Should You Worry About Europe's Back Door Bank Run?

By Keith Fitz-Gerald, Chief Investment Strategist, Money Map Report • @kfgtotalwealth • December 16, 2011

On Wednesday, Fitch Ratings Inc. downgraded its credit ratings on five of Europe's biggest banks, and while that decision made headlines, it's not the most important story to come out of Europe this week.

The real story, which the mainstream media is neglecting, is that there are signs of an underground run on Europe's banks.

Almost nobody's talking about it, but there are indications money is already moving out of the European Union (EU) faster than rats abandoning a sinking ship.

Not through the front door, mind you. There are no lines, no distraught customers and no teller windows being boarded up – not yet, anyway.

For now the run is through the back door, and there are four things that make me think so:

1. Italy's planned ban on cash transactions over 1,000 euros, or about $1,300.
2. French, Spanish, and Italian banks have run out of collateral and are now pledging real assets.
3. Swiss officials are preparing for the end of the euro with capital control measures.
4. Europe's CEOs are actively preparing for the end of the euro despite governmental reassurances.

Signs of a Run

Let's start with Italy and Prime Minister Mario Monti's plans to restrict cash transactions over 1,000 euros (down from the current limit of 2,500 euros, or about $3,200).

Ostensibly the move is about reducing tax evasion by prohibiting the movement of large sums of cash outside the official transactional system, but I think it speaks to something far more sinister – namely that the Italian government knows things are going to get far worse than they're publicly admitting.

Consider: Cash is a stored value mechanism. There's not a lot of it because at any given point in time, most of it is on deposit with banks in any country. That's as true in Italy as it is here in the United States when real interest rates are positive during "healthy" times.

But when real interest rates turn negative, people are likely to withdraw cash and stuff it quite literally under mattresses or in coffee tins. (Real interest rates are the official lending interest rates as adjusted for inflation.)

In such an environment, holding cash in a bank becomes nothing more than an imputed tax and a disincentive for deposits. It's also a significant thorn in the side of central bankers who want to control their country's money supply, because cash can operate outside the system and, specifically, logjam reform efforts.

The reason is really pretty simple. If you have negative real interest rates, and cash transactions are largely restricted or removed altogether, then the only way to effectively use cash is to withdraw it and spend it… immediately.

In other words, by limiting cash transactions to 1,000 euros or less, Italy is putting into place a punitive financial control fully intended to keep money moving in a system lest it become worthless or worse – hoarded and worthless.

Now let's move on to banks.

Banking Breakdown

Many investors have never thought about it before, but there are really only three sources of funding for a bank:

1. Money that's effectively "lent" to the bank by customers placing their assets on deposit;
2. Short-term money market funds;
3. And long-term bonds or securitized products based on long-term paper sold to bond investors.

Together, the three funding sources are like the legs on a stool – lose any one of them and the stool will topple over because it is no longer balanced. Cut the legs down and the stool collapses – that's what is happening now.

Individuals, pension funds and institutions alike are withdrawing funds from Italian, Spanish and French banks. Money has long since left Greece, Ireland, and Portugal.

Thing is, though, it's not just European money that's fleeing. Various reports from The Economist, Bloomberg, CNBC and others suggest that American financials may have pulled more than 40% of their funds from all European banks and nearly two-thirds of their total deposits away from French banks. This is drying up short-term lending capacity and driving up interbank lending costs.

At the same time, money managers the world over are selling their European bonds. This is driving prices lower and yields higher to the point where the cost of debt is now prohibitive (bond prices and yields move in opposite directions). As a result, new bank bond issuance may be down as much as 85% over the past two years, which further hobbles cash hungry European banks.

Finally, facing a near total loss of short-term financing alternatives and having run out of short-term liquidity needed to operate, a number of EU banks are reportedly having to pledge real assets as collateral for badly needed loans.

Normally, banks would use loans, leases or receivables to accomplish the same thing. The fact that they're now having to throw in real estate, their own property, and other assets into the mix signals extreme levels of financial stress that are far worse than what's been disclosed publicly.

Bracing for the Inevitable

Swiss Finance Minister Eveline Widmer-Schlumpf noted to the Swiss Parliament that she's got a working group examining capital controls and negative interest rates as a means of preventing an economy-crushing Swiss franc appreciation when the euro fails. That's not if the euro fails, but when the Euro fails.

This is an especially dire sign because capital control measures like those the Swiss officials are considering are inevitably the end of any failed monetary system.

European CEOs and their companies are taking matters into their own hands by actively preparing for the destruction of the euro.

Some, like German machinery maker GEA Group AG (PINK: GEAGY) are limiting the maximum funds on deposit with any single bank. Others, like Grupo Gowex, are moving cash and deposits to Germany away from Spanish banks (and Grupo Gowex is a Spanish company based in Madrid, so this is especially telling). BMW plans to cut production by 30% while also tapping into central bank reserves. According to Chief Financial Officer Friedrich Eichiner, the company is already reducing its leasing portfolio to cope with the potential decrease in car values that would impact its borrowing capacity.

As for what all this means for our money, that's pretty clear – think SAFETY FIRST. The return of your capital is far more important than the return on your capital at the moment.

Here's what I suggest.

1. Buy dollars – I know they're a bad long-term bet, but short-term, they're the best looking horse in the global glue factory as long as the euro is under pressure.
2. Stick with what you have in place now and manage risk with trailing stops. Confine new stock purchases to high-growth, low-debt emerging markets rather than low-growth, high-debt developed markets.
3. Short gold and oil in the short-term. Both are priced in dollars, which means both will fall as the dollar rises in conjunction with panic in the EU.
4. Purchase inverse funds that track the broader markets. If the euro fails, it will tank the broader markets. Then, once it becomes clear that the world will live on, the markets will disconnect from Europe and begin to rise again in earnest.
5. Run the other way if people tell you that banks are a great investment. They are speculative at best given the number of skeletons still in the closet.

News and Related Story Links:

• Money Morning:
  Maverick Judge Jed Rakoff Stares Down The Street
• Money Morning:
  Why the Fed's Latest Rescue Effort is Doomed
• Money Morning:
  
  European Bond Traders Are Going For the Jugular
• Money Morning:
  How Much Cash Should You Hold?
• Money Morning:
  Don't Buy Into Europe's Latest Rescue Effort – The Continent's Banks Are About to Go Bust