Wednesday, August 24, 2011

The price of becoming Swedish

Europe seems to lurch from crisis to crisis and the time between them has shrunk dramatically from months to days. Where does it all end? (See this hilarious account of what's wrong with Europe).

To put the European sovereign debt problem into context, what we have is the case of a number of peripheral countries that have taken on too much debt. The question then becomes, who bears the pain of this situation? There are four principal solutions:
  1. Default/restructuring - the banks first take most of the pain, which would result in a European banking crisis that threatens the stability of the global financial system.
  2. The ECB goes nuclear with QE - The European Central Bank buys up peripheral debt on an un-sterilized basis to the tune of, pick a number, €1T? €2T? €3T? In this case, the euro tanks and inflation breaks out in the eurozone.
  3. Political integration (in addition to economic integration) - National constitutions get changed and a central authority (Brussels?) assumes greater authority over the budgets and policies of individual EU member states. There is little or no political support for this solution and riots would likely break out all over Europe. The strong EU member states, mainly Germany, bears much of the pain for bailing out its partners.
  4. One or more countries (Greece? Portugal? Spain? Germany?) leave the euro - There is no mechanism for leaving the euro. This amount to a form of succession. How do you unscramble an omelette? Widespread confusion and chaos would rule in the financial markets and such an event would likely spark a financial conflagration that spreads around the globe.
The least costly option, in my opinion, is option 1. Force the bank shareholders and bond holders to take the pain and at the same time nationalize the troubled banks, much like the Swedish approach to their banking crisis of 1991-2 (also see this description of the Swedish solution in the wake of the Lehman Crisis of 2008).

A Euro-TARP for a prepackaged banking crisis?
How much would a Swedish style bailout cost?

If the EU or its member states nationalized the banking system, the first cut estimate comes from the current market cap of the European banking sector, which is roughly €300 billion.

For a more conservative estimate, I considered Tier 1 capital, which includes preferred shares and subordinated debt in addition to common equity. I added up all of the Tier 1 capital of the eurozone banks (ex-UK, Norway and Sweden) shown in the European Banking Authority's stress test of 2010. That figure came to roughly €800 billion. Note that estimate is more conservative because the list of banks include banks which are not exchange-listed such the German Landesbanks. True, there is some problem with this data set. The banking balance sheets does date from December 2009 but I couldn't find the a more up to date table Tier 1 capital and the point of this exercise is not to be exact, but to get a ballpark figure. (If anyone has access to the Tier 1 capital figures from the 2011 stress test please contact me at cam at hbhinvestments dot com).

So the ballpark estimate for nationalization ranges from €300 billion to €800 billion. The bill could even be less. During Sweden's banking crisis, not all banks had to be nationalized and some found private solutions.

The price of such a rescue campaign is roughly equivalent to TARP, which is very do-able and affordable given the stakes involved. The question is whether the EU member states have the political will to run roughshod over the bankers and financiers to do it.

For now, there is little political will to do anything, which has led to an impasse. Regardless whether the political will is there, I believe it's the right solution. Here is how the Reformed Broker put it [emphasis added]:
After 40 years of pain avoidance, can we just rip off the f**kin' band-aid already? Enough with the asset price protection, it is the root cause of everything bad about the economy right now. Had we saved the banking system and said f**k the banks themselves, we'd be two thirds of the way out of this by now. Had we gone Swedish instead of Japanese and said the banks are now "Wards of the State" until cleaned up, then yes, we probably would have seen Dow 5000...but so what? Was stopping at Dow 6500 so much better? We would have had an unencumbered financial system at this point, one healthy enough to cope with a new leg down in housing, rather than the debt-ridden George Romero zombie film we find ourselves re-watching every quarter.

He was writing about the US economy and how the Fed and the Obama Administration should handle things, but the same comment applies to Europe as well.

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