Hunting Depositor Risk In The Eurozone

“In the future, German Chancellor Angela Merkel said, ‘banks must save themselves.’

---Der Spiegel, April 1, 2013

“We strive to be the most respected Investor Relations team by delivering financial transparency and outstanding communication.” 
--Deutsche Bank Investor Relations

Europe has solved the problem of failing banks dragging down their governments with the cost of bailouts. Henceforth, the costs of bank resolution will be borne by bank bondholders and depositors, instead of by German taxpayers.

This is a very clean solution to a complex problem. If the eurozone’s banking system were viewed as a contingent liability of Germany, Germany would no longer be rated AAA, since the potential ongoing bailout costs are enormous.

By severing the link between governments and their banks, the size of Germany’s contingent liability (and hence the cost of defending the euro) becomes manageable. It is clear that the ongoing bills for maintaining the solvency of the eurozone banking system will continue to be large. These bills must be paid upon presentation because the ECB won’t lend to “insolvent” banks (an incredibly stupid policy). Hence there is a limit to the degree that such bills can be postponed. (Remember that the Cyprus bailout was precipitated by an ECB ultimatum.)

German finance minister Wolfgang Schaeuble and prime minister Angela Merkel have been vocal in welcoming this new paradigm. It solves their biggest problem: how to hold the eurozone together without bankrupting Germany. And, in addition, the Germans like the new policy because it hands the bill to the guilty parties. As Schaeuble said:  “We decided to have the owners and creditors take part in the costs of the rescue - in other words those who helped cause the crisis." (I will observe that, in all known cases of bank insolvency, the guilty parties are defaulting borrowers, not bondholders and uninsured depositors, but that's a quibble.)

Now that European bank resolution policy has changed from “Too Big To Fail” to “Too Expensive To Rescue”, a bank analyst must turn his gaze towards those eurozone banks likely to need assistance, who are now candidates for defaulting on their liabilities (sorry, for bailing-in their creditors). One might start by asking if there are any solvent banks in the eurozone, given the combination of the banks’ large exposures to troubled sovereigns/banks, plus their rotten real estate portfolios. The short answer, of course, is that there is no way of knowing which eurozone banks are insolvent because of the uselessness of European financial reporting.

Take Deutsche Bank, the avatar of German banking excellence. At year-end, it had a “core capital” ratio of 8% on the basis of Tier One Capital to Risk Weighted Assets. But its ratio of equity to book assets was 2.3%, with EUR 57B in equity supporting EUR 2.2 trillion in book assets . This puzzling anomoly results from the fact that Deutsche's risk-weighted assets are EUR 334B, or 15% of book assets. Potential depositors should pay no attention to the EUR 2.2 trillion in book assets, which have no analytic information value!! Deutsche Bank must have a really high-quality balance sheet to be so riskless. Or does it?

The rather obvious analytic schedules that a diligent uninsured depositor might desire are:

1. A schedule of eurozone government bond and bank exposure by country, showing face, MTM, and carrying values.

2. A schedule of loan and problem loan books by industry and country, showing face, MTM (where available) and book values.

I couldn’t find these on DB’s financial reporting, and I looked. I'm not saying they're not disclosed somewhere; I'm saying I couldn't find them and I'm not a layman. Maybe they're not translated into foreign; I wouldn't know.

My understanding is that under European accounting rules, eurozone government bonds are carried at face value until legally impaired (as in the case of Greece). If this is correct, this would mean that Deutsche is carrying all Club Med government bonds (except Greece, but including Cyprus) at full value, rather than at market or at impaired value. In other words, under eurozone bank accounting, all eurozone government debt is AAA until it defaults; no impairment or MTM is permitted. This renders regulatory capital ratios useless. It also means, if this is indeed the case, that Deutsche's risk asset calculation doesn't include any of the PIIGSC depreciated government bonds except Greece. I would be happy to be corrected on this supposition. You would think that, if I am wrong, Deutsche's IR department would make a point of showing how it carries eurozone government bonds. If it does, I didn't see it.

How well is DB’s massive global real estate portfolio provisioned (or marked)? Unless there is a schedule that I couldn’t find, it's a secret. In fact, I couldn’t even find out the size of DB’s RE portfolio, although I am not saying it isn’t disclosed somewhere in all that fabulous transparency.

How can a bondholder or uninsured depositor  really be confident that Deutsche Bank’s EUR 57B of equity is sufficient to absorb the entire expected loss of a EUR 2.2 trillion balance sheet, especially given the opacity of that balance sheet?

