Through the latest financial crisis, I warned readers that the costs of banking
bailouts in Europe would far outstrip those of the United States. Following
from my "quick and dirty" summary at the bottom of last week's article (see
Dismal math, Asia Times Online, October 4, 2008), this article expands
on the subject at some length.
Before delving into the minutiae of total costs to the government though, a
brief recap of recent events as follows:
Ireland guaranteed all bank deposits as well as interbank lending last week for
all its banks, in effect providing a sovereign guarantee on the entire banking
system at an indeterminate cost to taxpayers
Other countries in Europe including Greece followed suit in terms of
guaranteeing all bank deposits. Anecdotally, this wasn't
enough to actually stop outflows of funds from the banking sector in some
countries.
Germany stepped in to directly rescue Hypo Real Estate over the last weekend,
after a previously agreed rescue plan involving other banks fell through,
leaving the government with the wreckage.
Even the usually insular French got into the act by suggesting the creation of
cross-border bailout fund that was, however, rebuffed by Germany, as the latter
believes its financial institutions aren't facing any imminent danger in the
current market crisis.
Iceland had to nationalize its largest bank Kaupthing on Thursday, marking the
third bank after Glitnir and Landsbanki to be taken over by the government.
This drove strategic trades that are discussed later in the article.
The UK announced the most comprehensive series of bank interventions seen of
late, marking a culmination of government involvement in the sector after the
collapse of Northern Rock last year (see
Rocking the land of Poppins, Asia Times Online, September 22,
2007); under the plan the government will provide up to 500 billion pounds
(US$844 billion) in assistance for the sector including fresh injections of
capital that have been modelled on the rescue of AIG by the US government.
Spain announced a 50 billion euro (US$68 billion) emergency fund earlier this
week to provide liquidity by buying assets directly from Spanish banks. Nordic
countries like Sweden and Denmark also extended deposit guarantees and in some
cases also covered unsecured debt issued by the banks.
In conjunction with the US Fed, both the Bank of England and the European
Central Bank this week cut interest rates by 50 basis points, signaling their
willingness to provide greater liquidity to the broader economy while
suspending inflation targeting for the interim period. This move will cut the
incomes of millions of pensioners across Europe, therefore the overall economic
impact on the "old" continent is not a straightforward positive as it is in the
case of the US.
Who bails out the guarantors?
As highlighted in my previous article on the subject, the major hurdle that
needs to be crossed by Europe at some point in the near future pertains not so
much to the health of their banking systems as the viability of their sovereign
finances. The idea of a "risk-free" European sovereign appears an oxymoron at
the current juncture.
In response to the above-mentioned article, a reader complained that estimates
for repaying bank debt should be based not so much on the total borrowing but
the actual scale of losses incurred. The steps taken by European governments
detailed above point to their wholesale undertaking of banking liabilities;
secondly, I do not believe that government-owned entities will be managed any
better (and probably a whole lot worse) than private enterprises, especially in
lucrative areas such as banking.
Even giving generous allowances for this reader's view doesn't change my
fundamental conclusion from last week, which is that European sovereigns simply
cannot afford the banking bailout that is being proposed: which is perhaps the
main reason for Germany to demur on continent-wide bailout that would unfairly
expose German savers to the profligacy shown by Spanish and Irish bankers.
Let us first look at select European countries, continuing from the analysis of
last week.
Bank Assets
/GDP %
Additional
funding %
Capital
Injctn. %
Res.Mtgs.
% GDP
Bailout loss
@ 25%
Iceland
1300
325
130
76
19
Switzerland
1000
250
100
102
25
Belgium
600
150
60
36
9
Holland
600
150
60
98
25
Italy
300
75
30
19
5
France
300
75
30
32
8
UK
300
75
30
83
21
Ireland
300
75
30
70
18
The first column details bank assets as percentage of gross domestic product.
This figure is derived from looking at the biggest banks in each country, and
then rounded down - for example, 1,369% in the case of Iceland became 1,300%.
Since most European banks can no longer borrow in the interbank market or in
bond markets, governments will need to step in to provide funding.
The second column makes a generous assumption that such funding is capped at
only 25% of the asset base (in practice, for countries at the top of this table
the actual number will be closer to 40%). While some will argue that such
funding is not a "loss", governments are likely to tie them to social
objectives such as uneconomic lending to individuals and small companies,
thereby making the program a permanent diversion of resources to the banking
sector.
The third column details the cost of the UK-style injection of capital, which
is again calculated at a liberal (10%) rather than conservative (25%)
proportion of outstanding assets. Both these columns are expressed as
proportion of the underlying GDP to make the overall analysis comparable.
