Bubbles and Busts'  Instablog

Recently Mike Sax, who has an interesting blog titled Diary of a Republic Hater, offered this claim:

No one I speak to thinks the banks are a good bet even at bargain basement levels. Not Nanute, not dwb at Money Illusion, now WOJ who writes Bubbles and Busts has added his name to the list.

My position on the large US banks has remained skeptical for quite some time. Although reported earnings have been strong over the past couple years, a decent percentage of those earnings stemmed from debt-value adjustments (DVA) and the release of loan loss reserves. Add to those uncertainties the continuing halt of market-to-market accounting, unknown off-balance sheet positions and on-going legal liabilities due to frauds stemming for mortgages to LIBOR. Further,JPM is now openly discussing traders' marking positions to hide losses, which is almost certainly far more pervasive than the disclosure suggests. The lack of transparency at these financial institutions simply presents more risk than I'm willing to take.

For some investors the earnings potential of the major banks may be significant enough to overlook the lack of transparency. As I pointed out to Mike in the comments:

Check out this post from the Brooklyn Investor (http://brooklyninvestor.blogspot.com/2012/06/banks-real-nightmare.html.) Low interest rates could be terrible for bank earnings.

That post shows the disastrous effects of low interest rates on the earnings potential for Japanese banks. Apparently the Bank of International Settlements (BIS) also fears a similar occurrence in the US. Timothy Taylor drew my attention to a BIS paper on Dangers of Continually Expansionary Monetary Policy. The section, noted by Taylor, most pertinent to this discussion is:

"Implications of effective balance sheet repair as a precondition for sustained growth"

"Ultimately, there is even the risk that prolonged monetary easing delays balance sheet repair and the return to a self-sustaining recovery through a number of channels. First, prolonged unusually accommodative monetary conditions mask underlying balance sheet problems and reduce incentives to address them head-on. ... [L]arge-scale asset purchases and unconditional liquidity support together with very low interest rates can undermine the perceived need to deal with banks' impaired assets. ... And low interest rates reduce the opportunity cost of carrying non-performing loans and may lead banks to overestimate repayment capacity. All this could perpetuate weak balance sheets and lead to a misallocation of credit. ...

"Second, monetary easing may over time undermine banks' profitability. ... Low returns on fixed income assets also create difficulties for life insurance companies and pension funds. Serious negative profit margin problems associated with the low interest rate environment contributed to a number of life insurance company failures in Japan in the late 1990s and early 2000s. ...

"Third, low short- and long-term interest rates may create risks of renewed excessive risk-taking. ... However, low interest rates can over time foster the build-up of financial vulnerabilities by triggering a search for yield in unwelcome segments. There is ample empirical evidence that this channel played an important role in the run-up to the financial crisis. Recent large trading losses by some financial institutions may indicate pockets of excessive risk-taking and require scrutiny.

"Fourth, aggressive and protracted monetary accommodation may distort financial markets. Low interest rates and central bank balance sheet policy measures have changed the dynamics of overnight money markets, which may complicate the exit from monetary accommodation ..."

The combination of all these risks is simply too large for me to consider investing in the big banks, even at current low levels. Obviously my position on the banks could be too risk averse and the stocks may prove big winners. In my opinion, there are many other sectors and companies with equally compelling valuations, better prospects and less uncertainty. Ultimately the decision is up to you though...best of luck!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Last month I countered positive remarks from Market Monetarists on the success of the Swiss central bank (SNB) in placing a currency floor against the euro with claims that the SNB was being forced to defend its action by purchasing large sums of euros. A few days later it was revealed that SNB Foreign-Currency Holdings Hit Record On Intervention. Over the past month the SNB has continued to protect its currency floor by purchasing foreign-currency, which signals the expectations channel of monetary policy (in this instance) is much weaker than some had presumed.

Today, I think Marcus Nunes (another Market Monetarist) is making a similar mistake in highlighting Australia's consistent growth as a success of monetary policy. There are many charts in Marcus' post, but I presume an important one to highlight is Australia's NGDP during the past two decades (the post compares the relative success of Australia to New Zealand):Chart 8 is intended to depict how monetary policy maintained NGDP growth near trend through the Asia Crisis and above trend throughout the global financial crisis. A concern of many non-Market Monetarists is what portion of NGDP growth will be derived from inflation versus real growth. To address that question, Marcus offers the following chart and notes:

Chart 11 shows that generally, inflation has not been an 'issue' in either country.

