November 27, 2011

The Coming Contagion

If it was just Europe and if the crisis could be contained there, I believe that I would not have as dour of an economic outlook as I do now.  But Europe is critical to the world’s economy.  A huge percentage of global lending is from European banks, and they are almost all contracting their balance sheets.  In a banking balance-sheet crisis, you reduce the debt you can, not the debt that is the most needed or reliable.  The same thing happens when an investment banking firm blows up – they sell the assets that they can, not necessarily the bad assets that they want and need to. 

Those who think this is all a non-event say that US net exposure to European banks is not all that large, and that while it may not be a non-event, it’s not system-threatening.  But gross exposure is huge, and we see that regulators and other authorities are becoming concerned.  The problem is that as a bank sells risk insurance, it can buy protection from another bank to hedge it. But who is the counterparty? How solvent are they? It was only a month before Dexia collapsed that authorities and markets assured us that the bank was fine, and then it was nationalized.   If European banks are as bad as they appear to be, then that counterparty risk is huge!  Will sovereign nations step up and bail out US banks on the credit default swaps their banks sold?  Read an article that I wrote just a week or two ago where I point out how France and Germany cleverly changed the verbiage on the Dexia situation so that an actual default was not treated as such.  Actions have consequences and you’d better believe that the entities that were on the other end of those transactions have long memories. 

Contagion is the #1 risk on the minds of European leaders and regulatory authorities, and it should be in the US, too.  Since the ECB is for now off the table as a source of unlimited funds, there are calls for funds from a variety of sources.  But the only realistic one is IMF participation and that should be promptly stamped out. US funds (which are the majority in the IMF fund) should not be used for governments of the size of Italy and Spain – or for any other European country.  These are not third-world countries.  This is a European issue of their own making and not the responsibility of US taxpayers.  And the U.S. is soon to face up with debt problems of our own making.

There is no credible source other than the ECB for the amount of funds needed.  Europe is at the end of the road until Germany acquiesces on Eurobonds and printing money.    And time is not on the Europeans’ side. Until there is a solution, world markets are going to continue to roil.  

And then there are other international problems and they too, will be visited upon the U.S.  Since Europe is the most pressing issue, I will continue to focus most of my writings on what is going on there.  Just keep in mind that we also will need to address China, Japan, India and the Middle East - all of which have some huge issues.

Disconcerting Economic Headlines To Keep On Your Radar

Something really bad will happen at Bank of America.
Organization and structural problems are threatening to upend Bank of America.  The state of Bank of America's governance and finances is so bad right now that regulators are threatening enforcement action if management doesn't get its act together.  I believe that there is something (BAD) going on at B of A – we just don’t know the extent of it yet.

Jefferies will fail.
Capital shortfalls at Jefferies have spooked investors recently, and now ratings agency Egan-Jones is threatening another downgrade unless the investment bank can raise $1 billion.  The failure of a mid-market investment firm like Jefferies would escalate panic about Europe, and would probably provoke a sharp tightening in bank liquidity. Traders might also begin to speculate against firms similar to Jefferies—too small to be bailed out by the FDIC under current rules but nonetheless important to the financial sector.

Investors in MF Global are never going to get their money back.
There has been criminal activity in this mess.  Because of the involvement of John Corzine, it has been delayed – for the time being.

The IMF will try to bail out Europe and U.S. taxpayers will take the fall.
The International Monetary Fund is making lots of moves— The IMF is preparing a 600 billion euro bailout for Italy in case the debt crisis worsens, Italian daily La Stampa reported citing IMF officials (via AFP).  The IMF would guarantee rates of 4 or 5 percent on the loan, far better than borrowing costs far better than the commercial debt market where yields have reached as high as 8 percent.  The loan is intended to give the new Mario Monti government 12 to 18 months to launch necessary reforms.
The size of the loan may require joint action with the ECB: "This scenario is because resistance from Berlin to a greater role for the ECB in helping states in difficulty -- starting with Italy -- could be overcome if the funds are given out under strict IMF surveillance," the report said.
This would be the second big move from the IMF this week after unveiling a huge liquidity program on Tuesday.  At the beginning of the month, Silvio Berlusconi announced that he had refused an offer of money from the IMF. Obviously this gambit did not assuage the market and Il Cavaliere was out within days.
An IMF bailout means money coming from the US taxpayer.  The U.S. will end up with the bill of any IMF expansion of IMF resources. The U.S. is the largest individual financier for the IMF, contributing 17.7% of its funds.

Germany is going to royally screw over Europe—and the rest of the world.
The Eurozone is quickly fissuring into two different camps—those who believe that stronger action (European Central Bank monetization of sovereign debt, Eurobonds, or some combination of the two) is necessary immediately, and those who want to wait for treaty change to fix the fiscal integration problems of the euro area.

France, the PIIGS, and many EU leaders are falling into the first camp, whereas Germany and the ECB are the staunch leaders of the second.  I think that Germany acquiesces on both Eurobonds and cranking up the money printing presses.  If they don’t, and relatively soon, I think that the world’s markets are going to get really volatile – and in a bad way.

