International Forecaster Weekly

Debt Overhang Hinders Recovery

Euro and European crises, a stress test, no solution in sight, lenders without sanity, banks nervous, austerity measures could force a depression, stage two of the credit crisis, most debt yet to be written off.

Bob Chapman | July 17, 2010

The crisis affecting Europe is nothing new. It goes back three years and the beginning of the credit crisis, 60% of the subprime CDOs, collateralized debt obligations, had been sold to European institutions. These were the mortgage bonds, which contained a variety of toxic waste, which the rating agencies, S&P, Moody’s and Fitch, in collusion with banks and brokerage houses, had sold as AAA bonds, when in fact their ratings should have been considerably lower. The holders of these bonds in many instances became insolvent and had to be bailed out by capital injections from central banks, most of the funds were lent by the Federal Reserve.

These debt problems, as in the US, have never been resolved. Those companies and institutions have over the past three years been allowed to keep two sets of books.

Six months ago the Greek crisis arose adding another financial and economic problem not only for Greece, but also for four other euro zone members and their debt holders, namely banks and other sovereign debt holders.

You might say the current additional crisis was frosting on the cake, because unbeknownst to most Europe has never emerged from its original crisis. We have now an internal bank and sovereign debt crisis combined. What is of passing interest is that the raters and sellers of the toxic waste, that started all this, have never been prosecuted nor pursued civilly.

European banks a year ago used a temporary ECB loan facility funded by more than $500 billion, which was in part funded by the Federal Reserve and has been due for the past two weeks. Needless to say, the introduction of the Greek crisis and the recognition of the problems in Portugal, Ireland, Italy and Spain have put European banking into a very compromised position. If the ECB liquidity is removed very simply the bottom could fall out. This is still a severe crisis with no solution in sight. What we have is crisis upon crisis caused in part by the US subprime crisis, but also the result of European credit expansion that began ten years ago and structural problems caused by one interest rate fits all within the euro zone. The cost of money fell during the past ten years due to perceived safety and guarantee that all euro zone debt would be equal to the quality of German debt. It did not work out that way and as it turned out Germany in varying degrees ended up carrying all the other members, especially when it came to balance of payments deficits.

In last weeks missive we cited the end of the one-year loan program for refinancing on July 1st. That now has been replaced by another facility. The new loans of $166 billion for three months and a $140 billion six-day facility and numerous other offerings now replace the original facility. The original one-year facility was for $557 billion. If you total the 3-month increments for a year at least $664 billion is available, plus the other goodies. The bottom line is more and more money is being lent into a failing system.

ECB President Jean-Claude Trichet in last week’s press conference would not give any details on the current “stress test,” but did say results would be published on July 23rd. He says there will be no quantitative easing, due to 1% interest rates. We wonder what he calls loans of $664 billion plus? This does not improve bank capitalization – it masks the lack of adequate capitalization and says nothing of their two sets of books.

Lenders under the ECB rule, one interest rate fits all, must have lost their sanity. In Spain in 2006, 700,000 homes were built, that was more than in the UK, France and Germany combined. Part of this was social engineering. A good many of them were for cheap housing for Latin American migrant workers. Today official unemployment is 21% and savings banks own almost 60% of all mortgages.

The availability of cheap money allowed banks to search for new markets. They had no compunction in making loans, because of the euro zone guarantee. It wasn’t long before they were making many subprime loans and they were in way over their heads, especially in Eastern Europe.

Such strong guarantees and low profit margins tempted German banks and savings banks to use derivatives and to buy US CDOs, and other toxic assets.

No one thought about demographics and resale as the European birthrate collapsed.

There is much consternation over issuing bank interest rates in the interbank circuit. The secret is banks again do not want to lend to each other, because they do not trust each other. This is the wholesale money market known as LIBOR. The ECB has stepped in to augment lending, but the solution is to only temporary lend. If confidence doesn’t return rates could shoot back up to near 5%. Last time the Fed came to the rescue, and it may end up that way again.

Contrary to what the IMF’s experts think global growth is about to take another swan dive and all banks with problems won’t be able to grow out of their problem. Making matters worse the clock is ticking. It is very obvious European banks are in serious trouble. Over the past year, if you add up all the loans received from the ECB, the total was $1.15 trillion.

