Europe's Firewall Has Some Loose Bricks

As Europe veers from one crisis to another, financial authorities led by European Central Bank President Mario Draghi have reassured the rest of the world that they have the firepower in place to keep the euro intact. Bond traders aren’t buying it.

Investors have shrugged off the Continent’s latest efforts to increase the bailout capacity of various lending programs, including new International Monetary Fund commitments, to €859 billion ($1.09 trillion). Already, we’re seeing diminishing returns to Europe’s piecemeal bailouts. On June 9, Spain received a €100 billion loan courtesy of the European Financial Stability Facility, a bailout fund created in 2010. By June 18, yields on the country’s 10- year government bonds were up more than one percentage point to 7.2 percent, the highest ever for Spain since it joined the euro. Italian borrowing costs have also surged since March, crossing 6 percent on June 13.

At the recent Group of Twenty meeting in Los Cabos, Mexico, European leaders made soothing pronouncements in support of the single currency. The IMF announced it would nearly double its own lending capacity to $456 billion, thanks to increased commitments from emerging countries such as China, Brazil, and India. Next month, Europe is set to unveil its permanent €500 billion bailout fund. All of this still falls short of what would be needed for a wholesale rescue of Spain and Italy, Europe’s third- and fourth-largest economies. Spain has €345 billion of principal and interest due through 2014; Italy faces €704 billion.

Yet at this point, the size of the financial firewall to contain the crisis is less important to investors than progress on creating some sort of enforceable fiscal discipline on EU member states. “There’s no magic number out there,” says Simon Johnson, an MIT professor and former chief economist at the IMF. Increased ECB lending will eventually lower the borrowing costs of countries such as Spain and Italy. “The question is by how much and for how long,” says Johnson. “Adding more credit in the system is merely papering over the cracks.”

One big reason Europe’s crisis has continued to unnerve the bond market is the circuitous way rescue funds have been distributed since the crisis began in 2010. The ECB is prohibited from lending directly to governments: Instead the central bank made funds available to banks, which in turn often used the money to buy their own governments’ debt.

This approach has created a negative feedback loop in which the contagion spreads back and forth between banks and governments. For example, Spain’s banking crisis morphed into a sovereign debt crisis as the realization took hold that the cost of saving the banking system would end up bankrupting the Spanish government. In Greece and Italy, the problem started with overindebted governments and spread to their countries’ banks, which are loaded down with deteriorating government bonds. “Markets are much more focused on crisis mechanics being developed that break the contagion cycle between sovereigns and banks,” than on the firewall, says Guillaume Menuet, a euro-zone senior economist at Citigroup Global Markets (C).

Investors might be reassured if Europe’s leaders moved to create a more unified banking system, one with a cross-border deposit insurance system and a stronger, pan-European bank regulator to replace the ineffective European Banking Authority. Officials have said they’re working on a proposal along those lines.

An even more ambitious goal is for Europe to craft a tighter fiscal union where sovereign spending levels are subject to enforceable controls. That may pave the way for the creation of Eurobonds, where countries collectively pool their debt.

All this would take months, if not years, of negotiations. Europe may not have that much time, especially if Italy and Spain get into serious trouble. The ultimate fear is that demand for Italian and Spanish debt dries up. “We’re talking more than a trillion dollars to cover the financing needs of those two countries if they were shut out of the markets,” says Paul Ashworth, chief economist at Capital Economics.

That’s the apocalyptic scenario. If Spain and Italy can hang on and Europe’s leaders demonstrate progress toward more fiscal and bank regulatory unity, then the firewall becomes relevant again. The bulwark at least will buy policy makers time as they work to address long-term issues.

The bottom line: European efforts to build a $1.09 trillion firewall to keep the debt crisis from spreading aren’t reassuring bond investors.

View the original article here

Europe's Crisis Spotlight Shifts to Spain

As Greece prepares for a June 17 election that may determine whether it exits the euro, the attention has shifted to Spain, where the problems are different—and much larger. Greece’s troubles stem from excessive government borrowing; Spain suffers from a property bust and its banks remain crippled by an estimated €184 billion ($230 billion) in troubled real estate assets. The government is struggling to devise a rescue plan as the country grapples with a deepening recession and 24 percent unemployment.

