A Spat over Downgrades

The governor of the French Central Bank, Christian Noyer, remarked yesterday that he thought the UK's AAA rating would be a better target for a downgrade than France's. As the FT reports:

„Earlier today the governor of the Bank of France suggested that France did not deserve a downgrade by ratings agencies; at least not before the UK.

A downgrade doesn’t strike me as justified based on economic fundamentals,” Christian Noyer told Le Telegramme, a Brittany-based newspaper. “Or if it is, they should start by downgrading the U.K., which has a bigger deficit, as much debt, more inflation, weaker growth and where bank lending is collapsing.”

The French are braced for a possible downgrade by Standard & Poor’s. For a head of a central bank – normally the most staid of characters – to talk like this is a sign of the mounting anxiety across the Channel.

The comments from Noyer, which are unlikely to slip down smoothly in the corridors of Whitehall and the City of London, follow broader tensions in the wake of David Cameron’s veto in the early hours of Friday morning.“

Clearly this is a case of the pot calling the kettle black. As far as we are concerned, neither France's nor the UK's triple A rating makes any sense whatsoever. Both are drowning in debt and unfunded liabilities. The UK only has a small advantage in terms of its central bank standing ready to monetize its debt – if that can be called an 'advantage'. It is one in the short term, but may prove to create a big problem in the long term.

Nonetheless, CDS on France and its bond yields both indicate that the markets believe France is the more likely downgrade candidate in the near term.  Via Bloomberg's 'chart of the day' feature, here is an interesting comparison of five year CDS on France, Indonesia and the Philippines – France is now considered a higher credit risk than the latter two.



5 year CDS prices show that France is currently considered a worse credit risk than the Philippines and Indonesia – click chart for better resolution.



Naturally, Noyer's comment met with a wave of indignation as well as some well-reasoned criticism from across the channel.

Damian Reece from the Telegraph asserts that Noyer is wrong and 'France lacks credibility'.

“As Nicolas Sarkozy himself pointed out on Monday: “What is important is the credibility of our economic policy and our strategy of reducing spending.”

The under-pressure President is right. France is at risk of losing its AAA status not because of politics, but because of credibility, or lack of it.  Noyer attacked the UK’s financial position as being worse than that of France which is true, up to a point.

Both countries’s public sector debts are running at about 85pc of GDP but when Britain’s private sector debts are added we’ve got one of the worst debt positions in the world.  Our annual deficit is 8.4pc of GDP this year, falling to 7.6pc next year while the French deficit is 5.7pc and 4.5pc respectively.

But France has the biggest debt burden of the top six eurozone nations, while its banks have the biggest exposure to the toxic government debts of the single currency’s worst offenders.  France, Italy and Germany need to repay, or refinance, about €519bn (£436bn) of debts by June, according to Bloomberg data.

So not only does France have enormous debts to refinance, its banks face huge potential losses from their own holdings of toxic debt which are likely to require bailouts from Paris – rather like the ones we completed in 2008 with RBS and Lloyds. “

Well, it's not certain yet that the RBS and Lloyds saga is over. As we have just seen in the euro area, banks can get into trouble all over again shortly after they've been bailed out. However, we certainly agree that the big French banks  are currently posing the greatest immediate risk to France's rating. It is widely held – and likely rightly so – that the French government will stand behind the big banks if they get into further trouble. Moreover, France will be very exposed to a potential worsening of the sovereign debt crisis through its commitments to the EFSF.  Recent utterances from French politicians indicate that they are expecting a downgrade of France's credit rating to be announced  shortly. Why else would they take pains to point out that 'it won't be the end of the world'?

Economist Andrew Lilico agrees in another Telegraph article that it is the exposure of the French government to the country's tottering banks that is at the heart of the well-grounded downgrade fears. Moreover, the risk of a collapse of the currency union can not be dismissed either:

What places the French sovereign in particular distress is its commitments to the banks. Whereas in the UK the Coalition government has taken significant (albeit still inadequate) steps to disentangle the government from the banking sector, such as the Vickers proposals and the treatment of the Southsea Mortgage and Investment Bank, the French government is more entangled with the banks than ever. Furthermore, there is a material risk of the euro collapsing entirely, with the consequence that the French repay their debts in New Francs or something – a currency that might well be devalued relative to the euro (because of the loss of Germany). After all, the ERM crisis of 1992-3 eventually reached France, and the Franc was not able to hold its peg against the Mark. Is France really so immune this time?”


(emphasis added)

Indeed. We expect that once Standard and Poors has finalized its post summit review of sovereign credit ratings in the euro area, both France and Austria are in grave danger of losing their AAA status.


Spain's Housing Market Takes Another Tumble

Meanwhile, Spain's still deflating housing bubble has embarked on another leg down. Please note that the chart below shows only what the national statistics agency admits to. The reality is far worse. Private sector estimates consistently show much larger declines in house prices.



Spains's house prices dive again.