If it were your money, would you keep uninsured deposits there?

An old rule of thumb in analyzing capital adequacy and leverage is: does the bank have sufficient free funding (equity) to be consistently profitable throughout the entire credit cycle? If the bank was always profitable, you could conclude that its capital was adequate for the kinds of risks that it took. It was a backward-looking but very effective way to assess capital adequacy. Has Deutsche been profitable throughout the entire credit cycle? No, it lost EUR 3.9B in 2008. That was after reporting a 6.5B profit in 2007 (how things change!). FY 2012 wasn't great either.

Despite my intellectual defects, I am an experienced bank analyst relying on Deutsche Bank’s public disclosure in order to render a risk assessment for a potential uninsured depositor. I can only say that, in the absence of TBTF, I would have my money elsewhere. 

Now we all know that Deutsche is really TBTF because of its systemic importance in Germany. This goes for Germany’s other problem children such as HSN Nordbanken and DEPFA, the issuer of those amazing risk-free pfandbriefe. All German banks are solvent by virtue of their address. I don't doubt this, no matter what Merkel and Schaeuble might say on any given day. German banks don't default on their senior debt or on their uninsured deposits (maybe because this is good public policy?).

But do we know this about the other problem children in the eurozone, such as Banca Monte dei Paschi or Bankia? Both are disaster areas that will require ongoing bailouts from someone. Are Spain and Italy inside the TBTF zone, or are they outside it, in the dreaded "Cyprus zone"?  That we will find out, when Spain or Italy ask for a bailout.

P.S.: This story appeared on FT.com just after my post went up. It tends to support my view that uninsured depositors should be cautious in their reliance on European bank financial reporting: http://www.ft.com/intl/cms/s/0/9d58ab6a-9c78-11e2-9a4b-00144feabdc0.htmlftcamp=crm/email/201343/nbe/InTodaysFT/product#axzz2PGeMJ6Sn

Verbatim Excerpts From The FY 2012 Press Release For Banca MPS

In 2012, the Montepaschi Group operated in an extraordinarily complex market environment characterised by a progressive slowdown in the economic growth and an exacerbation of the sovereign debt crisis in the Eurozone which caused an abrupt increase in credit spreads and restricted access to interbank and institutional markets, triggering at the same time a negative spiral for both stock prices and Italian government bonds.    

The unfavourable economic cycle, combined with persisting financial instability and a reduced confidence level of businesses and households led to an exceptional deterioration in credit quality

Loan loss provisions grew to EUR 2.7 bn with a provisioning rate of 188 bp under a provisioning policy in line with the current economic context.

Net impairment losses (reversals) on loans totalled approx. EUR 2,672 mln (vs. EUR 1,297 mln as at 31/12/2011), with Q4 2012 contributing roughly EUR 1,372 mln.

The impairment test on the Group's goodwill did not result in any losses other than those posted in the 2012 half-year report, when goodwill impairment losses were recognised in the consolidated accounts for an aggregate amount of EUR 1,528 mln

Net profit: -EUR 3.17 bn after total impairment charges of EUR 1.6 bn, of which EUR 1.5 bn on goodwill and approximately EUR 110 mln on Intangibles

The trend in direct funding was affected by the downturn in funding with institutional counterparties. Wholesale funding conditions for Italian banks continued to be very difficult for most of the year.

Cyprus Will Lead The Eurozone Prison Break

"Cyprus's economy will now go through a long and painful period of adjustment. But then it will pay back the loan when it is on a solid economic foundation."

---Wolfgang Schaeuble, German finance minister

Anglophone economists have been advocating euro exit for the peripheral eurozone economies since the crisis began three years ago. They have recommended exit because “internal devaluation” is vastly more destructive than external devaluation, and because these countries need inflation, not deflation. The counter-argument from Europe has been that exit would cause chaos plus the threatened loss of official flows. Countries cut off from the EU’s largesse would supposedly be forced to balance their current accounts overnight. It is also argued that, as the new currency depreciates, external debt denominated in euros would grow in both nominal and real terms.

The European arguments against exit are self-serving: creditors never advise their clients to walk away from their debts. The more debt that Europe can pile onto these countries, the more likely that the flows will reverse, and the greater the advantages of default. All of the peripherals should have left the euro when the crisis began, before incurring enormous debts and inflicting penury on themselves for no reason. In the end, all of the peripherals will be forced by their indebtedness to leave the euro, unless the ECB is willing to open the monetary floodgates immediately. All of the unemployment and national bankruptcy being incurred now is waste. In the end, the peripherals will have to suffer both the pain of internal devaluation and of euro exit and default.

