Harbors from Danger


Recent messages outlined risks in the economy and market place created by the U.S. government's economic policy during this mild but difficult recession. The increase in a huge and growing deficit complicates the enormous existing government debt and weakens the foundations of the global world economy.

This increased debt coincides dangerously with the highest debt-to-market value ratio since the 1930s depression. This puts lenders at risk plus there is an additional banking horror most investors don't even know. Banking debts have grown so large the FDIC quietly reduced deposit insurance in 1999. The FDIC changed the way your insurance is covered and there is a chance that you now have less FDIC insurance than you had before.

U.S. bank risks also grew during the economic boom as banks became lax in the good times. This looseness came to the surface over two years ago when the Federal Reserve Bank outlined the problem in its issue of Monetary Trends. Fed bank supervisors began expressing concern about the risk assumed by U.S. banks, especially the large banks with assets over $10 billion. This is when the FDIC changed its rules!

However, the banking problems run deeper. There is a huge distortion that could create a scandal worse than the U.S. Savings and Loan disaster of the early 90s. America's booming housing market swayed government backed Fannie Mae and Freddie Mac lenders to take greater risks. U.S. house pricing is notoriously cyclical and the drop in Wall Street can push housing prices down. Yet these agencies increased lending 20% per annum and now have 1.4 trillion of debt. Because of their quasi-official status, they have $32 of debt for each dollar of capital whereas large banks have $11.50 of debt per dollar of capital. They are making the same mistakes savings and loans made in the 80s. They are paying officials and staff way above public and most private sector rates. Even worse they are moving into "sub-prime" lending.

Here is the real rub. A dangerous house of cards has been built because these agencies are exempt from rules, which limit banks from holding too much exposure in any one company. Banks can hold all they want of Fannie Mae and Freddie Mac stuff.

Over a third of bank capital in the U.S. is held in this federal agency debt and equity, a highly concentrated risk despite the fact that during the 80s housing bust, Fannie Mae became technically insolvent, though regulators allowed it to keep operating. Now the risk of a future default has grown. This risk filters through the entire U.S. financial and banking system and is still growing. Congressman Richard Baker argued that this debacle may cost the U.S. taxpayer an amount that dwarfs the savings and loan cleanup!

So what happens if all these events come together at the same time, a falling U.S. dollar, a crash on Wall Street and bank failures, plus a U.S. recession and housing bust? This will be an economic mess. All the world needs is a catalyst to spark off the crash. How about rising oil prices caused by a war in Iraq?

Now we have to face another grave risk of weakened insurance companies. When I began my career over thirty years ago it was an insurance agent for Prudential Insurance Company. The only kind of investment insurance they offered in those days was whole life insurance. Thee insurance policies of those days did not pay much, about 3% guaranteed, plus dividends (which actually were pretty good), but at least policy holders were sure they would get what they invested back.

How those days have changed. Today Prudential is in stock broking, real estate and many Prudential policies offer all types of high and variable rewards.

Recently I wrote how Generali, one of Europe's largest insurers offers an insurance policy that pays 7% guaranteed.

But how do these companies make more money to pay policy holders when other investors cannot? This is a question I was pondering when I received this message from eClub advisor Teddy Christiansen.

"Gary, I think we all are wondering when we will finally reach the bottom of the Stock Market why do the stocks keep dropping in value. Here in Denmark I have seen growing problems in the Pension Funds and Life Insurance Companies. They are having a hard times keeping sufficient volume of reserves to keep their business running.

The have had to reduce their holding of stocks, trying to throw some clients out to reduce their business volume to maintain reserves dictated by Danish Legislation.

I think this is taking place all over the world. Investors who used borrowed funds to buy stock have suffered and this includes financial institutions. Now they are in trouble and as they liquidate to cover their loans they are pushing the market down even further.

I just read an article in the Leading Danish Newspaper – written by JON COX, REUTER about big financial problems in the Swiss Financial Sector.

The well known, large insurance group Winterthur just required a capital boost from Credit Suisse of 1.5 billion Swiss francs. Other Swiss insurance companies including Swiss Life and Zurich Re are facing big financial problems as well from having to sellpart of their portfolio at a much lower price than stated in their reports."

