How Corporate Zombies Are Threatening The Eurozone Economy

The recovery in Eurozone growth has become part of the synchronized global growth narrative that most investors are relying on to deliver further gains in equities as we head into 2018. However, the “Zombification” of a chunk of the Eurozone’s corporate sector is not only a major unaddressed structural problem, but it’s getting worse, especially in…you guessed it…Italy and Spain. According to the WSJ.

The Bank for International Settlements, the Basel-based central bank for central banks, defines a zombie as any firm which is at least 10 years old, publicly traded and has interest expenses that exceed the company’s earnings before interest and taxes. Other organizations use different criteria. About 10% of the companies in six eurozone countries, including France, Germany, Italy and Spain are zombies, according to the central bank’s latest data. The percentage is up sharply from 5.5% in 2007. In Italy and Spain, the percentage of zombie companies has tripled since 2007, the Organization for Economic Cooperation and Development estimated in January. Italy’s zombies employed about 10% of all workers and gobbled up nearly 20% of all the capital invested in 2013, the latest year for which figures are available.

The WSJ explains how the ECB’s negative interest rate policy and corporate bond buying are keeping a chunk of the corporate sector, especially in southern Europe on life support. In some cases, even the life support of low rates and debt restructuring is not preventing further deterioration in their metrics. These are the true “Zombie” companies who will probably never come back from being “undead”, i.e. technically dead but still animate. Belatedly, there is some realization of the risks.

Economists and central bankers say zombies undercut prices charged by healthier competitors, create artificial barriers to entry and prevent the flushing out of weak companies and bad loans that typically happens after downturns. Now that the European economy is in growth mode, those zombies and their related debt problems could become a drag on the entire continent.

 

“The zombification of the corporate sector and banks (is) a risk for future living standards,” Klaas Knot, a European Central Bank governor and the head of the Dutch central bank, said in an interview.

 

In some ways, zombie firms are an unintended side effect of years of easy money from the ECB, which rolled out aggressive stimulus policies, including negative interest rates, to support lending and growth. Those policies have been sharply criticized in some richer eurozone countries for making it easier for banks to keep struggling corporate borrowers alive.

Talking of realizing the risk, as usual, the Bundesbank is acting as Mario Draghi silent conscience.

The ECB said in late October it would extend its giant bond-buying program through next September, likely pushing back the date of any interest-rate increase until at least 2019. A small group of central-bank officials opposed the decision, including Jens Weidmann, president of Germany’s Bundesbank. In a speech in September, Mr. Weidmann cited an academic study that concluded a bond-buying program by the ECB in 2012 had helped stabilize banks in southern Europe and boost lending but resulted in more loans to weak companies by the same banks. There was no positive impact on employment or investment, the study found.

The WSJ focuses on two industries with structural challenges, namely retail and shipping, and begins with a company which is an archetypal Zombie, Stefanel.

Italian clothing maker and retailer Stefanel SpA became famous for its knitted coats and cardigans. Many economists, investors and bankers know Stefanel as something starkly different: a zombie company. It has posted an annual loss for nine of the last 10 years and restructured its bank debt at least six times, including several grace periods when Stefanel only had to pay interest on what it owed. After booming during Italy’s post-World War II expansion, Stefanel and its lumbering factories were overwhelmed by Spanish fast-fashion giant Zara and then battered by the economic slowdown that hit Italy in 2008. Stefanel is still alive but staggering. So are hundreds of other chronically unprofitable, highly indebted companies being kept afloat with new infusions from lenders and shareholders, especially in Southern Europe.

 

As the WSJ goes on to highlight, even the radical corporate and debt restructuring of Stefanel has only reduced its debt by 12%.

Banks restructured Stefanel’s debt even when the apparel maker’s financial problems worsened. The banks continued to collect interest, and some of the loans were repaid, but their decisions not to wipe the debt off their balance sheets meant the banks had less money for healthy firms. Stefanel’s lenders included Banca Monte dei Paschi di Siena, where bad loans peaked at nearly $58 billion in 2016. The Italian government took over the bank earlier this year.

