Category Archives: economics

Eclectica Fund’s April 2012 TEF Commentary

Eclectica Fund’s April 2012 Commentary

April 2012 TEF Commentary

April 2012 TEF Commentary


The French election: An inconvenient truth | The Economist

What do you expect when you have not balanced you budget since 1978…

The underlying problem is that, over the past ten years, France has lost competitiveness. In 2000 hourly labour costs in France were 8% lower than those in Germany, its main trading partner; today, they are 10% higher (see chart 2). French exports have stagnated while Germany’s have boomed. An employer today pays twice as much in social charges in France as he does in Germany. France’s unemployment rate is 10% next to 5.8% in Germany—and has not dipped below 7% for nearly 30 years.

This erosion of French competitiveness raises hard questions about the underlying social compact. Frenchmen cherish the notion that everyone has an equal right to decent services in good times and a generous safety net in bad. But what sort of level of support, in sickness, joblessness, infancy or old age, can France really afford to offer its citizens? How can the country justify its massive public administration—a millefeuille of communes, departments, regions and the central state—which employs 90 civil servants per 1,000 population, compared with 50 in Germany? How can France lighten the tax burden, including payroll social charges, so as to encourage entrepreneurship and job creation?

The French election

An inconvenient truth

The French have had a security wake-up call. But when it comes to the dangers facing their economy, they are still dozing

A WEEK after France was shaken by terrorist shootings in and around Toulouse, candidates for the country’s presidential election have gone back to the stump. The tone is a little less shrill, the contenders respectful of the sombre mood. Yet the return to electioneering has a surreal quality nonetheless, unlinked to the new concerns about security. For the country faces an imminent economic shock, which the presidential candidates are utterly failing to acknowledge.