The next two columns detail the share of residential mortgages to GDP and the
cost of a bailout at a loss proportion of 25%. This is important in the case of
Europe because of the similarity to Japan in terms of the meteoric rise in
property prices combined with the increasingly challenged demographic
situation. In the case of Japan, property prices fell 65% from peak to trough;
a conservative estimate of losses in the case of Europe would be around 50%.
From this loss figure we subtract existing equity contribution of mortgage
borrowers (again a liberal 25% of outstanding) to arrive at a loss of 25%.
Will the governments of Europe bail out individual borrowers in this fashion?
Being liberal democracies that have just stepped in to rescue their
much-reviled banking systems, it appears almost a certainty that such borrowers
will be rescued. It is quite likely that politicians will argue about the need
for compassion under the circumstances; this is also related to my point above
on government assistance on bank funding that will likely be tied to such
assistance to the mortgage borrowers.
The next stage is to calculate changes in sovereign leverage after including
the above changes - in the main, the impact of providing direct funding for
banks, capital injections and compensating residential mortgage borrowers for
their losses.
Current govt.
debt/GDP
Proforma
debt/GDP %
5 year
CDS spread
Iceland
33%
507
1300
Switzerland
50%
425
NA
Belgium
85%
304
45
Holland
45%
280
NA
Italy
104%
214
75
France
65%
178
29
UK
45%
169
50
Ireland
25%
148
73
Adding these figures to total government debt and including contingent
liabilities such as guaranteed interbank funding gives a very significant boost
to debt/GDP numbers across Europe (second column above).
For comparison, I have also included five-year credit default swap (a metric of
what it costs to insure against a sovereign default) spreads in the third
column. The point with this column is the trend for Iceland which now trades
significantly wider than most sovereigns (for example Indonesia is quoted at
around 600 basis points while China is quoted at 110 basis points). The rest of
Europe doesn't have the same level of spreads, but going down the path that
Iceland did makes it quite likely that one or more of such countries will find
itself in a similar predicament at some point.
With this information, it becomes easy to adopt an International Monetary
Fund-style framework wherein the governments are required to show budget
surpluses in order to repay debt. Most of the European sovereigns mentioned
above currently have a budget deficit, which suggests the need for bigger moves
in government expenses than appears superficially.
For example, countries like France, the UK and Italy all currently post budget
deficits of around 3% of GDP; therefore a swing to 1% surplus actually means a
4% move in the ratio of government expenses to incomes. The table below shows
the number of years that governments would need to repay debt while running the
surpluses mentioned - for example, Switzerland would take 170 years to repay
its gross government debt if it ran a surplus of 2.5% of GDP annually.
Time to repay debt (years) /
Annual Budget Surplus
1%
2.5%
5%
10%
Iceland
507
203
101
51
Switzerland
425
170
85
43
Belgium
304
122
61
30
Holland
280
112
56
28
Italy
214
86
43
21
France
178
71
36
18
UK
169
68
34
17
Ireland
148
59
40
15
These are horrible figures for even developing countries with young populations
to bear. When the demographic angle is considered, that is the ageing of Europe
that presents significant threats to the servicing of current debt loads leave
alone additional borrowing to bail out the banking system, it is quite easy to
conclude that European sovereigns are about as creditworthy as the average
overextended American burger-flipper who "owns" two condominiums in Miami.
Strategic implications
The extraordinary steps taken this week across Europe highlight the flaws of
the banking system, but equally of the willingness of politicians to be seen
riding to the rescue of the unctuous bankers.
Iceland's example is in particular startling. Confronting a virtual run on its
banking system, the country tried to stem the tide by nationalizing the
troubled institutions only to find that credit markets in turn shut for the
sovereign itself. This necessitated some desperate calls for help that went
completely unanswered by the capitals of Western Europe.
Only Russia bothered to return the phone call, and it may be willing to provide
longer-term assistance for the country. It is perhaps not the output of the
Icelandic fishing fleet that the Russians are after though; the country's
strategic position during the Cold War proved an unassailable advantage for the
US.
With both the US and EU in deep financial trouble, the chances of any quick
rescues of Iceland looks depressingly low, giving more than enough room for the
Russians to negotiate non-financial terms for their willingness to help. Pretty
soon, it is possible that Arab countries could look to providing similar deals
to take over parts of their old empire including Turkey, Spain et al by using
the leeway granted by the current financial crisis.
Utterly pointless
Europe (Asia Times Online, August 16, 2008) dealt with the longer-term
negative outlook for a continent that proved unwilling to stand up for itself
in the face of Russian aggression in Georgia. The wonders of the current
financial crisis are such that what looked like a long-shot just a little while
ago now looks like a slam dunk possibility.
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