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.

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