S&P Downgrades and Banks: Threats to Global Stability
Standard & Poor’s likes moving on Friday nights after the markets are closed. It was on a Friday night that it downgraded U.S. debt to AA+ from AAA. And on Friday night, Jan. 13, it downgraded France and Austria from AAA to AA+ and seven other European countries too — Cyprus, Italy, Portugal and Spain by two notches, Malta, Slovakia and Slovenia by one. Portugal, Cyprus, Ireland and Greece remain at junk status. Germany’s AAA rating stayed the same.
The markets weren’t shocked by last week’s wave of pre-broadcast S&P sovereign debt downgrades. For months, the question wasn’t “if” but “when.” And true to form, just as with the U.S. downgrade, S&P’s reasoning skated the surface of prevailing wisdom: Governments have too much debt and not enough income. That’s only part of the story.
Nowadays, when any sovereign gets downgraded by a rating agency, it’s not just because its debt repayment ability is questionable (the publicized logic of rating agencies), but because it incurred more expensive debt to float its banking system. These are institutional problems that in turn cause recurring national economic ones.
Nowhere in S&P’s statement about “global economic and financial crisis” did it clarify that governments (including the U.S.) were hit due to having backed big national banks (and international, American ones) that engaged in half a decade of leveraged speculation.
The United States
On Aug. 5, 2011, S&P downgraded U.S. government debt to AA+. This was four days after Congress voted to raise the national debt cap — to prevent a downgrade — preceded by political squabbling and the U.S. Treasury and Fed begging Congress to raise the debt cap. S&P, that beacon of accountability, claimed, “American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.” In other words, too much debt, too little income.
According to the U.S. Treasury, the main reason for the debt increase was a stalling economy — lack of enough incoming tax receipts to pay expenses (which include interest payments on growing debt). That’s not true. Tax receipts dropped $400 billion to $2.1 trillion in 2009 from a year earlier. Expenditures jumped to $3.5 trillion in 2009 from $3 trillion in 2008. Treasury debt ballooned by nearly $4 trillion from 2008 to 2009.
So where’s the money? About $1.6 trillion lies on the Fed’s books as excess reserves that banks — dealers for sovereign debt — put there. Nearly a trillion dollars went to backing Fannie Mae and Freddie Mac, which enabled banks to artificially overvalue related securities, and to extra interest payments. There was $700 billion in the Troubled Asset Relief Program, which though mostly repaid, never manifested into debt reduction, and hundreds of billions of dollars of asset guarantees underlying big bank mergers. So, 75 percent of the extra debt went to saving banks. S&P didn’t mention this. The policy repeated across the Atlantic.
The Irish government’s pain started when it guaranteed the bonds of Anglo Irish Bank in September 2008. In May 2010, Ireland Central Bank head Patrick Honohan assured the world that he’d have “two big banks fixed by the end of the year.” On that endorsement, the government backed bondholders on the banks’ behalf. The economy deteriorated.
Six months later, nobody would lend to Irish banks. Irish austerity promises didn’t change the fact that Irish banks weren’t big enough to contain their waste. By November 2010, banks paid for 60 billion euros of maturing bonds with emergency European Central Bank (ECB) loans, part of a bigger bailout, and the ECB became the backbone for the Irish bank guarantee scheme, whose participants included Ireland’s big financial firms: Irish Life & Permanent, Bank of Ireland, Allied Irish Bank, Anglo Irish Bank Corp. Ltd. and Irish Nationwide Building Society.
The ECB deemed the bailout a success. Yet by the summer of 2011, Ireland was downgraded to a notch above junk and households (and foreigners) accelerated their extraction of money from Irish banks, weakening the banks’ funding base further. The Irish government now owes 110 billion euros to the banks, the National Asset Management Agency (NAMA, aka “bad bank”), the EU, ECB and IMF, with no way to repay it.
According to a recent Business Week article, Spanish banks hold 30 billion euros ($41 billion) of “unsellable” real estate loans. Just like in the U.S., where smaller banks got hit hardest, small and mid-size Spanish banks did too. In addition, about 308 billion euros worth of Spanish loans are “troubled.” Home prices in Spain are off 28 percent from their April 2007 peak, with land values in the outskirts of urban areas down by as much as 75 percent.
In economic desperation, voters elected conservative party leader Mariano Rajoy as prime minister at the end of 2011. He promised to lead Spain to economic recovery by invoking austerity measures in return for backing to help the biggest Spanish banks.
