Tuesday, July 29, 2008







The fixed currency model of bank collapse

First observation: banks intermediate the current account deficit




Second observation: fixed exchange collapse with currency runs











Never much fun shorting the banks in such countries




Current account deficits, fixed exchange rates and Eastern Europe







Manifestations of the Baltic madness





Manifestations of the Baltic Madness in bank balance sheets













So what happens next?









Anonymous said...

very interesting post. do you have any idea at what point the fixed exchange rate could become unsustainable?

John Hempton said...

The exchange rate is sustainable so long as people will lend to them. There is only one group lending to the Baltics - and that is Swedish banks.

It becomes unsustainable when it no longer makes sense to lend to Swedish banks. That is why it is NOW. Swedbank is probably insolvent. It no longer makes sense to lend to them.

Mark Cheshire said...

Having personally experienced the Argentine currency and bank collapse, you are absolutely on the mark regarding how this will play out in the Baltics. I now live in Spain and anticipated the current crisis unfolding here while everyone was living the good life. While I know the future is going to be tough, I have difficulty applying your fixed currency banking model here, and understanding the next steps and who will be impacted most. I know you are monitoring things here from your "Spain Newsflash" post some time ago. I do not expect the Euro to break apart, so how will the massive 9.5% current account balance unwind? Will wholesale funding to banks freeze and lead to a wave of bank closures? Or will the pain be transfered to the economy as a whole? Or does the more robust nature of the Euro fixed currency regime buy more time from a run on the country and allow time for things to muddle through and be patched up? Any thoughts on how you would apply your bank model here?

Anonymous said...

Well, don't run shorting Swedbank just yet. First off, Hansa's Latvian assets are not in Lats, but are mostly in EUR (most loans are denominated in EUR). So if the Lat is devalued, it won't make Hansa insolvent automatically. (It might eventually, as loans get written off). Second, the latest data from Estonia puts its C/A deficit on annualized basis at around 10%, which is hardly unsustainable. Lithuania, as you pointed out yourself is actually "sensible", so no immediate danger just yet. So that leaves us with the Latvian risk of devaluation, which, if it ever happens, will not bring down Hansabank, let alone Swedbank.

Anonymous said...

did you check their hedges? usually they're fully hedged in risk countries.

also remittances can keep the exchange rate up for longer than shorts can be solvent.

Anonymous said...

Agreed with above, very interesting (just subscribed to the blog and have been reading all entries). Have you looked at Romania and Bulgaria in a similar fashion?
Per wikipedia's list, ROM has a 2007 CA deficit of $20 bn, BG's is $7 bn. The '08 estimates as a % of '08 GDP are ~22% for BG and ~15% for ROM per the IMF link at the bottom of the wiki article. As a comp, Lithuania's estimate is ~10-11%. Key difference is that the ROM leu is not pegged to the euro, while the BG lev is pegged at~2:1 euro.
Both countries have experienced a stupendous rise in property values and FDI, partially due to the new EU membership. Both countries, like you point out re the Baltics and Argentina, have growing middle classes whose standard of living has improved drastically over the last 10-15 yrs. Both countries have substantial remittances from their immigrants, and large gray/black economies (so large that the EU recently suspended BG's funding until further notice due to corruption). Another twist is that a large part of the immigrant population was doing semi- and unskilled work in, you guessed it, Spain's construction sector.
If the macro stats capture the gray economy to a certain extent, the remittances slow down, and we apply your analysis, it would seem that a devaluation of the BG lev is in order.
Any thoughts?

John Hempton said...

