[Viewpoint] Europe’s subprime quagmire

Back in 2007-2008, when the financial crisis was still called the “subprime” crisis, Europeans felt superior to the United States. European bankers surely knew better than to hand out so-called “Ninja” (no income, no job, no assets) loans. These days, however, Europeans have little reason to feel smug. Their leaders seem unable to come to grips with the euro zone’s debt crisis. Banks in Ireland and Spain are discovering that their customers are losing their jobs and income as the construction bust hits the national economies. And one could argue that a loan to the government of Greece or Portugal affords little more security than a Ninja loan. Indeed, lending to governments and banks in the European periphery represents the European equivalent of subprime lending in the U.S. (which was also concentrated in a few sunshine states).

Given the many similarities between the two crises’ basic features, European leaders could learn a lot from the U.S. experience.

The first lesson is that, despite the limited overall volume of subprime loans, the subprime crisis could blow up into the biggest financial crisis in living memory, because an overstretched financial system was unable to cope with even limited losses. Similarly, the combined debt of Greece, Ireland and Portugal is small relative to the euro zone economy, but the European banking system is still so weak that these countries’ debt problems can create a systemic crisis.

A second lesson is that dealing successfully with a financial crisis requires, most immediately, a strong dose of liquidity. Then, once the financial system has been stabilized, a combination of debt restructuring and recapitalization is required. Has the European Union followed this recipe?

After some hesitation, Europe showed that it could manage the first phase - a liquidity injection to prevent systemic collapse. Greece and Ireland received funding when they were shut out of the capital market. And the last EU summit announced the creation of a permanent European Stability Mechanism (ESM) - a sort of European Monetary Fund with an effective lending capacity of 500 billion euros.

This is about $700 billion, the same magnitude as the Troubled Asset Relief Program (TARP) instituted in late 2008 to keep U.S. financial markets from collapsing. The ESM should be sufficient to deal with the refinancing needs of Greece, Ireland and Portugal. It might even be sufficient to address Spanish government debt, though it would be a stretch.

But, just as the $700 billion TARP did not assuage nervousness in financial markets in 2008, so the ESM’s 500 billion euros seems to have left investors unimpressed. The risk premiums on the sovereign debt of Greece, Ireland and others have not diminished. The premiums paid by Portugal have actually soared since major ratings agencies, explicitly citing the agreement reached at the EU summit in late March, lowered the country’s sovereign-debt rating.

A third lesson derives from a little-noticed but vital aspect of the U.S. experience: debt reduction is comparatively easy in the U.S., because the no-recourse feature of most mortgages there limits repayment obligations to the value of the house. Moreover, the U.S. bankruptcy code can free consumers of their debt within months.

Of course, the millions of personal bankruptcies and home foreclosures in the U.S. are not popular, but they provide debt relief each time, thereby enabling households to make a fresh start. This steady flow of debt relief is allowing U.S. consumer spending to recover slowly.

By contrast, debt restructuring for either banks or governments is politically unacceptable in Europe. This implies that the crisis is likely to persist much longer than in the U.S., because households in Spain and Ireland will labor for decades to service mortgages on houses that they can no longer afford. And the Greek government faces an endless succession of budget cuts, with each step being more difficult than the last as the economy spirals down a black hole.

Debt relief created fewer problems for banks in the U.S. because a significant proportion of the subprime loans packaged into AAA-rated securities had been sold to gullible foreigners. A good proportion of the losses on subprime lending was thus borne by banks from Northern Europe, leaving these banks in no position to sustain further losses on their European peripheral lending. But this should compel a strong recapitalization program - not weak stress tests.

Europe is making a fundamental mistake by allowing the two key elements of any resolution of the crisis - namely, debt restructuring and real stress tests for banks - to remain taboo. As long as successive EU summits persist in this mistake, the crisis will fester and spread, eventually threatening the stability of the euro zone’s entire financial system.

*The writer is the director of the Centre for European Policy Studies.

By Daniel Gros