Ongoing European Debt Crisis

It's hard to say. The debt crisis has been sort of lost in all the maundering over Middle-Eastern refugees. I've been hoping that a leftist government in one of the debtor nations would get its act together and break the consensus, but I have no idea what the outcome would be. It depends entirely on the political will that they can muster to fight through the punitive actions that would be taken against their country.

Back during the euro debt crisis, while the ECB was buying government debt from Member States to keep Italian and Spanish government debt from imploding, German politicians fretted out loud about what exactly the ECB was buying. Among them was Frank Schäffler, at the time Member of the Federal Parliament, who in September 2011 said with uncanny accuracy:

“If the ECB continues like this, it will soon buy old bicycles and pay for them with new paper money.”

This is now coming to pass.

Italy, the Eurozone’s third largest economy, is in a full-blown banking crisis. Four small banks were rescued late last year. The big ones are teetering. Their stocks have crashed. They’re saddled with non-performing loans (defined as in default or approaching default). We’re not sure that the full extent of these NP Ls is even known.

The number officially tossed around is €201 billion. But even the ECB seems to doubt that number. Its new bank regulator, the Single Supervisory Mechanism, is now seeking additional information about NP Ls to get a handle on them.

Other numbers tossed around are over €300 billion, or 18% of total loans outstanding.

The IMF shed an even harsher light on this fiasco. It reported last year that over 80% of the NP Ls are corporate loans. Of all corporate loans, 30% were non-performing, with large regional differences, ranging from 17% in some of the northern regions to over 50% in some of the southern regions. The report:

High corporate NP Ls reflect both weak profitability in a severe recession as well the heavy indebtedness of many Italian firms, especially SM Es, which are among the highest in the Euro Area. This picture is consistent with corporate survey data which shows nearly 30% of corporate debt is owed by firms whose earnings (before interest and taxes) are insufficient to cover their interest payments.

The reason these NP Ls piled up over the years is because banks have been slow to, or have refused to, write them off or sell them to third parties at market rates. Recognizing the losses would have eaten up the banks’ scarce capital. Reality would have been too ugly to behold.

The study found that the average time for writing off bad loans has jumped to over six years by 2014. And this:

In 2013, on average less than 10% of bad debt, despite already being in a state of insolvency, was written off or sold. The bad debt write-off rate varies significantly across the major banks, with banks with the highest NPL ratios featuring the lowest write-off rates. The slow pace of write-offs is an important factor in the rapid buildup of NP Ls.

Now, to keep the banks from toppling, the ECB has an ingenious plan: it’s going to buy these toxic assets or accept them as collateral in return for cash.

That’s what the Italian Treasury told reporters, according to Reuters. Oh, but the ECB is not going to buy them directly. That would violate the rules; it can only buy assets that sport a relatively high credit rating. And this stuff is toxic.

So these loans are going to get bundled into structured Asset Backed Securities (ABS) and sliced into different tranches. The top tranches will be the last ones to absorb losses. A high credit rating will then be stamped on these senior tranches to make them eligible for ECB purchases, though they’re still backed by the same toxic loans, most of which won’t ever be repaid.

The ECB then buys these senior tranches of the ABS as part of its €62.4-billion per-month QE program that already includes about €2.2 billion for ABS (though it has been buying less). Alternatively, the ECB can accept these highly rated, toxic-loan-backed securities as collateral for cash via so-called repurchase agreements.

But buying even these senior tranches would violate the ECB’s own rules, which specify:

At the time of inclusion in the securitisation, a loan should not be in dispute, default, or unlikely to pay. The borrower associated with the loan should not be deemed credit-impaired (as defined in IAS 36).

Hilariously, the NP Ls, by definition, are either already in “default” or “unlikely to pay,” most of them have been so for years, and the borrower is already “deemed credit impaired” if the entity even still exists.

(...)

To sell lower-rated tranches to the ECB, the banks can dolly up the credit rating of these toxic-loan-backed securities by purchasing a guarantee from the Italian government, which, thanks to the ECB’s de-facto guarantee of Italian government debt, has a credit rating of BBB-, barely above junk, thus “investment grade.”

That’s good enough for the ECB. A guarantee by the Italian government would transfer Italy’s BBB- credit rating to even the lower tranches of these toxic-loan-backed securities.

Reuters got in touch with Standard & Poor’s, which wants to rate these securities because that’s how it makes its money. And then Reuters reported on this exchange about the “Italian scheme”:

“Standard & Poor’s evaluation of previous deals secured by NPL collateral have typically depended on numerous factors, as different collateral types may pose unique risks,” the rating agency wrote in about the Italian scheme.

“Generally, our credit analysis has focused on ascertaining the expected timing of cash flows and net proceeds from the liquidation of the assets.”

Reuters also cited an ECB source who’d said last November that buying re-bundled NP Ls could be an extreme option if the Eurozone’s economic situation became “really bad.”

So now, the situation has gotten “really bad.”

As the Italian banking crisis is elegantly spiraling out of control, the ECB is trying to get a grip on it by buying “old bicycles,” namely structured toxic-loan-backed securities whose underlying loans defaulted, on average, six years ago. In the process, the financial middlemen will extract a ton of money. The public in other countries will get to eat the toxic loans plus the money extracted by the middlemen. And the cherished bondholders of Italian banks are a step closer to their own personal bailout.

Because all the politicians would talk about how tough they would treat the Greeks in case they are elected.