|Europe's Double (Leverage) Trouble|
Europe has opted to go the route of history's long list of failed financial institutions. It has resorted to double leverage.
MINYANVILLE ORIGINAL When I was the Treasurer of Bank One, there was one quarterly financial metric that I paid close attention to: the double leverage ratio. (Albeit an oversimplification, the double leverage ratio is determined by dividing the capital of a bank by the capital of its parent bank holding company.)
Not surprisingly, what both the regulators and the rating agencies wanted was a ratio less than one. They did not want to see the holding company borrowing debt and then putting the proceeds from it into the bank as equity capital.
What brought this obscure ratio to my mind this week was Spain and the convoluted solution European policymakers yet again resorted to in their attempt to address that country’s banking sector capital shortfall. As proposed, European countries (through either the EFSF or ESM) will lend up to 100 billion euros to an agency of the Kingdom of Spain (the Fondo de Reestructuration Ordenada Bancaria or FROB) which, in turn, will use the proceeds to inject capital into troubled banks, most likely through contingent/convertible bonds.
Not surprisingly, what market participants have identified is the fact that by going through the multi-step process, the Kingdom of Spain is taking on yet more debt. But there are other complications to the proposal as well. Based on what happened in Greece, clearly the European System of Financial Supervisors/European Stability Mechanism will want super-senior creditor status (along with the European Central Bank and IMF) should Spain eventually default.
And then there is the fact that as of May, Spanish banks held almost one-third of Spanish sovereign debt. The more Spain borrows from other European nations and the IMF to put incremental capital into its banks, the more it effectively subordinates the Spanish bonds those same banks hold.
Back in October, when Belgium bailed out Dexia, I offered that Europe was well on its way to creating the financial system equivalent of the Beatles' song “I am The Walrus” – an “interpretive dance” in which "I am he as you are he as you are me." And we are all together. At every turn, rather than decoupling sovereigns from financials, European policymakers were only linking them more tightly together.
From my perspective, this week’s proposal only makes matters worse.
What I have been calling the European “interplex” is rapidly becoming conjoined twins: The sharing of critical systems between banks and sovereigns is growing more, rather than less, complex. Europe is no longer a case of two drunks leaning one against the other. Today, the bodies have been sewn together; policymakers have all but shut down one of the hearts, and with one circulatory system, the bodies -- adult conjoined twins, as it were -- now live or die as one.
You would have thought that European policymakers would have seen this consequence after Ireland’s banking crisis two years ago. Clearly this week’s actions suggest otherwise. Rather than seeking bank capital from an uncorrelated third party, Europe has opted to go the route of history’s long list of failed financial institutions. They have resorted to double leverage.
At best, Europe has bought time.
More likely, however, is that when the end comes, determining whether the sovereigns or the banks failed first will be like trying to settle which conjoined twin is expendable.
As proposed, Europe’s sovereigns and banks now live or die as one.
From my perspective, it didn’t have to be this way. Even this weekend, Europe had the chance to demonstrate its commitment to pulling troubled banks and troubled sovereigns apart.
Instead, they just put on their old Beatles' album.
Too bad we all have to sing along.
Position in SH and JPM
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