The "Neutron Bomb Of Capital Calculations" And A Kyle Bass Refresher
In a double-whammy of downbeat dystopian discussions, GMO and Kyle Bass are active on the inevitability of Europe's demise. Perhaps that is too strong but the two are focused directly, in separate pieces, on the huge need for capital and the dire dearth of it available. GMO's central focus on the direct capital needs of the European banking system in the case of a recovery (but under Basel III) and under stress scenarios. Dismissing the EBA's efforts, and recognizing that the problem is capital/solvency (if there were more, the market would not be worrying about liquidity and deposit flight), their 'neutron bomb' scenario where sovereign debt is recognized as a 'risky asset' (which seems more than plausible to us), the capital needs are almost EUR300bn with Spanish and French banks dominant but Italian and German banks are close behind. As Kyle Bass notes "There is no savior large enough with a magic potion of capital to stave off this unfortunate conclusion to the global debt super cycle.".
GMO asks - What if banks were forced to treat sovereign loans as risky assets, rather than enjoying the current risk weighting of 0%?
If the capital standard is raised to 9%, the needs are unimaginable: 289 billion euros. Spanish banks still have the largest capital demand, 69 billion euros; but French needs exceed those of Italian banks, and German capital demands at 43 billion euros barely lag those of the Italian banks.
...equity investors can survive but will not be smiling. As of December 7, 2011, the needs are 98% of the market capitalization on average for the Italian banks, 60% for the French banks, and 48% and 70% for Spanish and German banks, respectively.
The Neutron Bomb of Capital Calculations
One obvious question is whether one should move to so extreme a scenario as provisioning against all sovereign debts, or even all European sovereign debt. Ever-expanding capital requirements can be the neutron bomb of banking regulation; the branches might still be standing, but the banks themselves would be barely recognizable if they were to survive the cataclysm. Once the Germans understand that they too are exposed, they presumably will be amenable to more reasonable approaches to the sovereign debt problems, such as more generous volumes and maturities at collateral facilities or even a direct use of the ECB to support sovereigns so as to avoid crushing the banking system.
The cataclysm plays out because the banks do have an alternative to raising capital – shrink the balance sheet. Deleveraging is already going on in a number of countries, with loan-to-deposit ratios dropping in recent months in Portugal, Spain, and Italy. This reduces the capital needs of banks, but fairly quickly starts to cut into the muscle of the financial system. The banks have little alternative but to keep holding sovereign debt in the short term, since it is the collateral for their borrowing needs. In countries such as Spain, a big chunk of private sector loans cannot be reduced because they involve property that will be inactive for years, perhaps a decade. So, once banks trim their healthiest borrowers and perhaps reduce their overseas exposures, they quickly run into the need to cut loans to small and medium enterprises, providing another negative impulse to European growth.
Perhaps more serious is the direct risk that Spain’s real estate problems pose to Spanish banks, which could expand to indirect risks for other banks. Recent conversations in Spain have led me to the conclusion that there are over 200 billion euros of property loans on raw land and developments, which will have little income-producing potential this decade. While Spanish banks have done some provisioning, there is much more to do, and the losses will be high.The incoming Spanish government is rumored to be interested in accelerating this resolution through a good bank/bad bank solution.
A few of the banks could probably cover their capital needs through further asset sales, but most of the losses would probably have to be backstopped by capital infusions by the Spanish sovereign, temporarily raising its own deficit.
And as if that was not enough doom and gloom, Kyle Bass was on BNN this morning discussing not just European endgames but the US and Japan in his eloquent manner:
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A negative disposition on financial markets has made Kyle Bass a wealthy man.
He made millions betting on the collapse of the U.S. housing market. And as European policymakers scramble to solve their sovereign debt crisis and avert a breakup of the euro zone, the founder of Hayman Capital Management says investors should prepare for the worst when it comes to Europe.
"As the dominoes fall, it's clear that the peripheral countries that are in the news so much -- the PIIGS as we like to call them [Portugal, Ireland, Italy, Greece and Spain) -- will have to restructure their obligations," he tells BNN. "I think that's coming much sooner than others would think and that is something you must prepare for in 2012."
"You see the deposits leaving the periphery at an annualized rate of more than 20 percent. This is the final precursor for a sovereign default and it's happening while we speak."
Bass believes that the excessive leverage at European banks will continue to haunt the region.
"Europe's banks have three times as much leverage from equity to assets that U.S. banks have," he says. "Spain, by looking at a snapshot on a piece of paper looks like they might have a manageable scenario, but when they recap their banks they won't have a manageable scenario and they have to recap their banks and so do the rest of Europe."
Bass says Germany -- considered the economic powerhouse of Europe -- is no better: "[Germany currently has an] 82 percent on balance sovereign-to-debt GDP today…in a post-recap world Germany will be north of 100 percent and will also be in a very difficult scenario."
This leads to only a bad and worse outcome for Europe, as the cataclysm plays out because the banks do have an alternative to raising capital – shrink the balance sheet. Deleveraging is already going on in a number of countries, with loan-to-deposit ratios dropping in recent months in Portugal, Spain, and Italy. This reduces the capital needs of banks, but fairly quickly starts to cut into the muscle of the financial system. The banks have little alternative but to keep holding sovereign debt in the short term, since it is the collateral for their borrowing needs. And as we have been so vociferously explaining recently, should they be forced to delver even more, and sell reduce these sovereign assets, then the daisy-chain effect of de-hypothecation on shadow banking will not end well for anyone.
Full GMO note: