Yesterday, the European countries announced an agreement to make loans directly to the needy European banks, without attributing the loans as debts of the country where the bank operates. In small print, it was noted this will only happen months down the road and with the agreement to have a European (read German) banking supervisor to control all the banks. The stock markets exploded upward yesterday, Thursday, and continue to day.
What is the truth? Loans by the European Union (say to Italy where the individual countries ultimately provide the funds) lends directly to the banks (say Spanish banks) and not the sovereign country (say Spain). This is not an improvement in credit terms. The credit has worsened. The Spanish banks are broke and do not have the ability to repay. For more details on this, see my recent article European Banks: The Problem is Solvency not Liquidity. So removing the obligation from Spain as a sovereign government debtor worsens the quality of the credit.
What is the source of all the good feelings? It is an accounting trick. When the individual countries do not report the debt of their banks, they appear to look better when you look at each country's GDP to total debt ratio. This is a gimmick. Nothing has really changed. For those countries lending to countries with needy banking systems, the lending countries are actually downgrading their credit quality.
But then it gets worse. The European Banking Superintendent will only be implemented months down the road. The fact we have a European Banking Superintendent does nothing to alter the reality of the Latin European banking system (I refer to France, Spain, Italy, Portugal, Greece, and Cyprus). If they are broke today, they will be broke when there is a banking superintendent on a European wide basis. The only real question is will the new European Banking Superintendent tell the truth that Latin European banks are broke. First, he could call for significant new loans to paper over the lack of capital. But what if the new banking superintendent tells the truth: the banks are insolvent due to having inadequate capital to cover unrecognized losses? That will bring on collapse. It will be very interesting to see what he says months down the road.
New loans, which are disguised capital increases, are classic "kicking the can down the road". There are no real solutions. The effort is not to solve, but to defer the problem to a later date. This inevitably means the Europeans will pay more to fix the problem when it finally does explode. The question is not what is the truth. The question is when will the markets see the reality of this situation. When the markets do see the reality, markets will decline dramatically and probably chaotically. This should affect adversely all long indexes such as the S&P 500 (SPY) and favor short financial ETF´s (FAZ) (SKF).