The European Debt Crisis: Was the Rescue Package Enough?

The stock market's initial reaction appears to offer the answer of "yes", but then again we saw fairly convincing rallies early on in the financial crisis in 2007 (as I always like to remind people, our problems began in the summer of 2007, not 2008).  Equity markets often give false signals, perhaps more frequently than other markets.

As of right now, it does not appear that European debt markets are buying into the program here.  For instance, we have not seen Italian bond yields gap down:

The same troubling thing holds true in Portugal:

There rates are down a touch, but still nothing noticeable, considering that they are trading close to 1,000 basis points above German 10-year bonds.

The issue, as I see it, is a similar one to what we went through in 2009.  Let's back up for a moment here and state clearly why sovereign debt defaults are important to us: they threaten the health of major banks.  That's the whole reason that even more stable countries live in mortal fear of a Greece or a Portugal going under.  Banks like buying sovereign debt for their reserves due to its low default rate.  If the debt they buy becomes distressed so they have to mark it down or if the borrowers default, that undermines the banks' capitalization and they need to, at best, issue more shares to recapitalize, which dilutes the value of existing shareholders.  In a worst case scenario, the whole rotten thing comes crashing down and the banks fail catastrophically.  I think that we all know the consequences that stem from that scenario.

As such, just like the situation we faced in early 2009, this is about whether the banks can reasonably attain enough capital to recapitalize to offset massive losses coming down the pike.  In our case, it was the continuing doubts over the mountains of bad mortgages that banks were carrying on their books above the likely value that they could realize those assets at.  Investors speculated for weeks and months about just what kind of hits our banks would have to take and it caused our markets to go into a total tailspin that took the Dow down to 6,500 at one point.  Just an aside, there is no rational model by which one can call that a fair price for the market at that point.  What came along to really solve the issue were the stress tests of our banks that detailed the amounts our banks needed to raise in additional capital in order to survive two differing economic scenarios.  While there was criticism over the rigor of the tests at the time, it really did prove to be a turning point, along with expansionary monetary and fiscal policy that had begun just before that.  They put a number on how much the banks would have to raise and investors could use that figure to pivot their decision making on whether or not to buy shares.  Before that point, it had been somewhat of an unknown.

The markets had already begun a recovery before the release of the test results in May 2009 (the bottom was March 9th), including a massive rally in bank shares, but as the year went on, the financial stocks eventually added another huge leg to their rally in the summer as the recapitalizations went along without much incident.  From then on in, the markets regained confidence, and things began to return to some level of normalcy.  There were many other measures taken, so I don't want to exaggerate the importance of the stress tests, but the point is that once the health of the banks was assured, the markets and the economy at large could move on.

The key to Europe is whether the banks will now be sufficiently recapitalized.  The stress tests there have been of questionable credibility, often only focusing on macroeconomic conditions and not pricing in what would happen with large write-downs of sovereign debt.  That has started to change in the most recent iterations, but some analysts think that the stress tests are low-balling the needed capital by as much as $200 billion.  As long as investors are not convinced that the banks' balance sheets are now as secure as the Maginot Line... wait a moment... as unsinkable as the Titanic... as solid as the walls of Constantinople... erm, well, pretty safe, we will be prone to a renewed crisis.

Of course, history may well show that this was the turning point and many of the naysayers have been wrong. After all, credit spreads here did not really start coming in until a full month after the stock market bottomed in March of 2009.  (CLICK ON IMAGE FOR LARGER PICTURE)

                             

Spreads did not begin their true downward trajectory until early to mid April and did not actually reach quasi-normal levels until October.  In other words, it could be a while before we really know.  At this moment, I am doubtful that we have seen the last of this crisis.