Teddy is a member of the advisory board of our International E-Club and offers a unique bank management system – see http://www.garyascott.com/data/teddyintro.pdf – You are free to contact Teddy at about anything related to his 42 years experience with International Banking by E-mail at Teddy.Chr@Private.dk

A second confirmation of this risk came when the Financial Times expressed this concern in an article which suggest that the head of the head of Credit Suisse's CEO Lukas Mühlemann may be on the chopping block. The article stated:

The recent collapse in Credit Suisse's share price and profitability, combined with fears that it might need a big rights issue to repair its much expanded balance sheet, have taken a heavy toll on investor confidence in the 52-year-old Mr. Mühlemann's leadership.

Credit Suisse shares rose more than 3 per cent on Monday amid speculation that its board will meet on Tuesday to discuss Mr. Mühlemann's fate. The group refused to confirm the meeting. But attempts to arrange an orderly succession appear to have been overtaken by a more urgent need to restore confidence among the group's 80,000 staff.

"They were planning an orderly exit over two to three months but now they won't have the time," said a senior Zurich banker.

Walter Kielholz, 51, chief executive of Swiss Re, the triple-A rated reinsurer with close ties to Credit Suisse, is understood to have been sounded out about the possibility of taking over as non-executive chairman (he is currently vice-chairman).

There has also been talk about the return of Oswald Grübel, 59, former head of Credit Suisse's successful private banking operation.

He lost out in a power struggle with Thomas Wellauer, 46, a close ally of Mr Mühlemann who runs Credit Suisse Financial Services.

Mr Mühlemann, a former McKinsey management consultant, was hand picked to head Credit Suisse by Rainer Gut, the doyen of Swiss banking, who had dominated the bank for two decades.

Impressed by Mr Mühlemann's rapid turnround of Swiss Re, then a slumbering reinsurance giant, Mr Gut felt a non-banker was needed to revitalise Credit Suisse after the failure of his 1996 bid to merge with cross-town rival UBS. Mr Mühlemann started well. He cut costs, beefed up revenue growth and set his sights on turning Credit Suisse into one of the world's top five investment banks and asset gatherers.

In 3½ years he quadrupled Credit Suisse's market capitalisation to SFr117bn ($79bn), and by August 2000 it was bigger than UBS.

But Mr Mühlemann's reputation began to wane shortly after world equity markets peaked in March 2000.

There are three areas where his leadership has been called into question: Strategy: the SFr14.3bn acquisition of Winterthur, Switzerland's number two insurer, was designed to diversify Credit Suisse's earnings, while the SFr22bn acquisition of Donaldson, Lufkin & Jenrette, the US broker, was to give it critical mass in investment banking.

Instead, both increased the company's exposure to an equity bear market. Meanwhile, Credit Suisse's heavy write-off in its stake in Swiss Life, the country's biggest life assurer, has added to investor scepticism about the "bancassurance" strategy.

Corporate governance: clashes between US regulators and CSFB, which helped precipitate last year's departure of Allen Wheat, the free-wheeling boss of the investment banking unit, have tarnished the group's reputation. In addition, Mr Mühlemann's reputation has been damaged by his role on the board of Swissair, the bankrupt national airline, which could yet end in a court battle. Balance sheet: the decision to launch a SFr5bn share buyback last year and maintain the SFr2.4bn-a-year dividend has stretched the balance sheet.

Morgan Stanley estimates that, after adjusting for intangibles, the group's real tier one ratio is closer to 5.9 per cent than the 9 per cent reported at the end of March 2002.

Unless world equity markets recover sharply, Credit Suisse could have to raise substantial amounts of new equity, or change strategy. That is the real reason why talk of Mr Mühlemann's demise refuses to go away. It could also explain why some bankers do not rule out the possibility of an eventual merger with UBS. If Mr Gut, now the honorary chairman of Credit Suisse, thought it was a good idea in 1996, he would surely not object if UBS took up the idea now."

The warning from these two confirmations is that no institution no matter how respected, how time proved or large can be totally trusted. Our Friday June 21, message – see http://www.garyascott.com/investing/581/ – showed why smart investors will hold back now. These confirmations reinforce this need for caution.

This is a time when a barbell portfolio with a very few high risk-high potential investments are backed by lots of safe short-term bonds or cash. But where to invest? I answer this question in tomorrow's message by outlining some investments that can help during these market difficulties. I will talk about these investments and ideas at the upcoming International Investing course in Copenhagen this September. I hope to see you there. Until tomorrow, good global investing!

Gary


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