Interview
SATURDAY, JULY 16, 2011
Gloomy Forecast for Europe's Banks
By JACK WILLOUGHBY
A credit rater with a strong track record sees sovereign-debt defaults and bank woes in the Old World's future.
Time and again, Sean Egan and his team at Philadelphia-based Egan-Jones Ratings have made important calls months ahead of their better-known rivals. The firm has won grudging respect for its work on Ambac, CIT, Countrywide, General Motors, IndyMac, Lehman Brothers, MBIA and New Century, all of which encountered big problems after getting poor credit grades from Egan-Jones.
The firm is a Securities and Exchange Commission-regulated rating agency, whose customers pay for the research and the rating. In contrast, Moody's, S&P and Fitch are paid by the issuers of the securities that they are rating.
Sean Egan, co-founder and president, has a stunning prediction for Barron's readers: Forget about things getting better in Europe, he says; they will actually get worse. And who might be one of the patsies in all this? The American taxpayer, who could feasibly be stung as the Federal Reserve aids an ailing European Central Bank already depleted by too many bailouts. The big question: Will Europe, worn down by bailout after bailout, finally be forced to bail out the bailer—the ECB?
Barron's: We've been moving from crisis to crisis—first Ireland, then Greece and now Italy. What's going on?
Egan: Think of it as a bunch of political problems that are being driven by one central economic problem—the inability of Europe and its banks to handle and contain the damage sustained in the 2008 financial crisis. The resolution of this sovereign-debt crisis will remake the face of Europe over the next few years. This is going to be one truly big story—on the scale of the instability of Germany's Weimar Republic after World War I—and I can't see the political will or politicians with enough clout to forge a broad consensus. Everything seems to point toward instability, leaving democracies open to strong-arm government.
"The resolution of this sovereign-debt crisis will remake the face of Europe over the next few years." —Sean Egan
Look at the constant press battles over what to do about Greece, and the coverage of things like the riots in the streets. These battles, I contend, simply wear down the very will of the European public to deal with the root causes of its problems by focusing its attention on smaller, though volatile, issues.
What is it that people don't get?
The thing most people miss is how little control governments have over this economic problem. The headlines would indicate that the governments are in control. The market, however, drives them. The sovereign-debt problem and the European bank-stability dilemma are intertwined. Any default will lead to write-downs that will show the European banks as actual or near zombies—the walking dead, with big impending losses and little capital.
Painful as it will be, the situation must be addressed time and again when peripheral sovereigns like Greece, Ireland and Portugal default on their debt—as they inevitably must. The truth is, the debt holders will only receive a token amount of repayment—between 10% and 22% of face value. And that's nowhere near the level of recovery people are talking about now.
Look at Greece. Greece will likely not be good for any of its debt. The economy is shrinking. How can anyone think of adding more debt? A company that's losing money can't easily qualify for additional debt, yet officials keep talking about increasing Greece's burden. Greece is running a deficit. Also, it's going to be extremely difficult to sell Greece's assets in a timely fashion. Even so, with Greek 10-year rates in excess of 15%, Greece needs to solve its problems quickly, or face having many of its small businesses go under.
Is there any immediate solution?
You have to start from the possible. We believe that Greece can't reasonably support more than 40 billion euros [$56.7 billion] in taxes. That amounts to only 10% of the amount outstanding. That's why debt holders are likely to face a 90% haircut. And that's quite a different perspective than the 30% cut people talk about today. And, soon, Ireland and Portugal will find themselves in similar predicaments. And unless trends reverse, Spain, Italy and Belgium will follow. The write-downs on the coming defaults will make many European banks and insurance companies vulnerable, to say the least, with few if any mechanisms to rebuild capital. This weakness will eventually spread to the institution that supports the euro structure—the European Central Bank. It has lent its support to member-state banks taking deposits and loans from member banks in the euro zone's periphery.
What does the ECB's balance sheet look like?
On the asset side, in addition to €303 billion in assets, the ECB itself holds €113 billion in deposits of local banks and €150 billion in sovereign debt. The problem is that it has only €10 billion of equity, which would be eliminated by any reasonable write-down of the bank deposits or the sovereign debt. Little wonder that Jean-Claude Trichet, the ECB's head, has insisted that any bank bailout [won't] trigger charges for sovereign debt, which presumably would extend to the ECB. Reasonable investors would subscribe to the bank's needing an extra €90 billion in fresh capital. It can get that, but not quickly.
Where would the ECB find the capital?
Let's be clear, we are talking about Europe's central bank. Under normal operations, it can tap the central banks of members of the [European Union's] monetary system. It also presumably has swap lines with the Fed. In the worst case, it could print some currency, despite the current controls in place.
How much of a hit are U.S. taxpayers going to take for the euro chaos?
A definitive answer won't be known for years, but there will probably be several points of measurement. One is the U.S. contribution to the International Monetary Fund, which is being placed at risk with the various bailouts. Another is the swap lines provided to the ECB via the Fed in the event of some financial rupture. The third is the support provided to U.S. banks with direct and indirect exposure to Europe, including through credit-default swaps. That's difficult to estimate because of the opacity of the CDS market.
Explain the Fed swap lines.
