Rob Wessel is managing partner of Hamilton Capital, a Toronto-based fund manager specializing in financial services. An expanded version of this article can be found at www.hamilton-capital.com
To North American investors, Europe’s current sovereign debt crisis bears many similarities to the U.S. credit crisis of 2008-09: two similar-sized economies with too much debt, particularly within the financial system. And in each crisis, bank stocks have acted as a daily barometer of investor confidence.
But what’s happening in Europe is not a repeat of the credit crisis. There are three primary differences.
1. The potential losses in Europe are nowhere near as large
The potential losses from “toxic” assets in Europe are a fraction of those incurred in the credit crisis. In 2008, the market struggled to value an almost unfathomable $15-trillion (U.S.) of real estate loans while property prices were collapsing. Eventually, the monumental scale of the problem froze credit markets, contributing to a global recession.
In Europe, the toxic assets are much smaller. The sovereign debt for Greece, Portugal and Ireland totals less than $1-trillion. This rises to about $4.3-trillion if one includes Spain and Italy. While large, this is just one-quarter as large as the credit crisis. In 2008, there were numerous failing U.S. banks with loan portfolios larger than the sovereign debt of most European countries.
During the credit crisis, the financial system was extremely vulnerable to shocks, as most toxic assets were held by giant financial institutions that lacked the capital to absorb looming losses. At the extreme were Fannie Mae and Freddie Mac, with a staggering $4.5-trillion of exposures to real estate loans. U.S. banks held another $5-trillion of real estate loans.
In Europe, the amount of sovereign debt held by the 34 largest banks is much lower. Their combined exposure to the debt of those five problem countries is less than $500-billion. Excluding Italy and Spain, this declines to a manageable $135-billion. The lower bank exposures are the result of an increasing amount of sovereign debt effectively being nationalized by institutions such as the International Monetary Fund, the European Financial Stability Facility (EFSF) and the European Central Bank.
2. It’s a multidimensional crisis, not purely a banking crisis
At its core, the U.S. credit crisis was a banking crisis, making the path to resolution relatively straightforward. Losses in mortgages had to be recognized as incurred. Unfortunately, they were so enormous that by the time the worst was over, hundreds of banks had failed; Bank of America and Citigroup needed government rescues; and Fannie and Freddie had to be nationalized. The result was that government absorbed the financial sector’s losses on a large scale.
By contrast, the European crisis is multidimensional: it involves debilitating country debt and too much leverage in the banking system. It also includes complex geo-political issues, including the fate of euro currency. However, the most immediate risk is potential losses from government defaults or restructurings, triggering a banking crisis.
To forestall the latter, European banks have been raising capital (nearly $200-billion since April, 2010), and reducing their sovereign debt exposures through writedowns and public market sales. Crucially, they have also been building liquidity, which is vital. More than 50 per cent of bank funding in continental Europe comes from institutional investors, rather than individual depositors, making the system uniquely vulnerable to a liquidity crisis.
While these measures have not been enough to restore confidence, they have not been insignificant, either.
3. The political dimension makes the outcome more difficult to predict
So if the potential size of financial losses is smaller than in the American real-estate collapse, why are Europe’s troubles so serious? The answer is the significant political dimension of the European crisis, which makes a solution harder to achieve.
In the U.S. credit crisis, one government was able to make the difficult decisions to nationalize losses and force banks to recapitalize. In Europe, 17 countries must agree collectively, and then individually ratify those decisions, making policy consensus extremely difficult and the pace of implementation glacial.
Losses must be recognized eventually. However, except for Greece’s inevitable default, the “when, who, and how much” is still unclear. For each of these, politics will have a significant impact. In the meantime, European governments are essentially playing a high-stakes game of chicken with the markets, as they seek to enact the austerity with the least amount of pain.
The fate of Spain and Italy will determine the severity of the crisis
So, how does this end? During the U.S. crisis, and after almost two excruciating years, the financial markets got a genuine confidence-restoring solution. Top U.S. banks went through “stress tests” that resulted in them being forced to raise capital to repair their balance sheets. The complexity of the European crisis makes a singular solution less likely. Regardless of changes to the EFSF, for any solution to be long-lasting, countries in Europe have to do the hard work of eliminating their structural deficits.
The good news is that a banking crisis can be avoided. Policy makers have the resources they need to force the banks to recapitalize. That would ease the impact on North American markets and economies. The bad news is that the drag on growth from fiscal austerity could last for years. The most important factor determining the seriousness of the crisis will be if policy makers can find a way to ring-fence Spain and Italy until they can successfully find a way to get deficits under control and regain the market’s confidence.
If so, the crisis will be more benign. If not, the crisis will escalate, and is likely to include liquidity-driven bank failures, with the fate of the euro casting an ominous shadow over the world’s economy.