No. 1 Issue of 2012: Recession in Europe

I believe that the number one economic issue for 2012 will be a recession in Europe.  I don’t see how this will be avoidable. 

The sovereign debt crisis in Europe has not ended and a lot of the debt is turning over this year and must be financed in the face of greater scrutiny by the rating agencies. 

The solvency problems in the European banking system has not been resolved and with more severe capital requirements and a rising level of troubled loans on their balance sheets, commercial banks are not going to be in the mood to increase lending levels.

And the governmental austerity programs of Greece, Italy, and Spain are just beginning to hurt.  The pain will only rise over the next year or two.

Furthermore, the lack of leadership on the European continent (and elsewhere) is astounding!  How do you resolve a difficult situation when there are no leaders around to realistically deal with the problems embedded within the situation?

A European recession has a high probability of occurring, but the depth of the recession is still to be determined.  On the surface, one might think that the recession would be relatively shallow, but there are other factors one must filter into the picture that adds to the uncertainty of how deep the recession might be.

Given this picture as the most likely leading scenario for 2012, I believe that we must further focus our sights on two other factors. 

The first of these is how the recession might spread to other nations.  Contagion is obviously the biggest concern here.  If a recession hits an area as large as the eurozone, even if it is a modest one, the effects of that recession will spread to others.  The exports of non-European nations will drop.  And there will be financial markets consequences. 

It is highly unlikely that a European recession will be contained just to the continent.  And, since many of Europe’s trading partners are already facing economic expansion that is modest, at best, the repercussions could spread to a relatively large part of the world.

 The second factor is even more disturbing.  If we have a European recession in 2012, given the austerity programs that are being embedded in the economic policies of eurozone states, the likelihood that social unrest in these nations will accelerate both in the current year and beyond. 

We have already seen outbursts of social unease in 2011 and with the increasing information on greater income inequalities, higher levels of unemployment, lower pensions, and so forth, that will be in the news, social unrest can only increase. 

But, these protests will have the examples of the Arab spring to build upon.  As was seen in 2011, the use of modern information technology can only strengthen the capability of protesters to organize and to disrupt.  What happened in 2011 has not been lost on the discontented of the developed world.

And, what happens if a European recession spreads to other areas of the world.  The seeds of protest have already been planted in many areas, including the United States.  Just mention the word “occupy” and you will get your response.

Which leads me to one final point.  I believe that modern society is now going through a period of substantial transition, and, like most periods of substantial transition there will be a lot of suffering as the “new world” emerges and there will be a substantial period of uncertainty as we grapple with the issues and move into this “new world.”

Of course, this will be one of the major problems we have to face…the problem of identifying what needs major changes and what needs only minor adjustments.

With certainty, however, I will argue that the evolving information technology is going to play a huge role in whatever results.  People are going to be dealing with more and more information and they will have this information is “real time.”  There will be much greater connectivity between people.  Due to this there is going to have to be greater openness and transparency in life and this is going to force major changes on the way we do things and the speed at which people react.  Governments are going to have to respond to this.  Corporations are going to have to respond to this.  And, whole societies and their social structures are going to have to respond to this. 

Changes in the availability of information have resulted in major upheavals in the world from the use of mobile type in printing which occurred around 1450 CE and resulted in societal changes like the Renaissance and the Reformation…and the Enlightenment…to the creation of the typewriter, the telephone, the telegraph, the radio, and television.

In a very real sense, I believe that a worldview is passing.  A recession in Europe during 2012 would accelerate changes that are already in motion.  If I am correct, this conclusion does not present a real comfortable picture for the next five to ten years but in terms of the human suffering that will result and in terms of the needs involved in adapting to the changes.    

The Health of the Banking Systems in Europe and the United States

What still bothers me is that governments in both the United States and Europe have not resolved their problems with the solvency of their banking systems.

The question remains about how long these problems are going to be carried along.

