Macro: EU Summit – Hot Air only or circuit breaker ?

I don’t want to transform this blog into a macro blog, as I do not have the competence to really talk about macro events. However I wanted to follow up on the Bull case for Europe post to quickly look at the results of last week’s EU summit

As it is always best to ignore most of the press stuff, let’s look at the original statement:

In my opinion, the 120 bn “growth budget” is less important, as well as the intention to move to a fiscal union. The most important part in my opinion is this one:

Euro area summit statement

Eurozone heads of state or government decided:
to establish a single banking supervisory mechanism run the by the ECB, and, once this mechanism has been created, to provide the European Stability Mechanism (ESM) with the possibility to inject funds into banks directly.

Spain’s bank recapitalisation will begin under current rules, i.e. with assistance provided by the European Financial Stability Facility (EFSF) until the ESM becomes available. The funds will then be transferred to the ESM without gaining seniority status.

It was also agreed that EFSF/ESM funds can be used flexibly to buy bonds for member states that comply with common rules, recommendations and timetables.

The Eurogroup has been asked to implement these decisions by 9 July 2012.

I would call this decision the “Spanish bank circuit breaker”. Up to now, everyone was aware of the potential death spiral, if the ESM gives money to Spanish banks only via the government because this further incrases the debt load.

Interestingly, they did not specifiy what instruments should be used, My assumpton would be someform of “Contingent Convertible” which would provide much needed Tier 1 capital to Spanish banks. The ESM original document speaks of “lending”, but CoCo loans or bond would not violate this.

So in theory, we now have the “full package” for any Eurozone bank:

1) unlimited liquidity from the ECB plus
2) a big pot of potential bank equity from the ESM.

Draghi’s bazooka from last year was only a small bonfire without the possibility to inject capital.

For those who still remember the beginning of the crisis, this was exactly how the US TARP developed. The 700 bn USD fund was initially planned to buy mortgages etc. but was then used to inject money directly into banks. The “vicious circuit” was only broken, when Bazooka Paulson forced his Tarp funds into any large US banks.

So does this end the crisis ? Are banks stocks now good investments ?

I don’t think so, but this feature definitely reduces both, the probability and severity of a tail risk event.

As expected, the usual suspects again come out and say: This is not enough.

Like Nobel laureate Paul krugman, who of course demands a complete solution to any problem being implemented right now.

However, for me it looks like a necessary and logical next step. No solution but risk mitigation. And therefore important and good. I hope it leads to ample supply of loans for PIIGS companies in order to have time to implement necessary other reforms.

At some point in time one might want to start to look into PIIGS bank subordinated securities…….

7 comments

  • Well, I do not want to argue about these macro issues, because (like you and probably everybody else) I cannot predict the future of such a complex issue. Regarding wrong numbers:
    – the fact that interest-payments on mortgages were tax deductible is a well known fact and a big political mistake. The dutch housing-market is in decline (source:globalpropertyguide.com):

    “After almost 15 years of housing boom, the Dutch housing market started to become weak in 2008, mainly due to the global financial meltdown.

    In 2008, house prices fell by 5.3% (-7.5% in real terms)
    In 2009, house prices dropped by 1.5% (-2.4% in real terms)
    In 2010, house prices rose slightly by 1% (-0.7% in real terms)
    In 2011, house prices dropped by 3.8% (-6.2% in real terms)

    During the year to end-March 2012, the prices of existing homes sold in Netherlands fell by 4.7%, according to Statistics Netherlands (CBS).

    The Dutch economy is projected to contract by 0.5% in 2012. The economy entered recession in Q4 2011, when real GDP shrank by 0.6% both on a yearly and quarterly basis.”

    At least to me this sounds like a bit of a problem when you have loan-to-value ratios of up to 130%. Let´s just hope those who used their house as a tax-efficient ATM did not invest their money in the Dutch stock index AEX. At the beginning of 2008 the quote for the index was 500, today it is at 307… .

