20 September 2011

Greece: this is THE week

As reporter by Bloomberg: “European Union and International Monetary Fund inspectors hold a teleconference call today with Finance Minister Evangelos Venizelos, to judge whether the government is eligible for its next aid payment due next month and on track for a second rescue package approved by EU leaders July 21.”
So, here we are, finally, decision have to be taken after months of wrangling, (badly) communicating and ignoring reality.
To raise EUR 78 billion in 5 years, Greece is to bring additional taxes, including a property levy for EUR 2 billion: I am wondering how the Government intends to implement the measure since the new land registry is not yet finalized and how will they be able to privatize without a certainty regarding title of assets (real estate is part of the EUR 50 billion privatization program); the initial deadline was November 21 and December 30 2008 depending whether your are Greek resident or non-resident, then postponed to H1 2010, and now October 31, 2011. The fun is that Greece first launched a project to record the use and ownership of land in 1995, with EU subsidies, but it ran into repeated delays and nobody at EU did react… When the blind leads the blinds…
As reported by the English speaking Greek newspaper
Ekathimerini: Greece hopes to complete the registration of all its land by 2020. So far, 13.8 million titles have been recorded on the cadastre.” 2020!
Ekathimerini is an endless source of information on Greece dysfunctions: “The Citizens’ Protection Ministry Tuesday rebuffed a report in the Financial Times indicating that Greece may be temporarily ejected from the passport-free Schengen travel area for its failure to keep undocumented immigrants out of the bloc […] It added [the Greek Citizens’ Protection Ministry report] that the Commission should support member states “managing the massive burden” of guarding the bloc’s external borders from illegal immigration.” Oh, yes, give me more money!
Do you want more? Yes? Let’s carry on:
“Whereas more than 1,000 Greeks were losing their jobs in the private sector every day in August, the government was assuring civil servants with lifetime tenure that their job privileges were not in danger and the so-called reserve pool was not intended for them but only for employees in the greater public sector. […] In the meantime, many Greeks were surprised to hear the government had hired between 15,000 and 20,000 people in the public sector in various forms since the start of 2010.”
About the need to reduce expenditures: “…closing down one or two money-losing state entities, such as the the Hellenic Railways Organization (OSE)…”
This is a topical and typical subject: the Hellenic Railways. A few numbers tell you all; for 2009 consolidated accounts:
Turnover - EUR 174 million
Operating loss - EUR 359 million
Total loss – EUR 937 million
Accumulated losses – EUR 2.5 billion
LT debt EUR - 7.8 billion
Interest paid - EUR 388 million (2x the turnover!)
Employees’ compensation - EUR 291 million (more than the turnover)
The auditors commented that they could not conduct a tangible asset and inventories impairment test as well as updating the fair value of investment real estate assets.
I could not find the same information for 2010. According to data released by the Ministry of Finance, on a non-consolidated basis, for the 5 months to May 2011, the situation has improved but remained catastrophic, the turnover is 3x less than personnel expenses (EUR 40,000 / employee / year as an average i.e. 4x the minimum wage, quite nice, and excluding various benefits – EUR 48,000 in 2010), the net loss amounting to EUR 164 million.
As a whole, during the same period, public entities had revenues of EUR 512 million personal costs of EUR 399 million and losses of EUR 534 millions (more than revenues). This tells you all, and the situation is “better” than in 2010…
Greece’s officials are willing to raise taxes and cash via privatizations; good luck! For example privatizations raised EUR 400 millions whilst EUR 5 billion was planned for 2011 – 3 months left…
However, I have no doubt that Greece will get its EUR 8 billion early next month.

Ekathimerini: Investors sought for land registry
Ekathimerini: Land register invites private bids
Ekathimerini: Ministry rebuffs Schengen report
Ekathimerini: Civil servants in the firing line
Ministry of Finance:
Hellenic Railways Organization: Annual financial statements for 2009