The bank and Stefanel declined to comment. As part of a new restructuring plan, two distressed-debt funds will get a 71% stake in Stefanel by year-end for about $13 million. Giuseppe Stefanel, the founder’s son and company’s largest shareholder, will wind up with a stake of about 16%, down from his previous 56%. Banks owed $125 million by Stefanel will see that decline to about $110 million. Banks demanded that Mr. Stefanel give up control and step down as chief executive as a precondition for approving the turnaround plan, according to a person familiar with the matter. Mr. Stefanel will remain non-executive chairman and “have no control whatsoever,” the person said. Mr. Stefanel declined to comment.

We fear that this is unlikely to be enough to see Stefanel through the next downturn. But it’s not just southern Europe, German banks have been the largest lenders to the struggling shipping industry, where Zombie companies abound. Moody’s estimated that the five biggest German lenders to the shipping industry had roughly $26 billion of distressed shipping loans at the end of last year. This is a ratio of 37% compared with total shipping loans and was up from 28% the year before.

The relationship between Nordeutsche Vermoegen and HSH Nordbank is the example the WSJ cites to show how are keeping companies alive, barely. From the WSJ.

“Some of these zombie companies are getting financed at (interest rates of) 2% because banks are trying to throw good money after bad,” said Basil Karatzas, a shipping-industry consultant in New York…German shipping company Norddeutsche Vermoegen Holding GmbH & Co. KG suffered total losses of $1.1 billion from 2010 to 2015. Its debt quadrupled to more than $2 billion, or almost nine times revenue, from 2007 to 2010. The companthe “Zombification” of a chunk of the Eurozone’s corporate sector is not only a major unaddressed structural problem, but it’s getting worsey hasn’t reported annual results for 2016. In 2016, Norddeutsche Vermoegen got a half-billion euros in debt relief from HSH Nordbank, a German bank that was until recently the world’s largest lender to the shipping industry. According to the shipping company’s financial statements, Norddeutsche Vermoegen made a profit due to “loan forgiveness by the bank.” Norddeutsche Vermoegen and HSH Nordbank declined to comment.

The gravity of the situation has warranted greater scrutiny by the ECB as the article explains. Back in May, the ECB announced on-site inspection for banks with exposure to distressed shipping debt. In a speech earlier this month, Draghi acknowledged the bad debt problem, while lamenting that many banks lack the ability to absorb losses.

“We all know the damage that persistently high levels of NPLs can do to banks’ health and credit growth. And though NPL levels have been coming down for significant institutions – from around 7.5 per cent in early 2015 to 5.5 per cent now – the problem is not yet solved. “Many banks still lack the ability to absorb large losses, as their ratio of bad loans to capital and provisions remains high,” he said.

The ECB faces a Catch-22, pressing banks to address the problem more aggressively not only threatens the banks but the provision of credit to the broader economy. The WSJ highlights the Morgan Stanley view that a resolution in Italy, for example, will last a decade.

Italian banks have set aside half of the value of their $407 billion in gross problem loans at the end of 2016, according to the country’s central bank. That means the banks would be hit with billions of euros in additional losses if they sell the loans. Many lenders would rather hold on to the shaky loans and hope for the best. The ECB proposed last month requiring banks to set aside more cash to cover newly classified bad loans. The proposal was criticized by senior Italian officials, including former Prime Minister Matteo Renzi.

 

“If they pass new rules, credit to small businesses will be impossible,” he wrote on Twitter. Some banks in Italy have begun to tackle the problem, including by announcing plans to sell billions of dollars of bad loans within three years. Analysts at Morgan Stanley estimate it will take the country’s banks 10 years to reach the European average for nonperforming loans.

This impressive piece of journalism ends on a thought-provoking note from Portugal which perfectly describes the endless suffering of the corporate “undead” in structurally challenged industries.