Prime Minister Mariano Rajoy insists his country doesn’t need a bailout, though investors say otherwise. The cost of insuring Spanish sovereign debt rose to a record high on May 30, and yields on Spain’s 10-year bonds climbed close to the 7 percent level that led Greece, Ireland, and Portugal to seek bailouts from the European Union and the International Monetary Fund. Considering that Spain’s economy is almost twice as big as those of Greece, Portugal, and Ireland combined, the country poses the biggest test for European authorities yet. “It’s getting increasingly ugly,” says Georg Grodzki, who helps oversee $515 billion at Legal & General Investment Management in London.

Spain’s bank woes currently center on BFA-Bankia (BKIA), formed in 2010 by the merger of seven troubled savings banks. Its assets are equal to a third of the entire Spanish economy. After Bankia’s share price plummeted 43 percent in less than a year, Spain nationalized the bank on May 9. Bankia then asked for €19 billion of government funding to clean up bad loans. The bank has begun offering Spiderman beach towels to customers between 14 and 25 years old who add €300 to their accounts in a month. On May 30, Bank of Spain Governor Miguel Angel Fernandez Ordonez, who has faced criticism over the handling of the crisis, resigned a month before his term was to expire.

Spain has only about €5.3 billion left in the bank bailout fund it set up in 2009, but with its borrowing costs rising, the government wanted to avoid raising the cash in the markets. So Spanish officials got creative. On May 28, Spain signaled that it was considering giving banks government bonds that they could use as collateral to borrow fresh money from the European Central Bank. The government soon backed away from that plan, with Economy Minister Luis de Guindos saying its bank bailout fund would turn to the public markets to raise money for Bankia after all. At the same time the European Commission, the European Union’s central regulator, proposed that the euro-area permanent bailout fund inject cash directly into banks instead of channeling the money via national governments.

As the debate continues, Spain’s real estate problems are festering. For years the country relied on home and office building activity as a source of growth. At the height of the boom, construction accounted for more than 20 percent of Spanish gross domestic product. That’s the same level it reached in Ireland. While both countries experienced similar real estate booms and busts, their actions post-crash have been strikingly different. Ireland worked quickly to address the solvency of its banks—nationalizing them and removing billions of euros worth of toxic debt from their balance sheets by transferring it to a so-called bad bank.

Photograph by Angel Navarrete/BloombergAt the height of the boom, construction accounted for more than 20% of Spain's GDP

Spanish leaders shunned proposals to create a bad bank like Ireland’s. Instead, they pushed banks to absorb weaker lenders. “In Spain, there seemed to be an effort to smooth out the pace of activity rather than face the shock, as Ireland did,” says Cinzia Alcidi, an analyst at the Center for European Policy Studies in Brussels. “There was kind of a denial of the scale of the problem.”

In Ireland, new building came to a halt in 2008, and property values there have crashed about 60 percent since their peak in 2007. Spain has done everything it can to support property values. To help unload the 329,000 foreclosed homes they own without slashing prices, Spanish banks provide 100 percent financing on easy terms including interest-only payments. No such deals are available to buyers of nonbank-owned properties.

“Banks are employing financing like a weapon of mass destruction to sell their stock and keep prices artificially high,” says Mikel Echavarren, chief executive officer of Irea, a corporate finance company in Madrid that specializes in the real estate industry. Spanish banks report that property values have fallen by only 22 percent, according to Jesus Encinar, CEO of Idealista.com, a Spanish property website. Encinar estimates the decline without supports would be at least twice that.

Inflated real estate prices have also helped prop up Spanish developers, many of which are still building despite a glut of vacant homes. Rather than marking their loans as being in default, Spanish banks give developers new loans to pay off the old ones, says Ruben Manso, an economist at consulting firm Mansolivar & IAX and a former Bank of Spain inspector. “There has been a lot of cheating going on where banks have lent developers new money, classed as new lending, so they can pay off their original loans,” he says.

Whatever the government comes up with to address Bankia’s immediate cash needs, it will still have the larger real estate problem to deal with. “Spain has engaged in a policy of delay and pray,” says Echavarren. “The problem hasn’t been quantified by anyone because there is huge pressure not to tell the truth.”

