Wednesday, November 30, 2011

Deutsche Telekom: Hello! Anyone Home?

Responding to widespread consumer sentiment, the FCC has opposed Deutsche Telekom's proposed sale of T-Mobile and its subsequent merger with ATT.  The FCC draft study released today forcefully rebuts all the benefits of the merger to US wireless services, consumer pricing, and job creation. 

I went to T-Mobile's IR site and looked over their recently reported fiscal third quarter results.  It's hard to imagine what management was thinking in their running of U.S. T-Mobile.  Overall, adjusted EBITDA for US operations increased 9.2%, which is nothing to sneeze at, and the adjusted operating margin was 27.8%.  Again, no alarm bells going off yet. 

However, the adjusted operating margin in the US compares to an operating margin of 41.5% in Germany and 36% in the rest of Europe.  One thing that jumps out notably is the investment and roll out of network investment and product innovation for German customers, essentially bringing multimedia services to smart phones and other devices.  It is very impressive, and probably accounts for revenue growth, subscriber growth and EBITDA margins in Germany and probably in Europe.

There has been essentially no such investment in the US T-Mobile network.  For full disclosure, I have been with T-Mobile as a personal customer for probably more than a decade.  I've also experienced ATT as a corporate customer a few times.  T-Mobile's early decision to build a GSM network seemed savvy to me, since it allowed a customer to be able to operate easily in Europe where GSM was the network choice, as opposed to ATT's original CDMA.  Rates per minute were always the best, and the customer service was top notch, miles ahead of any of our other providers.

T-Mobile poured millions into a wildly successful brand identity campaign with Catherine Zeta-Jones, but the campaign was focused solely on price, with no reference to the network or customer service.  One of the reasons was the DT was investing nothing in T-Mobile's network, which makes no sense.  For wireless, the network is the product.  Verizon, meanwhile, beat us to death with the "Can you hear me now?" 

Over the past five quarters, T-Mobile has had an exodus of contract customers, about 1.2 million customers lost.  But, what would one expect?  The announcement of the merger made it an open field for everyone, including the moribund Sprint to poach customers.  Plus, anyone who has dealt with ATT probably went to jump into the arms of Verizon.  So, the result shouldn't have been surprising.

On the other hand, over the same past five quarters, T-Mobile has added about 1.2 million pre-paid customers, which seem like they should be more profitable than some big users on T-Mobile data plans.  Overall, net adds were about zero for the trailing five quarters. 

US revenue for the fiscal third quarter was down to 3.7 billion euros from 4.1 billion euros in the prior year period.  Data network development expenditures by DT in the US had been flat at fairly low levels for the past five quarters.

Talking as I do with T-Mobile retailers and customer service people, you can feel the demoralizing effect of the proposed merger and the subsequent exodus of contract customers.  They were told to bombard existing customers with trade-up offers and useless text offers. It's not their fault, but the fault of poor management.

It appears during the entire tenure of DT's ownership of T-Mobile that it has been run in almost a harvesting mode.  This market is full of customers who are knowledgeable, demanding and sticky.  DT has made a mess of their investment, which is curious given their strong track record.  However, look at their competition in Europe.   That probably explains much of their monopoly-like 42% operating margins in Germany.

I hope that T-Mobile is not collateral damage in this tug of war with regulators about the ATT deal. 

Monday, November 28, 2011

Pulling Out of Afghanistan

                                                                    Source: Radio Free Europe/Radio Liberty
An Afghani mother brings her child to a village distribution center for drinking water.

Alexander Star's thoughtful New York Times Book Review article on recent books about Afghanistan quotes an observer who characterizes the situation as "a perpetually escalating stalemate."  This is a perfectly apt description of the situation. 