In Portugal, a program set up in 2012 by the government as part of the country’s bailout aimed to help heavily indebted companies reach agreements with creditors, avoid insolvency and free up money to invest and grow. In practice, the revitalization program can discourage banks from pulling the plug on battered companies, said Antonio Samagaio, an accounting professor at ISEG-Lisbon School of Economics and Management. The reason: The program allows lenders to take fewer write-downs because debt that isn’t forgiven still is considered performing for accounting purposes. Lisgráfica Impressão e Artes Gráficas SA, one of Portugal’s largest printers, entered the program in early 2013. Banks forgave 65% of the company’s debt and agreed to extend repayments. That helped Lisgráfica to keep most of its workers on the job. Now, though, Lisgráfica is having trouble making its debt payments. The company’s revenue has been hurt by the advertising decline at newspaper and magazine clients. Lisgráfica’s losses are widening.

Of course, at the heart of these structural problems are the failure by central banks too, firstly not create an artificial sense of prosperity via credit bubbles, but secondly, to accept some shorter-term pain for longer-term free-market gain. As Schumpeter asserted “The process of creative destruction is the essential fact about capitalism”, but this isn’t capitalism.  

Fed Hints During Next Recession It Will Roll Out Income Targeting, NIRP  

In a moment of rare insight, two weeks ago in response to a question “Why is establishment media romanticizing communism? Authoritarianism, poverty, starvation, secret police, murder, mass incarceration? WTF?”, we said that this was simply a “prelude to central bank funded universal income”, or in other words, Fed-funded and guaranteed cash for everyone.

On Thursday afternoon, in a stark warning of what’s to come, San Francisco Fed President John Williams confirmed our suspicions when he said that to fight the next recession, global central bankers will be forced to come up with a whole new toolkit of “solutions”, as simply cutting interest rates won’t well, cut it anymore, and in addition to more QE and forward guidance – both of which were used widely in the last recession – the Fed may have to use negative interest rates, as well as untried tools including so-called price-level targeting or nominal-income targeting.

The bolded is a tacit admission that as a result of the aging workforce and the dramatic slack which still remains in the labor force, the US central bank will have to take drastic steps to preserve social order and cohesion.

According to Williams’, Reuters reports, central bankers should take this moment of “relative economic calm” to rethink their approach to monetary policy. Others have echoed Williams’ implicit admission that as a result of 9 years of Fed attempts to stimulate the economy – yet merely ending up with the biggest asset bubble in history – the US finds itself in a dead economic end, such as Chicago Fed Bank President Charles Evans, who recently urged a strategy review at the Fed, but Williams’ call for a worldwide review is considerably more ambitious.

Among Williams’ other suggestions include not only negative interest rates but also raising the inflation target – to 3%, 4% or more, in an attempt to crush debt by making life unbearable for the majority of the population – as it considers new monetary policy frameworks. Still, even the most dovish Fed lunatic has to admit that such strategies would have costs, including those that diverge greatly from the Fed’s current approach. Or maybe not: “price-level targeting, he said, is advantageous because it fits “relatively easily” into the current framework.”

Considering that for the better part of a decade the Fed prescribed lower rates and ZIRP as the cure to the moribund US economy, only to flip and then propose higher rates as the solution to all problems, it is not surprising that even the most insane proposals are currently being contemplated because they fit “relatively easily” into the current framework.

Additionally, confirming that the Fed has learned nothing at all, during a Q&A in San Francisco, Williams said that “negative interest rates need to be on the list” of potential tools the Fed could use in a severe recession. He also said that QE remains more effective in terms of cost-benefit, but “would not exclude that as an option if the circumstances warranted it.”

“If all of us get stuck at the lower bound” then “policy spillovers are far more negative,” Williams said of global economic interconnectedness. “I’m not pushing for” some “United Nations of policy.”

And, touching on our post from mid-September, in which we pointed out that the BOC was preparing to revising its mandate, Williams also said that “the Fed and all central banks should have Canada-like practice of revisiting inflation target every 5 years.”

