How might the euro zone collapse? Until a few months ago, excessive debt and gaping budget deficits threatened to fell the pig, hence the ubiquitous term "debt crisis." It is now morphing quickly into a banking crisis.
Bank failures and bank runs weren't supposed to happen at this stage in the crisis, thanks to the European Central Bank pumping €1-trillion in ultra-cheap loans into the banking system since December. They have now emerged as the biggest danger to the integrity of the euro zone and the wider European Union. Cyprus, one of the smallest members of the EU, has admitted it may seek a bailout for its banks. Spain too may be on the verge of seeking a bailout, after botching the recapitalization of its third biggest lender, Bankia.
The plunging sovereign bond yields in Germany, Britain and the United States tell you that something is seriously wrong with the banking system on the euro zone's Mediterranean frontier. This morning, Germany's 10-year bond yield was just under 1.2 per cent. This tells you that vast amounts of capital are leaving the Mediterranean – the flight for safety – and being plunked into the bonds of the strongest countries.
German yields at 1.2 per cent, and U.S. yields at 1.5 per cent are alarming. Strategist Marshall Auerback, of Toronto's Pinetree Capital, says that U.S. yields never went below 2 per cent between 1919 and 1941. That period included the Great Depression, massive price deflation and the start of the Second World War. "It has to be that there is a giant bank run with some of the money going into anything that is believed to be safe," he says.
On Thursday, the Spanish government revealed that €97-billion in capital had been yanked out of the country in the first quarter of this year. That's a serious amount of loot, equivalent to about 10 per cent of Spain's gross domestic product. Will the capital flight stop in the second quarter? Unlikely, given Spain's need to find €19-billion to bail out Bankia and the country's dire economic and financial shape. Spanish bond yields have climbed to 6.5 per cent, dangerously close to the level – 7 per cent – that ultimately triggered the bailouts of Greece, Ireland and Portugal.
Little Cyprus is in the midst of banking hell. Its economy and banks are heavily exposed to Greece, with predictable results. On Friday, Cyprus said a bailout may be in the offing. "I don't take it as a given that we will negotiate entry into a support mechanism [but] I don't want to absolutely exclude it," Cypriot president Demetris Christofias told a news conference.
The country's second largest lender, Cyprus Popular, faces nationalization if it does not find new investors by mid-year. It needs €1.8-billion to meet its Tier 1 capital requirements. The figure doesn't seem like a lot. But for the EU's third smallest economy, it's a fortune, equivalent to 10 per cent of GDP. Other Cypriot banks are bound to get into trouble too, because, all together, they reportedly have €23-billion of exposure to Greece. That's well above the country's GDP.
Spain's banking system is turning into a nightmare too. Bankia was already rescued once by Madrid. The €19-billion cost of the second rescue is four times the last estimate, made only two weeks ago. The trouble is, Madrid has no idea where the money will come from. Its bailout plan, floated last week, was quickly shot down by the European Central Bank. Madrid's idea was to plug the hole in Bankia's finances with the equivalent value in Spanish bonds, which would then be swapped for cash at the ECB.
With the ECB out of the picture, many of Spain's other banks in decline and the Spanish economy deteriorating at an alarming rate, thanks to the lingering aftereffects of Europe's biggest housing boom gone bust, an international bailout looks increasingly likely. The most logical source is the European Stability Mechanism, the new bailout fund topped up with €500-billion, which is supposed to come into effect next month. The International Monetary Fund would probably join the bailout effort, as it did when Greece, Ireland and Spain got into trouble.
How much Spain might need is an open question. Analysts at UBS have estimated that the Spanish banking system might need as much as €120-billion of fresh capital. The irony is that Spain's banks were considered among the strongest European banks when the credit crunch hit in 2008. Even during the recession in 2009-2010, they were considered fairly healthy. In retrospect, they should have raised capital when they could have. As the crisis proves merciless, they have lost their chance.