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Asher Edelman on Euro banks and the liquidity crisis

Flickr. Mario Draghi’s ECB is helping fuel a possible implosion by propping up the E.U. banking sector, says Asher Edelman.

Octavian Report: How did you get your start in finance?

Asher Edelman: I worked as a “runner” in high school. We used to deliver the actual certificates on Wall Street. I worked for the firm that Bernard Baruch dealt through, Sartorius and Company. He was a friend of my grandfather who got me the job.

I became a research assistant during the summers, while still in high school. After college I was offered a job with an old-line arbitrage firm called Halley and Stieglitz, and I took it, with a lot of amusing intervals in between. At 24, I opened an office for them on Madison Avenue and 67th Street, where we specialized in option hedging and trading but with clients’ money and doing conversions and various forms of creating high rates of interest at no risk for the firm. Then, I joined a firm called Carter, Berlind, and Weill, which eventually became Shearson Lehman. I worked for them for a short time in the States, and then in Europe, in late 1965, and started what eventually became the investment banking offices and trading business of Lehman Brothers abroad.

After four years, when I was 29, I came back and started my own firm, Mack, Bushnell, and Edelman. We became sort of a much smaller Donaldson, Lufkin, and Jenrette in a way, except we did more principal trading than they did. We developed a series of derivatives, mainly focused on convertible bonds and options, and for a while had the largest hedging business on the CBOE. Ultimately, I trimmed that business down because the 1970’s were an odd time in the world, as you may recall — sort of like what’s going to happen next year. We trimmed the business down to a trading arbitrage house, along with what eventually became what they then called corporate raiding (what we now call whatever we call it).

I trimmed that to completely my own firm or firms, which led to the deals that you read about in the late 1970s and 1980s. Then in 1988, I left Wall Street and moved to Switzerland and ran an art museum over there. We opened in 1990, and I closed it in 1995. I didn’t want to be an administrator any more. I returned to New York in 2002 and began to develop the art and art finance business.

OR: Did Wall Street change dramatically over that period of time?

Edelman: People were still thinking up through the mid-1980s, and then they became reactive and have stayed reactive ever since. For example, we’re in an interesting liquidity crisis now. Actually, we’ve been in an interesting liquidity crisis for a very long time, but now it’s emphatic. Very little thinking goes on anymore, either on Wall Street or in the general world of economics. I think most developments are reactive, and the reactions have to do much more with popular culture than working through the real details and facts.

There was a time when your investment bankers and your lawyers were really working for you. I think that as the 1980s emerged, the investment banks and lawyers began working more and more for themselves, and you could see that in the quality of the work that they gave their clients, and the protection that they offered declined.

OR: When you look back over your career, does the current moment remind you of another particular time?

Edelman: I think there are two things that may play out. We could go gradually into recession, and like in the 1970s the war drums will beat and you’ll get a tremendous impact from the war machine. The war machine imbalances the economy so that you’ll have certain sectors of the economy that are lively and basically inflationary, because war machines are inflationary by nature. The rest of the economy will head for the doghouse.

OR: That would be driven by a Republican presidential victory in 2016?

Edelman: Not necessarily. It could be driven by a Clinton victory or by a Republican victory, because all of them work closely with, let’s say, the warriors or the warrior-producers, and believe that America should be in a certain position in terms of arms sales and controlling the world. They understand very well, I believe, that there’s a certain economy that supports them politically when the war machine is turning. We’ve seen that pretty often, and you almost always see it in very difficult economic times. It’s an American tradition.

I also think you can have another bang, as in 2008. We look at that through the perspective of markets, because that’s where we have been brought up. I think it is really a matter of economics. The markets follow, or they don’t. Maybe they precede. But I think that isn’t really the important issue. I think the important issue is: what happens next economically? It could be one of two things, and nothing else. It will either be slipping into serious, long-term recession. I don’t think we’ve ever slipped out of recession, by the way, because the GDP can grow, but the GDP’s growth does not fuel consumption on any levels other than the top, at this point.

You have half of the nation, or maybe 80 percent, struggling as though we were in a recession, and maybe a half to 20 percent not in a recession. That’s still a recession, as we judge recessions, and will probably come either gradually — meaning in the next few months — or soon. If it’s very soon, I think you’ll probably see various markets back below their 2011 numbers.

How will it happen? People would tell you that it’s oil, and that is a factor, but it has positives, too. People will tell you that it’s emerging markets. Certainly, emerging markets are problematic today, because China and other sources of demand have dried up, and emerging markets have an effect on the rest of the world. But they were in the same doldrums for 50 years. It’s only for the last 10 or 15 that they’ve been changing, and we’ve managed both before and after.
If we’re going to have another economic crash, it’s probably going to come from left field. The reasons are probably never the evident reasons, because the evident reasons get absorbed in the day-to-day lives and in the day-to-day views of people, and they get used to it. We’re now used to 50 people being killed in Nigeria every day or ISIS raiding even Saudi Arabia or Egypt in total economic chaos. These events don’t really have much of an effect on the so-called civilized world’s economics.

