On Monday, I warned Money Morning readers how the ‘…Spanish Bank ‘Bankia’ is the poster child for this banking sickness. Formed in December 2010 from the consolidation of seven regional ‘cajas’, the Spanish government initially injected €4.5 billion into the bank. That amount predictably evaporated and Bankia is now subject to a massive recapitalisation plan.’
Let’s look at the Bankia deal in more detail. The government’s initial rescue plan was to take a €19 billion equity stake in the company by issuing its own debt to itself and giving it to the bank. Bankia would then use the debt as collateral to borrow cash from the European Central Bank (ECB) for a term of three years. The cash would count as equity and help recapitalise the bank.
In this way the Spanish government tried to create tangible equity by conjuring up debt from nothing. Thankfully, even for the ECB that was a step too far, and they knocked it on the head.
Before I go any further, I want to explain what bank equity is.
Every company, including banks, has a ‘capital structure’. The capital structure is really just a way of explaining how companies finance their assets. Assets are the things that generate a company’s revenue and profits, but they don’t just magically appear. The assets must be purchased (financed) with either debt or equity (combined, debt and equity represent a company’s liabilities on the balance sheet).
As you probably know, debt is borrowed money, usually with a fixed cost and a fixed term. The cost of equity is indeterminate, as is its term. You, as an investor in the ‘equity’ market, always invest in a company’s equity.
The other thing to remember is that in the ‘capital structure’ equity sits below debt…it is less secure. So if a company’s assets shrink for whatever reason (like a property downturn), so must the liabilities. Equity takes the first hit, followed by the different levels of debt holders.
The Difference With Banks
Banks differ from ordinary companies in that they are highly leveraged. That is, they have a lot of debt and not much equity financing their assets. So it doesn’t take much of a fall in asset values to wipe out the equity holders, i.e. a share price going to zero. When that happens the bank would go into bankruptcy and restructuring.
Debt holders would take a hit to absorb any further losses. These debt holders may only get back 50 cents in the dollar in a bankruptcy. With the balance sheet cleaned up, the bank could then relist and get on with business…presumably with a new, more risk-averse management team and board.
But in the modern world, where banks are Too Big To Fail (TBTF), that doesn’t happen. And it’s why this market continues to be so fragile…and why economies are not, and won’t recover from this crisis.
Let me explain…
The Spanish government wanted to inject €19 billion of equity into Bankia. That is, it wanted to protect bondholders and put taxpayer funds at risk from further writedowns. If the bank is in such bad shape, why not just wipe out existing equity holders, let the bondholders absorb other losses, and inject taxpayer funds after a restructure?
So why doesn’t this happen?
In my view, it’s because the global banking system is interconnected via a web of deceit. Banks issue pieces of paper (debt, to fund their assets) and other banks, insurance companies, and money market funds buy that paper. Many banks then bet on the TBTF/bailout theme by buying derivatives of that paper.
It sounds confusing, I know. That’s because it is. Global financial markets have turned into a massive casino where the banking system is the house. Governments are just the croupiers.
Why You Should Be Worried
The problem with this cosy little arrangement is that as more and more bad debt piles up in the banking system, it clogs up activity in the real economy. Economic growth grinds to a halt. The growth that authorities crave to pull nations out of the debt-dynamic hole becomes impossible to achieve. You can mask something all you like on the books, but in reality the situation deteriorates.
This failure to clean up the banks – which encourages even more speculation in the derivatives market – is going to eventually lead to a huge bust.
Share prices will plummet and the derivatives market will be in disarray. If you were at our After America conference in March you might recall the title of Satyajit Das’ presentation – ‘The Great Re-set’.
Perhaps that is what we will see…a re-setting of the system…the forces of Mother Nature to be denied no longer. When that happens, THAT will be the signal to buy with your ears pinned back. Falling share prices really are a good thing, because it increases the future return from long-term investments.
Or perhaps the spivs and charlatans who pass for leaders these days may have a few more rabbits left in the hat, to be conjured when things seem at their most bleak.
No one knows how this will play out. But I feel very uneasy about this market action. I know there are many who are sanguine, based on the promise of more bailouts and more money printing. But that just seems too easy… the default, hopeful belief.
Some things are bigger than central bankers, politicians and Jamie Dimon. The global credit market and the mountain of derivatives rising behind it certainly are.
Greg Canavan
Editor, Sound Money. Sound Investments.
From the Archives…
Why You Should Wish For a Falling Market
2012-06-08 – Greg Canavan
Why the U.S. Dollar is Really Rising
2012-06-07 – Keith Fitz-Gerald
How This Bear Market Could Last Another 18 Years… Just Like Japan’s
2012-06-06 – Kris Sayce
The Banking Plan That Could Be A Game-Changer for Gold
2012-06-05 – Dr. Alex Cowie
Best Investment Strategies For the Times Ahead
2012-06-04 – Nick Hubble
