We’ve said for some time that European banks are (believe it or not) in even worse shape on average than their US peers, although the public at large is far more aware of the problems here by virtue of our financial system having hit the wall so spectacularly. While US firms waded into risky waters with reckless abandon, so too did their EU cohort. And while the American firms may have gotten in deeper, the Euro banks have much smaller equity bases relative to the size of their balance sheets, and thus vastly less tolerance for error.
Two stories in the last two days give more detail. The first is from Der Spiegel, on the Swiss banks (hat tip reader Saboor) and the second, from Ambrose Evans-Pritchard in the Telegraph, gives more general comments.
First, from Der Spiegel:
The Swiss economy is dwarfed by the size of its leading banks, and there are growing worries about their health. The government says everything is fine, but some disagree….
“First and foremost it is the financial center of Switzerland that will bleed,” prophecies Beat Bernet, bank expert at the University of St. Gallen. By now people are even contemplating the unthinkable: the collapse of Europe’s leading bank, the largest money manager in the world, UBS.
The Swiss have been forced once already to wave goodbye to a national icon. Swissair, whose solidity earned it the moniker “the flying bank,” shut down in 2001. It was a traumatic crash-landing for the whole country, and Swissair’s collapse cost the state over 2 billion Swiss francs (€1.3 billion). The big banks also bore guilt for the failure. As later became public, UBS had refused to extend funding to Swissair for emergency operations. This is how the bank earned its nasty nickname among the populace, “United Bandits of Switzerland.”
Now, UBS is once again in the hotseat. Since the financial crisis began, the firm has experienced heavy losses and has seen writedowns of 45 billion Swiss francs (€29 billion). The investment bankers on Wall Street allowed themselves to run riot, above all with the meagre savings of small deposit-holders…. As the Neue Zürcher Zeitung recently put it — with refreshing openness — “the nicest thing you can say about the American bankers — and about their imitators as UBS — is that they were unscrupulous.”
Many are fearful of the consequences should UBS capsize. Switzerland’s gross domestic product totals 512 billion Swiss francs (€332.1 billion). UBS’s balance sheet adds up to 2 trillion Swiss francs (€1.3 trillion) — four times as much. Even Switzerland’s second biggest bank, Credit Suisse, oversees assets totalling 1.2 trillion Swiss francs (€778.4 billion). Together UBS and Credit Suisse have over 640 billion Swiss francs (€415.1 billion) in outstanding loans.
“We owe this crisis an uncomfortable revelation: UBS and Credit Suisse are too big for Switzerland,” wrote the ex-editor-in-chief of the German weekly Die Zeit, Roger de Weck, last week in the Swiss periodical Das Magazin. “If they went bankrupt, a flourishing country would be ruined.”
From the Telegraph (note that the article also has pointed observations about US banks):
The Fed, the Treasury, and Congress have managed to take some sort of coherent action. [Yves here, note he deems it to be a “bad plan” but still preferable to doing nothing] The jury is out on Europe, where the hurricane is now smashing the banking system. Those such as German finance minister Peer Steinbruck – who thought the sub-prime crisis was just an “American problem” – have had a rude shock.
The collapse of Hypo Real with €400 billion of liabilities has made him face the unsettling truth that German banks have played a big part in this $10 trillion speculative venture undertaken by the whole global banking industry.
Europeans borrowed vast sums in dollars in the offshore money markets when dollar credit was cheap. This was leveraged by multiples of 50 or 60 to fund whatever craze was in fashion – Russia, Brazil, infrastructure. The credit crunch has left these banks floundering.
They have to pay back a lot of dollars, yet the underlying assets are crumbling. They are caught in a self-feeding spiral of “deleveraging”. Even those European banks that stuck to stodgy investments are caught in a vice, since many rely to some degree on three-month loans for funds. That market is jammed shut. They cannot roll-over their loan books. This way lies sudden death, as Hypo discovered.
Who in the eurozone can do what Alistair Darling has just done in extremis to save Britain’s banks, as this $10 trillion house of cards falls down? There is no EU treasury or debt union to back up the single currency. The ECB is not allowed to launch bail-outs by EU law.
Each country must save its own skin, yet none has full control of the policy instruments. Germany has vetoed French and Italian ideas for an EU lifeboat fund. The former knows exactly where that leads.
It is a Trojan horse that will be used one day to co-opt German taxpayers into rescues for less Teutonic EMU kin. One can sympathise with Berlin. But sharing debts with Italy and Spain was implicit when they agreed to launch the euro. A shared currency entails obligations.
We have reached the watershed moment when Germany has to decide whether to put its full sovereign weight behind the EMU project or reveal that it is not prepared to do so in a crisis. This is a very dangerous set of circumstances for monetary union.
42 comments
Comments are closed.
Germany is not big enough to save the Euro – it will save itself first, backed by large reserves of gold. The Club Med countries will have to split off and float their currencies separately, at much lower levels. The Swiss Franc will plunge, so much for being a safe haven. A two tier Europe awaits (did it ever really go away?)
Please – your headline is “Why EU banks look Precarious” and your first piece of evidence is about Swiss banks. Switzerland is *not in* the EU. On the other hand, it is true that Swiss banks are not in good shape. Given the presence of UBS (for instance) in the American economy, I think this bodes poorly as much for the U.S. as the EU. (Switzerland – which is *not in* the EU – obviously fares the worst.)
Your second piece is from Ambrose Evans-Pritchard, who is just another foaming anti-EU Torygraph hack. As I understand it, Hypo Real was actually suffering from a liquidity crunch, rather than the solvency problems of the American banks. That is a big difference.
Let's think. EUR spirals to zero, because without Germany it has no value. All pan-Euro institutions fall, since there's no EUR to pay for chauffeur-driven "talks."
Russia and Germany make a pact: one gets oil & gas, the other gets Ukraine, Poland, and Georgia. Both invite Nato to um f off and take US military out of Germany by next Tuesday or else.
Grim stuff. Last chance! Tear up those CDS chits now by deeming them illegal betting slips. The cookoo clock you save may be your own.
A few matters of fact:
1. EU=European Union, Switzerland is not part of it;
2. Reliance on equity, not only by banks but all companies, is much smaller in Europe than in the USA;
3. Not all liabilities are created equal.
I will elaborate on the 3rd: In the US banks have rather relaxed lending standards, and with inflated appraisals and the originate to distribute model so vigorously employed over the past several years, lots of deadbeats were put in homes with inflated prices. This will affect ALL mortgage related holdings of US banks and SOME holdings of European banks.
From the European banks, biggest exposure to US mortgages have UBS (non-EU bank through its US investment bank), Fortis, Dexia, Deutsche Bank.
In Europe mortgages are not the same animal as in the US: full recourse, large down payment (at least 20%), income to monthly payment ratio of at least 4 times, unemployment benefits that run 2 years at 80% employment pay up to €5,850. Add to this the extremely low mobility of Europeans (in France 80% live their whole life in the town born, relative to 30% in the US) and you realize that there aren’t really lots of deadbeats in new homes that can cause trouble. And you Yves may have already forgotten the covered bond idea floated by Paulson: EU banks keep loans on their books and make sure they take on good risk, not originate to disribute.
This may prove to be a timely post. I have been suspicious of Credit Suisse’s Lehman exposure. Nothing definitive, but a confluence of small things.
– CS was the preferred destination of Lehman employees leaving Lehman over the summer
– CS was the first to register for the ISDA auction
– CS made the second most requests for physical settlements (they may only be custodians and not the owners)
– Bank loans to Lehman would be very much expected for the style of the bank (leaning towards wealth management and private banking)
We’ll know soon enough, $320bn of money changing hands tomorrow afternoon.
baychev,
– Subprime, low loan standards, are not necessary for a housing bubble. They merely change the details of it.
– European banks, except French ones and HSBC, have loans:deposits around 130%, and leverage of 40x-60x. With deleveraging there is less capital available and the price of it will continue to rise until they have made enormous steps to reduce their reliance on foreign borrowed deposits. This was enabled because insurance was bought to appease regulators, unfortunately the monolines and AIG can’t lend the same credit they used to forcing write downs in risk weighted assets and hurting Tier 1 capital further
– If the rate of foreign borrowing were not enough, have you looked at the Yen or Dollar lately? 2 denominations providing those deposits or funding for business, and they are through the roof causing instant big losses for anyone that needs to unwind in the near term
You should read the banking segment of the World Economic Forum’s recent report. Also worth you reading is about the 1867 financial crisis that indeed was related to a housing boom in Europe in an era without subprime, without borrowed deposits, and without several levels of FOREX, insurance and other sensitivities.just one more perspective from a past financial crisis
If you care to disagree that excess deposits and strong Tier 1 ratios are king, I suggest you look at the relative pricing in the stock market for money center banks. If they are meaningless, you could arbitrage 100-200% out of each pair easily based on their P/E
EHP: I think there is a statue of limitations on these things, and 1867 is on the other side. baychev was not arguing that there was not a housing bubble in Europe – there clearly was, and housing prices in many countries will fall 50% or more. He’s arguing that banks will not suffer as much as American ones. Why? Housebuyers had to put more skin in the game (20% being typical), and in many cases the loans are full recourse. Banks won’t suffer as much – but the European individual, who has to pay back the loan, suffers more.
I wonder how much of that Swiss GDP is attributable to it’s vulnerable financial sector?
baychev,
Sorry for the EU miscue in the headline. It has been corrected.
One factor I have never seen get sufficient attention is the derivatives exposure (not just credit default swaps, but exotic options) of the large European players, In the US, it was the investment banks. Citi and JPM are reasonably big, but (by reputation, market participants are welcome to correct me) not powerhouses. By contrast, UBS is a very large derivatives player, as is SocGen and Paribas. I believe Deutsche and Credit Suisse are large too they were in the past, but (I’m not current on the industry rankings, so forgive me). Not as sure re Barclays.
Basically, you need a really large balance sheet to be a serious OTC derivatives player. Once you get past JPM and Citi, you don’t have enough heft. The derivatives exposure of the big European banks is a major offset to their lesser subprime/housing exposure. And remember again, they run with on average half the equity of US banks.
a,
baychev sought to give confidence to loans made in Europe. I was jut pointing out the irrelevance of that at best, and at worst look at GE capital who has 1 in 6 British mortgages presently delinquent.
