Tuesday, October 25, 2011

The poisoned bank recap chalice

We don't have the full details of the eurozone Grand Plan to be unveiled on Wednesday, but some details are clear. One of the key components of the proposal is to force a number of major European banks to recapitalize their capital base to 9% within a relatively short period. Banks would be encouraged to seek capital privately first. If that is not available, the bank could then turn to the individual member state, and failing that, to the EFSF.

This is a version of the Swedish solution, whereby shareholders and bondholders take the first hit in any recapitalization before the state injects equity. I have long been an advocate of this approach, but even that proposal needs a re-think. That's because the eurozone problem stems from too much sovereign debt accumulated by a number of EU member states and much of that debt was stuffed into eurozone banks. So the solution of the state rescuing the banks who lent the state too much money becomes a circular problem of trying to insure yourself.

What's more, the spectacle of EU states trying to rescue themselves has become too big. John Hussman put some scale to the size of the problem this week [emphasis added]:
My guess is that European leaders will force a bank recapitalization within days - probably 100 billion euros, preferably 200 billion, but the larger number is doubtful because at present market values, European banks would have to sell new shares in nearly the same quantity as their current outstanding float in order to acquire the new capital. Yet Stratfor correctly notes that even in the event of a 200 billion recapitalization, a 50% haircut on Greek debt "would absorb more than half of that 200 billion euros. A mere 8 percent haircut on Italian debt would absorb the remainder." So a good chunk of the present EFSF could end up recapitalizing banks, especially if too little is raised from private investors. This would leave little ammunition against any further strains, should they develop.
The current rumor is that size of the forced bank recapitalization will be about  €108 billion, which would be roughly half the value of market float at current prices. Bank CEOs who are incentivized by their share prices would be highly reluctant to go to the market and dilute their equity base by being a forced seller. By demanding that banks recapitalize quickly, the risks is that banks shrink their balance sheet by calling in loans in order to conform with the 9% capital target. This would result in an old-fashioned credit crunch, and in the face of the latest European PMI already pointing to recessionary conditions, such a policy would topple Europe's fragile economy into a deeper abyss.

€2 trillion = 20% of global FX reserves
If those aren't the solutions, then where else could the EU get the money? I wrote on Sunday that Europe has three choices:
  • Get more money internally from the strong states within the EU such as Germany;
  • Get more money externally, e.g. the US or BRIC countries; or
  • The ECB prints the money.
Given that Merkel is already on thin ice by asking the Bundestag to approve the latest EFSF proposals, the prospect of more funds from Germany is off the table. What about the United States, BRIC and Gulf State SWFs? While stories such as Norway's SWF is ready to invest are helpful, STRATFOR (sorry no link) put the scale of the problem into context:
[T]o put the magnitude of Europe’s crisis in context, it would take nearly 20 percent of the worlds accumulated foreign exchange reserves to account for the approximately 2 trillion euros needed to contain the EU debt crisis for a mere 3 years. The unlikelihood of such funds materializing is compounded by the fact that most of the foreign currency reserves are held by low-income countries with little political room to bail out one of the world’s wealthiest economic zones.
The kinds of shock-and-awe eurozone rescue figures that have been bandied about have been in the order of €2 trillion, which amounts to roughly 20% of global foreign exchange reserves? China has already signaled its reluctance to step up and help in a meaningful way. How likely are the other emerging market countries come to the rescue?

In short, forcing European banks to drink from the poisoned bank recapitalization chalice today could the policy mistake that plunges Europe and the world into a synchronized global slowdown. Don't expect other players, such as the IMF or emerging market economies to come to the rescue because the scale of the problem is just too big.

I guess it's all up to Super Mario now.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Eddie said...

Sell on the news.

Macro Rants said...

The fate of the European world depends on "Super Mario"?

I suppose it is inconvenient to point out that before he put on his blue tights and red cape - Super Mario worked at Goldman Sachs?

And Goldman was instrumental in arranging all sorts of off balance sheet swaps that hid the true extent of Greece's debts?

So in other words, the fox with the feathers sticking out of his mouth is being asked to guard the hen house which no longer has any live hens inside?

This sounds more like a Monty Python skit than a developed economy.

keithpiccirillo said...

Draghi translates to Dragon in Italian.

Nathan said...

Cam, Thank you so much for your insights. I lurk via Google Reader.

How would a further contraction in available European credit impact the Canadian economy? How would it impact Canadian equity and bond markets (beyond a knee jerk reaction to headlines)? Are there factors beyond the potential credit contraction (e.g. CDS exposure) that would significantly impact us in Canada


Student of the Humble Student and layman in equities markets.