The awkward truth is that France, the second-biggest economy in the euro zone after Germany, faces a public-finance squeeze. French public spending now accounts for 56% of GDP (see chart 1), compared with an OECD average of 43.3%: higher even than in Sweden. For years France has offered its people a Swedish-style social model of services, benefits and protection, but has failed to create enough wealth to pay for it.
Today France continues to behave as if it enjoyed Sweden’s or Germany’s public finances, when in truth they are closer to those of Spain. Although France and Germany have comparable public-debt levels, at over 80% of GDP, Germany’s is now inching downwards whereas France’s is at 90% and rising. One rating agency has already stripped France of its AAA credit rating over worries about high debt and low growth. The country’s auditor, the Cour des Comptes, chaired by Didier Migaud, a former Socialist deputy, has warned that unless “difficult decisions” are taken this year and next on spending, public debt could reach 100% by 2015 or 2016.
The underlying problem is that, over the past ten years, France has lost competitiveness. In 2000 hourly labour costs in France were 8% lower than those in Germany, its main trading partner; today, they are 10% higher (see chart 2). French exports have stagnated while Germany’s have boomed. An employer today pays twice as much in social charges in France as he does in Germany. France’s unemployment rate is 10% next to 5.8% in Germany—and has not dipped below 7% for nearly 30 years.
This erosion of French competitiveness raises hard questions about the underlying social compact. Frenchmen cherish the notion that everyone has an equal right to decent services in good times and a generous safety net in bad. But what sort of level of support, in sickness, joblessness, infancy or old age, can France really afford to offer its citizens? How can the country justify its massive public administration—a millefeuille of communes, departments, regions and the central state—which employs 90 civil servants per 1,000 population, compared with 50 in Germany? How can France lighten the tax burden, including payroll social charges, so as to encourage entrepreneurship and job creation?
Put simply, France is about to face the tough choices that Gerhard Schröder, Germany’s former chancellor, confronted in the early 2000s or that Sweden did in the mid-1990s, when its own unsustainable social system collapsed. The euro-zone crisis, which has made bond markets unsparing of slack economic management, means that these decisions have become both more urgent and more difficult. Whoever is elected at France’s two-round presidential election on April 22nd and May 6th will face a choice. If he fails to be tough enough on the deficit, markets will react badly, and France could find itself at the centre of a new euro-zone financing crisis. If he tackles the deficit with tax increases across the board and even spending cuts, voters will not be remotely prepared for it.
“The real risk for the euro zone now is not Greece, but France,” says a top French finance boss. Nicolas Baverez, a commentator who foresaw the country’s looming debt problems in a bestselling book of 2003, agrees: “I’m convinced that France will be the centre of the next shock in the euro zone.”
The candidates, however, are masterfully managing to duck all this. Before the Toulouse shootings intervened, the campaign turned around such pressing matters as halal slaughterhouses, immigration and tax exiles. Although both Nicolas Sarkozy, the Gaullist incumbent, and François Hollande, his Socialist rival, have embraced deficit reduction, each vowing to bring France’s budget deficit down to 3% of GDP next year, neither is promising to do so by making radical spending cuts.
 Browse our slideshow guide to the leading candidates for the French presidency
Both presidential front-runners instead rely heavily on balancing the books through tax increases. Mr Sarkozy has already raised corporate and income tax. He now says he wants to tax even those who leave France for tax reasons. Mr Hollande promises a 75% top income-tax rate on those earning over €1m ($1.3m) a year, which means they would pay over 90% after social charges. He also wants to increase the annual wealth tax, levied annually on assets worth over €1.3m, and tax dividends more. He vows to raise the minimum wage, create 60,000 teaching jobs, lower the minimum retirement age to 60 for those who began work young, and “renegotiate” the European fiscal compact, a hard-won deal that seeks to guarantee budgetary discipline.
How can France be holding an election that so signally fails to confront the right questions? What are the chances that any of the candidates, if elected, is ready to face up to the shock that is to come?
Get Flash Player
A parallel universe
Last summer Jean-Pascal Tricoire, the chief executive of Schneider Electric, a French energy-services company founded in Burgundy in 1836, packed up and moved to Hong Kong to run the company from Asia. He took two top executives with him; others followed. They join a new French exodus to Hong Kong, particularly among entrepreneurs. Schneider Electric’s official headquarters, and tax domicile, remains in France. But with only 8% of annual turnover in France these days, the firm’s eyes are on the rest of the world.
Spend time with the chiefs of France’s foremost companies and, like Schneider Electric, their concerns are global. They talk about Brazil and China, and are constantly watching their international competitiveness. With more Fortune 500 companies than any other European country, France has a global leader in almost every sector from insurance (AXA) to cosmetics (L’Oréal). These firms know full well how damaging a 75% tax rate, for instance, would be. “A catastrophe,” says one boss. “Completely mad,” says another.
Yet ordinary French folk seem almost uniquely hostile to these very companies, and to the globalised markets that have helped to make their economy the fifth-largest in the world. Only 31% of the French agree that the free-market economy is the best system available, according to a poll by Globescan, a polling firm (see chart 3); across ten years of polling, the French have consistently been among the most distrustful of capitalism. This is the France that voted “no” in 2005 to the draft European Union constitution, amid fears about Polish plumbers flooding into France under single-market rules. And this is the France that made a book calling for “deglobalisation” a bestseller last year.
The French live with this national contradiction—enjoying the wealth and jobs that global companies have brought, while denouncing the system that created them—because the governing elite and the media convince them that they are victims of global markets. Trade unionists get far more air-time than businessmen. The French have consistently been told that they are the largely innocent victims of reckless bankers who lent foolishly, or wanton financial speculators, or “Anglo-Saxon” credit-ratings agencies. Mr Sarkozy has called for capitalism to become “moral” so as to curb such abuse. Mr Hollande has declared that his “main opponent is the world of finance”. Few politicians care to point out that a big part of the problem is the debt that successive French governments themselves have built up over the decades. Why?
The explanation is part conviction, part calculation. Neither the French right nor the left has ever fully embraced market-friendly thinking, except under duress. Despite the occasional liberal impulse, Mr Sarkozy is part of the Gaullist family, which largely rejects such a doctrine. Most of today’s Socialist leaders cut their political teeth working for François Mitterrand (Mr Hollande was on his presidential staff); the party still worries far more about redistribution than wealth creation. “The soul of France”, declared Mr Hollande when launching his campaign, “is equality.” Liberal candidates in France tend to get nowhere. Ten years ago the most recent such presidential hopeful, Alain Madelin, got just 3.9% of the vote.
Dangerous talk
