What's Europe's Biggest Loser? Germany

DURHAM, N.C. ( TheStreet) -- The debt crisis in Europe is a known unknown. It is obvious there is a crisis, but no one knows how bad it will get. An unanswered question is whether the aftershocks will be strong enough to derail the U.S.'s fragile economy.

There are four facts that are important to understand:
  1. Most European banks are insolvent.
  2. The European Central Bank is massively monetizing to keep the system operational.
  3. Germany is doing a backdoor bailout of peripheral countries by racking up huge IOUs issued by the ECB.
  4. The eurozone is now an official "Transfer Union."

Let's go through these one by one.

1. Zombie Banks

We all know that the so-called stress tests aren't really testing a stressed scenario. The latest round of European stress tests showed a short-fall of 115 billion euros. Details It is safe to assume that there is a much larger deficit.

It is instructive to look at the indirect evidence.
  • European banks don't want to do business with one another because they don't trust one another's solvency.
  • The ECB has had to take extraordinary measures, which include three-year loans at very cheap rates Details .
  • The ECB has had to allow European banks to pledge lower-quality collateral (because the higher-quality collateral is running out -- or has run out) Details .
  • Investors are wary of these banks and are shifting business to non-eurozone banks they perceive to be safer.
  • Policy makers have imposed and extended short-sale bans on eurozone banks Details .

2. Euros, Euros Everywhere

The difference between spin and reality is stark. There has been so much talk about the ECB being stubborn and not willing to turn on the spigot. The reality is quite different.

The ECB balance sheet has exploded to 2.7 trillion euros, which is approaching one-quarter of the eurozone's GDP. This is a bigger expansion than the Federal Reserve undertook in the depth of the U.S. financial crisis. Details

The ECB is also effectively monetizing by making subsidized, three-year, 1% loans to eurozone banks. This is called Long-Term Refinancing Operations, or LTRO. It is simple for the banks to take these loans and then invest in many other assets that are yielding 4% or more. The spread is a direct subsidy to these banks. However, many banks are not doing this. They are taking the loan and depositing the proceeds at the ECB (at a rate of 25 bps) to "reduce" their risk.

As mentioned earlier, accepting lower-quality collateral is another way of monetizing.

The Federal Reserve is involved by making it easier for European banks to get access to dollar funding. Details (subscription may be required)

3. Backdoor German-Sponsored Bailout

A number of months ago I highlighted a story in Frankfurter Allgemeine about the TARGET2 system. (It's like the Fedwire system in the U.S.; TARGET stands for Trans-European Automated Real-time Gross settlement Express Transfer.) Here is a good introduction to TARGET2. See pp. 35-40.

It is a fact that the credit risk of the Bundesbank has dramatically increased. Let's just look at one channel -- Germany's trade surplus. It used to be that given the surplus with peripheral countries, Germany could just buy peripheral assets. They are not doing that anymore. Instead, they are taking credits with the ECB in the form of TARGET2 balances.

A massive amount of private savings in Germany is effectively "invested" in the ECB. We all know that the ECB's risk has mushroomed. The balance sheet has expanded to 22% of eurozone GDP; they have increased duration; they have lowered the quality of collateral; and they hold, by my estimates, three-quarters of a trillion euros of peripheral exposure. It is close to 1 trillion euros if we include the near-peripheral countries.

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