

HFM: "Who are they stealing that from?"

BC: "Swedbank"

HFM: "So why didn't you say so?"

---

Well there is a reason that I didn't say so - which is that you wouldn't believe me if I posted the short hand. But what a 2o percent current account deficit means is that the AVERAGE PERSON spends 20% more than they earn.

This is of course impossible unless they are not going to repay it.

Borrowing without intention or ability to repay is the economic (but not moral) equivalent of stealing... and it doesn't matter what currency that borrowing is in...

This "theft" is so large that Swedbank is nearly insolvent.

And Swedbank management are steadfast in their belief that nothing is fundamentally wrong. Well they would say that, wouldn't they...

Further comments and corrections on yesterday’s post

As expected yesterday’s post drew more reaction (and visitors) than any previous post on this blog. There are a few corrections to make (mostly minor). But I should also share with my readers a taste of the comments that came through the mail.

The only really substantive comment – which came both on the blog and through the mail – was that I underestimated the importance of lending in Euro (rather than Lats) in Latvia (and presumably the other Baltic states).

That is fair enough. Consumers can have a high price loan in Lats or a low price loan in Euro. They take the low price loan in Euro.

However if the currency suddenly halves a lot of distressed borrowers (and I will prove over the next few days that they are distressed) will suddenly owe twice as much as they previously owed. Hansa Bank will then implode in credit risk. Credit risk, currency risk – you pick your poison…

It all reminds me of a flight I was once on between Singapore and Sydney where I sat next to the regional head of credit for Citigroup. He was the perfect upper-mid-level executive – and would only talk about the distant past. However he pointed out that many risks that banks face are equivalent in extrema. For instance if you have lent to people in a currency where interest rates suddenly go to 50 percent (as happens in some devaluation crises), your funding cost (deposits) will rapidly go to 50%. However if you pass that on to your borrowers they will fail. You will suffer credit risk and possibly go insolvent. If however you have offered fixed loans to your borrowers you will wind up with huge funding mismatches – and possibly go insolvent. For small moves there is a difference between credit risk and interest rate risk. For large moves there is no effective difference. The same analysis applies to currency and credit risks.

The second set of comments came down to whether it was possible for Swedbank to go insolvent even if Hansa were a complete disaster. Swedbank has about 40 billion Swedish Kroner in Hansa (including both debt and equity stakes). Swedbank has tangible capital closer to 50 billion Swedish Kroner. If everything goes to zero (which it won’t) then Swedbank still has tangible equity they would argue. And Hansa – no matter what happens – will get some recoveries.

That may be right. Swedbank will look considerably worse than Washington Mutual does now but it may be solvent. Indeed WaMu has blown up considerably less capital than Swedbank does under any variant of that model. But then I think WaMu is solvent. (Regular readers know I own the subordinated debt.)

I used to think – and I made it clear in the post – that Swedbank probably survived. After their conference call and the lack of indication that they will ever pull the plug – I now think they probably fold. However if they pulled the plug now and were straightforward with the risks they were taking the stock would almost certainly stay above zero. [Memo to Swedbank management – now is your time.]

Thirdly there was some objection to my characterisation of the Latvian economy as being driven by sex tourism. Thailand would have a similar objection. But there was a more politically correct way of saying it. One reader wrote:

“A pint of lager costs the same in Tallin as it does in Mayfair, despite earnings power being 4-10x higher in the latter.”

You could argue similar about property prices...

Some noted that I got the currency crises confused when I talked about the fall in the Thai Baht. I did. The Thai Baht only fell by about 60%. The Rupiah fell something between 80 and 90. I never traded anything in Thailand – but I did buy HM Sampoerna near the base of the currency crisis in Indonesia – so I remembered the good side of this (buying really cheap assets). The exact fall is a detail lost in my memory. And I wish all my stocks could be Sampoernas...

Several noted that there was little new in my post. One sell side stock analyst from Scandinavia said that there was nothing new in my post – quibbled about minor errors – and said that it was what he believed but he wasn’t allowed to be so blunt. Several pointed out that the uber-bear Roubini has been saying the same thing. He has – albeit less with less colour!

There were several comments from people who had lived through the Argentine crisis who thought that I had the character of crises spot on. There were a few people from the Baltic republics who didn’t feel it was inaccurate though quibbled about minor details.

Some people noted that the biggest risk to a short position was the geo-political significance of the Baltic States. Simple question: if there is a crisis do you think Putin will take advantage?

And that I think is the real reason this situation is allowed to go on. Nobody thinks the economy of the Baltics will collapse without Western bailout. They are watching the geopolitics. And maybe they are right. I don’t do politics very well.

Further comments much appreciated.

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.

-------------

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.

Interesting - and negative for Ambac

GE used to be in the bond insurance game. It sold GICs as per Ambac and MBIA.

This news story (repeated below) suggests that GE is being investigated as part of an industry wide probe into the marketing of these contracts.

Presumably that investigation includes Ambac and MBIA - and it differs from other investigations going on into those companies.

This is negative.

----------

GE finance unit says 2 units probed over marketing
Monday July 28, 10:14 am ET GE finance arm says 2 units are being examined over marketing, sales of financial instruments HARTFORD, Conn. (AP) -- The finance arm of General Electric Co. says two units are being investigated in connection with an industrywide probe into marketing and sales of guaranteed investment contracts and other financial instruments to municipalities.

In a filing Friday with the U.S. Securities and Exchange Commission, General Electric Capital Corp. said GE Funding CMS and GE Funding Capital Market Services Inc. have been subpoenaed for information.

GE Funding Capital Market Services has received notice that the SEC staff may recommend that the agency bring a civil injunction or begin an administrative proceeding in connection with the bidding for financial instruments associated with municipal securities by former employees of GE Funding Capital Market Services.

General Electric Capital said it is cooperating with the SEC and antitrust division of the Department of Justice.