This morning we read, “Ireland’s Largest Banks Given Failing Grades.” It is assumed that the government is going to take over the banks and the price tag is going to be a minimum of about $35 billion. (http://professional.wsj.com/article/SB10001424052748703806304576234180828120692.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Following up on this there is the article about the bank problems in Spain, “Spain May Take Over CAM as Deal Talks Fail.” Here again we have the possibility of nationalizing another bank. Moody’s Investors Service estimates that the minimum needed to get the Spanish savings banks adequately capitalized at between €40 billion to €60 billion. (http://professional.wsj.com/article/SB10001424052748703806304576234912073054934.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

On a smaller scale, we have another fiscal crisis in Portugal as it became known that the government’s financial figures were incorrect and that budget matters are worse than was expected. This news came a few days after Portugal’s credit rating had been downgraded once again. This, and the concern that Portugal may not be able to meet bond repayments falling in April and June, has raised new issues about the solvency of the Portuguese banking system.

In addition, we are still awaiting the results of the recently administered “stress tests” of European banks. There is substantial concern about what these “tests” might show.

And, question marks still hang over the health of the smaller banks…that is smaller than the biggest 25 commercial banks…in the United States banking system. The number of commercial banks on the FDIC’s list of problem banks was just under 900 on December 31, 2010. In all of 2010, 157 commercial banks failed while mergers occurred for 197 other banking organizations, many of them not exactly healthy.

This means that almost 12 percent of the commercial banks of the United States are on the problem list of the FDIC. Some put the number of commercial banks that are facing severe operating difficulties at 40 percent of the banking system.

I have argued that a major reason for the quantitative easing on the part of the Federal Reserve is to provide sufficient liquidity for the “smaller”, “troubled” commercial banks so that the FDIC can close or arrange mergers for as many of these banks as possible in an orderly fashion.

The concern over the health of the commercial banks in American and Europe is real.

And, now we are seeing just how extensive the financial crisis was in both Europe and the United States in 2008/2009. These banking systems collapsed together. And, the banking systems have continued to fail to resolve their issues together.

The release of the Federal Reserve statistics on borrowings from the Fed’s discount window, “Fed Kept Taps Open for Banks in Crisis”, is amazing in many respects. Some of the biggest borrowers, it turns out were from Europe. The Fed certainly became the worldwide “lender of last resort.” And, the Fed added large amounts of “junk” in the process. (http://professional.wsj.com/article/SB10001424052748704530204576235213193119194.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

The problems arose from real estate lending and the problems that continue are related to real estate lending.

The question that remains concerns the depths of the problems that still exist in the European and United States banking systems.

People I know are still in shock over the sale of the Wilmington Trust Company in early November 2010, a bank that everyone thought was in pristine shape. (http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount)

This subject came up again in discussions I was a part of during the past weekend.

The concern? How many more situations like that of the Wilmington Trust Company are there “out there”?

This is the worry that we cannot seem to shake.

And, the debate always seems to come back to one thing: Why is the Federal Reserve acting in the way it is? Injecting $1.5 trillion of excess reserves into the banking system does not make a lot of sense…unless the banking system is less solvent than we are being told.

There is a lot of discomfort… in both Europe and the United States…when it comes to looking at the banking system. Unfortunately, we may never understand how bad off the banks have been until we get more and more information in bits and pieces as things work themselves out.

The World Debt Crisis Lingers

The Federal Reserve, the European Central Bank, the Bank of England, and others, are all desperate to keep interest rates from rising. The debt overhang in the developed world is humongous and any substantial rise in interest rates would just exacerbate the financial crisis that hangs over Europe and America.

We observe the debt crisis all around us. Gretchen Morgenson writes in the Sunday New York Times about the need of commercial banks to write off billions of dollars of mortgage loans sold to Fannie Mae and Freddie Mac. The article is “$2.6 Billion to Cover Bad Loans: It’s a Start,” (http://www.nytimes.com/2011/01/09/business/09gret.html?_r=1&ref=fairgame). She writes, “Analysts in JPMorgan Chase’s own research unit published a report last fall stating that possible mortgage repurchase liabilities for the overall banking industry ranged from a best case of $20 bill to a worst case of $90 billion.”

