Thursday, December 1, 2011

France should ring-fence its banks now

There are two ways that Italy and Spain can be rescued from collapse: either the eurozone agrees to issue eurobonds which are guaranteed on a joint-and-several basis by all 17 members, which would be used to refinance maturing debt; or the ECB agrees to act as bond buyer of last resort and establishes a standing bid for Italian and Spanish bonds at an agreed yield.

If either of these events occur, Italy and Spain will be able to continue to repay maturing debt. If neither of these events occur, then at some point the bond market will close to Italy and Spain, as it did to Greece. (The bond market may have already closed, since the ECB does not disclose its purchases by individual country.)

Under the bad scenario, Italy and Spain will have to restructure their debt and/or leave the euro. Either way, banks will be faced with substantial writedowns.

Which brings us to France. France is a strong credit (somewhere in the AA category) despite its banking system’s exposures to Italy and Spain. Its banks, however, are not strong credits on a standalone basis, because of their eurozone exposures as well as general unprofitability.

The weakness of France’s banks (especially BNP) is contaminating France’s own credit, such that France is having to pay yields as much as 2% above Germany. It is time for France to bailout its banks, and thus demonstrate its ability to withstand defaults by Italy and Spain.

There are a number of ways for France to bailout its banks, but here is a pretty common method: Establish a state owned entity (or use an existing state institution such as CDC) to buy marketable assets (i.e., sovereign bonds) at current market prices (below their current accounting value) and make up the losses with new equity. That way, the banks would no longer be at risk of further writedowns on this paper, and should thus regain their credibility in the debt market. There is much less of a problem with exposures to Italian and Spanish banks; these are manageable and declining, with the ECB taking up the slack.

For reasons that I can’t fully understand, the rating agencies have said that if France incurs additional indebtedness in order to bailout its banks, it is likely to lose its AAA rating. Since these costs are known contingent liabilities, this threat suggests that the agencies are using mechanical debt ratios, as opposed to taking into account contingent liabilities. This is particularly peculiar for S&P, which has been saying for over a decade that it takes into account the contingent liability posed by the banking system when analyzing sovereigns.

In any case, France has already lost its AAA in the bond market, partly in anticipation of a downgrade, and partly due to the weakness of its banks. In my opinion, France should bite the bullet now, take the downgrade, and move on. This would give the bond market one less thing to worry about.

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