Financial pundits have been recycling a favorite meme from 2007-2008 -- that despondent markets are responding to negative "headline risk" rather than positive fundamentals. As in 2008, that's an assertion that investors accept at their peril. Here's why:
First and foremost, with the sovereign debt crisis in Europe, we are not dealing with routine difficulties that can be worked out with minimal fallout to the global economy. As with the failure of Lehman and AIG, these events will eventually, if unchecked, threaten to cause another sudden stop in the global payments system. Trade and commerce will grind to a halt, however momentarily, as they did in late 2008.
Second, the shaky state of Europe's sovereign dominos has some important similarities to the U.S. subprime crisis, the one that so many pundits and policymakers predicted would be "contained." Investors need to understand that financial assets (loans, debt, credit obligations) are created with leverage. At a leverage ratio of ten-to-one, a lender can create $10 worth of loans from $1 worth of capital. While that should make for more efficient use of (and higher returns on) capital, it also amplifies risk dramatically.
For example, if you have $1 and loan it to someone, the most you can lose is $1 if the loan goes bad; in other words, if 100% of your loans go bad, your worst case capital position is $0.
However, if you make $10 worth of loans, and just 10% of them ($1 worth) go bad, then your capital position is $0 and you're insolvent. If 50% of them ($5) go bad, then your capital position is negative, $1 - $5 = -$4. To figure out how much of a loss will wipe out your capital, simply invert the leverage ratio. For example, if it's 10, then 1/10 = 10%, meaning that a 10% loss on your loan portfolio will wipe out your capital.
The banks of continental Europe, just like bank holding companies in the U.S., have had a dangerous love affair with leverage over the past two decades. They reached unprecedented levels by 2007-2008; by some measures they were as high as 50 or even 70 for some individual banks, and perhaps 70 for broker-dealers as a whole. At 50-to-1, it takes only a 2% loss to wipe out your capital (1/50 = .02). Since the first wave of the crisis (Bear-Lehman-AIG), it looks as though leverage ratios have retreated to around twenty or so, meaning that a 5% loss on assets is enough to wipe out banks' capital.
Losses on Greek debt are over 5%, so if they were carried at something like 20:1 leverage, they've already wiped out an amount equal to their face value.
To try to get a back-of-the-envelope handle on how much damage the eurozone crisis could do, let's start with just the external sovereign debt of the PIIGS economies. The total is estimated at 3.9T euros, which is about 3.7% of global financial wealth, if we go by U.N. statistics [.pdf]. We could assume that debt is carried at leverage ratios of 20, but that might be a bit aggressive, as it ignores unlevered holders like pension funds and individuals, so let's assume it's closer to 15. That means that a 10% markdown on 3.9T in assets, or a 390B euro loss, would result in (390B)(15) = 5.85T euros in losses, or almost $7T at current exchange rates. That's equivalent to amost 50% of the EU's 2009 GDP, and 11% of world GDP.
The following table shows various loss scenarios for different levels of leverage and losses, using 3.7% as the weight of PIIGS external sovereign debt to world financial assets:
Click to enlarge
We've highlighted the 15th row as a reasonable estimate for leverage. We've also highlighted the columns showing losses of 25%, 50%, and 75% on PIIGS debt. 75% may seem extreme, but S&P has pegged 70% as the likely loss in a default (TOH Reggie Middleton, who's been rather prescient on the eurozone's troubles). We've also highlighted in orange the outcomes that would "wipe out" global financial wealth -- they appear to be outside the realm of possibilities, at least for now.
The resulting losses, assuming 3.7% is a reasonable estimate of the total weight of external PIIGS sovereign debt in global financial assets, are 14%, 28%, and 42%. These ignore internal and private sector debt of PIIGS economies, other contagion or knock on effects, and the debt of other European issuers (for example, some Swiss banks are believed to be in dire straits due to their exposure to central and eastern public debt). In other words, these are the best case "ring fence" outcomes.
We can also safely assume that the effects would fall disproportionately on riskier assets like equities, so the actual decline in stock markets is likely to be higher than these figures, offset by gains in sovereign debt of other countries (U.S., Germany, France, U.K., etc) and -- of course -- cold hard cash.
The Vanguard Total World Stock Index ETF (VT) is 17% below its 52 week high. If we could assume that the total losses on PIIGS debt would be no more than 3%, that underlying leverage is no more than 15, and that their economies and tax revenues were set to expand, then it would make sense to start wading back into risky assets. However, given the policy and operating stance of the ECB, and imminent fiscal contraction across the continent and the British Isles, there is almost zero likelihood that either condition one or three even comes close to reality.
Instead, we appear to be back to the future of 2008, when pundits and analysts mused that investors were reacting to "headline risk" and ignoring strong fundamentals. If only it were so...
Until world leaders change their tune on fiscal and monetary policy, we are headed once again for serious carnage. Thus, we view the rally earlier in the week was a technical bounce, rather than a buying opportunity. Accordingly, we are positioning clients much more defensively and, where appropriate, helping them speculate on the downside.
Disclosure: Some clients long FXP, GLL, TLT, and/or TWM