Troika to extend the unsustainable Greek debt by decades

The Euorzone leadership remains uneasy with the third bailout of Greece. This unease can be seen in the recent delay to the start of the negotiations, with the Troika staff in Athens siting "technical issues". The actual reason has to do with the fact that Greece's creditors have yet to reach an agreement among themselves. Apparently some Eurozone nations are still pushing for additional requirements that go beyond the austerity measures the Greek parliament recently passed.

The challenges surrounding the new bailout are severe. The intrusive nature of reform enforcement by the creditors is likely to worsen the already intense animosity in Greece toward the Troika institutions.

Bloomberg: - Previous memorandums committing Greece to enforce reforms on everything from the rules of bank recapitalizations to evaluating the “impact of the changes in milk pasteurization and sale procedures,” have prompted dissenters to claim that Greece has turned into a “debt colony.” Creditors argue that changes are necessary to stabilize the country’s finances and set it on course to sustainable growth.

Furthermore, the negotiations will once again be taking place "under the gun" as the next payment to the ECB of over €3bn is due on August 20th.

Assuming the deal will be completed in August as the can gets kicked much further down the road, Greece is being set up for a massive maturity wall, with little chance of principal repayment. And any form of debt principal forgiveness is off the table.

Natixis: - [Greek debt forgiveness] is unlikely to come about given the opposition of many Member States (Germany notably), the position of the Eurogroup over this issue (“nominal haircuts on the debt cannot be undertaken”) and the legal obstacle (measure would be in breach of Treaty). Under these conditions, this leaves one option, namely a re-profiling of Greek debt without touching the principal.

Out of the EUR82bn-EUR86bn lent by the ESM, part could be applied to repurchase the debt held by the ECB and to repay early the IMF (which in total would represent EUR25bn). [It] follows that the financing requirement of the Greek State, assuming there is a 20-year grace period and repayments are spread over 40 years, would correspond to the primary balances and repayments of principal and interest in respect of market debt held by private creditors (i.e. TBills, GGB PSI, new GGB and debt issued under foreign law)

According to Natixis here is what the liability term structure is expected to look like after the completion of this third bailout. How Troika lenders can possibly get comfortable leaving a small nation with this type of a debt profile is unfathomable. And yet, this is the most likely outcome of the upcoming negotiations.

Source: Natixis

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Eurozone banks hold record amounts if sovereign paper

The Eurozone's financial regulatory framework, combined with the ECB's monetary policy, has created an environment in which holding sovereign bonds is the optimal outcome for many of the area's banks.

Source: Natixis

This has two major consequences:

1. Government bonds crowd out private sector credit, limiting loan growth in a number of countries.

2. Banks are becoming more intertwined with their central governments - something that was part of the cause of the debt crisis. Governments depend on banks for cheap funding and banks depend on their governments for support (bailout) in case of a liquidity crunch.


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From our sponsor:

Anglo Irish Bank back in the news

As promised in the previous post on Ireland, here is an interesting e-mail from a reader discussing some of the facts around the Irish banking system bailout - particularly as it relates to Anglo Irish Bank:

The Irish Independent newspaper carries recordings of two bank employees, John Bowe and Peter Fitzgerald, discussing the finances of the insolvent bank Anglo Irish Bank (rebranded as IBRC : Irish Bank Resolution Corporation). Both men held senior positions at Anglo at the time.

In September 2008, Anglo requested a meeting with the then Minister for Finance Brian Lenihan requesting a government bailout to solve their “liquidity problem”.

The other Irish banks also lobbied Lenihan and this led to the creation of the Bank Guarantee indemnifying all of the Irish retail bank liabilities to the value of €450 billion.

The Guarantee’s introduction caused consternation in Ireland, UK and throughout the Eurozone because it saw deposit flight from the UK banks to Irish banks (Alistair Darling at the time had strong words with Lenihan).

Anglo claimed that its problems were temporary and that it needed bridging liquidity when in fact the bank was gravely insolvent.

Anglo’s accumulated reserves and shareholder funds were eviscerated, with questions arising about loans to directors, an alleged Guiness-type share support scheme and a bizarre cash where deposits from other Irish banks were put on deposit at Anglo at their balance sheet date to artificially boost their deposit balance for reporting purposes (see link). 

Anglo Irish Bank would eventually receive funding totalling €30 billion before being rebranded in July 2011 to the name IBRC : Irish Bank Resolution Corporation.

A series of promissory notes were created to cover the cost of €30 billion cost of refinancing, all funded by the hard pressed Irish taxpayer IBRC was subsequently liquidated in March 2013 (see discussion).

The Irish Independent newspaper claims to have a lot of tapes which it intends to publish here. The conversations that were taped using the banks recording system were recorded a few weeks prior to the Anglo meeting with Brian Lenihan in September 2008. 

You will hear the Anglo bankers talking about how they told the Irish Central Bank about what it (ICB) needed to do to save the Irish banking system, by saving Anglo.

It is explosive stuff and the contents of these tapes has led to a lot of public anger about the bailing of this insolvent bank.

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From our sponsor:

After sticking it to Ireland a few years back, EU "fixes" the bank bailout plan

Ireland was the one country in the Eurozone "periphery" that seemed to be bucking the trend (see post). Many had hoped that the nation will be able to withstand the Eurozone recession due to its strong trade balance. Exports were really humming until global growth stalled last year (see post). Ireland's trade balance turned negative again and does not seem to be recovering. Furthermore, domestic demand is now weakening.