The Financial Times reports that “US Regional Banks Set for Consolidation,” (http://www.ft.com/cms/s/0/2388dd24-1c27-11e0-9b56-00144feab49a.html#axzz1AjUYZy6X). The gist of this article is that commercial banks have about $1,500 billion in commercial real estate loans coming due over the next four years. People have been watching these loans for about 18 months now, but they have been kept “evergreen” as bank lenders have continually renewed these loans to keep them on the books till “something good happens.” The article list 15 regional banks that have loan portfolios consisting of, at least 38% of their loans in commercial real estate loans. Seven of these banks have more than 50% of their loans in commercial real estate. The smallest of these banks is $4.2 billion in asset size.

Many corporations in the United States and Europe still have massive debt loads that continue to increase. Several times a week there is more news about corporations facing bankruptcy. Yesterday, Sbarro announced that it was hiring bankruptcy lawyers (http://professional.wsj.com/article/SB10001424052748704458204576074214100579944.html?mod=ITP_marketplace_0&mg=reno-wsj). Last week, the Philadelphia company Tastykake indicated that it was looking for someone to buy it because of the debt problems it was having.

Another article in the New York Times on Sunday reported on “The Crisis That Isn’t Going Away,” (http://www.nytimes.com/2011/01/08/business/global/08euro.html?scp=1&sq=the%20crisis%20that%20isn't%20going%20away&st=cse). This article was about a report produced by Willem Buiter, Chief Economist at Citigroup, who claims that debt restructuring in Greece, Ireland, and Spain is inevitable: “All bank and sovereign debt is now at risk…” European debt levels, he argues, are unsustainable.

This argument is re-enforced by the information contained in another article in the Financial Times, “Europe’s Woes Put Debt Restructuring Back on the Agenda,” (http://www.ft.com/cms/s/0/c25cc3e6-1cec-11e0-8c86-00144feab49a.html#axzz1AjUYZy6X).

Not only is the sovereign debt of Portugal currently under attack but Belgian bonds came under attack yesterday.

The debt estimates for 2013 are downright scary: Greece is expected to have its debt at 144% of GDP in 2013; Italy at 120%; Belgium at 106%; Ireland at 105%; Portugal at 92%; France at 90%; the UK at 86%; and Spain at 79%.

And, what about European banks? Check out the article “Fears Mount Over European Debt, Banks,” (http://www.ft.com/cms/s/0/c25cc3e6-1cec-11e0-8c86-00144feab49a.html#axzz1AjUYZy6X). European banks are expected to go through a new “stress” test this year, one that will be much tougher than the “joke” that was administered last year. There is great concern about how these European banks will fare in the new test.

And what about government debt in America? New governors are taking a tough stance on the budgets for the upcoming year. Jerry Brown is seeking $12.5 billion in spending cuts for the upcoming California budget. And, Andrew Cuomo in New York is asking for salary cuts of 10% and is seeking even more cuts elsewhere. The governor of Illinois is (seriously) hoping that the lame-duck legislature will pass a substantial tax increase on corporations before they leave. Still many states are in dire straits, hoping to avoid bankruptcy. And, there are dozens of municipal governments on the edge of declaring bankruptcy.

Oh, and what about the federal government: Have you seen the projections for interest expense going forward given the deficits that are expected in the future?

Now, what if long term interest rates were to rise by another 100 basis points? 150% basis points?

Just how much longer can the central bankers of the world keep long term interest rates below where the market believe they should be?

Research indicates that central bank actions can keep long term interest rates lower than market conditions warrant for a short period of time. However, to maintain the rates at below market levels, central banks must inject increasing amounts of money.

QE2 was announced as a policy decision to get the economy growing faster so that the unemployment rate would be brought down.

