Portugal’s Rickety Banking System
After the unseemly bankruptcy of the Espirito Santo Group and the associated bank, then Portugal’s second biggest (likely a result of not praying enough, see: “Big Portuguese Bank Gets Into Trouble” and “Fears Over Banco Espirito Santo Escalate” for the gory details), Portugal’s state-run deposit insurance fund basically ran out of money.
It turns out that Europe’s new Bank Recovery and Resolution Directive (BRRD for short) came just in time for Portugal. At the end of 2015, another Portuguese bank bit the dust, the country’s seventh largest lender by assets, Banif. Portugal’s government once again decided to bail the bank out, but with strings attached. Subordinated bondholders and shareholders were essentially wiped out, which is as it should be.
Banif SA, weekly. Although this is hard to see on this linear chart, the stock rose by 40% today, to €0.002. Shareholders are allegedly planning to throw a wild party in Lisbon over the weekend (we were unable to confirm this rumor) – click to enlarge.
Senior bondholders and depositors were spared however, with Portugal’s overburdened taxpayers once again footing the bill. According to the FT:
Portugal has agreed a €2.2bn state rescue for Banco International do Funchal (Banif), splitting the Madeira-based lender into “good” and “bad” banks and selling its healthy assets to Spain’s Santander for €150m in the country’s second bank bailout in less than 18 months.
António Costa, Portugal’s new socialist prime minister, said the bailout would involve “a high cost for taxpayers” but had the advantage of being “a definitive solution”. Branches would open normally on Monday, he said. The rescue, which “bails in” shareholders and subordinated creditors, follows the €4.9bn bailout in August last year of Banco Espírito Santo, once Portugal’s largest listed bank, whose healthy assets, split off into Novo Banco, remain unsold.
In a statement late on Sunday night, the Bank of Portugal said the rescue of Banif would involve “total public support” estimated at €2.25bn to cover “future contingencies”, of which €1.76bn would come directly from the state and €489m from a bank resolution fund, to which all banks contribute. The bailout protects depositors and senior creditors and ensures that Banif’s operations, transferred to Santander Totta, the Spanish group’s Portuguese subsidiary, will continue to “function normally”, the central bank said.
Shareholders and subordinated creditors would be left in Banif, retaining “a very restricted group of assets” that are to be liquidated, the Bank of Portugal said. “Problematic assets” would be transferred to a special asset management vehicle. The rescue partly mirrors the 2014 bailout of BES, which was split into “good” and “bad” banks after its profits were hit by exposure to the heavily indebted Espírito Santo family business empire.
Banif is Portugal’s seventh largest lender with total assets valued at €12.8bn in June, equivalent to about 7 per cent of Portugal’s gross domestic product, and deposits totalling €6.3bn. The bank is the dominant lender in the Portuguese islands of Madeira and the Azores, where it accounts for more than 30 per cent of total deposits.”
Since no deposits were wiped out as a result of the bail-out, Portugal’s money supply won’t be affected. However, Banif’s downfall is a reminder that Portugal’s banking system remains quite rickety. We dimly remember someone saying that the bail-out of BES would be the last such problem. Evidently it wasn’t.
Still, there is nothing overly unusual here – the socialist prime minister decided that it would be better to spare senior bondholders and depositors and let taxpayers eat the losses, but at least it was decided to bail someone in. However, what happened next was a lot less benign.
Governments Trying to Subvert the Law
The first euro area government that has tried to subvert the law governing the relations between creditors and borrowers was that of Austria. It was recently ignominiously stopped from doing so by the country’s Constitutional Court, which declared the so-called “Hypo Alpe Adria Special Law” unconstitutional.
What the government tried to do in this case was to stiff certain classes of creditors in spite of the fact that their bonds had been guaranteed by the now essentially insolvent province of Carinthia. As one can easily imagine, this decision didn’t go down well with the affected creditors and they sued the government. Austria’s Constitutional Court rightly concluded that the government had attempted to subvert essential legal principles and repealed the law in its entirety.
Specifically, the court cited in its ruling that reversing the guarantees to bondholders was in conflict with the constitution, that the law represented an unacceptable breach of property rights and that it treated creditors holding guarantees unfairly by dividing them into different classes, in spite of the fact that they should be treated pari passu.
