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Banks push Germany to the brink
Three years as one of the worst stock markets in the world doesn't mean Germany's troubles are almost over. Here's how its decline resembles Japan's-- and why things are likely to get worse.
By Jon D. Markman
The German stock market has been the worst performer in the developed world over the past three years, and most of the emerging world, as well. Yet it is possible that the worst is yet to come in Frankfurt, as this epic plunge in equity values has only recently begun to erode the creditworthiness of German stocks majority holders -- large banks at the countrys moldering core.
The slow-motion collapse has not induced the sort of public anguish in Germany that the bear market has engendered in the United States because relatively few of the nations citizens are shareholders. But bank failures -- in the unlikely event theyre allowed to occur -- could change that, since most German workers put their income in savings accounts and depend on an increasingly shaky latticework of bank-backed bonds for their retirement. And the damage would not be limited to the Continent, as German financial institutions own such U.S. market stalwarts as the Pimco and Scudder families of mutual funds, among others.
Risk on the Rhine has intensified in recent weeks, as the countrys break with the United States over the disarmament of Iraq has led to the possibility that the United States could close some of its military bases there and pull out a significant percentage of its 70,000 troops. These troops are a major source of revenue for local German governments and retailers, and a wholesale redeployment of U.S. troops to friendlier and lower-cost countries like Poland and Bulgaria could weaken an already extremely fragile economy. Last week, Bulgarias defense minister told reporters that his government had high-level talks with the Pentagon about the possibility of providing four or five bases to the United States.
How much has the stock market in Frankfurt already suffered?- Over the past three years, the benchmark measure of U.S. stocks, the Dow Jones Industrial Average ($INDU), has fallen 24%, from 10,400 to 7,890.
- During the same time period, the benchmark measure of the German stock market, the Frankfurt DAX ($DE:DAX) has plunged 69%, from 7,960 to 2,547.
- If the Dow had fallen as much as the DAX from its peak, it would be currently hovering around the 3,220 level.
What a comedown for a country whose economy not long ago seemed as formidable as Japan's -- and now seems a candidate to follow Japan down a decadelong rat hole.
Debt downgrade ahead?
The analogy is more apt than you might imagine, for the trap for both countries economic demise was set in a postwar system that allowed banks to invest heavily in the equities of companies to which they lent money. The problem was exacerbated in Germany in the early 1990s because the government encouraged banks to make ill-considered loans to bail out its Eastern Bloc cousins following the fall of the Iron Curtain. West Germany, as the country was formerly known, was expected to be the locomotive of growth for East Germany and, for that matter, the entire European Monetary Union. But that growth did not materialize, ruining hundreds of business plans. Additionally, in many cases, West German banks ended up lending millions of deutschemarks against real estate and state-owned businesses in the east that had far more political than economic value. These deals have come dramatically undone, leaving the banks with massive losses.
The crisis has essentially led critics to view Germany, in the extreme, as if it were a gigantic junk bond. Buying into the debt or equity of the countrys largest international firms, such as car maker DaimlerChrysler (DCX, news, msgs) or financial-services giant Allianz (AZ, news, msgs), at the right moment will yield enormous profits. But blow the timing, and youre going to feel like a big, fat schweinhund.
Timing is growing trickier by the day, as little progress has been made since the sovereign debt-rating chief at Fitch Investor Services said in December that Germany's triple-A rating could "no longer be taken for granted." Likewise, Standard & Poor's at the same time pointed to the country's fiscal deterioration as an indication that it "has begun to fall behind its triple-A rated peers in terms of fiscal and economic indicators." The agency said its rating of German debt could come under pressure if the country did not adopt a consistent long-term approach in addressing the challenges of eliminating structural budget deficits, increasing employment and growth, and putting the increasingly overburdened health and pension systems on a more solid footing."
A downgrade, if it comes, would be a huge psychological blow to Germany at the same time it would make borrowing much more expensive. From a financial standpoint, the country would be forced to shrug off its mantle as a financial superpower and join the likes of Canada, Spain and Sweden among the world's somewhat flimsier AA+ credits -- a humiliating step down from AAA. The good news, according to Fitch managing director Fred Puorro, is that a downgrade would probably finally force Germany to consider deep structural change just as the United States did after its savings-and-loan crisis in the 1980s. A key improvement, he said, would be a consolidation in the number of banks from 2,700 to more like 1,500.
Conflicts of interest
To explain why the fit between the declines in Germany and Japan is so apt, we turn to Christopher von Schirach-Szmigiel, a finance professor at Penn State University and an authority on the subject.
Von Schirach-Szmigiel said in an interview that the similarity starts with the two countries patterns of saving. In both Germany and Japan, most workers put their money in banks, not the stock market. The banks then take workers money and put it to work in the debt and equity of corporations.
You would probably imagine that the banks would wisely invest workers funds in a diverse cross-section of industries, but events have proven that notion nave. Both German and Japanese banks have been heavily involved in the ownership of their countries major corporations since 1946, when relationships between a handful of leading families and businesses was replaced with a relationship between a handful of government-controlled banks and businesses. As a result, Deutsche Bank (DB, news, msgs), Dresdner Bank and others are not just lenders to companies, but also to their majority owners -- an often-toxic conflict that has led repeatedly to misallocation of capital.