What we’re not used to, and what we haven’t paid attention to, if it hits like a bomb, are the things that create what we saw in 2008 and which leave us with a very, very big stone to push up the mountain.

The two things I see that could put us back there very quickly are, first, the illiquidity of almost every form of debt at the moment. You can’t resell it. And by the way, this has nothing to do with Dodd-Frank, because before Dodd-Frank, we had 2007-2008. You can’t blame Dodd-Frank. Then, we have in that marketplace of no liquidity the second thing: derivatives portfolios in U.S. banks that, if you examine their backing, are greater than the GDP of the entire world and more than three times what they were in 2007. You have no liquidity, and you have all of this silliness going on, and you have the banks themselves who use it as a form of speculating. And regulators who don’t have a clue.

Until we have Glass-Steagall back, we will always have banks that prefer not to lend and use their capital to speculate. That will always be a drag on the economy and a risk to the economy. That doesn’t mean we’re going to get Glass-Steagall back, but banks should be in a position where lending is their main business. Investment banks and other forms of speculative vehicles, where the risk is to the shareholders and the bondholders, should be the people who play the other games. This isn’t the case with the banks today.

Free capital should not be used for speculation. Capital for speculation should be capital that earns some of the profits of the speculation, indeed most of the profits, and loses when the speculation loses. You should not have free capital to speculate with, given to the banks by both their depositors and the government.

You have to hope that Bernie Sanders wins in November, because otherwise the banks will go along on their merry way, and then when it really all hits, it will hit even worse. Bernie may not be able to get anything done, but I think there’s no one else in the race who has a program that might possibly work for this country.

OR: Do you think European banks are particularly vulnerable?

Edelman: There we get into the most interesting issue of all. I’ve dedicated time recently to considering the distressed debt in Europe. Generally speaking, the banks in Europe — the biggest, the smallest, the government ones too — have been in a business of cronyism for the last 25 or maybe 50 years, though they do not play derivatives games at the level that we do.

Let’s say I own a bank. Call it the Espirito Santo Bank, in Portugal. That bank is related to a string of companies, in total value (theoretically, because they’re all bankrupt now) larger than any other semi-private or private string of companies in Europe. Legally, I can’t actually lend to those companies, but I do that anyway through other routes. However, I have an arrangement with all the other banks in Portugal, or most of them. That arrangement is as follows. You, Mr. Government Bank, lend to my clients, and I will lend to the people who you can’t lend to, or where you’re up to the limit. We will have a handshake that will protect us.

Multiply that by six or seven major banks in a small country like Portugal, all doing that for each other. Now, imagine the central company group has a scandal or a swindle, and goes bankrupt. In that bankruptcy, 10 billion euros are missing, of which probably two billion euros were actually stolen, and the rest is lost. As a result, the institution in the center cannot wash the other hands, so they’re all sitting on bad paper. However, that happens in every country in Europe, and the cronyism is extraordinary. Now, it gets even more interesting. What do you do? Let’s say some of the bad paper was loans against real estate and this has been going on for 15 years — and then that real estate defaults. These banks don’t write off their defaults at all. They sit on them for two, three, four, five years. They don’t re-sell the debt at all.

But forget that for a moment. We now have foreclosed. Some of our other banking friends have defaults as well, on other pieces of real estate. We set up a holding company, and we dump all this real estate into the holding company. We declare whatever value the default was to be the value of the property in this holding company. So we have a holding company with, in many cases, almost worthless real estate: land, buildings that have no tenants anymore. And we’re carrying that effectively at par on our balance sheet, because we now own an equity interest in those holding companies.

That is not good capital from a reserve point of view, but our balance sheet still looks pretty cool. We look like we have equity and we have assets, and we don’t. This is the case throughout Europe. Now suddenly, the government comes along. In the case of Espirito Santo, they split it into a good bank and a bad bank and they put up more than four billion euros to rescue it. This money comes from the larger fund the E.U. set up to bail out Portugal.
That’s great, because they’re going to pay it back. They’re going to sell the “good bank,” and blah, blah, blah. The good bank is called Novo Bank. Some of these assets are carried at par. The loans are non-recourse and the collateral is worthless. Maybe, from a strategic point of view, it’s worth a million euros, and carried at 40. There are hundreds of such loans that are still on the books of Novo Bank.

The government attempts to sell Novo Bank to get their four billion back. What do you know? Apollo didn’t think it was worth four billion, and the Chinese bankers didn’t think it was worth four billion. They said, “There’s a lot of stuff in here that has no value.” What did the government owners do? They said, “OK, that’s fine, we’ll fix it.” Goldman Sachs, a shareholder of Novo Bank which was in its own way maybe a little aggressive towards the end, loans them $835 million in clients’ money. The central bank said, “$835 million from Goldman clients, and Goldman’s a shareholder in this company? Let’s move it over to the bad bank.” Where the $835 million becomes worthless.