14 September 2011

Greece’s race to default and European Banks’ recapitalization

What I wrote 18 moths ago is unfolding and Greece is racing toward default and policy makers must decide who will bear the burden: taxpayers by continuing extending credit lines and the ECB buying sovereign debt in the secondary market to artificially maintain low interest rates and allow banks to offload their junk assets, or the private sector by recapitalizing banks - bondholders taking an haircut.
European banks’ share prices are nearing their lowest since the nadir of the financial crisis in 2008-2009, and French banks are now over 50% down compared to their 2011 high and counting. According to Bloomberg, European banks are trading at 0.58 X book value, indicating that there is not much trust in the value of their assets.
1. Greece
Greece is asked to deepen its austerity measures in a self-fulfilling downward GPD spiral (and lower tax receipts) that will lead to a full-blown depression for Greeks together with  social unrest, and possibly a threat to democracy when the population will become so desperate it will take desperate actions (and what will happen to Greece can occur elsewhere in Europe). Greece needs economic growth to fulfill its commitments and austerity without devaluation is just a death kiss.
GDP growth was downgraded in September to -5.3% in 2011 (-3.5% forecasted by the EU in May) and these GDP numbers were helped by a plunge in the trade deficit (not surprising for a country entering into depression). The HCPI is flat from January to August but is sharply down in July and August. I have stopped assessing the impact of continuing downgrades and a worsening situation; my last calculation early September was a EUR 29 billion deficit for 2011 (EUR 19 billion in the Greek budget), 160% debt/GDP and 13% deficit/GDP at the end of the year.
I do not see how Greece could even issue 13 and 26 weeks bills, the more at acceptable yields, with EUR 2 billion due on each of October 14 and 21; add interest payments plus deficit to plug and a default is there by end of October or at the latest end of November where EUR 5.6 billion of debt are coming due (Greece has still a bit of cash at the Treasury plus could ask the Central bank to sell some gold or pay an exceptional interim dividend or any other form of transfer). In addition, at the end of July, Greece had EUR 6.5 billion in arrears to third parties… Greece’s CDS are pricing de 98% risk of default.
On Monday, Greece’s bond yields reached a record with the 1 year at 110%, 2 year at 63% and 10 year at 21% which just tells you the story: at these levels it is meaningless; Greece is bankrupt and European leaders have failed their mandate so far whilst they have a fiduciary duty to defend their citizens and must restructure unserviceable sovereign debt. Numbers from the EBA show that financial institutions as a whole can sustain such a restructuring with a haircut of 50% (even 75% is workable). For the banks that need to raise equity/dispose of assets where existing shareholders and bondholders do not act, their ownership will be transferred to a more competent stewardship, existing shareholder being wiped out and bondholder paying the price for bad investments. This would most probably translate into larger deficits which would be better accepted by markets since we would have seen the trough of this crisis and, hopefully, sound foundations would have been laid down.
In any case, but for a massive fiscal transfer which is most unlikely, I expect the standard of living of Greeks to go down anywhere between 40 and 50% over the next few years.
It strikes me that instead of pouring money at Greece et al, it would be better for European Government to recapitalize banks if the private sector is falling to do so; yes, this would end up nationalizing some banks, so what? Temporary nationalizations would be preferable (with the firing of boards and management) than a rampant crisis that will not be solved adequately by throwing good money after bad.
2. Banks
Following, a recent article published on Markets & Beyond where I analyzed banks’ risk on a PIIGS’s sovereign default, I found a few estimates concerning the need for recapitalizing European banks ranging from EUR 200 billion (IMF - before a downward revision after a EU complaint – sic!) to EUR 1 trillion (Goldman Sachs – they talk their own book) in order to cover all Bank’s write-downs, and not only sovereign debt.
Crédit Agricole and Société Générale ratings were downgraded this morning with negative outlook, and BNP Paribas will probably follow: they will cut assets to boost capital ratios, the deleveraging process has much more to go. Most spreads are increasing, some dramatically, at a time where their access to short term financing is cut by some large money market funds: share prices are 50%+ down since the high of the year, French banks being particularly hit (I repeat once again that Italian banks as a whole have a meaningless exposure to PIGS and are less risky than French ones– they are hit because of their holding of Italian sovereign debt but I do not believe that Italy will default). I have written several times that France is in a worse situation than Italy I many ways.
The sharply increasing cost of financing for many banks is not sustainable beyond the short term and will start soon to fuel through the real economy weighting further on a dismayed European growth. Some will see their access to the interbank market closed, if not already occurring.
On Monday, Dexia CDS spread shoot up to 1569 basis points at mid-day (+225 b.p.), worse than Portugal and Venezuela: this is just telling what the market thinks about the quality of Dexia asset portfolio and exposure to local authorities and municipalities debt (do not forget that Dexia was the largest foreign borrower with the FED during the 2008-2009 financial crisis); its exposure to Greece sovereign debt is the worst of any bank surveyed by the EBA but BNP Paribas (yes, worse than Commerzbank!), with a  total exposure to PIGS (sovereign, banks and other private sector) standing at EUR 43.9 billion (EUR 10.6 billion excluding Spain) according to the numbers published by the EBA: Dexia has EUR 17 billion of core capita, enough to absorb a Greek default, private sector included (and a Portuguese one – no exposure to Ireland). However, Dexia could not sustain a collapse of banks in Spain with a EUR 23.6 billion exposure. I also guess that the interbank market is closed to Dexia.
