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The problems in Europe have come to the forefront again and I believe will eventually negatively impact the U.S. economy and stock market much more that it has already. While it can't be forecast when this will occur, I believe it is more a question of when and not if.

Two rounds of ECB financing is just kicking the can down the road

The two rounds of funding provided by the European Central Bank (ECB) have temporarily reduced liquidity problems but have not done away with them. In addition, it has allowed Spanish and Italian banks to buy their government's debt. This raises red flags since if the countries' sovereign debt loses value, it would have a huge negative impact on the banks. And the banks then wouldn't be able to buy the next round of debt from their own country and therefore the countries' interest rates would meaningfully increase. Essentially countries are providing funds to banks for banks to buy debt from the countries. Eventually the music stops.

This is a video by John Clarke and Bryan Dawe that describes this situation as well as any article I have read.

The first round of the ECB's LTRO program was for 489 billion euros (about $636 billion) in December 2011 and was mainly used by banks in Greece, Ireland, Italy and Spain. The borrowing cost only 1% per year for three years. The second round was for 530 billion euros (about $689 billion) in February 2012 with 800 banks participating.

However the banks are running out of assets or collateral that the ECB will take for funding. It is possible that the ECB will increase the type of assets that the banks could use, but this of course would raise the risk to the ECB.

Compounding the challenges are:

  • Germany's PMI dropping to 49.6 (below 50 shows contraction) in the latest reading

  • Germany's Manufacturing PMI dropping to 45, near a three year low

  • France's PMI dropping to 44.7, a three year low

  • Germany and France account for about half of the eurozone's GDP

  • Unemployment in Spain and Greece is running around 25%

  • Youth unemployment in Spain and Greece is about 50%

  • China's PMI dropped to 48.7; the seventh consecutive month the reading has dropped

Greece leaving the euro

Without getting into a long dissertation on Greece leaving the euro, the talk has gone from 'it isn't going to happen' to rhetoric about contingency plans being made. Overall, I believe it would be a shock to the financial markets not due to the direct impact from Greece's leaving but due to the implications for other countries such as Spain, Portugal and Italy.

I believe one of the best indications that it could occur would be a run on Greece's banks as individuals and companies withdraw or transfer euros before a "Bank Holiday" is announced. The euros would be replaced with drachmas, which would be worth at best 75% or possibly under 50% of the euro's value in the frozen accounts. The Greek government would also be shut out of borrowing money for upwards to a decade.

Keep an eye out for a bank run

Given all the concerns there has been a decent outflow of cash, mainly in Greece but also other countries. The two charts below show the potential problems. The first depicts the percentage of deposits in Italy, Spain and Portugal that can be withdrawn at a moment's notice. Almost 1 trillion euros can be withdrawn at a moments notice in Italy, with smaller but still significant amounts in Spain and Portugal.

Also, a bank run can accelerate based on others withdrawing money and not due to a change in the financial position of the bank or country. Bank runs can take on a life of their own.

The second chart below has information only through March 2012 and shows the results of rational people reacting to the current situation. Note that this does not have April data when withdrawals in Greece accelerated.

Spain seems to be the next problem, and it would have a much worse effect than Greece

Spain is Europe's fifth largest country (after Germany, U.K., France, Italy) and is the twelfth largest economy in the world. Note that Greece is the 32nd largest economy in the world.

Even with the ECB programs, Spain's 10 year bond now has a 6.45% yield which is approaching the 7% levels that Greece and Italy have seen. Bankia (Spain's third or fourth largest bank depending on who is reporting) asked for a 19 billion euro ($24 billion) bailout last Friday and has essentially been nationalized.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

Source: Europe: Slow Train Wreck Or House Of Cards?