Meanwhile, the idea of Fed targeting, or funding, “income” is hardly new: back in July, Deutsche Bank was the first institution to admit that the Fed has created “universal basic income for the rich”:

The accommodation and QE have acted as a free insurance policy for the owners of risk, which, given the demographics of stock market participation, in effect has functioned as universal basic income for the rich. It is not difficult to see how disruptive unwind of stimulus could become. Clearly, in this context risk has become a binding constraint.

It is only “symmetric” that everyone else should also benefit from the Fed’s monetary generosity during the next recession.

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Finally, for those curious what will really happen after the next “great liquidity crisis”, JPM’s Marko Kolanovic laid out a comprehensive checklist one month ago. It predicted not only price targeting (i.e., stocks), but also negative income taxes, progressive corporate taxes, new taxes on tech companies, and, of course, hyperinflation. Here is the excerpt.

What will governments and central banks do in the scenario of a great liquidity crisis? If the standard rate cutting and bond purchases don’t suffice, central banks may more explicitly target asset prices (e.g., equities). This may be controversial in light of the potential impact of central bank actions in driving inequality between asset owners and labor. Other ‘out of the box’ solutions could include a negative income tax (one can call this ‘QE for labor’), progressive corporate tax, universal income and others. To address growing pressure on labor from AI, new taxes or settlements may be levied on Technology companies (for instance, they may be required to pick up the social tab for labor destruction brought by artificial intelligence, in an analogy to industrial companies addressing environmental impacts). While we think unlikely, a tail risk could be a backlash against central banks that prompts significant changes in the monetary system. In many possible outcomes, inflation is likely to pick up.

 

The next crisis is also likely to result in social tensions similar to those witnessed 50 years ago in 1968. In 1968, TV and investigative journalism provided a generation of baby boomers access to unfiltered information on social developments such as Vietnam and other proxy wars, Civil rights movements, income inequality, etc. Similar to 1968, the internet today (social media, leaked documents, etc.) provides millennials with unrestricted access to information on a surprisingly similar range of issues. In addition to information, the internet provides a platform for various social groups to become more self-aware, united and organized. Groups span various social dimensions based on differences in income/wealth, race, generation, political party affiliations, and independent stripes ranging from alt-left to alt-right movements. In fact, many recent developments such as the US presidential election, Brexit, independence movements in Europe, etc., already illustrate social tensions that are likely to be amplified in the next financial crisis. How did markets evolve in the aftermath of 1968? Monetary systems were completely revamped (Bretton Woods), inflation rapidly increased, and equities produced zero returns for a decade. The decade ended with a famously wrong Businessweek article ‘the death of equities’ in 1979.

Kolanovic’s warning may have sounded whimsical one month ago. Now, in light of Williams’ words, it appears that it may serve as a blueprint for what comes next.

Congress Discloses Complete Number, Amount Of Harassment Settlements In Past 20 Years

 While it’s not surprising that 2007 – the year when spirits were high, housing prices had just hit a record and the financial bubble was about to burst but not yet- was a “swinging one” on the Hill, with a whopping 25 sexual harassment settlements, the most in the past 20 years, we wonder what happened in 2002 when only 10 settlements led to a near-record $4 million in awards. This question was prompted by the first-ever release of Congressional harassment records, unveiled yesterday for the first time by the Congressional Office of Compliance.

Below is the breakdown of settlement number by year since 1997…

… and the amount quietly paid out in settlement awards:

To be sure, the controversial and sensitive issue of Congressional harassments has taken center stage this week, with female lawmakers making fresh allegations of sexual harassment against unnamed members who are currently in office, and the unveiling of a new bill on Wednesday to change how sexual harassment complaints are reported and resolved. On Thursday, a former Playboy playmate shared her story of being groped and kissed without her consent by Sen. Al Franken in 2006.

