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October’14 Newsletter: National Debts Reappear, Old Issues Remain Unsolved

Something is rotten in the European Union! It looks like a hide and seek game, where countries and banks are playing a very dangerous game for the citizens’ future. Thus, between political instabilities, stealthy defaults, unhealthy and reckless banks and a real estate market that is artificially boucing back, there are many concerns about the EU’s future.

Political Instabilities And Stealthy Defaults

Notwithstanding somewhat better than expected economic data over the summer, the focus has already returned to the far from solved problem of European financial sector and government debt. Political concerns are again paramount. For example, Italy is on the front pages because the government is seen as weak and unlikely to implement serious measures that address the national debt. Italy’s 10 year bond yield, at 4.37%, is substantially higher (about 250 bp) than that of Germany (1.81%).

By contrast, and despite its disappointing GDP numbers, France projects a better image of its political scenario, and thus enjoys easier access to the debt markets, its bonds trading at levels only 50bp above those of Germany. The spread differential reflects market fear that Italy may lose the German lifeline: Markets believe that Germany and countries supported by Germany will honour their debts, and the difference between France and Italy is probably no more than that.

But in absolute terms many of these yields appear remarkably low given the recent warnings of more defaults and reschedulings by European countries. Portuguese bond yields, at 6.75% look low compared to speculation about another renegotiation.

By far the single most important development this year is Poland’s September decision to selectively default on government debt obligations. In the past, workers paid into both state and private pension funds, and major international asset managers such as PIMCO ran the private funds. Four weeks ago, pensioners learnt that government bonds in their private funds will be “transferred to a state pension fund”. No compensation will be offered to savers, no pension will be paid from the new fund. The stated purpose of this “overhaul” of private pensions is to reduce government debt from around 55% of GDP by 8 percentage points. The flamboyant language and accounting entries can be expressed more simply as either confiscation or default. And if Poland considers a debt/ GDP ratio of 55% unsustainable, what are the chances of Italy at 127%?

As if to rub in the point, Polish officials justified the announcement by saying that the old pension system just “made public debt appear higher than it really was”. In their search for magical solutions to their debt problems, we expect other countries to follow Poland’s example in generalities if not specifics. They will contrive and implement exotic debt cancellation strategies, but the real name of the game will be “default”.

Are Banks Healthy And Is the Real Estate Market Bouncing Back?

As the ECB prepares to assume primary responsibility for supervision of banks, it is undertaking asset quality and stress tests. Yet, its record is poor. For example, in July 2011 it signed off as safe the Franco Belgian bank Dexia only for the bank to collapse in October.

The European Parliament’s main financial reporting and supervision committee, ECON, now suspects why these tests are difficult to perform: the accounts upon which the numbers are based are deficient. At the end of September, ECON voted to recommend restrictions on the €60 million of funding for the two accounting standard setting bodies. Why is this so important? Because the qualifications imposed upon the two, the IASB (International Accounting Standards Board) and EFRAG (European Financial Reporting Advisory Group) go to the root of one of the most heated debates in the world of number crunching. The IASB drafts the accounting standards, then EFRAG recommends them to the European Commission and certifies that they comply with EU law.

The question at the core of the debate is whether these harmonized International Financial Reporting Standards (IFRS) cuts across the fundamental purpose of accounting, to enable creditors to assess whether or not they are lending to a solvent bank.

A growing number of UK investors, led by the British Universities Superannuation Scheme, together with a British shareholder body, the Pensions Investment Research Council believe IFRS allow banks to appear much healthier than they are. They highlight the laxity of mark-to-market accounting (soft market value tests), and even the use of mark-to-model accounting (values taken from spreadsheets at inception of transactions). The IASB have simply dismissed the concerns by denying that a profit figure calculated under IFRS was ever meant to be a basis for distributions of dividends, and have recently procured a legal opinion refuting the charge that the standards are at variance with the laws of either the UK or the EU.

The ECON vote highlights the difficulty faced by the ECB’s asset-quality assessors. If the accounting rules are incorrect, it will be very difficult to assess the adequacy of the capital levels backing those assets. It may well be the case that multiple, large European banks are insolvent.

Despite these worries about bank solvency, real estate markets have bounced a little. In the UK house prices are up 9% in the past year. In Ireland the market is improving despite the strictest austerity policies, and in Dublin alone the property market is up by 10 per cent this year. In Spain the housing market had its sharpest gains since 2007 this August.

But is this evidence of a genuine recovery? In most cases, the recent rise in prices is misleading because of the scale of the previous declines. Skeptics go further and argue that even this small improvement is a central bank induced mini bubble. Furthermore, the close relationships between central banks and the “bad banks” (into which many property assets have been transferred) have created a supply side squeeze that has forced up prices. Ireland’s property “bad bank” NAMA has 14,000 properties on its books, but has only sold 700. In one district of Dublin called South Dublin, it has been reported that 40 % of this year’s property sales have been “executor sales”, meaning the owner has died. Since there has been no outbreak of the plague in South Dublin, this implies that a combination of slow release by NAMA, negative equity of homeowners, and restrictions on bank mortgage loans are constipating the market and pushing up prices.

Spain’s “bad bank” is called SAREB. It is taking a different approach and has recently advertised for sale several portfolios across all sectors, tourist resorts, office buildings, over 2,000 homes and loans to property developers. We will therefore soon observe the strength of Spain’s property market recovery.

Banks Are Reckless Again

The Bank for International Settlements’ September Quarterly Review casts doubt on the reported return to health of US and some European banks. Because the traditional interbank lending market remains weak, banks have been funding themselves in other ways. Subordinated debt, a type of liability that counts as bank capital (Tier 2), has become the vogue. Compared with the year to June 2012, the subsequent 12 months saw subordinated debt issuance by US banks increase by 1000%. For European banks the increase has been 350%; volumes were $22 bn and $52 bn respectively. Also notable is the $70 billion growth since 2009 of the market for contingent convertible bonds. Contingent convertibles, (Cocos), are another hybrid form of capital. Both Cocos and subordinated debt instruments make banks appear far less leveraged than they really are because both are primarily forms of debt that have loss-absorption characteristics. Central banks have facilitated these liability issuances in various ways.

On the asset side, banks are lending to higher yielding, lower rated riskier borrowers and competing by offering “leveraged loans”. These loans involve very large sums: they hardly go to small and medium-size companies, and are characterized by weaker covenant and security packages. BIS notes that 45% of all new loans in the first half of 2013 were leveraged. This compares with the leveraged sector’s peak loan market share of 35% before the banking crash.

Why this surge in loans to weak credits? Bank managers are able to book profits by writing such loans, knowing they can delay recognition of expected losses should the loan suffer problems. Some can be converted into derivative format to further bring forward the profit. The accounting rules discussed above in Europe, only slightly different in the US, encourage this trend. Of course, this does not bode well for the future of the banking world. Yet, why should the banks be cautious, if the European Central Bank is officially in charge of bailing them out?

Another reason why profits are urgently needed is to offset the fines and settlements imposed by regulators and enforcement agencies on many banks. Staggering sums are now mentioned. JP Morgan’s 2012 trading calamity has cost the bank $920 million in fines to four regulators, but is dwarfed by the $11 billion likely total of fines and compensation payments to US authorities that the pre crash mortgage scandal will cost that bank. Why pay so much? The sticking point appears to be the possibility of criminal charges, and it seems that an odd plea bargain is taking place, with the Attorney General agreeing to reduce the scope of criminal investigations in return for an increased settlement payment. In all these scandals a consistent defence that banks mount is that they have identified the culprits and fired them. But if the criminals have all been fired, why would the present managers be spending so much on the plea bargain? Some might perhaps venture to say that banks are being pushed to being reckless by regulators and fines, and then pulled to being reckless by the same old system in which supervision is merely a veil.

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