My main point was that European banks will feel the pain (save HSBC, French Banks, maybe conservative Italian banks not named UniCredit, German banks without huge Level 3 assets) simply because they rely on borrowing just to maintain their existing (impaired) book of business. That means they have the furthest to fall in this game of deleveraging.
I do agree that recourse loans are an important distinction for pricing recovery rates. The downside of recourse loans are that they encourage things like arson fraud, and that the pain is still there domestically but the borrowers are bearing a larger share of the burden than in America.
The Euro has been overpriced for at least a year based on flows of trade (same goes for other European currencies such as the GBP, NOK), and even if the USD/CHF/JPY ease in price European banks needing to settle loans in foreign currencies in the next few years (other than South Korea maybe) will face losses on the currency change.
We must be careful about separating nationalist/emotional notions from the underlying risks present.
yves smith,
One anecdote regarding derivatives exposure. JP Morgan and Merrill Lynch were heavily involved, both were the only banks to even offer Credit Default Swaps to individual investors. JP Morgan hasn’t shown any cracks yet, but there is a crowd that are patiently watching how their situation unfolds.
In one positive sign it appears that the counter-party risk in settling CDSs have been going well with the governments keen on preventing a chain reaction due to differences between total and net exposure.
This comment is not intended to contradict you on the relative rankings in the world for derivative exposure (assuming you’re talking about more than options and futures ;)
“One factor I have never seen get sufficient attention is the derivatives exposure (not just credit default swaps, but exotic options) of the large European players, In the US, it was the investment banks. Citi and JPM are reasonably big, but (by reputation, market participants are welcome to correct me) not powerhouses. By contrast, UBS is a very large derivatives player, as is SocGen and Paribas. I believe Deutsche and Credit Suisse are large too they were in the past, but (I’m not current on the industry rankings, so forgive me).”
I think you will get a good idea of the relative sizes of the players based on their announced losses vis-a-vis Lehman. Not perfect, but in the ballpark.
There are of course other derivatives besides CDSs and exotics. Every exotics derivatives player will have a much bigger vanilla book, if only because 1/ you need to hedge the exotic stuff with the vanilla, and 2/ need to know the vanilla market in order to price the exotics.
One question – I have heard it said the AIG bailout was more for the European banks than the US banks…I believe the EU gave regulatory capital relief for assets backed by Insurers than US regulations. Anyone aware of any posts that delve further into that topic?
eveilhenry,
My point is that EU banks (bar English ones) are very well protected by the equity cushion and ability to pay of their borrowers. I don’t have data on the Spanish banking sector but my bet for failures in the EU would be there after the UK/Ireland.
I fully agree with you that ratios are important to compare peers. However, you fail to appreciate fully the mixture of debt on both sides of the Atlantic: no recourse loans guaranteed by the promise to pay of Joe Sixpack who can be laid off with no more than 2 weeks notice, unemployment benefits capped around $2,000 and has negative savings rate for years in the USA vs any French/German/Italian/Dutch borrower with full recourse loan, stable job that he may not lose for at least 6 months after his employer wants to rid of him, average savings of 12% annual income, unepmloyment benefits for 2 years up to €5,850 (in France) and substantial equity in his home. Those are not identical and the situation in the EU will clearly not lead to any significant write offs on EU loans.
If you have to choose in which bank to invest which would you pick:
A) Bank with 25:1 leverage and NINJA loan potfolio;
B) Bank with 50:1 leverage and full recourse loan portfolio and borrowers with stable income AND SAVINGS.
I would always go with B.
But there are weak spots: UK/Ireland/Spain and of course the newly added Baltic Republics/Romania/Bulgaria who in fact are the subprime EU market. They are not using the Euro but most loans are denominated in Euro and the Austrian and Swedish banks have exposure to those markets.
From the MarkIt credit event auction it looked like the broker/dealers have written net protection of $4.2bn to Lehman debt, but I am not sure how the hedgies and insurers were treated: separately or the banks acted as their agents.
And my take on the surge of the JPY is unwinding of carry trades, and the USD is benefitting from the huge redemption requests from the hedgies ($100-600bn estimates). Have you forgotten that EM and diversification were quite hip until mid last year? All those dollars are coming back and guess what? The diversified folk is being frontrun on the currency market. If you doubt look at 2005 USD rally caused by a tax reduction for repatriated foreign corp profits. Even Buffett got burned $2bn with his long term approach although he was right. Short term interests always preceeed long term ones!
EVP: "JP Morgan hasn't shown any cracks yet, but there is a crowd that are patiently watching how their situation unfolds."
unanswered questions re: JPM & LEH —
why did JPM freeze LEH's cash on Friday night pre-fall?
why was LEH allowed to fail when their bankruptcy turned out to be the trigger to the domino chain?