The bottom line: Less than two weeks after being nationalized, Bankia said it needed €19 billion to resolve bad loans.

With Neil Callanan, Dara Doyle, Charles Penty, Emma Ross-Thomas, and Sharon Smyth

View the original article here

Europe’s $39 Trillion Pension Threat Grows as Economies Sputter

January 11, 2012, 1:48 AM EST By Rebecca Christie and Peter Woodifield

(See EXT4 for more on the sovereign debt crisis.)

Jan. 11 (Bloomberg) -- Even before the euro crisis, people were worried about Europe’s pension bomb.

State-funded pension obligations in 19 of the European Union nations were about five times higher than their combined gross debt, according to a study commissioned by the European Central Bank. The countries in the report compiled by the Research Center for Generational Contracts at Freiburg University in 2009 had almost 30 trillion euros ($39.3 trillion) of projected obligations to their existing populations.

Germany accounted for 7.6 trillion euros and France 6.7 trillion euros of the liabilities, authors Christoph Mueller, Bernd Raffelhueschen and Olaf Weddige said in the report.

“This is a totally unsustainable situation that quite clearly has to be reversed,” Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics in Washington, said in a telephone interview.

A recession threatening the world’s second-biggest economic bloc, along with efforts to reduce debt across Europe, is exacerbating the financial risks. Stable or falling birthrates, plus rising life expectancies, are adding to pressures, with the proportion of economic output devoted to spending on retirement benefits projected to rise by a quarter to 14 percent by 2060, according to the ECB report.

Increased retirement ages and lower benefits must be part of any package to hold the 17-nation euro area together, according to analysts, including Fergal McGuinness, the Zurich- based head of Marsh & McLennan Cos.’s Mercer’s pensions consulting unit for central and eastern Europe.

Ageing Populations

Europe has the highest proportion of people aged over 60 of any region in the world, and that is forecast to rise to almost 35 percent by 2050 from 22 percent in 2009, according to a report from the United Nations. That compares with a global estimate of 22 percent by 2050, up from 11 percent in 2009.

The number of people aged over 65 in the 34 countries in the Organization for Economic Cooperation and Development is forecast to more than quadruple to 350 million in 2050 from 85 million in 1970. Life expectancy in Europe is increasing at the rate of five hours a day, according to Charles Cowling, managing director of JLT Pension Capital Strategies Ltd. in London.

In so-called developed countries, the average lifespan will reach almost 83 by 2050, up from about 75 in 2009, the UN said.

Cutting Costs

Governments and companies have taken steps to reduce future costs with policy makers having increased retirement ages in countries, including France, Germany, Greece, Italy and the U.K.

“Irrespective of whether you’re inside or outside the euro or anything else, raising retirement ages is one of the structural reforms that all of Europe has to do,” Kirkegaard said. “The crisis has forced them to address this. This is actually a positive thing in many ways.”

By 2060, the average French pension benefit will be 48 percent of the national average wage, compared with 63 percent now, said Stefan Moog, a researcher at Freiburg University in Freiburg, Germany.

Pension managers and governments are relying on economic growth to safeguard the promises they make. If the euro zone grows too slowly to bolster public and private coffers, the retirement plans may become unaffordable, according to Mercer’s McGuinness.

Benefits’ Squeeze

“The amount of money countries are going to spend on social security and long-term care is going to go up,” McGuinness said in an interview. “Governments with more generous social-security systems will have difficulty affording them. They will have to recognize these costs will impact their ability to reduce borrowings.”

State pension obligations in France and Germany are three times the size of their economies, according to data compiled by Mercer. It’s more sustainable in France than Germany because of France’s higher birthrate.

Last year, there were 4.2 people of working age for every pensioner in France. The ratio will fall to 1.9 by 2050, according to a report by Economist magazine in March. In Germany, the proportion will decline to 1.6 from 4.1 in the same period.

“That is going to put a lot of pressure on Germany’s ability to meet their promises,” McGuinness said. “What they are more likely to do is cut back benefits. Governments face a lot of longevity risks.”

Private pension funds are under pressure too with benchmark euro-area interest rates at the lowest level since the 13-year- old currency was introduced. Low rates mean pension plans have to hold more assets to back their long-term payout projections.

