Banco Espírito Santo (which means “Bank of the Holy Spirit,” and is also the name of a state in Brazil) seems to be under mounting financial stress — there was even concern that it was possibly insolvent — which sent shock waves throughout Europe’s economy and markets.

One of the largest owners of the banks’ stock is Espírito Financial Group, which is owned by Espírito Santo International, which in turn is controlled by a family based in Luxembourg. The bank owns bonds issued by the financial company.

An audit by Portuguese officials revealed that the financial company missed payments on some short-term debt. This brought into question the value of the bonds held by Banco Espírito Santo.

The bonds represent a significant portion of the bank’s capital, so if the bonds are worthless, then the bank has a capital problem. European regulators, bankers and investors were shocked! Well, at least they pretend to be.

While this situation is a bit unusual because it has to do with investments made by a bank, European banks in general are struggling because of bad loans. As 2014 wears on, this problem is only going to get worse, not better.

Financial research and rating firm, Fitch, estimates that bad loans on the books of European banks increased by 8.1% in 2013, topping one trillion euros.

Keep in mind that this is long after the financial crisis ended, after European Central Bank (ECB) leader Mario Draghi’s famous statement in 2012 that he would do “whatever it takes” to save the euro, and certainly long after European leaders began crowing about what a great recovery was occurring on the continent.

Economy of Bad Loans

It seems that reality and the typical European description of a new economic spring are quickly diverging.

Part of the increase in bad loans has been due to the simple fact that more people and companies are failing to repay. However, some of it was due to more stringent classifications on what qualifies as bad or impaired debt.

Large banks are using stricter guidelines to evaluate their loans because, at the end of 2014, the ECB will take over responsibility for these institutions, and will require the higher standards on evaluating holdings.

This is not to say that European bankers have stood idly by and watched their finances deteriorate. They have raised additional impairment reserves against losses. Unfortunately, against the one trillion of bad debt that sits on their books, the banks only have 570 billion euros of reserves.

The outcome of all this is that European banks have little confidence in each other’s finances. This curbs everyone’s appetite for interbank lending, which slows down credit creation and hampers economic activity.

So it might seem logical that this situation would make investors think twice before buying bonds from such entities, but that’s not the case.

Along with the bankrupt governments of Southern Europe, the banks in the economic bloc aren’t having any trouble raising funds. It seems that everyone is confident the ECB will bail out anyone and everyone with newly printed euros when the time comes.

But there’s a dark side to the story…

German bankers have been quick to agree with the Cypriot plan for dealing with bank failures, which means the confiscation of bank deposits above retail thresholds.

When this happens in a large European country like Portugal or Spain, there’ll be a lot of finger-pointing from businesses and citizens who rightly believe that their politicians and bankers have sold them down the river one more time.

The fragile nature of the economic recovery in Europe and their unwillingness to recognize their impaired debt is why we’ve shied away from investments on the continent.

While things are far from perfect in the U.S. markets, at least we can avoid the currency risk of holding euro-denominated assets when the ECB cranks up the printing press.



Follow me on Twitter @RJHSDent

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Rodney Johnson
Rodney works closely with Harry to study the purchasing power of people as they move through predictable stages of life, how that purchasing power drives our economy and how readers can use this information to invest successfully in the markets. Each month Rodney Johnson works with Harry Dent to uncover the next profitable investment based on demographic and cyclical trends in their flagship newsletter Boom & Bust. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. Along with Boom & Bust, Rodney is also the executive editor of our new service, Fortune Hunter and our Dent Cornerstone Portfolio.