Why Sovereign Defaults Matter... and Why Spain is a BIG Deal

Phoenix Capital Research's picture

The following is an excerpt from my latest client letter explaining why Spain is such a big deal and why when it defaults it’s game over for the EU.


I’ve received a number of emails asking me why Spain is such a big deal for the global banking system. To fully understand the implications of Spain, you first need to understand how the global financial system works “behind the scenes.”


We’ll start first with the US financial system, particularly the Primary Dealers which are the real controllers of the monetary supply (via lending).


If you’re unfamiliar with the Primary Dealers, these are the 18 banks at the top of the US private banking system. They’re in charge of handling US Treasury Debt auctions and as such they have unprecedented access to US debt both in terms of pricing and monetary control.


The Primary Dealers are:


1. Bank of America

?????2. Barclays Capital Inc.

3. BNP Paribas Securities Corp.

4. Cantor Fitzgerald & Co.

5. Citigroup Global Markets Inc.

6. Credit Suisse Securities (USA) LLC

7. Daiwa Securities America Inc.

8. Deutsche Bank Securities Inc.

9. Goldman, Sachs & Co.

10. HSBC Securities (USA) Inc.

11. J. P. Morgan Securities Inc.

12. Jefferies & Company Inc.

13. Mizuho Securities USA Inc.

14. Morgan Stanley & Co. Incorporated

15. Nomura Securities International Inc.

16. RBC Capital Markets

17. RBS Securities Inc.

18. UBS Securities LLC.


These are the firms that buy US Treasuries during debt auctions. Once the Treasury debt is acquired by the Primary Dealer, it’s parked on their balance sheet as an asset. The Primary Dealer can then leverage up that asset and also fractionally lend on it, i.e. create more debt and issue more loans, mortgages, corporate bonds, or what have you.


Put another way, Treasuries, or US sovereign bonds, are not only the primary asset on the large banks’ balance sheets, they are in fact the asset against which these banks lend/ extend additional debt into the monetary system.


A similar banking system exists in Europe though in that case there are no single unified EU bonds/ Primary Dealers. Instead we have 17 countries all of which issue sovereign bonds that their largest banks purchase and park on their balance sheets as assets against which they lend.


So, let us consider Spain.


According to data collected from the Bank for International Settlements, IMF, World Bank, UN Population Division, UK banks are sitting on €74 billion worth of Spanish sovereign debt while French banks and German banks are sitting on €112 billion €131 billion, respectively.


So, as a ballpark estimate, roughly €317 billion worth of Spanish sovereign debt is sitting on banks’ balance sheets in these three countries. This debt is then recorded as an asset against which these banks have leant out money to corporations, property developers, etc. at a ratio of more than 10 to 1.


Let me explain this last point. Basel III requirements which have yet to be implemented will require banks to have equity and Tier 1 capital equal to roughly 10% of risk weighted assets. Before this, Basel II only required equity and Tier 1 capital equal to 6% of risk weighted assets thereby permitting leverage of 16 to 1.


However, these ratios are only for risk-­?weighted assets. Let me explain this term: a bank’s risk weighted assets are determined on its in-­?house models based on how likely it is that a given asset (loan) will enter default.


In other words, the banks get to determine themselves how risky their loan portfolio is and then leverage their balance sheets accordingly. This is like asking an alcoholic to assess how much alcohol he should have.


Oh, and bank executives are highly incentivized to downplay the risks as their pay is often based on returns on equity (which in turn is based on leverage). So it shouldn’t be a surprise that EU banks are downplaying the risk to their portfolios.


What I’m trying to say here is that the entire EU banking system is based on capital requirements that are an absolute joke. The banks not the regulators determine how risky their assets are and leverage their balance sheets to the maximum levels possible based on their in-­?house assessments.


And to top it off, modern financial theory believes sovereign bonds to be “risk free.” So banks can use their sovereign bond exposure as a strength against which to balance out their riskier loans.


THIS is the fate that awaits the European banking system. Every single EU bank has leveraged itself based on financial models that consider sovereign bonds to be “risk free.” Moreover, EVERY EU bank is leverage to the hilt based on its OWN in-­?house assessment of the riskiness of its loan portfolio.


So... when Spain defaults (and it will) you will very likely find the entire Spanish banking system collapse. This in turn will bring the entire EU banking system to its knees as collateral calls and margin calls are made across the board when EU banks’ portfolios take a “haircut” on their senior most assets.


This is why Greece was a big deal and why the ECB and EU political leaders were so careful to manage its default... because they know that if anything resembling a messy default occurs, the ENTIRE banking system can be taken down.


With that in mind, the clock is ticking on Europe. On that note, I fully believe the EU in its current form is in its final chapters. Whether it’s through Spain imploding or Germany ultimately pulling out of the Euro, we’ve now reached the point of no return: the problems facing the EU (Spain and Italy) are too large to be bailed out. There simply aren’t any funds or entities large enough to handle these issues.


