Spain: Is This The Start of Something Big?

“Spain on Saturday agreed to accept a bailout for its cash-starved banks as European finance ministers offered an aid package of up to $125 billion (or €100).”

Note: this is for the banks only…not for Spain, itself…

The IMF had suggested that the minimum needed to stop the drain at Spanish banks was around $46 billion.  So, for once, it seems as if the finance ministers are finally trying to get their arms around the problem and not just “kick the can down the road”. 

After what we have seen over the last three years of so, it is easy to be skeptical.

To raise the credibility of the officials in the eurozone, this effort is going to have to be followed up by something more. 

Yes, the agreement has not really been signed and sealed yet, and I am looking further down the road. 

That, however, is the only way that credibility is going to become established.  One still shudders at the lack of leadership that exists within this community.

But, next steps are going to have to be made and they are going to have to follow right on the heels of this effort to halt the decline of the Spanish banking system.

The next steps are going to have to strongly indicate that the eurozone is following up this action with a real effort to create a European Banking Union!

This will not be a simple task, by any means, but it is the next thing on the agenda.

Yes, Europe needs a new unified fiscal authority to keep the eurozone together and to stabilize the euro.  This will be an even greater task than the building the European Banking Union.

The banking system needs to be saved first and this must be done in the short run.  The fear of a run on European banks seems real and this fear must be dealt with before we get to the sovereign debt issue.  Thus, full attention must be given to the issue of a banking union for it is the short run issue of consequence right now!

A major issue that will overshadow much of the debates relating to the creation of a European Banking Union is the giving up of sovereignty over banks that now reside within national jurisdiction.  That is, each individual nation in the eurozone is going to have to give up something very dear to them in order to achieve the creation of a banking union.  This surrender involves centuries of history, pain, dislike, and, in some cases, outright hatred.

Can the officials get over this hang-up?  Can they put the past behind them in order to save the future? 

Creating a banking union, however, is just the start.  If there are national issues that must be given up in creating a “federal” banking union, these issues pale when one considers what these nations must give up to create a “federal” government that oversees and controls the spending and taxing and so forth that have formerly been completely under the control and oversight of the individual nations themselves. 

But, it seems to me that there is very little to choose from in the present situation.

Let’s consider three possible outcomes from the current state.  First, a European Banking Union is formed followed by the formation of a federal European government that oversees and controls spending for the eurozone. 

Second, the eurozone falls apart and the individual nations now making up the union go on their merry way.

Third, some nations form a banking union and a federal government and other drop out of the community.

To me, the suffering and pain that would accompany the second and third choices would be very substantial.  The second and third options are just not pretty!

But, human beings can be very self-destructive at times and make choices that are stupid and against their own best interests.

In my mind, there is no real choice.  Somehow, someway, European officials are going to have to form a European Banking Union and are then going to have to follow this up with some kind of federal government that deals with the combined fiscal issues of the eurozone.

Therefore, I am pleased to see the discussions concerning the rescue of the Spanish banks going forward.  I am hopeful that these discussions will be followed up by the formation of a European Banking Union. 

Then, the big task…a federal European government that will discharge the responsibilities of the eurozone with respect to the fiscal affairs of the community.  Of course, this federal government will also have to deal with the restructuring of economies, work-rules, pensions, and so forth.

Seeing real, credible movement on the part of European officials, I believe, will be seen positively by international investors.  If these investors react positively to the movements to create a European Banking Union and then to the further efforts to create a federal European government, I believe that financial markets will rise and this will provide the support and encouragement for the project to continue. 

If this process gets started the European officials must not let the momentum or the international investment community will lose heart and argue that the officials were not fully into the idea in the first place.  Skepticism will set in again.

I see the possibility of getting started on the European Banking Union, however, as a real opportunity.  The issues here are not as great as those connected with the formation of a federal European government.  So, this is a chance to start on issues that are smaller and are clearer. 

The important thing is to get the process jump-started and then build on the momentum.      

The European Banking System

The banking system in Europe, particularly in Spain, is getting a lot of attention these days.  The specific case that has been in the news is that of Bankia, the fourth largest bank in Spain.