Yet, now we see what a farce the Fed has been playing on us. Chairman Bernanke, himself, just told Congress that the unemployment rate was not going to improve much at all, even if the economy picks up speed, and that it would take five to six years for the unemployment rate to even show much of a decline.

So, one can conclude from this that QE2 is not really aimed at getting the unemployment rate down.

I have argued for a long time that the reason the Fed was providing the financial markets with so much liquidity was because of all the insolvent banks “out there”. The Fed was helping to keep banks “open” so that the FDIC could close all the banks that needed closing in an orderly fashion.

I believe that investors are coming to realize that the Fed is not trying to keep rates down in order to spur on the economy. To me, this realization contributed to the fact that the yield on 10-year Treasury securities rose by about 100 basis points after the Fed laid out its plans for QE2. The financial markets just rebounded to levels that more closely approximated where the market should be if the Fed were not “messing” with it.

Bottom line: the debt problem is still real. There is a lot of debt “out there” and the value of this debt is not really the economic value of the debt. The central banks of the world are just trying to keep long term interest rates low in order to push off the day when the debt will have to be written down to a more realistic value. The problem is that more and more attention is being paid to the fact that this debt needs to be written down. And, until this write-down takes place, we cannot really recover, economically.

The European Situation and the Financial Markets

Are the financial markets the WikiLeaks of economics?

Politicians and economists and business people ignore what financial markets are saying at their peril.

The financial markets have not responded well to the “rescue” package for Ireland put together by the European Union. The news out of London: “The euro continued to slide Tuesday, falling to a 10-week low under $1.30 as Italian, Spanish, Portuguese and Irish bond-yield spreads all continued to widen relative to Germany.” (http://professional.wsj.com/article/SB10001424052748704679204575646211228101600.html?mod=WSJ_Currencies_LEFTTopNews&mg=reno-wsj)

“The euro had started the European day with a rally, helped by regular month-end flows in its favor. However, things turned sour again as it became apparent that the risks of contagion remained as strong as ever and that Italy is now being affected by the lack of investor confidence in the euro zone.

Like the debtor countries on the periphery, Italy watched the yield on its bonds rise relative to those of Germany as investors demanded greater returns for holding Italian debt.”

The Financial Times writes: “it is still hard to see how Ireland can repay all the debt it has now taken on. So it is unsurprising that the market sensed a fatal combination: governments lacked the means either to nix moral hazard or end the crisis by writing an enormous check.” (http://www.ft.com/cms/s/3/8540ea0a-fb9f-11df-b79a-00144feab49a.html#axzz16locxnQW)

The European banks still remain a problem. Not only do the banks have serious solvency issues facing them, the eurozone’s banking system is a much bigger proportion of the economy than the proportion found in other countries, especially the United States.

The financial markets are flashing a warning signal that the cost of insuring a bank default has risen severely in Europe and in Spain. Plus, given how large the banks are relative to the size of the economy, questions have arisen about the ability of these countries to continue to provide bailouts. The situation in the banking sector of Greece looks positively “great” relative to Ireland, France, Spain, and Portugal.

Yet people continue to ignore what the financial markets seem to be telling them. It is very easy to claim that the markets don’t really understand a situation or that the blame for a situation rests elsewhere. See, for example, the op-ed piece in the Financial Times, “Spain is threatened by a crisis made in Germany”: (http://www.ft.com/cms/s/0/bb515190-fbf2-11df-b7e9-00144feab49a.html#axzz16lsMDit2). Every time the author makes an argument that Spain stood up for Germany in earlier times, he only talks about individuals, not what was happening in the market place. He now makes the argument that Germany, out of short sightedness, is hurting Spain. There is nothing about markets or what markets are doing. It’s all personal, not business!

Spain has problems and the problems are of their own doing. Now they need to get their books in order. (See my post “Is the Euro Bad News for Spain,” http://seekingalpha.com/article/239065-is-the-euro-bad-news-for-spain.)