The last "anon" post is very interesting. I had factored into my views the grey-black market economies. In some sense I had probably over-factored them in because I started with the prostitution industry which is always black market.
Also - anyone that follows the Estonian situation will know that many companies are going bankrupt because they are being pinged for back-taxes. The black market is becoming less black.
But the whole of Eastern Europe looks like it has a serious imbalance. I hae been asked about pretty well every Eastern European banking name. Not many are pretty. Most however are not in anything like as deep as the Swedish are in the Balts. And nobody has the macroeconomic statistics of Latvia. Latvia is on a level of its own. Its macro stats are so implausible it is funny.
I hadn't factored in remittances to the extent I probably should have. There have been a few posts about remittances.
Its sort of obvious when you catch a taxi in London. The taxi-driver will hit you with a pile of racism about Eastern European electricians taking all the good jobs. But nobody seems to complain about the drop-dead-gorgeous Lithuanian girls serving in the sandwich bar at Canary Wharf. Remittances are clearly an issue.
The remittance twist - the Spanish construction industry - is one I had heard but had no idea how to quantify. The racial mix of Spain has changed dramatically through this boom (visible in official statistics) but Africans were what stood out. I hadn't picked up the Eastern European labourers to that extent.
The clincher to me are things like the Bentley dealer. Sydney has a Bentley dealer. Its a ferociously rich city with a large wealthy class. But if I google Bentley dealer Adelaide - guess what - I get Latvia. It takes a lot of remittances to pay for a Bentley. And most moderately rich cities (such as Adelaide Australia) cannot score a Bentley dealer.
Remittances to Argentina were also a big thing. And Mexico before the Peso crisis - and other places.
The problem with this movie is we have seen it before. It can last a long time. But it will end in tears.

Lithuanian said...

All this doomsday scenario presumes a run on the currency, which in turn requires 'Mr Soros' to borrow heavily in local currency (Lats). Do you have any suggestion who would lend this money to an obvious raider (given the fact that the banking market in the Baltics is very concentrated)? Hansabank?

John Hempton said...

Hansa is hardly going to lend the money to undo themselves.

The question is then "is an unsustainable exchange rate sustained forever if nobody can bet on it".

I doubt it. The Latvian economy is massively uncompetitive now - costs are too high.

It has inflation so costs are rising.

This makes it more uncompetitive.

It has a fixed exchange rate so there is no outlet.

At some point all Latvian export industry closes down because it is so uncompetitive.

And Latvians still borrow Euros which they cannot repay in Euros.

A Soros - if possible - would bring a rapid end. But the end will come anyway.

Anonymous said...

caveat emptor to anyone who's not familiar with the region. you can't draw inferences to other monetary systems/economies bc this is unique. agreed eastern europe is bankrupt and the balkans will probably be the EU doom scenario once again. but IF the convergence to euro MUST happen in the future, the central banks will keep the cash rates at extortionate 10% (as they do now) to prevent potential runs for a few years until euro happens. everyone functions in euros anyway now and inflation hasn't deterred them before.

jb said...

Had to look up a term you use a lot "wholesale funding." Didn't exist anywhere in wikipedia so I created the entry using FDIC info, check it:

John Hempton said...

That Wikipedia definition is spot on. General idea: a bank gets money in by opening the door - core deposits from its core customers.

These are often transaction accounts and at low rates. They tend to be "sticky".

They also get money from other sources - brokered deposits, hot money high rate deposits, securitisation, pledging assets, wholesale loans.

That money comes with strings attached - and is usually expensive. Sometimes it is also flighty.

Good funding is very valuable indeed in a crisis. It means that you don't need to go to a fickle market. A large part of why Wells Fargo does better than other banks is that it has a lot more good funding. [Wells has plenty of bad lending too - but its funding base remains better than most banks.]

Bad funding has lots of strings. It either requires you to pledge your good assets (which can't be done twice), or it is expensive (as some hot money deposits are) or it is fickle (as some capital markets are) or it subjects you to extra regulatory scrutiny (such as some brokered deposits).

My view is that the biggest problem faced by banks is not bad credit - its bad funding. During the boom people completely forgot about funding as a problem. I had that amazing (and drunken) discussion with Alliance and Leicester about funding issues - and senior guys in finance didn't think funding was an issue.

Tell that to Northern Rock when its funding walked out. Or Bear Stearns.

Anonymous said...

As far as I've understood, Latvia could devalue their currency overnight - it needs just a governmental decision.

In Estonia, however, there would have to be a change in law. I don't know how fast they could do that. In emergency, maybe over a weekend?

