Why the Crisis is not over and will recur – Part one

The Greek government has won its confidence vote.  Stock markets will rally.

So is it over? Crisis averted? MarketWatch think so. They’re already talking about this being see as the moment when Greece avoided default.  But they are wrong.

Step back and ask yourself why, after two years of virtually zero percent  Central Bank interest rates and trillions of Dollars, Euros and Yen pumped into the worlds’ banks and financial system, are we still having one moment of crisis after another?

Our leaders have no answer to this question beyond the ideologically driven claim that it is all the fault of too much public spending. Never stopping for one moment to wonder why the levels of public spending only suddenly became a crisis after the public purse was forced to take on massive debts in order to ‘save’ the banks, bankers and bond holders.

There are of course quite a number of reasons why we keep finding ourselves being drawn back to one crisis point after another.  I would like to look at just three; two simple, closely related reasons and one systemic one.

First the simple reasons.

We all know that banks are still holding undeclared bad debts. This is particularly worrying in Spain where the Caja’s have a small mountain range of undeclared debts. The problem is that ‘undeclared’ is much worse than it sounds.  “Undeclared’ sounds as if it’s simply a debt that hasn’t been added to the debt column. Sadly, the truth of it is that an undeclared ‘bad debt’ is actually held on the bank’s books as an asset.

A debt, from the banks point of view, is an income stream. The accountants look at both the flow of payments which the debt should bring in and the total value of it, should the bank wish to sell the debt on, and can account for either one as an asset. A cash flow asset or a capital asset. And, because banks are currently allowed to mark their ‘assets’ to model,  they can do this for any fraction, up to 100%, of its total face value for as long as they are not forced to value it in the market. I’ll leave you to guess what fraction of face value the banks are using in their accounts.

So the Spanish Caja’s, for example, have a couple of hundred Billion Euros in what the Central bank of Spain has euphemistically called ‘problematic’ loans. These are generally loans made to land developers which are tied to very large amounts of land all of which is perfectly empty – just fields – but zoned  as valuable ‘developments’, plus well over 100,000 empty houses.  Now loans are held on bank books as assets. They are its source of income. Which is fine IF the loans really are an asset to the banks. If they are an actual source of income. But when a loan is not bringing in any income and when the underlying asset is not even worth much, then it is a travesty to allow banks to hold a loss as an asset. It is an outright lie.

Not only are the banks not telling us how many bad debts they really have, they are actually counting those bad debts as assets. This is part of why the ‘Stress Tests’ have been so lamentably worthless. The tests are counting as assets, loans which are in fact bad.

When such loans are finally declared as officially bad, the problem is, therefore, that they do not simply  subtract from the Assets or Income columns. The negative effect on the bank is two fold. So, lets take as an example, a small Spanish Caja hiding, lets say, 6 billion of undeclared bad debts. When it finally can’t hide the fact that its loans are not bringing in a cash flow the bank writes down their value and its income stream but also looses 6 billion of assets.

When we hear of a bank loss it is tempting to imagine all else in the bank is unaffected. But the collapse of an asset robs the bank not only of income but also of part of its asset base – its solvency.

A sorry situation, but one compounded greatly by the second reason the crisis is not over and will recur.
It’s our old friend Leverage.  The banks are leveraged. Over the last couple of years the leverage of most of the world’s banks has not greatly decreased. But lets be generous and use a leverage level of just 10 to 1 which is far, far lower than any bank in Europe or America actually has.

Return to our Spanish Caja with its 6 billion in undeclared bad debts. So far we know, that when the bank can’t kick the can any further down the road, not only will 6 billion Euros of ‘new’ debt suddenly appear on its books, but at the exact same moment the bank will also find a 6 billion Euro hole in its income and assets. That’s when problem two kicks in. The bank is leveraged. Which means that the six billion in assets, which were actually bad loans pretending to be assets, were underpinning 10 times that value in other loans.

Remember, banks have to hold a certain amount of assets as the basis for their lending/liabilities. The ratio between the two, roughly speaking, is the leverage. So for each euro the bank holds, it lends out, in our example, ten euros. Let’s leave aside how this works. It’s not complicated but it would be a diversion to explain it here.

So the problem for our Caja

All banks are required to hold capital against their loans. The problem is that with leverage it only takes a small loss to destabilize very leveraged banks. And yet the banks remain leveraged and our politicians have done little or nothing to change this.

What is more, without enough assets the bank has nothing to pledge as collateral in order to borrow the cash it needs to service its day to day operations and obligations. This is why, when banks don’t have enough assets, we start to hear about liquidity drying up and banks not wanting to lend to each other. They don’t want to lend because they know the bank asking them for a loan doesn’t actually have enough assets to put up as collateral.

So those are two simple accounting reasons why the crisis is not over by a long way and why it keeps recurring. The other problem is systemic but in a way grows out of the first two problems.

So far we have talked about these problems the way any given bank might do when it looks at its own lies and accounts at the end of each day. But the real problems don’t start till you look at the relations between banks. It’s at this level that the real panic sets in.

When our leaders and the financial class talk about the ‘risk of contagion’ from a Greek default there is the tendency to think it means the money owed by Greek banks and government to banks in other countries which is the problem. And that is indeed a problem. The exact situation we just described for our Caja would unfold in those French and German banks upon whose books a Greek default would fall. German and French banks are holding ‘problematic’ loans made to Greek banks and the Government as assets and upon those ‘assets’ rests an inverted pyramid of other loans. The French banks ‘are exposed’ as the phrase goes to 53 billion euros of Greek debt, the German banks about 34 billion. So the French banks would have a 53 billion pile of new losses and a 53 billion euro hole in their asset base, AND if their leverage was only 10 to 1, which it isn’t, they would be looking at 530 billion in loans and liabilities without adequate foundation.

Thus at the moment Greece defaulted, for the French and German Banks it would not just be a question of absorbing a blow and staggering on. The French and German banks would need to raise 84 billion euros or face a run on their own solvency.

But that isn’t the bad news. That was just a recap. The bad new is this – when the Greek banks default, as they will whether it is put off for a few more months or not, when they do default, all the assets they are holding suddenly get valued and marked to market. Which means any other banks holding similar assets can no longer hide them away and value them to whatever model they choose. The true value, or lack thereof, of those ‘assets’ is revealed. And THAT is the part of the systemic danger not talked about very often.

The foundation of our leaders whole extend and pretend strategy is to make sure nothing is valued. All assets are covered by commercial confidentiality. None of the valuations which go to make up the ‘stress tests’ are ever revealed and in most cases not even the ECB knows since the banks being ‘tested’ keep their valuations as a ‘commerically sensitive’ secret. A default would suddenly expose all the assets to a market valuation and blow this entire mark to model charade out of the water. Systemic risk? You bet ! A systemic risk of the truth getting out.

So far  I haven’t actually said anything new at all. I have simply tried to tease things out in to a clear and simple form. Now, finally I would like to take a step back from the detail and make a broader, and I hope, deeper point about why the crisis keeps recurring.

But I will break here so that this article doesn’t get too long. The second part follows later today.