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Debt blame game

May 07 2012 07:49 Reuters

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London - Spain's plan to rid banks of toxic real estate assets is reviving the politically heated debate over how creditors and taxpayers should share the vast losses still being incurred by the eurozone debt crisis.

Nowhere is the issue in sharper relief than in Ireland.

The government took an €85bn International Monetary Fund (IMF)/European Union rescue package to bail out the country's banks, felled by a reckless decade-long building boom, and extended a blanket guarantee to €440bn of the banks' liabilities, including senior bonds.

As a result, Ireland's total debt soared from 44% of gross domestic product (GDP) in 2008 to 106% last year, according to the IMF.

The overriding reason why Dublin cannot bow to public calls to "burn the bond holders", even if it wanted to, is simple: the European Central Bank (ECB) would not permit it.

The ECB worries that imposing losses on senior bond holders in one country would instantly spread contagion throughout the 17-member eurozone.

So Iceland, not in the eurozone, could snub the creditors of its failed banks; Ireland could not.

This experience colours the advice that Irish academics proffer to Spain, which is hoping to cleanse banks of their sour property loans without adding to a public debt burden that is already so high that some investors believe Madrid too will need aid from the IMF and EU.

"Resolve the banks if you have to and don't get forced by the ECB into paying 100 cents on the dollar to bond holders in banks that are bust, which is what we were forced to do," said University College Dublin economics professor Colm McCarthy.

The ECB's fear that forcing losses on bond holders would rattle markets was borne out to a large extent during last year's negotiations over a second IMF/EU rescue for Greece.

After months of saying no, the ECB relented in July and accepted the need for holders of Greek sovereign bonds to take a 21% writedown. Soon after, the government bonds of Italy and Spain came under heavy pressure.

"The ECB would say the same would happen to the senior bond market. You'd kill it for a long, long time and they're anxious to avoid that," said Alan Ahearne, a professor of economics at the National University of Ireland in Galway.

Shareholders and owners of subordinated debt have shared in losses during the crisis and in some cases have been wiped out.

"But it's still the case that no senior bank bond holder has taken a loss in the euro area, and I see no signs of flexibility from the ECB on that,"” Ahearne said.

The state's broad shoulders

Ahearne learned the hard way what happens when a banking system is drowning in bad debt.

He was special adviser to late finance minister Brian Lenihan when Ireland set up a "bad bank", the National Asset Management Agency (NAMA), in December 2009 to buy tens of billions of euros of property loans that were under water and sinking fast.

Without a change of heart by the ECB, Ahearne said any losses in excess of Spanish banks' equity and subordinated debt would ultimately be borne by the state.

"If property prices keep falling - and they're likely to keep falling in an environment in which the economy is continuing to contract - those losses will be mounting.

"And unless something changes in the European approach, those losses will fall on the Spanish taxpayer," he said.

Officials in Madrid insist that Spanish banks' €184bn of troubled real estate assets are manageable, not least because new provisioning rules will force the lenders to write down some 60% of that total.

Nevertheless, the government wants banks to start transferring dud real estate assets soon, on a voluntary basis, to liquidation companies.

Spain has restructured its banking sector three times and is confident that a carve-up will obviate the need for another rescue of the banks, whose non-performing loan ratio has risen to 8.2%, an 18-year high.

Investors are less confident. Suspecting that the state will have to write a cheque at the end of the day, they have driven up yields on Spanish bonds that are unsustainably high in the long run. Ten-year yields eased on Friday to around 5.70 percent.

"Spain is trying to find a way to have its cake and eat it too. They want to get these assets of the balance sheets of the banks. On the other hand they don't want the central government to take on liabilities that would balloon out Spain’s debt to GDP.

"So they have to find a compromise,” said Marchel Alexandrovich, European financial economist at Jefferies, an investment bank, in London.

Catch a falling knife

Much depends on how far real estate prices still have to fall. So far, house prices in Spain are down 22% from their 2007 peak, compared with slumps of 34% in the United States and 49% in Ireland.

"Unfortunately, the Spanish government has not clearly explained how much more adjustment they expect for the Spanish housing market, what this implies for the banking sector, and how the government intends to deal with the consequences," Deutsche Bank economists Thomas Mayer and Jochen Moebert wrote.

Although Spanish property experts point to an array of factors that make it unlikely that prices will fall by more than another 15%, the IMF has said "greater reliance on public funding may be needed", while Moody's Investors Service sees a risk that the banks could still become a burden for the state.

In a note published on Friday, economists at Barclays Capital estimated future expected losses for the Spanish banking system of €198bn.

Banks had made €110bn of provisions as of the end of 2011, leaving €88bn of losses to be cover, BarCap calculated.

Profits over the next two years and buying back discounted junior debt might yield €40bn, but the investment bank saw a need for extra public sector support of €46bn to meet the shortfall in bank capital. The state has already injected €16bn of capital, it said.

In the absence of external investors, creating an asset management company, or bad bank, to buy the toxic loans would not reduce the fiscal cost for Spain of recapitalising the banks. But it could improve investor confidence if the tainted assets were sold for credible prices.

“This could pave the way for a return of private foreign capital into the country. However, the process may reinforce investor concerns if the valuation process shows large provisioning shortfalls,” BarCap concluded.

Balancing act

Trinity College Dublin economics professor Philip Lane said the trick was to purge the banks of sufficient risk so their books are "clean" once more in the eyes of the markets, without saddling the government with too big a bill.

"To guard against being overly generous from the taxpayer's point of view, some of the downside risk would stay at the bank. If the transfer values are too good, down the line it would be recouped from the banks," Lane said.

Ireland's experience shows just how difficult it can be to set the right price in fast-falling markets.

Even after Nama took a huge chunk of bad loans off Irish banks starting in February 2010, house prices continued to fall and mortgage arrears kept rising, exposing an additional capital shortfall last year of €24bn.

The total cost of recapitalisng Ireland's banks so far is estimated at €86bn, or 52% of GDP.

For McCarthy, the University College Dublin economist, making governments pay for disastrous private sector lending decisions is not just iniquitous. By refusing to countenance losses for senior bond holders, the ECB is destroying market discipline, he argued.

"We have built a moral hazard machine and it needs to be stopped," McCarthy said.

"There is no market discipline if you continue to give 100 cents on the dollar to people who bought bonds in banks that are closed in the Irish case."

Having governments assume banks' obligations to their creditors also risks doing permanent damage to the sovereign bond market because buyers will stay on strike if they cannot quantify states' contingent liabilities, he said.

"Clearly, the ECB thinks that bank debt is more important that sovereign debt. But there comes a point where these things just have to be faced.

"A sovereign insolvency in Spain, or in Italy for that matter, runs the risk of a very big financial catastrophe in Europe," McCarthy said. 

 
ecb  |  spain  |  europe debt crisis
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