Don't Buy Into Europe's Latest Rescue Effort - The Continent's Banks Are About to Go Bust

The latest plan to preserve the European Union (EU) and save the global banking sector is to force European banks to increase their equity capital.

The goal, of course, is to restore confidence and stability. But if that's the case, then why are so many analysts and savvy investors still nervous?

To put it bluntly, because they know it won't work.

As it stands, the capital shortage is about 200 billion euros ($277 billion) according to the International Monetary Fund (IMF). I think it's more like 1 trillion euros ($1.4 trillion) by the time you factor in all the cross holdings and the daisy chain of exposure that makes the entire banking system there look like Swiss cheese.

Why Recapitalization Won't Work

There are three things that are especially problematic to me:

1. European Union (EU) ministers apparently are going to put capital into the system without knowing how much it needs or exactly where to put it. Hard to believe, but thanks to the opaque nature of the derivatives markets, nobody can be sure exactly how much exposure any one bank or financial institution has.
2. Healthy banks that do not need an infusion will get one anyway. Rainer Skierka, who is a stock analyst at Bank Sarasin & Cie AG, shares my belief that this will lead to massive dilution for shareholders.
3. Any bank that is undercapitalized will effectively be the recipient of capital that has been diverted away from healthy banks and into its toxic financials. Unfortunately, this money will be placed at higher risk in an effort to earn the incremental income needed to backstop bad bets that already are on the books. That means shareholders who are led to believe things are improving will actually find their money at an even higher risk than before.

As I have noted repeatedly since this crisis began, regulators are fighting the wrong battle and have been since 2008. They are worried about liquidity when they should be worried about solvency.

Sure, a bank recapitalization can repair the banking system when it comes to keeping money moving in terms of short-term credit - but no amount of money can prepare European banks for a sovereign default or credit freeze because there literally isn't enough money on the planet to recapitalize the banking system unless you remove the risks that plague it.

The "system" is still at incredible risk.

The total worldwide notional derivatives exposure is more than $600 trillion dollars according to the Bank for International Settlements (BIS). And that's against a gross market value of merely $21.1 trillion.

In other words, banks have invested in instruments valued at $21 trillion but with a total exposure that's 28.4-times that -- or $600 trillion dollars.

This is why rogue traders are such a problem; they can take disproportionately large risks with not a lot of capital, which often leads to catastrophe.

Take Nick Leeson, the former derivatives broker who worked for Barings Bank. His leveraged trading losses eventually reached $1.4 billion, or twice Baring's available trading capital. Barings went under as a result.

More recently, Kweku Adoboli, who served as director of exchange traded funds (ETFs) at UBS AG (NYSE: UBS), blew a $2 billion hole in UBS' balance sheet.

Part of the problem is that n obody knows exactly how much cash banks spend to amass such investments because derivatives and sovereign debt trading instruments are still largely unregulated and "self policed" within the industry.

So what's this have to do with our money?

Everything.

Looming Liquidation

If there are additional downgrades of European or American banks ahead, or if the cost of credit default swaps (CDS) continue to rise, thus making new financing prohibitively expensive, the banks trading derivatives will have to post additional marginable collateral.

In plain English, this means the firms trading in derivatives will have to come up with huge amounts of cash they don't have. So they will sell everything but the kitchen sink as a means of raising it.

Consider what happened last time around.

Merrill Lynch said in a quarterly report in 2008 that a one-notch downgrade of its credit rating would require the firm to post an additional $3.2 billion of collateral on over-the-counter derivative trades. Around that same time, Morgan Stanley (NYSE: MS) estimated in a regulatory filing that a single-level downgrade would mean posting an extra $973 million. And Lehman Bros, before it collapsed, said a one-level downgrade would require about $200 million of additional collateral.

This is what was behind the massive drops in gold, silver, and the broader markets in late 2008. Credit locked up, the cost of capital rose and margin calls ensued. So banks and trading houses sold everything they could as quickly as they could to raise the necessary capital. The selling began in the metals markets because they are most liquid. Then it moved rapidly into the broader equity markets, causing a downdraft that most investors would like to forget.

We experienced a similar thing earlier this summer as a result of more downgrades and prohibitive CDS costs. Not surprisingly, the Standard & Poor's 500 Index fell 18% and gold tumbled 15% as the banks' trading arms raised capital to cover their bets.

And it will happen again when the latest plan fails.

If you're tempted to believe that the likes of BNP Paribas SA (PINK: BNPQY), JPMorgan Chase & Co. (NYSE: JPM), Goldman Sachs Group Inc. (NYSE: GS), and others care about anything other than their own hides when the downdraft starts, think again.

Not only will institutions like these begin selling at the first hint of a margin call or more ratings downgrades, but they will actively use their own proprietary funds to book more gains in the process - even if it means trading directly against their own clients.

Four Ways to Protect Yourself

So enjoy the rally while it lasts and do these four things in the meantime:

1. Sell into strength using trailing stops. That way you can capture the rally if it continues and move your money to the sidelines if it doesn't. Nobody knows how long the fairy tale will last so you might as well let the markets show you the way instead of trying to second guess them and risk being wrong.
2. Buy commodities. Holding energy and agricultural commodities as well as precious metals like gold and silver will help you preserve your wealth. Even after large pullbacks that may result from capital raising activities, the long-term direction for these is up. To minimize risks, buy in chunks or dollar cost average in over several months.
3. Go Global. Put new money to work in "glocal" stocks . These are companies with fortress-like balance sheets, globally diversified revenue and experienced management. Average in here, too. Things may get rocky but over time, but dividends are the best defensive measure available.
4. Short financials. If you're an aggressive trader, you can short individual banks or the entire financial sector. After all, "they" took us for a ride -- why not get even when the tables eventually turn?

News and Related Story Links:

• Money Morning:
  One of These Banks is Europe's Lehman Bros. - And We're Going to Profit From Its Collapse
• Money Morning:
  The Looming Bear Market: What You Can do That Washington Can't and Wall Street Won't