It's hard to think of a modern theater where our military leadership and the men and women under their command have done a better job of trying to understand and work within indigenous cultural and leadership norms.  Our model uses "Human Terrain Teams," working with embedded academics, who are often anthropologists or ethnographers.  The good news is that had we not pursued such an approach, we would have had to beat a Soviet-style retreat, licking our wounds.  The bad news is that for all the bravery and sacrifice of our troops, and for the billions in expenditures, the best we can hope for is a stalemate after the defanging of the Taliban.  It is time for a withdrawal.

Professor Noah Coburn spent two years in the Tajik village of Istalif working on what would become his Ph.D. dissertation at Boston University and his 2011 book, "Bazaar Politics."  Here's a link to an earlier 2009 presentation of Professor Coburn's at the American Institute of Afghanistan Studies.

Coburn found the village of Istalif to be relatively stable because no one was really in charge.  Westerners are captivated by stories of Afghanistan's maliks (elders).  Coborn characterizes the maliks as being the public faces of a village, which means that they meet with NGO representatives, for example. Their actual power and ability to command resources is extremely limited.  The mullahs exert influence which is restricted to within the walls of mosques in Afghanistan.  The merchants who form the Afghan business sector, often live in Kabul and are not respected because of the local caste system.  The merchants come from the caste of weavers, who are not of high caste.  Even government officials are generally not powerful, as the actual disbursement of funds is left to local councils. 

As long as no one set of actors tries to extend its influence at the expense of another, the system of leadership maintains a sort of "knife edge" equilibrium. 

NATO attempts to establish a centralized government in Kabul have clearly failed.  In President Karzai, the West is funding a presidency which is thought by the population and by international observers to not be legitimate.  It is also deeply corrupt.  President Karzai's public rhetoric about jumping directly into the arms of the Taliban are incomprehensible. The normal behavior would be to offer olive branches when funding is being discussed, but surely we have no reason to put any faith in the President's remarks now. 

The problem with Pakistan is something we have written about in this blog for a few years.  Their interests in Afghanistan have never been aligned with ours, and this will never change with the current Pakistani state.  Withdrawing from Afghanistan can reduce the amount of "aid" we need to pump in which is solely to buy support for our Afghan operations. 

One of the sadder comments Coburn makes is to say that no group is held in lower esteem in Afghan society than the cadre of publicity-seeking NGO's. I believe that the Central Asia Institute is an exception to this characterization.  Minnesota native Greg Mortenson's organization has had a tangible effect on helping to educate young women, at the invitation and with the support of local elders.  This kind of grass roots effort, which doesn't aim at reforming cultural norms about gender, religion or criminal punishment, has a chance of succeeding, though it is certainly not without its challenges. 

Let's see what happens with the upcoming international conference on the future of Afghanistan.  We shouldn't expect to hear anything that would undermine the benefits of a withdrawal from Afghanistan. 


Saturday, November 26, 2011

Russia In A Multipolar World

Fyodor Lukyanov has an interesting article in the Spring/Summer 2010 issue of the Journal of International Affairs, published by Columbia's School of International and Public Affairs.  We had a recent post about the Nord Stream gas pipeline and its importance for the growing Russo-European relationships. 

The author notes that Russia "has not acquired a new identity on the world stage since the break up of the Soviet Union."  I think this is the key to understanding why the Russo-American bilateral relationship has been foundering for the last three U.S. Presidencies. 

The old Soviet Union controlled the vast swath of the Eurasian land mass.  When the Soviet Union collapsed, 25 million ethnic Russians did not have a home in the new Russia, something that was inconceivable a decade before.  The consequences of the collapse, the author points out, are not yet known or understood.

The press images portraying President Putin as the black belt judoka capable of standing up to the weak and scurrilous leaders of  the U.S., Western Europe and China  never made much of an impression outside Russian boundaries.  Instead, there remains widespread dismay about how "modern" the new Russian republic really is.

The widespread crackdown and violent killing of Russian journalists is something that is anathema in many countries beyond the U.S. and Europe. While U.S. universities fall all over themselves establishing relationships with their Chinese counterparts, a similarly strong relationship with Russia would seem just as natural for the U.S., but it doesn't exist.  The images of Russian oligarchs duelling in a British court room about the division of billions in value to which they were not entitled seems other worldly.  None of these policies and  images are worthy of a true leader in a multi-polar world. 

