What Europe Means For You and Your Savings

Phoenix Capital Research's picture


In order to understand why we’re at risk of the financial system collapsing, you first need to understand how the global banking system works. When you or I buy an asset (say a house, or shares in a stock, or a Treasury bond), we do so because we’re looking to increase our wealth through either capital gains or through the income that asset will pay us in exchange for us parking our capital there.


In simple terms, you’re putting/ lending your money somewhere (especially if you’re buying a bond) in the hope of increasing the value or your money.


This is not how banks work. When a bank buys something, especially a bond, it parks that bond on its balance sheet as an “asset.” It then lends money out against that asset. This in of itself is not problematic except for the fact that the financial modeling of 99% of banks base assume that sovereign bonds are “risk-free.” Put another way, these models assume that the banks will always get their money back on 100 cents on the Dollar.


Yes, you read that correctly, despite the fact that world history is replete with examples of sovereign defaults (in the last 20 years alone we’ve seen more than 15 including countries as significant as Russia, Argentina, and Brazil), most banks assume that the sovereign bonds sitting on their balance sheets are risk free.


This phenomenon occurs worldwide, but given that it will be Europe, not the US that takes the system down, I’m going to focus on European bank models/ capital ratios.


You may or may not be familiar with EU banking law. EU banks are meant to comply with Basel II which is a series of capital requirements and other specifications meant to limit systemic risk.


In terms of capital ratios, Basel II requires that EU banks have equity and Tier 1 capital equal to 6% of risk weighted assets. On paper this idea was supposed to limit bank leverage to 16 to 1 (the bank has €1 in capital or equity for every €16 in loans).


However, the term “risk weighted assets” destroys this premise because it means that the bank’s loan portfolio and ultimately its leverage ratio are based on the bank’s in house models/ assumptions concerning the risk of its loans.


Let me give you an example…


Let’s say XYZ Bank lends out €50 million to a corporation. The bank won’t necessarily claim that all €50 million is “at risk.” Instead, the bank will claim that only a percentage of this €50 million is “at risk” based on the company’s credit rating, financial records (debt to equity, etc), and the like.


Thus, based on “in-house” risk modeling, European banks could in fact lend out much, much more than the Basel II requirements would imply. Considering that both bank profits and executive compensation were/are closely tied to more lenient definitions of “risk-weighted,” (i.e. lend as much as you possibly can) it’s safe to assume that EU banks are in fact much, much more leveraged.


Indeed, according to the IMF’s “official” analysis, EU banks as a whole are leveraged at 26 to 1. I would argue that in reality many of them are well north of 30 to 1 and possibly even up to 50 or 100 to 1.


The reason I can claim this with relative certainty is because the EU housing bubbles dwarfed that of the US. In the chart below the US housing bubble is the lowest line. After it comes Britain (blue) and Italy (orange) then Ireland (green) and finally Spain (dark blue).



You can only get bubbles of this magnitude if you’re lending to literally anyone with a pulse. And you can only lend that much if your in-house risk models believe that the risk of lending to anyone with a pulse is much, much lower than reality.


Hench, EU banks are likely leveraged at much, much more than 26 to 1. Indeed, considering how leveraged and toxic US banks’ (especially the investment banks’) balance sheets became from the US housing bubble, the above chart should give everyone pause when they consider the TRUE state of EU bank balance sheets.


This fact in of itself makes the possibility of a systemic collapse of the EU banking system relatively high. Let me give you an example to illustrate this point.


Let’s assume Bank XYZ in Europe has a loan portfolio of €300 million Euros and equity of €30 million Euros. This means the bank is “officially” leveraged at 10 to 1 (this would be a great leverage ratio for a European bank as most of them are leveraged to at least 26 to 1 or worse).


So… let’s say that 10% of the bank’s loans (read: assets) are in fact worth 50% of the value that the bank claims they’re worth (not unlikely if you’re talking about a PIIGS bank). This means that the bank’s actual loan portfolio is worth €285 million (10% of 300 is 30 and 50% of 30 is 15).


