Every Eurozone Bank (And Nation) For Itself

by: Adam Whitehead


Mario Draghi is preparing markets to accept that something from the ECB in March is better than nothing under the circumstances.

Developed nation central banks intensify the war on cash.

The war on cash is symbolic of the war on individual freedoms being waged in parallel.

The EU is capitulating to populism.

The Eurozone banking sector is discounting the fall in oil prices and the move into negative interest rates.

The last report suggested that Mario Draghi had overdone it by raising expectations for an expansion of QE in March. Evidently Draghi also thought so and began to cover his tracks with positive obfuscation. This obfuscation is highlighted by his comments below:

"What matters is that central banks act within their mandates to fulfill their mandates,"

"Challenges can be mitigated. They do not justify inaction."

"There are forces in the global economy today that are conspiring to hold inflation down,"

"Those forces might cause inflation to return more slowly to our objective. But there is no reason why they should lead to a permanently lower inflation rate."

His obfuscation implies that he is willing to accept that deflation in the Eurozone is not becoming entrenched. For conceding this point he does however reserve the right to do something which is seen as dealing with the temporary dip in inflation in order to uphold his mandate. Something is coming in March, but perhaps not a massive expansion of QE. The problem for Draghi, is that the something must be significant in size so as not to underwhelm, yet not so massive as to cause market panic by signaling that he is panicking. His positive obfuscation must therefore be interpreted as an attempt to frame market perceptions that anything is better than nothing.

It should also be noted that Draghi chose to temper his enthusiasm in a speech in Frankfurt. Given the German resistance to expanding QE, he decided that discretion was the better part of valour. In future if he speaks to a more QE-receptive audience, it will be interesting to see if the enthusiasm and hyperbole returns to his rhetoric. Should this be the case, then the probability of the expansion of QE by some larger degree in March will rise.

The European Commission (EC) is one such QE-receptive audience. It provided the libretto and stage, for Draghi to perform a future tour de force, with its latest economic forecasts. Inflation expectations were slashed in half from the previous November 2015 forecast and growth estimates were trimmed slightly. The current inflation projection is 0.5% which compares with the ECB's target of 2%.The culprits for these downward revisions were the emerging markets and falling oil prices.

With the benefit of hindsight, one can imagine that the timing of Draghi's soliloquy to the Germans and the EC's economic forecast were something more than coincidence. Given that Draghi recently made noises, about the loss of credibility for failing to hit his inflation target, the atmosphere of a fait accompli is heightened. He may also have viewed the upcoming Franco-German summit as an audience for his rhetoric.

Leading up to this summit, both the heads of the Bundesbank and Bank of France opined that the Eurozone is at a crossroads. They also suggested that, for it to head down the road that leads to continued existence, deeper financial integration from a joint Eurozone Finance Ministry would be helpful. They were unfortunately less forthcoming on whether this finance ministry should pursue German or French doctrine towards fiscal austerity, which undermined the whole basis of their positive joint statement.

Going into the Summit, both Merkel and Hollande are flagging politically at home. Merkel has no outright challengers yet, but they will materialize if she fails to take on board German anti-immigration sentiment fully in her new policies. Hollande would now poll in third place behind Marine Le Pen, if the latest opinion polls are anything to go by. Interestingly Sarkozy does not do well either, and would be beaten by former Prime Minister Juppe if he ran. There is therefore a leadership vacuum developing at the Franco-German heart of the European project. If the heart stops beating, the rest of the body will die. President Hollande is going to administer some surgery to his own valves with a cabinet reshuffle, in the hope that this will keep his political heart alive and ticking.

A major issue to be discussed at the Franco-German summit is what has been termed the "hollow alliance" aka NATO. In the previous report entitled 'Nudge Theory: The "Paneuropa" Project And The Diverging "Hollow Alliance"' the divergence of Europe and America was discussed. Europe, with the nudging of France and Germany, is drifting away from America towards a Eurocentric political arrangement with Russia. President Putin has cleverly exploited the waves of Syrian refugees heading towards the Eurozone out of range of Russian bombers. Retiring French foreign minister Laurent Fabius began the finger pointing for the failure of the "hollow alliance", with a parting cheap-shot which blamed President Obama's fear of military entanglement in the Middle East for causing allied Russian and Iranian support for Assad's war crimes.