Source: Barclays Capital

As a result Ireland's GDP contracted and the nation followed the rest of the Eurozone into a recession - just over 3 years after the Great Recession.

Source: Barclays Capital

Given Ireland's high government debt to GDP ratio (Ireland ranks third in the Eurozone after Greece and Italy), this is bad news. The hope was that the government can manage down its leverage as the GDP grows, but that's not how things turned out.

Source: Tradingeconomics

Unlike most of the other Eurozone nations whose debt to GDP trajectory was much more gradual, Ireland's ratio shot up rapidly in a matter of 4 years.  What makes Ireland somewhat unique in the Eurozone is that this debt spike is directly related to Ireland's bank bailout. The sad part is that Ireland's EU "friends" had a great deal to do with this. Here is why.

In the last couple of days the EU reached an agreement on dealing with failed banks.

The Express: - The European Union has today agreed to force investors and wealthy savers to share the costs of future bank failures, moving closer to drawing a line under years of taxpayer-funded bailouts that have prompted public outrage.

After seven hours of late-night talks, finance ministers from the bloc's 27 countries emerged with a blueprint to close or salvage banks in trouble.

The plan stipulates that shareholders, bondholders and depositors with more than 100,000 euros should share the burden of saving a bank.

If Ireland were allowed to implement anything resembling this provision during the financial crisis, its debt to GDP would never have reached anything close to the current levels.

During the financial crisis a great deal of the unsecured debt of Irish banks was held by the UK's and the Eurozone's banks. And neither the EU nor the ECB wanted to haircut these bonds. In order to "keep the peace" in the EU banking system, these bonds were not written down, forcing the Irish government to make the bondholders whole. It had no resources to do so and was forced to borrow tremendous amounts in order to cover these obligations. As losses on property portfolios inherited by the government mounted, so did the government debt (government guarantee had to cover increasingly larger losses). The austerity drive generated by this high government debt caused unemployment to spike and destroyed domestic demand. It may be a decade or longer before the nation fully recovers. Now that Ireland had paid the high price for covering its banks' obligations, the EU is about to implement the rules to force haircuts on unsecured creditors - something they refused to do for Ireland just a few years ago.

The next post will contain an email from a reader describing some of the ugly facts around the bailout of the Irish banking system.

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From our sponsor:

Too-big-to-fail Q&A. Get the facts.

The debate around "too big to fail" of the US banking system is often infused with political rhetoric and media hype. Let's go through some Q&A on the subject and discuss the facts.

Q: Did large banks take disproportionate amounts of real-estate related risk vs. smaller banks prior to the crisis?
A: No. That's a myth. Smaller banks were much more exposed to real estate (see discussion).

Q: Which "too big to fail" banks were directly bailed out by the US federal authorities during the 2008 crisis?
A: While hundreds of banks were forced to take TARP funds, only Citigroup received an explicit bailout to keep it afloat (one exception is Bank of America who received significant incremental assistance largely to support the acquisition of failed Merrill Lynch). Note that Bear Stearns, Merrill Lynch, Lehman, AIG, GM/GMAC, Chrysler, Fannie and Freddie were not banks and would not be subject to any "too big to fail" legislation. Neither was GE Capital and other corporations who relied on commercial paper funding and requited the Fed's support to keep them afloat. Wachovia may have become the second such large bank if it wasn't purchased by Wells. Failed foreign banks like UBS and RBS also would not be subject to any US too-big-to-fail laws.

Q: Why did Citi fail in 2008?
A: Citi ran into trouble because of a massive off-balance-sheet portfolio the firm funded with commercial paper. In late 2007, when the commercial paper market dried up, Citi was forced to take these assets onto its balance sheet. The bank was not sufficiently capitalized to absorb the losses resulting from these assets being written down.

Q: What were the assets Citi was "warehousing" off-balance-sheet?
A: A great deal of that portfolio were the "AAA" and other senior tranches of CDOs that Citi often helped originate (including mortgage related assets). Rating agencies were instrumental in helping banks like Citi structure these assets and keep them off balance sheet in CP conduits.

Q: Why did Citi (as well as many other banks) hold so much off-balance sheet?
A: Because they received a significantly more favorable capital treatment by doing so (the so-called "regulatory capital arbitrage" - see discussion from 2009).

Q: Did Citi break any state or federal laws by doing what it did?
A: No. All of this was perfectly legal and federal authorities were aware of these structures.

Q: Did derivatives positions play a major role in Citi's failure? Were other large US banks at risk of failure due to derivatives positions?
A: No. That's a myth. The bulk of structured credit positions (tranches) that brought down Citi were not derivatives (just to be clear, CDOs are not derivatives).

Q: What has been done since 2008 to make sure the Citi situation doesn't happen again?
A:

• The US regulators now have the ability to take over and manage an orderly unwind of any large US chartered bank. Banks are required to create a "living will" to guide the regulators in the unwind process. The goal is to force losses on creditors in an orderly fashion without significant disruptions to the financial system and without utilizing taxpayer money.
• Large banking institutions are now required to have more punitive capital ratios than smaller banks.
• Capital loopholes related to off-balance-sheet positions have been closed.
• Stress testing conducted by the Fed takes into account on- and off-balance sheet assets, forcing banks to maintain sufficient capital to be able to take a hit. US banks more than doubled the weighted average tier-1 common equity ratio since the crisis (see attached).

