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

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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.