The wanton destructiveness of this process is deeply disheartening. Millions of lives are being ruined on the altar of a half-baked idea, the notion of Europe as a "country". It is a bit ironic that capitalist Europe achieved final victory over communism, only to stumble twenty years later due to internal contradictions. The internal contradiction is the Protestant belief that all countries need hard currencies, or should have them anyway even if they don’t need them.

Creditors dislike bankruptcy, and do what they can to prevent it, including lending the borrower money to pay interest (e.g., Latin America in the 1980’s). They also threaten the borrower with dire consequences if he should default. They do not want Debtor #1 to see Debtor #2 walk away from his debts and begin a new life. Instead, they will try to accommodate Debtor #1 so that he won’t go bankrupt. Creditors do not do these things to help the debtor; they do it to preserve their principal.

The endgame for the peripherals will come when the pain of perpetual depression exceeds the fear of exit. For some countries, that day will come in a year or two. For one country that day has arrived, namely Cyprus. Until Cyprus, the word from Europe was “if you exit, we’ll burn your crops and your barn”. But for Cyprus, Europe has already burned down their crops and their barn. There is nothing left to save, and thus no reason to hand another dime to the extortionists.

The Cypriots are in the midst of a national catastrophe that is going to force them to make hard choices in the very near future. It won’t take long for them to get out their calculators and do the math. They have two options: (1) stay in the eurozone carrying an oppressive debt burden into eternity; or (2) exit the euro, default on their debt, and restore monetary sovereignty. Since they are going to have to default on their debt anyway, they may as well do it now and get the simultaneous benefit of devaluation.

The Cyprus situation is similar to Argentina, but not exactly. Argentina escaped an unsustainable debt burden by unilaterally repudiating its debt. The country has done much better as a result, but remains a financial outlaw, pursued by angry creditors around the world. Cyprus does not have to default in such a ham-fisted way.

First of all, most of Cyprus’s debt is to Europe, not private bondholders. Cyprus can reduce this debt in the time-honored debtor tradition: “Give me a break or you'll get nothing”. The troika won’t have much leverage in this negotiation, unless it plans to send its gunboats to Limassol. Bondholders can be handled in a similar fashion (see: Greece). Any debt incurred under Cypriot law can be redenominated and/or rescheduled by fiat. This is all eminently do-able.

The reason why Europe “rescued” Cyprus was to prevent it from escaping from the eurozone and setting a bad example for the other inmates. Once Cyprus escapes and gets away with it, Greece will follow in short order. The Portuguese are “good Europeans”, but regional solidarity gets old quickly when you’re starving. Portugal will exit once someone else has paved the way. (After all, Brussels can't declare war on half of Europe.)

One would hope that, before the rot seeps too deeply into the heart of the eurozone (e.g., Spain and Italy), the ECB would see the light and reflate the continent, thus preventing Armageddon. Right now, it's an even bet.

The Cyprus Doctrine Does Not Apply To German Pfandbriefe!!

“The need for capital is to be first and foremost covered by shareholders and the market, and where that doesn’t occur there will be coordinated aid from states. ---German deputy finance minister Joerg Asmussen,  Nov. 14, 2011

“If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders."

---Jeroen Dijsselbloem, Dutch finance minister, March 24, 2013

There you have it: the evolution of European bank resolution policy since 2011. In 2011, governments stood behind bank deposits; in 2013, bondholders and depositors stand behind bank deposits. The donor countries are united in this decision. Bloomberg today:

“The document from Germany and its allies refers to EU current proposal on handling bank failures. Germany, Finland, Denmark and the Netherlands renewed their call for the new rules to take effect in 2015, and said the new framework should be available as a way to break the vicious circle of countries and their banks dragging each other down. ‘We strongly believe that making all tools in the directive available by 2015 will allow resolution authorities to safeguard taxpayers’ money more effectively with immediate positive consequences. As soon as there are credible alternatives for financing bank failures, risks inherent to the banking sector will have a significantly weaker adverse impact on sovereign funding conditions,’ the paper said.”

So northern europe wants to introduce market discipline to European banking. Do they have any idea what they are recommending? Do they really mean for market discipline to be applied to northern european banks?

