“DEXIA’S DEMISE IS ONLY THE START”

Just how bad are the issues in the European banking system?  Really really bad.  Here is some cheerful (and honest) commentary on the state of the European banking system (via John Hussman):

“As we entered 2008, I put together a spreadsheet to track financial institutions that were of particular concern based on their gross leverage (the ratio of total assets to the institution’s own capital), and the ratio of tangible equity to total assets. The most leveraged institutions at the time were Fannie Mae, Freddie Mac, Bear Stearns, Merrill Lynch, and Lehman Brothers. That spreadsheet turned out to be a fairly good predictor of the institutions that would either fail, go into receivership, or require bailouts as a result of insolvency. The corresponding calculations for several major European Banks are below. These calculations essentially mirror Weil’s list. Landesbank Berlin, Deutsche Bank and Credit Agricole are of greatest concern. While Danske Bank technically has a higher leverage ratio than Commerzbank, it has a larger buffer in the form of common equity – Commerzbank has only 1% of tangible common equity against its assets, the other 2% being more bond-like preferred equity.

When you consider the fact that most U.S. banks, just before the U.S. credit crisis in 2008, sported gross leverage ratios of about 12 (where Citigroup, Morgan Stanley, Goldman Sachs and JP Morgan remain today), the gross leverage ratios of European banks today are truly astounding.”

“Weil ends his piece with a simple sentence: “Dexia’s demise is only the start.” We couldn’t agree more.”

Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig and Paul Pfleiderer have covered this issue more thoroughly than just about anyone else.  Their recent work on Europe shows just how bad the leverage issue is.  Leverage ratios are through the roof:

The problem in the modern banking system remains one of leverage where our banking institutions do everything they can to maximize their leverage in order to maximize profits.  It’s an inherent conflict of interest between the public purpose of issuing state money and being a profit maximizing entity.  Leverage is all well and good until the inevitable de-leveraging cycle hits and results in a balance sheet spiral in which asset price declines lead to fire sales of assets, illiquidity, general economic uncertainty as our banking system freezes up and bailouts.  THIS LEVERAGE IS NOT NECESSARY!   Admati, DeMarzo, Hellwig and Pfleiderer call it “an unnecessary evil”.  They conclude the high leverage is not inherent to banking and entails a large social cost.  They’re exactly right.  But we allow the banks to leverage government money without regulating them properly.  This is the equivalent of having politicians spend our common currency without ANY oversight.  The lunacy behind such a policy is absurd.  And it’s now resulted in risks to the global economy that quite frankly should never have existed in the first place.  But we tore down the regulations and now we have a global banking system that is bloated and ripe for massive contraction.

Credit Suisse has concluded that the European banking system is largely bankrupt and could require a €400B capital infusion:

“We present in this section an overview of the analysis which we published in our report ‘The lost decade’ – 15-Sep 2011. One of our conclusions was that the overall European banking sector is facing a €400bn capital shortfall which compares to a current market cap of €541bn.”

In the words of hedge funder Steve Cohen:

“Leverage, concentration and illiquidity are the three things that can kill you.”

Love him or hate him, Cohen is a master risk manager.  The global banking system could learn a thing or two from him.

The Europeans should ignore every bit of advice Tim Geithner has given them thus far.  If they’re going to save their banks they should go Swedish on them:

“To gain credibility from the markets and be accepted by our citizens, such a backstop needs to be guided by four principles. The purpose is to safeguard the financial system, not shareholders. Bank share purchases should be based on conservative market prices reflecting the value of the failing bank in the absence of support measures, with “haircuts” if necessary. Prices should be determined after due-diligence from a third party. Second, when taxpayers risk their money, they should receive the potential upside of the investment. This is vital in mitigating moral hazard.

Third, public capital injections warrant public control of bank management, including strict control of dividend policy, bonuses and salaries. This is vital to deter dangerous risk-taking and to ensure public support for using taxpayers’ money. Fourth, the backstop should operate at arms-length from national governments without political involvement in commercial decisions.”

