Markets spot a leak in the European bandaid

Last night's early surge on Wall Street – followed by a sickening fall as the shorters moved in – represents a significant and dangerous change in world markets.

In the past, after a European bailout package there has been a period of calm in markets where equities rallied and there was a rise in the euro.

With China now stimulating and the US mixing good news and bad there was a chance of a worthwhile rally for a few weeks. And that's what New York traders believed when last night they sent the Dow Index up to 12,650 in early trade. The Australian dollar nudged parity as money left the ‘safe haven' of the US dollar.

Then it was as though the markets suddenly understood what Karen Maley wrote yesterday (Risky manoeuvres on Spain's bailout circuit, June 11). Maley explained that this latest rescue package is just another European bandaid – and a leaky one – because it reduces the value of existing Spanish bonds. And as Spanish bonds are a major asset of the Spanish banks, suddenly it's clear the package increases the cost of rescuing them.

Given the decline in the value of both Spanish real estate and government bonds the banks desperately need $US100 billion plus in urgent equity injection. In other words, they effectively have no shareholders funds.

As Alan Kohler explains this morning, that Spanish problem is small compared to the problems that will soon emerge in Italy (The elefante in the room, June 12).

Then, if you want to be really alarmed, read Oliver Marc Hartwich's description of how the Germans are in the process of bankrupting their banking system (Believing in Europe's financial tooth fairy, June 12).

The Dow fell almost 2 per cent from that peak level with free fall towards the close as the shorters took over. It's lucky the Australian market was not open yesterday because we would have followed the Hong Kong market higher only to be followed by a big fall today.

When a European rescue package lasts only a week from expectation to the realisation that it's yet another a fraud we know that the end game is getting closer.

The European mess was always a banking problem, yet the Europeans saw it as primarily a country problem. Now gradually the horror that most of Europe's banks need major equity injections is setting in.

Had the Europeans acted a year or two ago, when bank share prices were higher, the position would have been manageable. Now only Germany has the money in Europe to provide that bank equity capital – and by not acting much earlier the Germans are now in a much weaker position to help. The longer the Europeans fiddle with what are rescue packages that don't work the weaker the Germans will become and worse the ultimate losses will be.

And remember that while our Australian banking system may be much less dependent on Europe than it was in 2009 it still requires overseas wholesale money for about 30 to 40 per cent of its funding. Much of this comes from Europe.

Maturities on those Australian bank overseas borrowings are spread for up to three years but the Australian banks have to assume that as the European crisis worsens, those borrowings will not be rolled over and that overseas money will simply not be available in anything like the amounts required. Australians will have to provide the deposits for their banking system. Deleveraging continues.