Ovebanked, Underfunded, and Overly Optimistic: The New Face of Sovereign Europe
Ireland has finally admitted the horrendous condition of its banking system. I actually give the government kudos for this, and await the moment when the US, China and the UK come forth with such frankness. That being said, things are a mess, I have forewarned of this mess for some time now. First, the lastest from Bloomberg: Ireland's Banks Will Need $43 Billion in Capital After 'Appalling' Lending
March 31 (Bloomberg) -- Ireland's banks need $43 billion in new capital after "appalling" lending decisions left the country's financial system on the brink of collapse. The fund-raising requirement was announced after the National Asset Management Agency said it will apply an average discount of 47 percent on the first block of loans it is buying from lenders as part of a plan to revive the financial system. The central bank set new capital buffers for Allied Irish Banks Plc and Bank of Ireland Plc and gave them 30 days to say how they will raise the funds.
"Our worst fears have been surpassed," Finance Minister Brian Lenihan said in the parliament in Dublin yesterday. "Irish banking made appalling lending decisions that will cost the taxpayer dearly for years to come."
Dublin-based Allied Irish needs to raise 7.4 billion euros to meet the capital targets, while cross-town rival Bank of Ireland will need 2.66 billion euros. Anglo Irish Bank Corp., nationalized last year, may need as much 18.3 billion euros. Customer-owned lenders Irish Nationwide and EBS will need 2.6 billion euros and 875 million euros, respectively.
The asset agency aims to cleanse banks of toxic loans, the legacy of plunging real-estate prices and the country's deepest recession. In all, it will buy loans with a book value of 80 billion euros ($107 billion), about half the size of the economy. Lenihan said the information from NAMA on the banks was "truly shocking."
Lenders must have an 8 percent core Tier 1 capital ratio, a key measure of financial strength, by the end of the year, according to the regulator. The equity core Tier 1 capital must increase to 7 percent.
AIB's equity core tier 1 ratio stood at 5 percent at the end of 2009 and Bank of Ireland's at 5.3 percent. Those ratios exclude a government investment of 3.5 billion euros in each bank, made at the start of 2009.
Credit-default swaps insuring Allied Irish Bank's debt against default fell 6.5 basis points to 195.5, according to CMA DataVision prices at 8:45 a.m. Contracts protecting Bank of Ireland's debt fell 7 basis points to 191 and swaps linked to Anglo Irish Bank's bonds were down 3.5 basis points at 347.5.
Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. A decline signals improving perceptions of credit quality.
If Allied Irish can't raise enough funds privately, the state will step in with aid, Lenihan said. It is "probable" the government will then end up with a majority stake, he said.
Ireland may not be able to afford to pump more money into the banks. The budget deficit widened to 11.7 percent of gross domestic product last year, almost four times the European Union limit, and the government spent the past year trying to convince investors the state is in control of its finances.
The premium investors charge to hold Irish 10-year debt over the German equivalent was at 139 basis points today compared with 284 basis points in March 2009, a 16-year high.
Ireland's debt agency said it doesn't envisage additional borrowing this year related to the bank recapitalization. It is sticking to its 2010 bond issuance forecast of about 20 billion euros, head of funding Oliver Whelan said in an interview.
"The bank losses, awful as they are, represent a one-off hit. It's water under the bridge," said Ciaran O'Hagan, a Paris-based fixed-income strategist at Societe Generale SA. [What is the logic behind this statement? Has the real estate market started increasing in value? Are the banks credits now increasing in quality? Will the stringent austerity plans of the government create an inflationary environment in lieu of a deflationary one for the bank's customer's assets???] "What's of more concern for investors in government bonds is the budget deficit. Slashing the chronic overspending and raising taxation by the Irish state is vital." [This is a circular argument. If the government raises taxes significantly in a weak economic environment, it will put pressure on the bank's lending consituents and the economy in general, presaging a possible furthering of bank losses!]
March 31 (Bloomberg) -- Kit Juckes, chief economist at ECU Group Plc, talks with Bloomberg's Linzie Janis about the outlook for Ireland's banks after the government set out plans to revive the country's financial system.
Now, notice how prescient my post of several months ago was, The Coming Pan-European Sovereign Debt Crisis:
I will attempt to illustrate the "Overbanked" argument and its ramifications for the mid-tier sovereign nations in detail below and over a series of additional posts.
