In this very short video clip, Carl Denninger quickly explains this problem on RT TV and RealEcon TV.
In laymen's terms, here's a fleshed-out explanation of what Carl is saying:
European banks (and to some extent US banks) have a huge amount of assets, but those assets are mostly state debt (i.e. bonds purchased by the banks from European governments -- in other words loans they have made to those governments.)
However, the banks have no collateral for these loans they've made. (Example: when you take out a mortgage on the house you are buying, the bank has your house as collateral; when you buy a new car, the bank has the legal right to seize "your' car if you should stop making payments on the car. Its collateral is "your' house and/or "your' car.)
In other words, if something goes wrong and these governments become unable to buy back the bonds (plus interest) that they sold to these big banks, then the customers of the banks are in trouble. Why? Because the bank loaned out 40 or 50 dollars to these governments for every dollar of depositor money it had in its possession. That's called "leverage': if you're a bank you can, by law, create some specified amount of money, say $50, out of thin air, with which to buy bonds (or whatever), for every dollar your customers have deposited on your bank. But if the government whose bonds you have purchased cannot redeem those bonds (i.e. pay back the loan), then (at least in Europe) your depositors and stockholders are screwed.
Another way to think of "leverage' is that when a bank has an asset, such as customer deposits, it then loans those assets out more than once, perhaps many times more than once. Historically, leverage of more than five- or six-times deposits were considered dangerous. In the late '90s JP Morgan was leveraged 10-12 times its deposits. Nowadays, leverages of 40-50 times deposits are tolerated by our regulatory agencies.
American depositors are protected, up to $250,000 per account, by the FDIC. If Spain defaults and BofA goes belly-up, the bank's shareholders get screwed, but the bank's customers' deposits are still safe -- as long as the FDIC is solvent! BofA's remaining assets, including the deposits and loan money owed to it, will get divvied up among its creditors, and life goes on. (But if the FDIC isn't able to cover the deposits, we've got much, much bigger problems than a failed bank.)
Of particular concern is that a lot of these big banks are invested in each other. This means that the actual value of CitiCorp stock could take a dive if BofA's stock dives. Depending on how much flexibility there is within the system, the shock of a couple of mega-banks failing could conceivably be distributed throughout the rest of the financial system. Otherwise, the entire system could fall apart. Problem is, no one knows for sure how much flexibility there really is within America's overall financial system.
Bottom line, the problem is that for those who are invested in European banks as stock holders and depositors, if you wait too long, you're not going to get your money back. Why not? Because unless the governments step in and begin to step up the tax revenue they collect from their citizen taxpayers, they're never going to have the money with which to pay the banks who bought their bonds, and therefore the banks are not going to have the money with which to pay their investors and depositors.
This problem is compounded by the fact that if you count the value of the bonds they've purchased from these governments, then financially speaking, many of these banks are several times the size of the economies of some of the governments whose bonds they've purchased. Therefore, the likelihood that all the customers of these banks (i.e. their depositors and investors) are going to get their money back is quite small. Hence the coming run on European (and America's biggest) banks, and the coming crash of the European economy (and possibly the US economy as well).
The potential negative consequences for America's biggest banks and the US stock market
Bank of America's beleaguered bank's shares crashed through the psychologically important $5 mark yesterday, the lowest they've traded since March 2009. Other bank stocks including Morgan Stanley fell even harder as investors fretted on renewed concerns about bank capital cushions and "a darkening economic outlook in Europe."
Back in December of 2009, Bank of America was trading near $15 a share, a far cry from the $5 at which it closed yesterday. The loss of two-thirds of its value far exceeds the drop in other battered financial institutions like Citigroup, JPMorgan Chase and Wells Fargo over the same period.
"This is like a fire in a 10-story building," said a former Federal Reserve bank examiner who now teaches courses on banking at Boston University. "It's burning through each floor as investors dump their shares."
Financial stocks fell by more than 2% Monday in the United States, leading the entire stock market down. During the day, "the focus shifted to European sovereign debt troubles, as the European Central Bank warned of a perilous year ahead. The sovereign debt crisis is colliding with slower economic growth and a dearth of market financing for banks." Citigroup fell 4.7% and Morgan Stanley 5.5%. For Bank of America, which tumbled 4.1%, trading below $5 represents one more cause for concern this year.
Even the $5 billion investment in BofA by Warren Buffett this summer has failed to mollify sellers -- Buffet has lost roughly $1.5 billion on the deal. Not surprisingly, "institutional money managers are quietly dumping their losers before 2012 arrives." Some observers had speculated that having its stock's value go below $5 would force some institutional investors to unload Bank of America stock and they were right.
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