The response from the Pentagon has been swift and unequivocal. Defence Secretary Carter recently announced that the budget for Europe in light of "Russian aggression" has been quadrupled; whereas that for the fight against ISIS has risen by fifty percent. The Cold War is back on and the Europeans are pawns in the game once again. The current Eurozone debt crisis is therefore a strategic national security threat to the United States. The Eurozone nations will be made aware of this situation in no uncertain terms, as they drift back into the kind of populism that has prompted American interventions of the past. This populism looks set to be floated in on the waves of easy money that have washed away social cohesion in the past by allegedly attempting to wash away the burdens of debt to foreign nations.

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Public opinion is now being framed to expect the latest policy tool from the ECB in relation to the currency in circulation. The ECB is widely expected to scrap the five hundred Euro note. This will allegedly deal a blow to organised crime, whilst simultaneously stimulating consumption. According to the spin doctors in Brussels, negative interest rates will cause a liquidity preference for cash by consumers. If said consumers keep this cash under the bed, because inflation is expected to fall, then there will be a depression. Apparently, since they won't be able to stash five hundred Euro notes under the bed, they will instead spend the masses of smaller bills which don't fit under the bed to stimulate the Eurozone economy. It is an interesting hypothesis, but it shows just how desperate and dangerous things are.

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Britain has however really thought it through, even though it does not as yet have negative interest rates. Britain intends to abolish cash, although it is only at the "thought experiment" stage at the moment according to the Governor of the Bank of England. If there is no cash, then the manifestation of liquidity preference with Pound notes under the bed has been systematically avoided. When negative interest rates are eventually applied, this means that there will be no run on the banks; and that depositors have no choice other than to have their wealth stolen.

The advent of "thought experiments" about the end of cash, combined with the emergence of government by committee, should be understood as signaling that advance preparations are already underway to address the problems that central banks and policy makers have created. The advent of "useful idiots", on this occasion in the form of refugees, is also a tactic commonly employed to frame public opinion to accept the loss of economic and political freedoms. Fortunately for Americans, the Constitution may preclude this form of stealing.

In Austria, a nation that prides itself on its constitutional authority to protect the freedom and privacy of the individual, there is a growing sense of unease at the inevitable road to serfdom if it remains within the EU. Deputy Economy Minister Harald Mahrer encapsulated this resistance when he recently commented that "we don't want someone to be able to track digitally what we buy, eat and drink, what books we read and what movies we watch".

Slovenian ECB Governing Council Member Bostjan Jazbec was far more rationale in his interpretation of what the ECB will do in March. In his opinion, if the data supports an expansion of QE this will be done. He was however also swift to emphasize that there are numerous other tools available besides bond buying. He also alluded to the need for elected policy makers to enact pro-growth policies. His analysis suggests that there is strong commitment to discuss all available options in the context of the economic data at the time.

(Source: Bloomberg)

The size of the risk building up for Draghi and the Eurozone, through the faith that he has engendered in the Eurozone sovereign debt market is epitomized by Spain. Draghi's "do whatever it takes" rhetoric has driven foreign participation in Spanish debt back to levels previously seen post Credit Crunch in 2010. In the absence of proportionate expansion of QE in the future and with the advent of negative yields, Spanish debt is facing a serious valuation call. Expectations and valuations are running way ahead of Draghi's actions, so a day or reckoning is coming potentially at the next ECB meeting in March. This valuation call becomes even more apposite if one considers the unfolding political situation in Spain.

Spanish politics has shifted back towards anti-austerity populism, which vitiates against the value and foreign participation in the sovereign debt market. Spain's recent shift towards left-wing populism has also seen a shift towards dirty tricks in relation to the country's relationship with the European Union. A recent story alleges that former Latvian Prime Minister Valdis Dombrovskis was paid a bribe to support Catalan independence. The fact that Dombrovskis has been European Commissioner for the Euro and Social Dialogue since November, gives the revelations an extra twist.

(Source: Bloomberg)

The side-deal being concocted between the EU and Britain to avoid the Brexit also has unintended consequences for the Spanish. Seeing flexibility as weakness the Catalans now see an opportunity to claim more "sovereignty" from Spain, whilst getting the benefits of remaining with the Eurozone. EU political leaders looked on in horror at the exceptional status awarded to Britain; not because they are jealous but because it opens the door to further populism. EU President Martin Schulz commented that political leaders now feel that "if Brits want to leave, let them leave".