I guess devaluation won't happen for a while - maybe this time next year. Prices of real-estate have dropped, but not yet collapsed. People in the Baltics do not seem to be in a real pain yet.

Does anybody know a way of shorting these currencies? One banking source tells me is difficult for a foreign private person to get a loan from Latvian and Estonian banks, if you do not have any income from there. Any otc currency derivatives available for private persons? Any betting companies offering bets on this one?

thanks, Martel

Anonymous said...

So, I went back to look at Unicredit's stats for Bulgaria (discussed above; bulbank.bg), and comped them to what Hansa has. Loans to customers are 5.2 bn BGL; deposits from customers are 6.3 bn BGL. Hardly the Hansa situation. (Raiffeisen was not mismatched either; ~2 BGL = 1 EUR).

No smoking gun there, but the macro stats in the UniCredit report caught my eye. Inflation for '02-'06 was 3-6.5%; it hits 12.5% at the end of 2007, and is ~15% now. Current account balance in '02 was (402) mm EUR. At the end of '07 it was (6.2) bn EUR. '06/'07 CA increase was 57%.

Bank credit growth has been ~40% (geometric) per year since '02.
Labor costs have been increasing at 15%+/yr since Q1 '07; hitting 21% in the last quarter (nsi.bg). Similar to the comment above, the costs are rising too quickly on all fronts (land, commodities, labor, energy) which slows exports so the CA grows further. The CA deficit has been covered by FDI (http://www.hedgeweek.com/
%20Special.pdf) which will, imho, be reversed due to (1) rapidly lowered productivity, (2) end of the RE speculation and (3) slower remittances.

Like they say, the higher they fly, the harder they fall.

Anonymous said...

John: Your bit about not making much money since the currency devalues is..uh..not sensible. Because: Presumably, one would short the stock at the PRE-crisis exchange rate, and buy it back at the POST-crisis level. You make money BOTH on the currency decline AND the stock decline. Right?
This means it's ok to look for banks in the "target" country, too.

John Hempton said...

Thanks anon for the comments - I took a look at several Eastern European banks. Hansa looked worst.

But then Latvia looked worst.


DB's comment is wrong.

I say Siam Commecial Bank at 75 Baht. I sell one share. I get 75 Baht cash which is left on deposit for me. If I am really unlikely they might make me collateralise it by putting up an extra 20 Baht.

So now I am short one share - 75 Baht at 25 Baht to the dollar - say
three dollars. I have 75 Baht (maybe 95 Baht) sitting in some collateral account somewhere.

I buy back the share for 5 Baht. It is a spectacularly good short.

I have a profit = say 70 baht - making this a spectacularly good short.

I go convert the Baht to dollars. But the exchange rate is now 65. I get - oh, $1 and a bit. And I had $3 at risk - and I got it right.

Its worse if I have to put up collateral because I lose money on the collateral too. That cost me say 40% of my profit.


Anonymous said...

Hi! I am from Latvia. What do you think, what happens to people deposits in EUR at worst scenario? We have legistlation, that government guarantees about 10 000 EUR for deposits. Where will they get this money?


Anonymous said...

Just proved my point: "The Estonian CEO of Hansabank, Priit Perens, told aripaev.ee that in case loans have been handed out in EEK, devaluation would make the situation easier, but as loans are based on EUR, devaluation would bankrupt Estonian economy." http://www.balticbusinessnews.com/Print.aspx?ArticleID=ba4449d7-bd41-4fe2-b7ba-bbf713312f8c

Mark Cheshire said...

To anon from Latvia, going by the Argentine experience it is best to get your money out of the bank, move it offshore, or into cash, or into stocks.

Aig said...

