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European Banks on the Brink

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Continent faces bigger losses than the US -- with less money.

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We've avoided armageddon -- at least for now. The cost to the US taxpayer has been a few trillion. Some in the media are loudly announcing the end of the recession, but there are a few more bumps in the road -- some of which are more like steep hills. As big as the subprime problem? Maybe.

When asked a few weeks ago what my biggest short-term concern was, I quickly replied, "European banks have the potential to create significant risk for the entire worldwide system." This week, we'll glance over the pond to see what gives me cause for concern. Then we'll briefly look at a few of the bumps I mentioned -- which are likely to stretch out any recovery, and possibly dip us back into recession.

Europe on the Brink

Globalization is a double-edged sword. On balance, it's brought prosperity to those who have embraced it, in the form of enhanced lifestyle, better health, longer life, and more. The more we need each other, the less likely we'll shoot each other (eliminating your customers isn't a good business strategy). And while the growth hasn't been even or smooth, only a Luddite would want to return to the early 1800s or 1900s -- or even 1975.

The other edge of that sword? We're connected in so very many ways -- far more than most of the world suspected. Who would have thought that insane lending policies at US mortgage banks would bring the world financial system to its knees, increasing unemployment and leading to a global recession? World trade is down 20% or more. US railroad shipments are down more than 20% year-over-year.

Chinese (and Asian) factories have seen their orders drop as US consumers have gone on strike. The US trade deficit was just $25 billion last month, and while our exports are still dropping, our imports are dropping more. Oil is becoming a bigger and bigger share of imports, and it doesn't come from Asian exporters.

The US is far and away the country with the largest gross domestic product (GDP). If California were a country, it would be the seventh largest, but few think of the state in such terms. For this letter, I'd like to think of Europe as a whole rather than as 27 countries. From that perspective, Europe is as economically important to the world as the US -- what happens there makes a difference in the US.

Last week, we looked at the precarious position of Japan, the second largest economy (or third, if you think of Europe as a whole). It was a sobering letter. When you realize the extent to which Japan has funded Asian expansion, what's happening there can't be good for the world.

But European banks have been much more aggressive in funding emerging-market expansion than US or Japanese banks: Western European banks have lent $4.5 trillion to various emerging-market countries, businesses, and consumers. Many Eastern European businesses borrowed in low-interest-rate euros. New homeowners in Hungary and the rest of Eastern Europe borrowed in Swiss francs and euros, and as their currencies have collapsed, they now find they owe more on their homes than the homes are worth.
No positions in stocks mentioned.

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