9/1/19: Banca Carige & the Promise of Euro Banks Insolvency Resolution Regime

Italy has been the testing ground for the European regulatory framework for resolution of insolvent banks for several years, running. In all past sagas, the framework has been shown to fall short of protecting the taxpayers from the risk contagion loops that dominated the banking sector insolvency resolution regimes during the Global Financial Crisis. And the latest problem bank, Carige, is no exception.

Per latest reports (https://www.ft.com/content/b9fe3384-1427-11e9-a581-4ff78404524e) the Italian Government is pushing toward nationalization of the troubled lender in need of at least EUR400 million in fresh capital - capital it can't raise in the markets. The Government is also set to guarantee new bonds sold by Carige.

Carige assets of ca EUR25 billion are set against current capitalization of just EUR84 million. Per V-Lab data, Banca Carige is suffering from a massive spike in liquidity risk, with illiquidity index (a measure of liquidity risk) spiking to its highest levels in more than 21 years:

In late December, the ECB has taken the unprecedented step of placing Banca Carige in temporary administration, with administrators given three-month mandate to reduce balance sheet risks and arrange sale/merger/takeover of the bank. As a part of this work, the administrators are trying to review the Italian Government guarantee (issued in December) that led to the Italian deposits guarantee fund (FITD) purchasing EUR320 million of Carige's bonds.  In a notable development, the purchased bonds are potentially convertible into equity in an event of Carige's capital levels falling below regulatory threshold. In other words, these are CoCo-type bonds, implying the state fund is carrying the entire risk of Carige's future capital breaches. Beyond this, there are on-going talks with the Government on the possible SGA SpA (state-owned bad assets fund) purchase of some of the Banca Carige's non-performing assets. As an important aside, the existent bondholders in Carige are not subject to the bail-in rules the EU has put forward as the core measure for reforming banking sector insolvency regime.

These guarantees, buy-ins into Carige's bonds, lack of bondholders bail-in, and potential purchases of the bank's troubled loans constitute a de facto bailout of the bank using sovereign (taxpayers) funds. In other words, the European banking insolvency regime core promise - of shielding taxpayers from the costs of banks bailouts - is simply an empty one.

11/6/16: Sovereign to Corporate Risk Spillovers

As noted recently in my posts on the new iteration in the Greek Crisis, we are now into the sixth year (officially) of the Euro area sovereign debt crisis. Alas, of course by unofficial, yet more realistic metrics, we are really into the ninth year of the crisis (who cares what you call it).

Now, you might just think that at the present, there is little to worry about, as the crisis seemed to have abated, if not completely gone away. But the problem is that the real lesson from the 2008-present crisis should be exactly the acquired awareness that such thinking is dangerous.

Here’s why. In a recent ECB working paper,  Augustin, Patrick and Boustanifar, Hamid and Breckenfelder, Johannes H. and Schnitzler, Jan, titled “Sovereign to Corporate Risk Spillovers” (January 18, 2016, ECB Working Paper No. 1878: http://ssrn.com/abstract=2717352) “quantify significant spillover effects from sovereign to corporate credit risk in Europe” in the wake of the announcement of the first Greek bailout on April 11, 2010.

“A ten percent increase in sovereign credit risk raises corporate credit risk on average by 1.1 percent after the bailout. These effects are more pronounced in countries that belong to the Eurozone and that are more financially distressed. Bank dependence, public ownership and the sovereign ceiling are channels that enhance the sovereign to corporate risk transfer.”

We should worry.

1) Corporate and sovereign bond risks are tied at a hip. And guess what we are witnessing today? A massive bubble in sovereign bonds and a bubble in corporate bonds. When one blows, the other will too. Be warned, per my contribution to the Summer edition of Manning Financial (LINK HERE).

2) Eurozone countries are at a greater contagion risk. Doh… like we never heard that before. But, still, good reminder to remember. I wrote a paper on that for the EU Parliament not long ago (LINK HERE).

3) Bank dependence is bad for contagion - in a sense that it increases contagion, not reduces it. And guess what the Eurozone been doing lately via ECB’s policy and via CMU and EBU? Right… increasing bank dependency. (LINK HERE)

In short, things might be a bit brighter today than they were yesterday, but tomorrow might bring another hurricane.

5/7/15: Votes are in... What's next for Greece?

With over 75% of votes counted in the Greek referendum, 61.6% of the votes counted are in favour of 'No'.

So what's next? Or rather, what can [we speculate] the 'next' might be?

Possible outcome: Grexit

• This can take place either as a part of an agreement between Greece and Institutions (unlikely, but structurally less painful, and accompanied by debt writedowns, a default or both), or
• It can take place 'uncooperatively' - with Greece simply monetising itself using new currency (more likely than cooperative Grexit, highly disruptive to all parties involved and accompanied, most likely, by a unilateral/disorderly default on ECB debt, IMF debt, EFSF debt and Samurai debt. Short term default on T-bills also possible).

Either form of Grexit will be painful, disruptive and nasty, with any positive outcome heavily conditional on post-Grexit policies (in other words, major reforms). The latter is highly unlikely with present Government in place and in general, given Greek modern history.

Grexit - especially disorderly - would likely follow a collapse of the early efforts to get the EU and Greece back to the negotiating table. Such a collapse would take place, most likely, under the strain of political pressures on EU players to play intransigence in the wake of what is clearly a very defiant Greek stance toward the EU 'Institutions' of Troika. 

Key to avoiding a disorderly / unilateral Grexit will be the IMF's ability to get European members of the Troika to re-engage. This will be tricky, as IMF very clearly staked its own negotiating corner last week by publicly identifying its red-line position in favour of debt relief and massive loans package restructuring. The EU 'Institutions' are clearly in the different camp here.

EU Institutions will most likely offer the same deal as pre-referendum. Greece will be 'compelled' to accept it by a threat of ELA withdrawal, but, given the size of the Syriza post-referendum mandate, such position will not be acceptable to Greece.  In the short run, ECB can allow ELA lift to facilitate transition to new currency, but such a move would be difficult to structure (ELA mandate is restrictive) and will result in more debt being accumulated by the Greek government that - at the very least - will have to guarantee this increase.

Problem with Grexit, however, is that we have no legal mechanism for this, implying that we might need a host of new measures to be prepared and passed across the EU to effect this.

Which brings us to another scenario: Status Quo

In this scenario - no player moves. We have a temporary stalemate. Greece will be cut off from ELA and within a week will need to monetise itself with new currency. 

Why? Because July 10th there is a T-bill maturing, default on which would trigger a cascade of defaults. Then on July 13th there is another IMF tranche maturing (EUR451 million with interest). Non-payment of either will likely force EFSF to trigger a default clause. Day after, Samurai bonds mature (Yen 20bn) - default here would trigger private sector default. More T-bills come up at July 17th and following that interest on private bonds also comes up on July 19th (EUR225 million). And then we have July 20th - ECB's EUR3.9 billion due, with additional EUR25mln on EIB bonds. Non-payment here will nearly certainly trigger EFSF cross-default.

Most likely scenario here would be parallel currency to cover internal bills due, while using euro reserves and receipts to fund external liabilities. Problem is - as parallel currency enters circulation, receipts in euro will fall off precipitously, leading inevitably to a full Grexit and a massive bail-in of depositors prior to that. Political fallout will be nasty.

Most likely outcome is, therefore, a New Deal

This will suit all parties concerned, but would have been more likely if Greece voted 'Yes' and then crashed the current Government. This is clearly not happening and the mandate for Syriza is now huge. Massive, in fact. 

So there will have to be a climb-down for the EU sides of the Troika. Most likely climb-down will be a short-term bridge loan to Greece (release of IMF tranche is currently impossible) and allowing use of EFSF funds for general debt redemptions purposes. 

The New Deal will also involve climb-down by the Greek government, which will, in my view, be forthcoming shortly after Tuesday, especially if ECB does not loosen ELA noose. 

Bad news is that even if EU side of Troika wants to engage with Greece, such an engagement will probably require approval of German (and others') parliament. Which will require time and can risk breaking up already fragile consensus within the EU. In fact, only consensus building tendency in the wake of today's vote is for a hard stand against Greece. Even in an emergency, EU is very slow to act on developing new 'bailouts' - in Cypriot case it took almost a year to get a deal going. For Portugal - almost 1.5 months. Urgency is on Greek side right now, not EU's, so anyone's guess is as good as mine as to how long it will take for a new deal to emerge.

That said, short-term approach under the status quo scenario above might work, as long as:

1. Greece engages actively, signalling willingness to deal;
2. Greece does not monetise directly via new currency (IOUs will do in the short run); 
3. IMF puts serious pressure on Europe (unlikely); 
4. ECB plays the required tune and keeps ELA going (somewhat likely); and
5. There is no fracturing of the EU consensus (if there is, all bets are off).

