European debt crisis – catching knives


by David Malone

Watching Europe deal with its debt crisis is like observing a knife catching competition in slow motion.  No matter how long it goes on, no matter how many times the idiot contestants see the outcome demonstrated, they all manage to express surprise or even dawning outrage when another of their digits is neatly sliced off and lands on the floor in front of them.  Quelle surprise!

And I can’t help but feel we are building towards another little finale of foolishness.  Portugal  was downgraded only a month ago.  A week ago Greece was dropped into the dim and sulfurous region of “Highly Speculative”  non investment grade debt.  And now Spain has been downgraded by Moody’s from Aa1 to Aa2.  Aa2 is still a high grade investment.  But Spain is moving down and that exposes Portugal again and brings Italy into the frame as well.

As always it is the reasons for the downgrade which are more important than the move itself.  Moody’s basically laughed in Spain’s face over Madrid’s estimated costs of bailing out Spain’s gored banking system.  Madrid said it would cost another 20 billion euros to shore up her banks.  Moody’s said at least 40-50 billion.  Which sounds bad but is only the hors d’oeuvre.  For the figures both Madrid and Moody’s come up with depend entirely on their assumptions about the broader economic outlook.  And both Madrid’s 20 billion and Moody’s 40-50 billion are based on a moderate, even benign scenario.  Using a  moderately more stressful scenario, the funding needs of the Spanish banks quickly climbs to 110-120 billion euros.

Which brings us to the second round of European Bank Stress tests.  These are the scenarios which underpin all the estimates of GDP growth or contraction, unemployment and bank losses.  The first round, conducted last year, was universally derided for being more worthless than the banks it was supposedly testing.  The only thing tested was everyone’s patience with the simpering shamelessness of the eurocrats and sneery arrogance of the bankers who defended them.  The markets treated the results with the utter contempt they deserved and downgrades ensued.

The second round of Stress Tests are supposed to confound the critics.  And in a sense they are doing exactly that.  No one can quite believe that the eurocrats and bankers are going to do the same again.  But it seems they are.  This time the banks will be tested against a whole, earth shattering 0.5% fall in GDP and 15% fall in the stock markets.  That is like testing a parachute by patting it and saying, “Well it feels lovely and plump!”

Inside the bag is another matter which neither the banks nor our ‘regulators’ are willing to let us see inside.  Because if we did this is what we would find.  A European bank, faced with needing to show a better ratio between risky assets (in this case bonds it had bought based on dodgy loans) and capital held, decided not to sell or mark down the bad loans, nor indeed to raise more capital, but to do something a lot cheaper.  The bank took out insurance on its poor loans in the form of CDS from a US company.  But if you take a look at what capital the insuring company has, surprise surprise, it doesn’t have the money to pay up if it had to.  Thanks to the indefatigable Karl Denninger at MarketTicker for that one.  As Karl points out, this is the same stupidity and greed which set up the bank implosion in the first place.

But while the stressless tests are administered and no one is allowed to see what kind of improvised expolsive financial devices the banks are building, reality is leaking out.  Moody’s also worried that whatever measures the central government is taking, the regional and local governments are another story.  Over half of Spain’s regional governments did not reign in their debts as they were supposed to.  The reason is simple.  Those regional governments are the ones who pay for lots of the services which people do not want cut.

The add in the sheer size of Europe’s overall borrowing.  The borrowing of just Europe’s banks, not including sovereign borrowing, is 2.4 Trillion euros over the next three years (till 2014).  This year Spain Portugal and Italy all have huge debts which need to be funded.   Some is old debt needing to be rolled over (a long debt that was funded for a short period and now needs to be refunded – like getting a new deal on your mortgage) and some new debts that need to be paid.

These three nations all have large debts (Italy has the largest amount) and are going to be trying to attract buyers of their debt at a time when their energy costs, thanks to Libya, are heading up.  Portugal is definitely being shepherded towards a punitive EU/IMF bail-out impoverishment programme.  Spain is looking increasingly like it will not make it, not intact anyway.  One solution which I think we will see being touted is for Spain to let American banks and funds ‘rescue’ the cajas.  What this would mean in reality is that American banks and investors would put in capital enough to keep the wheels turning, but probably not take on the debt load.  The argument would be that Spain can’t bail them out and fund them sufficiently to make them competitive.  The US banks will step up and say we can help with that in return for us now owning a chunk of the cajas.  The US banks would love this as the cajas are the well spring of deposits.  The long run would be America having a huge hold on Spanish banking cash.  

Of course it’s not just Europe trying to attract buyers for their debt.  Just add in America’s debt needs and the total debt for sale will be $5 trillion in just the next three years.

And before I go please remember that when people talk of bailing out a nation’s banks what it really means is bailing out the people and other banks who lent money to the bank in question.  They are the people and banks really being bailed out. And those banks, the real recipients of bail out money paid to Greece, Spain, Ireland and Portugal are the German, French and British banks.



David Malone is the author of the book Debt Generation. You can read and listen to excerpts from his book here: