Too-Big-To-Rescue

Dear readers,

As indicated in the previous newsletter we are preparing an academic paper on a potential alternative for central banks being a liquidity provider in times of crises and acting as the lender-of-last-resort. As you all know this is closely related to the moral hazard and too-big-to-fail issues.

Recent events have once again shown we are unfolding an endgame where socializing losses cannot continue at the current pace. Instead of a too-big-to-fail risk we are now entering into a dangerous zone of too-big-to-rescue.

In this weeks’ newsletter will show why we have reached this turning point with illustrated data on accumulated outstanding guarantees governments are taking onto their balance sheet. As an example we would take the EUR-zone country Belgium, which has recently come into the spotlight of financial markets due to the forced bailout of one of its banks. The author would like to stress that this is not an isolated case and that a similar exercise is trivial for other EUR-zone member states.

In case of the Kingdom of Belgium the current total public debt as a percentage of GDP is around 98%. Like many other governments this percentage rose quickly at the end of 2008 during the first Great Credit Crisis, in an attempt to save its banking industry.

As a reminder we sum up the amounts that were in large responsible for this rise of debt:

• 29 September 2008: Fortis Bank NV/SA a EUR 4.7 billion cash injection by the Federal Government of Belgium in exchange of 50%+1 shares in common equity of which 75% of shares were transferred to BNP Paribas. In exchange the Belgian Government became a 11.6% shareholder of the French bank. (bear in mind that at the moment of conversion the BNP Paribas share price was still well above EUR 60 per share compared to a share price of EUR 26.85 today)

• 30 September 2008: Dexia Bank NV/SA a EUR 1 billion cash injection of the Belgian Government next to another EUR 1 billion investment by the 3 regional governments of the country.

• 8 October 2011: Dexia Bank NV/SA is bailed out by France and Belgium, of which the Belgian government will pay EUR 4 billion for the Belgian franchise.

• 20 October 2008: Ethias received a EUR 1.5 billion cash injection by the 3 regional governments of the country.

• 27 October 2008: KBC Bank NV receives a EUR 3.5 billion direct investment by the Federal Government, where the proceeds are used to strengthen its Tier 1 capital by EUR 2.5 billion plus a solvency margin on its insurance business by EUR 1 billion. This operation is completed on the 19th of December 2009 by issuing non-transferable, non-voting core capital securities to the Belgian government at EUR 29.5 per share (current share price is EUR 9.5 per share). Then, the Flemish Government supported on aggregate another capital injection of EUR 3.5 billion between January 2009 and May 2009 based upon similar terms and conditions as the Belgian Government.

• On a side note, car manufacturers Ford Genk and Volvo Ghent received subsidies and tax relieves of respective EUR 9.3 million and EUR 300 million.

Unfortunately the rescuing of the banking industry did not stop with direct capital injections. Additional government guarantees had to be put in place for outstanding liabilities. The latter is becoming a hazardous situation for public finances in general.

As Belgium is concerned the following guarantees have been underwritten by the government:

KBC Bank: EUR 20 billion of which EUR 5.5 billion of super senior CDO risk and EUR 14.4 billion of counterparty risk on the mono-liner MBIA which wrote credit protection on the banks structured credit portfolio. 90% of default risk is guaranteed by the Belgian government with a 1st loss of EUR 3.2 billion.

Dexia Bank: during the first bailout in 2008 an aggregate of EUR 150 billion of guarantees were granted to the bank by France, Luxemburg and Belgium. These were up to EUR 90 billion re-written during the nationalization of the bank in October 2011, where the Belgian government takes up to 60.5% or EUR 54 billion of guarantees with a maturity of up to 10 years. Next to this guarantee the government inherits, as it is from now on the owner of Dexia Belgium, an un-collateralized credit line of EUR 20 billion to Dexia France. Apart from this credit facility it also inherited a sovereign bond portfolio of EUR 20 of which EUR 8.5 billion has exposure on Greece, Portugal, Italy, Spain and Ireland.

FSA (Financial Securities Assurance Inc.) a US daughter of Dexia NV/SA: USD 16 billion is jointly guaranteed by the French and Belgian government if losses exceed USD 4.5 billion.

Fortis NV/SA: EUR 150 million is guaranteed by the government for interbank transactions. Then a larger guarantee of EUR 5.365 billion is granted for a SPV that is set up to isolate toxic assets of Fortis.

