The European Banking System is Finally on the Verge of Collapse

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I hate to sound alarmist, but it looks as though the European banking system - and consequently the global banking system - is edging its way towards another epic collapse.

That means in just a few short months, stocks could be back at their 2009 lows while gold prices travel north of $2,500 an ounce.

This is the worst-case scenario that's been bandied about ever since Europe's debt problems first came to light.

How do we know that this is what's happening?

Because somebody is having trouble obtaining the money they need -- and they just borrowed it from the lender of last resort.

The European Central Bank (ECB) last week lent $500 million dollars to an undisclosed Eurozone bank through a credit mechanism that had been dormant for the past 12 months, with the exception of one $70 million draw in February.

This comes as no surprise - the warning signs have always been there.

In fact, I warned Money Morning readers just a few weeks ago that the Eurozone could have its own American International Group Inc. (NYSE: AIG) - or worse, its own Lehman Bros. Holdings Inc. (PINK: LEHMQ) - lurking somewhere in the shadows.

Still, while this may not surprise you, it certainly surprised the heck out of the rose-colored glasses crowd that can't seem to understand the European sovereign debt crisis is finally about to wash up on our shores.

That's why stocks in the United States and around the world have taken such a brutal beating recently. Officially the story is about the renewed worries over Europe's debt crisis and U.S. data that suggests we're once again sliding into a recession.

But what's really happening is that global traders are moving quickly to liquidate holdings and raise cash while they can.

That's why so-called risk assets like stocks, corporate bonds, industrial metals, oil and higher-yielding junk instruments are tanking, as gold, the dollar and the yen are bucking up.

The U.S. Federal Reserve already is engaging in damage control. President of the Federal Reserve Bank of New York William Dudley has said the risks of a double-dip recession are "quite low," despite anemic growth. And it's been rumored that U.S. Federal Reserve Chairman Ben S. Bernanke will telegraph new monetary stimulus measures Friday during his speech in Jackson Hole, WY.

But really, who are they kidding?

This crisis has nothing to do with liquidity (which is how the central bankers are trying to fight it) and everything to do with solvency (which is how they should be fighting it).

Not only are the risks of a global recession mounting by the minute, but I believe the concentration of risks is approaching critical mass.

A Return to 2008

First take a look at the Euribor-OIS swap (the spread between the Euro Interbank Offered Rate and the Overnight Indexed Swap). This swap, widely regarded as a gauge of fear in the European banking system, is at levels we haven't seen since April 2009, and is climbing rapidly towards levels we experienced during 2008 at the height of the financial crisis.

These rates, along with the London Interbank Offered Rate (LIBOR), represent a sort of feedback mechanism similar to the body's circulatory system. If the system goes into "shock" there will be a negative, self-sustaining reaction.

At the same time, shorter-term euro basis swaps have fallen to the lowest levels we've seen since Lehman Bros. blew up.

The premium that European banks are paying to borrow in dollars through the swaps market is at its most extreme level since the credit crisis of 2008. The cost of converting euro-based payments into dollars as measured by the three-month cross-currency basis swap fell as much as 93 basis points below the Euro Interbank Offered Rate (Euribor), indicating a higher premium to buy dollars.

Historically, anything in the neighborhood of -150 basis points suggests imminent bank failure.



European banking system

Meanwhile, funds parked in the ECB's "deposit facility" are rising, which means they aren't being lent to other banks. Funds at the ECB deposit facility hit their highest level - $209.3 billion (145.2 billion euros) - earlier this month. And ECB data shows commercial banks parked $154.4 billion (107.2 billion euros) in the central bank's deposit facility last Friday, up from $130.5 billion (90.5 billion euros) on Thursday.

This suggests banks are more concerned with having liquidity available to them via "official" sources rather than the open markets.

There are two reasons they would feel that way:

  1. Because they can't get it from other sources.
  2. And because they don't trust the other banks who would otherwise serve as their counter party.
Remember, banks only make 0.75% on their deposits at the ECB, which is a smaller return than what they'd receive by lending to other banks. This suggests banks value the return of their money more than the return on their money.

This happened before, most recently in Japan in the 1990s. I remember living in Japan at that time, and things got so bad that the spreads on overnight deposits actually went negative for short periods. That is, Japanese banks actually paid the Bank of Japan (BOJ) to hold their money because they were scared to hold it themselves.

Finally, non-U.S. bank reserves on deposit at the Federal Reserve declined from $900 billion on July 13 to $758 billion as of Aug. 3. I've done some calling around and heard from two confidential sources that the level may have fallen as low as $500 billion this week, which would be a near-50% drop in only weeks.

According to the Fed, foreign banking institutions hold approximately 25% of all commercial banking assets in the United States. That makes me think EU banks are calling money home not because they want to but because they need to.

How to Prepare for Another Banking Breakdown

So now what?

Well, if the data is even halfway accurate with regard to what it suggests, then stocks will likely retest their March 2009 lows. That means the Dow Jones Industrial Average could fall to the 6,600-level, while the Standard & Poor's 500 Index drops to 683, and the Nasdaq Composite Index slinks all the way down to 1,293.

Gold likely will head in the opposite direction to $2,500 an ounce or higher and 10-year Treasury bond yields may drop as low as 1.5%.

More immediately though, I expect central bankers to attempt one more Herculean effort to "save" things. Whether that intervention will take the form of a third round of quantitative easing (QE3) or another federal "stimulus" plan is unclear.

But regardless of what happen, these are the steps you should take:

  • Sell weaker positions and transition that money into companies you really want to own -particularly if they are the "glocals" we talk about so frequently, and especially if they have high dividend yields.
  • Begin tightening up your protective stops so that you can both capture gains and protect your capital as the market rolls over.
  • Buy commodities including gold, silver, oil and pharmaceuticals.
  • Invest in the specialized reverse exchange-traded funds (ETFs).
  • And, most importantly, KEEP BUYING - but change up your tactics to include dollar cost averaging. There's no sense in making all-or-nothing decisions when that type of thinking doesn't fit market conditions.
Remember, you miss 100% of the shots you don't take, so getting to the sidelines is not a profitable plan. Staying in the game always has been, and always will be, the way to profit.

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About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He’s a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean.

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