Magnifying a Magnificent Debt Bubble

Last week it was discovered that, Kweku Adoboli, a 31-year-old equities trader for the Swiss bank UBS, had gone rogue.  In a remarkable misadventure he managed to blow $2 billion of other people’s money at his employer’s expense.  Apparently, UBS noticed a big fat gaping hole in its trading records Wednesday night and promptly arrested Adoboli the following morning.  We don’t know what this has to do with anything, but, perhaps, it offers a valuable example of the current state of European banking.

By now you know that Greece is broke and that even after several bailouts by the European Union they can’t seem to get their act together.  In short, the Greek government promised far too much and borrowed far too much money for far too long.  No doubt, Greece behaved like reckless idiots.

But, it goes both ways. In addition to the Greek government, which borrowed more money than it can possibly repay, is the culpability of the European banks that overextended them credit.  The banks behaved like reckless idiots too.

Why did they lend Greece so much money?  Why did they imperil their finances and the finances of the European banking system making an abundance of bad loans?

We suppose Adoboli has a better answer to these questions than we do.  Nonetheless, we won’t let that hold us back from further rumination…

Guided By Moral Hazard

European banks across the continent are leveraged over 30 to 1.  They hold 30 euros in loans for every euro of capital they actually have on hand.  What this means is if their investments drop just 3 percent their capital is gone.

Obviously, European bankers were chasing profits with greedy abandon.  Where sovereign debts of other European countries were concerned a moral hazard guided the banker’s activities.  They loaned money to governments as if there was no risk whatsoever.

The banks operated under the belief that if a real crisis developed the European Union would bailout the country at risk of default.  Moreover, if the European Union were to ever object to a sovereign bailout, the European Central Bank would come to the rescue of the too big to fail banks at risk of insolvency.

We don’t doubt that these bankers are saucy and clever fellows.  Certainly they knew what they were doing…right?

One of the many entertaining aspects of world finance these days is the frequency and velocity at which crises unfold.  In fact, this week we may get to find out if the convictions of European bankers hold true.

Once again, we can thank Greece for making it all possible…

Magnifying a Magnificent Debt Bubble

Greece’s GDP represents less than 2 percent of the European Union’s economy.  Its output is practically insignificant.  By all accounts it’s nothing but a single straw.  Yet, where the European Union’s concerned, it may just be the straw that broke the camel’s back.

The perfect solution to a country’s insolvency problem is default.  It wipes the slate clean of bad debt and punishes lenders and borrowers in the process.  The lenders learn to not lend money to those who can’t pay it back.  And the country in default loses access to credit.  They are forced to live within their means.  Yet, for whatever reason, those in power will do practically anything, and everything, to prevent a default.

Thus far Greece has been given several chances to get their act together.  They’ve received bailout money in exchange for promises to cut spending.  Yet thus far Greece hasn’t kept up their end of the bargain…they’ve taken the bailout money, spent it, and then begged for more.  At the same time the banks have been given a free pass for making bad loans.

Nonetheless, the populace of the productive nations – like Germany – is fed up with having their hard earned money flushed into the Mediterranean Sea.  Should Germany demur to further Greek bailouts, European banks will be exposed as insolvent.  That’s when the financial system cracks up like it did when the Lehman Brothers house of cards collapsed three years ago.

But the central bankers of the world are determined to not let that happen.  Late last week it was announced that the European Central Bank, along with the U.S. Federal Reserve, Bank of England, Bank of Japan and Swiss National Bank would offer three-month dollar loans to Europe’s commercial banks.

Of course, this won’t solve a thing.  The bad debts don’t go away.  They don’t disappear. They become part of the balance sheets of these central banks.  Moreover, where do these central banks get the money to loan to European banks?

That’s the rub of all rubs…for they just create it from nothing.  More digital monetary credits are pumped into the banks, further perpetuating the problem and magnify a magnificent debt bubble.  When it explodes the carnage will be hell.

Sincerely,

MN Gordon
for Economic Prism

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