The End of an Era? Europe’s Sovereign Debt Problem
Jan 17, 2012
Posted by Jody Eisenman | Filed under Uncategorized
As history has shown us beyond a shadow of a doubt, no empire, no matter how great, will last forever. We have seen the collapse of the once great Egyptian, Persian, Greek, and Roman dynasties. More recently, we have seen the collapse of the British, Ottoman and Russian empires. Although all these countries (Persia is basically Iran and Iraq, and the Ottomans survive via Turkey) still exist, they are only a fraction of their former size and glory. Meanwhile, the continent of Europe has dominated the world for the past two thousand years. During the vast majority of this time, countries were at war with each other, jockeying for wealth and power. Finally, after two catastrophic world wars, the European Union was formed. In 1999, a uniform currency called the Euro was created. Although the Euro currency initially trade weakly in the foreign exchange markets (it traded as low as $.81 in January 2002), the euro then climbed rapidly and actually reached a peak of almost $1.60 in the summer of 2008. However, due the current economic problems in Europe, the euro has dropped rapidly. From a high of $1.48 last January, it has now plunged to $1.26. The problem, as usual, is debt.
On Friday, S & P downgraded nine countries sovereign debt, with France and Austria being the most prominent. Today, S & P further downgraded the ESFS (European Financial Stability Facility) to AA+. The ESFS is the primary lending arm for euro zone countries in trouble. As such, this will probably lead to a cost increase in the bonds they issue. In some perverse way it may not matter. If Italy or Spain will actually require a bailout, the amount of money required is perhaps as much as one trillion euros (that’s a 1 with nine zeros!), which is far beyond their current capability. However, even this problem is dwarfed by the sovereign default protection issue. It is believed that the largest European banks have hundreds of millions of dollars in sovereign risk exposure. In order to somewhat mitigate these risks, banks have purchased credit default swaps, which are insurance policies should a country default. However, many of these banks have sold these swaps to each other. In the case of the Italian and French banks (the largest exposure believed to be issued by UniCredit and Credit Agricole), it is difficult to see how they could possibly pay off these policies, as their balance sheets are already highly leveraged. Thus, should some of the PIGS (Portugal, Ireland, Greece and Spain and perhaps Italy) actually default; it could lead to a domino effect that might leave Europe devastated. I don’t see how the countries could possibly bail out these banks in the case of failure. The next few months will be telling.
