Thursday, August 4, 2011

Does the EU have the time to solve its debt crisis?

Judging by the markets reaction over the last two weeks to the proposed changes in the European Financial Stability Fund, the EU is running out of time to solve its debt crisis.  Yields on Spanish and Italian bonds are fast approaching the level at which the EU has previously had to bail out the periphery countries.

Judging by the markets reaction to the ECB restarting both its sovereign bond buying program and its six month liquidity program for banks, the EU is running out of time to solve its debt crisis.  EU capital markets sold off, Spain had to postpone a debt offering, and Swiss Francs and UK Gilts are trading at or close to record highs as EU investors look for alternative investments.

The fact that the EU is running out of time, does not mean that the solution has to be implemented overnight.  This is a critical distinction.

What is important is that the market believes that the solution will solve or lead to solving the problem.

Beginning in early 2008, your humble blogger engaged in numerous conversations with senior US Treasury officials.  They understood that disclosure was the long-run solution to the problem.  However, they were under political pressure to come up with a short term fix.  The result was TARP and a host of other government programs designed to bailout the banks.

The EU has returned to the same place it was at the start of the credit crisis.  Everyone is asking the question of who is solvent and who is not solvent.  This time though, the question applies to both countries and their banking systems.

Another key and critical difference is that the members of the EU have already dramatically increased their debt loads as a result of the earlier short term fix and central banks have lowered interest rates and flooded the market with liquidity.  As a result, they have a limited amount of capacity for engaging in additional bailouts.

Fortunately, the same long-run solution that should have been adopted at the start of the credit crisis in 2007 is still available.  Disclosure answers the question of who is solvent and who is not.  It also answers the question of how much capital is needed.

Please note, and this is very important, the market does not require that all of the capital be raised at once!

Let me use Security Pacific as an example to show you that the market is perfectly willing to let a bank that is currently insolvent work its way back to solvency.  In the mid-80s, Security Pacific was heavily exposed to loans to less developed countries.

It carried these loans at book value even though they were trading for 50% of book.  When John Reed and Citi lead the write-downs on loans to less developed countries, market participants could see exactly the size of the hole in Security Pacific's balance sheet.

Did everyone run and pull their deposits or investments from Security Pacific?  No.  Did its stock price collapse?  No.  In fact it increased significantly.

It was well understood by market participants that its earnings would be retained and not paid out in bonuses and equity would be raised to fill the hole.  And now market participants could even estimate how long this process would take.

What market participants fear is the unknown.  Disclosure eliminates this fear!

The quick and easy solution to the EU crisis is to adopt current asset and liability level disclosure for the banks in the EU system. 

Unlike bailouts, disclosure will end the debt crisis in a timely manner.  Without disclosure, the crisis will continue unabated.  I look forward to assisting the EU in the implementation of disclosure.

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