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Irish Bailout Is a Backdoor Bailout of European Banking System

Posted by Larry Doyle on November 18, 2010 6:20 AM |

What is going on in Ireland? Those forty shades of green look so inviting. How could it be that the Emerald Isle is the center of the current financial turmoil? Well it is…and it isn’t.

How is it that a variety of Irish officials can claim that they neither need nor want a bailout from the EU but a bailout is assuredly on the way? Are we witnessing a sovereign nation losing the ability to control its own affairs? There is no doubt the Irish are a proud people but are they also being overly stubborn at this juncture (believe me, I know proud and stubborn…!!)? Are the Irish failing to accept the inevitable? Hadn’t the Irish attempted a Swedish style approach in terms of aggressively recognizing losses within their financial sector?

While the answer to all of these questions is a varying degree of the affirmative (especially the proud and stubborn..!!), to truly understand what is happening in Ireland, we actually need to shift our focus to the European mainland. Really? Why’s that? Let’s navigate the tangled web and interconnectedness of the global banking system circa 2010.

The ‘bailout’ structured as a loan that the European Union is close to forcing the Irish government to swallow has as much to do with banking on the continent as it does with the banks in Ireland. While I have yet to see any major media outlets fully explore and expose this reality, on October 19th The Economist Intelligence Unit did just that in writing, France/Europe Economy: Feeling Exposed?:

Two recent reports have highlighted the extent of French banks’ exposure to the sovereign debt of risky peripheral euro area countries, which is far larger than implied by the European stress tests conducted earlier this year. French banks are the most heavily invested in Greek sovereign debt, and also have considerable holdings of Irish, Portuguese and Spanish public- and private-sector debt. Regional bailout facilities in place to support struggling euro area countries have reduced the risk of another near-term financial shock, but the interconnectedness of the larger European banks and their exposure to the weaker member states suggest that liquidity, and possibly solvency, concerns could emerge should the sovereign debt crisis take a sudden turn for the worse.

Lot of good those European bank stress tests did us, heh? Yes, those were a joke. In regard to a sovereign debt crisis, well it took not even a month from the time of The Economist’s report for that ‘turn for the worse’ to be upon us. Let’s navigate further into this web.

Market participants will be aware, however, that the unfolding sovereign debt crisis across the euro area still has a long way to run.

You think? Understatement of the year!!

Despite substantial official bailouts (and the prospect of additional support in the future), sovereign borrowing in peripheral euro area countries remains under enormous strain, as international investors balk at a combination of unsustainably large fiscal deficits, highly indebted private sectors, significant crossborder banking exposures, and structural competitiveness issues that will weigh on economic activity for years to come.

This statement is also known as ‘the new normal.’ If the author inserted California for ‘peripheral euro area countries,’ the author may have just defined the economic reality here in the United States as well.

This, in turn, explains investors’ continued focus on the perceived health of the euro area banking sector, which remains under close scrutiny despite most of the region’s financial institutions receiving an apparent clean bill of health in Europe-wide bank stress tests conducted by the Committee of European Banking Supervisors (CEBS) in July. Since then, the rigour of the stress tests has been called into question on a number of occasions, most recently by an Irish MEP (member of the Europe Parliament), Alan Kelly, who has requested an explanation from officials as to how Allied Irish Bank was deemed to be sufficiently robust to pass the tests only a few months before Irish taxpayers were forced to step in with a €3bn capital injection.

My, oh my! Once again, investors get fed a healthy dose of ‘garbage in, garbage out’ in terms of the rigor of bank stress tests. (I highlighted as much in a Bloomberg Businessweek debate this past June 17th, Sense on Cents Enters The Debate Room).

A closer examination of institutions’ balance sheets would suggest that the underlying fragility of the European banking sector continues to harbour a number of risks to the cohesion of the euro area. One such risk reflects the significant share of sovereign debt of peripheral “deficit” countries that is held by banks in the “core” countries, primarily France and Germany. Indeed, the need to limit damage to the France-German banking sectors was one of the driving factors in establishing the EFSF (European Financial Stability Fund).

BINGO!!! There is your answer as to why the French and Germans are force feeding this loan down the Irish throat.

Given the regional rescue facilities now in place, another major financial shock appears unlikely in the near term.

The Economist Intelligence Unit report is fabulous, but they missed this call.

….given the substantial exposure of core EU countries’ banks to the struggling euro area periphery, the complex web of crossborder linkages, and the uncertain outlook for many developed economies as fiscal austerity starts to bite, policymakers would be wise not to downplay the risks to the region’s banking sector should the sovereign debt crisis take a sudden turn for the worse.

Like now. But what happens when the dominoes wobbling in the other PIIGS (Portugal, Italy, Greece, Spain) start to topple even further?

Then what?

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

  • Brendan

    Using the same tricks here that they utilized on your side of the pond.

    Bail, bail, bail…

  • Scott Suess

    Hi Larry,

    Thanks your commentary on the Irish banks.

