Western European Banks' Exposure to Eastern Europe

This article is a translation of an article on my Swedish language blog.

Last week I wrote about Eastern Europe's loans from Western European Banks (in Swedish). Now I've taken the latest figures from BIS and made graphs to illustrate how the situation is. Please note that the figures are only for claims from banks. There may be other lenders too, but it's not as easy to find statistics for them.

First I'll present an illustration of which Eastern European countries have borrowed most. The colours indicate which in Western European countries the they have borrowed from belong. Click the graph for a sharper version.This graph shows clearly that we don't need to worry too much about Western Europe's banks if Macedonia, Moldova, Montenegro, Belarus, Albania, Bosnia or Serbia should be hit by a collapse of the economy and currency, since their loan volumes are relatively small. The other countries, however, are potential threats to Western Europe's banks. This becomes especially clear when one Western European country has a large proportion of the lending to a certain Eastern European country, e.g. Sweden to Estonia, Latvia and Lithuania.

Huge figures have been floating around when it comes to the exposure of Western European banks to Eastern Europe, but the total sum of bank lending is "only" slightly more than 1.4 trillion dollars, which should be quite close to the actual figure. This is still, however, a very large figure.

Now I'm going to look at it from "the other side", i.e. divided per lender country instead.Here you can see that Austria is at the top of the risk list for lending to Eastern Europe. As for Sweden we can note that the major part of the lending is to the three Baltic states. Since these three economies risk following each other, Sweden is much more exposed to a single risk factor.

However, absolute numbers don't often say that much. If Italy lends a bit over 200 billion dollars that's a larger share of the country's GDP than if Germany lends the same amount. So below I compare the banks' lending to Eastern Europe to the GDP of the countries (taken from the 2008 GDP estimates from the CIA Factbook).Then you suddenly see what a huge risk Austria is taking! Their banks have lent roughly 64% of the country's GDP just to Eastern Europe! Even a mild crisis in Eastern Europe would thus probably suffice to topple Austria's banks - we don't even need a serious crisis. The biggest Austrian claims are on Czechia, Romania and Hungary. At least Romania and Hungary are already on the problem radar...

By Austrian measures the other Western European countries have taken limited risks towards Eastern Europe, even if they definitely aren't negligible. Belgium's banks have lent about 25% of Belgium's GDP to Eastern Europe, and Swedish banks about 20% of our GDP, most of it to Estonia, Latvia and Lithuania.

Let us also take a look at which Eastern European countries have borrowed the most in relation to their GDP, and thus have taken a large risk. This is according to my usual identification mechanism for potential problems in this crisis. Large loans = large problem risk.Here you can see that Croatia and Estonia are in a risk class of their own. Their claims from foreign banks are more than 120% of their GDP. But Latvia, Hungary, Czechia, Slovakia, Lithuania and Bulgaria are also risk factors that cannot be ignored (the nominal sum of their borrowing according to the first graph in this article also plays a part here). Add to this the fact that GDP for many Eastern European countries is now falling rapidly, and we will quickly get even bigger loans-to-gdp ratios.

Part of the risk is also the currency risk. A large part of the loans from Western to Eastern Europe are denominated in euros or Swiss francs. This causes payment difficulties when the local currency sinks against the euro and/or the franc. Unfortunately I don't have any figures for how much of the loans are denominated in foreign currencies, but we can take a look at how some currencies have moved against the euro since the end of August last year.Here you can see that Ukraine's hryvnia and Poland's zloty have fared worst. We have all heard about Ukraine's problems, but there has not been much mention of Poland during this crisis. Hungary, Romania, Russia and Czechia have also been hit by falling currencies, though not as badly.

To conclude, we can see that the banks of several Western European countries have taken large risks towards the now faltering economies of Eastern Europe. There is an immediate risk that for example a currncy and/or economic collapse in one of the risk countries I've presented above could topple e.g. Austria's banks. This in turn would probably give serious repercussions for the whole euro area (Austria is part of it). As I see it it is only a matter of time before something drastic happens. Exactly what will happen is hard to predict, but Sweden is definitely also in the risk zone.

In this context it is interesting to note that the bank crisis of 1931 had its origins in Austria, where their then largest bank Creditanstalt went bankrupt in May of that year. Will we get a replay?

P.S. I recommend the following two articles by Ambrose Evans-Pritchard at the Telegraph for those who want to read more about the risks from Eastern Europe:
Failure to save East Europe will lead to worldwide meltdown
Eastern European currencies crumble as fears of debt crisis grow

Swedish and Danish Kronas and Interest Rates

This is a partial translation of my original article in Swedish.

