Let Sleeping Corpse Lie: Dawn of the Eurozone

Europe has long been a place of economic stagnation. Asides from the odd place or two such as Ireland or the Baltic States, Europe has generally seen its citizens’ standard of living stagnate over the years. Europeans are used to seeing inflation slowly eat away at their purchasing power, asset price inflation eat away at housing affordability and taxes reducing their disposable income. But when you are some of the richest people in the world as measured by per capita GDP stagnation isn’t the worst thing that can happen to you. What is about to happen to Europeans however is less tenable. What is about to happen to Europeans is a repeat of the Japanese experience with their ‘Lost Decades’, but in a World with heightened international competition and rapidly increasing productivity of developing nations this version of the Lost Decades syndrome will seem much more punishing.

On the face of it bank bailouts may seem like the appropriate thing to do when your banking system looks like a rocking Humpty Dumpty on the wall. The Japanese experience should have served as a warning to other governments against the dangers of bailing out banks. When Japan’s property and equity bubble burst at the end of the 90’s the government hit the bailout peddle full steam in an effort to avoid bank runs. The result, was the creation of Zombie banks. Bank’s in Japan had the real value of their assets crippled, forcing Japan’s central bank to come in and pump massive amounts of liquidity into the banking system to keep banks liquide. As banks used the extra liquidity to pay down their overstretched balance sheets’ liabilities, instead of lending them out into the real economy, growth stagnated for years. Japanese banks became simultaneously liquide and insolvent.

The usual process of bankruptcy is to have a judge look over the balance sheet of a corporation and determine how much of the liability side needs to be reduced to create a solvent and sustainably profitable firm. Equity investors are typically wiped out and debt investors get a ‘hair cut’ on their bonds, or see their bonds converted into equity (shares). The process reduces the debt of a bankrupt company to a level that can be covered sustainably. The alternative to this form of bankruptcy is a winding down of the business. If a company is recognized to have a permanently crippled business model and is expected to sustainably loose money, it becomes preferable to liquidate all assets and try and pay back as many debts as possible. In the US these two forms of bankruptcy are called chapters 11 and 7 respectively.

Following a chapter 11 bankruptcy two things may occur that will send a company back into bankruptcy or forced to liquidate. Either business conditions deteriorate and the company’s revenues no longer suffice to pay its interest costs, or the debt reduction is not steep enough from the get-go and the corporation’s normal revenues never really cover the newly diminished interest expense.

The emergence of Zombie banks would occur when both the above mentioned difficulties arise. Bailouts, taking the usual form of a capital injection (the government buying lots of newly issued shares, to the detriment of previous share owners) has the partial effect of of wiping out equity investors but saves debt investors. Without hair cuts to bonds a banks interest expense remains high hence crippling the banks ability to inject loans to underpin the real economy. This problem is further compounded by a lack of chapter 7 style bankruptcies.

Banks’ profit margins tend to be extremely narrow in the best of times; According to the Bank of International Settlements Spanish banks’ current profit margin as a percentage of assets is a measly 0.61% at present, while Germany’s big banks barely squeak out a 0.20% profit margin in 2011. Hundreds of variables will explain why European banks profit margins are razor sharp but Anglo-Saxon banks in Canada and Australia rise above the 1% mark, most economist and financial analyst would chalk up a big part of this discrepancy to the competitive nature of banking in different countries. Canada and Australia are countries were industry concentration is high whereas in the US and Europe the banking industry is atomized and fiercely competitive.

When chapter 7 style bankruptcies are effectively ruled out by bailouts, banking industries are prohibited from consolidating to a more natural level of concentration. Profitability is kept artificially low by excessive competition to issue loans and attract savings. The effect of too much competition in an environment where bank profitability is hampered by both excess industry atomization and crippled balance sheets is obviously the creation of Zombie banks. What European authorities are doing with bailouts is stopping progress in its tracks. While bank bankruptcies might raise long term interest rates in the sector, it would mostly lead to consolidation and concentration which would embolden banks to lend to the real economy. This is how over the counter European bailouts are killing growth.

