Christopher Whalen

News reports at the end of last week informed the financial markets that the European Banking Authority (“EBA”) failed only eight of the 90 banks examined in the most recent round of stress tests. These eight unfortunates “fell short of the required amount of capital under the tests’ simulations of a deep, two-year economic downturn,” the Wall Street Journal reports. “Those banks faced a total shortage of €2.5 billion ($3.54 billion) of capital, which banks rely on to soak up potential losses.”

Most analysts dismissed the EU stress test results out of hand because of the small number of banks identified as problematic. But investors need to understand that the stress test process in the EU, ridiculous as it may be, is only an indication of deeper problems beneath the surface regarding public disclosure and basic question of governance in the EU. Click here to read the latest report on Reuters.

The first point to be made is that the EBA banking authority does not really exist as a bank supervision agency. The EBA has no power to compel financial reporting from banks located in the 25 member nations, rendering the ability to supervise capital adequacy, much less stress testing, completely moot. The Telegraph in London ran a report today detailing the difficulty that the EBA had in obtaining information for the stress tests.

The second more important point, however, is that the culture of secrecy and a complete absence of public disclosure in the EU has doomed the process to failure. Richard Field, an expert on the mortgage sector who has been pushing for improved disclosure by the EBA and other agencies, says that EU officials are “directly contributing to financial market instability by not making the data available so that the risk of the banks they are supervising could be analyzed.”

The third point is that we do not need stress tests to understand that many of the banks of the EU are insolvent. An inspection of the data published by the International Monetary Fund suggests that many of the banking markets in the EU are badly decapitalized. Even Deutsche Bank, arguably the most important bank in Western Europe, has just €50 billion in capital supporting €1.7 trillion in total assets. Only by ignoring the sovereign and off-balance sheet footings of Deutsche and other major EU banks can anyone even for a moment pretend that these banks are solvent.

When you move from the relatively blissful climes of Germany down to Southern Europe, however, the situation becomes even more ridiculous. While many investors are still concerned by the prospect of sovereign default in Greece, Ireland or Italy, Spain arguably is the most problematic nation in the EU — and the least discussed.

The banks in Spain were run like little imitations of Countrywide Financial, the doomed US mortgage lending that was acquired by Bank of America in 2008, only with worse credit underwriting and record keeping. Indeed, to compare the largest banks in Spain to Countrywide does serious injustice to the American lender. Bad as some of the Countrywide loan production may have been, my view is that the poor credit underwriting and fraud seen in the Spanish real estate boom makes the American experience seem sublime by comparison.

The notion advanced by the EBA that any of the major Spanish banks are actually solvent is a fantasy, in my view, an opinion verified by the high levels of over-collateralization required by Spanish authorities. The excesses in the Spanish real estate sector rival the levels of idiocy seen in Ireland, but on a far larger scale. Some of the covered bonds issued by Spanish banks were so poorly underwritten that financial regulators in that country demanded as much as 80 percent over-collateralization (“OC”). This means that the bank had to pledge $1.80 in mortgages to raise $1.00 in new funding. This is more that 2x the highest level of over-collateralization required by the US Federal Home Loan Banks.

With such high levels of OC,  no surprise then that Spanish banks are feeling increased liquidity pressure in the markets, pressure driven by truly hideous asset quality, not by exposure to sovereign default. But, again, there is little meaningful public disclosure by Spanish banks regarding asset quality.

Last week, I was contacted by a major insurance group in the US who wanted me to travel to their offices and give them a presentation on the state of the EU banking system. I told them to save their money, that most EU banks are insolvent and that, for the purposes of analysis, they should treat all EU banks as sovereign credits, not as private concerns — at least until the EU takes a different approach to public disclosure for banks.

Back in October, after the meeting of the Federal Open Market Committee, the Associated Press reported that “The Federal Reserve is likely to take additional action to rejuvenate the economy and lower unemployment, an influential member of the central bank’s policymaking group said.”

Of course the Fed neither rejuvenates economies nor creates jobs.  For some reason members of the media attribute magical powers to the US central bank and its employees.

Part of the reason for this divine veneration is that there is little in the way of ideas or resources elsewhere in the federal government, thus the holy printing press is now well and truly the only game in town.

Since October the Fed has purchased hundreds of billions of dollars in US Treasury debt in an effort to force liquidity into private assets.  But while the U.S. central bank is able to float the Treasury’s red ink on a sea of new fiat paper dollars, overseas the great deflation has left global central banks largely emasculated.  Unable to create their own money with the ease of the Fed, even the largest central banks in Europe have gone begging for alms in the form of dollar swap lines from Chairman Bernanke.