So it is with today’s election. Rather than confronting these attitudes, and shaking the French out of their comfort zone, the two front-runners are pandering to popular reflexes. At a giant rally in Villepinte, north of Paris, Mr Sarkozy laid into EU trade rules, which he said had unleashed “savage” competition; called for a “Buy European Act” for public procurement if non-European trading partners did not open up their markets; and threatened to pull the country out of the Schengen passport-free zone, unless fellow members did more to control immigration from outside the area. Apparently without irony, the son of a Hungarian immigrant started to tread on nasty ground, with talk of “too many foreigners” in France. All this is meant to reassure fretful French voters, who think Europe is failing to protect them from global competition.
Certainly Mr Sarkozy can point to some useful liberalising reforms on his watch, such as a rise in the minimum retirement age from 60 to 62, or the granting of autonomy to universities. He also pointed to the crushing weight of French social charges on employers, which deter job creation and which he has trimmed a bit. But the politician who once wrote disapprovingly that France “has never stopped discouraging initiative and punishing success” has now raised taxes on the rich, and bashes big bosses and bankers at every turn.
All this is also tactical. In the first round of voting in France (as in America’s primaries), candidates try to shore up their base; in the run-off, they compete for the centre. On the far right Mr Sarkozy has to confront Marine Le Pen, the telegenic National Front candidate. Present polls put her in distant third or even fourth place, with 16%-18% of the first-round vote, compared with 28% or so each for Mr Sarkozy and Mr Hollande. But nobody has forgotten that her father, Jean-Marie, snatched a place in the second round in 2002 at the Socialists’ expense. The feisty Ms Le Pen, who has rid the party of its jack-booted image, is unlikely to repeat that feat. Her strong campaign nevertheless frames much of the election debate, with calls to leave the euro, reindustrialise the country and curb Islamification.
Mr Hollande faces a similar squeeze on the left. With a reputation as a moderate, who promises to introduce his own balanced-budget law, he has been struggling to keep the hard left at bay in the person of Jean-Luc Mélenchon, a one-time Trotskyite and former Socialist senator now backed by the Communist party. At a recent rally held, with theatrical symbolism, at the Bastille, Mr Mélenchon called for a “civic insurrection” against the “ancien régime”. He wants full pensions for all at 60, a 20% hike in the minimum wage and a cap on all salaries at €360,000 a year. With his tub-thumping style and gruff manner, Mr Mélenchon’s campaign has been a sensation. More than one in ten French people say they will vote for him.
Although most of this electorate would then swing behind Mr Hollande in the second round, Mr Mélenchon’s recent poll surge has been nibbling away at Mr Hollande’s numbers, depriving him of the momentum that might carry him to victory. Hence his plans for a new tax on financial transactions, the abolition of stock options and the 75% tax rate. Hence too his stinging attacks on finance and wealth, and denunciation of the new super-rich as “grasping and arrogant”.
Opération décryptage
Many French commentators dismiss all this as mere political posturing. Aides to both front-runners argue that, in reality, each understands what is at stake. The 75% tax rate, says Olivier Ferrand, head of Terra Nova, a Socialist-linked think-tank, is “just a symbolic measure”: even Mr Hollande has conceded that it will bring in little revenue, if any. Behind all the rhetoric, Mr Ferrand insists, “the Socialist Party has modernised, and does understand the need to improve competitiveness and control the deficit.”
Mr Hollande, a jovial character in private, rejects the idea that he is dangerous, stating as much—in English—as he arrived in London in February. He has put in charge of his campaign two men, Pierre Moscovici and Manuel Valls, who were once close to the moderate Dominique Strauss-Kahn, ex-boss of the IMF, who has been ruled out of the race by a sex scandal. Once in power, French Socialists can end up doing sound things. With Mr Strauss-Khan as his finance minister, Lionel Jospin, the Socialist prime minister in 1997-2002, privatised more French companies than all his predecessors put together. “We liberalised the economy, and opened up the markets to finance and privatisation,” recalled Mr Hollande before heading to London.
The obliviousness of spring
Yet it requires much forbearance on the part of the electorate to accept that the candidate will not do half the things he has said he will. There is a serious risk of disappointment if, for example, President Hollande were to say upon taking office: “We have examined the public accounts and, quel dommage, there is no money for anything I promised after all.” And in order to defuse this risk the new president would have to put into place at least some of his dafter ideas, if only as a political gesture. The last such measure the Socialists introduced was the 35-hour working week.
Decoding Mr Sarkozy is no easier. He has now eased off on some of his more unpleasant rhetoric, but plenty more is merely disingenuous. There is already, for instance, a Schengen review under way that would allow members to suspend free movement in certain circumstances. His idea of an American-style tax on the French abroad, but only on those who have left to avoid such taxes, would be all but impossible to apply. Perhaps he knows as much, and would do none of it. Indeed, Mr Sarkozy’s friends claim that he would turn out to be a reformist president if re-elected. “Sarkozy started to campaign by calling for German-style reforms,” says one adviser. “But he realised he had no chance of winning with that, because it’s unpopular, so he has gone for rightist, populist measures instead.” In office, claims the same adviser, he would turn out to be a “very active, reformist president”.
Amid all this doublespeak, the one candidate who has consistently talked about the need for debt reduction and spending cuts is François Bayrou, a centrist. He is a perennial presidential contender, without much of a party behind him, who gets off his tractor on his Béarn farm every five years to run for office in Paris. Mr Bayrou is no liberal: he wants a “fair price” for farm produce, and proposes voting rights for unions on company boards. But he at least promises €50 billion in spending cuts (alongside €50 billion in tax increases, including a new top income-tax rate of 50%, up from 44% now). Dismissing Mr Hollande’s 75% tax rate as “crazy”, he deplores the level of political debate. “We are not asking any of the questions on which France’s future survival depends,” says Mr Bayrou. “When a country doesn’t tackle any of these questions, it runs the risk of catastrophe.” For now, though, the voters do not seem to care for this message: Mr Bayrou’s numbers are no better than Mr Mélenchon’s, which have surged to 12-13%.
Promises to break
All of which leaves voters with the unenviable task of deciphering which part of each candidate’s message is credible, and which part pure fantasy. The best guess is that both front-runners, for their own political security, would need to put in place a couple of the barmier ideas. This could be damaging enough. In 2007, after equally tough talk about immigration, Mr Sarkozy went ahead and set up a ministry of national identity—only to abolish it later on, having caused much offence along the way. Were a President Hollande to implement his 75% tax rate—just when Britain has cut its top rate from 50% to 45%—it would send an untimely message abroad about the way France treats financial success, much as the 35-hour week tarnished the country’s image for years. His overall tax policy would tell aspiring French entrepreneurs that they might be better off launching a good idea elsewhere.
The inconvenient truth is that whoever emerges the victor on May 6th will need to show a tough approach to the deficit, in the face of wary bond markets and possible recession. A President Sarkozy would need to find new budget savings, despite his promise to “protect” the French from austerity. A President Hollande would be forced to postpone or scrap some of his spending pledges, and would get a taste of German steeliness if he insisted on pushing Chancellor Angela Merkel on the subject of reviewing the fiscal compact. Either way, the result would be a shock for the French, and one that neither candidate has remotely prepared them for.

