Subprime Europe

The Eurozone today resembles a 2008 vintage subprime CDO. The Greek, Irish and Portuguese periphery is the riskiest junior tranche, the Italians and the Spanish are, appropriately, the mezzanine tranche, with France and Germany forming the senior tranche. And just like 2007-8, all the liquidity is drying up, as seen in the need for the banks from these sates to keep going to the ECB’s discount window.

So all you need is a part of the junior tranche to default and the losses will rip through the junior into the mezzanine and will end up destroying the senior tranche as each bondholder dumps good to cover bad before the other guy does. Once again the CDO, despite its designer’s intent, stands or falls together, this time through contagion rather than correlation, but the principle is the same.

What will cause the CDO to implode? Exactly the austerity policies Germany demands of everyone else, which as we now see, has slowed growth in Germany’s main markets and Germany itself, to a standstill. Such sustained slow or negative growth will make bondholders still more nervous. And yet the German response will be the same – more austerity – more rules – more councils of the same people who have kicked the can down the road for a year and a half, and more declarations of ‘unshakable commitments’ to the Euro that no one believes anymore.

Europe has reached a point where its collective bank exposures are bigger than its collective bailout capacity. Like the CDO of legend, the income streams are running dry and correlation is rising to one. You can blame the state all you like, but its banking crisis at its core. The cover that the banks got from their bait and switch on the public is a one-time deal, and it is about to be rudely exposed.