It isn’t Italy that holds the key, it’s not even the ECB, “my friends”

By Fernando Fernandez, professor at IE Business School

Forget about short cuts and soft measures: Europe’s problem is that it has lost the market’s confidence, and in order to get it back it will have to take some hard measures.It’s a well worn phrase which is why I have permitted myself a certain amount of poetic license, because it seems to go perfectly with the confusion that is rife among markets and analysts following recent events. The feeling of insecurity is such that we are desperately seeking a lifeline to cling to. Someone is always up for the job of throwing said lifeline and public opinion seems to have honed in on two specific groups: governments comprised of technocrats and the European Central Bank (ECB). The former are expected to bring the required level of sanity and the ECB is supposed to start buying up debt with no thought for expenses. But once again it’s the wrong diagnosis.

The European Commission, according to its vice president Olli Rehn, has decided that the key lies in restoring confidence in fiscal sustainability and the financial system, and in speeding up reforms that stimulate growth potential. Hence we have to change our tune or we have to take notice of the Commission, but either way we should not be looking for short cuts.

The European problem is a simple one. Investors have lost confidence in the Euro, not just in Italy. Let’s not confuse the symptoms of this particular illness. They have done it for a series of institutional reasons – the well-known design faults of the Monetary Union – and mistakes made in the way the crisis has been managed. In my opinion they include two particularly big mistakes. The first was to declare that European sovereign debt is restructurable – albeit only Greek debt, but who on earth believes that at this stage – without having the necessary financial resources or legal instruments to effect an immediate exchange, and the second was to punish banks for their sovereign debt holdings without having the necessary resources to fill the hole created. Both decisions have had consequences that were impossible to recover from in the short-term: they have made sovereign debt a credit asset, a financial instrument that competes with emerging debt, and have eroded the credibility of the European banking system, which has been forced to divest its sovereign debt. 


IE Focus || Is this the solution to all debt problems?

By Ignacio de la Torre, professor at IE Business School

Investment banking has once again shown us the way to address the world’s enormous and recurring debt problem. It is, of course, by cheating.Although it may not have been noticed, investment banking has shown us the way solve the world’s enormous and recurring debt problem. What did the last entry in Lehman Brothers profit and loss statement show? Enormous profit. Let’s see why. The results of the third quarter of 2011 for Lehman Brothers produced “profits” as a consequence of the fall in value of the debt market of the banks themselves. In other words, if the risk of bankruptcy of, for instance, Morgan Stanley, increases, the price of its bonds falls, which means its “profits” will rise. Intuitive? That’s why the last entry in Lehman’s books was actually an enormous profit. The five main investment banks have posted “profits” totaling 15,000 million dollars obtained this way in the third quarter, which means that the position of the bank’s “own” funds is skewed by an equivalent amount, as is its solvency, measured in relative terms (value at risk) or absolute terms (leverage). In short, over 80% of the profits posted by investment banks in the third quarter of 2011 is a result of this fantasy.

Thus the profits of 6,200 million dollars posted by Bank of America contain a bonus dividend of 3,600 and a “profit” due to a fall of 1,700 million dollars in the amount of debt. Citigroup’s profits have risen by 74% to 3,800 million dollars thanks to the recognition of a “profit” derived from the drop of 1,900 million in its debt level. Morgan Stanley posted a profit of 2,150 million dollars, of which 3,400 were the result of a fall in the value of its debt, and JP Morgan posted a profit of 1,900 million dollars using the same system, beating the market with a profit of 1.02 dollars instead of the expected 91 cents (its shares fell by 4.8% – the market is not quite as simple as it looks). Unfortunately, this practice is also being employed in Europe, where UBS has posted a profit of 1,800 million Francs as a result of the fall in value of its debts. Its total profit was 1,000 million Francs, which means that if it hadn’t used the trick it would have posted losses, not profits, as a result of its trading scandal (2,300 million dollar loss).