Yves here. When the crisis was getting serious in the US, the Treasury tried twice to create a “remove bad exposures from bank balance sheets” approach. The first was when Hank Paulson tried to broker a private sector solution to the so-called SIV (structured investment vehicle) problem in the fall of 2007. This came about when the asset backed commercial paper market seized up starting in August 2007. SIVs were supposedly off-balance sheet vehicles that had a fair bit of subprime mortgage exposure. The structures varied, but they were somewhat to pretty dependent on commercial paper funding. While in theory the investors in these SIVs would just eat the losses, in practice many were ginormous customers of the banks and would insist on being made whole. And on top of that, it was revealed much later that the bank with the biggest SIV exposure, Citi, was so dopey as to have given a “liquidity put,” so it was explicitly on the hook if the SIVs could not roll their commercial paper (mind you, this is simplified but accurate enough for the purposes of today’s discussion).
We said from the get-go that Paulson’s solution of somehow selling the bad assets out of the SIVs would never work because if you sold them at market prices, you’d recognize the losses, so this was hardly a remedy. Paulson kept acting as if there was a way to get the assets out without having a subsidy somewhere, somehow. The government was not going to do this, and there was no way you’d find a private sector stooge to do that either.
Similarly, the TARP was originally supposed to transfer bad assets out of banks. Again, Paulson & Co spend time (not much time, mind you) acting as if the assets could be purchased at prices that didn’t amount to subsidies to banks. We debunked this idea and weren’t at all surprised to see this TARP scheme die an early death. As we wrote in 2008:
Long-standing readers and finance junkies may remember the Treasury’s structured investment vehicle fiasco of last fall. By way of background, banks had created off balance sheet entities called structured investment vehicles (SIVs) which contained subprime (and sometimes other) assets, funded by commercial paper and short-term debt. Like a regular bank, the economics worked because the assets were of longer maturity (3-5 years) than the funding sources, and short term money is generally cheaper than long-term funding.
Then the subprime crisis hit, lenders became very leery of funding subprime related assets, and the SIVs looked pretty certain, as it indeed played out, to produce losses. The banks had assumed they could simply let the SIVs fail, but were told in no uncertain terms by the debt investors that There Would Be Consequences if the SIVs went bust. Suddenly an off balance sheet exposure was not off balance sheet at all.
Hank Paulson attempted to ride to the rescue with an idea, the so called Master Liquidity Enhancement Conduit, that we said virtually from the get-go would not work. He wanted to set up a vehicle, to be managed by a third party that would buy the junky SIV holdings, which included risky real estate assets and murky stuff like collateralized debt obligations, and be funded by private investors. The problem was that there was no price which would solve the basic conundrum: investors were not willing to pay above market prices, and the banks were unwilling to sell at market. Paulson & Co. wasted nearly two months trying to breathe life into this stillborn idea, then abandoned the effort.
Ah, but the MLEC lives! It’s been retooled into the Paulson plan We still have a fund that will be managed by third parties. We still have the buying of drecky, hard to value assets, with emphasis on mortgage-related paper. And the taxpayer is being told that it is an investor, that it might actually make a profit on this venture.
And as with the MLEC, the big issue will be how to price the paper or at least some commentators treat that as an open question. But by foisting this on to chumps taxpayers, the problem goes away. It is clear now that the intent is to pay over whatever the book value of the paper is, both to recapitalize the banks and to generate high valuations that let other financial firms use these phony favorable prices for preparing their financial statements.
But the MLEC was designed to address the pressing problems of a year ago. The crisis has advanced considerably since then.
Remaining fixated on a solution that is badly out of date is tantamount to fortifying the Maginot Line when the blitzkrieg has rolled into the fields of France and the British are beating a retreat to Dunkirk. And I expect it will prove every bit as effective.
The big reason the revived Paulson idea died is he also tried pretending as before that there would be no subsidies. How will the Europeans finesse this wee problem?
By Don Quijones, Spain & Mexico, editor at Wolf Street. Originally published at Wolf Street
Events are moving so fast in Europe these days, it’s almost impossible to keep up. While much of the attention is being hogged by political developments, including the election in the Netherlands, Reuters published a report warning that the European banking sector may face even higher bad loan risks if the ECB begins to scale back its monetary stimulus programs, something it has already begun, albeit extremely tentatively.
