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European Banks on the Brink


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

Those Wild and Crazy Swiss

We think of Switzerland's clockwork banking style as stodgy and by-the-numbers. I've done business with Swiss private bankers, and indeed they are conservative. But somewhere, somehow, UBS (UBS) and Credit Suisse (CS) ran up a little leverage. Before the crisis, they were over 40:1. And now they're nearly at a nosebleed high of 70!

As an aside, I was in Switzerland about 2 years ago, meeting with some very well-known dignitaries. In a very off-the-record conversation, they told me UBS was technically bankrupt. As it turns out, there were a lot of banks around the world that were technically bankrupt.

The next graph underscores the problem of "too big to save." Let's say the US will eventually pump $1 trillion into the banking system (in taxpayer losses). That's about 7% of US GDP. We may not like it, but it doesn't stop the game. US bank assets are only twice US GDP. Switzerland and Ireland are over 7 times, the UK is over 5, and the Eurozone is at 4 times. And so it goes.

Eurozone banks are already reeling from losses from US subprime-related problems. They're now getting ready to deal with even deeper losses from their own lending portfolios. If the losses were just 5% of the portfolio -- an optimistic assumption -- they'd be 20% of Eurozone GDP.

But each country is responsible for its own banks. While it's thought that Germany will be able to handle its problems, the prognostication for Austria and Italy isn't so sanguine. Italy is already running a massive deficit and has no central bank to monetize its debt. The same goes for Portugal, Spain, Greece, and Ireland: 5% loan losses in Ireland would be 40% of GDP -- the equivalent for my fellow US citizens of about $5 trillion. Where does Europe find a few trillion dollars?

I was writing in late 2006 that the subprime lending market would end in tears. And I think the European banking crisis that's on the horizon has the potential to be every bit as big a problem as subprime loans. The world depended on Europeans banks for much of the lending that allowed for growth and development. Like their counterparts in the US, they're going to have to reduce their loan portfolios. Deleveraging isn't fun.

It takes a lot of time to build up a banking infrastructure that can raise the capital necessary to make and process loans. Europe is a big customer of the US and Asia. Their businesses are going to be hit hard by the lack of capital, which is of course no good for employment. We're all connected -- what happens in Rome no longer stays in Rome.

Let me reprint a graph from last week so you can burn it into your mind. The world needs to find $5 trillion to finance government debt issuance. And we need to fund private business and consumer debt. Where's all this money going to come from?

A Positive Third Quarter?

Those calling for the end of the recession are shouting that the third quarter may be positive in terms of GDP. It's possible, but only for statistical -- not for fundamental -- reasons. For instance, lower imports are a net positive for GDP, but lower imports mean a weaker economy. Government spending adds to GDP. Normally, if the government spends too much, then we get inflation, which is subtracted from nominal GDP to give us real (after-inflation) GDP. But inflation is low and getting lower, so there won't be much to subtract from nominal GDP. Are government spending and massive deficits signs of fundamental strength?

It's quite usual for there to be a positive quarter in the middle of a recession. Watch the fundamentals: industrial production, unemployment, capacity utilization, tax receipts, etc. When those turn up, or at least level off, the recession is over. Then we get to the long recovery.

Quick point: As I've noted, unemployment is at 9.5% and going to 11% -- hopefully no higher. Average hours worked per week is at an all-time low. The number of people working part-time but wanting full-time work is another 7%. And that part-time number is rising very rapidly.

When the recovery actually does begin to manifest itself -- and it eventually will, as we find the new normal -- employers are going to give their current employees more hours, not hire new workers. This is going to be a long, slow, painful, jobless recovery. Unemployment is going to remain stubbornly high.

And this Congress wants to raise taxes on small business, but 75% of the "rich" are small businesses. How do you expand your business in California or New York, where taxes will be over 60% by the time you add in local taxes? We'll talk about this next week.

And as a further preview, from an economic viewpoint, massively raising taxes in the middle of a recession is about as dumb as you can get. But it looks like that's where we're headed. Green shoots, my foot.
No positions in stocks mentioned.

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