Bankia is a special situation in that it was a consolidation of seven Spanish savings banks in December 2010.  It is obvious now that those involved in the consolidation basically put the banks together without recognizing the serious condition of the loan portfolios of the combining savings banks. 

The fact that the “hole” in Bankia’s balance sheet is so bad just highlights the incompetency of the Spanish banking authorities or their naivety given the serious state of the housing market crisis that Spain was undergoing at the time. 

Here again, one wonders what role the European interpretation of the financial crisis played on this restructuring of the seven savings banks into one.  If one assumes that the asset problems of the banks were connected with the liquidity of the loans, then, I guess, one does not feel that the value of the assets need to be written down.  If one were to assume that the asset problems were ones of insolvency, then the authorities should have responded in a different way. 

Europe, unfortunately…and incompetently…assumed that the problems faced by the banks were liquidity problems and not insolvency problems…and they just “kicked the can further down the road.”

“Can kicking” time seems to be over.

Now, however, the fear factor seems to be spreading beyond Spain to the rest of the European continent.  “A fierce debate is now taking place as to the best way to avert a run that, if it started, might be difficult to contain and could lead to massive capital flight from the Eurozone’s peripheral countries…”

Proposals for a banking union that includes integrated financial supervision and deposit insurance have been flying around Europe last week.

These proposals have been accompanied by increased calls for a “full economic and monetary union.”  But, again, this comes at a time when Greece may elect a government that rejects the agreed upon bailout provisions and at a time when Spain may also require a huge financial bailout to save not only its banking system but also its sovereign debt.  The rest of Europe may not readily accept either of these outcomes.

The difficulties faced by officials in Europe (I will not use the term “leaders” because I see none) are highlighted when put into contrast with the banking situation in the United States.  Although in the United States, Ben Bernanke and others at the Federal Reserve talked about the “liquidity” problems of the financial system, they were faced right away with solvency issues. 

The most prominent of these was, of course, the case of Lehman Brothers Holdings Inc., which filed for bankruptcy on September 15, 2008.  However, the Federal Reserve System and the Federal Deposit Insurance Corporation were faced with many, many more bank failures and bank consolidations soon after.  All told, since September 30, 2008, the number of institutions in the commercial banking system of the United States has dropped by 884 banks!  This is not an insignificant number.

In my opinion, the Federal Reserve ran its Quantitative Easing 2, at least in part, to help keep troubled commercial banks open and allow the FDIC to work with the banks in the worst shape to close or to find someone to acquire them in the smoothest and least disruptive manner possible.  In this the American regulators have been tremendously successful. 

Commercial banks have not really been giving out loans over this time period and hence help to underwrite the economic recovery.  But, the consolidation of the banking system has proceeded without much fanfare and this is not all bad!  At a bare minimum, this approach has provided some downside protection in the tepid economic recovery now taking place, protecting against any major disruptions from a cumulative closing of many banks within a short period of time.

The European situation seems to be going the other way.  Officials not only treated the banking situation as one big liquidity problem it added to the problem by forcing the European banks to take on more and more of the sovereign debt of the teetering peripheral countries of Europe.  Since the debt of the troubled European nations were assumed by European officials to be “riskless” the “troubled” banks could acquire the debt of the “troubled” European nations without suffering any decline in their existing credit rating.  

Thus, suspicious credit was added on top of suspicious credit at these banks.

And, the regulators went about their merry way without raising any kind of question or doubt about the solvency of these banks!  How blind can one be?

Then stress tests were administered…twice…by these same regulators in order to reassure depositors and investors of the soundness of the banks.  The stress tests were a “bad joke”.

As a result, “Since national regulators have lost the confidence of markets, they are having to bring in outsiders to assess how much capital their banks need.”  But, this could be a disaster if they are realistic and truly trustworthy.

Now, the authorities have to scramble.  The European Union not only does not have the fiscal authority to oversee the fiscal affairs of the member countries and the EU as a whole, it does not have a unified banking authority to oversee and regulate the banking activities that go on within the EU. 

