The ongoing deleveraging process in the Eurozone has kept a lid on U.S. equities, and in recent days, has caused a significant pullback that threatens to completely derail the annual “Santa Claus” rally. The matter of investor concern really goes to the lack of proper management of the process than the deleveraging itself. The disorganized and, at times, contentious mishandling of sovereign debt problems in outlying countries like Greece, Ireland and Portgual, now threatens the debt ratings of the core of the European Union, France and Germany. The United Kingdom has also stated its preference to remain outside of the euro.
The news seems to get worse every day. It was recently announced that the European Banking Authority found that the capital shortfall in EU banks is 8 percent higher than originally thought. Thus, in the aggregate, European banks need to raise €114.7 billion (approx. $149.1 billion) as an exceptional, temporary capital buffer against sovereign debt exposures and to ensure their individual Core Tier 1 capital ratio reaches 9 percent of risk-weighted assets by the end of June 2012.
The banks seem to be counting on deleveraging to help resolve their capital problems. Loans are reported as assets on a bank’s balance sheet. As households, corporations and governments continue to repay debt in order to shore up their balance sheets, banks reduce assets, which helps their balance sheets. However, deleveraging cannot be the sole method of recapitalizing banks. Doing so would result in a severe decline in lending activity, which in turn would cause large-scale economic damage.
What may be concerning investors (it worries me, anyway) is that the deleveraging process is well under way. In a recent research column, “Delveraging in the Eurozone,” Stephen Kinsella, Lecturer in Economics in the Kemmy Business School, University of Limerick, and Vincent O’Sullivan
Member of the FS Regulatory Centre of Excellence at PricewaterhouseCoopers, UK, note that “We can clearly see the deleveraging taking place within banks like Commerzbank ([loan-to-deposit ratio:] 137 to 123) or DNB (175 to 167), and we can see other banks with much larger loan-to-deposit ratios with less deleveraging taking place, like Danskebank (217 to 213), Swedbank (228 to 217), and Svenska (240 to 222). Even within this sample, there are clearly risks to deleveraging, and banks proceeding at different paces.“
With deleveraging well under way, and no coordinated effort to manage the process in sight, investors may be waiting to see whether the process results in one big drop in asset prices in 2012, representing a great buying opportunity, or whether the process may be more drawn out. Kinsella and O’Sullivan write: “Many analysts believe, however, that this deleveraging is just a start, and European banks will have to reduce their balance sheets by €1.5 to €2.5 trillion over the course of the next 18 months to meet more stringent capital requirements, according to research from Morgan Stanley (2011). Many private equity firms and hedge fund managers are eying up opportunities for bargains in 2012 on the back of anticipated deleveraging (The Economist 2011). Others believe the correction will be more protracted, probably drawn out over a ten-year period and with a trajectory similar to Japan’s financial woes during the 1990s.”
Part of the tension comes from the notion that governments will not let assets prices fall below a certain threshold. Meaning that public bailouts of weaker Eurozone banks would occur before an asset dump would drive prices further down. In addition, given the recent stock prices declines for Bank of America and Citigroup, investors are clearly concerned that European banks are not the only vulnerable financial institutions. Investing just keeps getting trickier.
Gregg D. Killoren
victoria1014