In order to roll these loans and expand profits these institutions and the total economies have to have growth and that won’t happen unless there is more quantitative easing, both in Europe as well as in the US and the UK.

We don’t know how they expect to accomplish this in Europe under austerity programs. Remember as well that the euro zone consists of 16 members and the EU has 27 members of which the 16 are part of. Efforts are being made to coordinate another European centralized bank regulator, which to us is the antithesis of what is needed. The ECB wasn’t able to prevent the fiasco of the past several years, so what makes the bureaucrats in Brussels and Frankfurt think a centralized regulator will work? Here we are back to more centralization. Europe has a banking crisis just like the UK and US have. They might consider fixing that first. Throwing temporary funds at insolvent institutions is not the answer. In the meantime banks still do not want to lend to each other and except for AAA companies they are reluctant to lend at all. The same syndrome is prevalent in the US, where business loans to small and medium sized businesses are off over 25%. This is a waiting game to see who goes under first. In addition, these banks, state banks, have issued $3.78 trillion in state debt. In order to pay back such loans governments have to reduce spending, which, of course, curtails growth. In socialist Europe governments make up a large part of overall spending.

We believe the austerity program will work long term, but in the interim Europe not only faces giant debt to service, but also could easily fall into depression. If this happens the profits needed to help banks recover won’t be there. The bottom line is Europe’s banks, like those in the US and UK, are in a box and they cannot get out. Almost all of them are insolvent and no matter what they do there is no easy way out. Now you can understand why another war is being prepared. It is to be a major distraction from these terrible economic and financial problems.

If Europe thinks for one second that devaluing the euro deliberately is going to solve their problems they are mistaken. Their goods may be 15% cheaper, but if other economies are in a tailspin, they are not going to be able to be buyers. The US and the UK are good examples.

The ECB has been progressively facilitating the purchase of state bonds to cut budget deficits, which is really no solution to the problem. The big floaters of these bonds have been those in the deepest of trouble, who cannot pay the interest and principal. Again, European banks that are insolvent continue to create money out of thin air as all within the fractional banking system do. The easy money still flows, as again the day of reckoning is thrown into the future. Every bank in Europe is probably going under. There is no way for these debts to be repaid. The game being played in Europe is different than that being played in the US and UK, but in the end they are all going under.

Stage two of the credit crisis is well underway having been kicked off by our elitists in Wall Street, banking and Washington. You might call this blow back from the delaying tactics used over the past almost three years. As you can see, policymakers do not have things under control. Greece is failing and the exposure of the other PIIGS brought a new dimension to the frailty of the world financial system.

The US dollar’s rally from 74 on the USDX to 89 was powerful. A head and shoulders formation makes the dollar very vulnerable. We recently saw it at 82.36. It could be the decent has begun. Those who own US Treasuries and other dollar denominated paper could be at great risk, especially with zero interest rates. In addition, there has been a major pullback in speculation as well, which will put further downward pressure on the dollar and Treasuries. Watch out because the technical play is over. Now the dollar has to fight to stay at the peak of being the world’s reserve currency, not because of the possibility of the SDR taking over, but because of its losing battle against the only real money, gold.

The debt overhang as we previously mentioned is staggering. In order to give you prospective, in 1998 debt to GDP was 257%. Today it is at 357%, which means the private sector is still overleveraged in a big way. This means inventories will be slow to liquidate, manufacturing will slow and unused space will expand in factories, retail and offices. Foreclosures continue a pace. No one really knows what the total of residential vacancies are, but the figure has to be near 1-1/2 years supply, whereas four months is normal. By the end of the year, that figure could be more than two years. The tax credits are over and now comes the avalanche. In addition, builders will build 535,000 homes this year. Next year should be a big year for builder bankruptcies. That is unless there is another tax credit or the Fed literally floods the economy with money and credit. After four years we just may start to cover our housing shorts. As we mentioned some time ago government intends to consolidate the housing industry into three companies, which will then be nationalized.

All of the above means higher unemployment. Building and manufacturing should reflect higher unemployment for years to come. America needs a net monthly gain of 150,000 jobs just to keep up with the birthrate. In the last 11 years eight million jobs were lost to free trade, globalization, offshoring and outsourcing, plus another 5.3 million jobs have been lost in our three year depression and some ten million are forced to work part-time or 34.1 hours per week. Unemployment is 22-3/8% and will hit 25%, the same as it was during the “Great Depression,” by the end of the year.

