The Euro-Short

Spain saw a real boom in housing construction up to the end of 2006, with 865,561 housing starts that year. Part was social engineering, but many homes were for cheap housing for Latin American migrant workers (Chapman, 2010). Easier access to credit, allows financial institutions to search for a new consumer, as in the U.K., France, and Germany, the entirety of the European Union backs all euro zone guarantees to the financial sector. It was not until late 2007, that the U.S. stock market began to implode on the implications of default on sub-prime mortgages within the United States (Niall Ferguson, 2009). “‘Turbo-capitalism’—the supremacy of finance capital over every aspect of social and personal life—is an exclusively Anglo-American invention, which the governments of Germany and France have opposed for a long time” (Schwarz, 2008), explains the World Socialist Web Site September 2008 adding, ”The call for a form of ‘regulated capitalism’—that can prevent risky speculative transactions, cutting down to size the power of finance capital and giving priority again to production and trade— is an illusion.” (Schwarz, 2008).

European banking—especially within the German banking system—is a highly leveraged industry, as it’s leverage ratio or assets divided by net worth is 52 to 1, compared to that of France which carries through leverage 28 to 1, and to the U.K. which carries 24 to 1, within the European Union as of October 11, 2008 (Wikipedia, 2010). Stronger loan guarantees and lower profit margins out of the EU, late 2006, allured German banks alongside several other savings banks within the European Union to enter into mortgage-backed derivative deals and buyout U.S. collateralized debt obligations, as to other variable “toxic assets.” (Chapman, 2010). European banks have approximately 75 percent as much exposure to U.S.-originated ‘toxic assets’ as the American banks (Niall Ferguson, 2009). The German government estimates, that there are ‘toxic assets’ with a nominal value of over $1 trillion (€800bn) on the balance sheets of these German banks. The IMF says, European and British banks have 75% as much exposure to U.S. toxic debt as American banks themselves, yet they have been much slower to take their punishment (Pritchard & Waterfield, 2009). To date, write-downs have been $885bn in the U.S. as the European banking sector is seen losing nearly $1.3 trillion in the 2007-10 period, according to International Monetary Fund forecasts in May (Cutler, Slater, & Comlay, 2010).

Spain, which has to repay 24.7 billion euros of debt this month, has the third-largest deficit in the euro region and “many of its banks are dependent on the European Central Bank for funds”, as taken directly from Bloomberg News. Bob Chapman, author of “Stage Two of the Credit Crisis”, believes:

“Sovereign bonds and CDOs are not worth the paper they are written on. Worse yet, European banks, 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.“

A more positive, yet cautious outlook, to combating the crumbling CDO markets has been marked “Market unfairly tarred with subprime brush”. The FT reports:

“It can appear a little unfair. Since the financial crisis began, the light that has been shone on structured finance securitisation, has seemed to focus in particular on ‘subprime’, a category that hardly exists in Europe. Nonetheless, the industry has been tarred by association with the travails in the US.“

“To that end, industry insiders were quietly pleased with a recent Standard & Poor’s report that showed European deals have suffered less than a 10th of the downgrades of their US relatives. In the two-and-a-half years between the start of the crisis and the end of 2009, just 0.39 per cent of European deals defaulted, the agency said, compared with a rate of 4.3 per cent in the US. The study, which covered €1,858bn ($2,540bn) of issuance, also showed that 12.4 per cent of European deals have suffered a rating downgrade against 40.6 per cent in the US.“

“‘The vast majority of European securities are weathering the crisis very well and our ratings of them have been relatively stable. The problems have been very much concentrated in US residential mortgage securities and related CDOs,’ says Ian Bell, head of European structured finance ratings at Standard & Poor’s.“

“So far this year, investors have snapped up the handful of new deals offered – mostly straightforward mortgage-backed products based on top-quality UK and Dutch loans. The rationale is that during the crisis, the market was paralysed by investor fears that their holdings were infected by US subprime, even if that was not the case. This led the entire asset class to plunge, because investors were not confident enough of the data they had to differentiate between deals with toxic loans and the more stable portfolios that made up most European portfolios. The question that remains however is whether there are enough investors to back an ABS recovery.“

German CDO market dealings, nevertheless, are where all market participants have indeed turned on their axes in recent memory. Niall Ferguson, the Laurence A. Tisch Professor of History at Harvard University and the William Ziegler Professor of Business Administration at Harvard Business School, on his blog :

“Under the Basel I rules, agreed in 1988, assets of banks are divided into five categories according to credit risk, with risk weights ranging from zero (for example, home country government bonds) to 100 per cent (corporate debt). International banks are required to hold capital equal to 8 per cent of their risk-weighted assets. Basel II, first published in 2004 but only gradually being adopted around the world, sets out more complex rules, distinguishing between credit risk, operational risk and market risk, the last of which mandates the use of Value at Risk (VaR) models, which calculate the likely exposure of a bank to losses on the basis of date from a relatively short time-period (e.g. the last two or three years). Liquidity risk is combined with other risks under the heading ‘residual risk’.

The lesson of the crisis is that the more countries followed these rules, the more vulnerable their banks became. First, risk-weighting assets ceased to be a meaningful exercise when rating agencies conferred Triple-A ratings (the highest possible score) on no fewer than 64,000 structured financial products such as Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDOs). These securities mainly originated in the U.S. and were often based on subprime mortgages. Bundled together, with their revenue streams divided into three different tranches, these lousy loans were transformed by financial alchemy from lead into gold, combining Triple-A ratings with higher returns than equivalently rated government bonds. German banks were among the most eager buyers of this fool’s gold.

