The European Death Spiral

Recently, we presented and discussed one of the biggest issues for European banks: the urgent need to delever substantially (to the tune of over €2.5 trillion) by selling assets, in order to placate various regulatory entities that banks are solvent, and, far more importantly, the market, which has so far proceeded not to short banks into oblivion only due to the ongoing short selling ban, and to the explicit backstop from the ECB (and, indirectly, the Fed). However, since deleveraging into an deflationary environment will certainly require bank bailouts due to collapsing asset prices, the question is what the impact of bailouts on banks will be. And here Bloomberg's Yalman Onaran explains all too vividly how not even in ponzinomic finance is there ever a free lunch... even if bought with free money. "If the Southern governments put money in their banks, their sovereign debt will go up, exacerbating their problems,” said Karel Lannoo, chief executive officer of the Centre for European Policy Studies in Brussels. “Then the banks’ losses will rise because they hold the government debt. That’s a vicious cycle. It’s hard to know which one to stabilize first, the sovereign bonds or the banks.”  And therein lies the rub, and the problem at the core of it all: when one is dealing with a continent and its insolvent financial system whose banks have underwater assets that amount to the size of the host nation's GDP, "It’s hard to know which one to stabilize first, the sovereign bonds or the banks." Recall that killing both birds with one silver bullet is what the failure that is the EFSF was supposed to do, by allowing sovereign debt rolls and fund bank nationalizations at the same time. Now that that hope is gone, all we have is the inevitable "death spiral."

The size of potential losses at European banks has scared away short-term creditors, squeezing the region’s lenders. The European Central Bank has stepped in to replace funds being withdrawn, providing unlimited cash and lowering requirements on the quality of collateral it will accept.


“We’re in a death spiral,” said Andy Brough, a fund manager at Schroders Plc in London. “As the yields on the peripheral bonds increase, value of the bonds decreases and the amount of capital the bank has to raise increases.”

And there you have it: a "bailout" of the insolvent banks by insolvent countries only shifts the balance, and redirects vigilante attention from either sovereigns to banks, and vice versa. Naturally, the longer there is no solution, absent wholesale defaults and massive losses by the status quo which is the only solution, the wider spreads for both entities will drift until finally neither Italy will be able to refinance, nor its banks, leading to an "out of control" freefall bankruptcy, that will have the most devastating consequences out of all possible options.

In the meantime, the only Hail Mary pass left is that someone will step in and buy the assets that are about to hit the market with the biggest Blue Light special since the winter of 2008, as suddenly every single bank rushes to market to catch the best bids into what will soon thereafter be a bidless market:

European banks have already announced 1.2 trillion euros of asset sales as they try to reach a 9 percent capital ratio by June, according to data compiled by Nomura Holdings Inc. The shrinking of bank balance sheets in the region may reach 3 trillion euros, Barclays Plc (BARC) estimates.


One European bank executive who requested anonymity because plans weren’t public said his company intended to comply with requirements of the stress tests by lending less in 2012. By giving the banks six months to comply, the EBA has provided a go-ahead for deleveraging, an EU official said, asking not to be identified to avoid interagency conflict.


The EU leaders’ agreement for tougher budgetary discipline coupled with banks cutting lending will cause a “huge recession” in Europe, AEI’s Lachman said. The result of the stress tests will be constrained lending, especially in the Southern countries, which will make their economic rut even worse, Lannoo said.


“North has fared well so far, but if the South derails further, then the North will trip too,” Lannoo said.

Needless to say, this one "death spiral" response leaves us quite skeptical, because try as hard as we may, we fail to see how one will find even a fraction of the €2.5 trillion in cash needed to purchase Eurobank assets without said banks, most of which are leveraged 30-40x, being forced to write down their entire equity tranche (very much the same way Dexia was one of the most successful banks in the most recent European stress test).

For those curious about the specifics of the upcoming devaluation, deleveraging, disposition and default wave, here is Morgan Stanley's recent analysis on just this topic.