There's a lot of talk about Europe at the moment, but it's kind of the way you talk about flooding when the waters don't reach your house. Sure, it must be real tough for the poor saps whose couches are bobbing around in their living rooms -- but meantime, what's for dinner?
Unfortunately, that European flood has only just started -- and financial messes have a habit of becoming global rather quickly. After all, it was problems in the American mortgage markets that first triggered the financial disasters unfolding in Europe today. And of course these European ructions have some sharp lessons for U.S. policy makers... not that our Congress with its 9% approval rating would listen anyway.
But let's start with some simple math. The multi-trillion euro question at the moment is: Are European banks solvent? And you don't have to be Einstein to figure out the right answer. At the start of this year, a Spanish ten-year bond yielded around 4.90%. If you were a Spanish bank, you quite likely chose to invest in that bond -- let's say €10 million of your shareholders' money.
So what's happened since then? Well, interest rates have gone up, up and up. For all that you hear about massive European bailout packages, those things have had almost no effect at all. When the European Central Bank lent out over €1 trillion in December through February, it bought financial peace for about six weeks. When Spain got a €100 billion bailout this past weekend, the financial respite lasted about three hours.
Interest rates on Spanish government debt have now hit 7.00%, the rate at which the country is almost certainly insolvent. But when interest rates go up, that's because bond prices are going down. (The two things are always inversely related: it's a mathematical truism.) And the collapse in bond prices means that the actual market value of that Spanish bank's €10 million investment is now only €8.5 million. It's lost 15% of its investment value in less than five months. That's an investment that Moody's has just downgraded to one notch above junk ... with a negative outlook.
That's a massive loss. Plenty of European banks holding this debt are very thinly capitalized. Deutsche Bank has equity that's just 2.7% of total assets. BNP Paribas has equity of 4.4% of assets. If those assets take a 15% loss, a fourth-grader could figure out that you can kiss good-bye to your shareholders' equity. It's gone, brother, it's gone. When MF Global went bankrupt, it did so because for essentially the same reasons, gambling on the same European bonds. Indeed when you think of the fuss that's been made over JP Morgan's recent $2 billion hedging loss, just remember that the Eurozone has plunged in excess of €1.5 trillion into 'stabilizing' its banking sector. Those banks mostly bought government bonds with the money... and those bonds have taken hideous losses recently. The loss of value is simply breathtaking.
So what does this mean? And what does it mean not just for the guys with water in their living rooms, but for we Americans, up on a hill, looking down at those floods?
First, a government with substantial debts, like those of Spain or Italy, cannot fund themselves at interest rates of just 7.00%. The burden is just too great. Secondly, European banks have accumulated too many bad assets, they've got too little shareholders' equity. Huge swathes of the European banking sector are bankrupt too. They'll go on trading for a while, because regulators will desperately keep kicking the can down the road for as long as they can. But bankrupt is bankrupt. At a certain point, you just won't be able to keep the Ponzi-ish pretense up any more.
At this point, the European common currency, the euro, is pretty much shot to shreds too. If a government defaults, it'll be obliged to exit the currency. We'll see the return of the drachma, the lira, the peseta. Those currencies protected their countries. They meant profligate governments could destroy value via currency devaluations instead of outright defaults. Because investors knew there would always be a high risk of value destruction, they demanded high -- and realistic -- interest rates by way of compensation.
In America, meantime, we have a profligate government, rapidly mounting debt and chaotically mismanaged 'too big to fail' banks. And these things are unsustainable. They kill a country. They are have killed Greece. They are killing Spain. They will kill Italy. They will threaten France. For the past 11 years, global GDP growth has been about 4% per annum. Growth in debt over the same period has been 12% per annum.
And our government is not acting. It needs to stabilize and reduce its debt. Not some time in an unspecified future, but right now. It needs to force banks to declare all their rotten assets. It needs to end the 'too big to fail' culture which came so close to ruining America in 2008 (and the big banks have just gotten bigger since then). Yet these things aren't happening. Our debt is still rising. We're watching the waters rise in our neighbor's back yards and we've forgotten that our own house is built on low ground by a failing levee. It's time to act and we're doing nothing.