European Debt Crisis You’re Not Hearing About

Yes it’s true, I have been silent for the last several days and it’s because there isn’t any real news in the press. By ‘news’ I am referring to the root of the word news, ‘new.’ Why waste everyone’s time harping on the same stuff?

So what’s new, if not news, quite yet? Little talked about in the European sovereign debt crisis is that a number of European banks are also in financial trouble.

Largely this trouble stems from, you guessed it, bad mortgages underwritten in the real estate bubble. You might have heard that Europe just got through with a number of ‘stress’ tests last Friday. Ostensibly these tests were to alleviate fears of individual banks defaulting. I won’t go into the results because these new stress tests, similar to those European bank stress tests of last year, are largely ornamental.

No, what I want to talk about is the fact that the European debt crisis may, in fact, get worse, even if the sovereign debt portion of it is resolved.  In fact, if one crisis is resolved, it may be the tipping point for the other.  Now that would be news; but how could it be?

It all goes back to those heady real estate bubble days. You see, a number of European banks that were looking to expand their mortgage underwriting profits after their home markets were saturated with mortgages looked to their near abroad for new transaction opportunities.

Frequently this meant that they looked to European nations that were not a part of the eurozone.  The eurozone means those European nations that use the euro as their currency. But not all European nations use the Euro.

What happened is that a number of marginal (i.e. poor credit) mortgages were underwritten in these European, yet non eurozone countries. Further, these mortgages required the homeowner to pay his/her mortgage in euros, even if their home country currency was not the euro.  It would be like someone in the U.S. having a mortgage that they had to pay in Mexican pesos, instead of the dollar.

This was done so that the banks could bundle mortgages from across Europe in mortgage backed securities all denominated in the largest currency in Europe, the euro.  This makes sense, yes?  Unless of course the euro starts to appreciate relative to non-euro, European currencies. Then homeowners in those countries have to come up with even more money in their home currency in order to pay their euro-denominated mortgage.

Ouch!

So if the European sovereign debt crisis is resolved it is likely to lead to an appreciation in the euro as investors regain confidence in Europe. But when this happens it will simultaneously increase the risk of default on a whole massive swath of mortgages held by private European banks.

This is the hidden crisis in Europe, the one that European leaders, the press and most of the investment community have yet to turn their attention toward.  So even if there is a resolution to the sovereign crisis, there is still a private bank crisis to deal with.  In my opinion, we are not out of the woods, yet…not even close.

Jason