Zombie Europe

By Delusional Economics, who is horrified at the state of economic commentary in Australia and is determined to cleanse the daily flow of vested interests propaganda to produce a balanced counterpoint. Cross posted from MacroBusiness.

One of the major themes that I have been discussing in Europe for a long period of time is the simple failure of logic in which the European periphery is being instructed to push deflationary policy onto their economies, yet at the same time expected to meet their existing, and growing, debt obligations. In the most extreme case this has led to what you now see in Greece, but I don’t think Portugal or Spain are far behind. This failing policy is leading to the ‘zombification’ of nations, in which they can’t grow out off their debts yet aren’t being allowed to fail on them either. Kept alive by an ever-growing lifeline of foreign aid when the real solution is to let the beast die and re-build from the ashes. I think if we compare Iceland to Ireland we are beginning to get a clear picture of the benefits of writing off the debts and starting anew.

As I have also spoken about over the last month or so, what is happening in the real economies of Europe is being replicated in the banking system. This is most apparent in the interbank market, as I said:

Although the LTRO does seem to have done some good for short term sovereign debt via supporting direct purchases, or at least the perception of them, it doesn’t appear to be helping in the area that central bank operations actually target. That is, interbank market stability.

The latest ECB data shows that banks parked a near record 446bn Euro in the ECB’s deposit facility, but this in itself isn’t a problem. What is the problem is that the increasing use of the ECB’s marginal lending facility shows that not all of these parked reserves are actually “excess to market requirements”.

What appears to be occurring is that banks are hoarding reserves instead of providing them to the interbank market. If I took a guess I would suggest that this being caused by deposits flowing out of periphery banks into the core (and probably some non-Euro markets). These flows require the periphery banks to recoup some of their lost reserves which they would normally do in the interbank market.

If this is correct then appears that the banks themselves have already decided that there are some “Zombies” in the system. Under these circumstances what should occur is that these banks are identified, assessed and broken up in a structured way in order to purge the financial system of entities that are no longer solvent. Yes, this would mean that investors in those entities would be out of pocket, but that is the risk of investing which is why you get paid a premium. “Dividends” I believed they are called !

However, as I have stated numerous times, the Europeans appear to believe that the normal tenants of investing need not apply on their continent so we continually see policies implemented across Europe to keep the poison in the patient. The ECB’s 3-year LTRO is the latest incarnation of the band-aid to cover the ever-growing wound. Instead of properly stress testing the financial institutions to determine which ones are insolvent and in need of removal, we have an operation by the central bank to provide massive amounts of excessive liquidity. The hope is that this will stabilise the the interbank market and therefore banks will go on their merry way doing what banks do, that is providing credit to the private sector within the bounds of monetary policy.

This approach appears to be failing as, even Mr Draghi has admitted, the interbank market is still frozen. However, even if this wasn’t the case I doubt very much whether periphery banks would be falling over themselves to lend because:

Firstly the banks appear to be using the facility to re-capitalise while at the same time they shrink their asset base in order to meet capital requirements, and secondly, in a poor economy the appetite and/or desire for credit is low and the availability of credit-worthy customers is limited.

In their downgrade of the EuroZone, S&P supported this assessment as they listed credit tightening as their number one reason why they took the downgrade action:

Today’s rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include:

(1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.

So how can this be? How is it that the ECB can provide the banking system with so much money, yet there is still a credit squeeze and therefore a deflationary tendency in the periphery ? Obviously S&P’s point 3 plays a part with government austerity driving an already stressed private sector to save over borrow. I will also note that banks aren’t really ever constrained by reserve liquidity, it is capital and credit worthy clients that they need, however that is also not the full story either.

As I stated above, the financial policies of Europe appear to be that insolvent financial entities must be kept alive at all costs, and in this regard the LTRO is playing its part. One clue to how this is occurring is available from the actions of the Italian government just before the 3-year LTRO commenced:

The Italian Treasury offered guarantees for bonds issued by banks to give them access to ECB liquidity, in a move to lower funding costs. These bonds will stay on the banks’ books until their expiration, according to a ruling announced by Italian Prime Minister Mario Monti earlier in December.

