The crisis deepens

ZURICH, Switzerland, Sept. 24 (UPI) -- Other countries that have been raking in cash like China and the oil-exporting states have sovereign wealth funds. The United States instead has been forced to resort to the opposite, a sovereign debt fund.

That, at least, was how it looked when U.S. Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke launched their $700 billion plan over the weekend. Around the world, critics sneered at the humbling of America's once-dominant financial system.

"The American empire in the world is reaching the end of its road," crowed Iranian President Mahmoud Ahmadinejad in his speech to the United Nations this week.

But then came two less-than-expected developments. The first was that their plan was not immediately hailed as the savior of the U.S. economy, but came in for considerable sniping in Congress and from doubting commentators. It no longer looks like a done deal, and the markets have been sinking again as a result, despite the awful warnings that Paulson and Bernanke delivered to Congress in their testimony Tuesday.

The second unexpected event was the accumulating evidence that while the United States is catching pneumonia, the rest of the world may be in even worse shape.

Start with Britain's banks, where one key event of last week's crisis was the government's pressure on Lloyds Bank to rescue the sinking HBOS, which had been formed from a merger of Royal Bank of Scotland and Halifax, Britain's biggest mortgage lender. That rescue is now under heavy fire, most ominously from Scotland, where it is seen as clever English bankers taking advantage of temporary troubles to buy up Scottish assets cheap.

Those "temporary troubles" took hold because of a heavy amount of short selling of British bank stocks, and matters calmed when short selling was banned and shorts contracts had to be disclosed. The U.S. hedge fund of John Paulson, it emerged, had put close to $2 billion into a bet that British banks were heading down fast, shorting up to 1 percent each of Royal Bank of Scotland, Lloyds, Barclays and HBOS.

But maybe the short sellers knew what they were doing. British and European banks, it now emerges, tend to be far more heavily leveraged than their U.S. counterparts. A recent Citigroup report reckoned that the average European bank's tier-one capital represented only 3.1 percent of tangible assets, about half the safety margin deemed essential in the United States.

"The dozen largest European banks have now, on average, an overall leverage ratio (shareholders' equity to total assets) of 35, which has actually increased so far this year, compared with less than 20 for the largest U.S. banks," argues Daniel Gros, who runs the leading Brussels think tank the Center for European Policy Studies.

He estimated Deutsche Bank's leverage ratio at 50, Barclays at about 60 and notes that while Fortis Bank's leverage ratio is about 33, its obligations amount to three times the GDP of Belgium, where it is based.

"The largest European banks have become not only too big to fail, but also too big to be saved," he concludes.

One of those giant European banks, France's Societe Generale, is now warning that the financial crisis is poised to get a great deal worse because of looming problems for emerging markets in general and China in particular.

"The collapse of emerging market economies will shake investors to the core. The great unwind has only just begun," said Albert Edwards, the bank's global strategist. "The consensus has a touching belief that emerging markets will prove resilient despite a deep downturn in developed economies. My view is that an outright contraction in global GDP is entirely possible next year.

"The big surprise in store is what could happen in China. The potential for a deep recession in the U.S. is already on the radar screen, but people will be stunned if China's economy contracts, as I believe it will. Investors could be massively caught out. We could see monthly trade surpluses in the U.S. within a year," he said.

This followed an ominous report from the China team of Fitch Ratings that China's banks are in trouble, having used an "underground market" to sidestep state restrictions on lending and keep the loans off their books. One such ploy, in which the banks act as loan-arranging brokers between clients, is now valued at $220 billion.

"These types of credit and/or institutions fall outside the traditional structures of financial supervision, exposing banks to a growing amount of risk that is for the most part hidden. By getting a portion of their credit off books, Chinese banks are able to comply with official loan quotas while in practice exceeding them," the Fitch team said. "The Chinese banking system is nearing the point at which it can no longer sustain additional large net withdrawals of liquidity without generating further strains on banks' ability to lend."

This is starting to sound apocalyptic. The Soc-Gen strategist goes on to predict that "the emerging market liquidity squeeze will intensify ferociously, and assets linked to the region will become toxic waste. That includes previously resilient banks such as HSBC, Standard Chartered and Banco Santander."

Meanwhile, another warning came from a banking forum in Beijing this week, where Tang Shuangning, chairman of China Everbright Bank, told the gathering, "Among all the financial crises, this may be the one that affects China most."

Whatever Congress finally agrees to do with the Paulson rescue plan, it looks as if this financial crisis has a lot further to run and a lot further to spread.