Is a Lehman-Style Event On the European Horizon?

This article was written by Idan Levitov, head analyst at anyoption.com.

Despite the countless times he has iterated his willingness to do whatever it takes, European Central Bank President Mario Draghi might be facing an insurmountable tidal wave that forever changes the course of the eurozone and greater European Union. Although the sovereign debt crisis was heralded as fixed, there are still lingering problems that policymakers have failed to tackle in the last few years.

The move towards fiscal austerity across the European Monetary Union inevitably left government officials short of fiscal policy tools with which to fix their respective economies, leading to the reemergence of the nonperforming loans issues and potential need for further bailouts. Unfortunately, the Italian banking system is just the tip of the iceberg for a currency union that is struggling to maintain its relevance as nationalistic fervor grips politics across the region.

Banking Crisis Has Already Landed

There are many risky institutions that are carrying large portfolios of derivatives and nonperforming loans across the euro area. Though the focus is primarily fixated on Italy considering its banking system is saddled with an estimated EUR 360 billion of souring loans, the problem goes much deeper and affects many more countries. While there is indeed the possibility that several Italian banks default, it is how the central bank and government solve the problem that really matters.

For a euro that is trying so desperately hard to regain credibility, bailing-in depositors may not be the best way forward, especially if its base of support revolt. Should depositors be forced to bail out banks instead of creditors and bondholders, support for the system could vanish as depositors force a modern-day bank run.

The European Commission may have rewritten the rules on bailouts

While the world’s oldest bank, Banca Monte di Paschi dei Siena, is on the verge of a complete meltdown, the other troubled institution that is also a ticking time bomb due to its extreme derivatives exposure is Deutsche Bank. As one of several very large global and systemically important multinational banks, Deutsche Bank’s balance sheet has more of what Warren Buffett decried as “financial weapons of mass destruction” than any other bank on the planet. The cross border exposure of Europe’s banking system means that one region’s institutions can quickly spread to others as another form of contagion.

The European Commission may have rewritten the rules on bailouts, forcing guarantees instead of direct government Liquidity Liquidity The term liquidity refers to the process, speed, and ease of which a given asset or security can be converted into cash. Notably, liquidity surmises a retention in market price, with the most liquid assets representing cash.The most liquid asset of all is cash itself.· In economics, liquidity is defined by how efficiently and quickly an asset can be converted into usable cash without materially affecting its market price. · Nothing is more liquid than cash, while other assets represent The term liquidity refers to the process, speed, and ease of which a given asset or security can be converted into cash. Notably, liquidity surmises a retention in market price, with the most liquid assets representing cash.The most liquid asset of all is cash itself.· In economics, liquidity is defined by how efficiently and quickly an asset can be converted into usable cash without materially affecting its market price. · Nothing is more liquid than cash, while other assets represent Read this Term injections, however, the lack of political unity means that any future crisis will be challenging to solve swiftly.

Certain Fundamentals Remain at Crisis Levels

Following the 2011 sovereign debt crisis, the favorite catch phrase of every euro area politician was 'austerity', or cost-cutting designed to bring down debt levels. If anything, these conditions have seen the opposite occur. Budget deficits remain a problem for almost all the core members of the euro area, the one exception being Germany which ran a surplus of 0.70% according to 2015 figures.

However, by comparison, Italy ran a -2.60% deficit in 2015, followed by France’s -3.60% deficit and Spain’s whopping -5.10% deficit. One of the key reasons that these regions are having trouble balancing budgets is persistently high levels of unemployment that are prevailing across the euro area. Although falling, the 10.10% unemployment figure is well above comparable numbers from other advanced economies, underlining the sluggishness of tackling structural deficiencies within member countries.

Even though borrowing costs are at record lows across the euro area countries, restrictive rules in place under the Maastricht Treaty which governs the monetary union are keeping the region from growing. When rates are at record lows, the smartest thing for a government to do is borrow as much as possible to retire debt that is more expensive due to higher yields.

In spite of the central bank making every effort to bring down borrowing costs and prod financial firms to lend, even charging interest on excess reserves deposited with the ECB, at trend growth remains elusive. Considering that growth has idled for so long, deflation is now a growing problem that the ECB is increasingly unable to tackle. As the bank slowly meets the limits of its powers, falling prices could be a very real threat to the stability of the euro area.

Draghi’s Tough Decision

For ECB President Draghi, these two-pronged developments could not have come at a worse time. Besides his fight against deflation and keeping the banking system healthy, his asset purchase program may be reaching its own self-imposed limits. The central bank is running out of sovereign debt and corporate debt to buy as supply dries up.

He also cannot buy debt that yields below a certain amount, further curtailing the availability of assets to purchase. As a result, the fight against deflation might very well take interest rates further into negative territory. While positive that the euro will hopefully follow interest rates to the downside, Draghi’s bazooka is running very short of any sort of ammunition with which he can fight any new crisis.

The bandage solutions of the last crisis are already beginning to haunt the ECB and government officials

Having already dropped interest rates to record lows and nearly exhausted the purchase program, Draghi may have very well shot himself in the foot. Should a systemically important bank such as Deutsche Bank fail or another nation need a new bailout package, it is increasingly hard to visualize a politically unified euro area that is prepared to fight another crisis considering current polarization. The bandage solutions of the last crisis are already beginning to haunt the ECB and government officials.

When the question arises as to how this time is different, the answer will be the same: it isn’t. Another Lehman style event could be just around the corner considering the current economic and banking environment. The real question is not whether it will cause a pronounced drop in the euro, but rather if it could lead to the end of the euro dream.