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European Sovereign Debt Crisis Gets Scary

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The simplest explanation of the European sovereign debt crisis came from Joe Weisenthal at the Business Insider website.  He compared the yield on the 5-year bond for Sweden with that of Finland, illustrated by charts, which tracked those yields for the past year:

Basically they look identical all through the year up until November and then BAM.  Finnish yields are exploding higher, right as Swedish yields are blasting lower.

The only obvious difference between the two:   Finland is part of the Eurozone, meaning it can’t print its own money. Sweden has no such risk.

While everyone’s attention was focused on the inability of Greece to pay the skyrocketing interest rates on its bonds, Italy snuck up on us.  The Italian debt crisis has become so huge that many commentators are voicing concern that “sovereign debt contagion” across the Eurozone is spreading faster than we could ever imagine.  The Los Angeles Times is now reporting that Moody’s Investors Service is ready to hit the panic button:

Throwing more logs on the Eurozone fire, Moody’s Investors Service said early Monday that the continent’s debt crisis now is “threatening the credit standing of all European sovereigns.”

That’s a not-so-subtle warning that even Moody’s top-rung Aaa ratings of countries including Germany, France, Austria and the Netherlands could be in jeopardy.

Meanwhile, every pundit seems to have a different opinion about how the crisis will unfold and what should be done about it.  The latest buzz concerns a widely-published rumor that the IMF is preparing a 600 billion euro ($794 billion) loan for Italy.  The problem with that scenario is that most of those billions would have to come from the United States – meaning that Congress would have to approve it.  Don’t count on it.  Former hedge fund manager, Bruce Krasting provided a good explanation of the Italian crisis and its consequences:

I think the Italian story is make or break.  Either this gets fixed or Italy defaults in less than six months.  The default option is not really an option that policy makers would consider.  If Italy can’t make it, then there will be a very big crashing sound.  It would end up taking out most of the global lenders, a fair number of countries would follow into Italy’s vortex.  In my opinion a default by Italy is certain to bring a global depression; one that would take many years to crawl out of.  The policy makers are aware of this too.

So I say something is brewing.  And yes, if there is a plan in the works it must involve the IMF.  And yes, it’s going to be big.

Please do not read this and conclude that some headline is coming that will make us all feel happy again.  I think headlines are coming.  But those headlines are likely to scare the crap out of the markets once the implications are understood.

In the real world of global finance the reality is that any country that is forced to accept an IMF bailout is also blocked from issuing debt in the public markets.  IMF (or other supranational debt) is ALWAYS senior to other indebtedness of the country. That’s just the way it works.  When Italy borrows money from the IMF it automatically subordinates the existing creditors. Lenders hate this.  They will vote with their feet and take a pass at Italian new debt issuance for a long time to come.  Once the process starts, it will not end.  There will be a snow ball of other creditors.  That’s exactly what happened in the 80’s when Mexico failed; within a year two dozen other countries were forced to their debt knees.  (I had a front row seat.)

I don’t see a way out of this box.  The liquidity crisis in Italy is scaring us to death, the solution will almost certainly kill us.

Forcing taxpayers to indemnify banks which made risky bets on European sovereign debt is popular with K Street lobbyists and their Congressional puppets.  This has led most people to assume that we will be handed the bill.  Fortunately, there are some smart people around, who are devising better ways to get “out of this box”.  Economist John Hussman of the Hussman Funds, proposed this idea to facilitate significant writedowns on Greek bonds while helping banks cope the impact of accepting 25 percent of the face value of those bonds, rather than the hoped-for 50 percent:

Given the extremely high leverage ratios of European banks, it appears doubtful that it will be possible to obtain adequate capital through new share issuance, as they would essentially have to duplicate the existing float.  For that reason, I suspect that before this is all over, much of the European banking system will be nationalized, much of the existing debt of the European banking system will be restructured, and those banks will gradually be recapitalized, post-restructuring and at much smaller leverage ratios, through new IPOs to the market.  That’s how to properly manage a restructuring – you keep what is essential to the economy, but you don’t reward the existing stock and bondholders – it’s essentially what we did with General Motors.  That outcome is not something to be feared (unless you’re a bank stockholder or bondholder), but is actually something that we should hope for if the global economy is to be unchained from the bad debts that were enabled by financial institutions that took on imponderably high levels of leverage.

Notably, credit default swaps are blowing out even in the U.S., despite leverage ratios that are substantially lower (in the 10-12 range, versus 30-40 in Europe).  As of last week, CDS spreads on U.S. financials were approaching and in some cases exceeding 2009 levels.  Bank stocks are also plumbing their 2009 depths, but with a striking degree of calm about it, and a definite tendency for scorching rallies on short-covering and “buy-the-dip” sentiment.  There is a strong mood on Wall Street that we should take these developments in stride.  I’m not convinced.  Our own measures remain defensive about the prospective return/risk tradeoff in the stock market.