The reaction from other European regulators and policy makers, with the exception of the UK, Catalonia and Italy was similarly negative. For some this double-standard on regulation was symbolic of a further destruction of the Eurozone itself. Soon, every nation will want its own unique deal like the British. As a result, EU leaders are now trying to stall the process of giving Britain selective membership terms. In consequence, the Brexit is back on and other EU nations are chancing their arms at trying to renegotiate their own EU membership terms and conditions.

(Source: The Daily Shot)

Italians are famous for their strategic mass surrenders, so it was therefore no surprise to see Italian Prime Minister Renzi opining in favour of the EU-UK compromise deal. This deal now sets a precedent for Italy (and any other Eurozone debt transgressor) to wriggle out of its economic commitments to the EU. Going from the sublime to the ridiculous, Renzi advocates that other Eurozone nations actually follow the example shown by Italy. Evidently each nation should abandon all fiscal deficit targets and then renegotiate its relationship with the EU. Renzi is actually advocating gaming the EU political and economic system. If every nation games it however, it will cease to exist other than in name. Cynics might say that this is all that it has been doing so far. They would therefore miss the point that Germany and a handful of other nations are no longer willing to finance this gaming with their own taxpayers' money.

Just in case the deal does not go through however and Britain leaves, Finance Minister Padoan has a positive story for Italian debt investors. According to his calculations, this year economic growth in Italy will make Italian debt look attractive to foreign investors. So far they have not been tempted. Perhaps they are worried by his additional pronouncement that a rise in inflation will reduce the real debt burden on the nation. Or perhaps they are just tracking the rising trend in Italian non-performing loans.

Padoan is now doing his part for the private placement memorandums in the upcoming attempts by Italian banks to sell their non-performing loans. The EU basically capitulated, in the face of a sliding equity market, by opining that the purchase of a state guarantee for the least risky tranche of the non-performing loans is not state aid. Italian banks now have the green light to try and get rid of the remainder of the bad debts on their books.

What the EU seems to have overlooked is that the sale of this bad debt will force the banks to realise losses that they have hitherto hidden away off balance sheet. Until the size of this iceberg lurking off balance sheet can be confidently quantified, the whole exercise of working through the bad debts looks fraught with danger.

The EU's waving of the white flag to Italy, also signals that Eurozone nations effectively have carte blanche to come up with creative ways of supporting their banks, with state aid that is not called state aid by the EU. Just because the EU does not call it state aid however means nothing. The fact is that taxpayers are on the hook for their banks.

Jean-Claude Juncker would love to extend this taxpayer liability to the richer nations in the Eurozone through mutualisation. The stealth move towards mutualisation is unlikely to fool the richer Eurozone nations. It is therefore likely that they will sit out the current bailout phase to see just how much national taxpayers are at risk for to their banks. The Eurozone bank bailout process is now beginning. During this phase, Mario Draghi is likely to demand an expansion of QE in order enable the bailout process. He is also likely to demand mutualisation of Eurozone debt. Germany on the other hand is likely to reject his demand for mutualisation. In light of the travails of its own banks however, Germany is likely to accept further QE.

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The real acme of political skill has however been shown by the Italian dynastic family companies, for whom the politicians and ministers have always been puppets.

(Source: Bloomberg)

These dynasties have survived the perversity and adversity of Italian politics and economics over the decades, so they should know a thing or two. Seeing a Eurozone in fragmentation they took their chips off the table and sold their businesses to the kinds of buyer who believed that Mario Draghi was going to single-handedly save the Euro and Eurozone with QE. To get a premium, these dynasties even engineered the support of Prime Minister Renzi and his economic reforms. Their decision to sell out stands in contrast to an economy which is now allegedly reforming its way to growth. Why did they sell if things are going to get better? They are now long cash and can buy back the companies (perhaps even in Lira!) when the Eurozone unwinds. One is reminded of the same insider arbitrage played by the Greek dynastic families who are now waiting offshore for fire-sales onshore in the old country.

(Source: The Daily Shot)

In a signal that the EU is caving in to the populist threat, Portugal's budget was given its approval in return for some token spending cuts. The approval process had been deadlocked for several months, until the recent quantum slippage towards populism stimulated a compromise by the EU. This new deal had the impact of widening Portugal's sovereign yield spread, since the government has been let off the borrowing hook. In reality then, Portugal is not off the hook since it will now have to pay more interest to borrow. This will then logically open Portugal up to a credit downgrade which will blow the spread even wider etc. etc. etc. The price for the political accommodation is higher borrowing costs to be borne by the Portuguese taxpayer.

