Euro Bank Crisis

Oh boy. Here we go again. It's not Brexit this time. But the UK's vote to leave the European Union is pushing a central problem to the forefront: Europe's banks are in bad shape, and it's going to be very difficult to fix them.

This time around, the euro banking crisis isn't starting in Greece or Spain. It's Italy that's the problem...

One bank in particular, Italy's Monte Paschi, looks like a complete disaster. A full third — yes, 33% of its loans — are being called "doubtful" (I guess that's a technical term). That amounts to 47 billion euros! At the current exchange rate, we're talking about $51 billion in bad loans.

That's obviously a huge number. I don't really know how a bank can manage to amass such a huge pile of bad loans. I'm sure the consistently bad Italian economy hasn't helped. But whatever the cause, Monte Paschi looks like it may be going right down the tubes...

The European Central Bank (ECB) is making a comical attempt to try to fix the oldest bank in the world. It's asked Monte Paschi to cut 8 billion euros of bad loans by the end of next year and another 6 billion euros in bad loans by the end of 2018. So the bank will dump 14 billion of its 47 billion in bad loans... in two and a half years.

Yeah, I'm sure all Monte Paschi's depositors and counterparties are totally fine leaving their cash exposed while this pitiful plan is implemented. Actually, strike that — depositors have been pulling their money out since January. On January 21, Monte Paschi said depositors were leaving in what amounted to a bank run. The stock fell 58% that month. Just yesterday, the stock fell 19%. The total loss this year is 78%. It doesn't look like it will be long before the loss is 100%.

And that's just Monte Paschi. Credit Suisse and Deutsche Bank look terrible, too.

When I first wrote about the looming Euro Bank crisis back in February, Deutsche Bank was down 37% in 2016. The loss is now 48%.

Impotent EU

The biggest problem, however, isn't really Monte Paschi or the total of 300 billion euros in bad debt that Italian banks are sitting on. It's that the European Union is not designed to deal with this kind of thing. Italy has to have ECB approval to bail its banks out.

Now, obviously bailouts are not the ideal response to a bank's bad loans. (Bailouts probably encourage banks to turn a blind eye to risk management — hey, if we make bad loans, no prob, we'll get bailed out.) But in this case, much like in the U.S. in 2009, bailouts are probably the only response that can help prevent a full-blown economic collapse.

But here's the thing: Monte Paschi has already been bailed out twice since the financial crisis. The ECB just approved the third bailout when it allowed the Italian government to guarantee 150 billion euros in bad loans at Italian banks. That's just fine and dandy... except that Italy's debt-to-GDP is around 130%. And EU members aren't allowed to just print euros like the U.S. central bank. So where's that 150 billion euros gonna come from?

Well, there's the Atlante Fund. A group of Italian bankers, insurers, and investors answered the Italian government's pleas in April to create a fund to buy bad debt and maybe even stock from banks. The fund has raised around... ummm... 5 billion euros. 5 billion euros to fix a 300 billion euro problem? Good luck with that...

The most contentious issue within the EU is sovereignty. Individual governments don't want to give up any more control to the EU itself. That's basically why the UK just voted to leave. You might remember that several fiscally sound EU countries were plenty mad when they had to help foot the bill to bail Greece out. And they're gonna be plenty mad again when they have to bail Italy out. And then Spain...

It's tough to see how this ends well... both for the banks and the EU.

UK: Who's Laughing Now?

There are a couple important points to make here. One, maybe the UK's vote to leave the EU wasn't as ill advised as it seemed at first. The EU is fundamentally flawed. That's not too surprising, really, that such an ambitious undertaking couldn't take into account all the variables and might need some tweaking along the way.

Maybe the UK should stick it out and help make the EU more workable. But it's tough for me to be too critical of the "leave" vote.

Another important point concerns our own Federal Reserve. I am well aware it's not at all popular to praise the Fed for how it handled the fallout from the financial crisis. And there's no reason a trillion in taxpayer-backed bailouts and guarantees should be popular. So I guess it's a good thing I'm not trying to win a popularity contest...

But seriously: Ben Bernanke and the Fed did the right thing when they poured money into the banks and insurers. Remember going to the bank in 2008 and getting as much cash as you could because you weren't sure that the ATMs would be working? Yeah, our economy was literally on the brink of collapse. And those guarantees from the Fed saved the day...

I would also add that the Fed has a done a good job of forcing banks to get their balance sheets together. The Fed raised Tier 1 capital requirements, made banks sell stock, administers annual stress tests — and the result is that U.S. banks are much, much healthier than Euro banks.

Now, my final point concerns what happens next. The S&P 500 is still within spitting distance of new all-time highs. And I think it's going to be a while before we get there. This Euro Bank crisis that's brewing isn't just going to go away. And the EU economy basically can't function until it's resolved.

Any bailouts in Europe have to be approved by member countries. So this is gonna take a while. And just in time for the traditionally weak summer months!

The U.S. dollar is likely to remain strong. That will be bad for oil, and maybe stocks, too. Gold typically doesn't like a strong dollar, expect when some banks are about to collapse. Gold likes that, so you can/should own some. I'm not wild about real estate, but there are some great REITs out there with solid yields that will stay solid because the Fed's not raising rates anytime soon.

Finally, get some cash together. I bet the Euro Bank crisis gives us some very attractive stock prices sometime in the next month or two.

Until next time,

Briton Ryle

@BritonRyle on Twitter

An 18-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.