Warning: More Bank Bailouts Possible

One area I haven’t commented on much is the ongoing European “debt crisis”.  The Greek debt crisis is a part of it, but it’s only the tip of the iceberg.  The roots are much deeper.  One reason I haven’t commented is because it’s fairly complex and requires a lot of background explanation which I haven’t had time to write.  Nonetheless, it’s something worth mentioning.  In particular because it’s likely to mean more big bank bailouts.

In short, the crisis involves the way the Euro currency zone is constructed.  Countries that use the Euro have surrendered their sovereignty on monetary policy – that’s now the purview of the European Central Bank (ECB).  This means that government debt levels do matter for countries in the Euro.  They can default because they don’t have control over their own currency.  The U.S., Japan, UK, Canada, Australia, and others can’t default because they control their own central bank and currency.  But Euro countries can.  In the case of Greece and Ireland this means a high likelihood of default.  When the global economy crashed three years ago, it sent the economies of most countries down.  This raised the debt-to-GDP level by reducing the denominator, the GDP number.  But a country in a recession needs to increase government spending and deficits to stimulate growth.  Instead, the construction of the Euro agreement and pressures from the ECB forced these countries to pursue an austerity-based policy of cutting government programs.  But the cutting of government spending has only worsened the recession and shrunk their GDP even more, reducing tax collections.  It’s made default more likely.

In the Greek case, default appears inevitable.  The question is how much of a loss do bondholders take and when.  Therein lies a problem.  The people who own the Greek debt are largely big French and German banks. These banks themselves aren’t exactly robust.   If Greece defaults at a level that will actually help Greece find it’s way out instead of simply delaying the crisis, then these banks will likely take very heavy losses.  The losses are large enough to jeopardize the solvency of the banks themselves.  So Greek default also means figuring out how to recapitalize these big banks.  These are so-called “too big to fail banks”.

Currently there are negotiations going on about how to structure a  Greek default, simultaneously prop up the Euro banks, and stop a possible contagion effect from spreading to Ireland, Portugal, Spain, Italy, and Belgium.  But there have been negotiations over this crisis for nearly two years now with much successs.  The German and French leaders have promised a comprehensive solution later this week. It was supposed to be today, but it’s been delayed to mid-week.

What does that have to do with the U.S.?  Nobody really knows.  The devil is in the details.  At first pass, big U.S. banks aren’t supposed to have much exposure to Greek debt, so they shouldn’t be endangered by a large Greek default.  But, the big U.S. banks like Citi, JP Morgan Chase, BofA, and Goldman Sachs have large stakes in the big Euro banks.  A failed Euro bank could have repercussions.  Of greater concern are derivatives, particularly Credit Default Swaps. The U.S. banks, particularly Goldman are known to have been active in selling these derivatives.  Since the derivative markets and positions are largely secret and non-transparent (a failure of the Dodd-Frank Financial Reform bill), we don’t know if a Greek default will trigger significant liabilities for these banks.

In separate news, Bank of America, is on a death-watch by some analysts.  Yves Smith at Naked Capitalism clues us in:

If you have any doubt that Bank of America is in trouble, this development should settle it. I’m late to this important story broken this morning by Bob Ivry of Bloomberg, but both Bill Black (who I interviewed just now) and I see this as a desperate (or at the very best, remarkably inept) move by Bank of America’s management.

The short form via Bloomberg:

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation…

Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.

That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, the OCC data show.

Now you would expect this move to be driven by adverse selection, that it, that BofA would move its WORST derivatives, that is, the ones that were riskiest or otherwise had high collateral posting requirements, to the sub. Bill Black confirmed that even though the details were sketchy, this is precisely what took place.

Part of BofA’s problems, well, actually a very large part of it’s problems stem from the loose and possibly illegal banking practices at Countrywide Mortgage which it took over in 2008.  Yves updates us on this here.

Bottom-line on all this:  expect more big bank bailouts of some kind in coming months.  It might only be big Euro banks.  It might only involve Bank of America.  But there’s significant,if less than probable, chance that we’ll have to see another round of bank bailouts.

A Quickie: Another Serious Down Day

Just time for a quickie.  The stock markets, not just the U.S., but worldwide, had another very bad day.  The major indices in the U.S., Dow Jones Industrials, Standard & Poor’s 500, NASDAQ, were all down from 4-4.6%.  This is on top of 6% decline on Monday and more declines in the last two weeks.  In fact, the last three weeks have seen the stock markets fall over 17%.

So what’s happening?  A lot of things. But as I’ve said before, it’s not worry about the U.S. defaulting on debt or having too large of a deficit.  If that were true, then bond prices would drop and interest rates rise.  Instead, we’ve seen almost as dramatic moves in the U.S. bond market.  Tonight the U.S. 10 year bond is trading with a 2.1% yield. A 2.1% interest rate!  It was 2.6% as recently as last Friday. We’re starting to see interest rates on government bonds move into the territory we say in 2008.

Yes, it’s fear. And it’s uncertainty.  But it’s fear over growth prospects in both the U.S. and Europe.  It’s also fear over financial system stability.  In the U.S., Bank of America, the second largest bank has been hit with a series of judgements,  lawsuits, and other problems dating back it’s sub-prime mortgage days that it’s looking pretty dodgy.  In Europe, the slow-motion train wreck that is the Euro and government bonds there is a serious concern.  The debt crisis contagion that started in Greece and spread to Ireland and Portugal, now seems to include Italy and maybe Spain.  Today, news came out that France’s debt rating might also be downgraded (remember, unlike the U.S. they don’t have their own central bank).  That set concerns for the health of the largest French banks.

On the uncertainty front, what the debt-ceiling debate and “deal” told us is that we’re on our own.  The politicians have no plans for helping the economy. Instead they’re in a rush to cut spending which will only make it worse.

So what to do when all looks frightful and uncertain?  Go to cash.  Or what’s essentially the same thing – U.S. bonds.  I’m not trying to recommend this or any strategy. I’m not an investment advisor. But that’s what’s happening.