Zombie banks Scandinavian edition and the threat of too big to fail

Across the world, governments are doing their level best to shore up weak banking systems in the wake of the most significant final crisis in decades.  Most market players appear to believe these efforts successful; why else have shares risen so dramatically from lows late last year and early this year?

While I do believe the efforts have indeed been successful, I am far from certain they have addressed the underlying problem: large quantities of unrecoverable debt from reckless lending.

Witness the most recent bank merger in Scandinavia between Nordea and Fionia Bank.   This event seems to have gone largely unnoticed outside of Scandinavia. But, the core issues of socialization of losses, zombie financial institutions, unrealized loan losses, and too big to fail institutions are the same ones at work in the U.S., the U.K., Switzerland, France, the Netherlands, and many other countries.

While all is fine and good in an environment of economic recovery and rising asset prices, there remains a lot of downside risk were we to face a renewed slump in the global economy.

Socialization of losses

Fionia is a failed bank in Denmark about which I wrote in February. The bank collapsed after taking large writedowns early this year.  However, the Danish government was loath to liquidate the institution. Instead, it transferred the assets of the bank to a new Fionia Bank, which it has just sold on to Nordea, the large Scandinavian giant.

You should notice two things about this transaction. First, the price is quite low: Nordea has acquired Fionia for $173 million. This pales in comparison to the well over $200 million writedowns Fionia took which caused it to fail.  Moreover, the Danish government subsequently pumped another $169 million into the bank in order to sanitize it for sale.

I have not seen any details of the saleregarding further contingent liabilities for the Danish taxpayer. But, to my mind it strikes me as similar to recent FDIC seizure/sale agreements for BankUnited and Guaranty, where the government took the lion’s share of losses and flogged the remaining assets off for a low price to a willing buyer.

Zombie financial institutions

But, then you have the zombie bank problem. The term ‘Zombie Bank’ was popularized during the S&L crisis by Edward Kane to connote banks which continued to operate but only as a result of government largesse as they were effectively insolvent.

Nordea had a very fine second quarter in which it showed net income of over 600 Million Euros. The Danish daily Berlingske Tidene even called the first half “one of the best in Nordea’s history.” But, how healthy is Nordea really?  It will weather the storm but the company has large residual exposure to unrealized losses in the Baltics.

More to the point, Sweden’s central bank, has lowered interest rates to effectively zero. This allows any financial institution in trouble to make a large gain due to interest-rate spreads (borrowing for much less than lending) or the carry trade (borrowing short and lending long). The Riksbank is actually running negative interest rates by charging banks to hold funds on deposit. Clearly, banks now have every incentive to lend and this will support the economy as long as rates remain low.

But, it’s not like those unrealized losses magically disappear.  The toxic assets are still there.  Asset price inflation makes them appear to become much less toxic.  But what happens when the economy in Sweden turns down or asset prices fall?

That’s when day turns to night and the zombie banks come out of their holes and terrorize the town.

Too big to fail

Flogging Fionia off on Nordea is a lot like having JPMorgan Chase buy Washington Mutual.  It only makes the acquiring company larger and more dangerous – too big to fail and too big to bail (out).  It is not a very good solution. Just ask Iceland.

By now you have seen David Cho’s piece in the Washington Post analysing this very problem in the United States.  He writes:

When the credit crisis struck last year, federal regulators pumped tens of billions of dollars into the nation’s leading financial institutions because the banks were so big that officials feared their failure would ruin the entire financial system.

Today, the biggest of those banks are even bigger.

The crisis may be turning out very well for many of the behemoths that dominate U.S. finance. A series of federally arranged mergers safely landed troubled banks on the decks of more stable firms. And it allowed the survivors to emerge from the turmoil with strengthened market positions, giving them even greater control over consumer lending and more potential to profit.