In the vast majority of cases I am familiar with, the people who ignore the information being generated by the financial markets end up losing. One needs to have an overwhelmingly strong case that the market is wrong before one places a bet. In fact, betting against the market is like setting up one-way bets for traders. (See my post “Interventionists are setting up one-way bets for traders”: http://seekingalpha.com/article/237076-interventionists-are-setting-up-one-way-bets-for-traders.)

Furthermore, when talking about the banks, we still find a lot of people not really understanding the difference between a liquidity problem and a solvency problem. A liquidity problem is a short-run problem pertaining to “asymmetric information.” Something happens, a bankruptcy in the case of the Penn Central situation, and the “buy-side” of the market begins to question the situation of other high-grade customers that have issued commercial paper. In cases like this a central bank provides liquidity to the market so that the buyers will return as prices begin to stabilize. But, this is a short-run event.

A solvency problem is much longer-term and the state of the organizations, banks in this case, is known in the marketplace. And, that is a problem as far as raising funds is concerned. Firms in this situation cannot raise funds because no one wants to lend to them due to their extremely weak financial condition. But, this is not a liquidity crisis, it is a solvency crisis. People would lend to the organization if they were not financially challenged.

Yet, this is what we read in the New York Times with respect to the European financial crisis: “Ireland’s banking problems are only the latest example of how seemingly solvent institutions can be brought to the brink because they cannot in the short term raise the cash needed to finance themselves. Only four months ago, Allied Irish Banks and Bank of Ireland were given a clean bill of health in the European Union’s official stress tests. One weakness of these tests was that they stressed solvency, not liquidity, although that may be remedied next year.

The two biggest Irish banks did not have a large enough base of stable retail deposits. The loan-to-deposit ratios at Allied Irish and Bank of Ireland stand at just above 160 percent, which made them excessively dependent on wholesale money from other banks and big investors. When that dried up, they had to turn to the European Central Bank. When deposits from corporate customers also started to flee, emergency action was required.” (http://www.nytimes.com/2010/11/30/business/global/30views.html?ref=todayspaper&pagewanted=print)

Maybe, just maybe, the stress tests were not strong enough, as many have claimed. Certainly “the markets” did not think that the banks were healthy. This is even admitted in the article: the banks were “excessively dependent on wholesale money” and “when that dried up” real problems ensued.

Come on…wholesale money is very sensitive to the financial condition of the banks. The banks may have passed the stress tests but they failed the market test. Who is kidding who? You believe the stress tests? I’ve got a bridge to sell you!

This is why many politicians and certain economists don’t like the market system. Market performance often contradicts the world views held by these politicians and economists. And, that makes them angry!

Bank Honesty is the Best Policy: the European Case

If the history of banking tells me anything, it tells me that banks are only fooling themselves if they think that they can hide bad assets and then outlast the drag these bad assets put on their performance.

Headlines read,” Europe's Banks Stressed By Sovereign Debts Regulators Ducked” (http://www.bloomberg.com/news/2010-09-06/europe-s-banks-stressed-by-sovereign-debts-eu-regulators-failed-to-examine.html) and “Europe’s Bank Stress Tests Minimized Debt Risk” (http://professional.wsj.com/article/SB10001424052748704392104575475520949440394.html?mod=wsjproe_hps_LEFTWhatsNews).

What do these people think they are doing? Who do these people think they are fooling?

Covering up a bank’s position always comes back to haunt the bank.

Now, we hear that not only have the bank’s covered up their positions, but regulators and government officials have covered up the real position of the European banks.

“Europe’s governments can’t afford to question the quality of bonds they’ve sold to banks, says Chris Skinner, chief executive officer of Balatro Ltd., a financial industry advisory firm in London. “Bankers have got Europe’s governments in their pockets, primarily because politicians cannot change the way lenders do business without undermining confidence in sovereign debt,” he says.

The secret of getting out of a financial quagmire is to identify everything, recognize and accept your problems, and then do something about them.