In the lead up to the 3-year LTRO the Italian banks created billions of euros worth of bonds and got their government to rubber stamp them. These bonds were never actually issued to the market, they were simply tossed over to the ECB as collateral to get a 1% loan. So how much did the Italian banks get ?

“It’s a 116 billion euros,” one senior banking source told Reuters. Two other sources confirmed that amount. The Italian figure includes 40.4 billion euros of state-backed bank bonds which were used as collateral for the loans.

So now the Italian banks have an additional 40.4 billion euros with which to purchase government paper, created from nowhere, and backstopped by the very sovereign that would later be the recipient the loan. The ECB’s mandate says that they can’t fund sovereigns directly, but it appears it is fine as long as there is a commercial bank acting as an intermediary and taking their “carry trade” cut. That technical point aside, what this shows is that banks now have a way to re-capitalise independent of the state of their other assets and liabilities.

For Italy, with its private sector in relatively good shape, its banking system may be able to weather the storm. In this particular case this operation is probably more about re-capitalising the banks after their exposures to other periphery nations and about funneling money to the government. However, what you will note is that the banking system can now profit independent of its loan book. So why would it bother taking the risk of lending? In an environment of increased capital requirements and a slowing economy it is far more likely that banks will use this additional capital as a buffer as they shrink down their asset base. In short, more consumption of fresh brains.

Given the relative strength of Italy it is doubtful that these operations were about avoiding the collapse of the commercial banks. That, however, may not be the case for somewhere like Spain. The Spanish banking system still has hundreds of billions of dollars in outstanding loan exposure to its now defunct housing market. Under these circumstances you would expect the Spanish banks to require a significant purging. However, once again, the LTRO prevents this occurring. Spanish banks only need to package up these non-performing loans in some type of eligible vehicle ( possibly with a sovereign rubber stamp ) and present them to the ECB for a 1% loan.

The definition of a zombie banks is:

… a financial institution that has an economic net worth less than zero but continues to operate because its ability to repay its debts is shored up by implicit or explicit government credit support.

I believe that definition fits in this case. The problem for the periphery nations and also the ECB in regard to the transmission of monetary policy is that , as Japan can attest to, zombie banks don’t lend. The irony for Germany and its push to raise the performance of peripheral countries is not lost on me.

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  1. jake chase

    The idea was never to energize the economy; the idea was to avoid ‘sovereign default’. The trillions in CDS are the dog; the real economy is the tail. Ultimately, you get unemployment of 25% and a buoyant stock market. If you don’t understand how this works read a little book called The Death of Money, written in 1993.

  2. ambrit

    Dear Sir;
    From down here ‘in the trenches,’ a large DIY box store, (not the Helpful Hardware Man,) the misapplication of values is biting directly into fundamentals. Since banks aren’t ‘encouraged’ to lend to the Main Street crowd, money is tightening. This sector should do just fine, thank you. People can’t afford new homes in any great number, so they are renovating those they have. DIY Land chuggs along on lower steam pressure. However, Management at the store level keeps getting signals from Corporate to the effect that they have to “squeeze harder Capn!” A fundamental disconnect is at work. In the face of stiff economic headwinds, weekly “Budget” is being kept high. The Street must be kept happy, at any cost. Thus, rumour now says that, and rumour has generally been accurate so far, sales floor empyoyees will soon be given ‘Sales Targets’ to meet or die trying.
    Customers have already begun to remark upon the depressed spirits of sales floor staff, and a drop off in quality and availability of competent assistance.
    Zombification is proceeding apace, everywhere!

      1. different clue

        There is still a single store hardware store in my little city called Stadium Hardware. I make a point to go there for my rare and occasional hardware needs, to do my part to keep a helpful hardware store in existence.

    1. Tim

      I’m in lower level retail management with a national chain and I see similar trends in my store. The year to year dropoff in our customer satisfaction metrics has been startling and it’s really no wonder why: the ratio of employees to average transactions is on a continual downward trend, morale among the remaining staff is low as they are made to pick up the slack, and even beyond that we’re frequently forced to reassign our remaining sales employees to receiving or inventory management tasks just to make sure essential operations are completed. This leaves a handful of sales floor employees scattered through the facility forced to field questions regarding 70,000+ SKUs. Of course, our labor budget is handed down from above and we have little influence on the situation on an in-store level, but that just makes it all the more frustrating. It’s madness, but that’s the way big box retail is headed in the good old USA, especially with the continued relative weakness in the labor market giving employers that much more leverage over employees whom, in better times, might quit rather than be subjected to such a relentless “more with less” bullwhip.

