Only one good option should Spain and Greece spiral down together

In his NY Times Dealbook article, Landon Thomas Jr. looks at the options available to EU policymakers for developing an action plan to handle a collapse of Spain's banking system and Greece leaving the EU.

It is not clear that policy makers have many good options. 

The money available to Europe within its main bailout fund, about €780 billion, or $997 billion, would not be enough to handle the twin calamities of a Greek euro exit and a Spanish banking implosion.... 

“When you have Greece and Spain happening at the same time, the problem becomes exponential and very, very dangerous,” said Stephen Jen, a former economist at the International Monetary Fund who runs a hedge fund in London. “So far, the policy has been to buy time and build a firewall — but that just makes the cost bigger. There is just no good ending here.”

Mr. Jen confirms that the EU adopted the Japanese model for handling a bank solvency led financial crisis.  The model is all about buying time and building firewalls while praying for a miracle to fix both the financial system and the economy.

Mr. Jen is right that the Japanese model does not have a good ending.

However, the EU policymakers do not have to continue pursuing the Japanese model.  They could instead adopt the Swedish model with ultra transparency (but then, I am getting ahead of Mr. Thomas' story).

The numbers do look dire. 

Stephane Deo, an economist at UBS, estimates that the cost of a Greek exit to European taxpayers would be €225 billion, assuming Greece defaulted on the money it now owes to European public institutions. 

But, he says, the real fear is that while that was happening, the slow-motion collapse of Spanish banks from toxic real estate loans could suddenly turn into a fast-moving bank run, as depositors pulled out their money.

With Spanish banks now holding deposits of €2.3 trillion, such a loss of confidence could be disastrous for Spain and for the highly interconnected global banking system....

Please re-read the highlighted text because the EU policymakers choice of policy is driven by the need to prevent a loss of confidence not just in Spanish depositors, but across the EU.

The Japanese model has been shown as ineffective as nobody believes that the Spanish banks are solvent.  This is not a bold statement.  It simply reflects the fact that Spain had a real estate bubble prior to the recession that has left it with 20+% unemployment.  This is a prescription for major, major loan losses.

Technocrats in Brussels will readily say that what is now keeping them up at night is Spain. 

They are trying to see beyond the tools that so far have kept a true crisis at bay: the two rounds of low-cost loans that the European Central Bank extended to commercial banks late last year and earlier this one, and the €780 billion bailout fund.

One potential new tool, according to Mr. Deo, would be for Europe to guarantee the bank deposits of at-risk countries like Spain. This would be similar to the way the U.S. government increased deposit insurance during the financial crisis in 2008 to head off a bank run....

Your humble blogger has been a long-time advocate of Europe guaranteeing the bank deposits.  It has the facilities in place, the European Financial Stability Fund and the European Stability Mechanism, to do it.

But such a drastic step might steel the shaky nerves of Spanish depositors. 

Just such a step was briefly considered by European policy makers last year. But it was shelved on the assumption that North European taxpayers would not be inclined to back the banking system in Spain — or in Italy, whose own banks have still not regained a solid footing, or in other euro zone convalescents. 

And without an allocation of new money, there could be no new guarantees for depositors. 

With deposit insurance, the North European taxpayers would not be backing the banking systems in Spain or Italy.  European deposit insurance would be repaid by the country and banks that use it.

The total banking deposits in Spain, Italy, Portugal and Ireland are €5.5 trillion, or seven times the size of the main European rescue vehicle, the European Financial Stability Facility.

A deposit insurance fund, as shown by the FDIC, does not have to be the same size as the total deposits it is insuring.  What is important is that it can credibly step in should a bank need more money than it can raise from the central bank to pay off its depositors.

The other problem is that a deposit guarantee does little good if the citizens of the country in question become convinced that their nation might soon abandon the euro for another currency — as seems to be the case in Greece, where more than €60 billion in deposits have fled banks since the crisis began. Those account holders fear having euros in the bank that could overnight become drachmas with half the value or less.

As previously discussed, the EU policymakers can put an end to this by abandoning their posturing that Greece would have to leave the EU if it does not agree to austerity.

So far in Spain, there has been little sign of mass flight of deposits, perhaps, in part, because no one is seriously talking right now about a Spanish exit from the euro. 

What has been happening, though, Spanish bankers say, is that deposits have been moving from riskier savings banks like Bankia to safer institutions like Santander and BBVA, both of which benefit from having substantial international operations. Bankia is deemed to be so close to the brink that Spain’s government has seized control of it. 

However, a bank jog is clearly going on as deposits are moving.

But there is no question that the Spanish problem with bad loans is growing worse by the month. Last week, official statistics disclosed that nonperforming loans through March were 8.37 percent of the total loans — the highest level since 1994, long before the adoption of the euro. 

And it is not only problems in commercial real estate and home-mortgage loans that are mounting. A recent report from Moody’s shows that small Spanish businesses — in many ways the backbone of the economy — are also defaulting in increasing numbers, a sign that the Spanish recession is started to feed on itself. 

This month the government ordered that Spanish banks increase their reserves against faulty loans to €84 billion. 

As the health of the banks that made all these loans — largely the casas, or savings banks — becomes more precarious, so will the danger that depositors big and small will seek the safety of banks outside Spain, with German banks the likely havens.... 

“After a certain point, there is a breaking point,” said Mr. Jen, the hedge fund manager.
Investors are now wondering if this is it.

Rather than reach the breaking point, your humble blogger recommends that the EU policymakers choose the one good option remaining and adopt the Swedish model with ultra transparency.

As previously discussed in my blueprint for saving the financial system, adopting this option maintains depositor confidence (see above) while at the same time dealing with the underlying issue of debt in the financial system that the borrowers cannot repay.