Add to Risks

Unless growth returns, fund managers will effectively be forced to take on more risk, said Phil Suttle, chief economist of the Washington-based Institute of International Finance.

“That creates problems because they all head into sectors that seem a great idea now, and then they blow up, whether it’s commodities or equities or whatever,” Suttle said. “You’re going to intensify the boom-bust cycle.”

The growing doubts facing the euro area is another planning hurdle as companies reconsider investment strategies amid concerns that Greece may default on its debt and spark a broader euro breakup.

The implied probability of one country leaving the euro by the end of 2013 rose to 53 percent on Jan. 9 from 45 percent a week earlier, based on wagers at InTrade.com, an Internet betting market. The probability of one country departing by the end of 2014 is 59 percent.

Pension plans in countries such as Greece or Portugal may benefit from exiting the euro as higher interest rates that would likely accompany a return to their national currencies would cut the cost of liabilities, while assets invested abroad would almost certainly gain in value, according to Mercer, a unit of Marsh & McLennan Cos.

U.K. Plan

In Britain, which has refused to join the euro, occupational pension funds have moved the risk of ensuring adequate retirement income to the employee from the employer in the past decade to curb pension-fund shortfalls.

Unfunded public-sector U.K. pension obligations across 1,500 public bodies totaled 1 trillion pounds ($1.57 trillion) in March 2010, the Treasury said Nov. 29 in the first set of audited Whole of Government Accounts. That compares with a total of 808 billion pounds of outstanding U.K. government bonds and accounts for 90 percent of all public-sector pension liabilities.

Royal Dutch Shell Plc, Europe’s largest oil company, was the last member of the benchmark FTSE 100 Index to close its defined-benefit pension plan to new entrants when it made the decision last month to do so. The company plans to introduce a fund for new employees next year that makes them responsible for ensuring they have enough to live on in old age.

Governments may have to follow the same path for their own employees as well as increasing the retirement age to at least 70 and possibly 75 to make the pensions affordable, Cowling wrote in an article published in July by Public Service Europe.

--Editors: James Hertling, Tim Quinson

To contact the reporters on this story: Rebecca Christie in Brussels at rchristie4@bloomberg.net; Peter Woodifield in Edinburgh at pwoodifield@bloomberg.net

To contact the editor responsible for this story: James Hertling at jhertling@bloomberg.net

View the original article here

King Says Debt Crisis Threatens to Hurt Europe’s Real Economy

December 27, 2011, 3:03 AM EST By Scott Hamilton and Gabi Thesing

(For more on the euro crisis, see EXT4.)

Dec. 23 (Bloomberg) -- Mervyn King, vice chairman of the European Systemic Risk Board, said Europe’s sovereign debt crisis is threatening to hurt the real economy and the outlook for financial stability has worsened.

Growth prospects “have deteriorated” since September, King, who is also governor of the Bank of England, said at a briefing hosted by the European Central Bank in Frankfurt yesterday. “Investors lack confidence to continue to provide normal levels of funding. Dependence on central banks has risen.”

The ECB loaned banks a record 489 billion euros ($636 billion) for three years on Dec. 21 to avert a credit crunch from the sovereign debt crisis. The central bank said earlier this week that the turmoil has taken on systemic proportions not seen since the 2008 collapse of Lehman Brothers Holdings Inc.

King said the outlook for financial stability has “worsened” since the last ESRB meeting in September, and while intervention by the ECB is expected to “assuage funding problems in the near term, in the longer term private funding markets must be revitalized.”

Bank shares have suffered this year as borrowing costs surged in the euro region. The Stoxx 600 Banks Index has fallen 28 percent since the end of June, compared with a 12 percent decline by the Stoxx Europe 600.

Capital Plea

King also appealed to banks not to “reduce lending to the real economy” as they increase their capital levels to meet new standards set by regulators.

“We are very conscious there is extreme risk aversion in private financial markets,” he said. “We want a more robust banking system so that whatever risks crystallize, whatever their source, the banking system is in a better position than 2008.”

There was “no discussion” at the ESRB meeting of any country leaving the euro area, King said. Still, “all financial institutions are advised to prepare for a wide range of contingencies,” he said.

Andrea Enria, the second ESRB vice chair who is also the chairman of the European Banking Authority, said he is “disappointed” by European leaders dithering over putting rescue measures in place, effectively delaying Europe’s bank recapitalization.

