European banks

John Mauldin wrote about European banks in his letter this week. 
Nothing really new but the problem is still not widely recognized in 
my (and the CDS markets) view. John did not go into speculation on
how this problem will be solved but I will: only debt-to-equity swaps
will do the trick! The problem can not be solved by just moving bad debt
around and it is too large to grow out over time by just not recognizing the
losses. Here is John Mauldin's view:

"As we have repeatedly said, Spain is set for a long, painful deflation that will
manifest itself via a spectacularly high unemployment level, a real estate 
collapse and general banking insolvencies. Consider this: the value of 
outstanding loans to Spanish developers has gone from just €33.5 billion in
 2000 to €318 billion in 2008, a rise of 850% in 8 years. If you add in 
construction sector debts, the overall value of outstanding loans to developers
 and construction companies rises to €470 billion. That's almost 50% of Spanish 
GDP. Most of these loans will go bad.

"Spanish banks are now facing a very bleak outlook. Spain's unemployment 
rate reached over 17% last month; there are now four million unemployed
 Spaniards and over one million families with not a single person employed
 in the family. Spain and Ireland had the worst housing bubbles in the world 
and now Spain has as many unsold homes as the US, even though the US is about
 six times bigger.

"Why are Spanish banks not insolvent? Spanish banks are not marking their
 real estate loans to market. We've often wondered how it is that our thesis 
for Spanish real estate and industrial collapse has not created more victims.
 The answer is simple according to an article in Expansion, the Spanish equivalent
 of the Financial Times, from the 19th of April titled 'Spanish banks control
 half of all real estate appraisals.' You can't make this stuff up. We haven't
 even begun to see the worst in Spain yet."

European banks are in far worse shape than their US counterparts. That 
is because they utilize far more leverage, on an average about 30 times 
leverage. How can that be, in what is supposed to be a conservative 
industry?

"European banks were only restricted on the basis of risk-weighted assets,
 unlike the US where it is the total leverage ratio that matters, so most 
European banks bought assets that were rated by Moody's and S&P, who couldn't
 rate their way out of a paper bag, and for anything that wasn't highly rated,
 they bought credit default swaps or guarantees from AIG and MBIA. Because of
 that European banks were able to lever up a lot more than their US 
counterparties. Given the much higher leverage levels and general worsening 
of collateral values, we think that all the shoes in Europe have not
 dropped."

European banks have assets of about 330% of their GDP, compared to US
 banking assets, which are about 50%. They have over $700 billion in loans
 to Asian businesses (which are watching their exports collapse) and $1.3
 trillion in loans to Eastern Europe, which is in a very serious recession, 
and so many of those loans are simply not going to be worth anything. Simply 
put, there is going to be a need for massive amounts of money to bail out 
European banks, or we'll watch their economies simply implode.

Where is the money for the bailouts going to come from? Germany? That will
 be a tough sell politically in a country that is in a much worse recession 
than the US. How do you tell your citizens you need to bail out banks in other
 countries with their tax dollars? Italian and Austrian banks are going to need
 a lot of capital, more than their governments can pay. It is going to be a 
very tough problem.