The global crash
Japanese lessons
After five years of crisis, the euro area risks Japanese-style economic stagnation
http://www.economist.com/node/21559952
Aug 4th 2012 | from the print edition
FIVE years ago, things looked rosy. In the first week of August 2007 forecasts by investors and major
central banks predicted growth rates of 2-3% in America and Europe. But on August 9th 2007 everything
changed. A French bank, BNP Paribas, announced big losses on subprime-mortgage investments. The same
day, the European Central Bank (ECB) was forced to inject €95 billion ($130 billion at the time) of
emergency liquidity. The crisis had begun.
During the first year, policymakers looked to Japan as a guide, or rather a warning. Japan’s debt bubble had
caused a “lost decade”, from 1991 to 2001. Analysts commonly drew three lessons. To avoid Japanesestyle stagnation it was vital, first, to act fast; second, to clean up battered balance-sheets; and, third, to
provide a bold economic stimulus. If Japan is taken as the yardstick, America and Britain have a mixed
record. The euro area looks as if it might be turning Japanese.
Debts took years to build up. Take the American consumer. Debt was around 70% of GDP in 2000, and
grew at around 4 percentage points a year to reach close to 100% of GDP by 2007. The same was true of
European banks and governments: debts rose hugely but steadily. It was not hard to spot debt mountains
forming.
The crisis erupted with the realisation that subprime exposures were widespread. Many assets were worth
less in the market than they had been bought for. Debts started to look unsustainable and interest rates
jumped. This meant governments, consumers and banks, after building up debt slowly, suddenly faced
much higher costs, as debts matured and they were forced to refinance at higher rates.
The reaction was quick. By the end of 2008 the Federal Reserve, the ECB and the Bank of England had
slashed official interest rates. Their aim was to offset the spike in debt costs that companies and consumers
were facing. The cuts were fast by Japanese standards (see top right-hand chart). It seemed the first lesson
had been learnt.
Falling asset prices meant that many banks and firms had debts that outweighed their assets. The Japanese
experience showed that the next job was to deal with these broken balance-sheets. There are three main
options: renegotiate debt, raise equity or go bankrupt.
In the efforts to reinvigorate balance-sheets, debt investors have reigned supreme. Debts have been
honoured. Indeed, a recent report from Deutsche Bank shows that even investors in risky high-yield debt
have had five great years. Bank bonds in America have returned 31%; in Europe, 25%.
As asset values fell, debt maintained its fixed value. This meant that equity, the balance-sheet shockabsorber, had to fall in value. So although debt caused the problem, equity took the pain. A Dow Jones
index of bank equity is down by more than 60% since 2007, according to Deutsche Bank. Some banks’
share prices are down by more than 95%.
In many cases, the equity buffers were too small, so governments stepped in, taking equity stakes in banks.
In both America and Europe governments stood behind their financial sectors. Balance-sheets were
repaired. It seemed the second lesson from Japan had been learnt too.
But the clean-up just moved the problem on. Governments borrowed to fund the bail-outs. So banks’
balance-sheets were strengthened at the expense of public ones. America’s support for the banks cost 5% of
GDP; Britain’s cash injection into its ailing banks was 9% of GDP. And household debt was still high.
A third lesson from Japan was to seek a strong stimulus: in a growing economy, high debt need not be a
problem. Take a household’s finances. A large mortgage is fine as long as breadwinners’ incomes are
sufficient to pay the interest and leave some to spare. Inflation helps too, as debts are fixed at their
historical values but wages should rise with inflation.
Following Japan’s example, central banks engaged in “quantitative easing” (QE), buying bonds for newly
created cash (see bottom left-hand chart). This aims to drive up bond prices, lowering yields and making
debt manageable. The QE programmes have been bolder than Japan’s and corporate-bond yields have
indeed fallen (see Buttonwood).
But although policymakers learnt some lessons from Japan, there are reasons to worry about the next five
years. In Britain and America there are two main concerns. First, the fiscal stimulus may not be bold
enough and in Britain is being withdrawn before the economy is back on its feet. Having supported banks,
governments are trying to cut deficits and have little to spend. Richard Koo of Nomura, a bank, reckons
Japan’s experience shows that governments should increase borrowing to mop up private-sector savings.
Second, government bail-outs can have long-term costs. In some cases, broken balance-sheets are a sign of
a broken business model; bankruptcy is then a better option, cleansing the economy of unproductive firms.
Japan kept too many bad firms going. There are signs of that in America and Britain too. The American
government’s bail-outs ran to over $601 billion, with 928 recipients across banking, insurance and car
industries. Britain has large stakes in two of its four big banks and has no clear plans to sell them.
The euro area is in a more dangerous position. Its recovery has been painfully slow (see bottom right-hand
chart). Its prospects look grim: data released on August 1st showed German, French and Italian
manufacturing contracting at an increasing rate (dragging Britain down with them). And to the meagre
stimulus and zombification of industry can be added a third Japanese trait—policy indecision. On August
2nd Mario Draghi, the ECB's head, indicated the bank's readiness to buy bonds again as part of a coordinated rescue plan. Stockmarkets initially fell, suggesting the investors are unconvinced that it will save
the euro area from aping Japan.
Buttonwood
Money for nothing
Companies are taking advantage of cheap borrowing
Aug 4th 2012 | from the print edition
IT IS not just America’s Treasury that is benefiting from ultra-low borrowing costs. On July 30th Unilever,
an Anglo-Dutch consumer-goods group, borrowed $1 billion in the bond markets, in two tranches: 0.45%
for three-year money and 0.85% over five years, both record lows for corporate debt. A week earlier IBM
had raised ten-year money at a rate of just 1.875%. The Spanish and Italian governments can only dream of
funding at such a low cost.
Multinational companies have some advantages over governments. Although they can be subject to
punitive taxation, they have the potential to move their operations to more welcoming jurisdictions. Their
revenues are not dependent on the fortunes of an individual economy. And large companies have been able
to strengthen their balance-sheets over the past five years, whereas governments have been forced deep into
deficit to prop up their economies.
Nevertheless, it is unusual for such a gap to emerge between the borrowing costs of big companies and
rich-world governments. But the low yield achieved by Unilever and IBM is part of two further trends: the
increased use of the bond markets by European companies and a new-found enthusiasm of investors for
corporate debt.
In the first half of 2012 European companies raised more money from the bond markets than from bank
loans, according to Dealogic (see chart). In the past, European companies have relied more on banks than
their American counterparts. But the crisis has led to a reduction in the “middleman” role of banks, a
process given the ugly name “disintermediation”.
Banks have two problems. First, regulators are pressuring them to make their balance-sheets safer, by
improving their capital ratios. Ideally they would do this by raising new capital in the form of equity; but
investors are reluctant to buy new bank shares. So the banks are tempted to shrink their balance-sheets
instead, which means restricting the supply of new loans.
European banks would be more than happy to lend money to most of the companies that are currently
tapping the bond market. But the second problem is that doubts about the bad debts banks may have on
their own books have caused their own financing costs to rise. As Fitch, a ratings agency, puts it: “Banks
now pay roughly the same—or higher—rates to borrow as the corporates they lend to.”
Although it should still, in theory, be profitable for banks to lend to small and medium-sized companies,
they seem unwilling to do so. The latest figures from the European Central Bank show that bank loans to
the private sector were down by 0.2% in the year to June. In Britain corporate lending has fallen by almost
5%. Nor is it economic, given the issuing costs, for small companies to borrow money in the bond market.
So it is very much a two-tier market: the big companies are gorging on the chance to raise money at very
low rates ($10 billion of bonds was raised on June 30th alone) while the minnows starve. These bonds are
bought by a wide range of investors, including insurance companies and hedge funds. But Marcus
Hiseman, the head of European corporate-debt capital markets at Morgan Stanley, says there is increasing
demand from other companies, which need somewhere to put their cash piles. Such money used to be
invested in bank deposits, either directly or indirectly via money-market funds. So this is another form of
“disintermediation”, with companies lending to each other and leaving out the banks.
Retail investors, desperate to find alternative sources of income in the face of record-low yields on bank
deposits, are another source of demand for corporate bonds. Most issues are not designed for Aunt Agatha;
the minimum investment is $100,000. But over the past couple of years a number of British issues, from the
likes of Tesco and National Grid, have specifically targeted small investors. Justin Urquhart Stewart of
Seven Investment Management says investors are happy to own bonds directly, provided the issuer is a
well-known name. Corporate-bond funds are seen as having high fees, he says, and gilts (Britishgovernment bonds) have “turned from a no-risk yield into a no-yield risk”.
