Eric Sprott: Investment Outlook (August 2011)

Although we don’t have the data for Spain or Italy, it does not escape us that those countries’ governments are likely highly aware of the effect a bank run could potentially have on their fiscal stability. Italy is a much bigger fish than Ireland or Greece. Its €1.8 trillion of borrowing in nominal terms is more than the debt of Greece, Spain, Portugal and Ireland, combined.¹⁴ Italy and Spain are too big to fail and too big to bail-out, so the future of the Eurozone will be seriously compromised if Italian and Spanish depositors take flight with their euros. To that effect, we found it very instructive to read about new provisions that the Eurozone’s rescue fund, the EFSF, recently incorporated into the latest Greek bail-out. Included among them is the ability for the EFSF to buy sovereign bonds in the secondary market, give EU states "precautionary credit lines" before they are shut out of credit market, and "lend governments money to recapitalize their banks".¹⁵ The sovereign crisis, at its root, is still a banking crisis. The banks hold loads of Eurozone sovereign debt. If depositors withdraw capital, those banks must sell some of those sovereign bonds to stay solvent. The EFSF provisions are there to provide the banks with the liquidity they need to survive deposit withdrawals. The question now is what will happen if the EFSF runs out of the funds to do so.

In our view, the depositors that chose to transfer their money out of their local Eurozone banks deserve some recognition, because they ‘get it’. The EU banks are still the root of this problem, and depositors are right to question the security of their deposits held with them. We have always postulated that the real problem in our financial system is too much leverage in the banking system. We are continually reminded of this fact every Friday when US bank failures are released. When you compare the failed banks’ assets to the cost the FDIC pays to make their depositors whole, it reveals how many times the banks have lost their equity capital. The key to remember here is that banks lend out our money and keep very little in reserve. If we assume they keep 5 cents of capital for every 95 cents they loan out – a 25% ‘implied write-down’ in Chart A would mean that the bank has effectively lost its capital six times over.

The banking situation in Europe is no different from that above – EU banks are also highly levered, but their situation is further complicated by the fact that what was once the most liquid and secure loan on European banks’ balance sheets – sovereign debt – is no longer liquid and secure. This makes EU banks extremely vulnerable to deposit withdrawals as it forces them to approach the ECB for help to maintain liquidity. There is only so much the ECB can do – if a true ‘liquidity event’ takes place, we can all rest assured that there will be no buyers of distressed assets in the sizes that European banks hold today, sovereign bonds, or not.

We discuss the EU banking crisis this month to remind everyone that we have very recently lived through two instances where the entire financial system almost collapsed. The first took place during the height of the 2008 crash. The second transpired in May 2010 when the ECB stepped in with its $1 trillion bailout package to avert disaster. All financial bailouts up to this point have been instigated with a desire to avert the first domino from falling. They have been instituted to avert contagion – a total financial meltdown that would effectively turn the global banking system into an Icelandic money trap – where no money can get in, or out.

We still don’t know if a financial collapse can be averted in Europe because investors and depositors are not all naïve to reality. The financial malfunction is ongoing and will not be prevented through these continual perverse financial machinations. If Eurozone depositors move their capital – more bailouts will be required, thereby increasing the sovereign debt levels and exacerbating the seemingly hopeless situation that much more.

As the questionnaire above suggests, we believe a growing number of European depositors are transferring their money out of EU banks, and many of them are reinvesting their capital into gold and silver for safety. It does not surprise us to see gold hitting all-time highs in euros and dollars. It’s worthwhile to acknowledge that those investors in Iceland and Ireland who had the foresight to convert their cash to gold before their countries’ respective bank runs have all fared extremely well in both nominal and real terms. We believe that gold and silver are the ultimate alternative for a chequing account in a vulnerable banking jurisdiction, and whether the ECB prints more euros or eventually defaults, both outcomes will continue to support a robust demand for precious metals as an alternative currency.

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1 Lyall, Sarah (November 1, 2008) "Iceland, Mired in Debt, Blames Britain for Woes". New York Times. Retrieved July 28, 2011 from:  http://www.nytimes.com/2008/11/02/world/europe/02iceland.html?pagewanted=all

2 Onaran, Yalman (February 1, 2011) "Iceland Shows Ireland Did ‘Wrong Things’ Saving Banks". Bloomberg. Retrieved July 28, 2011 from: http://www.bloomberg.com/news/2011-02-01/iceland-proves-ireland-did-wrong-things-saving-banks-instead-of-taxpayer.html

3 Lyons, Tom and O’Brien, Stephen (January 18, 2009) "€4bn ‘run’ triggered Anglo move". The Times. Retrieved July 28, 2011 from: http://www.timesonline.co.uk/tol/news/world/ireland/article5537566.ece

4 Ibid.

5 O’Brien, Dan (June 1, 2011) "€12bn decline in bank deposits in April is smallest since September". The Irish Times. Retrieved July 28, 2011 from: http://www.irishtimes.com/newspaper/finance/2011/0601/1224298206493.html

6 Humphries, Conor (July 8, 2011) "Irish banks’ ECB borrowing inches up in June". Reuters. Retrieved July 28, 2011 from: http://uk.reuters.com/article/2011/07/08/uk-ireland-centralbank-borrowings-idUKTRE76728R20110708

7 Finfacts Team (June 30, 2011) "Irish household bank deposits fell by €709m in May; Domestic banks’ central bank borrowing was €74bn". Finfacts.ie. Retrieved July 28, 2011 from: http://www.finfacts.ie/irishfinancenews/article_1022646.shtml

8 Ibid.

9 Humphries, Conor (July 8, 2011) "Irish banks’ ECB borrowing inches up in June". Reuters. Retrieved July 28, 2011 from: http://uk.reuters.com/article/2011/07/08/uk-ireland-centralbank-borrowings-idUKTRE76728R20110708

10 Ibid.

11 Brereton-Fukui, Natasha (June 27, 2011) "Moody’s warns on deposit outflows for Greek banks". Wall Street Journal. Retrieved July 28, 2011 from: http://www.marketwatch.com/story/moodys-warns-on-deposit-outflows-for-greek-banks-2011-06-27

12 Georgiopoulos, George (June 23, 2011) "ECB funding to Greek banks rises 12.3 pct m/m in May". Reuters. Retrieved July 28, 2011 from: http://www.reuters.com/article/2011/06/23/greece-ecb-idUSATH00620520110623

13 Koutantou, Angeliki and Melander, Ingrid (July 25, 2011) "ECB funding to Greek banks rises 5.6 pct m/m in June". Reuters. Retrieved July 28, 2011 from: http://www.reuters.com/article/2011/07/25/greece-banks-ecb-idUSATH00628220110725

14 Davis, Andrew (July 12, 2011) "Plunge Brings Europe Debt Crisis to Italy". Bloomberg. Retrieved July 28, 2011 from: http://www.bloomberg.com/news/2011-07-11/italian-plunge-brings-debt-crisis-to-europe-s-biggest-borrower.html

15 Baker, Luke and Toyer, Julien (July 21, 2011) "Europe agrees sweeping new action on debt crisis". Reuters. Retrieved July 28, 2011 from: http://www.reuters.com/article/2011/07/21/us-eurozone-idUSTRE76I5X620110721

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