How the European Banking sector sheltered from another financial crisis.

 

They are called COCOs (contingent convertible bonds) and are debt instruments issued by European financial institutions. They work similar to convertible bonds with a specific strike price that once breached, the bond can be converted to stock or equity. Investors of COCOs are individual investors in Europe and private banks. COCOs are high yield, high risk in European investing.

In the banking industry their use helps support the bank’s balance sheets by allowing them to convert the debt to stock when specific capital conditions require. They were created to prevent another financial crisis similar to that of 2007 – 2008 and help undercapitalized banks.

In contrast, the US banking industry prohibits to use COCOs, instead they issue preferred stock. Investors can benefit from convertible bonds since the bond can be converted to stock when the stock price is appreciated. The convertible features allows investors to have a fixed interest rate, and the capital appreciation from a rising stock price. Then receive fixed periodic interest payments on the life of the bond.

COCOs first made their appearance in 2014 to help financial institutions meet the BASEL III capital requirements (providing minimum standards for the banking industry). As part of those standards, a bank must maintain sufficient capital to be ab le to absorb a financial crisis and unexpected losses from bad investments or loans.

One type of capital is Tier 1 capital (the highest rated) to offset bad loans on the bank’s balance sheet. Tier1 includes retained earnings as well as shares of common stock.  COCOs act as additional Tier 1 capital. Instead of converting bonds to commons shares based on the stock price appreciation, COCOs investors agree to receive equity in exchange for the regular income received from the debt when the bank’s capital ratio falls below regulatory standards.

If a bank is having financial difficulty and is in need of capital this is reflected in the value of the shares. COCOs have an embedded option. An embedded option is a feature of a financial security (a bond in this case) that allows holders take specific actions against the other party. An embedded option gives the investor (call provision) the power to redeem the bond before its scheduled maturity. In the case of convertible bonds, they would have the right to exchange the bond for shares in the underlying stock. The banks that issued the COCOs benefits by raising capital from the bond issue.

However, if the bank has underwritten many bad loans (as in the case of Greek banks) they may fall below Tier 1 capital requirements. The stipulation carried by the COCOs states that the bank is not required to pay periodic interest payments, or may even write down the full debt to satisfy Tier 1.

When a bank converts COCOs to shares, they may move the value of the debt from the liability side of the balance sheet. This trial balance change allows the bank to underwrite additional loans.

 

Bill T. Alexandratos

October 2020

To contemplate the Bad Bank scenario

 

The Greek government seems to have reached a decision as to the fate of creating a “Bad Bank” to resolve the problem of bad loans appearing on the balance sheets of the four systemic Greek banks.

The banking system may undergo once again an overhaul by further shrinking with an apparent merger. Thus far, the government does not want to accept to proposal of the central bank of Greece to create a bad bank. They believed that the Hercules plan to handle the problem of non-performing loans is sufficient by securitizing bad loans.

To explain securitization banks are required to hold capital requirements, a certain portion of own equity for each different type of asset on their balance sheet so as to prevent them from high leverage. Financial regulators (SSM) have introduced complex capital requirement rules, which determine the minimum amount of equity a bank needs to have on its balance sheet. If a bank is well capitalized (meaning has sufficient equity) it be able to withstand adverse market conditions.

Based on the Basel rules, banks need to maintain a capital ratio based on the risk profile of the assets on their balance sheets. This means that different types of assets are weighted differently and thus more capital needs to be held for riskier assets. An example as to how types of assets can be ordered in terms of risk weight are: reserves 0%, treasury securities 0%, home mortgages 50%, commercial loans 100%.

The question arises as to why do banks need securitization, as the Greek banks have already began doing for the bad loans on their balance sheets. Capital is expensive and by definition, a more capitalized a bank is, the lower the return on equity (ROE) will be. Since all banks want to have a high ROE they have to work with risky assets. Regulations impede banks from holding more than a certain amount of risky assets without additional capitalization, which lowers profitability (we will see below that in the case of Greek banks it will expose losses).

The solution they came up with is securitization where Greek banks “package” a group of assets (in this case the bad loans) on their balance sheets and sold to investors. Greek banks have already done this and have created a special purpose vehicle where they will transfer these packaged loans to, and sell them to investors (many have already found investors (mutual funds). The special purpose vehicle (SPV) is a new company where the banks transfer the mortgage loans.

