BAD DEBT ALSO THREATENS EUROPE´S STRONGEST / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

Bad debt also threatens Europe’s strongest

By Wolfgang Münchau

Published: Last updated: May 23 2010 21:25

Is the eurozone insolvent? In the past few weeks, we have all focused on the solvency of Greece, Spain and Portugal. But we never seriously questioned the solvency of those who actually guarantee all those southern European debts.

The first thing to note is that you cannot answer that question with a cursory reference to the debt-to-gross domestic product ratios of eurozone countries. This macro perspective is of little use here. Those numbers tell us that the eurozone is in a better position than the US, the UK or Japan. The problem is that those headline numbers exclude contingent debt and the interconnectedness of financial flows.

The biggest category of contingent debt is made up of the various guarantees the eurozone has been handing out in the last couple of years. European Union governments have effectively guaranteed the liabilities of their entire banking sectors. They have guaranteed all bank deposits up to a certain limit. The eurozone member states guaranteed Greek debt for the next three years, and then extended the scheme to the rest of the eurozone. And those guarantees will probably have to be doubled again.

In last week’s column I remarked that it was no accident that the eurozone created a special purpose vehicle to manage this bail-out. It is not just the name that reminds us of those notorious financial structures that brought us the subprime crisis. There are in fact substantive parallels.

Like a dodgy subprime collateralised debt obligation, the eurozone’s SPV lacks transparency. The operational rules are not clear, and have been subject to disputes among member states since political leaders announced agreement. If you want to understand it, you had better read the small print.

One could also take a look at the debt the SPV insures. Colleagues at FT Alphaville dug up a brilliant report by the credit team at Credit Suisse, who pursued this question to the bitter end. Before the start of monetary union in 1999, EU countries borrowed at different interest rates, the spreads reflecting expectations about future exchange rate realignments and default probabilities. With the arrival of the euro, spreads almost disappeared. Just as subprime CDOs enjoyed triple A ratings because of the way they were constructed, the entire eurozone enjoyed a triple A rating on the back of Germany’s. This produced a massive credit boom in Spain and Portugal, and those credits were recycled through the eurozone banking system. Bankers in Düsseldorf, Munich and Paris bought those Spanish mortgage obligations and Greek sovereign bonds, proudly adding them to their fine collections of subprime CDOs.

Nicolas Véron, senior fellow of Bruegel, a Brussels-based think-tank, argued last week that the persistent failure by Germany and France to resolve the bad debts in their banking systems set a time bomb that might cause further instability. A combination of economic nationalism and political resistance in some countries prevents an effective resolution.

What is the size of the problem? International Monetary Fund estimates suggest that the eurozone is well behind the US in terms of writing off bad assets. I have heard credible reports suggesting that the underlying situation of the German Landesbanken is even worse than those estimates suggest. Last year, a story made the rounds in Germany, according to which a worst-case estimate would require write-offs in the region of €800bn – about a third of Germany’s annual GDP. If you were to add this to Germany’s public debt, you might jump to the conclusion that Greece should bail out Germany, not the other way round. While that is probably a little exaggerated, there are serious questions about whether the eurozone is still in a position to issue such massive guarantees. So, given what happened to those subprime CDOs, what hypothetical rating should we then attach to that €440bn eurozone SPV? A triple A?

I suspect that the important decision taken by Europe’s leaders this month was not the headline-grabbing SPV, but the decision to bully the ECB into monetising southern European debt. But that strategy, too, raises some disturbing questions.

Of course, another positive exit scenario would be a combination of strong growth and low interest rates – to help the banks generate big profits to allow them to write off their bad debts in small instalments year after year. The Credit Suisse report asked whether the slowdown in global growth might have the same effect on the eurozone that the slowdown in the US housing market had on subprime CDOs. As long as the eurozone governments can generate sufficient tax revenues, all is well. But if that were to stop, the eurozone’s debt edifice might break down like a house of cards. Even a 150 per cent debt-to-GDP ratio would be feasible if the eurozone had an intelligent growth strategy. But it never did, and it still does not.

I make no predictions here. But recent financial history teaches us that we must ask those questions and not blindly trust implausible promises, whether made by bankers or by politicians. I suspect that for as long as those Landesbanken and cajas stay unreformed, investors have good reason to treat the eurozone in the way they should have treated subprime CDOs.

Copyright The Financial Times Limited 2010.