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EU bank bailout coming, conference told

Bailout prediction: Lawrence McDonald expects a major recapitalisation of European banks to happen within a matter of months

Europe is set to bail out its “zombie banks” within the next few months, a banking industry expert told an audience of asset management professionals in Bermuda yesterday.

Lawrence McDonald, who witnessed a bank’s collapse from the inside when he was vice-president of distressed debt at Lehman Brothers when it folded in 2008, said Deutsche Bank’s situation now is eerily similar to his former employer’s plight shortly before its demise.

Mr McDonald, the head of global macro strategy at ACGA and a contributor to US business channel CNBC, was speaking at the World Alternative Investment Summit at the Fairmont Southampton.

Deutsche Bank’s shares took a pummelling after the US Justice Department announced its intention to fine Germany’s biggest bank $14 billion over matters relating to the subprime mortgage crisis. This has rekindled fears over the bank’s stability.

Mr McDonald said the problems were similar in some other big European banks.

“Deutsche Bank has about $16 billion of equity and $162 billion of debt,” Mr McDonald said. “In the US, Hank Paulson [the former US Treasury Secretary] got the big bank CEOs around a table in 2008 and said ‘you’re taking this money’. They took the pain and did the bailouts.

“That did not happen in the same way in Europe and this has been building up for years. The truth has been coming out one drop at a time. Soon six or eight banks will be forced to sit around the table. We expect a major recapitalisation to happen within the next three months.”

“Zombie banks” were not capable of financing the needs of an EU economy of more than 500 million people, he added.

The German government has stated it does not intend to give Deutsche Bank any help, but Mr McDonald brought up charts that he said suggested that matters were coming a to a head.

One graph showed that when the market believes the Deutsche Bank’s debt is getting riskier, the same applies to Germany’s debt — an example of “credit spread contagion”, Mr McDonald said.

There were clear signs that banks trusted each other less when lending between themselves — as occurred in the run-up to the global financial crisis — as signified by a widening spread between the Libor rate and the Fed Funds rate, he added.

Mr McDonald, the author of the New York Times bestseller A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers, specialises in identifying political and systemic risk leading to actionable trade advice.

He said the US presidential election was another source of market risk and that he had seen a clear correlation between Donald Trump’s fortunes and stock market volatility. At times when Mr Trump has risen in the polls, the VIX, a measure of S&P 500 Index volatility sometimes known as the “fear index” has risen too. The big banks, in particular, were seen as having a lot to lose if the Republican Party candidate wins in November.

Regardless of whether Mr Trump takes the White House, it is possible that over the coming weeks the perceived likelihood of him winning may increase, offering trading opportunities.

Another strong risk emanates from Asia and particularly China. Credit default swaps on major Asian financial institutions — indicating their perceived level of riskiness — had risen sharply just before the past two double-digit declines in the S&P 500 Index, Mr McDonald said, and they could likewise be an indicator of future dips.

Years of low interest rates had left investors craving yield, he said, and he saw a “hot bubble” inflating in the commercial real estate sector and strong demand for high-yield bonds.

“I had lunch with a fund manager from BlackRock, who told me that German and Japanese insurance companies are buying up high-yield bonds,” Mr McDonald said. “He said it’s like nothing he’s ever seen.”

That was one of the market-warping effects of negative interest rates that exist in both Europe and Japan, he added. Central banks were creating potentially “catastrophic, unprecedented bond volatility” by keeping rates so low for so long, he said.

The markets were functioning strangely, he warned, with an unusually high correlation — about 23 per cent — between stocks and bonds, which traditionally move in opposite directions.

The conference, which was opened by Michael Dunkley, the Premier, also featured Ross Webber, the chief executive officer of the Bermuda Business Development Agency, who said: “Bermuda’s economy is on the upswing — the recession is behind us.”

Mr Webber said much work had been done to bolster Bermuda’s asset management industry and that was now bearing fruit. Centaur Fund Services set up an office on the island earlier this year and he added that other managers and service providers were making plans to set up in Bermuda.

Mr Webber said there was a tendency among overseas politicians and media to lump all offshore financial centres together as an “axis of evil” and use them as a scapegoat.

Some offshore jurisdictions deserved their bad reputation for ignoring the changing regulatory landscape and embracing secrecy — but Bermuda was not one of them, he said.

Pointing to Bermuda’s success in the international reinsurance markets and its lengthy record of reliable claims-paying, he added: “Bermuda is a place to raise capital, not hide it.”

The likely exit of Britain from the European Union makes Bermuda even more attractive as a jurisdiction for fund managers, Mr Webber added, particularly as the island has applied for “passporting” rights to gain free access to EU markets.