And until yesterday, there was little specific data to help illuminate just how pervasive sexual harassment is on Capitol Hill, but finally, one figure has emerged: the total that the Office of Compliance, the office that handles harassment complaints, has paid to victims. On Thursday, the Office of Compliance released additional information indicating that it has paid victims more than $17 million since its creation in the 1990s. That includes all settlements, not just related to sexual harassment, but also discrimination and other cases.

According to CNN, an OOC spokeswoman said the office was releasing the extra data “due to the interest in the awards and settlement figures.” The OOC has come under fire in recent days for what lawmakers and Hill aides alike say are its antiquated policies that do not adequately protect victims who file complaints. CNN also learned that during the current Congress, no settlement payment approval requests have been made to the congressional committee charged with approving them.

Here’s what we know about that money:

When was this money paid out?

According to a report from the Office of Compliance, more than $17 million has been paid out in settlements over a period of 20 years — 1997 to 2017.

How many settlements have there been?

According to the OOC data released Thursday, there have been 264 settlements. On Wednesday, Rep. Jackie Speier, the California Democrat who unveiled a bill to reform the OOC, announced at a news conference Wednesday that there had been 260 settlements

Where did the settlement money come from?

Taxpayers. Once a settlement is reached, the money is not paid out of an individual lawmaker’s office but rather comes out of a special fund set up to handle this within the US Treasury — meaning taxpayers are footing the bill. The fund was set up by the Congressional Accountability Act, the 1995 law that created the Office of Compliance.

How many of the settlements were sexual harassment-related?

It’s not clear. Speier told CNN’s Wolf Blitzer on Wednesday that the 260 settlements represent those related to all kinds of complaints, including sexual harassment as well as racial, religious or disability-related discrimination complaints. The OOC has not made public the breakdown of the settlements, and Speier says she’s pursuing other avenues to find out the total.

In its latest disclosure, the OOC said that statistics on payments are “not further broken down into specific claims because settlements may involve cases that allege violations of more than one of the 13 statutes incorporated by the (Congressional Accountability Act).”

Who knows about the settlements and payments?

After a settlement is reached, a payment must be approved by the chairman and ranking member of the House administration committee, an aide to Chairman Gregg Harper, a Mississippi Republican, told CNN.
The aide also said that “since becoming chair of the committee, Chairman Harper has not received any settlement requests.” Harper became chairman of the panel at the beginning of this year. It’s not clear how many other lawmakers — if any — in addition to the House administration committee’s top two members are privy to details about the settlements and payments.

A source in House Speaker Paul Ryan‘s office told CNN that Ryan is not made aware of the details of harassment settlements. That source also said that the top Democrat and Republican on the House administration committee review proposed settlements and both must approve the payments. Similarly, a source in Minority Leader Nancy Pelosi‘s office told CNN that Pelosi also is not made aware of those details and that they are confined to the parties of the settlement and the leaders of the administration committee. “Leader Pelosi has expressed support for the efforts of Rep. Speier who is working on multiple bills to reform the secretive and woefully inadequate process,” the source added.

When asked about Ryan’s knowledge of any sexual harassment settlements, a spokesperson for Ryan’s office noted that the committee is conducting a full review of workplace harassment and discrimination.
What do these settlements tell us about the scope of the sexual harassment problem on Capitol Hill?

It is unclear how much of the $17 million is money paid to sexual harassment cases because of the Office of Compliance’s complex reporting process. However, even knowing that dollar figure doesn’t quantify the problem: a source within the Office of Compliance tells CNN that between 40 and 50% of harassment claims settle after mediation — an early stage in the multi-tiered reporting process.

And the number of settlements reached may not be indicative of how widespread sexual harassment is, as many victims chose not to proceed with OOC’s process for handling complaints. Tracy Manzer, a spokeswoman for Speier, told CNN last week 80% of people who have come to their office with stories of sexual misconduct in the last few weeks have chosen not to report the incidents to the OOC.

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Now if only we could find out just what happened in 2002 to make that year such an outlier in terms of settlement awards… although we have the feeling the Bill Clinton may somehow be involved.