For all the talk about a multi polar world, it remains just that: empty talk. Lukyanov dismisses the notion of a world of networked international relationships, without discrete polar focal points.  He rightly points out that our world has yet to find a suitable organizational replacement for the nation state model. 

The European Union was supposed to be the paradigm for the Brave New World in which national sovereignty was sacrificed on the altar of common currency and shared economic benefits.  We now know where that train is headed. Alternatively, the author notes we've had a number of multinational, humanitarian interventions, where a small number (as small as one) of states have acted to counteract evils such as ethnic cleansing. A particular nation's sovereignty was sacrificed because they were being bad actors on the humanitarian stage.  This kind of instrument, as we know, is subject to abuse, and this model has limited application.

To be fair, U.S. conduct of foreign policy has been abysmal through the past three administrations.  The author points out the lasting suspicion and distrust sown by the U.S. unilateral withdrawal from the ABM Treaty in 2001, without consultation or discussion with the Russians.  I don't know if we are capable of having a sustained, rational foreign policy position, but there's always hope.

In Asia, there are many actors vying for leadership positions, such as China, Russia, Japan, and India to name a few. Russia desperately needs a more economically modern, humane and enlightened identity in order to exert meaningful leadership in an emerging multi-polar world.

Friday, November 25, 2011

Winding Up The HP Conversation: What's Missing

Perhaps the most curious remark made by new CEO Meg Whitman on the recent HP conference call was her characterization of HP as a company that grows at GDP-like rates (it was a bit inaudible on the webcast).  While this kind of remark makes total sense from a longer-term perspective, it isn't what an institutional investor wants to hear.

Trees don't grow to the sky, and to be sure "long term growth rates" of 15% projected by most analysts for S+P 500 growth companies make little financial or economic sense.  Some of my savviest institutional investor customers spent lots of time trying to determine the "earnings power" of potential investments, i.e. what returns could they earn on the assets they had in place if volumes were growing at above-GDP rates, the company had pricing flexibility, and the economic and competitive backdrops were favorable.  For cyclical companies with significant leverage, the turnarounds in EPS were dramatic.

Stephen Penman, Professor of Accounting at the Columbia University Graduate School of Business, recently wrote a book, "Accounting for Value," in which he updates the Graham and Dodd approach made famous in their pioneering work on security analysis. He concludes that most investors overpay for growth and leave no "margin of safety" when they buy a stock.  The "margin of safety" is one of the key tenets of Graham and Dodd's approach.  Warren Buffett, a longstanding student and disciple of Graham and Dodd, recently announced a large equity stake in IBM, and not HP.  One would think that HP would show a reasonable margin of safety at current prices. 

HP was described by some analyts as trying bring expectations down as low as possible.  That's usually a tactic pursued by second rate companies.  Tweedy Browne is a distinguished value shop which has habitually avoided technology stocks.  They recently initiated positions in Google, which doesn't fit traditional value metrics.  However, they argue that given their huge cash flows, and large investments made to date in technological backbones like data centers, incremental revenue growth, acquisitions and entries in adjacent businesses can have large impacts on EPS. 

Their one concern about Google is a cultural one, namely that the management seems intent on changing the world, in their own words, as opposed to always making shareholder-friendly decisions.  HP on the face of things looks like a traditional  technology value stock.

Dodge and Cox, another traditional value shop, has a five percent or better ownership position in HP equity, between the Stock Fund, the Balanced Fund, and the International Stock Fund.  The company has a long standing position in HP bonds through the Income Fund, which has long been overweight corporates.  It looks like the Income Fund recently sold out of HP bonds because of their strong price out performance.  Aside from HP and extensive index fund ownership, we will see in coming months which other value investors may be accumulating shares in HP.

