U.S. Banks Aren’t Nearly Ready for Coming European Crisis

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By Simon JohnsonThe euro area faces a major economic crisis, most likely a series of rolling, country-specific problems involving some combination of failing banks and sovereigns that can’t pay their debts in full.This will culminate in systemwide stress, emergency liquidity loans from the European Central Bank and politicians from all the countries involved increasingly at one another’s throats.Even the optimists now say openly that Europe will only solve its problems when the alternatives look sufficiently bleak and time has run out. Less optimistic people increasingly think that the euro area will break up because all the proposed solutions are pie-in-the-sky. If the latter view is right -- or even if concern about dissolution grows in coming months -- markets, investors, regulators and governments need to worry not just about interest-rate risk and credit risk, but also dissolution risk.What’s more, they also need to worry a great deal about what the repricing of risk will do to the world’s thinly capitalized and highly leveraged megabanks. Officials, unfortunately, appear not to have thought about this at all; the Group of 20 meeting and communique last week exuded complacency and neglect.Very few people seem to have gotten their heads around dissolution risk. Here’s what it means: If you have a contract that requires you to be paid in euros and the euro no longer exists, what you will receive is unclear.

No Euro

As a warm-up, consider first a simple contract. Let’s say you have lent 1 million euros to a German bank, payable three months from now. If the euro suddenly ceases to exist and all countries revert to their original currencies, then you would probably receive payment in deutsche marks. You might be fine with this -- and congratulate yourself on not lending to an Italian bank, which is now paying off in lira.But what would the exchange rate be between new deutsche marks and euros? How would this affect the purchasing power of the loan repayment? More worrisome, what if Germany has gone back on the deutsche mark but the euro still exists -- issued by more inflation-inclined countries? Presumably you would be offered payment in the rapidly depreciating euro. If you contested such a repayment, the litigation could drag on for years.What if you lent to that German bank not in Frankfurt but in London? Would it matter if you lent to a branch (part of the parent) or a subsidiary (more clearly a British legal entity)? How would the British courts assess your claim to be repaid in relatively appreciated deutsche marks, rather than ever-less- appealing euros? With the euro depreciating further, should you wait to see what the courts decide? Or should you settle quickly in hope of recovering half of what you originally expected?What if you lent to the German bank in New York, but the transaction was run through an offshore subsidiary, for example in the Cayman Islands? Global banks are extremely complex in terms of the legal entities that overlap with business units. Do you really know which legal jurisdiction would cover all aspects of your transaction in the currency formerly known as the euro?Moving from relatively simple contracts to the complex world of derivatives, what would happen to the huge euro- denominated interest-rate swap market if euro dissolution is a real possibility? I’ve talked to various experts and heard a variety of fascinating opinions, but no one really knows.

Dissolution Risk

http://www.bloomberg.com/news/2012-06-24/u-s-banks-aren-t-nearly-ready-for-coming-european-crisis.html

Merkel Backs Debt Sharing In Germany Amid Closer EU Union Push

Chancellor Angela Merkel’s government agreed to underwrite the debt of Germany’s states, backing a form of burden-sharing that she is resisting at the euro-area level to combat the financial crisis.The federal government, facing pressure from the 16 states over tighter European Union budget rules that risked worsening a deficit squeeze, unexpectedly backed a form of shared liability to help the states meet constitutional budget limits. The two layers of government plan their first joint debt sale in 2013, the government press office said in an e-mailed statement.Joint debt sales in the 17-nation currency region “don’t make sense” as long as budgets are set by national governments, Schaeuble told ZDF television late yesterday. “As long as the national states make the decisions, they have to be liable. If you can spend money on my tab, you won’t be thrifty.”Merkel’s government backed down in a deal the opposition, which controls the upper house of parliament, said will help secure ratification of the EU’s fiscal pact in Germany. The accord doesn’t mean Germany is ready to assume similar liability for the euro zone, Finance Minister Wolfgang Schaeuble said.Bavaria, one of Germany’s richest states and home to the world’s two-biggest makers of luxury cars, Bayerische Motoren Werke AG and Audi AG, has deployed the same argument against shared debt sales in Germany, saying so-called Deutschland bonds would weaken budget discipline. Merkel’s spokesman, Steffen Seibert, said in March that she opposed the measure.

Merkel Concessions

http://www.bloomberg.com/news/2012-06-24/merkel-backs-debt-sharing-in-germany-amid-closer-eu-union-push.html

Moody’s Notices That Banks Are Risky, Four Years Too Late

Markets don’t always reflect the truth, but this time they did.One day after Moody’s Investors Service cut the credit ratings of 15 major U.S. and European banks, and hours after front pages around the world proclaimed the downgrades to be Big News, the markets stopped, sighed, shrugged and moved on. In fact, they rallied, with stocks and bonds of U.S. banks jumping by more than 1 percent. The reaction is reminiscent of the events of last August, when the U.S. government’s borrowing costs fell after Standard & Poor’sstripped the country of its AAA credit rating.Once upon a time, the proclamations of credit-rating companies and the resulting market moves tended to go in the same direction. Back in 2005, downgrades of General Motors and Ford caused the companies’ bonds to drop and whipped up a tempest in financial markets.What gives? First, there’s the obvious. At least in the U.S., banks have generally been building up their capital and cash reserves and paring down their holdings of soured loans and securities. So the downgrades contrast with recent experience.Second, and more important, ratings are by their nature backward-looking. They fall only after the problems of a borrower are obvious and demonstrable. So they should catch markets by surprise only if investors haven’t been doing their homework.

Too Late

Consider the rationale of Moody’s for its latest bank downgrades, which affected such big institutions as Citigroup Inc., Bank of America Corp., JPMorgan Chase & Co., Goldman Sachs Group, Deutsche Bank AG and Barclays Plc. The rater’s analysts noted that the banks, all of which have big trading operations, “have significant exposure to the volatility and risk of outsized losses inherent to capital markets activities” -- meaning that a market crash could cause them to lose so much money they would be unable to pay their creditors.The observation isn’t wrong. It’s just more than four years too late. The financial crisis of 2008 was enough to alert investors to the risk: The cost of default insurance on Goldman Sachs, for example, more than doubled when Bear Stearns failed in March 2008, quadrupled when Lehman Brothers Holdings Inc. went bankrupt in September 2008, and remains more than six times its pre-crisis level. Moody’s downgraded Goldman by one level in December 2008, and it took until now to do a second, two-level downgrade. The situation for all the other downgraded banks is similar.If markets are recognizing that credit ratings are old news -- and possibly even conflicted, given that the raters are paid by the entities they rate -- the development can only be seen as desirable. We’ll all be better off if financial regulators (who allow the ratings to affect measures of bank capital), pension- fund managers (who use the ratings to define their funds’ investment strategies) and lawmakers do the same.http://www.bloomberg.com/news/2012-06-22/moody-s-notices-that-banks-are-risky-four-years-too-late.html