In a rather possible scenario, EU does opt for a new deal with Greece, which will likely involve pretty much the same conditions as before, but will rely on removing IMF out of the equation altogether. In this case, EUR28.7 billion odd of Greek debt held by the IMF gets transferred to ESM. The same will apply to ECB's EUR19 billion of Greek debt. The result will be to cut Greek interest costs (carrot), and involve stricter conditionality and cross-default clauses (stick). Euro area 'Institutions' therefore will end up holding ca 73% of all Greek debt in that case. Terms restructuring (maturities extension) can further bring down Greek costs in the short run. 

The negative side of this is that such a restructuring & transfer will be challenged in Germany and Finland, and also possibly in the Netherlands. 

It is. perhaps, feasible, that a new deal can involve conversion of some liabilities held by the euro area institutions into growth-linked bonds (I am surprised this was refused to start with) and/or a direct conditional commitment (written into a new deal) to future writedowns of debt subject to targets on fiscal performance and reforms being met (again, same surprise here). Still, both measures will be opposed by Germany and other 'core' economies. 

Either way, two things are certain: One: there will be pain for Greece and Europe; and Two: there will be lots of uncertainty in coming weeks.

As a reminder of where that pain will fall (outside Greece):
Source: @Schuldensuehner 

31/10/2011: Europe's latest blunder

This is an unedited version of my article in October 30, 2011 edition of Sunday Times.

This week was a fruitful and productive one for Europe’s leaders. Not because the battered euro block has finally produced a feasible and effective solution to the raging debt, fiscal and banking crises sweeping across the common area, but because they spent the entire week doing what they do best: holding meetings and issuing communiqués.

The latest plan, unveiled this Wednesday, shows once again that the EU remains incapable of actually doing what needs to be done.

The real European disease is debt. Too much debt. Based on the latest IMF forecasts and statistics from the Bank for International Settlements by the end of 2011, combined public, household and non-financial corporate debts will reach 280% of GDP in the US. In France, the Netherlands, Sweden and Belgium, this number will be closer to 330-335%, in Italy – 314%, in Greece – 290%, in Portugal 375%, in Spain 360%, and in Ireland a whooping 415%.

The composition of these debts, and in particular the weight of public sector debts in total non-financial debt overhang, may differ, but the end result is the same for all of the above. Per August 2011 research paper from the Bank for International Settlements, combined private sector debt in excess of ca 250% of GDP results in a long term (aka permanent) reduction in future growth rates. This reduction, in turn, puts under pressure the ability of the indebted states to repay their obligations.

Further compounding the problem, European banking systems have become addicted to Government bonds as a form of capital. In the past, this addiction was actively encouraged by the Governments, regulators and the ECB. With the latest proposals in place, we are likely to see even more Government/EFSF debt piling into the banks in the long term.

Having ignored basic risk management rules, banks across the Euro area are now fully contaminated with their exposures to sovereign bonds that are about as bad – from the risk perspective – as the adjustable rate mortgage borrowers in the US. Based on the second set of stress tests carried by the European Banking Authority this summer, Greek haircut of 75%, as suggested by the IMF, against the core tier 1 requirement of 9% will imply a capital shortfall of €180 billion. Failing to recognize this, the EU plan unveiled on Wednesday calls for just €100 billion recapitalization under a 50% haircut.

This, of course is far too little too late for Greece and for Europe overall. To bring public debt to GDP levels back to the point of fiscal stabilization (under 100% of GDP) will require ca 20% write-down in Portugal, 40% in Italy, and 30% in Ireland. Europe’s problem is at least €730 billion-strong. It can become bigger yet if – as can be expected – Greece fails once again to deliver on prescribed fiscal adjustment measures and/or the write-downs trigger CDS calls and/or the credit contraction triggers by the measures leads to a new recession. All in, Euro area needs closer to €820-850 billion in funding in the form of both rights placements, assets disposal, and government capital supports.

Now, factor in the second order effects of the above numbers onto the real economy.

