Don't Believe European Bank Capital Ratios

As readers know, I have been skeptical of the way that eurozone bank capital ratios are calculated. This is because: (1) risk-weighted assets are small relative to book assets, which is dubious; (2) substantial amounts of bond portfolios are not marked to market; and (3) eurozone government bonds are assigned a low risk-weight.

In other words, eurozone regulatory capital ratios lack useful information content for uninsured depositors and other “investors”. This leads me to look at capital ratios which I can calculate myself using public data. One of these ratios is the classic  leverage ratio: common equity to book assets, artifacts of financial accounting.  I would prefer to use tangible common equity as the numerator, but I will settle, for today’s purposes, for just common equity.

I have made a list of the major banks of the major countries, and went onto their websites to get the most recent published balance sheet data. This took more effort than it should have. Not all IR websites are equally useful. I don’t want to point fingers but for some, the most recent balance sheet was elusive; for others it was offered but wouldn’t load (Mitsubishi and MPS, for example). Not to point fingers, but I distrust banks that seek to hide their financial data.

I have, using my hand-held calculator, compiled a schedule of the book leverage ratios of a few of the world’s major banks. Below is my schedule of leverage ratios, from lowest to highest, as I calculated them using what I could find on their websites. Most of the data is 12/31, the rest is 9/30.

Deutsche 2.6%

Mizuho 2.9%

Banca MPS 3.0%

Deutsche Pfandbrief: 3.4%

Barclay’s: 3.5%

Bankia: 3.6%

Sumitomo: 3.8%/

Commerz: 4.1%

Lloyd’s: 4.8%

RBC: 4.8%

BMO: 4.9%

BayernLB: 4.9%

Scotia: 5.0%

TD: 5.4%

Unicredito: 5.5%

Santander: 6.4%

BBVA: 6.7%

JPMorgan: 8.3%

BAC: 9.9%

Citi: 10.0%

Wells: 10.2%

Does this data have any information content? I would say: at least as much as the official regulatory capital ratios. Both are distorted, and neither is reliable. But I think that anything less than a 10% book equity-to-assets ratio is too low. Call me old-fashioned, but there is no substitute for common equity to absorb the unexpected losses from such “risk-free” assets as super-senior subprime CDOs and Club Med government bonds.

Is a eurozone bank really solvent if it would be completely wiped out by an Italian default? Shouldn’t such an exposure be either (a) subject to MTM; or (b) subject to impairment? Well guess what, in Euroland, Italian government bonds are worth their face value and have a zero risk-weight. If I’m wrong about this, someone please tell me. If I’m right, then eurozone bank capital ratios have no information content.

One of the most important lessons of the last five years is that there are no risk-free asset classes. Every asset class besides deposits at the central bank have proven risky. If one looks at the banks with the lowest capital ratios, one will see that most of them have had very large write-offs, which suggests that their asset portfolios contain substantial risk. Take Deutsche Pfandbrief Bank: it lost EUR 1.5B in 2009. Is EUR 3.3 the right amount of capital for such a bank?  Or Bankia: it lost EUR 21B in 2011-12. Is EUR 10B an adequate capital level for a bank which has written off EUR 21B over a two-year period? I don’t think so.

I think that the entire eurozone banking system is materially undercapitalized, and I think that games are being played to disguise that fact. This is why I don’t think that the eurozone should introduce “depositor discipline” at a time when most of its banks are either undercapitalized or insolvent.

Implications Of Eurozone Depositor Discipline For Cash Management

It is the explicit intention of the Eurogroup* to implement a new bank resolution regime for the EU that is intended to eliminate bank bailouts (TBTF). It provides that banks will be resolved at the expense of shareholders, bondholders and, if necessary, uninsured depositors. Consequently, wealthy individuals, businesses and fiduciaries will be expected to discriminate between good and bad depositories. This is an ill-advised public policy choice.

Under the new dispensation, eurozone depositors can handle this challenge in one of two ways: (1) the identification of banks likely to fail; or (2) the identification of banks which are likely to still be TBTF despite the new policy.

