by Keith Fitz-Gerald | October 17, 2011 4:27 pm
The latest plan to preserve the European Union (EU) and save the global banking sector is to force European banks to increase their equity capital.
The goal, of course, is to restore confidence and stability. But if that’s the case, then why are so many analysts and savvy investors still nervous?
To put it bluntly, it’s because they know it won’t work.
As it stands, the capital shortage is about $277 billion (200 billion euros) according to the International Monetary Fund. I think it’s more like $1.4 trillion by the time you factor in all the cross holdings and the daisy chain of exposure that makes the entire banking system there look like Swiss cheese.
There are three things that are especially problematic to me:
As I have noted repeatedly since this crisis began, regulators are fighting the wrong battle and have been since 2008. They are worried about liquidity when they should be worried about solvency.
Sure, a bank recapitalization can repair the banking system when it comes to keeping money moving — in terms of short-term credit — but no amount of money can prepare European banks for a sovereign default or credit freeze because there literally isn’t enough money on the planet to recapitalize the banking system unless you remove the risks that plague it.
The “system” is still at incredible risk.
The total worldwide notional derivatives exposure is more than $600 trillion dollars according to the Bank for International Settlements. And that’s against a gross market value of merely $21.1 trillion.
In other words, banks have invested in instruments valued at $21 trillion but with a total exposure that’s 28.4-times that – or $600 trillion dollars.
This is why rogue traders are such a problem – they can take disproportionately large risks with not a lot of capital, which often leads to catastrophe.
Take Nick Leeson, the former derivatives broker who worked for Barings Bank. His leveraged trading losses eventually reached $1.4 billion, or twice Baring’s available trading capital. Barings went under as a result.
More recently, Kweku Adoboli, who served as director of exchange traded funds (ETFs) at UBS AG (NYSE:UBS), blew a $2 billion hole in UBS’ balance sheet.
Part of the problem is that nobody knows exactly how much cash banks spend to amass such investments because derivatives and sovereign debt trading instruments are still largely unregulated and “self policed” within the industry.
So what does this have to do with our money?
If there are additional downgrades of European or American banks ahead, or if the cost of credit default swaps continue to rise, thus making new financing prohibitively expensive, the banks trading derivatives will have to post additional marginable collateral.
In plain English, this means the firms trading in derivatives will have to come up with huge amounts of cash they don’t have. So they will sell everything but the kitchen sink as a means of raising it.
Consider what happened the last time around.
Merrill Lynch said in a quarterly report in 2008 that a one-notch downgrade of its credit rating would require the firm to post an additional $3.2 billion of collateral on over-the-counter derivative trades. Around that same time, Morgan Stanley (NYSE:MS) estimated in a regulatory filing that a single-level downgrade would mean posting an extra $973 million. And Lehman Bros, before it collapsed, said a one-level downgrade would require about $200 million of additional collateral.
This is what was behind the massive drops in gold, silver, and the broader markets in late 2008. Credit locked up, the cost of capital rose and margin calls ensued. So banks and trading houses sold everything they could as quickly as they could to raise the necessary capital. The selling began in the metals markets because they are most liquid. Then it moved rapidly into the broader equity markets, causing a downdraft that most investors would like to forget.
We experienced a similar thing earlier this summer as a result of more downgrades and prohibitive CDS costs. Not surprisingly, the S&P 500 fell 18% and gold tumbled 15% as the banks’ trading arms raised capital to cover their bets.
And it will happen again when the latest plan fails.
If you’re tempted to believe that the likes of JPMorgan Chase & Co. (NYSE:JPM), Goldman Sachs Group Inc. (NYSE:GS) and others care about anything other than their own hides when the downdraft starts, think again.
Not only will institutions like these begin selling at the first hint of a margin call or more ratings downgrades, but they will actively use their own proprietary funds to book more gains in the process — even if it means trading directly against their own clients.
So enjoy the rally while it lasts and do these four things in the meantime:
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