So if you’re not already taking steps to prepare for the coming collapse, you need to do so now. I recently published a report showing investors how to prepare for this. It’s called How to Play the Collapse of the European Banking System and it explains exactly how the coming Crisis will unfold as well as which investment (both direct and backdoor) you can make to profit from it.


This report is 100% FREE. You can pick up a copy today at: http://www.gainspainscapital.com


Good Investing!


Graham Summers


PS. We also feature numerous other reports ALL devoted to helping you protect yourself, your portfolio, and your loved ones from the Second Round of the Great Crisis. Whether it’s a US Debt Default, runaway inflation, or even food shortages and bank holidays, our reports cover how to get through these situations safely and profitably.



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bill1102inf's picture

This has all happened before, your gold becomes worthless each and every time!

max2205's picture

OOPS, I think you called another bottom.....

derek_vineyard's picture

Its May.....the May/June 2012 crash guaranteed here will happen any day now.

Zero Govt's picture

"crash" or (another) kick of the can?

exartizo's picture

Good basic information Graham. But please stop agressively pedaling your newsletter.

You might be better served by simply placing a link to your web site with a note

that more information is available if someone is interested.

You lose credibility when you appear to have an axe to grind in your information.



cbxer55's picture

Its free, so what is his "axe to grind"? If he were charging for it, I would agree. But he is not, and I do not have a problem with it. Just do not read the last two paragraphs if it upsets your sensibilities so much. SHEESH!

ZippyBananaPants's picture

Please do not use the phrase "or what have you" if you are trying to sound intelligent.

GeneMarchbanks's picture

CoL shill. Find someone else to worship. The man is a joke.

shovelhead's picture

Like Paul Krugman, Bernanke's butt-boy?

TaxSlave's picture

Three cheers for the wonderful concept of Fractional Reserve.  In which the fraction is a joke and the reserve is always negative.

boiltherich's picture

What I’m trying to say here is that the entire EU banking system is based on capital requirements that are an absolute joke.

And mark-to-make-believe here is ANY different Graham? 

But I do agree with your final assessment that it is end times for the EMU if not the EU, and my main rational for that is that fiat has to have the confidence of the public in order to survive, the euro has lost the confidence of the globe and now only hangs on through sheer terror of it's implosion.  Though I do have to say that US and Swiss as well as Asian financial authorities are doing a remarkable job of keeping their currency falling in tandem with the euro, within a few bps of the 130 "peg" is by now a herculean task. 

I am familiar with all the primary dealers on your list but I just realized I have never seen an actual list of them before in one place, and though I knew some were foreign in a conceptual way it had never before struck me that most of them are foreign owned. 

dizzyfingers's picture

Oh-oh... there go those for-sale places in France, Spain, Portugal, Greece, etc., shown day after day on HGTV.

Just wonderin'... who sponsors HGTV?

Next will we be seeing all those overseas sales on HGTV again, "Your Home Value Is Under Water But We'll Find You A Buyer!"

Peter Pan's picture

Graham Summers was being savaged by some of the people leaving comments on one of his recent postings. His main prediction was for Europe to unravel in May or June. It seems he is getting warmer.

The bottom line is WOULD ANY OF US GO AND LIVE OR WORK AND BUY A HOUSE IN SPAIN, GREECE OR PORTUGAL RIGHT NOW EVEN IF WE KNEW THE LANGUAGE? Methinks not and that tells us where the whole thing is headed.

Zero Govt's picture

my personal criticism of Grahams articles was it was the exact same "Europocalypse" article, 4 times a week, for 2 weeks on the trot

not even the ragged BBC run repeats so often, thought my head was spinning

GOSPLAN HERO's picture

Euro crash followed by USD crash.

donsluck's picture

Euro crash = dollar strength, until the Euro is dead, THEN dollar crash.

boiltherich's picture

Fiat crash.  I think people are, have always, discounted the historic importance of this situation just as they always fail to recognize the significance of any present events and activities as historic turning points.  If the heads of governments in 1917 knew what kind of slaughter lay ahead of them in 4 years of WWI and the resulting end to royal and aristocratic power that resulted, along with the communist and democratic movements and the end to the imperial dynasties globally, they would have laid the old Archduke to rest with a funeral fit for a king and let that be that.  They thought that a war would be over in 3 months and the number of cannon fodder troops would be in the thousands, instead it was years and millions, it claimed the royal houses of Russia and Germany as well as others. 

What I am saying is that it is hard to see present as the past, can you put yourself 20 or 50 years in the future and look back on the breakup of the euro and maybe the EU itself?  The shift in Europe to the radical ends of the political spectrum, along with anti austerity there and Tea Party here are public anxiety and anger that is actually pretty free floating at the moment yet could jell in a day under the right circumstances, and would provide the power and motive behind historic shifts in the world.  I am trying to see it but the possibilities of good outcomes are so remote and slim now that I do not want to see where these events will lead us.