    I didn’t know why the other European Union countries wanted Ireland to take a bailout when the Irish insisted they didn’t need it.

    Perhaps the uncertainty in the Euro system will benefit our markets when European investors remove their bets?

    It seemed that during our last collapse, money shifted to the European markets. It has to go somewhere!

    • LD

      Scott,

      Thanks for your comment. The money is flowing into the emerging markets and they are getting increasingly concerned because the flood of capital (liquidity) is creating inflation concerns and asset bubbles in those countries.

      Jumping from the EU to the US is akin to going from the tiger’s den into the lion’s lair.

  • MHC

    Larry,

    Great piece.

    Having lived in London from 1998-2005 and having spent a bunch of time there on business trips to Dublin and golfing, I witnessed the Irish economy and the country boom on real estate and influx of foreign companies particularly in tech space (ie Ericcson etc) due to tax benefits (?) during that period. Like many parts of the world, land and property could only go up and not down.

    There was tremendous leverage being taken on real estate. The first time I played Old Head in its relatively early days, I remember hearing that 2 brothers had bought the land for EUR5mm, put money in to develop the course and it was quickly supposed valued at EUR85mm. At that time they were using the new value of Old Head to develop other properties. As many people and companies across the globe have experienced over the last few years, leverage cuts both ways.

    Also, after the Euro’s false start from parity to 84c vs the USD, many “investors” from the UK, including a lot of people from the City/Wall Street, became real estate geniuses by buying vacation homes in Southern Europe particularly Spain and Portugal. There was dramatic price appreciation from the increase in property values, along with the dramatic recovery of the EUR vs GBP. So if one paid EUR300k for a nice villa in Portugal, within a few years that villa was worth EUR500-600k AND an additional ~30%+ with the EUR rallying from sub 90c to 1.20 vs the USD, and GBP was much more stable. On paper, many people had doubled their money or more in quick fashion. Now many developments in Southern Europe are in tatters with the leverage unwind.

    I spent a lot of time in Germany 2002-2005 sourcing bad corporate loans. Dresdner Bank set up its own Bad Bank called the IRU (Investment Recovery Unit). I think that was around the time that the distressed buyers were called fleas by the German government.

    Over that time period, there was insatiable demand from buyers causing prices in most sectors (European Cable and UK Power in particular) to rise dramatically. Then the banks still with bad loans or those that had not sold thought they were smart by holding out for higher prices.

    Its been well-flagged that many of the “healthy” banks (even Barclays for one) would be insolvent had they been required to mark all their assets and bad loans at market vs keeping them at or close to par under the guise of being held to maturity to get around recognizing true intrinsic. Not sure on timing, but why did Barclays do a convertible preferred with one of the sovereign wealth funds at 18.5% ??????????????

    This year, the results of the European Stress tests were a joke given the unexpected (or intended to prop up the banks?) leniency of the parameters. Subsequent to its release, there was recognition that the parameters were flawed and too light.

    The banks now have no choice but to cleanse their balance sheet to improve their capital ratios. It’s a question of when and not if. They can’t hold out and wait for higher prices. Last year, we were very close to trading EUR100mm of 300mm bank debt facility of a French retail company. The buyer wouldn’t pay above very high 20s and the seller who was original holder was adamant about getting paid very low 30s. Nothing happened. Where is it now? ~20. That high 20s bid from our distressed buyer doesn’t look so bad now. Given the long term nature of their funding and horizon, they can afford to drop 10 points on EUR100mm while in mean time working to restructure the company. That original lender does not have the flexibility or the expertise to restructure.

    What is the future for UK-based investment banks? If you make GBP500k, it goes up to 60% on same schedule. This covers 2,500 institutions, basically every broker dealer and investment manager. This is intended to discourage excessive risk taking which is good intention. But its applicable to an incredibly broad range of roles: traders, head of groups, anyone involved in the oversight of risk and ANY officers of a company. So unless one is a commission based salesman of associate rank (not officer), you should be subject to such rules. London is already expensive enough given the cost of living (basically NYC costs but in GBP…ie $10 vs GBP10 for a movie ticket). Add in the special tax implemented on banks for bonus payments. Add in the personal tax rate going from ~40% up to ~50%. In my opinion, this FSA action will really negatively impact “The City” and London in general and its status as a global financial center. You have already seen many large institutions talking about moving operations overseas. And once someone uproots their family to places such as Switzerland with less tax, better cost of living, better quality of life (depending on one’s preference)……even if they were to alleviate the rules 2 years from now, I would expect people wouldn’t be uprooting again to move back.

    I don’t know whether your familiar with CreditSights….since its inception ~8 years ago has become the “go to” source primarily for the buyside of independent and impartial research over the last few years. Their global bank analyst team based in London is best-in-class.

    That’s my (long winded) 2 cents for u. Hope this was helpful to you as your insight is to me.

  • Irish

    We are going to bear the pain rather than the creditors of the French and German banks.

    Is that right?






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