The Next “Lehman Moment”… Coming in 2017?

The implosion of Bear Stearns was just the tip of the iceberg…

At the time, the full extent of the damage to the housing market was unknown. No one had an accurate sense of how broken the banks really were. And no one had any idea that the global economy was about to crack under all of the pressure.

But Bear Stearns’ collapse and the market reaction made it crystal clear that all was not well.

The signal that Bear Stearns was sending was not “All clear”… it was “Look out below!” But few were paying close attention.

This critical warning was ignored until it couldn’t be anymore. And then just months later, the world blew up with the collapse of Lehman Bros.

Following the Lehman bankruptcy, we saw a period of extreme volatility touching off the global financial crisis — a crisis we still feel today.

Bear Stearns was the event that should have alerted us to severe problems in the financial system. But it took an event like Lehman to trigger our fall over the cliff. Today, I fear we may have another Bear Stearns-type event that investors are again ignoring at their peril…

And that’s Brexit.

The Brits’ recent vote to leave the EU created short-term panic in the markets. And like Bear Stearns, Brexit signaled that there are deep problems in the financial system. Now all that’s necessary to send the world spiraling out of control is another Lehman-like trigger.

Leading up to the Brexit vote on Thursday, June 23, the Eurocrats and their allies in the media told us that a U.K. vote to leave the EU and restore its popular sovereignty would lead to financial Armageddon.

And the fear mongering worked for a time. Stock markets around the world plummeted the Friday after the Brits voted to leave. European stocks closed Friday with huge losses, with some seeing the steepest drop since 2008. Stocks in Asia and the U.S. also fell sharply, with the Dow Jones industrial average sinking 610 points. And more than $2 trillion of global stock market value was wiped out.

But the central bank planners made sure we knew that their nanny-state safety nets were there to cushion us. Bank of England chief Mark Carney pledged to provide an extra $345 billion to the financial system. European Central Bank head Mario Draghi said the ECB was “ready for all contingencies” after the Brexit referendum. And Fed Chair Janet Yellen said Brexit would justify a “cautious” approach to interest rate policy (i.e., no rate hike, with all options on the table).

Investors recognized their backstops were in place. And markets recovered quickly. And now the S&P 500 index is making new all-time highs.

We’ve received an “all-clear” signal yet again.

But like Bear Stearns in 2008, this post-Brexit market rebound is masking massive underlying problems. And this time the canary in the coal mine is European banks…

It’s no surprise that most European Union countries are trapped in an environment of negative growth, massive debt and sky-high unemployment. As Matthew Lynn of MarketWatch writes:

“Italy’s economy is smaller now than it was way back in 2000. Spain has been close to the edge of bankruptcy, and has seen unemployment soar past 20% of the workforce. France is stuck in endless recession, and struggling to maintain competitiveness against Germany.”

But the biggest problem is in the financial sector…

The EU’s largest banks that anchor its economy, like Deutsche Bank, are basically insolvent.

Deutsche Bank has startling leverage of 40 times. Leverage is the proportion of debts that a bank has compared with its equity/capital. That means Deutsche has 40 times more debt than equity/capital. Keep in mind that Lehman Bros. was only 31 times leveraged when it imploded in 2008 and sparked the worst global financial crisis since the Great Depression.

Europe’s banking crisis also extends to smaller banks. In Italy, 17% of bank loans are bad, for a total of $360 billion. During the worst of the 2008–09 financial crisis, only 5% of U.S. bank loans were bad.

Indeed, events have become so bad that Deutsche Bank chief economist David Folkerts-Landau has called for a continent-wide $166 billion bailout for European banks… similar to the Troubled Asset Relief Program (TARP) in the U.S. in 2008–09. And not surprisingly, European bank stocks are being decimated by the crisis.

Italy’s UniCredit has lost nearly 70% of its value. Royal Bank of Scotland has declined more than 55%. Credit Suisse, Deutsche Bank and Barclays have seen their shares decline by 50%.

No doubt the European Central Bank will step forward with new Ponzi schemes to bail these banks out. That might prevent a major collapse in the short term.

But there’s one event that’s going to be too big even for central banks to fix…

Britain’s decision to Brexit has emboldened anti-EU parties throughout Europe. Pro-EU governments are under fire in almost every member state. In fact, a shocking Pew poll taken recently finds that even EU-centric countries like Germany, Spain and the Netherlands show nearly 50% of their populations holding a negative opinion of the EU. That means the Germans, Spanish and Dutch are just as unhappy with the EU as the British were before Brexit.

But the most shocking result of all was that 61% of the French have an unfavorable view of the EU.

France was the country that laid the foundations for the European Union post-World War II. And now they want out the most. That sentiment will likely increase with the recent attacks in Nice, as many in France want more restrictive immigration policies than the EU allows. In fact, before the attacks, nearly 60% of French people wanted less immigration. That number will rise after Nice, as will the desire to get out from under the EU’s open border and uncontrolled immigration policies.

