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Right now, the entire world is in denial about the trouble that European banks are in. The situation is a replay of 2007 and 2008 when the extent of eventual write-downs from sub-prime mortgages in the US was known and specialists knew that in the event of such write-downs, US banks would be potentially bankrupt and the entire financial world could be thrown into crisis.

Today, European banks are in considerably worse shape than their US counterparts were in 2008. And the consequences of a European bank crisis for the global financial and economic systems could be just as severe and even more so than they were when the US financial system experienced its crisis in 2008-2009.

The State of European Banks

First, the capitalization levels of European banks are much lower than they were in the US and the potential write-downs are at least as severe. As can be seen in the table below, the tangible common equity to assets (TCE) ratio is less than 3.0% for most of the largest European banks, including Barclays (BCS), Deutsche Bank (DB) and Credit Suisse (CS).

European Bank Equity Capitalization

For all intents and purposes, European banks face a serious threat of bankruptcy, since write-downs on total assets are ultimately quite likely to exceed the value of common equity capital – perhaps by a very substantial amount.

It is important to clarify that operating with negative net worth is not a problem in and of itself for banks. As long as they have access to sufficient funding via deposits and central bank facilities, banks can operate with negative equity on a marked-to-market basis and still have value to equity shareholders. That is because bank profitability normally exceeds the cost of capital. For this reason, the intrinsic value of a bank generally exceeds its book value and is reflected in normalized P/BV ratios that typically exceed 1.0x.

The problem is that there is a very serious possibility that the eventual write-downs that European banks face could be so severe that the banks have negative net present value to equity shareholders. In other words, all of the projected future profitability of the current banking franchise (into perpetuity) discounted to the present may not exceed the value of the writedowns that the banks may have to make on their assets. In this event, equity shareholders would face a total loss and the banks would likely have to be taken into receivership by the state and restructured.

European banks face two main potential sources of losses that could wipe out all equity value:

1. Sovereign bonds. Less than one month ago, Dexia had passed the Euroopean “stress test” with flying colors and could brag that it was one of the “best capitalized” banks in Europe. Today, Dexia is on the verge of insolvency merely due to its exposure to the sovereign debt of a country as tiny and relatively insignificant as Greece. Reflect on this for a moment. If one of the “best capitalized” banks in Europe is on the verge of bankruptcy due to its exposure to Greek sovereign debt, what happens to the other European banks if the sovereign debt of Portugal, Ireland, Spain or Italy – exposures that are many magnitudes larger -- have to be written down to any substantial degree? The answer is clear – general insolvency.

2. Real estate bust. Real estate in Europe is way more overvalued than it was in the US at the height of the US property bubble. The trouble is, nobody has even begun to talk about the massive write-downs that European banks are going to have to take on their mortgage portfolios and their loans to property developers. Until now, property values in countries such as Spain have held remarkably steady at bubble levels – in large measure due to aggressive policies by banks designed to prevent foreclosures. However, this could change at any moment, and a melt-down could begin, particularly if European economies begin to contract.

There are several important consequences that could flow from a general insolvency crisis amongst European banks.

  • Importance of European Banks to Europe’s economies. Bank assets as a percent of the GDP of European countries are magnitudes higher than they were at their peak in the US. Furthermore, finance represents a much larger percentage of GDP in Europe than it ever did in the US. Thus, banking sector troubles could cause greater damage to European economies than they did to the US economy.
  • Importance of European Banks to Europe’s equity markets. European banks generally constitute a larger portion of European equity indices than was the case with US banks in 2008. Thus, the effect of a major decline or even bankruptcy in European banks on European equity markets could be even more dramatic than in the US.
  • Credit contraction and economic depression. A banking crisis would cause an immediate and deep contraction of credit to European businesses and households. The result of the concomitant liquidity crisis would be general economic collapse and depression throughout the European continent.
  • Spiraling sovereign debt crisis. Collapsing tax revenues and the cost associated with bank rescues would provoke either general sovereign defaults, a chaotic break-up of the EU and/or a massive inflation engineered by the ECB.

Dexia As Europe’s Bear Stearns

Dexia is Europe’s Bear Stearns. Right now, European officials seem more in denial than US officials were leading up to and immediately after the Bear Stearns crisis.

In 2008, US officials were publicly fretting about theoretical future risks such as “moral hazard” rather than focusing on the proximate problem, which was no less than an imminent collapse of the financial and economic system. Today, the dithering and penny-pinching of European leaders is even more pronounced.

As I stated in a recent article, European leaders seem to be “whistling past the graveyard,” hoping that some miracle will occur that will enable them to avoid taking drastic and expensive action to contain the evolving crisis.

Unfortunately, there is no alternative to drastic and costly action to save the European financial system and prevent the collapse of Europe’s economies – and perhaps the entire EU system. If dramatic and decisive actions are not taken within the next month, I believe that Europe will face a “Lehman Moment.” At that point, there may be no turning back for Europe.

What actions must be taken? Contrary to the approach currently favored by European officials, the most urgent need is not intervention to capitalize the banking system; it is to place a credible backstop on the sovereign debt of European countries. <

As Josef Ackermann, the CEO of Deutsche Bank has said,

It is not the capital funding of banks that is the problem, but rather the fact that government bonds have lost their status as risk-free assets.

Banks can operate with low and even negative levels of equity capital. However, no amount of equity capitalization can withstand the fallout from sovereign defaults of several European states.

Thus, as I have stated previously, the default of all European nations with the possible exception of Greece must be “taken off the table” credibly through authorization of an unlimited commitment by the ECB to purchase and/or finance the purchase of European sovereign debt of member states when and if interest rates on European sovereign bonds exceeds predetermined levels.

Conclusion

Unfortunately, European leaders have shown no signs of rising to the challenges that face them. For this reason, while European leaders may succeed in jawboning global markets higher one or several more times as prices fall to critical support levels and nervous traders cover shorts, the prognosis for Europe and the global economy is quite bleak.

I believe that there is currently at least a 50% probability of a severe financial crisis in Europe triggered by a combination of skyrocketing sovereign bond yields and insolvencies on the part of systemically important European banks.

As a consequence, in addition to selling and/or shorting European banks, investors should steer clear of US financials such as Citgroup (C), Bank of America (BAC), Morgan Stanley (MS) and JP Morgan (JPM).

Source: Global Financial Disaster Looms: European Banks Face Bankruptcy