Now it is "all Spain, all the time," just as it was all Greece, then all Italy, then all Greece again.
As a consequence of "all Spain, all the time," my recommendation of a basket of French and German banks -- Credit Agricole (CRARY.PK), Societe Generale (SCGLY.PK) and Deutsche Bank (DB) -- a few weeks ago that looked quite promising are now getting pummeled by the markets.
Should I get out of that bet and advise readers to do so as well? Or is there reason to think that what is happening in Spain likely will not bring down major French and German banks?
The first question is: What is going on in Spain? The second question is: What can fix it? The third question is: Is fixing it likely? The final question is: Do those answers suggest that the Spanish problem will have medium-term deleterious effects on the fortunes of the large French and German banks?
What Is Going On In Spain?
For as long I can remember the Spanish economy has been beset by high unemployment, particularly among the young, and relative labor market rigidity. Capital formation also has been difficult, with relatively few startup businesses. Unless these labor and investment market issues are addressed, it is hard to see how Spain can return to strong economic growth and meet its national and regional debt obligations. In addition, many of Spain's smaller banks remain weak, and apparently they have not taken the writedowns that the weak housing market would suggest must be taken. This lack of proper provisioning is apparently driving all sorts of silly transactions that are reminiscent of the Texas S&Ls that were said to be trading a dead horse for a dead cow and ascribing millions of dollars of value to each in the mid-1980s.
Not a very pretty picture. It is easy to see understand why it's "all Spain, all the time."
On April 4, 2012, Spain auctioned bonds of various maturities, and the auction was not a success. The rates were higher than expected and the amount taken up was smaller than the government had expected. The consequences for the global markets seem to have been immediate: They traded substantially lower in the U.S. as well as in Europe. That is quite extraordinary. Five years ago, hardly anyone knew that Spain or Italy issued debt regularly, much less the rates at which it was issued. Today, the interest rate on the Spanish 10-year bond goes up 20 or so basis points and the S&P 500 recedes a whole percentage point. About $3 billion of bond sales thus triggered market losses of something like $100 billion in S&P 500 companies alone. All told, stock losses in Europe and America might have been twice that in a single day! And, apparently pushed along by worries about Spain and possible contagion from that, the markets continued to go down for several days as open market prices for Spanish bonds pushed 10-year rates to the 6% area. Then on April 17, Spain conducted a more successful bond auction and markets rebounded somewhat. Obviously, there is great market sensitivity to small events.
Recent data from the Bank of Spain, Spain's central bank -- which is part of the ECB's system of central banks -- reveals that over the last two months, Spanish banks have been borrowing significantly more to support their liquidity. This means that the international credit markets are not lending to Spanish banks and, perhaps, that capital flight from Spain has increased. That capital flight is part of the problem can be derived from the government's recent restriction on cash transactions.
Liquidity problems are not serious problems as long as the lender of last resort is willing to provide funding. But as the international markets withdraw from a country or major bank, it becomes more and more difficult from an institution like the ECB to continue to supply sufficient liquidity.
There is no sensible way to suggest that, like Greece, Spain does not matter.
A Liquidity Issue Or A Solvency Issue?
Is Spain a solvency problem or a liquidity problem? In that sense, a country is much like a bank. It experiences liquidity problems because investors perceive that it has a solvency problem. Thus, since Spain clearly has a liquidity problem, we know that the investment world perceives that it has a solvency problem. Thus, unless we commentators have better information, we should not doubt that Spain has a solvency problem. But having a solvency "problem" does not necessarily mean that it cannot be solved. Although investors will stay away from a country or bank with a solvency problem because the potential losses from investment outweigh the potential gains, a country nevertheless might have the capacity to turn itself around.
We know less about how to judge a country's solvency than we do a company's. Companies have accounts that are prepared in accordance with GAAP or IAS and usually companies are audited. Countries are far more complex. Their liabilities often are not clearly known; nor is it clearly known to what extent a country can increase its tax collections without severely impacting its economy. Commentators talk blithely about benchmarks regarding the level of debt a country can sustain: 80%? 100%? 120%? Of GDP? Do we count state and local debt? Do we include underfunded pension schemes? Do we include current levels of welfare spending? Military spending? I submit that no one knows.
We also set interest rate benchmarks, like 7% -- above that level, a country cannot survive. Thus when the 6% level is reached, alarm bells go off. But if the 6% -- or even 7% -- is being paid on 5% of the country's total debt, the added cost has no significance. It is mostly a con game in which the country probably will be able to sustain its debt level if the market believes it can -- and probably cannot, if for a sustained period, the market believes it cannot.
So is Spain a solvency case or a liquidity case? I submit that there is no good answer at this time.
What Can Fix Spain?
The main Spanish problem right now is its need to continue to finance its maturing bonds and its significant deficit. The recent market action said that the market has its doubts about Spain's ability to do so. ECB President Mario Draghi addressed the market's concerns this way in his April 4 news conference. According to the Financial Times:
On that Spanish auction, Mr. Draghi says it's not so much a symptom of 'market unease' but rather 'market attention' -- i.e., that markets are expecting reforms from certain eurozone governments.
We need not buy Mr. Draghi's re-characterization in order to agree with his basic point: The markets are looking to the governments of Spain and Italy, in particular, to effect labor and business market reforms that fairly quickly bear fruit in the form of reduced unemployment and increased economic activity.
How long do the governments have to show such results? I am convinced that Mr. Draghi understands that they are going to need at least two years and that he is prepared to get them that two years so long as they are making progress. In that light, the FT reports:
A rare moment of praise from the ECB president for the eurozone's beleaguered governments. Progress in deficit countries since last autumn has been 'extraordinary,' both on the fiscal and structural side, he says.
