Mauldin Tells Benzinga Radio: European Banks in Real Trouble

Despite assurances and guarantees from European leaders that the banking crisis is contained and everything is in order, John Mauldin says we're close to to the tipping point where Europe's hush-hush problems become a world-wide financial disaster.

Mauldin, speaking with Benzinga Radio this week, said that we are right on the edge of disaster in Europe.

"Europe is at an inflection point; they are at the place where they can easily slide into recession and a banking crisis," he said. "It's kind of a well-known secret how bad European banks are capitalized and they lend money to their governments that simply don't have the ability to pay."

Under normal banking conditions, that may not be such a big deal. Banks factor in that a certain percentage of loans will default and keep reserves on hand to deal with those losses. But, as Mauldin points out, those reserves simply are not there for the debt held by governments. Without the reserves, those government defaults are going to doom some of these European banks.

"The crisis comes from the fact that one or more sovereign nations are going to default on their debt. Their banks are typically leveraged at least thirty — if not forty — to one, they don't count sovereign debt that they have lent to governments against their capital structures because in Europe every government official knows that sovereign nations can't default. Since sovereign nations can't default you don't have to account for them in your capital structures," Mauldin said.

Until, of course, the first government DOES default on the debt. Then the dominoes start to fall, and the European banking system starts to look and smell like Lehman Brothers circa 2008. Yikes.

Before you write this off as a problem "over there", keep in mind that we no longer have (for all intents and purposes) separate banking systems. Everyone trades with everyone else, and everyone is exposed when massive debt loads like this start to burst. It will affect American banks thousands of miles away, just as it will hurt Germany, who is one of the most financially secure nations on Earth. Mauldin hints that the crisis might even drive Germany right out of the euro altogether.

"You could easily see the Germans walk away. At some point they are going to walk away. The question becomes when and how, and whenever that happens, it's a credit crisis. That credit crisis will show up on a shore near and dear to us in the U.S. in the same way our subprime crisis visited them. Houses defaulting in Florida, Arizona, and California--what should that have to do with a small state bank in Germany? Well, enough to put them under; they thought they were buying AAA paper."

"It's a monumental mess up and its going to come back and bite everyone--the U.S. and everybody right on down," Mauldin said.

To understand the problem, you really need to see what the banks in Europe have been able to get away with for years and years. They've made a killing, financially, off being under-capitalized relative to their actual debt, primarily by not counting sovereign debt on the books. That's let them leverage capital and build a house of cards reminiscent of the 1920s American stock market...and we all know how well THAT little crisis ended up.

"They have been allowed to get away with this. Understand if you can borrow money at one percent and lend it out at three-and-a-half or four, and you leverage up thirty-to-one, you're making an enormous amount of money on your capital. That's what they have done; they have gotten greedy. I know the concept of a greedy banker, and we think of it as Wall Street, but it started in Europe and they really perfected it."

Despite that, Mauldin doesn't look at government as the necessary answer to these — or other — large-scale fiscal problems, particularly in the banking industry.

"Government regulations are the biggest hindrance to growth in this country. I was just reading that the average small bank has 1.2 people to deal with government regulations for every one person making loans. What's wrong with this picture?"

"I think shareholders should be allowed to vote to say, 'No, our company does not need to comply with Sarbanes-Oxley. We are perfectly capable of doing it without having to comply with Sarbanes Oxley,' and use the old standard of an audit," Mauldin said.

"For [large corporations], it's no big deal; it's a rounding error in their budget. If you are a $10MM in revenue company and you are spending $1MM on compliance, that is a lot of money. That money could go toward new technologies that will hire new employees. Sarbanes-Oxley was a bane of job growth and job creation in small businesses. It should be totally, utterly repealed, along with Dodd-Frank."

Not that Mauldin thinks government doesn't have a role to play. He sees government as going after the wrong bad guys.

"We fixed the wrong things. We didn't fix credit default swaps. CDS need to go on an exchange. They didn't go on an exchange because banks are making too much money. They had enough money to lobby to keep regulators from getting into their personal piggy banks. That is just wrong."

Listen to Benzinga's entire interview with John Mauldin here.

You can find John Mauldin's website here.