Bubbleland has been experiencing an unprecedented property boom for the past five years. Land values have shot through the roof, rising above 500% in some areas. The rising property prices fuelled a speculative boom, in which investors, home buyers, financiers, and real estate developers participated with great fervour.
Bubbleonians scrambled to buy land and homes, investors came to see property as the asset class to be in, and banks bent over backwards to finance property deals. The three major real estate developers of Bubbleland, Messers Bubble Constructions, Greedy Developers, and Fly-By-Night Realtors, purchased huge tracts of lands and have made massive investments in new residential and commercial projects.
Sensing the great business opportunity, the two government run banks of Bubbleland - Too Big to Fail Bank and Too Inter-connected To Fail Bank - lend massive amounts in home mortgage finance and to real estate developers. Then property prices crash and the party grinds to a halt. Fear and uncertainty about counter-party risks ensure that property sales get frozen and real estate credit runs dry.
Heavily leveraged purchasers, developers, and financiers are left holding assets whose values have plumetted three to five-fold. In the absence of continuing cash-flow from sales, debt-laden property developers face default. A substantial share of mortgage holders who purchased their homes during the boom have negative equity, stop paying their instalments. The knock-on effect of these defaults on both banks is massive. In three months, both are on the verge of going under, taking the financial system of Bubbleland with them.
The Government of Bubbleland steps in to avert a major financial meltdown and economy-wide recession. The Central Bank of Bubbleland (CBB) aggressively lowers interest rates and opens an unlimited liquidity access facility. It also provides massive amounts of loans at very attractive terms to both major and other smaller banks. The banks in turn reschedule the loans provided to the three major developers and the mortgage holders.
There is another sub-plot to the tale. As the crisis unfolds, driven by the massive credit-injections to keep the financial markets unfrozen, cassandras believe that inflationary pressures are taking hold. The inflation-targeting CBB hikes interest rates. The repayment burdens of the developers and mortgage holders climb. The balance sheets of the banks fall deeper into the red. Recession turns into a depression.
We could easily replace Bubbleland with Euro zone, the three property developers with Greece, Ireland, and Portugal, and the two banks with French and German banks, and the story and plots will be strikingly similar. Consider this NYT report
"Banks in well-off countries like Germany, France and the Netherlands, as well as Britain, hold a lot of Greek, Portuguese and Irish debt. And if these countries cannot pay their debts, they would have to reschedule them, reduce them or default, causing a major banking crisis in the rest of Europe. That reckoning would require governments to ask their taxpayers to recapitalize the banks... We have a banking crisis interwoven with a sovereign debt crisis."
The hope with the Bubbleland case is that once normalcy is restored, the borrowers will return to repaying their dues, and the banks (and their investors) will be back to getting the expected returns on their lending and investments. In simple terms, the fundamental assumption behind this bailout strategy is the hope that with reasonable time, the asset values will return to its bubble-era peak and property market will get unfrozen. This is critical for borrowers to repay their liabilities and lenders to get their balance sheets back in order.
In other words, the strategy revolves around the belief that it is a liquidity crisis and not a solvency problem. But what if the property market remains depressed for too long? It is after all not possible to keep re-scheduling loans to banks and homeowners forever. The liquidity strapped banks and developers will soon realize that there is no light at the end of the tunnel. Defaults and bankruptcy filings will become inevitable. The tax payers of Bubbleland have to pick up the tab for the massive losses that will ensue and bear the debilitating burden of its devastating impact on the economy.
Similarly, at some point in time, the lenders to Portugal (and their investors) and the Portuguese Government itself will realize the futility of such debt roll-overs. Government revenues are declining or at best stagnant, and debt-to-GDP-ratios are climbing. Borrowing costs are spiralling in the face of the double impact of lower credit rating and interest rate hikes.
Debt rescheduling will slowly turn into debt restructuring and even defaults. It is inevitable that the German and French banks will be forced into taking haircuts as sovereign defaults loom large and the European Commission will have to offer long-term concessional financial support to these countries.
Creditors will have to bear the costs of their recklessness and greed. Tax payers will end up bearing the costs of someone else's greed. It is certain that just as with Bubbleland, the denoument will not be pleasant for the Eurozone economies.