I have a new working hypothesis as to the first moving cause of the boom that led to bust of 2007-2008. It is the structure of the European banking system. Yes, the problem began in Europe, not the United States, and it is the same problem that caused the boom and bust in European housing and the European sovereign debt crisis. I will spell that out shortly. But first let me forecast that the ECB is on the case and is in the process of correcting that original problem, as well as providing liquidity to the banking sector and succor to the sovereign debt market. If the ECB is successful, it will rid the world of this economic scourge that has cost Europe and the U.S. so dearly. One can only hope that the American authorities will take similar actions to fix the American transmission mechanism that permitted the European problem to become an American one.
I recognize that is quite a mouthful of a lead paragraph. But I wanted readers to see how important it is to pay attention to the details of this article, even though it may seem technical at times.
The European Banks Did It
The "original sin" was the European countries implicitly guaranteeing all of the debts of their flagship banks. With that guarantee, the European banks were able to borrow money freely both in and outside of Europe-and both in euros and in dollars. Quite naturally, the more they borrowed, the more money they could make and the bigger their managers' paychecks and bonuses would be. And quite naturally, if you have the power to borrow, essentially without limit, you have to look for arbitrages for that borrowed money. And, as a consequence, you become "dumb money"-that is, money looking for a return without too much work.
There is a way that the European nations could have restrained the growth of their banks despite these incentives. That way would have been stringent capital requirements. But instead of making capital requirements more stringent, the European governments did the reverse: They adopted Basel II, which was a capital regime that was more lenient than the existing Basel I in that it enabled the large banks to game the system, effectively lowering their capital requirements very substantially, which permitted them, at the beginning of the 21st century, to grow quite quickly and to become the dumb money necessary to creating a series of international bubbles.
American Complicity
In Europe, it is easy to see that the ready availability of money led the banks to reduce their underwriting standards, and thereby to fuel the bubbles in housing in Spain, the U.K., Ireland, Iceland, and some other countries to lesser extents. To fuel the U.S. housing bubble, however, the European banks needed the complicity of American institutions, most notably the money market mutual funds (MMFs) and the investment banks, aided and abetted by the SEC. As we will see, the SEC played a key role in enabling the dollar funding to flow from America to Europe. And it was that dollar funding that, on the return trip, funded the U.S. housing bubble. (The SIVs set up by some European banks played similar roles, but with slightly different transmission mechanisms for the money to flow from the U.S to Europe.)
As the money flowed from the U.S. to Europe and back again, it got dumber and dumber, and that was what the U.S. investment banks needed in order to sell the horrible CDOs that they were creating out of the dead-on-arrival subprime loans that were all that an exhausted housing market could create after a decade of prosperity in the prime loan sector.
The SEC's two key roles were in permitting stable dollar pricing for MMFs, which had been in place since the 1970s, and in reducing the capital requirements applicable to investment banks. Dollar pricing for MMFs gives their investors a false sense of security. Thus, American money that is looking for a safe haven to earn a little bit of interest, invests in MMFs. They are convenient, and in the early 2000s, they paid a rate of return higher than American banks because they invested in the "riskless" paper of the European banks. It was riskless, of course, because of the implicit guarantees of the European sovereigns.
As a result of this transmission mechanism, the European banks were flush with dollars as well as euros. Those dollars had to come back to the U.S. in the form of investments. And the job of the U.S. investment banks is to create such dollar investments. And, moreover, the only market in the U.S. that is large enough to create investments on the scale demanded buy the European banks is the mortgage market. So now you see how logical it was that American institutions had to go so low down the scale of borrower capacity to repay: The American market was looking to provide product for the European banks that had borrowed so much from the American money markets based on their implicit sovereign guarantees.
It is, I hope I need hardly remind you, the boom that creates the bust. Thus it is the forces that created the boom that have to be mastered.
The New ECB
Another time I will spell out at greater length the way in which the same forces within Europe created the sovereign debt boom. Today I want to get ahead toward the ECB's program to address the fundamental problems.
The ECB's purchases of sovereign debt, interest rate reductions and bank liquidity actions have been grabbing the headlines. The unprecedented LTRO program under which banks can borrow for three years at low rates gets the most recent ink. These actions are easy marks for the pessimists because they, like all liquidity measures, are mere fingers in the dyke that push the real problems off into the future. But if we look closely, the ECB is, with the assistance of other key European institutions, taking important long-term steps to cure the original problem that led to the Great Recession and the European sovereign debt crisis.
First, the ECB is working hard to make certain that the new rules on European national budgets are meaningful. The ECB has been doing that for the last three months.
Second, the ECB is working to assist governments in Italy and elsewhere to reform their labor and business markets in ways that will make them freer and more capable of growth. The ECB has been doing that for many months.
Third, and perhaps most importantly, the ECB is working with the European Parliament to strengthen the Basel III capital requirements-and to build more stringent European and national capital requirements on top of them. (See this FT article and the Opinion of the European Central Bank dated January 25, 2012.) This is a fairly new thrust for the ECB.
The details of the new capital initiatives are important to specialists. But for most analysts and investors, it is enough to know that the capital requirements that the ECB is pushing and that the European Parliament is likely to adopt are sufficiently stringent that they will offset the European governments' guarantees of their banks' liabilities in the sense that the banks will no longer be able to grow without a proper basis in their capital accounts. That, by itself, will make European banking money much smarter. And it will restore European banks' ability to obtain liquidity for good projects on their own. The process of building the necessary capital will take a few years, but with the ECB's determination, the process is possible. And that is very good news indeed.
Consequences
When we get to the end of this complex tale of banks and bank capital, what should we see for the future? What we should see, if the European Parliament adopts what it has on the table, is a very good chance that the economic future will be brighter than most commentators have been predicting. And if that is correct, the stock market gains of the last few weeks are the beginning of a true bull market.
I recognize that each of the subjects I have discussed in this article is worth at least an article of its own, if not a PhD thesis. Many readers will not yet believe my assertions. I do not blame you. But just you wait . . . .
I believe this is the most important article I have written for Seeking Alpha.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
