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