Oh for the love of God. Belgium, too?

http://www.ft.com/cms/s/0/d9b8a3c0-1cba-11e0-a106-00144feab49a.html?ftcamp=rss

Belgium has long had heroic levels of public debt and recently an ailing financial system, too. This isn't a surprise, but when you look at a situation where Greece, Ireland, Portugal, Spain, Belgium and possibly Italy are all on the cusp it certainly does make the entire Euro region appear as a fetid turd. Take this together with the fact that Germany is growing increasingly unwilling to engage in bail-outs and that the German public is wondering why they continue to subsidize the weak members of the Euro-zone, it is becoming quite plausible that the Euro area will split apart. For some countries, it's even advisable

Now, while I have not been in the camp that says a run on U.S. debt is imminent, I do think that Congress' bold assertion that we may continue to cut taxes in the midst of a mammoth deficit raises the prospect. As we have control over our own currency, our ability to deal with a potential run is a lot stronger than that of other countries. Clearly, there is no sign of trouble in our bond markets at the moment, but debt crises can set in awfully quickly. Fortunately, we have a Federal Reserve that is able and willing to intervene as needed. Theoretically, if the market really freezes up, they can intervene and stabilize any blips.

By the way, in case you had any curiosity about the outcome of the next Irish election, don't. It won't even be close: http://www.irishcentral.com/news/Latest-poll-shows-continued-drop-in-support-for-Fianna-Fail--113189849.html

One good reason to stay away from Europe generally...

http://www.businessweek.com/news/2010-12-16/imf-eu-say-latvia-needs-adjustment-for-budget-goal.html

The case of Latvia is one where the country has followed all of the advice European Union and IMF policymakers have given them... and their economy has contracted over 20% from the peak and unemployment is unspeakably high.

http://online.wsj.com/article/SB10001424052748703471904576003370480205348.html

Instead of engaging in a policy of devaluation to make its goods and services more competitive around the world in a more normal fashion, the EU and IMF have basically force-fed deflation so that wages are being pushed down in a brutal fashion, which is one way to reduce imports... I guess. To paraphrase what Paul Krugman said about this, Latvia was told not to devalue its currency or it would face economic disaster. I respond with, "What exactly is a 20%+ contraction in GDP, 18%+ unemployment and dramatically falling living standards for everyone else?". What Latvia has been put through is nearly criminal.

If this is going to Europe's continued approach all around the periphery of the continent, investors are wise to stay away for the most part except for those European companies that do little business in Europe itself. Deflationary policies are good only for the holders of credit (and even there only in the short run) and bad for just about everyone else.

The Irish Financial Crisis Becomes a Political Crisis

http://www.nytimes.com/2010/11/23/world/europe/23ireland.html?_r=1

This has been an ongoing concern of mine for most of the European debt crisis. First, universal austerity simply does not work as a strategy for dealing with massive debt levels as its deflationary influence essentially digs the hole deeper as you are trying to get out. Secondly, it's politically damaging considering that it will coincide with a severe economic crisis. Ireland is in the midst of what can only be described as a depression and that will not correct anytime soon. In fact, it will get much much worse considering the magnitude of their fiscal contraction. The incumbent government will lose the next national election considering that the prime minister has a whopping 11% approval rating from the last poll I saw. Frankly, they should lose given that they have been in power for the boom and now the collapse.

This really is an issue where many Irish sense that their nationally sovereignty is at risk in these bailout agreements. At the same time, they really don't have a choice, but then again neither does Europe. The EU cannot allow Ireland and its banks to fail due to the collateral damage. It will be interesting if Ireland decides to take the approach that they will limit what austerity measures they put in place because they realize their importance to European financial stability. In the long run, Ireland's economic situation will get so bad that it risks severe political instability of the sort that we haven't seen in a while in most developed countries. They already have a 14.1% unemployment rate and that will not get better with the austerity measures being proposed.

As far as the EU's approach on all of this, I am doubtful of its long term viability. Basically, Germany and France are on the verge of backstopping Greece, Ireland, and then Portugal and Spain. If and when Spain becomes part of the mix, I really don't know that they are good for the money. At the same time, they are pursuing deeply deflationary policies which pose a particular problem in the context of a deflating asset bubble. The deflating real estate prices in Ireland, the UK and Spain are one of the major causes of the ongoing banking problems and austerity will only contribute to further deflation of those prices. As this pain continues, it will be difficult for governments to maintain policies of retrenchment.

Frankly, there is a serious risk that Europe is entering a deflationary spiral of a fairly severe magnitude, which will invariably lead to continued political instability.

Ireland and Financial Contagion

So, I believe it is time to bring out this table again of U.S. banking exposure:

As you can see, our banks have a fair amount of exposure to Ireland, but more worrying is this article from the Daily Telegraph. The exposure that British banks have to Ireland may be sufficient to sink them in their already battered state. What's more is that the current government in the UK is already somewhat hobbled by flagging approval ratings in the face of budget cuts. I am not certain how much stomach there is for potentially another big round of bailouts. International coordination might take some of the sting out of it, but we are looking at another round of substantial bailouts that are quite unpopular. Apparently, the IMF stands ready to save the day. The indications are that Ireland is actually the reluctant party and that the EU and and the IMF have been attempting to push for a bailout for some time.

Fundamentally, a bailout is needed to prevent a severe near term financial crisis in Ireland. While many have tried to point out that Ireland's government is funded through mid-2011, that is only relative to current spending. Ireland has guaranteed basically all deposits at domestic banks, meaning that widespread failures would trigger significant immediate government spending. In short, if the banking crisis gets bad enough, there is a solvency issue.

Frankly, I'm amazed that the Irish banks are still standing after a run amounting to 11% of deposits has already taken place. We'll see if an international backstop stops the bleeding. If you want to speculate on worthless Irish bank stocks, have at Anglo Irish (AIB), but what little is left of the value there is probably at risk even at these levels. At best we are probably talking serious dilution.

Europe Won't Stop Stalking Us

I was browsing Calculated Risk this morning as part of my normal morning crawl through financial websites (it actually relates to a portion of my work assignment so it isn't just leisure time for me) and found this very succinct breakdown of how the European debt crisis has not eased.

Obviously, the financial markets responded accordingly sending bonds and gold up while stocks declined. I guess now is as good a time as any to pull out my favorite little chart again:

Click to enlarge

So, as we can see here, there is a much greater reason to fear European contagion than Chinese contagion, at least from a financial sector standpoint. Though I don't have data on this, the really worrying thing is the amount of exposure that British and German banks have to the highly stressed countries. Perhaps more concerning is that the iron core of the EU, Germany, is probably not politically able to embark on further interventions. Angela Merkel's government is quite unpopular now (though so is nearly every incumbent government save Brazil's) and likely would fracture under the weight of another intervention. 

At this point, I think Jean Claude Trichet may want to reconsider his adherence to some fairly odd economic theories. He has placed far too much faith in what has been an anomalous economic performance out of Germany that has much more to do with little burps and belches of export demand than anything else. Domestic demand is flagging there as it is elsewhere in Europe. 

When viewing these sorts of crises, it's always hard to judge whether you are looking at Brazil in 1998, which bent but didn't break, or, say, Argentina in 2002. The telltale sign is to look for political instability in the afflicted countries and there we are seeing some twinges. If there is a cascade of government collapses then the rolling series of defaults long feared would seem likely. So far, it looks like that is under control, but it bears watching. 

U.S. Banks' Exposure to Risky Countries

I've heard quite a bit of talk about contagion from some of the more toxic countries in the world and I think it is helpful to actually quantify what we are talking about. I made this table based on data from the Federal Reserve on bank exposure by country:

As you can see, most of the high risk countries do not pose particularly mortal threats to the banking system. This is certainly true when you compare them to the size of the commercial and residential real estate portfolios that they had as of Q1 2008. The spill-over countries are a different story, with the UK being the most problematic if there suddenly was a complete collapse of the European financial system. However, that event looks increasingly unlikely. By the way, I included Australia and China due to their large and out of control real estate bubbles.

As such, I don't fear the risk of a sudden financial shock as much as I do the slow grind of deflation. With 10-year treasuries well below 3.0% now, I think the market is indicating the same.

European Bank Stress Tests vs. U.S. Stress Tests Part 2

I think that these stress tests are the equivalent of only testing what happens to a patient's heart when they walk ten feet. Bloomberg has a good article on the subject here: http://www.bloomberg.com/news/2010-07-23/eu-bank-stress-tests-fail-to-reassure-investors-wary-of-capital-criteria.html

In our stress tests, several banks were found to be in need of tens of billions in new capital, which they subsequently raised from markets that were satisfied about the stress tests' rigor. In this case, I rather doubt markets will be satisfied once they have time to digest the results.