Once investors buy the securitized assets the bank frees up its balance sheet and can invest in new securities, and banks profit from origination and commissions of the loans in the SPV. On the other hand, investors would buy these securities because they would have a return on investment compared to bond securities with similar credit ratings, and diversification benefits since some investors do not have a direct access to mortgage loans.

Strong supporters of the Hercules plan are the union of Hellenic banks and the heads of the four systemic banks, but those that monitor the Greek economy (IMF, EU commission) in their last reports, conclude on the same findings, which is that the Hercules plan is not enough for the consolidation of the Greek banking system and their portfolios.

Their capital is of poor quality giving the fact that there is the issue of the deferred tax credit (DTC, see previous article), which is composed of 60% of their total assets. The creating of the bad bank has also opponents among cabinet members since it will bring a shake up to the existing equilibrium in the banking system which has prevailed for years, and brought the annihilation and consolidation with a total market share of 90%.

The plan of the central bank and its governor is to create a band bank, and transfer the non-performing loans (NPL) worth more than €40 billion. This will clean up the banks’ balance sheets. The view in the European Union is that the current banking system in Greece is at a stalemate, and is unable to handle NPL’s. That is why they are determined and have giving their ok to go forward with the plan even though that may mean a further shrinkage in the number of banks by a merger, thus sacrificing a sacred cow.

The transfer of the NPL’s to the band bank will unveil the hidden losses on the balance sheets so as not to be considered state aid (from the DTC), with a valuation close to market value, lower than the valuation reported on the banks’ balance sheets. This will have a negative effect on their assets.

To alleviate this, the central bank of Greece proposes the provision of losses be treated in more than one fiscal year. The need of capital will be exposed and will be presented to the SSM in order to cover those needs. From this process the conclusion is that one of the systemic banks will be absorbed by the other three. The new European statute provision states that Capital enhancement is prohibited without a haircut to creditors and depositors, so to avoid this, the only solution is a merger.

 

Bill T. Alexandratos

October 2020

IMF Report on Greece

 

A report released by the IMF on the prospects of the World economies, the recession in Greece is expected to be 9.5% for 2020, while in 2021 the economy will turn to growth and is expected to grow by 4.1%.

The IMF’s expectations of recession for the southern European nations are: Spain -12.8%, Italy -10.6%, Portugal -10.0%, and France -9.8%. For the years 2021 and 2022 IMF predicts growth in GNP which mainly will come from the pandemic relief funding of the EU.

Greece is expected to receive €33.4 billion from the pandemic fund, which corresponds to 17.8% of the Greek GNP. Italy’s funding will correspond to 20% of GNP, and Spain’s funding 19% of GNP. According to the proposal by the EU commission, 93.5% of the total fund relief (which is €750 billion) is estimated to be used for public investments, mainly thru funding as well as in the form of loans.

The remaining 6.5% is to be used as guarantees for funding private investments. The report released by the IMF in the beginning of October 2020, points out that recession will continue for the second quarter of 2021 at a worldwide level and having a negative impact on Tourism, as to the timing of the funds to be received it is uncertain.

Greece’s public debt will start to subside as a percent of GNP in 2021, which is 200.5%, 187.3% in 2022, and 177% in 2023.

Public expenditures in Greece are also expected to decline in the coming years: 57.3% of GNP in 2020, 51.3% in 2021, 50.1% of GNP in 2022, and 49.5% of GNP in 2023. Public expenditures will remain below 50% until 2025.

Bill T. Alexandratos

Profitability of European Banks

 

The European Central Bank (ECB) announced today that 2^nd quarter earnings for the year 2019 amid their struggle to contain the volume of non-performing loans.

Amid the world pandemic banks reported a return of equity (ROE) of just 0.01%, compared to 6% one year ago. Seven of the nineteen banks reported a negative return on equity. Return of equity is a measure of financial performance, and is calculated by dividing net income by shareholders’ equity.

Shareholders’ equity is equal to the bank’s assets less its debt, so return on equity is a return on net assets, which is a measure on how effectively the management is using the assets to create profit.

For the Eurozone, the banks’ ROE was 5.8%, Spain 7%, Italy 5.6%, Greece 1%, Germany -0.2%, and Portugal 3.9%.

The total volume of non-performing loans stood at €503 billion, which almost remain the same three months ago, which was €501 billion. The purchase of debt by ECB for the months of August and September was just over €3 billion, while due to the pandemic program, the ECB has a total of €12.9 billion worth of European state debt.

In its upcoming Thursday meeting of the board of directors, the ECB is probably expected to announce an increase in the Pandemic Emergency Purchase Program (PEPP). PEPP is a temporary asset purchase program announced in March of 2020 by the ECB of private and public debt securities.

The program now stands at €750 billion and if the amount is increased, Greece may prove to be most favored, a key role in the decision will be the reconsideration of the projections as to the recession in the Eurozone.

The latest projections, according to ECB, is that recession for the Eurozone is expected from 8% to 12% for the year 2020.

 

Bill T. Alexandratos

 

 

The Bad Bank and the Deferrd Tax Credit : reducing bad debts of Greek Banks

Deferred tax credit has been an ally of the Greek banks when it was put into law. The purpose of the deferred tax credit (DTC) was to cover any needs that may had arisen as a result of the stress tests by the European central bank (ECB), as well as the hair cut that banks underwent on their bond portfolios as a result of the private sector investment (PSI) program.

DTC was aimed at being a tax incentive for banks for the purpose to compensate losses. They have the ability to offset losses due from PSI and bad loans with taxes due in the future. Since DTC has been passed into law, banks have already wrote these gains in their balance sheets, thus increasing their capital.

One may argue that this is creative accounting since it shows banks’ capital as overestimated. The reality is that for the next 20 or 30 years banks will deduct from this “cushion” taxes that should have been paid to the Greek treasury.

DTC will also be used to deduct an equal amount from their capital, should a need comes up from the stress tests. The DTC has the guarantee backing of the Greek treasury in case any bank reports losses on their income statements. This loss will have to be covered by the Greek treasury with cash. In return, the banks will issue rights of common shares whose value will correspond to 110% of the gain from the DTC. These rights will be converted to stock ownership. The benefits are estimated to be about €2.5 billion, while the profits from the stress tests are estimated at €300 - €500 million.

In addition to non-performing loans (loans in delay, not expected to be paid) banks have added loans not being expected to be paid due to the pandemic. So if a bank reports a loss it would be required to issue share capital increase, and if that is not covered by existing shareholders, then the government will have to step in and pay in cash. The banks started to get rid of these loans from their balance sheets by securitizing them as were instructed by the SSM (supervisory mechanism by the ECB), but due to the pandemic this process has stopped for a while. The sale of these securitized portfolios has been put on hold until market conditions (economic growth) returns in 2021.

Two banks have made progress such as Alpha bank and bank of Piraeus. They estimated their losses from non-performing loans at €2 billion and €1 billion, respectively. The idea is to clean up the banks’ balance sheets, transfer the bad debts to a “bad bank”.

A bad bank is set up to buy the bad loans and other illiquid assets of a financial institution. The entity holding these non-performing assets will sell these holdings to the band bank at market price. By transferring these assets, the original institution cleans up its balance sheet, but will be forced to report write down.

A write down is a reduction in the book value of an asset (bad loans) when its fair market value has fallen below book value. A write down becomes a write off if the entire value of the asset becomes worthless. Write downs have a serious impact on the company’s net income and balance sheet.

For example, during the financial crisis of 2002-2008 the drop in the market value of assets on the balance sheets, forced financial institutions to raise capital in order to meet minimum capital requirements.

The solution of the bad bank is one policy that the Bank of Greece supports and will soon present its plan to the government. DTC correspond to 56% of owners’ equity. One can assume what this may mean as far as real capital banks have in the event of having to come up with capital to cover for losses.

The gradual decrease of the capital adequacy (than bank’s capital to risk) of Greek banks, and the degree of dependency, requires then return to profitability of Greek banks. Covid and new generation of non-performing loans due to the pandemic, requires banks to make increased projections for allowance for doubtful accounts.

Recently the IMF expressed its doubt on the DTC and believes the Greek budget may be under pressure in the future. DTC was placed in law in 2004 and the Greek government at the time used it PSI program and bad debts. Despite objections from the EU, Greece claimed that it was used successfully (in 2014) by Italy, Spain, and Portugal. The fact is that the aforementioned nations did use DTC but on the contrary to Greece, these countries first solved the problems of bad loans, and then activated the DTC.