We should take this with a grain of salt, but it indicates that Mr. Draghi feels those governments are on the right track. That means to me that he is prepared to continue to support them with liquidity -- "whatever it takes," as I have said before.
Given That The ECB Will Provide A Two-Year Window, Is It Likely That Spain Can Show Sufficient Progress In That Period To Satisfy The Capital Markets?
Fundamental reforms do not bear fruit over night. And two years is not a very long time. But natural cyclicality also is on Spain's side. Although I recognize that many commentators predict a downward spiral due to austerity measures, I am less convinced that government austerity necessarily exerts a downward pressure on an economy beyond the short term, so long as competitive markets are enabled to function. But I do not know whether they will function in Spain within such a short period of time. My best guess is that Spain will show progress but that its progress will not be so outstanding that its debt crisis is over within two years. What happens then?
My assumption is that a combination of the European Financial Stabilization Fund (EFSF) and the ECB manage to give Spain more time. It was easy to say that Greece had to suffer and that investors in Greek bonds had to suffer as well. It would be a very different thing to say anything similar about Spain. Spain is large; it has been in the EC and the euro from the beginning; the people of Spain elected a conservative government on the promise of an austerity program, on which the Rajoy government largely has delivered. By contrast, Greece entered the euro on somewhat false pretenses, the people have fought against market liberalization, and the Greek government has only enacted reforms under direct threat of funding being withheld. Greece also is, obviously, small compared with Spain. For these reasons, Draghi and his ECB, so long as it is assisted by the EFSF, will keep the rain in Spain from becoming a deluge.
Given a little more time, I think Spain will begin to turn the corner. Will its debts by then be too great? I think that is not knowable ex-ante. But that means we have to look something like four years down the road, by which time many other things will have changed. What things? I do not know.
But on the upside, for example, the price of energy could decline substantially. If that happened, it would reduce the amount that Europeans spend on energy (much of which is imported), freeing up substantial consumer spending on domestic products and services.
On the downside, for example, political unrest could undermine the government's attempts to restructure the economy.
I do not have the answer to what will happen in Spain. But we should not underestimate the commitment of the "European Elite".
Impact On European Banks
Let us focus back on the French and German banks to see what things might influence their financial position three or four years down the road.
I spent some time this week with Credit Agricole's 2011 year-end financial statements -- an annual report of close to 500 pages. Frankly, the business is too complex for me to pretend to understand its details. There may be terrible stuff in the details or there may be great opportunities lurking. I will not try to parse all that. I am concerned with whether the bank has a profitable core, whether its problems are likely to render that profitable core worthless, and what would be the benefits of a return to profitability.
I think I can see an answer to the last question. By my computation, the stock is trading (as of April 13) at about 0.26% of tangible book value; that is about 8.45 billion euros of market cap vs. about 32 billion euros of tangible common equity. That means that if the company could return to moderate profitability sufficient for it to earn a market rate of return, its stock should triple. If it did that in, say, a three-year span, that would be a return for which it would be worth taking some risk. Looking backward, the stock traded at almost that level within the last year.
Is it likely that Credit Agricole will return to profitability? And how is that question related to Spain?
Credit Agricole does not have enormous direct exposure to Spain. It owns part of a Spanish bank, but the investment is not very large. But if everything in the European banking system is related to Spain through the mechanism of the Spanish central bank and the ECB, then contagion of some sort seems possible, perhaps even likely. And Credit Agricole does have substantial exposure to French government bonds, and any contagion from Spain or Italy could substantially affect the value of those bonds.
On the other hand, Credit Agricole remains a very strong French consumer bank. Although its management has, over the last 15 years or so, made almost every fashionable mistake for a large bank to make -- from venturing into markets it did not understand, to building up a still-weak investment banking group, to buying American CDOs backed by subprime loans, etc. -- the heart of the bank remains a very strong and potentially very profitable branch system (owned by the regional banks that, circularly, control Credit Agricole SA). That system has over 700 billion euros of fairly stable deposits and access to small businesses all over France. The banking and insurance group's total, global liabilities are about 1700 billion euros, so the core is less than half the group's funding. But it is substantial enough to form the basis for future profitability, if management can focus and pull back from its less successful ventures, as it seems to be doing under pressure from the new European capital requirements.
The bank took a substantial charge against 2011 earnings in connection with getting out of some businesses and restructuring others. In theory, a business should take the full amount of the charge in order to put that sort of event behind it -- big bath accounting, as it sometimes is called. Did Credit Agricole do that? I have my doubts. I would bet that there is more to come. But so long as that "more to come" is accompanied by reductions in the overall balance sheet, as it must be to meet capital percentage targets, then another few billion euros of restructuring charges will not kill the bank.
My biggest concern about Credit Agricole is that its capital in relation to its total assets is so low -- slightly under 2%. Although European capital requirements do not include such a gearing ratio, I believe that capital markets do look at that ratio. If I am correct, Credit Agricole will have a hard time returning to the capital markets for substantial funding for some time. That likely will force it to continue to shrink, with continuing charges against earnings. Thus, it likely will take a couple of years for it to shrink back toward its profitable core.
But I do not think the troubles in Spain and Italy are going to cause Credit Agricole to fail. Therefore, I am not selling my modest bet on its fortunes. Of course, like any other investment, diligence is constantly necessary. And diligence might well lead to increasing the size of the investment at some point. I will confess that I did buy a few more shares last week.