There are dangers. Corporate bonds are less liquid than government debt; they are no less vulnerable to the
ravages of inflation; and they are more likely to default if the global economy slides back into recession.
But finance directors can hardly be blamed for taking advantage of such a favourable climate.
The Greek economy
Promises, promises
The reform programme is badly behind
schedule
Aug 4th 2012 | ATHENS | from the print edition
BY LATE July Greece had completed only about 100 out of more than 300 reform benchmarks set by
international lenders after their last visit to Athens in February. Two elections this year have not helped to
speed things up. And despite two bail-outs since May 2010, left-of-centre politicians are still trying to
dilute or delay a raft of fiscal and structural measures needed for Greece to stay in the euro zone and pull
the economy out of a five-year slump.
Take, for example, Evangelos Venizelos, leader of the PanHellenic Socialist Movement (Pasok), a junior
partner in the six-week-old coalition government led by Antonis Samaras, the conservative prime minister
(pictured left, with José Manuel Barroso, president of the European Commission). When he was finance
minister, Mr Venizelos pushed through parliament a €11.5 billion ($14.1 billion) package of spending cuts
agreed upon in March as part of the second bail-out. They are to be implemented in 2013 and 2014 and the
details are being worked out. Yet on July 29th Mr Venizelos, trying to rebuild Pasok’s popularity with
Greek voters, defiantly suggested the reforms be spread out over four years, not two (he later backtracked).
Greece has legislated plenty of reforms but failed to implement many of them, say frustrated officials from
the “troika” (the European Commission, the International Monetary Fund and the European Central Bank)
responsible for overseeing the process. A former government adviser says: “A huge amount of work has
been done, yet almost nothing has actually been completed to the satisfaction of our partners.”
The stakes are higher than ever. Greece will not receive any more rescue funding until the medium-term
package is in place. Without that money, the government will run out of cash to pay pensions and publicsector salaries in September, if not sooner. A disorderly exit from the euro could follow within a few
weeks, warned Yannis Stournaras, the finance minister.
Greece has performed badly on many measures. On privatisation, the troika has set an ambitious goal of
€50 billion in revenues. But this year’s target of €3 billion has been slashed to €300m. Only two disposals
are likely to be completed by December: the state lottery and the former international broadcasting centre
for the 2004 Athens Olympics, now a shopping mall. Almost 80 legislative and administrative measures
will be needed before the next six deals can go ahead.
Greece is supposed to raise €19 billion in privatisation income by 2015, and the remaining €31 billion over
the following decade. Yet even if the deal pipeline is accelerated by the new chairman and chief executive
of the Hellenic Asset Development Fund (TAIPED), the privatisation agency, appointed last month by the
coalition government, few investors are likely to appear until it becomes clear whether Greece will stay in
the euro zone.
An overhaul of the tax administration, including closures and mergers of 200 regional tax offices, was due
to be completed in June. Little progress has been made, and no new deadline has been set. Corruption
among tax inspectors is rife, according to the state auditor. Only €10 billion of some €40 billion of
outstanding taxes can be collected, a government adviser says. Officials are likely to keep reforms on a
back burner, fearing that revenues would plunge if they attempt to transfer or sack taxmen. Several hundred
big tax evaders have been identified, yet so far none has been convicted or imprisoned.
Piecemeal adoption of measures and failure to crack down on corruption have left the health system in
disarray. Spending on prescription drugs has been reduced, but another €1 billion (0.5% of GDP) of annual
cuts have still to be made, as doctors and hospital procurement departments are reluctant to switch from
expensive branded drugs to cheaper generic versions. Plans to reduce costs by merging or closing about
one-third of state hospitals are running well behind schedule.
Ready, aim, don’t fire
Last year’s target of cutting 30,000 public-sector jobs and transferring workers to a strategic reserve on
lower pay was missed by a wide margin. Following pressure from trade unions, fewer than 10,000 workers
were sent to the reserve. The medium-term programme calls for shedding 150,000 public-sector jobs by
2015, but with unemployment already at 22.5% the government is trying to find other ways of reducing the
payroll—for example, hiring one worker for every ten who retire or leave. This year’s goal of 15,000 job
reductions is unlikely to be achieved.
