The Trade Deficit Isn’t the Boogeyman

By John Mauldin

Trading Math

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How US Banks took over the financial world

Ten years after the global financial crisis, Europe’s banks are in retreat

Martin Arnold in London


  © FT montage/Dreamstime
 

Three days before Lehman Brothers filed for bankruptcy in September 2008, Bob Diamond was ushered into a large conference room with “buyer” hand-written on the door at the New York Federal Reserve Bank in Manhattan.

As the Barclays boss closed on a deal for Lehman, Mr Diamond says that the opportunity looked “wonderful” — even if he remains frustrated that he could not reach agreement before it collapsed which, he says, may have saved the world from the worst of the financial crisis. In the end, Barclays bought much of Lehman’s US operations out of bankruptcy.

At that time, Barclays was among the European banks riding high even as the US banking system went into meltdown, with ambitions to be among those left to pick over what was left after the subprime crisis had run its course.

A few months earlier, Royal Bank of Scotland had become the world’s biggest bank by assets by outbidding Barclays to acquire Dutch rival ABN Amro.




But as shares in the biggest US banks were being pounded by waves of panic about which might collapse next, few could imagine then how the implosion of the debt-fuelled housing bubble would ultimately result in the US financial sector surging back stronger than ever.

Over the next decade, Wall Street’s top groups would go on to establish a seemingly unshakeable dominance in global corporate and investment banking.

European banks, meanwhile, have been forced into a steady retreat — weakened by the subsequent eurozone debt crisis and overtaken in the global rankings by resurgent US rivals as well as the even faster growing Chinese state-owned banks.

According to figures compiled by the Financial Times, the top five European banks — HSBC, RBS, BNP Paribas, Barclays and Deutsche Bank — made close to $60bn of combined net profits in 2007. This was a fifth higher than the earnings of their main US rivals: JPMorgan Chase, Bank of America, Citigroup, Morgan Stanley and Goldman Sachs.

By 2017, the picture had changed drastically. The net profits of European groups had shrunk over two-thirds to $17.5bn, more than a quarter below the $24.4bn that JPMorgan earned on its own last year. Indeed, JPMorgan’s $380bn market capitalisation exceeds that of its five European rivals combined.

Between 2006 and 2016, the top five US banks gained 6 percentage points of market share in global wholesale banking revenues, while the top five Europeans have lost 4 percentage points, according to research by Oliver Wyman and Morgan Stanley.



Senior bankers trace the contrasting fortunes back to the different responses to the crisis on each side of the Atlantic.

The US, led by Treasury secretary Hank Paulson, forced its big banks to go on a crash diet by forcibly injecting government funds and blocking them from repaying it — or from paying dividends and bonuses — until they had passed a stress test.

“It totally stabilised the US system,” says Paul Achleitner, Deutsche Bank’s chairman and a former colleague of Mr Paulson at Goldman. “It allowed them to radically write off all kinds of stuff that they had there, and yes, they replenished. Over here [in Europe], you couldn’t possibly do any of the above.”

Bankers such as Mr Diamond and Mr Achleitner say Europe is now making a big strategic mistake by leaving itself exposed to increasingly blatant US economic nationalism, particularly under Donald Trump’s presidency. 'If you’re a bank, you’re bad, so let’s penalise you.'



Bob Diamond, former Barclays chief executive. © Charlie Bibby/FT“



As American banks have shown through history, they go hot and cold on commitment to markets outside the US,” says Bill Winters, the former JPMorgan executive now running the emerging markets lender Standard Chartered.

“So I think it would be imprudent for Europe to find itself in a position where their conduits to international capital markets are entirely companies that do not have a vested interest in the local economy.”

Others share the mounting concerns that US banks will retreat in the next crisis, leaving European companies with less access to funding.


Frédéric Oudéa, chief executive of Société Générale  Deutsche Bank chairman Paul Achleitner

Bill Winters, former JPMorgan executive


“For European industry to have to rely on American banks for the raising of capital, for mergers and acquisitions, for intermediation of equity and investment is geopolitically somewhat challenging,” says Andrea Orcel, head of UBS’s investment bank, which has retrenched significantly since the crisis.

He describes UBS as a “little” David against Goliath. “David can win, but your challenge is a little bit steeper.”

European politicians, however, mostly seem untroubled, showing little sympathy for the continuing struggles of regional banks that are still considered politically toxic. Even the companies that rely on bank finance seem unfazed. Corporate treasurers point out that banks are queueing up in Europe to provide access to cheap funding.