Then, they go on and keep trying to sell Novo Bank, and they discover it’s not very good. What’s going on here? “We don’t have enough asset value to get anything much out of it.” A bond was floated under Portuguese law, not English or American law, for, I believe, 1.2 billion euros. The central bank came in and said “We can’t get our four billion back here. Let’s move these notes over to the bad bank.” Another 1.2 billion euros taken from creditors of the bank to satisfy the equity holder, the government!

They’re never going to get their four billion anyway, but now they’ve taken more than two billion away from debtholders, just sort of by declaring that they’re taking them away. The situation is quite the same in Italy, if you begin to look at what’s happened to some of the smaller banks. Though the big banks are in the same position. It’s the same in all the other banks in Portugal. It’s quite the same in Greece. It’s quite the same in Cyprus. It’s quite the same in France. This exists throughout Europe. This is being very well hidden, because now they have a central European money source, and that money source appears to be Germany. They’re all contributing towards maintaining the life of these banks, and more importantly maintaining sovereign liquidity.

You see Portugal, Spain, and others selling debt to the marketplace at the same rates, almost, as Germany. How do you think that’s going on? That is a product of the quantitative easing in Europe. The central banks are buying the other banks’ debt. That is essentially how they’re continuing to keep these rates where they are for the sovereigns. It can’t be done forever. There are too many countries and one currency.

I think that eventually this is unveiled, maybe sooner rather than later. When it’s clear that these banks are bankrupt, and that the governments have no chance of existing, that could be the catalyst for 2008 again, and it would be the catalyst for a very long-term depression. Not oil prices, not all the rest of this stuff. If you’re going to get something very serious, that’s where it’s going to come from.

OR: Espirito Santo already blew up, and Greece blew up the market.

Edelman: It hasn’t. You have a government-owned bank, Caixa, that is completely blown up, too. It hasn’t blown up. It’s only partially blown up.

OR: Do you think that this thing has to move to a large country for it to really have an impact more broadly?

Edelman: No. Is France a large country? It’s in the same situation. Germany’s in a slightly different situation. You’re not required to fund your pension plans in Germany, so if companies like Volkswagen actually got in real trouble, which is not unlikely, the government has to fund the pensions. The government doesn’t have the money to fund the pensions. I had a company in Germany, and when I decided that I wanted to reduce it or to close it, I was advised by the attorneys, “Simply put it in a bankruptcy, because then the government will take over the pensions. They have to, and you’ll never have to fund them.” Germany’s not quite as good as it looks, if business ever really slows down. There’s no country in Europe that really is comfortable. Maybe Switzerland, maybe Norway.

OR: Do you see the euro breaking apart?

Edelman: I think the euro, for the benefit of the smaller countries, needs to break apart. They need a fresh start. They need a currency that they can manipulate themselves, not be restricted by commitments to a system that doesn’t work. I have friends in government in Greece, and I think that Greece should have broken away, right away, and would have had a chance of survival. Because they’re just being beaten to death. Can you imagine? The European Union is telling them, “You keep the refugees, and we’re not going to give you money to support them.” It’s insane. There’s no common market. There’s no common good. It worked when things were good, but it doesn’t work when things are bad. It has to break up. It has to break up, even if the rest doesn’t happen.

OR: Do you think there will be huge amounts of quantitative easing before that happens?

Edelman: Yes, I think they’re going to keep kicking the can down the road. They’ve been doing it for 40 years, but I’m not sure they can do it for another 40; maybe another four, maximum.

OR: So you see a massive crisis hitting Europe in the next five years?

Edelman: Yes. And I think it could happen in the next two or three years. Or one year.

OR: Do you think Europe is more troubling than the slowdown in China?

Edelman: I think Europe is more of an emergency than China. I think China started out very poor and might get poorer for a while, but I don’t think they’ve had the time to build this façade of financial mystery and veils. They’ll have bankruptcies, they’ll have whatever they have, but it’s not that much of an engine of demand. It remains an engine of supply. I don’t think China is so relevant here.
The problems that we’re seeing in the marketplaces, which people are pinning again on China, the emerging markets, and oil, may be the problems in the markets: they all affect earnings in one way or another, and consumption. But I don’t think those are the real problems in the economy. Those are things that time works through. Those are not big bangs.

OR: Do you think the lack of liquidity is due to bank insolvency?

Edelman: It’s clear that the underlying businesses there are not able to carry their debt loads assumed when the world was buying stocks and looking for yield of any kind. It was reactionary. Anything you put out there with eight or nine percent would get eaten up. No one looked at what was behind it. What is this company? What is it doing? How is it going to pay my debt? “Oh, it’s going to buy something, or it’s going to do this.” That’s bull.

