Some Reflections On The Plan As The Details Emerge

``It was the president of the European Central Bank who urged governments to take measures to help in financing and in some cases recapitalizing financial institutions,'' Zapatero said at a press conference in Paris today. ``We don't need to do this at the moment but if we do need to we will.''

Well, despite Zpt's "don't blame me, blame Trichet" speak, the plan has been introduced and we are starting to see some numbers, although we are still a long way short of getting actual drill-down details of what is involved, and how it is going to be financed, so apart from being mind-boggling, the numbers we are being offered are, in fact, almost meaningless. Take an ´x´ and attach a lot of zeros to it, 'x' can range from one to a trillion. Or put another way "I'm trumping you, now let's see if you can trump me". But, for what it is worth, AP are saying this:

European governments overcame their differences to put $2.3 trillion on the line
Monday in guarantees and other emergency measures to save the banking system in their most unified response yet to the global financial crisis.

Now $2.3 trillion does sound like quite a lot, so it would be interesting to know just how the number had been arrived at - other than asking "what looks so big that no one will dare say it doesn't seem to be enough - I mean, are there anything vaguely resembling detailed studies, and breakdowns lying behind all this? Only a thought. Anyway, according to the AP report about 250 billion euros ($341 billion) of the European pledges (I like that word, like in a charity auction) was earmarked to be spent on recapitalizing banks by buying stakes - but again we have no breakdown of who is doing what on this front.


The German package alone is said to be worth as much as 500 billion euros ($671 billion) - well, you know, they are thorough the Germans.

"We are taking drastic action, no question about it ... so that what we have experienced is not repeated," German Chancellor Angela Merkel told reporters.

Chancellor Angela Merkel's government has "pledged" 400 billion euros in loan guarantees, plus as much as 80 billion euros to recapitalize banks in distress and another 20 billion euros in the budget to cover potential losses from loans. The total value of the rescue package will amount to about 20 percent of German gross domestic product. The plan, which was agreed to by the German cabinet yesterday but will have to go through parliament for final approval, includes, among other provisions, reforms of Germany’s lending, insurance supervisory and insolvency laws.

The French government has "pledged" to provide up to 360 billion euros to help banks, 320 billion euros in guarantees for bank refinancing and 40 billion for bank capital injection, and the Netherlands will put up 198 billion euros in interbank loan guarantees, which will be added to the 23 billion euro fund set up last week to help financial institutions like Fortis. The Austrian government will set up an 85 billion-euro clearing house to be run by the Austrian Kontrollbank and this will provide cash by holding illiquid bank assets as collateral. Austria also "pledged" to buy banking shares if and when domestic financial institutions seek to sell new stock. It should not escape out notice that the Austrian stock market was temporarily closed last Friday afternoon after a rout of the Austrian banking sector (and particularly Erste Bank) which is especially exposed in Eastern Europe. In fact Austrian shares are down this year more than any others in the Eurozone in recent months.

Italy will guarantee some bank debt and buy preferred stock in banks if necessary, according to Finance Minister Giulio Tremonti , but he did not provide figures (which is hardly surprising given that if Italy is to avoid problems with the credit ratings agencies it has very little money indeed to spend without making direct cuts in services). Tremonti limited himself to saying that Italy would put forward "as much is necessary'' to shore up the country's banking system, and that the government was going to act on a case by case basis. Portugal has guaranteed $27 billion - or nearly 12 percent of annual GDP - in an attempt to encourage banks to lend to each other.

Spain's cabinet have approved measures to guarantee as much as 100 billion euros of bank debt this year (to be followed by an unspecified further amount next year) and authorized the government to buy shares in banks in need of capital. Prime Minister Jose Luis Rodriguez Zapatero was at pains to stress that no banks needed additional capital now and the measure was ``preventative and precautionary.'' As far as I can see a significant part of the money Spain is allocating will be used to buy up Cedulas Hipotecarias and other financial instruments which are due for "rollover" in the months to come.

Looked At In The Cold Light Of Day

Having now had the opportunity to sleep on all this overnight (always a good thing to do when taking decisions about important matters I feel) I still think (obviously) that Europe's leaders have done what had to be done, even if the weaknesses in what has been decided now do seem a lot clearer in the cold hard light of day (although, as I was at pains to stress yesterday, they probably couldn't have done much more at this point in any event). The numbers need to be to some extent vague (we wouldn't want to set the credit ratings agencies off looking too hard into the fiscal implications of everything just yet, now would we), and in any event waht is being offered is a guarantee, which it is hoped may never actually be called on. So rather than announcing the extent of their actual immediate involvement, what they have tried to do is put a limit on how far they are willing to go, in the hope that this quantity will be just too much for anyone in their right mind to try to bet against.

