2013 Q1 Letter: Spanish Mortgages, Cypriot Banks & Earth Day
We hope 2013 has gotten off to a good start for you.
We want to start off by wishing you a Happy Earth Day! We exhibited at the Green Festival in NYC over the weekend, and it was great to see so many friends there, and to make some new ones. We are always pleasantly surprised by the number of people who are eager to learn more about Socially Responsible Investing and how their portfolio can do good as it grows.
The first quarter of 2013 saw risk assets continue to rally. Despite continued concerns about the state of continental Europe, major US stock indices reached fresh all-time highs in March, six years after they last reached such elevated levels. The effects of inflation and dividends that have accrued to investors effectively cancel each other out, and so it is rather impressive that six years after the first warning signs of the impending credit crisis appeared, investors have regained most of the lost ground. Of course, the constitution of the indices have changed, many enterprises that were mainstays of the Dow and S&P have been expelled from them and new upstarts have taken their place. That, however, is the creative destruction of the market at work.
In Europe, a low-grade fire continues to smolder and it seems as if the news continues to get gloomier. March brought news that overall unemployment in the Euro-zone reached 11%, a level not seen for over 50 years. Investors should not be sanguine; the economic crisis in Europe is severe and will take many years to recede. The roots of Europe’s problems lie in the excess of development, spending and borrowing that occurred in the Medittereanean states, most of it funded by loans from the North. It has been illuminating to see the difference in responses between crisis-stricken Northern European countries and those in the South, which appear to have played out like a parody of Max Weber.
The first casualties of the crisis were Iceland and Latvia. Both are small countries with financial sectors that had recently ballooned. Another was Ireland. In each instance, the general population seemed almost resigned to the effects of the bubble bursting. It was almost as if, as per the caricature, Northern Europeans were used to misfortune and hardship, taking it in stride. Draconian measures were taken in all three countries. Banks were liquidated, along with real-estate developers and many ordinary businesses caught in the indiscriminate downturn. Meanwhile, families adapted quickly to a far less comfortable lifestyle, embracing austerity with an almost welcome sense of Lutheran penance.
Meanwhile, similarly crisis-stricken countries in the South (Greece, Spain, Italy and now Cyprus) have seen wide-spread unrest as their citizenry have resisted austerity measures every step of the way. We empathize immensely with the ordinary people caught in economic events that are not of their making. In many cases, individuals with limited financial experience just happened to have made poorly timed decisions, with no understanding that there are good and bad times to extend oneself by taking on debt. For the past three years, Eurozone nations have been haggling over how to apportion the blame and cost of the cleanup.
This quarter saw two diverging answers appear. The first is from Spain and was not widely covered though it has far-reaching implications. The second is from Cyprus and was widely covered by the media due to its dramatic nature.
Spanish mortgages are very different from American mortgages in one key respect: a mortgage in Spain is both a secured debt and a personally guaranteed, recourse loan. Lenders can repossess the property securing the loan, and continue to pursue the borrower for any shortfall or costs resulting from the repossession, till the entire debt is repaid. A Spaniard who has his house repossessed and sold by the bank will continue to owe the bank any shortfall between the sale price and the amount of the mortgage. Personal bankruptcy is not an option for most, so it is almost impossible to start with a clean slate.
Many Spaniards discovered the nature of their mortgage debt after the crisis, and after home prices were halved. Thousands of ordinary Spaniards have been evicted from homes they owned due to delays in mortgage payments and subsequently find themselves owing the bank tens or hundreds of thousands of Euros since the property does not cover the entire debt. Scores of former homeowners have been driven to suicide to escape crushing debts. Meanwhile, unemployment in Spain hovers around 25%. These are truly depression-era conditions, and they have seen wide-scale protests similar to the depression.
Amidst all this turmoil, The European Court of Justice heard a case brought by an evicted home-owner, Mohammed Aziz, and decided the original terms of the mortgage agreement were unfair. Spanish courts can now overturn evictions and repossessions on the grounds of consumer protection.
Meanwhile in Cyprus, an event almost as remarkable was briefly averted. For a few days, it looked like deposit insurance was about to be over-ridden for all Cyprus bank customers. The largest Cyprus banks found themselves facing large losses on recent purchases of Greek sovereign debt. As part of a deal to provide rescue funds for them, Northern European finance ministries insisted that depositors bear some share of the burden. Late one Sunday, a plan was announced to levy a 5-7% charge against small depositors and a much larger one against those with deposits larger than 100,000 Euros. As one might expect, this led to pandemonium in the streets and in the Cyprus parliament.
In one way, this episode was a good reminder for us all that deposit guarantees are only as good as the political will that stands behind them. In the case of Cyprus, its Eurozone partners were politically unwilling to rescue the banking system of an offshore financial center widely reviled in the tabloids as a conduit for tax-evasion. Sweden’s politicians did not find it palatable to make whole Russian businessmen. We do agree that large depositors should face some losses during major bank failures. In recent years, many have forgotten that their deposits are liabilities of the banks and only as sound as the institution’s health. Indiscriminate bank rescues perpetuate moral hazard. That said, we believe it was a grave mistake even to suggest that smaller depositors would no longer enjoy full deposit coverage for their accounts. It doesn’t matter whether the levy is called a wealth tax or a deposit charge, imposing losses on small depositors weakens the banking system for everyone. What’s even more embarrassing than the sight of finance ministers making mistakes that Bagehot warned against 150 years ago is that the moment the plan saw clear light of day and they heard the uproar, all the decisions were reversed. So, the EU members have managed to look weak and incompetent while scaring small depositors and instigating a full-fledged bank run within the Eurozone.
So what does this mean for investors in the short and long-term? We believe the European crisis has yet to reach it’s denouement. We live in a interconnected world, and despite record profits for US corporations, any rapid deterioration in Europe or Asia could impact US stocks very quickly. We believe investors will be well-served to exercise caution in equities markets and consider taking profits selectively. Meanwhile, bond investors have to reconcile two competing concerns: any eventual removal of quantitative easing will hurt bond prices, especially since we are seeing record low yields and record highs for bonds. That said, a recession or crisis in Asia or Europe would lead to a flight to quality and likely support US bonds of all types.
Regards,
Louis Berger Subir Grewal