Europe is Heading for a Mini-Depression
Despite a nearly-$1 trillion rescue operation, financial conditions in the eurozone continue to deteriorate. All the gauges of market stress are edging upwards and credit default swaps (CDS) spreads have widened to levels not seen since the weekend of the emergency euro-summit. Libor (the London Interbank Offered Rate) is on the rise and liquidity is draining from the commercial paper and money markets. According to the Federal Reserve, the total amount of (foreign banks’) commercial paper has shrunk 15 percent or $32 billion since late April. Central bank officials insist that there’s no chance of another Lehman-type meltdown, but their actions don’t match their words. Apart from the massive $920 billion EU Stabilization Fund, the European Central Bank has beefed-up its liquidity facilities and is aggressively purchasing state bonds from struggling countries in the south. Without the ECB’s assistance, the slow-motion slide into recession could turn into a full-blown market crash. Brussels has every reason to be worried.
From the Wall Street Journal:
"In the latest indication that European banks are in ill health, the European Central Bank warned late Monday that euro-zone banks face €195 billion ($239.26 billion) in write-downs this year and the next due to an economic outlook that remained "clouded by uncertainty….Europe’s intertwined banking system remains stressed. Investors have hammered the sector, banks are stashing near-record amounts of deposits at the ECB—€305 billion as of Friday—instead of lending the funds to other institutions, risk-wary U.S. financial institutions are reducing their exposure to euro-zone banks." ("ECB Warns Write-Downs Could Reach $239 Billion" David Enrich and Stephen Fidler, Wall Street Journal)
German and French banks have vast exposure to public and private debt in Club Med countries; Spain, Greece, Portugal and Italy. When those countries finances begin to teeter, it’s harder for the banks to exchange assets in the repo market where they get the bulk of their funding. They are forced to take a "haircut" on the value of their collateral which erodes their capital cushion and pushes them closer to default. This is what happened in the US when the French Bank Paribas started listing in late 2007. PIMCO’s Paul McCulley explains the origins of the financial crisis in a speech he gave at the Fed’s annual symposium in Jackson Hole. Here’s an excerpt:
"If you have to pick a day for the Minsky Moment [the economist Hyman Minsky wrote extensively about the modalities of economic crisis], it was August 9. And, actually, it didn’t happen here in the United States. It happened in France, when Paribas Bank (BNP) said that it could not value the toxic mortgage assets in three of its off-balance sheet vehicles, and that, therefore, the liability holders, who thought they could get out at any time, were frozen. I remember the day like my son’s birthday. And that happens every year. Because the unraveling started on that day. In fact, it was later that month that I actually coined the term "Shadow Banking System"….
“…What’s going on is really simple. We’re having a run on the Shadow Banking System and the only question is how intensely it will self-feed as its assets and liabilities are put back onto the balance sheet of the conventional banking system…..It was pretty much an orderly run up until September 15, 2008. (Lehman Bros default) And it was orderly primarily because the Fed…evoked Section 13-3 of the Federal Reserve Act in March of 2008 in order to facilitate the merger of under-a-run Bear Stearns into JPMorgan. Concurrently, the Fed opened its balance sheet to the biggest shadow banks of all, the investment banks that were primary dealers, including most important, the big five. It was called the Primary Dealer Credit Facility." ("McCulley: After the Crisis, Planning a New Financial Structure", Credit Writedowns)
So when Paribas made its announcement on August 9, the collateral (mainly mortgage-backed securities) that the banks had been using in exchange for funding in the repo market, was called into question. No one really knew what these mortgage-backed securities were worth, because many were comprised of subprime loans that would never be repaid. Thus, repo transactions slowed to a crawl, interbank lending collapsed, libor spiked to record highs, and the banking system suffered a major heart attack.
Now it’s Europe’s turn. But don’t expect a repeat of the Fed’s strategy. The member states won’t allow the ECB to dictate policy without deliberation. Germany has already forbidden quantitative easing (QE) unless the funds that are used to purchase state bonds are sterilized, that is, unless the ECB soaks up the extra liquidity via some other offsetting transaction.
