Monday, August 8, 2011

Why Stocks are plummeting now--By Shan Saeed

Get ready for financial turmoil till 2013. There would be fear, volatility and uncertainity in the market for a very long time. What's the problem with the stock market? I think the Wall Street Journal said best with a line that might have been pulled from any one of my reports over the last three years…

The economies of Europe and the United States have arrived at the moment when they no longer have any conceivable hope of being able to pay for the huge public commitments they've amassed the past 40 years…

Now… I have to give you a sincere warning. There's no good way to sugarcoat this stuff. I shall share with you about details some of the fundamental, structural problems that led to Europe's current debt crisis and the stock market turmoil this week.

I already know some people might say " this is way over my head… I don't need to know this stuff. I don't care about Europe…" Many of you will wonder why you bother reading the paper at all…

Let me start with a few basic numbers so that investors will have the facts behind the scope of the debt problem in Europe…

There are two sides to the European debt crisis "coin." First, there are the banks. In the 17-member euro zone, there are 7,856 regulated financial institutions. For a variety of reasons (which will become clear to you momentarily), it's critical these institutions not fail. Unfortunately, in many cases, the value of their assets has been seriously impaired by the U.S. real estate crisis and the subsequent European debt crisis. Even more troubling, unlike the biggest U.S. banks, many of the biggest European banks rely almost exclusively on extremely short-term financing.

Looking at the 90 biggest banks in Europe (those covered under the latest stress test), I found out that they collectively face €5.4 trillion (yes, trillion) in principal loans coming due in the next 24 months. That equals 45% of Europe's entire GDP. These amounts are staggeringly large and are concentrated in the biggest banks. In Italy, for example, the two largest banks have debt maturities amounting to 9% of Italy's GDP in the next 24 months. People might recall: Names of these two banks… Here's a hint: One of them used to be called Kredit-Anstalt.)

The only way these debts can be refinanced (aka "rolled over") is if private creditors believe the European Central Bank (ECB) will fully stand behind these bonds. If any one of these banks is allowed to fail – à la Lehman Brothers – it will be a complete catastrophe. None of the major European banks will be able to refinance. They will all fail. All of them. Soc Gen and Unicredit might collapse. This is the latest update on 9th August-2011..Bank of America might collapse as well. Its down 17% in the market value.

The other side of the coin is the sovereign debt loads of the euro zone member states. Here again, there are large near-term maturities.

For example, through July 2012, Italy faces sovereign maturity amounts equal to more than 20% of GDP – not including the 5%-10% of GDP annual deficit it's also expected to run. There is no doubt that without the euro – without the ECB – Italy's government would be unable to refinance these debts at an interest rate it could afford to pay. Even with the currently explicit backing of the ECB, Italian CDS (credit default swap) markets are pricing in a 25% chance of sovereign default within the next five years.

Spain, France, Portugal, and Greece also have large near-term maturities over the next 12 months. If any one of these countries is allowed to default, they will all default. All of them. Bail out is the solution. Only default and restructuring can restore market confidence.

Investors might reasonably wonder… why in the world would these countries organize their financial affairs in this reckless way? It doesn't make any sense… until you begin to understand how the euro zone banking system actually works. It's a paper system that has no accountability attached. In the current system, countries are rewarded for taking on debt because there's never a clearing of the relative accounts.

Here's the core problem: The ECB operates a cross-border payment system that never settles accounts – ever. As a result, there was never any real limit to credit creation in the various euro zone countries. Instead, debts were allowed to build between central banks without any limit. In such a system, who borrows the most wins – at least until the entire system collapses.

Let me give you more detail on this point, because it's really, really important…

In 2010, depositors in Ireland worried their banks would fail because of all the bad real estate loans they held. Depositors took money from Irish banks and moved the capital into German banks. They withdrew roughly €50 billion from Ireland, or 52% of Ireland's GDP. That's a huge amount of capital. In a standalone country (like Mexico, for example) this amount of capital flight would have exhausted the country's foreign reserves, leading to bank failures and sovereign default. But that didn't happen in Ireland, because the ECB continued to provide fresh capital to Ireland's national bank at the same discount rate that was available to all national banks in Europe.

