Eurozone shows how losses are transferred from banks to taxpayers

In discussing the difference between the Japanese and Swedish models for handling a bank solvency led financial crisis, your humble blogger noted that under the Japanese model losses are transferred to the taxpayers while under the Swedish model losses are taken by the banking system today.

Bloomberg ran an interesting article that documents how losses have been shifted from the Eurozone banking system to the taxpayers and hence real economy.

Delaying Greece’s debt restructuring by more than a year reduced banks’ potential losses as firms trimmed their holdings and most of the risk shifted to European taxpayers. 

When Greece was first rescued by the European Union and the International Monetary Fund in May 2010, lenders in other EU nations held $68 billion of its sovereign debt, according to the Bank for International Settlements. If Greece had defaulted, banks would have lost $51 billion at a 25 percent recovery rate. 

Banks’ holdings of Greek bonds fell by more than half to about $31 billion over the next 15 months, according to BIS, cutting creditors’ losses at last week’s swap by at least 45 percent.

Lenders are protected against further losses thanks to sweeteners from the EU to encourage the exchange. 

Meanwhile, Greece’s debt remains almost unchanged and the risk of future default is now mostly borne by the public. The same playbook is being used with Portugal and Ireland. 

“This is a horrible deal for the EU taxpayer,” said Raoul Ruparel, chief economist at Open Europe, a London-based research group. “The longer we wait for these restructurings, the worse the deal gets for the public. There’s an ongoing risk transfer from the banks to the taxpayers.”

Either banks take the losses today, the Swedish model, or the taxpayer gets the losses, the Japanese model.

Clearly, the Eurozone's policymakers have adopted the Japanese model and prefer to spend the taxpayers money absorbing the losses on the excesses in the financial system rather.

The alternative that is still available is to require the banks to absorb the losses today and rebuild their book capital through retention of future earnings.  This frees up the taxpayers' money to be used on stimulating economic growth.

Interestingly, the Japanese model has managed to preserve their banking system, but at the same time seen their economy shrink from 1995 to 2010.

On the face of it, the swap chopped 137 billion euros ($179 billion) from Greece’s 368 billion-euro debt burden. The actual reduction is less than half of that because the country has to borrow from the EU and the IMF to provide new debt to private creditors and to recapitalize banks and pension funds that can’t handle losses from the swap. 

The new borrowing -- in effect, replacing private with public debt -- will amount to 78 billion euros, according to the EU, leaving the actual relief from the swap at 59 billion euros. Greece also will need to draw money from a second, 130 billion- euro EU and IMF rescue fund to repay other private debt and finance the government’s budget deficit.... 

When all IMF and EU loans promised to Greece are disbursed, 66 percent to 75 percent of the country’s debt will be held by the public. In 2010, before the first bailout and before the ECB started buying its bonds, Greece had about 310 billion euros of debt, all held by the private sector.

Under the Swedish model, a 25 percent recovery rate on 2010 private sector holdings implies that Greece's outstanding debt would have been reduced by over 225 billion euros.

Compare and contrast that with what has occurred under the Japanese model where Greece netted a 59 billion euro reduction in debt outstanding.

If Greece has to restructure again, or defaults, taxpayers will be on the hook. 

“The swap doesn’t achieve debt sustainability for Greece,” said Nicola Mai, an economist at JPMorgan Chase & Co. in London. “Debt relief going forward will have to come from the public sector.” 

Banks reduced holdings of Greek bonds as they matured. Greece used loans from the IMF and the EU to make those payments....

So the banks got bailed out and the losses get transferred to the taxpayers.

“Relative to where banks were a year ago, they’re at a much better point,” said Roger Lister, a New York-based analyst who covers European lenders for credit-ratings firm DBRS Inc. “They may still face future losses, but those will be at a much smaller scale because their exposure is reduced greatly after all the actions by the EU.” 

The EU’s moves have favored banks, especially the weakest lenders that couldn’t bear losses from a Greek default, according to Peter Tchir, founder of New York-based hedge fund TF Market Advisors. 

“Every policy seems to be designed to help the zombie banks survive,” said Tchir, whose company focuses on European credit markets....

Please re-read Mr. Tchir's comment because under the Japanese model every policy is designed to protect the banks and in particular, the meaningless accounting construct known as book capital.

A similar shift of risk to taxpayers is happening with Portugal and Ireland. 

The ECB has bought 20 billion euros of each nation’s debt, according to Open Europe estimates, while the EU and the IMF provided 78 billion euros and 85 billion euros, respectively, in new loans to replace private financing for the two countries. 

In Ireland, most of the public money has been used to pay the debt of failed Irish banks. The ECB and the Irish central bank have taken over financing of the lenders, providing about 140 billion euros of funding and transferring risk to taxpayers. 

Since the November 2010 bailout of Ireland, European lenders have reduced their exposure to that country’s banking system by more than half to 61 billion euros. While current and past Irish governments have tried to stop paying banks’ debts with public funds, the EU has rejected the requests....

By rejecting the requests, the negative impact of the losses is transferred to the taxpayers and the real economy.

Portugal’s borrowing costs rose this month on concern the country might follow Greece into a debt restructuring....

“As long as they continue to push for reforms, there won’t be a political motivation to get the private sector involved and take losses...

Even if the political will materializes for a restructuring that involves private bondholders, it might be too late. Most of Portugal’s debt has shifted to the public, said Open Europe’s Ruparel. 

“They’d like us to believe Greece was a special case and won’t be repeated in other cases,” Ruparel said. “Greece is the worst case, but not a special case.”

What about Spain and Italy?