Europe borrows from Peter to lend to Peter

July 28, 2009

jamessaft1(James Saft is a Reuters columnist. The opinions expressed are his own)Europe’s experiment in borrowing from Peter to pay Peter argues for a slow economic recovery with a low ceiling.Data released by the European Central Bank on Monday showed that the supply in money is growing at best haltingly and that loan growth to euro zone households and businesses is at its lowest since records began.Annual loan growth to the private sector slowed to 1.5 percent in June from 1.8 percent in May while the broader measure of money supply growth hit 3.5 percent.Loans to non-financial corporations grew at a 2.8 percent annual rate, and actually fell from May. Household lending wasn’t that peppy either, with the growth rate falling to a paltry 0.7 percent annual rate.Banks in Europe aren’t lending to consumers and businesses for a really sound set of fundamental reasons — borrowers know they ought not to be borrowing and the banks know that, of those who are asking for money, a disturbing minority can’t be trusted.Demand is poor in other words and what demand their is has been skewed to the feckless end of the spectrum.But there is one area of the market where both supply and demand seem to be growing healthily, or if you prefer, strongly: loans to governments.There was an absolute surge in banks assets in June, with government bond purchases by banks up 53 billion euros, a 16 percent annual growth rate, and outright loans to governments up 19 billion euros, up 2.5 percent year on year. Financial institution holdings of government debt has risen by 271 billion euros in the year to June.”This increase represents 3.0 percent of GDP and is thereby financing roughly half of the net general government borrowing requirement,” according to Julian Callow at Barclays Capital in London.And this credit is from the same banks which borrowed 442 billion euros last month for a whole year at a fixed interest rate of 1.0 percent. At the same time overnight deposits at the European Central Bank rose yet again to 195 billion euros, further indicating that funds are not making it into the private economy.Europe’s banks are borrowing from Peter to lend to Peter.PECULIAR ARRANGEMENTSThe circularity of it all is admirable. Banks in Europe borrow at very low rates from the European Central Bank. At least to judge by the data, much of the money is ending up in government bonds. This government debt is being issued, at least in part, to fund banking bailouts. Everybody is happy right?Of course there are some substantial ancillary benefits: banks themselves will make handsome, low risk money by collecting the difference between the cheap financing they get from one arm of government and the slightly more expensive rate they collect from Europe’s governments for holding their bonds.This rebuilds a capital base that has been sorely eroded by higher risk lending, but it is a slow process. It also does very little to encourage better banking practices for the next cycle. It does not take a genius to borrow from one arm of government and make a float lending to another, and as such we can’t really say that Europe’s banks are going to have their weakest members thinned out.What it does do is make government borrowing cheaper than it would otherwise be, which on balance is no bad thing. Given the difficulties some of the weaker euro zone governments were facing earlier in the year, a captive, or at least pliant, class of government bond buyers is a useful counterbalance to the more flighty behavior of people who can’t borrow money directly from the ECB.A lot of lending to banks, and lending and spending by governments can help ease a recession but its unclear if it can be the basis of a strong recovery.Politicians, inside and outside of the euro zone, are fond of leaning on banks to lend to the real economy in greater amounts at easier rates.British Treasury Minister Alistair Darling met with bank chiefs on Monday to urge them to lend more to small businesses, a type of photo opportunity we may be seeing more of as the recovery drags on and growth fails to ignite.It is good theater but it does little to address the underlying issues of poor prospects for corporate investment and the economy-wide need to retire or destroy debt.If things work out well it is just possible that in a year or so good business with good prospects will have real complaints about not being able to get adequate funding.At that point we will see if the borrowing from Peter to lend to Peter arrangement has worked or if it will prove to be a too slow and too indiscriminate way of healing the banking system.( At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

It’s tough to modify your way out of a hole

July 14, 2009

jamessaft1(James Saft is a Reuters columnist. The opinions expressed are his own) If you thought the U.S. housing crash could be blunted if only lenders would cut delinquent borrowers a break, it is perhaps time to move on to another vain hope.That’s right, the loan modification movement – pushed by the U.S. administration and others as a means of keeping non-paying borrowers in their houses, keeping those same houses from flooding the market as foreclosures, and even helping beleaguered lenders – is running into a reality-shaped wall.An exhaustive study of loan modifications by economists at the Boston Federal Reserve, under which delinquent borrowers are given lower rates, more time, or even cuts in the principal amount owed, showed fundamental problems with the way that idea works when put into practice.Looking at data that covers about 60 percent of U.S. mortgages the authors, Manuel Adelino, Kristopher Gerardi, and Paul S. Willen, came up with two important conclusions.First, securitization, whatever its other shortcomings, is not an important factor in stopping loan servicers from cutting deals with delinquent borrowers.Second, and even more importantly, lenders don’t renegotiate for a simple, unanswerable reason: it is not in their best interest financially.Virtually every rescue plan in the U.S. since the crisis began in 2007 has been in part a loan modification program, the most recent being the Making Home Affordable plan the Obama administration unveiled in February.The thinking is that, as a foreclosure can cost the lender between 30 and 50 percent of the value of the loan, deals can be struck with borrowers for a lot less than that leave everyone better off.Sadly, very few loans are being modified – only about 3.0 percent of delinquent loans – with many blaming securitization, which can make a loan modification toxic for one class of lender but beneficial for another.Seeing as how securitization was part of the way finance spun of control and the bubble was inflated, this was a satisfying narrative, but a false one according to the Fed study. They found no significant differences in the rate of renegotiation among loans that were in private-label securitizations and those actually owned by the servicer doing the negotiating with the borrowers.NEITHER A BORROWER NOR A MODIFIER… The real issue is that, in the vast majority of instances, banks are better off not modifying.For one thing, about 30 percent of borrowers who become delinquent get back on track before foreclosure. Since its very hard to know which borrowers will become payers again, this implies that 30 percent of the money expended in modifying loans is wasted, at least from the lenders point of view.Secondly, a huge percentage of borrowers who are given new improved terms go and become delinquent all over again. A whopping 40 to 50 percent of borrowers who get modified loans are 60 days delinquent again six months later.For them, and for their banks, it is just delaying the inevitable, and expensive to boot, as falling property prices make putting off foreclosing and liquidating costly.The implication is that unless the government wants to pony up much larger amounts of money to entice lenders to modify loans, we are not going to make much of a dent in the wave of foreclosures washing across the economy. This could be done, and possibly support house prices in the process, but at a very high costs.The real issue is that there are too many houses for the supply of credit worthy borrowers. The re-default rate shows that, as does the low clearing price when banks sell foreclosed houses.Housing needs to fall in value, less of it needs to be built, and more people should become renters. That is going to continue to eat away at bank capital and act as a drag on growth.Beyond that, there is a real question about the long-term consequences of mass loan modification. If the incentives are there more borrowers will become selectively delinquent and fewer who become delinquent will in the end catch up with their payments. Why should they?That means higher loan rates than would otherwise be the case.The thinking behind loan modification has interesting parallels in the rest of the economy, where policy makers are following similar strategies for banks and corporate borrowers.Rather than simply cutting back on leverage, probably via default, there seems to be a consensus for stringing struggling borrowers, and lenders, along, hoping that something turns up.Ultimately, it seems likely that strategy is about as successful in the rest of the economy as it seems to be in housing. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)