THE NEW EURO BANKING AND BOND BUYING DEAL

A colleague of mine, who goes by “19th & H”, had the following reactions to yesterday’s Euro banking deal. I thought they were worth posting as a guest blog post ( ;

-Samer

Last night, the euro area agreed on yet another deal, and this is one seems significant for Spanish and perhaps Irish banks, although questions remain. It seems that Germany, after losing the semi-final against Italy yesterday, has realized that it winning streak may be over……

The first reaction of global markets (equities, oil, bonds) was positive, but we will have to see how long it will last (the half-life of euphoria after European deals had fallen to about 3 hours)….

This has reduced the risk in the short term of a euro area break-up although bond markets are now realizing that Italy will officially become a recipient of (limited) European funds.

Direct injection

The deal allows the EFSF and ESM financing vehicles to directly inject capital into banks. This is good news for Spain and its banks. You may remember that the original announcement two weeks ago of a ■100 billion bank loan to Spain’s bank bail-out fund FROB had about a 3-hour positive effect, until investors started to realize that this would increase sovereign debt, and that Spain would carry the risk of losses.

Under the new deal, the capital injection bypasses the FROB and the Spanish sovereign, so it will not add to public debt. Given Spain relatively low sovereign debt, the main concern has always been the contingent liability of bank recapitalizations, so it is hoped that the vicious circle of weakening banks and sovereign in Spain has broken. Spain is still suffering from a deep recession and unemployment, so there will still be a lot of tension on its public finances though.

Seniority

The second concern was that the uncertainty whether the original loan to the FROB of two weeks ago would have seniority status over all other Spanish bond holders. For EFSF loan this apparently decided case by case, while for the ESM this was automatic. This means that any intervention in any bond market would automatically move all other creditors down the ladder and increase risk of default for everyone else. Once market realized this, Spain’s bond yields went even higher than before the deal of two weeks ago.

The new deal removes this seniority status, so EFSF and ESM loans will not receive any preferential treatment. This is good news for the remaining private-sector bond holders.

These are major concessions from Germany, as it had always insisted on loans through the sovereign to retain influence to push through reforms.

Single banks supervisor

The ECB will host a single banks supervisor for the entire euro area. This seems to include not just cross-border banks but also regional banks. As it was the regional cajas savings banks that were making the largest losses in Spain, this seems to make sense. It is a major concession from Germany, as it wanted to exclude its own Landesbanken from European supervision (those banks made major bets on the US subprime market, and some had to be bailed out). Apparently, the euro-area supervisor will also be able to force recapitalizations and wind down failing banks, which would reduce political influence to keep national champions artificially alive.

Although this seems to be a concession of Germany, it will also have more influence on other euro area banks, and the seat will be in Frankfurt at the ECB. Meanwhile, the UK will be happy that its own banks are not included by this supervisor.

Direct bond buying but less direct monitoring

The new deal will also allow the two funds to directly buy bonds on the primary and secondary market. I thought that this had already been agreed earlier, but maybe there were some obstacles. This will make the ECB and Draghi happy, as they have stopped buying bonds since end-2011.

It was also agreed that new bail-out would not necessarily have the same IMF-EU-ECB monitoring as was the case in Greece, Ireland and Portugal, which carried a big stigma (comparable to the stigma attached to the IMF’s own programs). As the IMF introduced Flexible and Precautionary Credit Lines for good performers, the euro area will do something similar. Given that bond market have largely forced austerity and structural reforms in Italy and Spain, they can now ask for ESFS/ESM help without being subject to humiliating missions.

Italy pushed hard for this deal, so Italy will probably be the next recipient of funds, which completes the PIIGS acronym that had been buzzing around since 2010 (we would almost forget that Cyprus has also requested bail-out this week due mostly to banking sector exposure to Greece).

It is hinted that the Ireland deal may be revised to have fewer conditions and monitoring, as it was a case similar to Spain (the banking sector collapse dragged down the sovereign), which could be good news for Ireland.

Questions remain

Although this could take pressure off Spain’s banks and sovereign and Ireland, while also benefiting Italy through bond buying, many questions remain.

The big question remains how much firepower the EFSF and ESM have. The ■500 billion EFSF has already been partly used for the Greek, Portugal and Ireland bail-outs, and will inject up to ■100 billion into Spanish banks, so how much influence can it have on Italy’s trillion euro bond market? Similar question for the ESM, which will become active soon, but has a similar size.

