How to Protect Yourself As Europe Banks Fail

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tdp2664 InvestorPlace The latest plan to preserve the European Union (EU) and save the global banking sector is to force European banks to increase their equity capital. The goal, of course, is to restore confidence and stability. But if that’s the case, then why are so many analysts and savvy investors still nervous? To put it bluntly, it’s because they know it won’t work. As it stands, the capital shortage is about $277 billion (200 billion euros) according to the International Monetary Fund. I think it’s more like $1.4 trillion by the time you factor in all the cross holdings and the daisy chain of exposure that makes the entire banking system there look like Swiss cheese. Why Recapitalization Won’t Work There are three things that are especially problematic to me: European Union ministers apparently are going to put capital into the system without knowing how much it needs or exactly where to put it. Hard to believe, but thanks to the opaque nature of the derivatives markets, nobody can be sure exactly how much exposure any one bank or financial institution has. Healthy banks that do not need an infusion will get one anyway. Rainer Skierka, who is a stock analyst at Bank Sarasin & Cie AG (SWF: BSAN ), shares my belief that this will lead to massive dilution for shareholders. Any bank that is undercapitalized will effectively be the recipient of capital that has been diverted away from healthy banks and into its toxic financials. Unfortunately, this money will be placed at higher risk in an effort to earn the incremental income needed to backstop bad bets that already are on the books. That means shareholders who are led to believe things are improving will actually find their money at an even higher risk than before. As I have noted repeatedly since this crisis began, regulators are fighting the wrong battle and have been since 2008 . They are worried about liquidity when they should be worried about solvency. Sure, a bank recapitalization can repair the banking system when it comes to keeping money moving — in terms of short-term credit — but no amount of money can prepare European banks for a sovereign default or credit freeze because there literally isn’t enough money on the planet to recapitalize the banking system unless you remove the risks that plague it. The “system” is still at incredible risk. The total worldwide notional derivatives exposure is more than $600 trillion dollars according to the Bank for International Settlements . And that’s against a gross market value of merely $21.1 trillion. In other words, banks have invested in instruments valued at $21 trillion but with a total exposure that’s 28.4-times that – or $600 trillion dollars. This is why rogue traders are such a problem – they can take disproportionately large risks with not a lot of capital, which often leads to catastrophe. Take Nick Leeson, the former derivatives broker who worked for Barings Bank. His leveraged trading losses eventually reached $1.4 billion, or twice Baring’s available trading capital. Barings went under as a result. More recently, Kweku Adoboli, who served as director of exchange traded funds (ETFs) at UBS AG (NYSE: UBS ), blew a $2 billion hole in UBS’ balance sheet. Part of the problem is that nobody knows exactly how much cash banks spend to amass such investments because derivatives and sovereign debt trading instruments are still largely unregulated and “self policed” within the industry. So what does this have to do with our money? Everything.