How Much Trouble Could Big Banks Be In? Lots!

The future of the Euro and the Eurozone is bleak and will likely look like a series of prolonged, rolling crises that slowly evolve to reveal just how critically the financial health of each country is affected by their individual sovereign debt and their failing banks.

The inevitable result will be severe Eurozone-wide stress, emergency liquidity loans from the IMF and the European Central Bank and politicians from all the countries involved increasingly attacking each other  over allegations of blame and corruption. To no good end.

Even the optimists now say openly that Europe will only solve its problems when there are no options left and time has run out. Less optimistic analysts increasingly think that the Eurozone will break up because all the proposed solutions are essentially Pollyannaish jokes. Let’s say the realists are right, and Europe starts to dissolve. Markets, investors, regulators and governments can stop worrying about interest-rate and credit risk, and start worrying about dissolution risk.

More importantly, they need to start worrying seriously about what the repricing of risk will do to the world’s thinly capitalized and highly leveraged megabanks. European officials, strangely, appear not to have thought about this at all; the Group of 20 meeting last week seemed to communicate a weird form of complacency and calm.

So, for all of the European officials and the U.S. bankers, here’s what dissolution risk means:  If you have a contract that requires you to be paid in euros and the euro no longer exists, what you will receive is not real clear. See? That’s dissolution risk.

Let’s say you have lent 1 million euros to a German bank, payable three months from now. If the euro suddenly ceases to exist and all countries revert to their original currencies, then you would probably receive payment in deutsche marks. You might be fine with this — and congratulate yourself on not lending to an Italian bank, which is now paying off in lira.

But what would the exchange rate be between new deutsche marks and euros? How would this affect the purchasing power of the loan repayment? More worrisome, what if Germany has gone back on the deutsche mark but the euro still exists — issued by more inflation-inclined countries? Presumably you would be offered payment in the rapidly depreciating euro. If you contested such a repayment, the litigation could drag on for years.

What if you lent to that German bank not in Frankfurt but in London? Would it matter if you lent to a branch (part of the parent) or a subsidiary (more clearly a British legal entity)? How would the British courts assess your claim to be repaid in relatively appreciated deutsche marks, rather than ever-less- appealing euros? With the euro depreciating further, should you wait to see what the courts decide? Or should you settle quickly in hope of recovering half of what you originally expected?

What if you lent to the German bank in New York, but the transaction was run through an offshore subsidiary, for example in the Cayman Islands? Global banks are extremely complex in terms of the legal entities that overlap with business units. Do you really know which legal jurisdiction would cover all aspects of your transaction in the currency formerly known as the euro?

Moving from relatively simple contracts to the complex world of derivatives, what would happen to the huge euro-denominated interest-rate swap market if euro dissolution is a real possibility? Guess what? No one really knows.

But, what I am really talking about here is the balance sheets of the really big banks. For example, in recently released filings with banking regulators, JPMorgan Chase & Co. revealed that $50 billion in losses could hypothetically bring down the bank. JPMorgan’s total balance sheet is valued, under U.S. accounting standards, at about $2.3 trillion. But U.S. rules allow a more generous netting of derivatives — offsetting long with short positions between the same counterparties — than European banks are allowed. HA!

The problem is that the netting effect can be overstated because derivatives contracts often don’t offset each other precisely. Worse, when traders smell trouble at a bank that has taken on too much risk, they tend to close out their derivatives positions quickly, leaving supposedly netted contracts exposed. Remember the final days of Lehman Brothers?

When one bank defaults and its derivatives counterpart does not, the failing bank must pay many contracts at once. The counterpart, however, wouldn’t provide a matching acceleration in its payments, which would be owed under the originally agreed schedule. This discrepancy could cause a “run” on a highly leveraged bank as counterparties attempt to close out positions with suspect banks while they can. The point is that the netting shown on a bank balance sheet can paper over this dynamic. And that means that JPMorgan’s regulatory filings vastly understate the potential danger.

JPMorgan’s balance sheet, using the European method isn’t $2.3 trillion, but closer to $4 trillion. That would make it the largest bank in the world. Holy Moly!

What are the odds that JPMorgan would lose no more than $50 billion on assets of $4 trillion, much of which is complex derivatives, in a euro-area breakup, an event that would easily be the biggest financial crisis in world history? Slim. And, None.

No one on these shores seems to see the storm coming. In an effort to forestall the impending global crisis, the Federal Reserve should be insisting that big U.S. banks increase their capital levels by suspending dividends, and set up emergency liquidity facilities with an emergency and across-the-board suspension of dividend payments, but it won’t. The Fed is convinced that its recent stress tests show U.S. banks have enough capital even though these tests didn’t model serious euro dissolution risk and the effect on global derivatives markets.