The government allowed losses to be offset with profits for the next 20 years, which means, the banks will not pay any taxes due for profits until the amount of €19 billion is fulfilled (the amount of DTC). The amount of €19 billion is shown on the banks’ balance sheets at capital.

Thus the banks struggle to show profitability so as to depreciate the DTC, otherwise, if they report losses in any fiscal year, the public treasury will step in to provide cash for the increased in share capital, and this create a fiscal burden which will show up in the public debt as well as create a budget deficit.

The other problem which worries some in the EU is that if none of the existing shareholders are able to cover the increased of share capital, this will create a dilution of the current shareholders, as well as government subsidy.

To provide some data (Wood research 2018) which shows the magnitude of the problem, during fiscal 2017, the balance sheets showed the percentage of capital of common equity Tier1 (CET) (mostly common stock held by a bank) corresponded to 63% of DTC. Therefore of the total capital CET1 worth €25.8 billion, €16.2 billion came from DTC, while €10 billion real capital.

So the Bank of Greece believes that to tackle this problem the solution is the bad bank, a special purpose vehicle which will transfer all the bad loans to, as well as part of the DTC. By doing both, the ratio of non-performing loans will be reduced, and the capital base of the Greek banks will be improved. A more realistic plan that the creative accounting currently in existence.

Non-performing loans are currently estimated to be €40 billion along with the DTC which is €7.4 billion. The Bank of Greece expects to reduce the percentage of bad loans by 47%.

Bill T. Alexandratos

October 2020

OECD’s Economic Summary Outlook due to the Pandemic

The Organization of Economic Cooperation and Development (OECD) is a unique forum where the governments of 36 member states with market economies work with each other to promote economic growth, fighting poverty, prosperity and sustainable development.

The OECD publishes economic reports, statistical databases, analyses, and forecasts on the outlook for economic growth worldwide. Reports can be global, regional, or national in nature. The group analyzes and reports on the impact of social policy issues (such as the corona virus) on economic growth, and makes policy recommendations designed to promote growth with sensitivity to environmental issues. The organization also seeks to eliminate bribery and other financial crime worldwide.

According to the OECD it predicts that the corona virus pandemic will have a world impact on the economies. Economies will decline into a recession -6%, and this in the event there is no new outbreak in the fall of 2020 as the pandemic has consumed per capita GNP.

Many businesses will not reopen and this will increase unemployment and reduce production. The pandemic has uncovered how the world economies are correlated between them, meaning that the pandemic had shocking effects that were easily transmitted throughout the world.

At the same time it is difficult for one country (especially the economic weaker ones) to turn its economy to growth when the world economies have not recovered. This insecure environment which brought about a lockdown has had an impact on total demand. Consumption has decreased as a result by consumers, and investments are predicted to decrease by 10.5%. World commerce will also have an impact on the economies and especially to countries that are depended on exports.

 The economic recession brings about a risk of massive defaults imminent since businesses will not be able to further sustain any additional financing. The pandemic will also impact countries with high debt making them easily vulnerable, mainly the emerging market economies.

Bill T. Alexandratos

June 2020

ECB Decides to Increase Qunatitative Easing amid fears of Recession

The European Central Bank in its meeting today, June 4, 2020, decided to extend the Quantitative Easing by six months, and the amount of financing provided to the European banking system by €600 billion, to €1.35 trillion.

The aftermath of the pandemic has brought fears that a recession is at the doorstep of the European economies, and expectations are that a slowdown of GNP will reach 8% or even higher. At the same time the central bank has set an inflation target of 2%, while interest rates will remain stable.

The ECB has set three different interest rates: the main refinancing rate, which is the interest rate banks pay to the ECB for financing for a period of one week. In this case, banks must provide collateral which is a guarantee that the funds will be returned.

The second interest rate is the marginal facilitation facility interest rate, which is the overnight interest rate that banks pay to the ECB. Banks also provide securities as collateral.

And lastly, the third interest rate in the monetary policy of the ECB is the interest rate facilitation deposit. This interest rate is the rate banks receive for overnight deposits kept at the ECB. Since 2014 this rate is negative.

Bill T. Alexandratos

June 2020