Multinational companies typically have a stable of at least a dozen banks — a mix of local and international lenders that can support global operations — to meet financing needs. “European banks have retrenched, but others have stepped in to pick up the slack,” says Sarah Boyce at the UK’s Association of Corporate Treasurers.

But Ms Boyce, the former director of treasury at British chocolate maker Cadbury, says there is risk of complacency when banks are queueing up to service companies as they are now.

“In the last crisis everybody took their ball home and retrenched to their domestic market,” she says. “There is a real risk the American banks will do exactly the same in the next crisis.”

In the past decade, the five European banks tracked by the FT have shrunk their revenues by 20 per cent, their assets by 15 per cent and their workforce by almost 30 per cent. Meanwhile, their five Wall Street rivals have grown their revenues by 12 per cent and their assets by 10 per cent, while their headcount has shrunk by less than 10 per cent.


There are some who believe that Europe’s shrinking banks should be celebrated. Sitting in the peaceful courtyard of Oxford university’s All Souls College, where he is warden, Sir John Vickers says: “You had in effect a huge taxpayer-backed subsidy for risk-taking and that ended in tears. So pulling back from that is directionally a good thing.”

“The [banks’] balance sheets got so overblown with a lot of activities which I believe were completely unproductive so there is no social loss or economic loss in their disappearance,” says Sir John, who chaired the commission that drafted Britain’s policy response to the 2008 crisis.


Sir John Vickers: 'You had in effect a huge taxpayer-backed subsidy for risk-taking and that ended in tears. So pulling back from that is directionally a good thing.' © Charlie Bibby/FT



RBS remains the most extreme example of a European bank in retreat. For a spell in 2008, it was the world’s biggest bank by assets until being bailed out by Gordon Brown’s Labour government a month after Lehman collapsed.

Since then, RBS has been engaged in a drawn-out restructuring, shedding more than 60 per cent of its assets and 70 per cent of staff.

Ewen Stevenson, finance director at RBS, says the European corporate and investment banking market suffers from “an excess of capacity” that drags the profitability of most banks in the region down below their cost of capital, meaning that they are destroying value.

“So it is a concern, but it is a multi-faceted problem that I don’t think would get solved just by insisting that European investment banks continue to exist at scale,” he says.

As well as being slower to flush toxic assets out of their balance sheets, European banks have also suffered from the political stigma around the sector in the aftermath of the crisis.

“Across much of Europe you saw almost the application of biblical justice, which is if you’re a bank, you’re bad, so let’s penalise you, as opposed to let’s make you healthy again,” says Mr Diamond, who was pushed out by regulators as Barclays chief executive in 2012 and now runs private equity funds that buy assets from banks.

Since the crisis, most European countries have introduced bank-specific taxes and laws, such as the bonus cap and the Mifid II investor-protection rules, which do not apply in the US.

But Andrew Tyrie, the former chairman of the Treasury committee of backbench MPs who now chairs the Competition and Markets Authority, says the UK had little choice but to rein in its banks after the crisis because they had grown so large relative to the size of the British economy.

“As a proportion of GDP the US banking sector is much smaller than that of the UK, so the price of a regulatory mistake may be relatively less severe,” he says.




The US government is now unwinding parts of its post-crisis financial regulation, such as the Volcker rule restricting proprietary trading by banks, but Mr Tyrie says Britain must be wary of following suit.

“The UK cannot afford to allow any such reconsideration to weaken vigilance over systemic risk,” says Mr Tyrie, who chaired a parliamentary commission on bank reform.

There are structural reasons for the outperformance of US banks, which benefit from a dominant position in a homogeneous domestic market that boasts the world’s largest investment banking fee pool.

Europe has no truly pan-European banks, its economic growth remains sluggish, and the eurozone banking union is unfinished. Added to that, Brexit now looks set to further fragment the market.

Frédéric Oudéa, chief executive of Société Générale points out that US banks can charge triple the fees for an initial public offering and 30 per cent more for bond issues than in Europe. “I would not call it an oligopoly, but it is not far off,” he says.

At a time when the US is using sanctions against countries like Russia, Iran and Turkey as a way to harness the dominance of the dollar in international trade and achieve its foreign policy goals, some argue that strong, global banks are more important than ever for Europe.

Mr Achleitner says he has been asking politicians in Berlin if they are happy leaving the US to be the world’s financial policeman since he became chairman of Deutsche Bank six years ago.

His questions grew louder when the US panicked investors in 2016 by threatening Germany’s biggest bank with a $14bn fine for alleged mortgage securities mis-selling before the crisis.

“Six years ago they were quite indifferent to the question if we need big international banks in Germany,” says the Deutsche Bank chairman. “In the current political environment this position has changed fundamentally.”