Portugal illustrates that from this point in time Mario Draghi's tractor beam only collapses spreads of sovereigns that can control their borrowing. It also illustrates the idea that a mutualization of Eurozone debt and bank deposits is no longer discounted by Mr Market.

Next up on the re-negotiation of terms in relation to its fiscal problems is Spain. In May the European Commission will issue a statement on its opinion of Spain's breach of its deficit target goals. Judging by the latitude awarded to Portugal and Italy and Britain Spain will get off lightly.

(Source: Bloomberg)

The latest shoe to drop in the demise of the Eurozone banking sector comes from the falling oil price. Analysts and rating agencies are now trying to put a value on the exposure of the Eurozone banking sector to the energy sector. As a consequence, the alleged consumer tailwind from low oil prices is meeting an equal and opposite headwind from the banking sector. Bank of America estimates the losses as equivalent to 6% of pretax profits over the next three years. It is ironic to think that the QE which caused the bubble in oil prices, followed by the bubble in energy lending, is now undermining the banking system.

(Source: Bloomberg)

As the transmission process of falling income and then falling share prices feeds through to lending, the credit creation process will slowdown. Analysts at RBS estimate that there is a 12 month lag between the collapse of share prices feeding through to weaker credit creation. The fall in banks shares is therefore signaling recession like lending conditions in 2017.

(Source: Bloomberg)

The collapse in Eurozone bank shares now mirrors the collapse in the oil price with a time lag effect. Investors who have rotated out of the energy sector into the financials, with the view that low oil prices would cause the ECB to ease, have walked into a trap. It is not just about the losses on oil based lending though.

Mario Draghi's permanent flirtation with negative interest rates has some seriously negative implications for lending margins and also the ability of banks to fund themselves with deposits. The ECB (like the BOJ) however assumes that bank profitability is of secondary importance to the 2% inflation target. The ECB seems destined to press on with this attack on the banking sector. Falling bank share prices therefore reflect this fear of the inevitable from the ECB.

(Source: The Daily Shot)

Bank contingent capital bonds (co-co bonds), which allow the banks to skip interest payments and convert the bonds into common equity, had been the best performing asset class in 2015. In 2016, they are now the worst. The fear that the banks will skip payments and convert these bonds into equity has destroyed their prices. The fact that the European Banking Authority (EBA) has been crusading to have the exact conditions of the contingency triggers clearly communicated, by the banks and their regulators, has also heightened the tension. Nothing however prompts disclosure as well as the dramatic fall in stock price. Deutsche was the first European institution which was forced to disclose that it will still be making interest payments on its co-co bonds, after the slide in its share price forced the disclosure.

Deutsche Bank is now an embarrassing example of how national banking agendas vitiate against the unified European approach to banking and disclosure. In order to dig itself out of trouble, Deutsche is now in camera with the German banking regulator and the Bundesbank, discussing how it can arbitrage the legal rules and market prices to its advantage. Finance Minister Schaeuble was happy to perjure himself by agreeing with CEO John Cryan that the bank is solid because both gentlemen understand how this façade will be erected.

The bank has struck a deal with its regulators, on how much capital it needs to show to its shareholders and counterparties so that it will be able to reduce its debt liabilities whilst appearing to meet liquidity and solvency rules. Deeply discounted debt securities can then be bought back to improve the capital adequacy picture. Its share price can then rally, and it will presumably then issue shares (to German institutional buyers) at the higher price in order to cover its true capital adequacy requirements.

German obligations to the wider Eurozone are of secondary importance when the nation's banks come calling on national solidarity. After considering how to buy back some of its heavily discounted bonds in the market, without signaling its true intentions and capabilities, the buying began with a modest purchase of its senior unsecured debt. The capital adequacy rule arbitrage trade is now in process at the bank.

This flagrant gaming of the opaque rules on capital adequacy and disclosure, therefore makes all other German attempts to reform the European banking system and its economy look like hypocrisy. It also gives the green light to all other Eurozone nations to bend the rules. Germany is therefore as guilty as any other nation of nudging the Eurozone project into further degeneration. The Brits already got away with it!