Sweden and Denmark have gone different ways when it comes to currencies. Both countries have kronas, as you probably know, and have not joined the euro. But while the Danish krona is pegged to the euro through the European Exchange Rate Mechanism ERM the Swedish krona has no peg. This can be seen from how the Swedish krona, being a small currency, fluctuates much more than the euro against the dollar.As you can see from the graph above one paid about 9.30-9.50 Swedish kronor for a euro until the beginning of September 2008. When the crisis then gained momentum the krona fell against the euro so that one at times had to pay more than 11 kronor for a euro (today we're at 10.76 kronor per euro). This means that the krona lost about 13% against the euro, just because we have a small currency, which is not attractive to investors in a crisis. Theoretically a weak currency should be good for our export industry (Sweden runs a current account surplus) but in a global crisis where world trade is generally diminishing one can question how much this is worth.

The Danish krona however has been stable around 7.45 DKK/EUR all the time - lucky them, one could believe. But the Danes have been hit by something else - look at the diagram below for the rates of the Danish central bank (red), the European Central Bank (blue) and the Swedish central bank (green):Danmarks nationalbank had to raise their rate at the beginning of October to defend the value of the Danish krona against the euro, when ECB and Sweden instead lowered their rates to cushion the effects of the financial crisis. Even though the Danish central bank rate has been lowered in three steps since then, it is still a good deal higher than the ECB rate, which has also been lowered during this period. The higher interest rate climate in Denmark can also be seen when you look at the interbank rates - Danish 3 month CIBOR was at 3.9317% today, while Swedish 3 month STIBOR was at 2.023%. A rather hefty difference, I would say. So this is the price Denmark pays for its stronger currency.

Now voices are being raised in Sweden for us to join the euro. The Swedish small enterprises association's leader Anna-Stina Nordmark Nilsson and professor of economics Harry Flam have written an article each in Sweden's two largest newspapers where they argue for joining the euro. Well, it might not be very good timing to join the euro now, when it seems the euro co-operation itself might break.

Anyway, Sweden cannot join the euro straight away, since a country's currency must be part of the ERM for two years first according to the rules. So the Swedish euro friends will have to wait for the continuing onslaught of the financial crisis before they get what they want.

Wild Price Swings Could Implode Hedge Funds

I guess nobody has missed the wild swings during the first weeks of 2008 in the prices of just about everything that can be traded.

• S&P 500 stock index from 1471 down to 1388 up again to 1429 down again to 1270 up again to 1396 down again to 1317. A span of about 16%.
  
• Crude oil from 95 up to 100 down again to 86 up again to 92 down again to 87 $/barrel. A span of about 16%.
  
• Gold from 840 up to 912 down again to 860 up again to 930 down again to 885 $/oz. A span of about 11%.
• 10 year US treasury note yield from 4.05% down to 3.28% up again to 3.74% down again to 3.53% up again today to 3.74%.
• And so on...

These wild swings in prices of equities and commodities have been very hard to predict. Now, hedge funds all around the world are making bets all the time on the direction that certain prices will take, and these bets are often highly leveraged (i.e. they borrowed a lot of money to bet). This means that a number of hedge funds have probably made bad bets over the last few weeks, some of them maybe bad enough to "implode" the fund, because prices have quickly and unexpectedly moved in the "wrong" direction. So I predict that we will soon see a number of hedge fund failures, and some of them might be rather spectacular.
We have already seen an example of what can happen when big trades go wrong in the case of the "rogue trader" at the French bank Société Générale. The losses in this case were about €4.9 billion, enough to topple most hedge funds.

Oil and Other Commodity Prices

I haven't had time to write for a while, but now I'm back with this year's first post.

One of my favourite bloggers, Stefan Karlsson, wrote about rising commodity prices today. I feel I have to comment on what he said, but since this comment is much longer than his blog post, I post it here on my own blog instead.

Stefan says "anyone who tells you that the commodity price boom reflects the alleged 'peak oil' doesn't know what they're talking about". I would instead say they are parallel developments.

Now why does Stefan say "alleged" peak oil? Isn't Stefan Karlsson convinced yet about the imminence of peak oil? I'm not saying he has to believe all the doomer stuff you can read on many peak oil sites, but I do hope he has read enough facts to understand that peak oil is here, and will most probably have profound effects on our lives.

In my opinion, the oil price does (partly) reflect "peak oil", because demand has outpaced supply. Take a look at the second chart at http://oljepris.se/statistik and you will see that world production has been essentially flat since April 2005, after rising until then. Many experts who have studied oil production, e.g. Matt Simmons, argue convincingly that the world has passed peak oil and is now on a "plateau" of oil production. Even if the peak is a number of years away, most of the "easy" oil is already taken out of the ground. What is left is (on average) much harder to extract (e.g. in remote regions, have to use more advanced techniques to extract, under deep seas etc). Extracting a barrel of oil on average costs much more now than 10 years ago. There are also other factors involved in oil prices, e.g. military conflicts etc. But price action alone does not refute the fact of "peak oil". Not even when compared to other commodity prices.

