The Smartest Man in Europe

The headline may seem like an April Fool’s joke at first since Jeroen Dijsselbloem is hardly a household name. But the Netherlands native has found himself in the crosshairs of many investors and bloggers.

Despite all the harsh press, this Dutch politician is shaping the recovery in the EU. And he may be doing a better job than earlier attempts, too.

Dijsselbloem has been the Minister of Finance in the Netherlands since 2012, and became the president of the Euro Group and president of the Board of Governors of the European Stability Mechanism this year. He also nationalized SNS Reaal to prevent a bankruptcy. So he’s in deep with major decision makers in the EU, and can impact future policy.

That’s why investors were so spooked after Dijsselbloem said that Cyprus would serve as a template for future bank bailouts last week. EU bank stocks – especially those in Spain and Italy – suffered immediate haircuts, shedding more than 5% in minutes. Meanwhile, bond yields spiked in Italy, shooting the cost of debt financing higher. Naturally, investors were a little more than annoyed with Dijsselbloem.

Though he may be disliked at the moment, Dijsselbloem’s comments were both wise and prudent – even if they were as unintentional as he’s now claiming.

His comment that Cyprus would serve as a template likely irked many investors and bankers because it added uncertainty and risk back into the system. People were quick to assume that future rescues would cause bank runs. Though that fear is unfounded, the template comment could momentarily lower deposits, and will almost certainly reduce the risk premium investors assign to financial earnings on investments, especially on banks. This will result in higher bond yields and lower equity prices, and could perhaps become a major turning point in stocks should the valuations shift enough.

So how were his comments wise and prudent?

Though I agree that scaring depositors doesn’t seem like the responsible course of action, his template comment was blown way out of proportion. There won’t be a bank run because seizing uninsured deposits (what happened in Cyprus) is the very last resort.

Depositors in Italy, Spain, Greece, etc., do not need to withdraw their funds tomorrow because if the bank is in trouble and can’t recapitalize itself, shareholders and bondholders will be the first to contribute. This will mark a change from the past, when bondholders rarely lost much, if any, of the initial investment. Depositors will be the last, and least likely, contributors. So a run on banks, which is investors’ primary worry, is unlikely to occur.

With a short-term run on EU banks ruled out, many investors may point out the decline of banks’ share prices or rise in 10-year government yields as reasons why Dijsselbloem’s comments were silly. However, these investors are focusing on the wrong Dijsselbloem commentary.

Financial Times correspondent Peter Spiegel published more comments from the interview with Dijsselbloem. This excerpt indicates that Dijsselbloem believes that worried investors will make the financial system healthier. I agree.

Dijsselbloem said, “If I finance a bank and I know if the bank will get in trouble, I will be hit and I will lose money, I will put a price on that.” He continued with, “I think it is a sound economic principle. And having cheap money because the risk will be covered by the government, and I will always get my money back, is not leading to the right decisions in the financial sector.”

This is an important step for the EU to take. Though access to money will remain easy and inexpensive, leadership is putting their foot down and saying that concessions going forward will be tougher on everyone in rescue situations. This is good news, although I’ll admit it initially appears bad.

Investors have to get used to accepting risk. Bailouts and rescues have been commonplace during the past five years. Though I won’t remark on the bailouts themselves, their prevalence has built a perception in the investor community that taxpayers – via government rescues – will pick up the tab in emergencies.

It seems that Dijsselbloem is saying taxpayers won’t be so quick to save banks in the future, at least without considerable penalties. This is a necessary step – albeit a painful stride – to make.

A main cause of the financial crisis was poor risk management. Investors weren’t collecting enough premium for being on the hook for credit default swap contracts. And when financial institutions went under, no one but the government was solvent enough to pay as bills were racked up.

We’re seeing similar mis-pricings in the bond market, and it could lead to another solvency dilemma. The IMF predicts Italy’s GDP growth will be -1% this year and 0.5% next year. Its debt-to-GDP ratio is 126%. Meanwhile, unemployment in Italy hit a 22-year high of 11.7%. Does anyone really believe this is a financially healthy nation?

Bondholders seem to. The rate on Italian 10-year bonds is 4.5% and near a five-year low. That’s a premium of only 2% compared to Germany and U.S. 10-year yields, too.

Italy’s economy has slowly deteriorated and 34 of its bank’s credit ratings were downgraded during the past year. Yet the 10-year yield is down to 4.5% from 7% in January 2012 and the FTSE Italia Banks Index had doubled from a July low before retreating this January.

Investors are overpaying because risk has left the system. This could cause a repeat of the corporate credit crisis we saw five years ago. And it’s imperative that doesn’t happen again.

Large investors needed a reminder that someone (the taxpayer) remains at risk. Institutions needed a reality check. I believe that’s what they got from Jeroen Dijsselbloem. Next week we’ll continue this debate (feel free to add your comments), and I’ll also explain how Ben Bernanke is taxing your deposits right now.

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