Day: July 26, 2012

Yesterday, the markets exploded higher on ECB President Mario Draghi’s comments that the ECB stands by ready to do whatever is needed to hold the EU together

We’ve seen this exact same game plan before in 2008 when Hank Paulson claimed that getting a blank check from Congress to battle the US banking Crisis would be like having a bazooka: the markets would be shocked and awed back into functioning properly.

Setting aside the absurdity of an alleged capitalist claiming that government policy could scare the market into behaving properly, we all know that Paulson’s bazooka turned out to be a peashooter. Indeed, all he got for his efforts (combined with the SEC banning short selling on financial institutions) was about two months of market gains.

The ECB’s Mario Draghi appears to have taken a page straight out of Paulson’s playbook (obviously he didn’t bother paying attention to how this particular play panned out). His comments have the same vagueness and the same illusory sense of control.

With that in mind, I ask all of you to make a note of yesterday’s date, July 27 2012, because it’s going to go down in Europe’s history as the “bazooka moment.”

Once again we have a monetary authority figure (another former Goldman Sachs employee to boot) claiming he can shock and awe the markets into behaving properly. His comments assisted by short-selling bans in Europe, have sent stocks through the roof.

However, I have no doubt that these effects will be even more short-lived than Paulson’s bazooka. The reasons are numerous. Here are a few worth exploring if you’re actually buying into this rally:

1)   Spain requested a €100 billion bailout in June… it then requested €300 billion this month… and Spain’s Prime Minister admitted via text message that the real capital needs are in the ballpark of €500 billion, assuming he knows what he’s talking about and Spanish banks have been honest with him (HIGHLY doubtful).

2)   Greece, without additional intervention, will run out of money by mid-August. The ECB no longer accepts Greece bonds as collateral. The IMF has halted funding to Greece. And Germany’s politicians are pushing Merkel to give Greece the boot. So who is going to stop Greece from defaulting?

3)   Speaking of which, Greece has now seen a 20% contraction in GDP. This is akin to Argentina in 2001 when the entire financial system there imploded. Expect the same to happen in Greece the very minute that the money tap is turned off.

4)   Germany is already on the hook for €1 trillion in backdoor bailouts to the EU and is now on negative watch for Moody’s. Do you think Merkel will let Germany lose its AAA status the year before she’s up for election?

5)   Germany, thanks to its EU interventions, now has a Debt to GDP ratio of 90%: the level at which its own solvency is called into question.

If you think the ECB can contain this mess, you’re wrong. The ECB is out of ammo. How do I know?

1)   The ECB hasn’t bought a single EU Sovereign Bond in 16 weeks.

2)   The ECB blew over €1 trillion via LTRO 1 and LTRO 2 only to find that

1. The effects lasted less than two months
2. The markets punished those banks that called on the ECB for aid (these requests were seen as public admissions of insolvency)

3)   If the ECB hits the print button and monetizes, Germany will walk. End of story. The word Weimar is still fresh in the German collective memory.  And the German population is already outraged by their country’s EU interventions, the risk of losing their AAA status, and the fact they’re now heading into a recession.

4)   Angela Merkel has told Draghi and others that there will not be Eurobonds as long as she lives. Unlike Draghi, she’s not bluffing.

5)   And finally, the ECB’s balance sheet is roughly $4 trillion. The EU banking system is $46 trillion. And EU bank derivative exposure is north of $200 trillion. How exactly can the ECB contain this mess?

It can’t. Draghi is pulling a classic Central Banker stunt: verbal intervention. If Draghi could in fact solve this mess, he would have already done so. The EU Crisis started in 2010 after all. And here we are, over two years later, and even Greece, which only comprises 2% of EU GDP, has yet to see its problems solved.

If the ECB cannot solve Greece’s problems, how on earth could it solve those of Spain or the entire EU for that matter?

The answer is obvious: it can’t.

Best Regards,

Graham Summers

As noted in yesterday’s piece concerning how and why Europe could bring about systemic risk, EU banks are likely leveraged at much, much more than 26 to 1.

Indeed, considering how leveraged and toxic US banks’ (especially the investment banks’) balance sheets became from the US housing bubble, the chart I showed you should give everyone pause when they consider the TRUE state of EU bank balance sheets.

This fact in of itself makes the possibility of a systemic collapse of the EU banking system relatively high. Let me give you an example to illustrate this point.

Let’s assume Bank XYZ in Europe has a loan portfolio of €300 million Euros and equity of €30 million Euros. This means the bank is “officially” leveraged at 10 to 1 (this would be a great leverage ratio for a European bank as most of them are leveraged to at least 26 to 1 or worse).

So… let’s say that 10% of the bank’s loans (read: assets) are in fact worth 50% of the value that the bank claims they’re worth (not unlikely if you’re talking about a PIIGS bank). This means that the bank’s actual loan portfolio is worth €285 million (10% of 300 is 30 and 50% of 30 is 15).

With equity of only €30 million, the bank, at some point, will have to take writedowns or one time charges on its loan portfolio that would erase HALF of its equity. At this point, the bank becomes leveraged at 19 to 1 (€285 million in assets on €15 million in equity).

This announcement would result in:

1)   Depositors pulling their funds from the bank (thereby rendering it even more insolvent)

2)   The bank’s shares plunging on the market (raising its leverage levels even higher as equity falls further).

Thus, at a leverage ratio of 10 to 1, even a 50% hit on 10% of a bank’s loan portfolio can result in the bank needing a bailout or even collapsing.

Now, what if that €300 million in loans is actually the amount the bank’s in-house risk models believe to be “at risk” and the REAL loan portfolio is around €800 million?

Immediately, we realize that the bank is in fact leveraged at 26 to 1. At this level even a 4% drop in asset prices erases ALL equity rendering the bank insolvent.

And yet, based on Basel II requirements, this bank can claim in all public disclosures that it is only leveraged at 10 to 1. With this in mind, you should understand why the banks lobbied so hard against a rapid implementation of Basel III capital requirements (which would require equity and capital equal to 10.5% of all of risk-weighted assets.)

Indeed, Basel III requirements which were meant to go in effect at the end of 2012 will now gradually begin to be implemented in 2013. And banks will have until 2015 to adjust to the new capital requirements and until 2019 conservation buffers in place.

With that in mind, take my XYZ bank example, apply it to all of Europe, assume leverage ratios of 26 to 1 at the very minimum (Lehman blew up when it was leveraged at 30 to 1), and take another look at the housing bubbles in the above chart.

In simple terms Europe’s entire €46 trillion banking system is in far worse shape than even the US investment banks were going into 2008. And this is based on their leverage ratios alone.

However, even this analysis doesn’t go deep enough to explain how and why Europe will implode. Indeed, I’ve spent the last six months digging as deep as I can into the financial system to find the unquantifiable risks that aren’t being discussed by the financial industry.

I’ve found them. And they are worse than anything I expected to find. Indeed, what I’ve discovered is more horrifying than I’d care to admit. And I would very much like to share this information with you.

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However, you can access it via my Private Wealth Advisory newsletter.

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Graham Summers

Chief Market Strategist

Phoenix Capital Research