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| Christopher Flowers, chairman of JC Flowers |
Echoing fears that European policymakers remain in a state of cognitive dissonance – recognizing the need for root-and-branch overhaul of peripheral banks, but backtracking on joint liability plans – Christopher Flowers, the legendary FIG investor who now runs the £2.3 billion ($3.5 billion) private equity group JC Flowers, sounded the alarm over the negative sovereign-bank feedback loop. In a shot across the bows of market bulls, who cite the return of capital flows to weaker eurozone states, Flowers issued a stark warning: "There is a scenario where we have a Lehman-type event: we wake up some Thursday and a big country is in trouble.
"And the ECB will have to decide to support banks x, y, z. And then the ECB will, in fact, decide to own bank x, y, z. So this leisurely pace [of negotiation between eurozone policymakers] will end and we will wake up on a Monday morning with a European banking union."
Europe’s failure to restructure its weaker banks contrasts with the successful US model of receivership, whereby the equity is wiped out, assets are written down to economic value, junior creditors take losses and a debt-to-equity swap is typically enacted.
By reducing the troubled bank’s liabilities, the Federal Deposit Insurance Corporation helps to expedite a largely market-driven process to ensure the financial institution remains a going concern while depositor preference is ensured, paving the way for bank solvency, Flowers said.
In comments made at a conference organized by the Association for Financial Markets in Europe, he said: "Resolving banks that have gone broke has a long history, and we have participated in a bunch of these types of deals. The way it is supposed to work is that the government is supposed to remove the risks of the assets.
"That’s what the FDIC has done a zillion times. The good thing about that is that the bank comes out of the other side. It has got capital. It wants to lend and to do business. This helps get the economy going. It’s a good system."
Flowers said banks in the eurozone periphery have largely failed to recognize losses, in favour of rolling over loans to borrowers who are unable to pay, aided by regulators’ reluctance to see systemically important banks write down assets on a mark-to-market basis. This game of ‘extend and pretend’ will ensure that the eurozone credit mechanism remains impaired, imperilling an economic recovery, he said.
Look around
"This [US model of receivership] has not been visibly adopted in Europe. Look at Spain. No. Look at Greece. No. Look at SNS and the Netherlands. No. Look around [and ask whether eurozone banks have been restructured]: no, no, no."
He added: "There are two things [to note] here. Yes, the government is supposed to protect you, but also you need to work out whether the government is able to honour their commitments. I assume that it is inevitable that banks will sit there and [in the end] use that [US-style] format because that’s the one that works."
The politics of negotiating a joint liability plan across 17 eurozone states, cultural differences and the challenge of subsiding wholesale funding for distressed banks account for Europe’s failure to stabilize its banking system compared with the US, Olivier Sarkozy, head of global financial services group at Carlyle, said at the same conference.
"If 50% of [a given bank’s] liabilities are funded in the wholesale markets and the sovereign is funding itself at 6% to 7%, then it stands to reason that as those liabilities reprice it will reprice at the sovereign level plus. In this context, it does not matter how much of a guarantee you have on the credit or the assets of a bank – it is just not going to get funding if 50% of its liabilities is being repriced."
The half-brother of former French president Nicolas Sarkozy added: "You need a rate guarantee on the liability side of the balance sheet, which complicates matters. That’s why Europe did not move like the US. I don’t expect to see that changing anytime soon."
Famed for distressed-bank investing after snapping up Japan’s failed Long-Term Credit Bank in 2000, Flowers, a former Goldman Sachs partner, moved to London last year to seek better opportunities for the $2.3 billion fund raised in 2008. The IMF predicted in an October 2012 report that European banks were likely to try to offload some $2.8 trillion of assets, 7% of total assets, in the next two years, although FIG M&A deal volumes have in recent years not met expectations.
Flowers made his largest foray in the UK market last month with a deal to buy Cabot Credit Management, a consumer debt company, for a rumoured £800 million including debt.
On FIG M&A opportunities in Europe, Flowers painted a mixed picture: "We see a lot of opportunity in Europe but lacklustre growth and residual concerns about the euro makes us worried." By contrast, competition for US banking assets remains strong, buoyed up by the availability of structured financing, he said.
Underscoring the appetite for high-yielding distressed European banking assets, especially among US private equity firms, Sarkozy said at the same conference: "The US banking sector is no longer investable for the returns we are trying to achieve. We are looking for leverage and cashflow streams that can withstand the negative economic environment."