Remember those scary times back in 2009 through 2012 when it looked like the PIIGS might all default, threatening another huge global financial crisis? Fortunately, the bail-outs (and bail-ins) were successful and the problems of European fiscal solvency were largely solved - except, they weren't. Today, it seems that the markets have mostly forgotten about (or at least discounted) the possibility of sovereign defaults from the Euro area, based on the strong performance of the equity markets in both the US and the EU and the reduced interest rates required for EU debt. However, in reviewing the overall health of the major Eurozone countries, it does not appear that things are getting better and in a few ways things seem to be even worse than they were before.
Recently, a report came out from the IMF (the same IMF that is heavily involved in the various bail-outs in the EU) by Reinhart and Rogoff of Harvard and "This Time is Different" fame, stating that debt levels in developed countries were beyond the point where they could be solved by austerity, forbearance and growth. Essentially, their argument was that restructurings or conversions and high inflation were going to be necessary tools employed to bring the debt levels under control. Like anything else, timing is the most important aspect of any trade - and the most difficult to predict. However, investors wishing to protect their portfolios or profit outright from European fiscal problems should look into the region's banks as a shorting opportunity. Contrary to the United States, the European banks have never been re-capitalized and are thus more susceptible to shocks than American banks. The most over-valued banks in the region that I have followed are Credit Agricole (OTCPK:CRARY), BNP Paribas (OTCQX:BNPQY), Deutsche Bank (NYSE:DB), BBVA (NYSE:BBVA) and especially Banco Santander (NYSE:SAN). These companies will likely be the first casualties when the next shoe drops in Europe.
The EU is in fiscal trouble due to a history of member countries spending more on benefits and services than they collected in taxes - often a lot more. The Maastricht Treaty, which codified the creation of the EU, mandated that member countries maintain certain debt and deficit limits. Through various shenanigans (often with help from outside consultants, such as Goldman Sachs) politicians were able to find creative ways to still meet the nominal requirements of the Treaty, while at the same time providing all of the handouts which helped them get elected. Following the 2007-2009 financial crisis, all EU member countries to varying degrees were hit hard with high unemployment, falling investment values - and much lower tax revenues. Government deficits soared and rating agencies responded by lowering ratings and investors responded by selling government bonds.
Into this mess stepped the IMF who worked with the comparatively fiscally healthy countries in the EU and elsewhere to agree to provide loans to help the more fiscally profligate countries. Since the first iteration of the bailouts didn't successfully calm market fears, subsequent bailout programs were needed. As of this writing there have been many different bailout funds, including the GLF (Greek Loan Facility), EFSM (European Financial Stabilisation Mechanism), EFSF (European Financial Stability Facility) as well as direct interventions by the IMF, World Bank and various other countries through bilateral agreements (i.e. Russia to Cyprus). The EFSM and EFSF ultimately were discontinued upon the introduction of the ESM (European Stability Mechanism) which was meant to be a permanent firewall for EU countries, able to dispense up to €500 Billion in funding to head off potential financial risks. Unfortunately, I do not believe that the ESM, or any other bailout fund, will be able to contain the crisis indefinitely.
There are many potential criticisms of the ESM, but I feel that the biggest problems come from the fact that of €700 Billion in assets (€500 Billion to lend as needed and €200 Billion to keep in reserves) only €80 Billion is to be contributed from the EU member countries themselves and the remainder (€620 Billion) is to be borrowed. Beyond the fact that it seems illogical on its face that a spending crisis can be solved by borrowing, there is substantial risk that the market will not be interested in contributing €620 Billion in ESM bonds that will go directly to high risk governments - at least at reasonably low rates. Additional problems are that countries with very dubious debt problems themselves, such as France and Italy, are heavy contributors to this program. By taking investment stakes from countries with many different investment grades and hoping to turn the combined product into AAA rated bonds, I can't help but feel that the design is heavily similar to the securitization of Mortgage Backed Securities during the housing boom in the mid-2000's and likely will lead to similar results - if the market buys into the scheme in the first place. The last major problem is that this agreement further plays into seeping resentments and stereotypes that are present in Europe already. Those parties involved in structuring the ESM program, especially Angela Merkel from Germany, took pains to structure the agreement in such a way that it would avoid the need for popular referendums. That was for good reason as the more fiscally prudent countries have already and will continue to have a difficult time convincing their populations that it is in their own best interest to continue to pay higher taxes to bail out their southern neighbors. Those in the higher risk countries will continue to feel that they are being persecuted by their northern neighbors, who provide loans only on the condition of higher taxes and lower spending. Nationalist and extremist parties are flourishing throughout Europe from Hungary to Greece to France, with election totals of some of the more well established extremist parties gaining upwards of 20% of the vote in recent years in each of those countries. The tensions now unfolding seem likely to exacerbate civil unrest and could lead the way to riots and revolution - either through the ballot box or through other means. Ultimately, I think that the risk for major civil and political turmoil is high throughout the region and severely underestimated in risk premiums assigned to the region.
So, what about the underlying fundamentals? On a high level the below chart is telling:
As can be seen from the above chart, despite the well-publicized austerity measures undertaken by countries such as Greece and Italy, the debt levels accelerated in 2007-2009, and that brought on so much investor angst, are not decreasing. Without looking at anything else, it is apparent that even with all of the momentum for reform, all of the hand wringing over difficult decisions, the protests over cut pension benefits and salaries, and a million other real or imagined hardships endured by the EU citizenry in the past few years in the name of austerity, that no substantial progress has been made in the vast majority of these countries in regards to their debt. Does anyone then think that real progress will ever be made without significant structural reforms to the existing debt? Add in the fact that Europe has a birthrate below replacement level that will lead to decreasing population in many countries and then consider the fact that the remaining population is aging and thus will require a progressively higher level of public support - and it seems inevitable that any lasting solution must involve settlements, restructurings, and ultimately, confiscation of assets - either outright or through inflation.
Interestingly, since the introduction of the ESM, the market has settled with interest rates dramatically lowering throughout the Euro region. Below is a chart showing the perceived risk premium measured in interest rates for the various Euro countries.
Into this environment, I feel that the patient investor can repeat the success of investors such as Kyle Bass, who correctly predicted both the housing crisis in the US in 2007 and the Greek Sovereign Default in 2009 (and who, interestingly, is currently short European banks). However, one major difference from the previous two macro shorting opportunities is that the next round of the European crisis can be successfully shorted by the retail investor through the purchase of options and specifically put options. Obviously, timing is everything, and unfortunately, that is the most difficult factor to predict. However, in my view, there is sufficient risk of a major flare up in Europe risk to keep oneself hedged to the degree possible. The biggest risk, besides the timing, is paradoxically that other regions of the world lose control financially (most likely Japan) and there is a flight to perceived safety in Europe. If that were to happen, by shorting the financial sector, the overall instability of such an event would likely still result in falling equity prices in general and the finance sector in particular.
The best trades at this point, depending on level of risk, would be to purchase long dated out of the money put options (LEAPS) with expiration up to two years off. Although there is a good deal of premium priced into longer duration options, the potential increase in volatility, as well as the decreased frequency needed to roll over the trade, makes the higher premium worthwhile, in my opinion. Currently, SAN is trading at $8.76 per share and a put option can be purchased with expiration of January 15, 2016, at strike price of $7.00 per share for $0.99 per share, or at strike price of $5.00 per share for $0.55 per share.