With equity of only €30 million, the bank, at some point, will have to take writedowns or one time charges on its loan portfolio that would erase HALF of its equity. At this point, the bank becomes leveraged at 19 to 1 (€285 million in assets on €15 million in equity).


This announcement would result in:


  1. Depositors pulling their funds from the bank (thereby rendering it even more insolvent)
  2. The bank’s shares plunging on the market (raising its leverage levels even higher as equity falls further).


Thus, at a leverage ratio of 10 to 1, even a 50% hit on 10% of a bank’s loan portfolio can result in the bank needing a bailout or even collapsing.


Now, what if that €300 million in loans is actually the amount the bank’s in-house risk models believe to be “at risk” and the REAL loan portfolio is around €800 million?


Immediately, we realize that the bank is in fact leveraged at 26 to 1. At this level even a 4% drop in asset prices erases ALL equity rendering the bank insolvent.


And yet, based on Basel II requirements, this bank can claim in all public disclosures that it is only leveraged at 10 to 1. With this in mind, you should understand why the banks lobbied so hard against a rapid implementation of Basel III capital requirements (which would require equity and capital equal to 10.5% of all of risk-weighted assets.)


Indeed, Basel III requirements which were meant to go in effect at the end of 2012 will now gradually begin to be implemented in 2013. And banks will have until 2015 to adjust to the new capital requirements and until 2019 conservation buffers in place.


With that in mind, take my XYZ bank example, apply it to all of Europe, assume leverage ratios of 26 to 1 at the very minimum (Lehman blew up when it was leveraged at 30 to 1), and take another look at the housing bubbles in the above chart.


In simple terms Europe’s entire €46 trillion banking system is in far worse shape than even the US investment banks were going into 2008. And this is based on their leverage ratios alone.


Now, let’s take this process further…


Historically, most depositor banks made their money on the spread between the interest rates they pay depositors and the interest they receive on the loans they make. This is why they were so highly incentivized to leverage themselves to the gills.


Given that a bank’s share price and executive compensation are closely tied to its profits, you can imagine just why a bank would want to leverage itself as much as possible.


Even under this traditional banking model, Europe would be at high risk of systemic collapse. However, thanks to the fact that many large banks have shifted into trading as a means of generating profits, there’s a second even more frightening reason why the EU banking system will very likely implode.


I’ve explained this situation to my clients over at Gains Pains & Capital in a report titled, What Europe’s Crisis Means For You. I’m making this report 100% FREE to the public.




To pick up a copy, swing by: http://gainspainscapital.com/?page_id=1977


Be Prepared,


Graham Summers




Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
malek's picture

Ahem... if you lookup the chart yourself at http://www.economist.com/houseprices

then you will find South Africa to be in even a bigger bubble than Spain. Do they lend to everyone with a pulse in South Africa? Not to my knowledge.

Jack Sheet's picture

Shit. Does this mean Graham Summers is stuck at the top of the ZH front page for whole frigging weekend.

Tinky's picture

You missed an important point:

He did not state in this post that he will tell us exactly how the European crisis will unfold if we follow a link. So it could have been worse, and perhaps he's learning...

Encroaching Darkness's picture

Seems reasonable, as far as it goes. However, Ben Bernanke has been accomodating the Euro Banks with something called "dollar swaps" I believe? Whether or not he has taken collateral, against the collapse of the Euro, is unknown. That's the way it works now - the Fed is a "private corporation", so unless Harry Reid finds a horse head in his bed and allows a vote on Ron Paul's "audit the Fed" bill, we won't know what our public servants and private servants have agreed to on our behalf. In fact, until it all collapses in flames (Euro first from PIIGS failure, then USD from knock-on liability, derivatives and unknown agreements) most folks won't realize anything is wrong. Until the EBT cards fail, that is.....


I hope by now you have multiple asset classes, multiple locations and multiple plans in place; we won't have to wait long now.

spinone's picture

As long as OPEC only takes dollars for oil, no worries.

LowProfile's picture


As long as those oil dollars can buy gold, no worries.

