Monday, 11 April 2016

Italian Bank Bail-Out Plan

Global banks are bankrupt. They are like zombies, a living dead, that are allowed to continue to walk the Earth only because of the process of "extend and pretend", as central banks have stuffed them full of liquidity. Some of them are more zombified than others. The US banks had a lot of their debts written down in 2008, as US property prices crashed, but the US financial system still has over $1 trillion of student debt, much of which is probably not going to be repayable. It has an equal amount of credit card debt and so on. But, the most obvious zombification is in Europe, the latest manifestation is in Italy, where, reports today indicate that the Italian government is meeting with banks to set up an Italian “bad bank” to take bad debts off the hands of Italian banks, and to provide €5 billion of financing.

The global financial meltdown of 2008/9 took until the beginning of 2010, before it manifest itself in the Eurozone Debt Crisis. That took the form of the sharp rise in interest rates on the sovereign debt of a series of European peripheral economies, whose debts were unlikely to get repaid. Those sovereign debts were often largely held by the commercial banks in each of those peripheral economies, and because the global financial system is so inter-related, as 2008 demonstrated, those banks themselves borrowed in global financial markets, so that if they collapsed, it meant that the other European and global banks that had loaned them money, also would not get paid. A lot of this borrowing and financing is done via an ever growing series of derivative products, that bundle up financial assets, which are then sold as commodities on global financial markets. Its why its impossible to know the full extent of the level of debt and third party risk. But, we do know that Deutsche Bank in Germany is reported to have exposure to around $75 trillion of such derivatives!

The question of the insolvency of commercial banks, and the insolvency of states in Europe, has then been inseparable. But, for the commercial banks, the further issue has been not only that they had exposed themselves to vast amounts of debt to governments, but they had exposed themselves to vast amounts of debts to private households. In the US the extent of that in relation to Student Debt and Credit card debt has been mentioned, the same is true in the UK. But in the UK and across Europe a large part of this household debt is in the form of mortgages on astronomically over priced houses. That was indicated in Greece, Spain and Ireland when property prices crashed there from their previously bubbled up levels. It began to occur in the UK in 2008, before the Bank of England slashed official interest rates, started the programme of QE, and the government began a series of measures to prop up the property bubble, and prevent it from bursting.

British banks have loans outstanding worth about 160% of UK GDP. But 35% of these loans went to other financial institutions, 42.7% went to households for mortgages and another 10.1% went to commercial real estate and construction. Manufacturing received just 1.4% of the total! UK banking’s main activity is just leveraging up existing property assets.

In Ireland, when the property bubble burst and prices fell by around 50-60, the Irish Banks collapsed, and the Irish State was conned into bailing them out. The cost of that was that the Irish State then imposed huge levels of austerity on the real economy, sending it into recession just to maintain the fiction of paper asset prices. In Greece, vast amounts of liquidity has been pumped into the economy, nearly all of which has simply gone to enable existing debts by Greece to be repaid to other European lenders, whilst again massive levels of austerity have cratered the real Greek economy, which continues to suffer from an inadequate amount of capital.

The same process then played out in Portugal, and in Cyprus. In Spain and Italy, something similar was about to play out, when the ECB eventually stepped in to say that it was going to be providing large amounts of liquidity so that European commercial banks could continue to function. It did so via several instalments of LTRO's (Long Term Refinancing Operations), whereby it lent money for 3-4 years to banks at low rates of interest. It has then added to that by starting large amounts of QE, whereby it provides liquidity to the banks, in exchange for the largely worthless sovereign and mortgage bonds those banks have on their balance sheet. Rather than using the liquidity to lend to European businesses, as the data above indicates in relation to UK banks, the banks used this liquidity to simply speculate further in the purchase of sovereign bonds that were underwritten by the ECB. That is why the prices of those bonds has been forced higher, whilst other borrowers face high levels of interest.

But, the underlying problem is that the banks are insolvent, and the basic fact is that the banks have massive debts, whilst the banks' assets, in the shape of the property against which mortgages have been given, and of the bonds and other financial assets given as collateral, are worth only a small fraction of the book value at which they are listed, if they are worth anything at all.

In this latest bail-out, the Italian government is proposing to throw in €5 billion of funding to establish a bad bank for Italian bank assets. But, the fact is that looking at just the property loans on the books of the Italian banks, it probably requires more like €100 billion to cover the gap between the book value and the actual market value of those assets. If past experience is anything to go by, the figure could be twice that amount.

