In a remarkable piece of world-wide cooperation, many of the world's central banks have agreed to provide liquidity funding for European banks, mostly dollar swaps. Not surprisingly, the European and U.S. markets are up nicely, and gold is down about $40/oz. The markets feels good now, because they got a shot of morphine.
Unfortunately, this solved the problem du jour, nothing more. The European problem is not a banking liquidity problem but is instead a banking solvency problem. Since the last financial crisis, they have not increased their capital nearly as much as the U.S. banks have.
The accounting mechanics are this: Assume you paid $1,000 for a bond that now appears as an asset worth $1,000. However, if the market value of that bond drops to only $700, the bondholder has lost $300. That amount has to be subtracted from income. If there is no income, that amount has to be subtracted from the bank's capital. If the bank lends twenty times the amount of its capital, then the bank has to reduce its loans outstanding by $6,000. Because that is difficult to do, there is a real dis-incentive to making loans now, if you expect to take losses against capital later.
Eventually, the governments of Europe will have to inject capital into their banks. They need a U.S.-style TARP. This would go a long ways in restoring the confidence necessary before banks can actually raise capital from the market. If the world's central banks did this, it would be a shot of penicillin! (It doesn't make you feel better quickly but does actually fix the problem.)
Then, the bull rally will be believable but not yet.
Unfortunately, this solved the problem du jour, nothing more. The European problem is not a banking liquidity problem but is instead a banking solvency problem. Since the last financial crisis, they have not increased their capital nearly as much as the U.S. banks have.
The accounting mechanics are this: Assume you paid $1,000 for a bond that now appears as an asset worth $1,000. However, if the market value of that bond drops to only $700, the bondholder has lost $300. That amount has to be subtracted from income. If there is no income, that amount has to be subtracted from the bank's capital. If the bank lends twenty times the amount of its capital, then the bank has to reduce its loans outstanding by $6,000. Because that is difficult to do, there is a real dis-incentive to making loans now, if you expect to take losses against capital later.
Eventually, the governments of Europe will have to inject capital into their banks. They need a U.S.-style TARP. This would go a long ways in restoring the confidence necessary before banks can actually raise capital from the market. If the world's central banks did this, it would be a shot of penicillin! (It doesn't make you feel better quickly but does actually fix the problem.)
Then, the bull rally will be believable but not yet.