Gemeentelijke Holding ( a cooperative structure of Belgian local authorities: among the regional and federal governments a guarantee of EUR 1.5 billion had to be granted to cover a loan of the Holding to finance a participation for a capital increase in Dexia Bank.

Arco (a Belgian cooperation linked to the Christian Workers’ Union). Via the deposit guarantee system a guarantee has been granted for up to EUR 1.5 billion to cover losses on Dexia shares.

NMBS Holding (Belgian Rail Road) A Belgian government guarantee to cover 80% of a sale and lease back operation with AIG. Guarantee in EUR equals EUR 260 mio.

Then we do not take into account pension liabilities that have been taken over by the Belgian government, such as the Belgacom Pension fund for a minimum liability of EUR 5.8 billion, pension fund of the Port Authorities of Antwerp etc. The fee the government received in exchange of taking over the liabilities was deposited into a so called Silver fund which invested in EUR sovereign bonds such as Germany, France but also Italy, Greece etc…..

The above list already accounts for over EUR 140 billion of guarantees. The entire amount is not at risk. However, taken into account that a lot of these guarantees are related to sovereign and toxic paper that is facing haircuts of 50% and even more (Greece will eventually be faced with haircuts of up to 80-90% and the same can be argued for toxic assets in the portfolio of Fortis, KBC and Dexia), it is not unrealistic to assume that the outstanding public debt as a percentage of GDP can rapidly rise to levels far above 120%.

These are levels well above those like Portugal, and close to those of Italy, both countries that are already spit out by the bond market. Considering these levels, the government is hardly capable of executing its moral hazard role it has been playing over the last couple of years. This means that if one of their last standing banks, that is KBC, would need to ask for additional government support, the Belgian government would get stuck between a rock and a hard plate.

If it would be forced into a situation where it has to rescue the bank, the public debt would shoot well above the levels of Italy as it would have to take on additional guarantees such as an impaired Irish loan portfolio of EUR 18 billion, which the bank is carrying.

If on the other hand the government argues the bank is too-big-to-rescue, it would trigger a run on the Belgian banking system as we have seen in Iceland back in 2008, and as a result the Belgian government would see its liabilities sky rocket as well due to the deposit guarantee system that it is responsible for.

In both cases an eminent bankruptcy is around the corner and the country would need to ask for direct support from the ECB, which is more and more hesitant to step in, as we have seen in its recent market operations.

As we mentioned earlier on, the above described scenario can be applied on other countries such as Ireland, Portugal, Italy and even France. Between now and 2014 the EUR zone would need a sovereign refinancing together with a banking recapitalisation of close to EUR 4 trillion.

These are numbers that sends chills through your spine and show that Europe or more in general the world is in a structural state of balance sheet depression. Inspired by the work of Reinhart & Rogoff, the BIS recently published a report on "The Real Effects of Debt". (1)Its conclusion is that the deleveraging process will continue most of this decade. Taking the above mentioned numbers into account, we certainly are not going to challenge this.

Nevertheless this brings us to the one million dollar question which has kept us awake over the last 3 years: will it either be deflation or inflation that the world economy will be facing?

The answer is not straight forward. Most probably the outcome will be similar to what the EUR-zone has been coping with over the last decade. Certain regions will be struggling with deflationary price pressures. Other regions will see (considerable) upward price pressures.

As for Europe is concerned we share the view of analyst Simon Hunt.(2) Germany and the ECB will have to decide whether they want to safe the EUR project or allow it to explode with a big bang. Either they agree upon the ECB, probably in cooperation with the EFSF, to open up the printing machine where even Ben Bernanke would start feeling uncomfortable with. However, the chance that this decision will be vetoed by either the old Bundesbank lobby or the German’s Constitutional Court is immense high. Nevertheless, this would further destabilize the system and trigger acceleration in asset inflation.

If they decide not to walk down that road, they will be forced to throw in the towel and accept the fact that the EUR project has failed in its current form. This conclusion will cause even more chaos as this would push the European economy into a deep recession, not to use the word of depression, as all member states will have to introduce their own currencies again. This will put in motion a severe deleveraging process that would deflate all asset prices.

As both scenarios could come straight out of a horror movie it is up to our European and global leaders to start thinking out of the box and start working on a new monetary order as we are in the final stages of the End Game.

 
[1] Cecchetti, Mohanty, Zampolli "The Real Effects of Debt", Bank of International Settlements, September 2011 
[2] John Maulding, Outside the Box, 21st November 2011