Whenever we talk about rescuing overleveraged Europe, it is always about Spain, Italy, Portugal, Ireland, and Greece - the European periphery loaded with debt that they cannot possibly repay.
But a closer look at the recent IMF data reveals that German and French banks need rescue more than anybody (Global Financial Stability Report, IMF October 2012 table 2.1).
The German and French banks' leverage is in excess of 40 to 1, i.e. for every 40 dollars or so of tangible assets, they hold only one dollar of tangible equity as the graph shows:
Even a small loss can wipe out all equity of these highly geared banks.
Such high leverage was evident only at some of the most troubled US banks during the Global Financial Crisis. The US banks have now reduced their leverage to more reasonable 14 times. Portuguese, Spanish and Italian banks' leverages hover around 20 times, while Ireland's is at low 12 times - well below that of Germany and France.
Yet, the most leveraged and vulnerable German banks are being perceived as a safe-haven and attract deposits from the peripheral Europe. This erodes the peripheral banks' capital base, raises interest rates in the weaker countries and, at the same time, helps German economy by lowering local interest rates and by an expansion of German banking system's Tier 1 capital base.
The German and French banks geared up during the decade of low interest rates for the whole Eurozone. They advanced cheap euro-loans at low German rates to the periphery's non-financial firms and to some extent to their Governments. The periphery's financial institutions remained conservatively geared and household debt levels ended up not much different from the rest of the world as the IMF table shows:
Source: IMF October 2012
The German economy is perceived as the strongest European pillar with capacity to underwrite the periphery rescue. In return, Merkel demands more austerity and submission to fiscal controls. IMF adds pressure with calls for European banking union, centralized banks tighter regulation and supervision, safety nets, adequate pan-euro area backstops for deposit insurance and bank resolution, and a bank resolution mechanism. Without these, argues IMF, the cost of banks' capital will still be linked to their home country, while a sovereign's creditworthiness will remain tied to that of its banks.
Eurozone countries gave up the rights to print their own money and are at the mercy of the European Central Bank. ECB was neither ready nor legally equipped to deal with the crisis. Only now, after three years of bureaucratic and political maneuvers under pressure from panicking markets, a more coherent Eurozone rescue plan is being formulated.
The ECB/EU/IMF/Fed patch-up rescues for Europe over the last three years were buying time and foremost saving the German and French private banks. The IMF chart below illustrates the story: ECB and various European rescue vehicles shifted the ownership of the risky debt from German and French private banks to public sector, ensuring banks' survival under their current ownership structure. Some speculate the broader public ownership makes the debt easier to write off:
Source: IMF October 2012
The recent pledge by Mario Draghi, the ECB President, to do "whatever it takes" to save the euro and the announcement of the OMT program (Outright Monetary Transactions), which involves purchase of one- to three-year maturities in secondary sovereign bond markets, ensure that the process of private banks deleveraging will continue.
IMF expects that European banks will deleverage between $2.3 to $4.4 trillion or between 6% and 12% of bank assets in a period from Q3, 2011 to Q4, 2013. This is a significant macroeconomic force that will impact global markets in a number of ways. Some of the sold assets will find new owners, some sovereign debt will end on the ECB's balance sheet and run to maturity out of the market's sight and investors' minds, and the newly created money will be injected to the banking system despite sterilizing attempts.
In the process, German and French core banks will gradually reduce their leverage, rebuild their balance sheets, perhaps acquire some of the weaker peripheral banks and get ready for new consumer and business credit formation. By that time, hopefully, businesses and individuals will deleverage themselves sufficiently to take on new loans. The gradual positive improvement for investors is likely to take some time with many hick-ups on the way.
European banks deleveraging may create investment opportunities
First, one can with a higher degree of probability assume that the European core banks will not only survive, but eventually prosper with continuing ECB support. This means European bank shares and debt may represent good value when bought on dips at times of political uncertainty and distress.
The markets received the recent ECB announcements well. Both European Financial Sector's shares (represented by an ETF: EUFN) and European Debt (EU) rose sharply outperforming the S&P 500 index - see chart below:
^GSPC = S&P 500 (shaded area)
EUFN = European Financial Shares ETF
EU = European Debt ETF
Source: cpgli.com, Yahoo Finance
Second, banks that will receive the newly created ECB cash will look for higher yield and anti-inflationary assets. Corporate debt, takeovers finance, commodities, energy, oil, emerging markets, perhaps some gold were typical trading targets in the past in such circumstance.
Third, banks will eventually ease the constraints on housing loans and consumer credit that would add to economic growth.
The global economy should continue to recover and over time prosper in this scenario albeit we should not expect a smooth ride. Destabilization of the Middle East, for example, could easily spoil the game for "risk on" global macro investors.