Desperation masked by euphoria: Kohler

The IMF’s latest Global Financial Stability Report is another triumph of detail over clarity, but the bottom line seems to be that there we are less than half-way through the bank write-downs.

The headlines this morning focus on a reduction in estimated financial sector write-downs from $US4 trillion to $US3.4 trillion. Oh, well that’s all right then.

Of that, $US2.8 trillion is banks, and of that, $US1.3 trillion in write-downs have been taken – $US1.5 trillion to go.

A few things jump at you from the detail: the average loss rate on commercial mortgage securities in the US, UK and Europe is 27%; on consumer bank loans in the US and UK it is 17%; on residential mortgage securities in Europe it is 13.5%.

These are appalling loss rates, and put the debate over bankers’ bonuses into sharp relief.

And less than half of the losses have been recognised so far. European banks, according to the IMF, still need to raise about $US380 billion in new capital.

The world’s financial regulators and political leaders seem to be getting their minds around most aspects of the problem – the incentives to take excessive risks that are embedded in bonus structures, the lack of transparency in over-the-counter markets, too much leverage on too little capital.

But the one thing that no one has come up with yet is a solution for “too big to fail”.

Nations have nearly bankrupted themselves bailing out banks and cleaning up their mess. The UK, for example, is running a budget deficit of 12% of GDP with government debt already approaching 100% of GDP and gross public and private debt approaching 500%. Iceland went broke at gross 580% debt to GDP.

But the banks that caused the problem and that were deemed too big to fail, requiring taxpayer bailouts, are still too big to fail. And according to the IMF they still have a lot of write-downs to come – especially in Europe and the UK.

Total estimated bank write-downs in the UK are $US604 billion, of which about $US200 billion have been taken. For Europe there seems to be another $US500 billion to go, although this is not spelled out.

The big question: where is this money going to come from? Who is going to invest in pounds and euros and then put that money to work in banks that can’t pay dividends, or are paying dividends out of new capital like Ponzi schemes?

France seems to be doing okay, but Spain is clearly in a Depression and Germany is as vulnerable to world trade as China but doesn’t have the budgetary firepower to offset it as China did.

The IMF estimates German public debt to GDP at 91.4% by 2014 and the government’s revenues will fall short by €350 billion over the next four years.

And as the government there runs out of stimulus money (Germany’s own cash for clunkers car replacement subsidies program ended this month) banks are still tightening lending to preserve capital.

It’s the same story in the UK, except slightly worse. Last night the British statistical office lifted spirits by revising the decline in second quarter GDP from 0.7% to 0.6%. The overall contraction of UK GDP is now 5.5% from the second quarter of 2008.

Likewise, this morning the US Commerce Department has produced its final revision of second quarter GDP as well – the contraction has been revised from 1% to 0.7%.

This is clearly good news, especially since it is based on an improvement in actual consumer and business spending rather than a revision of inventory levels.

But the danger of a double dip recession is contained in the IMF’s report on bank write-downs to come, and especially in the UK and Europe.

China and other big global wealth accumulators still have an incentive to buy US dollars, so the US debt may be manageable with a steady depreciation of the currency.

But why will China or anybody else invest in sterling? It’s true that shares in Centro Property and other debt-laden property companies have soared lately, so maybe there’s a counter-cyclical investment story for the UK and Europe.

But that only works during a period of euphoria, like now. If, or rather when, there is another bout of risk-aversion, supplicant nations like Britain, Germany and Spain and most of the rest of Europe, will be in the gun.

This article first appeared on Business Spectator.