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What is needed to cleap up the eurozone house - clean-up the banks and restructure pigs debt

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European banks have been very good at lobbying to make sure European countries are baling out Greece and others, whilst our analysis shows that they could sustain a PIGS default.

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What is needed to cleap up the eurozone house - clean-up the banks and restructure pigs debt

  1. 1. http://marketsandbeyond.blogspot.com/ http://www.pcgwm.com/ 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 andthe need for banks (and any other holder of PIGS debt) to take their losses. Governmentscannot and should not maintain mismanaged banks (either directly or via the ECB or anyother vehicle) under life support, shareholders should take their responsibilities (eitherinject equity or face huge losses) and fire management and boards; bondholders will alsoincur losses on their investments with failing banks. It will be painful but it is utterlynecessary and urgent to clean the mess one for all.1. The situation is not as desperate as painted by banks on a PIGS basisThe 90 European banks surveyed by the European Banking Authority could absorb aGreek, Portuguese, Irish and Spanish default, based on two scenarii Markets & Beyond runon its financial model (50% and 75% haircut of their sovereign debt holdings) andmaintain a ratio of Common Equity / Risk Weighted Assets of 7% as per Basle IIIrecommendations to be implemented by 01/01 2019 (I am not discussing the Basle IIIdecisions whilst still casting doubts about its efficiency in case of a new round of financialcrisis with CDS for example; also nothing is dealt with sovereign debt which still deservesthe 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, theFranco-Belgian bank is added), well within the limits of what is sustainable without theneed to raise new equity to abide by the Basle III rules - the picture is different on anindividual basis. Even if they needed to plug the gap, EUR 40 billion is not the end of theworld and manageable.This analysis confirms Markets & Beyond previous findings that Italian banks areinsulated from a PIGS sovereign debt default with less than EUR 5 billion at risk, i.e. lessthan Dexia alone…I therefore conclude that banks lobbied very successfully to protect their owninterests to the detriment of public interest at large.On an individual basis, 3 German banks (DZ Bank, Hypo and WGZ – Norddeustche isundercapitalized despite being less exposed to PIGS countries) and Dexia would see their 1
  2. 2. http://marketsandbeyond.blogspot.com/ http://www.pcgwm.com/capital structure seriously impaired on a PIGS default (40% + of their core capital wipedout), 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 theMaastricht treaty and ECB charter were torn apart), having in the region of EUR 110-120billion of PIGS exposure. This is nevertheless also perfectly manageable by Eurozonecountries, and better than extending an unlimited and wasteful lifeline to Greece andconsorts.Does this mean Eurozone banks do not need to be recapitalized? No; in a slowingeconomy, default risk will increase in other sectors of banks’ credit portfolios and moreimportantly they must be able to face their exposure to CDS and other derivativeinstruments. Spanish banks are still deeply exposed to a real estate market which has yetto clean its inventories and find a bottom. I unfortunately could not find enough datareadily available (my next task) to analyze them and quantify the risk banks (and othersellers of these OTC derivatives) are facing, but my sense is that it is large indeed andcapital needs are probably in the hundreds of billion. But this recapitalization is notrequired to absorb a PIGS default.Indeed, on a 50% write-down basis on PIGS, I calculate a EUR 200 billion capital loss forEuropean banks (an average of EUR 2.2 billion per bank surveyed). This is large butsustainable and is equivalent of the two bailouts of Greece (still to be approved by alleurozone countries parliaments).What if Italy is getting into real trouble? Eurozone banks exposure to Italian debt is EUR686 billion, Italian banks holding 24% of this total. We are talking large numbers but notout of reach. Several banks would need to be recapitalized, but again it would bemanageable even on the basis of a 75% haircut which I do not expect for all PIIGS, and notItaly in particular ( number below on 75% haircut / 50% haircut):German Banks: EUR 24 billion / 9 billionFrench banks: EUR 19 billion / 0.4 billionBelgian banks: EUR 11 billion / 0.0 billionItalian banks: EUR 127 billion / 3.0 billionThis also shows how much a difference a 75% and 50% haircut it makes. The longerEurozone governments wait the higher the price to pay. 2
  3. 3. http://marketsandbeyond.blogspot.com/ http://www.pcgwm.com/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 capitalinjection but for a few exceptions; for once, I therefore agree with European authoritiesbut it is time to stop the mess spilling over.2. It is time to draw a line on the sandOver a year ago it was clear that the Greek problem will not be contained and Greece’sdefault was inevitable.All over-optimistic growth forecasts are now revised downwards (like Greece last year) andall commitments regarding budget deficit reduction will no be met. This will in turn inducea renewed round of uncertainty on the BIGSPIF (yes, I add France and Belgium toPortugal, Ireland, Italy, Greece and Spain) quality of credit ratings. Eurozone countriescan no longer support the financial sector nor artificially spur consumer demand (which isuseless 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 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 3
  4. 4. http://marketsandbeyond.blogspot.com/ http://www.pcgwm.com/ 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 further the capital allocated to these activities therefore reducing their leverage and improving 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 canbe saved instead of continuing with dogma and blindness.Source:Letter from the IFRS to the ESMA: Accounting for available-for sale (AFS) sovereign debthttp://www.ifrs.org/NR/rdonlyres/949CAE0C-3E3B-4F64-9F1D-53B491458880/0/LettertoESMA4August2011.pdfFinancial Times: IMF and eurozone clash over estimateshttp://www.ft.com/cms/s/0/16d26bc8-d3f5-11e0-b7eb-00144feab49a.html#axzz1WgI28SokFinancial Times: Europe bank regulator plans radical funding aidhttp://www.ft.com/intl/cms/s/0/4906eefc-d328-11e0-9ba8-00144feab49a.html#axzz1WgI28SokFinancial Times: Lagarde calls for urgent action on bankshttp://www.ft.com/intl/cms/s/0/9f857244-d0d0-11e0-8891-00144feab49a.html#axzz1WgI28Sok 4

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