France’s clear discontent with the EU can’t be overstated. The EU might survive Brexit. But a French divorce from the EU would be cataclysmic, both financially and politically. It would mark the official end of the EU.

Of course, we’re told by “experts” that Frexit will never happen. Brexit wasn’t going to happen either… until it did. The fact is the French have the wind in their sails following Brexit. And the French opinion of the EU is more negative than the British.

Add that to the fact that Marine Le Pen, leader of the French far-right National Front, pledges to hold an immediate referendum on France’s EU membership if she becomes president next April. And she’s surging in the polls! Bottom line, the future of the European Union is in doubt.

What Happens if the EU Breaks Up?

There’s no doubt that an event of this magnitude could trigger an even greater global collapse than Lehman Bros. did. While there are far too many variables to predict, an EU breakup would certainly cause extreme volatility and dysfunction in all global markets. And a potential Frexit is the catalyst.

If a vote to Frexit appeared likely, you’d see market panic even before the first vote was cast.

Bank runs would spread as consumers sought the safety of cash well before the actual earth-shattering event took place. It would start in French banks… and the knock-on effects would spread to other European banks that have relationships with French banks. This would create a huge decline in confidence, leading to a European-wide decline in bank lending.

And these bank runs would spread into a more widespread financial crisis in the global financial sector. Non-eurozone financial institutions in the U.S. and Asia would come under immense pressure because they too have heavy exposure to European banks.

An EU crackup would also mean the end of the euro. And that would mean new currencies would have to be established. The uncompetitive currencies in southern member states like Spain would quickly lose value. Others in economic powerhouses, like Germany in the north, would skyrocket. That means exports would be cheap for some countries and expensive for others. And that means the imposition of tariffs to make things “fair.” Trade wars, anyone?

In less-competitive EU countries, investors would lose trust in the value of their money, since they are no longer backstopped by the EU. This would lead to massive inflation spikes and buying power erosion.

Countries with weakened currencies and bank failures would see sovereign defaults on an epic scale. This would further imperil the banking system across our globalized economy. Also, existing EU business contracts, trade deals and financial transactions would have to be established in entirely new currencies. And the legal validity of existing euro-denominated deals would be unknowable.

A breakup of the EU would lead to finance and trade across Europe and the world disrupted en masse. And I’ve only laid out a handful of possible best-case scenarios. In short, an EU breakup would unleash a massive liquidity crisis and a global recession that would make 2007–09 look like a walk in the park.

Look, I’m not here telling you this because I’m certain it will happen. I’m not making a prediction and betting all of my chips on it. Investment success is not about making the right predictions. It’s all about preparation. Are you prepared for the scenario I have described?

The point is that an EU breakup would launch fears of these kinds of chaotic events in investors’ minds. And markets loathe chaos.

After the Bear Stearns implosion and subsequent market panic and recovery in 2008, the “geniuses” on Wall Street and in the financial media said all was well. Bear Stearns was just a minor hiccup in the road to everlasting prosperity and double-digit returns in the stock market.

Sound familiar?

But that wasn’t a true reflection of the conditions underlying the global economy and financial system at the time. The enormous mortgage market fraud and the massive vat of bubbling poison it produced were still there. The fact is that conditions were ripe for a collapse long before the Bear warning shot was first fired. All it took was a cataclysmic event like Lehman Bros.’ demise for the dominoes to fall. And they fell quickly.

We find ourselves in a similar place today. Brexit was our warning shot that our financial system and markets aren’t sound. But Brexit wasn’t the trigger for a major collapse. That’s because our central bank planners rode to the rescue with trillion-dollar assurances that they will make everything nice when things get messy.

But this corrupt system doesn’t rest on a solid foundation of high productivity, low debt and robust savings and investment. Those are the things that produce sound economic growth and stable economies. Instead, we have a rigged and unsustainable edifice built on money printing and debt. It’s just a matter of time before it blows wide open.

And our monetary overlords have run out of tools to deal with the next crisis. QE, ZIRP and NIRP have all failed. We’re worse off than we were before 2008. Sure, they may try “helicopter money.” But that’s a sign that central banks have lost all control. It would only spread more fear and panic in the markets.

Look, I believe a major collapse is coming. And all it’s going to take is a catalyst just like Lehman.

Once the stress of a major trigger like a potential Frexit vote and a potential EU crackup hits, the collapse will be sudden as everyone heads for the exits all at once. When that happens, the ECB, Federal Reserve and the other central banks will contort themselves into pretzels trying to come up with new schemes to prolong the bubble.

But there will be no bullets left in their chambers. You can only do so much to preserve a fundamentally flawed financial foundation.

Every game ends at some time. And this one has been going on a really long time.

Regards,

Michael Covel
for The Daily Reckoning

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