The OTC derivatives, CDS in particular, represent the last frontier concerning risk. I have not read anywhere sensible information about who owes and who owns what to/from who, so it is impossible to figure out who is at risk and for the owners of CDS what is their counterparty ability to fulfill their commitments. This really is a black hole.
A few last words:
  • During the weekend, there was rumors that Germany was preparing for a Greek default (50% haircut – it maybe more up to 75% in my opinion) and plan B was design to shore up/save German banks from a collapse (I guess via a recapitalization). Germans are sensible people (like Finns).  Those who do not survive will be bailed out, but shareholders and bondholders would take the first hit this time, at last.
  • European banks volunteered for a 21% haircut, which would be a very good deal for them since the Greek debt is trading at much lower prices in the market. It is worth mentioning that some do not believe that their losses would be limited to that number (RBS provisioned 50%). I doubt it is a good deal for Greece.
  • RWA with zero allocation for sovereign risk is non-sense. There are insisting discussions/rumors that Basle III would be toned down in order to avoid a collapse in banks lending and increase in the cost of financing: this is again an efficient lobbying by banks but pure bullshit (see conclusion).
  • The ban on short selling to avoid the so-call (ugly) speculators to drive financial stocks down demonstrated that “proper” investors are driving them sharply down.
  • Since the financial crisis was triggered in August 2007, the strategy followed has been to concentrate risk instead of a largely mutualizing it, i.e. shareholders and bondholders bearing most if not all the cost of wrong investments/governance and leaving both complacent/incompetent Boards and greedy Management at the helm of now endangered financial institutions. This strategy was wrong.
  • Bank of England Chief Economist John Vickers has recommended the separation of banks’ consumer and investment banking activities: this is going in the right direction (in fact back to the period before the “Big Bang” in the late eighties)
  • Board of directors should be accountable before courts and pay-back all remunerations received since the trigger of the financial crisis in 2007; they should also not to be able to hold any directorships in the future as well as serve a suspended jail sentence (say one week) to make the point: it is really time to name and shame.
Banks can survive a PIGS default on a sovereign basis with existing shareholders’ funds. When taking into account the exposure to the private and inter-banking sectors, Spain might be a different story with debts due to banks in the Europe totalizing USD 568 billion and who knows how much of the private sector assets are at risk. Italy would be a game changer. So the crisis needs to be contained to the PIG; this could have done at a much lower cost in 2009 and 2010 and the spill over risk was much more limited.
It is most likely that the ECB will step up it purchase of Italian and Spanish (and Belgium and French) debt since this is the only viable European institution which can on the spot respond to the debt situation and expand its balance sheet quasi-indefinitely by printing money. It is also most probable that this over-indebtedness will be resolved via inflation as usual (at 5% per annum – an inflation rate perfectly sustainable - over 5 years 22% of principal are wiped out and 39% over 10 years).
Please, beware of lobbying by the financial sector: Empirical evidence doe not support the affirmation that much higher levels of equity funding, and less debt, would mean that banks’ funding costs would be much higher. A recent Bank of England report concludes:
“In retrospect we believe a huge mistake was made in letting banks come to have much less equity funding – certainly relative to un-weighted assets – than was normal in earlier times…We believe the results reported here show that there is a need to break out of the way of thinking that leads to the “equity is scarce and expensive” conclusion. That would help us get to a situation where it will be normal to have banks finance a much higher proportion of their lending with equity than had been assumed in recent decades to be acceptable. And that change would be a return to a position that served our economic development rather well, rather than a leap into the unknown.”
We must also go back to the roots of capitalism where success is rewarded and failure is sanctioned otherwise success is meaningless, and success needs to be clearly redefine to adequately reward it.
It is also time for a new generation of politicians (I am not discussing age but attitude) to replace our failed leaders who share the responsibility of the mess we are in, at best by incompetence and sheer populism, at worse by complicity: democracy as we have known it is at stake. The eurozone creation was “sold” to the public as a mere unified forex zone where tourism would be easier and inflation checked (a lie), and never as a monetary union that demanded homogenization among participating countries on a social and fiscal basis. Under the current structure and membership the eurozone is a failure: a structural change or a different geographical perimeter is required.
Credibility and psychology are key and European leaders lacked both, hence the absence of confidence by markets and European citizens. This needs to be redressed, urgently.Finally, a word from Romano Prodi, EU Commission President, in December 2001:
“I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.”
Bank of England: Optimal bank capital
Bloomberg: Europe Banks Valued at Post-Lehman Low
Greece Ministry of Finance: General Government Monthly Cash Data and Arrears
Hellenic Statistical Authority
UBS Investment Research: Euro break-up – the consequences
Goldman Sachs: Banks as bystanders at the sovereign stage of the crisis
Bloomberg: Britain to Implement Vickers’ Bank Protection Plan by 2019

