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.

DJIA             +5.5%

NASDAQ     -1.8%

S & P             FLAT

Russell 2000 -5.5%

Anecdotal stories among brokers and investors indicate to me that most people lost money. I believe the reason why was because the market was sort of trendless. Just when you thought we were in an uptrend, we would selloff. Then, when it looked like the market was falling apart, we would rally. I think a lot of people got whipsawed in and out and it cost them plenty of money. According to Hedge Fund Research most funds lost money, including some notable names like Bill Gross and John Paulson. On the plus side, James Simons from Renaissance and Ray Dalio from Bridgewater had excellent years. Speaking of Bridgewater (which manages over $120BB); they remain quite bearish for 2012. They have done well for investors by maintaining a bearish stance on the global economy. On the other hand, Citicorp believes that we are now in a ten year secular bull market. Opinions are like brains, everyone’s got some. 

Finally, in a sign of the times, it seems that 131 year old Eastman Kodak may be on the verge on bankruptcy. EK launched its’ first camera at the end of the nineteenth century and went on to dominate the film industry. As late as 1997, shares traded as high as $90/share. Today, will everything moving to digital film, EK no longer has much of a business. EK shares closed yesterday at 47 cents. This is the nature of the world, with new industries being created to replace obsolete ones. However, there is no question that change is accelerating at a rapid rate. I like to tell my employees that virtually everything I use in my office (wireless, fax, personal computer, email, digital TV, etc) barely existed 20 years ago. If you want to read an excellent book on this trend, please read (maybe on your Kindle!) Future Shock by Alvin Toffler.  The book was originally written in 1984, and it is all the more true today. I highly recommend it!

Compounding the Mets’ problems is that they are trying to shrink their payroll at a time when they have unperformed on the field. In 2010, the Mets spent about $140mm. This year, they are expected to come in around $100m, perhaps even less. However, $57mm is already guaranteed to just three players! One of whom is Johan Santana, who underwent shoulder surgery and may not even to able to pitch. They lost three of the best players (Closer Rodriguez, CF Beltran to trades, and superstar SS Reyes to free agency) and have made little effort to replace them. In addition to the $57mm, they are committed to another $22mm to 6 other players. That leaves the Mets with almost $80mm committed to nine players, which means they have, at most, $20mm to spend on the other 28 guys on their 40 man roster. The team has finished under .500 for the past three years, and attendance has plunged from over $4mm in 2008 to around $2.3mm last year, despite the fact they are in a brand new ballpark. Based on their current roster, its’ a good bet they will finish near the bottom of the league in 2012.

It is incredible to me that the current owners refuse to sell a majority interest in a business that continues to lose money every year. Until the Wilpons sell the team, it looks like a lot more misery for us fans. One can only hope that the mounting losses will eventually cause the owners to sell out and begin a new era.

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.

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.

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.

However, the major news, as usual, came from across the pond in Europe. Just days after a bailout package was announced, Greek Prime Minister Papandreou stunned everyone by announcing that this package could only be accepted via a referendum of the voters. There is real doubt how this vote will turn out. Is the average Greek citizen going to vote for an austerity plan that calls for increased taxes and longer working hours? The leaders of France and Germany have called Papandreou in for an emergency meeting. Meanwhile, the news of this supposed bailout blowing up hit the equity markets hard. This drama is being closely watched in Italy, Ireland and Portugal, all countries who could be the next to go. After all, if Greece gets a 50% haircut, what happens to the other weak sisters? Although Merkel has been adamant that this type of bailout will not happen again, I doubt anyone seriously believes her. If Greece eventually defaults, I believe there is a really strong chance this could spread to Italy. If Italy and Greece go, will Portugal and Ireland default as well? Furthermore, what does this mean to France, whose banks own a huge portion of this debt? These are the questions that keep traders, analysts and investors up at night.

However, the European plan is somewhat short on details. First of all, if the Greek debt holders are going to take a 50% haircut, isn’t this essentially a default? Well, not according to ISDA (International Swaps and Derivatives Association). Remember how a CDS buyer is entitled to his money in case of a default? The ISDA has decided that since this plan is “voluntary” on behalf of the bondholders, this does technically constitute a default. There are a lot of angry Greek CDS holders out there. By the way, even with this write down, the Greek debt load is still expected to be 120% of GDP in 2020. It is hard for me to believe that it’s just a question of time before they default anyway. Meanwhile, the price of Spanish and Italian bonds barely moved, perhaps signaling that there is still significant doubt over how effective this plan will be. In fact, Italy sold 10 year bonds at a rate of 6.06% via auction on Friday, up from 5.86% last month. This was a new all-time high on rates since the euro was created in 1999. As I have stated many times, it is simply an unsustainable model to have most of the industrialized world heavily in debt with no method of repayment, other than continuing to borrow more and more. There will eventually come a time when investors are unwilling to buy bonds. When this happens, all hell will break loose.

I read a terrific book last week called Boomerang by Michael Lewis. Lewis may be best known to moviegoers for “Moneyball” and “The Blind Side”, but on Wall Street, he is considered to be a superb financial writer. Lewis’ first book was called “Liar’s Poker”, which is the story of his experiences as a young bond trader at Salomon Brothers (the firm has since been absorbed by Goldman Sachs). After several other books, he shined with “The Big Short”, about how a few hedge fund guys like John Paulson made a fortune in the subprime collapse. His newest book is about Kyle Bass and the coming potential crisis in Europe. Bass believes that the subprime situation was only the tip of the iceberg, and the real crisis is yet to come in Greece, Ireland and other overleveraged countries. Lewis takes us of a tour of each country, with additional chapters on Germany (the ultimate decision maker in the ECB) and California. Lewis has an excellent ability to put difficult financial concepts into a format that the average reader cannot only understand, but find interesting. I highly recommend it!