      1. ambrit

        Dear Tim;
        Thank you for the unbiased Management perspective. I’ve been told point blank that I am going to meet my sales goals and metrics or they will “replace (me) with someone who does know how to sell.” I was hired on the strength of my ‘real world’ trades experience! I must admit to a weakness in pushing in house credit cards and ‘fries with that burger.’ So, if I’m not a good fit with the corporate mould, why wasn’t I told up front what the parameters were? Yes, I know, all I do is whine. The good news is, they threaten to ‘demote’ me to the night stocking crew or part time day shift. “Don’t throw me in de briar patch Mistah Wolf!”
        I am in a halfway decent state. Our house is paid for, so are the cars. We have a little financial cushion in the bank. We don’t owe very much to only one creditor. I’m alright Jack.
        The ones I’m feeling sorry for are the younger folk who are trying to live like their parents did on a lot less. Now there is real fear and apprehension. From what I’ve read about the Great Depression, this malaise was a primary effect of the bad times had by (nearly) all. If so, we’re already suffering through a stealth Depression.

  3. Frank

    “The irony for Germany and its push to raise the performance of peripheral countries is not lost on me”

    Not very difficult to understand: the German banking system is full of bad loans and I’m not speaking about southern sovereigns only. Most of the crap bought during the roaring period of the subprime era are still on the books. Some of them are in the KFW balance sheet a public bank that Germany DO NOT consolidate (about 400 billions). For Germany the only important thing is continuing being financed by crazy people buying 10y bunds at sub 2%. Like all the other long term government bonds at 2% is pure madness.

  4. Frank Speaking

    “…zombie banks don’t lend”

    I believe that tells the tale on the current condition of several TBTF institutions right here in the good ole US of A.

  5. craazyman

    the only zombie in my life is my cash stash.

    I’m about ready to throw in the towel and go long. I just want something that goes straight up 300% in 6 months so I can ascend to Paris. Europe’s big enough to take care of itself.

    nobody knows what money is anyway, so when you pool and measure it with equations it’s garbage-in, garbage-out.

  6. Ignacio

    As in Italy, one of the first movements of the new “treasury secretary” in Spain was to offer guarantees to bank bonds posibly to make them eligible for LTRO.

  7. RBHoughton

    Write-offs are the thing energising London and New York. If Europe goes that way, the AngloAmerican economic system cannot survive in its current form.

    Their preferred option appears to be to sink the Euro and bring European production under the USD – its a takeover – and that addition might just be sufficent to reduce leverage to a level that recovery might be possible in time.

  8. Fiver

    Where have we heard “the banks aren’t lending” lament before?

    Just as witnessed in the US, this isn’t about the well-being of Europe. It’s about the stripping of Europe to feed to the strongest cannibal capitalists. Only after 3 years of massive Fed intervention, overt and covert, the abandonment of any pretense of honest accounting or accountability, the biggest corporate tax gifts ever, major export gains via devaluation (stealing business) and stunning BS profits from relentlessly gaming markets (including commodity markets) did the US economy achieve the current happy state where carmakers are now back to the insane sales/financing incentive practices that existed for quite some time pre-crisis – all while, yet again, not 1 thing is done to foster real income growth for the working population. Which is part of why I think the US is over the course of 2012 entering a little non-housing boomlet (plenty of massaging of key official data) for a couple years – no memory is shorter than a US consumer trained from birth to “live in the moment” of a “once-in-a..” deal or a banker with the keys to the Treasury.

    It’s going to take 1 more hammering before it finally hits home for real – that the only real solution is a fundamental re-distribution of wealth and power and it’s going to be an epochal struggle to achieve, if possible at all. That Boomers, the most favored generation in all of history, just up and quit as citizens with membership and duties in a larger society is going to make it a very, very much tougher row to hoe.

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