LIBOR: Liquidity Or Insolvency? June 2, 2010, Bob Eisenbeis, Chief Monetary Economist
Hand wringing has begun again as the LIBOR has risen and LIBOR-OIS spreads have also begun widening. The cost to European banks of borrowing, as reflected in that spread, has risen in the last week or so to over 200 basis points. Commentators are suggesting that we may be on the cusp of another liquidity crisis, similar to the one in the fall of 2008. Remember that at the time Lehman Brothers failed, the spread paid by US banks had widened to over 325 basis points. This time it is European banks that are paying the premium relative to US banks, and rightly so.
The Fed has responded to the perceived demand for dollar liquidity in Europe by reinstituting the swap lines with foreign central banks. This time the lines are unbounded. But is the problem really a lack of liquidity? We think not. The draw on the swap lines has been minuscule, amounting to about $9.2 billion in week one and dropping to $1.2 billion in week two. We fear that European policy makers may be about to make the same mistake US policy makers made in 2008, and that is to flood the market with liquidity in an attempt to force the rate down, without asking the obvious questions: Who is paying those higher rates and why?
European banks are facing those penalty rates because of market uncertainty about their financial condition and doubt about the ability of their respective sovereign governments to live up to their guarantee commitments. This is dramatically illustrated in the chart of sovereign and bank CDS spreads released over this weekend by the ECB in its June 2010 Financial Stability Report (see pg. 77). European banks suffered significantly in 2008, but did not write down as many of their questionable assets as did US banks. The ECB estimates that European banks face potential write downs of 228 billion euros this year and next.
Treasury Secretary Geithner has been pressing the Europeans to release the results of the stress tests that were run by European supervisors and that were held confidential, as a means of calming markets. We note, however, that the weakest banks were apparently omitted, and it is not publicly known what stresses were assumed. Clearly, the tests weren't conducted the way they were in the US, not that that was the model to follow. But at least the results were finally made public.
Now European banks and their supervisors are faced with the critical problem of how to deal with the low-quality sovereign debt on their balance sheets. Given the large government ownership and extension of blanket guarantees for the liabilities of the largest institutions, governments are on the hook, one way or another. Jim Bianco of Bianco Research provided recent data as of this May for financial-system losses and capital raised, and detailed the exposure of German, French, Swiss, and UK banks to the four most challenged countries in Europe: Spain, Ireland, Portugal, and Greece. European banks have recognized about half the total losses ($562 billion) experienced by US banks ($1.2 trillion) and have raised about $567 billion in new capital. Bianco suggests that the major banks in the countries mentioned above have about $1.5 trillion in exposure to sovereign debt of the fiscally challenged governments listed above. Subsequently, others have published exposures of European banks that are as high as $2.5 trillion.
So, in the face of this uncertainty, the question is, what are the actual exposures of these institutions? Have they recognized all their losses and can they cover their exposures to sovereign debt? Given the low capital charges under Basel standards for sovereign debt and the role that AIG played in helping European banks avoid capital standards, markets are reflecting skepticism about those institutions, given the uncertainty about how Europe will deal with its fiscal challenge.
Flooding the markets with liquidity isn't the answer to a fundamental solvency and asset-quality problem and will only postpone dealing with the underlying issues. From an investor's perspective, this means that interest rates are likely to remain below one percent worldwide for an "extended period of time." Uncertainty will rule the day until policy makers face the reality that markets need to know. It also means that there will be continued pressure in the short run on the euro, until the fiscal situation is finally resolved. On that point, the response of Germany is a plus, but the fallout and political backlash may create additional uncertainty.
A related issue, relevant for US policy makers, is the role that systemic risk planning and coordination has played in helping the Europeans identify and plan for a crisis of this type. House and Senate policy makers are crafting an elaborate structure whose purpose is to measure, monitor, and coordinate policy responses to head off systemic risk problems. However, the Europeans have engaged in such exercises for years, yet they both failed to anticipate the current problems and seem to have been totally unprepared for the events that have unfolded. The likely lesson for the U.S. is that pinning hopes on such exercises may be illusory and merely cosmetic.
In the meanwhile, as far as markets and investors are concerned, the dollar and Treasuries look better and better, and this will put additional downward pressure on US interest rates, providing further stimulus for the US economy and equity markets.
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