Credit Writedowns

The European Union is an existential crisis because its crowning achievement, the single currency, has come under assault from all sides. The continued existence of the Euro has even been called into question as country after country within the euro zone has been forced into bailouts and austerity. The heart of the problem is, as elsewhere in the industrialized world, stems from the unseemly growth in private credit that preceded the financial crisis in 2008 and the private debt overhang that accompanied that credit growth, even in the aftermath of extensive asset price deflation. Put simply, many private sector households and businesses across the industrialized world are upside down, in negative equity, bust by common definitions of balance sheet solvency. And the result has been and continues to be crisis.

Regarding Cyprus, recently I heard someone claim that depositors are not creditors of a bank despite the fact that deposits are bank liabilities. This is bollocks. Depositors are indeed creditors, particularly in Europe where they are legally pari passu with other unsecured creditors. Below is an extract from a presentation given by an ECB expert on bank resolution schemes addressing who gets preferential treatment in carving up the losses.

As I indicated three months ago, the IMF now supports capital controls in specific and extraordinary circumstances, particularly in view of its experience in Iceland. This is now relevant given the situation in Cyprus. Matina Stevins of Dow Jones has learned that EU and ECB officials are now working on a contingency plan for Cyprus which includes capital controls. Likely, they would go into place as soon as Cypriot banks re-open for business.

This morning we learned that after hours of tense negotiation, Europe has hammered out a 10bn euro “bailout” of Cyprus. I put the term bailout in quotes because the key feature of this deal is the bail-in of Cypriot depositors to the tune of 5.8bn euros. This means that depositors went to sleep on Friday night and woke up Saturday to find that their money, deposited safely in Cypriot banks had been seized and used to “bail out” the country. I see this as an extreme measure which, if the European banking crisis continues, will have very negative implications for bank depositor confidence in other European periphery countries.

The Spanish bank run caused by redenomination risk is over. And Spanish bond yields are now back to around the 5% level today. Apparently, the ECB’s monetisation scheme has worked – and without Spain’s having entered a Troika program yet too. That tells you how important currency sovereignty is. Let me spell out what’s happening here and why with a few thoughts on how things will proceed going forward.

Yesterday I wrote a lot about this topic for Gold subscribers, asking “Will Merkel grant ‘austerity model’ Ireland retroactive bank recap mutualisation?” This post gives a full account of the European bank recap issue, so I won’t re-hash any of that here. Briefly, the issue is whether the Irish government will get debt relief for having bailed out its banks [...]

Two weeks ago I told you that Spanish Prime Minister Mariano Rajoy’s humiliating defeat to Merkel had narrowed options to sovereign bailout, monetisation or default for Spain. Now that the Spanish bank bailout is unraveling and Catalonia is threatening secession, I want to revisit this theme. I believe the basic conclusions are the same but I want to update you with my [...]

Yalman Onaran has written up a lengthy review of the deposit flight now ongoing in Europe. It is a reminder that Mario Draghi’s plan to backstop Spanish and Italian sovereign debt can only do so much to stop redenomination risk, the purported worry of the ECB in intervening. A total of 326 billion euros ($425 billion) was pulled from banks [...]

It is clear that lending to Spanish banks is now funded entirely via TARGET2 (borrowing from the rest of the Eurosystem) rather than with deposits. In fact deposits at the Bank of Spain by the Spanish government and Spanish banks (excess reserves) have been declining since the second 3y LTRO. These sources of funding have since been replaced by TARGET2, as the Eurosystem outside of Bank of Spain is now fully supporting the Spanish banking system .

Quick post here to highlight then continued losses in Spanish property markets and the effect on Spanish banks. House prices in Spain were down 11.2% year-on-year in July. That’s the largest fall since March 2011 and it brings all in losses since the financial crisis to 31%. That tells you that Spain’s house price declines are in an acceleration phase, meaning that much greater losses are about to crystallise on Spanish bank balance sheets. This is a real interlocking problem that has led to fears of redomination risk and bank deposit runs.

Many orthodox economists ironically adopt something close to a “loan pusher” argument: the excess global saving pushed interest rates down, leading to excessive borrowing by debtor nations that consumed beyond their means. Although the framework is somewhat different from the current account imbalance story, the conclusion is the same: too many imports flowing to heavily indebted profligate consumers. This can be supplemented with the mercantilist story—Germany is also guilty because it pushed cheap exports onto the importers. As I have tried to make clear, there is something to that but it is far too simple. The EMU could easily have self-destructed even with no current account deficits anywhere. And the US does not self-destruct in spite of current account deficits everywhere (internally and externally).

Just when you think that things can get no worse in Spain, they do.