Europe's Debtor's Prison

This appeared on the front page of Sunday’s New York Time’s business section:


“IT’S a $2.6 trillion mystery. 


That’s the amount that foreign banks and other financial companies have lent to public and private institutions in Greece, Spain and Portugal, three countries so mired in economic troubles that analysts and investors assume that a significant portion of that mountain of debt may never be repaid.  The problem is, alas, that no one – not investors, not regulators, not even bankers themselves – knows exactly which banks are sitting on the biggest stockpiles of rotting loans within that pile. And doubt, as it always does during economic crises, has made Europe’s already vulnerable financial system occasionally appear to seize up. Early last month, in an indication of just how dangerous the situation had become, European banks – which appear to hold more than half of that $2.6 trillion in debt – nearly stopped lending money to one another. 


Now, with government resources strained and confidence in European economies eroding, some analysts say the Continent’s banks have to come clean with a transparent and rigorous accounting of their woes. Until then, they say, nobody will be able to wrestle effectively with Europe’s mounting problems.” (end of NY Times excerpt)


What I would like to add is that these are only some of the problems with the EU. The situation in the EU’s banking system is analogous to the US banking system’s problems following the non-agency MBS collapse of 2008. In order to stabilize the system, the government had to perform many heroics. Here is a list of what it took in the US:


1> The FDIC guaranteed all bank debt issued under their TLG program;

2> The Fed/Treasury guaranteed money market accounts;

3> Direct purchases of Commercial Paper by the Fed;

4> Massive infusions directly into banks via TARP;

5> Asset price supports via the Fed’s TALF program, and the Treasury’s PPIP program;

6> FDIC guarantees on assets they are liquidating from failed banks;

7> Expanded FDIC insurance from $100,000 to $250,000 per account, in addition to extended guarantees for business accounts at commercial banks;

8> Repeal of mark to market accounting for most non-agency MBS, which were under-water assets likely to take a loss due to mortgage defaults;

9> A multitude of failed programs to stabilize the underlying mortgage market;

10> Loan guarantees by the FDIC for Citibank of $300+ billion, and for Bank of America for $100+ billion;

11> Fed assisted bail-outs for AIG and Bear Stearns, and forced mergers of many banks into larger banks;

12> The government’s rescue and conservator-ship of FNMA and FHLMC, with over $5 trillion of loan guarantees outstanding;

13> Extended lending programs by the Fed to domestic banks and international central banks;

14> Monetization of $1.7 trillion of treasury and mortgage debt by the Fed, also known as “printing money”;

15> Revised regulatory capital requirements for the insurance industry for non-agency residential MBS.


When you add up the sum of these programs, it appears that that the government missed nothing. The sum of these programs was for the government to guarantee everything in sight. Clearly the system had failed and many things needed to be done.


In contrast, Europe is just starting to get their arms around their problems. The problems with a sovereign debt issues is that the default, or threat of a default of a sovereign entity, also calls into question the viability of the debts of all other entities within the failing country. In short, it becomes a mess. The NYT believes the size of the European problem is $2.6 trillion. However, there are many debts between private companies which do not touch the banking system, so I would venture to think the problem is bigger than $2.6 trillion.


Does the problems in Europe compare to that which occurred in the US housing market in 2008? That is part and parcel the problem. It is not known how far and deep the problems will extend. For the moment, the EU has put a band-aid around the debts of the weaker EU members, namely Greece, Spain and Portugal, through their open market purchases of this debt. Parallel to this, the EU is attacking the cause of their problems through austerity measures on the sovereign level. While these plans might work in theory, the unknown aspect of these programs is to see whether austerity has a negative feedback loop into the revenue streams of these countries. In other words, does austerity cause overall economic activity to drop, which in turn reduces tax revenues, and pushes more recipients into government safety network programs? Despite much pain, and their best intentions, austerity could backfire in a big way!


Clearly the implementation of austerity programs is needed to right the failing finances of the governments. Even countries with relatively good finances, like Germany, have announced austerity measures. And when you talk about austerity, you are also introducing the idea that a euro-zone led economic slowdown is inevitable. This is the big story for 2010.


What will this coming slowdown lead to? The current sell-off in stock markets, and the 25% drop in the Euro are sign-posts which we need to keep in mind. While I fully expect the slowdown to have additional negative consequences for the financial markets, the next discussion points to various technical signs that suggest that the scare trade could be over for the time being.


* Markets and timing: below is a potential scenario which suggests that the current fear trade could go away for the next month or so:


* Bonds – As I have been harping on in March and April, I have been keenly aware of bullish bond market seasonal trends which typically run from early May to mid June. To that end, the seasonals have been right on. If the end of the seasonals means that interest rates are set to rise, it is possible that the other trends of the last 6 weeks could reverse themselves, so I am on the alert for that. Accordingly, I have sold the 10 year treasury notes I purchased in March. In terms of yields, the 10 year note retraced between 38% and 50% of rate rise from late in 2008 to the recent high at 4%, so from that perspective, the rally has extended far enough for it to have reached the targets I set out previously.

10 year Treasury yields, since January 2007


* Stocks – will stocks move higher, if bonds are poised to decline? Clearly, it seems that this could happen.  The world seems tired of the sovereign situation for the time being, and I am very cognizant that the stock markets might have found a support shelf around 1040 on the S&P. Nonetheless, I am very concerned about the intensity of the selling on Friday, that the strong down day (99.2% of all volume was on a down-tick) is a harbinger of a greater sell-off to follow. The next chart shows the 1040 support shelf which has managed to act as a support level in October and February, and most recently on May 25th and yesterday. When the market was making lows yesterday, it occurred to me that there were more up stocks than down stocks, which is considered a bullish divergence, and possibly a sign that the strength of the sell-off was waning.


A similar support shelf was formed in 2008 around the low 1100s, see the next graph.

S&P 500 index since March 2009

My concern is that if the support shelf is taken out, then the subsequent sell-off will be fast and swift. On October 6, 2008, the S&P was down 9% intra-day, before bouncing after the low 1100 support shelf was taken out. In other words, if the 1040 support shelf is a defining line in the sand, it will be very hard to execute a trade on the down side if it is taken out. This is what Put options were invented for, although, I will be the first to admit that they can be very expensive. Nonetheless, I am approaching the current market with a sense of trepidation, and not to get too smug in my bearish thesis for the next month or two.

This does not mean that I will be buying any stocks, but rather will be defensive about the strength of my near term conviction about being short. Accordingly, as expensive as they are, I am relying on put options to capture the possibility that the 1040 support shelf could get taken out.


* The Euro – commentators have long talked about a 118 target for the Euro, which is how low the Euro got over the last few days. The next chart shows 10 years of history for the Euro. As you can see, 118 acted as a resistance level in 2003, and a support level from 2004 to 2006. Accordingly, if the euro is bouncing off the 118 support level, then this would auger for a temporary end to the fear trade, which would be supportive to the near term for stocks and bearish for bonds.

Before I declare the Euro sell-off over, I want to see additional confirmation that it has broken out of the recent down channels. The steeper (red) channel on the last graph comes through at 1.2250 now, and a move above that level will be the first sign that the trend has ended. I will be watching this before I call the current euro induced fear trade over.