Point two: Value at Risk models gave those who believed in them a completely misleading sense of their own security. Financial risk is not in fact normally distributed (as these models assumed), and no meaningful inferences can be drawn from just a few years of data about the probability of a major financial crisis.

Finally, Basel II completely understated the importance of liquidity risk. When credit markets seized up in 2007 and again in late 2008 it swiftly became apparent that banks which had expanded their assets to the maximum extent—and often beyond it, by using off-balance-sheet vehicles like conduits and structured investment vehicles (SIVs)—were hugely vulnerable on the liabilities side of their balance sheets. Deposits are all very well, and are unlikely to vanish overnight if they are covered by some kind of government-mandated insurance, but loans from other banks or from the commercial paper market are another matter. Suddenly banks that could not roll over their debts teetered on the brink of collapse.

For all these reasons, European banks—and especially German banks—are in fact in a worse position than their American counterparts.“

Henceforward, how does the German government plan to deal on mounting capitulation within the U.S. and European derivatives markets with anticipation for when they implode? German Chancellor Angela Merkel’s government considered a plan back in March of 2009 to take over toxic bank assets until they mature, enabling lenders to avoid massive write-offs while dodging adding to bailout funds (Bloomberg, 2009). The Banking Act of 2009, already, provides a permanent regime to allow the FSA, the UK Treasury and the Bank of England to resolve failing banks in the UK (Barclays PLC ARLO II Limted Prospectus, 2010, pg. 33). Under this Banking Act, these authorities are given powers, including (a) the power to issue share transfer orders pursuant to which all or some of the securities issued by a bank may be transferred to a commercial purchaser or Bank of England entity and (b) the power to transfer all or some of the property, rights and liabilities of the UK bank to a purchaser or Bank of England entity. A share transfer order can extend to a wide range of securities including shares and bonds issued by a UK bank (including the Bank), or its holding company such as a Barclays PLC and warrants for such shares and bonds (Barclays PLC ARLO II Limted Prospectus, 2010, pg. 33). The Banking Act powers apply regardless of any contractual restrictions and compensation may be payable in the context of both share transfer orders and property appropriation. The Banking Act also gives the Bank of England the power to override, vary or impose contractual obligations between a UK bank or its holding company and its former group undertakings for reasonable consideration, in order to enable any transferee or successor bank of the UK bank to operate effectively (Barclays PLC ARLO II Limted Prospectus, 2010, pg. 33).

So as German banks gradually spinoff these “bad-assets” to larger euro-zone guarantees, there is still the question as to whether European government officials can be trusted in upcoming elections, to keeping their word with disheartened voters all across Europe. As taken from the World Socialist Web Site, a campaign against “Anglo-American finance capitalism” is nothing more but political ploy. ”It would have everyone forget that German governments under Gerhard Schröder and Angela Merkel and French governments under Jacques Chirac and Nicolas Sarkozy all praised this ‘turbo-capitalism’ for many years as the economic model to adopt. In Germany, the reform of labour laws, the deregulation of the jobs market, the cutbacks in spending on social programmes and health, the constant lowering of workers’ wages and the increase in top manager salaries was always justified by saying it was necessary to create an attractive climate for international investors.”. So then, what will government officials try and justify to their political party-wings and opposition this time around, after all is said and done for the European financial sector?? ”A real opposition to the dominance of finance capital can only be developed through the unity of the international working class, including American workers, on the basis of a socialist programme” (Schwarz, 2008).

Endnotes:
http://www.niallferguson.com/site/FERG/Templates/ArticleItem.aspx?pageid=212
http://www.informationclearinghouse.info/article25969.htm
http://www.wsws.org/articles/2008/sep2008/euro-s26.shtml
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/4593539/European-banks-toxic-debts-risk-overwhelming-EU-governments.html
http://uk.reuters.com/article/idUKLDE66014P20100701
http://www.eulerhermes.com/en/documents/group_pr_-_construction_-_041708_-_en.pdf/group_pr_-_construction_-_041708_-_en.pdf
http://www.financialregulator.ie/securities-markets/prospectus/Lists/ProspectusDocuments/Attachments/7028/42802-Prospectus%20-%20Series.PDF
http://www.businessweek.com/news/2010-03-15/commercial-mortgage-debt-rallies-as-talf-ending-credit-markets.html
http://www.businessweek.com/news/2010-06-04/goldman-sachs-arranges-loan-fund-amid-clo-revival-update1-.html
http://www.ft.com/cms/s/0/c88824d6-543d-11df-b75d-00144feab49a.html
http://www.risk.net/credit/news/1650919/dealers-prepping-cdos
http://www.ise.ie/app/specSecList.asp?list=full
http://www.bloomberg.com/news/2010-07-20/spanish-borrowing-costs-decline-as-government-sells-7-8-billion-of-bills.html
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aVZmxkR02mwE&refer=worldwide
http://www.efinancialnews.com/story/2010-04-26/trust-issue-goldman-sec-ikb
http://online.wsj.com/article/SB10001424052748704388304575202562283283500.html
http://en.wikipedia.org/wiki/Banking_in_Germany

* The Big Short??? There is no “One Big Short”… They are ALL Big Shorts!!! (so to speak). Just gaze at the sheer size of getting long or short on any CDO contract… Betting all your money up on these leveraged deals, may place YOU the lucky person holding the short of a lifetime…