Banks, companies and investors are preparing themselves for a collapse of the euro. Cross-border bank lending is falling, asset managers are shunning Europe and money is flowing into German real estate and bonds. The euro remains stable against the dollar because America has debt problems too. But unlike the euro, the dollar’s structure isn’t in doubt.08/13/2012 By Martin Hesse
Otmar Issing is looking a bit tired. The former chief economist at the European Central Bank (ECB) is sitting on a barstool in a room adjoining the Frankfurt Stock Exchange. He resembles a father whose troubled teenager has fallen in with the wrong crowd. Issing is just about to explain again all the things that have gone wrong with the euro, and why the current, as yet unsuccessful efforts to save the European common currency are cause for grave concern.
He begins with an anecdote. “Dear Otmar, congratulations on an impossible job.” That’s what the late Nobel Prize-winning American economist Milton Friedman wrote to him when Issing became a member of the ECB Executive Board. Right from the start, Friedman didn’t believe that the new currency would survive. Issing at the time saw the euro as an “experiment” that was nevertheless worth fighting for.
Fourteen years later, Issing is still fighting long after he’s gone into retirement. But just next door on the stock exchange floor, and in other financial centers around the world, apparently a great many people believe that Friedman’s prophecy will soon be fulfilled.
Banks, investors and companies are bracing themselves for the possibility that the euro will break up — and are thus increasing the likelihood that precisely this will happen.
There is increasing anxiety, particularly because politicians have not managed to solve the problems. Despite all their efforts, the situation in Greece appears hopeless. Spain is in trouble and, to make matters worse, Germany’s Constitutional Court will decide in September whether the European Stability Mechanism (ESM) is even compatible with the German constitution.
There’s a growing sense of resentment in both lending and borrowing countries — and in the nations that could soon join their ranks. German politicians such as Bavarian Finance Minister Markus Söder of the conservative Christian Social Union (CSU) are openly calling for Greece to be thrown out of the euro zone. Meanwhile the the leader of Germany’s opposition center-left Social Democrats (SPD), Sigmar Gabriel, is urging the euro countries to share liability for the debts.
On the financial markets, the political wrangling over the right way to resolve the crisis has accomplished primarily one thing: it has fueled fears of a collapse of the euro.
Cross-Border Bank Lending Down
Banks are particularly worried. “Banks and companies are starting to finance their operations locally,” says Thomas Mayer who until recently was the chief economist at Deutsche Bank, which, along with other financial institutions, has been reducing its risks in crisis-ridden countries for months now. The flow of money across borders has dried up because the banks are afraid of suffering losses.
According to the ECB, cross-border lending among euro-zone banks is steadily declining, especially since the summer of 2011. In June, these interbank transactions reached their lowest level since the outbreak of the financial crisis in 2007.
In addition to scaling back their loans to companies and financial institutions in other European countries, banks are even severing connections to their own subsidiaries abroad. Germany’s Commerzbank and Deutsche Bank apparently prefer to see their branches in Spain and Italy tap into ECB funds, rather than finance them themselves. At the same time, these banks are parking excess capital reserves at the central bank. They are preparing themselves for the eventuality that southern European countries will reintroduce their national currencies and drastically devalue them.
“Even the watchdogs don’t like to see banks take cross-border risks, although in an absurd way this runs contrary to the concept of the monetary union,” says Mayer.
Since the height of the financial crisis in 2008, the EU Commission has been pressuring European banks to reduce their business, primarily abroad, in a bid to strengthen their capital base. Furthermore, the watchdogs have introduced strict limitations on the flow of money within financial institutions. Regulators require that banks in each country independently finance themselves. For instance, Germany’s Federal Financial Supervisory Authority (BaFin) insists that HypoVereinsbank keeps its money in Germany. When the parent bank, Unicredit in Milan, asks for an excessive amount of money to be transferred from the German subsidiary to Italy, BaFin intervenes.
Unicredit is an ideal example of how banks are turning back the clocks in Europe: The bank, which always prided itself as a truly pan-European institution, now grants many liberties to its regional subsidiaries, while benefiting less from the actual advantages of a European bank. High-ranking bank managers admit that, if push came to shove, this would make it possible to quickly sell off individual parts of the financial group.
