Clouds On The European Horizon?

Includes: ERO, FXE
by: John M. Mason

The environment in Europe has been relatively placid over the past year or so. To me, the greatest evidence of this peace has been the flow of risk-averse money out of the American financial markets and the return of these funds to Europe.

This flow of funds, I have argued, has been the cause of the recent rise in longer-term United States Treasury issued. Although I have written quite a few posts on this issue, the most recent one appeared earlier this month when I asked the question " Are Treasury Bonds Peaking for Now?"

Whether or not this flow of money continues depends, to a very large extent, on the continued calm of the European financial markets. The calm in the European financial markets depends primarily, I have argued, on three things: first, the cleaning up of the European banks; second, on the unification of the banking system in Europe; and third, the fiscal unification of the members of the European Community.

Wolfgang Münchau of the Financial Times points to the troublesome situation in Italy and one of the prime reasons why the fiscal union may be very difficult to achieve. The collapse of the coalition of Enrico Letta, the Italian Prime Minister has created difficulties both now and in the future for the Italian economy to rebound and for the Italian fiscal situation to improve substantially so as to permit Italy into such a fiscal unification.

Münchau argues that Italy can neither get its economy sufficiently in order so as to achieve the productivity growth it needs to compete in a modern European society, nor get its debt position in order so that a fiscal union can become possible. But, Italy is not alone in its shortfall.

The second issue, and the one that Münchau argues is "the single largest constraint on the resumption of eurozone growth" and on the European banking union, is "the continued failure to clean up the banks."

A banking union would help, he continues, "but only if it were to break the relationship between banks and sovereigns and clean up balance sheets."

This is not going to happen, however, because the effort to "clean up balance sheets" will require billion and billions of euros to provide capital to fill up the hole that would be left by writing off the bad assets of the eurozone banks.

And, the bad assets still remaining on the books of European banks far exceed the problem that still remain in the banking system of the United States.

In essence, bad assets still remain on the books of commercial banks that are still open in both the United States and in Europe. I have continually referred to this problem such as my recent posts titled Many Smaller Banks Still a Question Mark and The Federal Reserve Won't Taper: Commercial Banks in Worse Shape than Thought. The Wall Street Journal has supported this claim on September 30, "Staying Alive: Weak Banks Hang On."

The depth of the situation in Europe is greater and the magnitude of the capital infusion needed is substantially larger. For example, a New York Times article states "European banks have a stock market value of only 70 percent of what their assets alone are worth, according to central bank figures."

Furthermore, "the European Banking Authority estimated last week that the biggest banks in the European Union will need about 70 billion euros in capital to meet new regulatory requirements. Other estimates are even higher."

Münchau argues "Would it not be irresponsible to admit that banks need several hundred billion euros in new capital when threat money is simply not there?"

The reason that this number has gotten so large is that no one has dealt with the problem…any possible solution to the situation has just gotten postponed.

In the New York Times article we read that "zombie banks are a plague on the economy." Zombie banks are banks that appear to be alive…but are really dead.

"To avoid having to book losses from bad loans and be exposed as insolvent, zombie banks continue lending to keep deadbeat borrowers afloat, rather than putting money into healthy businesses."

In my post, mentioned above, about "Many Smaller Banks Still a Question Mark," the issue is raised that something similar is going on relative to the commercial real estate portfolios of these banks.

As a step toward the unification of the European banking system, it is expected that the European Central Bank will be given responsibility for greater supervision of European banks in October. This authority will then be formally published in early November and will take effect a year later. In anticipation of taking on this authority the ECB gave already begun to look for a bank supervisory leader and will attempt to hire about 1,000 staff members during the coming year. But, this would only establish the ECB as an enforcer. It would not establish the complete banking union that so many people believe is necessary for the survival of the euro.

And, this does not fully deal with the existing issue. And, there is a possibility that some in Europe…particularly Germany and perhaps the Netherlands and other of the prosperous European nations will not come up with the funds necessary to support such an operation. This could limit or bring down the whole effort.

Or, the effort could be supported by these nations but that then they might attach all sorts of strings to the structure so as to lessen or negate most of the strength of the union. There is deep political resistance to these ideas in many of the nations mentioned.

And, what happens if these attempts do not reach completion? Well, there are a lot of people that say it is premature for people to get "giddy" over the possibility that the tree needs of the eurozone mentioned above will be met. And, if this is so, then it is too early to really be euphoric over the financial stability that now exists and that monies planted in "safe havens" will return to Europe. In fact, if the problems in the banking sector are not resolved then another financial crisis could appear and the risk-averse money could, once again, leave the continent.

So, as Yogi Berra said, it is not over until it is over. The calm of the past year or so has been good and the flow of funds back to Europe has been healing. Let's hope that this scenario will continue. But, we have not crossed the finish line yet and a lot can happen between now and when the finish is reached. Until this, we must still be aware…and be able to act and respond to any disruption that might take place over the near term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.