If I knew little about the Australian economy, Marcus' display of graphs and explanation might prove very convincing. However, having long been a fan of Steve Keen (an Australian economist), I was surprised at the lack of discussion regarding Australia's housing market. Keen, a highly regarded Post-Keynesian, has for years been pointing out the positive and negative effects of private credit on growth. Regarding this topic, Keen frequently points out similarities between the US and Australia. Here's a chart from Steve's blog comparing Australian and US real house prices:
After nearly doubling between the mid-1990's to 2005, US house prices have now given back most of the gains. Meanwhile, in Australia, house prices nearly tripled from the late-1980's to the recent peak in 2010. Currently house prices remain at levels double those witnessed in the mid-1990's. Similar to the US, the rise in home values is not well accounted for in national inflation data. As Keen regularly notes, a major factor in both housing bubbles and macroeconomic cycles (frequently overlooked by mainstream economists and monetarists) is private debt. Below is a chart comparing the levels of private debt in Australia and the US:
During the extended period of growth in Australia, private debt to GDP has been growing consistently. The rise in private debt and housing prices, which supported Australian growth for two decades, have now turned south. Similar, more exaggerated, drops in the US were at the heart of the US crisis and continuing economic malaise. As the housing bubble in Australia busts and private sector deleveraging speeds up, the Australian central bank (RBA) will be unable to overcome the deflationary momentum. GDP growth in Australia has been slowing of late and the most recent unemployment report showed a surprise uptick. If Keen is right, monetary policy is likely to prove inept in the coming years as NGDP falls below trend without large fiscal stimulus.

The US experienced a great-run of economic growth on the back of a staggering rise in private debt that ultimately caused the subsequent crash and stagnation. Australia appears to have built its remarkable run on the same principles and will soon find out if the optimism was equally misplaced. Market Monetarists are claiming Australia a success, while the Post-Keynesians are warning of impending trouble. My bet is on Steve Keen and the Post-K's. Where's yours?

Along the way I have warned that Spain suffered from significant macroeconomic challenges that, at the time, appeared unrecognised by the markets. I also provided some analysis that the country's problems were far greater in magnitude than something than could be fixed by simply lowering government sector deficits:

The private sector accumulated large debts on the back foreign capital inflows leading to a housing bubble. This bubble has since collapsed leaving the private sector in a position of significant wealth loss and indebtedness, the banking system holding significant and growing levels of bad debts and the economy structured around the delivery of a failed industry.

…

The growing unemployment is leading to a slowing of industrial production, which means that even though the country is importing less it also appears to be exporting less. Combine this with the interest payments on borrowings from the rest of the world and at this point Spain continues to run a current account deficit which, in the most basic terms, means Spain is still paying others more than it is being paid back. That is, the external sector is still in deficit.

So with the external sector in this state and the private sector unable and/or unwilling to take on additional debt as it attempt to mend its balance sheet after an 'asset shock', the only sector left to provide for the short fall in national income is the government sector. If it fails to do so then the economy will continue to shrink until a new balance is found between the sectors at some lower national income, and therefore GDP.

It may appear logical to you that this must occur, and I don't totally disagree, but that doesn't change the fact that under these circumstances there is simply no way that the private sector will be able to continue to make payments on the debts it has accumulated during the period of significantly higher income. This is a major unaddressed issue. (my emphasis)

And this is the monetary trap much of the European periphery now find themselves in. Structural issues within their economies together with their pseudo non-floating currency means they are neither able to shrink nor grow out of their debts. Without significant debt restructuring they are left to flounder in a viscous spiral downwards.

Read it at Macro Business
Spain: The next leg down
By Delusion Economics

The most recent EU summit concluded with a memorandum of understanding (MoU) for Spain which by most accounts appears to largely reinforce the failed bailout measures used for Greece, Ireland and Portugal. In return for bank bailout funds, that are obviously inadequate, Spain must remain "committed to correct the present excessive deficit situation by 2014." Although the allowable deficits for 2012 and 2013 were raised, the new levels are still overly optimistic given economic conditions. Recognizing this reality, Prime Minister Rajoy has already decided to raise VAT taxes. Considering that Spanish housing still has further to drop and the external sector is unlikely to improve, based on worsening global growth prospects, the pain in Spain will continue.

Related posts:
Spain Should Bailout Households Not Banks
Despite Bailouts, Irish Banks Remain Insolvent...Spain Too?

Crisis Events in Europe Speeding Up

Pain in Spain is Only Beginning

Nouriel Roubini - Get Ready for the Spanish Bailout

Private Debt Continues to Drag Down Europe