It looks as if the anxiety in Europe is rising.  Mario Draghi, in the words of the New York Times, has issued a challenge: “A Terse Warning for Euro States: Do Something Now” The Times article goes on to say “The note of frustration and urgency in Mr. Draghi’s voice was a sharp contrast to six months ago…”

It is time that someone listened!

Can Europe Really Reform and Restructure?

Europeans, apparently, don’t want any further integration.   The Pew Research Center in eight EU countries found that “the public is more doubtful about EU membership and the single currency and is shifting decisively against handing Brussels more power over national budgets.”

I have jut returned from two weeks in Italy.  The following comments represent some of the impressions I gathered on the trip.

National divisions are just one reason, although a major one, for the continued failure of the European Union to reach some form of resolution to the ongoing financial crisis.  Whether these divisions can be overcome in the longer term is, of course, a concern of many that a unified solution can be achieved. 

But, there are many other hurdles that work against moving Europe into some greater form of common union.

So much public attention has been given to the fiscal affairs of the national governments and rightly so.  But, there is another aspect to these fiscal affairs that go beyond the ability of the governments to repay their debts.  This other aspect is the social framework that has been built up in these countries through the actual spending that has taken place.

I have often discussed some of the structural problems in the United States created by government spending aimed at keeping people employed in the jobs that they have been working in and to build up government payrolls at the local level, as well as at the national level, to keep people employed and happy.  The consequences of these kinds of policies include rising levels of under-employment, reaching maybe 20 percent of the working age population, and bloated state and local government budgets supporting excessively generous hiring practices and underfunded pensions.

Well, from what I saw and the people I talked with, when compared with Europe, the United States is a “Scrooge” when it comes to this kind of behavior!

And, if the United States has an un-employment rate a little over 8 percent and an under-employment rate of around 20 percent, what is the situation in Europe where countries face 20 to 25 percent government measured un-employment?  What is the level of under-employment in these countries?

In addition, what is the situation in the bloated government bureaucracies and the school systems in these European countries?  The university systems in these countries are, to me, frightening.

Another truly amazing thing to me is three-hour lunch hours…mandated!

What about the spread of information technology?  This, of course, is one of the major things driving modern society.  Read an interesting article that appeared in the New York Times yesterday.  “Italy remains well behind most other West European countries in the reach of the Internet….”

I was discussing the use of information technology in the financial field, especially in banking, with a very advanced thinking Italian, someone who has spent quite a few years in America.  His comment was that Italy was many years behind the United States banks in adopting modern computer technology to daily banking transactions.

And, everywhere I saw industrial zones created to support manufacturing employment with empty parking lots and houses and business buildings standing uncompleted with nothing around them to indicate that activity would return to them soon.

The one thought I took away from trip was that although Europe has a fiscal crisis to deal with in terms of getting their financial affairs in order, the much bigger problem faced by the Europeans is the need for the reform and restructuring of the way they do things.

Modern technology is being used in these European countries, but the technology is being used to maintain a lifestyle that existed in another century.  This is not unlike some radical religious groups that use modern information technology to retain a hold on their medieval social practices. 

In my reading of history, the advance of information technology always wins.  The advancement may be diverted or delayed for some period of time but the spread of information always triumphs in the end. 

The transformation is not easy and will not be easy in the case of Europe.  There will need to be much social change along the way and the existing structure of classes, intellectual as well as wealth and business, along with the current philosophies pertaining to labor unions and governments, will put up substantial barriers to the changes that are needed. 

An example of this given in the New York Times article quoted above is the efforts made by former Italian prime minister Silvio Berlusconi to protect his media business empire from intrusions of the Internet.

The whole world is going through massive changes and no one group, organization, or nation, is going to be able to avoid the changes.  I knew many of the countries in the eurozone were behind the curve in this transition.  I have argued that Europe seemed to be devoid of the leaders needed to guide their countries through this period.  But, my recent trip has made me more pessimistic about the ability of the European Union to throw off their blinders and actually carry out the reform and restructuring that is needed. 

A conclusion like this can only make one more pessimistic about investing in Europe.  I like to think of myself as a value investor that invests for the longer term.  In terms of Europe, therefore, the longer term, in my view, just got that much longer.   