01 September 2011

What is needed to clean-up the eurozone house? Clean-up the banks and restructure PIGS debt!

I have a number of times discussed the necessary restructuring (default) of PIGS debt and the need for banks (and any other holder of PIGS debt) to take their losses. Governments cannot and should not maintain mismanaged banks (either directly or via the ECB or any other vehicle) under life support, shareholders should take their responsibilities (either inject equity or face huge losses) and fire management and boards; bondholders will also incur losses on their investments with failing banks. It will be painful but it is utterly necessary and urgent to clean the mess one for all.
1. The situation is not as desperate as painted by banks on a PIGS basis

The 90 European banks surveyed by the European Banking Authority could absorb a Greek, Portuguese, Irish and Spanish default, based on two scenarii Markets & Beyond run on its financial model (50% and 75% haircut of their sovereign debt holdings) and maintain a ratio of Common Equity / Risk Weighted Assets of 7% as per Basle III recommendations to be implemented by 01/01 2019 (I am not discussing the Basle III decisions whilst still casting doubts about its efficiency in case of a new round of financial crisis with CDS for example; also nothing is dealt with sovereign debt which still deserves the lowest capital allocation despite what we are witnessing).

According to our analysis, in the worst-case scenario, German banks would have to write-down EUR 22 billion and French banks EUR 18 billion (EUR 23 billion if Dexia, the Franco-Belgian bank is added), well within the limits of what is sustainable without the need to raise new equity to abide by the Basle III rules - the picture is different on an individual basis. Even if they needed to plug the gap, EUR 40 billion is not the end of the world and manageable.
This analysis confirms Markets & Beyond previous findings that Italian banks are insulated from a PIGS sovereign debt default with less than EUR 5 billion at risk, i.e. less than Dexia alone…
I therefore conclude that banks lobbied very successfully to protect their own interests to the detriment of public interest at large.
On an individual basis, 3 German banks (DZ Bank, Hypo and WGZ – Norddeustche is undercapitalized despite being less exposed to PIGS countries) and Dexia would see their capital structure seriously impaired on a PIGS default (40% + of their core capital wiped out), and only WGZ (Dexia not far behind) on a PIG one.
Overall, the 90 banks surveyed displayed EUR 1,000 trillion of core capital vs. EUR 136 billion and EUR 400 billion of PIG and PIGS exposure respectively.
However, the ECB would need to be recapitalized (or another trick used, after all the Maastricht treaty and ECB charter were torn apart), having in the region of EUR 110-120 billion of PIGS exposure. This is nevertheless also perfectly manageable by Eurozone countries, and better than extending an unlimited and wasteful lifeline to Greece and consorts.
Does this mean Eurozone banks do not need to be recapitalized? No; in a slowing economy, default risk will increase in other sectors of banks’ credit portfolios and more importantly they must be able to face their exposure to CDS and other derivative instruments. Spanish banks are still deeply exposed to a real estate market which has yet to clean its inventories and find a bottom. I unfortunately could not find enough data readily available (my next task) to analyze them and quantify the risk banks (and other sellers of these OTC derivatives) are facing, but my sense is that it is large indeed and capital needs are probably in the hundreds of billion. But this recapitalization is not required to absorb a PIGS default.
Indeed, on a 50% write-down basis on PIGS, I calculate a EUR 200 billion capital loss for European banks (an average of EUR 2.2 billion per bank surveyed). This is large but sustainable and is equivalent of the two bailouts of Greece (still to be approved by all eurozone countries parliaments).