The total stock of non-performing loans (NPL) in the EU is estimated at over €1 trillion, or 5.4% of total loans, a ratio three times higher than in other major regions of the world.
On a country-by-country basis, things take look even scarier. Currently 10 (out of 28) EU countries have an NPL ratio above 10% (orders of magnitude higher than what is generally considered safe). And among Eurozone countries, where the ECB’s monetary policies have direct impact, there are these NPL stalwarts:
- Ireland: 15.8%
- Italy: 16.6%
- Portugal: 19.2%
- Slovenia: 19.7%
- Greece: 46.6%
- Cyprus: 49%
That bears repeating: in Greece and Cyprus, two of the Eurozone’s most bailed out economies, virtually half of all the bank loans are toxic.
Then there’s Italy, whose €350 billion of NPLs account for roughly a third of Europe’s entire bad debt stock. Italy’s government and financial sector have spent the last year and a half failing spectacularly to come up with a solution to the problem. The two “bad bank” funds they created to help clean up the banks’ toxic balance sheets, Atlante I and Atlante II, are the financial equivalent of bringing a butter knife to a machete fight. So underfunded are they, they even strugggled to hold aloft smaller, regional Italian banks like Veneto Banca and Popolare di Vicenza, which are now pleading for a bailout from Rome, which in turn is pleading for clemency from Brussels.
What little funds Atlante I and Atlante II have left are hemorrhaging value as the “assets” they’ve been used to buy up, invariably at prices that were way too high (often at over 40 cents on the euro), continue to deteriorate. The recent decision of Italy’s two biggest banks, Unicredit and Intesa Sao Paolo, to significantly write down their investment in Atlante is almost certain to discourage the private sector from pumping fresh funds into bailing out weaker banks.
Which means someone else must step in, and soon. And that someone is almost certain to be the European taxpayer.
In February ECB Vice President Vitor Constancio called for the creation of a whole new class of government-backed “bad banks” to help buy some of the €1 trillion of bad loans putrefying on bank balance sheets. Constancio’s idea bore a striking resemblance to a formal proposal put forward by the European Banking Authority (EBA) for the creation of a massive EU-wide bad bank that, in the words of EBA president Andrea Enria, would “make it much easier to achieve critical mass and to create a well functioning market for (impaired) assets.”
Here’s how it would work, according to Enria’s words (emphasis added):
The banks would sell their non-performing loans to the asset management company at a price reflecting the real economic value of the loans, which is likely to be below the book value, but above the market price currently prevailing in illiquid markets. So the banks will likely have to take additional losses.
The asset manager would then have three years to sell those assets to private investors. There would be a guarantee from the member state of each bank transferring assets to the asset management company, underpinned by warrants on each bank’s equity. This would protect the asset management company from future losses if the final sale price is below the initial transfer price.
One of the biggest advantages of launching an EU-wide bad bank is that it would avoid the sort of public “resistance” that would occur if it was done at a national level, says Enria. Italian lenders would presumably be able to continuing pricing bad loans at or around 40 cents on the euro on average, even though their real value — i.e. the current value priced by the market — is often much lower. The difference between the market price, if any, and the price the banks end up receiving for their bad debt will be covered by Europe’s taxpayers.
If given the green light, the scheme would pave the way to the biggest one-off bail out of European banks in history. It would be Euro-TARP on angel dust, with even fewer checks and balances and much less likelihood of ever recovering taxpayer funds. According to a banker source cited by Reuters, while Germany has not yet endorsed the EBA plan, the EU documents describe the development of a secondary market for NPLs as a priority. According to Enria, the EBA hopes to finalize matters “at the European level” in the Spring.
The documents also include proposals for a wider “restructuring of banking sectors” as states address the NPLs problem. This “could lead to mergers among EU banks after they offload their bad loans,” a banking industry official said.
In other words, EU taxpayers would have to spend potentially hundreds of billions of euros saving yet more banks from the consequences of their own acts and bail out their bondholders and potentially their stockholders too, with funds desperately needed in other areas. Those banks, once saved and their balance sheets cleansed, would then be handed on a platter to much bigger banks. In return, taxpayers would end up with an even more concentrated, consolidated, interconnected financial system that is even more prone to abuse, corruption, and excess. By Don Quijones.
The ECB’s policy isn’t about creating inflation but about keeping a financial system and a currency union from collapsing upon each other. Read… ECB Trapped in its Own “Doom Loop” as Inflation Surges