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Jun24th2010|fromPRINTEDITION
ACCORDINGtotheversionoffinancialhistoryfavouredbyAmerica’sTreasuryandtheFederalReserve,the“stresstests”theydidonbigAmericanbanksinthefirsthalfof2009wereaturning-pointinthecrisis.Byindependentlyexaminingbanks’books,estimatinglosses,makingpublictheresultsandforcingbankstoraisecapital,theyrestoredmarketconfidence.
Realityismorecomplexthanthat—thebail-outsofCitigroupandBankofAmericainearly2009hadjustabittodowithrestoringconfidence,too.EuropeanstendtoviewthetestsasadazzlingpieceofPR,followedbybrazentrumpet-blowing.OnebankersaystheAmericanexperiencewasboth“fantasticandalittledepressing”.Aregulatoragrees:
“Peoplehaveanaiveviewaboutwhatstresstestscandeliver.”
Yetwithfundingmarketsalmostclosedtosomeoftheirbanks,manyEuropeanshavechangedtheirminds.ThedifficultiesofSpanishbanksarewellknown.Portugal’sbankshavealsobeentappingtheEuropeanCentralBank(ECBatafuriouspace.ThereistalkthatthemalaisehasspreadtoItaly.Americansareparticularlyreluctanttolend.HuwvanSteenisatMorganStanleysaysthatmorebanksnowacceptthatanAmerican-stylestresstestmaybeneededtorestoreconfidence.Spainhasbecomeapassionateadvocateandothershavesignedup,too.OnJune17ththeEuropeanUnion’sleadersagreedthatstresstestsshouldbemadepublicinlateJuly.
Thegoodnewsisthataprocessalreadyexistsfordoingstresstests.ThebadnewsisthatitinvolvesthekindofEuropeangroup-hugthatinspiresderision,notconfidence,inhedge-fundmanagers.America’stestswereruninmilitarystylebytheFed,withtheTreasurywritingthecheques.InEuropetheeconomicscenarioisbeingsetbytheECBandtheEuropeanCommission,whichistheninterpretedbytheCommitteeofEuropeanBankingSupervisors(CEBS,aquangoofregulatorsrunwithaskeletalstaff,whichinturnliaiseswithnationalsupervisorsineachcountry.
CEBSdidorganisesometestslastyear,on22banks,buttheresultswerekeptprivate.Ithasjustfinishedgatheringdataon25banksinwhatwasmeanttobejustanotherroutineandconfidentialtest.Thesedatawillformthefoundationofthesouped-uppublicteststhepoliticianswant,althoughmorebankswillbeincluded.YetgiventhestakesandcomparedwiththemightyFed,CEBSisfathomsoutofitsdepth.
Alotdepends,then,onnationalregulators,whichdohaverealmuscleandresources.Butitishardtoavoidtheimpressionofinconsistency.Asupervisorfromamedium-sizedcountrysaysithasplayeda“prettypassive”roleintheCEBStests,withthebanksinterpretingwhatthebroadmacroeconomicscenariomightmean.Inanotherbigcountry,theregulatorsaysitjustpluggedtheCEBSscenariointoitsmodelandsentthemtheresults.Thisisconcerning.DanielTarullo,aFedgovernor,
recentlyemphasisedthatsomeAmericanbanksweren’tmuchgoodatdoingstresstestsontheirownandthatsupervisors’judgment,notjustmodels,wasvital.ThetestsarebeingtakenseriouslybyregulatorsinFranceandSpain,atleast,whichcouldpressureotherstofollowsuit.
ThatstillleavesthedelicateissueofhowtofactorinEurope’ssovereign-debtjitters.Thetestsareunlikelytoassumeasovereigncollapse,withthepossibleexceptionofGreece.Imagininganythingworsewouldbetrickypolitically;
italsogoesbeyondwhatmostofficialsviewasaplausibleworst-casescenario.“Idon’tneedtorunastresstesttounderstandwhatadefaultofItalymeans,”saysone.Insteadthetestswillprobablyassumeslowergrowthasaresultofbunged-updebtmarketsandgetbankstorecognisethemarketpriceofsovereigninstrumentsintheirtradingbooks(butnotintheirlargerloanbooks.Aswellasthismiddle-of-the-road“worstcase”,thetestswillalsodefinebanks’capitalgenerously,usingTier-1capitalratherthanthemorestringentmeasureofcoreequity,whichtheAmericansusedandnewBaselrulesendorse.
MarcoAnnunziata,thechiefeconomistatUniCredit,saysa“stress-testlite”won’tbemuchuse.Twothingswouldhelp.ThefirstisareallyseriouskickofthetyresinSpain.IfinvestorsareconvincedthatallbaddebtsinSpain’sbankingsystemhavebeenrevealedandifSpain’sgovernmentshowsitcanraisethecashtorecapitaliseweaklenders,thenfearsaboutthecountry’ssolvencyshouldrecede.Thatinturnwouldmakea“nosovereigndefault”assumptioninothercountries’testsmoreplausible.SofarSpain’sbail-outfundhasraised€12billion($15billionandfacesdrawdownsof€10billion.Providingthetotalbillstaysbelow,say,€50billion,itsgovernmentshouldeasilybeabletoraisethecash,eveninnastydebtmarkets.
