Follow-up on Italian banks

In a letter to Financial Times on 23 February, the Director-General of the Italian Treasury provides some info directly related to my previous post.

Vinzenco la Via writes that:

"Between the beginning of 2015 and the beginning of 2016, the Italian government introduced radical changes in the banking sector (...) The new system will exploit economies of scale, allow better use and allocation of skills, and permit better market access, while improving the management of non-performing loans.

Vinzenco, I love what you write.

My only question is: Why did it take you so long??? Where were you between 2008 and 2015?

I know. You were fighting the deeply entrenched interests in the financial sector which had put personal interests ahead of the common good. And various governments had been unwilling or unable to make a serious push to force the banks in this direction.

Has anybody got the guts to make an analysis of the costs to the society of not acting with far more resolve? I'm just asking..

Now I am curious about what happens in the French banking sector. Not to mention in what remains of the partially reformed savings bank sector in Spain.

Euro-Tarp? Maybe... look at Italy

In the dying days of the Bush administration, then Secretary of the Treasury Hank Paulson introduced a US 1tn program called  the Troubled Asset Relief Program, or TARP for short. Translated into plain words, it was an offer to the banks that the Federal Government would buy the worst stinking pieces of bad loans the banks carried on their balances. And it was clear that not too many questions would be asked.

It was a variation of one of the elements in the famous rescue of the Nordic banking sector in the 1990's. At that time, banks signed up to be rescued, the insolvent ones were taken over by the Finance Ministries, who then combed through the bank balances, hunting for the worst stinking pieces of bad loans. The bad loans were then folded into a company which was floated on the market with a time limited loss guarantee from the government.

In the Nordics, shareholders lost their investments and boards and management lost their jobs. In the US the management largely kept their jobs while the shareholders saw their holdings diluted severely.

However, in both cases, the action contributed to "clean out" the bank balances, meaning that the banks relatively quickly could get back to the core business of a bank: to receive deposits and lend money.

Not so in Europe. 8 years after the onset of the crisis, and two "asset quality reviews" later we are stuck in a situation large European banks are sitting with unrealised losses, which - if they were realised - would lead to the demise of the banks in question. I - and several others with me - have a sneaking suspicion that this state of things holds back European bank lending in a significant way.

Last week, the ECB gave a startling confirmation of the gravity of the situation.

Since 2015, the ECB has tried its own version of quantitative easing or QE. This of course refers to the programs whereby central banks in the US, UK, Japan and Canada have purchased enormous amounts of their own government bonds in the market. Some covered bonds, such as mortgage backed bonds have also been purchased. All in the purpose of forcing down interest rates, particularly in the longer maturities.

ECB faces a particular problem in implementing a QE, since its statutes prevents it from financing the individual governments by buying their government bonds. A compromise was found, whereby government bonds were eligible if bought in proportion with the shareholdings in ECB of the individual countries.

It would of course mean that ECB was forced to buy mostly German Bunds - even if it is a relatively small bond market. There are tons of e.g. Italian bonds on the market, but ECB cannot buy that many of those. Then there is some agency debt out there, but having to buy 60bn EUR worth of bonds each month seems to be a problem.

So ECB has had a brainwave: Let us buy some of the worst stinking pieces of bad loans the banks have been carrying on their balances. In casu the Italian banks, who suddenly admit to have a small sum of 225 bn EUR of bad debts they would really, really like somebody else to buy from them.

Which is possible for ECB if the Italian government is guaranteeing the debt. Once that obstacle is cleared away, we can start guessing which other banks are sitting on a mountain of bad debts.

In other words, the ECB QE program is now morphing into a Euro-Tarp. I am sure that the Germans are shaking their heads or even worse. I do not really care. The TARP program gave the US banks a headstart to recover even if bank regulators had to hold their noses while buying the bad debt.

Here in Europe we have had a very peculiar attitude. We want to punish the banks for doing a dirty on us all, so we want them to recover without any help. But we do not want to punish them so badly that the boards and bank managements were actually kicked out. So the "Swedish solution" was also excluded.

The result has been that it has taken waaay too long time for credit growth to return to Europe. It has held back consumption and investment. When we will be writing the story of the financial crisis in Europe, the lack of dealing properly with the banks will stand out as a monumental error.

