Thursday, July 7, 2016

Me Dr Doom? No so much but I am a realist

The problem with Hollywood's view of Wall Street and of finance in general is that everyone seem to expect the massive cliff hanger with a visual and satisfying denouement.  Reality is rarely that way.

Over the past three years I have made three big prognostications:
  1. Greece would soon be out of the Euro (so far I am wrong)
  2. That European banks are in real trouble (see more below)
  3. That UK would vote to exit -- and why there are some justification (I was right, but the reason why people voted to leave had more to do with xenophobia and parochialism)
Lets get back to item 2 on my list.  I said that European banks were in trouble, that they were grossly undercapitalized and that they needed to change things.  Since then, the big ones (DB, SocGen etc etc) have reduced lending (why do you think there is a stagnation in Europe) and increased capital to meet their risk capital obligations.  So what happened? Over the past 30 months DB has seen its share price go from around  Euro50 to about Euro 12 as of yesterday's close.  However, during the 2008/2016 period, DB has increased its off balance sheet risk dramatically -- look at the massive derivatives book -- which according to DB is well hedge.  

The reality is that DB has taken some massive capital hits over the past 24 months, racking some impressive losses over the period. According to BIS it still is within the threshold of acceptable, but then these are the same guys who said that a bank Belgian, Dexia, was fine; the same morning Dexia was declared insolvency... so treat BIS bank rating with a massive grain of salt (I would in fact suggest a large chunk of cristal salt). 

Back to my initial point, the real world banking collapse is more like a Monty Python sketch then a Hollywood action movie, pieces are slow to move and their direction seems pre-ordained, almost like a tragedy.  What is happening in the PIGS could/was foretold years ago.  The massive pressures on the Southern European economies reflected itself in business failures -- banks were left holding the bag.  No amount of capital (we are talking north of 15% of assets being unrecoverable) would save these institution.  (12/7:  I should add that the Southern European banks failed to boost their capital between 2008/2014 hoping that a recovery would save them...)

Like Nero, the ECB is watching Europe's southern banks burn, not realizing that it will affect the backbone of Europe's Northern banks establishment.  Watch DB and SocGen suddenly receive state aid once the chips start falling (BTW no one knows what are the contagion risks here).  

So two years ago, I said Europe's banks were in grave danger since then the stock price of the biggest bank has fallen by nearly 80% (SocGen is off by only 50%), in the south price drops has been catastrophic; Banco de Monte de Paschi that was trading around Euro 6.0 in 2014 now trades at Euro 0.27 giving the bank a market capitalisation of Euro 5 billion.  It is hard to see how that bank, with nearly Euro 170 billion in assets -- and nearly Euro 25 billion in bad debt (15% of assets) can fix its problem via new issuance, and according to the ECB a bad bank scenario is off.

I was right, being the owner of a European bank over the past 24 months has been a disaster.  Now how does this translate into the real world?  The answer is Lehman Brothers -- we just don't know. The problems of MdP could bleed into some of Germany's Landesbanks -- who have trades with; SocGen and DB.  That is what we call contagion.  For Italians the consequences are even more severe, because the death of these banks will shut down the country's payment system -- money is maybe at the heart of all evil, but it's still the "lubricant in the system".

So my prediction if you were an investor were right, for the bleed through to the rest of the financial system -- it will take time, and it will happen.  One thing for sure, the ECB will have to take care of Europe's banking system -- very soon!








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