Start the conversation
Comment on This Story
Or to contact Money Morning Customer Service, click here.
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:
- 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.
- 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.
- 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:
- 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.
- 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.
- 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.
- 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
About the Author
Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.
Why would you ever short a stock when you can buy puts?
You guys are awesome.
I am a UK investor. I have only just found your site. Not only have I found your ideas interesting, but I also find it good to see views that are rather like my own from the other side of the "Pond". Thank you
I happen to be a subscriber to your newsletter and the Oxford club. Do you have ANY idea how confusing it is when you are warning everyone to sell into strength because there could be a total collapse when Alex Green and Louis Basenese is saying stay in the game and don't let the doomsayers get you out of the market? What is an average investor to do when you guys are sending out such conflicting info? Frankly, I am more than sick of it and might cancel my subscriptions.
Allen
please cancel. go and read the mainstreams big fella.
I find your article on european banks interesting,have been studying this for some time,if we look
at what happened in the 1921 in Europe,then in the 30's ueropes banks were in trouble and had a huge effect on the globe.This funding they are doing,I agree is not large enough,its a temporary band aid.
I am a canadian investing in large canadian oil and gas stocks,plus pipelines
Your fear-laced piece is more of the same pessimistic, wrong-headed policy to stop the economic slide and induce normally rational people to tank the markets. Reread the same conservative policies applied to post-1929 conditions and see how they produced Depression. The solution is liquidity–proposed for Euro Zone banks. There does need to be a means test for banks to focus on the weak banks, and ignore the strong ones. If Europe follows Geithner and Bernancke's Fed, they'll be better off later. Our economists can't seem to understand the lessons of the 30's Depression and may be doomed to repeat the political fascism that follows 'retraction' policies. Better consult a broader range of economic/market advisors before putting this "fearful" analysis into the ether.
Keith Fitz-Gerald you are right of course except for one thing. The Banks are only the financial expression of the capitalist system, which is rapidly heading for the garbage dump of history. Do I need to explain ?
The Banks are but an expression of the capitalist system. If the Banks are bankrupt, then the capitalist system as a whole is bankrupt and a major Depression is just around the corner, that cannot be fixed any longer by any government unless with the printing press. No manipulation by the banks will help, no manipulation by the U.S. Government will help. If the banks cannot make a profit, industry also cannot
make a profit, and without profit banks as well as industry are stuffed. This incidentaly applies also to the governments, which will, by necessity be replaced by the people.
This was written in 1848 and still holds true. I remember George Bush proclaiming that "Communism is dead." His Son, bailed out the banks and opened the way not to fascism in the U.S. of A., but to socialism. The question is?: Will the American peole remember ? The world will be holding its breath !!!
You could also buy into the argument that the Politicians we see today are simply Party people who have been educated from a young age to become elected as leaders without any real life experience.
I cannot name any post war politician in any country today who has had to work a 9-5 job on a regular income and thus meet others of their community and all levels of that community.
The result of this is the present financial circus where those in charge really have no idea . What the USA needs is another "Baroness Thatcher". Perhaps this Herman guy has some idea? Afterall he doesn't fit the present mold does he?
So, let me get this straight, gold goes down as banks raise capital to meet margin calls, but it goes up as everyone seeks a safe haven from fiat currencies
And in times of fear about debt and inflation, the world flees to one of the most indebted and overprinted of fiat currencies, the US dollar
Go figure. I'll just sit this one out, on a pile of gold
We sure live in weird times
Let,s continue to rearrange the chairs, on the TITANIC !!!
clever
But the markets have had months to digest Euro dysentery, and have discounted much of what is to come. The record numbers of Bears are still stuck perseverating over the malaise. The markets will not oblige them and will teach yet another lesson.
Doom and gloom, all we need is a little love, not money.