(remember that weekend of high-level discussions inside the FED HQ?)
what about this $138 billion advance from the FED via JPM to LEH to settle security transactions?
then shortly after, LEH requesting authority from bankruptcy court to give special status to claims of JPM, the same organization that effectively brought the hammer down on their company?
how much of that $138 billion went right back to JPM to settle certain transactions?
perhaps this is why JPM has yet to show any 'cracks'?
things that make you go 'hmmmmm'…
Yves,
Since you give us a choice (“believe it or not”), I will choose not to believe that banks on the European Continent are in worse shape than banks in the US or UK. But what does it matter what you, I, or precious Ambrose believe? Every day, there is new information and we get tons delightful surprises that may change our perceptions about who has been good (or smart) and who has been naughty (or stupid). It may turn out that a bank in Kansas or in Mongolia is much stronger than USB or the country of Belgium (just wild guesses, of course). So, let us wait and see.
Warren Buffett has famously said ‘It’s only when the tide goes out that you learn who’s been swimming naked’. Before that, anyone can pretend to wear a swimsuit.
Here is a perspective from Hong Kong, where I live. What really surprised me about this crisis is that a mere drop of 25% in the real estate market could bring such damages to the American financial system and drag Europe along the way.
From 98 to 03, The real estate in HK dropped by around 60%, producing a lot of homes with negative equities. Yet, there was no banking crisis. The reasons were 1.) a significant downpayment; 2.) most HK homebuyers had some savings, to which a bank could lay a claim when a homebuyer walked away from his mortgage.
I guess EU is similar to HK. A fall in the EU real estate market should not be as bad as the current American fall.
The damage to EU shall be limited to the American financial products bought by EU banks. But the damage is still quite serious.
Also, what about the Iceland bankruptcy? It seemed that few have been affected by it, except the bitter exchange of words between UK and Iceland.
It is really strange reading Ambrose Evans-Pritchard bemoan the fact that the European Union refuses to operate as a super-state. This would be like Atrios, or some other prominent Iraq War critic, suddenly one day demanding to know why we don’t have twenty more divisions in Iraq.
So OK, perhaps Evans-Pritchard has changed his mind about the best political structure of Europe. Fair enough, the current crisis has given him a different prism though which to see. But why can’t he just admit he has been so very wrong for the past two decades? Of course that may bring up the question of why we should take him seriously now after he has fought for years against the very political structure that he now claims is necessary to save Europe from financial disaster, namely a European-level super state.
No doubt about that the Lehman disaster weighs heavily on US and European banks. Most banks in Friday’s auction were actually large US institutions. Since they are positioned internationally I suspect that most of the $270 billion of the expected cash payments are actually coming from European sources. That would explain the shock wave rushing also through the European banking system since Lehman.
It is beyond me to understand how the US government could let a system relevant bank like Lehman fail. The Lehman bankruptcy was the financial equivalent of declaring war to Europe.
Evans-Pritchard has presented himself as a notorious anglophile and he generally does not support his writings with facts but rather speculations about how the future will turn out. Nevertheless his warnings point to an important issue. European banks are due to lack of a centralized response more in danger to succumb to the impact of the worst financial crisis since the Great Depression.
Ambrose Evans-Pritchard is always very frothy. Unfortunately, he often has useful facts, so we have to read him, but it is impossible to judge their importance without checking oneself. For example, this week, according to Evans-Pritchard, the Hungarian Forint “plunged” against the Swiss Frank, threatening state bankruptcy for Hungary – a look at the chart shows that “declined” would be the appropriate term).
I’ve been thinking that one could use the level of frothiness in Evans-Pritchard’s articles as a contrarian indicator. Perhaps when it reaches the top of the scale (or goes off the scale) we can all start to relax.
Any ideas how to measure it?
I will lay the looming UBS disaster to changing the Swiss franc from gold backing to backing by whatever. Backing a currency by whatever may be OK for a country that can thumb its noses at its depositors, but it does not work if a country is building a major business out of banking.
Eventually whatever evaporates, leaving a bank with no assets, only asses in charge.
It is becoming more and more clear that the 20th century’s infatuation with paper and the 21st century’s infatuation with electrons is going to lead to tears. We have gone from minor panics in the 1800s, to major currency collapses (Germany, pick your European country outside Swissy) and repudiations (dollar, pound, swiss franc) in the 1900s, to worldwide collapse in the 2Ks.
The most interesting thing out of the latest problems are Merkel’s stepping back from the Euro. Germans are already talking about going back to the sturdy Mark.
IMHO, just keep in mind:
Lehman Brothers is acting as financial advisor to CME Group and Skadden,
Arps, Slate, Meagher & Flom LLP is acting as CME Group's legal advisor.
CME Group (http://www.cmegroup.com) is the world's largest and most
diverse exchange. Formed by the 2007 merger of the Chicago Mercantile
Exchange (CME) and the Chicago Board of Trade (CBOT), CME Group serves the
risk management needs of customers around the globe. As an international
marketplace, CME Group brings buyers and sellers together on the CME Globex
electronic trading platform and on its trading floors.
Lehman Brothers Inc. is a subsidiary of Lehman Brothers Holdings, the exchange holding company noted, but it is "a separate company with its own accounts, assets and customers." Those accounts, assets and customers, CME continued, "are protected through a comprehensive federal statutory and regulatory regime and other financial safeguards and risk management protections provided by CME Clearing."
CME spokesman Allan Schoenberg said Mr. Donohue wanted to be at the CME’s Chicago headquarters to monitor developments, although “Lehman, the CME Group clearing member, continues to meet all of its obligation to CME Clearing and continues to operate as normal.”
