Wednesday, December 15, 2010

Europe Gets a Second Chance to Cure Solvency Crisis

As the credit crisis was slowly unfolding in early 2008, European and US central bankers and the national financial officials of their respective countries made the decision that their banking systems must be saved.  Their tools of choice were guarantees, temporary capital injections, suspension of mark-to-market accounting and unlimited liquidity for the commercial banks (call this the "liquidity policy").

Unfortunately, before using any of these tools they failed to:
  • Identify all the sources of losses and determine how big the losses actually were for each bank; and
  • Agree on who would bear the losses that were in the global banking system.  
By not doing so, they left themselves without an exit strategy for returning the banks to a capital market system where investors have the potential for gains and losses.

Re-introducing banks to this type of capital markets system is virtually impossible given that the liquidity policy does not directly address the issue of solvency.  The policy does not answer the question of what are the losses on each bank's balance sheet.  Who is solvent and who is insolvent?

Investors today do not want to buy the losses that should have been incurred by the investors who were bailed out by the liquidity policy.  The only way investors today are going to be comfortable accepting the possibility of losses is if they can independently determine that they are not buying the old losses.

This point needs to be repeated.

Investors are not compensated for buying someone else's investment losses.  They are not going to buy bank or sovereign debt where they think they are buying losses that have already been incurred but have not been disclosed.

Today, Europe once again is faced with the issue of what to do with the losses in its banking system.  An issue that has now also morphed into a sovereign debt crisis.

Based on the discussions surrounding the European Financial Stability Facility, it appears that European financial officials are responding to the solvency/sovereign debt crisis with the classic definition of insanity - repeating the same thing over and over again and expecting a different result.  

Even though the liquidity policy did not end the solvency crisis that began in 2008, the financial officials are proposing more of the same.  And why is this approach going to produce a different result this time?

Ireland provides a case study in the ongoing failure of this approach to address solvency and why it is unlikely to produce a different result this time.
The bailout is supposed to tide Ireland over for years as it recovers, and give it room to mend its finances until it can borrow in financial markets again.
Yet it is still unclear if the money will be enough. Irish regulators and I.M.F. officials found no new surprises when they pored over the banks’ books recently, and they said they doubted that the banks would need more capital or that mortgage defaults would surge. But if Irish homeowners, who feel particularly duty-bound to make their payments, change their behavior, that could increase defaults and push banks to tap the reserve of 25 billion euros. Regulators will test the banks again in March for any new threats from residential or other mortgages.
Even if the banks pass the latest stress tests, banking experts worry that problems may surface later.
“I reckon 35 billion euros is not going to be enough,” said Alan Dukes, a former finance minister whom the government tapped to unwind Anglo Irish before it was nationalized in January.
“The number that’s there at the moment is based on what we can expect of the commercial property market,” Mr. Dukes said. “I don’t think any assessment has been made of the possible impact of mortgage defaults.”
 As readers of this blog know, the cure for the solvency crisis is:
  1. Provide current asset level information to the credit and equity market analysts so they can independently value each bank's assets and therefore each bank's solvency;
  2. If a bank is seen as insolvent, then it can either be recapitalized or closed;
  3. Banks can be recapitalized either by raising money in the capital markets or government investment.
With this cure, investors know they are not buying someone else's losses and banks can return on their own to the capital markets.

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