U.S. banks will be hit hard by an imminent European crisis.
It is widely accepted that escalation of the Eurozone crisis will have an effect on the U.S. financial system. However, Fitch dramatically escalated those fears when it released a report last week saying that U.S. banks stand to take a big hit if the economic situation in Europe gets any worse.
Now the Federal Reserve is requiring 31 banks to stress test their portfolios.  Forget the worry on this – it’s a done deal.

Greece will not get its next tranche of aid in time.
Despite forming a new national unity government, Greek lawmakers are still posing problems complicating disbursement of the next round of aid from the first bailout.
EU leaders led by German Chancellor Angela Merkel are demanding that Greek lawmakers sign a commitment to passing austerity measures before the aid will be disbersed. Conservative leader Antonis Samaris, however, says his party doesn't want to.
Greece is really coming down to the wire here, and must receive aid within 20 days to avoid default.  Greece has NO bargaining chips, yet they are acting like they are in control of their own destiny.  I fully expect the atmosphere to get much worse.

The U.S. will slide back into recession.
Economic data has, on the whole, been beating expectations recently – if you want to believe the numbers (I don’t).
Recent consumer sentiment and initial jobless claims misses, an ominous economic surprise index, and a downward revision of Q3 GDP are just a few of the headlines indicating that the U.S. might actually be headed for a double-dip recession after all – if it’s to be believed that we ever left the first one.

China will experience a hard landing.
HSBC Flash PMI fell to 48.0 from 51.1 for November, a 32-month low for the indicator. This is stoking fears of a hard landing for the Chinese economy.  China’s economic numbers are more heavily manipulated than those of the U.S.  Whatever you read out of China, assume that the actual case is worse.
The headlines we've seen about China's underground banking system over the last few months aren't helping things either.  China’s regular banking system is in tatters, too. Be wary of investing in any company domiciled in China.

France might lose its AAA credit rating.
Fears about a downgrade of French sovereign debt have been moving markets all week.  Forget about this as a fear- it’s a done deal.
France has long been the subject of downgrade speculation, but now the credit agencies are adding fuel to that fire. Meanwhile, yields on French bonds are blowing out.  The Markets are tlling us all we need to know.  The downgrade is imminent.

The 20 European Banks With The Most PIIGS Exposure

 The following list shows those 20 banks with the most exposure to Portugal, Ireland, Italy, Greece and Spain.  Keep in mind as you look at this list that there are billions of dollars in money market instruments that each of these banks have issued and are outstanding - and that the U.S. banks have both direct exposure to these banks and indirect exposure to those money market instruments.  Also, some of these instruments may be in the Money Market Funds that you have in your investment and retirement portfolios.  This is NOT just a European problem!

PIIG Exposure
Market Cap
Common Equity
Exposure as a % Equity
#1 - Allied Irish Banks (Ireland)
$129.02 billion
$2.00 billion
$0.387 billion
#2 - Banca MPS (Italy)
$290.98 billion
$7.96 billion
$6.24 billion
#3 - Banco Popular Español (Spain)
$182.94 billion
$6.91 billion
$9.49 billion
#4 - Intesa Sanpaolo Group (Italy)
$607.03 billion
$51.06 billion
$37.07 billion
#5 - EFG Eurobank Ergasias (Greece)
$76.01 billion
$2.07 billion
$4.74 billion
#6 - BBVA (Spain)
$552.90 billion
$52.80 billion
$35.39 billion
#7 - Bank of Ireland (Ireland)
$102.43 billion
$1.39 billion
$7.40 billion
#8 - Unicredit (Italy)
$541.54 billion
$34.41 billion
$50.59 billion
#9 - Banco Santander (Spain)
$567.20 billion
$92.08 billion
$59.51 billion
#10 - Dexia (Belgium)
$132.95 billion
$5.229 billion
$10.34 billion
#11 - Commerzbank (Germany)
$67.38 billion
$18.45 billion
$14.60 billion
#12 - BNP Paribas (France)
$280.96 billion
$79.91 billion
$78.43 billion

#13 - Deutsche Bank (Germany)

$140.61 billion
$49.73 billion
$43.02 billion

#14 - Credit Agricole (France)

$192.06 billion
$29.97 billion
$65.50 billion

#15 - KBC Bank (Belgium)

$39.70 billion
$9.05 billion
$16.09 billion

#16 - DZ Bank (Germany)

$24.69 billion

$10.34 billion

#17 - Landesbank Baden-Württemberg (Germany)

$32.05 billion
$11.27 billion
$13.94 billion

#18 - Barclays (UK)

$123.51 billion
$43.91 billion
$65.510 billion

#19 - Landesbank Berlin (Germany)

$13.11 billion
$5.60 billion
$7.31 billion

#20 - Royal Bank of Scotland Group (UK)

$146.42 billion
$60.96 billion
$83.58 billion