To me, this is one of the reasons why the restructuring of the American banking system is proceeding as well as it is. I believe that the FDIC (and others) has identified most of the problems in the commercial banking industry, and they are substantial. But, they are generally known. The FDIC, along with the Federal Reserve, is working to resolve these banking problems in an orderly fashion. The FDIC is arranging mergers and is closing banks on a regular basis and the Federal Reserve is subsidizing the banking industry by keeping its target interest rate close to zero and by maintaining massive amounts of excess reserves in the banking system.

One does not see this happening in Europe. As a consequence, clouds still hang over the financial markets as, for example, yields on 10-year Greek bonds are around 11.25 percent relative to yield of about 2.25 percent on similar German bonds. This is true on other debt issued by Eurozone countries and this risk issue also shows up in the spreads on bank bonds.

There are more questions about “when” Greece is going to default on its bonds rather than “whether” it will default on its bonds.

Economic recoveries cannot really take place until the banking system of a country is sufficiently healthy. (See my post, “No Banking, No Recovery” on the situation in the United States: http://seekingalpha.com/article/218027-no-banks-no-recovery.)

But this problem seems to go deeper. This is from the Bloomberg article.

“While they’re stuck with their government bond holdings, Europe’s banks are also still carrying much of the troubled assets they had during the 2008 meltdown. Euro-zone lenders will have written down about 3 percent of their assets from the peak of the credit crisis by the end of 2010, compared with 7 percent for U.S. banks, the IMF estimated in April. The steeper writedowns by U.S. banks are partly because they held a higher proportion of securities, the IMF said.

That doesn’t excuse the lack of candor shown by many European lenders about the unsellable assets on their books, says Raghuram Rajan, a finance professor at the University of Chicago. “European banks haven’t owned up to the large amounts of toxic debt that they hold,” says Rajan, who was chief economist at the IMF from 2003 to 2007.

“The stress tests weren’t severe enough,” says Julian Chillingworth, who helps manage $21 billion at Rathbone Brothers Plc, an investment firm in London. “Many bond investors aren’t convinced the Greeks are out of the woods.” And if the Greeks haven’t emerged from their crisis yet, then neither have the European banks that hold their debt”.

If we are going to have banking systems that are stronger and less subject to systemic risk, bankers, regulators, and public officials must realize that good risk management includes openness and transparency. Bankers, historically, have been among the leaders in securing the “cover up” of bank positions and the quality of bank assets. They do not need the help of regulators and politicians to reinforce this tendency.

Europe and the Solvency Issue

More and more people are becoming aware of the fact that the problem in Europe is one of solvency and not liquidity! Yesterday, the European Central Bank warned “that euro-zone banks face a €195 billion in write-downs this year and next due to an economic outlook that remained ’clouded by uncertainty.’” (See http://online.wsj.com/article/SB20001424052748703406604575278620471963334.html#mod=todays_us_money_and_investing.) This is equivalent to slightly more than $239 billion.

Not only that but it is estimated that these banks will need to refinance roughly €800 by the end of 2010. (See http://www.nytimes.com/2010/06/01/business/global/01ecb.html?ref=business.) This is equivalent to about $984 billion or roughly $1.0 trillion.

More and more people are beginning to realize that countries within the European Union are going to have to restructure loans and this will mean that many euro-zone banks are going to have to write down many of the assets they have on their balance sheets. Hence, we face the problem of the solvency of the banking system.

Why has it taken so long for these people to realize that the problem is a solvency problem?

The reason, I believe, is that the mainstream economic models we have been working with over the past 50 years have focused upon “liquidity” issues. Debt has played very little role in these models.

Yes, I know that some ‘fringe’ economists like Hyman Minsky wrote about these issues, but try and find any kind of a discussion of debt and solvency in major macroeconomic textbooks.