In fact, rather than demanding gold or valuable securities in exchange for the euros that were deposited, all the German central bank (the Bundesbank) got was an I.O.U. from the Central Bank of Ireland. As a result, the Bundesbank is now the largest creditor to the system. It's currently owed €336 billion, which is a larger amount of money than all of the bailout packages combined. In this way, it's virtually impossible for any bank in the euro zone to default – as long, that is, as the Bundesbank is willing to accept those IOUs.

This fundamental lack of accountability or restraint led to enormous increases in total debt, both on the public and private sides of the debt coin in Europe. Why make the hard decisions about who will get a loan if you can get access to more funding, no matter what happens?

Rarely does the "free money" spigot stay open for long. Some of Europe's central banks are now facing huge losses. And the taxpayers of Germany – the ultimate owners of the Bundesbank – are refusing to continue with the system. They're not fools. Germany's head of state is now demanding both sovereign creditors and bank creditors accept some of the losses.

That's why credit default swaps are now beginning to soar – because the market doesn't know how to price the risk of default. The bigger problem is if credit was priced with the possibility of default, few banks and few European countries would be left solvent.

Here's one more surprising fact about the European crisis: Most of the problem could be avoided if there were real and meaningful cuts made to public sector employees' wages and benefits. Take Greece for example. Everyone believes Greeks don't pay taxes. The solution, according to the IMF, is to collect more taxes. But the truth is entirely different: Greeks were already paying more taxes as a percentage of GDP than either the U.S. or Japan.

Even after the IMF package, the Greek deficit is projected to be €17 billion, or 7.6% of GDP. And that's the conundrum. Can you allow most of Europe to operate at a huge deficit, which ends up as losses at the Bundesbank… or do you demand discipline in the system and cause a catastrophic series of defaults?

Investors/ People continue to believe the ECB must, eventually, paper over these bad debts with an enormous bond-buying program that would dwarf the quantitative easing seen so far in the U.S. And it is believed – as I have written for many months – the U.S. Federal Reserve will ultimately backstop the program to ensure it doesn't destroy the euro. But still… how long will anyone, anywhere, accept the paper currencies of obviously bankrupt governments and their puppet banks? I am not sure. and not not optimistic at thispoint of time.

By the way… lest you think we just dreamed this up this week… here's what I wrote about the risks Italy (and the euro) posed to the global economy last July…

Some market participants clearly hoped the $125 billion Fed-orchestrated bailout of Greece would be the end of Europe's sovereign debt worries. They say these small economies "don't matter." But I know otherwise…

The Greek crisis (and the other European debt crises yet to come) is merely a precursor to the "real world" debt crisis of 2010-2012. (I say "real world" because a crisis among developed nations will dwarf the "emerging-market" debt default cycle of the late 1990s.) Likewise, both the emerging-market crises of the last decade, the Internet bubble that followed, and the real estate bubble after that were all merely stepping stones towards the ultimate collapse of the world's untenable, paper-backed monetary standard…

Many of the world's developed economies have been fueling growth with foreign debts. This growth and the asset values created under the euro standard are unsustainable for the simple reason that debt service cannot be made and creditors are unwilling to extend these debts on reasonable terms. These problems have no simple answers. They will spread from creditor to creditor and intensify as the market realizes these defaults are unstoppable. The next major country likely to experience a credit crisis is Italy, which has enormous exposure through its banks to Eastern Europe and the rest of Europe's weak economies.

Italy 's public debt totals €1.7 trillion – seven times the size of Greece. Italy is the world's third-largest sovereign borrower. It cannot be bailed out – it is simply too big. Meanwhile, it cannot possibly hope to pay back its debts as long as it remains in the euro. In fact, Italy has been in recession almost since the day it adopted the euro: Its economy has grown by a total of 0.54% over the last decade. The total public debt to GDP will soon surpass 120%. At that point, it will become progressively more difficult for Italy to extend its foreign debts because all of the foreign creditors will know these debts will never be repaid. A default and devaluation will be the only way to restart Italy's economy.

Finally… what should investors do about all these risks? Hold plenty of gold and silver bullion. Short financial stocks. Hold cash in sound currencies. Buy farmland. Buy energy – during the corrections. Don't believe a word anyone from the banks or the government. Investors should execute their own rsearch that is the golden rule of investment.

Disclaimer: This is just a research piece and not an investment advice. Please execute your own due diligence before making any strategic investment or taking position or entering into an financial contract. All financial transactions carry a RISK.

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