Europe; Coming Unglued

The financial media have, as usual, been watching a different movie.

The financial media have, as usual, been watching a different movie.

A friend recently said in reply to a comment, 'I think we're going to hell in a basket.' She is probably right but not for the reasons she thinks. My friend was referring to the consequences of Brexit. I am referring to the structural issues which are baked into the Eurozone and which are coming unwound at a pace which is very likely to accelerate throughout 2017. Standing close to an exploding bomb is never a good idea. The further away we are the better although it will take more than the English Channel and the political aspiration, if not commitment to leave, to save us from at least some of the backblast.

Political risk in Europe appears to be growing. The truth is, it never went away. It was simply subdued temporarily by successive ECB bailouts which have rescued (some) ailing banks but have done nothing to correct the systemic flaws in the Euro which have ruined southern European economies. Now, as political risk takes front and centre stage with Le Pen soaring in the polls the underlying economic risks which have been fermenting for years are at risk of ripping loose. The means of transmission are again, most likely to be the banks. You see, nothing has really changed.

We saw during the last period of Euro stress in 2011-12 that a sell off in bonds hit the balance sheets of European banks who tend to hold their own governments debt which increased their need for bailouts. In turn, that hits depositor and investor confidence which damage the banks even more creating a death spiral requiring direct central government intervention. As you may have guessed, the three countries with the banking sector most exposed to their own governments debt are Italy, Spain and Portugal.

With the ECB scaling back its bond purchases and the rising incidence of inflation yields have been rising. More importantly, spreads have been widening reflecting growing risk between member states.

Markets have so far placed a low delta on a Le Pen victory in France. Markets are being naïve. The French electoral system is designed to keep the door firmly shut against extremist parties but with the other candidates carrying baggage of their own her defeat is far from certain. Italy’s election meanwhile could result in a government under the influence of the Five Star Movement of the Northern League, both of which are committed to leaving the EU. Markets would not wait for an EU referendum result in these countries. Merely scheduling one will result in financial chaos. Meanwhile another Greek crisis similar to 2015 looks baked in when they run out of money in July.

Investors are hardened to serial crisis in these countries but are broadly complacent in their thinking that after a lot of fuss there will be another bailout and normal business will resume. Italy’s banks still hold 276bn in bad loans and the countries debt to GDP ratio stands at 134%. With 12% of the country’s bank assets being held in national debt there is a financial death spiral just waiting to be triggered. A small issue here is that Italy is the third biggest economy in the Euro block. That won’t be an easy fix.

Portugal meanwhile is back where it started with debt as high as it was in 2010. The 78bn Euro bailout there did not reverse economic trends. It did though, save the banks, for now.

The ever sensible and cautious Germans have been trying for years to neutralise this threat, first with a proposal to limit the amount of domestic sovereign debt that a bank could own. Germany failed. The second German proposal was adopted. That was to require that bank bond holders take a draw down, to zero if necessary, before government money could be used to bail out. Unfortunately, when Banca Monti Dei Paschi ran onto the rocks in December the rules were bent out of shape by using out of date stress tests and reimbursing debtholders saying they had been misled. That prevented a political fuss in Italy but has left the potential financial death spiral in place.

Other ideas, mostly based on the ‘bad bank,’ approach have circulated in recent years and include creating two classes of bonds, pooled together from the Eurozone countries, and divided into ‘safe,’ and lets call it ‘less safe.’ Loosely, that would be Germany plus one or two other countries and the rest. Unfortunately, the Germans are not big fans of either of these plans or any of their derivatives. The Germans in fact have been playing a quite crafty and streetwise game and who could blame them. German banks have pulled back their lending to non-German companies in the Eurozone over the past few years. Their appetite for shared risk is diminishing and the banks preference for keeping their money inside their national borders reflects this.

Germany itself has its own handcart of problems. Germany will of course work hard to keep the Eurozone together but it is not without its critics from both within and from outside. Germany is under constant criticism for having the largest trade surplus in the world, something that has not gone unnoticed by the Trump administration. It is ironic that Germany is the most powerful member of the very institutions that were imposed upon it in post war Europe. Indeed, the Euro was created years later in part to tie a reunified Germany to France and losing the Mark was the price paid for reunification. The trade off for Southern Europe in being unable to devalue was access to Northern European borrowing rates which allowed much needed structural reforms to be put firmly on the back burner.

Monetary union with fiscal union blocked potential wealth distributing mechanisms and acceptance of risk sharing required Southern Europe to gift their fiscal policies to Brussels. The Eurozone crisis and subsequent austerity measures have created fertile ground for growing resentment which has fanned the flames of populist movements which are gaining traction across the Eurozone. The refugee crisis and local political scandals have poured kerosene on an already politically volatile state. Growing recent civil unrest in France, (not much reported in the UK), and less violent demonstrations in Germany, reflect the heightened political volatility.

Political and economic structural tensions in Europe will continue to rise across the Continent in the coming months. They may well be contained and then abate. Protectionist rhetoric from Washington however complicates matters somewhat and are anathema to Germany’s export led economy. How the global economy, which has been designed and built around the free movement of people, goods and services reacts to fundamental changes driven by Washington remains an open question. Certainly, a much stronger dollar would be deflationary and wipe out the glimpses of inflation we are now seeing and that has a world of implications starting with Emerging markets and the $9tr of foreign dollar denominated loans which are ticking away.