The impact this crisis will have on the stock market explains why mainstream news media coverage has consistently understated the magnitude of the situation.  It will be interesting to observe how the “happy talk” gets amped-up as the situation deteriorates.


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Straight Talk On The European Financial Mess

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The European sovereign debt crisis has generated an enormous amount of nonsensical coverage by the news media.  Most of this coverage appears targeted at American investors, who are regularly assured that a Grand Solution to all of Europe’s financial problems is “just around the corner” thanks to the heroic work of European finance ministers.

Fortunately, a number of commentators have raised some significant objections about all of the misleading “spin” on this subject.  Some pointed criticism has come from Michael Shedlock (a/k/a Mish) who recently posted this complaint:

I am tired of nonsensical headlines that have a zero percent chance of happening.

In a subsequent piece, Mish targeted a report from Bloomberg News which bore what he described as a misleading headline:  “EU Sees Progress on Banks”.  Not surprisingly, clicking on the Bloomberg link will reveal that the story now has a different headline.

For those in search of an easy-to-read explanation of the European financial situation, I recommend an essay by Robert Kuttner, appearing at the Huffington Post.  Here are a few highlights:

The deepening European financial crisis is the direct result of the failure of Western leaders to fix the banking system during the first crisis that began in 2007.  Barring a miracle of statesmanship, we are in for Financial Crisis II, and it will look more like a depression than a recession.

*   *   *

Beginning in 2008, the collapse of Bear Stearns revealed the extent of pyramid schemes and interlocking risks that had come to characterize the global banking system.  But Western leaders have stuck to the same pro-Wall-Street strategy:  throw money at the problem, disguise the true extent of the vulnerability, provide flimsy reassurances to money markets, and don’t require any fundamental changes in the business models of the world’s banks to bring greater simplicity, transparency or insulation from contagion.

As a consequence, we face a repeat of 2008.  Precisely the same kinds of off-balance sheet pyramids of debts and interlocking risks that caused Bear Stearns, then AIG, Lehman Brothers and Merrill Lynch to blow up are still in place.

Following Tim Geithner’s playbook, the European authorities conducted “stress tests” and reported in June that the shortfall in the capital of Europe’s banks was only about $100 billion.  But nobody believes that rosy scenario.

*   *   *

But to solely blame Europe and its institutions is to excuse the source of the storms.  That is the political power of the banks to block fundamental reform.

The financial system has mutated into a doomsday machine where banks make their money by originating securities and sticking someone else with the risk.  None of the reforms, beginning with Dodd-Frank and its European counterparts, has changed that fundamental business model.

As usual, the best analysis of the European financial situation comes from economist John Hussman of the Hussman Funds.  Dr. Hussman’s essay explores several dimensions of the European crisis in addition to noting some of the ongoing “shenanigans” employed by American financial institutions.  Here are a few of my favorite passages from Hussman’s latest Weekly Market Comment:

Incomprehensibly large bailout figures now get tossed around unexamined in the wake of the 2008-2009 crisis (blessed, of course, by Wall Street), while funding toward NIH, NSF and other essential purposes has been increasingly squeezed.  At the urging of Treasury Secretary Timothy Geithner, Europe has been encouraged to follow the “big bazooka” approach to the banking system.  That global fiscal policy is forced into austere spending cuts for research, education, and social services as a result of financial recklessness, but we’ve become conditioned not to blink, much less wince, at gargantuan bailout figures to defend the bloated financial institutions that made bad investments at 20- 30- and 40-to-1 leverage, is Timothy Geithner’s triumph and humanity’s collective loss.

*   *   *

A clean solution to the European debt problem does not exist. The road ahead will likely be tortuous.

The way that Europe can be expected to deal with this is as follows.  First, European banks will not have their losses limited to the optimistic but unrealistic 21% haircut that they were hoping to sustain.  In order to avoid the European Financial Stability Fund from being swallowed whole by a Greek default, leaving next-to-nothing to prevent broader contagion, the probable Greek default will be around 50%-60%.  Note that Greek obligations of all maturities, including 1-year notes, are trading at prices about 40 or below, so a 50% haircut would actually be an upgrade.  Given the likely time needed to sustainably narrow Greek deficits, a default of that size is also the only way that another later crisis would be prevented (at least for a decade, and hopefully much longer).

*   *   *

Of course, Europe wouldn’t need to blow all of these public resources or impose depression on Greek citizens if bank stockholders and bondholders were required to absorb the losses that result from the mind-boggling leverage taken by European banks.  It’s that leverage (born of inadequate capital requirements and regulation), not simply bad investments or even Greek default per se, that is at the core of the crisis.

Given the fact that the European crisis appears to be reaching an important crossroads, the Occupy Wall Street protest seems well-timed.  The need for significant financial reform is frequently highlighted in most commentaries concerning the European situation.  Whether our venal politicians will seriously address this situation remains to be seen.  I’m not holding my breath.


 

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