Is Eastern Europe on the Brink Of An Asian Style Crisis?

* In terms of expected lost output and the sell-off in CEE markets, what's currently happening in the CEE looks like a market meltdown on the same scale as the Asian Crisis of 1997, according to Danske

CEE Today: Echoes of Asia circa 1997
* Danske: In those CEE countries least affected by the crisis (i.e. Poland, Czech Republic, Slovakia and Slovenia), GDP is like to drop at least 2-5%, while those countries worst affected (i.e. the Baltic States, Bulgaria, Romania and Ukraine) are likely to face double-digit declines in GDP. In other words, in terms of expected output lost in the region, this is as bad as or even worse than the Asian crisis of 1997-98
* See related spotlight issue: Fast Growth In Eastern Europe Has Come To An End
* External imbalances in CEE of today rival, and in some cases exceed, the build-up of imbalances in pre-crisis Asia - i.e. current account deficits in Southeast Asia from 1995-97 fell within the 3.0-8.5% of GDP range, while those in CEE were well over 10% of GDP in Romania, Bulgaria and the Baltics in 2008 (Stokes)
* The Asian crisis was, in many respects, a crisis of private debt rather than public debt, and so have been the crises hitting Hungary, Latvia and Ukraine
* Foreign-denominated loans helped fuel growth in eastern European economies including Poland, Romania and Ukraine, which compares with the Asia in the 1990s
* Krugman: "Key to the Asian crisis — and of Argentina’s collapse in 2002 — was the way domestic players leveraged themselves up with foreign-currency loans. When the capital inflows dried up, and the Asian currencies plunged, these debts suddenly became a much bigger burden, decimating balance sheets and causing a downward spiral of deleveraging
* There is no reason why the sell-off of CEE currencies should cease soon, unless there is substantial intervention from the EU and/or the ECB to support markets. Danske thinks it unlikely local authorities will be able to muster sufficient resources to curb the sell-off in CEE currencies in the present environment. See related spotlight issue: Eastern European Currencies: Under Pressure

Differences between Asia circa 97 and CEE of today
* Bank Austria sees four key difference between 'Asia of 1997' and Emerging Europe of today:
* 1) Fx reserves in relation to short-term debt are generally higher in EE than they were in Asia - that is, CEE policymakers have a greater ability to plug financing gaps than some Asian central banks did
* 2) FDI as % of GDP is higher in most EE countries now than in most Asian countries in 1996. Countries in EE have a lower reliance on more volatile portfolio financing
* 3) Quality of banking regulation and enforcement of the regulation is arguably far better in CEE now than in pre-crisis Asia
* 4) A significant number of CEE countries are EU members. Not only does this significantly strengthen institutional and regulatory environment (and reduce capital flight risk), it also increases the likelihood of external support if needed

Are Europe's Banks In Worse Shape Than U.S. Banks? EU Commission Warns Of Systemic Danger

* Feb 12 Telegraph: Confidential EU finance minister memo: The toxic debts of European banks risk overwhelming a number of EU governments and may pose a “systemic” danger to the broader EU banking system. EU banks hold balance sheet assets of €41.2 trillion (€25 trillion in EMU, or 2.7 times annual GDP)--> see banking systems in Germany, France, Italy, Spain
* cont.: EU banks have $1,600bn of exposure to Eastern Europe -- increasingly viewed as Europe’s subprime debacle, and EU corporate debts are 95% of GDP compared to 50% in the US, a mounting concern as default rates surge.
* GoldmanSachs (not online): We estimate total gross losses of Eurozone owned banks at EUR915bn (10% of GDP). Banks have so far written down the equivalent of 4% of GDP. Even if the remaining 6% would fall on the taxpayers, this would not pose any overwhelming risk to the Eurozones aggregate fiscal position (projection for 75% of GDP)
* Daniel Gros/Stefano Micossi: The “overall leverage ratio” - a measure of total assets to shareholder equity - of the average European bank is 35 due to large in-house investment banking operations, compared with less than 20 for the largest U.S. banks. This means that relatively small writedowns on their assets could have a devastating impact on a bank’s capital
* BNP Paribas: see "To the Rescue" for size and composition of individual capital and guarantee schemes. So far, Eurozone governments pledged over EUR2T in guarantees and capital (22.6% of GDP). UK pledged EUR385bn (25% of GDP), and CH EUR4bn (1% of GDP). Compare with U.S. $2.6T (=EUR2T or 18% of GDP).
* Thomas et al.: flow of 40% of U.S. originated securitizations are held abroad (mostly in EU)--> out of $10trillion 'shadow banking system' assets to be shed by the global banking system according to IMF, about $4 trillion are held abroad.
* BIS, ECB data shows that among main net buyers of U.S. originated assets are Germany and France, whereas the UK has large two-way flows but low net seller position vis a vis the U.S.
* Dec 2 IRA: We hear from a very well placed Buy Side investor with extensive business interests in the US and EU that three primary banking institutions in Europe, two French and one German, have such significant CDS exposure and other problems that they cannot even begin to fund the payouts anticipated over the next quarter. The funding squeeze reportedly is exacerbated by a near-collapse among weaker players in the hedge fund market.This past summer, when the bank put out a call for redemptions of $4 billion in hedge fund investments, says the source, only $400 million was returned. And the French bank also used these same hedge funds and others to reinsure some of its own CDS exposure--> the investor claims that EU officials are considering a moratorium on CDS payments by the three Euroland banks in question. The banks would be given ten years to write down their CDS and hedge fund exposures and would receive additional infusions of capital by their respective governments.

