Tuesday, November 30, 2010

Stopping the European Contagion Problem

It is not enough to just predict European contagion as the result of a solvency spiral.  It is necessary to also describe why it is happening now and what it would take to stop it.

Since 2007, many individuals have predicted that the issue of bank solvency would spiral out of control in Europe.

This prediction was based on looking at the capacity of countries to recapitalize their banking system for both direct and indirect losses related to the real estate and credit bubbles.  Like dominoes, countries could be ranked by their relative shortfall in recapitalization capacity if their banks experienced worst case losses.  Under this analysis, no European country could afford to recapitalize their banking system for the direct and indirect losses from their banking system's exposure.

This prediction and its supporting analysis have not been lost on European financial officials.  As reported by GFSNews, Mr. Honohan said [emphasis added]:

"As fears grew that the crisis affecting Ireland might spread to more indebted Eurozone nations, the governor of the country's central bank launched an incendiary attack today on credit analysts who he said 'assume the worst' about the country's banking sector.

Governor Patrick Honohan, in an address to a conference of chartered accountants in Dublin, argued that credit analysts do not have enough information about the health of the Irish banking sector and should undergo 'euthanasia'.

Honohan said: 'If there is no information, the credit analyst tends to assume the worst. They think, 'if the actual situation were good, would the bank not have been at pains to disclose it. Since it is not disclosed, it must be bad'.

However, it is not enough to predict that there might be an issue of solvency.  It is also necessary to describe the trigger mechanism that set off the solvency spiral in 2010.

As of September, the Irish government was using an independent third party to look at the performance of all the loans on the balance sheets of Irish banks, identify problem loans and value these loans so they could be purchased by a "bad" bank run by the Irish government.  Despite repeated rounds of purchasing bad loans at increasing discounts, the Irish government said that it did not need a bailout.  This position served to anchor investor estimates of the losses on the bad loans and prevented the beginning of the solvency spiral.

The discussion of the Eur 85 billion bailout destroyed the credibility of the valuation of these loans.  The solvency spiral began as investors attempted to come up with a new method for estimating the losses on the bad loans.

Naturally, investors gravitate to the only verifiable information they have, assume the worse and adopt a show me posture.

The original book value of the loans in the Irish banking system exceeds Eur 300 billion.  This is a conservative estimate of the potential size of the hole in the Irish banking system.  Presumably, the loans are worth something, but now the burden is on the government and the banks to show why this estimate of the losses is not accurate.

Unfortunately, the problem with this conservative estimate is the implications for contagion throughout the European Union and the global financial system.

What does this say about the value of the loans on other European banks who syndicated loans with the Irish banks?  What does this say about the value of any direct exposures the European banks have to the Irish banks?

Now that investors are focused on other European banks, another issue emerges.  Investors already have one example of a country that apparently hid the size of its banking problem (this is ironic because the Irish government tried to face up to and put their problem behind them).  Why should investors believe in the absence of any supporting loan-level performance data the pronouncements of other European governments on the issue of the solvency of their financial institutions?

Are the governments in Portugal and Spain trying to hide the problems with their financial institutions?  Investors might easily take the lesson they learned in Ireland and assume the worse case for the assets in these countries banking systems.

Like Ireland, the worse case assumption about the assets in their banking systems implies losses greater than these countries can handle.

Like Ireland, the solution for stopping the solvency spiral in Portugal, Spain and the rest of Europe is to re-anchor the credit analyst estimates of loss to actual performance and not to worse case assumptions.  

In his speech, Governor Honohan provided the solution:  "communicating more [current loan-level performance] information to the market would not only enlist the expertise of market credit analysts in a way helpful to all, but could lower the cost of term borrowing as investors regain confidence." 

Enlisting the expertise of the market credit analysts requires disclosure of current loan-level performance information for all loans on the balance sheets of the banks so that the analysts can independently analyze and value the loans.  

Any government that enlists the expertise of the market credit analysts by requiring disclosure by its banks of current loan-level performance is making an incredibly powerful statement. It is saying emphatically that its banking system is solvent and here is the data to show that fact.

There is one country that has suggested that it is thinking along these lines.  In England, the Bank of England is planning on substituting market discipline for bank examination.  To do so will require having banks disclose current loan-level performance information.

Besides halting the solvency spiral, benefits of adopting current loan-level performance disclosure should include a reduction in the cost of funds to that country's banks, an ability to unwind all government programs that support the credit and banking markets and, most importantly, a restoration of confidence in the country's financial markets. With confidence restored in the financial markets, business and consumer confidence should also return.

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