Sovereign Risk Alpha: The Banks Are Bigger Than Many of the Sovereigns
This is just a sampling of individual banks whose assets dwarf the GDP of the nations in which they're domiciled. To make matters even worse, leverage is rampant in Europe, even after the debacle which we are trying to get through has shown the risks of such an approach. A sudden deleveraging can wreak havoc upon these economies. Keep in mind that on an aggregate basis, these banks are even more of a force to be reckoned with. I have identified Greek banks with adjusted leverage of nearly 90x whose assets are nearly 30% of the Greek GDP, and that is without factoring the inevitable run on the bank that they are probably experiencing. Throw in the hidden NPAs that I cannot discern from my desk in NY, and you have a bank that has problems, levered into a country that has even more problems.
Notice how Ireland is the nation with the second highest NPA to GDP ratio. This was definitely not hard to see coming. In addition, Ireland has significant foreign claims - both against it and against other countries, many of whom are embattled in their own sovereign crisis. This portends the massive exporting and importing of financial contagion. Reference my earlier post, Financial Contagion vs. Economic Contagion: Does the Market Underestimate the Effects of the Latter? wherein I demonstrate that Ireland's banking woes can easily reverberate throughout the rest of Europe, affecting nations that many pundits never bothered to consider. Irish banks will be selling off assets, issuing assets and bonds in an attempt to raise capital just as the Irish government (contrary to their proclamations) will probably be issuing debt to recapitalize certain banks. This comes at a time when the Eurozone capital markets will be quite crowded.
Expected higher fiscal deficit and bond maturities due in 2010 have increased the need for bond auction financing for all major European economies. Amongst all major European economies, France and Italy have the highest roll over debt due for 2010 of €281,585 million and €243,586 million, respectively.
While Germany and France are expected to have the highest fiscal deficit of €125.1 billion and €96.0 billion, respectively in absolute amount for 2010 (this is without taking into consideration any possible bailout of Greece and/or the PIIGS, which will be a very difficult political feat given the current fiscal circumstances), Ireland and Spain are expected to have the highest fiscal deficit as percentage of GDP of 12% and 11%, respectively. See our newly released Spanish fiscal analysis for a more in-depth perspective, see our premium subscriber report on Spain's fiscal condition and prospects: Spain public finances projections_033010 2010-03-31 04:41:22 705.14 Kb
Overall, in terms of total financing needed for 2010 (which includes 2010 bond maturities, short-term roll over debt and fiscal deficit), France and Germany top the list with € 377.5 billion and €341.6 billion, respectively while the total finance needed as percentage of GDP is expected to be highest for Belgium and Ireland at 26.3% and 22.4%, respectively.
However, the recent spate of bond auction failures across Europe is forcing governments to increase premiums on new bond auctions (higher yields), which in turn is resulting in a decline in existing bond prices.
PIIGS - A troublesome area
Now, to focus on the contagion effect of Ireland, specifically, let's borrow from our yet to be released foreign claims model in order to see who may be effected from the rush to pull capital out of extant positions to fill the leveraged NPA holes left by the banks...
Ireland has the largest claims against the UK as a percentage of the its respective GDP, the largest in the world. In the rush to raise cash to sell assets, expect some fire sales in the UK. For those who may be wondering how this may affect the UK, see our premium subscription report on the UK's public finances and prospects (recently updated to include the last round of government projections): UK Public Finances March 2010 2010-03-29 06:20:38 615.90 Kb
Ireland can also be expected to pull assets our of the ailing PIIGS group as well, since they are, bar none, the biggest lender to that group as a percentage of GDP. No wonder their banks are having problems. There biggest exposure? Italy! See our premium analysis of Italy's public finances and prospects: Italy public finances projection 2010-03-22 10:47:41 588.19 Kb as well as their other major exposures: Spain public finances projections_033010 2010-03-31 04:41:22 705.14 Kb and Greece Public Finances Projections 2010-03-15 11:33:27 694.35 Kb.
Of particular interest may be the prospects of the various banks caught in this interwoven web (premium subscription material). To date, these analyses have proven to be right on the money:
- Greek Banking Fundamental Tear Sheet
- Italian Banking Macro-Fundamental Discussion Note
- Spanish Banking Macro Discussion Note
Ireland also has the second highest claims (as percent of GDP) against the central and eastern European nations, who happen to be in a full blown depression. The withdrawal of assets, banking support and credit will exacerbate both Ireland's problems and that of these nations. See The Depression is Already Here for Some Members of Europe, and It Just Might Be Contagious! to find that Ireland can exacerbate the problems of Austrian, Swedish and Belgian banks by pulling capital out of the CEE region, and yes, they are truly in a depression:
Austria, Belgium and Sweden, while apparently healthy from a cursory perspective, have between one quarter to one half of their GDPs exposed to central and eastern European countries facing a full blown Depression!