I ask this because I have spent two hours on Moodys.com looking up dodgy eurozone banks, of which there is a cornucopia. True, most of the troubled banks in Europe are inconsequential---but not all of them. Here are some of the big ones with their asset size in EUR billions and their Moody’s Financial Strength Rating:

Banco Popular: D, 158B

Dexia Credit Local: E, 362B

BPCE: D, 1175B

Natixis: D, 561B

Credit Foncier: D-, 166B

Banca MPS: E, 232B

Caixa Geral: E, 120B

Deutsche Pfandbriefe Bank: E+, 104B

Norddeustsche Landesbank, D, 225B

HSH Nordbanken, E, 138B

The most interesting of these doubtful names is Deutsche Pfandbriefe Bank. This is the bank that the Germans don’t want to talk about; it’s much too special. Germany is proud of its century-old pfandbriefe system, which is a cross between securitization and secured debt. It’s two mints in one. It is foolproof and has never suffered a default, not even during the nineteen forties. And, like the Holy Trinity, it is a mystery. How can mortgage-backed securities issued by negligible banks be considered blue chip investments? Why, because of the magic of pfandbriefe, which can turn graffitti-covered east Berlin apartment blocs into pure gold, so long as you don’t ask how. It’s too special and you wouldn’t understand.

While Germany has been preaching market discipline and raw capitalism to the rest of Europe, she has been busily using taxpayer money to rescue her crappy legacy financial system: landesbanks, mortgage banks, and the Holy Sparkassen. Have you ever read or heard of the Bundesanstalt für Finanzmarktstabilisierung, or of the Sonderfonds Finanzmarktstabilisierung? Well, they are names for the German TARP, and they have been very busy bailing out all sorts of German trainwrecks, including  landesbanken, grossbanken, and hypothekenbanken. You name it, they’ve bailed them out. The Cyprus Doctrine does not apply in Germany.

So my question to Schaueble, Merkel, and Weidmann is: why aren’t uninsured creditors of the Deutsche Pfandbriefe Bank, NordLB and HSH Nordbanken at risk of a bail-in? Is there some secret handshake that lets creditors of these banks know that they are guaranteed, and that their true risk is sovereign and nothing less?  And if they really are sovereign risk, does this mean that there are two classes of deposits in the eurozone: good deposits and bad deposits? The Dutch finance minister with the complicated name said that “government-insured bank deposits are only as safe as the government that's doing the insuring”. So therefore all those dodgy German banks are just great, but beware the rest!

Cyprus Was The Last Eurozone Crisis

It appears that the donor peoples of the eurozone have shifted from the stance of “we will do whatever it takes to keep the ship afloat” to the stance of “creditors of bad credits should expect to incur losses”. The donor peoples lack the intellectual coherence to fully understand what they have just decided, but clearly they are much more comfortable with their new stance. It feels better. It seems more just. It is consistent with the Protestant Work Ethic, as opposed to Mediterranean Immorality.

That’s fine; we can all live with that. But it does contradict the previous assertion that “we will do whatever it takes to keep the ship afloat”. It means that the North no longer underwrites the creditors of the South. The Troika, the EFSF/ESM, the ECB, the OMT--those are all now inoperative, obsolete, no longer available. Instead, make your own decisions, and live with the consequences; we’re out of here.

Remember all those bromides from Jean-Claude Juncker, Ollie Rehn, Manuel Barroso, Herman Van Rompuy, Mario Draghi, Jean-Claude Trichet---am I forgetting anyone? Remember all those words about what was “unthinkable” and “not under discussion”? Well, forget it. No longer applies. All that is now not only thinkable, but policy. Keep up with the times!

Yes, bond spreads are quiescent, and there have been no runs on southern banks. That certainly proves that the new policy is a success--markets are now more mature and able to engage in fine distinctions between good banks and bad banks, and between good countries and bad countries. Cyprus was a bad country--but the only one! All the others are good--until they turn bad. The markets will have no trouble keeping up with this economic dynamism.

So here is my prediction: none of the PIIGSSC* will have any more fiscal or banking problems; that’s all in the past. The recaps are done; the refinancings have been put to bed; the markets are wide open for their debt and that of their banks and corporates. Smooth sailing ahead.

And, if I’m wrong and there is another “crisis”, it won’t really be a crisis at all, because the creditors will absorb the entire loss, even if the credit is Italy or Spain.

__________________________________________________________________________

*The PIIGSSC: Portugal, Ireland, Italy, Greece, Spain, Slovenia, Cyprus.