Officials with the Bundesbank say that ECB head Jean Claude Trichet has launched a "stealth bailout" of the eurozone banks holding Greek debt. The facts appear to support the claims. Greece has already received the $135 billion bailout, enough to meet its funding needs until 2012. But the ECB has purchased an additional $25 billion in Greek debt in the last three weeks. That means the debt must have been purchased from French or German banks. It looks like Trichet is trying to pull a fast-one on Germany by secretly diverting money to underwater banks.
From the Wall Street Journal:
"ECB critics within the Bundesbank say the price of Greek bonds is now largely irrelevant to Athens, making the main beneficiaries of the bond purchases the banks that hold much of Greece’s roughly €300 billion in outstanding debt…. ‘We haven’t gone beyond our goal of re-establishing a more correct transmission mechanism of our monetary policy,’ said Mr. Trichet…… ‘In simple words: We are not printing money.’" ("Bundesbank Attacks ECB Bond-Buying Plan", David Crawford Brian Blackstone, Wall Street Journal)
German officials haven’t been fooled by the hype surrounding quantitative easing. In a recent interview in Der Spiegel, Bundesbank chief Karl Otto Pöhl summed up the ECB’s efforts like this:
"It was about protecting German banks, but especially the French banks, from debt write-offs. On the day that the rescue package was agreed on, shares of French banks rose by up to 24 per cent. Looking at that, you can see what this was really about — namely, rescuing the banks and the rich Greeks."
This is a banking crisis not a sovereign debt crisis. Bank funding is getting more expensive because shadow banks are not willing to pay as much for collateral that looks dodgy. The problem is particular to the repo system, where the demand for triple A collateral creates a powerful incentive for ratings inflation. High ratings lead to mispriced risk and credit excesses. When the bubble finally bursts, assets prices plunge, leaving balance sheets deep in the red. If the banks had done their jobs and performed due diligence, they would have seen that Greece was headed for trouble and their bonds were a bad investment. But they purchased the debt anyway, to boost leverage and to increase short-term profitability. Now the downgrades are coming fast and furious, and the "run" on the shadow banking system is gaining momentum. Eventually, Greece will have to restructure its debt and the losses will push banks in France and Germany into default. Equity and bondholders will be wiped out or suffer big losses.
The amount of money at stake is huge, certainly enough to trigger another banking crisis. Here’s an excerpt from the Wall Street Journal:
"All told, more than €2 trillion of public and private debt from Greece, Spain and Portugal is sitting on the balance sheets of financial institutions outside the three countries, according to a Royal Bank of Scotland report last week. Investors, bankers and government officials are worried that as that debt loses value, banks across Europe could be saddled with losses.
"‘Make no mistake: This is big,’ said Jacques Cailloux, RBS’s chief European economist and the report’s author. ‘We’re talking about systemic risk [and] the potential for contagion.’” ("ECB Warns Write-Downs Could Reach $239 Billion" David Enrich and Stephen Fidler, Wall Street Journal)
EU banks are over-leveraged, under-capitalized, and too exposed to emerging market debt. In the next 12 months, they’ll have to roll over more than $400 billion in loans in a market where funding is scarce and liquidity is drying up. The ECB should present a plan for restructuring Greek debt now instead of trying to keep the bubble afloat and hoping for a miracle.
The run on the shadow system is forcing more banks to seek funding from the ECB. The central bank has loaned out more than $850 billion and that figure is expected to rise. The ECB’s balance sheet is proof that the wholesale funding system is broken and needs basic structural change. The EU is moving forward with a raft of regulatory reforms on everything from hedge funds to naked shorts, from corporate governance to a financial transaction tax, from tighter oversight on CDS to revamping the ratings agencies. So far, however, the shadow banking system has escaped their attention, which is unfortunate. The system is inherently unstable and will lead to more serious crises in the future. Financial institutions that act as banks (investment banks, hedge funds, insurers) must be regulated as banks, that’s the bottom line. The dangers of maximizing leverage and unsupervised credit expansion, should be clear to everyone by now.
MIKE WHITNEY lives in Washington state. He can be reached at email@example.com