These exposed countries are surrounded by much larger (GDP-wise and geo-politically) countries who have severe structural fiscal deficiencies and excessive debt as a proportion to their GDPs, not to mention being highly "OVERBANKED" (a term that I have coined).
So as to quiet those pundits who feel I am being sensationalist, let's take this step by step.
Depression (Wikipedia): In economics, a depression is a sustained, long-term downturn in economic activity in one or more economies. It is a more severe downturn than a recession, which is seen as part of a normal business cycle.
Considered a rare and extreme form of recession, a depression is characterized by its length, and by abnormal increases in unemployment, falls in the availability of credit, shrinking output and investment, numerous bankruptcies, reduced amounts of trade and commerce, as well as highly volatile relative currency value fluctuations, mostly devaluations. Price deflation, financial crisis and bank failures are also common elements of a depression.
There is no widely agreed definition for a depression, though some have been proposed. In the United States the National Bureau of Economic Research determines contractions and expansions in the business cycle, but does not declare depressions. Generally, periods labeled depressions are marked by a substantial and sustained shortfall of the ability to purchase goods relative to the amount that could be produced using current resources and technology (potential output). Another proposed definition of depression includes two general rules: 1) a decline in real GDP exceeding 10%, or 2) a recession lasting 2 or more years.
Before we go on, let's graphically what a depression would look like in this modern day and age...
A depression is characterized by its length, and by abnormal increases in unemployment.
A depression is characterized by ... shrinking output and investment ... reduced amounts of trade and commerce.
In order for the CEE region to improve, it must avoid the shocks associated with financial and economic contagion from far flung regions such as Ireland. The reality of the matter is that it may not be that easy. BoomBustBlog premium subscribers may download the CEE bank exposure analysis to see which banks we feel have the highest exposure to such an incident, or more realistically, string of incidents: Banks exposed to Central and Eastern Europe.
From an empirical perspective, Ireland is in a prime position to export contagion. Not only does it have the 2nd highest banking NPAs to GDP ratios in the developed world, it has one of the highest foreign claim to GDP rations as well. I have already demonstrated how these foreign claims just happen to be concentrated in today's problem areas, but Ireland has spread this exposure far and wide as well. It is second only to Switzerland (due to Swiss private banking industry) in claims against developed countries. It is also second only to the Swiss in its total foreign claims as a % of GDP.
Next up in my Pan-European Sovereign Debt Crisis analysis, a closer look at Spain, a thorough analysis of Ireland's public finances prospects, an empirical look at Portugal and the total Foreign claims model. To illustrate how complex the foreign claims web is, imagine the intertwined prospects presented here for Ireland, multiplied by all of the nations of economic significance in the world!
For the complete Pan-European Sovereign Debt Crisis series, see:
- The Coming Pan-European Sovereign Debt Crisis - introduces the crisis and identified it as a pan-European problem, not a localized one.
- What Country is Next in the Coming Pan-European Sovereign Debt Crisis? - illustrates the potential for the domino effect
- The Pan-European Sovereign Debt Crisis: If I Were to Short Any Country, What Country Would That Be.. - attempts to illustrate the highly interdependent weaknesses in Europe's sovereign nations can effect even the perceived "stronger" nations.
- The Coming Pan-European Soverign Debt Crisis, Pt 4: The Spread to Western European Countries
- The Depression is Already Here for Some Members of Europe, and It Just Might Be Contagious!
- The Beginning of the Endgame is Coming???
- I Think It's Confirmed, Greece Will Be the First Domino to Fall
- Smoking Swap Guns Are Beginning to Litter EuroLand, Sovereign Debt Buyer Beware!
- Financial Contagion vs. Economic Contagion: Does the Market Underestimate the Effects of the Latter?
- "Greek Crisis Is Over, Region Safe", Prodi Says - I say Liar, Liar, Pants on Fire!
- Germany Finally Comes Out and Says, "We're Not Touching Greece" - Well, Sort of...
- The Greece and the Greek Banks Get the Word "First" Etched on the Side of Their Domino
- As I Warned Earlier, Latvian Government Collapses Exacerbating Financial Crisis
- Once You Catch a Few EU Countries "Stretching the Truth", Why Should You Trust the Rest?
- Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!