The implicit assumption must be that both funds will soon obtain European banking licenses, and would be able to borrow on the market. In order to make an impact on Italian yields, it will need to borrow a lot on the market. Would investors lend to an EFSF/ESM which will on-lend to Italy at a lower rate than lending to Italy directly? If that is the case, investors must assume that either EFSF/ESM’s economists are much smarter than those working in Italy, or they must believe that the funds will still be entirely underwritten by the strong European sovereigns.

Creating a new banking supervisor from scratch will take a while, and many details need to be fleshed out. There is no agreement on a common deposit insurance, which could still expose some sovereigns to the risk of a bank run that exceeds their own national deposit insurance funds.

All in all, this deal has the potential to divert bond market attention away from Spain, but now they will have to deal with Italy.

BIG BANKS GETTING BIGGER … AND THAT’S NOT EVEN HALF THE STORY

After the crisis of 2008, global finance, starting in the United States, plainly needed better regulation and supervision. Lots of institutions had turned out to enjoy taxpayer backing because they were perceived to be too big to fail. Huge derivatives exposures had gone unnoticed. Supervisory responsibilities were too fragmented. The Dodd-Frank act came into life in July 2010, and attempted to address these issues under four axes: securitisation, compensation, liquidation and systemic risk (too big to fail). Two years now since Dodd-Frank, how has the situation evolved?

Several analysts, using data from the FFIEC, recently picked up on the very verifiable story that America’s big 5 have in fact gotten even bigger compared to pre-crisis levels. see here and here. I reworked the numbers using the same source data and came up with a slightly nuanced outcome: big banks are indeed as big or even bigger than what they were prior to Dodd-Frank (depending on what your base comparison year is), but the ratio of the top 5 bank holding companies to real US GDP (most other analysts use nominal GDP) has been steadily decreasing since 2009. It currently stands at 65% of real US GDP, or $8.7 trillions (see below), compared to 68% at end-2009. So, to be fair, if we’re trying to answer the question of whether Dodd-Frank brought about positive changes to the “too big to fail” dilemma, the comparison should be between today and 2010, not 2007.

This said, I personally think that the emphasis should be placed more on the soundness and stability of a bank rather than its relative size, the simple argument being that if a bank is well capitalized, liquid, and overall sound in its credit positions, then the “fail” part of “too big to fail” would be taken care of, and the “too big” part would become irrelevant. Krugman and I seem to be in agreement, and he further adds that “the pursuit of a world in which everyone is small enough to fail is the pursuit of a golden age that never was.” Regulate and supervise, and do it right and airtight.

Speaking of banking stability and soundness, are big banks today any more solvent (and, by direct consequence, less leveraged) than they were pre-crisis?  Hardly, judging by the latest data, again from the FFIEC. See for yourself below. Granted, the Tier 1 leverage ratio is hardly a comprehensive assessment of bank stability and soundness (I should know, I’ve been drafting banking sector stability reports for the IMF for 10 years), but it is a fundamental measure of solvency, hence potential bankruptcy and failure. This is what the Fed’s stress testings are all about: will the banks have enough capital to sustain operations and pay back shareholders and creditors in severely adverse scenarios? The news was conveyed last month in the resultsof the Federal Reserve’s latest bank stress tests. As presented by the Fed, most of the news was good. Some large financial institutions were judged likely to have sufficient equity capital even if the U.S. economy were to experience a significant downturn. With that, banks such as JPMorgan were allowed to increase their dividends and even buy back shares. But there’s a problem, and it’s not a small one. If you buy the Fed’s view of what is likely to constitute stress, there is some justification for its action. But why would we let banks reduce their capital in the face of so much financial and economic uncertainty around the world (re: Europe)? We all know that lower equity at big banks means higher expected losses for taxpayers down the road: The disaster of 2008 caused about a 50 percent increase in U.S. debt relative to gross domestic product — the second largest shock to the country’s balance sheet after World War II.

On these stress tests, the Fed’s assumption in the stress scenario that Europe would have a mild recession seems too benign given the latest developments re: Spain, Portugal, Greece. How much faith do we have in these stress tests? a combined 96 percent of North American financial services professionals were “not at all confident” or only “somewhat confident” that the Fed’s stress testing addresses all of the important risks to the banking system, according to a recent Sybase survey.

So we’ve established that big banks are as big or even bigger than they were pre-Dodd-Frank, and possibly as thinly capitalized and over-leveraged as ever, but are they more prosperous?  you bet, not quite as rich as 2007, but getting there quickly and steadily. See below.

The financial system it seems hasn’t become safer since September 2008. We are not in a strong position to weather any financial storm that starts gathering on the horizon, and that should be ample cause for concern.

-Samer