“We have always been quite adamant in all occasions, also in the debate running up to the decision, that this should have been a comprehensive package,” Enria said. This includes “recapitalization, some measures -- funding guarantees -- addressing the funding problems and strengthening of the European Financial Stability Facility and of the tools to deal with the sovereign crisis.”

The ESRB, which aims to warn of brewing risks in the financial system, was set up in January as part of a new European architecture designed to ward off another financial crisis such as that which followed the Lehman collapse. Its 65- member board is headed by ECB President Mario Draghi.

--With assistance from Rainer Buergin in Berlin. Editors: Fergal O’Brien, Craig Stirling

To contact the reporters on this story: Scott Hamilton in London at shamilton8@bloomberg.net; Gabi Thesing in London at gthesing@bloomberg.net

To contact the editors responsible for this story: Craig Stirling at cstirling1@bloomberg.net; James Hertling at jhertling@bloomberg.net

View the original article here

Europe’s Debt Plague Spreads to Italy

Alessandra Benedetti/Bloomberg

By Jeffrey Donovan

Italy, long considered too big to fail, now looms as the Continent’s biggest possible failure. Amid indecision in Brussels over Greece’s woes and squabbling in Prime Minister Silvio Berlusconi’s Cabinet, Italy’s bonds soared to their highest yields since the euro’s introduction, and its stock market hit a two-year low as investors bet that Europe’s biggest debtor will struggle to pay its bills.

With markets jittery over results of European bank stress tests due on July 15, UniCredit, Intesa Sanpaolo, and other Italian banks have seen their shares suffer. On July 12, Milan trading in UniCredit was suspended after the stock plunged 7 percent. UniCredit later pared its losses, and Bank of Italy Governor Mario Draghi—set to take over as president of the European Central Bank in October—said on July 13 that he was “certain” Italian lenders would pass the tests.

While Italy’s €1.8 trillion ($2.6 trillion) debt pile has long made it seem like an easy target for speculators, until this summer the country had sidestepped the worst of Europe’s sovereign debt crisis. Finance Minister Giulio Tremonti helped trim the budget deficit to 4.6 percent of output last year, less than half the gap in Greece, Spain, or Ireland. Prudent lending meant Italy never had real estate bubbles like those that devastated Ireland and Spain, and more than half its bonds are held at home. Those factors seemed enough to shield the country from market turbulence.

Then on May 21, Standard & Poor’s lowered its outlook on Italy to negative from stable, fretting that political gridlock might slow cost-cutting amid chronically weak growth. Ten days later, Berlusconi’s ruling bloc was routed in local elections across Italy, raising the chances his government may fall before its term ends in 2013, jeopardizing economic reforms. His grip on power slipped further on June 14 when voters in a referendum stymied his bid to end a ban on nuclear power and privatize water distribution. Moody’s Investors Service chimed in on June 17, warning that it, too, may cut its credit rating on Italy. “If these market pressures persist, Italy’s financing costs could soon approach unsustainable levels,” says Vladimir Pillonca, an economist at Societe Generale in London.

The defeats sparked bickering in the ruling coalition. They also raised fresh criticism of Tremonti, whose fiscal rigor has never been popular and who is blamed by many for choking the euro zone’s third-largest economy. Tensions spiked after Tremonti was captured on video calling a fellow minister “a moron” and Berlusconi told la Repubblica newspaper that Tremonti “isn’t a team player.”

The bond market rout began on July 4, three days after the government approved austerity measures to balance the budget by 2014. Confusion surrounded the plan, which originally promised €47 billion, a figure later trimmed to €40 billion. Investors, worried that most savings measures kick in after 2013, when a new government will likely be in office, sent Italian bond yields soaring. To calm markets, Tremonti on July 12 departed early from a Brussels summit on Greece and rushed to Rome to push Parliament to approve the government’s austerity plan. While deputies indicated they would pass a modified package on July 15 and yields later eased back from record levels, Europe’s debt crisis had already entered a new phase.

The bottom line: With political turmoil in Rome, yields on Italian 10-year bonds have soared on concerns the country will be unable to pay its debts.

Donovan is a reporter for Bloomberg News.

View the original article here