The clearing of the trades, which eliminates counterparty risk, is backed by $4 billion in cash and four layers of financial safety nets totaling more than $64 billion. Last year, CME Clearing cleared trades worth $1.2 quadrillion in notional value.
How clearing is handled is particularly sensitive because the Russell 2000 contracts will stop trading on the CME on Thursday to become an exclusive listing on the IntercontinentalExchange Inc.’s New York Board of Trade subsidiary. Many participants, including Lehman, traditionally an active player in the equity index arena, must close all their CME Russell positions no later than Thursday.
> That was a story from Sept 16, so obviously, no need to worry about good ol LEH…
Yves:
Barclays balance sheet is quite ‘interesting’:
http://brontecapital.blogspot.com/2008/06/barclays-strange-stranger-and-truly.html
kevin de bruxelles,
Evans-Pritchard's point seems to be that the crisis has blown up at a point where the Euro block is neither one thing (a collection of nation states with full control over all their own economic policies), nor the other (a single state with full control over all its economic policies), and that this will make crisis management more complicated.
Seems a plausible claim to me, and I can't see why making it would oblige him to repudiate his previous vocal & ideological opposition to a European superstate.
Yves
BR had some figures about US derivatives exposure that may be some sort of basis for comparison with Barclays
http://bp2.blogger.com/_H2DePAZe2gA/R9sT8yG-HKI/AAAAAAAAA7k/A-SlM2Kotng/s1600-h/OCCpg1.png
Posted on 17th March 08 if the above link gets chopped off. Barclays comes in just behind BoA, Citi and JPM for total exposure.
Not sure where Barclays would show up in with this exciting tabulation by Chris Whalen, linked to by Barry R.
http://www.institutionalriskanalytics.com/research/bankcds.pdf
I was really surprised by this because nobody had mentioned it. European Banks seem to be the biggest issuers in the US commercial paper market, 34% of unsecured and 48% of asset-backed according to a graph that comes with this article
http://online.wsj.com/article/SB122339483324611667.html
This suggests that European Banks should be in real trouble because a lot of their short-term borrowing is presumably in USD and Yen. Depfa, the subsidiary of Hypo Real Estate went down because the market froze up.
Isn’t it likely that the huge run the Euro had over the last few years is to a large extent the result of the USD becoming a carry-trade currency.
Does anybody have a different explanation?
Richard Smith,
Well Evans-Pritchard is certainly correct that the European Union is not an entity with full control over its economic policies (of course considering the deeply intertwined global economic networks, no political entity has full control over their policies but I think I know what you mean anyway). But this is primarily, as De Gaulle always warned, because of British opposition, voiced by propagandists like Evans-Pritchard, to a United States of Europe, where Britain would be relegated to something similar to the status of the State of New York in America. So the least Evans-Pritchard could do is to provide some of the history as to why the EU is unable to act as super-state and where he stood in that debate.
His article sets the scene by discussing all the steps the US government has taken, and then basically says the EU is a failure because it has not taken the same thing steps. Of course the unspoken premise is that the problems in the EU are as serious as in the US. I would say this is totally false. There are no doubt potentially grave banking issues in the EU. But the primary difference with the US is that the European continental economic model based on a balance of trade, conservative use of credit, and healthy social safety nets; is fundamentally sound. Once the banks are sorted the Europeans will find (for a while) the lower Euro will only help their exports.
But even on the banking issue, why doesn’t Evans-Pritchard judge the steps already taken by the individual nations. After all it was this political model, a series of nation states in a loose confederation, that he and his mates have been pushing for so long. The fact is that this model has actually worked quite well so far (obviously it is still early days). For example Belgium has two banks, Fortis and Dexia, that are too large for Belgium alone to bail out. I would say that the moves Belgium has taken together with her neighbours France, The Netherlands, and Luxembourg have every chance of succeeding (although Fortis is not out of the woods yet). But instead he bases his whole case on some incoherent potential issues about Germany not wanting to write a blank check to the Catholic nations on the periphery.
If anything Evans-Pritchard has reason to claim that his model was right after all. In the case of Europe an institution on the EU level with the powers of the US Treasury Department might overreach and end up doing too much, or the wrong things, like TARP in the US.
But claiming victory in that previous war would not serve Evans-Pritchard’s propaganda goal today, which is to make sure Britain does not panic and join the Euro once any future run on Sterling gets started. So his analysis must remain fact-free, since the facts aren’t pointing to his preconceived idea that Europe is a basket case. What he is really after are headlines that diss Europe hard, while hoping that readers don’t look too closely at the arguments upon which those headlines are based.
kevin,
too right, I phrased that quite horribly & I appreciate your benign interpretation of what I was trying to say.
Thanks for peeling off the layers of spin. I knew some of this but there's more than I had spotted.
FWIW I suspect, unoriginally, that the really impressive banking problems (potentially worse than the US) are likely to be in the politically semi-detached bits of geographical Europe (UK, Switzerland, Sweden) and that any of those countries might suddenly find themselves looking wistfully at the Euro bloc if one of their big banks really blew up. So I can see why AEP might do some pre-emptive eurodissing.
