Wednesday, April 18, 2012 - Euro Debt, Iceland, the IMF, and Forgiveness

DOW – 82 = 13,032
SPX – 5 = 1385
NAS – 11 = 3031
10 YR YLD -.03 = 1.98%

OIL – 1.43 = 102.77
GOLD – 8.00 = 1643.00
SILV - .08 = 31.73
PLAT – 5.00 = 1581.00

Spain's non-performing loans as a proportion of total lending jumped to 8.16% in February, up from 7.91% in January and the highest level in 18 years. Data from the Bank of Spain show that Spanish banks are burdened with about 176 billion euros of "troubled" real estate assets and that 21% of the 298 billion euros of loans linked to property developers are non-performing. Despite the increase in the country's bad loans, the yield on Spain's 10-year bond fell to a 1-1/2 week low of 5.72% on optimism over tomorrows auctions of 2-year and 10-year Spanish securities.

Will Europe and its increasingly ugly currency, the euro, get out of the crisis in one piece? This is probably the biggest question for the global economy right now. There is increasing concern that Spain and Italy will eventually default. Maybe the euro will survive but nobody seems confident of that right now. And it appears Europe is facing an economic depression which will diminish living standards and create social unrest and take years to work though. A best case scenario is years of stagnation. Actually there is another solution and we'll get to that in a few moments.

The fate of the euro has global consequences. Europe is the largest marketplace in the world. When Euro-countries and companies and the general population pull back and stop spending and investing and buying, it won't take long for the effect to be felt in the United States.

The problems with the Euro are structural; a currency union without an accompanying political union. Seventeen individual states all share the same money, but still chart their own budgetary courses. Over the past few years that meant the global marketplace was expected to treat Greece and Germany as equals. The idea was that the risks were the same because the currency was the same. The currency masked the fundamental differences that distinguished the fiscal soundness of individual member states, giving less-disciplined governments access to too much credit. And now the PIIGS, (Portugal, Ireland, Italy, Greece, and Spain) are buried in debt.

One solution is to allow the European Central Bank to issue bonds for the entire Union backed by all members. Germany doesn't like the idea of putting its credit on the line. Maybe the Germans have a fear of inflation built on the hyper-inflationary past of the Weimar Republic. Maybe the Germans have some moralistic reason to think they are financially superior, more economically worthy. Whatever the reason, the response is to impose austerity. Tighten the belt. Put the brakes on the economy. Unfortunately the prescription for starvation is not a diet. Austerity ensures that Europe cannot grow robustly, enhancing the debt burdens of weaker states. The cure is as bad as the disease. Europe will not shrink its way to prosperity.

Italy’s prime minister has abandoned the notion that Italy can balance its budget during a deepening recession. Slow growth, not profligate public spending, is the No. 1 problem in Italy. And in Spain, where a recession is causing a wave of loan delinquencies and defaults. Investors are bailing out of Spanish government bonds for fear the government will be overstretched trying to save Spanish banks.

Italian Prime Minister Mario Monti is the technocrat who is supposed to get Italy’s finances back on the straight and narrow. After meeting in Rome today, his cabinet announced that it’s now projecting the federal budget to show a deficit equal to 0.5 percent of gross domestic product in 2013, worse than a previous forecast of a 0.1 percent deficit. Prices of Italian bonds dropped on the news.

The International Monetary Fund is starting to catch on. They realize that it is one thing to throw money at the wayward banks, but it is another matter to get the money moving through the economy. And they have come to realize that households burdened by debt will not go out and spend. Last week, the IMF targeted household debt reduction policies. You probably haven't heard much about it because it involve debt forgiveness and mortgage write-downs. The IMF issued a report using Iceland as an example. Iceland defaulted and they have recently forced banks to accept reductions in mortgage interest payments of up to 40% and many distressed households had a portion of the debt written off. The economy there has now recovered remarkably since its bank-led collapse in 2008.

It found that countries, like Ireland, that saw house prices and household borrowing skyrocket, saw a longer than average period of recession after the bursting of the housing bubble. A large part of this protracted recession it said is due to households trying to reduce their debt levels, which in turn leads to less spending in the economy, driving the recession deeper and further. In the case of Iceland the situation was more difficult, due in part to the much bigger proportion of the population that was affected, and to the wide presence of foreign currency mortgages.

The government and the newly constructed Icelandic banks developed a template to be used in case by case restructuring discussions between borrowers and lenders. The templates facilitated substantial debt write-downs designed to align secured debt with the supporting collateral (that is, bring the loan into line with the value of the house) and align debt service with the ability to repay.

The IMF found that such case by case negotiations safeguard property rights and reduce moral hazard, but they take time. As of January of this year, only 35% of the case by case restructuring applications had been processed. To speed things up, Iceland has introduced a debt forgiveness plan which writes down deeply underwater mortgages to 110% of the households' pledgeable assets.

It noted that only when a comprehensive framework was put in place and a clear expiration date for relief measures announced that debt write-downs finally took off. As of January 2012, 15 to 20% of all Icelandic mortgages have been or are in the process of being written down.

In the US in the 1930's the Roosevelt administration introduced the Home Owners Loan Corporation, which bought distressed mortgages from banks with government bonds, with federal guarantees on principal and interest. It then restructured these mortgages to make them more affordable to borrowers.

80% of the restructured loans (some 800,000) were protected from repossession by the measure, and the mortgages were subsequently sold on over time for a nominal profit at the time the program was brought to an end in 1951. The mortgage purchases amounted to 8.4% of 1933's GDP in the US.

The IMF said "a key feature of the HOLC was the effective transfer of funds to credit constrained households with distressed balance sheets and a high marginal propensity to consume, which mitigated the negative effects on aggregate demand" caused by the recession and need for household deleveraging.

The main mechanism to make loans more affordable was to extend the term of the mortgage - sometimes doubling the term - and converting it from a variable to a fixed rate. In a number of cases the HOLC also wrote off part of the principal to ensure that no loans exceeded 80% of the appraised value of the house.

Austerity is not the solution. Increasing debt to pay for unsustainable debt is not the answer. When debt is unsustainable you can't grow your way out of it and you certainly can't shrink your way out of it.

I've told you for a long time that when debt becomes unsustainable there are three outcomes: slow default, quick default, or default due to war or catastrophe. There is actually one more outcome – debt forgiveness. It is rare, but it might actually be the answer.