Sovereign
Risk Alpha: The Banks Are Bigger Than Many of the Sovereigns

This is just a sampling of
individual banks whose assets dwarf the GDP of the nations in which
they're domiciled. To make matters even worse, leverage is rampant in
Europe, even after the debacle which we are trying to get through has
shown the risks of such an approach. A sudden deleveraging can wreak
havoc upon these economies. Keep in mind that on an aggregate basis,
these banks are even more of a force to be reckoned with. I have
identified Greek banks with adjusted leverage of nearly 90x whose assets
are nearly 30% of the Greek GDP, and that is without factoring the
inevitable run on the bank that they are probably experiencing. Throw in
the hidden NPAs that I cannot discern from my desk in NY, and you have a
bank that has problems, levered into a country that has even more
problems.

Many countries
in the Eurozone will have to do some serious belt tightening, and I
don't mean just the current whipping boys of the media and red bull
juiced CDS traders either (from The
Coming Pan-European Soverign Debt Crisis, Pt 4: The Spread to Western
European Countries):

Expected higher fiscal deficit and bond maturities due in 2010
have increased the need for bond auction financing for all major
European economies.

Amongst all major European economies, France and Italy have the
highest roll over debt due for 2010 of €281,585 million and €243,586
million, respectively.

While Germany and France are expected to have the highest fiscal
deficit of €125.1 billion and €96.0 billion, respectively in
absolute amount for 2010 (this is without taking into consideration any
possible bailout of Greece and/or the PIIGS, which will be a very
difficult political feat given the current fiscal circumstances), Ireland
and Spain are expected to have the highest fiscal deficit as percentage
of GDP of 12% and 11%, respectively.

Overall, in terms of total financing needed for 2010 (which
includes 2010 bond maturities, short-term roll over debt and fiscal
deficit), France and Germany top the list with € 377.5 billion and
€341.6 billion, respectively while the total finance needed as
percentage of GDP is expected to be highest for Belgium and Ireland at
26.3% and 22.4%, respectively.

However, the recent spate of bond auction failures across Europe
is forcing governments to increase premiums on new bond auctions
(higher yields), which in turn is resulting in a decline in existing
bond prices.

PIIGS - A troublesome area

So, pray tell, what happens when austerity measures hit these
countries that need to reign in the debt from the (I say current, others
say past) financial crisis by raising taxes, cutting services, firing
state workers either outright or through attrition and reducing wages.
The quick answer: lower aggregate demand for goods and services. Raise
the price (through taxation), lower the demand. Lower income and wealth
(through taxation, layoffs and wage decreases) and you lower demand as
well.

What does this portend for the four or five largest
economies on Earth (US, China, Germany, Japan and the UK) all of which
also happen to be the largest exporters? Well, they obviously will be
exporting a lot less. This is even more notable when you take into
consideration those economies who are very heavily dependent on exports,
ex. China and Germany - the countries that are considered the anchors
of stability right now. Germany cannot be the export and economic
powerhouse that it currently is if the PIIGS, US, UK and the Eurozone
tighten their belts. China cannot bring the world out of recession if
the world won't buy lots of their stuff. This means that these two
countries will have to make a significant (negative) adjustment to
counter the drop in global exports.

I never believed the sell side
mantra of China leading the way out of this to begin with. See Can
China Control the "Side-Effects" of its Stimulus-Led Growth? Let's Look
at the Facts - Explains the potential fallout of the
excessive fiscal stimulus in China. While not European, it is quite
likely to kick off the daisy chain effect. See also Signs
of a China Credit and Real Asset Bubble Are Now Unmistakable!

Now,
even assuming the bigger companies can handle it (even though, at the
very least it will dampen GDP), the smaller countries reliant on exports
may get crushed, transforming the economic contagion back into
financial contagion to be injected into the Eurozone. See The
Depression is Already Here for Some Members of Europe, and It Just
Might Be Contagious!:

Austria,
Belgium and Sweden, while apparently healthy from a cursory
perspective, have between one quarter to one half of their GDPs exposed
to central and eastern European countries facing a full blown
Depression!

Click to Enlarge...

These exposed countries are
surrounded by much larger (GDP-wise and geo-politically) countries who
have severe structural fiscal deficiencies and excessive debt as a
proportion to their GDPs, not to mention being highly "OVERBANKED" (a
term that I have coined).

... Countries in this region are
highly dependent on foreign trade, with exports accounting for more than
50% of GDP for many countries. Sharp declines in exports have triggered
a series of internal predicaments including rampant and rising
unemployment as well as declines in domestic demand that exacerbate
trade account imbalances through declines in imports. However, the
problems for these countries have been aggravated by huge foreign
indebtedness and the resultant interest and income payments that put
additional pressure on the balance of payments. While currency
depreciation could have provided some much needed respite (although that
can be seriously debated), for countries like Latvia, Estonia,
Lithuania, Bulgaria and Ukraine which have a fixed currency peg to Euro,
the option is not available. As a result, Latvia, Lithuania and Estonia
have witnessed double digit negative real growth in GDP and are
witnessing structural issues of deflationary pressures (owing to price
and wage cuts) and very high unemployment levels. Click any graphic
to enlarge...

Source: IMF, European Commission

The
banking crisis (borne from reliance on boom/bust cycle economics)
deposited a very large problem in the lap of the economy. Simply
transferring half of the problem to sovereigns while changing accounting
rules to hide the other half does absolutely nothing to solve or even
ameliorate hide the problem. At the very best, sovereign nations my have
succeeded in quelling the risk of financial contagion leading to part
two of the crisis in exchange for exporting economic contagion that will
(on the optimistic side) restrain growth for at least a couple of years
and quite possibly send us back into a global recession (and
increasing possibility).

The
upcoming presentation of the Sovereign risk model will tie the Economic
vs. Financial contagion thesis together in a very big way. We are also
going through the proposed austerity measures and plans of all of the
major contributors to this contagion to inform subscribers of the
practical likelihood of success, and if unsuccessful, the timing of the
potential fall.

Subscription material
detailing those entities which we feel are most vulnerable can be found
here:

• Banks exposed to Central and Eastern Europe
• Greek Banking Fundamental Tear Sheet
• Italian Banking Macro-Fundamental Discussion Note
• Spanish Banking Macro Discussion Note

Prior posts on this topic:

2. The
Coming Pan-European Sovereign Debt Crisis - introduces the
crisis and identified it as a pan-European problem, not a localized one.

3. What
Country is Next in the Coming Pan-European Sovereign Debt Crisis? -
illustrates the potential for the domino effect

4. The
Pan-European Sovereign Debt Crisis: If I Were to Short Any Country, What
Country Would That Be.. - attempts to illustrate the highly
interdependent weaknesses in Europe's sovereign nations can effect even
the perceived "stronger" nations.

5. The
Coming Pan-European Soverign Debt Crisis, Pt 4: The Spread to Western
European Countries

6. The
Depression is Already Here for Some Members of Europe, and It Just Might
Be Contagious!

7. The
Beginning of the Endgame is Coming???

8. I
Think It's Confirmed, Greece Will Be the First Domino to Fall

9. Smoking Swap Guns Are
Beginning to Litter EuroLand, Sovereign Debt Buyer Beware!