In effect, the bankers are sketching predetermined breaking points on the European map. “Since private capital is no longer flowing, the central bankers are stepping into the breach,” explains Mayer. The economist goes on to explain that the risk of a breakup has been transferred to taxpayers. “Over the long term, the monetary union can’t be maintained without private investors,” he argues, “because it would only be artificially kept alive.”
The fear of a collapse is not limited to banks. Early last week, Shell startled the markets. “There’s been a shift in our willingness to take credit risk in Europe,” said CFO Simon Henry.
He said that the oil giant, which has cash reserves of over $17 billion (€13.8 billion), would rather invest this money in US government bonds or deposit it on US bank accounts than risk it in Europe. “Many companies are now taking the route that US money market funds already took a year ago: They are no longer so willing to park their reserves in European banks,” says Uwe Burkert, head of credit analysis at the Landesbank Baden-Württemberg, a publicly-owned regional bank based in the southern German state of Baden-Württemberg.
And the anonymous mass of investors, ranging from German small investors to insurance companies and American hedge funds, is looking for ways to protect themselves from the collapse of the currency — or even to benefit from it. This is reflected in the flows of capital between southern and northern Europe, rapidly rising real estate prices in Germany and zero interest rates for German sovereign bonds.
‘Euro Experiment is Increasingly Viewed as a Failure’
One person who has long expected the euro to break up is Philipp Vorndran, 50, chief strategist at Flossbach von Storch, a company that deals in asset management. Vorndran’s signature mustache may be somewhat out of step with the times, but his views aren’t. “On the financial markets, the euro experiment is increasingly viewed as a failure,” says the investment strategist, who once studied under euro architect Issing and now shares his skepticism. For the past three years, Vorndran has been preparing his clients for major changes in the composition of the monetary union.
They are now primarily investing their money in tangible assets such as real estate. The stock market rally of the past weeks can also be explained by this flight of capital into real assets. After a long decline in the number of private investors, the German Equities Institute (DAI) has registered a significant rise in the number of shareholders in Germany.
Particularly large amounts of money have recently flowed into German sovereign bonds, although with short maturity periods they now generate no interest whatsoever. “The low interest rates for German government bonds reflect the fear that the euro will break apart,” says interest-rate expert Burkert. Investors are searching for a safe haven. “At the same time, they are speculating that these bonds would gain value if the euro were actually to break apart.”
The most radical option to protect oneself against a collapse of the euro is to completely withdraw from the monetary zone. The current trend doesn’t yet amount to a large-scale capital flight from the euro zone. In May, (the ECB does not publish more current figures) more direct investments and securities investments actually flowed into Europe than out again. Nonetheless, this fell far short of balancing out the capital outflows during the troubled winter quarters, which amounted to over €140 billion.
The exchange rate of the euro only partially reflects the concerns that investors harbor about the currency. So far, the losses have remained within limits. But the explanation for this doesn’t provide much consolation: The main alternative, the US dollar, appears relatively unappealing for major investors from Asia and other regions. “Everyone is looking for the lesser of two evils,” says a Frankfurt investment banker, as he laconically sums up the situation. Yet there’s growing skepticism about the euro, not least because, in contrast to America and Asia, Europe is headed for a recession. Mayer, the former economist at Deutsche Bank, says that he expects the exchange rates to soon fall below 1.20 dollars.
“We notice that it’s becoming increasingly difficult to sell Asians and Americans on investments in Europe,” says asset manager Vorndran, although the US, Japan and the UK have massive debt problems and “are all lying in the same hospital ward,” as he puts it. “But it’s still better to invest in a weak currency than in one whose structure is jeopardized.”
Hedge Fund Gurus Give Euro Thumbs Down
Indeed, investors are increasingly speculating directly against the euro. The amount of open financial betting against the common currency — known as short positioning — has rapidly risen over the past 12 months. When ECB President Mario Draghi said three weeks ago that there was no point in wagering against the euro, anti-euro warriors grew a bit more anxious.
One of these warriors is John Paulson. The hedge fund manager once made billions by betting on a collapse of the American real estate market. Not surprisingly, the financial world sat up and took notice when Paulson, who is now widely despised in America as a crisis profiteer, announced in the spring that he would bet on a collapse of the euro.