All things being equal, the most likely source of support for the ECB is the U.S. via Ben Bernanke, who during the first signs of the crisis, ginned up more than $580 billion in dollar swaps in 2008 and 2009 with central banks around the world. These lines went out in a size and with a velocity never before seen in the Federal Reserve system, but were repaid. The swap lines have been extended through August 2012. The dollar-liquidity swap lines are with four major central banks—the ECB, The Bank of England, The Swiss National Bank and the Bank of Canada. The lines with the ECB are unlimited. The rationale was that there is no credit risk, because they are short-term, and the ECB was interposing itself between the sick European member banks and the Fed.
But consider the shape that the ECB is in, with less than 3% of capital underlying its growing array of bad assets. The European Central Bank's capital levels are getting perilously thin. There's nothing backing the ECB but the guarantees of the euro countries—many hard-pressed themselves.
Why have the major rating agencies been so slow at recognizing the depth of the problems in Europe?
The big rating agencies remain hampered by political blowback, and the conflict whereby the issuer still pays for the rating. It's been amazing how after several congressional hearings, scores of lawsuits, and colorful reports from Senator Carl Levin [the Michigan Democrat on the Homeland Security and Governmental Affairs committee] and Commissioner Phil Angelides [of the financial crisis committee], the essential conflict remains.
The issuer-pay ratings conflict has two pernicious effects. It makes the rating agencies slow to change, and too reactive when they do. Look at Europe. For months, the agencies did nothing on Portugal. Then, Moody's drops Portugal a whopping four ratings notches in one shot—from investment-grade to junk. That's ridiculously reactive, and it forces institutions to sell securities into an illiquid market. In December 2010, we at Egan-Jones had reduced Portugal's rating to the same level that Moody's issued only weeks ago.
We believe that you get the right results when the incentives align correctly. Look at the headlines. The EU actually says it regrets Moody's decision to cut the credit ratings of Ireland and Portugal. Moody's must listen, because the governments pay for the ratings.
What else do you see that others do not?
We believe that American investors are severely underestimating the scale of the European sovereign-debt crisis. They overestimate the amount of debt that Greece, Ireland and Portugal can realistically shoulder, given the sorry state of their economies.
Afraid of taking crippling write-downs, European bankers keep moving the goal posts, pretending everything is fine. They know that the situations in Ireland and Portugal are not significantly better than in Greece. The Irish Republic's debt is €200 billion, on top of which the government has guaranteed an additional €400 billion to support their banking system. Unfortunately, all this debt sits on top of a tax base that produces annual tax revenue of €34 billion.
Portugal's debt is €160 billion, while its tax-revenue base is €38 billion.
Can't the euro system pull together to get through its members' collective troubles?
I hope so, but I have my doubts. The EU is at a distinct disadvantage in this stage of the sovereign crisis, compared with the U.S. in 2008. Its decision-making requires huge amounts of diplomacy. Hank Paulson, when he was Secretary of the Treasury, could work up a bailout in three phone calls. Trichet has to make 20, and still wouldn't have a workable plan. The euro system is a monetary arrangement without a fiscal backbone.
And European banks are starting at a much lower capital base than the U.S. banks did in 2008; they're in worse shape. There's no steep yield curve to ease rebuilding capital. And finally the dollar, not the euro, is still the world's currency of choice. Even if they wanted to, the Europeans can't just print their way out of trouble like the U.S. has done. Big changes must come if the euro is going to survive. Ultimately, there's going to have to be an adjustment to the structure, whereby countries that violate fiscal controls are asked to leave, or fiscal authority must shift to Brussels. Right now, there are no checks and balances.
Are most of the European banks essentially zombies—the walking dead?
Using the simplest estimates for the European banks and applying them to current capital positions, we find most of these banks to be under water. They don't have enough capital to meet the expected losses from the peripheral countries.
Most worrisome are the U.K. banks, because of the size of their euro debt holdings, and their home countries' aversion to a possible second bailout. We've produced a table estimating the future impairment of future European and British banks. Lloyds Banking Group [ticker: LYG], Royal Bank of Scotland Group [RBS] and Barclays [BCS] stick out like sore thumbs. France has shown a willingness to backstop its banks, even though they have a sizeable exposure to places like Greece. Germany, which spent billions to take back East Germany, would be willing to support a troubled Deutsche Bank [DB].
Overall, we have a classic example of a liquidity problem that has morphed into a solvency problem. Technically, the International Monetary Fund should be the proper forum for resolving these international issues. But the IMF doesn't have the punch or the speed to compete with Ben Bernanke and his accommodating Federal Reserve System.
So we can expect the European issue to be in the headlines for months to come?
Absolutely. This a multifaceted problem that's destabilizing democracies and driving under businesses with loan-sharking rates. Look for the Greece situation to be replayed in Ireland, Portugal, Spain, Belgium and Italy. We're seeing the initial steps of the reordering of the banking system in Europe. Ultimately, it will result in the emergence of a handful of safe banks. Companies dependent upon bank funding are likely to face extreme pressure over the next couple of years. They are going to [get] squeezed real hard.
Investors should look for bank mergers, major asset sales and widespread company restructuring. The sovereign-debt crisis is probably the biggest credit event faced since the decline of the Weimar Republic. Forget about post-World War II. This is bigger.
Thanks, Sean.
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