J.P. Morgan Chase, an amalgam of some of Wall Street’s most storied institutions, now holds more than $1 of every $10 on deposit in this country. So does Bank of America, scarred by its acquisition of Merrill Lynch and partly government-owned as a result of the crisis, as does Wells Fargo, the biggest West Coast bank. Those three banks, plus government-rescued and -owned Citigroup, now issue one of every two mortgages and about two of every three credit cards, federal data show.

But this is not just an American problem. It is a systemic problem that affects Europe even more. Look at the list of the top twenty-five European banks by asset size. Almost every Western European country is plagued by the Icelandic problem of institutions that are too big to fail, but too big to rescue.

In fact, Denmark is near the top of my list with one institution, Danske Bank, having assets nearly 200% of GDP. Were I to have added Sweden to this list, they would come in ahead of Denmark with four banks having assets of over 300% of GDP. (Nordea – 2008 assets: 474 billion euros, SEB – 213 billion euros, Handelsbanken – 212 billion euros, and Swedbank – 179 billion euros.

Germany is taking the lead on putting an end to too big to fail – or at least solve this problem on a global basis. Peer Steinbrück, the German finance minister, is trying to force the G-20 to agree to “international rules that facilitate the insolvency and liquidation of large, internationally active banks.”

Concluding thoughts

Felix Salmon suggests a surcharge on bank size.  The idea is that taxing banks, penalizing them for becoming to large, one can use a more free-market approach to curb these institutions.  I like the idea, but I do think more will be necessary.  The bank size surcharge is one most banks would willingly pay if it means in good times they can pocket more excess profit in good times than the tax penalizes them.

And it is good times that are important. if the Federal Reserve and other central banks continue to lower interest rates to extremely low levels, banks will extend credit recklessly in good times because of a false price signal the interest rates display. Only when a downturn takes place will banks recognize they have over-lent and that the size surcharge was not a good bet.

I am sceptical that anything meaningful will come of Steinbrück’s plan in an environment were everyone is talking about economic recovery.  The urgency seems to have passed. But, the threat posed by toxic assets and by megabanks has not.

Note: Originally, this article stated that Nordea had ‘huge’ exposure in the Baltics.  This has now been changed to ‘large’ and I have added the line ‘It will weather the storm.’ I do believe that Nordea is the best-positioned of the large banks headquartered in Sweden.  They are the best bank to take on a Fionia Bank. However, I am using their acquisition of Fionia as a vehicle for a larger discussion about acquisitions like this to talk about too big to fail.

17 Comments
  1. aitrader says

    Good analysis. The Swede on the street thinks the recession is over. The MSM here just called it a “ketchup recovery” meaning that it is surely coming but slower than expected (like the old Heinz ketchup commerical where it takes time for the ketchup to exit an upended bottle).

    The old Swedish Nordbanken merged with a Finnish bank and renamed the new entity spanning Finland and Sweden Nordea. They have tried repeatedly to gain a foothold in Denmark but have been rebuffed at each try by the Danes. The latest merger is a way for them to finally access the Danish market. I suspect they see the toxic asset problem as merely the price of admission.

    As you may recall I do not see Swedbank surviving. I think November is around the time we will see the toxic assets overwhelm their ability to patch up and hide them. Nordea has been suspending principal and in some cases even interest payments for their biggest loans for some time now to avoid having to report mark-to-market losses. Obviously they hope the global economy will recover and these customers can resume paying. In effect they have bet the farm on an early recovery. My best guess is they will lose that bet, though I think Nordea’s problems will be papered over and covered by the Swedish, Finnish, and Danish governments behind the scenes and we will hear little or nothing about it in the media.

    1. Edward Harrison says

      Thanks for the Nordea links. It does help put some of this in perspective.

  2. chegewara says

    while i agree that there will be problems in scandi bank space, your article has several mistakes:
    a) This pales in comparison to the well over $200 billion writedowns Fionia took which caused it to fail.
    surely u mean million here

    b) But, how healthy is Nordea really? The company has huge residual exposure to unrealized losses in the Baltics.
    I strongly encourage u to perform actual analysis. You might find that Nordea unlike SEB and Swedbank has minimal exposure to the Baltics.

