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.

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

HUNTSVILLE, Ala., Aug 30 – In an unintended irony for a continent with a great public transport infrastructure Europe’s debt rescue plans are turning into a train wreck. Consider that as Greek two-year interest rates stood at 45 percent on Monday, officials and interests in the euro zone descended into an unseemly mix of squabbling over assets, denying the undeniable and disagreeing about first principles. Even as weak as recent U.S. economic data has been, these fractures, which imply heightened risk of a bank-centered market crisis, are surely the main source of the recent extreme financial volatility.

Most interesting was the intervention by newly minted International Monetary Fund Managing Director Christine Lagarde on Saturday who warned “developments this summer have indicated we are in a dangerous new phase.”

Lagarde went on to say that Europe’s banks need “urgent recapitalization,” using public funds if necessary, and advised that one option would be to use the European Financial Stability Fund (EFSF), or some other vehicle, to inject capital into banks directly.

Here we have the head of the IMF, a woman who was until recently the finance minister of France, more or less asserting that the bank stress tests are best disregarded and that people should have real doubts about the banks they do business with, invest in and lend to.

This is nothing that cannot be seen in market prices, of course, but it’s a bit as if U.S. Treasury Secretary Tim Geithner were to leave government service, set up as an equity analyst and come out with a “sell” rating on Bank of America.

Not helpful, even if perhaps true.

Lagarde said that Europe risks a liquidity crisis, though surely any crisis that comes as a result of people withdrawing credit from banks because they have not got enough capital has to be classed as a crisis of solvency.

Euro zone officials were quick to stamp on the idea, pointing out there were well known remedial steps being taken as a result of the stress tests, and that new banking regulations offered further protection. It is good that euro zone officials can agree that they’ve solved the bank capital problem, because very few others seem to agree.

On other issues, European officialdom is showing comical, if destructive, disagreement. Take Finland’s demand for collateral as part of its participation in the rescue of Greece. This demand immediately sparked a round of “me too” demands from other smaller euro zone players, states whose share of the package is about 10 percent. To an outsider, this looks suspiciously like a lack of faith in Greece and in their European partners. It has the feel not of a rescue of a sovereign state and euro zone partner, but of in-fighting among the creditors in a bankruptcy.

While Finland appears to have backed off from some of its demands, the situation hardly inspires confidence.

A LITTLE LOCAL DIFFICULTY

And of course even within countries there are deep political divisions over the right path. Germany is an excellent case in point; Chancellor Angela Merkel last week came out against Finland’s bilateral deal and euro zone common bonds, while maintaining that she would be able to push through approval by parliament of the expansion of the EFSF. Reports in German media indicate substantial opposition within Merkel’s somewhat shaky coalition, meaning she may be forced to seek votes from the opposition. Merkel has canceled a long-planned visit to Russia on Sept. 7, the day of the vote.

The ECB’s decision to buy Spanish and Italian debt on the open market, a thus far successful effort to cap interest rates for the two vulnerable states, has left it subject to strong criticism that it has overstepped its bounds and compromised its independence.

German President Christian Wulff last week inveighed against the ECB’s action and against the last-minute nature of recent policy-making.

“I regard the massive acquisition of the bonds of individual states via the European Central Bank as legally questionable,” he said, speaking at an economics conference in Lindau, Germany.

Wulff cited an article in the European Union’s fundamental treaty, which he said prohibits the ECB from buying bonds directly from governments.

“Decisions have to be made in parliament in a liberal democracy. That is where legitimacy lies,” he said. This is an interesting echo of the less well tempered criticism of Ben Bernanke by presidential hopeful Rick Perry, who said that further radical easing by the central bank would be “treacherous, almost treasonous.”

The truth, perhaps, is that Europe is a group in an impossible situation, just as the Fed is an institution in an untenable position. Groups of people in impossible situations tend only to act when forced, and only rarely are able to act in concert.

Expect an active and unsettling September.

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.

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

The proposed bailout of Greece probably can’t escape the scarlet D of default, at least if the ratings agencies follow their own guidelines.

Even if the deal goes through, it is insufficient to solve Greece’s debt problems, only buying time for those involved to work out how best to engineer a transfer of bank losses to taxpayers.

Greece approved an austerity package on Wednesday, removing one road-block to further support, but it is still unclear how to get banks to participate in debt relief — a German requirement — without prompting a destabilizing event of default on Greece as a sovereign creditor.

French banks have proposed a burden-sharing plan, supposed to be voluntary, which EU officials are pushing as a means to thread this particular needle.

Under the plan, holders of Greek bonds maturing in the next three years would agree to roll over half of their exposure into new Greek 30-year bonds. Another 20 percent would go to fund a vehicle to act as collateral against Greek default.

The new Greek debt would have an interest rate of 5.5 percent, massively below Greece’s free-market funding cost, plus a potential sweetener of another 2.5 percent depending on Greek GDP growth.

Well, if it walks like a default and quacks like a default; it may just be a default.

This is a deal that is patently designed to avoid a default, and patently makes banks accept diminished economic returns, all important criteria of financial default.