The Fed is dead wrong about that, and the pending Euro-crisis is very real. Our mega-banks are in no position to weather even the known storm, let alone the real storm when all the European counter-parties pony up to the bar with their real exposures, and the true sovereign debt gets exposed. Then, what do you think that means for smaller banks? 

How do you think that might affect the U.S. economic recovery? What is gold trading at? $1,575 an ounce?  Hmmmm.

Grexit Day!

So, the burning question of the day is who will prevail in Athens?

As Greek voters prepare to the go to the polls on Sunday and central banks around the world prepare to enter crisis mode if far left-wing candidate Alexis Tsipras wins and reneges on the country’s bailout package, thus threatening euro zone solidarity, the Greek economy may slip into something resembling medieval Europe‘s Dark Ages.

All of the money managers in the U.S. and around the globe will have a busy afternoon and evening watching and waiting and finally executing their market calls. BlackBerries and iPhones will be at the ready during Father’s Day barbecues. Most predict a future for the Euro, though admittedly fraught with weakness and instability.

In recent days, international companies have been divesting their Greek branches. French supermarket giant Carrefour SA  sold its Greek branch to its local partner at a loss, Coca Cola’s Greek operations were downgraded by Moody’s Investors Service, and various import-export insurance companies have stopped covering transactions with Greek companies.

In addition, Greece risks blackouts as Russian gas giant Gazprom has said it will cut the country off if it does not pay its bills by June 22 

While international companies have withdrawn from Greece, the Greeks themselves have stopped buying everything from clothing to medicine.

The only things that have been selling well recently have been staple foods like pasta and canned goods, which have been flying off the shelves. Greeks are stocking up on non-perishable food in panic-buying mode as they prepare for shadowy worst-case-scenarios following the election. A quiet rush on banks has been occurring, with $1 billion in deposits leaving Greek banks each day for some time.

As for the euro itself, it may not really matter much, at least in the medium term, as most money managers are betting that the euro, the currency of 17 nations from the Baltic to the Mediterranean, will eventually weaken, whatever the outcome on Sunday.

“The hundred billion bought us two hours of relief, and then interest rates began to go up again and markets began to zoom in on Italy,” says one money manager, referring to last weekend’s 100 billion euro bailout for Spanish banks. “It has become a systemic issue. Until we see a lasting resolution of those doubts, we feel the euro will remain under pressure.”

If the left-wing parties win in Greece and back away from austerity, prompting a default or a disorderly exit from the euro, “we would expect the euro to drop like a stone,” says another money manager. “The consequences would be dramatic.” The currency could sink to parity with the dollar, he says.

The larger point is that whatever happens in Athens, doubts about Spain and Italy will only continue to grow. Those nations’ debt loads are large, and both are increasingly seen as unable to make the kind of changes that will persuade investors to keep buying their debt.

The ultimate answer is for European governments, led by Germany, to agree on concrete and credible steps toward greater fiscal and political integration, including the issuance of broader euro zone debt. That would eventually allow Spain and Italy to borrow what they need with Continent wide backing. In addition, leaders should come up with a euro zone wide bank guarantee to avert full-scale bank runs in shaky countries.

Ultimately, the market will force policy makers’ hands. But with 17 parties sitting at the table, the decisions are glacial. The markets move in a rapid-fire fashion. The stakes are increasing every day. 

Greece, Germany And The Endless Dance.

My view on Greece, the Eurozone, the endless talks and Germany. It seems that the only common view among the participants in the various talks, is a desire to try to avoid a disorderly default.  Beyond that, there is a severe disconnect fostered by parallel realities that seem unable to intersect. Accordingly, a deal that can hold up both in the streets of Greece and in the markets, is both illusive and unlikely.

The following appears to be the pretty-universally-held German policy position:

Yes, since 2004 we have been in surplus and have benefited tremendously from debt fueled over-consumption in the periphery.

Yes, we provided the loans (together with our core partners) to irresponsible borrowers who lacked the fiscal fortitude to protect our money.  Shame on us, but we still want our money back (Greece is the only exception we believe we will have to make – and even then, only the private sector will suffer losses).

Yes, we were a little irresponsible in the early days of monetary union, when the periphery was enjoying the benefits of competitive wages and the global situation was not as unbalanced.  But we quickly recognized the error of our ways, remembered that we are Germans, and took steps to cut our deficit.

What you Americans don’t understand is that after we entered surplus and could have shrunk our debt-to-GDP ratio using growth alone, we flogged ourselves with policy aimed at limiting consumption, increasing savings and avoiding a renewed encounter with the dreaded One Hundred Trillion Reichsmark Note inflation that we fear every day of our lives.

And during the Great Recession we didn’t just lay off all our workers like you did – we are civilized, we shared jobs (kurzarbeit).

