The Next Hit

We have avoided Armageddon, at least for now and some have been loudly announcing the end of the recession. I am part of this and we are not out of the woods yet and there are a few more bumps in the road, and can be quite steep hills. As big as the sub-problem? Maybe.

When asked few weeks ago, what was my biggest concern – it would be European banks, which I have been highlighting many times the potential to create significant risk for the entire global system. This may be even dip us back into recession.

The insane lending policies in US mortgage banks has bring the world financial system to its knees, but one rarely knows the fact that Europe’s banks have been much aggressive in funding emerging markets expansion than US or Japanese banks. To compound the problem, the Europe’s banking system is in far worse shape than the US system. The losses may be bigger and their capital to meet those losses is certainly less.

Regulators in the UK allowed 20:1 leverage on a regular basis. It is now almost 40:1 and with tangible common equity (TCE), which includes preferred shares is around 55. This compared to US situation of which the average leverage of Tier 1 Capital of the five largest banks is in the range of 12:1 and is actually down from ten years ago. The assets of UK banks are about 5 times as large as UK GDP and by comparison, for the US, the ratio is barely 2:1.

And now turn to Eurozone. Leverage is now 35:1 and with TCE is almost 55. Now, this is the real issue and according to some Austrian-economist friends “Good, they should al be allowed to die” and this could potentially raise unemployment rate to something like 20%. This is a global risk, not just localized to Ireland or Spain or Austria.

I have some dealings with Swiss private bankers and they are known to be conservative. But somewhat, somewhere, some of them ran up a little leverage of nearly at nosebleed high 65%. According to a friend of mine, these banks are technically bankrupt.

Eurozone banks are already reeling from losses from US sub-prime related problems. Compounding this is Switzerland and Ireland’s bank assets are over 7 times, the UK is over 5 and the Eurozone on average of 4 times. Now, they have to face with even deeper losses from their own lending portfolios. Assuming that the losses were just optimistically 5% of the portfolio, it would be 20% of Eurozone GDP. The same goes for Portugal, Spain, Greece and Ireland. A 5% loan losses in Ireland would be 40% of GDP, the equivalent of US$5 trillion and I wonder where does Europe to find few trillion dollars?

After all, we are all connected, and what happens in Rome, no longer stays in Rome. Burn this into your mind!