Read the whole article online here: The French election: An inconvenient truth | The Economist

Canada To Allow Wealth Funds To Invest In Its Financial Institutions – #SWF

Canada To Allow Wealth Funds To Invest In Its Financial Institutions –

OTTAWA (Dow Jones)–The Canadian government said Thursday it plans to introduce legislation to allow foreign and domestic sovereign-wealth funds to invest in Canadian financial institutions, a move which would allow banks and insurance companies to raise capital to meet new Basel banking rules.

Canada is believed to be the only G-7 country that explicitly bars sovereign-wealth funds from investing in its financial institutions, which puts lenders and insurers at a disadvantage when it comes to raising capital. The proposed legislation aims to level the playing field, and could attract investments …

Seethe whole story here, subscription required: UPDATE: Canada To Allow Wealth Funds To Invest In Its Financial Institutions –

Hmmm… Holland – Outside the Box Investment Newsletter – John Mauldin

Hmmm… Holland

John Mauldin

March 26, 2012

For your Outside the Box today I treat you to another big, juicy slab of Grant Williams’ Things That Make You Go Hmmm… I don’t want to be all Grant all the time, but this is just so good I couldn’t resist. This week, Grant is digging deep into the history and mystery of the European Union, taking us all the way back to the first inter-country treaty in April 1951 and then following the rather tortuous bureaucratic proceedings that led, by hook and by crook, to today’s increasingly problematic eurozone.

Grant then zeroes in on the ever-stalwart Dutch, who, it now appears, are in something of a pickle. He notes that the Dutch “were signatories to the Treaties of Paris and Rome and to every major European Treaty since and are staunch supporters of a unified Europe as well as having a reputation for being amongst the more fiscally disciplined members of the EU.” And in September of last year, the Dutch prime minister and his finance minister penned a rather incendiary little diatribe on eurozone behavior that built, with eminently sensible Dutch logic, to the conclusion that “Countries that do not want to submit to this [new, rigorous fiscal] regime can choose to leave the eurozone. Whoever wants to be part of the eurozone must adhere to the agreements and cannot systematically ignore the rules. In the future, the ultimate sanction can be to force countries to leave the euro.”

How unfortunate, then, that a mere six months later – and just days after Spain’s unilateral decision to favor its own budget projections over those dictated by Brussels, who did we find but the Dutch confessing that they too would violate, by a mile, the fiscal deficit limit imposed by the EU’s new treaty. And to make matters worse, Geert Wilders, head of the far-right-wing Freedom Party and a key player in the right-of-center coalition that now governs Holland, has been making noises about a Dutch referendum on continued eurozone membership.

Grant then jumps right across the Channel to catch us up on the antics of the English government, whose much-ballyhooed austerity program appears to be anything but, depending as it does on some rather figmentary revenue assumptions and other fiscal legerdemain. I haven’t included that portion of this issue of Hmmm…, because I want to keep the focus this week on eurozone woes (England is not in the euro and didn’t sign the new EU treaty, arousing much Continental ire), and to mention that I’m in Paris, attending a very powerful conference on central-bank monetary policy and strategies for dealing with sovereign debt. Organized by the Global Interdependence Center (GIC), the conference could hardly be more timely. I’m here with good friend (and long-time GIC supporter) David Kotok, who mentions today in his own commentary that:

“Our private meetings here involve bankers, central bankers, investors, and money managers – the gamut of those interested in financial markets and economics. We find that one theme persists. All of them are watching the credit spreads involving Portugal and Spain. They realize the market is sending a message of concern. The market is saying that the episode with Greece is not over, and the contagion is spreading in spite of the massive liquidity injections of the European Central Bank. They observe and discuss the use of collective action clauses and how they have to adjust their portfolios now that a government has inserted itself in a retroactive forced alteration of a debt structure. In public, they are polite, but they dissect the risks strenuously. In private, the debates become fierce.” (You can read David’s whole piece on the Cumberland Advisors website.)

He’s right: the tension here, both behind closed doors where the “players” assemble and in public, between the European leadership and their increasingly disgruntled constituencies, is palpable.

