Citi analysts forecast rate reductions
The weekend’s events have highlighted European fragility in the financial crisis, note Citigroup analysts. In the UK, the eighth biggest mortgage lender (in terms of mortgage lending in 2007) has been nationalised. In all, four of the top 10 mortgage lenders have now been nationalised or required an emergency rescue since mid-07.
A major Benelux bank has required a public sector bailout, with the governments of Belgium, the Netherlands and Luxembourg jointly taking a 49% stake.
In Germany, the German government and a consortium of banks provided EUR35 bln to a large German Bank that is specialized on real estate and government funding.
In Denmark, trading in the shares of a small bank was stopped on Friday after the failure of one of the bank’s large customers, a property speculator, and the bank was sold over the weekend. In total, six minor Danish banks have now been sold/merged or bailed out by the state so far in recent months.
European house value erosion
Although each of these cases has particular features, they are not isolated events. Rather, they are symptoms of Europe’s major vulnerabilities to the credit crunch, note Citigroup analysts. These vulnerabilities stem from the large rise in corporate and household debt in recent years, international linkages, and the banking sector’s relatively low overall cushion of capital and underlying profitability.
Although the overall European housing boom has been smaller than that in the US, the surges in house prices in some countries – notably the UK, Spain, Ireland and France – have all exceeded the US so far this decade. In turn, house prices are now flat or falling across most European countries, with adverse economic and financial effects. The drop in house prices is causing weakness in housebuilding (especially in Ireland, France and Spain), adverse wealth effects on consumers (especially in the UK, Spain and Ireland) and widespread erosion of the value of mortgage collateral on lenders’ balance sheets. But, whereas the US housing adjustment has been underway for over two years, the European housing adjustment has only started last year. Most of the decline in European house prices probably still lies ahead.
Credit quality
In addition, corporate debt levels have risen sharply across many European countries in recent years, reflecting debt-driven M&A activity, private equity deals and share buybacks (especially in the UK), as well as strong capital spending and high corporate financing gaps (especially Spain, France and Italy among major countries). The aggregate euro area corporate financing gap last year was not far short of the 1999-2001 peak as a share of value added, and the financing gap ex-Germany was already above the 1999-2001 peak. With the sharp rise in corporate debts, 59% of credit ratings changes for European issuers in 2006-07 were downgrades, despite strong economic growth and high profit growth. Now, with profits suffering, the deterioration in credit quality is even more rapid: in Q2 this year, 78% of credit ratings changes for European issuers were downgrades, the worst quarter since Q1-2003.
International linkages
As well as the deterioration in credit quality within Western Europe, many European banks also have sizeable exposure to probable losses in the US and to potential risks in high-credit-growth countries in Eastern Europe (including the Baltics). The IMF recently published estimates that European banks’ aggregate exposure to US subprime mortgages is 73% as big as US banks’ exposure to US subprime mortgages. The regular upward pressure on USD interbank rates in European trading session and injections of dollar liquidity by the ECB, BoE and SNB have highlighted the sizeable USD exposures among European banks.
The IMF report that exposure to Eastern Europe (often via foreign currency mortgages) varies quite widely, but Austrian and Swedish banks stand out as having exposure equal to 10% or more of total assets.
The adverse effect of these pressures on banks is exacerbated by underlying weaknesses, because – even in the good years of 2005-06 – European banks in aggregate had lower profits and lower interest margins than US banks, and have built up greater leverage (i.e. total assets/equity) in recent years. Citi’s equity analysts have argued that many European banks face sizeable capital shortfalls. This gives banks less cushion to absorb financial strains and losses.
Economic Effects
In total, Citi’s equity analysts suspect that both the European economy and European financial system are more vulnerable than many realise. These pressures already have led to a sharp tightening of bank lending standards, as evident in the ECB and BoE surveys, and a further tightening is likely in coming months (the next BoE lending survey is due Thursday).
Of course, such financial retrenchment is logical for each individual bank, but the collective effect is to deepen the downturn in economic growth and asset prices, hence exacerbating the strains in the financial system.