So monumental that it will almost be on a par with the German insistence on draconian savings programs to curb government debt creation in an environment of weak consumer demands.

Cameron's nightmare - and EU's

So the UK got a watered-down set of modifications to the various EU agreements, delivered with sufficient gravitas that Cameron could declare victory and go home and call the promised referendum to take place on 23 June.

Anybody just vaguely familiar with EU's workings knew already that nothing substantial could be negotiated in a few months. Substantial changes require changes to the treaties, and with 28 member states it will take at least 5 years to change as much as a comma.

But now the referendum has been called - with potential disastrous consequences for EU, Europe and not the least, for the EU.

EU created peace
It is worthwhile to remember the historical roots of the EU. Since Germany created itself as a national state under the stewardship of Bismarck, the country always had the uncomfortable geopolitical situation of having strong and often bellicose neighbours to the east and to the west: Russia and France. Bismarck saw this clearly and built a national strategy on the necessity to be able to fight a two-front war. This national strategy touched upon education, infrastructure, industrial production and defense. The strategy required speed, mobility and technological and tactical advantages. It is probably not wrong to claim that Germany's situation today is a direct consequence of the geopolitical situation and of Bismarck's response.

After Germany had tried to "solve" the geopolitical dilemma twice, each time ending in defeat, the US influence over Europe led to a major geopolitical change. By putting Germany under the US nuclear umbrella and by uniting Germany and her erstwhile enemy France in a close political and economic cooperation, Germany could finally forget the need to fight two enemies at once. The existence of the EU changed important geopolitical parameters.

EU is in other words the political and economic "leg" of the post-WWII re-organisation of the European map. Together with NATO, EU has been spectacularly effective. So much so that people today forget how efficient the combo has been in preventing war in Europe. The 70 years of peace in Europe since 1945 has been one of the longest and most prosperous periods in the continent's war-torn history.

The Britons have always had an ambivalent relationship to EU: why participate in the club of losers (of WWII) when we were one of the victors? For centuries Britain managed to survive nicely by playing the other European nations against each other and profiting from her naval superiority.

And now?

Fast forward to today. Many brits appear to have forgotten entirely that they do not any longer dominate the seas. They do not any longer have colonies. And more seriously: The Americans do not any longer consider the "Special Relationship" between USA and Great Britain as particularly special. President Obama even told the Brits directly that Great Britain would be more useful to the USA inside the EU than out.

Europe has also lost in importance on a global scale. The larger powers do not any longer focus on the Europe. Instead it is China's growth, Russia's possible reemergence as a major player and the continued global dogfight over access to oil and minerals that dominate. Britain may have been good at manipulating the other European nations into wars for 400 years. That ability is just much less marketable today.

Zbigniew Brzezinsky, a former national security adviser to US president Carter put it brutally: Great Britain is not a geostrategic player… Its ambivalence regarding European unification and its waning special relationship with America have made Great Britain increasingly irrelevant (The Grand Chessboard: American Primacy and Its Geostrategic Imperatives (1998)).

A tactical error
In 2013 Prime minister Cameron feared a major incursion on traditional Tory ground by the UK Independence Party. In order to placate the notoriously loud Euro-sceptical wing of his party and in order to convince euro-sceptical voters of his own credentials in this department, he promised a referendum on "in or out", in case he was re-elected as PM.

At that time, not much looked as if it would ever happen. The Tories were lagging Labour in the opinion polls, UKIP seemed to be a threat, and the Lib Dems still had some credibility and were not at all foreign to threaten Cameron to switch sides if needed.

And then things began to pear-shaped. First there was the 2014 Scottish referendum on independence. Scotland was deeper divided than expected and the outcome too close for comfort (55% voted to stay in the UK, 45% against). The next act was the 2015 general elections. The Conservatives had nearly no representation north of the border. So Scottish voters who wanted to vent their frustration hit Labour hard. The party was viped out in Scotland and that alone was enough that an expected national majority evaporated. UKIP did worse than expected because of a very weak party organisation, and the Lib Dems were hit badly by the law saying that the junior partner in a coalition partner most often suffer badly at the next elections (ask FDP in Germany).

Suddenly Cameron had a majority in Parliament - and had given a promise to the right wing of his party to make a decisive referendum after a round of negotiations with the EU. He had solidly painted himself into a corner with no way out. Except of course by resigning, which is not on the cards for now.

Refugees
The European refugee crisis has changed the dynamics in Europe as well as in the UK. By many voters not steeped in history, "migrants" of any colour and shape are seen as the result of Europe's open borders and flagrant disrespect for national values. Europe has certainly not handled the refugee crisis in a reassuring way, and it has given wind in the sails to illiberal nationalist parties across the continent.

Also in the UK, this particular political mood has gained strongly despite the weakness of UKIP. It is visible in the fact that Cameron's negotiation strategy has been to gain concessions on "migrants" even if the people in question are far from being refugees. Most often they are quite skilled labourers who quickly find jobs, particularly in the UK construction sector.

So the refugee crisis has in Cameron's strategy morphed into a general "bash the migrants" policy - which obviously annoys the eastern European EU members.

How bad could it end?
We may be heading towards one of those rare moments in history where one man's actions actually matter.  Cameron's wrong reading of the situation inside his own party in 2013 could now lead to the following scenario:

Were UK to leave the EU, Cameron will be toast having campaigned for UK to remain in the EU and will have to resign. His own party, the Conservatives, will suffer a deep division that will take decades to heal.

Both the EU and the UK ends up weaker and destabilised.

Egged on by national conservative movements, more countries will ask for substantial opt-outs, in particular in the fields of EU law and integration. Scotland will request independence from the UK as the Scots are firmly in favour of a continued EU membership.

The EU may end up being split and the UK may be torn apart. That could be the parting shot for independence movements elsewhere, in Catalonia, in Belgium and who knows, in Wales?

Cameron may still go down in history as the man who made the worst tactical gamble possible and refused to see the implications of it until it was too late.

And over in Moscow, Putin and his inner circle will be all smiles.

Same old, same old

Famously, the rapper Eminem declared "I'm back" on one of his albums and reviewers noted with some surprise: Has he been gone at all?

I have not been away, I have been working my blog under the name "Connecting the dots" and it is likely to reappear soon under that name soon. But until that is in place, I will publish my opinions here.

When I review what I wrote in 2012, it is surprising to see how little has changed:

QE is still in place, except that ECB has now replaced FED as the driver. Economic growth is still way weaker than politicians hope, and the reasons are the same: consumers are still saving too much and the European banks still carry too many bad loans on the balance in order for them to lend freely.

Japan remains an unmitigated disaster. Seen from the helicopter it is incredible that anybody is still surprised to see that a country with a rapidly shrinking population is experiencing negative growth.

The German establishment is still fighting against a reasonable European monetary policy, based on a mixture of angst and a rigid belief that rest of Europe must become like Germany in order for healthy economic growth to return to the continent.

Egged on by the Tea Party, US Republicans have taken further steps away from economic sanity - one would have sworn that it was impossible. The only good thing is that the political paralysis has created a situation where the economy has been able to recover healthily, undisturbed by ideological incursions.

A couple of things are new, though. Some countries have negative interest rates, Denmark, Sweden, Germany, Switzerland. Oil has fallen to comfortable levels. Russia is trying to reestablish Soviet era glory on the backdrop of an impending economic disaster.

And then over to a subject as relevant today as in 2012: The European monetary policy and in particularly the impact of the debt crisis on certain South European countries. Italy is of course the 800 pound gorilla in the room with a government debt in excess of 130 per cent of GDP and more than 2,000 bn EUR.

Add that Italian banks still drag a ton of bad debts along. 8 years after the onset of the financial crisis, many banks in Europe's south (broadly defined) have still not managed to write off the bad loans and move on.

Italy, German wise men and haircuts

I found this article and it is interesting reading. Apparently the German Council of Economic Advisors now recommend that before the institutions of the Eurozone will help a country with a bail-out, the holders of the country's debt will have to take a "haircut", i.e. a programmed loss of a certain percentage of the bonds. Rumours are that Finance Minister Schäuble is backing the proposal.

This breaks with a tradition that has survived even the Greek debt crisis: Eurozone countries holding debt of another Eurozone country will not suffer losses on that debt. Private debt holders, however, can lose money, as they did in the case of Greece.