Other global central banks are chronically short dollars and the Fed is the proverbial tail wagging the global doggie.  Treasury Secretary Timothy Geithner brags about collecting hundreds of billions in nominal greenbacks recovered from the TARP, Ally Financial and AIG bailouts, among others, but it is Fed Chairman Ben Bernanke and his colleagues on the Federal Open Market Committee who are playing the big game with trillions of new fiat paper dollars.

The Daily Bail asks: “Will Bernanke Scoop Up $50 Billion Of Ireland’s Toxic Assets? Fine Gael Seeks MASSIVE Loan From U.S. Fed” This is a very good question since the Irish government likely to be elected in a week or so is going to face an assortment of very unpleasant choices.  If Ireland’s new political coalition goes hat in hand to the American central bank, the new regime is not likely to last very long, especially with the IRA now talking of great conspiracies among private business.

Neither are Chairman Bernanke and the Fed likely to endure if they continue to play the role of de facto global central planning agency without explicit legal authority from Congress.  The trouble here is both one of legal authority and the deleterious effects of current Fed policies.  The more the Fed tries to help the domestic economy with low rates and explicit bailouts, the worse our collective predicament.  Recall the advice of Martin Mayer, who always taught that the Fed (and government generally) should emulate the physician and “first do no harm.”

The Fed keeps interest rates artificially low to “help” the current situation, but in doing so only stokes inflation and bubbles in sectors such as food, energy and strategic commodities — and also market sectors such as equities.  In the past, the central bank has attempted to fine tune the national economy, most recently in the period a decade ago when then-Chairman Alan Greenspan stepped on the monetary gas.  Not only did the resulting surge in cheap credit stoke a domestic housing boom in the US, but it created booms in global financial assets and also internationally traded goods that impacted investment and asset allocation decisions around the world.

With the 30-plus percentage decline in US housing prices so far and another 10-20% in prospect this year and in 2012 before we hit the bottom, the Fed faces continued asset price deflation at home even as the impact of its accommodative policies are already boosting global inflation.  The combination of volatile weather and poor logistical planning in terms of stockpiles could make the global food supply situation acute in 2011-2012.  The Fed, not hedge funds, is making the situation worse in markets for energy, commodities and food.

The Fed’s extreme monetary policies used to bail out the largest banks are creating bubbles with cheap credit.  Look at the bull market in commercial real estate assets, for example, an entirely speculative financial phenomenon.   Prices for well-located assets are driven up by speculative interest among investors who prefer CRE risk to zero yields on Treasury paper.  But is there sufficient cash flow under these assets to support these valuations?

With yields on longer maturities climbing, it seems that the greatest risk facing the Fed is the transition from life support to something that resembles a sustainable run rate.  Trouble is, Bernanke and a majority on the FOMC still seem to be making policy decisions based upon domestic criteria, this even as the extreme easy money policies of the Greenspan/Bernanke era have already achieved the implicit policy goal of asset price reflation.  It’s all relative, you understand.  When an election-focused White House calls for economic recovery, Bernanke, like Greenspan before him, dutifully steps on the gas, seemingly heedless of the risks.

Of course, classical reflationists argue that the Fed is doing precisely the right thing by using low interest rates to force liquidity into private assets.  One reader of my work rebukes those who argue for monetary restraint and invokes Irving Fisher in his famous 1931 “Econometrica” article.  By lowering rates on Treasury bonds below where they might otherwise be, he argues, Bernanke “is likely to push investors into corporate bonds and lower spreads–which, in the end, are the ONLY real engines of growth in the financial markets.”

The trouble with this argument, like the neo-Keynesian corollary about the use of debt to fund fiscal stimulus, is that expedients such as low interest rates and deficit spending are meant to stimulate economic growth on the margins, not to replace private sector demand and economic activity that does not exist.  Bernanke and his fellow travelers on the FOMC, it seems, have entirely embraced the world view of Paul Krugman and Robert Reich, and echoed among the inflationati in the EU led by Martin Wolf, that new monetary emissions are an apt replacement for fiscal spending.

The problem with living in a world where relativity is the operative standard is that there is no truth in an objective sense.  Political survival, not civil society, is the first priority, so members of the FOMC will say and do anything to get through the day, no matter how internally inconsistent or reckless.  Until Bernanke and the FOMC start to recognize that their well-intentioned efforts to help the domestic US economy are creating the precursor for future global economic collapse, we cannot truly bring the Fed under effective public control and begin the process of national restructuring in America.