However, this kind of underwriting process is, by its very nature, open to all sorts of uses, and abuses.

To take just one immediate example, Banco Santander have this morning announced that they are taking over the 75% they didn't already own of the US-based Philadelphia-thrift Sovereign Bancorp - for some $1.9 billion. They already had a 25 percent stake in Sovereign and will now buy up the remainder in exchange for their own stock. Sovereign Bancorp has received a drubbing in the stockmarkets due to rising mortgage delinquencies as the US housing market has tumbled. Its stock has lost nearly two-thirds of its value in the year to date, and clearly given the money Paulson is offering may well look attractively priced as the US housing market steadies up. The question is, would Santander have felt in a position to make this acquisition before last Saturday's decision? There is no clear answer to this question, but it is a point at least worth bearing in mind.

The second example that comes into my (Barcelona based) head is a the sudden rum-rum of builders cranes and drills that I can hear in the streets around me, after weeks of what seemed like ominous silence. Is it only in my district, or are builders all over Spain now going back to work, following a sudden availability of loan extensions and overdraft rollovers from the banking sector? I know Zpt said we wanted to ease up the liquidity seize-up in the small business sector, but did it have to be precisely these small business that had their credit "eased up" (and not other, more currently relevant ones)? Bluntly put, what is the point of spending what are effectively scarce resources (and at the end of the day taxpayers money) building more houses, when there are already at least a million you still can't sell!

Now.... in the Santander case the point is, with loans and debts guaranteed at home, and Spanish property prices set to take a beating, why not buy up cheap US banks where the house prices are probably already near their bottom? But this is hardly what the average Spanish taxpayer thought they were giving the green light to. However, once you give a blanket underwrite to the banking sector, there is really little you can do to stop this, since banks are commercial enterprises, and have to do what is best for them and their shareholders. All of this has already come up in the context of the notorious Irish "excesses" in accessing ECB funding, and in - for example - the McQuarrie proposal (subsequently dropped) to take paper backed by Australian car loans over for presentation at the Irish central bank.

And in the "bailing out the builders" case, the position is even more scandalous, since what we really need on the table at this point is a plan to downsize the sector, and close down at least half the industry (compensating on the way the banks for some of their losses, since if not...), not a lease of life to what are already effectively the living dead. Spanish construction currently represent 11% of GDP. On any rational criteria, the most that can be hoped for 3 years from now is 5.5 % - 6%, and it is not unlikely given the excess of building we have had recently that we may be down to 3.5% to 4% (which is the level to be found, for example, in Germany).

So let us be clear, this whole package is a "lesser evil" situation. The greater evil would be a banking sector which went bust, with all the attendant consequences. But even though it is a lesser evil, there clearly are limits to what is acceptable, and someone should be policing all this, if for no other reason than to protect the hard earned contributions of the average Spanish taxpayer.

But, we also need to be clear, that this is just a first move. The banks are now "as safe as houses", and the bloodletting has stopped. But it is now essential that we use the breathing space which this provides to address the structural problems in the real economy, which are going to be large. Spain is about to go into the most serious recession in living memory, and there are two important groups of people who are not protected at this point: the builders and the private mortgage holders.

Both groups are now going to find themselves flooded with unsupportable demands on their finances. The former since there is now less than half the market there was for their product, and the latter because the value of what they own is going to fall, while their debt isn't. Simply issuing government debt to pay builders for housing which no one is going to be able to buy at cost price is no solution, one day or another the government will run out of the ability to issue debt. If the government issues debt it should be to save those construction companies which are "systemic", and viable over a longer term horizon, and to close down the rest. But to do this we need a realistic study of the future of the industry, and of what will, and what will not be viable. But where is this study?

And meantime the taxpayers money keeps flowing.

On the other front, the private household one, we need to think of all those young two-earner families who are already finding themselves in considerable difficulty paying their mortgages, and who may soon find that one or other of the wage-earners is out of work as the recession starts to really bite, and while the INEM unemployment payments may help for a year or so, what happens after that? I mean, we need to be clear, we are digging in for a long winter here.

So the next steps need to be a plan for downsizing permanently the construction industry, and some provision for "distressed" mortgage holders, just like we have been seeing in the US really.

And the big question is that all of this will cost money, and money is going to be in short supply in Spain over the next few years - especially if we are thinking of paying down the external debt, which we have to be really - and so we wend our way back upstream to the banks, and to the European support.

"I am not sure as you are that the plan is global. In the sense that if for
example a big spanish bank would default, that the german will use their
taxpayer money to refloat it." - from comments.

Well look, I agree with the comment above to the extent that nothing has been clearly spelt out, and what I think we may well see is a game of playing "chicken" here. I mean by this that, in the event that talking turns out to have been easier than acting, Spain no doubt will end up threatening that a systemic bank is about to go, and do this all the way up to the brink, and up to the point that the others feel they have no alternative but to provide support. Actually, Spanish politicians may be quite useless when it comes to some things (like being proactive rather than reactive) but this is a game they seem to excell at, so I suspect that they will find themselves in their element here, and I think they will get a result. Any going back on the committment not to let a systemic bank fail would have important consequences for the whole eurozone, and I will not say more than that at this point.

"Spain is making available euro 50bn. So Spanish cedulas are more of a problem!!
Now what is interesting is that the spanish plan makes euro 100bn "aval"
available until the end of 2008. So we will probably need more for 2009." - from comments

Well, yes, this is about the size of the problem. What they are hoping is that they can "restart" the economy in 2009, but I think this is a pipedream. We may well need this sort of funding every year as the securities are rolled over all the way through to 2012 and beyond. I doubt there is going to be any important wholesale market in Spanish RMBS-type paper before the correction is over, and this has all the hallmarks now of being a very long drawn out affair.

One of the main advantages of a Schumpeter-style "creative destruction" process, is that it is nasty, brutish, but short, and after everything has crashed you can briskly get on with the rebound. Spain's process is likely to be much longer than in either the US or Ireland, since property prices have been much slower to fall, and builders are not being allowed to go bust in any sizeable numbers, yet. But until house prices fall the market will not "bottom", people will not start buying again and the whole process cannot restart.

So we won't "bottom" here until much later than the UK and Ireland, and there will be no significant RMBS market till we do bottom. I mean, I think people have missed the very important point that the German Pfandebriefe, on which the cedulas were modelled, were introduced as part of the POST 1995 rescue package and bank bailout, AFTER property prices had already dropped, thus, since prices had already fallen (and in Germany property prices have been stuck more or less at this level since) these securities were "safe as houses" since the underlying asset was essentially stable.

"The major diference in point of views: some thougth the Spanish banks had only
a liquidity problem, others insisted on a solvency problem." - from comments

This point is very interesting, since this debate is obviously raging inside Spain at this moment. Personally I would say that the two points of view are valid, in the sense that what we have now (and have had since Sept 2007) is a liquidity problem in the banking sector. But what we will have when property prices drop and builders go bust is a solvency problem. So both views are correct, and the only thing we need to get straight to understand the difference between them is the timing involved.

As I keep stressing one of the points we should never lose sight of here are the implications of all this for the real economy. In only the latest example of such impacts Japanese automaker Nissan yesterday announced it was going to cut 1,680 jobs here in Barcelona, as the economic downturn across Europe has weakened demand for its larger 4X4 vehicles and trucks.

Update Wednesday 15 October

As I keep stressing one of the clear implications of last weekends decision is that fiscal policy will come under pressure, since the various respective governments are going to have to assume more debt, and it isn't obvious where the money is going to come from.

Ireland Takes The Lead

Ireland has been one of the first countries to actually come clean, and has announced that it intends to abandon European Union fiscal rules next year. The Dublin government is projecting Ireland's largest budget deficit in 20 years, as the economy slows under the weight of a housing slump and the international credit crunch. Announcing the budget for 2009, Brian Lenihan, finance minister, said the general government deficit would be "just above €12bn" next year, or 6.5 per cent of gross domestic product.

Under the current stability and growth pact rules, countries have to keep borrowing to less than 3 per cent of GDP through the economic cycle. Brian Lenihan said the "the international credit crisis has compounded and deepened the downturn in our construction sector and led to a fall off in consumer ­confidence".

Irish public finances, which had been in surplus for nine of the past 10 years, have now deteriorated by 7 percentage points. Ireland's finance minister projected that economic output would contract by a further 1 per cent next year, after a 1.5 per cent decine this year. Public debt is now set to rise from 25 per cent of GDP - one of the lowest rates in the European Union - to 44 per cent next year.

The worsening state of the public finances comes amid growing expectations that Dublin will also need to follow other EU governments and inject capital into its banking sector, adding further to public debt. Two weeks ago Ireland offered to guarantee the liabilities of its banks, but it is notable how Irish bank shares have generally failed to benefit from the price lift across Europe this week, so it now looks as if some form of recapitalisation or other will be unavoidable.

In the first official hint that equity injections by the government might be on
the cards, Pat Neary, the Irish regulator, told a parliamentary committee on
Tuesday that "the rules of the game are changing internationally". He
said: "Market expectations could push other banks to seek equity injections,
irrespective of whether or not they continue to meet their regulatory
requirements".