    The ultimate problem of scandi is scandi itself. Corporates are too leveraged, there was a housing bubble. Banks are amongst the most leveraged in the world.

    Cheers

    1. Edward Harrison says

      If you notice, I never made any direct comparisons between Swedbank, SEB and Nordea. So, obviously, I am aware that Nordea is in a much better position than Swedbank or SEB on capital and exposure to the Baltics as I have written in the past. But, Nordea does still have large exposure (“Impaired loans in the Baltic region as a whole – including both non-performing and performing – have run up to 418 million Euros, equivalent to 550 basis points of total loans and receivables.”)
      https://pro.creditwritedowns.com/2009/07/earnings-results-at-swedish-banks-show-large-writedowns-in-baltics.html

      The comparison I did make was to JPMorgan Chase, the bank which is the best positioned of the large American banks, the point being that Nordea may be well-capitalized compared to its rivals and a likely buyer of banks like Fionia, but it is still too large.

      1. chegewara says

        my remark only related to this sentence:
        The company has HUGE residual exposure to unrealized losses in the Baltics.

        Nordea derives about 2% of revenues from the Baltics. Together Poland, Baltics and Russia are less than 6% of revenues. Of total assets, only 1.5% are in the Baltics. Baltics, Poland and Russia are together less than 3% of total assets. This is hardly HUGE, and even if there was a 100% writedown on Baltics this is not lethal.

        A bigger problem at Nordea is leverage: 180% LDR and a tangible equity ratio of less than 4%. Most of the Nordea’s assets are in Finland (37.4%) and then in Denmark (23.5%), which unlike Sweden (36%) cannot depreciate the currency to aid their corporate sector. I fully expect Nordea to suffer on the basis of that.

        1. Edward Harrison says

          Agreed, it is not lethal – hence the comparison to JPMorgan Chase. In my view, it is large given the amount of capital but I think this is a question more of style and semantics than substance. I take your point.

          Going back to the JPM comparison, Nordea has a lot of ‘real economy’ exposure in Scandinavia as you indicate. Similarly, I have pointed out the same for JPM. While, I believe both to be the healthiest large banks, another downturn would weaken the capital position.

          https://pro.creditwritedowns.com/2008/11/jpmorgan-chase-large-exposure-to-real-economy-downturn.html

          The discussion about Nordea is a bit of a red herring. I used it to highlight the increasing concentration in bank sectors throughout Western Europe and North America resulting from this crisis. While we may believe the likes of JPM, HSBC or Credit Suisse are well-capitalised and this poses no problem, these banks could as easily become like Bank of America, RBS, or UBS, their less well-positioned big bank brethren.

          So, my concern is more SEB and Swedbank in Sweden (hence the zombie bank title), but large banks more generally.

        2. aitrader says

          Some anecdotal headlines about Nordea’s problems:

          “Konkurshot tvingar banker ta över Dometic”

          Banktuptcy threat forces banks to take over Dometic

          Explains how Nordea just became owner of a refrigerator maker after it defaulted and went belly up.

          http://www.dn.se/ekonomi/konkurshot-tvingar-banker-ta-over-dometic-1.936868

          “Nyemissioner för 60 miljarder”

          New stock issuance for 60 billion SEK

          Several large firms on the Swedish OMX exchange have been forced to issue stock to the tune of 60 billion SEK recently. Nordea alone accounted for half of this amount.

          http://www.svd.se/naringsliv/nyheter/artikel_3319435.svd

          “Tuff höst väntar rederierna”

          Tough Fall awaits shippers

          Talks about Nordea’s exposure to shippers and the bank’s exposure to potential defaults.