Q: Do large US banks have a funding advantage relative to small banks?
A: Not any longer. According to notes from the meeting of the Federal Advisory Council
and the Board of Governors (attached - h/t Colin Wiles ‏@forteology), "studies point to a significant decrease in any funding advantage that large U.S. financial institutions may have had in the past relative to smaller financial institutions and also relative to nonfinancial institutions at comparable ratings levels. Increased capital and liquidity, in addition to meeting the demands of many regulatory bodies, has largely, if not entirely, eroded any cost-of-funding advantage that large banks may have had."

Q: What is the downside of breaking up banks like JPMorgan?
A: Large US corporations need large banks to provide credit and capital markets access/services (Boeing is not going to use Queens County Savings Bank or a broker like Sandler O'Neill - great institutions, but way too small). Without large US banks, US companies will turn to foreign banks and will be at the mercy of those institutions' capital availability and regulatory frameworks. Foreign banks will also begin dominating US capital markets primary activities (bond issuance, IPOs, debt syndications, etc.) And in an event of a credit crisis foreign banks (who are to some extent controlled by foreign governments) will give priority to their domestic corporations, putting US firms at risk.

Q: How large are US largest banks relative to the US total economic output? How does it compare to other countries?
A: See chart below:

So before jumping on the "too big to fail" bandwagon, get the facts.


Meeting of the Federal Advisory Council

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The Eurozone's commitment to supporting Spanish banks questioned by S&P, others

Kostas Kalevras had another good post on the latest data release from the Bank of Spain (here). The good news is that Spanish banks' borrowings from the ECB fell in September, following the ECB's commitment to do "whatever is necessary" to make sure Spain (and others) stay in the Eurozone - reducing the redenomination risk. Nevertheless the latest data from the nation's banking sector still shows declines in lending and losses associated with rising bad loan balances.

Source: Bank of Spain (here)

The collapsing property market is taking its toll. Much of the "corporate" debt in the chart below represents loans to property developers.

NPL = Non-performing loans (Source: BNP Paribas)

Independent analysts and rating agencies continue to be skeptical about a successful bailout of the Spanish banking system by the Eurozone governments. Estimates of the banking system's capital requirements vary considerably from the official figures, pointing to the fact that funds committed so far may be insufficient. And in spite of the commitments made back in June, not a cent of this aid has reached any of the Spanish banks, as key details of the bailout are sill being negotiated (see discussion).

In fact the S&P's downgrade of Spain's government debt was a direct result of the uncertainty around the use of ESM to support Spanish and other periphery banks.

S&P: - A policy setting framework among the eurozone governments that in our opinion still lacks predictability. Our understanding from recent statements is that the Eurogroup's commitment to break the vicious circle between banks and sovereigns [see post], as announced at a summit on June 29, does not extend to enabling the European Stability Mechanism to recapitalize large ongoing European banks. Our previous assumption (which was a key factor in our decision to affirm our ratings on Spain on Aug. 1, 2012) was that official loans to distressed Spanish financial institutions would eventually be mutualized among eurozone governments and thus Spanish net general government debt would remain below 80% of GDP beyond 2015.

S&P's downgrade was to BBB-, one notch above "junk". The impending Moody's action may not be so kind. With junk status, the use of Spanish bonds as collateral at the ECB will require special approvals while bank holders of such debt will be required to allocate more regulatory capital to these positions.

SoberLook.com

Transfer issues will plague Spanish bank bailout

The Spanish bank bailout process still lacks sufficient detail - after months since the announcement (see discussion). Here is the latest:

1. The so-called “Bad Bank” will use 10% equity injection and 90% guaranteed by the Spanish government to “buy” assets from the banks. It means that Bad Bank bonds will be “exchanged” for problem assets.

2. In turn Spanish banks will be able to use these government guaranteed Bad Bank bonds (which they got in exchange for distressed assets) as collateral at the ECB to access more funding. That means that the ECB'a balance sheet will grow further.

3. Private participation is expected in this program, particularly for the healthier institutions. Spain expects some 55% private participation – wishful thinking given that foreign investors are staying away.

4. Assets to be transferred include:

CS: - i) Performing and non performing developer loans, (ii) Foreclosed and Reposessed Real Estate assets and (iii) The equity stakes on Real Estate companies – but small loans/assets will be excluded (below €100,000 for assets and €250,000 for developer loans).

5. Transfers to start before year-end (Dec 1st).

6. The biggest unresolved issue however is the determination of the transfer price. The official statement on valuation is completely vague: “an economic value determined in a detailed valuation process, which will allow the participation of private investors”. Transfer price problems were the reason the original TARP proposal failed in the US. And improper transfer pricing also created later problems for the IBRC, the Irish version of Bad Bank (resulting in tremendous losses for the taxpayers). If assets are really moved at levels that could be cleared in the market, the bank losses could be materially higher than estimated. To bureaucrats in Spain this represents details that will be hammered out later, but if they want the private sector to participate and the government to avoid further "bleeding" via Bad Bank losses, the transfer valuation issue needs to be on top of the agenda.

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Desperate for more ECB funding and running out of collateral, Spain is creating a new type of covered bonds

Spanish banks are running out of collateral that can be pledged at the ECB. The ECB no longer permits banks' own bonds guaranteed by their government (beyond what's already been pledged) to be used as collateral (see the document in this post).

What about using more covered bonds? Unfortunately with unemployment pushing 25% and housing declining quickly, demand for mortgages has dried up.