As deeply embarrassing as this ruling was for Austria’s government, the attendant sighs of relief of bondholders could be heard across Europe. By desperately trying to avert a bankruptcy of the province of Carinthia (an event for which no legal provisions exist!), the government had created a huge question mark over government debt guarantees all over Europe. If one government could get away with suspending them by legislative fiat, couldn’t all of them expected to do so if push came to shove?
Photo credit: Heinz Peter Bader / Reuters
As a first test of the BRRD, the HAA special law turned out to be a costly failure. The cost cannot simply be measured in terms of the additional amounts the country’s taxpayers are now forced to fork over – the real cost is hidden, and comes in the form of lost trust. As the FT noted at the time:
“Germany’s VOeB association of public banks said that the law would have led to incalculable costs by undermining investor confidence in Austria. The country now faced “the considerable task of winning back the lost trust of national and international investors — which could be regarded as a Herculean task”, said Liane Buchholz, the VOeB’s managing director.”
Giving it Another Try in Portugal
But we know governments. We have already seen the lengths to which assorted Greek governments and the government of Argentina have gone in recent years to stiff their creditors. More recently, Ukraine got in on the act as well. So given the fact that the banking system, governments and central banks are engaged in a complex three-card Monte designed to fund welfare/warfare statism by issuing mountains of unsound and unpayable debt that “backs” an equally fast growing mountain of irredeemable “money”, we knew it would only be a question of time before someone tried to pull the same stunt again.
Who better suited for this task than Portugal’s new socialist government? Remember the bailout of BES and the creation of a “good bank” and a “bad bank”? Take a gander at the following chart from Bloomberg:
Five senior BES bonds that had hitherto been assigned to the “good bank” are reassigned overnight, without warning, to the “bad bank”. Bondholders lost 80% of their money between the evening of December 29 and the morning of December 30 – click to enlarge.
As Bloomberg notes, this is “setting a dangerous precedent” – indeed, it is not much different from the precedent almost set by Austria’s government. Here is the problem in a nutshell: the government, or rather the ECB, suddenly “discovered” – and this shouldn’t really surprise anyone – that the financial hole that has been torn into BES is actually gaping a lot wider than had been hitherto assumed. According to Bloomberg, this caused Portugal’s government to opt for instant expropriation – a new year’s surprise present for BES bondholders, so to speak:
“If you owned any of those five bonds on Tuesday, you were owed money by Novo Banco, the good bank. On Wednesday, you were told that your bonds had been transferred to BES, the bad bank. The Portuguese central bank selected five of Novo Banco’s 52 senior bonds, worth about 1.95 billion euros ($2.1 billion), and reassigned them — thus backfilling a 1.4 billion-euro hole in the “good” bank’s balance sheet that had been revealed in November by the European Central Bank’s stress tests of the institution.”
The core problem with this decision should be glaringly obvious: once again, the government is arbitrarily picking winners and losers. Senior bondholders are no longer treated pari passu – certain types of bonds suddenly seem to confer different property rights than others – in spite of the fact that all these bonds are part of the class of “senior bank bonds”.
There is in principle absolutely nothing wrong with bailing in bondholders – in fact, this is precisely the way to go. However, the essential principle that creditors holding instruments of the same seniority have to be treated equally is something the bond markets of the whole world are relying on. Without this principle, what point is there in creating different levels of seniority, which are attended by different levels of risk and hence involve different costs and rewards?
One wonders of course on what grounds precisely these five bond issues were selected and not any of the others. That’s simple, actually – as Bloomberg explains:
“It seems likely that Portugal’s choice of bonds wasn’t completely arbitrary; the documentation for the selected securities says they are governed by Portuguese law, rather than U.K. or U.S. law.”
In short, the government already knows it would lose its case in London and New York courts – because, naturally, the bondholders are preparing to sue. So it has picked bonds the covenants of which are governed by Portuguese law, in the hope that the courts in Lisbon will be sympathetic to acts of selective expropriation by the Portuguese government.