And yet, after a tough winter, Paris is bursting with the hopeful energy of spring, and I’m very glad to be here.

Your learning a lot and loving it analyst,

John Mauldin, Editor
Outside the Box

Things That Make You Go Hmmm…

Grant Williams
March 25, 2012

On March 25, 1957 in Rome, two representatives each from West Germany, Italy, the Netherlands, Belgium and Luxembourg sat around a large, fancy table, took out their large, fancy fountain pens and signed a rather large and fancy document that was rather grandly known as The Treaty of Rome. At a stroke the European Economic Community (or ‘Common Market’) was established (along with the European Atomic Energy Commission those…

See the whole article here: Hmmm… Holland – Outside the Box Investment Newsletter – John Mauldin

The Bats Affair: When Machines Humiliate Their Masters – Businessweek

By Brian Bremner
March 23, 2012 6:18 PM EDT

The spectacularly botched initial public offering of Bats Global Markets on March 23 is so rich in irony that it’s difficult to know where to begin. What’s far less amusing is the prospect that the current era of high-frequency trading, in which powerful computers sift through massive information flows in search of price discrepancies and split-second trades, will bring even more episodes of market mayhem far more costly to investors and the broader economy.

In the annals of business screw-ups, Bats has certainly made its mark. Bats stands for Better Alternative Trading System and the company runs two exchanges that collectively rank third in terms of U.S. share trading, behind New York Stock Exchange and Nasdaq. The Bats exchanges account for 11 percent to 12 percent of daily U.S. equity trading, according to its website. The company came of age with the expansion of high-frequency trading over the last decade and the proliferation of quant-jock-driven electronic firms that dominate the buying and selling of U.S. equities. Bats founder Dave Cummings is chairman and owner of high-frequency trading firm Tradebot Systems.

Today was supposed to be the Lenexa (Kan.)-based company’s moment in the limelight as it tried to sell about 6.3 million shares in the $16 to $18 dollar per share range. Instead, something went terribly wrong. The company’s shares somehow ended up trading for pennies per share early in the trading day on both the Bats bourse and Nasdaq, according to data reviewed in this Bloomberg story. Then tech investors and Apple fanboys the world over were dismayed when a single trade for 100 shares executed on the Bats market sent Apple’s shares to $542 per share, down sharply from recent levels. (The company set a new 52-week high of $609 per share on March 21.) The stock temporarily halted trading and recovered.

It’s far too early to know what went wrong, though Bats took the unusual step of withdrawing its IPO late in the trading day. “In the wake of today’s technical issues, which affected the trading of certain stocks, including that of Bats, we believe withdrawing the IPO is the appropriate action to take for our company and our shareholders,” said Joe Ratterman, chairman, president, and chief executive officer of Bats.

As it happens, the Securities and Exchange Commission has started reviewing whether the trading practices of high-frequency trading firms has given them an unfair advantage over other investors. More fundamentally, it’s not clear that the SEC—or even experienced Wall Street traders—really have a handle as to whether computer driven trading is a good thing or a dangerously disruptive one. These days, about 55 percent of U.S. equity-trading volume comes from firms using high-frequency trading strategies, according to Bloomberg.

Stock trading circa 2012 is increasingly controlled by former computer scientists and mathematicians—and the computers at their disposal—that look at stocks not as traditional value investors looking at earnings and growth, but as streams of price data. When, say, the price of a futures contract strays from an underlying stock, the machines pounce and execute a trade. Back in May 2010, during the fabled flash crash, these digital networks temporarily went haywire and triggered a market panic.

High-frequency trading advocates say all this automation creates far more liquidity and makes the markets efficient. That may be true; there is no stuffing this genie back into the bottle. Yet regulators had better figure out whether or not we have the effective safeguards in place to prevent computerized trading system meltdowns from doing serious damage to investors.

Jim Rogers Blog: My Advice To Young People: Get Into Agriculture

Jim Rogers with some handy advice for the younger ones among us.

Jim Rogers Blog: My Advice To Young People: Get Into Agriculture: My advice to young people would be to get into agriculture. If you want to make money over the next 20 years, agriculture is the way to go. …

The MasterMetals Blog

Swiss Secrecy Besieged Makes Banks Fret World Money Lure Fading – Bloomberg

Switzerland is the biggest manager of offshore wealth in the world, with about a 27 percent share, according to the Boston Consulting Group’s 2011 Global Wealth report. Clients fromGermanyItaly, Saudi Arabia, the U.S. and France make up about 42 percent of all offshore wealth managed in the country, the report said.

Should Switzerland abolish banking secrecy, it could risk losing as much as 700 billion francs ($768 billion) in the worst case, or about half of all money managed by Swiss banks on behalf of private clients not domiciled in the country, said Teodoro Cocca, a professor of wealth management at Johannes Kepler University in Linz, Austria. Such a shock would be enough to put the country into a recession, according to a study by Banu Simmons-Sueer at Zurich-based KOF Swiss Economic Institute.