The US Bond Market and the Situation in the Eurozone

In my last post, I wrote about the bond market in the United States and how the European situation is impacting the structure of yields in US financial markets.  My conclusion was that the “flight to quality” being experienced in world financial markets has led to a situation in which the supply of funds to United States financial markets has resulted is extremely low long-term interest rates and a negative yield on the US Treasuries inflation-adjusted securities (TIPS). (http://seekingalpha.com/article/551121-what-are-the-bond-markets-trying-to-tell-us) 

The question then becomes, if the extremely low long-term interest rates are a consequence of a “flight” of funds from European markets and this condition will last in some form until the European Union “gets it act in order” what will be a condition of Europe “getting its act in order”?

Over the past two years or so the efforts of the European Union to resolve the sovereign debt crisis has “kindly” been referred to as “kicking the can down the road.”  No one seemingly wants to “get their hands around the situation” and work to resolve the crisis.  Consequently, the crisis lingers on with recurrent bouts of national concern like that now being focused on Spain. 

It should be obvious by now that “kicking the can down the road” is not going to end the sovereign debt crisis in Europe. 

The current direction in which European elections are headed seems, if anything, a step backward in the process.  But, Europeans are tired of all the austerity.  They want to throw existing policymakers out of office and elect someone else…it doesn’t really seem to matter who.  And, we are seeing this played out in this weekend’s elections in France and Greece.  This following the situation in the Netherlands where the existing government was defeated, the 10^th such government to lose power since the debt crisis began.  

Tom Sargent, an economist who won the Nobel Prize last year, suggested in his Nobel Prize winning acceptance speech that the current problems being faced by the nations of the eurozone are similar to those faced by the United States as it was trying to become a unified country in the late 18^th century.  The European Union now is like the US under the Articles of Confederation at that time.  The US had to become a unified country under a Constitution and establish its fiscal credibility before it could operate as a nation among the other nations of the world.  Sargent suggests that Europe must achieve the same goal. (http://www.nobelprize.org/nobel_prizes/economics/laureates/2011/sargent-lecture.html)

While the fiscal crises of the states was going on during this period in the United States there was also a banking crisis going on in the private sector, a lot of it caused by the credit problems faced by the states.

Taking the experience of the United States as an example, one can argue that the only way the European Union is going to “get its arms around the problems” is to form a fiscal union amongst it members that will supplement the monetary union that is already in existence. Many anticipated this next step when the original monetary union was formed. (http://www.ft.com/intl/cms/s/0/50a1f9fe-9466-11e1-8e90-00144feab49a.html#axzz1tp5ngu6K)

However, the fiscal union implies more.  A federal union of countries is going to have to establish its credit standing in the world which means that it will have to be able to issue debt with the “joint and several liability” of the eurozone backing it.  Of course, this implies that the new fiscal union of eurozone countries will conduct it budget operations on a sound basis. 

Furthermore, the eurozone is going to have to move to save European banks.  The European Central Bank cannot solve the whole problem through its “liquidity” efforts.  The countries of the European Union are going to have to provide funds directly to the European banks that need them.  This will not be inexpensive in the short-run.  Hopefully, over the longer run the European Union will get a large portion of the funds back.

European banks are even in worse shape that United States banks.  Bloomberg Markets magazine has just released its list of the strongest banks in the world.  There are only four European banks in the top twenty: two from Sweden, one from the U.K. and one from Switzerland. (http://www.bloomberg.com/news/2012-05-02/canadians-dominate-world-s-10-strongest-banks.html)

Whoops!  None of those banks are in countries in the European Union.  Seems like the strongest banks in the world are not in countries that have pursued the policies of credit inflation that have created huge amounts of debt.

The problem is: who is going to lead Europe into a fiscal union?

Angela Merkel, the German Chancellor, has indicated that that is the direction in which she is headed.  Yet, it is not altogether clear that the German people will accept a fiscal union because so much of the load of the new union will be placed on Germany.  Furthermore, you have the move to new governments within the European Union that “anti-austerity” and “anti-German.”