Is it possible to identify banks likely to fail? Yes, one can easily make up a list of troubled banks, that is, banks which have already reported problems in their financials, e.g.,  Banca MPS, Commerzbank, Credit Foncier, Deutsche Pfandbrief, Bankia, etc. But what about banks that may be at risk of failure but which have not yet reported problems in their financial disclosure? Identifying these banks is more difficult, but not impossible which is why rating agencies and other bank credit analysts exist: to spot and flag the weak and the aged.

But if one could identify the banks that would never be allowed to default on their deposits, wouldn't that be a lot easier than looking for creditworthy banks? It doesn’t take a an astrophysicist to answer the question: what are the names of the biggest banks in the strongest countries in Europe? These banks, no matter how awful, will always be TBTF, because they are important and their governments can afford to bail them out. Frankly, I’d prefer to be exposed to a small bank in the North than a big bank in the South. Uninsured depositors at Deutsche Bank and its Northern peers will always be protected no matter what happens in terms of solvency.

The US has had a two-tiered bank resolution regime for forty years (since Franklin National in 1974). Small banks are allowed to default, while big banks (now called Sifis**) are rescued at the expense of the FDIC, plus shareholders and holding company creditors. Uninsured depositors of big banks have always been protected. (Note: WAMU was not a Sifi.)  

Since the 1980s, Congress has passed a slew of laws seeking to minimize bailouts without creating financial instability, most recently Dodd-Frank. Dodd-Frank permits*** bailouts of Sifis, to the consternation of the Wall Street-haters.

In the US, institutional depositors know that they should avoid having large uninsured deposits in banks that are not Sifis. IBM’s treasury function is not going to concentrate its global cash management at the Citizen's Bank of Armonk.

However, depositor discipline will come a novelty to European corporate treasurers, especially those domiciled in Club Med. If your government may not be able to rescue its banks, you will need to find a safe place to keep your euros: a big bank from a strong country. But it is not clear that this would include such a bank's branches in your country. There is certainly a risk that, if your country imposes exchange controls or redenominates, deposits at domestic branches of foreign banks will be caught up by that law. (My understanding is that, in Cyprus, deposits in domestic branches of foreign banks were not confiscated, but they have been subjected to the "temporary" exchange controls.)

This suggests that the prudent institutional depositor in a Club Med country will have to keep his deposits at a large foreign bank at a branch outside the jurisdiction of his government. So, for example, a large Portuguese insurance company will want to keep its euros on deposit in a big German bank at a branch outside of Portugal. This is do-able, and shouldn't overly inconvenience the large Portuguese insurance company.

But what about the Portuguese bank that currently has these deposits? Won't it be a problem for that bank to lose its institutional depositors? What can the Portuguese government say to depositors to reassure them that it will have the resources to maintain the solvency of the banking system? It seems to me that this would lead the Portuguese government to preemptively and decisively recapitalize all of its banks in order to ensure that there could be no question of their solvency. But, in point of fact,  I don't think that the Portuguese government has the money to do that, nor do I think that Spain or Italy have the money either.

This is in part because, the more that a government incurs debt to recapitalize its banks, the more likely it is that its debt ratio (D/GDP) will cross the IMF's red line. Once that red line is crossed, the IMF (hence, the troika) won't lend. In that case, the country must haircut its bondholders or its depositors to bring its debt below the red line.

The knowledge that eurozone bailouts are conditional encourages bondholders and depositors to lower their risk limits for Club Med. This is happening at risk committees around the world. If your bank has $10B in exposure to Portugal and a $5B risk limit, that exposure will have to come down. Consequently, private-sector bank deposits and other credit exposures for Club Med will decline, with implications for both bank liquidity and monetary policy.

______________________________________________________________

*Eurogroup: the committee of the finance ministers of the eurozone. The unit that runs the eurozone. Headed by Dutch finance minister Jeroen Dijisselbloem, who advocates “bailing in” uninsured depositors because they are “investors”.

**Sifi: "systemically-important financial institution", i.e., TBTF.

***We owe this important safeguard to Rep. Barney Frank, who deserves a monument in the Financial Stability Hall of Fame. Replacing Barney Frank, an informed intellectual, as chair of the House Banking Committee, with Rep. Maxine Waters was truly unfortunate. Personalities matter in financial crises; everyone respected Barney, and for good reason. There would have been no TARP if it weren’t for him and Nancy Pelosi.