But peak oil definitely plays a strong part in oil prices. The inability to increase production in spite of rising demand and sharply rising prices over several years confirms this. If you want more detailed analysis of peak oil, you can get all the information you want (and more) from The Oil Drum and Energy Bulletin.

So why have other commodities shown strong price gains too?

1. Just like for oil, demand has outpaced supply for many commodities (e.g. metals). Starting up new mines is a long process. It takes years of prospecting, government permits etc. The global economic boom of the last few years seems to have caught miners by surprise, with a demand for commodities that by far exceeded most predictions (remember, most "predictors" are notably bad at predicting things like this in advance).
2. Many other commodities are probably also near their global production peaks, e.g. platinum. The production of any finite resource can be Hubbert linearised to get an approximation of the production curve. A notable example of "peaked" commodities is uranium. Just take a look at a graph of global production and you will see that global production seems to have peaked in 1980, and since 1985 the shortfall in production has been made up by using military stockpiles (see for example the chart at the bottom of this article). The price action of uranium over the last few years confirms this situation.
3. Just like for oil, the "best" ores for other commodities have been extracted first. Take the example of copper. When copper was first discovered during the stone age, naturally occuring pure copper was used. Then somebody discovered how to extract copper from certain ores, and the best ores were mined first. Gradually over the years, ores with lower and lower percentage grades of copper have been mined. During the last century we have rapidly mined our way through most of the good ores for most commodities, at a pace never seen before in history.
4. As for food prices, we seem to have reached "peak food" rather close to "peak oil". It seems that the world is simply not capable of producing more food simply for reasons of ecological limits. Global grain stockpiles are now at something like 27-year lows. And population still growing. And demanding more and better food.
5. Increased affluence among large parts of the world's population has created a stronger demand for everything from meat to diesel to microwave ovens. This is actually strongly connected to number 1 above.
6. Food prices have become (loosely) connected to oil prices because of the grain-to-ethanol boom.
   

Now, even if we have passed "peak oil" (which I believe we have), that does not mean that oil prices cannot sink from current levels. Since the margins for world oil supply are so tight today, small differences in production or demand make big differences in price. With the coming recession, I think we will see a lot of "demand destruction", as it is euphemistically called. I therefore guess that oil prices will decline substantially later this year. $65/barrel is not impossible. This is of course blasphemy to many of my fellow "peak oilers", most of whom seem to be convinced that we will see $150 or $200 per barrel oil soon. But I predict that "demand destruction" over 1-2 years will be faster than production declines. Of course a swift economic downturn might also have a similar effect on many other commodities. Though not uranium, I suppose, because nuclear reactors will not be shut down, even if we have an economic crisis.

First Card of the CDS Game - ACA Downgraded to Junk

Now the whole house of cards built from Credit Default Swaps (CDS) is starting to come down. Yesterday the credit insurer ACA had its credit rating by Standard & Poor's cut all the way from "A" to "CCC". As I said last Friday the New York Stock Exchange announced they would delist them, so today's news was rather expected. A credit rating of "CCC" essentially means "bankrupt". This means that all the bonds they insured get their credit ratings lowered, and there will be big writedowns and maybe forced sales. Now we'll get to know who's been doing business with ACA. Canadian bank CIBC came out straight away and said that they have "insured" $3.5 billion of subprime loans with ACA. I suspect Merrill Lynch and Bear Stearns are feeling the heat too, because they have discussed "bailing out" ACA (to save themselves, I suppose). Even if this is possible, which I doubt, it would probably cost them billions. Then what happens when they have to bail out the next credit insurer that goes bust. FGIC, MBIA and Ambac are good candidates for this.
I started writing this post yesterday - and sure enough here we go today (the day after their AAA rating was affirmed by S&P) MBIA comes out and says that they "insured $8.1 billion of so-called CDOs-squared, which repackage other CDOs and securities linked to subprime mortgages". For those who don't know, CDO-squareds are considered very risky.
Things seem to be happening very quickly right now. What next? Will things quieten down over Christmas, or will we see more problems building up every day?

Potential problems in the CDS markets is something I mentioned already in my first post in August. Now it's starting to get serious.

The moral of the story is:
No insurance is safer than the insurance company itself!

