The balance sheets of European banks (NYSEARCA:KBE) are piled high with legacy assets — mortgages, real-estate, and other loans–that are tying up precious capital and constricting the banks’ ability to make new, more productive loans.
At the same time, the banks’ traditional sources of funding–other banks and institutional investors–have begun drying up as the European crisis intensifies.
This leaves the banks desperately needing to raise cash to survive.
The first plan was to sell off the crap assets.
But according to Gareth Gore in the International Financing Review, this plan has failed, because buyers won’t pony up the prices the banks want them to pay.
(The banks want to sell their assets near “par”–the value the banks are carrying the assets for on their books–because then the banks won’t have to take losses that would further deplete their capital. The buyers, meanwhile, want deals, and they know that time is working in their favor.)
So now that banks are moving to Plan B, says Gore, which is financial engineering.
Specifically, the banks are packaging up bunches of crap assets, putting pretty bows on the packages, and then using the packages as “collateral” with which to obtain emergency loans from the ECB.
In other words, it’s the pre-crisis “securitization” game all over again.
Even if the European banks can engineer a way to get themselves the funding they need to survive, they’re still planning to significantly reduce the amount of credit they’re extending. And although this is wise for the banks, it’s bad news for the economy.
According to Gore, big European banks like SocGen and BNP Paribas have promised to shrink their collective balance sheets by a staggering 5 trillion euros over the next three years, which is about the size of Bank of America (NYSE:BAC), JP Morgan (NYSE:JPM), and Citigroup (NYSE:C) combined.
Unless other lenders fill in the gap (unlikely), this “deleveraging” will severely constrict the supply of credit to the European economy.
Read more cool stories at Business Insider.