    • Oskar,

      there is no doubt that the Dutch are nnot in a perfect position either, maybe that is the reason why they are relativel quiet in the whle discussion ?

      MMI

  • In my opinion it is very dangerous and difficult to draw any conclusions from the “results” of recent negotiations (please remember, that no contract on these new agreements was yet signed). I agree with you, that macro-assumptions are very often a 50/50-bet. If you look at the negative side of it (which the english-speaking press is unwilling to discuss), these are some of the problems:
    – these political agreements need to be turned into actual national laws/households, a process that will get increasingly difficult as citizens in northern Europe become aware of the dimension of the Club-Med debt
    – the eventual size of the capital-pool needed is unknown even to experts. In the Dutch parliament-hearing a well-respected expert was quite honest when he said that nobody knows how much a protection plan for southern european banks and countries will cost.
    – this will eventually lead to more public resistance in the north, especially once interest-rates for bunds etc. start to rise and taxes need to be raised to pay these higher interest-rates
    – the financial power of the northern countries is fastly overestimated. Unless harsh measures (taxes) against safers and consumers in these countries are executed, the public debt ratios will become unfavourable or even unsustainable (the Netherlands just found out that their issuance of new debt in 2013 equals 4.5% and that is, of course, before making the decided transfer-payments to the south; private debt in the Netherlands has reached 240% of disposable income, the second-highest in Europe!).
    – if you try to break it down to the bank-level: who knows how to evaluate their balance-sheets? Even the most basic questions remain unanswered. If you take into account for exmple, that Commerzbank announced two days ago the liquidation of its subsidiary Eurohypo it makes you wonder if one should look at other banks as a going concern… . and Eurohypo, despite its flaws, was not a bank run by corrupt politicians (and their families) in corrupt countries.

    In order to see a light at the end of the tunnel one would have to see political reforms, prosecution of fraud and corruption, a comptetetive labour-market and functioning public institutions in those countries (Italy, Spain, Greece, France?) who ask for transfer-payments. That is the precondition for sustainable growth. The motivation to do these steps will of course diminish if “free” money is available.

    • Oskar,

      thanksfor the comments. Of course no one knows what the theoretical costs of a full blown Club med Rescue would be.

      However people often use wrong headline numbers to prove some points.

      In your case for instance the private debt number in the Netherlands: By chance, i have looked into this issue. Yes private debt in the netherland is significant, but this is mostly due to tax reasons. if you buy a house in the Netherlands, you try to get as much debt funding as possible because you can deduct interest againsst income.

      Normally, Dutch people take out 130% mortages (!!!) and invest the remainder at a positive after tax spread.

      If you look for instance here, that Dutch “net worth” is significant. By the way in Italy as well.

      So one should always doublecheck any number which is used in those discussion. Any EUR of debt is someone else’s asset. One should not forget this.

      MMI

      • Hi MMI,
        Your link shows what I can’t understand in the discussions: The net wealth of households in Italy for example is high. AFAIK even higher than in Germany. I can’t see why the northern countries should pay for them. Maybe Germany should pay cash to every citizen pushing up gross debt and apply for help 🙂

        I know Italy said: we can’t tax private assets, but on the long run I see no alternative. To tax only real estate is disparate.and thus unfair.

  • Hi Martin,

    I would assume that the new loans have to be junior at least to senior unsecured and tier 2 in order to qualify as “tier 1” capital which is what the banks need.

    So I would look at senior unsecured and Tier 2 bonds first.

    MMI

  • If the injected money is cheap equity holders will profit. Existing Bonds are senior to equity anyway. As long as this is voluntary the equity holders can only profit because there will be more options to get capital.

    What do you think are the implications for bondholders of banks?

    Would this new “loans” be senior to the old ones? If so why would you consider subordinated securities? I would consider them if equity would be injected into the banks and not only new loans.

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