Credit Insurers in Trouble

Reuters reports today that ACA Capital Holdings will be delisted by the New York Stock Exchange. ACA "provides financial guaranty insurance products to participants in the global credit derivatives markets, structured finance capital markets and municipal finance capital markets." In other words, it is a "monoline" credit insurer, just like MBIA and Ambac, that I have mentioned before on my "black list". ACA's shares have fallen from about $15 in June to about $0.50 today. Their latest economic report (from September 2007) is rather interesting - a net loss of about $-1 billion for the last quarter - total equity now about $-0.88 billion - meaning they are essentially bankrupt. The interesting thing is they have "insured" about $68 billion of "collateralized debt obligations" (CDOs), a form of repackaged debt. Now all that "insurance" is basically worthless. Who owns on all those "insured" CDOs? How did a company that had about $6 billion in total assets at the end of 2006 get to "insure" more than ten times as much in debt? It doesn't take a very high default rate on the underlying loans to erase the company. And who was stupid enough to pay for "insurance" from them? And by how many billions of dollars will they have to write their CDO assets down?
Now ACA is a comparatively small player in the CDS field. Ambac is one of the two biggest "monolines", and yesterday Bloomberg reported that Ambac reinsures $29 billion with Assured Guaranty Ltd., to "avoid the crippling loss of its AAA credit rating". On 5 December, Moody's basically gave Ambac and MBIA two weeks to raise more money or risk a credit rating downgrade. Ambac "guarantees" a mind-boggling $556 billion of securities, with total assets of only $22 billion and total equity of only $5.6 billion (as of September economic report). And they are losing money ($0.36 billion last quarter - I expect much more this quarter, cf. estimates for MBIA below). The deal with Assured Guaranty doesn't really change that much for Ambac - the riskiest debts are not included in the deal. And Ambac have so far not managed to raise any more money.
MBIA seems to be slightly better off - they managed to raise $1 billion from Warburg Pincus. MBIA "guarantees" $652 billion of securities, but their financial status is stronger than Ambac's - $45 billion in total assets, $6.5 billion in total equity and only lost $37 million last quarter. However, Barclays Capital expects MBIA to post losses of between $2.3 billion and $4.2 billion, which would of course make their financial situation precarious to say the least.
Now the string of credit insurers going bust seems to have started with ACA, and I expect Ambac to follow within a few months. MBIA could survive a year, perhaps. Some people might even think this is optimistic. According to Bloomberg "If all the companies were to falter, $2.4 trillion of insured securities would be thrown into doubt, costing as much as $200 billion". My guess is that cost is underestimated, as with all costs so far in this credit mess. However, the biggest risk if the credit insurers falter is that many of those who now hold the "insured" debt are only allowed to hold investment grade rated debt, or have a maximum percentage of non-investment grade debt that they may hold. This means that they would have to sell the "insured" debt if the insurers fail or are downgraded. This sudden selling would lead to lower prices for these classes of debt, thereby increasing losses, if buyers can be find at all in these frozen credit markets.
Ironically, Ambac announced yesterday that "International Securitisation Report (ISR) has named Ambac Monoline Insurer of the Year". Wow! Sounds really great, doesn't it? And it gets better: "Ambac has had an active year closing many noteworthy transactions. This award underscores the company's ability to use our in-depth knowledge and expertise to help issuers and financial advisors structure innovative transactions across a diverse range of asset classes and jurisdictions." It's a pity this award comes just as they seem to be on the brink of bankruptcy.

Norwegian Oil Production

The Norwegian Finance Minister Kristin Halvorsen is quoted today by Verdens Gang as saying "our oil can become worthless" because of "climate taxes" on burnt oil. She said this in Bali, where she flew for the climate meeting. Of course this climate meeting burns loads of fossil fuels just to get all the politicians there. But I suppose it is important that they get to discuss this, and shine a bit in the press before reality comes swooping in and they can't fly that much or that far any more. Later a spokesman for Halvorsen denied "considering cutting oil production for environmental concerns" and that "There is nothing in the government (program) declaration about a reduction in the pace of production" and "it was not an problematic issue".
However, reality says that the pace of oil production in Norway is problematic. Today Norway is the world's fifth largest oil exporter, pumping roughly 2.4 million barrels per day. However, production has fallen sharply since the top around the year 2000, and is not likely to reverse that trend. So even though what Kristin Halvorsen said was a bit confused, it is likely that they will have to use some kind of cover-up for why they are reducing their oil production.
Also, implying that their oil will become worth less in the future is pure nonsense. With world oil production probably in permanent decline, the remaining oil will on average just become worth more and more. Of course prices will jump up and down, depending on economic factors, but the main price trend for oil is up. It might even make sense for some big producer countries to voluntarily reduce their production in order to boost the price, thereby making even more money in the long run, and saving some of their reserves for hard times. So far, however, nobody seems interested in doing this, but time will tell whether we will see such policies in the future.