* Macro/consumer-demand situation is very grim, but don't read too much into it
* HansaBank is likely to be funded within the SwedBank group since loans-to-deposits rations seem to be reversed in Swedish branches as compared to Baltic branches. It makes perfect business sence to "recycle" excess deposits from Swedish branches in the fast-growing Baltic states.
* [I agree that] by far most of bank assets is the Baltics are EUR assets, not local currency denominated assets. Devaluation is risk to banks is a rather remote risk. Solvency risk is much higher.
* [I agree that] competitiveness of the economies has decreased in a major way due to sharp across-the-board increase of production costs. This adds to solvency risk.
* HansaBank in Latvia has about EUR 1.7b in loans, considerable part of it in mortgages. As real estate prices have decreased by about 30%, there is a considerable number of negative equity cases. How/when this will show up, if at all, on bank balance sheets and P/L?
* I expect NO devaluation. Some players sit in short local currency positions, but I consider it a costly and very low probability bet. [It's a much longer story why.]
* I expect things to straighten out in the next 12-24 months with the current crisis as a milestone between extra hot, consumer-demand-driven growth to normal, sustainable economic environment. Some of the factors contributing to such limited optimism is that (a) individuals are competitive even if the economy is not, (b) exports growing faster than imports, (c) considerable part of income is derived abroad.

Anonymous said...

The central bank (BoL) has declared no devaluation at whatever the cirumstances. They have claimed to exchange all cash in cirrculation to euro if it becomes necessary.

From this we see that the central bank is not going to sterilize any drop in money supply if it is going to happen. The central bank is an independent institution and it may keep its promise on no devaluation even at sky-high short term interest rates and economic depresioin.

Is there any sound way how to force the central bank to devalue the Latvian currency?

John Hempton said...

No there is no obvious way to force the central bank to devalue.

Because to date the foreign currency has been provided by Swedbank.


But lets try the thought experiment. Suppose Swedbank decides that it cannot keep lending Euro to Latvia.

There is no new supply of Euro.

And the central bank swaps all the Lati to Euro.

And Latvia remains expensive. And Latvian shoppers head off to other countries to do their shopping.

And they take their Euro.

Then the supply of Euro actually circulating in Latvia will crash.

There will be a vast shortage of currency. A HUGE money squeeze.

Sounds like the mega-recession. And prices in Latvia fall very fast (inflation is falling now).

And there is massive credit losses because there simply is not the Euro to repay the loans.

And I win on my short anyway.

The BoL is between a rock and a very hard place.

Anonymous said...

Bentley is not an indicator, Riga has a lot of Russians, from Moscow, with huge 'black' cash purses in offshore accounts. They buy Bentleys in cash. Riga's black money pools are enourmous..
Remittances, i.e. official statistics for Latvia claimed them to be at 10.1% of GDP in 2006. Estonia ant Lithuania at much less extent. These official numbers are believed to be at 10-50% of unofficial (real) flows..

Juris said...

Small comment on John's comment from August 4, 2008 10:27 PM.

I think it is wrong to assume that if Swedish banks stop supply of Euros, people will take their hard-earned Lats and convert them to Euros to continue shopping abroad.

It can happen only in short term and, IMHO, this "short term" is happening now. If swedes do not give us euros to spend, we cannot spend them. :)

If we spend more than we get, we quickly squeeze money supply, we curb business, we get bankruptcies, unemployment and everything else that - you guessed it - cuts spending and investment, ending in sustainable current account deficit, supported by EU funds, remittances and FDI.

These two things - cutting euro supply and decreasing imports are not concurrent by default and these curves may even not be parallel. I am not quite a macroeconomist, but I believe that the major imbalances in Latvian economy (e.g. high share of construction in GDP) plus prevailing pessimistic expectations can make the decrease of imports concurrent with slowdown in external funding.

In a pair recession-devaluation, I am betting on recession. Slightly oversimplifying - how can you devalue Lat, if nobody has it? :)

Aig said...

John Hempton:


Sounds like the mega-recession ....
And I win on my short anyway.




I tend to agree with the theory and some empirical evidence [ http://www.trades4u.com/pictures/fx%20valuation%20model.pdf ] that higher inflation and higher interest rates cause short supply of local currency and lead to stronger currency.

If there is a huge money squeeze and mega recession [and both are very likely and already happening], it doesn't mean you win on short currency position. The opposite is much more likely.

