It was only a few months ago that everyone was told to move on, the euro was fixed and the Eurozone was on its way to recovery and eventual prosperity in uniform political solidarity. There was some apprehension because that proclamation was the third made in as many years, but this time was supposed to be different because there were no longer any inhibitions out of Frankfurt. The ECB went “all in” on the euro, ipso facto, this time was really different.
I think that says a lot about what has happened in Cyprus. Buoyed by the ECB’s forceful reaction from September 2012 and evident market “acceptance” of that full measure, the concept of the bail-in became, in the minds of policymakers, more acceptable. The bail-in itself, a policy measure whereby depositors are taken out of their current place atop the capital structure and forcefully converted into first-loss position, has been discussed for well over a year (and probably even further back in time in private conversations). It had no prayer of being pulled out in Spain during last summer’s bank “jog”.
The loss of deposit “money” out of Spain in the middle of 2012 was driven less by credit risk of bank entities (though they were failing regularly) and more by concerns of Spain being driven out of the euro altogether. It was currency hedging of deposits in a multi-national setting. So the ECB applied a currency-saving approach by essentially guaranteeing a price for sovereign debt. Voila, currency crisis averted!
But that was a fundamental misreading of what ails Europe as a whole. Travails and financial travesty in 2013 is not really a liquidity problem, it continues to be a solvency issue. The transmission of solvency as a fundamental drawback into the currency problem is the simple fact that some parts of Europe are more solvent than others. Intervening in pricing mechanisms makes no difference – it simply tries to “fool” investors back into the erstwhile insolvent regions long enough to apply ad hoc, poorly-conceived recap policies.
This two-step approach required gullible investors to purchase troubled debt under the ECB backstop while various bank mechanisms were applied to re-arrange asset schemes. In Spain, for example, Bankia was formed out of seven regional cajas to pool resources, including capital. It was solvency “solution” that did little to address true solvency deficiencies.
When these incoherent solvency solutions inevitably proved inadequate, the Europeans pulled out the “bad bank” scenario. In Spain, it took the form of the Fondo de Restructuracion Ordenada Bancaria (FROB), which then created SAREB (the asset management company for FROB).
Originally, under a July 2012 agreement, funding for FROB was to be provided by the EFSF and was to amount to €100 billion, but the EFSF ran into legal and funding issues of its own. In November, the obligations for this recap effort were transferred from the EFSF to the ESM (these acronyms are really unimportant now). On December 5, 2012, the ESM priced 2 bills and 3 floating rate notes to raise about €40 billion. Klaus Regling, the managing director for the ESM, proclaimed, “This is the first financial assistance provided by the European Stability Mechanism. It is an important event as the ESM has now started to actively fulfill its role as the permanent rescue mechanism for the euro zone.”
There was no shortage of confidence, including that seen in asset market prices, that this time was different.
Now, after such hubris has given European officials the confidence to steal deposits in Cyprus (without democratic approval of elected Cyprus officials), there seems to be a brewing mismatch between ESM actions and their expectations for FROB and SAREB. Dubbed the “men in black” by Spanish media, representatives from ESM policymakers (colloquially the “troika”) are questioning what actually happened to the bailout “money”.
The translation is rough, but the gist is:
“The ‘men in black’ Sareb not conceive that a discount has demanded draconian payment of transfers of assets from brick to bubble, immediately afterwards, claiming an additional margin of 25% on retail prices. This spread is absolutely about 13,000 million euros over the 51,000 that have been acquired by the bad bank. It is, in sum, an amount equal to 30% of the resources used in the capitalization of troubled institutions.”
What Google is trying to translate from elconfidencial is that SAREB and FROB have been unable, in the “troika’s” view, to sell off “bad” assets acquired from the recapitalization efforts of “Group 1” Spanish banks, including Bankia. What they are saying is, in essence, that SAREB overpaid these Group 1 banks by about 25% over retail, amounting to a total subsidy to these banks of 30% of ESM-forwarded resources (estimated at €41 billion).
If this is correct, then SAREB and FROB are going to need more capitalization “money” to take a further haircut on the “bad” assets they now hold.
What’s more, those losses at closer to market prices should have been borne by the Group 1 banks themselves. But we know that Bankia, for example, had no further ability to absorb losses. FROB recently “valued” Bankia’s equity at €0.01, meaning any more losses would have pushed up the capital structure potentially to bond holders and, just perhaps, depositors.
Again, it is a solvency problem in Spain. Bailouts or ins or anything in between only re-arranges the pockets of bad assets that remain uncleared from the wider system simply because there just is not enough capital to refrain from impairing a broad section of the aggregate capital structure. The ECB and its political compatriots have been doing everything they can to “contain” capital structure damage, including supporting pricing regimes that have no relation to true “value”.
Now that bail-ins are back on the table, currently undergoing beta testing in Cyprus, the solvency issue and the lack of sufficient capital structure combines to dissolve the unearned optimism. Yet it has not dawned on policymakers that this is still a very dangerous game whose ultimate end is very much in doubt. In my opinion, this is really an intractable problem related to decades of over-financialization; there is simply not enough real economy potential to support the weight of real solvency.
But we can expect, at least every year, a proclamation that it is finally dealt with, and that this time is different.
At least one aspect is different, though largely negative however. As I mentioned, policymakers have been emboldened and have yet to grasp the fire with which they play. From Reuters earlier today:
“Now the likelihood is rising that tough treatment of big depositors will be written into a new EU law, making losses for large savers a permanent feature of future banking crises.
“You need to be able to do the bail-in as well with deposits,” said Gunnar Hokmark, an influential member of the European Parliament, who is leading negotiations with EU countries to finalize a law for winding up problem banks.”
Mr. Hokmark indicates that he believes there is wide support in the European parliament for this kind of legal framework – making the Cyprus beta test a codified reality. Given a banking system still well within the throngs of insolvency and inadequate capital, leave it to truly free markets to define a truly free solution:
“The savings, better under the mattress.” How often have we heard this phrase! The difficult economic situation in recent months and various scandals involving financial institutions have led many to dream about fluffy Spanish euros. Sleep feeling the hard-won banknotes. Francisco Santos also dreamed, and woke up to make it happen: you created the first mattress with built-in safe.
Maybe this time will really be different (and not in the “good” way).
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