Eurozone’s bottomless pit of debt

The reason the new money was needed was almost as terrifying as the number itself. Although the banks had been forced to take account of their exposure to disastrous property investments, their likely losses on mortgages had been left to one side. Previous stress tests had glossed over that problem.

Investors reckon banks and regulators across Europe are colluding to mask the true extent of the problem loans they built up during the financial crisis.

The scale of the new Irish bailout offers a glimpse of how appalling those issues could be.

Ireland’s cash injection amounts to about €17,000 a head for every Irish citizen, or roughly half the country’s annual economic output. On these relative measures, the total sum being thrown to Ireland’s banks is about ten times more than the amount British taxpayers ploughed into Royal Bank of Scotland, Lloyds Banking Group, Bradford & Bingley and Northern Rock.

“What’s happening in Ireland really is extraordinary,” said a senior executive at a European bank. “The only good thing is that they are determined to bring their problems out into the open. That’s not true for most of Europe.

“If you were to apply the Irish stress test across the rest of the eurozone, the number you would come up for the subsequent capital shortfall would be alarming.”

Portugal is already standing on the brink of receiving an international bailout package. Economists at Barclays Capital claimed last week that the country has only about €6 billion of cash left, barely enough to see it through the month. It also revealed that its public finances are in a much worse state than previously claimed — blaming an accounting error for the difference.

Greece, meanwhile, is still expected to default on its debts, sooner or later, in spite of continued negotiations with the European Union and the International Monetary Fund.

Yet the big unknown for Europe remains the banking sector. Although EU regulators have just launched their own stress tests on the health of banks, investors have already dismissed the exercise as a publicity stunt that will shy away from revealing the type of problems unearthed in Ireland.

Spain and Germany are still under scrutiny. One of Italy’s smaller banks launched an unexpected €1 billion share issue last week, raising concerns that Italian institutions may also be about to reveal a swathe of bad news.

For the debt-addled states of the eurozone an end to a year-long period of crisis still seems a long way off. More governments are likely to fall.

“We are heading back into a period of big market uncertainties across Europe,” said another senior banker. “The only way to get to the bottom of it is to know the extent of the property problem and see economies stabilise. None of that has happened.”

There are two types of problems weighing down the eurozone. Ireland’s state finances were sunk by its decision to stand behind its banks. When those banks fell into a bottomless pit of debt, the government’s previously impressive finances spun out of control.

In Greece and Portugal, it is the problems of the state that have infected the banks. Now the whole eurozone has slowed down, investors can’t see how either country can grow its economy fast enough to pay off its national debt. So they expect the banks will be hit with soaring bad-debt charges as austerity measures bite, and unemployment soars.

Both versions of the problems result in banks being cut off by the international financial markets. And both problems are being treated with the same medicine — a big injection of cash from an international bailout fund, and a steady drip of cash from the European Central Bank (ECB) to tide over banks that are struggling to raise cash in the markets.

Dozens of banks across Europe now depend on the ECB just to open their doors every day. They pawn bonds and loans with the central bank every day in exchange for the hard cash they need to run their business because market sources are no longer willing to lend. The ECB has started to refer to these institutions unofficially as “addicted banks”.

“Understandably, the ECB wants to wean all the addicted banks off its balance sheet,” said Frank Engels, senior European economist at Barclays Capital. “Not all those institutions are in peripheral countries.”

Many of Germany’s regional banks are rumoured to be among the addicts. Hypo Real Estate, the German property lender that was owned by the private equity firm JC Flowers before its nationalisation in 2009, is also thought to be dependent on the ECB.

Ireland, however, has more addicted banks than any other EU country. The ECB has been in talks with the Irish government about replacing all the short-term loans that are keeping its banks afloat with a new, longer-term €60 billion facility.

That would allow the banks to wind themselves down slowly without launching fire sales of their assets.

The same mechanism could then be used to wean troubled banks across Europe off ECB support, but that idea appears to have split the ECB.

“I don’t see what problem that would solve,” said a senior banker. “All you do is nationalise the funding problems of Europe’s banks inside the ECB. History shows that the way you deal with a bank crisis is to own up to your problems and get it all out there.

“This plan seems to be all about hiding the problem in a different place. Then you end up with a lost decade — a long period of no growth.”

The one bright spot to have emerged from the current confusion is Spain. Like Ireland, it enjoyed a huge property boom after joining the euro, fuelled by the artificially low interest rates that came with the new currency. Like Ireland, that boom has now turned to bust, with “ghost towns” of halffinished developments littering the countryside.

Property developers owe more than €300 billion to Spanish banks — equivalent to about one-third of the country’s GDP.

Nonetheless, the financial markets seem to have dismissed the idea that Spain will follow Greece, Ireland — and probably Portugal — in seeking an international bailout.

A large proportion of the problem loans in Spain were originated by cajas, small regional savings banks. A forced consolidation of these tiny lenders has cut their number from 45 to 17. Although many of the cajas are likely to end up being partly nationalised, that now looks like a manageable problem.

“The official estimates on the size of the cajas’ capital shortfalls are on the low side,” said Antonio Garcia Pascual, chief southern European economist at Barclays Capital. “Yet even if you take higher market estimates for the recapitalisation needs, it does not become too big a problem for the sovereign to handle. For example, even if you factored in a capital shortfall of €90 billion and assumed that all of that capital would have to be raised by the state, Spain’s debt to GDP ratio would be below the EU average.

“That’s in part why, over these past few weeks, Spanish sovereign debt has started to delink a little from the other periphery countries.”

Keeping Spain afloat has been the key objective of all the eurozone’s efforts to agree new bailout mechanisms and rescue funds. The view has been that if Spain falls to a bailout, then speculators will turn their attention to somewhere else in the eurozone — maybe Belgium, maybe Italy, possibly even France.

Protecting Spain doesn’t necessarily solve the eurozone’s problems, but it does dampen the general sense of fear — at least for now.