By Dr. Lynn Reaser
Nearly a month has passed since European governments, the International Monetary Fund, and the U.S. Federal Reserve announced a rescue plan to backstop Greece and prevent financial contagion from spreading to Portugal, Spain, Ireland, and other countries. Yet, investors remain on edge and markets have experienced huge bouts of volatility.
Interest rates on corporate bonds have climbed while yields on safe-haven Treasury securities have pledged. European banks have been reluctant to lend to one another, while U.S. financial institutions have also shunned their counterparts across the pond. While this is partly a liquidity problem, more fundamentally, it is a solvency issue. In that respect, it is similar to the situation in America in the fall of 2008. At that time, liquidity had dried up in the U.S. markets, but that condition reflected fears that major financial institutions would fail (an event borne out by the collapse of Lehman Brothers.) Solvent firms and individuals had access to credit. For example, it is doubtful that Warren Buffett would have experienced difficulty in securing an expansion of his personal credit line.
At this point, it seems likely that eventually Greece will need to restructure its loans, imposing losses on some of its bondholders. The rescue package may delay this event for one or two years, but Greek debt will remain high for a number of years in the future. Currently, about $2.5 trillion of public and private debt from Greece, Portugal, and Spain resides on the balance sheets of European banks outside these three countries. The European Central Bank warned this week that European banks could face write-downs of about $240 billion on various types of private and public credit over the next two years.
According to the Organization of Economic Co-operation and Development, major U.S. banks are currently operating with leverage ratios (assets divided by common equity) of 12 to 17. In contrast, major European banks have leverage ratios of 21 to 49.
The road to solvency will not be easy. Greece has begun budget-cutting efforts, including scaling back various benefits and moves to privatize various government operations. European banks will need to raise substantial amounts of capital. The sooner these steps are taken, the sooner investors will regain their trust.