A European Banking Disaster Is Inevitable

 |  Includes: FXE
by: James Wood

This article describes existing conditions in Europe that make inevitable a collapse in significant parts of the European banking system. In turn, this will lead to dramatic negative effects on world stock markets and international banking for several years.

The majority opinion is that this is simply not possible. Most people are convinced that some European government authority will step forward, much as the Fed did in 2008, to stop the problem. This article explains why this is very unlikely now and what is the most probable scenario for the next several years.

First we must deal with the conviction of most people that this European banking collapse is impossible. For over 30 years, our governments have bailed out the Western world economies by simply printing money and the Fed and Central banks lending at low rates. Most people’s gut reaction is that this will work once again and no rational government authority could let a collapse happen by not taking action at the moment of truth. We need to look dispassionately at the facts. There are sound reasons why it will not work this time and it is unlikely to even be tried in Europe.

To understand this problem, let´s look briefly at the 2002 to 2008 US experience of sub prime mortgage bonds. What is relevant here is that people had clear explanations why the subprime mortgage bonds would collapse in value. However, until it was too late, the vast majority of people either did not want to believe it or those who knew were making so much money that they did not want to admit it. I encourage you to read Michael Lewis' "The Big Short." The vast majority of people erroneously thought that housing prices could not decline. People did not understand how the rating agencies said something was triple A but was in fact junk. Almost no one read the prospectuses, and less they understood how credit was rated on borrowers. Many housing borrowers without means were given housing loans. Today this is all clear. If we had continued the lending practices and Fed policies generally used up to about 1980, the problem would not have happened. But before it exploded, the vast majority of people could not believe the system was at risk. We have a similar case now with the European banking situation. Looking dispassionately at the facts will make it clear that there is no practical solution other than a dramatic failure of large parts of the European banking system thereby causing years of decline of the financial and stock markets as well as the European countries’ economic development.

Let´s summarize the European problem. First, there is a well publicized liquidity problem and probable solvency problem of the Southern European countries. It is generally accepted that the Southern countries cannot solve their sovereign debt problems in the short term by themselves. What is less understood is that we are going to have major liquidity issues in the European banks and this will turn out to be the most immediate problem. All of the southern European countries are on the verge of having unsolvable liquidity problems (i.e. They do not have the money to carry on their normal activities and pay all their obligations when they come due). The Southern European banks are on the verge of liquidity problems that will soon become solvency problems. The immediate trigger of the collapse will be recognition by the financial markets that the southern European banks do not have the money to pay their obligations. At that moment, no one or no government will effectively be able to deal with the panic of good banks trying to get out of the bad banks before it is too late.

We have a superb example of this in MF Global (OTC:MFGLQ), led by Jon Corzine. Corzine is a former leader of Goldman Sachs, a former US governor and US Senator. Corzine suffered from an outsized ego that led him to want to “get back into the big time”. The tragic result was he bought Southern European government bonds for his brokerage operation, MF Global. When the markets realized the MF Global would have to take losses on the bond investments exceeding its capital, they cut the credit lines to Global. It was only a matter of days between having a liquidity problem (not being able to fund the loan portfolio) to being bankrupt. US clients of MF Global now find there is $1.2 billion of their money missing from Global segregated brokerage accounts that legally had to be separated from the Global company accounts.

The MF Global case will now be repeated many times over with banks in the Southern European countries and will spread to the Northern European countries. We now look at the chain of events that will make this play out this way. In practice, there will be a tremendous pressure at the sovereign level because several Southern European nations do not have the ability to pay the interest and principal on their loans.

At a sovereign level, the problem of the US and Southern Europe are very similar. There is too much debt, a rapidly growing fiscal deficit and a lack of political consensus on how to deal effectively with the problem. But Southern Europe is much worse with no printing press, and a much worse labor problem making political consensus on what to do harder to deal with. Greece and Portugal cannot meet their sovereign debt obligations without someone else picking up the bill. Spain and Italy could soon be there, particularly if borrowing costs for sovereign debts continue in the 7% to 8% range or even higher.

Those of us who have dealt with the Latin America sovereign debt issues over the last decades know sovereign debt issues can drag on unresolved for years. But commercial bank issues can and will explode independently of the sovereign issues. It is the commercial banks that will probably be the real tipping point into the explosive consequences. Generally speaking the press has not picked up much of this. MF Global seems to be treated as an isolated case, but it is merely first of many liquidity and solvency bank problems to come, probably very soon.

Four interrelated issues make the commercial bank and other private financial companies’ problems what is so immediate and explosive: 1) customer withdrawals of their deposits in their national banks; 2) lenders’ unwillingness to make loans to other banks perceived to have problems; 3) bank’s inability to raise significant new amounts of capital; and 4) the unwillingness of the citizens of the country with problems to accept the sacrifice that is required to put country accounts into order. The problems with European unions will be a particularly critical factor in preventing viable solutions to the sovereign debt imbalances, which in turns leads to the crisis for the commercial banks.