What's missing from HP in our opinion is leadership, both from the board room and from the revolving door of the executive suite.  This is a serious cultural issue, more worrisome than any cultural issue at Google.  It is the same board in place, and a CEO who came from the very same board which made any number of large, foolish decisions.  The IBM turnaround had a clear beginning with Lew Gerstner. It was fortified by Sam Palmisano and is being handed off to Virginia Rometty; the entire process had gravitas, circumspection and strong hands at the tiller.  HP has under performing assets, a portfolio of businesses with no unified vision or mission in the marketplace, low expectations and a new CEO with smaller company experience driving this very large ship.  Without a cultural transformation, it might become a nice short-term trade, when stronger 2H 2012 earnings become visible, but it's a long way from being a great investment yet. 

Wednesday, November 23, 2011

Thanksgiving and Gratitude

Last Sunday in church, the priest's homily had a long, rambling discourse about "brokenness," which for him was a broken health care system, broken roads, broken schools, a broken Catholic church and so on in the endless drum beat of the modern, secular political religion.  Ironically, he and the rest of the congregation had arrived easily by car over great roads and were sitting comfortably in a beautiful worship space, united by our belief with no reference to any divisive status. 

Looking around our congregation, I thought about my middle class friends from Argentina, Brazil and Venezuela.  As attached as they are to their homelands, they are always concerned about kidnappings in their capital cities when they go home at the end of the year.  We, on the other hand, can pick a random spot on the U.S. map, drive there and walk around without fear.  We can step out of our house and go to a market with no fear of a pipe bomb being tossed from a car, as in the Middle East.  I'm grateful for this peace and freedom that I can take for granted.

Having tutored in schools since my college days, I know that our Catholic schools are challenged more than ever by the modern immigrant influx where the students are way behind their chronological age levels in basic math skills.  Our schools don't complain of being broken. They just get on with the job and give to their students unreservedly.  Hundreds of volunteers work every day to do things from tutoring, serving lunches, providing school yard security and doing bookkeeping for the schools.  What's broken for these students are the corrupt dictatorships in their home countries which offered no hope for their parents; now their children can be educated in Catholic schools in which most of the students do not pay tuition.  Are they turned away?  No.  Does the school run a deficit?  Yes.  Is the financial model "broken?"  Yes, but it doesn't matter for today, because the schools aren't broken: they are doing their jobs which is serving the poor, which is what we should be doing. The Christophers motto is "It is better to light one candle than to stand and curse the darkness."

Taizan Maezumi Roshi, writes in his book, "Appreciate Your Life:"
"What is the I that is blocking this realization?  It is my dualistic functioning.  There is nothing wrong with duality itself, that is how our mind functions.  But as long as we remain in the confinement of duality, we are swayed by such opposing values as right and wrong, good and bad.  These are only temporary aspects. Something appears to be good or bad or right or wrong or long or short or big or small--but what is it overall?  The same thing with our life.  We must see what is beyond our duality.  Our life literally comes down to right now. Now! Here! What is it?"  That's the challenge for each of us every day.

Here in the Upper Midwest, it is a beautiful autumnal day in early winter, where the light and smells of the earth can be enjoyed  by anyone without cost.  Our families and our communities can draw nearer over this Thanksgiving holiday, enjoying each other's company in relative bounty, even as they reach out to help others.  Looking out the window, watching people come and go, makes me feel grateful. 

Tuesday, November 22, 2011

HP Conference Call Gives No Comfort For Investors

HP's 4th Quarter and fiscal year-end conference call marked new CEO Meg Whitman's debut after eight weeks on the job; it gave no comfort for investors, and analysts from Goldman, Morgan Stanley and Citigroup seemed almost comatose, not challenging the disjointed and contradictory presentation.  The stock sunk immediately after the call, on healthy volume.