Why The ECB Allowed The Cyprus Banks To Default On Their Deposits

At his April 4th press conference, ECB head Mario Draghi explained why the ECB cut off emergency liquidity assistance (ELA) to the Cyprus banks and forced them to default:

"I think one should always be mindful of what the ECB can do and what it cannot do. We cannot replace capital that is lacking in the banking system. That is quite clear...

When the (ECB) Governing Council objected to Emergency Liquidity Assistance (ELA), it acted within its mandate. It objected to extending ELA to non-viable banks and thus did not replace what could have been fiscal action. ELA can be extended only to solvent and viable banks. Now, in the absence of a recapitalization programme, these Cypriot banks would not have been solvent and viable. At that point in time, the Governing Council assessed there was no programme in place, and that’s why it had to do what it did."

In a nutshell: the ECB’s mandate does not permit it to lend to insolvent banks. This means that, for eurozone countries lacking adequate fiscal resources to recapitalize their banks, their problem banks will have to default on their liabilities unless Germany is willing to contribute to the bailout via the ESM.

This is a dangerous policy, because it requires depositors to make an assessment of the solvency of a country’s banking system, and of the country’s willingness and ability to recapitalize its banks. These are both very complex decisions which effectively convert a substantial portion of eurozone bank deposits into risk assets. In other words, they are no longer money, and depositors are now investors. When deposits are no longer money, they tend to decline.

I must say that this is a very un-European way to view bank deposits. Not long ago, deposit defaults were unheard of. Now they are policy.

In 1997-98 during the East Asian financial crisis, many observers said that “China's banks are next”. They said this because no one believed that the big Chinese banks were solvent (although there was no way to be sure). The reason these people were wrong was that, in China, bank solvency didn’t matter. The government guaranteed the banks, and the People’s Bank was happy to lend against that guarantee. The People’s Bank did not demand that China recapitalize the banks because it took no risk that the banks would be wound up. Thus, the system remained liquid despite its probable insolvency.

This approach to bank solvency was pretty standard throughout the world, except in Hong Kong and the US. It certainly operated in France and Germany, where the Bundesbank and the Banque de France routinely lent to insolvent banks with the understanding that ultimate solvency was a fiscal matter. When WestLB and Credit Lyonnais were going through their travails, no one was worried that they would be cut off from central bank liquidity.

Even in the US, when the big TBTF banks were in trouble in the early nineties, the Fed never (to my knowledge) threatened to cut off their liquidity. It did communicate with Treasury about the problem, but it  didn’t make any threats.

Requiring banks to be solvent in order to receive central bank liquidity only makes sense if there is a competent fiscal authority to maintain bank solvency. The eurozone has that in some countries, but not all. It is now up to depositors to make that judgement.

My Advice To The New Head Of The Bank Of Japan

“Haruhiko Kuroda is kicking off his term running the Bank of Japan today, announcing plans to double the Japanese monetary base in order to hit Shinzo Abe's two percent inflation target.

---Matthew Yglesias, Slate: “BOJ's Kuroda Vows To Use ‘Every Means Available’ To Fight Deflation”,  April 4, 2013

Well, first of all, when the PM made his big inflationary announcement, I advised readers not to expect much. That is because the Western media don’t understand that the elected Japanese cabinet is less powerful than the unelected Japanese bureaucracy (the “Mandarins”). If you have watched the old BBC series “Yes, Minister”, you will understand, but Japan is actually worse than Britain on this score. Remember that even the divine Emperor was cowed by his cabinet (i.e., his Army ministers) on a number of occasions between 1931 and 1945. Under the pathetic MacArthur Constitution, with the Emperor stripped of his power, no one is in charge; certainly not the elected government. (Have you ever noticed how fast newly-elected Japanese PMs become “discredited” or “unpopular” in the media? That isn’t personal--it’s institutional. It’s to keep them weak. And they routinely do the same thing to the Emperor and his family.)