As Bloomberg remarks, the consequences of this decision are nigh incalculable – and bank bondholders across Europe are likely to once again hold their collective breath:
“Portugal isn’t the only country refurbishing its banking industry. Germany’s savings banks will need to bolster their capital in the coming months under the new EU rules, and the fourfold increase in bad loans held by Italy’s banks since 2008 means the central bank there has some housecleaning of its own to do. Consolidation — in the form of forced intermingling of stronger and weaker banks — is likely in both countries. Investors who own debt issued by German or Italian banks will no doubt reflect carefully on what just happened in Portugal.”
If we were holding any of these bonds, we’d shoot first and ask questions later. Surely if ever there was a time to get out of Dodge, this is it.
In principle, the BRRD, or “bail-in directive” as it is also known, is quite a good idea. The fact that lending money to fractionally reserved banks or even merely depositing it with them, involves risks needed to be firmly reestablished. One simply cannot expect that banks and their creditors will be bailed out by taxpayers at every opportunity. Besides, the admission that there are risks in banking that have hitherto been glossed over or have even been lied about was long overdue. However, Europe’s governments are now likely to find out that the current monetary system with its fractionally reserved banks is actually incompatible with this admission, so to speak.
By arbitrarily meting out unequal treatment to similar classes of creditors, they are unwittingly hastening this process of recognition. In that sense, we actually welcome the Portuguese government’s attempt to stiff certain BES bondholders (although we still regard the case as such as plainly illegal and contemptible). It will now become even more difficult to keep assorted banking zombies on artificial life support. A lot of unsound credit is likely to be liquidated faster than had been expected to date. Artificial credit expansion is going to become even harder to implement. Unfortunately none of this is going to keep governments from trying to confiscate as much wealth as possible in a doomed attempt to keep the unworkable system of “third way” socialist regulatory statism going.
In this context, we want to leave you with a few quotes by Ludwig von Mises, which go to the heart of matter and some of which we are convinced will once again turn out to be prophetic – especially the ones that proclaim that the so-called “mixed economy” is just as certain to fail as the communist economies were. (from: Bureaucracy, The Anti-Capitalistic Mentality, Human Action, Planned Chaos and Planning for Freedom).
“Sorry boys and girls, you will have to choose. You can either have capitalism, freedom, prosperity and personal responsibility,or you can have socialism, tyranny, poverty and ‘security’. You cannot have both.”
“The Welfare State is merely a method for transforming the market economy step by step into socialism.”
“An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.”
“The issue is always the same: the government or the market. There is no third solution.”
“Capitalism and socialism are two distinct patterns of social organization. Private control of the means of production and public control are contradictory notions and not merely contrary notions. There is no such thing as a mixed economy, a system that would stand midway between capitalism and socialism.”
“Contrary to a popular fallacy there is no middle way, no third system possible as a pattern of a permanent social order. The citizens must choose between capitalism and socialism.”
Charts by 4traders/Trading View, Bloomberg
Dear Readers! We are happy to report that we have reached our turn-of-the-year funding goal and want to extend a special thank you to all of you who have chipped in. We are very grateful for your support! As a general remark, according to usually well informed circles, exercising the donation button in between funding drives is definitely legal and highly appreciated as well.
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
One Response to “The EU Bail-In Directive: Dark Clouds are Gathering”
Most read in the last 20 days:
- How the Welfare State Dies
Hollande Threatens to Ban Protests Brexit has diverted attention from another little drama playing out in Europe. As of the time of writing, if you Google “Hollande threatens to ban protests” or variations thereof, you will find Russian, South African and even Iranian press reports on the topic. Otherwise, it's basically crickets (sole exception: Politico). Gee, we wonder why? They don't like him anymore: 120.000 protesters recently turned Paris into a war zone. All...
- Free Speech Under Attack
Offending People Left and Right Bill Bonner, whose Diaries we republish here, is well-known for being an equal opportunity offender - meaning that political affiliation, gender, age, or any other defining characteristics won't save worthy targets from getting offended. As far as we are concerned, we generally try not to be unnecessarily rude to people, but occasionally giving offense is not exactly beneath us either. The motto of the equal opportunity...
- Toward Freedom: Will The UK Write History?
Mutating Promises We are less than one week away from the EU referendum, the moment when the British people will be called upon to make a historic decision – will they vote to “Brexit” or to “Bremain”? Both camps have been going at each other with fierce campaigns to tilt the vote in their direction, but according to the latest polls, with the “Leave” camp’s latest surge still within the margin of error, the outcome is too close to call. The battle lines are...