Meanwhile, the top six Spanish banks sit on $33 billion of foreclosed assets, having set aside $105 billion in write-downs against bad loans since 2008, with an additional $60 billion to come. The backdrop is a 23 percent unemployment rate, triple its 7.9 percent level in May 2009. Property transactions continue to decline. Foreclosures keep ramping up. The gap between what banks want to sell foreclosed or troubled property for, and what investors are wiling to pay, continues to widen, forcing more small and mid-size banks to buckle under larger than anticipated losses, which in turn squeezes liquidity out of local usage.
According to a 2010 SEC report from the National Bank of Greece (NBG), loans to businesses and households were expected to remain low [due to] “downward pressure on household disposable incomes and firms’ profitability from the austerity measures.” It wasn’t kidding. In order for the NBG (or any bank) to reduce its dependency on ECB funding, it has to reduce loans to its own economy.
The ECB agreed to accept worse collateral (with junk ratings), including bank-issued bonds with Greek government guarantees (under a May 2010 rule change for all member countries). The ECB bought Greek (and other) government bonds in the secondary markets to support their value and, thus, their value as loan collateral. As with the Fed’s quantitative easing measures, euro-style, this only perpetuates a fantasy of demand.
After four rounds of austerity measures, nationwide protests, 110 billion euros in IMF and ECB bailouts to keep bondholders (and banks) happy, escalating interest rates driving borrowing costs higher, a downgrade to junk, and a prime minister swap, Greece remains in tatters with more pain to come.
Portugal and Italy
Last summer, S&P warned that it would downgrade Portugal if it didn’t play ball with the IMF and EU over a 78 billion euro bailout. So Portugal towed the austerity line. Its economy deteriorated. S&P downgraded it to junk status.
The IMF and EU declared that Italy also needed “structural reform,” meaning public austerity and privatization. National assets went up for fire sale, as they did in Spain and Portugal, to the highest international bidder. Now, the high borrowing costs the government faces as a result of bolstering the banking system, paying bondholders and selling infrastructure has resulted in more downgrades and dim prospects.
According to the Italian Central Bank, 500 Italian cities are facing losses on derivatives contracts. JPMorgan Chase and Banca IMI are accepting Italian government bonds as collateral, rather than less-risky U.S. Treasuries or cash, certain that the ECB will step in to buy, and thus prop up, Italian bonds if needed, as it did in August 2011.
As Greece showed, using high-cost sovereign debt as collateral leads to more bailouts to ensure big lenders get their money back. JPMorgan Chase, having weathered the U.S. subprime crisis with support from the Fed, isn’t about to lose on that bet. Meanwhile, several Italian towns, the city of Milan and the Tuscany region are suing the big American, German, Swiss and French banks over derivative losses and misleading asset purchases, but those institutions will likely get bailout money anyway.
Bailout Economics Doesn’t Work
ECB bailout money didn’t (and won’t) go toward helping any European country’s local economy, any more than it went to aiding the mainstream U.S. economy. The ECB and IMF, at the Fed, U.S. Treasury and U.S. administration’s urging, camouflaged the insolvency of European banks, perpetuating losses with bailouts and forcing cowardly governments to support them, while turning a blind eye to boosting core economies.
Meanwhile, banks with access to the ECB’s “window” are taking the money and immediately putting it back into the ECB as reserves. Overnight deposits at the ECB continue to break records, currently hovering at about 500 billion euros ($640 billion). As in the U.S., European banks are not using that liquidity to help fix local economies, but hoarding it to preserve themselves. The total amount on reserve is 98 percent of the amount made available in emergency three-year loans in late December at 1 percent interest; banks get 0.25 percent, so are paying 0.75 percent interest for the loans, far less than the market would charge.
There’s an ugly pattern here. Central entities such as the Fed, ECB and IMF perpetuate strategies that further undermine economies through emergency loan facilities and bond and derivatives bailouts, with a chorus of rating agency downgrades to spur them on. Governments get stuck trying to raise money at harsher terms plus repay the bailouts that caused those terms to be higher. Banks run more scared and hoard cheap money that doesn’t go into helping populations, exacerbating the damaging economic effects. It doesn’t take a genius to see where this is going: more bailouts, more fears of bank losses, assuaging pushy bondholders, more downgrades, more austerity. Rinse, repeat.