Is Europe in Debt Denial?

10/07/2011 8:00 am EST


Jim Jubak

Founder and Editor,

Greece will surely default on its loans, dragging Europe into a deeper financial crisis. Leaders need to find ways to protect Spain and Portugal before it’s too late.

This is how it starts: The strongest banks announce bigger write-downs. The weaker banks break into pieces, putting the healthier parts up for sale and looking to create a bad bank to house the worst assets.

Governments extend guarantees and promises of guarantees in an effort to calm financial markets. Some governments push to recognize hard financial truths, and other governments go into a defensive crouch.

Yes, this is how preparations for a Greek default begin. So far, the moves are slow and piecemeal, aimed at preventing a panic that would spread destruction across weak and strong European banks alike. And there’s certainly nothing yet that resembles a unified Eurozone response.

Facing the Real Danger
The lack of a common response isn’t the worst problem in the early preparations for a Greek default. So far, all the effort is aimed at stabilizing the banking sector, with no credible preparation that would keep a Greek default from endangering Portugal or Italy, the two most vulnerable Eurozone members.

While guaranteeing Europe’s banks is necessary to prevent a Greek default from taking down the Eurozone’s financial system, it is by no means enough to tackle what long ago ceased to be a Greek debt crisis and has become a Euro debt crisis.

The current danger is that the political and financial leaders of the Eurozone will decide that getting the regions’ banks ready for a Greek default is enough. If they don’t figure out how to build an effective barricade in front of Portugal and Italy at a minimum, and Spain and France as well, then I think a Greek default will quickly lead the financial markets to start pricing in other defaults.

There’s still time to put those barricades in place, but the carpenters seem fully occupied with the work of building the scaffolding to protect the banks from a Greek default.

It’s by no means clear that this effort will be in time or adequate. I see no signs of work on protecting the Eurozone’s troubled countries. (For my most recent take on when Greece will default, see my recent column.)

Let’s see what we can learn about the work being done to prepare for a Greek default—and how much more needs to be done.

For the Eurozone’s strongest banks, preparing for a Greek default means writing down Greek government debt even further, announcing a big hit to profits, and further tightening costs.

For example, Deutsche Bank (DB) announced October 4 that it would write down its Greek debt holdings by an additional $250 million. That write-down will be reflected in the bank’s third-quarter earnings report scheduled for October 25.

Forget about that full-year target for pre-tax profits of $13 billion. Third-quarter results will be lower than expected, although the bank would remain profitable for the period, said CEO Josef Ackermann. To cut costs going forward, the bank will eliminate about 500 jobs in its corporate banking and securities division over the next six months.

Not pleasant, certainly, especially for those being let go into a slowing global economy. Most of the job cuts will come from outside Germany.

NEXT: A Look at Dexia


A Look at Dexia
For the Eurozone’s weakest banks, preparing for a Greek default means breaking up, selling off what can be sold, and creating a bad-bank stump. At least that’s the plan being forced on Dexia, the French-Belgian lender.

(I say lender instead of bank because most of the company’s business is in arranging financing for municipalities. Although it does operate a retail bank in Belgium, a private bank in Luxembourg, a retail lender in Turkey, and an asset-management business.)

Dexia needed a government rescue in the dark days after the Lehman Brothers bankruptcy in 2008. Now Dexia is back at the table, looking for government support that would save it from losses in its portfolio of almost $28 billion in debt from Greece and other troubled Eurozone countries.

That portfolio has made it impossible for Dexia to fund its operations by borrowing in the financial markets. Again.

What went wrong? In a nutshell, Dexia ran out of time to fix the problems left over from 2008.

In the years before the mortgage-backed asset, real-estate lending bubble burst in 2008, Dexia had padded its profit margins by funding itself with cheap, short-term money raised from money-market funds and similar sources of short-term cash.

That was great. Borrowing cheaply in the short-term markets and lending less cheaply in the long-term markets was very profitable—until the short-term markets froze and no one would lend Dexia money anymore.

At the time of the first Dexia bailout, it needed to tap short-term markets for about $350 billion to fund operations. That was $350 billion that Dexia suddenly found itself unable to borrow.

Dexia wound up borrowing $58.5 billion by the end of December 2008 from the US Federal Reserve (yes, in 2008 the Fed acted as lender of last resort to the world in order to avert a meltdown of the global financial system), and also received an $8.4 billion bailout from France and Belgium.