MJ,
That is a key fact, wish I had known of that earlier, thanks.
Richard Smith,
Thanks for the derivatives info. The problem is that aggregate figures really don’t give a very good picture of the degree of risk. Some markets, like interest rate and currency swaps, are OTC but (like foreign exchange forwards) are for many instruments normally very liquid and not terribly risky (and like the analogy to forwards, you also have ones that are thin, like long dated forwards or exotic currencies).
Those “yes there is some risk but it really isn’t all that bad” type of derivatives are lumped in with the ones that are more exotic, which generally means customized to a small or considerable degree. They are hedged dynamically, so when trading markets start becoming illiquid, suddenly your ability to hedge is impaired. The instruments you use to hedge may suddenly not be available to adjust your hedges in the size you need, or they may have become prohibitively costly. Or certain inputs into your models may have become dubious (how do you estimate implied volatility on a lot of instruments these days?)
And then we have CDS, which is more an insurance product than a derivative, but gets lumped in the derivative bucket…..
MJ,
Isn’t it likely that the huge run the Euro had over the last few years is to a large extent the result of the USD becoming a carry-trade currency?
No, such a carry trade would have the opposite effect – strengthening of the USD and weakening of EUR.
kevin de bruxelles,
I second your opinion – the EU model of a differing bunch of somewhat distrustful nations precludes large-scale mismanagement, such as TARP. Funny to see all the anglo-saxon libertarians suddenly getting Jesus, and criticizing the EU for not being a super-state.
Hi Yves,
Yes, extremely frustrating not to be able to split out the exotics. BarCap do market themselves as exotics experts, but ‘they must have plenty’ doesn’t exactly pin it down.
CDS: $2.4Trn, which isn’t much of the total outstandings.
If I had to calculate implieds in these markets I think I’d want a stiff drink before and a lie down in a darkened room after. And a quick read of Taleb after that.
kevin de bruxelles,
You charge that Evans-Pritchard is a propagandist and also assert that the European banks are in better shape than US banks with no supporting information. We have REPEATEDLY pointed out that European banks have far less capital than US banks, so there have vastly less room for error. And our prior posts, plus the comment thread above, points out many ways European banks have in fact not been conservative: direct purchase of US instruments, particularly the worst, late cycle subprime paper and CDOs, reliance on dollar and yen funding, particularly commercial paper, which is close to trading by appointment, and larger (relative to the entire financial system) derivative exposures. The European financial system is more concentrated than the US. We have over 7000 banks.
I have also said, starting back in January, that a colleague of mine with top level regulatory connections in the US and Europe (he speaks to Trichet, for instance) had said that the European banks were in worse shape than US ones> He has top level security clearances and cannot tell me more. But other information he has provided on moves the US would make, such as the partial nationalization of banks, has proven to be correct, and he made these reports when the idea would have been dismissed as daft.
The Financial Times has raised concerns about the EU similar to that of Evans-Pritchard. So I assume you'd call them propagandists too? Similarly, I have US investors with substantial overseas experience who have similar worries. They are certainly not propagandists, yet voice the same concerns.
As for the Fortis and Dexia bailouts, the issues re those was addressed by Wolfgang Munchau, a German economist, that they happened to have the good luck to not be overwhelmingly large and involved countries that had rational leadership and were thus willing to make compromises. He argued that this was good luck and that there would be banks that would fail that would not lend themselves to compromise.
So the substance of Evans-Pritchard's charges is not only defensible, but likely correct. Thus the charge that he is a propagandist does not bear any scrutiny. And propagandists usually are in the employ of someone seeking to put out a particular spin.
Evans-Pritchard regularly hyperventilates about matters that he sees as risky. He clearly hews to the Austrian school of economics, and they tend to take an apolyptic view. But he was right about inflation versus deflation, and has made other accurate observations. Plus he is not alone among Brits in having a cutting writing style (Question Time and Oxbridge debating encourages it).
kevin de bruxelles,
To provide further support for the view that worries about the EU’s ability to handle bank crises is valid, see this note from one of my investor-correspondents (who by the way visits Europe frequently and reads and speaks German, perhaps other non-English languages, I don’t know his full repertoire).
I would appreciate it if you deal with the substance of arguments, rather than fling around terms like “propagandist” which is simply an ad hominem attack and does nothing to address the arguments made.
What most people don’t seem to understand are on the institutional limitations of EMU. Monetary policy is the only policy instrument which can be exercised at the European level, combined with the emphasis of that policy on the control of inflation (i.e. an asymmetric inflation target which is also too low) tends to generate a deflationary economic environment as any signs of inflation or “overheating” of some part of the European economy is likely to be met by increase in the interest rate. This is exacerbated by the lack of active fiscal policy and the absence of other mechanisms (such as the promotion of investment) to stimulate aggregate demand. The current crisis serves to illustrate that the existing institutional framework is not adequate.
The size of the EU budget is relatively small, around 1.3 per-cent of the combined GDP of EU members, and is still dominated by the Common Agricultural Policy. Also, by mandate, the EU budget must be balanced. Under these conditions, there is no scope for active fiscal policy.