Paulson is not the only one. Investor legend George Soros, who no longer personally manages his Quantum Funds, said in an interview in April that — if he were still active — he would bet against the euro if Europe’s politicians failed to adopt a new course. The investor war against the common currency is particularly delicate because it’s additionally fueled by major investors from the euro zone. German insurers and managers of large family fortunes have reportedly invested with Paulson and other hedge funds. “They’re sawing at the limb that they’re sitting on,” says an insider.
So far, the wager by the hedge funds has not paid off, and Paulson recently suffered major losses.
But the deciding match still has to be played.
Translated from the German by Paul Cohen
- DER SPIEGEL: Investors Prepare for Euro Collapse (investmentwatchblog.com)
- Spiegel: Investors Prepare For Euro Collapse | ZeroHedge (underinformation.wordpress.com)
- Spanish Banks’ ECB Loans Rise as Rajoy Mulls Second Bailout Call – Bloomberg (bloomberg.com)
- Stop Fooling Yourself… NO Entity On Earth Can Stop This (zerohedge.com)
- Things Are Going To Collapse Again In Europe ( Bank of America and AMP) (ampgoldportfolio.com)
- Merkel Returns to Crisis as Leaders Squabble Over Bond Purchases (bloomberg.com)
- Hedge Funds Capitulate on European Shorts Fastest Since 2009 (bloomberg.com)
- The Market Oracle – DK Matai – European Bankers And Top Politicians Fear Collapse Of The Euro – 12 August 2012 (lucas2012infos.wordpress.com)
Euro zone leaders agreed in principle on June 29 to establish a joint banking supervisor for the 17-nation single currency area, based on the European Central Bank, although most of the crucial details remain to be worked out.
The proposal was a tentative first step towards a European banking union that could eventually feature a joint deposit guarantee and a bank resolution fund, to prevent bank runs or collapses sending shock waves around the continent.
The leaders agreed that the euro zone’s permanent bailout fund, the 500 billion euro ($620 billion) European Stability Mechanism, would be able to inject capital directly into banks on strict conditions once the joint supervisor is established.
But the rush to put first elements of such a system in place by next year may come too late.
Deposit flight from Spanish banks has been gaining pace and it is not clear a euro zone agreement to lend Madrid up to 100 billion euros in rescue funds will reverse the flows if investors fear Spain may face a full sovereign bailout.
Many banks are reorganizing, or being forced to reorganize, along national lines, accentuating a deepening north-south divide within the currency bloc.
An invisible financial wall, potentially as dangerous as the Iron Curtain that once divided eastern and western Europe, is slowly going up inside the euro area.
The interest rate gap between north European creditor countries such as Germany and the Netherlands, whose borrowing costs are at an all-time low, and southern debtor countries like Spain and Italy, where bond yields have risen to near pre-euro levels, threatens to entrench a lasting divergence.
Since government credit ratings and bond yields effectively set a floor for the borrowing costs of banks and businesses in their jurisdiction, the best-managed Spanish or Italian banks or companies have to pay far more for loans, if they can get them, than their worst-managed German or Dutch peers.
The longer that situation goes on, the less chance there is of a recovery in southern Europe and the bigger will grow the wealth gap between north and south.
With ever-higher unemployment and poverty levels in southern countries, a political backlash, already fierce in Greece and seething in Spain and Italy, seems inexorable.
European Central Bank President Mario Draghi acknowledged as he cut interest rates last week that the north-south disconnect was making it more difficult to run a single monetary policy.
Two huge injections of cheap three-year loans into the euro zone banking system this year, amounting to 1 trillion euros, bought only a few months’ respite.
“It is not clear that there are measures that can be effective in a highly fragmented area,” Draghi told journalists.
Conservative German economists led by Hans-Werner Sinn, head of the Ifo institute, are warning of dire consequences for Germany from ballooning claims via the ECB’s system for settling payments among national central banks, known as TARGET2.
If a southern country were to default or leave the euro, they contend, Germany would be left with an astronomical bill, far beyond its theoretical limit of 211 billion euros liability for euro zone bailout funds.
As long as European monetary union is permanent and irreversible, such cross-border claims and capital flows within the currency area should not matter any more than money moving between Texas and California does.
But even the faintest prospect of a Day of Reckoning changes that calculus radically.