Interesting Perspective on Bottom Fishing in Europe

There's a good Wall Street Journal article about the dangers of some of the more popular European ETFs. The principal issue that the authors highlight is that these indexes may be too heavily tilted toward the banks. As someone who lost a fair amount of money on bank stocks during the worst of our financial crisis, I am more discerning about bottom fishing than I used to be, so this caught my attention.

I still think there might be some money to be made in the broad ETFs like EWP, but indeed the better way to play this rout of European stocks is to look for the companies least effected by the crisis, but that have gotten destroyed anyway. The article mentions Telefonica (TEF), which has gotten absolutely clobbered and now yields over 8% with an 8-9 PE, depending on which earnings estimates you use. That's not bad and also Telefonica is unlikely to suffer severe damage. Communications outlays are not as vulnerable as other forms of consumer discretionary spending.

The same goes for stocks here. United Technologies (UTX) is down from $77 to $66 and it really isn't that likely to be effected by primary, secondary, or even tertiary effects of the European crisis.

What do you all think? Does this view make sense to you?

German Regional Elections and Their Consequences

It pays to follow results such as these when we are in the middle of a crisis. Whatever you think of Angela Merkel, the rout of her party and its coalition partners in the North Rhine-Westphalia regional elections might spell deepened trouble for financial markets this coming week. Her government's backing for the bailout package for Greece seems to have a lot to do with these election results. As such, continued sovereign intervention in the European financial crisis appears doubtful. This is especially true as the most recent election result in the United Kingdom still has not produced a definitive outcome, and whatever coalition government emerges will be too weak to take on something as unpopular as bailing out fragile southern European economies. 


Stay tuned and keep your eyes peeled. This may have already been anticipated by financial markets, but one cannot be sure. 


Update: It appears given market futures that this is not having a huge impact on the markets and that they are instead focusing on the larger than expected responses by the EU and ECB in the last 24 hours. I'm glad to see that Jean Claude Trichet lost out and that the ECB will be providing assistance to governments should they be shut out of the private bond markets. His prior unwillingness was the cause of the Thursday and Friday blood baths. 

Making Money Off of Europe's Mess: Spain

There is no question that the Euro Zone is troubled right now and will be for some time to come. Greece, Portugal, Ireland, Spain, and possibly Italy are all going to be in the soup for several years. In Greece, nominal GDP is not expected to recover to pre-crisis levels until 2017. Spain and Portugal probably aren't quite that bad, but Spain is clearly still reeling under the collapse of their massive property bubble. Portugal is more troubled than Spain, but it is harder to play Portuguese stocks from here due to relatively few Portuguese ADRs. Sure, there is Portugal Telecom (PT), but that is a stock that is neither good to short or long. It's just not particularly dynamic.

As far as Spain goes, this is an interesting one to watch. The worst of the real estate crisis is making its way through the banks now, though there will be heavy residual damage for a few years to come. The continued malaise of the real economy in Spain will lead to escalating consumer/business defaults and delinquency rates, putting pressure on profits. Additionally, if a major financial crisis befalls Portugal, Spain would likely suffer some collateral damage in both financial markets and real economic activity with reduced exports.

All of the problems both specific to Spain and general to the Euro region have caused Spanish stocks to languish while the rest of the world continues to erase the losses from 2007-2008 very rapidly. The iShares Spain ETF (EWP) is off from a 52-week high of $52.67 a share and is now muddling around $39.62. Similarly, major Spanish banks such as Banco Satander (STD) and BBVA (BBVA) are at very depressed levels. Compared to other regions of the world that have had nice recoveries in their financial markets, this presents a major opportunity.

However, I am not sold on the idea that it would be wise to get involved just yet. It is not at all clear that the debt crisis is anywhere near resolution yet. Also, with Moody's and S&P continuing to downgrade all of the suspect European countries' debt, who knows what might happen.

What do you all think?