For 60 years, most Europeans have assumed that their strategic interests are aligned with the US, but Mr Achleitner says this is now changing. “The hard-nosed fact is there may be elements where it deviates and they just become much more accentuated under the current US president,” he says.


Additional reporting by Patrick Jenkins

Companies Are Buying Back Stock as Executives Sell at Record Clip

By Vito J. Racanelli



It’s been a huge year for U.S. corporate stock buybacks. They’ve been a powerful support to the bull market, particularly since individual investors have generally not been putting money into equities. Indeed, retail investors have not returned to equities in significant numbers since the financial crisis.

U.S. public companies have announced $835 billion in stock buybacks so far this year, already more than the previous annual record of $810 billion in 2007, according to TrimTabs Investment Research.

Wasn’t 2007 just before the top of the previous bull market? Yes, and there’s talk the total could reach $1 trillion this year.

In light of the big jump in corporate stock repurchases, it is notable that executives at those companies are doing the exact opposite: dumping their shares at a record clip. Again, according to TrimTabs, corporate insiders sold $10.3 billion worth of stock in August. That’s the highest amount of selling in the month of August over the past 10 years, says David Santschi, director of liquidity research at TrimTabs. The previous high was $9.3 billion in August 2017.

“It’s picked up quite a lot in the summer,” he adds.

Meanwhile, in September, insiders bailed out of their own company shares to the tune of $7 billion, he says, topping the previous 10-year September high of $5.7 billion in 2012. TrimTab’s database includes all Form 4 Securities and Exchange Commission filings that officers, directors, and major holders must file.

So does this presage a market top? Not necessarily, Santschi says. It’s a dictum on Wall Street that insider buying is more meaningful than insider selling, particularly when it comes to an individual company. And, yes, this is compensation, so a certain amount of selling is to be expected.

That said, there are a couple of conclusions that come to mind. First, investors should note that managers appear to be saying one thing—that their companies’ stock is cheap enough to spend corporate capital on—but doing another, selling personal shares. In other words, there’s a little bit of cognitive dissonance. “Insiders are doing something differently with their own money than with shareholders’ money,” Santschi notes. It’s perhaps even more interesting to remember that many companies have borrowed to fund those big buybacks, thanks to artificially low interest rates.

Second, it behooves investors to follow the life cycle of corporate shares. Some market critics like to say that large corporations are cash-management machines for executives. In other words, companies buy back shares, put them into their treasury, and artificially boost earnings per share. Often, they aren’t all retired and a portion of them return to the pool of outstanding shares via executive stock compensation.

Whether insider sales on a broad level predict weaker aggregate stock returns has been debated for decades, notes Paul Shea, strategic economist at Miller Tabak, a market research and wealth-management firm. The best recent studies, however, show that insider sales do predict worse returns, and investors should thus be concerned by this development, he says.

To be clear, Shea adds, there is no evidence that even these elevated levels of insider sales suggest a significant upcoming drop in stock prices. Yet it’s one metric that, more often than not, is followed by abnormally lower returns in stocks at the broad-market level.

Investors should expect upcoming returns for about the next 12 months to be “several percentage points below” the S&P 500’s historic inflation-adjusted average annual return of 7.2%, he says. Other indicators, including the spread between dividends and three-month Treasurys, and current monetary policy, also suggest weaker than usual returns, Shea says.

These days companies are flush with cash and the economy is roaring, but it might be better to watch what insiders do than listen to what they say.

Collapsing Investment Doesn’t Mean Collapsing China

President Trump’s trade negotiators may be watching the wrong numbers on China

By Nathaniel Taplin

Make America Germany Again

The Democratic Party’s left flank has ideas for fixing the country

Some of them have a Mitteleuropa flavour



TUCKER CARLSON, a Fox News host, and Bernie Sanders, a democratic-socialist senator, seldom agree. Yet on the matter of billionaires supposedly sponging off taxpayer largesse, they are completely simpatico. On September 5th Mr Sanders introduced a bill which would force large firms to pay taxes exactly equal to the amount of safety-net benefits consumed by their employees, including food stamps, housing vouchers and Medicaid. The target of Mr Sanders’s legislation, titled the “Stop Bad Employers by Zeroing Out Subsidies” or “Stop BEZOS” Act, was clear. Attacking Jeff Bezos, the founder and boss of Amazon, is a uniquely bipartisan pastime. The left of the Democratic Party views him as a latter-day Ebenezer Scrooge. Trump-cheerleaders like Mr Carlson despise him for owning the meddlesome Washington Post. Mainstream economists took a dismal view of the pitch.

