Saturday, August 6, 2011

Debt Crisis 2.0: The solvency crisis re-emerges with a vengeance

As a column in the Guardian observed,
The conventional wisdom is that August is a sleepy month for markets, with politicians, policymakers and investors all at the beach rather than at their desks. The conventional wisdom is wrong.  
The credit crunch really kicked off on 9 August 2007, when the French bank BNP Paribas suspended three of its investment funds that had been dabbling in US sub-prime mortgages. 
Within a week, the Bank of England's Mervyn King was getting warnings that Northern Rock was in grave danger if the squeeze in money markets dragged on (not that it had any effect on Threadneedle Street's policies). Over the course of that month, the interest rate that banks charged each other for loans – the London inter-bank offered rate (Libor) – surged. 
Investors and commentators began talking about a credit crunch.... These were the first steps that led to the collapse of Northern Rock in September, and ultimately to a near-death experience for the world financial system. And yesterday you could have been forgiven for thinking that it was happening all over again.... 
What investors are demanding right now is not urgent American spending cuts, but a port in a storm – which means IOUs from DC, Swiss francs and gold. What they don't want is assets associated with the eurozone periphery: whether that be government bonds from Italy and Spain, or British banks (which took a pounding yesterday). 
This is a reflection of the return of the question:  who is solvent and who is insolvent.
The alarming thing, as the European commission president, José Manuel Barroso, pointed out yesterday, is that the eurozone periphery keeps expanding. Italy and Spain are now in the firing line. But Belgium is in the distance, too: the gap between the interest on Belgian government loans and their German equivalents has now widened out to over 2.2 percentage points.... Incredibly, a gap has even opened up between French government bonds and those issued by Germany. 
As this blog has repeatedly pointed out, without current asset and liability-level disclosure, market participants have no way of evaluating the solvency of any financial institution or its host country.  This sets up the necessary conditions for contagion.  This is reflected in the expansion of the eurozone periphery.
... At the height of the banking crisis of 2008, policymakers had two priorities: first, prop up the banks; second, protect the real economies as far as possible from the impact of the crash. This time, the task is again twofold, only much bigger: first, prop up the European banks, and ensure emergency low-cost loans for Spain and Italy; second, another round of reflation. Yet this requires money and moreover statecraft of a kind that has gone awol from European politics.
A column by Andrew Lilico in the Telegraph independently addresses the idea of propping up the European banks.
I’ll sketch this in five parts. First, the banks. Then the euro. Then monetary policy. Then fiscal policy. Then growth. 
But before we begin, accept this: the denial, delay-and-hope, no-creditor-shall-lose bailout strategy pursued since early 2008, as well as being immoral and destructive, has failed. Until policy-makers really embrace that point, at least to themselves, no progress can be made. 
The banks- Introduce Special Administration Regimes for banks. Now. Not tomorrow.
- Make depositors preferred creditors, overturning current bond contracts.
- If banks are insolvent but essentially going concerns, impose debt-equity swaps in special administration and provide unlimited liquidity to see off bank runs.
- If banks are insolvent, restructure or liquidate.
- Withdraw all government guarantees.
- Do not provide any further government recapitalisation funds. Especially resist the temptation to throw yet more good money after bad in the banks previously bailed out.
- Enact longer-term structural reforms– quickly. 
Regular readers know that the first step in re-establishing a solvent banking system and confidence in this fact is disclosure of all the current asset and liability-level data.  Without taking this step, market participants will not trust that the financial system is solvent no matter how it is reconfigured.

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