Changes in demand for loans to households (seasonally adjusted, source: Bank of Spain)

That means mortgage-backed covered bonds (Cedulas) can no longer be issued. These bonds were quite popular in the Eurozone during the bubble years, but are now mostly sitting at the ECB as collateral.

In a desperate attempt to create more covered bonds in order to extract additional lending from the ECB, the Spanish government is about to authorize a new type of securitization structure:

Reuters: - Spanish banks are hoping that the new structure - Cedulas de Internacionalizacion (CI) - will extend this funding lifeline by allowing collateral, previously excluded, to be used.

Under the terms of the new law, export finance credit from high quality financial institutions or guaranteed public sector entities can be used to back a new issue.

This would have the added benefit of lowering issuers' funding costs because covered bonds benefit from lower haircut valuations compared with securitisation, Moody's said.

The ECB accepts self-issued covered bonds as collateral, but not self-issued senior unsecured debt, it added.

Spanish banks are already borrowing €337bn from the ECB (in practice the banks are borrowing from the Bank of Spain who is funding all that lending via TARGET2 loans from the Eurosystem). With these new bonds in place the central bank lending will increase further. Over time the nation's whole economy will in effect be funded by the central bank and any private credit that can be packaged into covered bonds will be pledged as collateral.

Spanish banks' borrowing from the ECB

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Spain's banks face Ireland style recap; will include sub debt haircuts and triggering CDS

As discussed here in April (see this post), Spain's banking system needs Ireland-style bank recapitalization. And that's precisely what Spain's banks are going to get. The "bad bank" entity, unceremoniously named the Asset Management Company (AMC), will become the proud owner of bad property loans. This is the equivalent of the Irish Bank Resolution Corp.

EFSF bonds will be used instead of cash for recapitalization (discussed here back in June). The banks as well as AMC will be able to use the EFSF bonds as collateral at the ECB.

Source: Barclays Capital

The theory that somehow EFSF financing will not force haircuts on debt holders is nonsense. Haircuts are coming and they will be particularly painful for subordinated debt holders. The subordinated component of these banks' capital structures is quite large.

Barclays Capital: - ... the Spanish authorities will amend existing legislation by the end of August to ensure full participation in the liability management exercises. We expect the new legislation to give the Spanish authorities the power to alter the terms of existing subordinated debt in a way that is detrimental to bondholders...

Spanish banks have large subordinated capital structures. There is €64bn of subordinated debt outstanding at Spanish banks, of which €38bn is tier 2 and €26bn is tier 1. We estimate that €15bn of capital could be raised through a combination of voluntary and mandatory subordinated liability exchanges.
...
We expect these transactions to include a coercive element. For example, early stage transactions could be voluntary, but could contain a collective action clause (CAC). If activated, which usually occurs when voluntary participation in the transaction is above a certain threshold, the CAC would reduce the claims of the holdouts by modifying the terms of the instruments. If this fails, Spanish authorities would be able to invoke the powers granted to them under the new legislation to effectively reduce the bond principal through statutory means.

What makes this process especially difficult is that many of the sub debt holders are retail customers of these banks.

WSJ: - According to the draft, Spain will have to introduce a new law by the end of the summer that would allow losses to be forced on subordinated debt holders and hybrid capital holders. Many subordinated debt holders are ordinary depositors.

And the losses at Spanish banks continue to pile up. Unwilling to write off or mark down bad debt quickly, Spain's banking system is taking in losses in a painful liner fashion (see chart below - those who have seen a number of economic charts over the years will recognize that this linear pace of write-downs looks artificial). The latest release from the Bank of Spain (see this post from Kostas Kalevras) once again shows an increase in "Doubtful debtors" balance.

Doubtful debtors (€bn)

The subordinated debt CDS for Spanish banks is widening as loss expectations increase. Given the anticipation of significant haircuts on the subordinated debt, the sub to senior CDS spread ratio, particularly for the weaker banks has risen in the past week.

Source: Barclays Capital

Expect a number of these sub CDS to trigger as the recap process goes into full gear and true losses are recognized.

SoberLook.com

China's banking sector under pressure

Concerns about China's banking system's bad loan portfolios continue to surface.

China Daily: - The Chinese banking system is facing growing pressure from an increase in non-performing loans [NPLs] and an expected decline in profits in the first half of this year, due to a faster-than-expected economic slowdown as well as a narrowing net interest margin, a leading Chinese banker has warned.

Given the amount of control the authorities have over the banking system, Beijing should have no problem isolating and "removing" bad assets (a form of bank recapitalization). However, concerned about bank liquidity in the case of worsening economic conditions and rising NPLs, China Banking Regulatory Commission will be imposing new rules on the banking system. The Commission is particularly concerned about flight of deposit base such as the one faced by Spain.

Bloomberg: - China plans to retain a cap on loans at 75 percent of deposits and may add further requirements that constrain credit growth under draft rules, a senior official at the banking regulator said.

This, combined with China's rate cuts, is capping potential profitability and putting pressure on bank shares.

Industrial and Commercial Bank of China Ltd- A-Shares

 

SoberLook.com

Strangely, Mario Monti may object to a full blown banking union

As expected, the bickering over the proposed Eurozone banking union has begun. And as discussed, the stronger economies will object to the scheme.

WSJ: - The idea of closer European banking ties gained steam earlier this month when European Central Bank President Mario Draghi raised the issue in testimony to the European Parliament.