Swiss Secrecy Besieged Makes Banks Fret World Money Lure Fading

Gianluca Colla/Bloomberg

A tram passes a UBS building in Zurich.

When UBS AG (UBSN) celebrated its 150th anniversary in Zurich last month with 600 guests dining on Ossetra caviar and Wagyu beef, there was no jubilation in the executives’ speeches.

Trust “cannot be tied to a far-dated founding year; trust constantly has to be won anew,” Chairman Kaspar Villiger told guests at the dinner prepared by Philippe Rochat, the Swiss chef whose restaurant is one of two in the country to earn three Michelin stars. “Reputation is the most important capital for a bank. It takes just a thoughtless action to lose it and the sweat of thousands to rebuild it.”

Just about every UBS executive gathered in Hallenstadion, where sporting events, concerts and shareholder meetings are held, could relate to what Villiger was talking about. For almost three years he and former Chief Executive Officer Oswald Gruebel tried to rebuild the reputation of Switzerland‘s largest lender, damaged by a near bankruptcy in 2008 and the unprecedented delivery of data about affluent clients to the U.S. to avoid a criminal indictment.

UBS’s image of solidity, based on conservative risk management and capital strength, was tarnished again last year when the Zurich-based bank discovered a $2.3 billion loss from unauthorized trading. Gruebel, 68, found himself a guest at the anniversary dinner rather than the host after he left his job in September. Villiger, 71, plans to step down in May.

Other guests included Marcel Ospel, who helped put UBS on the global map and whose ambitions in investment banking contributed to more than $57 billion in writedowns and losses related to mortgage-backed securities, and Eveline Widmer- Schlumpf, the Swiss minister who in 2008 had to bail out UBS.

Sullied Image

While the bank has recovered from near insolvency, its sullied image exemplifies a fall from grace of financial institutions that contributed almost one-third of the country’s economic growth between 1990 and 2009. It’s a transformation that resonates around the world as the banking industry struggles to overcome resentment for the excesses and opacity that led to the 2008 collapse of Lehman Brothers Holdings Inc.

Switzerland and its banks benefited from laws protecting secrecy. The inflow of foreign money seeking a haven in the country contributed for decades to lower interest rates, making borrowing and expansion cheaper for domestic companies and boosting household wealth. Now, what promises to be the biggest shake-up Swiss financial firms have seen in 80 years is bound to leave scars on the economy.

“The problem with any good thing is that it’s too good to be true,” Gruebel said in an interview this month. “If you have that for too long, there comes a day when it falls apart. And that’s the case with bank secrecy.”

‘Historical Moment’

The pursuit of UBS by U.S. tax authorities has opened floodgates to attacks on other Swiss banks that threaten to tear down the bastion of secrecy. UBS and Credit Suisse Group AG (CSGN), the country’s second-largest lender, also are facing stricter capital and liquidity rules forcing them to shrink more and faster than international rivals.

“It’s a really historical moment,” Tobias Straumann, a lecturer in economic history at Zurich University, said in a phone interview. “It’s the first time that we have an open discussion on both of the issues. We had two external shocks: one economic and one political.”

Switzerland Bleeding

The blows already are bleeding through to the economy. The banking industry’s contribution to economic output in the country shrank to 6.7 percent in 2010 from 8.7 percent in 2007, according to Swiss Bankers Association data. That’s still a bigger share of gross domestic product from banks than in the U.K. or the U.S. More than 40 percent of that comes from wealth management, making it the industry’s most important business.

Switzerland is the biggest manager of offshore wealth in the world, with about a 27 percent share, according to the Boston Consulting Group’s 2011 Global Wealth report. Clients from GermanyItaly, Saudi Arabia, the U.S. and France make up about 42 percent of all offshore wealth managed in the country, the report said.

Should Switzerland abolish banking secrecy, it could risk losing as much as 700 billion francs ($768 billion) in the worst case, or about half of all money managed by Swiss banks on behalf of private clients not domiciled in the country, said Teodoro Cocca, a professor of wealth management at Johannes Kepler University in Linz, Austria. Such a shock would be enough to put the country into a recession, according to a study by Banu Simmons-Sueer at Zurich-based KOF Swiss Economic Institute.

“Looking at the last 12 months, the likelihood of such a worst-case outcome has increased,” Cocca said in a phone interview. “The attacks on Swiss banking secrecy and the actions of the Swiss government clearly go in one direction, and that is toward weakening of Swiss banking secrecy.”

Tax Evasion

The government has been in talks for more than a year with U.S. authorities, who after getting data on about 4,700 UBS clients are now investigating 11 other banks, including Credit Suisse, for alleged assistance in tax evasion.

Wegelin & Co., a 270-year-old Swiss bank, had to sell itself to save its non-U.S. business before the U.S. indicted the firm last month. Philipp Hildebrand, head of the Swiss central bank, had to step down in January after information about his wife’s foreign-exchange transactions was leaked by a Bank Sarasin & Cie. AG employee. Bank secrecy has become a point of mockery: A photograph in Neue Luzerner Zeitung featured a masked man at a carnival last month offering “cheap” Swiss client-account data on a compact disc as a “special offer.”