Customer withdrawal of their deposits in their national banks. You are a Greek citizen or company with all your savings in a Greek bank. You are afraid maybe Greece will leave the eurozone and your euros will be converted into drachmas (the former Greek currency) with only half the value of the euro. What do you do? You get your money out into a safe place where your principal value is protected. Currency flight is as old as prostitution. This has already begun and we are starting to hear about large amounts of currency flows. All of the Southern European countries are affected. When you lose a significant portion of your deposit base, a bank liquidity crisis is nearby, and insolvency comes shortly if the liquidity problem is not quickly solved. When (not if) the losses begin in the Northern European banks on the Southern European countries' unpaid loans, this can well lead to a lack of confidence in the Northern European banks resulting first in liquidity problems and then the risk of insolvency. We have a prime example in Dexia, the Belgium bank, where this problem has already occurred and the Belgium and French governments had to bail it out a few months ago. While Northern European governments can still bail out their banks, the Southern European countries cannot practically bail out their banks. This fact about the Southern European banks is a critical determinant of the coming banking collapse.

Lenders’ unwillingness to make loans to other banks perceived to have problems. Where there is the slightest doubt, banks are refusing to make new loans and demanding repayment of outstanding loans from many Southern European banks. No bank, in today’s environment, wants to risk having bad loans with another financial institution. Short-term dollar loans by US non-bank financial institutions to European banks, both north and south, have essentially dried up and ceased to exist. As soon as a press release comes out saying a bank has exposure in Southern European countries, the publicity puts the bank under pressure to cancel those loans. One example of the last week is the Jefferies case where rumors where put out that it might go bankrupt like MF Global. The bad publicity has forced Jefferies to reduce exposure to Europe. Likewise coming stress tests in the US and Europe are forcing banks to cut exposure. This reduction in ability of the recipient banks to have money to lend means they inevitably shrink their loan portfolios. Reduced lending lessens business activity, which lessens the ability to create jobs and expand the economy. A European contraction is now under way as each bank lends less and thereby makes the European economy smaller and more vulnerable to default.

Bank inability to raise significant new amounts of capital. Investors do not want to invest in a bank that needs money. Forced capital increases lowers existing share owner per share value and tends to be very expensive at times of crisis. We now have a shrinking deposit base, a shrinking borrowing base and limited ability to raise capital. A smaller European banking system means a smaller European economy. Per capita income will be going down. Jobs will be going down. Government income taxes from business and individuals will now be going down.

The unwillingness of the citizens of problem countries to accept the sacrifice that is required to put country accounts into order. The citizens of the Southern countries, and in particular the unions, simply are not willing to give up the social and economic gains they have had during the last 30 to 50 years. They cannot deal with the fact the inflated salaries and onerous work rules in their country have made their country uncompetitive in world markets. Lower income is a necessary cost to putting the country accounts in order. In a recent article, I explain that most of these people will prefer to withdraw from the European Monetary Union and take devaluation of their money before taking straightforward reductions in income (increased taxes, lower benefits, etc.). It is not the case that leaving the euro is better. But for most non-economists, devaluation appears less painful. For citizens, particularly unions, denying needed economic reform it is conceivably the most important of the four points. Democratic rejection of reform is rarely discussed as a critical determinant of whether essential reform can really be done in the Southern European countries.

In summary, there are four powerful reasons why there will be no ECB bonds or guarantees to solve the current European bank problems. The problem will progress from the Southern European banks to the Northern European banks.

Let’s now deal with the issue that many think the European Central Bank or the IMF is going to guarantee all the bonds necessary. This plan means covering all the Southern European financial needs, including Italy, Spain, Portugal, Greece and Ireland because their borrowing costs are too high to be sustainable. I list below the three fundamental reasons why neither the ECB nor the IMF will guarantee all of the Southern European obligations at this time.

  1. Angela Merkel and the people of Germany are clear that the Southern European nations will never put their economic house in order if Germany agrees to pay (which is what guaranteeing means) all their unpaid loans. The southern countries do not have short-term financial problems. They have profound structural problems. There is no assurance these countries will, in the moment of truth, be willing to put their economic houses in order. The citizens of these countries are more likely to vote to leave the eurozone than face the structural reform necessary to be able to pay the debts they have. The IMF will almost certainly take the same decision not to guarantee until there is first proven structural reform.
  2. Structural reforms will take at least two years before one can see if a country is sincere about reform. For this reason, Angela Merkel is proposing reforms, but there will be no German guarantees for a couple of years to first see if the countries promising reform are serious. The current problems of the banks will explode long before a two-year waiting period.
  3. One alternative is Germany may propose changes in the European Union governance whereby it de facto controls the internal political decisions of the southern countries. These changes might permit Germany to trust the necessary reforms will be carried out in the southern countries. It is highly unlikely the southern countries will approve such a loss of self-determination.

The ECB mission is to keep inflation in check. What happens if the ECB surprises us and directly or indirectly funds the southern European nations? For the reason stated above, I view this as simply not practical. But if the ECB did fund or guarantee the southern countries, it will fall apart in one to two years. The European countries, and in particular Germany, will be in a much worse position. Then these countries will have to face the same issues outlined above, plus considerable new debt, and we will have the same European banking collapse.

Summarizing, most people intuitively think there is a solution to the European financial problems that involves someone signing some guarantees and we go happily on. However, this simply does not work. The financial system is already downsizing. The European economy is contracting and there will inevitably be major bankruptcies, particularly in the banking system, in every European country before we finish this economic downturn over the next five years or so.

Disclosure: I am long SKF.