James Saft

By Jim Saft
James Saft is a Reuters columnist. The opinions expressed are his own.

Having demonstrated how poorly austerity worked in Greece, Europe may be on the verge of giving it a try in credit markets.

Plans to rescue the euro zone and its banks might land Europe in an extended credit crunch, a very poor outcome given the continent’s continued heavy reliance on bank financing.

While details are depressingly vague as to the how, plans seem afoot to insist on widespread recapitalization in European banks as part of an overall financial crisis package. The idea, broadly, is that the euro zone will write down Greek debt sufficiently, while establishing a backstop to stop a run on other weak states’ debt and then recapitalize the banks so that they can withstand the losses inherent in the exercise.

The U.S. banking recapitalization of 2009 is widely viewed as the model here, if not in form then in outcome, as U.S. banks are now far better capitalized than their European peers.

There are, at least, two severe problems with this.

Firstly, a look at the U.S. will show that while its banks as independent entities were saved, their ability to play their role in intermediating capital was compromised, at least in part because they were not aggressive enough in writing down doubtful housing-related debts. That’s an important contributing factor in creating a frail, shaky recovery in the U.S., and could easily happen in Europe.

“Markets may also fear adverse unintended consequences; for example, proposals to strengthen bank capital ratios that banks try to meet by accelerating the shrinkage of balance sheets,” George Magnus, senior economic advisor at UBS, wrote in a note to clients.

“This would deepen the euro zone’s growth crisis and make higher capital ratio goals retreat ever further into the distance.”

Europe, like the U.S., is going through a balance sheet recession. That means everyone is trying to repay debts at the same time, suppressing growth, inflation and asset prices. Government austerity is exacerbating this, but an extended credit crunch as banks try to rebuild balance sheets will only make matters worse.

This is not to say that Europe’s banks don’t need to shrink, as does its sovereign debt. Euro zone plans to save itself seem to have moved from simply trying to restore confidence, an impossibility as a stand-alone plan, to adding capital to the mix. Without addressing the underlying indebtedness this is going to result in either failure or a very extended period of slow growth.

WRITEDOWN NEEDED

An attempt to shore up banks must come to terms with the other over-indebted borrowers in the euro zone, and not simply the sovereign ones.

Take Spanish house owners, for example, who already face huge difficulties in getting loans to finance real estate purchases. Independent economist Edward Hugh argues that Spain needs a substantial asset writedown program, something that bank recapitalization simply does not address.

One easy-to-foresee risk post a euro zone rescue is that continued weakness in housing in peripheral markets continues to stress bank capital, casting a shadow over funding markets and undermining confidence. Remember, euro zone banks have a loan to deposit ratio of about 108 percent, a good 20 percentage points higher than U.S. banks, and only about 10 percent below their own pre-crisis peaks.

A reduction in bank lending in Europe is going to be even more painful than it would be in the U.S. given the euro zone’s less deep and highly developed capital markets. Europe has no Fannie Mae or Freddie Mac, yet, to take the strain in housing finance. Middle-sized businesses are still very reliant on bank financing.

In the U.S., the Federal Reserve helped to mitigate the pain of bank recapitalization by creating conditions in financial markets where investors wanted to take on some risk, leading to a booming market in bond issuance for corporate borrowers. Thus far there is no talk of credit easing from the ECB but it would not at all be surprising if this is on the agenda in a year’s time, once the force of bank deleveraging has been felt.

This is not an argument for going easy on banks, their shareholders or their executives. If anything Europe needs to take a harder line — forcing writedowns of debts public and private and being prepared to deal with the consequences.

Those consequences would not be pretty for bank shareholders. Many banks would fail and need to be taken into temporary public administration.

The more controlled default there is as part of the euro zone’s rescue, the better the results will be in two years time.

From Dublin to Paris to Budapest to inside those brown UPS trucks delivering holiday packages, it has been a tough few weeks for savers and retirees.

Moves by the Irish, French and Hungarian governments, and by the famous delivery company, showed that in the post-crisis world retirees, present and future, will be paying much of the price and taking on more of the risk.

This goes beyond merely cutting back on pension benefits, rising to actual appropriation of supposedly long-term retirement assets to help fund short term emergencies.

Let’s start with Ireland, which is kicking in 10 billion euros from its National Pensions Reserve Fund into an 85 billion euro package of support for its banks.

Trust me, this does not reduce the risk profile of the NPRF, which was set up as a sovereign wealth fund to help pay for state retirement benefits.

Putting aside jokes about sovereignty and wealth, of which there is appreciably less in Ireland than formerly, this is effectively a transfer of wealth from the Irish people to its banks. Or rather, to the institutions, mostly European banks, which hold Irish bank debt, none of whom as senior creditors will share in the pain.

In many jurisdictions if Ireland were a corporation and the NPRF part of the corporation’s pension fund, then making such a move would be illegal, and quite rightly so.

Of course this is not the first time that the NPRF has been used in this way. It has already “invested” 7 billion euros into Irish banks and has pledged another 3.7 billion to struggling Allied Irish Banks.

Also under consideration is a regulatory move that would effectively compel some private Irish pension funds to hold more Irish government debt, thereby providing the state with a captive investor base but hugely raising the risks for savers.

On to Hungary, which is seeking to cut its very high level of public debt as it prepares for entry to a euro single currency which may well self-destruct before it ever gets the chance to join. Hungary’s government last week finalized new rules designed to force members of private pension plans to opt back into a state controlled pay-as-you go option.

The idea, such as it is, is that participants in the private plans will fork over their $14 billion or so in savings, equal to about 10 percent of Hungary’s GDP, to the government in exchange for a pledge of a pension from the state. Hungary plans to use the funds to make pension payments to current retirees this year and next as well as to pay down government debt.

It is, in short, an outrage.

PACKAGES SOMETIMES GET LOST
Earlier this month France launched a move similar to Ireland’s as part of legislation that raised the age of retirement.

France is transferring more than 20 billion euros of assets belonging to its Fonds de Reserve pour les Retraites (FRR), a funded portion of its retirement system, to Cades, a fund designed to be run down to pay for social benefits.

The transfer will take place over a number of years and the mix of assets held by the FRR in the meantime will shift radically, implying a large shift to government debt. Very convenient for the French Treasury but perhaps not so good for future retirees.

Finally, let’s turn to UPS, which earlier this month became one of the most notable of a string of U.S. companies to sell bonds in order to fund its obligations to its underfunded pension fund. UPS sold $2 billion of bonds due in 2021 and 2040, with the longer dated portion yielding about 5.0 percent.

A decade of paltry equity market returns and current low bond yields, which are used to calculate future liabilities to retirees, have left many firms, including UPS, with funding deficits.

Debt financing pension obligations is in essence a plan to try and make a spread between the cost of financing and the returns the company is able to make on its pension assets.

Borrowing to speculate in financial markets to make up for a lack of previous saving; what could possibly go wrong?

To be fair, UPS, which is one of many large U.S. corporations making similar moves, can’t be equated with Ireland or Hungary. UPS has the same legal obligation to its pension fund no matter how it chooses to fund it, so the bond issue from that perspective does not raise the risk for retirees.

That said, a participant in a company pension plan is dependent on the ability of the company to meet its obligations. The more debt the company takes on, the higher that risk is.

Savers of all types are being asked to shoulder risks they did not sign on for, the costs of which they will inevitably bear.

(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.email James Saft at jamessaft@jamessaft.com)