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Simple Math Says Europe Is Bankrupt

by Mitch Feierstein about 5 years 1 week ago

There’s a lot of talk about Europe at the moment, but it’s kind of the way you talk about flooding when the waters don’t reach your house. Sure, it must be real tough for the poor saps whose couches are bobbing around in their living rooms — but meantime, what’s for dinner?

This is better than when we both worked at Goldman, QE infinity!

Unfortunately, that European flood has only just started — and financial messes have a habit of becoming global rather quickly. After all, it was problems in the American mortgage markets that first triggered the financial disasters unfolding in Europe today. And of course these European ructions have some sharp lessons for U.S. policy makers… not that our Congress with its 9% approval rating would listen anyway.

But let’s start with some simple math. The multi-trillion euro question at the moment is: Are European banks solvent? And you don’t have to be Einstein to figure out the right answer. At the start of this year, a Spanish ten-year bond yielded around 4.90%. If you were a Spanish bank, you quite likely chose to invest in that bond — let’s say €10 million of your shareholders’ money.

So what’s happened since then? Well, interest rates have gone up, up and up. For all that you hear about massive European bailout packages, those things have had almost no effect at all. When the European Central Bank lent out over €1 trillion in December through February, it bought financial peace for about six weeks. When Spain got a €100 billion bailout this past weekend, the financial respite lasted about three hours.

Interest rates on Spanish government debt have now hit 7.00%, the rate at which the country is almost certainly insolvent. But when interest rates go up, that’s because bond prices are going down. (The two things are always inversely related: it’s a mathematical truism.) And the collapse in bond prices means that the actual market value of that Spanish bank’s €10 million investment is now only €8.5 million. It’s lost 15% of its investment value in less than five months. That’s an investment that Moody’s has just downgraded to one notch above junk … with a negative outlook.

Wow, a 100 Billion Euro non-recourse loan and I got it done in time for the game!

That’s a massive loss. Plenty of European banks holding this debt are very thinly capitalized. Deutsche Bank has equity that’s just 2.7% of total assets. BNP Paribas has equity of 4.4% of assets. If those assets take a 15% loss, a fourth-grader could figure out that you can kiss good-bye to your shareholders’ equity. It’s gone, brother, it’s gone. When MF Global went bankrupt, it did so because for essentially the same reasons, gambling on the same European bonds. Indeed when you think of the fuss that’s been made over JP Morgan’s recent $2 billion hedging loss, just remember that the Eurozone has plunged in excess of €1.5 trillion into ‘stabilizing’ its banking sector. Those banks mostly bought government bonds with the money… and those bonds have taken hideous losses recently. The loss of value is simply breathtaking.

So what does this mean? And what does it mean not just for the guys with water in their living rooms, but for we Americans, up on a hill, looking down at those floods?

First, a government with substantial debts, like those of Spain or Italy, cannot fund themselves at interest rates of just 7.00%. The burden is just too great. Secondly, European banks have accumulated too many bad assets, they’ve got too little shareholders’ equity. Huge swathes of the European banking sector are bankrupt too. They’ll go on trading for a while, because regulators will desperately keep kicking the can down the road for as long as they can. But bankrupt is bankrupt. At a certain point, you just won’t be able to keep the Ponzi-ish pretense up any more.

At this point, the European common currency, the euro, is pretty much shot to shreds too. If a government defaults, it’ll be obliged to exit the currency. We’ll see the return of the drachma, the lira, the peseta. Those currencies protected their countries. They meant profligate governments could destroy value via currency devaluations instead of outright defaults. Because investors knew there would always be a high risk of value destruction, they demanded high — and realistic — interest rates by way of compensation.

In America, meantime, we have a profligate government, rapidly mounting debt and chaotically mismanaged ‘too big to fail’ banks. And these things are unsustainable. They kill a country. They are have killed Greece. They are killing Spain. They will kill Italy. They will threaten France. For the past 11 years, global GDP growth has been about 4% per annum. Growth in debt over the same period has been 12% per annum.

Clearly the time to act is now!

And our government is not acting. It needs to stabilize and reduce its debt. Not some time in an unspecified future, but right now. It needs to force banks to declare all their rotten assets. It needs to end the ‘too big to fail’ culture which came so close to ruining America in 2008 (and the big banks have just gotten bigger since then). Yet these things aren’t happening. Our debt is still rising. We’re watching the waters rise in our neighbor’s back yards and we’ve forgotten that our own house is built on low ground by a failing levee. It’s time to act and we’re doing nothing.

This was published in todays Huffington Post

5 Responses to: Simple Math Says Europe Is Bankrupt

  1. Mike says:

    What is being described above is certainly playing out from my point of view. George Sorros gave the euro 3 months so he is probably using money to hedge on that outcome (although will anyone be around to pay his profits?).

    What I still don’t understand is how the US, UK & Europe has been able to print trillions of dollars etc. without being punished more severely by the markets. I guess they are just being picked off one at a time. Spain, Italy, France, UK, Japan, Germany, and USA. Presumably derivative traders are trying to profit at every opportunity without a care that the financial security of hundreds of millions of ordinary people is being destroyed and in the end they will lose everything themselves.

    Pretty insane really.

    • eddiewano says:

      They are not being punished by the markets because they are all doing it together and their major off-sider (China) is pegged to the dollar. The markets are being cornered and trapped by government intention as they all seek the lowest possible exchange rate against each other. The proverbial “market” is a big dumb animal after all…

  2. philip meguire says:

    I have argued since 2008 that the mortgage debts of the UK and USA will remain indigestible until the Bank of England and the Fed engineer a rise in the price level of at least 30%. If salaries and house prices rose by 30% or more, people would be happy to pay their mortgages. It now looks like the same is true of the sovereign debts of Mediterranean nations.

    Europe is set for a massive wave of nationalisations of insolvent large banks. Will governments declare worthless the existing equity of those banks, in exchange for assuming the massive debts of zombie banks?

    In 2002, Argentina reduced, overnight and in one fell swoop, the value of all accounts in Argentine banks by 20%. Something similar will have to be done to the sovereign debts of several European nations. Continental Europe will also resort to a classic tactic of third world Ministries of Finance in the second half of last century. These Ministries will “order” banks to buy and hold tranches of sovereign debt, paying a rate of interest that will be set by ministerial direction, not by auction or underwriters. This will obligation will be seen as a cost of doing business, as a de facto tax that one pays in exchange for having a banking franchise. Banks will accordingly revise downward the rates of interest they pay on their deposits. Capital controls will be instituted first to prevent capital fleeing to banks located in jurisdictions able to offer higher interest rates. Greece, Spain and Portugal will become banana republics in all but name. This “lockdown” situation will prevail for 10-30 years.

    The Eurozone may contract to Germany, Austria, Netherlands and Luxemburg. The Czech, Slovak and Slovene Republics may join.

    The continental European welfare state will come to a fitful end over the next 25 years. To lower the cost of socialised medicine, doctors will be required to accept a substantial lowering of their incomes. 19th century hospitals will remain in existence for another 40 years.The real value of European old age pensions paid out of the public purse will decline, willy nilly, 20-35%. Europe will see that child allowances strongly encourage immigration from the Third World, and so will pull the plug on those allowances. Universities will begin charging fees comparable to those charged by American state universities. The dole will be limited to 1-2 years. And most of all, it will come to be understood that any rise in the public debt/GDP ratio during recessions, must be offset by declines in normal years.

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