- A Market Ready to Blow and the Flag of the Conquerors
Bold Prediction MICHAELS, Maryland – The flag in front of our hotel flies at half-mast. The little town of St. Michaels is a tourist and conference destination on the Chesapeake Bay. It is far from Orlando, and even farther from Daesh (a.k.a. ISIL) and the Mideast. St. Michaels, Maryland – the town that fooled the British (they say, today). Photo credit: Fletcher6 Out on the river, a sleek sailboat, with lacquered wood trim, glides by, making hardly a...
- Going... Going... Gone! The EU Begins to Splinter
Dark Social Mood Tsunami Washes Ashore Early this morning one might have been forgiven for thinking that Japan had probably just been hit by another tsunami. The Nikkei was down 1,300 points, the yen briefly soared above par. Gold had intermittently gained 100 smackers – if memory serves, the biggest nominal intra-day gain ever recorded (with the possible exception of one or two days in early 1980). Here is a picture of Haruhiko Kuroda in front of his Bloomberg monitor this...
- Rule Britannia
A Glorious Day What a glorious day for Britain and anyone among you who continues to believe in the ideas of liberty, freedom, and sovereign democratic rule. The British people have cast their vote and I have never ever felt so relieved about having been wrong. Against all expectations, the leave camp somehow managed to push the referendum across the center line, with 51.9% of voters counted electing to leave the European Union. Waving good-bye to...
- What Could Possibly Go Wrong?
A Convocation Of Gamblers The Wall Street Journal and BloombergView have just run articles on the shadow banking system in China. This has put me in a nostalgic mood. About 35 years ago when I was living in Japan, I made a side trip to Hong Kong. Asia's Sin City, Macau Photo credit: Nattee Chalermtiragool I took the hydrofoil to Macau one afternoon and the same service back early the next morning. On the morning trip, I am sure that I saw many of the...
- The Problem with Corporate Debt
Taking Off Like a Rocket There are actually two problems with corporate debt. One is that there is too much of it... the other is that a lot of it appears to be going sour. Harvey had a good time in recent years...well, not so much between mid 2014 and early 2016, but happy days are here again! Cartoon by Frank Modell As a brief report at Marketwatch last week (widely ignored as far as we are aware) informs us: “Businesses racked up debt in the...
- A Darwin Award for Capital Allocation
Beyond Human Capacity Distilling down and projecting out the economy’s limitless spectrum of interrelationships is near impossible to do with any regular accuracy. The inputs are too vast. The relationships are too erratic. The economy - complex and ever-changing interrelations. Image credit: Andrea Dionne Quite frankly, keeping tabs on it all is beyond human capacity. This also goes for the federal government. Even with all their data gatherers and...
- Janet Yellen’s $200-Trillion Debt Problem
Blame “Brexit” BALTIMORE – The U.S. stock market broke its losing streak on Thursday [and even more so on Monday, ed.]. After five straight losing sessions, the Dow eked out a 92-point gain. The financial media didn’t know what to say about it. So, we ended up with the typical inanities, myths, and claptrap. “Investors” are pushing the DJIA back up again..apparently any excuse will do at the moment. The idea may backfire though, as exactly the same thing happened...
- The Fed’s Doomsday Device
Bezzle BALTIMORE – Barron’s, in a lather, says the market is facing the “Two Horsemen of the Apocalypse.” Huh? Only two? There were four last time! Supposedly, the so-called Brexit – the vote in Britain this Thursday on whether to leave or remain in the European Union (EU) – and uncertainty over where the Fed will take U.S. interest rates are cutting down stocks faster than a Z-turn mower. But Brexit is a side show. As our contacts in London...
- Gold and Brexit
Going Up for the Wrong Reason Gold is soaring. It should—and a lot—but in my view not for the reason it is. Indeed gold is insurance for uncertain times, a time that Brexit seems to represent. But insurance is an administrative cost — one must minimize its use. August gold contract, daily – gold has been strong of late, but this seems to be driven by “Brexit” fears - click to enlarge. Moreover, insuring against Brexit might ironically be equivalent...