‘Island of Bliss’

The Swiss financial industry has prospered from others’ misfortunes. Two world wars involving neighboring countries made neutral Switzerland a refuge for people concerned that their governments and currencies weren’t stable.

Secrecy laws were enacted in 1934 after French police arrested top bankers of Basler Handelsbank in Paris in October 1932 for aiding tax evasion by the bank’s high-profile French clients. Police confiscated a list of clients and later seized more money of tax evaders at other private banks in Geneva.

A run on Swiss banks that followed threatened their existence, and stopping the money flight became a priority, historian Peter Hug wrote in a chapter on banking secrecy in a 2002 book, “Memory, Money and Law.”

“Switzerland got rich through black money,” Sergio Ermotti, 51, who took over as CEO of UBS after Gruebel resigned, said in an interview with SonntagsBlick in October. “That will change in the future.”

Offshore Money

The flow of offshore money into Switzerland helped reduce interest rates in the country by more than 1 percentage point, benefiting private and corporate borrowers, Villiger, a former Swiss finance minister, said at UBS’s anniversary dinner. Switzerland still is seen as “an island of bliss” by observers abroad, Villiger said, adding that both the government and companies have to work hard to preserve that.

Hans J. Baer, whose family founded the Swiss private bank Julius Baer Group Ltd. (BAER), said in his 2004 book, “Be Embraced, Millions,” that banking secrecy “makes us fat but impotent” as it places Swiss banks outside of general competition.

The fat from wealth management helped fuel the expansion of investment banking and the balance sheets of UBS and Credit Suisse, so-called universal banks able to use cheap funding to boost leverage and profitability. Between 1998, when UBS was created through the merger of Union Bank of Switzerland and Swiss Bank Corp., and 2006, the combined assets of the two banks more than doubled to 3.65 trillion francs, more than seven times Swiss GDP that year.

‘Allergic to UBS’

That was followed by UBS’s losses related to mortgage- backed securities and a government bailout providing 6 billion francs of capital to help the firm spin off $39 billion of risky assets into a central bank fund. Although the bailout was smaller than what other countries spent propping up their lenders, the realization that failure of a big bank could topple the country fueled a backlash against investment banking.

“In private wealth management, both the employees and the customers felt threatened by the investment banks because they thought we give the banks money and they turn around and use it for their own speculation,” Peter Kurer, a former chairman of UBS, said in a phone interview.

Splitting off the investment banks — undoing the universal model prized by global lenders including Citigroup Inc. (C) — would help UBS and Credit Suisse regain the trust of shareholders and clients, Kurer has said.

Brand Damage

The negative image of investment banks in Switzerland remains strong, said Straumann, who wrote a report on UBS in the 2008 crisis. The loss from the unauthorized trading incident at UBS last year, which Straumann said could have happened at any bank, only added fuel to the fire.

“It’s not rational anymore,” Straumann said. “You just can’t talk to people in a normal way when you talk about UBS. People are allergic to UBS.”

Problems at home have taken a toll on the brands of UBS and Credit Suisse globally. UBS, which entered Interbrand’s ranking of the world’s top 100 brands at No. 45 in 2004 and rose to its highest ranking of 39 by 2007, slipped to 92nd last year. Credit Suisse entered the ranking at No. 80 in 2010 and fell to 82nd last year. JPMorgan Chase & Co. (JPM) rose from 30th in 2004 to 28th in 2011 and London-based HSBC Holdings Plc from 33rd to 32nd.

UBS and Credit Suisse also face capital requirements from Swiss regulators that go beyond demands on international rivals, making investment banking less profitable and pushing the banks to scale back. The firms said in November that they plan to shrink their total risk-weighted assets 33 percent to 270 billion francs and 23 percent to 285 billion francs, respectively, with most of the cuts in securities units.

‘Too Big’

Gruebel, who has served as CEO of both banks, said they’ll have to cut even more, to between 150 billion francs and 200 billion francs each, to be able to fulfill the new capital rules because retaining earnings won’t be enough.

“To believe they can stay at 300 billion francs or more of risk-weighted assets over the next years is a dream,” Gruebel said. “Both of their investment banks are too big today. The winner will be the one who will cut the most the quickest.”

Credit Suisse said last month it has speeded up the reduction of assets and plans to reach the level targeted for the end of this year by the end of March. Still, the Zurich- based lender is six to 12 months behind UBS in restructuring and the performance of its investment bank is “extremely disappointing,” Kian Abouhossein, a London-based analyst at JPMorgan, said in a Feb. 9 note.