Lending growth to households has slowed sharply in both the UK and euro area, but most of the slowdown in lending to non-financial corporations probably still lies ahead. The further fall in the euro area economic confidence index to 87.7 in September, the lowest since November 2001, suggests that the euro area is probably already in recession. The UK is probably also in recession now. In this environment, banks are likely to tighten credit conditions further, and pass on increasing funding costs relatively quickly. The interplay between credit rationing by strained banks and highly leveraged firms and households is likely to lead to a sharp slowdown in domestic demand, notably capital spending and consumption.
Even before this weekend, Citi’s growth forecasts for 2009 (growth of 0.5% for the euro area, minus 0.3% for the UK) were below consensus. Risks probably are to the downside even of our views. In this environment, risks of broad- based second round inflation effects are fading – as indicated by the marked drop in financial market inflation expectations in recent weeks.
Policy Responses
So far, the ECB’s policy response has been to focus on massive liquidity injections – in both Euros and USD – rather than to lower policy rates. Official rhetoric has continued to highlight inflation worries and, while acknowledging downside risks to growth, the ECB has generally assumed that financial conditions will improve enough to allow growth to recover during the year ahead. Similarly, the UK MPC has emphasised liquidity injections rather than lower policy rates since Q2, when various proxies suggested that inflation expectations were rising sharply. Across Europe (including the UK) pressures on specific institutions have been dealt with on a case-by-case basis, rescued either via nationalisation, public sector bailout, capital-raising, or an emergency private buyer.
The scope for such rescue packages is complicated by cross border linkages. In the Benelux case, the three governments work closely together in many areas and were able to achieve a rescue package. But, this may not always be possible quickly enough. As the IMF’s Jamie Caruana highlighted last Friday, Europe lacks appropriate rules to deal with cross border problems. When discussing the impact on the financial crisis on Europe at the EcoFin meeting on September 12/13, the Finance Ministers agreed to implement new rules regarding the supervision of cross-border institutions. However, as usual, implementation will be slow: the aim is that, by, 2012, a group of regulators, led by the regulator of the home country of a cross-border financial institution, will supervise such institutions. So, for now, financial supervision in Europe remains very fragmented on a country level. In turn, this may make the question of which country bears the cost for bailouts controversial, especially given that some banks have assets that are very large compared to the GDP of their host country. Moreover, as we have recently seen in other areas, e.g. the utility sector, the national interests of member states often differ, and this also can make common agreement on solutions harder. On top of that, in a range of European States the responsibilities in banking supervision are unclear, e.g. Germany, where the Bundesbank and the financial watchdog share banking supervision, and the UK, with the Tri-partite system between the BoE, FSA and Treasury.
In addition, it often is hard to know where problems will arise. The euro area banking sector is very fragmented compared to many other regions. Even after consolidation in recent years, there is a large number of small banks, often state-owned or co-operative banks in many EU countries. This fragmentation brings some degree of risk diversification, but also reduces the visibility of problems in the banking sector, as these institutions often report with large delays. Compared to the larger banks, the smaller EU banks also are more dependent on interest income and have relatively low profitability. According to the ECB’s EU banking sector stability report, in 2006 large banks reported an ROE of 20.4% while small banks reported 13.4%.
Moreover, while further liquidity additions and rescue operations are likely, these do not address the underlying problem that banks will need to raise more capital to cover losses and writedowns. It is possible, in theory, that banks and financial institutions overall will be able to raise enough capital privately (including from sovereign wealth funds) to break out of this vicious circle. But, frankly, at the moment, this does not seem very likely. Investors who contributed to capital raising exercises (often with arm twisting from central banks and regulators) in late 2007 and early 2008 have generally done badly and in some cases have been wiped out. The past few weeks suggest that the availability of extra private capital is limited and generally confined to specific firms. And this is not very surprising given that the European economies are not even near the end of the deterioration in credit quality.
As a result, we expect that the gathering evidence of a sharp economic downturn and falling inflation expectations, plus risks of a vicious circle between economic weakness, deteriorating credit quality and financial strains, will lead both the ECB and BoE to cut rates soon. Both may cut in October, especially if financial market conditions worsen further in coming days. But, in any case, easing is likely in Q4 anyway. Such easing will aim to rescue the economy from the adverse effects of the credit crunch, not to rescue the banks directly. Easing is unlikely to be rapid enough to quickly refloat asset prices. Hence, for both the MPC and ECB, Citi’s equity analysts expect that extended economic weakness will reduce inflation worries and allow policy rates eventually to fall markedly further than markets price in.