A new management team, brought in after France and Belgium bailed out Dexia in 2008, worked to reduce the lender’s reliance on short-term capital. By late June, the funding gap was down to $140 billion. Though that was huge progress, it proved insufficient when the short-term capital markets shut down again this summer.

Now the plan is to put roughly $130 billion in troubled assets (clearly more than the $30 billion in troubled sovereign debt) into a bad bank. The bank would be backed by guarantees from the French and Belgian governments. In addition, the governments would guarantee that customers of the Belgian retail bank won’t lose any money.

Additional funding would come from money raised from the sale of Dexia’s healthy divisions, such as the asset-management business and the Turkish retail lender, DenizBank.

The municipal-lending business will either be allowed to run down or merged with the French sovereign wealth fund or the retail-banking arm of the French post office. (Not so coincidentally, some of Dexia’s biggest municipal customers are French.)

NEXT: What’s Next for the Rest of Europe’s Banks?


What’s Next for the Rest of Europe’s Banks?
For other European banks, preparing for a Greek default means figuring out which of these two alternatives—Deutsche Bank or Dexia—is the better alternative.

You see, the Dexia collapse presents just one tiny challenge: Dexia got a clean bill of health in the second stress test run by the European Banking Authority on European banks back in June. Not only did Dexia pass, it got one of the highest scores handed out.

Out of the 91 financial institutions tested, Dexia came in 12th, with a core Tier 1 capital ratio of 10.4%. That was more than double the 5% level required to pass.

If Dexia needs a bailout in September after passing the stress test in July, there’s a good chance that the test either got its math wrong or tested for the wrong things.

In either case, Dexia’s collapse so soon after passing the test means that the global financial markets don’t have a clue as to which banks are sound, beyond a handful of high-profile banks with big retail deposit bases. Such as—oddly enough considering the troubles in Spain—Banco Santander (STD) and Banco Bilbao Vizcaya Argentaria (BBVA).

The safest thing to do is say, “the hell with all of them,” and refuse to do business with any European bank.

No wonder the big topic at the recently concluded meeting of Eurozone finance ministers was boosting bank capital. Exactly how seems, if you’ll pardon the expression, vague.

There’s no credible talk of another round of stress tests, and the fallback position seems to be "let national bank regulators do it."

Of course, these are the folks who, in France—to name just one instance—have helped banks such as BNP Paribas (BNPQY), Crédit Agricole (CRARY), and Société Générale (SCGLF) resist demands to write their Greek debt down to market prices.

“Time is running out” to decide if recapitalization is necessary, German Chancellor Angela Merkel warned this week. Troubled banks should first attempt to raise capital on their own and then call on national governments for help.

Of course, financial companies are understandably reluctant to admit that they’re undercapitalized. The unrealized losses in Dexia portfolio came to $11 billion, compared with the company’s equity base of $21 billion. Tangible equity estimated at $9.8 billion falls to $7 billion after write-downs on Greek and Italian sovereign debt, the Financial Times calculates.

Dexia should have known it was in trouble long ago.

Merkel’s Unfounded Optimism
It strikes me that Merkel is making a wish rather than stating a plan.

She has said she’s in favor of recapitalizing European banks, “if there is a joint assessment that the banks aren’t adequately capitalized.” That is, of course, exactly what there is not.

Right now, the prospect is that some countries—Germany, most prominently—are pressing ahead on their own to force weaker banks to raise capital, at the same time as the government is putting back in place the system it used to create bad banks after the Lehman bankruptcy in 2008.

Other countries—France, most prominently—still seem to be in denial about problems at Europe’s biggest banks. Dexia isn’t an indicator of potential problems at BNP Paribas, Credit Agricole, or Société Générale, finance officials in these countries contend. And foie gras, I reply.

And creating barricades to prevent any default by Greece from rippling out to Portugal or Italy? That’s even vaguer than the plan to recapitalize European banks.

I think there’s a good chance that the Eurozone’s AAA-rated countries will force Greece into default—or that Greece will decide the pain isn’t worth it anymore—sometime in early 2012. (I hope it’s not in December, but it could be that early.)

How confident do you feel that, at this pace, Europe will be ready?

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.


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