In that case, money would flood into German assets considered “safe” and out of securities and deposits in countries seen as at risk of leaving the monetary union. Some pessimists reckon we are already witnessing the early signs of such a process.
Any event that makes a euro exit by Greece – the most heavily indebted member state, which is off track on its second bailout program and in the fifth year of a recession – look more likely seems bound to accelerate those flows, despite repeated statements by EU leaders that Greece is a unique case.
“If it does occur, a crisis will propagate itself through the TARGET payments system of the European System of Central Banks,” U.S. economist Peter Garber, now a global strategist with Deutsche Bank, wrote in a prophetic 1999 research paper.
Either member governments would always be willing to let their national central banks give unlimited credit to each other, in which case a collapse would be impossible, or they might be unwilling to provide boundless credit, “and this will set the parameters for the dynamics of collapse”, Garber warned.
“The problem is that at the time of a sovereign debt crisis, large portions of a national balance sheet may suddenly flee to the ECB’s books, possibly overwhelming the capacity of a bailout fund to absorb the entire hit,” he wrote in 2010, after the start of the Greek crisis, in a report for Deutsche Bank.
European officials tend to roll their eyes at such theories, insisting the euro is forever, so the issue does not arise.
In practice, national regulators in some EU countries are moving quietly to try to reduce their home banks’ exposure to such an eventuality. The ECB itself last week set a limit on the amount of state-backed bank bonds that banks could use as collateral in its lending operations.
In one high-profile case, Germany’s financial regulator Bafin ordered HypoVereinsbank (HVB), the German subsidiary of UniCredit (CRDI.MI), to curb transfers to its parent bank in Italy last year, people familiar with the case said.
Such restrictions are legal, since bank supervision is at national level, but they run counter to the principle of the free movement of capital in the European Union’s single market and to an integrated currency union.
Whether a single euro zone banking supervisor would be able to overrule those curbs is one of the many uncertainties left by the summit deal. In any case, common supervision without joint deposit insurance may be insufficient to reverse capital flight.
German Chancellor Angela Merkel, keen to shield her grumpy taxpayers, has so far rejected any sharing of liability for guaranteeing bank deposits or winding up failed banks.
Veteran EU watchers say political determination to make the single currency irreversible will drive euro zone leaders to give birth to a full banking union, and the decision to create a joint supervisor effectively got them pregnant.
But for now, Europe’s financial disintegration seems to be moving faster than the forces of financial integration.
(Editing by David Holmes)
- Most-Accurate Forecasters See Euro Bottom at Odds With Options – Bloomberg (bloomberg.com)
- German president tells Angela Merkel to come clean on EU debt deal (independent.ie)
- Marsh on Monday: German anti-euro backlash gathers pace (marketwatch.com)
By Simon Johnson
Nov. 21 (Bloomberg) — You’ve probably never heard of Taunus Corp., but according to the Federal Reserve, it’s the U.S.’s eighth-largest bank holding company. Taunus, it turns out, is the North American subsidiary of Germany’s Deutsche Bank AG, with assets of just over $380 billion.
Deutsche Bank holds a large amount of European government and bank debt; it also has considerable exposure to lingering real estate problems in the U.S. The bank, therefore, could become a conduit for risk between the two economies. But which way is Deutsche Bank more likely to transmit danger — to or from the U.S.?
By any measure, Deutsche Bank is a giant. Its assets at the end of September totaled 2.28 trillion euros (according to the bank’s own website), or $3.08 trillion. In the latest ranking from The Banker, which uses 2010 data, Deutsche was the second- largest bank in the world by assets, behind only BNP Paribas SA.
The German bank, however, is thinly capitalized. Its total equity at the end of the third quarter was only 51.9 billion euros, implying a leverage ratio (total assets divided by equity) of almost 44. This is up from the second quarter, when leverage was about 36 (assets were 1.849 trillion euros and capital was 51.678 euros.)
Even by modern standards, this is very high leverage. JPMorgan Chase & Co. has a balance sheet about 20 percent smaller than Deutsche Bank’s, but more than twice as much Tier 1 capital, an important indicator of a bank’s financial strength. Bank of America Corp., whose weakness is a serious worry in the U.S. today, has twice Deutsche’s capital. (These comparisons use The Banker’s ranking of the top 25 banks.)
