Europe's banks - leverage comes home to roost

It looks as if the excessive leverage that European banks have entered into, with the tacit consent of their governments, is about to come crashing down about their ears - starting with Spain.  Bloomberg reports:

Spain’s surging bad loans are spurring doubt on whether the government can persuade investors that it can clean up the country’s banks without further damaging public finances.

Non-performing loans as a proportion of total lending jumped to 8.16 percent in February, the highest level since 1994, from less than 1 percent in 2007, according to Bank of Spain data published today. The ratio rose from 7.91 percent in January as 3.8 billion euros of loans soured in February, a 110 percent increase from the same month a year ago. That takes the total credit in the economy that the regulator lists as “doubtful” to 143.8 billion euros.

Defaults are rising and credit is shrinking at a record pace as 24 percent unemployment corrodes the quality of loans built up in the country’s credit boom and saps the appetite of banks to make new ones. Doubts about the extent of Spain’s non- performing loans problem is hurting bank stocks and driving up the government’s borrowing costs on investor concern that the expense of propping up ailing lenders may add to the debt burden.

. . .

Rajoy’s government announced plans in February to force banks to take their share of costs of 50 billion euros ($65.6 billion) for building provisions and capital to make them recognize losses on real estate piled up on their balance sheets during the country’s housing bust.

The Bank of Spain said late yesterday that lenders will take a total of 53.8 billion euros to meet the new requirements, including 29.1 billion euros in provisions and 15.6 billion euros to create capital buffers. While most companies would be able to comply “without major difficulty,” the central bank would tighten its vigilance over lenders that may struggle to meet the requirements, it said.

The plan implies a loss ratio for those assets of about 25 percent based on the fact that banks have already made provisions of 50 billion euros against total real estate risk of 340 billion euros, said Daragh Quinn, an analyst at Nomura International in Madrid.

Depending on how much the economy contracts and asset prices fall, further provisions of as much as 40 billion euros may be needed, said Daiwa’s Blattner.

“In light of the bleak profitability outlook for the Spanish banking sector, we are concerned whether banks will be able to put aside the provisions the government has requested,” he said.

There's more at the link.

As the inimitable Karl Denninger points out:

This is bad.  Very bad, when one considers that Western Banking Systems all depend on default rates closer to 1%, not 8%.

Why?  Because of leverage.  If you're running 30:1 gearing then a 3.3% loss wipes you out.  A 1% loss is tolerable, but just barely.

And all western "banking systems" have been run between 10:1 and more than 30:1 for the last couple of decades, with Europe consistently at or above the top end of that scale.

It's not just private funding either; worse is the government side.

. . .

The banks are doing this because they can borrow from the ECB at 1% and then "buy" Spanish 10 year debt at 6%.

. . .

You start with €1 billion in capital.  You buy €1 billion in Spanish bonds.  On these you expect to earn a 5% profit, because you paid 1% interest but will receive 6%.  That is, you will get €50 million in net profit on this transaction.

But that's not enough.  So you pledge the bonds you own into a repo transaction (say, with the ECB) and use that to borrow another €1 billion, with which you do it again.

And again.

And again.

Soon you have €10 billion in bonds.  And you have €500 million in annual interest profits!

That's damn good on €1 billion in [original] capital -- it's a return of 50% annually on your "investment."

But what happens if you suffer just a 1.5% loss on the capital value of those bonds?

You got a problem don't you?  You lose €150 million which is 15% of your capital.  You say "oh but the interest is still ok" and it initially is, except that the impairment will eventually result in a margin call.  Now what happens?  More selling shows up.  And when the decline in the capital value reaches 10%?  Oh gee, there's a billion euro hole which just happens to equal your capital, and now you're broke.

This is the problem facing Europe.  The entire system is levered like this and now, in a desperate attempt to keep the game going the banks are "eating their own tails" by buying up sovereign debt with loans from the ECB.  This is a desperate attempt to cover the losses on their property lending and yet all it winds up being is a sop to the governments which are deficit spending like mad to "prop up" their consumption.

This is a mathematical impossibility and everyone knows it, but the market is sticking its fingers in its ears and doing the "la la la la la la" game.

For now.

Again, more at the link.

Folks, what's happening with Spanish banks right now has already happened in Greece, and is building to the same point of crisis in Portugal and Italy.  It may well spread from there to banks in the rest of the Eurozone.  Many US banks have been doing precisely the same thing with the Federal Reserve - borrowing money at minimal interest rates (as close to zero as makes no difference), then investing the borrowed funds in US treasury bonds at higher rates of interest, then turning around and leveraging everything again and again and again.

That over-leveraged system is ready to come crashing down.  If - when? - it happens in Europe, it's only a matter of time - and not very much time - before its effects are felt here in the USA as well.  You can take that to the bank (if there are any banks willing to accept it, that is).

Peter