European Bank Accounting Is A Joke

On Sunday, Europe introduced the “Cyprus Doctrine”, which says that uninsured deposits are risk assets and that uninsured depositors are “investors”. The deposit claim has been transformed into a capital instrument. Henceforth, holders of uninsured deposits in European banks are supposed to do their homework, and make sure that they are not investing in uncreditworthy banks.

Connoisseurs of European bank regulation may recall that market discipline was one of the original “Basel Pillars” along with prudential supervision and capital adequacy. And now market discipline exists as a real pillar. Advocates of free markets and financial deregulation should applaud the introduction of the Cyprus Doctrine. (I would call it the “Dijsselbloem Doctrine” if I could spell or pronounce it. The Dutch need SpellCheck.) Indeed, the anti-regulation WSJ is just thrilled with the Cyprus Doctrine: “This is a useful lesson in the limits of government guarantees and a welcome blow against moral hazard”.

Banks won’t need to be regulated anymore because they are outside the safety net. Instead, depositors will police the banking system, rewarding the strong and punishing the weak. Bad banks will be weeded out; we will have fewer but better banks. Taxpayers and legislators will no longer need to  pay attention to the industry. Banks can be set free.

There is only one problem with European “depositor discipline”: European bank accounting and disclosure is a joke. There is little relationship between a European bank’s creditworthiness and its financial reporting. Both dead Cyprus banks were solvent according to their latest financials, and both passed the European Banking Authority’s 2011 stress test. I think that both Bankia and Banca MPS passed as well: I think everyone passed. The stress test was a joke. It was calibrated to pass everyone. All European banks are created equal--until they fail.

How are depositors supposed to be able to know where to put their money? You might think they could use bank ratings, but most European banks aren’t rated by Moody’s or anyone else. And Moody’s is not clairvoyant; it has to use the same bogus financial disclosure as everyone else. Bank executives seldom blurt out the fact that they are insolvent. Insolvent banks lie about their asset quality to anyone who will listen. They certainly lied to me when I was in the business. I found that one of the best sources of information about insolvent banks was market rumor and anecdote. Not actionable information, but more useful than the lies the banks told.

If you don’t believe that insolvent banks lie about their condition, read the annual report for any one of the banks which have had to be bailed out in the past few years. Not one of them said that they were insolvent, or that their loan portfolio was full of holes, or that their CDOs were mismarked, or that they were becoming illiquid. And I would add that European bank regulators act as advocates for their banks. They take criticism of their banks personally. Are these regulators now supposed to issue press releases pointing out which of their banks are no good and should be avoided at all costs?

I can’t help making one other observation that will make me sound arrogant. I have been a bank analyst since 1978. I have been following bank regulation for 35 years. Although I may be demented, I remember the lessons of those 35 years, the most important of which is that bank deposits make up most of the money supply and, as such, are contingent liabilities of the central bank. If you screw around with bank deposits, you are screwing around with the money supply which drives nominal growth. You can’t introduce depositor discipline while expecting economic growth. It’s one or the other.

The Eurozone Introduces "Depositor Discipline"

"If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?'. If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders."

---Jeroen Dijsselbloem, Dutch finance minister

"In a normal market economy an investor always has a risk of losing money. That's why I think it's fair and right, and also part of a normal market economy, that owners of a bank, investors, and biggest depositors - who can be seen as investors - take their own responsibility, in one way or another."

-- Jyrki Katainen, Finnish prime minister

So the Dutchman with the unspellable name, who is currently the head of the committee of eurozone finance ministers, has announced that no bank in the eurozone, no matter how important,  is TBTF. How this must warm the hearts of the Righteous. “We told those Levantines: No more of our good clean Protestant money will go toward paying for your sinful ways. Let your dirty depositors pay.” You know how good it feels for them to say that.

It has been interesting watching the northerners writhe in agony as they have had to write checks to the peripherals. Every time they have rescued a bankrupt bank, they have said “This is the last time: from now on, creditors and depositors will contribute.” But until now they never actually allowed that to happen. Now, not only do we see the junior creditors of Bankia being hit, we also see depositors in the big Cypriot banks being whacked. A breakthrough.

It is easy to destroy someone else’s economy. The IMF has done it a number of times. But when it comes to one’s own economy, one is more cautious. The northerners talk the talk when it isn’t their banks, but they have never walked the walk themselves. They bailed out all of their banks, big and small, during the crisis. In fact, they have been bailing out banks for years as a matter of routine.

The Germans have been the worst. They have rescued the landesbanks so many times that even the French got angry. WestLB? I don’t have enough fingers to count the number of its bailouts. WestLB has been magical in the way that every mark or euro poured into it has vaporized into the atmosphere, again and again. Where did it all go?

