COLUMN-A costly but worthy Dutch treat: James Saft

Tue Feb 5, 2013 2:59pm EST

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

Feb 5 (Reuters) - The Netherlands' nationalization of bank SNS Reaal underlines the euro zone's weak spots while illustrating the dangers of its plans to address them.

In wiping out SNS shareholders and some bond holders the Dutch government is trying to do the right thing, can't quite bring itself to go that far, and may end up paying the price anyway.

The Netherlands last week seized control of SNS, its fourth-largest financial services firm, in a $14 billion rescue, employing powers granted it under a new law passed last year. While senior bondholders and depositors were sheltered, the stakes of equity holders and subordinated bondholders were effectively expropriated.

SNS, which had already received one state bailout, was struggling under the weight of a large book of bad real estate loans and was suffering strong outflows of deposits thanks to worried savers.

First off, the news demonstrates that Europe's banking problems are far from over. Though optimists might argue that the bad loans SNS was on the hook for were already well known, the fact remains that the banking system across the euro zone and beyond is still struggling under the weight of bad lending decisions made before the crisis hit.

Secondly, SNS shows that taxpayers are going to continue to foot a hefty bill. The Dutch government's share of the bailout is nearly $5 billion, poking a sizable hole in the country's budget plans. That could have been higher, but for a $1.35 billion levy to be extracted from other Dutch banks in 2014 to help meet the cost of the bailout, as well as the forced contribution of investors.

The farthest-reaching implications of the nationalization may come from the Netherlands' decision to put subordinated bondholders on the hook for what will almost certainly be a complete wipeout of their investment. This has already started to ramp up what banks in the euro zone must pay to borrow money.

The bank bailouts at the height of the crisis spiked widespread, and justified, revulsion among taxpayers, who resented shelling out while investors who took foolish risks emerged largely unscathed. The Dutch Intervention Act, passed in 2012, was an attempt to rectify that, giving the government more wide-reaching powers and options for dealing with ailing banks.

In fact Jeroen Dijsselbloem, Minister of Finance, considered including senior bondholders in the expropriation, but blanched at how such a move would be received by financial markets.

"Theoretically, even more creditors of SNS REAAL and SNS Bank might have been expropriated, that is, creditors on an equal footing with depositors: the ordinary creditors," he said in a letter to parliament explaining the move.

"This includes uncovered bank bonds, also known as 'senior bonds'. This option was dropped, however, because of expected adverse effects on financial stability."

In other words, had the Netherlands made senior bondholders pay, other investors would have fled the bonds of other banks, potentially forcing some to their knees. That Dijsselbloem is the newly minted head of the Eurogroup of finance minister, and as such will play a key role in the debate over banking regulation, makes the move that much more significant.

SENIOR BONDS UNSCATHED

Addressing the moral hazard issues embedded in the global banking system is an important and worthy thing to do: it is also going to be expensive. When bank investors believe they will get the upside and the public will pick up the losses, they, and the banks they lend to, will ramp up risk recklessly.

On the other hand, when you condition investors to believe in their special status and then start to remove it, they get cranky. This can most clearly be seen in the performance of the bonds of European banks, which has been pretty poor for the past month, particularly since the SNS affair was announced. That's particularly true for subordinated bonds, but the higher funding costs have also bled over into senior debt.

This is one of those times when fixing the problem involves unavoidable near-term pain. Investors need to be taught that they will share in the losses, as well as gains, which their funds generate. As this sinks in, this will cause the cost of capital, debt and equity, for banks to rise, leaving them less able than they already are to make loans and otherwise play their economic role.

That's not what the euro zone economy needs right now, but the alternative, a system in which taxpayers insure private risk taking, is even less acceptable.

The Netherlands, in punishing some bond holders and sparing others, tried to steer a middle course, establishing the principle but hoping not to scare investors.

Investors, to judge by the bond markets, are figuring this out anyway. Expect bank financing costs in the euro zone to rise.

If this happens little by little, it will be a success.

If it happens all of a sudden, watch out. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)

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