With the Irish construction boom over, Christopher Wheeler of NCB stockbrokers calculates the collective bad debt charge of the three main Irish banks could reach 350 basis points of average loans in 2009 and 2010. He calculates the banks would need €14bn ($19bn, £11bn) of new equity to achieve a core tier one capital ratio of 9 per cent. This would put them broadly in line with UK banks under London's recapitalisation scheme.


And Greece Follows Close Behind

The Greek govenment has decided to issue additional treasury bonds, and is prepared to buy shares in banks to help support lenders and contain the impact of the credit crunch on the real economy, according to an announcement from Greece's finance minister earlier today (Wednesday).

"We will issue up to 8 billion euros ($10.93 billion) in bonds to support banks
... and are prepared to strengthen banks via share purchases up to 5 billion
euros,"

And Greece's central bank governor also warned today that the capital adequacy of the country's banks would likely decline due to the current world-wide credit crisis.

"According to rough calculations, this year, towards the end of the year and early next year, Greek bank capital adequacy is likely to drop somewhat due to the crisis," George Provopoulos told reporters.

The sum of 28 billion euros ($38 billion) pledged in support measures amounts to 11.4% of Greek GDP according to the finance minister.

"With a combination of state guarantees, state participation and increased liquidity that can reach 28 billion euros we will help the banking system to overcome the credit crunch," Finance Minister George Alogoskoufis told reporters after a cabinet meeting.

Under the plan, the government is prepared to boost the capital of Greek banks by up to 5.0 billion euros by buying preferred shares with voting rights. The government also vowed to guarantee up to 15 billion euros of capital market loans by banks and stands ready to issue 8.0 billion euros (about 3.5% of GDP) of special bonds to be able to inject liquidity into banks.

So the Greek govenment is also to issue new debt to support its banks, in addition to any fiscal deficit it may already be running to offset the economic downturn. Of course the Greek government (debt to GDP ratio just over 100%) can issue the bonds, but it is far from clear how enthusiastic the financial markets are actualy going to be to buy them from a country which is also running a current account deficit of 13% of GDP.

Portugal Also Announces Revisions To Growth And Deficit Plans

Portugal’s government also announced today that it expects a sharp drop in economic growth and has put plans to continue bringing its budget deficit into line with EU rules on hold in its budget proposals for 2009. Fernando Teixeira Santos, finance minister, said today that economic growth was expected to drop to to a 0.8 percent annual rate this year and 0.6 percent in 2009. This is down from previous government forecasts of 1.5 and 2 per cent respectively.

The 2009 budget deficit target is being set at 2.2 per cent of gross domestic product, unchanged from 2008. The government had previously agreed with the European Commission to cut the deficit to 1.5 per cent of GDP next year as part of the ongoing adjustment. The new target marks the postponement of what have been largely successful efforts to cut an earlier substantial budget deficit, which had spiralled to 6.8 per cent of GDP in 2004. This breach of the rules is really quite minor at this point, and, although Portugal suffers from congenitally weak growth, and has a 9% of GDP current account deficit, a major recessionary slump in output (Spanish style) is not expected.

Zapatero Forsees Bank Restructuring On The Horizon

Bank mergers are likely in Spain and other European countries due to the international financial crisis, Spanish Prime Minister Jose Luis Rodriguez Zapatero said earlier today.

"During a serious crisis like this, it's likely that not only in Spain but also
in other European countries, you will see mergers or restructurings," Zapatero
said during a session of Congress.

Car Sales Down

European new vehicle registrations fell 8.2 percent year-on-year in September despite two extra working days, as the fall-out from the financial crisis "hits auto manufacturers hard," vehicle manufacturers' association ACEA said.

The credit crunch is evidently hurting the automotive sector's ability to finance its daily operations. Demand for new cars is weakening, and customers are increasingly reluctant to make large purchases, or unable to find lenders willing to finance them, according to ACEA.

Registrations for the 27 European Union member states (EU27) and EFTA countries, which ACEA said include Bulgaria and Romania and exclude Malta and Cyprus, totalled 1,304,583 units, the lowest September level since 1998, ACEA said.

"Usually, September is a strong month for car sales that tend to pick up after
the calmer summer months," ACEA said, noting that over the first nine months of
the year, sales for the region were down 4.4 percent.

Western European markets saw new registrations fall 9.3 percent compared with September 2007, to 1,211,308 units. Among these, the French and German markets resisted best, with France growing 8.4 percent after a 7.1 percent drop in August, while Germany's September sales edged down just 1.5 percent after falling 10.4 percent in August.

The steepest declines were in the UK market, where sales fell 21.2 percent, and in Spain, down 32.2 percent. Italy was down 5.5 percent.

The new European member states saw growth of 7.8 percent in September, with 93,275 vehicles registered.