Archive for November, 2011
Contagion, the European Union, and the United States
Posted by Jody Eisenman | Filed under Uncategorized
While US stock markets have now declined for six straight days, all eyes are focusing on Europe. As I wrote a few days ago, the debt problems have begun to spread like a virus all across Europe. On Wednesday, the financial markets were stunned by the news of the German bond auction. Remember, Germany is the main financial arm of the European Central Bank, and has huge control over an eventual bailout. In the bond auction, it is generally accepted that the Finanzagentur (the German debt agency), retains about 10-20% of the auction for themselves. In this case, they were forced to retain 40%. It is now clear that credit is beginning to dry up all over Europe. Without credit, the financial markets freeze up. Everything grinds to a halt, and you will see a slew of bankruptcies. Remember what happened in the United States in 2008? The financial system came very close to a complete meltdown. Multiply this several times, and you have an idea what is going on in Europe. If the strongest country in Europe is having problems selling its’ bonds, what does that say about Italy, Spain and the Netherlands? The future of the Eurozone is on very shaky ground right now.
Meanwhile, comment by Mohammed El-Erian, head of PIMCO (the world’s largest mutual fund) were alarming. El-Erian called US economic conditions “terrifying”, and he believes that the chance of another recession here could be as high as 50%. As the case is in Europe, there is very little movement by the politicians. The debt committee collapsed without any recommendation for a solution. In a nutshell, you cannot continue to spend more than you take in. The longer you do this, the higher your debt gets, and more and more of your expenses must go to pay the interest. If rates start to rise, the interest payments will become almost unmanageable. This is the situation in Europe. In the United States, the debt has still not become catastrophic, as investors are still willing to buy Treasury bonds at very low yields. However, we keep bumping up against debt limits. As long as hard core Democrats will not agree to spending cuts and hard line Republicans will not agree to tax increases, there can be no compromise. Meanwhile, debts continue to increase, and liquidity is drying up. A solution both here and in Europe will need to be found quickly before the situation escalates out of control.
Contagion
Posted by Jody Eisenman | Filed under Uncategorized
It now appears that the crisis in Europe us spreading. As the ECB continues to fiddle, the rest of Europe is beginning to burn. The yields on Spanish bonds have jumped to almost 7% on their last ten year auction, as compared to 5.43% less than a month ago. French and Belgian yields are rising as well. Since the start of the ECB bond-buying program in May 2010, the ECB has purchased €187 billion of government bonds; which still has not prevented Italy and Spain from passing the critical threshold.
As I have written earlier, the issue in a nutshell is that Europe has way too much sovereign debt. The strategy among European countries has been to overspend their revenues, and then borrow more and more to finance it. This strategy has “worked” only because investors were willing to buy their bonds, and rates have remained relatively low. Now, rates are rising, which causes a multitude of problems. In simple terms, it means that even more of their expenses must go to pay the interest on their ever increasing debt. In order to try and keep rates in line, the ECB has been buying bonds. For a variety of reasons, this hasn’t worked. The total losses have been estimated at anywhere between 1 and 5 trillion. Now who owns these bonds? Mostly, European banks, especially those in France. Remember the US bank crisis in 2008? When your bank is allowed to leverage its’ balance sheet at 30 or even 40 to 1, it doesn’t take much of hit to your portfolio before you are bankrupt. This is what happened to Lehman Brothers, and is now possibly happening to several major European banks. The ECB’s method for dealing with this crisis is to quarrel among its’ members. At the end of the day, bailing countries out with billions of additional debt will only postpone the inevitable. In other words, unless countries begin to not only spend within their needs, they must run a surplus in order to gradually reduce their debt. If this does not happen soon, we are going to be looking at a very unpleasant ending.
Is This the End of Europe?
Posted by Jody Eisenman | Filed under Uncategorized
I have been trying to write a column on the debt crisis for some time. Unfortunately, I have been buried by work and this is the first chance I have to write! However, I need to address the situation in Europe, which is rapidly unraveling into a situation that could have catastrophic consequences. If this problem is not addressed very quickly, I don’t believe I’m exaggerating to say that we could be facing a full scale depression in Europe, and possibly here as well. The markets fell dramatically today, with the DJIA losing almost 400 points. Just what the heck is going on?
To understand the crisis, we must go back to the beginning. Instead of focusing on the complex economies of a typical European country, think of a family. Imagine you have a family that nets out $100,000/year in income, yet spends $120,000. Unless they cut their spending habits or find more income, their debt situation will grow every year. In addition, the family must keep paying interest on their loans. If their interest rate was 10%, then their debt will grow by that amount every year, even if they somehow manage not to borrow any more money. Any math student will understand that at some point, this family’s financial situation will reach a crisis point. Either they will be overwhelmed by interest payments, or even worse, the lenders may decide they are a poor credit risk and stop lending. The family is basically a financial disaster waiting to happen. OK< now shift to Europe. Most of the Eurozone countries are in the same situation as this family. They continue to spend more than they take in, and just borrow more and more money. In the case of Greece, an agreement was reached to bail them out by having the Greeks agree to cut spending and increase tax revenue. However, it also included a “voluntary” agreement by the current lenders (meaning bondholders) to agree to take a 50% loss on their investment. Why would anyone agree to this? Simply because the alternative was outright default, where the losses would be even greater.
Let’s fast forward to Italy. Unlike Greece, Italy has the Euro’s third largest economy and second largest debt burden. In fact, at $2.6 trillion, Italy’s debt is greater than Portugal, Ireland, Greece and Spain combined. A good measure of how investors feel about a bond issuer’s stability is the yield. As yields drop (such as for US treasuries), it is because of investor demand as they feel this is a good risk and are therefore willing to accept less of a return. Conversely, if investors feel that the risk is increasing, they will cut back on their lending (or stop entirely), thus forcing the country to borrow money at higher rates. Let’s look at the benchmark 10 year Italian government bond. During the summer, these yields were around 5%. By October 28, as a deal was reached on Greece, the yield went over 6%. By last Friday, it went to 6.37. Yesterday, they shot up to 6.77. Today, they closed at 7.25%, which is a great indication that investors are dumping Italian bonds rapidly. The European countries are unable to agree on a solution. On the one hand, no one wants to throw good money after bad. I’m not sure that the ECB could raise enough money to bail them out in any case. On the other hand, a default by Italy could be unthinkable. Currently, the leading holders of Italian debt are Germany with about $162 billion and France with $416 billion. A default could very well sink the French banks, as well as the country. Plus, if Italy defaults, I believe that Greece, Ireland and Portugal would probably follow suit soon after. If that were to happen, we are talking about a complete European collapse. Will the ECB print money in order to buy up Italian bonds? Will the IMF lead a massive bailout? None of these solutions are ideal, and they will require consent by several parties, something that has eluded the ECB. On the other hand, Italy is the last stand. A failure to stop this crisis soon could lead to a global meltdown the world has never seen.