Congressional Democrats, especially those eyeing a presidential run in 2020, are awash with bold policy ideas. In addition to Mr Sanders’s pitch, Kamala Harris, a Democratic senator from California, has offered a proposal to give generous tax credits to citizens who spend more than 30% of their incomes on rent. Elizabeth Warren, a progressive senator from Massachusetts, would like to up-end corporate boards by requiring that employees pick 40% of the members.

Start with Mr Sanders’s proposal. The cost of safety-net programmes like food benefits, Medicaid coverage and rental subsidies could easily amount to thousands of dollars per employee. A pitch to charge firms that amount would be a de facto head tax, strongly discouraging employment. “It’s essentially a tax on hiring low-skill workers, but worse,” says Samuel Hammond of the Niskanen Centre, a think-tank. “Since eligibility largely varies with children and dependants, it’s actually a tax on firms for hiring low-skill parents.” Companies would have perverse incentives to filter out the applicants they thought likeliest to be on benefits. Because they would be barred by law from asking about welfare status directly, they would probably resort to pernicious stereotypes (such as not hiring a middle-aged black woman without a wedding ring). It would also encourage companies to minimise low-skilled labour as much as possible, hastening automation.

Bad, worse, wurst

Ro Khanna, a Democrat from Silicon Valley, introduced an identical bill in the House of Representatives. While he concedes that automation is a real worry, he dismisses the discrimination critique offered by liberal economists. Though discrimination is notoriously difficult to prove in court, high penalties would still encourage firms to behave, Mr Khanna insists. Besides, he says, the point of the bill is to encourage companies to forgo the headache by paying their employees a higher minimum wage. “If you raise to a liveable wage, like $15 an hour, then you’re exempt. But if you’re not going to provide a decent wage, and you’re making trillions of dollars, then you’re going to be on the hook for all the public benefits that you’re consuming,” Mr Khanna says.




The idea that benefits schemes for low-income workers are corporate welfare is mainstream on the far left. Yet it is also quite strange, since it implies that for those at the bottom of the earnings distribution, wages would rise if the safety-net were slashed. “Some people could draw a message from the bill that programmes like SNAP [food stamps] or Medicaid are bad…because they’re fundamentally corporate subsidies,” says Robert Greenstein of the Centre on Budget and Public Priorities, a left-leaning think-tank. The earned-income tax credit, which operates explicitly as a wage subsidy for working-class families through the tax system, has been helpful in alleviating poverty. Indeed, many—including Mr Sanders—would like to see it expanded.

Similar problems haunt Ms Harris’s daring plan to offer tax credits for those facing high rents. She would like the federal government to reimburse households for rent that is over 30% of household income. Housing affordability is certainly a growing issue, especially in America’s booming cities. But that is because of constrained supply. Fuelling demand with billions in government cash while housing supply is stuck means that prices will only rise. The winners would be landlords, who would pocket most of the vast expenditure.

Ms Harris’s proposal would encourage people to rent flats well beyond their means. Those making less than $25,000 would get 100% of their excess rent subsidised by the government. In San Francisco, the costliest city in America, this means that such a person would pay at most $625 a month, even for a flat costing $4,681 a month. Uncle Sam would kick in the rest. Because the policy abruptly shifts reimbursement rates around cut-off points, those making $75,000 in San Francisco could lose as much as $8,500 of tax credits by making an additional dollar. In cities with high rents, those making up to $125,000 a year, hardly a needy bunch, would qualify for subsidies.

Wunderbar

Of all the proposals, Ms Warren’s Accountable Capitalism Act is the least destructive. Some of its provisions—like requiring firms with more than $1bn in revenue to obtain a federal charter and barring executives from selling shares for five years—are relatively modest. Others, like requiring corporations to create a “general public benefit”, seem vague and unenforceable. The most eye-catching proposal, which is for employees to elect 50% of the representatives on corporate boards of directors, seems radical but has been commonplace in Germany since 1976. Although such a system might not work as well in America, where employees are less likely to remain loyal for years, it is hardly the stuff of revolution.

None of the proposals will become law anytime soon. But they do foreshadow the themes of the next Democratic presidential primary, at a time when the party seems to be in its wilderness-wandering stage. Populist policies, such as sticking it to Mr Bezos, subsidising rent and giving more power to workers, are in the ascendant.

Why the Euro Won’t Replace the Dollar

By Matthew C. Klein


Photo: Joel Arbaje



Europe has a dream that the euro will overtake the U.S. dollar as the world’s reserve currency. It’s an old dream, but it’s based on a misconception.

