FYI | Sep 10 2008
By Greg Peel
A characteristic of the global credit crunch to date has been that all the focus has been on the US. And why not? What a sideshow.
We’ve seen the biggest US private mortgage lender, Countrywide, go close to bankruptcy before being bailed out by Bank of America. We’ve seen the fifth biggest investment bank, Bear Stearns, go close to bankruptcy before being bailed out by JP Morgan with help from the Fed. We’ve seen the biggest regional bank, IndyMac, go under. We’ve seen the government forced to step in and nationalise Fannie Mae and Freddie Mac. We now see Lehman Bros next on the list for some sort of rescue plan.
We have seen massive asset write-downs from all US institutions. We have seen related businesses such as monoline insurers Ambac and MBIA fight for survival and general insurer AIG take a big hit. Credit card provider American Express has also been trounced. We have seen share prices fall 50-90%.
But over in Europe, things have been comparatively quiet. Eerily so. At the very beginning of the credit crunch, Germany’s IKB Bank went under. Not long after, the UK’s Northern Rock was nationalised. In January, France’s Societe Generale had its “rogue trader” scare. Outside of some big write-downs from the likes of Germany’s Deutsche Bank, Switzerland’s Credit Suisse and UBS, and the UK’s Barclays, HSBC and HBOS, the headlines have been few and far between.
Yet now we see the economies of both the EU and UK contract in the second quarter. In the UK in particular, the housing market has begun to slump. But inflation remains at uncomfortable levels – levels which have seen the ECB make only the one rate change (up) since the credit crunch began and the Bank of England slow to implement rate cuts. In the meantime, the Fed has cut aggressively from 5.25% to 2%.
Credit securitisation markets around the world remain as good as closed, and no more so than in Europe. As is the case in the US and Australia, many smaller European banks rely heavily on funding through intermediation – through the bundling up and selling of asset-backed securities. But the shutters are down. Citi analysts note banks in Spain, Ireland and the UK are among the most affected by a lack of intermediated funding.
With a credit crunch and deleveraging process underway across the globe, one might assume the obvious reaction would be for businesses and households to stop trying to borrow more money, to pay down debt, and to increase deposits for a safe investment rather than persist with risky gearing. On this basis one might expect loan growth to slow, and deposit growth to accelerate.
Citi notes that in the first half of 2008, deposits into European banks grew by 350 billion euros, but loans grew by over 500 billion euros. This is counterintuitive. The analysts explain the situation as follows.
While households might be keen to fix their “balance sheets” and increase deposits, rising inflation is eroding real earnings power. Real interest paid on deposits is negative. What’s the attraction? You might as well start stuffing the mattress.
While loan growth is actually slowing as the deleveraging process continues, businesses are caught between a rock and a hard place. Financial institutions need to maintain funding to satisfy regulatory requirements. Corporates have previously borrowed on rolling longer dated commitments, and need to refinance those commitments to stay afloat. Shorter term finance is needed while everyone tries to sell assets – residential property, commercial property, infrastructure and so forth. There is a long queue, and there are few buyers with the capacity to step up without access to inexpensive funding, let alone the desire. Until assets can be sold, geared entities have to keep borrowing their way out of insolvency.
Thus European banks are finding their loan-to-deposit ratios have grown, and not shrunk as one might expect in times of financial turmoil and economic weakness. This puts even more pressure on European banks to borrow more money on already stretched balance sheets. With the death of pre-cedit crunch entities such as “structured investment vehicles” and “conduits” there is no one to buy asset-backed securities. Without deposit growth, banks have been forced to turn to central bank support.
The ECB was very quick to open up its lending facilities and to accept a wide variety of collateral in exchange for sovereign bonds. It moved ahead of the Fed, and despite the hype surrounding the Fed’s “heroic” opening of the discount window to investment banks and their motley collection of mortgage-backed securities, the ECB’s net was cast even wider. Jean-Claude Trichet’s response to the credit crunch has been to pump massive amounts of liquidity into the system while holding the cash rate fixed at 4% from the outset. That rate has recently been raised to 4.25% to battle inflation.
The result has been that European banks have swamped the ECB’s facilities in a desperate grab for cash. Not only were banks covering existing funding once provided by asset-backed securities, they were forced to create new securities and simply swap them immediately with the ECB for sovereign loans. This was not the intended spirit of the plan.
With loan growth exceeding deposit growth banks had to get their funding from somewhere, but now the ECB has moved to make that facility a lot more expensive. The central bank had little choice. With no end to the credit crunch and financial turmoil in sight, the “nth degree” risk is that European banks will carry on in pre-credit crunch mode and bleed the ECB coffers dry.
The ECB charges banks for its facility via a “haircut” on swap collateral. That haircut was originally 2% but is now 12%, with an additional 4.4% charged on assets for which there is no observable price. This means that for every $100 of collateral, banks were originally getting $98 worth of bonds, but now they are only getting $88. If they create some on-off security class to be swapped straight away – something which the ECB has no means of pricing, they will receive only $83.60. Put another way, $100 of ECB funding did cost $102 but now costs $113, or $120 for imaginative creations.
The bottom line is that European bank earnings, already under pressure, will be cut further by this additional funding cost. One is forced to consider that perhaps the ECB has seen no end to the crisis and is now prepared to let nature – or the free market – take more of its course. For a crisis such as this to be resolved, money must be allowed to pass from weak hands to strong, whatever the immediate ramifications.
That’s exactly what the US is not allowing, although few would disagree that allowing the “weak” to fail on that side of the pond would mean a devastating global depression. Can the US muddle through?
For now, it looks like the headlines emanating from Europe are yet to be written, but not long off.