One fundamental comment concerns the financial statement presentation: Big 4 auditors in my experience are usually reluctant to permit widespread use of non-GAAP financial measures in presentation of results, and they try to limit their use and keep the corresponding GAAP measures adjacent to the non-GAAP measures.  Although HP provides reconciliations in their slides (what they call a "bridge"), the management leans totally on non-GAAP measures of performance.  One of the problems with the non-GAAP measures is that they are not comparable across companies, since companies differ in what they consider one-time or non-operating items.

For the full fiscal year 2011, HP reported GAAP pre-tax income of $8,982 million, or $3.32 net per diluted share. Adding back charges for impairment of goodwill and purchased intangibles, amortization of purchased intangibles, restructuring, and acquisition related charges, produces $4,350 million of adjustments to pre-tax income.  At a 22% tax rate, non-GAAP adjusted EPS for 2011 becomes $4.88, like magic!  Similar hand-waving for the fourth quarter turned reported EPS of $0.12 into a non-GAAP EPS of $1.17.

By making these adjustments for comparability, the board and the management escape the fundamental problem that these large acquisitions now being written down were the avowed strategy of the company over a long period of time.  The adjustments are economic testimony to the fact that they were poorly conceived and executed.  Aren't these "operating" items for a company whose stated goal has been to make mega-acquisitions?  I realize that I'm mixing accounting with what the statements are trying to represent, but I hope the reader will indulge me.  In fact, CEO Whitman continued to talk about acquisitions in HP's future, saying only wanly that there might not be any more mega-deals. I certainly hope not!

In an amazing show of chutzpah, the management said that they would no longer give any forward guidance, except for EPS.  Consider what they said.  For fiscal 2012, management expects the company to earn at least $3.20 on a GAAP basis, compared to $3.32 on the same basis in the prior year, a decline of 3.6%.  I sincerely doubt that management will be compensated for 2012 on EPS, as suggested by CEO Whitman.

On a non-GAAP basis, management said that the company is expected to earn at least $4.00 per share, compared to $4.88 in the prior year period, on the same basis, a decline of 18%!  Buried in a footnote in one of the presentation slides is an item that says, "Full year fiscal 2012 non-GAAP diluted EPS estimates exclude after-tax costs of approximately $0.80 per share, related primarily the amortization and impairment of purchased intangibles, restructuring charges and acquisition-related charges."  So, the stream of "one time" items continues into 2012, and there will again be a difference between reported EPS and non-GAAP EPS.

The new CEO says that the number one question she faced when going out and talking to customers, partners and investors was "What is HP?"   She characterized the company as being No. 1 or No. 2 in all of its operating business segments.  Based on the performance of the segments and on their outlook, this statement seems inaccurate.  There was talk about how smoothly the Autonomy acquisition was going, with the companies "exchanging hundreds of sales leads," and yet the acquisition seemingly has no impact on EPS in 2012, but without any detailed guidance, this isn't easy to tease out.  Autonomy's website claims the company has 25,000 customers worldwide, many of which must be small and scattered across a variety of product offerings from social media analytics to eDiscovery.

The Personal Systems Group (PSG) which was going to be sold off by Whitman's predecessor will now be retained.  Based on its performance and outlook, it must be an industry No. 2 because there are only two horses in the race.  The company's commentary during the call was guiding strongly to single digit declines in PSG revenue in 2012 compared to 2011.  Disk drive shortages from Thailand flooding, widespread consumer spending declines for both notebooks and tablets, the failure to have an established tablet product in the market, and a decline in ASP's will all militate against revenue growth and margins may touch record lows. Fourth quarter 2011 operating margins in PSG were 5.7%, typical of a commodity business.  In the first half of FY 2012, these margins may drop as low as 2-3% before a macroeconomic industry upturn in the second half starts to raise units, price, and mix.  2012 seems like just putting a finger in the dike for this business.

