There are several versions of the following cartoon, but this rendition comes closer to the current situation we’re currently in. Two building inspectors inspecting a 60-story high-rise building walk too close to the edge of the roof and fall off. As they’re going down the side of the building, they look at the floors they’re passing and keep telling each other “so far, so good.” That’s exactly what European and U.S. politicians are doing right now as they push the problems down the line with temporary fixes and feel content with how things are going since they haven’t fallen apart completely yet. Unfortunately, one day, they almost always do, judging from the countless examples from history. Three years after Lehman’s fall and the onset of the worst global financial crisis since the Great Depression, politicians and regulators keep patting themselves on the back because they’ve managed to avert total collapse of the system and kept it running. However, the fundamental flaws aren’t fixed and the global economy faces the threat of a lost decade with high unemployment, stagnant growth, and jittery financial markets.

Another version of the building inspectors cartoon. Until you hit the bottom, it can look fine.

SOURCE: www.CartoonStock.com.

In July 2011, the European Union (EU) approved a second loan package for Greece, this time for €109 billion, still refusing to acknowledge that the country cannot pay its debts. Even though German Chancellor Angela Merkel wanted to show her electorate that the private sector contributed to the second Greek rescue, the continent’s zombie banks couldn’t be forced to take losses on their Greek holdings, so they were convinced to accept a debt exchange to extend the maturities of some Greek debt. But the new Greek patch won’t solve any of the problems that brought the region to this point.¹ The deal doesn’t reduce Greece’s debt load enough for it to afford staying current for long. The banks are putting off the day of reckoning even longer, but they are being allowed to dump some of their risks to the public sector. The European Central Bank (ECB) picks up the slack in funding Greek, Irish, Portuguese, and Spanish banks as their private creditors slowly get paid for the debt coming due. The EU and the International Monetary Fund (IMF) replace most of the sovereign debt as it comes due with their loans. Delaying the inevitable is increasing the costs to restructure Greece’s debt; the haircut from the country’s bonds that will be needed in 2015 is about 50 percent more than what is needed in 2011 to return the country’s finances to a sustainable path, according to Citigroup research.² Of course, the more the banks are allowed to wiggle out of their holdings of Greek debt, the bigger the burden that will end up on the shoulders of the European taxpayer.

Meanwhile, Ireland is struggling to escape the same predicament by exporting its way out of recession. Unlike Greece, Ireland has several competitive economic advantages, but those have not been enough to counter the negative impact of its overleveraged households that still need to reduce debt and the zombie banks that won’t die. The Irish economy eked out a 0.1 percent growth in the first quarter of 2011. Even though the IMF expects 0.5 percent expansion in 2011, some analysts estimate another 2 percent contraction for the fourth year in a row. Iceland, which did the opposite of Ireland when it came to broken banks, grew 3.4 percent in the first quarter of 2011, which most analysts expect it will maintain for the rest of the year. As Iceland sold its first international bond in the market in June, Ireland remained shut out of capital markets and continued to rely on IMF and EU funding to roll over its debt. In June 2011, Finance Minister Michael Noonan said the country had financing to last two more years, so he’s hoping things will be back to normal by that time and Ireland can borrow from markets again.³ But more of its banks’ and sovereign debt is slowly being shifted onto the EU taxpayers, who will, at the end, likely foot the bill as they did with Greece. In July, Moody’s credit ratings firm cut Ireland’s debt to junk, saying that the country would likely need additional IMF-EU support after 2013 before it can return to markets for funding.⁴

Of course Spain poses a much bigger threat to the future of the union than either Greece or Ireland, and the danger that the PIG trouble becomes a PIGS catastrophe was still very stark in mid-2011. Spain’s cajas are seeking private capital, some through initial public offerings, some through private equity investments. But the bad assets haven’t been completely cleaned up or taken outside the savings banks, and investors are reluctant to take the risk that the country’s housing market continues to deteriorate and saddle the banks with further losses. There is also fear that Spain’s regional governments could be hiding further fiscal problems, just as Greece did before a new administration took office in 2009. In June, the European Commission warned Spain that it hadn’t completed its house cleaning of the cajas. The commission also chided the government for basing its near-term budget plans on economic forecasts that were too optimistic. Two cajas managed to sell shares in IPOs in July, raising €3.6 billion together. The government seized a third savings bank that collapsed, injecting €2.8 billion into it and saying it would sell the caja soon.⁵

