Greetings,
Sometimes
it’s difficult to write economic articles, for the simple reason that
they always seem to be foreboding in nature. This article is no
different.
However, I persevere in the hope that doing so might
encourage people to prepare for that which awaits us economically, in
order that we might be a blessing to those in need during the difficult
times that are coming.
All economic eyes have been on the
European Union as of late. When “positive” news comes out then the
economy reacts violently upward. When uncertainty is reported then the
markets let us know.
What is likely going to happen in the
European Union? Is there a possibility of a solution that will work? Do
the various member nations understand the problem enough to arrive at a
solid solution?
I have good news and bad news. The good news
is that there’s a solution that will work to solve Europe’s economic
woes. The bad news is that there’s no possible way that I can see where
Europe will implement that solution.
Most of us have been
following the approval process among the 27 EU member nations for
the €440 billion EFSF (European Financial Stability Facility). This
“facility” would be funded by each member nation promising a certain
amount of the future labor of their inhabitants.
€440 billion
sure sounds like an awful lot of money! The only problem is that it is
nowhere close to enough money to perform the bank “recapitalization”
that they seek. Current estimates place the need at more than €2
trillion! How can the European Union transform the future labor of its
inhabitants into an amount that large? The answer is by using
“leverage”.
Let’s suppose that the EU places all of the €440
billion into an entity known as an SIV (Structured Investment Vehicle).
Let’s further assume that this full amount is used as “capital”. How
can the SIV grow itself into having €2 trillion in assets? The answer
is by selling large amounts of debt to investors. After all, debt +
equity = assets. All that has to happen is to sell over €1.5 trillion
in bonds to investors. These bonds would be rated AAA, since they would
be backed by the capital of the EFSF.
Now we’re going to assume
that all EU member nations agree to go further into debt by leveraging
their original promise of future labor. This isn’t assured to happen,
but we’ll assume it does. What happens if the €2 trillion of assets in
the SIV go completely bad? The EU member nations would be financially
crippled, with Germany and France needing to bail out most of the extra
leveraged debt. Do you think the German and French citizens would be
happy about this?
Ok, the SIV is in place and things are ready to roll. Now what?
The
EU has stated their intention to “recapitalize” banks that are in
major danger. How are they going to do this? Are they just going to add
more capital on top of existing capital in order to show a better
“Return on assets” for the banks? Let’s pretend that this is their
goal – and it’s probably very close to reality. Now what happens?
What
if bank depositors in the European Union begin to shift their accounts
over to the recapitalized banks instead of their current bank? What
would happen to the assets of the “non-recapitalized” banks? They would
begin to have very major problems since loans would have to be quickly
sold in order to give depositors back their money. In other words,
fixing a few banks through recapitalization could easily cause other
major banks to fail.
What would happen if even one major bank
failed? We would see all of the capital in that bank wiped out and we
would see the EU having to pay back the guarantee on deposits. However,
that’s not even close to the main problem. Major banks usually have an
enormous amount of CDS (Credit Default Swaps) written against them.
These are off balance sheet insurance contracts that pay off in the
event of loan defaults. One major bank might have over €500 million in
contracts that would be owed. How would the assets of the SIV cover
that scenario? One bank could possibly wipe out the entire capital
structure of the SIV. That would be really, really bad news.
The European Union Solution
As I stated earlier, there is a solution to the current economic dilemma in the European Union:
1) Suspend all market trading for one day.
2) Announce the “nationalization” of all publicly traded banks.
3)
Wipe out the entire capital structure of all publicly traded banks.
This means investors holding equity in those banks would lose their
entire investment.
4) Take all debt with a maturity greater than
six months and transfer it to equity. This means that many debt
holders would now own stock instead. Demand deposits and debt due in
less than six months would still appear as liabilities.
5) Use
the strengthened capital positions of the banks to increase “loan loss”
reserves on the assets. This will support the existing bad loans.
6) Leave the banks nationalized until economic conditions stabilize.
7) Perform an IPO (Initial Public Offering) to again transfer the banks to public ownership.
This is the only way that the European Union can escape what awaits them. Will they do it? No.
Asia in the Wings
The
economic focus of the world is currently on Western Europe. Watch for
Asia to begin taking center stage in the coming months as we enter the
next phase of worldwide deflation.
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