We've written before about HP's being overly reliant on the printing supplies business, which is included in Imaging and Printing Group (IPG).  The company pushed too much product into their wholesale and retail channels in 2011, and it hopes to work these off in the first half of FY 2012.  Operating profit in this segment had a recent peak at 17% in FY 2010, and it may spend FY 2012-2013 in the 13-14% range.  This is an industry leading business, but to paraphrase the CEO, "Printing is a coincident indicator of economic and business confidence and sensitive to price in a downturn."  Remember how we were all going to print studio-quality photos on our printers at home?  Not!

Services 2011 revenues of $36 billion is just behind PSG's 2011 revenues of roughly $40 billion.  As I think of the industry leaders in this segment, I think of IBM and Accenture, not HP.  CEO Whitman's talk about this business was not at all enthusiastic.  She talked about a multi-year turnaround for this business, the need to hire people who "can actually deliver what the customer wants," the need to invest in better quality sales people, and margin pressure in the basic service offerings. This does not sound like a No. 1 or No. 2 business leader in the industry.

IBM Global Services Revenue, by contrast, is projected by Credit Suisse to be $63 billion in 2012, with 33% gross margins and 15% pre-tax margins.  HP's management has suggested operating margins for Services in the 10-12% range for 2012-2013 on flat to low single digit revenue growth.

The Enterprise Server, Storage and Networking Business (ESSN) The company is one of the market leaders in Industry Standard Serves (ISS), but even this segment of the business would, according to management, be facing macroeconomic deceleration in upgrade and replacement cycles, continuing problems with Oracle's move away from the Itanium chip,  Facebook, Google and others building their own servers, and a deterioration in HP's traditional storage offerings. Now that Dell has acquired Compellent, they would seem to have a more innovative and attractive set of options for large volume storage customers. Operating margins in this business should continue to be under pressure in 2012.

The company will be ramping up its R&D spending, something which does not give us comfort given that previously high levels appear to have yielded nothing, which then required the company to purchase innovation expensively in the capital  markets.

Whatever FCF the company generates in FY 2012, it will be dedicated to paying down debt related to the Autonomy acquisition, and so cash returned to shareholders, which is a healthy percentage of the free cash flow, probably won't grow too much.

The HP value creation machine may be stuck in neutral almost certainly through Q1-2 FY 2012, and time continues to be on the value investor's side to see if this is the board and management team has the ability to restore the company's tarnished luster.

Thursday, November 17, 2011

QE2 Hasn't Affected The Economy

I noted this comment from my former colleague, Dr. Ward McCarthy, Chief Monetary Economist for Jeffries:

"...the logjam in the banking system is evidence that QE2 has not filtered into the real sector of the economy to any significant degree. So long as this persists, it will be an indication that the monetary policy transmission mechanism has not worked efficiently."

Yet we continually, and with blind faith, talk about monetary policy not being out of bullets in reducing the employment rate through a QE3.  I wish that Chairman Bernanke would get on a National White Board and explain this in five minutes without any acronyms or jargon. 

Saturday, November 12, 2011

Pimco's Kashkari Gloomy About Equity Returns

Pimco has always been a bond house, but lately they've made a concerted effort to develop mutual fund products for equity investors.  The equity mutual fund field is like the favela in Sao Paulo: dangerous and overcrowded.  Neel Kashkari, a Goldman and U.S. Treasury alumnus, is leading that charge into equity.  In a recent interview with Morningstar, Neel  didn't take a sunny view of equity returns.

Instead, he says that the U.S. is in a long period of adjustment which will mean much lower economic growth and lower asset returns than historical norms.  Like our posts on the so called consumer deleveraging, he says that it has barely begun and has a long way to go.  Large corporations, and to some extent the mid-market firms, have completed their deleveraging and are flush with cash.  However, they will find precious little sales growth here at home if the consumer sector continues on life support.  It's an interesting interview.

Of course, what's the conclusion following from Kashkari's world view?  Get connected with emerging markets. Brazil is apparently fully valued.  China has already produced negative surprises and may have more skeletons emerging from the closet.  Apparently, selected Russian companies may be value plays.

