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How to Stop the Domino Effect and Related Serial Bailouts in Europe

 Is 100 Billion Euros Enough to Solve the Irish Crisis? Part II

 
The Wall Street Journal noted today that "the Bazooka Theory of financial rescue does not work as advertised."  This comes as no surprise to readers of this blog. 

As previously discussed, in the absence of information there is no logical stopping point in the valuation of problem assets other than zero. 

Why?  Investors need the performance data on the problem assets if they are going to have anything to independently analyze, value and make informed investment decisions based on.  Without the performance data, investors can only guess. 

As of a couple of weeks ago, the Irish government was using an independent third party to look at the performance of all the loans on the balance sheets of Irish banks, identify problem loans and value these loans so they could be purchased by a "bad" bank run by the Irish government.  Despite repeated rounds of purchasing bad loans at increasing discounts, the Irish government said that it did not need a bailout.  This position served to anchor investor estimates of the losses on the bad loans.

The discussion of an 85 billion euro bailout destroys the credibility of the valuation of these loans and casts the investors adrift to come up with a new method for estimating the losses on the bad loans.

Naturally, investors gravitate to the only verifiable information they have, assume the worse and adopt a show me posture.

The original book value of the loans in the Irish banking system exceeds 300 billion euros.  In the absence of loan level information, this is a conservative estimate of the potential size of the hole in the Irish banking system.  Presumably, the loans are worth something, but now the burden is on the government and the banks to show why this estimate of the losses is not accurate.

Unfortunately, the problem with this conservative estimate is the implications for contagion throughout the European Union and the global financial system. 

What does this say about the value of the loans on other European banks who syndicated loans with the Irish banks?  What does this say about the value of any direct exposures the European banks have to the Irish banks?

Now that investors are focused on other European banks, another issue emerges.  Investors already have one example of a country that apparently hid the size of its banking problem (this is ironic because the Irish government tried to face up to and put their problem behind them).  Why should investors believe in the absence of any supporting loan-level performance data the pronouncements of other European governments on the issue of the solvency of their financial institutions? 

Are the governments in Portugal and Spain trying to hide the problems with their financial institutions?  Investors might easily take the lesson they learned in Ireland and assume the worse case for the assets in these countries banking systems.

Like Ireland, the worse case assumption about the assets in their banking systems implies losses greater than these countries can handle.

Who is next after Portugal and Spain?

The Bazooka Theory of financial rescue fails when investors assume the worse about asset performance.  The size of the losses under the worse case is significantly larger than the financial resources that governments can throw at the problem.

The only way for the European finance ministers to stop contagion is to provide current loan-level performance data on all the underlying assets and let the markets determine the real value of these assets and which, if any, financial institutions require more capital.

Once market values and capital requirements are known, then governments can step in to supply any needed capital.


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