Hideandseek
Second,thestresstestsshouldideallyprovideuniformdisclosureonindividualbanks’exposuretoweakercountries,soinvestorscanmaketheirownmindsup.SimonSamuelsofBarclaysCapitalsaysdisclosurehasbeenpatchytodate.Furthermore,whatfirmssayishardtoreconcilewiththeoverallestimates.Thishasledtoagameof“who’shidingdodgydebt?
”,somethingthatisfamiliartostudentsofthesubprimedebacle.Arecentstudyofconfidentialsubmissionsfromover30bigEuropeanbanksbyJean-Franç
oisTremblayofMoody’s,aratingsagency,concludedtheyhadexposuretoGreeceof€100billion.BasedondatafromtheBankforInternationalSettlementsthatleavesanother€90-oddbillionsittinginEurope’sbanks,presumablysmallerones.
IttookadecadebeforeJapan’ssupervisorslostpatienceandpublishedtheirestimatesofbanks’aggregatebaddebtsin2002and2003(promptingbankstoadmittomorelosses.AsinJapan,thebanksandregulatorshavelostthemarket’sfullconfidence.UnlikeJapan’sbanks,Europeanbanksrelyheavilyonwholesaleborrowingthatneedstoberefinancednow.Europewillhavetobitethebulletsoon.
Istherelifeafterdebt?
Richcountriesborrowedfromthefuture.Payingthebillwillbedifficult,andsowilllivinginathriftierworld
Theageofeasycreditanditsaftermath
DEBTisaspowerfuladrugasalcoholandnicotine.InboomtimesWesternconsumersusedittoenhancetheirlifestyles,companiesborrowedtoexpandtheirbusinessesandinvestorsemployeddebttoenhancetheirreturns.Foraslongastheboomlasted,MrMicawber’sfamousinjunctionappearedtobewrong:
whenannualexpenditureexceededincome,theresultwashappiness,notmisery.
Foralongtimedebtintherichworldhasgrownfasterthanincomes.Asourspecialreportthisweekspellsout,itisnotjustgovernmentdeficitsthathaveswelled.InAmericaprivate-sectordebtalonerosefromaround50%ofGDPin1950tonearly300%atitsrecentpeak.Theoriginsoftheboomgoevenfurtherback,reflectinghugechangesinsocialattitudes.Inthe19thcenturydefaultingborrowersweresenttoprison.ThegenerationthatlivedthroughtheGreatDepressionlearnedtoscrimpandsave.Butthewidertake-upofcreditcardsinthe1960screateda“buynow,paylater”society.Defaultbecamejustalifestylechoice.Therecklesslender,ratherthantheimprudentdebtor,waslikelytogettheblame.
Asconsumersleveragedup,sodidcompanies.TheaveragebondratingfellfromAin1981toBBB-today,justonenotchabovejunkstatus.Firmsthatheldcashontheirbalance-sheetswerecriticisedfortheirtimidity,whilebankruptcylaws,suchasAmerica’sChapter11,preventedcreditorsfromforeclosingoncompanies.Thatforgivingregimeencouragedentrepreneurs(inSiliconValleyabankruptcyislikeaduellingscarinaPrussianofficers’messbutalsoallowedtoomanyzombiecompaniestosurvive(lookattheairlines.Andnoindustrywasmoreaddictedtoleveragethanfinance.Banksranbalance-sheetswitheverlowerlevelsofequitycapital;
privateequityandhedgefunds,whichusedebtaggressively,churnedoutbillionaires.Theroadtoricheswassimple:
buyanassetwithborrowedmoney,thensitbackandwatchitspricerise.
Allthiswasencouragedbytheauthorities.Anytimeadebtcrisisthreatenedtheeconomy,centralbanksslashedinterestrates.Theprospectofsuchrescuesreducedtheriskoftakingonmoredebt.Bubbleswerecreated,firstinequities,theninhousing.Itwasamonetaryratchet,inwhicheachcycleendedwithmuchhigherdebtandmuchlowerinterestrates.Theend-gamewasreachedin2007-08wheninvestorsrealisedalotofthisdebtwouldnotberepaid.Asthecreditcrunchtightened,centralbankshadtocutshort-termratesto1%orbelow.
Andnowthereckoning
Rich-worldcountriesnowfacetwosetsofproblems.Themostpressingishowtopayofftheirdebts.Manypeoplewhohavecutbacktheircredit-cardspendingandfirmswhichhaveseentheircreditlinesslashedwouldbehorrifiedtoseehowlittletherichworld’soverallburdenhasfallen.Muchofthedebthasmerelymovedfromtheprivatetothepublicsectorasgovernmentshavecorrectlysteppedintosupportbanksandsavetheeconomyfromfallingintodepression.Andinthefuture,evenmoremoneywillhavetoberaised,becauseofgovernments’lavishpromisesofpensionsandhealthcarefortheretiringbaby-boomgeneration.
Allthisdebtwillhavetoberegularlyrefinancedandrolledover.Crisesofconfidencearelikely,giventhattherichworld’strendrateofgrowth(andthustheabilityofdebtorstoservicetheirloanslookssettoslow.Worse,muchprivatedebtissecuredagainstassets;
whilethevalueofthedebtisfixed,thevalueoftheassetscanfall.Thiscancauseaviciouscircleasdebtorsareforcedtosellassets,drivingpricesdown.Pilingupmoredebtdoesnotseemanoption.Thereislittle