Europe Banks on the Buddy System

 | Dec 20, 2011 | 3:14 PM EST
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Did someone sound an all clear in Europe? Is that why the CurrencyShares Euro Trust (FXE) -- the barometer for the euro, the linchpin behind all of this European madness -- rallied today? No, I don't think there was an all clear sounded. I do think there could be some corrupt bargains between European governments and struggling European banks that have changed the equation, at least for now.

For months, the banks in Europe have been under pressure to sell whatever isn't nailed down to raise capital, including the sovereign bonds that have weighed them down.

Now, the European authorities are going to start lending these banks money at very low interest rates so they can, yes, go buy government bonds, or perhaps buy back their own debt. The hope is that if they stop forcing the banks to sell sovereign bonds and actually let them buy short-term sovereign debt with money lent at 1%, these banks can rebuild their capital with the difference between the two rates.

So, a European bank borrows money at 1%, then goes and buys Spanish 6-month bills for 2.43%, which is what happened last night, and everybody wins. Spain gets the money to finance its humongous debt for a few more months, and the banks profit from the difference between the 2.43% Spanish yield and the 1% lifeline. Presumably, they can borrow a fortune from the authorities and do this trade over and over again.

That's why Spain's interest rates fell so low, because the last time Spain came to the market, when the banks were selling Spanish bonds themselves, Spain paid 5% for its money.

If the banks buy enough sovereign bonds and keep pocketing that difference, the authorities hope that the capital can be rebuilt over time while the countries get their acts together through higher taxes and better growth. Meanwhile, the banks can pay down their own high-cost debts, their subordinated debt, preferreds, and even senior debt, with the money, too.

It's a virtuous circle, and it works because the banks are borrowing at extremely low rates from the authorities and investing much higher.

One has to be skeptical of the Europeans. They have screwed everything up repeatedly. You know that this plan is going to cost a lot of money in the end when Italy starts coming to market with tens of billions in euros next year. But for right now, if you simply stop forcing the banks to sell, and you chose not to look at how they are doing and just let them be, you can do some real serious can-kicking that will make them stronger down the road.

So, let's just say it isn't new news; it's an absence of bad news, for the moment. And it's the bargain the authorities have struck with banks to stop having them raise equity and, instead, giving them a generous return to fix themselves while helping indebted countries muddle through. In other words, it's a see no evil approach because, in the end, the bankers over there are buddy-buddy with the politicians making, and allegedly enforcing, the rules.

For the moment, it's working.

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