The EU completed a new round of stress tests for the 90 largest banks in the region in July, but it failed to regain the credibility it was seeking. Only eight banks failed the tests and were asked to raise €2.5 billion, whereas analysts’ estimates of the capital needs ranged from €20 billion to €250 billion. One of the German landesbanks, Helaba Landesbank Hessen-Thüringen, withdrew from the tests at the last minute, disputing the calculations of capital levels, casting further doubt on the authority of the new EU banking regulator on the region’s lenders. Helaba wasn’t even among the worst hit landesbanks. The remaining German banks passed the tests, which assumed only a 25 percent loss on Greek sovereign debt while the prices of the country’s bonds were already about 50 cents on the dollar.⁶

Keeping Germany’s zombie banks on life support has left Chancellor Merkel in a tough spot: She has to look tough on Greece and other irresponsible nations while still protecting the banks who have loaned to those countries, making their irresponsible binges on housing and consumption possible. Thus Merkel played the toughie in the European drama unfolding in the summer of 2011, pretending that she wanted to punish the creditors too, only to be convinced by her French counterpart, Nicolas Sarkozy, to soften her stance so the weak German and French banks could survive longer. Merkel has been losing support domestically, though. Her party and its coalition partners were losing regional elections in 2011. In a June vote on a second Greek rescue, 10 legislators from the ruling coalition defected, a significant blow considering it has only a 20-vote majority in the Bundestag (German parliament).

Because they constantly postpone the solution to the zombie banking problem, the Germans and the French risk the collapse of the euro, which has given the two countries enormous political and economic power in the region. The collapse of the common currency would also seriously hit their economies, most likely sliding them back into recession. The PIGS are facing dismal prospects until then. For years to come, they will be stuck with high unemployment, stagnant economies, and a debt burden impossible to carry. The euro’s collapse would let them devalue their national currencies, which will reappear, but as Iceland’s case showed, devaluation is no panacea. The Irish, especially, are worried that the lack of the common currency could derail the foreign direct investment that has favored their country in the region partly because it has been part of the currency union.

Not only did the second Greek rescue package fail to allay fears over the weakest EU member’s chances of default, concern among investors spread to the ability of countries outside the PIGS club to pay their debts, engulfing Italy and even France in August 2011. The fears over France partly culminated from its banks’ exposures and vulnerability to the indebted countries. The shares of Société Générale, the second biggest French bank, dropped almost 50 percent over the course of one month.

Default by Greece and other members of the PIGS club will reverberate in financial markets across the globe. It will be felt especially in the United States, where the biggest banks have exposure to those countries through direct lending and through derivatives, especially credit default swaps. The short-term patches to keep the PIGS away from defaulting have saved the U.S. banks so far, just as they did for their European counterparts. Just a 10 basis-point (one-tenth of a percent) move on the value of their derivatives book could wipe out the capital of any of the large U.S. banks, according to R. Christopher Whalen, who rates banks.⁷ Concerns over their exposure to Europe helped send shares of U.S. banks down as well in August 2011. Bank of America and Citigroup led the rout, losing about one third of their market value in less than a month.

While Europe teetered on the brink of collapse, the U.S. zombies struggled with mounting losses from the housing market that continued declining. At the end of June 2011, Bank of America reached an agreement with some of the bond investors who’d sued it for the poorly underwritten mortgage-backed securities (MBS). The bank said it would write off about $20 billion for this settlement and other possible losses on its MBS liabilities—the stuff that went off balance sheet during the boom years so the banks could expand lending further, but the risk has come back. Although the deal with the investors could reduce uncertainties over future losses from this legacy issue, it covered about half of its exposure only and hasn’t eliminated further risk, Barclays Capital analysts said after the announcement. The agreement also faces legal challenges from some MBS-holders unsatisfied with the paltry sums to be paid by the bank. As part of the agreement with the MBS investors, Bank of America said it would transfer some of the worst loans to subcontractors to service. Former President Bill Clinton said that could lead to principal reductions for the worst underwater mortgages and hopefully provide a model for other banks to follow. The biggest banks, who are the biggest servicers and holders of the largest portfolios of second-lien mortgages, continued to oppose principal reductions.⁸ While the losses lurked, the housing market was stuck in a limbo, and the U.S. economy floundered, the bosses of the zombie banks and other Wall Street executives started making millions of dollars again. Citigroup CEO Vikram Pandit was awarded $16.7 million to encourage him to stay at the helm.⁹

Throughout 2011, U.S. banks kept increasing their lobbying activities against the rules that are supposed to reduce some of the risks to the system, trying to weaken Dodd-Frank reform, reverse some aspects of it, and resist international efforts to impose higher capital requirements on the largest banks. JPMorgan Chase CEO Jamie Dimon blamed the new regulations for the slowdown in the U.S. economy. The Financial Accounting Standards Board backed down on another one of its planned changes that the banks opposed. The proposed change would have limited the netting of derivatives on the balance sheet and force the top U.S. banks to show the true size of their balance sheets. It would also force them to hold more capital for those derivatives currently not counted.

