The Debt Crisis Will Blow Over By Christmas*

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— If you like catching up with Murray Dawes on YouTube, head over there now. He’s just recorded this week’s market update video – and he says he’s feeling bullish

–He reckons there could be a market rally in the offing… and if he’s right about that, he has an idea where the ASX could be headed. He also has an idea about what to do if it gets there… and that involves some pretty major selling. But Murray’s musings come with a caveat: “If Soc Gen or BNP fall over then all bets are off…” To watch Murray’s brand new market update video now – go here.

— Today’s comedic relief is brought to you, once again, by Europe. We weren’t going to write about the other side of the world today. But in this type of market you need an occasional good laugh, even if it threatens your wealth at the same time.

— After realising the plan to leverage the European Financial Stability Facility (EFSF) was idiotic, the lemmings in Europe are running over to a new ‘solution’ – bank recapitalisations. Like most things bureaucrats dream up, it’s good in theory. How it plays out in practice will be entirely different.

— That’s not the funny bit though. Check this out: Apparently European finance ministers have asked the European Banking Authority (EBA), Europe’s top (we use the word loosely) banking regulator, to stress test Europe’s banks – again.

— You may remember the same incompetent organisation conducted stress tests in 2010 and 2011. The latest one, completed in July this year, found European banks to have a capital deficiency of just €2.5bn. At the same time as Athens was burning, these pompous fools didn’t even model a sovereign default. Now, just a few months later we’re talking about a need for €200 billion in fresh bank equity.

— But instead of all being sacked and the organisation shut down – as would happen in the private sector – these imbeciles get another go. We can only conclude the EBA is a corrupt organisation in the palm of the bankers. And it’s supposed to be their regulator?

— Look, the bank recapitalisation plan is on the right track. We don’t dispute that. But it’s a plan being put together by a bunch of squabbling politicians who put their own re-election prospects ahead of anything else. So the chances of it actually being done properly are remote.

— As we wrote in our Sound Money. Sound Investments email update yesterday – bank recapitalisations will be beneficial as long as they are accompanied by bad debt write-downs. The main problem with the global economy today is the amount of bad debt festering on bank balance sheets. This impedes the creation of new, productive debt.

— It also affects confidence. Banking is – and has always been – a business based on confidence. Without it, banks are exposed as the highly leveraged and fragile institutions that they are.

— So to improve confidence you need to purge the bad debt out of the system. This requires bank recapitalisations to absorb the coming write-downs. Before we go any further, just what do we mean by ‘bank recapitalisation’?

— The process is best explained with reference to a bank’s balance sheet. In balance sheet land, a company’s assets are equal to its liabilities and equity. The ‘equity’ value of a company is traded on the stock market. It is this portion usually referred to as ‘bank capital’.

— If you’re still with us, we’ll show you French basket case Société Générale’s balance sheet.

Assets €1.158 trillion
Liabilities €1.106 trillion
Equity €52.1 billion

— Here’s how it works. A write down in the value of its assets must be matched by a write down in the value of the equity. If the value of the banks assets fell by just 5 per cent, all the equity would be wiped out and the bank would be insolvent. This just goes to show how highly leveraged European banks are.

— Actually the bank’s assets have probably already fallen by 5 per cent. Luckily, it’s not required to ‘mark its assets to market’. Banks aren’t allowed to fail remember?

— Société Générale’s current market capitalisation is just €14 billion. This is what investors think the bank’s equity value is worth. It will probably prove optimistic.

— This is where a recapitalisation comes in. The Euro bailout fund, the EFSF, will contribute funds to banks in need of new equity capital. This should take the form of ‘preferred equity’, which will rank above existing equity when it comes to absorbing write-downs. That way anyone punting on European bank shares will take a hit before new taxpayer funds do.

— If all the bad sovereign debt in the system is really purged (which it won’t be, but bear with us) most of the existing equity holders will be wiped out. The pie-in-the-sky plan would then be for the preferred equity to convert to ordinary equity. Once this whole debt crisis thing blows over, say by Christmas*, the taxpayers would sell out for a profit, proving the eurocrats’ plan to be pure genius.

— There’s no harm in dreaming of course, but it won’t work out that way. There will be squabbling about which banks receive capital and how much is actually needed. If estimates of €200 billion are correct, the recapitalisation plan will leave the EFSF just about empty, with no more funds to buy other struggling sovereign debt.

— And don’t forget, bad sovereign debt is the cause of the crisis. Insufficient bank capital is just a symptom of the problem. A Greek default still awaits.

— The Europeans are only just beginning to realise how big their problems are. So enjoy the rally, it won’t last for long.

* Remember in World War One the conventional European wisdom was the ‘it would be over by Christmas’. Christmas 1914 that is.

Publisher’s note: Greg Canavan is the foremost authority for retail investors on value investing in Australia. He’s the former head of Australasian Research for a major asset-management group and a regular guest on CNBC, Sky Business’s ‘The Perrett Report’ and Lateline Business. Greg shares his insight, ideas and investment recommendations with readers of his Sound Money. Sound Investments newsletter… to find out more information on Greg’s letter, go here.

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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3 Comments on "The Debt Crisis Will Blow Over By Christmas*"

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Joe
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“the taxpayers would sell out for a profit, proving the eurocrats’ plan to be pure genius”

Didn’t the British government have this ‘MASTER PLAN’ too. It’s not going well for their investments in Lloyds TSB, Northern Rock, and Halifax Bank of Scotland.

Ross
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EFSF is France, bank recap is Germany …. the schism. Poor old Adeneaur.

Patrick Donnelly
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Japan has been struggling for twenty two, 22, years! But they aren’t smart…… are they? We are smart, aren’t we?! Why would anyone ignore the lessons available from Japan? Perhaps they did not? Perhaps they decided that extend and pretend required the rape of the American housing market, even over Spitzer’s objections. When we, the illuminati, know there is going to be a fmine in funds, we decide to make it far worse and last for longer, by foisting rubbish mortgages onto foreign and domestic banks! We can make out like bandits, if only there was another Pearl Harbor, enabling… Read more »
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