Growth in the world economy is slipping but a severe recession may be avoided without major financial crises in 2012. 

But 2012 has the dice loaded against it because so much debt needs to be re-financed or rolled over. There is disquieting evidence of fragility in the financial system.

The Purchasing Managers’ Index (PMI) is a useful tool in measuring economic prospects. Present readings cause great concern. 

China’s manufacturing is sliding and it has predicted a chronic global recession. It has warned the present situation is much worse than 2008. 

Europe is also contracting, as well as Japan, Australia, Brazil, Taiwan and South Korea. Only the US has positive trends.

A slowing economy exacerbates financial pressures, especially for governments which lose expected revenue. Most governments hope to grow out of debt.

The European Central Bank (ECB) is being forced to provide an unprecedented degree of funding for banks in the eurozone. 

Readers may be unaware the ECB is not a single central bank but a collection of them. It has central policymaking but each national member is in charge of providing liquidity in its market.

Clearly some national central banks will be in surplus and others in deficit at any given time. Normally, surpluses are funnelled to deficit countries. 

Collateral crunch

The problem is that only the German Bundesbank is in surplus. But even that is tenuous: its assets are depleting and it will soon exhaust the liquid assets it can sell to fund further loans. It may be considering selling its gold holdings. If it does, German public opinion will be outraged.

London’s Daily Telegraph claimed last week that the eurozone banking system “is on the edge of collapse.” The problem is a “collateral crunch.” 

When a bank asks for funds, it has to post collateral; many European banks have insufficient collateral to post for short-term loans. 

They have no US Treasuries and are using gold. My sources expect several banks to come near to failure: these are Commerzbank (Germany), Credit Agricole (France), Société Générale (France) and Intesa (Italy).

Shadow banking

There is a massive system in world banking called shadow banking, worth about $US15 trillion. Shadow banking heaps leverage upon leverage. The recent fall of MF Global has revealed unlimited leverage. It has also seen more than a billion US dollars of clients’ funds disappear.

Briefly: the financial system is now turning massively to yet another frontier. This is called “hypothecation.” It is basically simple: imagine you have a mortgage and have posted your house as collateral. The bank will not get a claim on your house unless you default on the mortgage. But banks are selling the smell of the sausage – the potential default.The next step is “re-hypothecation,” where brokers gathers lots of the hypothecations together and posts them as collateral. They can then borrow against these “assets.”

I would not raise the issue unless it were significant. Re-hypothecation is now worth trillions of dollars. Its defenders say that it is a capital-efficient way to conduct operations.

There is more: the US Federal Reserve says that a broker “may hypothecate assets to the value of 140% of the client’s liability to the broker.” In short the Fed is encouraging massive leverage based on shadow collateral. 

It gets worse; in the UK there is no limit on hypothecation. This is appalling: London is the Wild West where companies open offices to launch completely unregulated operations. 

It is no coincidence that MF Global opened an office in London where it conducted a huge trade in its last days; days in which about a billion US dollars of client funds evaporated.

Re-hypothecation is a huge proportion of banking activity but it may be in “terminal failure,” according to Zero Hedge (www.zerohedge.com/news/why-uk-trail-mf-global-collapse-may-have-apocalyp...). 

The worst feature is that this massive activity is “off-balance sheet” and it creates “chains of counter-party risk.”

Buyout failures

Some years ago, leveraged buyouts (LBOs) were the darlings of the stock markets but most are now struggling. According to Moody’s, only five of the 40 biggest LBOs are enjoying higher credit ratings, 15 are lower and three are bankrupt. A quarter of the LBOs defaulted in 2008-10.

There will be a major problem when the LBOs of 2005-07 try to roll over their debt in 2012 as capital markets are almost closed to highly leveraged companies and banks are no longer adventurous. 

Industry insiders are scratching their heads in wonder how the LBOs can obtain the capital they desperately need.

Sovereign funding

The Royal Bank of Scotland suggests European banks alone require €810 billion in 2012. I have no estimates for other banks in the US, Australia, etc, but imagine that requirements will be very high, as few countries are net savers.

There is also a huge bulge of government debt in the UK, US and Europe that requires to be repaid. Italy and France require about €400 billion each, Spain €220 billion and the UK £220 billion. 

The Europeans could have difficulties as the ECB will be reluctant to assist. The indications are that investors will demand a high premium to compensate for the risk of default as Germany is taking an unaccommodating stance.

The collapse of MF Global indicates Wall Street has learned nothing from the 2008 crisis. The present focus is on the pillage of customer accounts but there are wider questions, such as why MF Global was allowed by “regulators” to trade at 40:1 leverage. This is higher than Bear Sterns and Lehman Bros.

The over-the-counter derivative market has reached a record $US708 trillion but it remains without adequate regulation and oversight. There will be more collapses as institutions continue to take wild bets.