Bailing Out Europe Again and Again

While it is hard to imagine, Europe's debt crisis is nearly entering its third year.  So far, Europe has managed to contain most of the damage to its own territory; the United States, Canada and the Far East are still showing economic growth levels that are modest but still positive and the crisis in the bond market has not spread beyond the Eurozone.  Unfortunately, everything is still not "well"; Greece is walking a debt tightrope, Portugal and Ireland are wards of the EU and the IMF and Spain and Italy hover near the doors of the casualty ward with bond yields that look like this, suggesting that all is not well:

A paper by Lee C. Buchheit and G. Mitu Gulati entitled "The Eurozone Debt Crisis - The Options Now" give us insight regarding what tactics the Eurozone can employ to assure the world that all is now well.

Looking back at the Latin American debt crisis of the 1980s and 1990s, the IMF enthusiastically and predictably prescribed the same formula for debt transgressors:

1.) Raise taxes

2.) Cut expenditures

3.) Restructure debt

This "program" forced debt holders and lenders to extend their loans or accept the consequences of a haircut to both principal and interest.

In the case of Greece, the "program" unfolded in a far different way.  Initially, Greece basically used taxpayers' money to repay existing lenders at par because there was a great fear of contagion as the crisis spread to Portugal, Ireland, Italy and Spain.  On top of that, since most of Greece's debt was held by French and German banks, a restructuring of the debt could have had severe negative consequences for the balance sheets of these supposedly "strong" banks.

By the summer of 2011, it became apparent to governments, the IMF and central banks that they were becoming the lender of last resort to Greece.  At that point, the "official sector" began to insist that the remaining private sector bondholders voluntarily agree to a restructuring of their claims against Greece.  The end result of this was a write-off of 53.5 percent of the nominal amount of the debt.  This process erased roughly €100 billion from Greece's outstanding debt held by the private sector.

While the Greek debt crisis is over for the present, other nations find themselves in the crosshairs.  The IMF and EU argue that nations like Spain and Italy have taken budgetary steps to avoid crises and that all that is required is time to let fiscal responsibility work its way through the system.  Once the bond market notices that the newfound budgetary constraints are permanent, the markets will reward the governments with lower interest rates on their debt.

In the meantime, how does the world deal with nations like Spain and Italy, potentially next in line for the "Greek treatment"?  Here are five steps that could be taken:

1.) Jolly the Market: Politicians from the debtor countries cajole the markets that the newfound voluntary fiscal restraint that these nations have adopted are permanent and irreversible and that eventually, everything will be okay and the markets will reward their good behaviour with lower interest rates.

2.) Massage the Yields: If the first option fails and yields do not fall voluntarily, the EU, the ECB and the IMF (the official sector) will take action in the bond market to force yields down by purchasing additional volumes of debt so that the debtor nations can borrow at reasonable rates.  As well, the official sector could offer a form of credit insurance, lending their "AAA" credit rating to that of the debtor nation and pushing yields down.  While these proposals look good on paper, the ECB's purchases of bonds from Greece, Ireland and Portugal at the beginning of the crisis did little to fix the problem over the long haul.

3.) Full Bailout: If the measures listed above fail, the debtor nation will require a full bailout from the official sector will be forced to bailout the full amount of the debt that is maturing during the period of the bailout program as well as covering the amount of budget deficits during that time.  This avoids the dreaded "default".  Unfortunately, this clearly did not work during the initial part of the Greek bailout.

4.) Reprofiling: If the official sector decides not to bailout existing creditors at par as they did in stage one of the Greek crisis, restructuring of the debt is required.  This can be done by moving the maturity of the debt to some point in the future by a fixed number of years.  This avoids a painful debt haircut and the interest owing on the debt remains at the coupon rate.  This has several advantages:

•    no loss of principal.

•    no need to fund maturing debt.

•    the private sector bears the weight of the restructuring.

•    interest rates remain relatively low.

5.) Full Restructuring: This is where Greece found itself in mid-2012.

Where does the European situation stand today?  Spain, with its debt of over €860 billion already finds itself at Step 2 - Massaging the Yields.  In September, the ECB began a program it called the Outright Monetary Transactions program (OMT) which will see the ECB purchase one to three year bonds of Eurozone countries in unlimited amounts (crank up those "printing presses") to push prices up and yields down.  This was also seen as a mechanism to reduce the interest rate spreads between the northern Eurozone nations and their less fiscally robust southern neighbours.  Unfortunately, as shown on this chart, the "supply of European debt is huge, particularly when Italy is included:

There are several significant risks to the OMT program:

1.) Potential losses to the ECB, should they be forced to declare the mark-to-market on their risky bond portfolio, could be staggering.  

2.) Investors will only buy the bonds at the lower yields created by the ECB purchases if they are assured that the ECB is standing behind them.

3.) Debt issuers may try to concentrate their bond issues at the short end of the curve (the one to three year period) where the OMT program is pushing yields down.  As the authors state, "Why borrow for ten years at 9% when one can borrow for two years at 3%?".  This artificial distortion in the yield curve could produce a very, very dire situation if the debt transgressing nations choose to issue only short-term debt.

4.) Austerity fatigue could erupt in the nations that are beneficiaries of the OMT program.  Since public resentment of austerity measures tends to rise when organizations like the IMF, ECB and others are involved in bailouts, the ECB could be backing itself into a corner when austerity fails.

As we can see from this paper, Europe as a whole has backed itself into a corner where the only options are extremely unpalatable over the long-term.  The only thing saving the world's economy right now is the pass that the United States and Japan are being given on their $27 trillion worth of sovereign debt.  Without that, the world would be awash in a sea of worth-less government-issued paper.

Canada's Healthy Banking System - Fact or Fiction?

