Fade the Great Rotation into Europe

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News last week that European Central Bank chief Mario Draghi was considering an end to the ECB’s extraordinary purchases of securities quickly let some air out of the Great Rotation into EU stocks. Sure the euro surged against a weakening dollar, but Europe’s mountain of bad debt remains unresolved — even after the election of Emmanuel Macron to the French presidency. Yet hope springs eternal in some quarters after Draghi’s claim of a successful “reflation.”

“All the signs now point to a strengthening and broadening recovery in the euro area,” Draghi told the ECB’s annual conference. “Deflationary forces have been replaced by reflationary ones,” the former head of the Bank of Italy declared. Draghi’s bull call on inflation provides optimism for relief on excessive levels of bad debt, albeit in a context where the EU’s rules on resolving dead banks remain entirely subjective.

The July 4 approval of the latest state-supported rescue for Banca Monte dei Paschi di Siena (Montepaschi) illustrates the deflationary challenges still facing Europe. As part of the overhaul, Reuters reports, Montepaschi “will transfer 26.1 billion euros to a privately funded special vehicle on market terms, with the operation partially funded by Italian bank rescue fund Atlante II.” The bank will receive 5 billion euros in new public equity funds for its third bailout in a decade.

Two weeks before the EU decision on rescuing Montepaschi, the Italian government supported the sale of two profoundly insolvent Italian banks. The assets of Popolare di Vicenza and Veneto Banca were sold to Intesa SanPaolo Group at an estimated cost to the government of 10 billion euros, marking Italy’s latest breech of the EU’s rules on state support for failing financial institutions.

Like Montepaschi, where retail investors were heavily subsidized, the Intesa SanPaolo transaction avoids imposing losses on senior debt and depositors, but wipes out the equity and junior debt. This outcome reflects political as well as financial constraints in Italy, but shows how far there is to go in the process of resolving bad banks in Europe.

Of note, Italy is being given control over the remaining “bad bank” to wind down as the assets and deposits are conveyed to Intesa SanPaolo. This permits a bailout of senior unsecured creditors. So Italy gets what it wants – continued circumvention of EU bailout rules. If a bank disappears, notes a well-placed EU observer, “state aid rules do not apply.”

Compare the sale of these two insolvent Italian banks with the resolution in early June of Banco Popular Espanol, which became the first EU bank to be resolved by the EU’s Single Resolution Board (SRB). Banco Popular had a third of total assets in bad loans and real estate owned, double the 15% average for all banks in Spain. (In the US, by comparison, non-performing loans plus real estate owned equaled less than 1% of total assets for all banks at the end of Q1 2017.)

“The resolution of Banco Popular, under which it was acquired by Banco Santander S.A., is consistent with the EU’s Bank Resolution and Recovery Directive (BRRD),” Moody’s notes, “which restricts the use of public funds to rescue failing banks. The route followed by the EU authorities in the case of Banco Popular contrasts with the approach taken elsewhere to other ailing banks, notably in the case of the troubled Italian lender Banca Monte dei Paschi di Siena S.p.A.”

The state bailout of Montepaschi, like the sale of the two smaller banks to Intesa SanPaolo, reflects political realities in Italy. “Montepaschi’s liability structure includes large volumes of bonds purchased by retail investors before the [Bank Resolution and Recovery Directive] introduction,” Moody’s continues. “Retail investors also accounted for around 40% of Banco Popular’s share capital and also held an undisclosed share of the bank’s Tier 2 instruments.”

Well-advised institutional investors fled Italian banks years ago, partly because they could not trust official disclosure. So the Rome government countenanced the sale of “deposits” to retail investors by Montepaschi and other Italian zombie banks. The process of selling the deposits and good assets of the two Italian zombie banks to Intesa SanPaolo, while retaining the toxic waste in a “bad bank”, represents the true cost of this latest example of moral hazard in Europe.

Draghi deserves considerable credit for the worsening situation at Montepaschi, starting with his tenure at the Bank of Italy. When the bank merged with Antonveneta, a troubled bank it bought from Spain’s Santander, Montepaschi’s troubles accelerated. Italy’s third-biggest lender, received a 4 billion euro state bailout in 2012.

The negative political consequences for the current government in Rome of the latest Montepaschi bailout are still unfolding, but Draghi and his fellow technocrats are the true authors of this mess. More, EU banks still face levels of bad debts that not only indicate insolvency, but under the EU’s often ignored fiscal rules, suggest a haircut for senior debt and depositors without state aid.

As with the EU today, American officials in the late 1970s and 1980s bent the rules regarding bank disclosure to enable most of the larger, internationally active US banks to avoid a painful debt restructuring. The Latin debt crisis, trouble in the oil patch, and the S&L debacle pushed some of America’s largest banks to the edge of bankruptcy, starting a process of deregulation that is still little understood by investors and analysts.

The Federal Reserve Board under Chairman Paul Volcker and other regulators allowed large banks to engage in off-balance sheet financial transactions that concealed tens of billions in loan exposures. This loosening of prudential standards regarding the treatment of off-balance sheet securities deals eventually led to the 2008 financial collapse. Three decades later, when concealed structured investment vehicles came back to issuers like Citigroup (NYSE:C), the results were disastrous.

Today, officials in Europe led by ECB chief Mario Draghi are playing a similar game, pretending that bad public and private debt on the books of EU banks and investment houses, and held by individuals, is somehow money good. As with the US in the 1980s, the stark reality inside the EU banking system is being concealed under a heavy dose of technocratic obfuscation.

Mountains of public debt in Europe also indicate proponents of the bullish EU equity trade may be a tad exuberant. Europe just dodged a bullet in Greece, where a last-minute deal with the International Monetary Fund allowed the member nations to kick the can down the road until next year. With debt at 200% of GDP, Greece is crippled economically and requires debt reduction in order to attract new investment.

Over the past few months, investors have driven yields on Greek debt to the lowest level in years. To that point, investor optimism on the EU is predicated on an eventual debt bailout for Greece. Yet investors won’t see any details on a long awaited Greek debt restructuring plan before the German elections later this year. The EU trade, as it were, depends an awful lot on what happens to Angela Merkel’s coalition this September.

Economic reality is slowly leading the EU down the road to the assumption of bad debt of weaker states by the stronger members of the federation led by Germany. EU economic commissioner Pierre Moscovici has called for “debt reduction” in Greece, a proposal that is met with a lukewarm response by Germans. But will Merkel ultimately go along?

“In the long run, in a completely integrated euro zone, we would talk about a ‘communitization’ of new debt, but we’re not going to start with that,” Moscovici told reporters last week.

The necessary condition for the bull case on the EU is that the Germans must eventually embrace a federated structure for Europe, this as part of a gradual approach being advanced by leaders such as Macron in France and Moscovici in Brussels.

Joint and several responsibility for all EU debts is the cost of unity. Such a scenario faces significant political and practical obstacles, most notably in Germany but also in France, where Macron must somehow convince his citizens to embrace German style economic behavior.

A gradualist plan for a European federation seems unworkable so long as member states are able to borrow against Europe’s collective credit without toeing the line on fiscal reforms – as in the case of Italy and its troubled banks.

“The euro crisis resulted from the fallacy that a monetary union would evolve into a political union,” writes Yanis Varoufakis, a former finance minister of Greece. “Today, a new gradualist fallacy threatens Europe: the belief that a federation-lite will evolve into a viable democratic federation.”

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