Capco Blog

The real threat to many European banks is the forced recognition of the need to foreclose

In recent days, most economic commentators have been fixated on the upcoming stress test results of a number of European banks. The list of concerns about the true benefits of the stress tests are far too long to be mentioned in this bulletin, but the main issue seems to be that the tests will not be realistic in the way in which they take account of the potential onslaught of defaults by a number of European sovereign borrowers. The logic goes that if there are a series of defaults by countries like Greece, Portugal, and Spain that banks in other major European economies, such as Germany, France, and the U.K., will face significant threats and might become insolvent because of their exposures to the sovereign debts of these countries. Of course, this is assuming that they are not technically insolvent already.

So, the European Central Bank is in a position of damned if they do and damned if they don’t. If the banks pass with flying colors then many will perceive that as a white wash and the implications for the banks’ share prices, and more importantly for the euro, would be quite severe. If a large enough number fail the test, then the implications are even worse. Presumably, when they first thought of the tests they did not think about how the markets might in fact react to the news of the results.

So, now, the ECB will be forced to use some game theoretic models, or undertake a number of interviews, to determine exactly how many banks need to be found to be in some sort of trouble for the markets to react positively, and how big should the recapitalizations be in order for the threat to the currency union to dissipate.

In my mind, if Germany’s constitutional court finds that Professors Hankel et al. are indeed correct and that bail-outs of banks exposed to Greek, Portuguese, Spanish, and Irish sovereign debt breach Germany’s supreme and sovereign Basic Law, then all this effort has been in vain. And there is nothing to say that they won’t succeed. I guess the choice is not a legal one, but a political one. If law supersedes politics in this case, then the end of the euro is much closer than many believe.

However, even if the legal case fails and the stress tests are deemed good news by the markets, I believe that the real threat facing European banks will not go away. The real threat could in fact come from a moderate economic recovery and increases in interest rates and cuts in direct and indirect provision of cheap capital support.

Right now, a combination of low interest rates and pretty much unlimited cheap liquidity are allowing European banks to delay recognition of defaults that would otherwise have been recognized in normal economic circumstances. I believe that this issue is just as important, if not more so, than the risk of sovereign defaults. This is because it would be much harder to justify providing capital reserve support to banks because of foreclosures than bailing out other national economies of the euro zone. And, these foreclosures will happen sooner or later, both in the residential and commercial real estate markets.

The corrections in property prices, irrespective of the worthless information provided by estate agents and mortgage lenders, both of whom have a lot to lose from acknowledging falling prices, are significantly more severe than many are willing to acknowledge. Yes, it is true that some multi-million dollar properties are exchanging hands in London, but that is due to the fact that the super rich have remained rich, while sterling has fallen through the floor. However, that does not mean that the price of the average home has not collapsed, and indeed will not do so more severely over the coming months as people realize that the huge amount of liquidity pumped into these economies has not had the desired effect and that the economy is still in a very weak position.

Add to this problem the potential cancellation of self-certificate mortgages in the U.K. and you can see that once rates do rise many will be forced to hand over the keys to their homes to the banks, who will be sitting on an ever increasing number of foreclosed properties over the coming years.

It is the true correction in the property markets, which has been artificially supported by low interest rates and the permission to banks to delay foreclosing, that should be incorporated into the stress tests that are currently being carried out by the ECB. What would happen if property prices, both residential and commercial, fall by a further 20% in the major European economies? How would the banks respond in that situation?

These are the real questions that the ECB cannot afford to ask, since everyone knows the answer. The issues that the stress tests will cover will certainly not appease those who are certain that European banks are in a much worse state than they or the ECB are willing to acknowledge and will undoubtedly not result in a dramatic turnaround in their share prices or the optimism for the currency union.

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