Two main things spell trouble for European, or more precisely, Euro-based financial institutions. The first one being a massive spike in European banks’ credit default swap (CDS) spreads, i.e. the cost of insuring against bankruptcy. There are still a lot of dodgy debt instruments and risky sovereign debt papers on these banks’ balance sheets and their complex inter-European credit exposure relationships further muddy the picture. As a result the market is starting to discount for massive losses caused by so-called “haircuts” (the restructuring of sovereign debt portfolios), especially in Greece, Ireland and Portugal.
It is precisely the seriousness of the sovereign debt spiral for the PIIGS countries and the resultant need for massive reform programmes that is the second “trouble-maker” for European banks. Such reform programmes will take the levels of standard of living in these countries back several years, and let the Baltic countries’ tough experiences of this serve as a clear warning of the severe consequences of such a scenario. There’s no doubt that fiscal spending in the PIIGS countries is too high and deficits are spiralling out of control. But herein lies the catch 22 in that cutting fiscal spending to reduce deficits would put too much strain on the overall already weak economies, making neither this nor debt restructuring a pleasant solution.
Pursuing the first (“haircut”) scenario would inevitably result in several banks going bankrupt, apart from the main PIIGS banks, located locally in each country, but also to a very large extent in Germany, France and the U.K. These banks would inevitably end up on government balance sheets, thus breaking the back of the economic recovery. The second (cutting fiscal spending) scenario, although less likely - given the associated political loose-loose stigma - will eventually come but will be driven by the demands of creditors (mainly Germany and France). This could result in massive write-downs on property, mortgage and commercial loans for all banks exposed to the PIGS. The peripheral banks will however have some more time to react before the export dependant economies of Northern Europe fall apart.
Up until now the strategy from European governments and the European Central Bank (ECB) has been “time heals all wounds”. Cheap short-term liquidity has been provided to boost Net Interest Income (NII) and correspondingly Shareholders Equity. Everything was going according to plan when some of the Eurozone’s minor economies (Greece, Ireland and Portugal) started to haemorrhage funds so now the situation’s possible ramifications for Europe’s banks are quite serious.
The ultimate message of all this being: stay out of European financials for the time being. The developments in this sector might be very messy.
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