Policy Response:

* The ECB drew up guidelines for European governments that are considering "bad banks" to house lenders' toxic assets. The ECB is also working on guidelines for governments that plan to guarantee toxic assets remaining on banks' books, another form of bank bailout.
* Meanwhile, the European Commission wants that toxic assets are written off at market value, and that any write-offs will first have to come out of shareholders’ capital. Once the capital falls below the Basel ceilings, it is up to the government to provide new capital, or to force the bank into bankruptcy procedures.
* The Treaty forbids the ECB or national central banks to provide credit to any EMU government directly (no bailout within EMU clause) However, the ECB Council can decide to buy government securities in the secondary markets if consistent with price stability objective (GoldmanSachs, not online)

The million $ question.

Have we hit rock bottom?

We have not.

As job losses accelerate (or even just accumulate) there will be more defaults to come on prime, Alt-a, auto loans, credit card loans, student loans, helocs, and any type of (semi excessive) lending that was allowed over the last decade. The products derived on all these credit are structured in such a way that the most senior tranches have the most credit protection (in other words, they are last to absorb any kind of loss). However, currently we are seeing CDO transactions (CDO's are a good benchmark, as they can entail the entire list of underlying collateral; from bank trust preferred stocks to Argentinean cattle) experiencing senior overcollateralization ratio's close to 20%. In other words, a 80% mark down is lingering. That said, the haircuts that have to be taken on collateral that suffered a ratings downgrade below a certain threshold could make it look like this downgraded collateral has no value left in it at all. All critique on Moody's and S&P's aside, even for a skeptical investor it would seem hard to believe these assets have became absolute empty clamps.

Now, the point I am trying to make, there is no such thing as a "safe structured product". We would not have structured it in the first place if the underlying was risk free. Are banks aware of this? I want to believe they are. But I am not sure. I spoke with a top banker of a European bank just a few weeks ago and he suggested just leaving everything at par on the books. "We're not looking to sell in this kind of market anyways, so we might as well hold to maturity" Obviously, this is impossible, but the deals will stop generating cash flow (interest and principal payment) at some point. As of today, a lot of large financial institutions are keeping these assets at par on their books. Even as we can assume with near certainty that cash flow will dry up for a lot of these deals.

Accounting regulations are supposed to push firm to mark these assets to market, but regulation left so many loopholes and ambiguity, we are far from marking to market. This is not a secret. Governments and oversight boards and institutions would commit a massive financial hara-kiri by imposing strict compliance of mark to market right now. Rather assets are kept at premiums that allow financial institutions to stay in a coma type of sleep, a few quarters, months, or even days away from final insolvency.

If we think of the shadow banking system in this context, the eventual damage we can expect is simply not comprehensible. Were regulation on banks is still somewhat existing; hedge funds, money market managers, investment banks and others alike lack any form of transparency. More so, a lot of the funding that is parked at these institutions has a limitation on the withdrawal of it. Once expired, we can expect margin calls to knock down a significant part of this market. Which in return will affect the banking industry.