Monday, 4 June 2012

The EU’s Systemic Risk: Why This Time IS Different

Europe will collapse before the end of the year and very likely before the end of the summer. When this Crisis hits it will be worse than 2008. And the world Central Banks will not be able to control the damage.

What makes this time different?

Several items:
1)   The Crisis coming from Europe will be far, far larger in scope than anything the Fed has dealt with before.
2)   The Fed is now politically toxic and cannot engage in aggressive monetary policy without experiencing severe political backlash (this is an election year).
3)   The Fed’s resources are spent to the point that the only thing the Fed could do would be to announce an ENORMOUS monetary program which would cause a Crisis in of itself.

Let me walk through each of these one at a time.

Regarding #1, we have several facts that we need to remember. They are:
1)   According to the IMF, European banks as a whole are leveraged at 26 to 1 (this data point is based on reported loans… the real leverage levels are likely much, much higher.) These are a Lehman Brothers leverage levels.
2)   The European Banking system is over $46 trillion in size (nearly 3X total EU GDP).
3)   The European Central Bank’s (ECB) balance sheet is now nearly $4 trillion in size (larger than Germany’s economy and roughly 1/3 the size of the ENTIRE EU’s GDP). Aside from the inflationary and systemic risks this poses (the ECB is now leveraged at over 36 to 1).
4)   Over a quarter of the ECB’s balance sheet is PIIGS debt which the ECB will dump any and all losses from onto national Central Banks (read: Germany)

So we’re talking about a banking system that is nearly four times that of the US ($46 trillion vs. $12 trillion) with at least twice the amount of leverage (26 to 1 for the EU vs. 13 to 1 for the US), and a Central Bank that has stuffed its balance sheet with loads of garbage debts, giving it a leverage level of 36 to 1.

And all of this is occurring in a region of 17 different countries none of which have a great history of getting along… at a time when old political tensions are rapidly heating up.

As bad as the above points may be, they don’t even come close to describing the REAL situation in Europe. 

Case in point, regarding leverage levels, PIMCO’s Co-CIO Mohammad El-Erian (one of the most connected insiders in the financial elite) recently noted that French banks (not Greece or Spain) currently have 1-1.5% capital relative to their assets, putting them at leverage levels of nearly 100-to-1.

And that’s France we’re talking about: one of the alleged key backstops for the EU as a whole.

To be clear, the Fed, indeed, Global Central Banks in general, have never had to deal with a problem the size of the coming EU’s Banking Crisis. There are already signs that bank runs are in progress in the PIIGS and now spreading to France (see El-Erian’s comments in the article above).

I want to stress all of these facts because I am often labeled as being just “doom and gloom” all the time. But I am not in fact doom and gloom. I am a realist. And EU is a colossal mess beyond the scope of anyone’s imagination. The World’s Central Banks cannot possibly hope to contain it. They literally have one of two choices:
1)   Monetize everything (hyperinflation)
2)   Allow the defaults and collapse to happen (mega-deflation)

If they opt for #1, Germany will leave the Euro. End of story. So even the initial impact of a massive coordinated effort to monetize debt would be rendered moot as the Euro currency would enter a free-fall, forcing the US dollar sharply higher which in turn would trigger a 2008 type event at the minimum.

Moreover, we need to consider that the Fed is now so politically toxic that Ben Bernanke is literally going on the campaign trail to attempt to convince the American people that the Fed is an honest and helpful organization. Put another way, there is NO CHANCE the Fed can announce a large-scale monetary policy unless a massive Crisis hits and stocks fall at least 15%.

Finally, regarding my third point… if the Fed were to announce a new policy it would have to be MASSIVE, as in more than $2 trillion in scope. Remember, the $600 billion spent during QE 2 barely bought three months of improved economic data in the US and that was a pre-emptive move by the Fed (the system wasn’t collapsing at the time).

So given that the Fed will only be able to announce a large scale program in reaction to a Crisis, whatever it didannounce would have to be ENORMOUS, a kind of shock and awe, attempt to rein in the markets.
Moreover, it would literally be THE LAST QE the Fed could hope to ever announce as political outrage from the ensuing Dollar collapse and inflationary pressures would likely see the open riots and/or the Fed dismantled (this has happened twice before in the US’s history).

In simple terms, the Fed’s hands are tied until a huge Crisis hits. And then, if the Fed acts it’s going to have to go “all in” with a massive program. If it does, we will still experience a Crisis, as the Dollar would collapse pushing inflation through the roof as well as interest rates (which in turn would destroy the banks as well as the US economy).

In simple terms, this time around, when Europe goes down (and it will) it’s going to be bigger than anything we’ve seen in our lifetimes. And this time around, the world Central Banks are already leveraged to the hilt having spent virtually all of their dry powder propping up the markets for the last four years.

Again, this time it is different. I realize most people believe the Fed can just hit “print” and solve everything, but they’re wrong. The last time the Fed hit “print” food prices hit records and revolutions began spreading in emerging markets. If the Fed does it again, especially in a more aggressive manner as it would have to, we would indeed enter a dark period in the world and the capital markets.

European Union$16 trillion
United States of America$14.5 trillion
China$5.8 trillion
Japan$5.4 trillion
European Central Bank$3.8 trillion
Germany$3.2 trillion
US Federal Reserve$2.8 trillion
France$2.5 trillion
United Kingdom$2.2 trillion

Banking SystemTotal AssetsTotal Assets Relative to GDPTotal Assets Relative to Central Bank Balance Sheet
Europe$46 trillion287%1,210%
US$12 trillion82%428%

This is not Doom and Gloom, this is reality.


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