By now gingerly suggesting that other countries must suffer a loss before help can be granted to a country in need, Germany will make sure that they will not be the only ones to insist on budget discipline. They simply obtain that everybody else will also stand to lose money. The effect is of course to avoid that Germany is the only villain to insist on budgetary discipline.

If the proposal is accepted by the other Eurozone countries, Germany will not be alone in resisting "frivolous" proposals from left-wing or populistic new governments in e.g. Portugal, Spain or, oh horror, Italy.

The Germans are understandably tired of being portrayed as latter day nazis imposing iron discipline on freedom-loving countries with young and dynamic governments, as it happened in Greece. The German proposal would remove the focus from Germany as the sole source of budgetary rectitude. Everybody else would have an incentive to put pressure on countries who habour pipe dreams of breaking with austerity demanded by the Eurozone.

It is intelligent, at least seen from a German point of view. To me it again looks as if Germany in its rigid adherence to the belief that every Eurozone country should become a mini-Germany continues to impose rules that simply imposes more instability in the name of stability.

The proposal will give other governments an incentive to put pressure on "irresponsible" governments. It will also give all investors a motive to sell government debt in the affected countries as soon as the word "bail-out" is mentioned.

Ideology continues to stand in the way of ending the economic crisis. Ideology prevents an economic policy that will support economic growth in Europe. Wonder if anybody has calculated the price Europe has paid as a result of a sluggish recovery over the past years.
  

Bank downgrade - yawn. Europe downhill. Spain

Banks downgrade
Moody’s has been doing a hatchet job on banks across Europe recently and yesterday saw Moody’s downgrade 15 large international banks. For some reason it came as a shock to many. I do not really get the point. The markets have known for years that something was wrong in the banking sector. The banks are forced to increase their capital base, reducing their profitability. Households are deleveraging, reducing income for the banks. So why is it a surprise that banks are a worse business now than before? The chart below compares global banks (blue line) to global equities (red line). Banks have underperformed the market badly – the market participants have been voting with their feet for years.

Europe
The “Flash” PMI for the Eurozone and for some of the larger countries were released yesterday. It was very bad reading, as the European contraction continues. The German index showed an accelerating contraction. German export orders continue to fall rapidly. The only question one can ask is how long it is allowed to continue. I wrote on Thursday that domestic and international pressure on Merkel to change her economic policies were mounting. Yesterday’s data release just confirms that economic policies in Europe must change and the sooner the better. IMF Chief Lagarde seized the opportunity to tell the German government that joint debt would be a very useful element in solving the crisis. I remain optimist that they will. Germany will find it in her own interest to adjust. The only question is when.


For a comparison, look at Industrial Production in USA (red line) and in the Euro-zone (blue line). Europe’s output has been falling whereas the US output has been increasing. The difference? The degree of austerity.

Spain
Two international consultancies had been asked to conduct an independent review of the capital injection needed to salvage the Spanish banks. They ended up with a maximum of 62bn EUR. Just some months ago the Spanish government believed that 25bn would be enough. Or at least that is what they said. Two weeks ago the same government asked for 100bn in help from the Euro-zone.


I think the 62bn is good news, on the condition that the two consultancies have built in enough buffers in to compensate for the continued recession in Spain that will increase the credit losses. At this moment it is not important if the necessary capital is 62bn or 100bn. We just need to get to a point where the markets finally begin to believe that the number is final. 

Finally, a move to rescue banks

Spain asked for a bailout from the EU and the other EU countries appear to have accepted it. It is not a general bailout as known from Greece, Portugal and Ireland, but limited to assistance in recapitalising the ailing savings banks. Apart from my firmly held conviction that the method chosen is the most expensive for everybody, it was positive that something happened.  Even if the details will take some weeks to hammer out, I think it is important to understand that this step is more momentous than the three previous bailouts. Finally the EU is moving to resolve the situation with Europe’s sick banks.

Importantly, the oversight with the package appears not to go to EU and IMF, but only to the EU and it is not a general control of the country’s spending, but only a control of the banking sector. It may be an important pointer that we are moving towards a “banking union” with a joint euro-zone banking regulator.

It ought also by now be clear that the crisis is not only about public sector debt. The four countries that had seen the strongest increase in private sector debt in 2000/2007 are also those where the banking sector is in deepest problems. UK, Spain, Ireland are involved in major rescue actions for their banking sector and the economies are suffering from protracted recessions or zero growth.

The fourth, Denmark, has escaped a deeper economic crisis because of a very efficient mortgage financing system, and relatively healthy public finances. But the economic growth is anaemic, the banking sector is still in deep trouble, and more than a quarter of the country’s banks have closed. The largest bank, Danske Bank, only survived through generous government loans.

Greece is in deep trouble because of public over spending to the tune of 15 per cent of GDP. Portugal needed its bailout because of a sclerotic economy and its government is fighting to rush economic reforms which should have been implemented 10/15 years ago.

So the lesson is that 1) bailouts are different from case to case, 2) it is good that EU is finally getting some focus on the banks and 3) private sector indebtedness is at least as important in the current economic crisis as the public sector debt. 

Portugal obtained EU’s accept to spend some 6.6 bn EUR out of its emergency facility to recapitalise the country’s four largest banks. Good news for two reasons: another banking rescue as in Spain, and it appears that the costs can be covered without increasing the emergency facility. It is a sign that Portugal’s economy is moving the right way. 

I still do not exclude that the best solution would be to keep the emergency facility in place until 2014 instead of 2013. We will see.

The German opposition may have some luck flexing its muscle (it controls the Bundesrat and could delay all legislation) and appears to have forced Chancellor Merkel to accept some kind of growth initiative for Germany. That is absolutely fine, it is completely in line with the fact that general elections will take place next year, but it is not enough. We still need more pressure on the government to accept something like the "redemption fund" that would change investors' perceptions of European government debt.

Five steps to European Happiness

Well, not quite. But the events in Spain, Portugal, and Germany are small steps in the right direction. All of them fall within the five requirements I listed back in December 2011. Here is the link to my blog post from back then.

Bank rescue. Chicken

Bank rescue
Today is the day where the EU should present its blueprint for salvaging the EU banks. In principle it is simple. We need an EU banking regulator, a deposit guarantee, and a big bag of money. But then the problems begin. Which authority should be given to the EU banking regulator? Who should be covered by the guarantee? And who is to pay? Enough open questions to ensure that it will take quite a while to make the scheme work.


There is one big issue that deserves some attention. EU has had as a principle to “protect smaller shareholders” who are supposedly “innocent” as regards the banks’ reckless lending practices. This principle stands in the way of something very important, the ability of the state/regulator/government to take full control over an insolvent bank.


Only by taking full control it becomes obvious to start the necessary process: to sell the non-performing assets, while the now government-owned banks can continue the activities that are absolutely indispensable in the society, namely payments and lending. 


It would then become possible to obtain an honest estimate of the losses. Eventually, it will lead to much smaller costs for the tax payers.


The key is of course that it is possible to temporarily suspend normal reserve requirements, because there is a deposit guarantee in place. As long as such a guarantee is in place, a nationalised bank can in principle operate without a capital base. 


It obviously requires that all shareholders must be wiped out. On this point I am more adamant that the EU Commission. It is normal capitalist logic that one can lose money through bad investments. There are no “innocent” investors. Protecting small investors should not stand in the way of providing a much larger public good: a restored and restructured banking sector.


Chicken
The venerable game of Chicken is played in a variety of ways. One is when two young men on motorbikes race towards each other on the white line. He who first veers away from the line is Chicken. If both stay the course, there is no Chicken. Only two dead bikers.


Germany’s Finance Minister Schäuble has given an interview in Handelsblatt. Under the heading “No easy way out for Europe”, Schäuble says “If government debts are made collective, and it leads to lower bond yields in the debtor countries, it would reduce the pressure to solve the problems”. Written in black on white: Germany resists an EU solution because it would remove the pressure on the debtor countries.


Apart from the fact that Mr S forgets that Spain’s government debt is lower than that of Germany, he says in plain words that Germany is playing Chicken with the rest of Europe.


Could that end up as badly as Motorbike Chicken? I am not alone in fearing just that. Germany’s former Foreign Minister Joschka Fischer has written an analysis of the European problem. He ends it with the following warning: “Germany destroyed itself – and the European order – twice in the twentieth century... It would be both tragic and ironic if a restored Germany, by peaceful means and with the best of intentions, brought about the ruin of the European order a third time.”


It cannot be stated any clearer than this.