Europe’s Subprime Quagmire

Banks in Ireland and Spain are discovering that their customers are losing their jobs and income as the construction bust hits the national economies. And one could argue that a loan to the government of Greece or Portugal affords little more security than a NINJA loan. Indeed, lending to governments and banks in the European periphery represents the European equivalent of subprime lending in the US (which was also concentrated in a few sunshine states).

Given the many similarities between the two crises’ basic features, European leaders could learn a lot from the US experience.

The first lesson is that, despite the limited overall volume of subprime loans, the subprime crisis could blow up into the biggest financial crisis in living memory, because an overstretched financial system was unable to cope with even limited losses. Similarly, the combined debt of Greece, Ireland, and Portugal is small relative to the eurozone economy, but the European banking system is still so weak that these countries’ debt problems can create a systemic crisis.

A second lesson is that dealing successfully with a financial crisis requires, most immediately, a strong dose of liquidity. Then, once the financial system has been stabilized, a combination of debt restructuring and recapitalization is required. Has the European Union followed this recipe?

After some hesitation, Europe showed that it could manage the first phase – a liquidity injection to prevent systemic collapse. Greece and Ireland received funding when they were shut out of the capital market. And the last EU summit announced the creation of a permanent European Stability Mechanism (ESM) – a sort of European Monetary Fund with an effective lending capacity of €500 billion.

This is equivalent to $700 billion, the same magnitude as the Troubled Asset Relief Program (TARP) instituted in late 2008 to keep US financial markets from collapsing. The ESM should be sufficient to deal with the refinancing needs of Greece, Ireland, and Portugal. It might even be sufficient to address Spanish government debt, though this would be a stretch.

But, just as the $700 billion TARP did not assuage nervousness financial markets in 2008, so the ESM’s €500 billion seems to have left investors unimpressed. The risk premia on the sovereign debt of Greece, Ireland, and others have not diminished. The premia paid by Portugal have actually soared since major ratings agencies, explicitly citing the agreement reached at the EU summit in late March, lowered the country’s sovereign-debt rating.

In the US, the turning point came with the authorities’ stress tests of banks in early 2009. The tests were seen as credible; indeed, their results prompted US officials to force several major banks to increase their capital.

This did not happen in last year’s European version of the US stress tests, and this year’s stress tests in Europe are unlikely to be tougher. The reason is simple: the US authorities checked whether their banks could survive the sort of downturn that the market feared most at the time. By contrast, European authorities refuse to test the scenario that the market currently fears most: losses on loans to banks and governments on Europe’s periphery.

A third lesson derives from a little-noticed but vital aspect of the US experience: debt reduction is comparatively easy in the US, because the no-recourse feature of most mortgages there limits repayment obligations to the value of the house. Moreover, the US bankruptcy code can free consumers of their debt within months.

Of course, the millions of personal bankruptcies and home foreclosures in the US are not popular, but they provide debt relief each time, thereby enabling households to make a fresh start. This steady flow of debt relief is allowing US consumer spending to recover slowly.

By contrast, debt restructuring for either banks or governments is politically unacceptable in Europe. This implies that the crisis is likely to persist much longer than in the US, because households in Spain and Ireland will labor for decades to service mortgages on houses that they can no longer afford. And the Greek government faces an endless succession of budget cuts, with each step being more difficult than the last as the economy spirals down a black hole.

Debt relief created fewer problems for banks in the US because a significant proportion of the subprime loans packaged into AAA-rated securities had been sold to gullible foreigners. A good proportion of the losses on subprime lending was thus borne by banks from Northern Europe, leaving these banks in no position to sustain further losses on their European peripheral lending. But this should compel a strong recapitalization program – not weak stress tests.

Europe is making a fundamental mistake by allowing the two key elements of any resolution of the crisis – namely, debt restructuring and real stress tests for banks – to remain taboo. As long as successive EU summits persist in this mistake, the crisis will fester and spread, eventually threatening the stability of the eurozone’s entire financial system.