I know some very smart people sitting on short position and tell them that I disagree.

Latvia has gone trough a much tougher economic enironment in mid-90s with interbank rates/government bond rates at around 40%, inflation much higher than that and stable currency.

I had a number of discussions with big hedge fund managers then where the story went like "high interest rates will break the economy, should we sell the currency etc." "What is inflation, if you get 40% on government bonds etc." It denied conventional wisdom, but proved to be true that it doesn't matter what the inflation is, if the exchange rate peg is trustworthy .

Today I believe that the peg to euro is trustworthy unless the political system in any of the Baltic countries is so rotten and corrupted that politicians will induce devaluation to profit from it. But I guess it is not so rotten and I'm sure that central banks have financial capability and competence to keep the currency peg until introduction of euro in the next 5 years or so.

John Hempton said...


I am not short the Lat. I am short Swedbank.

Choice. Lat devalues. Swedbank craters.

Lat doesn't devalue and there is a mega recession. Hansbank loses a lot of money. Swedbank survives but stock goes down.

I am NOT short Lat. I just like the bet either way.


Aig said...


Regarding SwedBank valuation & shorting opportunity, it seems to me that the case doesn't pass the acid test [if the premise is that the stock will tank because of the bank's exposure to the Baltics].

* [Only] about 1/4 of SwedBank's total loan portfolio is exposure to the Baltics
* Loans made in Y2006 and before are likely to be very well secured [something like commercial property in prime areas at EUR600/sq.m.].
* New loans from mid-2007 are likely to be made on very conservative basis.
* In Y2007 EUR5b new loans were made in the Baltics by HansaBank group. The worst-case-scenario: for those €5b loans the assets provided as a pledge are worth just the same €5b. Generally, borrowers do not walk away even if there is negative equity and, therefore, it is unlikely that SwedBank/HansaBank will record a loss on this piece of assets. Even if property prices decline another 20% to below replacement cost and every Y2007 borrower walks away from its obligations [what is highly unlikely], the loss will not exceed €1b. But then SwedBank itself generates about €1.25b in annual profits.
* The CEO of HansaBank Latvia has been replaced in Y2007. Former CEO was excellent in marketing and building market share [with great success]. The current CEO before was vice-president in charge for risk management. It tells me that SwedBank itself has recognised and addressed the problem before anybody else noticed.
* Last, but not the least, there is a significant risk to get caught in trend reversal as the prevailing pessimism regarding financial stocks may suddenly change to optimistic expectation that the worst of sub-prime morass is behind.

All the above mentioned tells to me that there should be better shorting opportunities out there, EGO, RRI, PSMT [all U.S. stocks] to mention a few.


Latvia resident said...

Last year happened already a small run on the Lat. Over one weekend, while the banks were closed, suddenly foreign exchange became scarce on the streets. Every foreign currency appreciated by something like 5-10%. On Monday the crisis was already over as the CB jacked up interest rates to 12% and supplied currency.

Fact of the matter is that it is extremely difficult to short the Lat in a sizable manner, the FX market is extremely small.

Anonymous said...

Aug. 20 (Bloomberg) -- Latvia's unemployment rate fell to 6.3 percent in the second quarter from 6.5 percent in the previous three-month period.

Anonymous said...

(Bloomberg) -- Estonian overdue loans as a share of total credit were unchanged in July from the previous month, the central bank said.
The share of loans overdue for more than 60 days stood at 1.8 percent of all credits, the same as in June, the Tallinn-based Eesti Pank said in an e-mail today.

Bagsnatcher said...

Dear John

Enlightening reading. I live in Sweden and work for a bank (no not THAT bank) I too am short Swedbank for the same reasons as you. If you have time then please take a look at their Q2 report where they state that they've bought alot of their own morgage papers (spintab. Can you explain why they do this cause to me it looks like they are sitting on "another bomb" there. The spread btw spintab and govt papers widened to 55 points from 40 last week causing a few banks to revalue a hefty loss....

pendolino said...

how about an update on what you got right and wrong in retrospect since you penned this post?

Scoby said...

lol very interesting

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