What the banks have tried to do via “extend and pretend” is to keep these worthless properties on their books, rather than sell them in large quantities. They were able to do that, because of the cheap loans that central banks have provided to them. The loans and other forms of liquidity that the banks have received has provided them with the cash flow to be able to continue to function. What it has not done is to change the fact that they are bust, and they are bust because the real value of the assets on their balance sheets is still only a fraction of what it appears to be.

This is the nature of zombified businesses in general. It means that they have just enough liquidity to be able to cover their current running costs, and maybe to cover the interest payments on their own borrowings, but they do not have enough earnings to be able to pay down their large levels of debt. For thirty years that was seen as unimportant for businesses, including banks, and for households, because it was assumed that the nominal value of financial assets, and of property would continue to rise at phenomenal levels so that it would quickly become a multiple of the capital that was borrowed. But, it was, of course, a mirage, because the rise in nominal asset prices was based on nothing other than a bubble that sooner or late bursts, exposing the real value of the assets, and the extent to which the debt still exceeds it.

If we take the Italian banks now their capital, like that of every bank comprises a number of elements. Firstly, it is made up of the money that shareholders provide to the bank, and in return for which they get shares, and so the entitlement to interest, in the shape of dividends, on the money they have loaned to the bank. A similar situation exists with bonds issued by the bank. Another element of the bank capital is the cash it receives from depositors. All of this money received by the bank forms part of its assets. It is money it can use to make loans. At the same time, this money it receives also creates liabilities. The shareholders are entitled to try to recover the money they have loaned to the bank, in the event it is wound up. The same applies with bondholders. People who deposit money with the bank, as savings, are entitled to take that money out of the bank.

The other element of bank capital is the collateral it receives in exchange for the loans it makes. When a bank lends someone £100,000 as a mortgage to buy a house, the bank itself takes possession of the deeds for the house, giving it the ability to sell the house, and thereby recover its capital, should the borrower fail to pay up. All of this capital, provides the basis for the bank to make loans, and it is on this basis that the bank makes its trading profits, by being able to charge a higher rate of interest to borrowers than it pays itself to borrow money.

If the bank's capital shrinks, its ability to lend money declines, and so its ability to make profits also declines.

If we then consider the Italian Banks, if the real value of the property it has on its books, against which it has advanced mortgages and other loans is actually €100 billion less than it appears in those banks books, then those banks real capital is lower by that amount. But, banks do not just lend money equal to their capital. They lend far more than that. On the back of €100 billion of capital, the banks would be likely to lend around €1 trillion. If Italian banks were to reduce their lending by €1 trillion the economic effects can be easily imagined.

On CNBC, this morning, anchor Steve Sedgwick, pointed out the reality of the banks situation that they have vast amounts of this property on their books, the debts against which are not likely to get repaid. The answer, he said, quite rightly, is that the banks should just put all this property on the market and sell it, for whatever they can get for it, and thereby clear the decks. The Italian pundit he was interviewing, however, recognised why this hasn't happened, and was not likely to happen voluntarily. If the banks put all this property on the market, there would be a fire-sale. The property prices would crash, and that would probably mean that lots of other people would find that the houses they thought were worth €100,000 were only worth €20,000.

The banks capital would be reduced massively, and unless that capital was replenished by other means, it would mean the banks could lend much less money. The supply of loanable money-capital would be reduced significantly, so that global interest rates would rise sharply, slashing the prices of other financial assets such as bonds and shares. But, replenishing the banks' capital to make up for this drop of €100 billion in the actual value of property on its books, would require the issuing of huge numbers of new shares, or bonds, and that would mean not only that large amounts of money-capital would be required to buy those bonds and shares, but this increased supply of those bonds and shares, would cause share and bond prices to fall sharply. It would cause a new financial crash, because these effects in Italy would quickly spread to other European banks, and from their into the global financial system. That is before this same process plays out with the banks in the UK and the rest of the EU.

That is why the authorities are doing all they can to keep the property bubble inflated, to only allow a certain number of properties on to the market at any one time, so as to stop a fire sale of property prices. But, the drop in European bank shares over recent months, the ridiculous amounts of liquidity being pumped into circulation, the implementation of negative interest rates and so on, shows that they are looking more and more like King Canute trying to hold back an ever advancing tide.  

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