In his last State of the Union speech as president of the European Commission, Jean-Claude Juncker pledged “to strengthen the international role of the euro.” Yet the dollar’s preponderance in foreign reserves and in international trade comes from specific properties of the U.S. financial system that most European governments do not want to emulate. Global use of the euro is incompatible with the other priorities of European governments, particularly sovereign debt reduction.

European complaints about the dollar are not new. The seeds were planted shortly after the D-Day landings, when the Allies agreed at the Bretton Woods Conference to create a postwar monetary regime of fixed exchange rates centered on the dollar. This dollar-based payments system gave Europeans good reason to hold safe dollar-denominated assets they could use to settle debts or pay for imports in emergencies. Those reserve assets lubricated international trade, but they were also debts Americans owed to the rest of the world.

In the 1950s and 1960s, those debts funded growing financial outflows from the U.S. The U.S. had effectively become the world’s bank, exploiting its overvalued exchange rate to buy long-term risky assets abroad with funds raised from short-term “deposits” sold to foreigners. The French particularly resented what they saw as an “exorbitant privilege” that allowed Americans to buy European assets on the cheap. Europeans eventually responded by converting their dollars into gold bullion at the official U.S. fixed price of $35 an ounce.

The Nixon administration was unwilling to defend an arbitrary exchange rate by stifling American domestic spending or selling all the Treasury’s bullion. Instead, it officially broke the dollar’s link to gold  in 1971. The supposed privilege had actually been a burden: Foreigners accumulated reserves at the expense of Americans borrowing more and more from the rest of the world. By 1971, those debts had become unpayable—and rather than honor its obligations in gold, the U.S. government effectively defaulted.
This did not end foreign demand for U.S. financial assets—much to the annoyance of the architects of the euro. The “One Market, One Money” report, published in 1990 by the European Commission, complained that “permanent asymmetries regarding the burden of adjustment have persisted…because of the special international significance of the dollar.” They hoped their new single currency “could finally be a decisive building block for a more stable multi-polar monetary regime.”

The report’s authors failed to appreciate that the dollar’s “international significance” requires Americans to satisfy foreign demand for dollar-denominated fixed income by increasing their indebtedness. This was demonstrated most clearly in the 2000s. Many emerging markets were traumatized by the crises of the late 1990s and were determined to avoid a repeat. At the same time, oil exporters were enjoying a windfall thanks to soaring prices and wanted to save in preparation for the eventual reversal. The combined effect was a large increase in the demand for safe assets in hard currencies.

While the U.S. federal government consistently ran budget deficits, the growth in public debt was far too small to satisfy foreign savers. Financial innovations, most notably “private label” mortgage bonds and their derivatives, were therefore needed to bridge the gap between supply and demand. This turned out to be a disaster for both the mortgage borrowers and many of the end investors, but it was the only way to reconcile foreigners’ seemingly insatiable need to hold U.S. bonds with America’s relatively restrictive fiscal policy.

This unfortunate episode shows why the euro is unlikely to achieve equivalent status to the dollar: Beyond the likely unwillingness of the European private sector to go on a borrowing binge so soon after the financial crisis, there is already an acute shortage of safe euro-denominated assets available. Moreover, this shortage is being made worse by policy.

In 2007, the governments of the euro area had about €4.8 trillion ($5.6 trillion) in debt securities outstanding. Back then, all of that debt was considered equally “safe” by regulators, monetary policy makers, and—crucially—by investors.

The total face value of euro-area government bonds has since grown to nearly €8 trillion, but that number needs to be adjusted for credit risk, since the new European consensus is that countries unable to raise funds in the markets will have to default on their obligations. Less than €2 trillion of euro-area sovereign bond debt is issued by AAA-rated borrowers (Germany, Luxembourg, and the Netherlands), and even adding in the relatively safe countries of Austria, Finland, and France only brings the total up to €4.1 trillion. Moreover, the European Central Bank has bought roughly €1.1 trillion of those bonds, shrinking the supply available for investors still further.

This shortage is being exacerbated by the obsessions of policy makers. A new joint proposal to reform the euro area’s budget rules from France’s Council of Economic Analysis and Germany’s Council of Economic Experts, for example, explicitly says that “a major aim of our proposed rule is to reduce public debt.” The German government has already been paying down its debt for several years, even though an anonymous former International Monetary Fund economist convincingly argues that German government debt “could reasonably—and quite sustainably—approach 240 percent of GDP,” given the country’s high level of domestic savings.

There is no inherent reason why the euro could not become a credible alternative to the dollar for international payments and reserves. All the Europeans would need to do is replace their national sovereign debts with a single government bond market explicitly backed by the ECB and unconstrained by any fiscal rules. Until they are prepared to do that, however, Juncker’s ambition will remain nothing more than a dream.