Simon Hebb: Europe counts the cost after a case of financial forgiveness

Of particular poignancy is the advice given to Copperfield by Mr Micawber: “Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.”

Mr Micawber’s famous quote seems very relevant as we see scenes of Greek people protesting on the streets of Athens, but the well read reader will ironically observe that Mr Micawber always failed to follow his own good advice. But this is precisely what millions of people in Europe and America are confronting: misery and mistrust. In recent weeks, we have seen protests on the streets of Athens, London, Dublin and Lisbon as each indebted nation confronts its financial realities. In America, the Democrats and Republicans seem incapable of the political compromises and courage needed to secure sustainable national finances.

Not surprisingly, investors took fright, and share markets quivered lower while bond prices, excluding those of the “peripheral” European markets, rose.

But such financial market behaviour has now been reversed, and the trigger for it was the Greek parliamentary vote on a commitment to national austerity. To continue with the morality tale, the sinner has admitted fault and shown a desire to correct his ways, and so a process for winning forgiveness has been laid out.

In this case, forgiveness refers to debt forgiveness or allowing a debtor not to pay his debts either in total or within the period previously agreed or perhaps both.

This is what Greece’s EU and IMF creditors appear to have agreed to, but only if the Greeks mend their spendthrift ways by agreeing to further cuts in their government’s budget and further tax increases.

Recently, international voices demanding a restructuring of Greek debts had reached a crescendo, and politicians across Europe urged the banks to support their political resolve with a commitment to make further loans for long periods at below market rates. In effect, there has been an agreement to restructure Greece’s debts in such a way that Greece can avoid defaulting formally on its loans. Such an arrangement saves the faces of politicians across the eurozone, but it also helps to inoculate the European Central Bank and commercial banks across the whole of Europe and beyond from the risk of contagion to their balance sheets.

Formally the agreement must be approved by the Board of the IMF on Friday and by EU finance ministers on next Monday. Moreover, new funds, which amount to well over 100 billion euros over the period to 2014, will only be provided by the scheme if the Greeks keep to their side of the bargain. The problem sprang not only from Greek profligacy, but also from the fact that Greece is bound within the euro, and thus cannot act unilaterally without terrible consequences.

There is also the major, but unquantifiable, problem of the likely threats to the capital in the banking system in both the eurozone and the UK, for not only are they exposed to the debt of sovereign nations, which may struggle to repay their debts, but also they carry enormous volumes of loans on commercial and residential property. In my opinion, this issue lies at the heart of the entire problem.

In the course of the next few years, the majority of banks will have to build their capital reserves. In part, this is being demanded by new and emerging regulations, but more importantly they are likely to have to write off sizeable volumes of loans from both their property and sovereign debt portfolios.

This will take time. They will retain profits and they will issue new capital. In Spain the cajas, or savings banks, will be privatised. If the agreement with Greece holds, the prices at which they can issue new shares, and the time within which they can do it, will both improve. These latest developments provide relief to, but not a final resolution of, Europe’s financial woes. Over the course of the next few years, not just Greece but also Ireland and Portugal are likely to have to restructure their debts. Many commercial and residential property loans will be written off, which will be of particular concern in Spain and the UK.

But with luck, and the implementation of the agreement with Greece, these last few weeks may prove to have been the point of greatest stress upon the ramparts of the European banking system. However, we must not forget that sinners often stray again and that forgiveness may have a delicate constitution.

* Simon Hebb is an investment manager at Harrogate-based Gore Browne Investment Management.