Daniel K. Tarullo, a Fed governor appointed by President Obama and one of the loudest critics of Basel II rules that had eased capital requirements for banks in 2004, emerged as a new voice for tough regulation. Tarullo, who wasn’t as assertive in Basel talks in 2010 as FDIC Chairman Sheila Bair, is a strong believer of higher capital buffers and less wiggle room for banks to determine how risky their assets are. He could carry on Bair’s mantle in international regulatory debates and weigh in at home as well. On the extra capital charge being considered for the top banks, Tarullo was quickly crushed by Treasury Secretary Timothy Geithner, the friend of the bankers. Geithner talked down the need for a big charge and the Basel Committee on Banking Supervision came up with 1 to 2.5 percent in June 2011.¹⁰

In July 2011, Obama announced an appointment for the Comptroller of the Currency, a crucial regulatory role that was carried out by an acting chief for over a year. Pressure was mounting on Obama to replace the acting Comptroller, John G. Walsh, who repeatedly took the sides of the banks during Dodd-Frank reform’s formulation and in the implementation phase. Senators Jeff Merkley, Carl Levin, and Sherrod Brown were among those who renewed calls in June to replace Walsh after he publicly attacked financial reforms as being too tough on the banks. Geithner was accused by some on Capitol Hill of protecting Walsh and dragging his feet on the replacement. Although there were reports of Geithner’s potential departure around that time, those were later quashed and banks’ best ally remains at the helm.¹¹

As Geithner refused to clean up the banking system like his European counterparts, and bank CEOs blamed rules for their shackles, the unresolved fundamental problems of the zombies and the housing market slowed the economic recovery in the United States. After falling for four months, the unemployment rolls started rising again in April 2011 and the rate of participation in the labor market fell to a 30-year low as Americans lost hope in finding jobs. It looked like the economy was on the verge of a second recession in August 2011 as recovery almost ground to a halt, with the first quarter growth figure revised down to 0.4 percent and second quarter to 1 percent. While the Fed’s quantitative easing policies provided only temporary boosts to the U.S. economy in 2009 and 2010, it continued to create inflation worldwide. The money sloshing around pushed energy and food prices up, increasing the possibility of further social unrest in poor countries, the World Bank warned in April 2011. Those price increases started causing inflation in the United States even as the economy weakened, raising the specter of stagflation—rising prices during an economic downturn. Even the strongest nation’s credit rating came under scrutiny as ratings agencies lowered their outlook on the U.S. rating to negative, based on concerns of rising budget deficits and the lack of plans to reduce them. In August, one of them in fact lowered the country’s credit rating from AAA to AA+. That was the first time in history that the United States lost its top-notch creditworthiness.¹²

In the second half of 2011, it looked less and less likely that the politicians on both sides of the Atlantic Ocean could continue kicking the can down the road for too much longer. They need to face the truth soon about the indebted consumers and nations and about the banks that gave them the loans. The cartoon’s building inspectors might be approaching the ground level in their aerial survey. The end can be good for neither the inspectors nor the politicians imitating them.

Notes

1. Luke Baker and Julien Toyer, “Europe Agrees to Sweeping Rescue Plan for Greek Crisis,” Reuters, July 22, 2011; Rebecca Christie, “Banks Agree to Participate in Greek Bond Exchange, Debt Buyback,” Bloomberg News, July 22, 2011.

2. Stefan Nedialkov, Ronit Ghose, and Alex Atienza, “Hellenic Banks—Fancy a Haircut?” Citigroup research report, April 20, 2011.

3. Central Statistics Office (Ireland), “Quarterly National Accounts—Quarter 1 2011,” published June 23, 2011; Ernst & Young, “Outlook for Ireland,” Ernst & Young Eurozone Forecast, Summer Edition, June 2011; Statistics Iceland, “Quarterly National Accounts, 1st Quarter 2011,” published June 8, 2011; Gaurav Panchal, “Noonan Says Ireland Has Enough Money to Last Into 2H 2013,” Bloomberg News, June 7, 2011.