As the WSJ reports:

“Spanish house prices fell at their fastest pace in two years in the third quarter, as the country's three-year property bust continues to take a toll on the euro zone's fourth-largest economy.

House prices decreased on average by 7.4% in the third quarter from the same period a year ago, with prices of used homes down a whopping 9.6% in the period, the country's statistics agency INE said Thursday.  This compares with a 6.8% fall in second-quarter house prices, and marks the third consecutive quarter of accelerated price drops after prices stabilized somewhat in late 2010. The reading also represents the third-biggest quarterly fall in house prices since the sector went bust in early 2008.

The data comes as Spain's incoming Prime Minister Mariano Rajoy is considering cleanup plans for the country's ailing banking sector, including the possible creation of a state-funded "bad bank" to acquire impaired property loans.

Overall, Spanish banks hold over €400 billion ($520 billion)—equivalent to 40% of Spain's gross domestic product—in loans to the construction and real-estate sector, backed by collateral that loses value as property prices slide further. In addition, the central bank estimates that around €180 billion in loans to builders and developers is "potentially problematic."


Spain's banks have used every trick in the book and then some to avoid having to recognize their losses on loans to the real estate sector. As the Alphaville blog notes, citing a recent report by Fitch on repossessed properties in Spain:

“Achieved sales prices on repossessed properties are not only 43% lower than the valuations carried out at the time of loan origination, but also 32% lower than the re-valuations carried out at the time of repossession.”


Oops!  It gets better (here are some of the tricks the banks routinely employ to escape having to report the losses):

“Some banks are protecting their transactions by either buying back defaulted loans or selling the underlying collateral to intra-group entities above market prices. This insulates transactions from the full impact of house price declines; however, constraints on banks‘ liquidity mean that current levels of originator support are unlikely to persist.”


In short, they're now running out of 'extend and pretend' space. The true state of affairs is about to be revealed. As to the deviation of actually achievable property prices from the prices indicated by the official house price index, here is a comparison of actually observed house price declines versus the official estimates, across a broad group of loan servicers ('HPD' = house price decline,'HPI' = official house price index):



The average difference between actual prices achieved vs. the official price index was 17%. Note here that apart from a handful of high loan-to-value RMBS portfolios, the bulk are 'prime' or 'near prime' loan pools – click chart for better resolution.



With Spain's economy in depression-like conditions and the oversupply of housing having dotted the landscape with numerous 'ghost towns', there is certainly no relief in sight. It is astonishing that the market is currently fairly sanguine about Spain's sovereign debt, since it is to be expected that the government will end up bearing much higher costs for the  banking system clean-up  than is currently officially estimated.

Moreover, Spain too faces an onerous debt rollover schedule in 2012:



Spain, like Italy, sees a large bulk of its debt maturing in 2012. This is likely going to make for 'interesting times' – click chart for better resolution.



Meanwhile, S&P just cut the ratings of ten Spanish banks. As Reuters reports:

Standard & Poor's cut the credit ratings of 10 Spanish banks on Thursday and said they remained on watch for a possible further cut subject to a review of Spain's sovereign rating.

The banks include Bankia (BKIA.MC) and its holding company, CaixabankMC and its holding company, Ibercaja, Bankinter (BKT.MC), Sabadell (SABE.MC) and Popular (POP.MC).

S&P said the cut came after it applied new ratings criteria and updated its group methodology for banks. The criteria were changed in November to increase clarity regarding hybrid capital instruments. Spanish banks are heavily exposed to bad, and potentially bad, loans after a prolonged housing bubble burst in 2007, and risks remain even after prolonged restructuring and recapitalization.

The economy is stagnant, the banks are depending on the European Central Bank for liquidity, and many of them must raise more capital as well.


(emphasis added)

The markets are more or less ignoring these developments at the moment, but they will likely come back into focus in the new year.


EFSF Preliminary Prospectus Issued

Meanwhile, the EU has issued a preliminary prospectus for the 'new and enhanced' EFSF bailout vehicle.  The current version of the prospectus can be downloaded here (pdf).

The funniest part of it is probably where it tells us that Italy is responsible for 19.18% of the fund's capital and capital guarantees and Spain for 12.75%.

So what happens if one or both of them need to be bailed out? They guarantee their own bailouts?

The prospectus is still a work in progress and as the FT informs us, it is now being considered to include a warning to investors that the 'euro may cease to be a lawful currency'.

The European Financial Stability Facility, which is creating the products to insure bonds of troubled countries against default, is debating whether the “risk factors” should be included in the final version.

In the latest draft of the prospectus, seen by the Financial Times, a summary of the dangers to investors includes: “Risks arising from a Reference Sovereign ceasing to use the euro as its lawful currency, […] or the cessation of the euro as a lawful currency”.

Including such a warning in an official document from the eurozone’s own rescue fund would be a surprising move. European leaders have frequently insisted that a euro break-up is unthinkable, although last month France’s Nicolas Sarkozy and Germany’s Angela Merkel accepted for the first time that Greece might leave.