Of course, saving the banks is just the start.  If Europe really wants to fix their banking crisis they need to fix the currency imbalance which will inevitably recur if it is not resolved.  That means creating autonomous monetary unions of some sort (full union or full break-up).   If they’re willing to save the banks, they should at least have the decency to save the citizens from inevitable depression that will result if this currency crisis is allowed to persist.  Saving the banks from their stupid decisions is not a cure to the disease that is ravaging Europe.  Take it from an American where that lesson has been learned the hard way….

 

 

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. If it wasn’t already clear, here in black and white is why there is such vehement bank pushback against a larger Greek bond haircut. You’re absolutely right Cullen, the bulk of these guys need to be put into receivership; learn from the U.S.’s mistakes.

    • Oh no, everything will be fine, they have banned short selling the EU banks. lol.

      What a whitewash.

      If shorting was open for business I think this crisis would already have bottomed an we would be consolidating for a true recovery.

      But no, kick the can is still the status quo.

  2. Re-regulate the banks before you recapitalize them. Otherwise they will just burn through the new capital the same way that they burned through the old and you will be right back where you started.

    It’s not a coincidence that we have had two banking crises in three years, just over a decade after banks were deregulated.

  3. EUC was created despite the inherent disimilar characteristics of the citizens of the composing countries. (much greater than what is represented by our unionized individual states and therefore the US cannot be looked at as a entity to replicate). These disimilarities were evident during the good times (with the aid of the US investment bankers) and are becoming more pronounced during the economic unraveling.

    We are witnessing what 3 decades of unrealistic optimism creates. Those who were pessimistic during the past 30 years and shorted the markets had the arses handed to them in exchange for their cash.

    Now as the markets have passed the inflection point, we are watching economies unravel and it is now the overly optimistic camp that is having their arses handed to them in exchange for their cash.

  4. I see an alarming lack of Spanish banks (and/or ‘cajas’) in the list. Obviously with their fantasy marked-to-fantasy assets they maybe do not looks as bad, but they are amongst the most: iliquid, leveraged and concentrated on Europe, all related to real estate assets obviously.

    This may be worse even that what you think! We are talking trillions here.

    • He did make it clear it was only a list of some prominent European banks. Hussman is very aware of Spain. Spoke with Bill Hester, his partner, today. He will be updating their May 2010 post on the valuation of international markets in the next few weeks. He believes Europe has a high probability of revisiting the 2009 lows. That is pretty incredible given that US stocks as a whole never got real cheap then, but international stocks did. Europe saw yields of around 7% to get an idea. That we haven’t seen anywhere else since 1982. So I am bullish, if Europe drops a good 30% plus from here :^) If not, then it is an okay opportunity. Nothing particularly special.

  5. Are there any optimists out there on the European banks? Is it at all realistic to think that a combination of the IMF, the ECB, the EFSF, and German taxpayers can bail them out and prevent a financial crisis like Lehman? How long can it be staved off? Will it take a recapitalization effort of more than a Trillion?

  6. “Take it from an American where that lesson has been learned the hard way….”

    Always the optimist ;-)

  7. Dexia was brought down by a bank run. Not a classic run on deposits, but a sudden withdrawl of “hot money” financing. If the situation in the Eurozone is as bad as it seems, why hasn’t there been an actual run on deposits yet? Why are so many EZ businesses keeping all their money in EZ banks? Deposit insurance in the Eurozone is pretty low, and if many banks failed at once it is unlikely that the state governments could make good on the guarantees without an unlimited backstop from the ECB. Unlimited backstops are something that the ECB has not yet been willing to do.

    • Bank runs have their own logic. Banking is all about duration mismatch and leverage; even sound institutions can be vulnerable to a run in the right circumstances. The European banking system has deep solvency problems if sovereign debt is marked to market rather than being held to maturity, and high leverage means there is little margin for error. It will matter when it matters, and that could be tomorrow, or never.

  8. No mention of the difference in derivative accounting (IFRS = gross, GAAP = net) and its affect on using gross leverage here? Come on now.

  9. one thing lacks in this leverage table: off balance sheet comitments..eh eh eh