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Tuesday, October 18, 2011

EURO Bank Crisis : Be Afraid, be very afraid..

says James A. Kostohryz in his SEEKING ALPHA post, "Global Financial Disaster Looms: European Banks Face Bankruptcy", excerpted below.

There are several important consequences that could flow from a general insolvency crisis amongst European banks.

· Importance of European Banks to Europe’s economies. Bank assets as a percent of the GDP of European countries are magnitudes higher than they were at their peak in the US. Furthermore, finance represents a much larger percentage of GDP in Europe than it ever did in the US. Thus, banking sector troubles could cause greater damage to European economies than they did to the US economy.

· Importance of European Banks to Europe’s equity markets. European banks generally constitute a larger portion of European equity indices than was the case with US banks in 2008. Thus, the effect of a major decline or even bankruptcy in European banks on European equity markets could be even more dramatic than in the US.

· Credit contraction and economic depression. A banking crisis would cause an immediate and deep contraction of credit to European businesses and households. The result of the concomitant liquidity crisis would be general economic collapse and depression throughout the European continent.

· Spiraling sovereign debt crisis. Collapsing tax revenues and the cost associated with bank rescues would provoke either general sovereign defaults, a chaotic break-up of the EU and/or a massive inflation engineered by the ECB.

As I stated in a recent article, European leaders seem to be “whistling past the graveyard,” hoping that some miracle will occur that will enable them to avoid taking drastic and expensive action to contain the evolving crisis.

Unfortunately, there is no alternative to drastic and costly action to save the European financial system and prevent the collapse of Europe’s economies – and perhaps the entire EU system. If dramatic and decisive actions are not taken within the next month, I believe that Europe will face a “Lehman Moment.” At that point, there may be no turning back for Europe.

What actions must be taken? Contrary to the approach currently favored by European officials, the most urgent need is not intervention to capitalize the banking system; it is to place a credible backstop on the sovereign debt of European countries.

Banks can operate with low and even negative levels of equity capital. However, no amount of equity capitalization can withstand the fallout from sovereign defaults of several European states.

Thus, as I have stated previously, the default of all European nations with the possible exception of Greece must be “taken off the table” credibly through authorization of an unlimited commitment by the ECB to purchase and/or finance the purchase of European sovereign debt of member states when and if interest rates on European sovereign bonds exceeds predetermined levels.

What should we expect to happen to commodity prices as a consequence of a full-blown Euopean banking crisis ?  In a follow-up post,  Kostohryz argues  the following :

Is it a total certainty that the European banking system will experience a crisis such as the one experienced by US banks in 2008 and 2009? No. But the probability of such a fiasco is very high – at least 50% in my estimation.

And given this risk, commodity prices are way too high.

Based on global demand and supply projections from mid 2011, the fair price for oil and copper would probably be around $80 and perhaps $3.00 based on marginal all-in costs.

Speculative activity via ETFs, hedge funds and other mediums has consistently kept prices well above these equilibrium levels.

Economic theory posits, and historical experience confirms, that in a global crisis such as was experienced in 2008, commodity prices will tend to drop below their all-in marginal cost all the way down to their cash cost at a new and lower level of global demand. This means that oil prices can go to roughly $35 and copper can go to approximately $2.00.

With oil prices currently at $86 and copper prices at around $3.35, commodities prices are essentially discounting a zero percent probability of a global financial and economic crisis. This is absurd.

This is the number one reason why commodities and commodity stocks offer an attractive opportunity to short today.

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