The French don’t let any bank fail, not even nonsystemic dinosaurs like Credit Foncier. They run a convoy system that’s as tight as Japan’s. Large banks don’t fail in Europe, and small banks almost never do either.

So now the north wants to introduce “depositor discipline”. Depositors are now “investors” who bear responsibility for investigating the soundness (and morals) of the bank and the country in which they “invest” their deposits. Well, you can bet that from now on they will do just that. That means two things: (1) big depositors will look at the sovereign credit ratings of the country where they have deposits; and (2) they will look at the ratings of the banks where they deposit their money.

And now, since eurozone banks are no longer TBTF, those bank ratings are going to go down. This is what Moody’s has to say on the subject: “The authorities’ apparent willingness to accept the risk of contagion suggests that the landscape is shifting to the detriment of senior bank creditors in support scenarios”. So institutional depositors will now have to make sure that their money is placed with highly-rated banks in highly-rated countries. Second-class will no longer suffice. That is, unless they are prepared to “invest” in the resolution of the banks where they deposit their money. The eurozone is now a depositor’s minefield.

It just so happens that both France and Germany still have some weak banks which could serve as guinea pigs for this new policy. Germany has some dodgy landesbanks (Bayern, HSH Nordbanken, Bremer) which would be fascinating to see resolved. France also has some interesting names: Dexia, Credit Foncier, Credit Immobilier, Natixis, BPCE. Will these be wound up at a loss to their senior bondholders and depositors? So far, no bank issuer of pfandbriefe has ever been allowed to fail. Will that change? Will the legal robustness of pfandbriefe finally get tested in a bank failure? This new policy opens so many analytical doors.

Will we, as avid spectators, get to see the spectacle of large French and German banks defaulting on their bonds and deposits? Sadly, no. That’s only for the Levantines.

Bank Fraud In The Eurozone

It is quite evident that the scale of the Cypriot banks’ insolvency far exceeds their holdings of defaulted Greek government bonds. It appears that a very high proportion of their other assets are worthless also (although you wouldn’t know it by reading their audited financials). The phenomenon of horrific loan quality has characterized the eurozone banking crisis (sort of a truism, I guess). Notable examples have been Anglo-Irish in Ireland,  Bankia in Spain, Banca MPS in Italy, and now the Cypriot disaster. In each of these cases, the loan write-downs have been very large in percentage terms. When half of your loan book is bad, you are more than merely insolvent, you are suspiciously insolvent.

The general European reaction to this phenomenon has been “poor underwriting” and “real estate bubble”. You don’t hear enough about “bank fraud”. It’s worth remembering that for every large defaulted loan there is a rich borrower who is very possibly a crook. I recall a finance minister explaining that his country’s new president was honest because he had published the names of defaulted borrowers and was pursuing them for collection. Living in an anglosaxon country, I had always just assumed that banks pursued defaulted borrowers (at least outside of Texas). The finance minister explained that, in his country, banks had never pursued defaulted borrowers because they were all related or connected (also known as generals) . The new president was scrapping  that tradition. (Note: that president and his finance minister are long gone and I am sure that things are back to business as usual in their famously corrupt country.)

In Japan, after the real estate bubble collapsed, foreign entrepreneurs bought bad loans on the theory that they could foreclose, and then re-lease or resell the properties at market rates. These foreigners did not count on the fact that the Yakuza were the borrowers/owners/occupants, and disliked loan collectors.  

Bad loans, corruption and borrower fraud are peas in a pod. This certainly applies to Club Med. Billions of euros have “disappeared”, only they didn’t disappear--they are just in someone else’s bank account. I’m not denying that Club Med is dotted with half-built properties of every description: I’ve seen them myself. Not all the money went from one pocket to another--but a lot of it did. A lot of bad loans were made to “connected” borrowers, probably most of them. The tale of Bankia in Spain is particularly sordid, worse than Texas at its worst.

In the US, when the government was forced to pay off the liabilities of the entire bankrupt Savings & Loan industry, it took over their loans, foreclosed on the borrowers, seized their assets and then sold them to the public within two years (via the Resolution Trust Corporation). As far as I know, the whole operation was clean and above-board, and the government was able to recoup billions in the process. Not enough of the fraudsters went to jail, but they did have to give back their assets.