But Ms. Urpilainen said Finland couldn't accept a system that was based on shared liability.

"It is important to develop EU banking regulations and supervision and to safeguard depositors. However Finland cannot accept a banking union based on shared responsibility," she said in a written response to a question tabled by the opposition Finns Party.

She said the European Banking Authority could be mandated with new powers to oversee the European banking system, but added that national governments should still be the ultimate regulator of their financial systems.

"The European Banking Authority could be provided with stronger measures to ensure stronger national oversight. But this cannot change the principle that supervision should be implemented at the national level in the first instance," she said.

But even some in the Eurozone periphery may object to this banking union idea. Here is why.

It has been suggested that the euro area leaders should dip into the EFSF/ESM funds to provide a backstop to the yet-to-be-created entity that would guarantee Eurozone's deposits.

Reuters: - The euro zone's permanent bailout scheme, the European Stability Mechanism, could be used to backstop a fund to protect bank deposits or wind up failing lenders, according to a document prepared for European leaders meeting this week.

Without additional capital, such backstop would dramatically raise ESM's credit risk by increasing its exposure (with rapid downgrades by the rating agencies, etc.) If funds are diverted to guarantee depositors, there will be far fewer resources to support periphery governments. Funds going to Spain's banks, for example, are already taking a bite out of EFSF/ESM capitalization. And now the entity will be asked to guarantee  €11 trillion of deposits across the euro area?

Italy's banks are not nearly as troubled as Spain's, making Italy's objective different from its troubled neighbor. Italy needs investor confidence in its fiscal situation. Mario Monti has done a decent job in making some headway on this front by increasing taxes, cutting pensions, and pushing through significant labor reforms. But Italy also needs ESM's help in rolling its massive amounts of debt. Monti's goal therefore has been to release some of ESM funds specifically to buy periphery government debt - not to engage in rescuing banks or backstopping deposits. 

Reuters: - Italy put forward a proposal at a G20 summit in Mexico on Tuesday for the euro zone's rescue funds to start buying the debt of distressed European countries, and the idea is expected to be discussed at a meeting of leaders in Rome on Friday.

Therefore as strange is this may sound, Italy might actually side with Finland in objecting to the banking union in order to preserve EFSF/ESM. And with Italy objecting, the chances of the scheme being implemented as proposed are close to none.

SoberLook.com

Still too few details on Spain's bank bailout; cashless transaction may be preferred

Details are still scarce on the proposed bailout of the Spanish banking system. The thinking now is to have a "cashless" transaction in which the EFSF (and/or ESM) issues some bonds, but instead of selling them into the market, it delivers these bonds to Spain's bank rescue vehicle called FROB. FROB will then swap the EFSF bonds for equity of banks that need to be recapitalized. This avoids EFSF having to issue bonds in the capital markets and getting embarrassed if the market is not too receptive (as happened before).

Ideally FROB should also have the ability to haircut banks' unsecured debt or force a debt for equity swap if those banks become undercapitalized again. It's not clear if such provisions will be put in place, though some in the Eurozone have suggested it. Some (Finland for example) are also demanding the "bad bank" type split, similar to Ireland, but so far Spain is not going for it.

Source: BNP Paribas

FROB would supposedly pay EFSF back in 15 years (@3% rate). That's assuming FROB recovers the funds to pay EFSF back. If there are losses on this capital injection, the first say 10-15% would be absorbed by FROB (thus the Spanish government), but above that level losses would be shared with EFSF/ESM.

This needs to be finalized soon. The longer the uncertainty about this structure lingers, the more jittery the markets (and the rating agencies) will become.

SoberLook.com

In spite of the bailout of Spain's banks, periphery redenomination risks loom

The media is putting a great deal of emphasis on the EU-arranged Spanish bank rescue (discussed here), which will clearly provide Spain some much needed relief. But it's important to step back and look at the larger problem the Eurozone will still have to confront going forward. Here is a sobering assessment from Antonio Garcia Pascual of Barclays Capital:

Overall, the financial assistance by the EFSF/ESM to recapitalise Spanish banks is likely to be a net positive for Spain: the strict conditionality to complete the bank clean-up, including restructuring plans in line with EU state-aid rules and horizontal structural reforms of the domestic financial sector, should help restore credibility and transparency; it should also help alleviate funding pressures. However, the problem confronting Spain, and the rest of the periphery, is bigger.
... 

While the completion of bank recapitalisation processes is welcome, the solution to the crisis also requires the euro area/core to make explicit decisions and strong commitments to the periphery, especially after the PSI exercise and the open discussion of a Greek exit. In fact, should market events accelerate the ongoing capital reversal (and a Greek exit remains a material contagion risk), given the contagion to other weak economies (eg, Italy has been trading at a spread versus Spain of c.30-70bp for 10y bonds), it would be unlikely that the financial assistance could be circumscribed to the banks only or even to Spain alone. And for that, there are no sufficient rescue funds readily available (ie, for multi-year full-fledged programmes for Spain and, depending on contagion dynamics, for Italy as well).

So long as the euro area does not remove the tail risk of potential FX redenomination for periphery countries, medium- and long-term investment commitments by foreign capital (or even domestic) are unlikely and that creates a growth disadvantage in the periphery. And without growth prospects, there is little hope to emerge out of the crisis.