Moves to give teeth to Greece’s feeble competition agency have been delayed. As a result cartels still
control prices of many consumer products, and prices are still rising slowly, even though the economy has
shrunk by more than 13% in three years. Annual inflation was almost 3% last November, but had dropped
to 1% in June.
Corruption is one reason why Greece struggles to attract investors. (One local whistle-blower found an
unexploded grenade on his car windscreen last month.) Another is poor legislation. Red tape is still a
problem despite two new laws aimed at removing obstacles to investment. Yet more legislation to speed up
“fast-track” investment is awaited. Greece, home of the marathon, badly needs to start sprinting.
Suing the banks
Blood in the water
The onslaught of cases tied to LIBOR gains force
Aug 4th 2012 | NEW YORK | from the print edition
ANY American law firm with a respected financial practice now finds itself tantalised by the prospect of a
sinecure from a single emerging line of business: cases tied to the alleged rigging of the London Interbank
Offered Rate (LIBOR). With Barclays having acknowledged guilt already in a settlement with regulators,
and other large banks expected to follow in the near future, a big legal barrier has already been breached.
And since LIBOR was ubiquitous, the potential group of plaintiffs is vast. The result is the stuff of dreams
not only for aggressive plaintiff lawyers, but for the large established firms as well, most of which are
already logging many billable hours creating defences.
So far, at least 28 serious lawsuits have been filed. The most recent, for fraud, came from Berkshire Bank, a
small lender, on July 25th. It echoes a case filed in May by Wisconsin’s Community Bank & Trust under
Wisconsin racketeering statutes against Citigroup, Bank of America, and JPMorgan Chase (the American
banks on the LIBOR panel). The claim is that returns for mortgages or other loans tied to dollar-based
LIBOR were depressed because rates had been suppressed by banks manipulating LIBOR. The Community
Bank & Trust complaint puts the collective loss for America’s 7,000 small banks at $300m-500m annually
between August 2006 and May 2010. Consider this the potential price tag for the small fry.
All are either assigned or likely to be assigned to Naomi Buchwald, a judge in the Southern District of New
York. Most are structured as a class action, meaning that the ones that gain legal traction will automatically
include institutions with similar issues, an approach that dramatically increases the stakes. These cases
cover individuals and pension schemes which held LIBOR-denominated bonds as well as financial firms
that traded LIBOR products on the Chicago Mercantile Exchange.
Operating alone, Charles Schwab has brought three cases on behalf of fixed-income mutual funds. With
billions of dollars in assets, it can afford its own litigation, but if it has any success many others will
probably file parallel claims. They may have no choice. Dominic Auld, a lawyer at Labaton Sucharow,
does not yet have any clients involved in a LIBOR case, but he diligently compiles status reports on
litigation for many global asset-management firms which, as a matter of fiduciary responsibility, are
regularly discussing whether they should join existing cases or file new ones.
If there is hesitation it is because, despite the settlements, a case will not be easy to make. Tying culpability
to LIBOR is not straightforward. That is because it is not, by itself, a price. In theory it is the rate that a
bank must pay to borrow from others, but government intervention in the bank-funding market has made it
largely irrelevant. LIBOR stands largely as a theoretical judgment by banks on what they think they should
pay. No one is forced to use it, and those who do often add further costs (such as a credit spread).
Moreover, it will not be easy to establish what harm has been done. That will require determining what the
rate should have been for each trading day, minus any potential benefit. Working this out will be mindwrenchingly complex for many.
By the end of August lawyers for the plaintiffs are required to file statements opposing an early dismissal.
Defendant banks must respond within a month. A trial will probably come early next year. In the
meantime, other legal action tied to LIBOR is percolating in Japan, Canada and Singapore, and it would be
a shock if there were not more cases in America as well.
