This week’s second weekly-length post is just another review of the Price Waterhouse Coopers study that is big news in the German press. I have now seen the numbers in a bit more granular detail and I wanted to run through them for me because a few things need to be put in perspective. The interesting bit is that I haven’t seen these numbers reported anywhere in the-English language press. Yet, they are all over the German-language press. My understanding is that this is because the study was one undertaken by the Frankfurt office of PwC.
If you recall, the headline number was 1.05 trillion euros of non-performing loans for the entire European banking sector. Apparently this includes European Union countries and non-EU countries like Russia as well. A number of the figures don’t yet make sense to me, in particular the numbers for France, Spain and Ireland don’t add up.
Here’s the chart of the numbers via the Austrian newspaper Wirtschaftsblatt:
Some of the biggest numbers go to Germany, the UK, Italy and Spain as you would expect given the size of those economies. The problems, however, are in the contrast between Germany and France and Spain and Ireland, the contingent liabilities from exposure to the periphery, and the low numbers in Eastern Europe.
First, there’s Germany’s 196 billion euros of NPLs versus France’s meagre 88 billion euros. Germany’s population is only a third more than France’s. The economy is not double France’s. It suggests that French banks are underreporting expected loan losses as compared to their German counterparts. Even comparing France to Italy and the UK, which are similar in size gives you a sense that France has significantly underreported loan losses.
Then there is Ireland and Spain. I see the two economies as having similar problems in terms of the debt overhang from large property bubbles. However, Ireland has reported a huge number of NPLs in relation to the size of its economy. They are 4th on the list of European NPLs when they are minnow of an economy. For example, Ireland has a population of 4.5 million and a GDP of $217 billion according to the World bank. While Spain has a population ten times that at 47 million and a GDP of $1.49 trillion, seven times Ireland. If Spain were to report NPLs at the rate that Ireland has, it would have NPLs of nearly 800 billion euros when it now only has 136 billion euros of NPLs. It is undeniably true that Spain’s property bubble was nearly as large as Ireland’s relative to each’s economy’s size. So, when you see 136 billion of NPLs for Spain and 119 billion for Ireland, you know you have a huge underreporting problem in Spain.
This is exactly why analysts believe Spain will need a bailout and eventually default on its sovereign debt. If the government picks up the slack for the coming losses in Spain’s banking sector and at Spain’s regional governments, government debt to GDP will balloon. Other European governments don’t want to touch this. remember, this report was released in PwC’s Frankfurt office, so the Germans have to know that there is massive underreporting here. The Germans will resist any bank debt mutualisation because they know the magnitude of NPL underreporting in Spain means heavy, heavy losses. And that necessarily means private sector participation (PSP) in bank debt losses. I can’t overemphasise how important this is. Governments know that Spain’s banks are sitting on a time bomb and they will try to stay clear when this bomb blows up because they do not want to be saddled with contingent liabilites of this magnitude. Spanish bank debt holders will suffer greatly. And there is the potential for Spanish sovereign default if the Spanish government gets too close to these banks.
This is where the contingent liabilities come into play. The French number stands out for me because of how low it is relative not only to the size of its economy, but also relative to contingent liabilities. I have been following this story for some time and I know that French banks are very exposed to the periphery for example. Look at French bank exposure to Greece in 2011.
The biggest two were BNP Paribas and SocGen. Now I know these banks claim to have written down all their Greek exposure but this gives you a sense of the order of magnitude of French bank lending to the periphery and hence the contingent liabilities. Fitch wrote up a good piece on European bank exposure that I embedded into a post last June. I also have this chart of German bank exposure to the periphery and European bank exposure to Italy as compared to elsewhere.
You can see from the Italian chart that Italy is the real problem for Europe because that’s where the cross-border exposure is.
The conclusion here has to be that Italy really is the elephant in the room. Germany cannot let Italy fail. It needs to monetise to prevent that or its banks will be insolvent. Same for France. the exposure to Italy is massive. Spain is a large and difficult but manageable problem in terms of cross-border exposure. Italy is not manageable. An Italian default would be the worst disaster to hit the world economy since the Great Depression. It could be worse. See my post Running through Italian default scenarios for a more expansive analysis.
Let me flag one final story for you before I tie this together. The Austrians are very concerned about Eastern Europe because of Austrian bank exposure there. If you read any of the Austrian papers’ analysis of the PwC report, it is all about Austria and Eastern Europe whereas the German press talk about Germany, Spain and Greece. These NPL numbers for Eastern Europe seem low to me and I don’t even see the Baltics listed on the main chart I have. So I have to flag this as a potential underreporting problem as with Spain and France. We know Slovenia, for example, is having a terrible time with its banks. Some call them the Spain of Eastern Europe for that reason. What kind of NPLs do they have? They are not even on this chart. I think Eastern Europe could become a big problem as a result of economic contagion. I’ll leave it there on Eastern Europe.
My primary conclusion here is that European banks are clearly undercapitalised. This is why their equity valuations are so low, even as compared to Australian banks, which operate in a country of 22 million. The EU alone has a population of over 500 million people. That’s number one here. And that means more capital is needed. No one seems to be talking about this need for more capital in European banks. It’s as if the issue has receded from view. All anyone talks about now is the sovereign debt crisis and the banks in the periphery. But the undercapitalisation is a European-wide phenomenon.
Second, France, Spain and Eastern Europe are particular problems in terms of underreporting of NPLs. That says that undercapitalisation will end up being more severe than is currently anticipated by markets. Spain is already in the throes of a depression and crisis, so I am less concerned about the investment implications for equity holders there. French bank equity holders need to be concerned however.
Third, European bank debt holders need to be prepared for losses because private sector participation is coming. The Germans have already indicated that this is their working model going forward for Spain to avoid having taxpayers take the burden. And it makes sense. But that mean equity gets wiped out and then debt holders are going to take losses. Given the lack of capital in Europe, debt holders at the most undercapitalised institutions should expect heavy losses – and this includes senior unsecured debt holders as well.
Finally, the deflationary policy path Europe is taking is only exacerbating this problem, I expect the losses to get worse not better as a result. The worry has to be contingent liabilities crystallising from policy errors that result in sovereign defaults and/or a breakup of the euro zone. In my view, this makes it more likely that the ECB will begin to monetise the debt of Spain and Italy. Italy poses the most important hurdle for Europe given its low growth path, its high outstanding debt, high bond yields and heavy cross-border financial impact. Italy is the clearest example of a sovereign that is too big to fail. I expect Europe to do everything it can to keep Italy from defaulting and with bailouts now at an end, monetisation becomes the first port of call.