Since the beginning of the Great Recession, Canadians (and the rest of the world for that matter) have been bombarded with propaganda from the Harper government telling us all how Canada's private sector banking business is the eighth wonder of the modern world and how, without help, it managed to weather the worst that the economy could throw at it and arise from the ashes of 2009 unscathed.  Is this really the case or are we just being lulled into a false sense of security?

Researchers at the Centre for Policy Alternatives, a Canadian think-tank have released a report entitled "The Big Banks' Big Secret", authored by David Macdonald.  In this eye-opening report, Mr. Macdonald digs behind the headlines and examines the veracity of the mainstream claims that Canada's banks did, in fact, not require the massive bailouts that other banks around the world have required during and since the Great Recession nearly caused the world's banking system to implode.  In this posting, I will select a few of the salient points that will help us better understand just how healthy Canada's flagship banking sector really was and how we could be in for a bit of a surprise in the future.

Let's open with three quotes from Canada's pre-eminent Minister of Finance and his boss, the Prime Minister:

“...we have not had to put any taxpayers’ money into our financial system in Canada, nor do I anticipate that we’ll be obliged to do so.”

—Jim Flaherty, Minister of Finance

“Without wanting to appear arrogant or vain, which would be quite un-Canadian...while our system is not perfect, it has worked during this difficult time, I don’t want the government to be in the banking business in Canada.”

 —Jim Flaherty, Minister of Finance

“It is true, we have the only banks in the western world that are not looking at bailouts or anything like that...and we haven’t got any TARP money.” —Stephen Harper, Prime Minister

And lo, the fairy tale was born.

Through Mr. Macdonald's research, we find that the three preceding statements could not be further from the truth.  In actuality, between September 2008 and the peak of the crisis in March 2009, Canadian banks received $114 billion in support from three entities; the United States Federal Reserve, the Bank of Canada and Canada Mortgage and Housing Corporation (CMHC) (or in other words, Canada's taxpayers since we implicitly back any investments that CMHC makes through our annual, involuntary donations to Ottawa).  This "Extraordinary Financing Framework" was actually prepared to spend up to $200 billion to backstop Canada's banks and other industries.  Here is a graph showing the support given by month and the source of the money:

Notice that pretty blue wedge?  That's thanks to you and I, Canada's taxpayers.  This support was termed CMHC Insured Mortgage Purchase Plan or IMPP and you'll notice right away that it quite rapidly became the largest source of funding to Canada's banks.  Within four months of its inception, Canada's banks had receive $50 billion in cash (politely termed liquidity in bankerese) in exchange for mortgage-backed securities.  As I noted above, support for Canada's Big Five and a handful of their little buddies like ING, HSBC and National Bank among others had soared to $114 billion.  To put that number into perspective, that's 7 percent of Canada's 2007 GDP and represents a subsidy of $3400 for every man, woman and child in Canada.

You will also notice that the black and green portions of the bars rise and then disappear.  At the peak of the bailout, Canadian banks borrowed $33 billion from the Federal Reserve (black portion of the bar) as shown in this chart, noting that Scotiabank was the heaviest "feeder", with borrowings peaking at $11.9 billion, all of which was repaid by April 2010:

Let's not forget the largesse of the Bank of Canada.  The Bank of Canada stands behind a cloak of secrecy, refusing to release the amount of their loans to the banking sector, however, records of the Office of the Superintendent of Financial Institutions (the banks' boss) allowed Mr. Macdonald to estimate that Canada's banks had borrowed over $41 billion from Canada's central bank.  As shown in this chart, banks headquartered in other jurisdictions would also have been eligible to avail themselves of the Bank of Canada's generosity, including American banks that dipped very, very heavily into the very, very deep pockets of the Federal Reserve:

Remember, because of the cloak of secrecy under which Mr. Carney operates, we do not know how much the Bank of Canada loaned to the banking sector outside of Canada, however, it's comforting to know that Canada was there for its pals during the Great Crisis, isn't it?

Mr. Macdonald estimates that the biggest users of the Bank of Canada's liquidity was the Bank of Montreal, CIBC and Scotiabank whose borrowing peaked at $9.2 billion.  All three would have used those wonderful mortgage-backed securities and provincial bonds as collateral for the amounts borrowed.  All of the funds borrowed from the Bank of Canada were repaid on July 8, 2010.

Let's put all of these numbers into perspective.  Here is a summary of the estimated support for Canada's banking sector, showing the level of peak support to the market capitalization of the bank on the date of peak support:

Notice that three of the five banks, CIBC, BMO and Scotiabank, all maxed out their "credit cards" by finding themselves in a situation where their borrowing was equal to or in excess of their market value. This has two implications:

1.) Canadians could have been left holding the bag, owning a bank and its assets that were worth less than its debt.

2.) Canada's bankers have now been led to believe that they are too-big-to-fail and are now suffering from a bad case of moral hazard where, no matter how stupid they are, taxpayers and other parties will be there to back up their foolishness.

Why should this concern any of us now?  After all, this is two year old history.

This should be of extreme concern to all of us because Canada is one of the few developed nations in the world that has not suffered from a real estate market readjustment.  You'll notice that Canada's banks used mortgage-backed securities as collateral in 2008 - 2010.  What happens if Canada's real estate market takes a tumble and those mortgagees find themselves underwater?  So much for securitizing negative equity mortgages. On top of that, Canada's banks have very little protection from an avalanche of defaulting loans of all types as I posted here since their loan loss provisions are a tiny fraction of what could be required if the bottom fell out of Canada's real estate market or if default rates rose in lock-step with rising interest rates.

Mr. Macdonald's report should give all Canada's cause to reconsider what we think we know about Canada's banking sector.  It is quite apparent that all is not what it appears and appeared to be and that it is most definitely not all that we have been told that it is by Canada's political leadership.