Europe - The end of the Halcyon days

"Hi, I'm a _______ (add country) and I'm addicted to credit."

Greece, Ireland, now Portugal:
Banco Comercial Portugues SA (SUB) 5 Year CDS:
1472 bps +194 bps on the 6th of December +15%
Banco Espirito Santo SA (SUB) 5 Year CDS:
1467 bps +137 bps wider on the 6th of December +10.36%

These were the levels we had on the 22nd of November as published in the post Dominos in Europe:

From the 22nd of November until the 6th of December, Banco Comercial Portugues SA (SUB) 5 Year CDS has moved from 974 bps to 1472 bps, a mighty 51% increase. Banco Espirito Santo SA (SUB) 5 Year CDS, has moved from 974 bps as well to 1467, similar widening of 51% of the spread.

Any similarity with what has happened with Irish Banks Sub CDS 5 Year, which jumped above 1000 bps in September, would be of course be purely fortuitous...

Italian Financials SUB Cds are widening as seen on the 8th of December:

By accepting too early to guarantee its banking system, Ireland sealed its fate and part of its Sovereignty to Europe and the IMF. Private debt from the dodgy Irish banks have been in fact transferred to the Irish taxpayers. The Black Hole in the Irish banking system is too strong to resolve the outstanding issues as I pointed out back in November (The Irish Black Hole).
According to Dr Constantin Gurdgiev in his last post, the bailout package won't be enough to save both the Irish budget and the Irish banks. Something will have to give:
Economics 6/12/10: IMF stress tests for Irish banks
"It appears that the IMF was either not given the full realistic picture of the Irish banks balance sheets, or it is seriously underestimating the demand for future losses cover in the banks."

"Either way, the numbers continue to suggest that the €67 billion package of loans will not be enough to provide simultaneously a cover for Exchequer deficits and the funds required to underwrite losses and capital requirements of the banks. Somehow, the Irish Exchequer will have to make up for this shortfall."

Either bondholders of Irish banks debt agree take a haircut on both the sub and senior debt, or the Irish Goverment will have to cut more spending, which means more austerity for the Irish people.

On the 9th of December Fitch downgraded Ireland to BBB+ from A+, which automatically means a downgrade for Irish banks as well.

The Dominos keeps falling in Europe and France will also have to face the music at some point.
"France 'next' in Euro debt
firing line" by Hysni Kaso, 6th of December.

"The country's deficit is much, much higher than anyone realises. My view is that the markets are not prepared to finance it any more unless there is serious, structural reform. No one, not even France, can hide anymore."

These were the comments made by Xavier Rolet, CEO of the LSE. Mr Rolet is right, Germany has made great stride in implementing structural reforms which are today paying off (GDP growth, lower unemployment) whereas France has postponed structural reforms for too long. Time is running out.
France is a difficult country to reform. We have recently witnessed the difficulty, with the strikes and demonstrations relating to the increase in the retirement age from 60 to 62 then 67, when, it had already been set at 67 in many European countries.

France, like many other European countries has kicked the can down the road for to long, and now is running out of road. Structural reforms are needed, but given the looming presidential elections coming in 2012, don't expect any radical reforms in France anytime soon.
The solution for Europe is binary, it is either further integration or disintegration.

Peripheral Europe which is now the politically correct term for PIIGS, represents 17% of Pan-European GDP. Core European banks have 900 Billions USD in peripheral Europe. The ECB now owns or repo 350 Billions Euros of peripheral bonds. A nice transfer from the private hands to the public hands.

Although peripheral Europe is still sinking, macro fundamentals are very good for the likes of Sweden, Germany and Norway, to name a few.

The German economy expanded 3.90 percent in the third quarter of 2010:

The Swedish economy expanded 6.9 percent in the third quarter of 2010.

The major difficulties of the ongoing crisis is due to the characteristic of this recession being a balance sheet recession. In the post "Honey I shrunk the balance sheet", I indicated that in a balance sheet recession, and due to the amount of excess, the deleveraging process is a slow and painful and the road to repair households balance sheet is indeed a very long one. In previous recoveries, the GDP growth following a recession had been much more pronounced. Due to the nature of this particular nasty recession linked to the housing bubble, the recovery is at a much smaller pace as we can see in GDP growth figures in many countries.
What is making the crisis as well more acute in Spain, Portugal and Ireland is the high private sector leverage to GDP compared to other countries: Above 150% for Portugal, around 220% for Spain and close to 300% for Ireland.

The Euro can survive provided there is stronger integration and a tougher approaches to structural issues. France and Germany led the European project from the start. Germany seems to be left on its own to drive the project forward, given the lack of progress of reforms so far in France.

Jean-Claude Juncker and Giulio Tremonti's proposal was an interesting one.
So far both Germany and France are refusing the idea of issuing Euro-bonds.
A way of reducing the burden of debt for peripheral countries, would be to create a European Compensation house and to do some debt compression. They would need to allow creditors to swap the debt of peripheral countries into more solid Euro-bonds issued at the ECB level, provided their is a haircut on the existing peripheral debt. Unfortunately the game of kicking the can down the road is still well alive with French and German politicians. At some point restructuring of the debt for some peripheral countries will have to happen.

