June 18, 2012

Betting on European Banks: Doomed to Fail or Shrewd Investing?

University of Chicago economist warns of massive bank runs, Oakmark manager makes billion-dollar bet

An ATM for Bankia. The recent $100 billion loan to Spanish banks only alienated investors further. (Photo: AP) An ATM for Bankia. The recent $100 billion loan to Spanish banks only alienated investors further. (Photo: AP)

A Bank of England study of the implicit subsidy of banks finds that taxpayers are transferring significant resources to financial institutions.

Joseph Noss and Rhiannon Sowerbutts, two Bank of England economists, summarize their findings in a briefer article published on VoxEU.org, saying that estimates of the size of the subsidy for U.K. banks have ranged from 6 billion pounds ($9.4 billion) to as much as 100 billion pounds. (The two economists arrive at still higher potential costs, running to 120 billion pounds, in their study.)

The methods they use attempt to put a number on a taxpayer-borne cost that is not transparent, whether in the U.K., in peripheral European countries experiencing banking crises or in the U.S., where too-big-to-fail financial institutions remain controversial four years after Bear Stearns was not allowed to fail, but Lehman Brothers was.

Government support for banks has recently been a major issue with respect to peripheral Europe’s weakened financial institutions, like Spain’s Bankia. Spain borrowed 100 billion euros to recapitalize its banks, yet investors, far from being reassured, have actually shunned Spanish debt. Yields on Spain’s 10-year bond rose to new highs on Monday, reaching 7.28% before ending the day at 7.16%, a level economists generally view as unsustainable.

In a blog post Friday, University of Chicago economist John Cochrane wrote that a full-throttled bank run in Europe is on, and that the European Central Bank is knowingly “taking junk collateral” in the form of sovereign debt in return for its spigot of euros. Writes Cochrane:

“If the ECB doesn't stop this massive lending, it understands well that it will essentially end up monetizing all the debt of the southern tier, and a huge inflation will eventually break out…If the ECB decides to stop this massive lending, then the game is up. The banks fail, the governments guaranteeing the banks fail, and chaos erupts…”

While Cochrane is profoundly pessimistic about European banks, a famed portfolio manager and fellow Chicagoan has bet a billion dollars on them. Fortune magazine reports that Oakmark International’s David Herro, named Morningstar Manager of the Decade in the foreign equity category, believes that institutions like BNP Paribas, Bank of Ireland, Banco Santander and Intessa Sanpaolo are being dumped indiscriminately along with banks with less favorable income, capital and operations. 

Fortune quotes Herro saying, "We're invested in European financials because—buy low, sell high.”

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