By Martin Hutchinson
Chief Global Investing Strategist
Many markets in continental Europe haven’t exactly been the best places to invest over the past 20 years. And unless there are some big changes in France, Germany and Italy – and relatively soon – the future profit opportunities may continue to be as bland as day-old white bread.
Yes, France seems to offer some real promise – thanks to Nicholas Sarkozy, the country’s new, reform-minded president. But Germany and Italy are headed nowhere fast.
There’s a reason that investors in this part of the world have such big problems. And maybe the best way to explain it is this: Europeans just won’t euthanize the stupid. In France, Germany and Italy, the unions are very powerful and the masses generally seem to believe that well-established institutions should be rescued, because their failure would be so disruptive. Economically, if you let the stupid live, there’s no incentive for companies to act intelligently. Let me show you what I mean…
The German bank IKB Deutsche Industriebank AG was bailed out on Monday by other German banks to the tune of about $11 billion. Why the need for a bailout, you ask? Simple: It lost a bundle in the US sub-prime mortgage market, where it had a total exposure of $17 billion.
IKB was unquestionably stupid. It’s a medium-sized part of the Byzantine German banking system, part owned by other banks, which are themselves part owned by state and regional governments. It was primarily a corporate lender to medium-sized German companies, a role it filled pretty well.
As part of this role, it no doubt needed a U.S. office; after all many German companies export here, though in general only the large companies such as BMW and Siemens have U.S.-based operations that need financing.
Having opened that U.S. office, IKB’s mistake was to go beyond arranging introductions and having good lunches, and try to make money in a market in which they had neither an expertise nor a natural business.
If you’re a management hotshot who’s been made head of IKB’s U.S. operation and given a profit budget, you’re going to find it difficult to make that budget. The easiest way to do so, in a period when the markets are active, is with high-risk loans, generally sold to you by aggressive investment bankers.
The high-interest-rate payments and fees on the loans come in first, and make your budget, while the loan losses take some time to develop – hopefully not before you’ve been transferred back to Germany (with a pat on the back and a promotion for your “fine performance” dealing with all those undisciplined Yanks).
Normally, an internal “credit committee” is supposed to keep a bank from taking on too many risky investments. However, when already-complicated U.S. loans are then sliced and diced into collateralized loan obligations – and then sold to investors, like IKB – it becomes very difficult for the domestic credit committee of a German bank to figure out just what they’re getting into. Thus if the deal looks profitable, they generally allow it.
In IKB’s case, the most attractive possibilities seemed to be in the U.S. sub-prime mortgage market. For a time, IKB’s U.S. lending venture was profitable; indeed in 2006-2007 it had a far higher return than the other parts of its business.
It couldn’t last, however: The inevitable eventually occurred, and the bank was swamped by growing credit problems.
It’s an old story, but it’s also quite common. Indeed, it’s very likely that other foreign banks will face problems of their own, either in the sub-prime mortgage market, or in the leveraged buyout (LBO) market, where U.S. investment banks have been equally aggressive recently.
In the U.S. market, when a bank gets stung like this, authorities let the bank go belly up – unless it’s so big that the entire system might be endangered. Even when the problem is industrywide – as is true of the current sub-prime mortgage crisis – regulators and lawmakers are typically reluctant to sweep away the problems with one big bailout.
In Europe, however, the philosophy varies from one market to the next. Britain and Scandinavia take a fairly U.S. approach. In Eastern Europe, so much has gone bankrupt in the transition from Communism that they’re used to it, so they also take the U.S. approach.
But continental Europe just can’t bear to see its big companies fail. When Credit Lyonnais, the big French bank, lost gigantic amounts of money in the Michael Milken/Drexel Burnham Lambert junk-bond collapse of the early 1990s, French taxpayers essentially wrote a big check to save it, and it stayed in business until it was taken over by Credit Agricole a decade later.
Germany has “specialist banks” that fill carefully defined niches (German giant Deutsche Bank, for instance, was formed as a specialist bank for foreign trade in Berlin when it was founded in 1870; now it’s a global investment bank). So any specialist appears irreplaceable: If IKB disappeared, for instance, how would mid-sized firms find financing? Since IKB’s main business remains perfectly solid, it was natural for Germany to organize a bailout.
The problem with bailouts is that they reward stupidity. It’s not just in banking: Italy bailed out its Fiat automaker a few years ago, and it is now quite profitable. But these bailouts reward failure; they provide extra resources to banks and companies that make huge mistakes. This, in turn, encourages management to reinforce failure – if bailouts only happen when bankruptcy threatens, you’d better make sure that any losses are really big ones so that you grab politicians’ attention.
Countries that reward failure caused by stupidity get more stupidity, and less brilliance, since that spark of cleverness and innovation gets suppressed. The reason: Big, stupidly run companies that were subsidized to avoid failure can’t help but crowd out small companies that are now at a competitive and financial disadvantage. That’s the marketplace reality of this “we-can’t-let-it-fail” philosophy.
Even when some of these countries have excellent capabilities in particular area – and perhaps even a competitive or economic advantage, the higher taxes and onerous cost structures built up by these “failure-subsidy payments” prevent true success from being fully realized and adequately rewarded. And don’t even get me started talking about productivity – a key factor that separates winners from losers, no matter if we’re talking a single company, or an entire country. Brilliance and innovation are artificially suppressed, so productivity growth tends to be very sluggish.
In much of Europe, the market forces aren’t permitted to work their magic. Every now and then, a good investment opportunity arises in France, Germany or Italy. But there are nowhere near as many as there should be. That’s why you’re much more likely to make money in Asia, or in the United States.
Where market forces are allowed to work, profits are more likely to follow.
Martin O. Hutchinson is the Chief Global Investing Strategist for Money Morning, and an advisory panelist for the monthly investment newsletter, The Money Map Report. An investment banker with more than 25 years’ experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets