Ilargi: Debt Rattle – E/U in 2014?

By Raúl Ilargi Meijer, editor-in-chief of The Automatic Earth, Cross posted from Automatic Earth

Often when I want to write some simple comments on recent events, I start poking around a bit, and so much pops up that I think I should include, before long I don’t know how to start anymore, or finish, let alone appear coherent in between. Like in this case where Europe is the (intended) topic. But here goes, and I hope you distinguish a thread all the way through. Let’s start with Saxo Bank’s annual list of 10 outrageous predictions. Here are the ones that address Europe.

Ten outrageous predictions for 2014 – all of which are possible

Every December Saxo Bank publishes a list of ten outrageous predictions for the coming year. The idea is that the things on the list are unlikely and definitely not part of the consensus view, but that they are also possible.

1. EU wealth tax heralds return of Soviet-style economy

Panicking at deflation and lack of growth, the EU Commission will impose wealth taxes for anyone with savings in excess of USD or EUR 100,000 in the name of removing inequality and to secure sufficient funds to create a ‘crisis buffer’. It will be the final move towards a totalitarian European state and the low point for individual and property rights. The obvious trade is to buy hard assets and sell inflated intangible assets.

See, I don’t know that a wealth tax equals a totalitarian state. That would seem to depend on overall taxation levels. It’s perhaps politically a “clumsy” tax, but French president Hollande is a big – and vocal – champion, because he owes his throne to left-wing voters, and they like both the idea and his voicing it in public. Overall, I would say Europe has much bigger problems than a wealth tax. Certainly when I see headlines such as this one come in at Bloomberg this morning:

Accidental Tax Break Saves Wealthiest Americans $100 Billion

By shuffling his company stock in and out of more than 30 trusts, [Sheldon Adelson]’s given at least $7.9 billion to his heirs while legally avoiding about $2.8 billion in U.S. gift taxes since 2010, according to calculations based on data in Adelson’s U.S. Securities and Exchange Commission filings.

Hundreds of executives have used the technique, SEC filings show. These tax shelters may have cost the federal government more than $100 billion since 2000, says Richard Covey, the lawyer who pioneered the maneuver. That’s equivalent to about one-third of all estate and gift taxes the U.S. has collected since then.

The popularity of the shelter, known as the Walton grantor retained annuity trust, or GRAT, shows how easy it is for the wealthy to bypass estate and gift taxes. Even Covey says the practice, which involves rapidly churning assets into and out of trusts, makes a mockery of the tax code.”You can certainly say we can’t let this keep going if we’re going to have a sound system,” he says with a shrug.

If this sort of thing goes on in the US, I have no doubt it does in Europe too. Back to the Saxo list:

2. Anti-EU alliance will become the largest group in parliament

Following the European parliamentary elections in May, a pan-European, anti-EU transnational alliance will become the largest group in parliament.The new European Parliament chooses an anti-EU chairman and the European heads of state and government fail to pick a president of the European Commission, sending Europe back into political and economic turmoil.

European parliamentary elections tend to have a turnout of 10-15% in some countries. That makes them, at least potentially, easy fodder for the coalition of right-wing parties being formed right now. And why not? Percentages like that don’t look particularly strong for democratic systems to begin with. There are serious doubts about the European project in countries where unemployment and poverty are getting much worse than they’ve been in people’s living memories. Perhaps the EU brass should address those doubts instead of switching even more powers over to Brussels. They seem to be led more than anything by blind faith and ideology. And more than one can play at that game.

8. Germany in recession

Germany’s sustained outperformance will end in 2014, disappointing consensus. Years of excess thrift in Germany has seen even the US turn on the euro area’s largest economy and a coordinated plan by other key economies to reduce the excessive trade surplus cannot be ruled out. Add to this falling energy prices in the US, which induce German companies to move production to the West; lower competitiveness due to rising real wages; potential demands from the SPD, the new coalition partner, to improve the well-being of the lower and middle classes in Germany; and an emerging China that will focus more on domestic consumption following its recent Third Plenum.

Quite possible. Depends on what Angela Merkel wishes to use her next term in power for. More project Europe at the cost of the periphery is fast turning into a dangerous path. But “leaders” have been known to think themselves above the people before. And there are a few domestic issues. But the bigger ones are “pan-European”. John Mauldin:

The Monster that is Europe

Quick: I say “German banks,” and what’s the first thing that comes to your mind? The Bundesbank? Staid, no-nonsense central banking? The Bundesbank is all about maintaining the price of money – forget QE. Deutschebank? Big, German – must be stable and low-risk. The fact that southern Europeans are opening accounts left and right in DB must mean that DB is lower-risk than the local wild guys.

Except that they have the largest derivatives portfolio, at $70 trillion (but don’t worry because it all nets out, sort of, and of course there is no counter-party risk!), and they are the most highly leveraged bank in Europe (at 60:1 in the last tests – not a misprint), which might give you pause. Although their CEO argues that their leverage doesn’t matter. And keeps a straight face. Just saying… If something happens to DB, they are, in all likelihood, Too Big To Save, even for Germany.

And since we haven’t seen it in a while, here’s the latest Baltic Dry Index courtesy of Mauldin. As you can see, it’s still every bit as much on life support as last time. But it may be news that it has a strong German connection.

At the top of the market, Europe financed 75% of the ships being built, and German banks financed 75% of those, or maybe as much as 50% of the world’s total. Moody’s gave us an estimate this week that German banks will face credit losses of $22 billion in 2014. “Germany’s eight major ship financiers have lent a total of €105 billion to the sector, a fifth of which are categorized as non-performing,” Only 30% of the losses have been accounted for with loan-loss provisions. That is bad enough; but if what I am being told is true, the losses could soar much higher.

German banks are still financing ships that are not making debt payments, rolling over principal and more in an effort to avoid having to write down losses. Further credit is being extended to shipping companies in the hope that they can work out the problems, as the banks do not want to go into the ship-operating business.

How bad is it? Banks are taking control of ships, marking them down to a fraction of their cost, and then financing 100% of the cost of selling them to Greek shipping companies. Can we say irony? Greek shipping families basically operate tax-free (a point I wrote about some four years ago) and take a very long-term and conservative view. They sold ships to the Germans at the top of the market for very nice premiums and are now buying them back at significant discounts.

The ECB has actually provided huge amounts of capital for banks in an effort to get them to lend to businesses. But faced with regulatory risks and the significant requirement for increased reserve capital imposed by Basel III, the banks have taken the cheap money and bought their national government bonds, because the spreads are so high and the reserve capital required for making a sovereign loan is still bupkis (a technical banking term pertaining to European sovereign loan-loss provisions to insolvent governments).

So enough trouble for Germany. But even more interesting (for the sake of this article) is that Mauldin touches on a point in that last paragraph that warrants attention. I’ve written about it before, but there’s no harm in repeating it. Here’s the nutshell essence:

EU governments cannot borrow from the ECB (since it can’t buy sovereign debt outright), but banks can. So what happens is the banks do the borrowing and use the credit thus acquired to buy “their own” domestic sovereign debt. In other words, governments do de facto borrow from the ECB, but with a bank as (well-paid) middleman.

And that’s not even half the story. The banks that buy the sovereign bonds with ECB money/credit turn right around and offer those same bonds, which are listed as “safe”, or “cash good collateral”, to the ECB the next day as collateral in exchange for more loans. With which they proceed to buy more sovereign bonds, which provides wiggle room to their governments etc. It carries the strong odor of a scam, if not a Ponzi scheme.

You get the idea. The ECB knows this, Brussels knows this. All the muscular verbal blubber about not allowing the ECB to buy sovereign debt, it sure doesn’t seem to carry much value very long. And I’m being very kind there. In public, there’s a lot of talk about the strict rules governing bailouts and other support, but behind closed doors, none of these rules seem to matter.

I found it hard to get one single graph to tell the story, so I’ll give you three:

 

But the best graph is probably this one, from Tyler Durden in September 2013, especially since he explains the matter quite well:

Italian Bank Holdings Of Italian Debt Rise To All Time High

Wondering why the Italian bond market has been stable and “improving” in recent months, with yields relentlessly dropping as a mysterious bidder keeps waving it all in despite the complete political void in the government and what may be months of uncertainty for the country, and despite both PIMCO and BlackRock recently announcing they are taking a pass on the blue light special offered by BTPs? Simple. As the Bank of Italy reported earlier today, total holdings of Italian bonds by Italian banks hit an all time record of €351.6 billion in February.

Why are local banks loaded to the gills in the very security that may and will blow up their balance sheets when the ECB loses control of the European sovereign risk scene as it tends to do every year? Because courtesy of ECB generosity, Italian debt continues to be “cash good collateral” with the ECB, and as a result Italian banks can’t wait to pledge and repo it with Mario Draghi in exchange for virtually full cash allotment. In other words, the more debt the Italian Tesoro issues, the more fungible cash the Italian banks have to spend on such things as padding up their cap ratios and making their balance sheets appear like medieval (any reference to Feudal Europe is purely accidental) fortresses.

As I’m letting this sink in anew, I’m starting to think the entire EU is a Ponzi scheme, but that of course could not be true: they have democratic elections, after all. As the graphs above illustrate, the rise in total holdings of Italian bonds by Italian banks makes abundantly clear that there is no way other EU countries, especially the peripheral ones, and their banks, have left this one-of-a-kind profit opportunity alone.

But not to worry, since, as we know things go in this universe, here comes the cavalry:

Euro Zone Bank Assessment to Target Sovereign Risk

Daniele Nouy, currently head of France’s banking regulator, was nominated last week by the European Central Bank to chair the board of the so-called Single Supervisory Mechanism. The board will be housed at the ECB.

Ms. Nouy’s first big task will be to handle a planned clean-up of banks’ balance sheets that will take place over the coming year, before the single supervisor assumes formal responsibility for overseeing the euro zone’s biggest lenders in November 2014. The ECB, together with national banking supervisors will review banks’ assets and conduct a new round of stress tests, hoping to identify undercapitalized institutions.

At a confirmation hearing before European lawmakers on Wednesday, Ms. Nouy said the supervisor “will look at the most risky portfolios, including sovereign risk.” She warned that banks should ensure that their government-bond portfolios have a proper risk weighting – used in calculating how much capital they need to hold – or are offset with additional capital buffers.

In doing so, Ms. Nouy went a long way to aligning herself with Germany’s central bank, which has been pushing hard for minimum risk weightings on sovereign bonds. Bundesbank President Jens Weidmann argues that this would require banks to hold more capital to cushion against potential losses on the bonds, reducing the incentive to hold such debt, and consequently break the vicious circle between bank debt and sovereign debt that has plagued the euro zone for the last four years. As the value of sovereign bonds has declined in certain countries, banks holding that debt have been weakened, requiring state aid that has put governments under strain, driving their borrowing costs higher.

However, Ms. Nouy argued the case from a different angle, saying that it was necessary to redirect banks’ resources from governments to households and companies. “We need banks to finance the economy, and if they increase their holdings of sovereign exposures they are less able to finance the economy, which is important at the present time,” Ms. Nouy said. European policy makers hope that once the capital needs of banks are identified and addressed, and the ECB starts overseeing financial institutions, banks will kickstart lending to the private sector.

Ms. Nouy’s answer was prompted by a question from a delegate from Spain, a country where the “crowding out” of private lending by government debt has been particularly severe in recent years. Since the end of 2010, Spanish banks have cut their lending to households by €86 billion ($116 billion) and their lending to companies by €263 billion, but they have increased their holdings of government bonds by €124 billion in that time, according to ECB data.

Yeah, yeah. EU policymakers claim they want Europe’s – mostly severely weakened – banks to clean up their balance sheets AND hold more reserves against assets AND start lending to the private sector. No, honestly, you may think this is a timewarp, but we’re really on the verge of 2014, not 2007, and this long since broken-beyond-repair record is what they come up with. These ideas are so contradictory, as well as outdated, that they might as well throw in a demand for world peace for good measure and place the entire discussion at the intellectual level where it belongs: that of a Miss World pageant. Which also fits in nicely with the credibility level of EU bank stress tests.

But of course that’s just “public policy”. The real policy we just saw: with the convenient artificial distance between the EU and ECB “firmly in place”, here’s what happens, and I might as well quote myself here: “The banks that buy the sovereign bonds with ECB money/credit turn right around and offer those same bonds, which are listed as “safe”, or “cash good collateral”, to the ECB the next day as collateral in exchange for more loans. With which they proceed to buy more sovereign bonds”.

Sovereign bonds from the EU periphery are highly popular, because they return good yields, while the risk that makes such yields feasible is perceived as being covered by the EU as a whole, and in particular the ECB. So banks are not only encouraged to pull this trick with “domestic” bonds, though I read somewhere that in Portugal and Spain, domestic banks now apparently hold over 70% of their “own” sovereign bonds, EU banks buy other EU nations’ bonds too to play the same game.

And while the ECB’s official policy is to make sure that “government-bond portfolios have a proper risk weighting”, the unofficial policy says something different, namely that banks have bought themselves even more political power since 2007, with the ECB loans that they buy sovereign bonds with etc., you get the picture (though perhaps I should mention the shadow banking system that can’t really do bonds, and buys stocks with its free “cash”. Record S&P anyone?).

Now, what is the real Europe? I think this Bloomberg piece for instance gives a more realistic picture than the EU brass would ever allow us, lots of joyous numbers:

Spanish Defaults Surge as Banks Forced to Come Clean

Liliana Proano Males won’t be decorating her house in Madrid this Christmas because she’s about to lose it. Males and her husband, who was fired from his job during the depths of the financial crisis in 2009, can no longer afford their mortgage. With Spain’s persistently high unemployment rate now at 26%, the couple is among the 350,000 homeowners who may be foreclosed upon by lenders in the next two years as the housing crisis worsens, according to AFES, a Madrid-based association that advises on restructuring debt. Since 2008, about 150,000 families have been hit with a foreclosure. [..]

As mortgage defaults rise, lenders will have to set aside money to cover losses, hurting profits, according to Juan Villen, head of mortgages at Spanish property web site Idealista.com. Spanish banks absorbed €87 billion ($120 billion) of impairment charges last year after Economy Minister Luis de Guindos forced them to record more defaults on loans to developers. The government took €41 billion in European assistance to shore up its failing lenders. [..]

More than 5% of Spanish residential mortgages were in default in the third quarter, up from 3.5% a year earlier, according to data released today by the Bank of Spain. The level was 0.7% in 2007, the year before the real estate market imploded. AFES estimates a rise to 6% next year. Defaults as a proportion of all loans by Spanish lenders climbed to a record 13% in October from 12.7% the previous month, the central bank said today.

Defaults are rising partly because of changes required by the Bank of Spain that force lenders to book more soured mortgages. “When the real estate bubble burst in 2008, banks used refinancing en masse to cover up non-performing residential mortgage loans,” AFES President Carlos Banos said. “Refinancing only served to draw out the situation and exacerbate the problem.” Banks refinanced mortgages and granted grace periods in return for adding financial penalties and notary expenses to the principal of loans. [..]

In April, the Bank of Spain ordered lenders to review their portfolios of refinanced loans, including mortgages, to make sure they’re classified in a uniform way. Lenders had €208 billion of loans on their books that they’d restructured or refinanced as of the end of 2012, according to the regulator.

The review led the regulator to the preliminary conclusion that classifying all refinanced loans correctly would cause a €21 billion increase in defaults. Lenders would need to generate a further €5 billion of provisions to cover the losses. The default rate for Banco Santander’s Spanish mortgages jumped to 7% in September from 3.1% in June as it reclassified loans that it had refinanced. [..]

More than 4 million people have lost their jobs since the start of the credit crunch. The International Monetary Fund predicts the jobless rate won’t fall below 25% until 2018.

As Spain’s borrowing costs in 2012 surged to the highest level since the euro was introduced in 1999, the government introduced deficit reduction measures such as wage freezes and income tax hikes that ate up disposable income. Spanish households’ average income fell for a fourth year to €23,123 in 2012 compared with €25,556 at the start of the crisis in 2008, the National Statistics Institute said on Nov. 20. That left 22% of the population below the poverty threshold.

Spanish house prices have dropped an average of 40% since the peak in 2007 … [..]

Or how about Ambrose, always good for a nice quote:

Italy’s president fears violent insurrection in 2014 but offers no remedy

Events in Italy are turning serious. President Giorgio Napolitano has warned of “widespread social tension and unrest” in 2014 as the Long Slump drags on. Those living on the margins are being drawn into “indiscriminate and violent protest, a sterile lurch towards total opposition”.

His latest speech is a veritable Jeremiad. Thousands of companies are on the “brink of collapse”. Great masses of the working people are on the dole or at risk of losing their jobs. Very high rates of youth unemployment (41%) are leading to dangerous alienation. “The recession is still biting hard, and there is a pervasive sense that it will be difficult to escape, to find a way back to full growth,” he said.

Now why might that be? Might it not have something to do with the central overriding fact that Italy has a currency overvalued by 20% or more within EMU: that it is trapped in a 1930s fixed-exchange system run a 1930s central bank that is standing idly by (for political reasons) as M3 growth stalls, credit contracts, and deflation looms?

I’m not the biggest fan of Ambrose’s analyses, but his point here is valid, and increasingly so: how much longer can Italy (and others) deal with using a currency that is valued at levels that make it seem as if the entire EU has an economy as strong as Germany has? It’s one thing for markets to presume Germany will back the entire project in one way or another, but it’s quite another for a weak economy to be forced to use a strong currency. Countries like Italy should be able to devalue their currencies, but they’re not. And as long as the richer northern EU core doesn’t address that issue, things will keep on deteriorating in the south.

The Boys from Brussels are pushing hard to seal deals to not only make it increasingly difficult for member countries to leave, but indeed take more and more powers away from the members. The claim that Eurozone countries can still conduct their own financial and economic policies is no longer truly believable. At this very moment, they’re rushing through the next piece of the scheme, under the guise of taxpayers no longer being on the hook for failing banks (though they will be for at least another 10 years):

Europe rushes to seal banking union within 48 hours

European leaders are beginning a two-day summit on Thursday in an attempt to sign off on a banking union deal before the weekend. Five years after the financial crisis struck the euro zone, European leaders are meeting in Brussels in an attempt to seal a deal that would create a single banking union in the region by 2015, envisaged as a supervisory system to police the region’s banks and financially assist (or dismantle) them if necessary.

Banking union is seen as essential in restoring investors’ faith in the euro zone after weak banks across the region, from Ireland to Spain, were hit by the financial crisis, dragging weakened sovereigns down with them. Attempts to create a single supervisory system have not been simple, however, with disagreements ranging from who was to supervise the banks – it will now be the European Central Bank – to establishing a single fund to rescue failing lenders.

Under the deal, banks will provide the cash to pay for the closure of failed lenders, giving roughly €55 billion euros ($76 billion) over 10 years. But there is no agreement as yet on how to ensure there is enough money to deal with closures while the fund is being built up, or where it falls short.

For one, the euro zone’s largest economy Germany remains very reluctant to make its taxpayers liable for losses incurred by banks in fellow euro zone countries. It wants the government of the country where a failing bank is located to cover any shortfall in rescue funds.

Instead of trying to address the issues raised by the people, and in the streets, the very attitude that creates the space in which for instance an EU-wide anti-EU right-wing coalition can operate, and grow, Brussels, and most sitting governments, turn deaf ears to both the issues and the people. Unless they radically change their attitude, a loss in the upcoming European Parliament elections six months from now may well be the least of their worries when the time comes.

It’s a massive blunder, whether born from arrogant hubris or sheer stupidity, to act as if the financial crisis is something that takes place only, or even mainly, in the boardrooms of the political and financial system. The crisis takes place in the streets, and a stubborn refusal to address it there may well cause the EU to turn into E/U in 2014.