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