Exacerbating this problem are German banking rules that permit loans to companies whose capital structure consists of as little as 8% to 10% equity, with the rest composed of debt. And Von Schirach-Szmigiel says that banks regularly circumvent this regulation by allowing clients to issue stock at times when the balance is in danger of being breached. This compares to a worse practice in Japan, where banks may lend to companies at which equity makes up just 5% of the capital structure. In both cases, instead of forcing companies to solve their problems with responsible growth plans, banks keep throwing workers hard-earned money at them, hoping the problems go away. By contrast, a U.S. bank would generally be nervous about lending to a company if it had less than 20% of its own funds on its balance sheet, and 15% is an absolute non-starter.
Because there are so many interlocked relationships between German banks and their families of industrial customers, diminished equity values at the companies will ultimately lead to huge problems in the countrys overall financial structure. Commerzbank (CRZBY, news, msgs), Germanys third-largest bank, lost a quarter of its value in a single week in October after a number of its borrowers failed to deliver on payments and a liquidity crisis was feared. The incipient collapse was staunched when the federal Bundesbank hinted it would back the bank's credits and provide liquidity. But after a brief recovery it is in danger of sliding back into the abyss. "German banks have by far the lowest margins of any industrialized country in the world," Commerzbank chief Klaus-Peter Mueller said last month.
Things will worsen for Germany
Isolation from the United States under the leadership of Chancellor Gerhard Schroeder is not going to help. U.S. fund managers have cut their exposure to German equities; the growing rift could lead to a boycott of German goods or increased tariffs. Said Mark Anderson, a technology newsletter publisher who keeps close tabs on both the Japanese and German economies because of their prominent role as buyers of U.S. software and hardware: It looks like the first chapter of an economy in decline, not something near the end. Germany's gross domestic product grew just 0.2% in 2002, its slowest rate in nine years. The government expects growth of 1% this year, a view widely considered overly optimistic. Theres just too much debt to support the low level of economic activity. Whereas AAA-rated countries like the United Kingdom and United States have kept public debt to around 38%-45% of gross domestic product, Germanys debt is around 70% of GDP. (For comparison, AA+-rated Canada is at around 75%, Italy is at 100% and Japan is at a staggering 140%, says Puorro at Fitch.)
Where this ends is anyones guess. Japan has not figured how to end its cycle of recession, anemic recovery and deflation more than a dozen years after its stock market began to collapse. Presumably, economic allies in the European Union will help Germany to wriggle out of its crisis a lot sooner. A couple of stocks in the following table should show the first signs of life, if and when a recovery comes.
| Top 10 German big caps | | Company | Industry | Market cap ($ billions) | % Chg 1 yr | Rev growth yr/yr | Price/sales ratio | March 7 price | | BASF (BF, news, msgs) | Chemicals maker | 21.1 | -6.1 | -14.1 | 0.8 | $35.59 | | E.ON (EON, news, msgs) | Power/energy | 27 | -15.3 | -9 | 0.7 | $42.21 | | Deutsche Telekom (DT, news, msgs) | Telecom | 48.1 | -21.3 | 11.7 | 1.1 | $11.13 | | DaimlerChrysler (DCX, news, msgs) | Automaker | 30.9 | -26.3 | 15.3 | 0.2 | $29.35 | | Deutsche Bank (DB, news, msgs) | Money center bank | 25 | -32.2 | -14.5 | 0.4 | $41.17 | | Siemens (SI, news, msgs) | Conglomerates | 35.2 | -34.3 | -3.9 | 0.45 | 40.00 | | Schering (SHR, news, msgs) | Drug maker | 7.3 | -35.1 | 2.2 | 1.6 | $39.01 | | SAP (SAP, news, msgs) | Software maker | 25.8 | -40.8 | 19.2 | 3.3 | $19.50 | | Bayer (BAY, news, msgs) | Drug maker | 9.8 | -58.4 | -7.1 | 0.4 | $13.26 | | Allianz (AZ, news, msgs) | Insurer | 17.4 | -68.7 | 18.2 | 0.2 | $6.86 | | Infineon Technologies (IFX, news, msgs) | Semiconductor maker | 4.6 | -73.2 | -8.6 | 0.8 | $6.46 |
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Fine Print
Mondays action for the broad market indexes was another outside reversal day, and eerily reminiscent of Dec. 2 -- the day that marked the end of the October-November uptrend. In this case, the trend that would be reversed was the minor uptrend from Feb. 14 to Feb. 28. If you recall from my column on Dec. 4, Ready for a nasty reversal of fortune?, an outside reversal occurs when a days high and low are higher and lower than the previous days high and low, and the close is at whichever extreme would reverse the prior trend. The outside reversal on Dec. 2 was extremely robust, setting in motion a three-month decline after a two-month rally. The next outside reversal for the indexes occurred on Jan. 15, reversing the rally from Jan. 3 to Jan. 14. On that day, the high for the S&P 500 Index ($INX) was 932, and the close at 918 set in motion the decline into the low 800s in mid-February. Here are the numbers for the current reversal day: On Feb 28, the index high was 847, the low was 837 and the close was 841. On March 3, the high was 852, the low was 832 and the close was 834. There were also outside reversals in the Nasdaq Composite ($COMPX) and the Dow Jones Industrial Average ($INDU). Two convenient ways to play the German stock market are through the closed-end Germany Fund (GER, news, msgs) and the iShares MSCI Germany Index (EWG, news, msgs). The latter can be shorted, if thats your cup of tea.
Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at supermodels@jonmark.com. At the time of publication, his fund was short Deutsche Telekom and Siemens, but positions can change at any time.
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