          I recall reading that Dry Ships (NYSE:DRYS) had upwards of an 8 billion SEK loan from Nordea that it couldn’t pay. Nordea suspended all but interest last Spring. Not sure what the situation is today – I suspect both interest and principal may have been suspended to keep the loan on the assets side of the books.

        3. aitrader says

          Found the Dry Ships info in English:

          “Dry Ships reaches final deal on debt ppayment”

          http://www.smartbrief.com/news/sifma/companyData.jsp?companyId=11659

    2. Edward Harrison says

      You probably saw this:

      https://pro.creditwritedowns.com/2009/10/sweden-prepares-for-financial-collapse-in-latvia-and-major-bank-losses-at-home.html

      Notice the Nordea exposure is fairly large – though not fatal as I said here.

  3. ketzerisch says

    Great analysis.

    I don’t agree totally that size is indeed the problem. The problem lies in the fact that insolvency or not insolvency is a digital – zero or one – decision. Make it smooth and allow values in between and the problem will be drastically reduced.

    They way to do it: Make a law that all insolvency of a bank leads to an automatic debt-equity-swap of the last bond issued. If this is not enough to recapitalize the bank, convert more and more bonds until it is. Other deposits, like retail accounts, should be strictly senior to the bonds and each bank has to hold x-times (x=1?) the amount of retail money it takes.

    1. Edward Harrison says

      ketzerisch, the debt equity swap idea is a good one. One has to ask how we can get bondholders to eat losses before taxpayers.

      However, to say it leads to a grey area between solvency and insolvency is a bit of word parsing. If I loaned a company money, I expect payment in full, not a bunch of PIK preferred shares (a common thrown-in for high yield bond issues). Clearly, the swap is a default, which I see as technical insolvency.

      The problem you present is how is it that bondholders have inserted themselves in the capital structure ahead of US taxpayers. The answer is bailouts. In a bankruptcy or liquidation, bondholders would take haircuts or debt/equity swaps. So by bailing out institutions, taxpayers get stuffed but bondholders do not.

      And as we know, only too big to fail institutions got bailouts.

      1. ketzerisch says

        I agree. The point is also to take away the incentive of bailing from the politicians. With the current insolvency scheme, a politician face the threat of a second Lehman Brothers if he doesn’t bail. With a new insolvency scheme the threat is that a few bondholders will become shareholders. Not exactly the thing a politician is afraid of.

        Once the politicians don’t bail, the market will ask higher interest on the bonds and the leverage of the banks will come down to more sustainable levels due to market discipline.

    2. Edward Harrison says

      And, Willem Buiter is singing the same tune that you are. I will be linking to this post in the links tomorrow morning:

      http://www.ft.com/cms/s/0/76e13a4e-9725-11de-83c5-00144feabdc0.html

      Of course, he also sees this as a too big to fail issue as well.

      1. ketzerisch says

        Thanks for the link. Here are some more voices in favor of this or similar ideas:

        Henry Blodget in „Why Are We So Afraid To Fix Banks The Right Way?„
        http://clusterstock.alleyinsider.com/2009/1/why-are-we-so-afraid-to-fix-banks-the-right-way

        Luigi Zingales in „Yes we can, Mr Geithner
        http://www.voxeu.org/index.php?q=node/2807

        Renaud de Planta: Debt-equity swaps: a capitalist solution to the crisis
        http://www.ft.com/cms/s/0/6748e9d4-e315-11dd-a5cf-0000779fd2ac.html?nclick_check=1

        James Baker: How Washington can prevent ‘zombie banks’.
        http://www.ft.com/cms/s/0/b3f299a6-0697-11de-ab0f-000077b07658.html?nclick_check=1

        Felix Salom is not convinced:
        „Insolvent Banks: Why a Debt-for-Equity Swap Won’t Work„
        http://www.portfolio.com/views/blogs/market-movers/2009/01/19/insolvent-banks-why-a-debt-for-equity-swap-wont-work?tid=true

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