Fitch ratings agency has already said it would very likely view such a deal as a default, and while the other agencies have not yet commented a look at their criteria points to a similar view.

Standard & Poor’s own definition of default labels a distressed exchange offer, “whereby one or more financial obligation is either repurchased for an amount of cash or replaced by other instruments” as a Selective Default.

Moody’s similarly considers a distressed exchange as a default, if either that exchange amounts to a diminished financial obligation compared to the original debt or, the exchange has the effect of allowing the borrower to avoid a payment default in the future.

The ratings agencies will be under massive pressure to bend their rules, so it is always possible that they, perhaps two out of three of them, allow the deal to skate through.

But why would the banks volunteer for this deal?

The French proposal cleverly allows banks to mark the new debt as “held-to-maturity,” meaning that they are not compelled to recognize their obvious losses. It also buys time, not so much time for Greece to recover, because the deal is not generous enough to allow that, but for EU politicians to work out some way for the losses to passed along to taxpayers to shelter the banks.

FORK IN THE ROAD

If the French proposal is labeled a default, it won’t go through, as escaping default is one of its preconditions. This leaves open the possibility of a disorganized default in coming months, an event that would be so destabilizing that Germany may eventually relent on its insistence that private creditors pay a share.

If Greece is downgraded to “default”, the ECB has said it would refuse to accept Greek bonds as collateral for liquidity loans, an act that would at a stroke vaporize much of the Greek banking industry. The obvious thing is for the ECB to bend its rules, but even if it did, you can expect that a Greek default would immediately bring Portugal, Spain, Italy and Ireland back into play, with investors declining to finance them, or even worse, pulling funds from their banks en masse.

Even if the French proposal goes through, it, in combination with the new austerity package has done nothing to lighten Greece’s debt load, only buying time for its economy to recover or for a different political reality to dawn. But Greece’s economy isn’t going to recover any time soon, given the weight of the debt load and the self-reinforcing dynamics of austerity. It will continue to contract, making the debt burden worse.

While the Greek economy needs to reform, that process will not be fast enough to solve these issues, and arguably will be retarded by the severity of the austerity.

Perhaps the hope is that in a year or so opposition to socializing Greek debts will ease in Northern Europe, allowing for a bailout that does not damage banks, or damages them less at a time they have been able to rebuild sufficient capital.
The overall impression is of an elaborate dance intended to shelter banks from damage they are not strong enough to withstand.

That’s not just unfair, and ultimately unproductive, it is a sobering comment on just how weak growth will be while the banks are allowed to heal.

(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.)

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

HUNTSVILLE, Ala. — With QE2 set to end in five weeks and with Greece rolling downhill towards default, the world is not best placed to withstand a weakening economy.

That, however, is exactly what looks to be happening, as Asian demand is hit by a cooling China and a struggling Japan.

Let’s take a look at the evidence:

Japan’s economy shrank by 0.9 percent in the three months to March, battered by the earthquake, tsunami and ongoing nuclear fiasco.

The preliminary HSBC/Markit purchasing managers’ index for China fell to 51.1 in May from a final reading of 51.8 in April, holding in expansionary territory above 50 but amidst growing evidence that China is coming off the boil. Chinese demand for raw materials and semi-finished products has been one of the global economy’s principal supports, but now a monetary policy tightening campaign may be gaining traction.

The Chicago Fed national index, derived itself from 85 economic indicators, came in at negative 0.45 in April compared to 0.32 in March. There are numerous signals of an industrial slowdown in the U.S., while the housing market continues to weaken, threatening financial stability and consumer spending.

Finally, in Europe the euro zone composite flash PMI, an indicator combining service sector and manufacturing purchasing, fell to 55.4 from 57.8. More worryingly, the headline manufacturing index had its biggest fall since Lehman Brothers failed, falling by 3.1 points to 54.8.

“All in all it seems to us that the odds are high that a domestic and global economic slowdown is already in place.  In the U.S. the slowdown is happening with only weeks to go before the end of QE2, a program that has been a major prop for even the tepid recovery we’ve undergone so far,” said Charlie Minter of fund managers Comstock Partners in a note to clients.

“For the stock market nothing seems to matter until, suddenly, it does.”

It has begun to matter recently to the stock market, which has fallen in recent sessions after a sustained rally. The bond market has already figured this out; since mid-April U.S. 10-year yields are down more than 12 percent to 3.12 percent. Given that the U.S. debt market faces a debt showdown and the end of QE2, both factors which should theoretically send yields higher, this slide in yields shows real doubts about future growth.

CRUEL SUMMER

It is worth noting that the euro zone’s woes were not this time concentrated in the weak peripheral states; this time Germany got whacked too. That may well reflect the wrench thrown into production from Japanese plant closings, which in itself will self-correct. It is also likely reflecting a slowdown in demand for German products from China. If you believe that Chinese demand was artificially boosted by very easy credit, and that Chinese demand in turn was driving global growth, then this is an indicator of a very busy and volatile summer in financial markets.

