Europe Plan In Works Is A Game Changer

by: James A. Kostohryz

Back on August 4, in an article entitled “Market to Force Hand of Central Banks,” I said some things that are looking increasingly prescient:

Investors should beware of the probabilities of major announcements of creative schemes to be implemented by central banks around the world in a coordinated manner. There are many alternatives….

Perhaps the most intriguing option could be the creation of funds that would collateralize or guarantee interest payments on bondholders of long term debt. The funds would guarantee only interest payments and not principal, to get more bang for the buck. This could be funded initially with central bank guarantees, backed up by sale of assets by beneficiary countries. The assets would be sold in conjunction with central banks, say the ECB, and the funds would then serve as a collateral base for guarantee facilities.

I estimate that such funds would become credible for a country like Spain with a fund with equity equivalent to 7% or so of GDP. For a country like Greece, the figure might be something more like 12%. Italy, perhaps 10%. All of these countries have marketable public assets of this order of magnitude.

There are many creative arrangements that can be thought of. I expect central banks to actively consider them in the coming days.

The announcement of such plans could catch the markets by surprise and generate violent rallies.

At the time that this was written, I was the only analyst that I am aware of that was discussing the possibility of leveraging equity as a means of multiplying the resources available for a Europe-wide rescue.

The press is now reporting that European officials are discussing just such a scheme. Specifically, discussions are centered on leveraging the roughly $400 billion in the European Financial Stability Fund (EFSF) into a $2 trillion facility. The idea of using proceeds from asset sales as collateral is also being discussed as part of the plan.

There are several ways that this could be done. One way would be to seed a special European bank with $400 billion in equity. This bank would then receive low interest European Central Bank (ECB) funding. The new bank’s raison d’etre would be to purchase the sovereign debt of European countries if bond yields exceeded targeted levels. This would essentially place a “put” beneath the market for European sovereign bonds. As a result, investors and traders could feel relatively confident of making bond purchases given that they know that this massive fund will bail them out if bond prices fell below a certain level.

Another way would be for the ECB to purchase the bonds directly. A guarantee fund would be established that would guarantee payment of interest and/or principal up to a certain amount.

Another idea would be to apply the guarantee only to long-term debt and guarantee interest payments for five years. This arrangement would provide maximum leverage. For example, assuming long-term interest rates of 4.0%, this arrangement could back $10 trillion in long-term debt. That would be mega-over-kill as peripheral European countries do not even have that much debt outstanding, much less long-term debt.

The point is this: By using leverage, Europe can essentially put the bond-market panic to sleep for a good while. This will give them time to implement the necessary institutional reforms that would then provide investors with confidence regarding longer-term viability.

Many Germans of the orthodox bent are going to be pulled into this kicking and screaming. And their constant whining and thrashing may unnerve markets at times. But ultimately, Germany is the primary beneficiary of the Euro and if the Germans want to save it, they are going to have to bite the bullet.

What About The European Banks?

Another thing being discussed widely is recapitalization of the European banking system – perhaps through a Tarp-type mechanism.

Frankly, it is my belief that such a mechanism will not be necessary if the sovereign debt crisis can be ended. If the sovereign debt crisis is put to sleep, the main perceived risk of European banks will be taken off the table and most major banks such as Banco Santander (STD), Deutsche Bank (DB) and ING (ING) should be able to raise equity and long-term debt (that counts as capital under Basle rules) in public markets with relative ease.

Solving the European debt problem essentially kills two birds with one stone.

The Cat Is Out Of The Bag

When details of a proposal like this become public, the proposal takes on a life of its own. Expectations are created and it almost becomes impossible not to implement it.

Many policy-makers involved in the process probably feel that the proposal is still in an embryonic stage requiring many hurdles to clear, politically and technically. Most of them would probably tell you that a workable and credible plan is a very long way from being enacted. And in a certain sense, that is true. However, in a more important sense, something along these lines is essentially a done deal. The Europeans simply cannot not do this now.

Once things get to this point, history suggests that it is only a matter of when, not if.

Market Impact

The very high likelihood that a plan like this will be worked out and implemented is a landmark event. It essentially assures that any further market declines will be contained. There will be no global panic meltdown such as that experienced in 2008-2009.

Many other factors such as a global growth scare or disappointing earnings could push the US equity market (^SPX, ^DJIA, ^IXIC, ^NDX) down towards my previously discussed target of 950-1,020 on the S&P 500. However, with the S&P 500 currently at 1,136, the downside of 116-186 points is no greater than the upside that is probably of a similar magnitude (1,252-1,322).

Thus, on a tactical basis, I see no reason to be either long or short stocks (SPY, DIA, QQQ) at this time.

On a strategic basis, investors may now seriously consider accumulation of stocks such as Apple (AAPL), Microsoft (MSFT), Intel (INTC), AT&T (T), Verizon (VZ), Pepsi (PEP) and Goldman Sachs (GS). While these stocks may ultimately fall 10%-20% further, on a long-term basis all of these stocks have well over 100% capital appreciation potential plus the attractive dividends (actual and potential) and dividend growth that several of them offer.

Furthermore, while this is ultimately not the catalyst that will propel US long-term bond yields (^TNX ^TYX) higher, this will undoubtedly ease the crushing rush to safety that has been driving bond ETFs such as TLT higher and inverse ETFs such as IEF, TBT and SBND lower. 10Y bond yields should begin to settle above the 2.0% level until the resolution of various longer-term catalysts that I have discussed manifest.

The very complex political and institutional situation in Europe will make the road to an ultimate solution quite bumpy. There will probably be many starts and apparent stops along the way as the public kicks and screams and various politicians and policymakers position, posture and haggle. However, it is becoming increasingly clear that disaster will ultimately be averted.

Europe is being pulled inexorably in the direction of a grand bailout scheme tied to greater fiscal integration because ultimately, this is the least bad alternative available.

Disclosure: I am short TLT and long TBT and SBND.