As America waits to see if the Fed is going to inject $5 trillion into the US economy, Spanish banks stumbled and borrowed $161 billion from the ECB in June, an 18% increase from May. Spain is in deep trouble as European bankers and politicians continue to lie concerning Europe’s financial problems. There is no liquidity. Germany realizes this and wants to write off 2/3’s of the PIIGS debt, and finally exit the euro. It is also significant that no one has lent funds to any Spanish financial entity for more than two months, except the ECB. We should also mention that $560 billion has already been written off since the beginning of the global credit crisis in 2007, now almost three years old.

Spain has the 3rd largest deficit among countries in the euro zone. One third of the euro zone members are insolvent and that is why stress tests have not been released and probably won’t be. Even the solvent nations and their banks are in serious trouble. Sovereign bonds and CDOs are not worth the paper they are written on. Worse yet, they, like US banks and other corporations, are carrying two sets of books. If one set of books were kept all the toxic waste would have to be written off and that would deplete their capital and most likely put them out of business. Is it no wonder banks do not want to lend to each other? Banks and nations are lying, the ECB and its president Jean-Claude Trichet are lying about it. European banks were almost all involved in the same speculative activities that the US banks were involved in. The ECB is doing the same thing in Europe that the Fed has done in the US, and both are equally insolvent. It is incredible that the public doesn’t understand that the system is broken. The bankers still control the system from behind the scenes and still are making billions. European lenders have $3.3 trillion at risk in PIIGS loans. German banks alone are preparing to write off some $325 billion this year – a bill to be paid by German taxpayers. It is now only a matter of time until the PIIGS leave the euro zone and the euro is no more. The write offs could last 30 to 50 years, and that as well could be how long the depression will last. Ninety-five percent (95%) of the bad debt on average in Europe and the US has yet to be written off. Worse yet, nothing has been done to solve these problems, which has resulted in record unemployment in Europe and the US. The ECB has lent out $1.3 trillion it created out of thin air. This means the world will experience the Japanese experience of the past 18 years for another 30 to 50 years. In addition, most of this is done in secret, so the citizens won’t know what is going on. Banks are doing their own stress tests and lying about the results. Even at that the results are dreadful. Derivatives now reflect 60% losses on Greek bonds. By the time this is over all the bad paper will be 62.5% written off, not just in Europe but in the US and UK as well, as we predicted months ago. This is where we are headed and it is not good. Your only protection is gold and silver assets.

As we said a month ago we expect the euro to trade between $1.1875 and $1.30 for several months, indicating the dollar rally is over. As we also noted earlier the strong dollar would hurt the US balance of payments and so it did. It would have been much worse if oil prices hadn’t conveniently dropped $15.00 a barrel. May saw the worse deficit in 18-months as it widened to $42.3 billion. The deficit with Europe rose $6.2 billion and imports rose by 3.2%. The biggest deficit was with China, up 15.4%, $22.3 billion, or 53% of the deficit.

In Europe, as we have seen in the US, we only see short-term fixes, with the public footing the bill for the bailout of elitist bankers. If it wasn’t for the Fed and ECB’s buying of sovereign debt and CDOs, the system would have collapsed almost three years ago.

As we noted earlier, Spain’s debt to GDP is 54%, but their private sector debt is 180% of GDP.

Greece has a new BB+ rating, which is junk. The government wants to play by the ECB rules and the public wants out of debt and the euro.

Foreign investors reduced purchases of long-term U.S. securities in May, reining in their buying of U.S. government and corporate bonds, the Treasury Department said on Friday.

Net long-term capital inflows fell to $35.4 billion in May from a downwardly revised $81.5 billion inflow in April.

Net overall capital inflows into the United States, which include short-term securities such as Treasury bills, edged up to $17.5 billion in May from the prior month's $13 billion.

Buying of Treasury notes and bonds fell sharply, with foreigners snapping up a net $14.9 billion in May compared with $76.4 billion in April. China remained the biggest Treasury holder but saw its total stash slip by $32.5 billion.