Global markets have ignored, more or less, the euro zone’s issues for more than a year, but did so in a very supportive atmosphere. The Federal Reserve was buying up Treasuries, sending cash into risk markets in waves, while China continued to grow at a blistering pace. It may be that China is important not just because its slowdown affects demand, but because it lets investors focus on the actual prospects in the euro zone.

Will Germany and France be as willing to foot the bill for Greece if their own manufacturing bases begin to shrink? It is possible but a lot less likely.

Meanwhile the crisis both builds and spreads, with a dispute over debt reprofiling (a sort of doe-eyed default) between the European Central Bank and European officials and a fantasy plan by Greece to raise 15 billion euros through asset sales.

Greece may turn out to be a minor worry; Belgium and Italy have been threatened with credit downgrades by Fitch.

So what happens from here? A palatable outcome would be a gentle decline in economic momentum followed by a strong second half. This makes absorbing the impact from Europe easier, and makes it easier for Europe to come to terms with itself.

A less likely, perhaps, but still possible scenario is that the manufacturing slowdown gains speeds just as Europe faces a contagion from the periphery, either to parts of the core, to the banking system of the core, or both.

At this point the Federal Reserve will have an ugly choice; does it extend and expand quantitative easing to support the newly weakening economy, or does it sit tight, brace for the recession and hope something else will turn up?

(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.)

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

Greece cannot be saved without debt relief, and debt relief for Greece may mean what amounts to a mass Jubilee with debt write-offs and recapitalizations needed for weak banks and nations across the euro zone.

Little wonder that officials delay, deny and only belatedly try to negotiate openly with reality.

Greece’s credit rating was downgraded by Standard & Poor’s to B on Monday, taking it two steps further into junk territory, just days after a secret meeting of euro zone finance ministers  gave rise to rumors that the country would soon leave the common currency zone.

EU officials have said a new aid package for Greece (and Ireland) is on the way, and S&P foresees commercial creditors paying their share too, which even if it is only an extension of the maturity of the bonds is tantamount to a default.

“Although an extension of maturities with no principal discount would likely imply a recovery greater than 50 percent, our projections suggest that principal reductions of 50 percent or more could eventually be required to restore Greece’s debt burden to a sustainable level, given trend growth potential of the Greek economy,” S&P said in explaining its action.

This brought on a fit of scoffing from Greek officials, who said there had been no deterioration since S&P’s last evaluation in March. Gentle notice to officials: ratings agencies are famous not for being always wrong, but for being behind the curve. When they are downgrading you furiously it means everyone else already knows you are a poor credit.

For evidence of this you need only look at financial markets, which have been busily downgrading S&P in hard currency terms. Greek two-year debt is currently yielding north of 25 percent, while Greek debt overall is trading at levels that imply a 40 percent discount.

The overall message from the hard-hearted financial markets is that austerity without meaningful debt relief will not work. As odious as it may be to German and Finnish taxpayers, Greece is not going to be able to bear the load if its economy carries on shrinking. The same is self-evidently true for Ireland and Portugal. Spain’s saving grace, if you can call it that, is that it is so big and important that by the time we get to imposing conditions on it we will have moved to a far more radical game plan, one involving significant debt relief.

A GRAND RECAPITALIZATION

The European quest to maintain the fiction that the debts will be repaid fully is particularly quixotic, in that the ECB is strenuously acting to keep a lid on inflation, most recently by lifting interest rates by a quarter of a percentage point. While U.S. policy is not above its own polite fictions, at least it is consistent; they are still playing the same game of inflating spending by inflating asset prices, hoping that eventually inflation will eat gently away at the debts.

The ECB will hardly emerge unscathed from a restructuring of Greek debt, at least from one bold enough to lift the country out of its problems. The ECB is profoundly exposed to Greece, not just directly through bonds it has purchased, but also as a massive (91 billion euro) lender to Greek banks. And what are those loans collateralized with? Much of it are loans issued by or guaranteed by the Greek state.

JP Morgan estimates that a 50 percent reduction in Greek debt obligations would cost the ECB 32 billion euros, or about 40 percent of its member central bank’s reserves and capital.  Such a haircut might be withstand-able, though it would likely wipe out the capital of the Greek central bank, but such a haircut, when it happens, will not happen in isolation.

“We need a very comprehensive solution very fast, not only for Greece but for the other problem countries,” Peter Bofinger, one of the German government’s wise men economic advisors told Reuters Insider television.

“If we don’t reach this solution I am not sure that the euro area will remain intact for the next 12 months.”

Greek banks will need to be recapitalized, for a start, not a terrifying prospect, but so too quite likely will many banks outside Greece, and not solely due to losses on Greek credits.

While authorities may want to put off a Greek restructuring until 2013, when new measures to handle bailouts come into force, they’d be far better off addressing the multiple bailouts that are needed, including of banks, all at the same time.

That’s because a  Greek restructuring will speed contagion to Spain, to Portugal, to Ireland and to banks. If that restructuring is inevitable, and it looks as if it both is and is coming soon, then better to have an orderly debt Jubilee, with taxpayers and shareholders sharing the pain, than to allow the markets and that old enemy, events, to set the agenda.

(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.)