That’s why there’s a lack of liquidity. There was a lot of liquidity, but it didn’t come from banks. The liquidity came from companies and people who had nothing to do with their money. Now, they see that didn’t work. They were supposed to think, but they didn’t think.

OR: Where do you see the art market going from here?

Edelman: The art market has gone completely quiet in the last six months. It’s a very hard market to measure. We have the advantage of being able to monitor a great deal of the private life of the art market, the private transactions as well as the auction transactions. Whatever happens in the economy now, the art market’s going to look like the early 1990s, when you didn’t really know how much it was down or not because it didn’t trade very much. There was reluctance from sellers because they thought they weren’t getting enough, and certainly there were reluctant buyers. So things didn’t really come to the market and get taken up. You really didn’t know what the values were. I think the same thing is happening now. I think you could be looking at a couple years of an art market that’s hard to judge, and that probably drips down.

OR: In the early 1990s, there was a real collapse.

Edelman: You had a collapse of the type of art that’s already collapsed now; all the stuff that’s been going from $20,000 to $200,000 is back at $20,000 at best already. You had that kind of collapse. It was more evident because there were fewer names and you could track them, but you’ve had that in the last six months already.

What happened in the very early 1990s has happened. What happens next is what happens to the quality stuff, the blue chips. I mean blue chip in the sense of high-quality, long-proven artists. We don’t really know what’s happened there yet. We know it’s lower, but it hasn’t collapsed. The junk has collapsed. In 1990 Jasper Johns went down from, say, $1 million to $600,000. I don’t think that’s absurd. The market’s going back to 2011 or before, if what I think is going to happen happens. How far down is that? 40 percent, probably.

OR: Let’s talk about the blue chip side of the market — say, a Basquiat that climbed from $1 million to $10 million to $50 million. Do you see it going back to $10 million?

Edelman: I’m in the business of financing art, so I will tell you one thing right off. You cannot take outliers as anything to do with the market. When you’re dealing with the market, you need to take the outliers out.

Why is that? Because if one or two of the people who are going to be at that auction to buy the $50-million Basquiat decided they weren’t going to be at that auction, it wouldn’t sell. It’s an outlier. However, if you take Basquiats that have gone from $1 million to $5 million — not outliers, that’s in the band — I believe they’ll be down to $3 million.

We’re developing indexes that relate to reality, and not simply to sales at auction houses. Remember, the current published indexes are on sales, not on non-sales. They’re kind of dumb, if you think about it. I’ve never seen an art market — and I think we’re better at measuring than anyone else around — down more than 40 percent, as an art market.

OR: Do you see people leaving the art market and not coming back?

Edelman: No, I think that people will leave and they will come back, just as they came back to stocks and big houses. Look at the real estate market in New York today. Do not fool yourself and think that it’s hot, because it ain’t. It’s cold, and it’s only getting started. It becomes a social event now. It was an asset class last week.

The other problem which we’ve never experienced since before Roosevelt is that we’ve gone through an entire recessionary period, which is now going to repeat, without doing anything to stimulate consumption in the bottom half of the society. You say that we’ve stimulated, but the stimulation has all been monetary; very, very little fiscal stimulation. Monetary stimulation has nothing to do with the masses. It does nothing for them. The only part of it that does anything for them is the stupidest part of all, which is the government guaranteeing their mortgages. Why shouldn’t banks be responsible for lending to people who can pay the banks? Why are we doing dumb things like this? Why do we engineer recoveries that have to collapse?

In 2000, when markets collapsed, the recovery that was engineered was a real- estate recovery. Everybody has to own a house, and the government’s going to make sure that you can all own one. You’ll lose it later, but we have a recovery. This recovery that we’ve had now has been engineered around shares. The government has made it possible — the government and other powers, obviously — for shares to go up, in every way possible, but that is not a recovery from a recession. That is shares going up. The way you recover from a recession on a more permanent basis is to figure out how you get money into the hands of people who spend it. The people who spend all of their money are the bottom three-fourths, not the top quarter. It’s exactly the opposite of what we’ve done.

OR: What should people short? What are you bullish on?

Edelman: I use my money financing art, at the moment at 50 percent and under. I don’t think very much about shorting. The European banks have fallen apart already. I don’t really like to pick market timing. I was always a different kind of person: I looked at underlying assets, what I could sell them for today, and what they might sell for if there’s a downturn. If that was double what the shares sold for, I would do the transaction and see what I could do with it after looking at all the governance issues. The rest of my business was a trading business. It was an option-hedging business, a bond-hedging business, somewhat of a risk arbitrage business, and eventually a distressed business, because that’s the same kind of thing as I was doing anyway, except it’s even cheaper.