By Pater Tenebrarum
A Curious Collapse
Ever since the ECB has begun to implement its assorted money printing programs in recent years - lately culminating in an outright QE program involving government bonds, agency bonds, ABS and covered bonds - bank reserves and the euro area money supply have soared. Bank reserves deposited with the central bank can be seen as equivalent to the cash assets of banks. The greater the proportion of such reserves (plus vault cash) relative to their outstanding deposit liabilities, the more of the outstanding deposit money is, in fact, represented by "covered" money substitutes as opposed to fiduciary media.
Euro area true money supply (excl. deposits held by non-residents) - the action since 2007-2008 largely reflects the ECB's money printing efforts, as private banks have barely expanded credit on a euro area-wide basis since then.
Many funny tricks have been employed to keep euro area banks and governments afloat during the sovereign debt crisis. Essentially, these consisted of a version of WorldCom propping up Enron, with the central bank's printing press as a go-between.
As an example, here is how Italian banks and the Italian government are helping each other in pretending that they are more solvent than they really are: the banks buy government properties (everything from office buildings to military barracks) from the government and pay for them with government bonds. The government then leases the buildings back from the banks, and the banks turn the properties into asset-backed securities. The Italian government then slaps a "guarantee" on these securities, which makes them eligible for repo with the ECB. The banks then repo these ABS with the ECB and take the proceeds to buy more Italian government bonds - and back to step one. Simply put, this is a Ponzi scheme of gargantuan proportions.
Still, in view of these concerted efforts to reliquefy the banking system, one would expect that European banks should be at least temporarily solvent, more or less. Since they have barely expanded credit to the private sector, preferring instead to invest in government bonds, the markets should, in theory, have little to worry about.
Euro area bank loans to non-financial corporations, with annual growth rate (blue line).
In fact, on account of new capital regulations, European banks are almost forced to amass government securities - as government bonds have been declared to represent "risk-free" assets, which reveals an astounding degree of chutzpah on the part of European authorities in the wake of the sovereign debt crisis.
This makes one wonder why the Euro Stoxx Bank Index suddenly looks like this:
The Euro Stoxx bank index has been in free fall since July.
Clearly, something is rotten here - but what?
Bail-Ins, Dud Loans, Insolvent Zombies and Hidden Risks
Back in September last year, with the bank index still close to its highs of the year, we referred to European banks as "Insolvent Zombies". This may have sounded a bit uncharitable at the time, but it is beginning to look like an ever more accurate description by the day. In December, we reminded readers that European banks are still sitting on €1 trillion in non-performing dud loans (see "Still Drowning in Bad Loans" for details).
In January, we finally got around to writing about the new European "bail-in" regulations, noting that these were bound to bring about unintended consequences. We pointed out that while there is absolutely nothing wrong with exposing bank creditors to risk and sparing taxpayers from involuntarily shouldering the same, such an approach would, over time, likely prove completely incompatible with a fractionally reserved banking system - especially one as highly leveraged and teetering on the brink as that in a number of European countries.
We moreover pointed out that some governments have begun to apply the new regulations in rather arbitrary fashion - for instance, as a means to escape guarantees they themselves have extended to creditors. Two bank collapses in Portugal and the still-festering Heta (formerly HAA) wind-down in Austria served as recent examples.
This seems indeed to be on the minds of investors, who have begun to sell convertible and subordinated bank bonds left and right. And in concert with the decline in bonds and stocks, risk measures like CDS spreads on senior bank debt have begun to surge. Below are several charts we have taken from a recent article by Peter Tchir, who has commented on the situation at Forbes.
I-Traxx senior financials CDS index - this index tracks CDS spreads on the senior debt of 30 major financial institutions.
Deutsche Bank CoCos: these convertible bonds have special features that allow for "automatic" conversions and the suspension of coupon payments, making them eligible as Tier 1 capital under Basel 3. Investors have liked this instruments - until they suddenly stopped liking them.
Mr. Tchir agrees that the arbitrary manner in which bail-ins have been pursued - especially the overnight bail-in of senior creditors of BES by the Portuguese government's decision to reassign five different bonds from the "good bank" to the "bad bank" ad hoc - must have contributed to investors getting cold feet.
However, he also argues that Mr. Draghi can surely be relied upon to keep Europe's zombie banks in a state of suspended animation, and that the surge in CDS spreads is so far not much to worry about, at least if compared to where they went in the last crisis period - as the long-term chart below shows:
5-year CDS spreads on senior bank debt, long term: Deutsche Bank (yellow line), Mediobanca (green line), Credit Suisse (orange line) and Societe Generale (blue line).
We would, however, note that this is precisely how it started last time around as well. The fact that CDS spreads have not yet moved even higher doesn't seem a good reason not to be concerned. As far as Mr. Draghi's abilities to keep the zombies staggering about are concerned, point taken - they are certainly formidable, as demonstrated by the Italian snow-job we have described above.
However, the ECB can certainly not jump in and "rescue" individual institutions that are in trouble - it can merely hope to keep up confidence in the debt-laden system as a whole. Banks that are beneath its notice due to not being regarded as "systemically relevant" are out of luck in any case - they are prime bail-in material, as Italian bank creditors have just found out to their chagrin.
Many of said creditors in Italy were small savers who were talked into buying subordinated bank bonds by their own house banks (the same thing has previously happened in Spain as well). Why have their banks talked them into taking such risks? The new bank regulations are, in fact, the main reason! European regulators have wittingly or unwittingly promoted the transfer of bank risk to widows and orphans - literally.
Italy's negative TARGET-2 balances have begun to deteriorate sharply again, likely indicating growing capital flight.
We confess, we are a bit more worried than Mr. Tchir seems to be at the current juncture. After all, we regard the euro area crisis as being in suspended animation as well, in a sense. The essential problems haven't been resolved, they have merely been papered over - with truly staggering amounts of paper and promises. In the course of this, giant contingent liabilities have piled up on the balance sheets of euro area governments, several of which are guaranteeing the debt of others, while being the subjects of debt guarantees at the same time, due to their de facto insolvency.
However, this is not the only thing that worries us. Apart from the astonishing €1 trillion in dud loans that remain on European bank balance sheets in spite of serial bail-outs and the erection of numerous "bad bank" structures into which such loans are "disappeared" so as not to mar the statistics any longer, one must keep in mind that economic confidence has been crumbling for almost two years:
The huge increase in the ratio of gold to commodities, which has begun to rise concurrently with the beginning of the sharp rise in junk bond yields, is a sign that economic confidence is crumbling.
Prior to the last crisis, European banks were known to be among the largest financiers of commodity traders and Asian emerging market companies. We have a strong suspicion that this hasn't magically changed in recent years, especially as the EM and commodity universe seemed to be fine again for several years once Mr. Bernanke started up his printing press and China pumped up its money and credit supply like a drunken sailor in the wake of the 2008 crisis.
Well, they are no longer fine. In fact, the debt of commodity producers and emerging market companies has been plunging to distressed levels at warp speed since the middle of last year. This is likely to get worse if China is forced to "let the yuan go" (just to be safe, put down your coffee before clicking on the link).
Then, there is the fact that banks perforce remain exposed to what occurs in the financial markets. Their proprietary portfolios have shrunk, but that doesn't mean they don't remain intertwined with the markets through all sorts of funding channels, including numerous opaque ones in the shadow banking system. The problem with this is that confidence is very fragile, and credit stress often emerges from entirely unexpected places (as, for e.g., happened in 2008).
It is possible that we are worrying too much - after all, both European and US banks have certainly taken a lot of action to shore up their capital. However, it seems to us that the next wave of economic troubles is already washing ashore before they had a chance to fully recover from the last crisis. Obviously, not all banks are affected by this to the same extent, but the banking system is deeply interconnected, so even institutions that appear relatively insulated from the currently brewing set of problems may actually suffer damage if things get out of hand.
All signs are that things are, in fact, in danger of getting out of hand, even if it seems to us as though it is time for at least a brief pause in the mini panic in risk assets we have observed in recent weeks. This is just a reminder that oil prices and the yuan are not the only things on the minds of market participants at the moment. As is seemingly always the case, when it rains, it pours.
Charts by: ECB, BigCharts, Peter Tchir / Bloomberg, StockCharts