How can a U.S. investor, particularly an individual investor, take these kinds of risks in a low return world without significant risk premia?  Macroeconomic data for all these countries is barely acceptable, the financial press is weak or non-existent, corporate governance is of poor quality and not monitored by strong watchdog groups, and the auditing function is hostage to low quality national partners and shielded from accountability by the structures of the major accounting firms.  Does this sound like an answer to low U.S. returns? 

Look at what happened to Southeastern Asset Management, which runs the Longleaf Funds, very successful long-term value oriented investors.  Mason Hawkins and Stanley Cates have put together the ingredients I look for in a good equity mutual fund manager: good people, an ethical culture, a sound research process and approach to valuation, and manager incentives that are aligned with shareholder interests. Their employees are the largest shareholders across their family of equity mutual funds and have been since time immemorial.  This is the way it should be, but it's rare.

Southeastern has been rattled by being a long-term 5% plus shareholder in Japan's Olympus Corporation, which may have been hiding trading losses for a decade or more.  This is a Tokyo Stock Exchange listed large capitalization company with good businesses and a long track record.  I understand the statistical issues of this being "an n of one" on the TSE or in a diversified portfolio.  My point is look what is still happening even in foreign markets which we consider "developed."

Think now about the same investor's position in a Brazilian oil company, software company, or REIT?  The outside investor is at a tremendous information disadvantage.  Even depending on analysts stationed in the country is no assurance of risk mitigation.  It depends on culture, people and processes in those local operations, which are difficult to manage from afar.  If emerging market investing is an answer, it will have to be on a company-by-company basis.  I don't think it makes sense for investors to buy into, for example, the "Brazilian Miracle," or the "Indian Miracle," or any other gold rush country. 

Reading Kashkari's piece made me lament for the eras of 8% equity returns, which are still embedded in the long-term projections of many public and private pension funds.  The maiden of high returns has vanished, as Neel suggests.   I had to turn to Bill Withers and his baleful tune, "Ain't No Sunshine When She's Gone."  I can go back to my investment statements with some comfort.  Thanks, Bill.

Tuesday, November 8, 2011

Nord Stream Is The Big News In Europe Today

The Western press front pages were replete with Italian Prime Minister Berlusconi looking heavenward as he contemplated his announced resignation. Or was he thinking about AC Milan's recent run of form in Serie A?  There was nothing new in today's tedious play-acting in Greece and Italy. 

The news of fundamental economic importance was the opening of phase I of the Nord Stream underwater gas pipeline which links Russia's vast Siberian gas reserves with Germany.  The 1,200 km long pipeline can carry 27.5 bcm of gas, and when phase II is completed in 2012, Nord Stream can supply about 10% of the European Union's energy needs with the relatively green, fuel of choice for residential and industrial consumers. 

This is a sharp stick in the eye for Ukraine, Belarus and Poland, which had earned revenue from gas transmitted by older, overland pipelines through their territories.  Ukraine's efforts at disrupting supply in the past for political reasons are now neutralized.  Russia may eventually have from 25-33% of the EU's gas market supplied from its reserves.  As Russian President Medvedev said with some understatement, "We are going to put into operation the first stage of a new partnership with Russia and the European Union."  Gazprom OAO will own 51% of the Nord Stream venture.

We've always said that Russia's proclivities were naturally towards a stronger partnership with Europe than towards a wary partnership with America.  This massive technical and financial undertaking is a good start.  Relationships have been quietly building in other areas too, like football.  Gazprom has been a prominent uniform sponsor for Schalke 04 a great Bundesliga club with a rabid fan following. 

One curious item to note about the ribbon cutting for Nord Stream was that Chancellor Merkel was joined by the French Prime Minister Fillon and not by her erstwhile political companion of recent months, French President Sarcozy.  Germany has in principle gained access to more secure natural gas supplies through the Nord Stream joint venture, which strenghtens its economic prospects for the future, given the growing convergence of interests with Russia. 