Private equity’s mega-deals
Too big to veil
The largest leveraged buy-outs fared better than the doomsayers predicted. But
private-equity firms have no right to boast
Aug 4th 2012 | from the print edition
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CRITICS predicted the largest private-equity deals would end up like the giant python in Florida, which
exploded in 2005 after it hungrily devoured an alligator. During the 2006-07 bubble, buy-out firms hunted
iconic companies at sky-high prices with oodles of borrowed money. Then the economy turned. Boston
Consulting Group forecast in 2008 that the majority of companies owned by private equity would default
on their debts.
A look at the 20 largest deals, however, shows that most will turn out better than predicted. In June KKR
agreed to sell a 45% stake in Alliance Boots, a British pharmacy chain, for $6.7 billion to Walgreens,
which has the option to buy the rest in three years. If this happens, KKR will make 2.2 times its money.
Kinder Morgan, a pipeline operator owned by Carlyle and three others, did an initial public offering (IPO)
last year; the owners may triple their money. Even Hilton, a hotel chain bought by Blackstone at the peak
of the bubble, could defy the doomsayers. The investment could be worth 2.5 times the initial value when
Hilton goes public.
There are, of course, some carcasses. The 2007 leveraged buy-out of Archstone, a property company, by
Lehman Brothers and Tishman Speyer was a disaster and is partly blamed for Lehman’s demise. The
biggest buy-out in history is a spectacular failure: TXU, a Texan utility owned by KKR, TPG and Goldman
Sachs, has suffered from a huge debt load and falling gas prices. The question is when, not if, it will file for
bankruptcy.
What determined whether these deals flew or flopped? Companies in recession-resistant industries
performed better. So did deals done before the peak of the bubble in 2007, says Colin Blaydon of
Dartmouth’s Tuck School of Business: they were cheaper and had less debt. Swift pay-outs were key too.
Blackstone sold most of Equity Office Properties immediately after its 2007 buy-out, which helped it pay
down debt. When possible, private-equity firms piled on more debt to pay themselves early. By the time
HCA, a health-care firm, went public in March 2011, its buy-out owners had taken out nearly enough in
dividends to recoup their investment.
Low interest rates, however, are why most deals have avoided bankruptcy. Private-equity firms have been
able to refinance, and yield-starved investors have given some of these deals a second life.
Two boom-era phenomena, “covenant-lite” debt and “payment in kind” loans, also helped. The former
made it hard for creditors to force the company into bankruptcy, and the latter enabled firms to pay off
creditors with new debt instead of cash. Private-equity firms have managed to push back the “wall of debt”
that critics thought would crush them this year or next. Many do not see significant debt maturities until
2016 or later. With any luck they will already have offloaded their companies onto the public market by
then.
Several companies have technically defaulted but restructured behind closed doors. TXU, Caesars, Clear
Channel and Freescale did “distressed exchanges”, in which creditors accept losses in return for new debt.
Buy-out firms also protected themselves by aggressively buying back bank debt at distressed prices when
they could. Creditors will be the ones to suffer most from private equity’s exuberance.
Amazingly, most private-equity firms’ returns will be fine if the IPO market stabilises enough to list their
companies. Even KKR, which invested in nine of the 20 largest buy-outs and will have to write off its $2
billion investment in TXU, may see its 2006 fund make money. TPG, which invested in seven of the 20, is
one of the worst performers, with exposure to TXU, Caesars and Freescale (the latter two have lost 60% of
their value). At the least TPG will probably return money to investors when the fund winds up. But that
takes ten years, a long wait for a small return.
How will private-equity firms have managed to turn a profit, when they overleveraged and overpaid?
Typically they do not invest more than 10% of a fund in any one deal, so diversification helped. So did
perverse “deal” fees. Buy-out firms charge the firm they are acquiring around 1-2% of the deal for the
privilege of being purchased. TXU paid its sponsors $300m at acquisition and at least $35m a year to be
managed and advised.
Whereas private-equity firms may be toasting catastrophe averted, investors have less to celebrate. Most
mega-deals were done by “clubs” of firms, so investors have multiple exposures to some of the worst deals.
How the companies themselves will fare is a separate consideration. Their debts may leave a lasting scar.
Private equity’s reputation should be bruised a bit too. The techniques many firms used to keep their
companies alive amount to little more than financial engineering, says Peter Morris, the author of “Private
Equity, Public Loss?”. The industry’s boasts of value creation may look hollow, at least for many of the
mega-deals.