Rosenberg: Payback's A Bitch For Banks Stuck Holding Euro Debt

david rosenberg

Gluskin-Sheff’s David Rosenberg sees some element of karmic beauty in the sovereign debt crisis, and how it might affect banks.


First the governments bail out the banks who were (are) basically insolvent.  
Then these governments, especially in Europe, see their balance sheets explode
and face escalating concerns over sovereign default.  The IMF now predicts that
the government debt-to-GDP ratio in the G20 nations will explode to 118% by
2014 from pre-crisis levels of around 80%.  

Now, the ball is put back onto the banks because many have exposure to the
areas of Europe that are facing substantial fiscal problems right now.  According
to the Wall Street Journal, U.K. banks have $193 billion of exposure to Ireland. 
German banks have the same amount of exposure and an additional $240
billion to Spain.  Many international bond mutual funds also have sizeable
exposure to sovereign debt of Portugal, Ireland, Greece and Spain as well. 
Contagion risks are back.  Stay defensive and expect to see heightened volatility.  
In a nutshell, toxic assets have basically been swept under the rug in the hopes
that we will outgrow the problem.  Leverage ratios across every level of society
are still reaching unprecedented levels as the public sector sacrifices the
sanctity of its balance sheet in its quest to stabilise the dubious financial
position of the household and banking sectors in many parts of the world. 

Whatever bad assets have been resolved have almost entirely been placed on the
books of governments and central banks, which now have their own particular set
of risks, as we have witnessed very recently in places like Dubai, Mexico, and
Greece, not to mention at the state and local government level in the United
States.  We simply have not seen a reduction in the percentage of properties with
mortgages that are “under water”, hence the FDIC has identified 7% of banking
sector assets ($850 billion) that are in “trouble”, so how can it possibly be that the
financial system is anywhere close to some stable equilibrium?  
When accurately measured, including the shadow inventory from bank
foreclosures, there is still nearly two year’s worth of unsold housing inventory in
the United States, and commercial vacancy rates are poised to reach
unprecedented highs, and this excess supply is bound to unleash another round
of price deflation and debt defaults this year.  The balance sheets of
governments are rapidly in decline across a broad continuum, and it is
particularly questionable as to whether Europe is in sound enough financial
shape to weather another banking-related storm. 

The global economy is set to cool off.  Not only is China and India warding off
inflation with credit tightening measures but most of the fiscal and monetary
stimulus thrust in the U.S.A. and Canada is behind us as well.  And, the fiscal
tourniquet is about to be applied in many parts of Europe, especially the PIIGS
(referring to Portugal, Ireland, Italy, Greece and Spain — these countries account
for a nontrivial 37% of Eurozone GDP).  Greece’s GDP has already contracted by
3.0% YoY, as of Q4, and is expected to contract 1.1% in 2010 and 0.3% in 2011
as a 13% deficit-to-GDP ratio is sliced from 13% to 3% (assuming this fiscal goal
can be achieved politically).  Portugal has a 9.2% deficit-to-GDP ratio that is in
need of repair and Spain has a deficit ratio that is even worse, at 11.4% of GDP.

The bottom line is that even if the fiscally-challenged countries of Europe do not
end up defaulting, or leaving the Union, the reality is that they will have to take
draconian measures to meet their financial obligations.  Devaluation was the
answer in the past in Greece but it cannot rely on that quick fix this time around
without leaving EMU and if it did, then that could make it even harder to service
its Euro-denominated debts — at least not without a restructuring.  And, if
Greece did attempt at a debt restructuring, rest assured that Italy, Spain,
Portugal and Ireland would be next — we are talking about a combined $2 trillion
of potential sovereign debt restructuring that would more than triple the $600
billion direct cost of the Lehman bankruptcy.  

This poses a hurdle over global growth prospects at a time when Asia will feel
the pinch from the credit-tightening moves in China and India.  And heightened
risk premia will also exert a dampening global dynamic of their own in terms of
economic decision-making by businesses and households alike.  The intense
sovereign risk concerns are not limited to Europe either.  In the U.S.A. we saw
CDS spreads widen out to their highest levels since the equity markets were
coming off their lows last April.  According to the FT, the Markit iTrax SivX index
of CDS on 15 western European sovereign credits rose above 100bps on Friday
for the first time ever. 

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