The last report observed the manoeuvres, by the commercial banks and their regulators, to avoid disclosure on their mutual arrangements in relation to the raising of risk capital and contingent restrictions to be placed on shareholder distributions. It was observed that the European Commission and the ECB had aligned interest in mutualizing the deposit and sovereign debt risk created by states guaranteeing their banks. The ECB was specifically at risk of capital loss from a negative liquidity event in the banking and sovereign debt sectors.

European Economics Commissioner Pierre Moscovici tried to assuage market fears by opining that "we can see that the European banking system is much more solid than in the past, we have to have confidence in it". He was obviously not including Mr Market in the "we". In fact his "we" seems to specifically refer to those with a vested interest in ignoring Mr Market's advice.

To highlight just how risky the situation is and how averse to clarity of disclosure the ECB is, Governing Council member Klaas Knot tried to frame market expectations about capital adequacy requirements. According to his timeline, there will be no specific communication on individual bank capital adequacy requirements until 2019. The Eurozone banking crisis can therefore drag on for another three years, if the ECB has its way. There may not even be a Eurozone by then!

Knot then had the temerity to say that he sees no lingering capital problems and also sees moderate credit growth that will evolve further over time as a consequence of QE. He has obviously not taken on board what Mario Draghi has been saying about the need for central bankers to retain their credibility.

In a related discussion of the Japanese banking sector, entitled "The BOJ Contributes To the Global Banking Crisis", it was explained how negative interest rates and QE have undermined the Japanese banks. Banks have been crowded out of less risky assets into riskier assets, with no appropriate yield protection, by central bank buying of financial assets and zero interest rate policy. The central banks have therefore created the systemic risk in the banking sector themselves. Since they are already buyers of first resort through QE, they cannot also be buyers of last resort when the crisis occurs because they already own everything. The limits of QE and negative interest rates have apparently been presented by the banking sector.

One would normally assume that rational central banks would give up the ghost on QE and revert to normal central banking behaviour. Their credibility in addition to the size of their balance sheets and potential capital losses however precludes them from rationality. They will therefore actually try and expand QE rather than scale it back going forward.

Sensing that Mario Draghi is nudging the ECB towards another round of QE expansion, the Bank for International Settlements (NASDAQ:BIS) felt the need to issue a warning. This warning should also be put into the context of the upcoming hearing by the German Constitutional Court on the legality of QE. BIS general manager Jaime Caruana warned that central banks should not feel responsible to do more QE in the face of the current global economic slowdown.

He then issued a specific warning for the Eurozone banking sector at a Eurozone Banking Authority (EBA) conference, which confirmed that the BIS also sees the banking crisis morphing into a sovereign debt crisis. In his opinion, there is too much national discretion in relation to the interpretation of Eurozone banking rules. It should be remembered from the last report that the EBA is very militantly pursuing the Eurozone commercial banks, for a clearer disclosure of the cosy relationship between national regulators and their banks about the contingencies for regulatory capital raising. The EBA and the BIS are clearly on a mission.

The various aligned initiative by the BIS, EBA and German Constitutional Court should be viewed as challenges and obstacles to Mario Draghi's desire to expand QE, in the face of a banking crisis that is morphing into a sovereign debt crisis. They should also be viewed as obstacles and challenges to Jean-Claude Juncker's desire to mutualize sovereign debt and bank deposit insurance.

To scale the obstacles being erected to QE, the ECB recently released its document entitled the Agreement on Net Financial Assets (ANFA). This document reports in details the holdings of the Eurozone central banks. This agreement was signed at the inception of the Euro, in order to safeguard against the potential for national central banks and the ECB to monetize sovereign debt. Since the Germans have started to plaintively level the criticism that QE illegally monetizes sovereign debt, the ECB has been prompted to release its evidence for the defence. According to the newly released document, the ECB and national central banks hold $547 billion in assets.

(Source: Bloomberg)

The latest Eurozone inflation expectations data may however be all that Draghi needs and the market requires for an expansion of QE in March. Jens Weidmann did his best to head this off by opining that inflation will return, but just a bit later than initially thought. His response only serves to highlight the fact that Draghi will now be emboldened to act in March. The way that his French opposite number Monsieur Villeroy de Galhau opined that "the war on deflation" has not been won yet is seemingly just the war cry that Draghi wishes to hear. The language used by Greek ECB Governing Council member Yannis Stournaras was more revealing. According to him "Mr Draghi enjoys strong support, I would say almost unanimous, in the Governing Council". Almost! Who can he mean? "Almost" should be enough for Draghi though.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.