And by the way, before you tell us how to handle our periphery, you must remember that you in the U.S. were incredibly irresponsible too and destroyed the entire world economy, and now you are obsessed with deflation and are printing money like drunken sailors which will, of course, inevitably result in the dreaded One Hundred Trillion Reichsmark Note inflation that we fear every day of our lives.

Yes, yes, we studied Brüning and the deflation of the early 30′s that you say really brought about the National Socialism that nearly destroyed us and resulted in global horror, but we nevertheless attribute the trouble to the Weimar inflation.

Don’t blame us for being incredibly productive and economically abstemious, we can’t help it if we make the best cars and everyone wants to buy them.  And it is not our fault that the countries of the periphery are unproductive anachronisms that make nothing anyone wants to buy at the prices for which they want to sell their goods. OK, we should have noticed the latter before we lent them all the money (and probably should have looked more closely at their books) – but it was the euphoria of European unification that made us do it, we’re only human.

No full fiscal union, no Eurobonds….don’t even think about it.

It’s one thing for Bavarians to share their wealth and income with northern and eastern Germany, but you must be kidding if you think we can get our electorate to support sending their money to support slothful southerners.

We will never permit the ECB to monetize the sovereign debts of its member countries the way you have done in the U.S., the U.K. and Japan. Not only isn’t that the deal we made with each other but it will tank the Euro and result in the dreaded One Hundred Trillion Reichsmark Note inflation that we fear every day of our lives.

There will be no exiting of any country from the Euro System. The System was only designed as part of a continuum leading to the full unification of greater Germ…uh…Europe.

But we are not yet in a position to support the transfer of national authorities, and we Germans are not prepared to surrender national sovereignty (but we really did think that the suggestion for installing an Oberführer to supervise Greece was a nifty idea and aren’t sure why it got people so upset). [Fine, no one really used the word Oberführer]

Finally, we believe in the written word – in law and in treaty.  We can make more promises to each other and – unlike the last two times – we can this time honor them. Why do you doubt that?

All of this ends with a full-throated advocacy of the concept that has become known as “expansionary austerity” which forms the bedrock of German and other core nations’ policies towards the massively over-indebted periphery:  Countries that have been irresponsible borrowers need only to demonstrate their fiscal discipline and prudence, reduce their indebtedness and reform their inefficiencies and over-regulation and investment and growth will resume because markets will once again have confidence in the economies of those countries.

Yes, there it is…the return of the same confidence fairy that supply-siders hold out as the magic pixie dust that allows economies to fly once more, without regard to the adequacy of demand, or the competitiveness of a given nation relative to others.

There are many quite practical reasons why “Austerianism” will not work, and countless others have written on the subject at length.  Here are three important ones:

1. The continuing presence of several of the GIPSI’s within the Euro System effectively blocks two of the three transmission mechanisms that would otherwise enable those countries to re-balance trade.  They can neither devalue their currencies nor, given their membership in the EU, can they restrict trade and take action (which would be highly unlikely anyway) to internalize production.
2. The world in general is fighting over insufficient demand relative to a global glut in the supply of labor, productive capacity and capital.  Within the Eurozone, the countries of the core have been the principal beneficiaries of whatever internal and external demand exists.  Yes, this results from their superior productivity and manufacturing talents, but – relative to global demand – is substantially enhanced by the weakness of the Euro relative to the value of former or reconstituted core currencies.  Even if the German view were to suddenly change relative to ECB monetization, the devaluation would be universal (throughout the zone) and would not re-balance trade amongst the 17 member countries.
3. The core-recommended re-balancing transmission mechanism – internal devaluation (falling wages and prices – to the level of depression if the pixie dust doesn’t work its magic) – is functionally impossible.  It is the economic equivalent of ancient bloodletting.  Not only does it it result in killing off even more internal demand, but it necessitates a level of austerity that cannot possibly be tolerated by citizens of countries that still enjoy sovereign borders and popularly elected governments, merely to repay foreign creditors.  They will simply refuse, at the ballot box or through other means.  To believe otherwise is very much akin to believing in fairies.

A friend of mine who is into Opera (and I am not), likened the German response to Eurozone realities, to Act II of Richard Wagner’s ring series opera, Seigfried.  As Fafner the dragon is awoken from his slumber and warned by the conniving Alberich that the hero Siegfried is on his way to kill Fafner, the fearless dragon dismisses Alberich’s warning and returns to sleep.

The world cannot afford the luxury of sleeping on this.  What is at stake here is more than the issue of recovering monies lent to Greece.  A very substantial amount of European capital is at stake and plans to recover it by placing the populations of the GIPSI’s  (Greece, Ireland, Portugal, Spain and Italy) under indentured servitude to their creditors are the stuff of fairies and pixie dust.

It is past time to tighten the belt at both ends, recognize the money that has been lost throughout the periphery, recapitalize core institutions and bite the bullet on the secession of the defaulting nations. It’s inevitable anyway.