I don’t see any evidence of this happening in Europe. In the case of Bankia, the government intends to hold onto its bad loans for years. An uncollected loan is an outright gift to the borrower, and Bankia’s borrowers are well-connected. In the case of Banca MPS, I’m sure that we will also start hearing hair-raising tales of corruption, and very little about loan collection.

What we are witnessing in European banking today is a saga of bad assets carried as good assets, bogus accounting, hopeless insolvency, and billions in uncollected bad loans. A good definition of a Third World country is one in which bank loans are made but not collected. My gut tells me that Club Med fits  that definition.

Europe's Newest Currency: The Nonconvertible Euro

“Today the Cypriot parliament will vote on capital controls allowing authorities to restrict noncash transactions, curtail check cashing, limit withdrawals and to even convert current accounts into fixed-term deposits when banks reopen on Tuesday... There have also been discussions over eurozone-enforced controls on Cyprus, including freezes on savings and a requirement that all bank transfers are approved by a central bank, Handelsblatt reported today.”

---today’s Telegraph

The Cyprus resolution that is being cobbled together this weekend would involve a haircut on uninsured deposits and banking sector consolidation in exchange for the troika’s recapitalization of what’s left of the banking system. This would permit the ECB to continue to fund the remaining Cypriot banks, allowing them to continue to function in euro without have to redenominate. Cyprus would not default on its government debt and would remain in the eurozone.

There would also presumably be a new austerity package for the government involving the usual “impossible” and “unthinkable” reforms. In theory, the government and legislature will capitulate completely to the troika’s entire list of demands.

This plan is supposed to put the Cypriot crisis to bed for the medium-term.

In addition to the haircutting of uninsured deposits, it appears that remaining uninsured (and insured?) deposits while remaining “whole” will not be unfrozen and will be not be convertible into real euros. As the Telegraph reports above, the Cypriot euro will remain subject to currency restrictions including even the possibility of forced conversion into longer-term instruments.

Cyprus will have a nonconvertible currency for some period of time until something even worse happens: redenomination back into pounds. There will be a powerful incentive for capital flight before that happens.

As any Argentine or Venezuelan will tell you, when you can’t wire your money to Miami, you fill your suitcase and fly it there. Will Cyprus try to prevent the physical movement of large quantities of cash from Cyprus to anywhere else (Israel, Lebanon, or even Northern Cyprus, which is literally across the street)? Perhaps Cypriots will try to exchange euro notes in Cyprus for convertible rubles in Russia. The Argentines and Venezuelans will need to establish a school in Limassol for “Living With A Nonconvertible Currency”.

Will a parallel currency market develop for Cyprus euros at a discount to convertible euros abroad? I presume that that will happen. Business must go on, and payments must be made. We should also see the underinvoicing of exports and the overinvoicing of imports, as is normal for blocked currencies.

And where will rich Cypriots want to park their money? My guess would be as far from the EU as possible, such as Dubai. Their natural depository is London, but that might not be safe from their government’s clutches. Similarly, it will be safer to keep cash in anonymous safe-deposit boxes, rather than in bank accounts which can be more easily identified and confiscated.

Of course, the development of the Cypriot currency system is monumentally unimportant to the rest of us. But it may serve as a wake-up call to Greeks, Portuguese and other residents of Club Med who are relying on Europe’s promise that depository confiscation and/or currency controls will never happen there. They know those promises mean nothing. The holders of Club Med government bonds know that they can be defaulted upon (Greece), and the holders of Club Med bank deposits know that they can be frozen and/or haircut. Soon they may learn that a euro can go from being convertible to being nonconvertible to being another currency altogether. Ask any Latin American.

Will Germany Turn Europe Into Latin America?

The headline in today's Journal is "Merkel's Hard Line, Vilified In Nicosia, Cheers Germany". Some quotes:

"Cyprus lives off a banking sector with low taxes and lax regulation that is completely out of whack. As a result, Cyprus is insolvent and no one outside of Cyprus is responsible for that…We've taken measures in all countries to protect ourselves against contagion effects."

--Wolfgang Schaueble, Finance Minister

"Merkel has nothing to lose in Cyprus."

--Ulrike Guerot, European Council on Foreign Relations

Germany is happy about the Cyrpus banking crisis because it will punish Cypriot sinfulness. I guess the sin is that the eurozone is no place for an offshore banking center/tax haven, which is debatable. But that decision should have been made before Cyprus was admitted into the eurozone. Now its banks have EUR 50 or 60 billion in euro-denominated deposits which Germany wants it to default on. The Journal says that "one reason that Berlin is taking such a hard line on Cyprus now is that it sees the country's crisis as a unique opportunity to end its reliance on tax refugees". This is punishing shoplifting with the death penalty.