“If you put something like this in the prospectus, you must consider what possible signal effect it has,” said one European official.


(emphasis added)

Oh well, at least it would be honest to include this warning, even if it has a bad 'signal effect'.



In the context of our recent article regarding the 'Tiny Tax', here is another very interesting article on the subject by Michael S. Rozeff, 'A 400 Percent (and Higher) Excise Tax', which we highly recommend.


Charts by: WSJ, Fitch, Der Spiegel, Bloomberg





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6 Responses to “A Downgrade Spat, Spain’s House Prices Tumble, EFSF Draft Prospectus Released”

  • If they were going to tax anything in speculation, I would tax the use of borrowed money. Stealing a persons capital isn’t going to cure anything and will probably impoverish the nation, as government will consume the seed corn. And, pulling liquidity will probably cause a crash. Of course, the HFT wall streeters will be exempt.

    France looks like it could be on the verge of chaos. Things look to be going down hill there very quickly. Amazes me so many people believe they can pay their bills by the ECB printing money. Also, Doug Noland has a nice write up on the Target2 mess that appears to be accumulating that Pater wrote on yesterday. People buying anything going into this mess have to be crazy. Recovery in the US has been greatly exaggerated in this light.

    • Hubert:

      “People buying anything going into this mess have to be crazy”
      Maybe. But we are in this mess for some years now and it now looks as this epic battle will endure somewhat longer.
      People standing away will not be happy either with their savings watered down.
      And People shorting into this wall of credit/money soon coming out the ECB are maybe not crazy but at least very courageous.

      • I would agree that one should not underestimate the effect all this monetary pumping could have on securities prices in the short term – especially as the latest Fed minutes strongly indicate that the FOMC is leaning toward providing more stimulus as well.

  • Belmont Boy:

    Re: your addendum linking to Rozeff, and my comment appended to your “Tiny Tax” article…

    It is my understanding Hutchinson proposes not a percentage tax, but a fixed tax. Maybe one cent per share. So, even in as small a trade of 100 shares of a $5 stock, the cost to the trader would be no more than a dollar added to a commission of, say, $7. An exemption for penny stock trades would avert truly exorbitant taxation; and besides, it is unlikely penny stocks are much subject to HFT in the first place, due to their low capitalizations and general illiquidity.

    To me, the questions are:

    1. Where does the tax money go? Could it be “sterilized,” so to speak? For example, could it be recycled to market participants on a per-account basis, and thereby kept out of the government’s maw? So, someone who trades maybe a million net per year total (the threshold for eligibility would have to be higher than nominal,) would receive the same “rebate” as large institutions that trade in the billions.

    2. How do you avoid the “slippery slope?” The off-the-top-of-my-head idea that I just suggested in 1 might be an answer.

    3. Just how destructive is HFT anyway?

    As to the last point: neither you nor Hutchinson wants any Tobin tax to provide more revenue to the government. Your engagement with him in a discussion of the effects of HFT, and of the desirability and potential means of disincentivizing it, would be interesting.

    • RedQueenRace:

      > It is my understanding Hutchinson proposes not a percentage tax, but a fixed tax. Maybe one cent per share.

      Maybe he has changed and I missed it but I’ve seen him call for a “small percentage” on the total transaction.

      > As to the last point: neither you nor Hutchinson wants any Tobin tax to provide more revenue to the government

      Again, my experience with Hutchinson on this does not match. He has specifically mentioned it as a possible source of revenue. Here’s one example : http://moneymorning.com/2010/08/25/tobin-tax-2/

      In looking at this you will see him specify it as a rate. He does have a much lower initial starting rate but some of the problems are

      1) There is no guarantee a rate anything like this will be picked – I recall 0.25% as the number being bandied about a a year (or 2+) back

      2) No tax is static as they act like crack to the government, especially when the initial “dosage” is very low.

      3) He assumes ceteris paribus for revenue calculations as well as the conclusion that the impact will be small. In addition to directly increased expense ratios for mutual funds, bid/ask will almost certainly widen and I would not want to be an investor in, say, an S&P 500 index fund that is trying to rebalance. Note that all such funds will be trying to do the same thing. Who will take the other side of their trades? At what price(s)? Whoever does, it will not be to the benefit of MF investors and there will be no way to “sterilize” that.

      Your third question is key and should be the first question as the answer could moot the others. Before proposing “solutions” it needs to be determined that this is a problem worth solving.

    • I should note that if $7 were added to every transaction I make, my transaction costs would increase by nearly 80% (currently a flat rate of $8.95 per trade). This is not an insignificant change, especially when considered in round turn terms. it sure would add up quickly for active traders.
      As to HFT, my gut feeling if you will is that if the practice is indeed harmful, then it will eventually self-destruct. That may lead to some short term market upheaval, but the markets would quickly reprice thereafter.

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