SoberLook.com

Spanish "bailout lite" - right on schedule

Looks like the EU bailout of Spain is right on schedule (as discussed here) - the bond spread levels turned out to be a good predictor of an impending bailout as was the case with Portugal. And it is likely to take the form of an Ireland-style bank recapitalization (as see this post for more background).

Reuters: - A bailout for Spain's teetering banks, once requested by Madrid, could amount to as much as 100 billion euros, two senior EU sources told Reuters on Saturday.

Spain has not yet made a formal request for European aid but it could come during a conference call of euro zone finance ministers, the sources, who were both on an earlier call to discuss the technicalities of a rescue, said.

"A decision on Spain will only be taken ... by the ministers (in a second call). Madrid has not officially asked for help yet," one of the officials said. "The statement will mention 100 billion euros as an upper limit."

The Eurogroup of finance ministers is scheduled to begin its call at 4 p.m. Brussels time (1400 GMT). Earlier, its chairman, Jean-Claude Juncker, called for a "quick solution".

Several EU sources told Reuters on Friday that Madrid was expected to ask the currency bloc for help with recapitalizing its banks this weekend, becoming the fourth country to seek assistance since Europe's debt crisis began.

Apparently the IMF will supervise the "rescue plan". But unlike the situation with Portugal, this plan is expected to focus on the banking system instead of setting up new government austerity requirements - for now.

Reuters: - Conditions in the plan would be related to the banks and would probably not add to the austerity measures and structural economic reforms which Rajoy's government has already put in place, EU and German sources said.

A "bailout lite" would help salve Spanish pride. Spain is the world's 12th largest economy and No. 4 in the euro zone. EU and German officials have cited national pride as a barrier to requesting a full assistance programme.

Spanish pride? To quote Stuart Stevens, "pride is a powerful narcotic, but it doesn't do much for the auto-immune system".

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The public is now focused on Spanish banks

Google Insights for Search is pointing to yet another shift in global (at least English speaking) public's focus. News search frequency for "Spain bank" (as in bank bailout) has now surpassed "greece exit", which peaked in May. Based on this, Spain's banking system seems to be of greater concern to the public than Greece exiting the Eurozone.

Google Insights for Search

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The market to Spain: recapitalize the banks or face funding problems

Spain's banking system and regional debt problems are now becoming the key driver behind the risk aversion sweeping  the Eurozone. The German current 3-month bill yield is now firmly in the negative territory. People are paying the German government to hold on to their euros.

German current 3-month bill yield

Spanish authorities continue to deny there is a problem. It's all because of the euro...

Reuters: - Prime Minister Mariano Rajoy pinned the blame for the rising borrowing costs on concern about the future of the euro.

... while the denial of the inevitable continues.

He again ruled out seeking outside aid to revive a banking sector laid low by a property boom that has long since bust.

And now the nation's ability to meet its near-term funding requirements are being questioned.

Reuters: - Spain's trump card is that it has issued well over half the debt it needs to this year, in the first five months.

But that advantage is being eroded.

The government said last week its highly indebted regions faced 36 billion euros of debt refinancing bills this year, way above the previously stated 8 billion. Catalonia said it was running out of options and needed central government help.

A plan to recapitalize Bankia with Spanish government bonds, which the bank could then use as collateral to get cash from the ECB, could add to the government's refinancing problems.

Spain's Treasury insisted it would repay debt maturing without problems.

"We are in a very strong position (to meet debt maturing shortly)," said Ignacio Fernandez Palomero, deputy director of public debt at the Treasury, pointing to redemptions in July and October, when Spain has big amounts due.

Spain's central government and regions need to refinance 117.5 billion euros of debt by the end of the year, while funding a deficit worth 52 billion euros.

Not a problem...  Except the market doesn't buy it.

The euros going into German bills are coming out of Spain, as the country's 5- and 10-year spread to Germany as well as the 5-years CDS hit new records today.

Spain 10y spread to Germany

What's even more concerning is the change in the sovereign spread curve shape. The chart below shows Spanish bond spreads to German bonds by maturity - now and a month ago.

Spanish bond spread (to Germany) curve

The shorter tenors (3-5yr) have widened out more than the longer tenors as the spread curve becomes steeper in the short end and inverted in the longer end. The market is pricing in a higher probability of default closer in time - as usually happens with distressed names. A similar situation is developing in the CDS curve.

Spain CDS spread curve (green is now, yellow is 1m ago)

The 5-year CDS is now implying 44% probability of default in the next 5 years, assuming a 50 cent on the euro recovery (the probability drops for the same spread if the expected recovery is lower).

The market is now saying to Spain: recapitalize your banks or your funding situation becomes untenable.

"The events at Bankia will reinforce the view that the upcoming external review should identify a significant recapitalization need for the Spanish banking system," analysts at Nomura said in a note, putting a recapitalization of the whole sector at between 50 and 60 billion euros, with the main listed banks requiring an additional 16 billion euros.

Nomura said only BBVA, Santander and Sabadell would not need to strengthen their capital, while the government would need to clean up smaller lenders it has already propped up, such as Banco de Valencia, Novacaixagalicia and Catalunya Caixa.

"Given the current economic and political uncertainties facing the euro zone, this could see additional pressure on Spain to consider using external funds for the bank recapitalization," Nomura said.

Spanish bank bailout now seems inevitable..

SoberLook.com

Spanish spreads hit new records as larger bank bailout expectations grow

As expectations of ever larger bank bailouts in Spain hit the market, both the 5-year and the 10-year Spanish government spread to Germany reached new records, with the 5-year spread exceeding the November high for the first time.