Owed to Germany:

Countries Cross-border bank exposure:

Canada, a great example of successful structural reforms and efficient banking regulation

When United States economy tanked, everyone was expecting the Canadian economy to follow the same fate given how connected both economies are.

It was not the case.

Jim Flaherty, Canadian's finance minister attributed the resilience of the Canadian economy to its "boring" financial system, rock solid and heavily regulated.
Leverage for banks was capped to around 20 times.

Maybe Canadians are strict followers of Austrian economics and have learnt more about the importance of a sound financial system?

Truth is Canadians are much more conservative than their American neighbors when it comes to lending. But the main difference as well compared to the US is that the government did not interfere in the way the housing market was financed: No Fannie Mae or Freddie Mac (we know the story on how well these two ex "private" companies are doing at the moment, losing billions after billions of dollars but that's another story to come in my blog).

Also Canadian banks have truly been much better than their US counterpats in managing risk and cutting risk when needed.

This is a link to a very good article from the Wall Street Journal regarding the Canadian Banks.

http://online.wsj.com/article/SB124165325829393691.html

"Start with the housing sector. Canadian banks are not compelled by laws such as our Community Reinvestment Act to lend to less creditworthy borrowers. Nor does Canada have agencies like Fannie Mae and Freddie Mac promoting "affordable housing" through guarantees or purchases of high-risk and securitized loans. With fewer incentives to sell off their mortgage loans, Canadian banks held a larger share of them on their balance sheets. Bank-held mortgages tend to perform more soundly than securitized ones.

In the U.S., Federal Housing Administration programs allowed mortgages with only a 3% down payment, while the Federal Home Loan Bank provided multiple subsidies to finance borrowing. In Canada, if a down payment is less than 20% of the value of a home, the mortgage holder must purchase mortgage insurance. Mortgage interest is not tax deductible.

The differences do not end there. A homeowner in the U.S. can simply walk away from his loan if the balance on his mortgage exceeds the value of his house. The lender has no recourse except to take the house in satisfaction of the debt. Canadian mortgage holders are held strictly responsible for their home loans and banks can launch claims against their other assets.

And yet Canada's homeownership rate equals that in the U.S. (Both fluctuate, in the mid to high 60% range.)"

Yes that's the way it should be done! Banks like individuals have skin in the game, simple as that, and they are accountable for it.

As a fact reminder, in the US, one quarter of US household are in negative equity territory.

Update from Reuters on the trend in the US Housing:

http://www.reuters.com/article/idUSN0720997220100510

"The percentage of American single-family homes with mortgages in negative equity rose to 23.3 percent in the first quarter from 21.4 percent in the fourth quarter, according to the Zillow Real Estate Market Reports."

It doesn't bode well for the American banks balance sheet...

Although during the recession the Bank of Canada reduced its benchmark interest rate to 0.25% and injected liquidity, given the latest price action in the housing market, the authorities are already moving to prevent the bubble to grow and a rate hike is expected in June.

Furthermore, Canada has been hugely successful in reducing its debt burden since 1995.
Canada's debt-to-GDP ratio is now around 53%.
Canada's debt burden has dropped by more than 50 percentage points from its peak in 1995. At that time it was the second-highest in the G8: from 68% in 1995 to about 29% in 2008.





Canada's debt chart 1979 to 2008:



How was this achieved?

By a radical 20% cut in spending imposed by the federal government in the 1990s which led to a cut of 47,000 civil servants jobs.

Canada was at the time close to the brink.

Here are the details of the cuts they proceeded with and what the government of Prime Minister Jean Chretien targeted, as per the following link from an article of The Times from Alexander Frean, Ottawa :

http://business.timesonline.co.uk/tol/business/economics/article7127360.ece

"There were big cuts in fisheries (22 per cent), defence (more than 15 per cent), transport (50 per cent) and international aid (20 per cent) departments but benefits for the elderly increased by 15 per cent over six years and spending on aboriginal peoples and children rose by around 10 per cent."

"They believe that other countries have something to learn from their country’s experience. One said: “Some nations think you cannot just eliminate the public debt. But we have shown that it is possible.” "

It was brutal but it did put the country back in the right direction.

This is what Europe needs to adress in relation to its public finances issues. They need to follow Canada and cut agressively. Spain and Portugal as well as Greece should apply the Canadian recipe. The UK as well would be wise to follow a similar path and the task is truly daunting for the new coalition government.
Ireland, Spain and Portugal are on the right track, Greece is in a difficult position due to a very lax fiscal system and general widespread corruption.
France has hardly started reducing public spending and it is a concern given the last balanced budget was in 1980 and budget surplus was 1976.

The projections for the Canadian Economy going forward are very good as per below's link:

http://www.shindico.com/news/articles/2010/030510_2.htm

"In 1994, when Canada's deficit peaked before federal spending cuts, including to provincial transfers, started the road to surplus, the only industrialized nation in the world with a worse fiscal picture than Canada was Italy. Canada's debt-to-GDP ratio was over 70 per cent.

In 2009-10, when the deficit hit a record $53.8 billion, Canada had the best record of any nation in the G7 on most economic indicators, including debt-to-GDP ratio.

In 2008-09, the debt-to-GDP ratio was 29 per cent, the lowest in 29 years. It will peak at 35.4 per cent in 2010-11 and then begin dropping again slowly hitting 31.9 per cent in 2014-15."