Why the Bailout in Spain Won’t Work

It was not enough. And it may never be enough.

The euro zone’s offer of $125 billion to bail out Spanish banks over the weekend was hailed by finance ministers and officials across Europe as a masterstroke. Germany’s finance minister, Wolfgang Schäuble, suggested no further bailouts would be needed, saying, “Spain is on the right track.” On Sunday, some analysts and investors even applauded, with David R. Kotok, co-founder and chief investment officer of Cumberland Advisors, proclaiming: “Euro zone leaders rose to the occasion.” How wrong they were.
By now, it should be apparent that the bailout has failed — or is at least on its way to failing.

After a brief rally Monday morning, stock markets in Spain swooned. The 10-year Spanish bond — perhaps the greatest indicator of confidence, or in this case a lack of confidence — jumped higher, to about 6.5 percent, demonstrating that investors were now even more anxious about the country’s ability to pay back its debts than they were the day before the bailout was announced. Seven percent was the threshold that preceded the government bailouts for Greece, Ireland and Portugal in 2010 and 2011. The cost on Monday of buying credit-default swaps — or insurance — on Spanish debt spiked, too.

Indeed, it now appears that the bailout could make things in Spain worse, not better. And market indicators for the next domino in line for a bailout, Italy, point in the wrong direction.

This was bound to happen. That’s because bailing out the banks in each European country individually is a fool’s errand.

Experts often note — wrongly — that TARP, the Troubled Asset Relief Program that pumped $700 billion into the banking system in the United States, arrested the financial crisis in 2008. TARP, to some degree, has become the model for Europe.

But we forget history: TARP was only one component of the bailout. Perhaps more important — consider it the unsung hero of ending the crisis — was the government’s unilateral move to raise the amount of money the Federal Deposit Insurance Corporation could insure, increasing the account limit to $250,000 from $100,000 and fully backstopping the entire money-market industry.

Investors and bank customers who were considering taking their deposits and running in 2008 no longer had reason to do so once deposits and money-market funds had been guaranteed. Keeping your money at Citigroup or Bank of America was relatively indistinguishable from a safety standpoint.

That is not the case in Europe. Customers of Spanish banks still have reason to worry about the solvency of their banks — and their country — making it reasonable for them to take their money from Spanish banks and send it to banks in safer countries like Germany. Indeed, the bailout makes it less likely Spain can pay back its debts because the new loan of up to $125 billion was just added to its huge debt pile. Worse, Spanish banks had been the biggest buyers of Spanish debt (a farce of a way to prop up the economy) and that most likely won’t continue.

As a result, it could be argued that it would be irresponsible for an individual or company, which has a fiduciary duty to its shareholders, not to move its money out of Spanish banks. Of course, money leaving the banks can become a self-fulfilling vicious cycle that virtually no amount of bank bailouts can plug. (By the way, countries like Spain have their own version of F.D.I.C., but it is all but worthless if you believe the country could collapse under its own debt.)

Ultimately, the only real way to begin to ensure the safety of the banks in Spain — and all of Europe — is to create a euro zone deposit guarantee system so that there would be no reason for a depositor to withdraw money. European leaders are expected to address the idea, along with regional banking regulation and a way to recapitalize ailing euro zone institutions, at a summit meeting at the end of the month. Oddly enough, such a deposit guarantee would probably be pretty cheap. The psychological effect of such a guarantee would most likely ensure the solvency of more banks than the guarantee would ever have to pay out. That was the experience in the United States.

Of course, there’s a catch. A euro zone deposit guarantee would require agreement from all the countries that use the euro, which is something that the leaders there seem incapable of reaching because ultimately it would mean tighter integration and, yes, a loss of sovereignty.

And here’s another problem with a euro zone deposit guarantee: Unless you believe the euro is going to remain the standard — that countries like Greece or Spain won’t be forced out or secede from the currency — even the guarantee might not be enough, unless the guarantee holds for all currencies. For example, if a Spanish bank customer is worried that his euros might one day turn into pesetas — even with a deposit guarantee in place — he may well move his money.

In the meantime, this piecemeal approach is bound to fail. Kicking the can down the road, to use again an overused phrase, at some point will fail — and that’s what may have just happened.

Source: http://dealbook.nytimes.com/2012/06/11/why-the-bailout-in-spain-wont-work/

Prowling Bond Vigilantes Should Stress Out Big U.S. Banks

Banks are notoriously complex. But in one respect, they are pretty simple; like other companies, banks depend on access to a raw material to build products and need to purchase it at a price that allows them to generate a profit.

For banks, that raw material is money. Whether banks can persuade credit investors to provide it comes down to confidence and capital. And as the European crisis shows, doubts on either can mean suppliers charge too high a price or simply walk away.

That is worth remembering as the Federal Reserve prepares for another round of "stress tests" to determine whether some big U.S. firms can return capital to shareholders. The Fed last week said that it would require 31 banks to undergo tests early next year and that it will single out six firms—J.P. Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs Group and Morgan Stanley—for a separate exam that assumes a global credit crunch.

In doing so, the Fed will again grapple with the question of how much capital is enough. That is particularly tricky because the Fed wants banks to hold enough capital to absorb losses but also doesn't want to constrain lending and, thereby, economic growth. And the Fed faces an added dilemma. It has decided the economy is so fragile that extraordinary monetary-policy actions are appropriate and even more may be needed. That in itself argues against banks doing anything other than stockpiling capital.

For their part, banks argue that holding too much capital hampers credit creation. They also worry that holding more capital makes it tough to generate higher returns on equity, affecting valuations. As it is, the major U.S. banks have Tier 1 common ratios based on existing rules of between 8% and 11%, healthy levels.

Yet any doubt about capital sufficiency means banks can lose access to funding. That, too, can have adverse economic consequences. In a note Friday, analysts at Morgan Stanley argued that "bank funding is as big a brake on bank lending as bank capital." Banks that can't raise funds have to shrink their balance sheets.

So it is good the Fed's coming stress tests look stressful. In its worst-case scenarios, the Fed will ask banks to consider their capital buffers in the event unemployment hits 13% in early 2013, real gross domestic product shrinks almost 8% in the beginning of 2012, home prices fall another 20% between now and early 2014 and stock markets fall 50% over the next 12 months.

That strikes some as overkill. "The only adverse event the Fed left out is a direct asteroid strike on a major banking center," Karen Petrou of Federal Financial Analytics said in a report.

But the lack of investor confidence in banks justifies a harsh approach. Of the six biggest banks, none are trading above book value, and only Wells trades above tangible book. Given this, the Fed needs to be mindful of credit investors. Granted, the Fed has been able to print money without bond vigilantes exacting revenge. But the vigilantes are present in bank credit markets, as Europe's institutions know.



Even U.S. banks are feeling some heat. The price of insuring against default at the biggest institutions, for example, has jumped. Late last week, it cost about $474,000 to insure $10 million of Bank of America debt, compared with $157,000 in January, according to Markit. J.P. Morgan's 4.35% debt due August 2021, meanwhile, traded at a premium of about 2.79 percentage points to Treasurys last week, according to MarketAxess. That compared with a spread of about 1.7 percentage points at the end of August.

Clearly, the bond vigilantes are on the prowl. The Fed shouldn't do anything that spurs them to further action.

Source: http://online.wsj.com/article/SB10001424052970203764804577060581490016436.html