Healthy Capital Ratio
Globally, Deutsche’s capital ratios are relatively healthy, judging by the banking industry’s standard measures. At the end of the third quarter, its Tier 1 capital ratio was 13.8 percent (up from 12.3 percent at the end of 2010) and its core Tier 1, which excludes hybrid debt that can convert into equity, was 10.1 percent.
How does such a highly leveraged bank become “well- capitalized”? The answer is that “risk-weighted assets” were 337.6 billion euros as of Sept. 30. But what is a low risk- weight asset in the European context today? Incredibly, it is sovereign debt, which of course is far from riskless at the moment.
Perhaps Deutsche Bank holds mostly German government debt, which still has safe-haven value. But it’s likely that Deutsche also holds a significant amount of Italian and French government bonds.
Still, the bigger risks are probably in the U.S. Deutsche Bank is a significant trustee for mortgages, having been heavily involved in the issuance and distribution of mortgage-backed securities during the housing bubble. Yves Smith, writing on the naked capitalism.com blog, says Deutsche Bank is one of the U.S.’s four biggest securitization trustees. Many questions on whether paperwork was done properly and whether the rights of investors have been protected hang over these trusts.
Let’s take a look just at Taunus Corp., named after a range of mountains outside the parent bank’s Frankfurt headquarters. The latest figures (from the Fed data, using the consolidated financial statement at the end of the third quarter) show Taunus with total equity capital of just $4.876 billion. This implies an eye-popping leverage ratio of around 78.
Why would the Federal Reserve and the new council of regulators known as the Financial Stability Oversight Council allow Deutsche Bank to operate in the U.S. with sky-high leverage — with its huge implied risk to the rest of the financial system? Presumably, in the past, U.S. authorities have taken the view that Deutsche Bank had a strong enough balance sheet worldwide that more capital could be provided to its American subsidiary, if needed.
Such a presumption now seems questionable, at best. Earlier this year, Bloomberg News reported that Taunus needed almost $20 billion of additional funds to meet U.S. capital standards, and that Deutsche Bank was trying to declassify Taunus as a bank- holding company to avoid capital requirements entirely. It’s unclear where this process now stands, but it’s also not obvious how declassification would help U.S. or global financial stability. Financial reform advocates hopefully will press hard on this issue.
All of this raises troubling questions. Have U.S. bank supervisors really satisfied themselves, through onsite inspections, that Deutsche Bank’s risk weights accurately reflect market conditions and the increasing structural weakness of the euro area? Can U.S. regulators document their satisfaction beyond the materials produced for the European Banking Authority, which earlier this year oversaw stress tests that pronounced now-collapsed Dexia as well-capitalized? (Actually, Dexia had stronger capital ratios than Deutsche Bank.)
In their prescient, pre-crisis book, “Too Big To Fail” (not to be confused with the more recent Andrew Ross Sorkin book of the same title), Gary H. Stern and Ron J. Feldman, in 2004 nailed the incentive distortions that encouraged risk-taking and brought the financial sector to its knees. No one else came close to them in getting this right. Included in their analysis are examples of banks that could have been regarded as having moral hazard issues because of their size. Deutsche Bank is No. 4 on their list of large, complex banking organizations by asset size.
This dog did not bark during the 2008 crisis, partly because most foreign governments were seen as having strong enough balance sheets to back their banks’ worldwide operations. But this is no longer necessarily true for euro-area governments.
Even in 2008-2009, this may have been illusory. According to published reports, Deutsche Bank received considerable assistance from the Federal Reserve, including $11.8 billion through the American International Group bailout and $2 billion through the Fed’s discount window. Deutsche was the second- largest discount-window borrower and the largest user of the Fed’s Term Asset-Backed Securities Lending Facility during the crisis.
Asking for Trouble
Deutsche Bank and, if necessary, the German government should be required to inject substantially more capital into Taunus. Allowing business as usual is asking for trouble, particularly as Deutsche wants to remain focused on relatively risky investment banking. Recently it named as chairman Paul Achleitner, the finance director at Allianz SE, the German insurance company, and an ex-Goldman Sachs executive, worrying even some of its shareholders.
This would be a good time for Congress to dig more deeply into the risks that Deutsche Bank poses to financial stability in the U.S. and around the world.
(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)