Thursday, November 3, 2011

European Central Bank May Need Life Support

Last night's post talked about the precarious nature of the ECB's balance sheet, based on a paper by a Columbia Business School professor.  I just saw this discussion in today's online Wall Street Journal:

"The reality is that efforts to leverage the European Financial Stability Facility are in disarray – and will remain so until the current political uncertainty over Greece, and maybe now Italy, has passed. And the bank recapitalizations are not due to be completed until June 2012. The only contagion defence available to the euro zone is the European Central Bank which may be reluctant to step into the breach. After all, if Greece is forced into a disorderly default, it would likely repudiate all its debt, including that held by the ECB. That would blow a €50 billion hole in the ECB’s balance sheet and destroy the credibility of its Securities Markets Program."

The balance sheet of a traditional central bank has to be above reproach.  The ECB may have short-term issues, and for it to be a factor in a longer-term working out of the Euro crisis it's balance sheet will have to undergo a wholesale swapping out for multinational, EU guaranteed bonds.  Can we get there from here? 

Wednesday, November 2, 2011

Papendreou Agonistes: Greece Throws Down The Gauntlet

For all the hectoring that Greek Prime Minister Papendreou may soon face from the German Chancellor and French Prime Minister, his gambit of calling for a referendum seems politically and economically rational.  Under a scenario of further fiscal discipline mandated by the EU, economic growth prospects are dismal which means growing political unrest and instability in Greece.  The Greek political leadership will not be able to influence the path of future events, other than to be reacting to serial crises.

If, on the other hand, a referendum goes were to go forward and pass, Greece could resurrect the drachma, gain control over its future monetary policy and have an exchange rate to adjust for differential inflation levels with the rest of the EU and for payment imbalances.  A run on the banks would have to be forestalled, but Argentina suffered through a bank run in 2001 and reemerged healthier five years later.

Asset markets would be thrown into turmoil, but everything would eventually be remeasured, and life would go on, with limited access to the capital markets for some time.  However, from the political standpoint, Greece would be in charge of its monetary and fiscal policies, as opposed to the popular perception that the country is at the mercy of Germany and France.  Short-run economic growth prospects in this scenario shouldn't be much worse than under the current euro structure, assuming that fiscal discipline continues and revenues are eventually raised through higher taxes and better collections.

The important element for a politician is that Greece is in charge of its own destiny, even if that means being a pariah for a few years.

Back in July, we wrote about the limited options for the European Central Bank. We focused on " the fundamental problem of economic imbalances within the European Union."  Professor David Beim of the Columbia University School of Business puts forward a cogent analysis in his October 9 paper, "Can the Euro Be Saved?"

The seminal formulations of the economic and currency union idea were put forward by Robert Mundell, Roland McKinnon, Peter Kenen, Douglas Dosser and others in the 1960s.  As Beim rightly points out, these models were predicated on the countries being broadly similar, especially as regards having common or similar rates of inflation. If they were not, a currency union must inevitably end in a debt crisis, driven by persistent payments imbalances.  That's where the EU is today.

We've said from the beginning that no politician on our planet will willingly cede national sovereignty over fiscal policy, because that would be either a literal or political death sentence. We've written earlier, "we are moving, like a slow motion train wreck, towards a default of some kind, semantically within or outside the euro."

Professor Beim agrees, "Greek debt restructuring and exit from the euro needs to happen in the near future and will happen with certainty in the medium future."

Professor Beim raises a really important point, which has been glossed over in all the focus on Greece, and that is the balance sheet of the European Central Bank.  He reads the September 30, 2011 balance sheet showing 2.3 trillion euros of assets, composed of 1.14 trillion of bank loans and distressed sovereign debt!

As he says, "The ECB itself needs to be bailed out, replacing its risking assets with European Financial Stabilisation Mechanism (EFSM) euro-bonds, to the extent that this can be done at this late stage." 
This recapitalisation itself will be a Herculean undertaking.