Criminal Investigation

Credit Suisse, which had smaller writedowns from the subprime crisis than UBS, expanded its investment bank in 2010 to gain a bigger market share from competitors struggling with losses. The bank had added about 2,000 people to the securities unit since 2009 before announcing two rounds of job cuts last year. The expansion was wrong in retrospect, CEO Brady Dougan, 52, told SonntagsBlick in an interview last month.

The headcount at Credit Suisse’s investment bank at the end of 2011 was 12 percent higher than at the end of 2006, while the unit’s net revenue for the year was 44 percent lower than five years ago. UBS’s investment bank cut staff by 21 percent over the same period as revenue slumped 56 percent.

Credit Suisse, unlike UBS, still faces a U.S. criminal investigation into tax evasion. UBS avoided prosecution in 2009 by admitting it aided tax evasion, paying $780 million and handing over data on 250 accounts. It later disclosed information on about 4,450 more. Credit Suisse is doing “everything” it can to help resolve the U.S. probe, Dougan said in an interview last month. The bank didn’t take any clients from UBS as the latter was shutting down its business with Americans, he said.

UBS and Credit Suisse declined to make executives available to comment for this article.

White Money

Still, both firms are better prepared than smaller private banks for changes that may be coming with Switzerland’s so- called white-money strategy of relying only on declared assets, Cocca said. UBS and Credit Suisse have through the years built out their onshore wealth-management businesses around the globe.

“Other players in Switzerland, some of the smaller banks, have a more backward-looking strategy,” said Cocca. “They believe that they can stay a bit under the radar. Wegelin is an absolute clear example for that.”

Wegelin, the St. Gallen-based private bank, last month became the first Swiss lender to face criminal charges in the U.S. crackdown on offshore firms suspected of abetting tax evasion. Wegelin helped Americans hide more than $1.2 billion in assets and evade taxes, wooing clients fleeing UBS, according to an indictment filed in federal court in New York.

The bank said last month it will “make every effort to resolve this matter within the boundaries of respectful cooperation with the U.S. and obedience to Swiss law.”

Negotiation or Enforcement

While most private banks now say they accept only money declared to tax authorities, they disagree about how to make sure customers actually pay taxes, weakening Switzerland’s position in negotiations with the U.S. and other countries, Cocca said. Kurer, UBS’s general counsel and then chairman during the U.S. investigation, said talks with Washington probably will “drag on for a while.”

Reaching an agreement on a governmental level, as Switzerland is trying to do, “will be extremely difficult because it will require on the American side also a view that this should be solved politically rather than by enforcement actions,” Kurer said. “And I just don’t see that.”

The U.S. has successfully challenged Swiss banks before. In 1998, firms led by Credit Suisse and UBS reached a $1.25 billion settlement with Jewish groups that accused them of holding on to the assets of Holocaust victims. The accord came after U.S. local governments threatened to boycott the banks and divest Swiss investments. This century, countries including Germany and the U.K. also sought to pierce Swiss bank secrecy.

Information Exchange

Last year’s agreements to collect taxes on money held by German and U.K. clients in Switzerland while keeping their identities secret are awaiting approval amid criticism by the European Union and Germany’s Social Democratic Party opposition, which says the deals let tax evaders off too easy.

“The Europeans want automatic information exchange from us,” UBS’s Villiger said yesterday at an event organized by the Zurich Economics Society, referring to the collection of data by governments from financial institutions on income paid to non- residents for transmission to their countries of residence. “Actually, it’s not very efficient.”

People should be given time to legalize assets, some of which might have come from a long time ago, he said.

Asset Decline

Banks in Switzerland are “likely to experience a significant decline in assets owned by Western European clients” in the coming years, according to the Boston Consulting report. The German and U.K. deals alone may cause Swiss wealth managers to lose about 47 billion francs in assets, a study by consulting firm Booz & Co. said in November.

That’s adding pressure on profit margins at private banks as managing offshore money has been more profitable and new rules are raising compliance costs. The Swiss regulator also is planning an overhaul of rules governing the sale of financial products to individuals after bank customers suffered billions of dollars of losses from Lehman Brothers structured notes and Bernard Madoff’s fraud.

The average cost-to-income ratio of Swiss offshore private banks rose by 5 percentage points in 2010 to 72 percent, Boston Consulting said. In 2007, that ratio stood at 54 percent.

Tax Treaties

Implementing bilateral tax treaties may be more costly for many banks than agreeing to an automatic information exchange, which some politicians and bankers are advocating. In 20 years, Switzerland probably will have information exchange, Villiger said yesterday.

Meanwhile, with tax deals in flux and banking secrecy under attack, wealth managers must persuade clients that holding their money in Switzerland still has advantages. That will be challenging, Gruebel, the former CEO of UBS, said.

“How can we convince somebody outside of Switzerland to bring their money into Switzerland and pay taxes?” he said. “If we really want this white-money strategy, we have to come up with something which is cleverer than anything else in the world. And we don’t have much time to figure it out.”

To contact the reporter on this story: Elena Logutenkova in Zurich

To contact the editor responsible for this story: Frank Connelly