Excess debt is causing global banking problems. Euro-Area debt is estimated to be 443% of GDP, third highest in the world, far above the US at 355% and completely unmanageable in a currency union burdened with a one-size-fits-none monetary policy and huge sovereign debt problems. Insolvent European banks sold many CDS, so counterparty risk is huge. A Greek or any other significant default will precipitate a European banking crisis in the foreseeable future. Markets are already speculating on Portuguese negotiations for haircuts and Ireland can’t be far behind, as it elected the current government to negotiate haircuts on private holdings of bank debt. The Lehman default occurred 13 months after the US TED spread crossed 100 basis points. The European equivalent crossed 100 basis points in September 2011, so its banking crisis would occur this autumn if a year or so is a normal incubation period.
Contagion to US (and global) banking systems is inevitable given counterparty risks, debt loads (and refi needs), and capital requirements (no matter how well hidden by MtM math), no matter how many times we are told net exposure is small or non-current loans are reserved.
Lombard Street Research: Contagion to the US
US interbank markets have also been showing the strain of problems in the EA, with the 3-month LIBOR-OIS spread tracking the upward trend in the cost of EA interbank lending (see chart 9).
US banks’ exposure to the EA through lending to governments and exposures to financial and nonfinancial institutions is significant. According to data from the BIS, US banks’ total claims on Club Med banks, plus Germany and France, and the UK banking system, comprise around 80% of US banks’ total equity (see chart 10). Bank claims on government and the private sector are reasonably transparent in the UK, but not in the US – so concerns over EA exposure are likely to resurface this year.
In addition to this exposure to the EA crisis, US banks must work through the remaining legacy of the domestically-generated subprime crisis. Falling loan loss provisions (see chart 11) have delivered practically all the sector’s net operating revenue growth over the last two years. Pre-provision net operating revenue has been flat.
Noncurrent real estate loans in the US remain elevated, at 6.5% of the total – compared with only 0.7% in the 2005-06 period – and stand to rise again if the US economy deteriorates in 2012. Banks’ quarterly rate of provisioning looks inadequate to cope with even current levels of noncurrent loans. Quarterly provisions are currently around one-third of their 2008 average, but noncurrent loans are down by only 20% since their Q1 2010 peak. Provisions were only $18.6 billion in Q3 2011, their lowest since 2007 Q3. Noncurrent loans would have to fall quite sharply to justify this level of provisioning, when in fact the opposite is the more likely outcome. Raising the loan loss allowance to 100% of total noncurrent loans would require an extra $112 billion of provisions, in addition to the amount needed to cope with current write-offs. Real estate net charge-offs are currently around $14 billion per quarter.
The banks are ill placed to absorb increased loan loss provisions and the subsequent pressure on overall profitability. 14% of US banks are still reporting negative quarterly net income – down from a peak of 35% in Q4 2009, but double the average of 7.5% in 2005-06. At the sector level, net interest income growth in particular has ground to a halt, falling on an annual basis for the last three quarters – the longest period of contraction on record (see chart 12). Indeed, the last time annual net income growth contracted outright was in Q4 1989, and that was only for one quarter.
Downward pressure on longer term yields from slow growth, low inflation and Fed interventions will continue to erode banks’ ability to generate net interest income growth. In addition, the Congressional Budget Office predicts the Treasury’s tax take will rise by an average of 1½ percentage points a year from fiscal 2011 to fiscal 2014, so growth will be minimal and defaults will rise.
US banks are in a poor position to withstand a European banking crisis. They appear well capitalised with assets 11.9 times net tangible equity. However, they need an estimated $400-$600 billion of capital to absorb the cost of marking their toxic assets to market, which raises their effective leverage to 19 to 28 times – too high to weather the recession and European banking crisis without significant failures. In addition, Professor Robert Reich of the University of California at Berkeley wrote that Wall Street’s total exposure to the EA totals about $2.7 trillion, not far short of triple the equity of American banks.
Global contagion
Global financial assets were only slightly greater than global GDP in 1980 but 3 3/8 times greater in 2010 with the increase in debt outstanding rising from a fraction of GDP to 2½ times accounting for the rise. The collapse of the credit bubble shows Ponzi debt had pervaded the credit structure, so deleveraging and a drop in asset prices to levels that incomes and production could sustain was necessary. Governments immediately engaged in an all-out battle to prevent this necessary correction. As a result, the People’s Bank of China balance sheet has expanded by an average rate of 43% a year over the last five years, the Fed’s by about one-third, the Bank of England’s by over one-fifth and the ECB’s by one-sixth. Printing money on his unheard of scale reversed a significant part of the 2008-09 losses in asset markets – but the cost has been the rising insolvency of governments and banks.
Insolvency will keep dragging the EA economy down until sovereign and bank balance sheets are repaired. Eliminating the Ponzi debt without fracturing the entire credit system is impossible. The next section will offer some ways of minimizing the damage and preventing recurrences but deleveraging is absolutely essential to restore optimum growth. Total industrial production in the OECD remains below the pre Great Recession peak and widespread falling real incomes show the lower income brackets are in a depression. Other developed nations are in less dire straits than the EA, but slow economic growth and deteriorating sovereign balance sheets are pushing many of them in the same direction. Banking problems are becoming more acute and Europe is the canary. The ECB didn’t prevent broad money from beginning to fall – even though it increased its balance sheet by almost half in the last seven months of 2011. The same is likely to happen in other developed nations.
The contagion will likely show up as a risk premium in the credit markets initially as we suggest the recent underperformance of both US and European bank credit relative to stocks is a canary to keep an eye on.