4. Dietmar Hornung and Bart Oosterveld, “Moody’s Downgrades Ireland to Ba1; Outlook Remains Negative,” Moody’s Investors Service press release, July 12, 2011.

5. Economist Intelligence Unit, “Spain: Tough Sell,” EIU Business Europe Select, June 1, 2011; European Commission, “Council Recommendation on the National Reform Programme 2011 of Spain and Delivering a Council Opinion on the Updated Stability Programme of Spain, 2011–2014,” SEC (2011) 817 Final, June 7, 2011; Victor Mallet, “ ‘Bankrupt’ Claim Heightens Spanish Regional Debt Fears,” Financial Times, June 6, 2011; Charles Penty and Ben Sills, “Bankia Drops in Madrid Trading Debut After Cutting IPO Price,” Bloomberg News, July 20, 2011; Charles Penty and Ben Sills, “Civica Unchanged in Madrid Debut After $849 Million IPO,” Bloomberg News, July 21, 2011; Christopher Bjork, “Spain’s CAM Will Get EUR2.8B Injection From Bailout Fund,” Dow Jones, July 14, 2011.

6. David Enrich, and Sara Schaefer Muñoz, “Few Banks Fail EU Exams,” Wall Street Journal, July 16–17, 2011; James Wilson and Brooke Masters, “German Bank Snubs Stress Tests,” Financial Times, July 14, 2011; Gavin Finch, “EU Stress Tests Include Writedown in Greek Government Bonds,” Bloomberg News, July 15, 2011; “Results of the 2011 EU-Wide Stress Test,” European Banking Authority press release, July 15, 2011.

7. R. Christopher Whalen, “The World Held Hostage by Credit Default Swaps,” The Institutional Risk Analyst, June 21, 2011.

8. Bank of America Corp., “Bank of America Announces Agreement on Legacy Countrywide Mortgage Repurchase and Servicing Claims,” company press release, June 29, 2011; Jason M. Goldberg, Brian Morton, Matthew, J. Keating, and Inna Blyakher, “CFC Agreement Reduces, Doesn’t Eliminate Uncertainties (Now Including Capital),” Barclays Capital research report, June 30, 2011; Hugh Son, “Bill Clinton Says BofA Deal May Lead to Principal Reduction,” Bloomberg News, June 30, 2011.

9. U.S. Securities and Exchange Commission company filing by Citigroup Inc., Form 8-K, file number 1-9924, filed on May 17, 2011; Citigroup Inc., “Statement by Citi Chairman Richard D. Parsons on Retention Award to CEO Vikram S. Pandit,” company press release, May 18, 2011.

10. Michael R. Crittenden, “CEO Tells Fed Chief New Rules Hurt Banks.” Wall Street Journal, June 8, 2011; Mark Pengelly, “Boon to US leverage ratios as FASB ditches netting proposals,” Risk, June 27, 2011; Daniel K. Tarullo, “Regulating Systemically Important Financial Firms,” speech given at the Peter G. Peterson Institute for International Economics, Washington, DC, June 3, 2011.

11. Damian Paletta and Carol E. Lee, “Geithner Toys With Leaving,” Wall Street Journal, July 1, 2011; Tahman Bradley, “Geithner Staying On at Treasury,” ABC News, August 7, 2011; Binyamin Appelbaum, “Official From F.D.I.C. Picked to Lead Banking Regulator,” New York Times, July 2, 2011; Alan Zibel and Victoria McGrane, “Senators Call For Obama to Replace OCC’s Walsh,” Dow Jones Newswires, June 22, 2011; Tom Braithwaite, “Warning on Bank Rules Reform,” Financial Times, June 22, 2011.

12. Bureau of Labor Statistics data; Chris Giles, “World Bank Warns on Threat of Social Unrest,” Financial Times, April 15, 2011; Peter Morici, “Inflation Moves to Center Stage, Highlights Fed and G20 Impotence,” Daily Commentary, April 15, 2011; Standard & Poor’s Rating Services, “S&P Lowers United States LT Rtg To ‘AA+’; Outlook Negative,” press release, August 5, 2011; Moody’s Investors Service, “Moody’s Places U.S. Aaa Government Bond Rating and Related Ratings on Review for Possible Downgrade,” press release, July 13, 2011.