Greece’s race to default...                     Monday, Greece’s bond yields re...                    sharply increasing cost of fina...                      •   Since the financial crisis w...                    that served our economic d...                    of England: Optimal ban...
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Greece's race to default and european banks' recapitalization


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Greece will default by end of October and the ECB will dramatically expand its balance sheet to provide liquidity to banks and buy Spanish and Italian sovereign debt in the secondary market to maintain financing costs at acceptable levels.

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Greece's race to default and european banks' recapitalization

  1. 1. Greece’s race to default and European Banks’ recapitalizationWhat I wrote 18 moths ago is unfolding and Greece is racing toward default andpolicy makers must decide who will bear the burden: taxpayers by continuingextending credit lines and the ECB buying sovereign debt in the secondary market toartificially maintain low interest rates and allow banks to offload their junk assets, or theprivate sector by recapitalizing banks - bondholders taking an haircut.European banks’ share prices are nearing their lowest since the nadir of the financial crisisin 2008-2009, and French banks are now over 50% down compared to their 2011 high andcounting. 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. GreeceGreece is asked to deepen its austerity measures in a self-fulfilling downwardGPD spiral (and lower tax receipts) that will lead to a full-blown depression forGreeks together with social unrest, and possibly a threat to democracy when thepopulation will become so desperate it will take desperate actions (and what will happento Greece can occur elsewhere in Europe). Greece needs economic growth to fulfillits 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 EUin May) and these GDP numbers were helped by a plunge in the trade deficit (notsurprising for a country entering into depression). The HCPI is flat from January toAugust but is sharply down in July and August. I have stopped assessing the impact ofcontinuing downgrades and a worsening situation; my last calculation early Septemberwas 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 atacceptable yields, with EUR 2 billion due on each of October 14 and 21; add interestpayments plus deficit to plug and a default is there by end of October or at the latestend of November where EUR 5.6 billion of debt are coming due (Greece has still a bit ofcash at the Treasury plus could ask the Central bank to sell some gold or pay anexceptional 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 de98% risk of default. 1
  2. 2. 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; Greeceis bankrupt and European leaders have failed their mandate so far whilst theyhave a fiduciary duty to defend their citizens and must restructure unserviceable sovereigndebt. Numbers from the EBA show that financial institutions as a whole can sustain such arestructuring with a haircut of 50% (even 75% is workable). For the banks that need toraise equity/dispose of assets where existing shareholders and bondholders do not act,their ownership will be transferred to a more competent stewardship, existingshareholder being wiped out and bondholder paying the price for badinvestments. This would most probably translate into larger deficits which would be betteraccepted 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 standardof 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 forEuropean 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 wouldbe preferable (with the firing of boards and management) than a rampant crisis that willnot be solved adequately by throwing good money after bad.2. BanksFollowing, a recent article published on Markets & Beyond where I analyzed banks’ risk ona PIIGS’s sovereign default, I found a few estimates concerning the need for recapitalizingEuropean banks ranging from EUR 200 billion (IMF - before a downward revision after aEU complaint – sic!) to EUR 1 trillion (Goldman Sachs – they talk their own book) inorder to cover all Bank’s write-downs, and not only sovereign debt.Crédit Agricole and Société Générale ratings were downgraded this morning with negativeoutlook, 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, somedramatically, at a time where their access to short term financing is cut by some largemoney market funds: share prices are 50%+ down since the high of the year, French banksbeing particularly hit (I repeat once again that Italian banks as a whole have a meaninglessexposure to PIGS and are less risky than French ones– they are hit because of theirholding of Italian sovereign debt but I do not believe that Italy will default). I have writtenseveral times that France is in a worse situation than Italy I many ways. 2
  3. 3. sharply increasing cost of financing for many banks is not sustainable beyond theshort term and will start soon to fuel through the real economy weighting further on adismayed European growth. Some will see their access to the interbank market closed, ifnot already occurring.On Monday, Dexia CDS spread shoot up to 1569 basis points at mid-day (+225 b.p.), worsethan Portugal and Venezuela: this is just telling what the market thinks about the qualityof Dexia asset portfolio and exposure to local authorities and municipalities debt (do notforget that Dexia was the largest foreign borrower with the FED during the 2008-2009financial crisis); its exposure to Greece sovereign debt is the worst of any bank surveyed bythe 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 billionexcluding Spain) according to the numbers published by the EBA: Dexia has EUR 17billion of core capita, enough to absorb a Greek default, private sector included (and aPortuguese one – no exposure to Ireland). However, Dexia could not sustain a collapse ofbanks in Spain with a EUR 23.6 billion exposure. I also guess that the interbank market isclosed to Dexia.The OTC derivatives, CDS in particular, represent the last frontier concerningrisk. I have not read anywhere sensible information about who owes and who owns whatto/from who, so it is impossible to figure out who is at risk and for the owners of CDS whatis 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. 3
  4. 4. • 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.ConclusionBanks 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 USD568 billion and who knows how much of the private sector assets are at risk. Italy wouldbe a game changer. So the crisis needs to be contained to the PIG; this could have doneat 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 whichcan 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-indebtednesswill be resolved via inflation as usual (at 5% per annum – an inflation rate perfectlysustainable - 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 notsupport the affirmation that much higher levels of equity funding, and lessdebt, would mean that banks’ funding costs would be much higher. A recentBank of England report concludes that “In retrospect we believe a huge mistake was madein letting banks come to have much less equity funding – certainly relative to un-weightedassets – than was normal in earlier times…We believe the results reported here show thatthere is a need to break out of the way of thinking that leads to the “equity is scarce andexpensive” conclusion. That would help us get to a situation where it will be normal tohave banks finance a much higher proportion of their lending with equity than had beenassumed in recent decades to be acceptable. And that change would be a return to a 4
  5. 5. that served our economic development rather well, rather than a leap into theunknown.”We must also go back to the roots of capitalism where success is rewarded andfailure is sanctioned otherwise success is meaningless, and success needs to be clearlyredefine to adequately reward it.It is also time for a new generation of politicians (I am not discussing age butattitude) to replace our failed leaders who share the responsibility of the messwe are in, at best by incompetence and sheer populism, at worse by complicity: democracyas we have known it is at stake. The eurozone creation was “sold” to the public as a mereunified forex zone where tourism would be easier and inflation checked (a lie), and neveras a monetary union that demanded homogenization among participating countries on asocial and fiscal basis. Under the current structure and membership the eurozone is afailure: a structural change or a different geographical perimeter is required.Credibility and psychology are key and European leaders lacked both, hence the absence ofconfidence by markets and European citizens. This needs to be redressed, urgently.Finally, a word from Romano Prodi, EU Commission President, in December 2001: “I amsure the Euro will oblige us to introduce a new set of economic policy instruments. It ispolitically impossible to propose that now. But some day there will be a crisis and newinstruments will be created.” 5
  6. 6. of England: Optimal bank capital Europe Banks Valued at Post-Lehman Low Ministry of Finance: General Government Monthly Cash Data and Arrears Statistical Authority Investment Research: Euro break-up – the consequencesGoldman Sachs: Banks as bystanders at the sovereign stage of the crisisBloomberg: Britain to Implement Vickers’ Bank Protection Plan by 2019 6