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Stocks in Europe, Asia, US continue to decline – European banks on the second wave of the subprime crisis

As anticipated in our previous posts (unfortunately), shares continue to decline today on all the major markets, especially in Europe and Asia. There is an old investment adagio which says that “No news is bad news” (Ernest Hemingway, “For Whom The Bell Tolls). In this particular case, no good economic news means bad news for our shares investments.

On the other hand, if you understand a little bit how the modern financial system works, you will find the evolution normal. Let’s start with a short briefing on how the subprime crisis propagates across the globe:

Everybody knows that subprime crisis, which now affects all the major financial institutions, comes form the US housing market (mostly, but not only). Subprime loans are those granted to the borrowers not normally accepted by the banks, because they are too risky (in most cases they have small or intermittent revenues which does not grant them access to the normal bank loans). These persons have been granted credits above a normal risk rate, at much higher interest rates, by risk-taking financial institutions. And of course, when the houses prices started to fell, the defaults on these credits increased dramatically, making the loans irrecoverable by both the lenders and the loaning persons.

How does this affect the “serious” major banks? Well, the financial institutions who lend to sub-primers re-packaged their exposure in big bulks of credits, with high risks and high revenues, and resold them to the big banks. In most cases, those big banks (all started with Citibank) bought big assets, with no clear idea of the exposure behind. And the prices of these packages continued to increase, making the banks to revalue these assets higher and higher along the last years (they were allowed to do so by the Basel II principles, who allowed free “fair value updating” by the banks themselves!). No wonder they want to improve the Basel II agreement!

It is a little bit too late. The subbprime packages have been re-sold to other banks, derivatives have been created on this, and so the exposure on those risks has actually increased hundreds of times to their initial value. And now, the last buyers (who are at the end of this “trophic” purchase chain of bad loans), are discovering that they have overvalued assets on their balance sheets. And that they are undercapitalised compared to their rules of capitalization (established by themselves or by their regalement national banks).

The latest victims of this subprime crisis UBS AG, Deutsche Bank AG and Mitsubishi UFJ Financial Group Inc. retreated after analysts said the two largest U.S. mortgage finance companies may have to raise a combined $75 billion. Merrill Lynch & Co. fell in Germany after Wachovia Corp. slashed its earnings forecast for the third-biggest U.S. securities firm.

Right after our yesterday’s article, the European car makers sank as PSA Peugeot Citroen SA warned of a “greater slowdown” in demand in Europe and Fiat SpA said it will close four auto plants. These 7 companies were enough to make the MSCI World Index loose 0.7 percent to 1,355.74 at 12:31 p.m. in London, extending its decline from an October record to 19.4 percent. Futureson the Standard & Poor’s 500 Index fell 0.3 percent, indicating the benchmark for American equities may slip into a bear market today. The S&P 500 was down 19.99 percent from its all-time high as of yesterday’s close.

I’ll ask our usual DoItInvest question – what does this mean for our investment strategy (shares)? Well, painful times are ahead for these companies, but probably they will emerge slimmer and more cautious out of the crisis. As usually, the question is “when?” the crisis will end – and my guess is that in between 2 and 4 weeks, when it is time to check again the financial health of these banking companies (if they are still alive!) and buy some shares (after the investors have marked their shares quotations down by selling them). Good luck with investing!

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