Still, Germans have benefitted more than any country in Europe from the monetary union and from its reunification and from integration with other European countries.  Germany stands to continue to benefit from “more Europe” rather than less. 

And, this is true of the rest of Europe.  It is not an easy path to a new European future, a united Europe, but it will, in the end, produce the greatest amount of wealth and prosperity for the continent as a whole. 

This is a massive undertaking.  A movement in this direction will not resolve all of Europe’s growth problems, its unemployment problems, or, its real estate problems in the near term.  To stay separate, however, in my mind, is almost unthinkable.  We might get a taste of this soon in Greece if a new government comes to power that cannot follow up on the conditions of the recent bailout.  If the new government is unable to deliver, the European Union may ask for it to withdraw.  My sense is that this would be pretty bad.

In terms of the United States bond market, I believe that it will not take the full consolidation of the European fiscal union to reverse the flow of funds coming into US financial markets.  What is needed, however, is some credible leadership to arise in Europe that can achieve some credible gains in movement toward the union.  Given the elections coming up this weekend and in the near term, it is hard to see such leadership ascending.  So, it may be awhile before yield relationships return to more normal levels.        

Europe Hasn't Got It Yet!

The yield on the 10-year bond issued by Portugal jumped by 70 basis points yesterday coming close to a 14 percent yield.

Today, Greek 10-year bonds jumped dramatically to yield more than 38 percent.

Spain’s prime minister begged other officials in the eurozone to ease up on the deficit targets his country is supposed to hit. 

The European Union is being urged to cut the cost of Ireland’s bailout.

800 European banks obtained €530 billion in three-year loans this week from the European Central Bank…up from 523 banks and €489 billion in three-year loans in December 2011.

The head of Germany’s Bundesbank has attacked the president of the European Central Bank, Mario Draghi, over the behavior of the ECB.

France is facing a change in government in the up coming elections.

The European recession continues.

And, protests increase throughout the eurozone.

A system is dysfunctional when the solutions it tries over and over again fail to resolve the problems that are plaguing the system.

One keeps hoping that the pain that the system is feeling will finally become great enough so that the system will try to find a new solution…even if that new system presents a new set of difficulties.

Officials in Europe have continually looked at their situation and provided the diagnosis that their problem is one of liquidity.  Hence, these officials provided more liquidity to their system, first through debt repayment postponements, then through bailouts, then through debt-restructurings, and now through three-year loans to banks to buy time for sovereign nations to get their act in order.

But, the nations that are helped never really deliver. 

No one seems to trust Greece. (http://seekingalpha.com/article/374631-liar-liar-pants-on-fire-the-greek-case) 

Investor’s increasingly believe that Portugal will need a second bail-out.

Ireland is now going to hold a referendum on the fiscal compact of the eurozone.

And, Spain is coming nowhere close to meeting its targets on debt reduction and hence is demanding relief from the targets.

Nothing seems to be holding together. 

So, could it be that maybe…maybe…the problem is one of insolvency and not liquidity?

But, no one likes the I-word.

Liquidity problems can be blamed on that shady crowd of international financial interests and speculators. 

Thus, it is assumed that if sufficient liquidity is provided the markets then this will defeat these “greedy bastards” and everyone can get back to business as usual. 

However if the problem is one of insolvency, this means that the blame must be placed on the governments themselves and the politicians that run these governments. 

But, have you ever seen a politician take the blame for anything?

No standing government will ever take the responsibility for creating a fiscal crisis.  But, that is what we have and until some of these governments are forced to accept the fact that the problems that they are now facing exist because they are insolvent we will get no resolution of the problems.

My best guess is that this stalemate will continue because there are no leaders that will step up and declare that “the Emperor is wearing no clothes.”

European officials will continue to fight the fantasy of illiquidity.  And, they will continue to fight this fantasy even as the recession they are facing worsens.  That is what a dysfunctional system does.

To continue this fantasy, we learn that the International Swaps and Derivatives Association has declared that in the Greek situation there has not been a “credit event” and thus the credit default swaps associated with the Greed debt cannot be exercised.  Where is Walt Disney when you need him?