5yr Spain sovereign spread to Germany

10yr Spain sovereign spread to Germany

Boston.com: - The board of Bankia, the large Spanish bank that was taken over by the government, met Friday to discuss a restructuring plan that will include a request for more state aid, bolstering calls for a coordinated relief blueprint for Europe’s fragile financial sector.

Trading in shares of Bankia, the country’s fourth-largest lender, were suspended Friday while its board determined how much new aid it needs. The bank’s shares have whipped about violently in recent weeks on fears it could succumb to the massive losses it has built up in the country’s collapsed real estate sector.

The bailouts were never built into the debt to GDP ratio projections. The debt levels have strayed from the target even before the additional support for the banking system became necessary. Nobody really believes that Bankia is an isolated case, raising the possibility that Spain would need to undertake an Ireland-style banking recapitalization. That may require external support from EFSF/IMF, which frightens existing bond holders as they continue to sell Spanish debt.

SoberLook.com

Does Vicker's recommendation resolve the "too big to fail" issue?

Sir John Vicker

The UK is getting ready to begin the process of separating the nation's banks' "investment" and "consumer" businesses, implementing the so-called John Vicker Independent Commission Recommendations. British politicians keep talking about solving the "too big to fail" problem with this new legislation, which is to go into effect in its final form by 2015 (4 years earlier than originally proposed).

In addition to the bank "breakup" provisions, the rules would impose a 10% capital ratio for banks with another 7-10% of debt that could be converted into equity if a bank were to run into financial trouble. It all sounds great in theory, but a number of questions remain.

1. Bonds that convert to equity when a bank is in distress are the worst type of instrument for investors.  It has all the downside of an equity security but a limited upside of a bond.  That means the yield on these should be at least as high as equity returns. Therefore banks will not only be issuing large amounts of equity to get to the 10% capital ratio, but will also try to sell these equity-like securities. The UK banks will be raising capital at exactly the same time as the eurozone banks will be flooding the markets.  This is clearly going to present a challenge.

2. Since the new "consumer" portion of the banks will now be viewed as having implicit government support, it has the potential of creating "moral hazard". With competition growing over time, these units will provide consumers with below market funding - and we've seen how that movie ends.

3. The "consumer" unit will be responsible for small to medium size business loans. This would obviously include loans to real estate developers - because those tend to be medium sized businesses. In the US the bulk of FDIC insured bank failures have been due to commercial real estate loans to small and medium sized developers (single and multi-family housing projects, office buildings, shopping centers, etc.). Irish banks failed because of lending to construction firms in saturated markets - particularly in Dublin. Again we are setting up a system that will use its implicit guarantees to potentially create bubble markets.

4. The "investment banking" units will be immediately downgraded because they have no implicit support.

Bloomberg: Standard and Poor’s said Sept. 14 the elements of a bank outside the ring fence face a credit-ratings cut as they won’t be able to count on government support.

That's where all the loans to large corporations are housed. These units will have much more trouble funding themselves particularly in the current environment.  This should make corporate loans relatively expensive - in spite of them usually being better credit than consumer loans. But large UK corporations do not have to borrow from or conduct capital markets business (bond issuance, IPOs, etc.) with UK banks and will simply go abroad to obtain credit.  Swiss, German, US, Canadian, and Australian banks will have no trouble grabbing UK banks' market share for servicing large UK corporations. UK banks will simply end up shrinking or selling these divisions.

The UK's new financial services industry will look quite different - almost like a set of regulated power utilities.  But it's not at all clear this industry will no longer be "too big to fail".

SoberLook.com

"Join OWS" Email Exchange

Names have been changed.  The email exchange is real.
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Dear Ron,

I spent much of Saturday marching around lower Manhattan and shouting things like "Banks got bailed out; we got sold out!". The primary result of that action for me is the realization that, however much I support Occupy Wall Street, these things are best left to people your son's age (assuming that they are not anti-OWS, like my kids are!).

But what should be obvious to everybody is that, once the bad guys realize the depth of support for OWS, they will resort to obfuscation, propaganda, embedding hidden fees and hidden risks in deals, etc.

What is needed is an organization of financial professionals who will stand against that. People who DON'T run banks, but who know about the financial markets. People who are not complicit in the chicanery, but who know what goes on. In other words, us.

Now neither of us have time to do this now, but, then again, it may not be time yet. The mood of the country is STILL not ready for meaningful financial reform, but perhaps it will be in a year or two. Kids out of the house and time for something new?

Have a great day,
Fred

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Dear Fred,

Sounds like you've had an exciting weekend. I should introduce you to a friend of mine Jerome Berry who is out there marching as well.

My personal view is that the bulk of people working for financial firms are decent folks. They don't deserve the abuse my friend got because his job was to sell insurance for AIG. There are countless people busting their ass in operations, accounting, technology, customer service, etc. Yes they get paid more than the average Joe, but trying to live in NJ with 3 kids and paying the crazy taxes and outrageous home prices puts many back at the national average or below in terms of their standard of living. And now they will be asked to pay more in taxes because OWS people need to collect their unemployment check.