Many post-World War II discussions of money and the demand for money are “framed” within the terminology developed by John Maynard Keynes in the 1930s, around the term liquidity preference, “The term introduced by Keynes to denote the demand for money.” (This is from the Glossary of the macroeconomic textbook by the Keynesian economist Olivier Blanchard.)

Moving from liquidity preference we get the concept of “liquidity trap” from the Keynesian dogma: “The case where nominal interest rates are equal to zero and monetary policy cannot, therefore, decrease them further.” (This, too, comes from Blanchard.) That is, people want to hold money and don’t want to loan money to invest in plant or equipment or inventories and so forth.

Obviously, this latter possibility resonates with Keynesian fundamentalists in terms of the situation that has existed over the past year or so.

The problem with this is that the idea of liquidity preference and the liquidity trap apply to the future. People don’t want to invest privately and just want to hold money because the expectations of future investment performance are so low and so risky that money is the safer way to hold their wealth. This is why, in the Keynesian paradigm, government deficit spending works because people will buy the government debt and the government can then “invest” and put people back to work whereas the private sector cannot.

But, what if the problem is that people and businesses (including banks) are so in debt that they cannot spend and that the cash they are holding is to provide them with funds to exist on in the future? That is, what if people and businesses are bankrupt or are facing bankruptcy because of the debt they have accumulated and are hoarding their wealth in very liquid assets so that they can buy what they need out of what remains of their wealth?

Maybe economic cycles are connected with credit inflations or debt deflations, cumulative buildups of debt followed by the need to unwind the excessive use of leverage built up in the earlier period. This cyclical behavior contains the problem of solvency, not liquidity. (Keynes, interested in the short run, focused on liquidity. Irving Fisher, the prominent American economist from the 1920s, focused on the longer run and wrote about debt deflations.)

It seems that economic policymakers in Europe (and in the United States) have been interpreting the problems of the last two years or so as a liquidity problem. Hence the responses of the leaders of the European Union have been couched in terms of solving their economic and fiscal issues by making sure that there is sufficient liquidity in financial markets for them to continue to function. Yet, the problems have not gone away because the issues of restructuring the debt and asset write-downs have either been ignored or pushed under the covers so that they don’t have to be discussed.

This has been true in the United States as well. The United States Treasury Department responded with the TARP program that was, at least initially, aimed at providing liquidity for ill-liquid assets on the books of banks and other institutions. (See my post of November 16, 2008,”The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.) Furthermore, much of the effort of the Federal Reserve in 2008 and 2009 was aimed at providing liquidity to the banking system and the financial markets and not to problems of solvency.

In fact, I have been arguing over the last six months or so that the real reason why the Federal Reserve is keeping its target Federal Funds rate so low is that there are real asset problems in many of the small- to medium sized commercial banks. The Fed is keeping the rates low so as to help the banking system escape the “solvency” problem of the smaller banks from getting worse while the FDIC works through the liquidation process. Note, again, that the FDIC is closing more than 3.5 banks per week through May 28, 2010 and has 775 banks (There are about one out of every eight commercial banks on the problem list!) on its watch list, a number that is still increasing every quarter.

“The challenges for banks in the 16-nation euro-zone include exposure to a weakening commercial real estate market, hundreds of billions of euros in bad debts, economic problems in East European countries, and a potential collision between the banks’ own substantial refinancing needs and government demand for additional loans.” This quote is taken from the New York Times article referenced above.

The source of this concern? The European Central Bank!

The problem with a solvency crisis is that ultimately assets must be written down to more realistic values. In the cumulative process that occurs in the euphoric credit inflation that precedes a debt problem, asset values attain unrealistic levels. That is why people and businesses (including banks) continue to leverage up their balance sheets.

Valuations eventually must be put on a more realistic basis. This is where the European Union is at the present time. The unanswered question is, how far must valuations be reduced to achieve this realistic basis. And, of course, the bigger concern is whether or not these reductions can be achieved without inducing a cumulative debt deflation. No one really has the answer to either of these questions before the fact.

However, the excesses of the past must be paid for!