Europe And The Banks: Just The Beginning

Includes: ADRU, ERO, EU, EUFN
by: Michael Shulman

Why is it always the banks? It has always been the banks – going back to the moneylenders in Roman times who were often killed as a way of reducing state debt. Pogroms against Jewish moneylenders occurred for hundreds of years in Europe as a way for a monarch to cheaply make his subjects happy – and wealthier – and better able to pay more in taxes to the crown. Not to mention canceling his own debts.

And, metaphorically speaking, voters in Europe right now would like to kill their bankers. Many see recent discussions and headlines as leading to a near term endgame to the debt and banking crisis. It is not -- and policymakers and the bond market will kill their stocks, over time.

European banks have loaned institutions and people money who did not deserve the loan at the interest rate charged – the interest rate is supposed to incorporate the risk of a borrower defaulting. In the past, up until around a decade or two ago, a risky borrower could not get money or if he did he would pay an astronomical interest rate. Today, he may pay a higher rate than the best borrowers but the bank can then buy a derivative called a CDS (credit default swap) that essentially insures the loan. If the loan defaults, the bank gets paid back in full for the value of the loan if they have bought enough CDS. The problem with this system is that it creates true moral hazard – the banks have to worry far less about who they lend to and at what rate. The insanity of this system is that derivatives are unregulated, creating a myriad of problems and potential disasters that will bounce back on the banks and the taxpayers.

First, no one knows how many CDS are outstanding and how much collateral has been posted to support the failure of a loan and the subsequent need for the issuer of the CDS to make good on the losses of that loan. Second, since the system is unregulated, anyone can buy a derivative on debt, the equivalent, to paraphrase Michael Lewis in Boomerang, of buying fire insurance on my neighbors’ house, something we all know is illegal because you would lose a lot of houses that way. Third, CDS are priced and require amounts of collateral based on the risk posed by that individual derivative. There is no pricing mechanism and no way to determine the adequacy of collateral levels based on the possibility of systemic risk failure – that CDS from two, five ten or a hundred banks or countries would be “called in” if several or more than several institutions or countries default at the same time.

Fourth, banks buying CDS can use this to justify using an otherwise “dodgy” loan – let us say a Greek bond? – as core capital fort the bank as the loan itself is “bulletproof.” Oh yes, banks in Europe can still count Greek bonds as core capital although this is due to the ECB waiving regulations, not CDS.

Fifth, banks buying these CDS to protect their balance sheet themselves have issued debt that in turn is insured through other CDS. That means if an issuer of CDS fails to pay, and a bank runs into trouble, the cost of CDS on their own debt becomes too great, they cannot borrow, if they cannot borrow, they are insolvent and other CDS on that bank may end up being called in and so on. The systemic risk is now spread everywhere.

Back to the banks. The problem is not a bank. Or one nation’s nations banking system. The problem is the system. The word "credit" is derived from the Latin credere – to trust. In the past when trust in one bank ends, that lack of trust could spread and drain the system of liquidity. Now it is worse - legal obligations kick in – obligations that cannot be met if everything nears failure at once.

And that is why it is always the banks – the domino effect, in the good old days, of failing trust and now, the far more dangerous domino effect of credit default swaps.

The only solution is to provide more capital to the banks before a failure – namely the upcoming Greek bond default. And the hope (and prayer) in Europe is this will stop any contagion. That is not going to happen – bond markets are global and the market will simply hit the next country after Greece – probably Portugal – and so on. Interest rates will rise; CDS will become unaffordable as insurance; CDS on the debt of banks known or thought to hold too much sovereign debt will become unaffordable and they will not be able to borrow. Illiquidity then insolvency.

And this is what Paulson and Bernanke and Geithner prevented here and the Europeans are trying to do.

Europe will put in place a bank re-capitalization programs before the Greek default. Over time whatever modest bank re-capitalization plans are soon implemented in Europe will be too small. Why? There will be contagion they are hoping does not happen. And they need to placate financially illiterate and increasingly arrogant German politicians and German voters. Whatever bank re-capitalization plan emerges in the coming days, it is just the beginning and will have to be expanded, and expanded again, and again. The problem is not a couple of hundred billion euros as is being discussed in the headlines – the problem is trillions of euros, the toxic assets never written off after the Lehman crash, Greek debt (310 billion), Portuguese debt (328 billion euros), Italian debt (1.6 trillion euros). Those three buckets alone are more than two trillion euros. Cut that by 50% and you need a trillion dollars in new capital for European banks since sovereign debt is considered by most to be core capital.

Unlike in the US, the Europeans, even the British once in a while, have no problem nationalizing things and they will not re-cap the banks for non-voting preferred shares a la TARP. They have no problem whacking shareholders – so traders will do the same. European banks, over the next three years, are going to be great short opportunities and the only question traders need ask themselves is what is the price the dilution of shareholders will end.

This is not complicated – Deutsche Bank (NYSE:DB) cannot possibly escape this mess. It is the biggest German bank and it has exposure to who knows what. It may be asked to back up the hopelessly inept Landesbanks, state-owned banks that make our Savings and Loans in the 1908s look well-managed. The stock is currently at $40, I would expect it will retest and go below its Lehman crash lows, to around $20-$22. It all depends on how fast the crisis accelerates.