EU House of Cards

Today’s comedic relief is brought to you, once again, by Europe. We weren’t going to write about the other side of the world today. But in this type of market you need an occasional good laugh, even if it threatens your wealth at the same time.

— After realizing the plan to leverage the European Financial Stability Facility (EFSF) was idiotic, the lemmings in Europe are running over to a new ‘solution’ – bank recapitalization. Like most things bureaucrats dream up, it’s good in theory. How it plays out in practice will be entirely different.

— That’s not the funny bit though. Check this out: Apparently European finance ministers have asked the European Banking Authority (EBA), Europe’s top (we use the word loosely) banking regulator, to stress test Europe’s banks – again.

— You may remember the same incompetent organization conducted stress tests in 2010 and 2011. The latest one, completed in July this year, found European banks to have a capital deficiency of just €2.5bn. At the same time as Athens was burning, these pompous fools didn’t even model a sovereign default. Now, just a few months later we’re talking about a need for €200 billion in fresh bank equity.

— But instead of all being sacked and the organization shut down – as would happen in the private sector – these imbeciles get another go. We can only conclude the EBA is a corrupt organization in the palm of the bankers. And it’s supposed to be their regulator?

— Look, the bank recapitalization plan is on the right track. We don’t dispute that. But it’s a plan being put together by a bunch of squabbling politicians who put their own re-election prospects ahead of anything else. So the chances of it actually being done properly are remote.

— As we wrote in our Sound Money. Sound Investments email update yesterday – bank recapitalization will be beneficial as long as they are accompanied by bad debt write-downs. The main problem with the global economy today is the amount of bad debt festering on bank balance sheets. This impedes the creation of new, productive debt.

— It also affects confidence. Banking is – and has always been – a business based on confidence. Without it, banks are exposed as the highly leveraged and fragile institutions that they are.

— So to improve confidence you need to purge the bad debt out of the system. This requires bank recapitalization to absorb the coming write-downs. Before we go any further, just what do we mean by ‘bank recapitalization’?

— The process is best explained with reference to a bank’s balance sheet. In balance sheet land, a company’s assets are equal to its liabilities and equity. The ‘equity’ value of a company is traded on the stock market. It is this portion usually referred to as ‘bank capital’.

— If you’re still with us, we’ll show you French basket case Société Générale’s balance sheet.

Assets €1.158 trillion

Liabilities €1.106 trillion

Equity €52.1 billion

— Here’s how it works. A write down in the value of its assets must be matched by a write down in the value of the equity. If the value of the banks assets fell by just 5 per cent, all the equity would be wiped out and the bank would be insolvent. This just goes to show how highly leveraged European banks are.

— Actually the bank’s assets have probably already fallen by 5 per cent. Luckily, it’s not required to ‘mark its assets to market’. Banks aren’t allowed to fail remember?

— Société Générale’s current market capitalization is just €14 billion. This is what investors think the bank’s equity value is worth. It will probably prove optimistic.

— This is where a recapitalization comes in. The Euro bailout fund, the EFSF, will contribute funds to banks in need of new equity capital. This should take the form of ‘preferred equity’, which will rank above existing equity when it comes to absorbing write-downs. That way anyone punting on European bank shares will take a hit before new taxpayer funds do.

— If all the bad sovereign debt in the system is really purged (which it won’t be, but bear with us) most of the existing equity holders will be wiped out. The pie-in-the-sky plan would then be for the preferred equity to convert to ordinary equity. Once this whole debt crisis thing blows over, say by Christmas*, the taxpayers would sell out for a profit, proving the eurocrats’ plan to be pure genius.

— There’s no harm in dreaming of course, but it won’t work out that way. There will be squabbling about which banks receive capital and how much is actually needed. If estimates of €200 billion are correct, the recapitalization plan will leave the EFSF just about empty, with no more funds to buy other struggling sovereign debt.

— And don’t forget, bad sovereign debt is the cause of the crisis. Insufficient bank capital is just a symptom of the problem. A Greek default still awaits.

— The Europeans are only just beginning to realize how big their problems are. So enjoy the rally, it won’t last for long.

* Remember in World War One the conventional European wisdom was the ‘it would be over by Christmas’. Christmas 1914 that is.

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