Germans are very skilled at making things and being thrifty. They are economically admirable in every way except one: they have never accepted modern capital markets. They have resisted anglosaxon capitalism for forty years, and they still don't accept it. Germany (like France) believes in intermediated financial markets which can be controlled by the authorities in order to ensure financial stability. They don't trust independent market actors like hedge funds, US investment banks or rating agencies. You can make an argument that they are right, but it's way too late. They lost that battle and global finance is now substantially anglosaxonized.

A large percentage of European capital flows today are disintermediated, especially cross-border. And anyway, foreign banks are no more controllable than hedge funds. The creation of the eurozone by itself substantially reduced the power of national authorities. Consequently, the European capital market is now more powerful than the European national authorities. Germany doesn't like this for good reasons, but it is a fact that she can't change. Causing Cyprus to default is not a good way to deal with this issue.

So where's the black swan here? What did everyone miss? The markets knew that the Cyprus banks were insolvent because of Greece’s default. They knew that Cyprus had billions in offshore deposits. They knew that the Cypriot political system (like Greece's) is politically incapable of accepting any form of IMF-style austerity. Everyone has known  about this witches' brew. But, everyone figured,  the Cyprus problem is a rounding-error, and Europe always manages to kick the can down the road. It’ll get fixed. That’s certainly what I’ve been predicting.

What we didn't know was that Germany wants a crisis in Cyprus. Germany wants Cyprus to default on its bank deposits. That wasn’t understood until now. That’s the black swan. In retrospect, we can see the explanation: bailout fatigue on the part of the thrifty German people; the desire to disallow the enabling of tax evasion by a eurozone member; and outspoken distaste for the Russian kleptocracy. But the truly dangerous part of the German rationale is the mistaken opinion that a Cyprus banking collapse is manageable. This is the same stupid complacency that led to Lehman.

A Cypriot banking collapse will have unpredictable consequences; it’s a shot in the dark. It will inevitably create contagion--maybe not immediately, but eventually. Credit committees work on schedules. If Cyprus goes, risk limits for southern Europe will be reduced. Investments, deposits and capital flows will be redirected. Southern European banks will lose deposits not just from foreigners, but also from domestic investors and corporations.

A deposit freeze affects every bank, not just the weak. A Spanish millionaire is no safer in Banco Santander's headquarters office in Madrid than in the tiny caja down the street. Remember: if Cyprus blows up, Cypriots with deposits in foreign banks will not be affected. The key is getting your money out of the country.

This is a classic Latin American banking discussion. I’ve sat through scores of them. Southern Europe is at risk of going back to a Latin American-style financial system. Latin American depositors instinctively understand that you must keep your company's money and your family's wealth in a hard-currency deposit in a big bank in a strong country. Southern Europeans used to know this: it was called a numbered Swiss bank account. They are relearning this lesson. Let me be clear about what is happening here: we already have within the eurozone billions of nonconvertible euros. That’s a word you haven’t heard lately, unless you live in Venezuela or Cuba.

The West has spent the last sixty years building an institutional framework to allow global trade and capital flows. This has meant the dismantling of currency controls, capital controls, trade barriers and barriers to foreign investment. As this structure has been built, lessons have been learned: Don't lend or borrow foreign currency. Don't build up short-term foreign debt. Capital inflows can go both ways. The eurozone was supposed to be an enhancement to the globalization of finance. It was supposed to do for the eurozone what the dollar zone has done for the Americans.

If eurozone bank deposits now become subject to sovereign risk, that will reverse the whole process. No one can be that reckless, and the Germans aren't supposed to be reckless. They are what economists call "a serious country". Let's hope they stick to that tradition.

A Brief Note on Deposit Freezes

Deposit freezes almost never end well. They are imposed during banking crises in order to stop bank runs. Unless the reason for the lack of depositor confidence is removed or the deposits are rescheduled, the run will resume when the freeze ends. The only way to end a freeze without default is to restore confidence with a guarantee from a  creditworthy guarantor backed by unlimited resources. Unlimited resources means a printing press.* There is only one such entity in the eurozone, the ECB, or the ESM backstopped by the ECB. There is no evidence that anyone is even discussing such a resolution. Germany wants a default.

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*The US ended its deposit freeze in 1933 by forcing many banks to default and then guaranteeing the rest. Millions of innocent people lost their savings.