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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.
Will Greece Bring Europe To Its’ Knees?
Posted by Jody Eisenman | Filed under Uncategorized
When we left off over the weekend, the stock market had turned in a tremendous October rally. However, I warned people that the plan was short on details, and the Euro bond market yields were showing caution. In the last two trading days, the DJIA has lost close to 600 points, and the S & P dropped 67 more. Two important news events have cratered stock prices. The first event concerned MF Global, the financial firm run by former Goldman Sachs head Jon Corzine. In an effort to boost profits, MF made major bets on the sovereign debt of several European countries. In all too typical Wall Street tradition, these bets were substantially larger than the net capital of the entire firm. Needless to say, when the bonds dropped in value, the firm watched their rating downgraded to junk and investors fleeing for safer havens. Yesterday morning, they filed Chapter 11. To make this story even worse, regulators are investigated the alleged disappearance of hundreds of millions of dollars in investor funds that may have been co-mingled with the assets of the firm. I sincerely hope these allegations are untrue. In any case, MF Global had been in business for over 200 years.
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.
Stock Market Explodes, Euro Bonds Yawn
Posted by Jody Eisenman | Filed under Uncategorized
Although Monday is the official end of October, the US stock markets have turned in their best month in 27 years. Right now, the S & P 500 is up about 14% for the month, wiping out the horrendous third quarter. Much of the gains were due to the apparent resolution to the Greek crisis, albeit a temporary one. Additionally, roughly ¾ of all companies reporting this past week have beat analysts’ estimates according to Bloomberg.com. Stocks have now been up four weeks in a row with the VIX now dropping all the way back to 24.53. The volatility index had peaked above 45 on October 3.
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.