The other problem is the payments system: The Maastricht Treaty led to the establishment of two new institutions in the area of central banking in Europe: the European Central Bank (ECB) and the European System of Central Banks (ESCB), with the latter comprising the ECB and the pre-existing national central banks (NCBs) of EU countries (ECB 1999c). While not mentioned in the Treaty, it is the Eurosystem which is the actual entity performing the central banking functions for the euro and Euroland, comprising the ECB and the NCBs of only those EU countries that have adopted the euro.
Within this narrower system of central banks, on which the following focuses, the ECB is supposed to be in the driving seat; as Article 107(3) of the Treaty establishing the European Community (TEC) says that the Eurosystem is “governed by the decision-making bodies of the ECB.”
The relevant bodies are the Governing Council (ECB Council) and the Executive Board (ECB Board). The former includes the members of the ECB Board as well as the NCBs’ Governors. The ECB Council’s job is to adopt the guidelines and take the decisions necessary to ensure the performance of the tasks entrusted to the Eurosystem. Particularly, the ECB Council formulates monetary policy, including the decisions relating to intermediate monetary
objectives, key interest rates, and the supply of reserves, and establishes the necessary guidelines for their implementation. Meeting twice monthly, since November 2001, decisions on the monetary policy stance are normally only taken at the first meeting of the month.
The ECB Board includes six members: the President, Vice-President, and four other members, to be “appointed among persons of recognized standing and professional experience in monetary or banking matters by common accord of the Heads of State of Government” (Art. 112 TEC). The Board is charged with implementing monetary policy in accordance with the guidelines and decisions laid down by the ECB Council, which involves giving the necessary instructions to the NCBs.
For the actual execution of the ECB’s policies is largely left to the NCBs. This follows the principle of decentralization, requiring that “to the extent deemed possible and appropriate: “the ECB shall have recourse to the [NCBs] to carry out operations that form part of the tasks of the [Eurosystem]” (Art. 12 Statute of the ESCB). While the ECB is the supposed head of the system, the NCBs, in turn, “are an integral part of the [Eurosystem] and shall act in accordance with the guidelines and instructions of the ECB. The Governing Council shall take the necessary steps to ensure compliance with the guidelines and instructions of the ECB, and shall require that any necessary information be given to it” (Art. 14(3) Statute).
This peculiar design of the Eurosystem’s structure reflects a balancing act of national interests and European aspirations that raises a number of issues. On the one hand, a single currency means a single monetary policy common to all member countries, which requires clear leadership in policymaking and commonality in policy execution. On the other hand, completely abolishing existing NCBs (together with the national currency symbols) and starting from scratch was deemed politically impossible.
And now this half-baked compromise is coming home to roost. As a solution, the NCBs were combined to a system of central banks, with a new head added to it. The point is that while the NCBs lost their previous authority in monetary policy matters, they may still be engaged in other central banking functions that have a more national rather than system-wide focus. Recall here that Euroland
lacks a common fiscal authority, as for the time being fiscal policy remains under national
control.
One issue is that conflicts can thus arise between system-wide responsibilities and other more national functions and interests. Another that the NCBs, given their loss of monetary policy authority, could also be expected to keenly fight against any further drains of their prerogatives vis-à-vis their respective national authorities and players. This is what is happening in Germany today. In this regard, the lack of a common fiscal authority that could provide the “deep pockets” required in case of serious financial system problems and bank re-capitalizations creates huge problems for the euro, as we see today.
Essentially, the NCBs continue to be in charge within their respective national financial systems, as national lenders of last resort in case of country-specific problems, while it remains to be seen how cross-border systemic problems would play out and be responded to should they arise. Tomaso Padoa-Schioppa, a former ECB Board member in charge of this area saw this as a case of “constructive ambiguity.” But the markets clearly regard otherwise.
As to the question of what comes next, nobody knows. This is the real problem. It would be very messy, indeed chaotic, to go back to national currencies and would no doubt exacerbate the current systemic stress. More likely, I think is what I suggested to Yves the other day: it will end with the payments system being closed down until it reopens with bank deposit insurance at the ‘federal level’-in this case from the ECB itself. That’s the only real solution, along with scrapping the Stability Pact so that additional aggregate demand can be created.
ESSENTIALLY, THE EUROZONE NATIONAL GOVTS. CAN’T FUNCTION WITHOUT BEING ABLE TO ISSUE NEW DEBT.
ONCE SUSPECT, MARKET FORCES TEND TO TEST THE LIMITS VIA ‘PRICE DISCOVERY’
SO FAR IT’S BEEN GERMANY, ITALY, AND BELGIUM. THE REST CAN’T BE FAR BEHIND, AS FALLING ASSET PRICES CUMULATIVELY TAKE THEIR TOLL.
ESSENTIALLY, THE EUROZONE NATIONAL GOVTS. CAN’T FUNCTION WITHOUT BEING ABLE TO ISSUE NEW DEBT
LOL, sweetie, this is even truer for the US government.
mmm…I *thought* I’d better stand back…
I still haven’t managed to spell out my actual Barclays point – they are doing American style debt IB with Euro-style balance sheet gearing. Their risk management must be order of magnitude better than anyone else’s.
I’d better shut up now.
max,
actually no, borrowing in USD and then lending in other currencies is exactly the carry trade.
