Europe's Problems Are Not Over: Proceed With Caution

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Wow, what a run. The S&P 500 has rallied over 11% from its lows, in just 5 trading days. News that European Central Banks and governments there will do anything and everything to recapitalize their banks has calmed markets, sending risk assets upward in violent fashion. But, two things to note here. 1) Simply put, this kind of volatility isn’t usually associated with bull markets, and 2) the Europeans’ promises to recap their banks is short on details, and in all proposed deals, is likely not enough to fix the sovereign debt problems there (barring default). Here is why.

US Banks Recapped in 2008

First let’s back up to what happened in the US in 2008. After the mortgage and subprime meltdown, the US banking system essentially became insolvent. Losses on mortgages in the $1-2 Trillion dollar neighborhood sent all banks to the brink, and only ultralow Fed Funds rates, the myriad of lending programs (in effect bank subsidies), plus huge cash injections from the US Treasury (via TARP) prevented panic from leading to a full blown financial meltdown. Lehman and Bear Stearns disappeared, gobbled up by Chapter 11 and JP Morgan respectively, but other firms were spared by massive US government intervention.

What is most important to note about the US however, is that not only were banks recapitalized by the Fed and the Treasury, but losses were also recognized. Banks also stopped funding risky mortgages. Mortgage loans have been written off, bad debts expunged and loss reserves bolstered. While sometimes this didn’t happen as quickly as it should have, defaults and delinquencies have led to big loss reserves taken by US banks against their loan books. Finally, the US government’s balance sheet also at the time was big enough to deal with even $2TT in losses. US GDP is $15TT; it was feasible to shift debt from the banking sector to the taxpayer and spare financial ruin.

European Banks Status

Europe though faces a different sort of problem. Namely, how do you shift private sector banking losses to European government balance sheets, when the governments themselves are teetering on the edge insolvency? It is not mortgage debt that banks can write off over time. It is billions of Euro’s of sovereign debt that are the problem assets in the European banking system. According to the European Banking Authority, Europe’s 90 biggest banks hold €326BB of Italian debt, 287BB of Spanish debt, and 90BB of Greek debt. That is over 700BB of problem debt just among these 3 (insolvent or near-insolvent) countries.

Now here is the crux of the problem. According to Credit Suisse, European banks have approximately 811BB of tangible capital against this debt. At the same time European banks also still hold €397BB of subprime mortgage debt. Not only do they have piles of terrible US mortgage debt still, but also €700BB of bad sovereign debt. If all of this eventually recovers an optimistic 50 cents on the dollar, then €500-600BB of losses clearly would wipe out 60-75% of European bank capital. Add in other PIIGS debt plus Belgium and it becomes potentially 100% of their tangible equity capital.

Backstopping bad European sovereign debt with several insolvent European government’s balance sheets is simply not feasible. The only real solution here to curing this sick patient is taking write-downs on this debt, letting the weak governments restructure (ie default), and moving forward. Note that this has to happen eventually. It’s just a matter of when. Insolvent debtors do not become solvent when debts are this high.

What Will Probably Happen

The enlarged €780BB European Financial Stability Facility (EFSF) will eventually get passed I believe. The Slovakians rejected the expansion of the EFSF yesterday but will likely come around in a few days time. They are the last of the 17 EU nations to vote on the enhanced EFSF and pressure to pass this will force their hand. What I think is telling is the table below, illustrating the guarantee amounts by the various PIIGS plus Belgium, the fiscal criminals so to speak in Europe.

EFSF Enlargement


€ 15

€ 27


€ 12

€ 22


€ 7

€ 12


€ 79

€ 139


€ 11

€ 20


€ 52

€ 93

€ 177

€ 313





€ 440

€ 780

How do you get funding from Greece and Italy when they have neither the capital to fund nor the ability to guarantee these amounts? Don’t forget too, that the EFSF has already used 250BB of its guarantees bailing out Greece, Ireland and Portugal. So an enlarged facility would amount to additional capacity of only 530BB.

On Wednesday, European Commissioner Jose Barroso said he’ll present ideas for recapitalizing European banks. There is a summit meeting scheduled for October 23rd, and the markets are now expecting details. However, given what I see as worthless IOUs from weak countires, the only plan I see coming is the monetization of debt via printing massive amounts of Euro’s.

Germany & France

Supposedly Angela Merkel and Nicholas Sarkozy have also agreed on a plan to recap European banks. Fiscal unity seems unlikely, but perhaps Angela has come around to issuing Eurobonds. Or perhaps they will propose using EFSF funds to recap banks, as well as letting the EFSF borrow from the ECB. If the ECB prints Euro’s to lend to the EFSF, then we are talking monetization and almost unlimited reserves. Germany is against this maneuver, but again, given the alternative, perhaps they will come around.

Also, I am not sure how €530BB of additional facility capacity can solve both the problems with banks, and the deficits that need funding. The banking losses I outline above, €500-600 would eat up the rest of the EFSF’s capacity. But if the PIIGS & Belgium run deficits expected to be €150 every single year, then in another year Europe is back at square one. An enlarged EFSF will need to be replenished and more deficits will make debt ratios that much worse. Where does the money come from, and when does this charade end?

Finally, levering the EFSF also seems implausible to me. The EFSF has to have a AAA rating. How does borrowing money against guarantees that are 40% worthless really work? Isn’t this the kind of financial engineering what got the world into this mess? This entire process seems likely to me to lead to just a bigger mess down the road to deal with.

As far as the markets go, I fully expect that a Slovakian thumbs up to the enhanced EFSF will move equities higher. Maybe an agreement with the ECB to lend to the EFSF will enable Europeans to kick this can into mid 2012, and create another run up in stocks. As Peter Tchir of TF Market Advisors aptly penned recently,

“Remember, nothing, not a single thing [proposed] does anything to address that people and banks and countries borrowed more than they can pay back, and people lent to them on terms making it difficult to extract any value if they don't pay the debt back.”

Meantime I am keeping exposure light, adding to my gold (and oil) stash, and looking to short the Euro against further rallies. I suggest shorting German bunds too. Ultimately their balance sheet will be used to bail out their weaker neighbors, and has to lead to pressure there. German Debt to GDP is over 80% (according to Eurostat), its commitment to the enlarged EFSF is €210BB, and German 10 year bonds are yielding a meager 2.1%. Good luck.

Disclosure: I am short SPY.

Additional disclosure: Short Euros, Long gold.