There is however bailouts of the under the counter sorts. The ECB has done what the Bank of Japan has tried before it, albeit in its own way. The ECB’s LTRO (Long Term Refinancing Operations) have been used to increase the liquidity of banks in Europe. Instead of its normal refinancing operation, lending to banks for less than 6 months with adequate collateral posted, the ECB has accepted lower quality collateral (despite what it may say) and refinanced at maturities up to 3 years at favorable rates. The idea was to buttress banks’ balance sheets to avoid a dry up in lending. The effect however was to lend cheaply to banks in PIIGS countries (but also elsewhere) who then plowed the money back into high yielding Spanish, Italian governments bonds and the like. So we are in a funny situation, bank profits in Europe are dismal (Italy’s banking sector is yielding -1.22% profits over assets) but their net interest margins are creeping up, all while real business is starved for credit.

Astute observers will have seen this all before, in Japan. Most will be distressed at the pueril actions of leading bureaucrat financiers and economists. Many now regret the resignations of Jurgen Stark and Axel Weber, some of the last monetary hawks who warned against the current ECB roster of economists frivolous policies. Time alone will tell how foolish or not the current fiscal and monetary policies of the Eurozone are. Let’s all hope that a repeat of Japanese banking woes don’t make a repeat appearance and finally slay what was one of the noblest experiments of our times.

Spanish Bank’s Get Government Brokered Bailout

Madrid / Brussels. While Spanish Prime Minister Mariano Rajoy continues to deny Spain’s need to bailout its banking sector an informal agreement has been reached on the possibility of Spain taping 100 Billion Euros for the purpose of restructuring its banks. The agreement was apparently reached in less than two hours over the weekend at which time Spain was offered $125 Billion with virtually no strings attached. While the details of the agreement remain unannounced, previous rounds of austerity measures and structural reforms were enough to convince Northern Europe of Spanish fiscal credibility and bailout merit.

Whether the European Stability Mechanism will be employed to fund the European loan to Spain or whether the temporary European Financial Stability Facility will be used remains to be negotiated as the ESM is not slated to be in operation before the end of June 2012. Spanish borrowing needs till the end of the year amount to roughly 70 Billion Euros and estimates for a banking bailout in Spain have ranged from 40 to 90 Billion Euros, meaning the European loan could very possibly be large enough to cover all governmental liquidity needs till 2013. If that is the case the nominal yield on Spanish debt will matter little in for the short term and give Spain another 6 months to implement structural reform conducive to growth.

The loan will be provided to the Fund for Orderly Bank Restructuring (FOBR), a Spanish regulatory group created in 2009 to oversee bank mergers and acquisitions, with the objective to ensure that all banking groups in Spain remain solvent. With a war-chest previously estimated at 99 Billion Euros minus the Bankia bailout, the European loan will bring the FOBR’s capital firepower up to ~180 Billion Euros.

The downside of the loan is that it would bring Spanish debt to GDP levels up to ~90%, a historically undesirable number. Another worry for investors is whether the ESM or EFSF will be the loan issuers. ESM issued loans and rescue passages will have senior status and subordinate all previously issued bonds and treasury bills, while the EFSF originated loans have the same status as privately marketed debt securities. This uncertainty wiped out all the gain in Spanish bond prices initially generated by the announcement. It is widely speculated that the loan will not subordinate private debt as Germany and co. would like to see Spain return to capital markets to finance its deficits at reasonable yields.

Another concern is the continued slid in property values that could lead to higher bad loan ratios at the banks. Banking loans past due by 3 months have already reached highs not seen since the mid 90’s, at a staggering 143.5 Billion Euros. With property values continuing to slide and unemployment still at ~24% the risk of a continued slid in Spanish bank assets may eclipse the size of the current bailout proposal.

Negotiations are expected to resume once Mariano Rajoy has finished watching the Euro football championship, which might be soon seeing as the Spaniards could not even beat Italy in round robin play.