If you look at the results of Depfa bank, their long-term liabilities stayed constant in the last 2 years while short-term doubled, they funded their whole business with short-term borrowing until they couldn’t and so they brought down Hypo.
Still, I find it simply amazing that European banks are the biggest issuer of US commercial paper.
You cant say that a us bank levered 25 is higher capitalized compared to an european bank levered 50 times.Simply, you have to weigh in assets to the risks taken,ROEW, and i guess that gives you a different picture. European banks off balance sheets is much smaller than american ones which securitized many loans and much of that recoursable. Level 3 in us banks tell me that are hiding big losses. Besides UBS and CS are too levered simply because they consolidate in the balance sheet their larger private banking arms. By the way JPM is the largest issuer of derivates , almost 8 trillions!!! and apparently was saved by the FED disguising a clearance operation benefiting LE(LEH assets was 0,6 trillions and the clearance funds totalled 0,14 trillions , so it is amazing that assets turn over is 4 days!!! come on!! ).
Anon of 10:17 PM,
With all due respect, much of what you say is simply wrong.
Securitized loans and instruments like CDOs ARE non-recourse, none have every come back to any of the originators. What did come back were off balance sheet vehicles (SIVs); those are completely different that securitized MBS or CDOs. And the CDOs that Merrill held were on balance sheet, unsold origination inventory, not the result of being forced to take it back. You are 100% wrong on this issue.
Similarly, funds managed on behalf of customers are not consolidated. They cannot be. Banks are holding them in custody. They have no ownership interest in them and thus they can in no way, shape, or form be considered assets of the bank. You are confusing them with bank deposits. Any private banking customer that had some of its funds in deposits at UBS would have those counted on the banks’ balance sheet, like any depositor. But assets under management in UBS operated investment vehicles would NOT be included, nor would any funds managed in segregated accounts.
For instance, the UBS March 31 financial report shows that UBS had 3 trillion in Swiss francs in “client assets”):
http://www.ubs.com/1/e/investors/08q1/0011.html
The total balance sheet as of that date was only 2.2 trillion Swiss francs:
http://www.ubs.com/1/e/investors/08q1/0001.html
from Evans-Pritchard:
It is a Trojan horse that will be used one day to co-opt German taxpayers into rescues for less Teutonic EMU kin. One can sympathise with Berlin. But sharing debts with Italy and Spain was implicit when they agreed to launch the euro. A shared currency entails obligations.
What E-P writes here is true, but it is not as such an argument against the position of Berlin or the EuroZone more generally.
Should there be severe problems in any EuroZone states, then it is almost certain that the rest of the EuroZone will come to the rescue. There isn’t really any other choice, after all.
But this is not the same thing as the creation of a “trojan horse” (E-P’s own terminology) that could be used to provide “stealth” bailouts of states that are in difficulty. Rather, coordinated support of state X would mean a recognition by all involved that the rest of the EuroZone is actually supporting state X, and that state X will need to get its financial house in order.
In a way this is similar to the discussion of support vs nationalization of banks. On option is simply to pump money into the banks, keeping the banks afloat, but doing little actually to address the problems. Another is to nationalize the banks and actually put the books in order. The first serves only to cover up the problem, the second serves (or at least can serve) actually to solve them.
Yves Smith
As for the Fortis and Dexia bailouts, the issues re those was addressed by Wolfgang Munchau, a German economist, that they happened to have the good luck to not be overwhelmingly large and involved countries that had rational leadership and were thus willing to make compromises. He argued that this was good luck and that there would be banks that would fail that would not lend themselves to compromise.
The problem with this argument is that there isn’t actually any evidence supporting it. Yes, there could be instances of bank failures too large to support, and there could be instance where coordination and compromise failed, but Munchau hasn’t provided any evidence that such actually is the case.
To be sure, the fact that coordinated action has worked so far is no proof that it will continue to work in all cases. But, absent some evidence to the contrary, there is no reason to think that it will not.
And, at least so far as I have seen, Munchau hasn’t provided any such evidence, but only innuendo about the supposed irrationality of political leadership.
Yves,
I am not sure why you reacted that way you did. If you read my comments you would see that I completely agree with your friend’s view. I said that the EU does indeed have a grave banking problem. Perhaps I have not been clear. My whole point is that the EU is incapable of dealing with this crisis on their level due to the lack of the proper political architecture that your friend articulates wonderfully in his email. I also openly agreed with Evans-Pritchard’s (in the first sentence of my last comment) points that the EU is incapable of dealing with this crisis. But my main point is that we are where we are today due to the Evans-Pritchard’s of the world fighting greater EU political union. My other point was that the overall economic system on the other hand was sound so that when the banking crisis is sorted out Europe will rebound. So in a sense I agree with much that you say. What I reject though is any notion that the Euro is finished.
So what are our choices, listen to Evans-Pritchard and destroy the EU and the Euro or get the job done with the national institutions that we have? The leaders of Europe are going to war with the institutions they have, but as soon as this crisis passes we need to build up the proper EU-level institutions to make sure this never happens again, or if it does, that we are ready for it. And in this battle we will be fighting tooth and nail against the writings of Evans-Pritchard.
Anyway, I enjoy your blog but perhaps I should keep a lower profile in the future