Fixed it

Eireann go Brach's picture

Graham on several of your previous articles you mentioned the Euro would crash by July?

Treeplanter's picture

A great many have been surprised by how good the fraud crew is at buying time.  I thought the can had hit the ice wall, but they seem to have found a large trebuchet to send it farther.  They have run out of road, but there are trails north of the ice wall.

Jack Sheet's picture

He didn't say which year, did he ?

Landrew's picture

You look at a chart of the Euro! The Euro hit 120! A ten year low to the dollar in JULY!

Parabolic's picture

Who the F**k buys a house as an asset anymore??

cbxer55's picture

There are still some flippers out there. A house two doors down that was foreclosed on two years ago, and stood empty since, has been bought by a man and woman. They are renevating the hell out of it without living in it. New roof, carpets, floors, the obligatory granite countertops, etc. They bought it about a month ago for the same price it sold for when new in 89, $89,000 dollars. It is a two story 2200 sq. ft. house, so it will probably sell for a nice sum when finished, if they can find a sucker to buy it.

HardAssets's picture

A few still buy houses - - - as an emotional attachment

and because they were always taught it is 'the smart thing to do'  (recently heard from relative despite laying out for them the evidence & case for why this isn't a good idea now)

max2205's picture

Great start to the weekend. Same old story I see

disabledvet's picture

Not as presented here. Generally i'm not a fan of "the Phoenix" as his advice constantly "flames out." (perhaps Phonix Investment--as in "hooked on" would be a better name?) Anywho THIS IS SPOT ON. Nothing at ALL old about it because it get's right to the heart of The Grand Speculation that is "the financing of Europe." The answer to me has been the same not only all along...but continues to be going forward...namely a "stealth dollarization." We know this to be true because of the Fed activities that were exposed when Bloomberg News demanded and got the FOIL request regarding the actions taken in 2008. The biggest recipient of bailout largesse was a BELGIAN bank...not an American one! To me this is where Hooked on Phonix Investments fall flat...not taking into account the "duality" of the Fed and ECB. Still..."lot of logistics" being brought up in this article. And with it "a lot of linguistics" as well. http://www.youtube.com/watch?v=thqGFCinOPs

LowProfile's picture

I wouldn't be so sure the Fed and the ECB are on the same page.

I called for a USD rally last July until the EU situation is resolved, so far so good.  I am impressed they were able to levitate stocks at the same time, but that's starting to look a little shaky now.

The EUR is structured so that it will survive this period well, although gold priced in EUR will likely soar before the final event (when it moonshots in USD). The EUR will then almost certainly supplant the USD as the preferred medium of exchange after this is all done, at least for the West (the East will likely get the RMB or some Eastern-style EUR-type regional currency union equivalent).

Gold will become the reserve currency of choice.  I'm not so optimistic about silver long term (because central banks don't hold any, and thus don't stand to benefit by revaluing it upwards), but near term I expect it to do well.

So much for trashing the dollar to achieve the current administration's goals (per a high-ranking Obama toadie, via Kyle Bass).  Damn those unintended consequences...  Mind you all, if Mittens get in instead, I don't expect anything different.

Place your bets.

engineertheeconomy's picture

Storm the capital and arrest em all. Take the Gold fronm Fort Knox and give it back to the people. Let them use Gold, Silver and whatever else they want for money, let them trade and barter. Get the Government out of their lives and off their backs. Give the American people their Land and Homes back. End the Fed for once and for all. See the illusion as it exists. Everything that you have ever been taught is a lie

I just made more sense in 2 minutes that all of the articles that Phoenix Capital has ever written combined. Ask for my free report... 

Treeplanter's picture

Made sense?  No, you just masturbated.  

HardAssets's picture

Find some colonels and brigadier generals who have learned some finance & economics and it might even work. (Have heard that anyone at higher pay grades have been fully co-opted).

LowProfile's picture

Works for me, but I will be mightily surprised if central banks don't try and retain some power (instead of risking all and possibly losing all).