Yesterday European bank stocks were punished once again. Their CDS (Credit Default Swaps), which are securities against payment defaults, shot up to historic highs. The fuse is lit for Dexia (who is extremely exposed to sovereign debt), French municipalities and near-term financing. It was of little importance that Dexia was one of the best performers in recent stress tests. Yesterday France and Belgium tried to back Dexia without divesting any funds.
All provided that France's AAA rating is not endangered. The United States is vigilant and will force its banks to reduce their lines of credit to the Eurozone, exacerbating liquidity difficulties. Big losses would be incurred if Greece fails, and we already know that they cannot meet their obligations. But a European banking and sovereign debt contagion is a different story.
The problem is excess debt, whether public or private. The debt needs to be cleared up by loan forgiveness given the widespread lack of liquidity, so it is necessary to recapitalize the banking system and allow it to absorb losses. This step needs to be completed before a fire breaks out and Greece's default brings down the rest of Europe and the United States.
A debt forgiveness strategy would require funds that neither state treasuries nor the recovery fund has right now. Perhaps the recovery fund has to be leveraged in order to proceed, something that going forward will involve the usual risks associated with printing money. But as Dexia is showing right now, we ought to be wary of a domino effect within a banking sector that is thirsting for cash. Europe cannot allow itself to tarry any longer, because the solutions are getting more expensive each day and we are approaching a severe slowdown colored by frozen credit markets and investment fear.