Abe was able to install a loyal ally, Mr. Kuroda,  as head of the BoJ, no mean achievement. And Mr. Kuroda has said almost all the right things (see above). But let’s remember that when it comes to reflationary monetary policy, the whole point is to target outcomes (inflation), not inputs (the monetary base). Doubling the monetary base sounds like a big deal, until you look at modern monetary history. It doesn’t matter how much you grow the monetary base; what matters is an unconditional pledge to create inflation at all costs. The goal is inflation, not a bigger BoJ balance sheet. Why is it that only anglosaxon central bankers can understand this point?

Probably the greatest central banker in world history (albeit a Dutchman) was FDR. When the monetary policy experts told him that there was absolutely nothing he could do to raise farm prices, he ignored them with his Dutchess County noblesse. He decided, on the advice of a collection of land-grant college quacks, to leave the gold standard, and to raise the price of gold until farm prices rose as he desired. Each day he would set a new, higher, gold price. And lo and behold, the 1929-33 deflation reversed, and farm prices started to rise  and farm foreclosures began to fall. Unemployment went down and the greatest bull market in history ensued. If you had bought stock on the day of FDR’s inauguration, you would have doubled, and then tripled your money. The wonders of a successful inflation policy. (Note to Mario Draghi: is this too hard to understand?)

Here is all that Kuroda-san has to do. First of all, stop talking about the size of your balance sheet; it’s irrelevant.  Just buy gold with yen until the price of gold starts to rise as desired. Once Mr. Kuroda starts to raise the price of gold, his nominal anchor, he will get inflation. It doesn’t matter how big his balance sheet gets, or how much yen M2 grows. Going forward, the only policy objective of the BoJ should be to raise the price of gold. 

This is not gai-jin hocus-pocus: the BoJ did this in the thirties, as Bernanke has reminded them.

Handicapping Europe's Next Fiasco

Now that Europe is living under the “Cyprus Doctrine”, which provides that no eurozone bank is too big to be rescued, we must ask: what is the profile of the next eurozone bank to explode? Here are my suggested criteria:

1. Hopelessly insolvent

2. Utterly worthless accounting

3. Discredited regulator

4. Highly indebted government

5. Politically controversial

6. Associated with the wrong political party

7. An embarrassment to Mario Draghi (i.e, not his best friend)

If you input these criteria into my supercomputer, only one name pops out: Banca Monte dei Paschi di Siena, the world’s oldest and most insolvent bank. I don’t say this gleefully, because MPS is a venerable institution, like the papacy, the British monarchy and the imperial Japanese throne. Our ephemeral civilization should not discard such things lightly. I have visited MPS, and I have seen their books which go back to 1472. They invented banking and double-entry bookkeeping. I bow before their ancient heritage. Who can imagine a business that lasts for over 500 years?

But now, they’re toast, at least as a business. Anything wrong you could do, they did. Not only that, but they are affiliated with the wrong political party. They are the Enron of Tuscany, and I say that in sadness. But they are, as we used to say at Moody’s, a dead bank. And I say that cognizant of their having been recently bailed out in the billions: they’re still dead. They’re dead because no one knows the depth of their insolvency, and no rational corporate treasurer would keep more than ten cents on deposit there. They are a ward of the bankrupt Italian state and the unreliable ECB. The ECB killed the Cypriot banks--will it kill MPS too? You have to put your money on YES, that is, unless Wolfgang Schaeuble says something different which he won’t. Are you willing to bet that, when push comes to shove, that Schaeuble  will fork over the X billion euros needed to keep MPS solvent in Draghi’s eyes--Draghi, the guy in the crosshairs over MPS’s insolvency? No you’re not; no one is. Over the next month, the ECB will become MPS’s only uninsured depositor. (Can you believe how screwed up the eurozone financial system is? It’s a wonderland of bad policy.)

I will note  that Italy has no government, as in, there is no government. One of the leading parties, Five Star, opposes giving MPS another dime. The Great And The Good, represented by Honest Man Mario Monti, lost the last election--they lost. In other words, Germany’s “responsible” candidate lost. The Italian people are not lining up for a Greek depression; they are voting for the anti-austerity parties, the anti-German parties. So do not count on parliament voting for a few more billions for MPS to satisfy Sr. Draghi. We are not in Kansas anymore, we are in a new world of angry voters, hard constraints and hard deadlines, something entirely new for southern Europe.

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.

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