With, for the moment, inflation at the gates and with bond yields rising in France and the periphery, the increased cost of debt repayments will do nothing to stabilise matters. Equities meanwhile have been skipping along without a care in the world. They may be about to stumble. For what it is worth, I firmly believe that the whole rotten construct is closer than most believe to coming completely unglued. Let’s hope that the financial boffins at the Bank of England are earning their money and are stress testing the banking and clearing system to destruction. It won’t be so very long before risk managers across the City are once again obsessed with counter party risk.

As a quiet postscript, those investment banks such as HSBC and Morgan Stanley who are making noises about moving some staff to Frankfurt and Paris, good luck. You are going to very much need it.

Italian Bond Job


It's been a wee while since we've had a serious financial article. Step forward David Malone; writer, chum and a man with an informative and analytical view of the simmering European Debt Crisis. I'm afraid it just won't go away. This piece was published by the Guardian yesterday and is well worth a few minutes of your time if you missed it.

 

Banking's Bond Holders & The Double Standards Over Debt Repayment 


Our wealth is disappearing because we are paying off not only our debts but those of bankers and their bond holders

When this financial crisis began nearly four years ago the story seemed simple. The banks were broke and they told our leaders that unless the taxpayers bailed them out and took their private debts on to the public account, then the world would end. Our politicians believed them. We took on huge debts and bailed out the banks. Right or wrong, at least the story seemed straightforward: they owed us huge sums of money. Then as the crisis continued, a new group most of us had never heard of appeared – the bond holders. It turned out the banks owed huge sums to the bond holders too, and so did we. The story of who owed whom began to change.

Gradually the story became less about the banks owing us money and more about owing the bond holders.

It seems to me that our governments and their financial advisers from the banks have a double standard when it comes to debt and its repayment; one which greatly benefits the financial world and punishes the taxpayer.

On the one hand, the debts of private banks and those who own that debt, the bond holders, are being protected from any losses by the publicly funded bailouts. Public debt, on the other hand, at the insistence of the same banks and bond holders we have bailed out, is being paid down at breakneck speed, no matter what the cost in unemployment and the destruction of social services.

This double standard is creating two different groups with very different financial prospects: one group made of the bankers and their bond holders (the financial class), is doing rather well because, by not having to pay off its debts, its wealth – the money to make more money – is being maintained. The other group, the rest of us, find our wealth is disappearing because we are paying off not only our debts but theirs as well. Our welfare, pensions and pay are all being cut in order to appease the bond holders, while the banks and the money they owe us, seems to have almost disappeared from the story altogether.

So who are the bond holders and why are Europe's banks more concerned to pay them than us?

Finding out who the bond holders of a bank or a nation is isn't all that easy. But a few days ago Barclays compiled a chart of the top 40 holders of Greek debt. One name on the list is illuminating. EFG (European Financial Group) is the largest private holder of Greek debt. Only national banks and international lenders such as the ECB hold more.

So who is EFG? Well, they are a Luxembourg-registered group of companies. So are they from Luxembourg? Actually, no. The heart of the group is EFG Bank, which is a Swiss private bank. So they're Swiss? Not quite. The bank is 40% owned by the Greek Latsis family, whose fortune is managed by Spiro Latsis.

So when Greek taxpayers have their wages cut, their pensions shrunk and see the assets of the nation sold off, they will be helping to protect the Latsis's investment in Greek debt. And it's no accident that EFG Bank holds a lot of Greek debt. The bank set up a special fund in 2009, during the crisis, specifically to buy up Greek government debt.

EFG was also a bond holder of Anglo Irish Bank. So not one but two sets of European taxpayers have been "protecting" EFG's debt investments.

All of which becomes more interesting when you step back and realise that EFG is not only a bond holder but also one of the banks being bailed out. EFG's Greek banking arm EFG Ergasias is one of the four Greek banks most reliant on ECB funding for its survival. No wonder the CEO of EFG Bank said that the Greek decision to enforce austerity and avoid default was "necessary".

EFG is not unique. The fact of the matter is that the banks are debtors and the cause of the crisis. But as bond holders they reappear in the story now not as debtors but creditors, not as the cause of the crisis but as those trying to solve it.

And for those of you who are tempted to think, well that's just Greece for you, the same dynamic is here in the UK.

In the UK we have the government considering a cap on benefits to families.The communities secretary, Eric Pickles, warned us this would lead to repossessions, homelessness and a cut in the number of people who could afford new houses, which would mean that developers would probably not build half the promised 56,000 affordable homes due to be built by 2015. Those homes would not be built because the banks would not lend to the developers with the prospect of there not being any buyers.

At the same time, a report from EC Harris LLP revealed that London has a pipeline of £21bn in luxury builds for the super-wealthy over the next 10 years, 4,000 of which will be built by 2014-15. The banks are falling over each other to lend for those projects.

And who will buy those luxury homes? Well, it will be those who are doing well out of this crisis. The bankers and the bond holders.

And one last little detail just to complete the picture. One of the companies that sells and brokers deals for the luxury end of the London market is EFG.