By Mike Whitney
MW– It seems like people in the US are not really paying much attention to the problems in Europe, but these problems appear to be getting worse all the time. Would you say that we are on the brink of another financial crisis?
MT—We could very be possibly on the brink of another financial crisis. It is very important to track the build up in liquidity issues. Most financial crisis originate from liquidity issues, when interbanking market starts freezing. We have not yet reached that point, but there are definitely some ongoing concerns with rumours right now involving some major European banks.
MW–Can you explain what’s going on in eurozone credit markets in terms that the average guy can understand?
MT–The recent significant increase in credit spreads for many financial institutions have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates, not only for peripheral countries but, for financial institutions located in these peripherals countries and to some extent, financial institutions exposed to these peripheral countries via their bond exposure. Although most European banks have covered their funding needs for 2011, as well as having the European Central Banks providing liquidity support, liquidity assessments were not included in the latest European Banking Association stress tests we had in July. The lack of disclosure is problematic because as suspicion rises between banks, liquidity is dwindling, and in effect term funding markets are shut down for weaker players.
So far larger banks have only been able to secure funding via covered bonds which are bonds secured by pools of prime loans. If issuance remains at a very low level for European banks, it will become at some point problematic.
The lack of disclosure of liquidity coverage ratio, which in effect would allow market participants to reassure their banking counterparties that they have sufficient high liquidity assets to withstand acute stress test scenario for 30 days, is a big issue. Under Basel III banks will have to comply, meaning that for banks, the stock of highly quality liquid assets should be sufficient to cover 30 days of cash outflows under an adverse scenario.
You would have thought that following the 2008 debacle banks would have disclosed more information and become more transparent, unfortunately, it is not the case, hence the heightened tensions we are currently seeing.
MW–I was shocked by the charts that you have on your blogsite, macronomy.blogspot.com It looks to me like the lights are “blinking red”. EU countries in the south are paying more for capital, it’s getting harder for the banks to fund themselves, and insuring against default is getting more expensive. Even if the financial system doesn’t blow up, don’t these things suggest a slowdown in economic activity that will trigger another recession?
MT–Yes, indeed it does suggest a risk of a slow down in economic activity in southern european countries. Potentially it could trigger another recession. Because bank funding is a key source for bank earnings, and their ability to lend to their domestic economy, therefore a drag on the economic recovery if it doesn’t happen smoothly. Lack of funding could mean that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery so another recession. As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.
MW–The Financial Times reported that many EU banks have been selling their best assets to build their capital cushions. But–if that’s the case–then all they have left is illiquid assests that no one’s going to want to buy if conditions continue to deteriorate. Do you see this as a possiblity? Do you think the ECB will have to buy up a lot of garbage assets like the Fed did after Lehman Brothers crashed?
MT–At the moment, with covered bonds issuance, banks are pledging their best assets. In relation to your assertion relating to illiquid assets, and “garbage”, the ECB is already acccepting lower rated collateral from the weaker players, which cannot access funding at reasonable rates, namely banks from peripheral countries in distress, Ireland, Portugal, Greece. But, the FED also accepted dubious lower rated collateral, from US banks during the financial crisis of 2008. I do not think the ECB will do like the FED, first because the ECB is not the FED and does not have the same powers and the same balance sheet size, and that is a big difference.
Second, the ECB has been supporting Italian and Spanish bonds since the 8th of August, by buying Italian and Spanish government bonds on the secondary market. But it can only be temporary. The ECB’s balance sheet is limited currently. It has to step in, because the EFSF extended firepower has yet to be approved by numerous European parliaments. The resignation of Juergen Stark from the board of the ECB is linked to the unconventional purchases from the ECB of government bonds in the secondary market which he clearly disapproved. What Europe lacks in effect is a Temporary Liquidity Guarantee Program which was implemented in the US by the FDIC, which would alleviate funding costs for European banks. Unsecured bond issuance is key for European banks and given the market is completely shut down at the moment, a similar Debt Guarantee Program (the Debt Guarantee Program was to provide liquidity to the inter-bank lending market and promote stability in the unsecured funding market and not to encourage innovative, exotic or complex funding structures or to protect lenders who make risky loans) which was set up in October 2008 in the US, would drastically alleviate ongoing funding concerns.
MW– Here’s an excerpt from an article in Bloomberg that I’d like you to comment on. Bloomberg News:
“The eight largest U.S. money-market funds halved investments in German and U.K. banks over the past 12 months, eliminated their lending to Italian and Spanish firms and reduced investments in French banks, data compiled by Bloomberg and published in today’s Bloomberg Risk newsletter showed.”
Is this a “bank run”?
MT–No it is not a bank run. It is basically tied up to what I discussed in your previous question, namely that, because of lack of disclosure and more transparency from European banks regarding their liquidity position, as suspicion arise, lack of trust develops and create dangerous situations. If the situation goes on for too long, it could become problematic, particularly in relation to 2012 funding needs which are consequent for European banks.
MW–Here’s a “shocker” that appeared in Tuesday’s Wall Street Journal in an article titled “The Trouble With French Banks; A BNP Paribas executive makes his concerns known”:
‘We can no longer borrow dollars. U.S. money-market funds are not lending to us anymore,” a bank executive for BNP Paribas, who declines to be named, told me last week. “Since we don’t have access to dollars anymore, we’re creating a market in euros. This is a first. . . . We hope it will work, otherwise the downward spiral will be hell. We will no longer be trusted at all and no one will lend to us anymore.” (Wall Street Journal)
How close are we to disaster?
MT–We are getting closer to a disaster because of lack of political solution relating to the ongoing Greek crisis, and the contagion effect we are seeing building up in the peripherals but, mostly beacause Europe lacks a similar US TLGP program. So, because this mechanism is absent in the European space, continuous funding pressures, mean that banks, such as BNP Paribas and Societe Generale will be selling some assets to built capital cushions as you mentioned in your question 4. On top of that, you have a few major elections coming up in Europe (Spain in November, France presidential election in May next year, etc.), which are slowing down even more critical decision making.
MW–There are a lot of very smart people trying to figure out how the eurozone can get through this mess, but I don’t see how. The political obstacles appear to be insurmountable. What do you think will happen; will the eurozone muddle through this mess or is this the “end of the line”?
MT–It is not going to be a smooth ride for sure. I do not think it is the end of the line, end of the day if Germany decides to leave the euro they have too much to lose. They have been very big beneficiaries of the euro zone so far, although in Europe we are clearly staring at the abyss. The ball is in the political camp, but, given the politicial agendas showing up with upcoming elections, there is potential for the situation to turn nasty.
What markets hate most are uncertainties, we are going through a period of lasting volatility and heightened tensions. It did not have to be that way in the first place, but the can kicking game in Europe has been decisively played to maximum effect, for too long. Unfortunately for European politicians, it is decision time, make or break, and we can only watch and hope for a good outcome from the sidelines.