As nearly every proclamation and warning that I have given in 2010 has come to pass in 2011, the coming mass restructuring of the European banking system is nigh upon us. Let me make this perfectly clear.
Despite what you may have heard, those banks and institutions holding and hoarding EU periphery debt are getting slaughtered.
Let’s walk through the simply math. I borrow €100 million with €10 million equity and purchase €110 million in bonds from Greece at par. These bonds are now roughly half of what I paid for them. That is a €55 million loss on a €10 million equity investment. A 550% loss! This is not rocket science, yet there are many who are dismissing this concept as sensationalist. Try dismissing it as basic math, first!
Exactly one year ago tomorrow, I went through this scenario in the article “How Greece Killed Its Own Banks!“, which my regular readers should be quite familiar with.
…. Insolvency! The gorging on quickly to be devalued debt was the absolutely last thing the Greek banks needed as they were suffering from a classic run on the bank due to deposits being pulled out at a record pace. So assuming the aforementioned drain on liquidity from a bank run (mitigated in part or in full by support from the ECB), imagine what happens when a very significant portion of your bond portfolio performs as follows (please note that these numbers were drawn before the bond market route of the 27th)…
Well, one year later and things have gotten much worse. Ireland and Portugal have joined the bailout brigade as well as Greece’s bonds tumbling even further – post bailout!
Greece’s shorter term bonds are on a backwards tear, with the 2 year breaching the 20% mark while the 10 years pushing 15. This is not only unsustainable, but a sign that the market not only expects a restructuring but is forcibly extracting compensation for said restructuring ahead of time.
So, anyone who doesn’t think that a country that is in recession paying 20% on its debt AFTER it was just bailed out with global interest rates at cyclical low combined with the ECB raising rates is simply delusional. The next question any realist would ask is not if Greece is going to default or restructure, but what happens when they actually do?
Well, if you remember my rants concerning the EU’s “Delay & Pray” strategy of classifying these sovereign junk bonds as hold to maturity assets marked at par, you realize that there are hundreds of millions of euros of losses sitting on bank balance sheets RIGHT NOW, levered much more than 10x to 15x times. These assets are also currently going down in value, not static or rising. This means that not only are their gaping holes in the balance sheets of European banks all over that everybody seems to be ignoring, those wholes are being ripped wider and wider as time goes by.
Well, if Greece does default or restructure (and the market is telling us that Reggie is right in that this is a foregone conclusion), then…
The chart above illustrates what would happen if Greece were to restructure to the point where it would come into compliance with the Maastricht Treaty. Of course, if Greece were to do such, it would not happen in a vacuum. You see, if Greece were to restructure than all of those banks who were playing “Hide the Sausage” would be forced to come clean and mark all of that bad debt to market. Germany would lose a full 23% of its tier one capital, and Germany is the number one economy and banking system in the EU, formerly thought of as untouchable!. Hey, hold on… It gets better.
Not only do other periphery countries hold Greek debt that, if properly marked or defaulted on, would tear a hole through their domiciled banks tier 1 capital… They countries would most likely face extreme rate pressures in addition to internal socio-political pressure to default on their obligations as well as their tax paying populace undergo extreme austerity measures, mostly to save banks and bondholders. This is a pretty tough sell, even for the best political minds.
So, what happens if Portugal and Ireland decide to default/restructure as well???
Basically, a domino effect all throughout the European banking system. OF course if Portugal, Ireland and Greece fall, Spain is the country that would be in the cross hairs and I would not ignore any of the other countries either. Every country that falls adds weight to the remaining countries backs. And to think, some of those central bank types thought Lehman Brothers was a fiasco. Hmmm, they ain’t seen nothing yet! Just so you are aware that I don’t bite my tongue to assuage the audience, this is the same message presented in more detail at the ING RE Valuation conference in Amsterdam.
Throughout the week, I will post additional clips from the conference. Professional and institutional subscribers should feel free to contact me via email if they want to discuss analysis that I haven’t released on the blog pertaining to this topic. Next, I will discuss the potential fate of EU countries not mentioned (in detail) in this missive, for no one is truly immune to a banking collapse.
See the UK and Eurozone on BoomBustBlog for more EU opinion and analysis.