Thursday, October 11, 2012

8 Reasons Europe’s Crisis is Spreading

The behavior of financial markets�along with�world events indicate that Europe’s financial crisis is (unfortunately) spreading. This is not a scare tactic, but an honest evaluation of the facts. Let’s analyze some of the reasons behind this.

1. Europe’s banks are undercapitalized. Last week, European banks in France and elsewhere needed an emergency cash infusion from a coalition of world central banks. The International Monetary Fund, in its “Global Financial Stability Report,” estimates $408 billion in banks’ risk exposure to toxic government debt from countries like Greece, Ireland and Portugal. Because Europe’s crisis is moving so rapidly, even IMF is having trouble estimating the true liabilities for European banks. Just last month, IMF said it would take only $272 billion to cover banks’ capital shortfall.

2. Banks still aren’t properly managing risk. The global banking system is a mess because banks are deficient at underwriting and managing financial risk. The fact that European banks are overexposed to toxic sovereign debt is proof enough. Furthermore, UBS (NYSE:UBS) is the latest poster child for incompetence when it comes to supervising its traders. It’s never a good time to announce $2.3 billion in losses from bunk trades, but doing it during the middle of a credit crisis is surreal. How many other banks are at jeopardy for this same kind of nonsense?

3. Credit downgrades. We don’t advocate putting implicit faith in credit ratings because history has taught us they are nothing more than financial opinions — and frequently, not very accurate ones. Still, a gander at the latest downgrading trend is troublesome. Intuitive observers will note this is not an isolated phenomenon, but a global trend. Sovereign debt from Greece and Portugal, after several downgrades, is now rated junk. Ireland has been downgraded, Italy was downgraded this week, and Japanese, along with U.S. debt, was lowered in August. The pace at which government debt is being downgrade is accelerating and reversing this trend won’t be easy.

4. Too many cooks in the kitchen. One of Europe’s problems in solving its crisis is bureaucracy. Between the Economic and Monetary Union, European Banking Authority and EU finance ministers, everyone has an opinion on how to fix things, but nobody can execute. Layered on top of this melting pot, are individual countries within the euro zone, each with its own distinct set of financial regulators with their own viewpoints. It’s a conglomeration of confusion.

5. Poor enforcement track record. Financial regulators are prodigious at inventing new rules but much less proficient at enforcing them. In many ways, Europe’s crisis is just like the U.S.’ — a colossal failure by regulators to regulate. Rules are of no protection if they are selectively enforced or not enforced at all.

6. Over-concentration of financial power. The Oscar-winning documentary film “Inside Job” was too angry of a film for me and badly missed at articulating the fourth-grade antics of Wall Street’s elite. Nonetheless, it explained how the U.S. financial services industry became too large too fast. What’s changed since then? More assets and power have been concentrated in fewer surviving firms, which has increased everyone’s risk should one of these institutions fail. The problem of “too big to fail” still hasn’t be solved domestically or internationally.

7. Squandering public funds. Instead of letting troubled financial institutions or governments fail, regulators and quasi-regulators have thrown (and continue to throw) trillions of dollars trying to save them. In the U.S. it was a $700 billion bailout, and in Europe it’s already topped $1 trillion. These headline bailout figures, which are being funded largely by taxpayers, probably are much higher than reported. While financial bailouts in the name of saving humanity or even a country are excellent devices for delaying the inevitable reckoning day, they don’t completely stop its arrival. Furthermore, the financial liabilities associated with massive financial bailouts already have begun destabilizing the financial condition of world governments previously determined as “strong.”

8. Global flood into “safe-haven” investments. Regardless of whether you believe in gold as an investment or not, its substantial rise has been fueled, in part, by the failure of governments to prudently manage their finances. As a result, money is flowing out of stocks and into assets deemed “safe” like U.S. Treasuries, gold, precious metals and Swiss francs. As a side note, I grudgingly use the deceitful phrase “safe-haven” because it suggests a false sense of security. In reality, no single investment security or asset class is technically “safe,” no matter what persuasive marketers argue. Everything is subject to rises and falls at any given moment.

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