Teaser: The effects of the U. S. subprime crisis have not been fully felt in Europe yet



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Global Market Brief: The Subprime Crisis Goes to Europe
Teaser:

The effects of the U.S. subprime crisis have not been fully felt in Europe -- yet.

Analysis

The full impact of the U.S. subprime crisis has yet to be felt in Europe. The European banks involved in securities backed by the subprime mortgage loans have certainly already felt the credit crunch and are responding accordingly by looking for ways to raise capital, but the contagion of the overall financial mess can still hit Europe in a number of different -- and in some aspects, more intense -- ways than it already has. Many European banks could, in fact, already be deeper in the U.S. subprime morass than some U.S. banks, though it is impossible to be certain because information trickles in as banks disclose it, and most banks are not forthcoming (or completely certain) about the extent of their involvement.


The subprime mortgage crisis became an issue in August 2007, when it became evident that a slew of bad loans for subprime (financially unreliable) customers were going into default (loans can go into default -- I looked it up to doublecheck OK), causing a major correction of housing prices in the United States. The crisis spread throughout the market for mortgage-backed securities traded by financial institutions, a vehicle [I would leave the “financial” here, since just saying “vehicle” may be confusing for people] (I figured the "financial" was redundant, since we say "mortgage-backed securities traded by financial institutions" -- if we need any description at all, could we maybe say "investment vehicle"? - YES) particularly favored by prominent European banks such as UBS, Deutche Bank, HSBC, and many others. Even though not all subprime mortgages were/are bad loans, the crisis has spread because investors have essentially lost faith in the soundness of a whole category of investments.
The collapse of mortgage-backed security markets led the banks to lose serious confidence in their ability to provide credit. This precipitated a loss of liquidity (essentially, money) as banks started to cut back on "interbank loans," which allow banks to borrow money quickly among themselves at the end of the business day to cover their accounts. Banks, both American and European, became wary of lending to each other because they were unsure of how far down the "American bad debt" cookie jar their arms were stuck. Because the current credit squeeze could develop into a full-blown credit crisis, banks have been attempting to raise capital. One way is to obtain the money from sovereign wealth funds; another is to lower their operating costs and dividends. A particularly prominent example unveiled in recent days is Barclays, which is raising more than $8 billion from both sovereign wealth funds and sale of shares following similar efforts by the Royal Bank of Scotland ($24 billion) and HBOS ($8 billion).
To understand Europe's vulnerabilities to the looming crisis, it is necessary to realize that unlike the United States, Europe has a heterogeneous banking system with multiple built-in vulnerabilities. The overarching and primary vulnerability is systemic and can be explained culturally to an extent, but there are also regional and local aspects that bear consideration.
The main vulnerability is that the European Central Bank (ECB) cannot solve the problem. The ECB has oversight over monetary policy -- which mainly boils down to setting interest rates -- for the entire eurozone and conducts its business in the anti-inflationary manner that has become the hallmark of German banks since the 1920s Weimar hyperinflation. However, the ECB alone cannot stave off a continent-wide financial crisis. The different European countries have enough control over their lending practices to make an EU-wide solution practically impossible, especially in situations when the ECB monetary policy does not mesh with what the local conditions require.
On a general structural level, most European banks have close ties to the European industrial conglomerates and the government. This is as much a cultural and historic variable as it is a financial one. In the United States, the bulk of financial regulation has always served to prevent collusion between banks and businesses; a slew of laws, some with roots in the aftermath of the Great Depression, prevent banks from being highly invested in U.S. corporations, effectively creating a firewall between the real economy and the financial sector. Europe never experienced that concern, or at least never saw a political impetus to create such financial regulation, because the collusion between banks and businesses was encouraged. The European families that started banks and industrial enterprises were often closely linked to each other (or were the same families, as is the case in some Asian countries). Due to these close family and business ties, the European corporations rely heavily on investment from domestic banks and rely less on private capital raised from the sale of stock (as is more common in the United States). Therefore, in times of a liquidity crisis European businesses would be left with few alternatives they are used to and comfortable with.

 

The heterogeneity of the European banking system presents another problem, particularly if the ECB were to try mitigating the crisis on a Europe-wide level, which is basically impossible (as noted above). (I think we could end this sentence at the word "problem" -- we already say it would be impossible for the ECB to try to solve the problem Europe-wide, and the ECB isn't even actually mentioned in the next 2 paragraphs OK, do what you think is the best for this part) The adoption of the euro brought many benefits to individual countries. With the euro came stability and decreased interest rates for consumers. In particular, the low interest rates and strong economic growth has made mortgage lending much more of a viable option for many consumers in countries such as Ireland, Spain and Italy that previously would not have been able to afford it due to locally imposed high interest rates. In previous years, Europe's smaller economies set interest rates on the back of their own financial systems, meaning that mortgage interest rates had to be high. With the adoption of the euro, suddenly even the small economies could enjoy low interest rates.
This, combined with relatively lax lending policies, has created a pool of mortgages in a number of European countries -- particularly in Spain and Ireland -- that should be thought of as "subprime" even though they do not meet the technical U.S. criteria for that label. Spanish banks have been particularly liberal in lending to young immigrants from Latin America with no credit history. In fact, 98 percent of new mortgages in Spain have variable rates, which usually means that after the first five years of low interest the rate shoots up. In Ireland, lenders were willing to advance borrowers up to 125 percent of the total loan as recently as last year. While such practices are giving way to tighter lending requirements, the damage was already done during the housing boom in previous years. Only German banks have truly stringent lending policies; as a result, only 43 percent of the total home stock in Germany is actually owned by residents, with the rest being owned by landlords.
Moreover, housing markets in a number of European countries still have not had price corrections, and the fear is that a credit crunch and/or the collapse of local banking systems could precipitate such a correction, making it more dramatic and severe than it normally would be. (In fact, most European housing markets have actually been more overvalued than even the U.S. housing market was before the current crisis.) With a slowing European economy, tighter mortgage lending rules and high interest rates imposed by the ECB to protect the euro, the number of foreclosures in Europe would increase. European borrowers who had been enticed with variable rates would see their interest rates spike, increasing the overall number of foreclosures and thus flooding the housing market with available homes. Concurrently, the banks would have to tighten lending rules to prevent future foreclosures, pricing out customers with poor or no credit that would otherwise keep the demand for homes high. The twin effect of a rising supply of homes and falling demand due to the shrinking pool of consumers would have a devastating effect on the now already inflated house prices.
[INSERT GRAPH OF EUROPEAN HOUSING PRICES]
A collapse of the housing market could then precipitate a further contagion of banking crises throughout Europe -- not to mention the adverse effects it would have on the construction industry and consumer confidence.
Following a major banking crisis in Western Europe, Central Europe and the Balkans could be the ones suffering most. Since the beginning of the decade, Central Europe has consistently outgrown Western Europe, with 5.8 percent gross domestic product growth in 2007 compared to 2.6 percent for the euro area, but the capital that made that growth possible has come from western Europe GREAT. The European Union's expansion to the east has in some ways been motivated by the prospect of opening up new markets where capital could fuel solid growth, since Western Europe is less likely to be able to sustain more than 3 percent growth a year. Essentially, Central Europe has offered greater return for investment throughout this decade. While foreign direct investment in east-central Europe made up 40 percent of the net inflow in 2007, the rest came from the now-volatile Western European banks, which sunk more than $1 trillion in assets into Eastern European markets. That would be a lot of assets to pull out to shore up reserves at bank headquarters in Western Europe. Central Europe and particularly the Balkans would have a difficult time coping with such a move.
[INSERT GRAPH OF EASTERN EUROPEANs AND THEIR LIABILITY TO FOREIGN BANKS]
Central Europe and the Balkans are also susceptible to a severe crisis because foreign banks have loaned a lot of money to domestic banks. In many cases, a country's entire banking system is actually foreign-owned (such as Serbia's). Western banks involved directly in "emerging Europe" (Scandinavian banks in the Baltic states and Austrian and Italian banks in the Balkans) were not involved in the U.S. subprime crisis, but they could be vulnerable when the rest of the major Western banks decide to pull their capital back to shore up dwindling reserves or investments closer at home, thus affecting the total cost of credit. On top of this, the financial institutions in the new crop of Central European banks are inexperienced, and even with the best due diligence and tightest lending rules (which are not yet in place) they are going to have a rocky start, which goes without saying for the banks in the Balkans.
The normal effect of a financial crisis is a re-evaluation of risk in investment portfolios; essentially the banks have to go back to all the loans they have financed and ask themselves who received loans but should not have. This leads to painful economic crises as credit becomes more expensive. The problem in Europe is that the U.S. subprime problem, combined with a potential for a local mortgage crisis, could precipitate a much greater system-wide readjustment described above. This would force big banks in Europe to rethink the loans they made to Central Europe, the Balkans and their own mortgage customers, which -- unlike in the United States -- include large corporations.
The financial crisis needs to be addressed by individual countries separately. Unlike the U.S. Federal Reserve, the ECB is almost exclusively concerned with the stability of the euro and keeping inflation down. It therefore does not have the authority to intervene directly into the banking system of an EU member state. But even if the ECB had the authority to intervene on a country-by-country basis, the financial crisis will not be the same throughout the continent and local problems will necessitate local solutions. Therefore, individual European countries will be on their own when it comes to making decisions on whether to bail out struggling financial institutions or just let them collapse.
Many of Europe's banks are just as deeply entangled -- if not more so -- in the U.S. subprime markets as many U.S. banks. While the crisis has yet to fully unfold in the United States, it has yet to really begin hitting Europe. But it will, very shortly.

Related:


http://www.stratfor.com/u_s_subprime_crisis_and_pain_come

http://www.stratfor.com/analysis/europe_ecb_tries_soften_subprime_blow

http://www.stratfor.com/analysis/eu_inflationary_pressures_and_ecbs_limited_options

http://www.stratfor.com/analysis/u_s_foreign_investment_and_stock_market

http://www.stratfor.com/global_market_brief_major_economies_recession_fighting_tools
GRAPHICS:

https://clearspace.stratfor.com/docs/DOC-2532

https://clearspace.stratfor.com/docs/DOC-2530

please disregard the list of sub-prime banks, only use the map.


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