A Brief History Of The Financial Crisis: Avoid European Financials

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It would be comical if it wasn't so sad (all those wrecked hopes and lives). All that money being pumped around, and around, and then around again...

Here is basically what happened since the financial crisis began:

1) Money from tax-payers and central banks to banks
Banks (and shadowbanks) overleveraged and made bad bets. Bets went wrong, banks had to be bailed out, or otherwise the whole financial system would have come down.

To stave-off a 1930s style depression, governments and central banks alike opened the floodgates, Talf, TARP, QE1, QE2, operation twist, whatever it was called you can be sure of one thing, a bank near you was getting funded.

2) Money from banks to governments
Banks, infused by central bank and tax money, invested in government bonds, largely because households were paying off debts rather than taking on new ones and corporations had plenty of cash but little reason to expand production capacity because of the plight households.

So, much of the money went to government bonds, which suited everybody. Banks because it gave them a nice, supposedly safe, spread over base money, governments because it kept their financing costs low in a time when deficits were ballooning.

The details might differ, but until here, the stories of the US and the euro area are reasonably similar.

3) Money from central banks to banks and back again, sort off.
Much of the aid of central banks to the banking system actually never left. It was kept at the accounts banks have at their central bank as part of bank reserves. These ballooned.

Then, in the euro area, they did something stupid. They started talking about the possibility of a Greek default, and then implemented it in the form of a (roughly) 21% 'haircut' in the summer. This single policy blunder escalated the euro crisis. Suddenly people woke up to the fact that bonds from countries that can't print their own money are inherently less safe compared to bonds from countries that can.

Hence, bond yields of the weakest of these countries started to rise, which is why countries like Italy and Spain pay a whopping 3x the interest rates on 10 year debt compared to Britain and the US while their public finance situation is comparable if not actually somewhat better.

4) Money from Central Banks to banks
One effect was to create problems for Spain and Italy to roll-over their debt (and finance their deficits) at rates that would not escalate their public finance situation. By lack of alternatives, enter the ECB, starting to buy up their debt in the secondary market.

5) Money from banks to central banks and back again
Since most sovereign debt from countries in trouble is held by the banks in those countries, these are in the firing line. Depositors and investors alike are running and the resulting capital flight is serious.

In Ireland the two leading banks lost €65 billion in deposits from the end of 2008 to the end of 2010—equal to 52 percent of Irish gross national product. Similar deposit losses have occurred in Greece. As bond yields rise, the local banks tend to buy, because their futures are inextricably tied to the survival of their sovereign. Foreign institutions tend to sell bonds back to the local banks of the government that issued them. Finally, corporations and households tend to save outside their local banks, and foreign bank branches tend to reduce the size of their balance sheets in troubled nations. All these transactions generate capital outflows [Boone and Johnson]

Indeed. And where does it go? Well, mostly to banks in perceived safe countries, Germany, Luxemburg, the Netherlands, Finland, see figure below.

What do these banks do with it? Well, they mostly park it at... the ECB.

6) Money from central banks to banks
To counterbalance this capital flight, and the general uncertainty as banks are reluctant to lend to one another via money markets, the ECB provides unlimited liquidity and even longer-term loans to these banks suffering from capital flight and mistrust.

Those one-year loans are especially interesting as there is no word on whether these will be rolled over or have to be paid back (with interest) at the end of the year. So what do banks do with it? Here is Felix Salmon:

So the banks borrowing this money are unlikely to turn around and lend it to small businesses on a five-year term, or otherwise use it to increase lending and boost the real economy. Instead, they’re much more likely to invest it in bonds which carry a decent yield, especially from Spain and Italy. Because those bonds yield somewhere between 2.3% and 4.4% — significantly more than the cost of the ECB funds — the banks should be able to take their ECB money, invest it in short-dated Spanish and Italian debt, and get a comfortable yield pickup along the way. For instance, suppose you buy an Italian bond yielding 3.9% which matures in December 2012, while borrowing money from the ECB at 1%. Put €1 billion into that trade, and you make a profit of €29 million.

So we're back to money from banks to governments. The ECB is happy as it helps keep these rates low. Until they don't.

Avoid European financials
There will be a whole lot more money from governments and central banks to banks. There will have to be, because the alternative is so much worse. But whether this will be able stem the underlying decay remains very much to be seen.

Many banks will be forced to recapitalize, either by themselves, or by governments, or even with the help of the EFSF (if the Slovaks play ball later today and vote yes to the reform proposals).

We don't think this will be done on attractive terms. Merkel is in charge here, and she has always insisted on considerable private investment sharing of the burden. The German tax payer can only do so much..

So European bank stocks are not going to thrive, more Dexia's will almost certainly follow, and we can only hope enough will be done to keep it all together.

We would stay away from European banks, apart perhaps from the best capitalized and least exposed to sovereign risks, but it's not easy to see which ones these are. Dexia passed the stress test with flying colours. So better to stay away at all.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.