Injecting €820 billion in new capital or, equivalently, providing some €1 trillion in fresh capital and bonds guarantees as envisaged under the EFSF proposals being readied by the European officials will increase broad money supply by 10%. This is consistent with long term ECB rates rising to well above their previous historical peak of 4.75% - triple the current rate. European banks trying to raise new capital and deleveraging foreign assets will saturate equity markets across Europe with capital demand. Reduced banking sector competition, pressures on the margins and higher funding costs will push retail rates into double-digit territory.

For European companies – more addicted to debt financing than their US counterparts and now competing for scarce equity investors against their European banks – this will mean a virtual shutting down of credit supply. Starved of domestic credit, European multinationals will aggressively divest out of the Continent and pursue jobs and investment growth in places where capital is more abundant – the US and Asia.

As Paul Krugman recently said, “The bitter truth is that it’s looking more and more as if the euro system is doomed. And the even more bitter truth is that given the way that system has been performing, Europe might be better off if it collapses sooner rather than later.”

Sadly, Krugman is correct. European cure proposals to the crises are worse than the disease itself and the Wednesday’s proposals for dealing with the crisis are case in point.

Firstly, banks recapitalizations – first via private equity raising and bond-to-equity conversions, then via sovereign/EFSF funding – risks extending the recapitalization procedures into the second half of 2012 and simultaneously increase the risk premia on banks funding. In other words, credit crunch is likely to get worse and last longer. Most likely, this will require additional guarantees to ensure the funding market does not collapse in the process. The ECB balance sheet exposure to peripheral banks and sovereign debts – currently at €590 billion, up from €444 billion back in June 2011 – will become impossible to unwind.

Secondly, the insurance option for sovereign bonds issuance is likely to be insufficient in cover and, coupled with greater seniority accorded to EFSF debt can lead to a rise in yields on Government bonds. This, in turn, will amplify pressure on countries, such as Spain and Italy which are facing demand for new bonds issuance and existent debt roll over of some €1.3-1.5 trillion over 2012-2014.

Thirdly, leveraging EFSF to some €1 trillion via creation of an SPIV (Special Purpose Investment Vehicle) will create a nightmarishly complex sovereign debt structure.

Under leverage EFSF option, a country borrowing from the fund €1 billion will receive only a small fraction of the money directly from the fund itself, with the balance being borrowed from international lenders that may include IMF. In order to secure such lending, the EFSF will require seniority for international lenders over and above any other sovereign debt issued by the borrowing state. This will de facto prevent the EFSF borrower from raising new funding in the capital markets in the future.

In all of this, Ireland is but a small- albeit a high risk – player with the power to influence some of the EU decisions, especially those that matter most. Alongside the EFSF reforms and banks recapitalizations, the EU will require stronger fiscal and sovereign debt oversight measures, and ultimately closer integration.

The Irish Government should make it clear from the earliest date possible that Ireland’s participation in this process is conditional on three measures. First, Irish banks debts to the euro system should be written down to the tune of €60-70 billion, allowing for clawing back some of the funds injected into banks as capital and providing a stronger cushion for a households’ debt writeoff. Second, we should demand that the debt-for-equity swaps explicitly encouraged as the means for recapitalization of the euro area banks in Wednesday agreement be applied to Irish banks. These swaps can be used to further reduce previously committed funds and reverse some of the debt accumulated by the Exchequer (on and off its balancesheet). Third, Irish Government should make it unequivocally clear that we will veto any tax harmonization in the future.

On the net, European solutions unveiled this Wednesday are simply not going to work. In Q1 2012 the latest recapitalization of Euro area banks and Greece will run out of steam. Next time around, this will happen in the environment of slower growth and possibly a full-blown recession with Spain, Italy and Portugal all running into deeper fiscal troubles. The real price of Europe’s serial failures to deal with the crisis will be the real economy of the euro zone.

Box-out:

This week’s CSO-compiled Residential Property Price Index (RPPI) had posted another 1.49 percent monthly fall in house prices nationwide. Exactly four years ago, at the peak of residential property valuations, RPPI stood at 130.5. At the end of September this year, the index was just 72.8 or 44 percent below the peak. The misery of falling prices is now impacting not only hundreds of thousands of negative equity mortgage holders, but even the all-mighty Nama. Nama referenced its original valuations of the assets it took over from the banks to November 30, 2009. Since then, residential prices in the nation have fallen 29.5% and apartments prices (the category of property more frequently related to Nama loans) have fallen 33.9%. All in, Nama will now require a 35% uplift on its assets (55% for apartments) to break even, not including the organization’s gargantuan costs of managing its assets.