There is no shortage of greedy, corrupt, and overpaid executives, but in my view they are no different than say auto, oil, pharma, food, insurance, etc. executives - all of whom get some sort of government support. It's much more fashionable however to protest against Goldman than say Exxon or Archer Daniels Midland, who in my view do much more damage to an average American than Goldman ever did. Their lobby is also more powerful than that of most financial institutions. Nobody seems to be protesting that the greedy insurance industry got bailed out (guys like Hartford or MetLife) or the auto industry got rewarded for their incompetence. Many people don't even know they were part of TARP. GE got more support from the Fed than most financial institutions. And nobody seems to be protesting against the rating agencies - who are still doing their thing.

People want me to move my money from Chase to a community bank, but I saw how community banks put real estate developers on their board and funded their "local" development projects with depositor money - just to be bailed out by the FDIC. I am not defending the large banking organizations, but I'd just like to see some balance.

With regard to setting up an organization, the best way to start is to set up a LinkedIn group. It's free and you quickly get traction. Once the group gets big enough you set up an event or two and the momentum picks up. I'd be happy to help with this.

All the best,
Ron

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Dear Ron,

The nuanced views that you put forward in your email are precisely the kind of thing that needs to be more prominent in the public discourse. For example, I assume your friend Jerome is in finance (In fact, he may have conducted the first interview that I ever had for a financial job!). You would never know from the media or from OWS that there are many people in finance who would agree with him.

While it is true that execs in other industries are just as greedy as Wall Street execs, they have less of a baleful influence over the economy as a whole. Our economy would not be in recession if it were not for the massive contraction of credit that took place as the result of the mortgage market going bust. If you have a job and most of the people you know have jobs, it is easy to forget the widespread suffering that recessions cause: divorces, bankruptcies, deteriorating health because of inability to pay for good food, drugs, and medical care, and even suicides.

Admittedly, there is plenty of blame to go around for this recession, as was expressed so eloquently by the attached column by Thomas Friedman. Nevertheless, in the eyes of the law, “everybody’s doing it,” is not a legitimate defense. Nor should it be.

As you well know, the big banks have plenty to answer for in creating the current economic mess. In Friedman’s words, either “some of our country’s best-paid bankers were overrated dopes who had no idea what they were selling, or greedy cynics who did know and turned a blind eye.” Either way, there was a massive failure in corporate governance.

There was also a massive failure in corporate governance at Enron, at WorldComm, and at GM. But Enron, WorldComm, and GM all declared bankruptcy, and there were significant management changes. Of the many banks that were technically bankrupt, only Bear and Lehman (who both happened to be competitors of Sec. Paulson’s old firm, Goldman Sachs) were allowed to go under. The remaining banks are still managed by many of the same people, people who have lost more money in the latest fiasco than all banks have ever made in the entire history of banking.

Of course, the bankers had their enablers, the rating agencies, the big accounting firms, government regulators, and the foolish people who bought homes they couldn’t afford. I hold the rating agencies especially accountable because they seem to have rated sub-prime mortgage backed securities with models that they knew were flawed. Why? Because they were being paid $250,000 for, at most, a man week’s worth of work. This isn’t quite fraud, but it sure stinks!

Anyway, that’s why I’m part of OWS.

But I am certainly open to other people's point of view. My son Peter, for example, agrees more with you than with me!

Regards,
Fred

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Dear Fred,

Thanks for the explanation. I am also very open-minded on this issue. Here are a few points for further discussion.

1. I understand the suffering caused by the recession and the contraction of credit. Personally I got hurt tremendously by this. It's just not clear to me how the large financial institutions caused the crisis. We had a real estate bubble with highly leveraged homeowners who kept leveraging to the max, taking out home equity (taking vacations) or mortgages they couldn't afford. Many were flipping homes. Many were buying with the goal to refinance later and take equity out. Just like the Dutch tulip bubble, this one burst when people could no longer refinance. And everyone got hurt including the large financial institutions.

2. Financial institutions failed not as much because of corporate governance but because of the structure of their assets and liabilities. They relied on short-term funding to finance their illiquid assets (Bear, Lehman, Citi). This has been the case long before the real estate bubble (some 30 years) and neither the Fed nor the SEC or even the Basle Committee ever told them to do otherwise. By the way, the MF Global default was due to the same problem. Their European bond holdings were 1-3 years in maturity, while they financed them overnight in the repo market. If they had locked in term financing (match-funded) these investments, MF would still be OK.

3. With respect to not allowing large banks to fail, the decision was approved by the US Congress. Neither the Bush administration nor the Fed could have done this unilaterally. So our elective representatives chose to inject capital into these firms - whether they asked for it or not. The larger firms got funding from private sources: Morgan Stanley from Mitsubishi, Goldman from Buffett, but the government forced them to take the TARP money. I don't see how it's their fault. Again, I am not defending them, just trying to understand the logic here.

4. I agree these firms overpaid their people. And the people getting paid the most were often the worst assholes and often quite incompetent. But the last time I checked, overpaying people isn't against the law. If I own a company and hire you at some ridiculous pay level, it's nobody's business but mine and other shareholders'. The shareholders of these firms didn't seem to complain as long as the companies were profitable. Maybe they should get more active on this issue when they elect their directors.

5. People running most of the large financial institutions have in fact changed. Chuck Prince at Citi got replaced, John Mack at Morgan Stanley is out, BofA/Merrill, UBS, etc. have all new management. GS, JPM, CS were the healthier of the institutions (limited losses), so their management remained.

My science background makes me a skeptic, but like I said I am quite open-minded if I see good empirical evidence. I might be the next to join OWS after all.

Enjoy your weekend downtown.
Ron

(to be continued)

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