Potential Eastern European Economic Collapse Worries Me

| About: Morgan Stanley (RNE)

The economy and the markets have gone through a traumatic shock unlike anything we have seen in seven decades. You know the story by now - housing bubble collapse, Lehman bankruptcy, subprime mess, credit market implosion, deleveraging, etc.

I believe the market had priced all of this in, and more, given the record spreads in credit and dirt cheap valuations in equity. If we are to break to new lows, then another convulsive shock must occur to the economy. There must be something as big or bigger than what has already been experienced to send the market into a free-fall once again.

Bears argue that the shock is going to be commercial real estate and/or credit cards. I disagree. I believe the market has already priced in the decline for both. The REIT ETF, ticker IYR, fell 77% from the highs, while credit card giant American Express (NYSE:AXP) fell over 80%. Those are depression-like returns. These are well known and have already occurred. I also believe that both are no where near as threatening as what has already happened in the housing and mortgage markets.

But there is one thing that I believe is not well known, and it does worry me.

And that is the potential collapse of Eastern Europe.

The collapse of the economies of Eastern Europe is an event that could rival or even surpass the collapse of the housing market, and I do not think American investors fully realize the ramifications of such a collapse.

The region is not particularly important in terms of global output. However, it is the exposure of European banks to the former eastern-bloc countries that could cause a chain reaction which could bring down the European banking system, causing the economy to plunge further and markets to collapse once again. Given the hodge-podge of European financial regulation and a patchwork political system, the European authorities are less able to respond to such a crisis than the United States.

By some accounts, the eastern European countries are in worse shape than the Asian countries were at the start of the Asian Contagion in 1997, with sky-high indebtedness and large current account deficits. Western European banks financed the borrowing in eastern Europe, and large defaults could bankrupt the European financial industry.

I do not know if the ultimate denouement is the implosion of the European banking system triggered by a collapse of the highly-indebted countries in Eastern Europe, but it worries me.