Summit Expectations

The next ten days in Europe are critical, not only for the resolution of the peripheral sovereign debt crisis, but also for the future of the Eurozone. Morgan Stanley's Daniele Antonucci expects the following announcements at the upcoming policy meetings ("EU Summits" from 10/21-10/24, especially the Merkel/Sarkozy meeting on 10/22): (1) bank recapitalization providing higher Basel III Tier 1 ratios, primarily backed/funded by the strong sovereigns (France, Germany) and the EFSF (2) larger PSI for Greece, with NPV of haircuts increased to a range of 30-50% from 21% (3) disbursement of a further (specifically, sixth) loan tranche of the first bailout package and confirmation of second package (4) strong push (in Antonucci's words, a "political committment") towards Euro area economic coordination; it is highly possible that such coordination would involve some sort of legally-complex Eurobond issuance.

More on point (1): MS's 10/21 European Credit Strategy report includes a fascinating chart depicting capital ratios across Western Europe, with the standard T1 ratio along the x-axis and tangible common equity to tangible assets on the y-axis. Here we see the average ratios to be approximately 10% and 4%, respectively:

Interestingly, PIGS look relatively better off and France/Germany look worse when using the TCE/TA metric. The charts below plot the iTraxx SenFin (banks included in the senior debt CDS index) against the two previously discussed US and EU capital ratios:

So, then, what might all this mean? One of the most important differences in the two measures of bank capitalization involves the concept of risk-weighted assets (RWA). The MS strategists elegantly explain: "The source of Europe's low risk weightings, and market concern, is sovereign debt." Indeed, the banks in the iTraxx SenFin index hold roughly €700b in PIGS debt, but this debt is given a zero percent risk weighting (a sheer anomaly given current conditions, but historically sovereign debt has been deemed risk- free). This "makes for a relatively simple storyline: Europe's capital ratios are excessively flattered by risky sovereign exposure." But, however, we must remember that this €700b in sovereign debt exposure represents a mere 3% of the European banking system's €35t in total assets, a fact making the sovereign debt weighting "frankly irrelevant." In addition, mortgage delinquencies (percent of mortgages 90D past due) are significantly lower in Europe (lower leverage, higher underwriting standards) than in the United States, perhaps providing a reasonable justification for the lower risk weightings of European debt.

Ultimately--as I have said before--making sense of Eurozone bank recapitalization demands multifaceted and flexible analysis. More to come next week.