What if Italy is getting into real trouble? Eurozone banks exposure to Italian debt is EUR 686 billion, Italian banks holding 24% of this total. We are talking large numbers but not out of reach. Several banks would need to be recapitalized, but again it would be manageable even on the basis of a 75% haircut which I do not expect for all PIIGS, and not Italy in particular ( number below on 75% haircut / 50% haircut):
German Banks: EUR 24 billion / 9 billion
French banks: EUR 19 billion / 0.4 billion
Belgian banks: EUR 11 billion / 0.0 billion
Italian banks: EUR 127 billion / 3.0 billion
This also shows how much a difference a 75% and 50% haircut it makes. The longer Eurozone governments wait the higher the price to pay.
And do not forget that EUR 200 billions is “only” 3 years of 2010 net profits.
On the basis of sovereign risk, my second conclusion is that banks do not need capital injection but for a few exceptions; for once, I therefore agree with European authorities but it is time to stop the mess spilling over.
2. It is time to draw a line on the sand
Over a year ago it was clear that the Greek problem will not be contained and Greece’s default was inevitable.
All over-optimistic growth forecasts are now revised downwards (like Greece last year) and all commitments regarding budget deficit reduction will no be met. This will in turn induce a renewed round of uncertainty on the BIGSPIF (yes, I add France and Belgium to Portugal, Ireland, Italy, Greece and Spain) quality of credit ratings. Eurozone countries can no longer support the financial sector nor artificially spur consumer demand (which is useless in such a crisis anyway – it just buys time for politicians).
It is therefore time to draw a line in the sand.
  • Banks (and Insurance companies) must bear the cost and consequences of their mismanagement: they must write-down non-performing assets and book loses incurred on their sovereign debt portfolios. In a rare occurrence, on August 4, the Chairman of the International Financial Reporting Standards wrote a letter to the Chairman of the European Securities and Market Authority, outlining the discrepancies between fair value valuation amongst banks, resulting in write-downs ranging from 21% (BNP Paribas) to 51% (RBS), the former being unrealistic and not abiding by rule IAS 39 about assets fair-value calculation. Banks must value assets the same way and follow IAS 39 recommendation. This letter was made public Tuesday 31 August after reports from the Financial Times on Monday. The suppression of FASB 157 rule on fair value accounting during the crisis did not fix banks’ balance sheet but instead allowed them to camouflage the problems; FASB 157 should be re-instated.
  • Banks needing capital will have to sell assets and/or go to their shareholders; failing that, shareholders will be wiped out and bondholders will probably incur some losses. These banks will temporarily become state-owned or will be sold to buyers. Collectively, banks could bear a 50% write-down on the Greek debt with less than one year after tax profit (EUR 68 billion vs. EUR 77 billion in 2010).
  • All deposits will have to be guaranteed to avoid a run on banks (in the future a levy on banks and insurance companies will have to be implemented to contribute to a fund that would be large enough to sustain a future financial crisis without a recourse to public aid).
  • Solvent banks / other investors would buy “clean” assets from bankrupt banks, the same way the FDIC is doing in the US, non-performing assets being either auctioned out / written down to zero or parked in a pan-European agency at market price for future sale.
  • Reduce commercial banks’ trading activities for their own account in an orderly way to reduce their leverage and improve their solvency ratio.
  • Isolate trading activities for the banks’ own account within structures that would work autonomously without any access to banks’ capital beyond what would be allocated at the start of their operations. 
Tackling the eurozone crumbling edifice with pragmatism is the best way to save what can be saved instead of continuing with dogma and blindness.

Letter from the IFRS to the ESMA: Accounting for available-for sale (AFS) sovereign debt

Financial Times: IMF and eurozone clash over estimates

Financial Times: Europe bank regulator plans radical funding aid

Financial Times: Lagarde calls for urgent action on banks